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What Is the Profits Perspective and What Makes It So Powerful?
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The profits perspective is a view of the operation of the economy that focuses on the specific transactions and corresponding flows of funds that determine total business profits. Obviously profits are important to the behavior of the business sector, yet they are often ignored in economic forecasting. Profits are the motivation for business activity, the reward for success, and ultimately the means through which firms can continue to exist and grow. Therefore, changes in profitability are keys to understanding decisions that the business sector will make on employment, output, and investment in the future. Open Flexible Framework The power and practicality of the profits perspective arise from the fact that it is not a set of simultaneous equations—it is not a closed model of any kind. Rather, it is a dynamic framework that takes into account any and all important influences on economic performance that the user can identify, and it reveals the impact of these developments on profits and future economic activity. Economists often create models of the economy with simplistic assumptions about behavior and knowledge and with rigid, abstract rules governing economic processes. Such models do produce precise results that are provable in terms of the models’ assumptions, and such precision is often useful in academic discussion. However, the price of "solvability" is the great distance between the models and reality. The profits perspective puts reality first. The Key: The Profits Equation The foundation of the profits perspective is the equation for total business sector profits, which is also called "the profits identity." On this foundation is built a broad, adaptable view of the economy that highlights the economic activities that determine the magnitude of total business sector profits and the influence of profits on subsequent activities. Economics, as popularly practiced, ignores the questions "What determines the flow of net profits to business?" and "Where do profits come from?" A great mystery in the development of modern economic thought is the conspicuous absence of profits from the study of macroeconomics. The notions of profits and profit maximization permeate theory in microeconomics (the study of individual firms and markets), but when the subject is the entire economic system, profits strangely vanish. Yet, there is a clear, exact answer to the question "Where do profits come from?" The Prevailing Wisdom Has It Wrong One basic view, the neoclassical paradigm, has to an extraordinary degree monopolized macroeconomic thought during the past fifty years. It has dominated macroeconomics as taught in colleges and graduate schools, as employed in business economics, and as applied in public policy analysis. It has been the basic framework shared over the decades by Keynesians, monetarists, supply-siders, and other groups of economists. In the neoclassical paradigm, profits do not exist, or rather, to be technical about it, they continually gravitate to zero. The assumption that profits equal zero at equilibrium and the economy continually approaches equilibrium produces a definition of profits that is very different from the definition accountants and business people use. Yet in the real world, where economic performance is continually changing in level and character, swings in profits from quarter to quarter, year to year, and even era to era are vital aspects of the story. Economic practitioners involved in business cycle or macroeconomic policy analysis tend to be heavily influenced by the academic tradition in which they were educated. Therefore, when they do address the issue of total business profits, their macroeconomic theory is of little help. Many resort to generalizing from microeconomic analysis, and, in doing so, frequently commit the logical sin known as the fallacy of composition—assuming what is true for one individual is necessarily true for all individuals together. For example, analysts widely cited cost-cutting through job elimination as a positive force for profits in the early 1990s. Yet, the macroeconomic impact on profits was not so simple. Every job eliminated also represented lost personal income and lost consumer spending; that is, it represented lost business revenue as well as reduced expenses. A Perspective That is Broad, Flexible and Powerful The profits perspective, unlike more common macroeconomic frameworks, encompasses not only flows of funds (profits, GDP, personal income, and other "income statement" concepts), but also levels of assets and liabilities (real estate, P&E capacity, inventories, debt, stock market capitalization, and other "balance sheet" concepts). Thus, the profits approach facilitates analysis of the effects of economic activities on household, corporate, and government balance sheets and conversely, the impact of changes in balance sheets on profits and economic activity. In sum, the profits perspective represents an effort to develop a multifaceted, realistic approach to a vastly complicated human system. One can accept the complexity inherent in an economic system and still describe and reach conclusions about properties, processes, trends, and potential outcomes. To learn more about the Profits Perspective Please click here to view a copy of Where Profits Come From
THE JEROME LEVY FORECASTING CENTER, LLC
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