The Profit Problem

Over at naked capitalism Philip Pilkington has a post on profits in a capitalist economy:

We imagine an island. On this island we find a capitalist (or an ‘entrepreneur’ to use more politically correct language), a bank, ten workers and a government. Five of the workers are bakers and five of them are builders. We assume that the capitalist does not consume anything and that there are no input costs apart from the cost of labour. In addition to this capital goods (machines etc.) do not depreciate in value (wear down etc.). Finally, the workers do not save. In other words: they consume all that they earn.

(This seems silly but we can include these variables in more complex models, some of which will be dealt with in more condensed form later. For now let us just say that all this occurs because the island is magic and a wizard created it…).

The capitalist must pay the workers at least $1 a day as the government has a minimum wage law in place. So, the capitalist hires five workers (the builders) to build a bread factory – spending $5. He then hires the other five workers (bakers) to make bread in the factory – spending an additional $5. All of this money is raised from the local bank which charges him a rate of $1 interest a day. The capitalist ends up with a giant loaf of bread which he sells to the workers for all their wages – the bread thus sells for $10 and each worker gets a 10% share.

We must stop here for a moment to highlight an important fact. Note that the overall amount of spending power in the economy – that is, the workers’ aggregate wages – determines the price of the bread. The bread is divided into ten because there are ten workers, but it is the amount they are paid that sets the price of the bread. More on this in a moment, for now we get back to our fairytale.

At this point, the capitalist has a brand new bread factory and his $10 back which, after paying making his interest payment for the day, totals $9. He then hires his five bakers once more at $1 each and bakes another giant loaf. If this loaf were allowed to go directly to market a deflation would result and he would only get $5 for the loaf – with each worker getting a 20% share. This is because the same capitalist, since he already has his factory built, no longer needs to hire the five builders and so only the five bakers are employed. If there were no other actors in the economy these builders would remain unemployed and the aforementioned deflation would result. However, Roosevelt II has just been elected and, being the clever president that he is, he deficit spends to hire the builders to build a road in front of the bread factory – paying the minimum rate of $1 per worker.

At the end of the working day, the builders once more join the bakers at the factory door and, since everyone has received their wages, the bread sells at its previous rate – the capitalist gets $10 (after interest payments he has $9), the workers all get a 10% share of the giant loaf and there is no deflation. This time, however, the capitalist ends up with a tangible profit because the government has taken over the task of investment.

I take the post as an argument that, when you have a fiat currency (as we do), the government shouldn’t borrow the money that it spends in excess of revenues but should simply conjure it out of thin air. That has its own problems but they may well be less significant than those that face us now, largely for doing exactly what he suggests.

As I see it his model has a number of problems:

• It has internal inconsistencies. For example rather than “a government” the island should have “a king” or “a bureaucrat”. That makes a difference: kings and bureaucrats need to be paid, too.
• The capitalist never seeks to increase his profits by expanding, making his operations more efficient, or expanding into other areas. Like Scrooge McDuck he just piles his money up in a vault.
• It ignores deadweight loss.
• The government has no revenues and has no costs of finance. The only explanation I have for that is that the government is creating the money it spends.
• Why don’t the builders become bakers?
• He assumes some of the most contentious issues, e.g. sticky wages.

Ultimately, the most damning thing about his model is that it’s just too steady-state. At every step after the second step (when “the government” steps in to ensure that the builders remain builders but nonetheless don’t starve) nothing ever changes. There are no variable input costs. Every new infrastructure program has exactly the same value as the first. The government bureaucrat, who is now doing more work administering all of those spending programs, never demands a larger share, and so on. It’s a lovely Brussels-hued world.

In the real world, however, roads in front of the bakery are more valuable, whether viewed economically or socially, than bridges to nowhere, there is no particular reason to have the same number of builders forever, capitalists and bureaucrats both consume, too, and governments that overextend themselves whether by borrowing too much, by minting too much money, or by building infrastructure that isn’t really necessary lose the confidence of the people and the whole shebang comes crashing to a halt.

I look forward to criticisms of the model in comments from those better informed than I.