Problems with a “Fair Rate of Return”
By Robert P. Murphy
If you want to do business in Venezuela, you will have to let the government do your bookkeeping to make sure you aren’t making too much. Venezuelan president Nicolás Maduro’s decree, called the “Organic Law of Fair Prices,” sets a maximum “fair” profit at 30 percent of costs.
Besides the practical problems of implementing such a measure, the ceiling rests on a basic misconception: the idea that there is such a thing as “fair” or “excessive” profits misunderstands the function of profit — and loss — in a market economy.
To bemoan a capitalist earning high profits is like complaining about a surgeon saving too many lives.
The Profit-and-Loss Test
The great Austrian economist Ludwig von Mises cherished the market process because he thought it was a wonderful institution for using the world’s scarce resources in the way that best serves consumers. The market prices of various resources, from labor hours to tons of iron to acres of farmland, show entrepreneurs how valuable those resources are in the most valuable activity — as judged by the spending decisions of consumers — and thus provide the right incentives to deploy them rationally.
As I detail in my new book on Misesian thought, Choice: Cooperation, Enterprise, and Human Action, we can understand Mises’s perspective by imagining a silly scenario where a building contractor decides to coat apartment interiors with solid gold. Surely tenants would be willing to pay a lot more in rent if their apartment had gold-coated countertops. So why would this be a foolish move for our entrepreneur?
The answer, of course, is that even though revenues might be much higher, the use of gold would drive the monetary costs of the project higher still. The decision to start using large amounts of gold would transform the previously profitable operation into a loser.
Ultimately, value is subjective, so maybe the entrepreneur would go forward with his plan. Perhaps it’s a publicity stunt, or perhaps he wants to use some of his personal wealth to take a public stand for sound money. Nonetheless, his accountant would inform him of the monetary implications of his plan. To the extent that the builder is in construction in order to “make money,” the market prices will guide him to abandon the foolish idea of coating apartments with gold.
Now here’s the important element: notice that although the high market price of gold keeps it from being wasted in over-the-top apartment decoration, there are lines of production that can profitably use gold. For example, jewelers who sell necklaces can do a similar calculation and decide, “The extra amount my customers would be willing to pay for a gold necklace rather than, say, a silver necklace justifies the extra expense of putting gold into necklaces rather than silver.”
Indeed, it has to be the case that some entrepreneur can ultimately afford to use a given resource, because otherwise its owners couldn’t make money from it. To paraphrase Yogi Berra, it wouldn’t make sense to say of a resource, Nobody uses that input anymore — it’s too expensive.
Perils of Cost-Plus Pricing
The great thing about Mises’s view of profits is that his conception shines when we enter the world of dynamic uncertainty. The mathematical neoclassical models of “general equilibrium” are elegant, but they really only work well to describe a situation once everything settles down. Mises recognized the importance of profits in adjusting plans to reality.
In particular, if an investor makes an “above normal” rate of profit, it means that she anticipated future conditions better than others did. She recognized that in the original configuration, the market process was not correctly identifying the scarcity of certain inputs; they were too cheap. So this farsighted entrepreneur spotted the discrepancy and swooped in to reap the bargain. In the process, she bid up the prices of the too-cheap inputs and (by supplying more output down the road) pushed down the price of the too-expensive output.
In contrast, a static conception leads to absurdities such as recommending that local governments monopolize utilities like retail electricity providers and then allow their investors to earn a “fair” rate of return through cost-plus pricing.
The fundamental problem with this approach (from an economic perspective) is that it views “costs of production” as given. If a company knows that it can charge its “cost” plus a margin for profit, then there is no incentive to figure out ways of delivering megawatt-hours more cheaply.
Gaming the System
Here’s another twist, which I just recently learned from an expert on energy markets: if the officially allowed profit margin is higher than the going rate of interest, then the owners of a publicly regulated utility can borrow to become leveraged, thus magnifying the actual rate of return their shareholders enjoy.
For example, suppose the government oversight board allows the utility to earn 5 percent on its operation. But suppose the owners vote to have the utility issue bonds at 3 percent, and they raise as much outside debt as they themselves put into the company with their original investment. So if the utility is funded with, say, $50 million from initial investors and $50 million in bonds, then the regulators might think it satisfies the rule to let them earn a total of $5 million in accounting profit. (That’s a 5 percent return on the $100 million put into the company.)
But after paying 3 percent to the bondholders on their loans of $50 million (which is $1.5 million), the owners of the utility are left with $3.5 million of earnings, to be distributed on the basis of their out-of-pocket $50 million investment. That’s a 7 percent return, not the 5 percent return the public utility board thought it was bestowing.
The market process uses the tool of profit-and-loss accounting to steer entrepreneurs into economical decisions. Attempts to substitute another system for genuine capitalism will lead to unintended consequences.
Robert P. Murphy is author of Choice: Cooperation, Enterprise, and Human Action (Independent Institute, 2015).
Comment by R. Nelson Nash – This article first appeared in a publication by The Foundation for Economic Education.