Profit Incentives and Social Welfare

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One of the most profound fallacies of Western Capitalism is the notion that firms and industries can via market competition self regulate themselves. In his ‘Wealth of Nations’, and perhaps without full recognition of all of it’s dimensions, Adam Smith assumed stated fallacy in 1776, and shortly was proved wrong. It is fact that the industrial revolution that transpired in Western Europe in the 1800s after the penning of Wealth of Nations was laced with strife between owners of capital, workers, and governments. Some of the events were good, some not so good.

While it relates to a man who was so caught up with ruling the world, a man who eventually crashed and burned, during the winter of 1806–07, Napoleon Bonaparte, Emperor of France (after the revolution no less), loaned manufacturers in France 6,000,000 francs at a maximum interest rate of 2% so they would not have to lay off workers. One wonders why Napoleon, imbued with such wisdom, would rather go fighting on the battlefield so he could rule over all of Europe. With Russia so far off, and having conquered everyone else but Britain, what exactly was Napoleon after still? The decision to invade Russia in reality was Napoleon’s Waterloo. When your military strength is reduced to 100,000 soldiers from a height of 600,000, remaining invincible on the battlefield eminently is difficult.

On then to the ‘not so good events’. Between 1810 and 1812 in England, and about 1819 in Vienne, France, there occurred cases of Luddism, that is, destruction of machines because they were perceived by the working class as weapons of the bourgeois for facilitation of their oppression. Frictions between the bourgeois and the working class would continue throughout the course of the Industrial Revolution, right up until 2019. Over time, it became increasingly clear that relations between workers and employers of labor were demanding of government regulation. Clearly, market competition was insufficient for ensuring capitalism did not generate social frictions.

In presence of the assertion that market competition in of itself is insufficient for regulation of behavior of firms, the specter of fraud and misdeeds perhaps comes to mind. Specter of firms, such as Enron and MCI Worldcom.

Suppose, however, all firms act ethically and non-fraudulently. In presence of ethical and non-fraudulent behavior, in of itself, market competition, equivalently, ‘self regulation’ still would be incapable of generating ‘best case’ regulation within different industries.

The rationale for insufficiency of market competition at generating best case regulation is simple and straightforward, which is, the profit motive. You see, there exist profit levels that are good for a single firm, yet bad for all of society. Feasibility of profit levels that are bad for any one firm is the reason the United States pays farmers sometimes not to grow more crops. If the farmer grows more crops, he makes more money in the short-run, hence has incentive. Given subsidies typically do not equate to profits given up, profit incentives remain in play. Regardless, the government induces farmers not to make more money in a given time frame.

The economic rationale for such regulation? Whenever a firm seeks to maximize profits, it does so without consideration for effects of it’s profits on the rest of society. If a farmer grows more crops and prices for crops fall, the farmer can end up eventually in a worse equilibrium, an equilibrium within which he would increasingly have to farm more land to maintain his or her income level. While income can be maintained by farming more land, quality of life typically will deteriorate because a lot more time is spent in order to make exactly the same amount of money.

In order to ensure this bad equilibrium is avoided, government regulates production such that farmers live off productivity, as opposed to farm acreage. Given it cannot conceivably be the case that each farmer can measure the impact of it’s profit making on other farmers, or rest of society, the onus falls on government to measure or anticipate such impact and respond accordingly.

In Financial Economics, the social welfare planner, which always is government, seeks to achieve equilibriums that maximize social welfare. In this respect, actions that improve GDP Per Capita from say US$57,000 to US$62,000 improve social welfare even if 50 companies fail in process.

Whenever the Federal Reserve increases interest rates significantly, this supposedly is good for all of society, yet is hurtful for some firms, perhaps can lead to closure of some firms because they are unable to continue to afford financing. The Federal Reserve acts in interest of the entire society, yet while some firms benefit, others suffer harm.

While it is true that distributional effects of improvements to social welfare matter, lopsidedness of distributional effects either are evidence that firms continue to expropriate workers, or evidence that firms are not innovating with the times.

Note that if 50 companies fail, but have all of their employees absorbed by newly formed companies, employment remains buoyant. Only when 50 companies fail, and employees are left to flounder does society have a problem. But then the problem is dearth of new innovations, a problem for which both workers and owners of capital, more so owners of capital who may have not done enough to direct employees towards actualization of new innovations are responsible.

While distributional effects of regulation matter, discussions that revolve around sharing of a cake are interesting only if the cake increases in size. Fighting over a cake whose size is shrinking never induces good equilibriums. Just ask the people of Venezuela. While distribution of new wealth matters then and is important, it is managed by entirely different sets of regulations. While the Federal Reserve can care, it is not responsible for ensuring new wealth facilitated by it’s policies are equitably distributed.

With respect to distributional effects, it perhaps ought to be the case that if a firm has in it’s profit reserves at least 12x it’s monthly payroll, in event of a recession, workers should not be laid off until 12 months after incidence of a recession. This provides workers with 12 months at the very least to prepare for the possibility they are to lose their jobs.

This sort of regulation gives firms the incentive to seek to increase revenues in midst of a recession. Given they are stuck with their employees for 12 months, it can become optimal to create teams which perhaps spend an entire week brainstorming for new ideas that generate additional revenues and profits. Better to seek to increase profits in those 12 months than think of all of the money that could be saved 12 months in future. If a firm does not generate new ideas in those 12 months, it perhaps does not need to lay off employees, it perhaps files for bankruptcy protection, perhaps loses it all. In presence of such regulation, the race for new ideas within all of the large publicly quoted firms just might ensure the recession does not last quite as long as anticipated.

In summary, given each individual firm is myopic in the sense of having understanding of adverse effects on society and itself of it’s profit incentives, in of itself, market competition never is sufficient for arrival at optimal regulation of firms. The important thing about government regulation is to not have too much or too little of it. Whenever the search for balance is overly politicized, we all are worse off for it.

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Educator and Researcher, Believer in Spirituality, Life is serious business, but we all are pilgrims so I write about important stuff with empathy and ethos

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