Of Risk and Profit

I seem to keep running into discussions of risk and profit lately, so I thought it might be interesting to spend a few minutes on the topic. What got me started was a post by Matt Bruenig entitled "Capitalism does not reward risk" wherein he says:

Capitalism does not reward risk-taking. This is easily shown. Suppose Noah and I each invest in ways that are identical in all regards with respect to risk. If capitalism rewarded risk-taking, then each of us would get an identical return. But we don’t necessarily. Suppose Noah’s investment leads to him receiving a large return, while mine leads to me receiving nothing and even losing what I put in. In that possible scenario, even though we behaved in a relevantly identical fashion, capitalism distributed us different amounts. Noah was rewarded for risk-taking. I was punished.

This is true as far as it goes. Risk taking, in the abstract, is not rewarded by capitalism. What I would argue that capitalism does do is allow you to achieve rewards by taking calculated risks, if those risks work out. Let's think this out via a couple of examples.

Jerome is a carpenter. He thinks that he's come up with a clever idea that will allow him to build a mechanical lathe and make beautiful table legs, bedposts and banisters very quickly, much more quickly than his hand lathe. However, it's going to take an investment of $200,000 dollars in equipment and several months of experimenting for Jerome to get it to work. He talks to various rich men in town and finds an investor who provides him with $250,000 so that he can but his materials and take half a year off work to get it all right.

At this point, the world splits in half.

In world A) Jerome's invention works out. He can produce beautiful woodwork in minutes instead of hours. He sells it for just a little less than a hand carved piece, but because they take so much less time he makes much, much more money. Last year Jerome made $100,000 but this year he makes $750,000. According to their agreement, Jerome gives half the profits to his investor, and keeps the other half for himself. He expands his shop and makes even more money the next year, but not another shop is building a similar set of machinery and soon he has more competition, the prices begin to fall, and he has to work hard and come up with more innovations or else see his profits fall.

In world B) Jerome's invention fails to pan out, his investor loses everything, and he has to go back to spinning wood on his hand lathe.

In both worlds Jerome takes a large risk. In one, he realizes large gains, in another he loses everything.

He was able to find an investor willing to provide him with that money because there was the possibility of large gains. Perhaps the investor thought there was a 1 in 4 chance the investment would work out. He loaned money in return for a share in the profits. In the world where this worked, he got all his money back in the first year and started making profits too. In the world where it didn't work out, he lost everything. If he had ten or twenty investment projects going at a time, some fail and some work, and the end result is that if he picks good risks he makes a profit by helping these aspiring business men.

Now how is it that we say that capitalism rewards risks? Well, the idea that Jerome's investor can invest in Jerome's business, and that they can form a contract whereby they will spit the profits that result, is a capitalistic idea. The money produced by the venture they have put money and work into belongs to them. If they didn't get to keep the profits produced, there would be no reason for them to take the risk in the first place. The investor would have no reason to lend money if there weren't a way to get a return on his money, and Jerome would not be able to secure the capital he needed to do his project if he weren't able to promise a return on that capital. Further, the fact that they can enter into a joint ownership agreement where the investor's capital entitles him to a return on the profits allows both of them to engage profitably in risks that would not make sense in terms of a loan. If the a capital investment was not possible, and Jerome instead had to get a loan, he would need to promise to pay 300%+ interest to compensate his investor for a risk of 1 in 4. Jerome would probably not want to take on a debt of $250,000 at 300% interest if there was a 3 in 4 chance that his invention wouldn't work out and he'd end up owing massive amounts of money with no way to pay it off. So the structure of investment and return makes Jerome's innovation possible.

Another key element that allows this investment and innovation is the concept of profits based on market pricing. Jerome makes his money back because he can charge only slightly less than a hand lathe carpenter and win lots of business at huge profits. But what if we don't accept the idea that Jerome can charge based on what people expect his product to cost?

This piece lays out an alternative concept of profit which it argues is the true Catholic understanding:

For modern man - that is, for post-Enlightenment, laissez-faire, neo-liberal capitalist man - profit is the difference between gross revenue and expenses. It is the result of a simple equation; simply subtract expenses from revenue and the difference is your profit. Thus, in order to maximize profit, the difference between revenue and expenses must be made as great as possible, and he is the most savvy, most astute businessman who can figure out how to enlarge that gap. For modern man, Profit = Revenue - Expenses.

But for pre-modern man - that is, for the man living under Christendom and working within the traditional understanding of economic relationships - profit is defined as a just recompense for some particular work. The amount of the recompense is relative to the work done.

We see in the traditional understanding, labor and profit are linked - the fact of the profit and its amount are related directly to the work performed. This is why my friend had a guilty conscience about taking 90% profit. He knew that, relative to the quick, inexpensive work performed, there is no way 90% profit could be considered "just recompense" for the work performed. There is a moral linkage between the work done and the recompense for that labor.

Notice, however, that in the modern definition, this linkage is not there. If profit is simply revenue minus expense, there is really no moral or logical connection between the work done and the amount of profit gathered. This is why those who subscribe to the modern definition have no moral scruples about pocketing 90% profit, for they see no necessary connection between the profit and the work done. Profit is simply whatever the businessman is able to pocket - though no doubt they would feel quite ripped off had they found someone took 90% profit at their expense. The pre-modern medieval definition, on the other hand, maintains a moral and logical connection between work and recompense, ensuring that financial actions remain situated on a spectrum of justice (another example of the superiority of the harmonious medieval mind over the fractured worldview of the moderns).

(For the record, let me just note that I really don't care what the profit margins of someone I buy from are, so long as I get what I want for a price I'm okay with -- unless that seller has made some false representation to me about his costs in order to justify the price he's charging. But I digress.)

Now, Jerome lived in a world with this other conception of profit and price, he might be in trouble. If the price he's allowed to charge for his woodwork is based only on the amount of work that he does, and not in the perceived value to the customer, then if he can produce a piece of woodwork in ten minutes that takes another carpenter two hours, he can only charge 1/12th the price -- a price based on the amount of time that he spent. Now, maybe he'd make some up on volume (while putting lots of other carpenters out of business) but unless he's going to get into the business of shipping woodwork all over the world there's not going to be enough demand for him to make back his investment if he has to sell his woodwork at 1/12th the going price. So one of the things that rewards the risk-taking of Jerome and his investor is an understanding of market pricing in which they are allowed to charge basically the same as the process they are replacing. This means that inventions that vastly increase productivity will have a large potential return, and so it's worth taking risks to see if you can invent such a thing. If you're not allowed to charge based on perceived value rather than time invested, then people like Jerome won't be able to afford to invest the time to develop productivity increasing inventions.