Where does profit come from?

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.

Vanity and greed represented on the Prague Astronomical Clock (photo by Sebaso)

Vanity and greed represented on the Prague Astronomical Clock (photo by Sebaso)

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]

11 comments on “Where does profit come from?

  1. andy grundrisse says:

    This is a very good article, I consider myself fortunate to have come across this web site. If the operators consider my comments at all valuable, I would be honored to submit analyses for their consideration.
    There is a simpler way to understand surplus value and profit creation.
    Left out of this summary of the history of the labor theory of value was the role played by arguably the first modern economists, the Physiocrats of France. Of course this oversight is understandable given the limitations of writing a short article. But when you look closely at agriculture the ultimate irreducible source of profit becomes clear.
    I live in Ecuador and so I will use bananas as an example ( Ecuador produces the world’s finest bananas, don’t be taken in by bananas grown elsewhere like Colombia under extremely repressive working conditions ). Bananas reproduce primarily through rhyzomes. You can separate a part of the root of a mature banana plant and replant it elsewhere and a new banana plant will grow. In less than a year, the new banana plant will be over six feet tall, and produce two large stalks comprising dozens of bananas each year. nothing else is needed, just human labor and nature. The two stalks of bananas produced each year by the new plant represent profit, pure and simple. Nothing else is necessary.
    Or take corn as an example. You can take an ear of corn and separate out the individual kernels and plant them. The next year you could easily have over sixty corn plants each producing an ear, sometimes two. From one ear of corn you have generated sixty. again, all that is required is human labor and the productive power of nature. No capital is necessary.
    From these two examples it is abundantly clear that the one irreducible essential element to generating surplus or profit is human labor.
    Modern mainstream economists fail to distinguish between creation of surplus value / profit and distribution of surplus value / profit. So for example when the stock market goes up, this does not constitute creation of value or profit but rather distribution of profit or surplus among the various capitalists, each of whom is competing to appropriate the greatest amount of value created by others ( the workers).

    • Andy, thanks for adding to the discussion. Indeed, I could only go into so much detail in the post. John Locke, as I noted, is generally credited with being the person who began to develop the modern concept of the labor theory of value, and his theory was based on improvements to land adding value, a similar concept to your discussion of agriculture. Nature provides resources but it requires human labor to convert them for human use. Your point about the stock market is also important — financiers don’t produce wealth, they extract it. One important reason for the economic malaise is that so much wealth has been extracted that the wealthy can’t find enough productive uses for it, so they speculate instead, generating more economic instability.

      • andy grundrisse says:

        I would like to invite you to come to Ecuador and see first hand what is going on here. We have a president who has a Phd in economics from the university of Illinois and who speaks four languages fluently ( Spanish, English, French and Quitchua ). He has declared a significant portion of Ecuador’s external debt as illegal and stopped making payments on it. He has developed and promulgated one of the most innovative environmental programs in the world today ( the Yasuni initiative ). He has made an offer of political asylum to Wikileaks founder Assuange ( Assuange is currently living in the Ecuadorian consulate in London). Under his leadership, poverty has significantly declined, education expanded, health care improved and the economy grown. Ecuador did not suffer any banking problems during the 2008 global crisis and the professional class has thrived.

        Come and see for yourself.

        • Ecuador, Bolivia and Venezuela are offering the world alternatives to neo-liberalism, and Argentina set an example when it renounced its odious debt a decade ago. We should be paying more attention to these alternatives.

    • andy grundrisse says:

      First of all, I want to wish a happy and healthy new year to Pete and all the readers of this blog.

      Without wishing to clog up the blog, I would like to make two additional comments.

      Use value and exchange value are two different dimensions of a commodity, kind of like the X and Y co ordinate of a point on a graph. They are not really comparable. The use value of the shirt is that it keeps us warm and dry. The exchange value of the shirt is that the shirt requires a certain amount of socially necessary labor for its production and therefore can be exchanged for a different product in which is incorporated a similar amount of socially necessary labor. It is confusing and misleading to say that the use value of the shirt is eight hours of labor. In the same way knowing that that the X co ordinate of a point is 8 doesn’t enable us to say anything intelligent about its Y co ordinate. You could say they are apples and bananas.

      Second, we have to distinguish between relative profit and absolute profit. The circulation of commodities generates relative profit as one trader outwits the other, but not absolute profit since the profits of one trader are offset by the losses of the other. If I sell a counterfeit quarter for 25 cents then surely I have made a 25 cent profit, but the poor soul who purchased the fake, has suffered a 25 cent loss. Hence no absolute profit, only relative profit, which certainly appears exactly like absolute profit to the party that realizes it, but when viewed from the perspective of the economy overall, the true relation is clear. The challenge is to explain the source of absolute profit assuming that everything trades for its fair value.

      The fair value of a commodity is the amount of socially necessary labor necessary for its production, and by its production is included the socially necessary labor for the production of the machinery and equipment necessary to make it ( the cost of the machinery allocated over the total production of the machine over its useful life). Labor, or more technically, labor-power is no different. The value of labor power, as with every other commodity, is the amount of labor necessary to produce it, or in this case that amount of money sufficient so that the worker can show up for work the following day, in other words, the amount of money necessary to maintain him/her. But this amount is very different than the amount of time an individual can actually work. The Achuar, living deep in the Ecuadorian rain forest, need only a few hours each day to obtain the things they need to live. The rest of their time is leisure, or surplus. The difference between the amount of time it takes to produce the things necessary to maintain the worker, and the amount of time a worker can work in a day is surplus. Here is the most important point: Labor power is unique among all commodities in that its use value is the production of exchange value, and therefore only labor power has the potential to produce surplus or profit. All surplus / profit comes from labor.

      Modern economics seeks to avoid the problem altogether by essentially denying even the existence of profit. Instead there are simply returns to the various factors of production, interest as a return for the capital supplied, rent as a return to the land supplied, and wages as a return to the labor supplied. Economists call any profit above this, excess profit which, they say, is quickly eliminated through competitive pressures. In doing this economists confuse and confound distribution with production.

      The 19th century economist David Ricardo demonstrated this perfectly in his debates with Malthus over the Corn laws, taxes imposed on imported food. Increasing import levies on food leads to an increase in the rents on agricultural lands, without the landlord having done a thing. He hasn’t affected production a bit, but the increased taxes on imports, leads to an increase in the price of food, which allows the landlord to increase his rents and appropriate a greater share of the proceeds, without having contributed anything new or different to the productive process. It is for this reason that Ricardo referred to “the parasitical landlord class” and, by the way, why Keynes openly cheered for “the euthanasia of the rentiers”.

      I apologize for going on so long and appreciate everyone’s forbearance, but I feel these points are important to make. Pete, you can edit or abridge this as you see fit.

      Pete, Keep on Trucking

      • Andy, thank you for your valuable contributions to an important discussion. I wouldn’t dream of abridging your comments.

        I’d like to zoom in on your statement that: “Modern economics seeks to avoid the problem altogether by essentially denying even the existence of profit.” That is so true! Indeed, the obscuring of the source of profits (employee labor-power) is critical to all classical economics (not just Chicago School/neoliberalism). By falsely claiming the source of profit is circulation rather than production relations, profit can be attributed to the business acumen of the capitalist, thereby justifying towering inequality.

        This falsity also justifies longer working hours and harsher working conditions in the name of “efficiency” by making “efficiency” a “necessary” adjustment imposed by a “job creator” who alone understands the “market.” Greater efficiency, in reality, is the extraction of more surplus value from the workers. We work many more hours than we need to sustain ourselves and produce enough to provide for society’s needs. We could work only a few hours a day, like the Achuar (albeit in very different work!), if we didn’t have capitalists to extract surplus value. Nor would our jobs be moved to other parts of the world to reduce labor costs and impose less safe working conditions.

        If we worked for ourselves in a collective, we would produce a much smaller surplus, enough to provide for future investment and to pay taxes, so we would work fewer hours, have more control over our working lives and keep our jobs in our local communities.

  2. the Heretick says:

    not being a trained economist i would still like to add my 2 cents.
    broken down to basics nothing gets done in the physical world w/o work being accomplished in the scientific sense of the word.
    the formation of the solar system can be looked at as work, energy expended to change the state of some object, matter in its simplest form, if you will.
    the sun provides free energy, it does work, so to speak, by growing plants, heating the planet, etc.
    thru monarchies, feudalism, and up thru capitalism the trick has been to separate the workers (labor) from the fruits of their labor.
    now with globalism and abundant energy sources capital is able to utilize machines, ever more adept machines to dispossess the proletariat of any claim to any sort of wealth. the use of machines alleviates the need for capital to need labor at all, leaving workers as paupers much as medieval serfs were left landless.

    off-shoring of jobs, chasing lower wages, enriches the ruling class at the expense of labor worldwide, the win/win scenario pushed by the intelligentsia is nothing but a damnable lie. globalism, cast as creating heaven on earth does nothing but enrich the already wealthy, burn up resources, and create massive social dislocation which in turn causes social problems; to be answered once again with the application of machine power in the form of the surveillance/police state.

    at least that’s my view here from the cheap seats.

    • A few days go I watched the movie Elysium, which depicts a future world in which the bourgeoisie lives in luxury in a orbiting space station, with access to machines that cure any disease in moments, while the vast majority live in squalor on a polluted Earth, stripped of citizenship, brutally repressed by police robots and without access to health care. In the absence of organized resistance, that could be the future, but it wouldn’t last.

      The world of Elysium is a capitalist world, but such a world could not last as a functioning capitalist economy. Too few people would have the means to buy the products made in the capitalists’ factories, and in this movie the one local factory produced more police robots and security equipment for the government. This world could only exist as a fascist state imposed on a feudal economy, and probably would not be much more sustainable. The belief that seems to be held by many financiers and industrialists that they can build a big enough wall to keep the world at bay is not realistic. But the future will be a nightmare unless the world’s working people organize to create a better world.

  3. Scott says:

    First time reader/poster here, I came by your blog by way of counterpunch.

    A good summation of Marx’s LToV. However, I believe the LToV is open to some serious critique.

    How did Marx/do Marxists quantify the “value” part of the equation? The example you quote from Marx provides a very simplistic picture, containing only a few contributors, all of which are known and quantifiable. But, of course, in modern capitalism the number of contributors to production can be vast, often unpredictable/unquantifiable and even unknown. According to Marx and the LToV, these contributors must be quantified and then factored into the LToV equation to discover part of the surplus equation. There is no way this can be done, for it would be like charting reality itself. Therefore, labour value, as with all the other values, remain purely theoretical. They do not exist in reality.

    The Marxian view assumes there is a separation between ‘real’ and ‘speculative’ or ‘nominal’ or ‘financial’ capital. Actually, all capital is nominal or financial because all capital hinges on price and prices are set according to the machinations of business or finance, not on any ‘actual’ or ‘real’ value that transcends prices. The ‘value’ or price of so-called ‘real’ capital – eg plant, labour – is arbitrary and dependent on either the countless, unknowable variables demanded by the LToV equation or by equally arbitrary demands of business. It therefore must the latter that counts. A basic example: a fleet of trucks are assigned by accounting a particular value, diminishing yearly. Where this original value comes from is just as arbitrary – by arbitrary I mean set by the currents of financial markets – as the rate and values of annual depreciation. And these figures are not set by factoring in all the contributors and variables of production and cost. They are set arbitrarily, as financial figures, according to, in part, general market forces.

    • I don’t believe Marx intended his example as a model that could capture the totality of capitalist production; it was a method of conceptualizing the idea that labor power is the source of surplus value and thus capitalists’ profits. I note that the quoted mathematical example from Capital Volume III was then examined from every conceivable angle for dozens of pages. Marx was nothing if not thorough. The complexities of modern capitalism can indeed by highly difficult to capture, as you point out, and that is why, even among Marxists or heterodox economists more generally, the labor theory of value and the tendency of the rate of profit are hotly debated.

      • Scott says:

        “I don’t believe Marx intended his example as a model that could capture the totality of capitalist production; it was a method of conceptualizing the idea that labor power is the source of surplus value and thus capitalists’ profits.”

        Yes, his model seems to require quantification of all production inputs. Otherwise, quantifying or pricing only a few inputs (as per his example) would render the equation inaccurate and therefore useless. Unless he charts all inputs and quantifies them accurately his equation remains arbitrary. In other words, it is not a model one could ever use to actually figure out a specific instance of a surplus labour value in terms of a specific number. So the concept seems to remain untestable, faith-based.

        Veblen introduced us to the concept of profit as a matter of business rather than solely production with one outcome being that business can find profit via destruction of productive capacity.

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