April 22, 2016

High profits and low economics

Comment on Robert Solow on ‘Why Wages Aren’t Keeping Up’


Distribution theory suffers from the known fact that, after more than 200 years, economists still cannot tell the difference between income, profit, distributed profit, and retained profit. As the Palgrave Dictionary summarizes: “A satisfactory theory of profits is still elusive.” (Desai, 2008)

Therefore both, the defenders and attackers of the market economy have one property in common: they have no idea of what they are talking about. Distribution theory has come down to superficial observation, psychologism, sociologism, moralizing, and political blather.

Political economics is beside the point because overall monetary profit is determined by OBJECTIVE structural factors. Total profit of an investment economy is given with the formula shown on Wikimedia AXEC42
The profit ratio Qm/Y increases with the expenditure ratio of the household sector, the investment ratio of the business sector, and the distributed profit ratio. An expenditure ratio greater than 1 means that the debt of the household sector grows. Household sector and government sector deficits are the main driving forces of the business sector’s overall profit. Productivity plays NO role.

The crucial point is that bargaining power plays NO role at all for overall profit, it plays only a role in the distribution of total profit AMONG firms and the distribution of total output AMONG households. Roughly speaking this means that the familiar concepts of exploitation and class are superficial and misleading, see Profit for Marxists.

The relationship between wage and profit, too, is not well understood. A fall in the average wage rate has a deflationary effect but does NOT affect the profit ratio (if the expenditure, the investment, and the distributed profit ratio in the formula above are kept constant for the moment).

The pivotal point is those familiar distribution theories are false. For details see The Profit Theory is False Since Adam Smith. What About the True Distribution Theory?.

Conclusion: Solow’s post combines superficial observations with a provably false distribution theory.

Egmont Kakarot-Handtke

For details of the big picture see cross-references Profit/Distribution

COMMENT on don on Apr 22

Imagine for a moment the economy consists of two firms that produce the same good and are initially identical. The wage income of both firms is fully spent on the consumption good, so the overall profit in this simplified economy is initially zero and the market-clearing price is P=W/R, i.e. equal to unit wage costs.

Now the wage rate in firm A is halved and that in firm B remains unaltered because of a strong union. Profit in firm A increases. Because total wage income falls total consumption expenditures fall and the market-clearing price falls. This leaves firm B with a loss. The profit of firm A is equal to the loss of firm B and the TOTAL profit in the economy is still ZERO.

So what in effect happens is a REDISTRIBUTION of profit among firms. The union power in firm B has NO effect on OVERALL profit of the business sector, it has only an effect upon the REDISTRIBUTION of total output among the households, i.e. the real wage of firm B employees rises and falls for firm A employees.

If firms A and B belong to different countries the same argument applies to the world economy.

Your mistake is to look at one sector, and then to generalize what can be observed there, e.g. wage down/profit up, for the whole economy. This is the Fallacy of Composition. The total analysis shows: wage A down/profit A up/total profit UNCHANGED/price down/deflation. And this is roughly what you can observe if you take the world economy as a whole.

The elementary mistake of distribution theory is to generalize the effects of partial analysis. And this is why you cannot explain the OVERALL relation of profit and wage income and why the measured profit share has risen in the US.

The problem, though, is not that you and anne don’t get the point, the problem is that Solow reiterates a distribution theory that has been false since Ricardo.