The Profits (& Growth) Puzzle – A Tentative Solution to Finding and Keeping the Economics Grail

In a consistent [circular] flow conception, the total value of factor inputs must equal the total value of output at nominal prices, so that aggregate profit accruing to entrepreneurs must be zero. The same should be true of interest paid by entrepreneurs. Moreover, if all revenues accrue to owners of production factors, no monetary resources should be left for fresh investment leading to economic expansion…if the economy is indeed a circular flow, how can there also be profit-oriented entrepreneurship, interest, and economic growth?(Bezemer 2010)

Profit is the fundamental driver of capitalism but its explanation has seemed mysterious and puzzling. It was a problem that has fascinated Schumpeter, Marx and Keynes all of which came close to but never fully arrived at a satisfactory solution. Wagner’s view (recounted in (Graeber 2010)) that grail mythologies reflect the hunt for a mysterious and intangible force of wealth creation recognised at the origin of modern mercantile capitalism, seems to sum up the intellectual approach towards the concept. Mythological, a puzzle, for in both neo-classical and post Keynesian approaches it should not exist at all, at least in the short run and under idealised conditions, but even when the unrealism of those idealised assumptions are relaxed then profit should not exist in the long run, suggesting that it is only a residual resulting from asymmetry of information, ignorance, to be hunted down and eliminated once that ignorance is banished by competition. Profit though does not result from the absence of something but from the positive presence of certain conditions. It is real though not necessarily tangible. No we have not been dreaming profits exist and theory can simply explain the profits puzzle. In recent years there have been considerable strides to solve the puzzle, especially from circuitist thinkers, accountancy theory and from growth theory, but these have not yet pinned down the exact solution, its monetary, real and value relationship components, which I tentatively submit has a surprisingly simple solution.

1. The Neoclassical Approach – Defining Profits and Growth Away
The well-known thesis is that under ‘perfect competition’ profits cannot exist. Under a series of very strict conditions including no barriers for entry, no differentiated products, perfect flow of information etc. there is no scope for profit. An uncountably infinite number of producers are pure price takers. None can raise prices to create a profit because they would be instantly bid down. In recent years the mathematical assumptions behind the model have come under criticism. However even if you individually relax the key (none real world) assumptions, such as over differentiated products for example, then this means one of either two things, firstly there is no long run profits as the creation of profits attracts competitors and profits are again asymptotic to zero, or, the alternative case, there are no profits other than from degree of oligopoly, the ability of the seller to be a price maker rather than a price taker (Schumpeter 1934). The latter may be an explanation of rents but it is not an explanation of profits deriving from means other than rent (within the term rent I am including Marshallian quasi-rents from production from fixed assets with sunk costs because as Sraffa stressed their returns can be treated exactly as rent). Even money can be rented (interest). Any alienable factor can be rented if it has scarcity value which can add value in production. So in the neo-classical model of the firm, even if the strict assumptions of perfect competition are relaxed, there cannot be an inalienable source of profit, factor income, attributable to the actions of the firm, which cannot be rented from another agent. (note: I use factor income to refer to the income stream from ownership of a factor which may be over and above the level of factor returns necessary to keep that factor in its current use, i.e. it may earn a rent. Of course in the neoclassical perfect competition story this factor return can be any level infitessimably small above zero as all profits are pushed to zero). All factors incomes are exhausted, profits are zero. The neoclassical story is that of a single product market, there is no market for firms: equity markets. The tendency to zero profits is quite different from the classical assumption that profits rates tend to an average rate. Neoclassical theory assumes a rate of ‘normal profits’ sufficient to attract investment into an industry, but even if we introduce an equity market where investment does not take place where projected returns are below the average rate, then profits attract competition which drives profits back towards zero. The neoclassical approach in assuming a base case of perfect competition and equilibrium where ‘normal’ profits, within the confines of the theory, either are impossible or are driven towards zero. A theory that cannot explain profits or economic growth is a useless theory of capitalism. There has been a recognition of the problem in recent years with the attempts at ‘endogenous’ growth theory, but the result a mysterious ‘total factor productivity’ an unexplained residual (the Solow Residual) independent of individual factors simply again stresses the ‘puzzle’ of the source of profits and is incompatible with the assumptions of perfect competition which underlie general equilibrium theory. In neoclassical theory we can either have messy and real economic growth, or the perfection of general equilibrium, but not both.
(note 1: There is a flaw in the Okishio theorem that no capitalist ever rationally introduces a cost saving technique which causes the industry rate of profit to fall, and so there can be no tendency for the rate of profit to fall. It does not deal with sunk costs of durable capital and multiple investors making decisions about investing in such capital at the same time without full awareness of each other’s actions. In these cases the investment may or may not raise the rate of profit in the short term but once firms have to price at marginal rates when costs are sunk the average rate of profit across an industry will slump – as it did for example with railways once debts of initial fixed costs were fully amortized (amortized and depreciated in value terms that is not necessarily physically worn out). This is not to necessarily endorse the Marxian Theory of the Falling Rate of Profit, but simply to stress that without countervailing tendencies which I shall attempt to express, or massive write off of durable capital, one of the key drivers is a tendency to fall. Marx’s writings on this subject in Capital III are often characterised as ‘underconsumptionist’ and in that vein are flawed as they don’t account fully for capitalist consumption goods spending, as many early critics realised. However my reading is that this is expressed as a realisation problem long term and structurally, quite different from his shorter term theories of the business cycle, and here he may have been on to something) (note 2: By average rate of profit I do not assume a mean of all rates. Many firms will be making losses or have very low profit rates. It is projections of future profits that investors consider and industries with limited prospects will be disregarded as not investment candidates. The average rate is largely unobservable).

2. The Post Keynesian ‘Naive Surplus’ Approach
In the Post-Keynesian ‘surplus’ approach you take each factor of production, capital – fixed and circulating, labour, land – the discounted value of each is the cost of production (rent of money being itself a factor as later writers in the classical tradition understood – see our reconstruction of the waiting theory of interest here) – add them up, you then get total cost, add a profit markup to get price, and revenues minus costs is the surplus minus profits.  I still hold to this broad construction but there is a problem, it was seeing the surplus as being ‘left over’ – the absence of something (costs) rather than being positively created by some economic cause. You can describe a mathematical formula where profits are a residual: Revenue-Costs=Profit.  It would be formally correct, but is a necessary but not sufficient condition for the existence of profits.  The following values would satisfy the formula but we have no profit 0-0=0. You might protest that this is the definition of a non-economic event.  No production, no distribution.  But what then is an economic event, I would say actions which aim to create profit? Here a Marxian with M-C-M’ and an Austrian agree, and neo-classicals often flounder, the identification of a profit making activity is a positive act that is the commencement of the capitalistic process.  So enterprise is not just the absence of something (cost) ‘left over’, it is the enterprise of retention, after costs, of a positively identified revenue raising activity. Consequently we might rewrite the formula as follows: Identified Revenue Raising Activity-Costs=Profit. This is why I refer to the naïve’ surplus view, like the naïve productivity theory of interest mere productivity, or physical surplus, does not by itself guarantee value capture, that must be secured and realised.

3. Circuitism: An Insoluable Problem?
One of the key post-war contributions to Post Keynisan thinking has been French and Italian Circuitism. But in parallels to the neo-classical story profits are again defined out of existence. This was a particular theme in early Circuitist writings.

As various writers have pointed out … the account of the Monetary Circuit…leaves no room for the payment of interest in monetary form… all of the money issued in the production loan contract is spent as wages and then exchanged for production, held as deposits or used to purchase [financial assets]. There is no additional money with which to pay interest. … on the face of it there is no way of converting [the physical surplus from production] into money, since the firm cannot acquire more money from sales than it pays its workers. Since the only money existing in the market is the money that banks have lent to the firms they can only repay in money the principal and are unable to pay interest. … Some circuitists such as (Bossone 2001) and (Schmitt 1966) regard the interest problem as insoluble (Weir 2009)

With the assumption that the only ‘solution’ is ever increasing borrowing and ever increasing debt. For (Graziani 2003) for example the firm sector as a whole cannot make profits and debts must continually be rolled over.

In other words a ‘gap’ theory similar to Douglas and many ‘monetary cranks’ before (although like Keynes I do not necessarily regard the term as an insult if a flawed theory gives wider insights)..

A closely related problem, from Basil Moore, is the view that from the S=I savings=investment identity the monetary value of investment ex ante cannot be greater than the monetary value of savings ex poste. From this position it has been argued that credit cannot fulfil the role of bridging any gap between demand before and after production, an increase in demand necessary to both pay for the goods produced and interest on the loan.

These approaches represent fundamental misunderstandings of the role of interest, how that is accounted for and how interest recirculates through the economy. A naive circuitism also. In the last decade there have been great strides by writers sympathetic to the circuitist position to clear matters up; almost but not quite.

Most of the suggested circuitist solutions rely on the passage of time, that the world is quantitatively and qualitatively different after an injection of investment, and consumption logically following production. (Gnos 2006) for example relays on overlapping time periods. (Parguez 2004), and (Nell 2004) argue that because capital goods paid for generally before wages, any money spent by firms on goods purchased from other firms is returned to the firms sector via wages of the employees of capital goods firms and so is then available to repay debts. (Seccareccia 1996) argues that because of this recirculation bank loans include the money to pay out interest and profits.

Although there are (mostly) minor variations in the wiring of such explanations of the circuit all rely on that much neglected component of production – turnover. As all monies spent in production may be respent by workers in those industries and of intermediate goods suppliers before the final realisation of profit through the sale and consumption of the final consumer good. (Note: I do not accept here the Austrian concept of ‘average period of production’ where this period is a measure of capital intensity. This fails on capital theory grounds, in particular the arguments stressed by Kaldor. However a lengthening of the production period does provide greater opportunities for turnover of wages. The false Austrian approach is a failure of dimensionality where time, as in their interest rate and capital theories is a reification, a thing in itself, rather than simply the ordering of past physical events)

4. Towards a Possible Solution
I start with a number of assumptions.

a) Assume a world where profits exist rather than where definitionally they do not.
b) Interest can (in certain cases) add to the cost of production and hence the post-Keynesian ‘normal price’ of goods.
c) Interest is not the same as profit (though the two are closely related), interest is a discount on any other factor of production and in this manner money (in its commodity form) acts as a unique factor of production; the only factor which is a charge on all other factors by the holders of scarce money.
d) Production takes time. Profitability has a maturity gap requiring credit to fill. Profitable processes create value over time. Interest can capture some of that value to holders of mature liquid monetary assets.
e) Charged interest held in reserves and then invested or spent completes the monetary circuit through reflux. Providing (partially after Bentham) new money is used for consumption and production (in balanced reproduction) and not asset speculation then its recirculation and increased turnover will generate the money demand to pay interest through overlapping borrowing and spending in many markets at the same time.
f) Where production is profitable and money is injected then saving ex-poste will be greater than investment ex-ante through application of the Khan/Keynes multiplier effect. Demand driven growth (I will deal with supply driven growth in the next part).
g) One firm will be more profitable than another to the extent that either it owns factors which secure a rent (in which case they are transfer payments that do not add to growth), or, if it owns no such factors then profit must be due to a ‘missing factor’ a surplus of revenues from that factor above its costs – which does add to economic growth.
h) If a firm itself owns the cost element of this ‘missing factor’ it can raise its profits by the rate of profit it would otherwise have to pay for this cost to others.

Note on a) There are two issues here, money like any commodity factor, has an element which is price taking, the factor return necessary to secure it in production in that investment; and a rental element dependent on its relative scarcity and the ability to transfer income from profits between factor owners. Such rents have extensive and intensive margins – the first of which adds to cost but not relative cost, the second of which is a price making element which raises the necessary factor return. The second is that like any factor it only contributes to short run prices where a firm is profitable, otherwise price of goods in inventory has to maximise revenue to minimise losses (see (Machlup 1935)), it is only in the long run that costs are adjusted to the point of maximum revenue through imputation – this applies whether there is a strong degree of competition or oligopoly, the only difference being that oligopolies being more profitable are in a stronger position to be price makers than price takers. (Matchups’ view that interest on sunk capital does not add to cost is flawed if you assume that interest is part of the initial cost, as then the cost is not sunk until both premium and interest have been repaid.)

Note on b) Capital is not a single undifferentiated ‘thing’ like Knight’s Crusonia tree, Profits is not the same as a ‘factor return’ on capital, a capitalist might not even own his fixed capital, it could be rented, and yet the capitalist might make a far greater return, in using the rented capital, then the owner of the item of capital does.  That is the explanation for the additional value? Similarly a capitalist might not even own his or her own start up capital, they might take a loan, and the interest applies to the discounting of all factor costs during the period of production, so what ‘factor’ is owning the additional value which creates profit?

Note on e)The solution proposed by Bezemer and Thommassen (Bezemer 2010) is unsatisfactory. They suggest that credit for productive purposes (after Schumpeter) provides the monetary source for investment, whilst credit for consumption (inspired by Bentham) provides the source for profits. This is for several reasons. Firstly it unsatisfactory because it is only necessary to seek a source for profits outside investment if after fully accounting for all factor incomes there is a gap. Our analysis (below) suggests there is no gap and that prices of production already take into account interest costs (discounting). Secondly they raise the important question of reproduction, the relative rate of growth of production and consumption credit is a critical issue for the business cycle and relative prices, and whether prices reflect fundamentals, but it does not explain the source of profit, which is not simply a question of the source of money in the circuit as such money must be invested/consumed in a sector attracting profits. It is therefore primarily a question of valorisation/realisation. Take a simple thought experiment of a pure credit economy where there was no production credit only consumption credit, and therefore investment must be financed by Crusoe type savings. Aggregate demand would be attracted to a new product/service and demand would be drawn away from other products/services partially be displaced demand and partially through depression of aggregate demand through savings to invest in the new sector. There would be a relative price rise in the new sector which may lead to speculation and eventual erosion of profits. But the Benthamite approach cannot explain three things; firstly what is the source of profit in the new product/service before any new credit is granted, secondly how can expansion of consumer credit be the source of profits if in raising prices it induces intermediate goods producers to raise their prices leading prices back to rather than above the average rate of profit, finally, how can it explain the source of profits if in causing prices to rise above fundamentals it lowers not raises profits? The authors also undermine their own theory ‘there is no evidence that profit levels vary systematically with (capitalist or otherwise) consumption levels, not even in the long run.’

So far the tentative circuitist solutions and dealt with a-f, explaining how the money for profits and interest is created, flows and is reproduced. They have done this rather well, it is much less of a puzzle. If there is a positive time interval between issuing of the initial loan and the payment of the final wage and/or a positive time-interval between the first instalment of sales receipts and the last of any particular circuit, then a firm can pay interest to the bank in the form of money, receive it once more in money, use it again to pay its suppliers, and so use it to repay its loan in the usual way. This is a particular feature of the model of (Chapman 2006 ) where the continuous payment of interest, which immediately adds to what we have termed (after pre-neoclassical banking theory) ‘lending power’, which in later writings Keen explains as an intangible asset which creates the ability of a bank to lend, and is relent before production is completed. With recent work with the Fields Institute Keen has to many satisfactorily reconciled the accounting identity approach with that of credit injections acting as a discontinuous addition to aggregate demand, though there are still holdouts.

What these various writers have not explained is g to h above, what is the cause of profits and growth within the firm if factor incomes sum to price? They help explain the monetary source of profits, but don’t explain how profit is possible in value terms if factor incomes sum to price.

One can rightly suppose that firms borrow money from the banks and spend in advance the profits they expect to make. But this is not sufficient to solve the problem under discussion: being anticipated, the formation of profits is not explained but presupposed. (Gnos 2003, p333)

I won’t go through the solutions offered in detail, good summaries are provided by (Weir 2009). A key breakthrough worth highlighting though was by (Zezza 2004) which has inspired much subsequent stock/flow modelling of the monetary circuit, who stressed how much previous modelling of the circuit did not account for bank profits from interest payments The business model of banking of course is of banks making a profit on lending through borrowing short and lending long, their ability to do so depending on an intangible asset, lending power. What clue does this insight give us to profits in the none banking sector?

Put more broadly what then is this mysterious ‘missing factor’ and who benefits from it distributionally?

5. The Missing Factor – The Franchise Value of Equity

‘How can it be that we are wealthier today than people were 100 years ago?. . . This question is puzzling because, if you add up all the things we own, it is clear that the underlying quantity of raw materials has not changed over time,. … The total physical mass here on earth is the same as it has ever been, and now we have to divide this up among a much larger group of people. So how could it be that we have more total wealth per person than we ever did before? …There’s only one explanation for this increase in wealth. We took this raw material that was available to us and rearranged it in ways that made it more valuable. We took stuff that was not very valuable and made it much more valuable. … What lies underneath this process of rearrangement are instructions, formulas, recipes, methods of doing things – the things accountants classify as intangible assets if they recognize them at all. They tell us how to take something that is not very valuable and rearrange it into a new configuration that is more valuable.’ (Evans 1998)

Two lines of investigation led me to the conclusion presented here.

Firstly the theme on this blog of investigating the separate factor income flows (the four factor model – including money as a factor) was given additional impetus by coming across (Hobson 1910) ‘The Industrial System’.  Hobson is best remembered as being both a pioneer of the marginal productivity theory of distribution and also its fiercest critique. Hobson splits up factor costs.  The cost of keeping a factor employed in production and over and above this the ability of a factor to collect rent because of its scarcity value caused by the ownership of economic resources. Land rent (differential rent) falling wholly into the latter category. The approach is not altogether fully coherent and is not precisely mathematically defined, but key to his approach was the insight that a ‘residual’ approach towards profits, was untenable. The residual approach, this was well before (Sraffa 1960) wrote, was promoted by Taussig in seeking to retain key Ricardian elements in economics. After rent and costs of fixed and circulating capital were deducted a business had to meet the average rate of profit to attract further capital and stay in business in the long term.  What was left over was wages.  Hobson argued that this approach had logical flaws as all factor and output prices were determined simultaneously. You could take any of the factors in turn and leave one as last and then it becomes a residual. Also it does not explain why certain forms of labour earn more than others.

Given the importance that circuitist writers lay on wages being paid ex ante before revenues and profits are realised it untenable to treat profits as a surplus paid ex poste together with wages. Also Sraffa himself was uncomfortable with this, only giving up on ex ante payments after hitting a mathematical brick wall. Ex ante wage payments only make sense where the output good is the same as the wages good (as in a corn economy).

The second strand of inspiration was the line of investigation initiated by Neil Smith and taken up by Steve Keen that the power of bank lending results from an intangible asset held by banks. Our further investigation using the fundamental equation of accounting showed a flaw. This lending power came from nowhere, the fundamental equation suggested it had to come from equity. Furthermore similar investigations showed that this intangible asset that generates the ability to lend and profit from lending could be enhanced by undistributed profits – Keynes ‘revolving fund of credit’.

This begged a question. Could this explanation of the business model of banking also explain profits in other sectors? Finding the source of the ‘missing factor’ was key in the history of theories of interest rates. Perhaps there was a 5th factor specific to the firm? By using a Hobson like approach distinguishing between factor rents and factor returns could we distinguish profit sources from the ownership by the firm of assets which generate factor profit streams and profits generated by an intangible asset which is specific to the firm?

We can therefore define profits, form the perspective of an individual firms as follows:

  1. Π=( Factor Revenues[rental+factor returns]-Factor Costs)+(Franchise Value Revenues[rental+factor return]-Franchise Value Costs)

Where the capitalised Franchise Value Revenues is value of equity in the firm not attributable to alienable assets that if rented rather than owned would not make it possible for a firm to continue in operation.

To paraphrase (Greenwood 2006) firms purchase working capital by selling stock; they rent it by issuing debt. Debt owners however have no claim on profits once the investment the debt finances is sunk, so debt financiers are denied a longer term income stream of rents from franchise value. Equity buyers will therefore pay a premium over debt financing potentially leading to excessive issuance of debt.

Notes: By Franchise Value I refer to the full value of the intangible assets of the firm. Brand, business processes, IP etc. Many of these like R&D, marketing etc. will have an associated cost to maintain. Franchise value refers to the potential alienation of the firms business methods as a rented franchise whether actually alienated or not. The price here is the price of equity. Franchising per-se may not always be practical, though in some cases it may offer a quicker route to expansion, especially where franchises don’t directly compete in the same market. In other cases where intangible assets relate to a firms size and institutional knowledge franchising may be highly undesirable.  Franchise value belongs to the firm.  In many cases though the cost of maintaining franchise value will be relatively low, simply the act of the entrepreneur in running the business.   In which case the owners of the business will generate large rents from the returns to the factor being greater than the costs necessary to retain that factor in production.

Other factors in a competitive market will have their factor incomes driven down to the opportunity cost of the next best return, which in a hypothetical perfect competition world would be zero. In the real world there would be a degree of scarcity of these resources so they would return an oligopoly rent, which would be a pure transfer from other factor incomes, it would not create growth or be required to maintain that factor in production. The factor return of franchise value however can create economic growth rather than rentier extraction of income. It does this in one of three ways, firstly by transfer of allegiance from an alternative product to that of the firms, this is not a pure transfer payment as the velocity of money is increased, this is subject to diminishing returns however as velocity approaches zero and the costs of advertising etc. to secure brand transfer rise. The second way is through innovation, the creation of a new product or service or innovation in an existing product or service reducing factor income costs. A new product or service again increases velocity and may, if its input costs are lower than the goods that would otherwise have been bought may additionally increase profit for the innovating firm. An improved technique may reduce input costs whilst maintaining price and increasing profit. Finally by extending the market. The latter two aspects are likely to attract increasing returns providing this is with the organisational capacity of the firm and the capacity of/costs serving the local market at which point decreasing returns will set in. Although the first two of these possibilities will reduce profit at other firms all three will increase the average rate of profit and total factor income available for investment. This is not to say there will not be disproportionality between different sectors with different labour productivities during growth creating sectoral structural employment.

By dividing the sources of profit, which may of course be financed by different means, in this manner we can distinguish, as for example Michael Hudson’s work does, between productive growth and rentier income extraction. I should stress that speculation on intangible assets, like speculation on any asset, is not the same as investment, the profits are not yet realised and fundamentals are uncertain and may be far less than anticipated, as the dot-com bubble demonstrated.

This is a factor return to equity of the firm, not entrepreneurship per-se. There are many entrepreneurial actions that never attract financing. It is the entrepreneurial action however that gives the equity value, though not necessarily the entrepreneur that receives the benefits as the discount the venture capitalist applies to uncertainty may be very high. Entrepreneurial action is the action of combining other factors of production. Of course for many years theorists have speculated whether entrepreneurship earns a factor return, and often the response is that entrepreneurship is combinative of factors rather than being a factor in itself. Attempts to identify entrepreneurship as a factor like all others earning a ‘marginal product’ has run into difficulties.

[E]ntrepreneurs obtain remuneration for their activity in a very different manner than do laborers or lenders of capital. The latter provide factors of production which they sell to the entrepreneur at prices which they naturally try to make as high as possible. The entrepreneur proceeds quite otherwise; instead of selling something to the enterprise he identifies himself with the enterprise.. Some people doubtless will say that he provides the function of enterprise and receives as remuneration a sum which varies according to the results. But this is a tortured way of presenting the thing, inspired by an unhealthy desire to establish arbitrarily a symmetry with the other factors. In reality, the entrepreneur and the firm are one and the same. (Jean Marchal 1951)

The marginal or factor-of-production approach holds that entrepreneurs enter and exit the market for entrepreneurship based on (exogenous) profit rates. For Mises, Knight, and … Marchal, it is entrepreneurship that creates profit. (Klein 2010)

My previous approach on this matter was flawed in failing to account for how firms can capture franchise value which can be created by entrepreneurship but is not a return to entrepreneurship, rather it is an income returning to equity holders which correctly recognise the value creating potential of entrepreneurship. The new approach however avoids some of the key problems of the ‘entrepreneurship as a factor return’ approach with its focus on the firm and the creation of profits via intangible assets. Like interest it is a cross cutting factor were as interest acts as a ‘tax on profits’ to use Schumpeter’s phrase franchise value acts as a reservoir of profits to the owner of the firm, the intimate knowledge of the firm of its own products, market and technology gives it an edge over new entrants producing the same products and enable it to earn a ‘quasi rent’ from this knowledge.

Those of Austrian persuasion would argue that profit is not a return, i.e. a rent, it is the result of arbitrage activity due to the alertness of the entrepreneur, rather than being a ‘resource’, and that as a result entrepreneurship is not a class of productive factor. But our new approach is immune from the Austrian critique as it focuses on the actions on investors creating equity in the market positioning of entreprenuers, that if proven correct yield a profit. A correct hunch is a resource which can be capitalised and therefore earn a rent to the investor.

6. Similarities and Differences with Leibowitz’s Franchise Value Approach

This approach is related to the Franchise Value approach to firm valuation developed by former head of research at Solomon’s Martin Leibowitz. His approach is how firms should be valued in terms of their growth prospects. My starting point is how equity gains a return separate from factors which could be rented.

Leibowitz uses the ‘full payout’ approach to share valuation where all earnings from a firm are immediately paid out in dividends, and extends this approach to look at future earnings from organic growth. Given this assumption a firm’s organic growth would have to be financed from the markets not retained earnings and so would have to be at least equal to the risk adjusted cost of capital. Leibowitz then concludes that additional growth must earn a ‘franchise spread’ above this cost of capital.

To achieve a positive franchise spread a project would by definition have to draw on the resources that were unique or at least special to the firm – patents, licences, distribution networks, brand recognition, particularly efficient manufacturing capabilities, and so. In other words, to be additive to the firm’s economic value, a project must have some special franchise like quality…A firm’s growth derives from new projects having returns that provide a positive franchise spread above the [risk adjusted commodity cost of capital] …Thus the key to productive growth is the magnitude and returns associated with these franchise opportunities. It is these project opportunities which that are the source of the value derived from growth. (Leibowitz 2004)

This insight seems to have achieved little recognition from economists however, perhaps because it was expressed through a financing lens rather than economics. Where I differ from Leibowitz is that a good part of existing value must derive from franchise value, though the extent to which this can be projected as future profits and capitalised is full of controversy. Also much future investment will be replacement of non-durable fixed capital, and will be financed through retained earnings rather than the market, especially where the firm projects a higher than average rate of profits and the information asymmetry created by franchise value gives the firm an insight into future opportunities that the market would mark up as risk adding to the cost of capital. Also much investment is for securing rentier income from takeovers, asset stripping, arbitrage etc. again where the insights of the firm and synergies with the existing firms franchise value created asymmetries with competitors and a larger franchise spread with the new combined entity. For the case through where existing factors are rented and new investment in new processes must come from the market Leibowitz is spot on, new growth can only come and will only come from franchise value as the only source of growth related profits.

Consider the recent case of Starbuck’s tax evasion. A profitable company makes itself look unprofitable by ‘renting’ its franchise license from a company in another tax jurisdiction and so treating profits as a cost, wiping them out for tax purposes in the first country. If that does not tell us something about the root cause of profits nothing does.

7. The Theory of the Firm and the Economics of Growth

Our approach may offers insights into the unification of the theory of the firm and value theory.

Much of the advances in theory of the firm revolves around the puzzle of why do firms exist at all? The approach set out here would support the resources based view of (Penrose 1959) much more than the transactions centred view of (Coase 1937). In the resource based view firms exist (in non-tax justification terms) to capture and create intangible profit raising assets to greater extent that is possible with a sole practitioner owner/manager entrepreneur. Minimising transaction costs, like all costs, is simply the consequence of this cause.

In addition we now finally have an explanation for total factor productivity and the Solow residual. Also in separating out speculative asset fuelled ‘growth’ to capture rentier incomes from innovation fuelled growth through production we have a tool for analysing balance sheets and flow of funds accounts to determine economic fundamentals.

8. How Keynes, Schumpeter, Mises and Marx nearly got there

 Although modern neo-classical economics doesn’t recognise the existence of a ‘profits puzzle’ it greatly exercised the minds of our greatest economics thinkers.

(Marx 1885) of course in his M-C-M’ conception of the monetary circuit recognised the puzzle of profits, where does the addition money for profit come from? For him it was a monetary puzzle not a value puzzle as for him surplus value explained the source of profit. Whilst at this stage making no comment on exploitation theories of profit I note that if profit=sv=franchise value is taken as an identity then there must be a change between input and output prices as prices no longer=value. This adds some weight to that unfortunately most dogmatic of economic schools the Temporal Single System Approach, but with a reversed causation. It is the franchise value which creates a ‘hidden’ rise in value which if acted upon or if capable of being acted upon would lead to input prices rising to output prices,

For (Schumpeter 1934) approaching the issue back to any ‘originary’ factor, labour or land still posed the puzzle as these would be bid to zero in a competitive market. His solution, credit used to fund innovation by entrepreneurs, came very close to the solution presented here.

Mises fully recognised goodwill as a key cause of profits in several of his works

From the point of view of the seller good will is, as it were, a necessary factor of production. It is appraised accordingly. It does not matter that as a rule the money equivalent of the good will does not appear in book entries and balance sheets. If a business is sold, a price is paid for the good will provided it is possible to transfer it to the acquirer. ((von Mises 1949) Human Action Chapter XVI part 7)

but this insight did not permeate through to a full theory of factor returns and market process. Again the Austrian fear of accounting identities let them down.

The most tantalising near miss was Keynes who had a draft chapter on profits derived quasi-rents in his General Theory dropped in its final version (Bezemer 2010). Sadly this left Post-Keynsian economics without a full theory of price. Keynes was never able to get over the source of interest payments was in the discounted costs of factor inputs.

9. Conclusions

Our approach firmly centres profit as a disequilibrium arbitrage phenomenon where entrepreneur’s recognise the potential to transform factor inputs to higher value outputs in ways and means that cannot immediately and easily be copied by competitors. Whilst incorporating this ‘open ended’ view of the economy from Austrian thinking it does so in a way which is fully compatible with the sectoral balances approach adopted by Post-Keynsian economics (Vallageas 2000) (David Levy 2008) (Kalecki 1971) and enabling wider substitution between various equations. Indeed the great advantage of the sectoral identity approach, when combined with monetary balances, is the ability to create accurate models. A key task in developing the theory is extending the perspective from an individual firm to the whole economy in a coherent macroeconomic matter that has growth as an endogenous result. Indeed this new approach allows for a much more accurate treatment of the role of the firm, and different firm sectors, in such model.

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25 857-890.

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4((16)): 386–405.

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vol. 88(3): 495-515.

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University Press.

Greenwood, D. (2006). “The Dividend Puzzle: Are Shares Entitled to the Residual?” The Journal of Corporation Law(Fall ).

Hobson, J. A. (1910). The Industrial System, Longmans, Green.

Jean Marchal (1951). ” The Construction of a New. Theory of Profit.” American Economic Review (AER).

Kalecki, M. (1971). Selected Essays on the Dynamics of the Capitalist Economy: 1933-1970, University Press.

Klein, P. (2010). Is Entreprenuership a Factor of Production?

Leibowitz, M. L. (2004). Franchise Value: A Modern Approach to Security Analysis, Wiley.

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28 173-203.

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Approaches. G. D. E. J. Nell. London, Macmillan: 400-416.

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10 thoughts on “The Profits (& Growth) Puzzle – A Tentative Solution to Finding and Keeping the Economics Grail

  1. My two cents: profits depend on the unit of measure. We normally measure them in money but I think we can get a little more insight if we measure them using something simpler to start with. Let’s try cattle for a start.

    If we measure profits by subtracting numbers of cattle owned at the start of the year from numbers owned at the end of the year then it becomes obvious that, in the first instance, the only people in the economy making profits are cattle farmers. And this is because they are the only people who can create new cows. Of course once they have created the new cows they can then give them to non-farmers in exchange for other goods. So in the second instance, these non-farmers can make cattle profits by trading with farmers. And in the third instance the non-farmers can then trade with other non-farmers sharing out the cattle profits across the whole economy. So the amount of cattle profit is dependent on the extra cows created by the cattle farmers but once created it can be shared out across the entire economy by the trade in cows.

    Okay but cows aren’t money. So let’s look at something a little closer to money: gold. In the first instance the only people making gold profits are the gold miners because they are the only people digging it up. However like the cattle farmers they need to trade their product for other goods.and so in the second (and third) instance the new gold is shared throughout the economy. Thus everyone in the economy can make a gold profit, provided that the miners keep on dogging up new gold and trading it for non-gold with non-miners.

    So now with a couple of examples under our belt, we are ready to look at money. By analogy with the previous two examples, we see that in the first instance the only groups which can make a monetary profit are the government and the banks because they are the only groups which can create new money. However they can share this monetary profit with other institutions and individuals via trade.

    The government is the simplest to deal with since it can make new money and trade it directly for services. As long as it makes more money than it destroys via taxation, the with it can make a profit, since they receive more money from it than they have to give back. The government supplier firms can then share this new money through trade with non-government supplier firms so that they too can make a profit.

    Banks are rather more complicated. And I still haven’t thought through the whole thing here. But in any case…

    Banks create money by lending but that money is then destroyed when it is repaid. The only exception is the interest component which they are allowed to spend. In fact this bank spending is necessary if there is no government money creation since the bank spending must put into the economy enough money to allow the non-banks to pay the interest on their loans. If it doesn’t the firms will need to take out more loans next time to cover interest from their previous loans. In the more usual case where there is government creation of money, the banks share the monetary profit resulting from the government’s creation of money with the non-banks. The higher the rate of interest and the larger the total amount loaned, the larger the share of the new government money that the banks get.

    Just my two cents anyway. Maybe I’m right, maybe I’m wrong.

  2. Oh, well. Back to the drawing board, I suppose! I’m still thinking about your explanation. The Franchise Value idea of inalienable property associated with a firm is subtle. It sounds like the talent or intellectual capital associated with a skilled person. Would that be a fair comparison?

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  4. Your theory simultaneously mirrors Social Credit Theory and shows incomplete research and analysis of its ideas and policy mechanisms. The intangible asset of a Banking license of Keen and your Franchise Value of Equity are Social Credit’s Cultural Heritage of Productive Potential (Innovation), a communal asset whose value has been completely usurped by the Financial system. Douglas cannot simply be pigeon holed into the crank “interest is the whole problem” monetary reformers. His insights go much deeper than that and actually precede your own and the analysis of others you site. Finally, velocity theory is clearly invalidated by the ever present commercial and monetary realities of cost accounting’s conventions. A good synopsis of Social Credit can be found here:

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