The question “Where does profit come from?” initially seems as if it has an easy answer, but on closer inspection is a matter of considerable controversy. Ordinarily, we are given simple answers such as “buy low, sell high” or, that favorite fallback position, “the magic of the market.” Standard answers such as these rest on a presumption that circulation of a commodity is the source of profit. That presumption has deep roots, having been articulated by Adam Smith in his classic work Wealth of Nations.
To summarize, Smith wrote that fixed capital (such as machinery and factory buildings) increases the productive power of labor but can produce nothing without circulating capital (such as money and inventory) — from these starting points he concluded that the circulation of capital not only furnishes raw materials and the wages of labor, but is the source of profit. Smith believed that capitalists and land owners have to be rewarded for risk-taking; therefore, upward redistribution of income is required to ensure they will employ the resources they own.
That portion of Smith’s writings is readily accepted as gospel, treated as incontestable dogma in the same way that religious fundamentalists cling to their particular holy book.
That is only side of Adam Smith, however. The Scottish economist also wrote that labor is the “real measure” of the value of a commodity and is entitled to be rewarded. This latter perspective is often referred to as the “labor theory of value,” which has deeper roots than theories of circulation. The origination of the idea that labor adds value is generally credited to Ibn Khaldûn, a fourteenth century diplomat and government official who later became a scholar. He wrote in The Muqaddimah that labor is the source of value, arguing that profits, even when resulting “from something other than a craft, the value of the resulting profit and acquired [capital] must include the value of the labor by which it was obtained.”
The idea of labor creating value was picked up in the seventeenth century, most influentially by John Locke. In The Second Treatise of Government, Locke wrote that what is taken from the earth through labor rightfully becomes the property of the laborer. Cultivated land is more valuable than fallow land as a result of labor, Locke wrote, and he extended his concept to acknowledge that all manufactured products are given value by labor.
The labor theory of value
Among those who accepted this concept in the following century was Adam Smith. Another who did, but who also significantly advanced the theory, was Karl Marx. The labor theory of value provides a much different way of looking at the question of profit. In his Theories of Surplus Value (an unfinished book originally intended to be the fourth volume of Capital), Marx wrote that Smith’s conclusion that capital is the source of profit contradicts other passages in Wealth of Nations in which Smith wrote that command of labor is the source of value — if the latter is so, profits must originate from the differential between what labor is paid and the value of what labor has produced.
Marx pointed out that the value of a commodity would be the same if the workers sold the commodity themselves, thereby retaining the full value of what they produced rather than having much of it taken by the capitalist. The portion taken by the capitalist therefore is the source of the capitalist’s profit and not the circulation of the commodity.
Marx’s breakthrough was making a distinction between “labor” and “labor power.” It is labor power that is a source of profit. Specifically, what labor power produces is “surplus value.” Labor power is not the same as labor: Labor is the actual activity of production, whereas labor power is the workers’ mental and physical capabilities that are sold to capitalists.
Here we might object that nature is the source of much wealth; precious metals, oil and gas, among other resources, readily come to mind as sources of wealth. Natural resources are surely sources of wealth, but labor power is necessary to extract them and to produce the commodities that are to be sold by capitalists.
You produce, but don’t get paid for all of it
Surplus value is the difference between the value of what an employee produces and what the employee is paid — the surplus value is converted into the owner’s profit. This is a complicated concept and initially seems counter-intuitive. Machinery is a part of modern production and does not machinery increase efficiency? The machine presumably costs less over its life than the worker; isn’t that why capitalists buy machines, so they can employ fewer workers and increase productivity? True on both counts. But the value of machines is consumed in production — their value is transferred to the products that are produced with them. It is the physical labor of production that produces the commodity that is sold for more than was paid for the materials used to make it. This concept is easier to understand when it is applied across the life of a commodity rather than narrowly within only the enterprise that manufactures the final product.
Any product made for sale has an “exchange value.” This value is not necessarily the same as its “use value” — the intrinsic value a product has to the user of it. If it takes eight hours for an individual to make a shirt for herself, then the shirt might be said to have a use value of eight hours of labor. Perhaps instead of wearing it herself the shirtmaker wishes to barter the shirt for a pair of shoes. If the shoes require sixteen hours to make, the shoe maker is not likely to see that as a fair exchange. But if the shoe maker needs two shirts, then the labor that went into each side of the exchange is equal (assuming the skill and intensity of work are close to equal). In this example, the pair of shoes can be said to have the value of two shirts.
In a modern capitalist economy, the shirt or shoe is sold for money — its exchange value is the amount of money paid for it. But the shirtmaker working for a wage paid by a manufacturer will receive only a portion of that value — the difference, the surplus value, is the source of profit. If the capitalist willingly paid to his employees the full value of what they produce, he wouldn’t be a capitalist — there would be no profit.
The owner of the factory is not altruistic — he intends to extract surplus value. But that owner does not keep all the surplus value — he must share it with those who help circulate the commodity. Distributors and merchants assume the cost of circulation, part of the expense of a commodity, while sharing the surplus value. The distributor has specialized skills and can circulate the commodity more efficiently than the manufacturer; because the cost of circulating the commodity is thereby reduced, there is more surplus value to be shared.
Distribution of surplus value
In the following hypothetical case, the surplus value is shared with the distributor and the merchant. Let’s say the factory owner pays a wage that is equal to eight dollars to each worker for each widget. The owner sells the widget to the distributor for ten dollars, the distributor sells it to the merchant for twelve dollars and the merchant sells the widget for fourteen dollars. When the worker goes to the store to buy a widget, she pays fourteen dollars although she was paid only eight dollars to make one. Thus, the widget is worth six dollars more than what the factory owner paid to the worker, not the two-dollar difference between the wage and what the factory owner received for it.
The distribution of that surplus value can change among the capitalists. These capitalists compete against each other to earn a bigger profit, at the same time they cooperate in getting the product to market. The widget manufacturer might miscalculate the demand and overproduce, causing a glut that reduces the price that can be realized. Or a giant merchant chain becomes so big that it has the power to force lower prices — the chain wishes to sell the widget for less to undercut its smaller competitors, and possesses sufficient clout by virtue of its size to negotiate a discount, forcing the manufacturer to cut its wholesale prices.
If the manufacturer does not wish to see its profits reduced, it has to reduce its costs. The primary way it can do so is to lower its labor-power costs. This can mean cuts to wages or benefits, increased workloads, layoffs or moving production somewhere else. In each of these cases, the capitalist is buoying profit levels by extracting more surplus value. More will be extracted from the workforce through suppressing pay or an intensification of work.
The above example is of course an oversimplification. The factory owner has costs other than labor power, and employees do not create the widgets solely with bare hands. (And, in reality, the employee will be paid far less than the 80 percent of the factory owner’s proceeds in our hypothetical example.) There is machinery in the manufacturing process, and raw materials (including previously manufactured components) are needed to make the widgets. If the company’s shares are traded on a stock exchange, the shareholders will be expecting a hefty cut of the profits.
Labor power is the source of surplus value because raw materials and the value of the machinery are consumed in production while labor power produces more value than is paid for it. That does not mean that machines aren’t productive nor that they don’t raise the productivity of those who work with them. They do both. The surplus value contained in the machines placed in production was realized by the manufacturer of the machine upon selling it; the machines transfer their value to the commodities produced using them. (Payments might continue to be made on the machine after it is put into service, but the payments go to the lender who financed the machine’s purchase; interest is another sharing of surplus value. Paying rent is as well.)
A commodity is produced with direct labor, machines and raw materials, but the machines and raw materials assist labor in producing the surplus value — machines make labor more productive, enabling more surplus value to be extracted from each employee. (One worker using a bulldozer can do as much as several workers with shovels. Computerization also reduces the number of employees in an office; more work is done with fewer people.) Raw materials and other commodities are bought by the capitalist so they can be sold in a new form for a higher price. Raw materials and natural resources can’t do that by themselves — labor power is the only commodity that can add the value that becomes surplus value.
Extracting surplus value
Marx demonstrated this concept at the beginning of Volume III of Capital. The paragraph below is dense, and so requires commentary to unpack it. Marx himself spent three chapters covering dozens of pages to explicate this one-paragraph example, examining it from every angle, knowing that his many critics would attack him for any gap were his argument not air-tight. This blog normally avoids mathematical equations, but the one quoted below is unavoidable. The “400c” in the equation represents the cost of expenses (the “c” means “constant capital”); the “100v” represents the cost to the capitalist for wages (the “v” means “variable capital”) and the “100s” represents “surplus value.” In his example, Marx wrote:
“Let us say that the production of a certain article requires a capital in expenditure of £500: £20 for wear and tear of the instruments of labour, £380 for raw materials and £100 for labour-power. If we take the rate of surplus-value as 100 per cent, the value of the product is 400c + 100v + 100s = £600. After deducting the surplus-value of £100, there remains a commodity value of £500, and this simply replaces the capital expenditure of £500. This part of the value of the commodity, which replaces the price of the means of production consumed and the labour-power employed, simply replaces what the commodity cost the capitalist himself and is therefore the cost price of the commodity, as far as he is concerned.”
In this example, the capitalist, assuming the finished product has been sold at the market value of £600, has realized a profit of 20 percent. Because £200 was realized by the capitalist above the total £400 cost of raw materials (£380) and machine-use (£20) while only £100 was paid in wages (the “100v” in the equation), £100 in surplus value was extracted through paying the employees for only half of what they produced. It is by calculating labor-power separate from other inputs that the source of profit is discovered.
This crucial point is obscured when the cost of labor-power is subsumed in the overall expenditures; the capitalist’s profit appears to him or herself simply as the difference between the sum total of his or her costs and the sale price. Thus the profit appears to derive from the circulation (sale) of the commodity while in reality circulation is the realization of profit.
I’ve used examples based on manufacturing, but the same principle exists for white-collar office work.
It is not at all out of place to ask: Why shouldn’t the people who do the work earn the rewards? Why should bosses, shareholders and speculators accumulate so much at the expense of so many? Why should those who dedicate their lives to accumulating so much be anointed the guardians of morality and ethics when their ability to acquire money does not make them experts at anything other than greed?
But to change that, an economy would have to be based on cooperation rather then competition. Employees already cooperate with one another on the job; producing a product would be impossible otherwise. We can cooperate in managing our enterprises and with our communities just as well.
This post is adapted from my book It’s Not Over: Learning From the Socialist Experiment (copies available online for well under the list price). The sources used in this adaptation include Karl Marx, Capital, volume 3, pages 117-140, 392-416 [Vintage Books, 1981]; Marx, Theories of Surplus-Value, chapter 3 (“Adam Smith”), posted on the Marxist Archive web site; Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, book I, chapters 1-3, and book II, chapters 1-2, posted on the Marxist Archive web site; John G. Gurley, “Marx and the Critique of Capitalism,” anthologized in Randy Albelda, Christopher Gunn and William Waller (eds.), Alternatives to Economic Orthodoxy, pages 274-276 [M.E. Sharpe, 1987]; Antonio Negri, Marx Beyond Marx: Lessons from the Grundrisse, pages 74-76 [Autonomedia, 1991]; and Tom Bottomore (ed.), A Dictionary of Marxist Thought, pages 265-266 [Harvard University Press, 1983]