Why profit isn't necessarily exploitation

It seems that voters are not just losing faith in the ability of the free market to deliver widespread prosperity: some do not see profit as being morally acceptable at all, presuming it to be exploitation.

I believe that this is based upon a naive view that everything has an intrinsic value, and therefore that selling anything above that value amounts to profiteering. I'd like to explain just why that isn't so, based upon my own experiences.

Nearly 20 years ago, together with 3 colleagues with whom I had been working for the previous decade, I co-founded a small business. The business was entirely self-funded - we were in the position to do so, because our previous employer had closed down the place where we were working, and we had decent redundancy settlements due to our length of service - in my case, it amounted to about 9 months net take-home pay.

Where we had been working together previously, we specialised in the development of data communications products for PCs, which were used particularly in the financial arena, using a type of networking that was widely employed in the days before the internet, namely X.25. Despite the advent of the internet, there was still a market for X.25 products - but sufficiently small that the big players were no longer interested. The products of our former employer were designed for the old ISA-bus, which had just been superseded by the PCI-bus. This gave us our target market.

We therefore developed new software from scratch, and to start off with, while were proved out our solution, we bought in off-the-shelf PCI hardware on which to run it. We couldn't devote all of our time to software development - we also had to find a way of earning a living - so we did some contract work, consultancy and worked on projects for other companies. We also managed to negotiate a a deal to sell the hardware made by our former employer on licence, with a royalty on each sale, for which there was a ready if limited market (there was one customer buying maybe a couple of hundred or so products each year), which our former employer was no longer able to support.

On balance, I don't think things could have gone a great deal better to get us up and running, but even so, we earned enough cash to be able to pay ourselves salaries for only 7 of the first 12 months, thereby burning through up a sizeable chunk of my redundancy settlement.

Our basic costs were about £250k per year, with the cost of the employees (i.e. ourselves) being about £50,000 per person per annum, taking into account gross salary, employer's National Insurance, pension contributions, etc. We were renting an office for maybe £20k per year including business rates; electricity, phone and internet charges added still further, plus the cost of running our web-site. And then each of our employees needed at least one computer at about £1,000 each, but that was not something that was required every year - their useful life was more like 5 years.

Of course, not all of our time was spent on product development, being engaged in other revenue earning activities, so you could probably say the overheads were more likely to be about £125k per annum for the product side of our business. So, given we spent about 2 years developing our product, (total costs a quarter of a million pounds), and given that the hardware on which it was based cost us about £300 each, what would be the fair value of each product?

We would get back our investment if we sold 500 units at a margin of £500, or 1000 units at a margin of £250. Which of those is a more fair value? And if we continued to sell the product in the future, after recovering our investment, would that amount to profiteering?

Of course, we needed to make a total of £125k each year of accumulated margin simply in order to continue trading. And in fact, we needed to make more money than that for cash-flow reasons - payment terms are typically 30-90 days, during which time we would need to pay our suppliers, overheads and our own salaries.

We also needed to hold stock, partly because it is much cheaper to buy from your suppliers in volume, but also because customers sometimes want the product in a hurry and if you can't supply it quickly enough you might not just lose that particular sale but also future business. Furthermore, we needed profit to invest in future product development, and to be able to expand and employ other people.

At every step, there is risk. There is no guarantee of selling the target amount, and there is no guarantee the customers will pay in a timely fashion. Or indeed, at all. How does one value the risk when trying to calculate a fair price?

Even the salaries we were paying ourselves were somewhat arbitrary: what we were paying ourselves (when we actually had some cash in order to do so at all) was rather less than we could collectively have expected to earn if we were employed elsewhere at that time.

How could we therefore work out a fair value for our product?

In fact, we didn't have a great deal of the freedom to determine the selling price for our product; comparable products to ours existed, and being a new entrant into the market we couldn't price ours at a premium.

Typical customers, however, do not expect to pay list price - a 10% discount is usual for multiple units, with repeat customers getting 25% or so. When purchasing the 3rd party hardware at about £300 per unit, if we set the list price at £800, we would be  making a margin of £500 per unit, but after discounting it would be more like £300 per unit. Thus, in order to earn enough money for the company to be able to continue to trade, we would need to be selling well in excess of 400 units every year.

We needed to reduce the cost of the hardware we were selling, so despite our financial position being a little precarious, we employed a couple of engineers to develop our own hardware, in order to get our cost per unit down to about £200, increasing our margins to £400 per unit.

Then we had had an enormous stroke of luck: we managed to sell our newly developed hardware to a Canadian company who had won the contract to sell Lottery terminals in the Netherlands. This involved some 4500 units, a huge step up from volumes we had been shipping up to that point.

Substantially increasing volumes presents problems of its own: it is a major cash-flow headache. Obviously we didn't manufacture anything ourselves, but subcontracted that out to a specialist manufacturer with whom we had already managed to establish a relationship. We didn't have anything like the amount of cash necessary to fund the purchase of 500 units, let alone 4500, but fortunately they didn't all have to be delivered in one go. We managed to agree a delivery schedule with several batches, over a period of 2 years, with part payment in advance from the customer funding the purchase of the hardware from our supplier for each batch. But if something had gone wrong at any stage, we would have been horribly exposed, and it could have seen the demise of our business.

So, if making a profit is immoral, how should have we handled this situation? Should we have reduced the price specially for the Canadians? Would that also have meant price reductions for our other customers?

Of course we had to give a larger discount - over 50% on list - for the volumes we were shipping, but even so our customer paid rather less than they would have done had they gone elsewhere. In the end we made a profit of about £500k spread over 2 years, enough to pay ourselves the salaries we missed when we were getting started and to fund an small expansion of the business - we employed 2 more staff and moved to larger premises, and retained a buffer of cash within the business to fund future operations. And of course, we had to pay corporation tax. As it turned out, we needed that buffer - sales returned to more like their previous volumes, and we struggled to break even for the next couple of years.

The whole point is that is almost no relationship at all between the costs of the business and the value of a product that is sold any sort of of significant volumes; intrinsic value is a complete fiction.

The only way to establish a value is via the market: the selling price is constrained by what people are prepared pay, but everyone's circumstances differ. In some cases, a customer might need a unique feature of your product and be able to get such value out of it that they would be prepared to pay a substantial amount, but these customers are few and far between. More commonly, they might be able to use an alternative product. Some may not have a business case at all if they can't get your product cheap enough, and so just won't buy it if the cost is too great.

The only thing you can is work out how much you have to pay to buy in the components, and add a reasonable margin to pay a contribution to running costs, taking into account any discounts, and then gamble that you will sell enough to cover costs. If you get that gamble wrong then you are in trouble.

The same sort of issues applied to our suppliers' pricing: the subcontract manufacturer's costs didn't bear any resemblance to the price we paid per unit, because they were also manufacturing for a number of other clients. They had substantial overheads such as staff costs and rent, and the capital cost of the equipment they used. Then there were one-off tooling costs when producing a product for the first time in addition to the cost of the components. They could order some components in large volumes because they could also be used for products for other customers, but other more specialist components they purchased only for our product. They didn't make the circuit boards themselves; in high volumes it was economic to get them made in China, but that made no sense in lower volumes, due to shipping costs.

How would we know whether we were paying them a fair price? There are so many variables involved, it is just impossible to say that a product has an intrinsic value - profits are determined by the volumes in which something is sold, over which a company has little control.

In the 10 years in which I was a director of the company, we had a few other successes, sufficient indeed that we qualified for the Queen's Award for Enterprise, but we also developed products that didn't give us a return on our investment. Overall, I didn't earn significantly more than I would have done had I been employed elsewhere. In the end, I decided that the risks outweighed the rewards, and that in any case maybe on a personal level I wasn't cut out to be an entrepreneur, so I left (thereby improving the viability of the business now that the proceeds only had to be split 3 ways instead of 4). Hence I have returned to being a salary-man, as the Japanese put it.

I believe, however, it is quite fair to say that I more than deserved to profit from my win on the Lottery!

Getting across the ideas to support free enterprise

DRAFT - Work in Progress!


Supporters of a flourishing, enterprising society have a critical problem: leftist ideas have captured popular imagination, and capitalism as a concept has become tainted, toxic even.

In many ways, leftist analysis is correct, in that the problems they have identified are genuine: there is indeed too much greed and corruption, but they have conflated free-market capitalism with crony corporatism, with our current system having too much of the latter and too little of the former.  Unfortunately, the left's solutions are bogus; their cure is far worse than the disease, and they would throw out the capitalist baby instead of the corporatist bathwater.

In order to address this, we need to understand the leftist mindset, appeal to what motivates them, and tackle their false assumptions in terms they will understand. The work of Jonathan Haidt is very useful in this regard - moral foundation theory provides a key to open the door into their world. Essentially, they are most activated by the Care/Harm foundation - they care deeply about the disadvantaged.

Then then we need to find a way of communicating these ideas, explaining how a reformed capitalist system would deliver more of what they are looking for than Socialism could. Unfortunately, this also means we have to explain more complicated concepts, like Moral Hazard, and demonstrate that some policies that seem to provide care actually do more damage in the long term.

Here are some concepts I believe we need to get across, and misconceptions that need to be tackled, related to Fairness and Wealth Creation.

Fairness:

1. Reward for effort: it is only fair that those who work hard to produce wealth are rewarded. That's a fundamental reason for the establishment of the Labour Party in the first place - for the workers to get their fair share of the wealth they were responsible for creating. What is someone else's fair share of what you have worked for? If that is true of exploitative business owners, it's also true everyone in society.
2. Fairness & Risk: anyone risking their capital in order to create wealth is entitled to a reward for that investment, but those without skin in the game should not be able to take advantage.
3. Unfairness & Cronyism: crony corporatism provides too many opportunities for fat cats of various descriptions an easy life on the backs of the wealth-creators. 
4. Unfairness & Free-riding: in order to look after those who genuinely can't look after themselves, we need everyone who is able to make a contribution to do so. 
5. Unfairness & Debt: kicking the can down the road is appallingly unfair; how can it be fair for future generations to fund the lifestyles for members of the current generation who haven't earned it themselves? Burdening future generations with debt is immoral.

Wealth Creation:

1. Wealth underpins everything:  in order to properly care for others, someone has to produce the wealth in the first place
2. Money is not Wealth: people are mercantilist and think of wealth in terms of money, whereas wealth is actually what you can obtain with the money: houses, cars, phones, food, experiences, etc.
3. Wealth is Dynamic: it gets destroyed, and therefore further wealth needs to be created to replace it; for economic growth to occur there needs to be more creation than destruction. Some wealth is ephemeral (used concert ticket anyone?), other forms are durable, but even houses wear out over time if not maintained. 
4. Incentives: People are lazy - if they have opportunities to seek rent they will, those with vested interests especially.  People won't risk their capital unless they will be rewarded. Changing incentives alters behaviour - encouraging them to work hard or risk their capital (both of which play a part in creating wealth) instead of seeking rent (which doesn't)
5. Cooperation: societies do not thrive and become prosperous without cooperation 
6. Competition can be the opposite of greed: it is there to keep people honest and to discourage parasitic rent-seeking
7. Profit isn't necessarily exploitation (not perhaps so easy to explain!)
8. Privilege can be earned (and thus deserved)
9. Decentralisation: no society has ever flourished in the long term, except with 3 conditions: Independence, Dispersal of Power, and Interdependence

Markets:

• Housing is not a free market - that is why there is a shortage!

We need supporting evidence for those assertions, of course, but we need to appeal to emotion as well as to reason. We should not be afraid of adopting the Tripartite motto of the French Revolution: Liberté, égalité, fraternité, even if by "Equality" we mean Equality of Dignity and Equality before the Law rather than Equality of Outcome.

Ultimately, however, those of us on the right are prepared to deal with the world how it really is, not how we would like it to be: there are no solutions - only trade-offs. The perfect is the enemy of the good.

Ideally, we should be looking producing social media memes along those lines (and the list above is far from exhaustive). Exactly how do so so effectively is going to be a major challenge...

The Crisis of Labour

According to Adam Smith, there are 3 different types of people:

• labourers, who produce wealth through their own efforts;
• employers, who employ capital to produce wealth, for example through investing in machinery;
• rent-seekers, who don't actually produce any wealth themselves but who seek a return for the use of assets they own, particularly land.

Actually, that is not correct at all: there aren't 3 types of people, but these are different types of behaviour that can be exhibited by people; an individual can take on more than one of those roles at different times, or even at the same time, such as entrepreneurs who typically are both labourers and employers.

Before the industrial revolution, entrepreneurs were rare, or at least not sufficiently numerous nor effective to create a great of wealth, with anything they did produce being vulnerable to predation by the rent-seeking ruling classes, which reduced the incentive for them to make the effort. The vast majority of people worked on the land, with the landowners creaming off any profit produced through rent. Landowners were thus able to exploit their workers to have comfortable lives themselves, but the workers were too busy just surviving to do much about trying to improve their own lot - the times when they did organise collectively, such as the Peasants Revolt, are not remembered for being a great success. To be an agricultural labourer was such a precarious existence that many volunteered for the army, not exactly an attractive proposition if you consider the consequences of battle during, say, the Napoleonic Wars. That's not to say that all landowners exploited their workers; and indeed some noble families propagated a culture of duty to care for their tenants, providing relatively good quality housing. But it's quite clear, leaving aside the middle classes and professionals who inhabited the towns, that in the countryside there were 2 distinct classes, the working lower classes being exploited to a greater or lesser extent by the rent-seeking upper classes, the divisions between the  classes in England exacerbated by the lower classes being Anglo-Saxon in origin, and the upper classes being descendants of the Normans who came over with William the Bastard.

The Industrial Revolution changed things.  It should be noted that many early industrialists did not originate from the landed gentry, but were often non-conformists, who were not accepted into genteel society, and who thus had the incentive to work hard. These early capitalists provided opportunities for the workers; although the lot of many workers was still miserable, and exploitation continued, nevertheless for most it was an improvement on agricultural labouring, and slowly they were able to enhance their lives. Sufficiently indeed that, being based in greater centres of population, and with increasing leisure time. they were able to organise increasingly effectively in various ways, giving rise not just to unions, but to Friendly Societies and other self-help organisations, and eventually the Independent Labour Party. These achieved a great deal, improving the lot of the typical working man and woman substantially over time, enabling them to earn a fairer share of the wealth they had created.

The workers became more self-confident, better educated, and more aware of the possibility of being exploited, whether actual or not. They were thus ripe for seduction by Socialism.

Now Marxism makes no distinction between Employers and Rent-Seekers; it conflates the two categories into one: Capitalists. These are defined as the enemies of the working classes.

In truth, this is a mis-charaterisation: some of the capitalists had actually provided the means to enable the workers to achieve emancipation and therefore were effectively allies of the workers, rather than their enemies. Although there were undoubtedly many conflicts of interest between business owners and workers, by cooperating together they managed to create massive amounts of new wealth, at least some of which went to the workers. It also doesn't take account of the risk undertaken by entrepreneurs - they had more skin in the game than their labourers, and so it is quite fair that should take more of the rewards.

Of course, as noted originally, any one person can play any of the 3 roles, and so entrepreneurs can easily morph over time into rent-seekers. The problem is power: once entrepreneurs become successful, they achieve greater power, and no longer wishing take risks with what they have gained, instead look for easier opportunities to capture wealth.

It all boils down to fairness: clearly it is not fair to a worker to be supporting others better off than themselves who did not cooperate in the wealth creation process. Of course, it is very hard to determine the extent of any exploitation: no one actually knows the intrinsic value of anything - that's why we need markets.

But the point is, it is the predatory, parasitic rent-seekers who are the enemies of working people, not the capitalists. Or rather, it is the predatory rent-seeking behaviour that exploits the workers.

The truth is that free-market capitalism produced so much wealth that even the workers who had not received a fair reward for their labours still enjoyed a standard of living far in advance of their forebears before the industrial revolution. So much so indeed that, these days, those on benefits have a better standard of living than an average worker in the time of their great-grandfathers.

Exploitation of the wealth-creating workers, however, is still present. Rent-seeking parasitic predators are still with us, but have developed new forms. Fat cats of all sorts abound.

How has this happened?

Crony corporatism is a major factor; instead of having to own land in order to seek rent, being an executive in a major corporation is not so different from being a member of the nobility in a medieval principality; it can be a license to prey upon the workers.

Similarly, the growth of the state has provided all sorts of opportunities for parasitic elites to capture wealth. For example, the more laws and regulations there are, the more work there is for lawyers.

The list goes on: banksters, university administrators, local government executives, professionals of various descriptions, even train drivers. All earning substantially more than the workers who actually create the wealth that these modern-day parasites rely upon.

Union leaders, who enjoy cushy lifestyles at the direct expense of their members, are perhaps the ultimate example, especially those that benefit personally from trouble-making because only the activists take part in their appointment.

Ironically, the well-healed professional classes in public service have been successful not just in capturing more than their fair share of the wealth of the workers, but also in capturing the party of the workers; the Labour party is now dominated by university-educated metropolitan elites.

According to Robert Conquest, the simplest way to explain the behavior of any bureaucratic organization is to assume that it is controlled by a cabal of its enemies. In the case of the Labour Party, it really is.