Episode #242: Prices, Profits, and Fairness

Why is an oil or pharmaceutical company condemned for earning windfall profits when market conditions change, while an individual homeowner who realizes a tidy profit off of a hot real estate market is applauded?

Popular movie stars, directors, and entertainment companies can earn above-normal profits without so much as a whisper of public protest. Premium ice creams and chocolates are very expensive and yield profit margins that would have made the “robber barons” of yesterday blush.

Very few of us would continue working at 50 percent of our present salaries. Are we not charging what the market will bear?

Why are individuals and corporations held to different standards? Perhaps it is not so much price that bothers people as it is profits.

Market Competition leads a self-interested person to wake up in the morning, look outside at the earth and produce from its raw materials, not what he wants, but what others want. Not in the quantities he prefers, but in the quantities his neighbors prefer. Not at the price he dreams of charging, but at a price reflecting how much his neighbors value what he has done.
––Friedrich A. von Hayek

Capitalism offers nothing but frustrations and rebuffs to those who wish—because of claimed superiority of intelligence, birth, credentials, or ideals––to get without giving, to take without risking, to profit without sacrifice, to be exalted without humbling themselves to understand others and meet their needs.
––George Gilder

Throughout history the morality of profits and a just price has been debated endlessly, as it should be. The late Father Richard John Neuhaus, in his book Doing Well and Doing Good, explains the ancient debate of a “just” price:

The idea that there is a right amount or a “just” amount always runs up against the question, Compared to what? The conventional answer is that one pays what the market demands, or what the market will bear. From Athens to Elizabethan England to the Great Terror of the French Revolution, societies have experimented with “sumptuary laws” setting limits on people’s income and expenditures. The experiments have never worked out very well, the obvious reason being that it is almost impossible to agree on standards. Few egalitarians, even among the well-to-do, propose a top income limit that is less than what they themselves receive.

 During the Dark Ages merchants could be put to death for exceeding the communal concept of a “just” price (justum pretium, the right price). In A.D. 301, Diocletian, the Roman Emperor, issued an edict fixing prices for nearly 800 items and punishing violators with death. Severe shortages transpired.

In ancient China, India, Rome, and almost everywhere throughout the Middle Ages, all interest charges were called “usury” and were prohibited entirely, making economic progress through lending and risk-taking all but impossible.

Today, so-called “price gougers” are subject to societal condemnation, regulatory harassment, and editorial vitriol. Oil companies are frequently a prime target of public outrage, especially when prices at the pump vary from one city to another.

Pharmaceutical companies are held in special contempt when they charge $5 to $100 (or more) per pill, even if the dosage reduces more costly medical intervention by other means, such as surgery. In May 2000, the late Senator Paul Wellstone claimed, “We have an industry that makes exorbitant profits off sickness, misery, and illness of people, and that is obscene.” So what?

Orthopedists profit from people breaking their leg skiing, just as professors’ profit from students’ ignorance. Farmers profit from our hunger, but in reality they keep us from hunger. Drug companies profit by making us healthy.

The problem with a “just” price is who gets to decide what is just? The free market already provides an answer to this question—whatever someone is willing to pay. There is no objective standard for “fair,” which is why we have free speech rights, not fair speech rights.

Although it sounds heretical, it is not. An old legal maxim teaches: Emptor emit quam minimo potest, venditor vendit quam maximo potest (“The buyer buys for as little as possible; the seller sells for as much as possible”). Ultimately, the customer is sovereign, spending his or her money only when it provides value.

To believe the free market is imperfect with regard to the fairness of prices is to grossly underestimate your own sovereignty as a customer while putting your faith in some anonymous third party—usually a governmental regulatory agency or the courts—to determine what is “fair.”

Yet prices contain a wealth of information that no central agency can possibly possess, which is why wage and price controls have failed everywhere they have been tried (See “A Fair Price Utopia Gone Wrong” Case Study).

If it is immoral for a company to charge premium prices to customers, does it follow it is also immoral for customers to pay low prices? If prices are deemed “unreasonable” why do people pay them? Only unreasonable people pay unreasonable prices.

Case Study: A Fair Price Utopia Gone Wrong

Once upon a time there was a fair price utopia. In it, prices were set according to a theory of fair pricing. The price was based on the average product cost of all firms plus a standard percentage markup. Even if the costs of production for an identical good varied, the price was kept uniform for the customer. Although prices responded dynamically to changing average costs of production, this dynamism was tempered to maintain price stability. There were no unpleasant surprises. Buyers were supposed to enjoy complete transparency and control: by law, they could review the producer’s accounting and participate in determining the price. And the prices of basic staples like bread were subsidized to help the needy.

Beginning to sound familiar? That is because this utopia was the pricing system of the former United Soviet Socialist Republic. It was a pricing system designed to be fair. So what went wrong?

In might have been fair in theory, but not in actuality. Prices did not reflect the value as perceived by the consumer. The determination of value was done by overblown governmental departments based on complex calculations of cost and profit plus distribution costs, as well as consumption value and utility. Consumers had no idea how prices were actually determined. Supply did not respond to demand. Consumer goods were always in short supply no matter how strong the demand.

The system was imposed from above so that consumers had no voice. They consequently felt no compunction about flouting it. The black market flourished. Although in theory all consumers paid the same price, in actuality they did not.

The pricing system was inequitable, unequal, uncontrollable and opaque. The prices were wrong—and that’s not fair.

Excerpted from The Price is Wrong: Understanding What Makes a Price Seem Fair and the True Cost of Unfair Pricing, by Sarah Maxwell, PhD, 2008, page 164.

To believe prices are determined by greed is to believe sellers can establish prices at whatever level they desire, in effect never having to suffer losses or bankruptcy. Homes along the ocean front command high prices, but this does not prove fresh air causes greed. Prices convey information, while allocating resources and distributing income. If sellers are greedy than the counter argument can be made that buyers are also greedy and selfish, since they value seller’s products more than they do their money. Yet only the seller gets blamed. Probably because greed and selfishness do not, at all, explain this behavior.

Perhaps it is not so much price that bothers people as it is profits. Profits have a bad reputation because most people simply do not acknowledge where they come from. Profits come from risk. The entrepreneur gives long before she receives. She pays wages, vendors, landlords, and the other costs of running a business in advance of having anything left over (profits). Very few individuals work for 100 percent stock options, yet business owners, in effect, do exactly this, since profits are only left over after everyone else has been paid.

If it were true that profits caused high prices, then we should witness lower prices in those countries with no profits, such as socialist or communist countries. Yet all of the empirical evidence is to the contrary. Even though profits comprise only 10 percent of national income, they are crucial in allocating the other 90 percent. Of course, since most enterprises do not make an economic profit, perhaps we should say the pursuit of profit is the necessary ingredient. In any event, whenever someone laments a particular industry (or company) is making obscene profits, there is an effective retort: If you believe that, you would be crazy not sell everything you own and buy its stock.

Peter Drucker pointed out, “If archangels instead of businessmen sat in director’s chairs, they would still have to be concerned with profitability, despite their total lack of personal interests in making profits.”

Profits are an indicator that a useful social purpose is being filled and needs are being met. In a free market, no profit could exist without people voluntarily entering into a transaction where each receives more than they give up, what Harvard philosophy professor Robert Nozick cleverly coined “capitalist acts between consenting adults.” This is why George Gilder compares profits to altruism, since in enterprise gift giving precedes voluntary exchange—alter in Latin means “other.” For you to exchange you have to create something to exchange.

The essence of giving is not the absence of an expectation of earning a return, but the absence of a predetermined return. Profits are not guaranteed, and are determined by consumers, not greed. Gilder explains this eloquently:

A profit is the difference between what inputs cost the company and what they are worth to somebody else. It’s the index of the altruism of the process.

The moral code of capitalism is the essential altruism of enterprise. The most successful gifts are the most profitable––that is, gifts that are worth much more to the recipient than to the donor. The most successful givers, therefore, are the most altruistic––the most responsive to the desires of others.

The circle of giving (the profits of the economy) will grow as long as the gifts are consistently valued more by the receivers than by the givers. A gift is defined not by the absence of any return, but by the absence of a predetermined return. Unlike socialist investments, investments under capitalism are analogous to gifts, in that the returns are not preordained and depend for success entirely on understanding the needs of others. Profit thus emerges as an index of the altruism of a product.

Economists classify different types of profits as follows: 

Normal profits—The return to the owner, net economic return is zero, where costs include the cost of capital, the market rental rate of capital.

Supernormal profits—Profits in excess of normal profits. Occur when revenues exceed costs, again including the cost of capital. They are often identified with monopoly profits.

Rents—When an agent owns a good that has a special characteristic which, through no effort of the agent, is valuable. Professional athletes or musicians are often given as examples.

Profits from Immoral Activities—Extortion, theft, blackmail, etc.

Windfall profits—When the event causing the profits is a complete surprise to the profit maker. An example is the OPEC oil embargo of 1974.

This view of capitalism being a moral system is certainly not one that is propagated in the mainstream popular culture, where a populist refrain is “People before profits,” and the “bad guy” is portrayed as a businessman twice as much as any other occupation. As if profits and social responsibility are mutually exclusive. They are not.

This view is pernicious and completely out of touch with human behavior. In fact, given the realities of free-market exchanges—where both parties are better off after the exchange—profits are actually an indicator of social value created. Those who believe that earning a profit is morally neutral rather than a morally superior way for a corporation to discharge its responsibility should be asked if they believe deliberately running losses is ethical—particularly if it is with someone else’s money?