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the origins of profit, part 2

As I mentioned in part 1, it seems trivially true on the surface of it that if you buy something for a lower price and sell it for a higher price (a capital gain) that you've received more value than you've given, and hence that you haven't really "earned" the extra value you wind up with.

But there is a bit more to it than that. First, there is the question of whether between the buying and the selling, you've done something to add more value to it. And second, there is the question of time. If there was a long time which elapsed between when you bought it and when you sold it, perhaps it doesn't make sense to just directly compare the two prices, some adjustment is needed. I'll address these 2 points in order.

On the question of adding value to it in between the transactions, I think this is what my college friend was getting at by saying that perhaps I'm not considering thinking to be work. He's imagining that there is some thinking done that increased the value of the commodity and therefore, "added value" to it. For example, if an entrepreneur starts a business with some of his own capital, and hires a bunch of workers, and then after he's paid all of his workers he finds that his total costs were less than his revenues, perhaps the extra "profit" that he keeps has to do with the thought that went into organizing the business and managing the employees.

But really this is not a pure example of capital gains, because the entrepreneur in question is acting both as CEO and as investor at the same time. He's supplying both the capital and the management skills necessary to run the company. In a corporation, you can see a more pure example of why this should be split into two different things, where the investors supply the capital and the CEO is treated simply as another hired employee. Yes, the CEO must do a lot of real work to run the company, and yes he has to be compensated for that. But the investors don't do any work, they just supply the money. And yet often, there is still profit left over to give to the investors in the form of dividends. It's this profit that goes down on their tax forms as "capital gains" and it's this profit that I tend to think of as unearned, not the CEO's salary (inflated though it may be in present day).

This brings us to point 2, time. Perhaps the analogy to make here to see why capital gains might be fair is one between dividends and interest. Perhaps the added value the investors are supplying has to do with the fact that the value of the money they use to buy the stock is greater than the value of the money later when they sell the stock. If taken as a literal statement, the previous sentence would only be true if the "real" profit was 0 while the "nominal" profit was non-zero, in other words, the apparent profit was only due to inflation. Obviously, that's not true in most cases. Investors would not be happy, and indeed would not even bother investing, if their real profits were zero. But then, maybe the value the investor is adding is the use of his money for some period of time, so that his compensation in dividends is analogous to the interest that a lender of money is paid on a loan. This is the most deep and interesting part of the whole thing, which would lead into another discussion on whether the whole idea of getting paid interest on a loan is similarly unfair. (And interestingly, there is something called "Islamic banking" which is banking where it's illegal to charge interest on a loan because it's considered unfair and "usary" according to Islam. There were similar laws in
early Christian civilizations, but this ideal soon gave way to the more pragmatic practice of allowing bankers to charge interest.) Unfortunately, I don't feel I understand this one quite well enough to say much about it, so I'm going to skip over it for now. Let's assume for the sake of argument that charging interest on a loan is indeed fair, and that the Koran is a book of lies. I think we can skip over it by again separating out two different parts of the investor's returns, one due to the interest they would have earned if they'd left the money in a bank, and one due to the additional profit they received by choosing to instead invest it in a company.

Interestingly, when I looked this up on Wikipedia, I found that economists and accountants use two different definitions of profit. So the answer may turn out that capital gains are either partially earned or unearned depending on which definition you're using. Accountants tend to consider profit to be simply revenues minus costs, in other words the amount that is actually paid to the investor. Makes sense, but the economists do something similar to what I was suggesting in the previous paragraph and include in the costs one more type of cost which is "opportunity cost". By choosing to invest the money there rather than somewhere else, the investor is giving up the interest or dividends he or she might have earned on the money somewhere else. So the pure profit, or "economic profit"--as economists call it if the word "profit" itself is ambiguous--refers to how much extra money the investor made relative to a typical investment they could have made elsewhere.

And from looking at various Wikipedia pages, I get the sense that it is relatively well accepted that economic profits in a particular market are due to markets deviating from pure competitive equilibrium. In other words, they are always due to some kind of barrier to entry that makes it difficult for new businesses to break into the same market and compete with the existing firms. If it were easy to compete, then somebody would come into the market and undercut the huge profits of the existing firms, gradually driving the profits back down to the equilibrium "normal profit" level. The bottom line is that if anybody is making an economic profit (also called "abnormal profit" sometimes) then they are doing it because they have some privileged position that allows them to exclude others from competing, not because they are receiving the "fair market value" of the goods they are producing. So then the question becomes, what is this normal profit and does it differ from the interest that you'd receive on a risk-free asset like a longterm government bond plus a risk premium? If it doesn't differ, then I think we've come to an answer, namely that normal profits are fair if and only if charging interest on loans is fair, and abnormal profits are always unfair. (If it does differ, then the question is what else is entering the equation here?)

You pay capital gains tax not just on economic profits but on any profits including "normal" profits. So my conclusion is that capital gains are somewhere between partially earned and completely unearned, depending on whether you feel that charging interest on a loan is earned or unearned income. And I do have more to say about that, but as I said interest is something that's a lot more deep and mysterious and therefore my thoughts and beliefs on it are not as well formed or complete.


domino plural

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