What Determines Profits in Neoclassical Theory?

Naples and Aslanbeigui (1996) ask that question, review what neoclassical textbooks say, and find that the neoclassical story is incoherent and confused.

There is also some useful background on other issues. In neoclassical textbooks, entrepreneurship is sometimes treated as an actual factor of production, and sometimes not (Naples and Aslanbeigui 1996: 55). When entrepreneurship is regarded as a factor of production, then it is usually treated as a form of labour, but this raises the question why entrepreneurs should receive profits, a return which is a special income over and above their wages (Naples and Aslanbeigui 1996: 56). (Also, are entrepreneurs the owners of capital or the mangers of firms, or a combination of both?) A possible solution is that only entrepreneurs who are also owners of capital receive profits (Naples and Aslanbeigui 1996: 56).

But what causes profits to exist? There appear to be three broad answers: innovation, uncertainty, and monopoly (Naples and Aslanbeigui 1996: 57). The notion that innovation is a major source of profits is derived from Joseph Schumpeter’s theory of the entrepreneur, but as Naples and Aslanbeigui (1996: 57–58) point out this is highly problematic since most innovation does not originate from entrepreneurs/capitalists, but from researchers, managers or other employees who receive no profits from the firm.

Even when neoclassical theorists ascribe profits to uncertainty, they confuse and conflate true uncertainty with risk (Naples and Aslanbeigui 1996: 58), and argue that profits stem from the “risk premium” that entrepreneurs/capitalists demand when their risk rises and they can assess this risk accurately.

In the neoclassical convergence to long-run equilibrium, profits are competed away as firms enter markets and reduce profits to zero. Moreover, under the assumption of perfect information, it is the case that “no entrepreneurial services are needed or possible” at all! (Naples and Aslanbeigui 1996: 59–60). In short, “entrepreneurship becomes defunct in neoclassical long-run equilibrium” (Naples and Aslanbeigui 1996: 60).

Furthermore, in this long-run equilibrium, the “normal rate” of profit becomes equal to the rate of interest (Naples and Aslanbeigui 1996: 60). In other words, the rate of return on capital is the normal profit rate or equilibrium rate of interest (Naples and Aslanbeigui 1996: 64). A profit above the “normal rate” is called “economic profit” (Naples and Aslanbeigui 1996: 67), which will exist in disequilibrium situations.

In general equilibrium models, financial capital (loanable funds) is distinguished from physical capital, and the demand for loanable funds is determined by the marginal revenue product of the new capital goods (Naples and Aslanbeigui 1996: 60). The consequence is that the “supply of capital, therefore, becomes identical to the saving(s) of the households” (Naples and Aslanbeigui 1996: 61).

One of the strange consequences of this seems to be that the classes of pure capitalists and rentiers disappear in long-run equilibrium.

Naples and Aslanbeigui stress the problems of the Cambridge Capital Controversies that are ignored in textbooks: the circularity in trying to define the aggregate value of capital when this is dependent on the long-run profit/interest rate, but the latter is in turn determined by the aggregate value of capital (Naples and Aslanbeigui 1996: 61).

In reality, neoclassical theory, because of its neglect of the Cambridge Capital Controversies, has no coherent, defensible theory of the profit rate (Naples and Aslanbeigui 1996: 70).

Addendum
I will just note that in some textbooks and other discussions of neoclassical theory, there is another definition of “normal profit.” For example,

(1) “normal profit” seems to be also defined as the “opportunity cost” of the entrepreneur/capitalist or entrepreneur, or the minimum necessary to compensate him for his implicit costs.

It seems that “normal profit” in this usage just means the return to owners or owners/managers that is the minimum necessary to make them stay in business and not do something else. So here “normal profit” means a profit equal to opportunity cost, so that the “normal profit” equal to the interest rate on money loans in long-run equilibrium is a different concept.

(2) “excess profit”/“supernormal profit” is profit in excess of “normal profit.” In the long-run equilibrium position, supernormal profits will have fallen to zero.

Of course there are also accounting definitions of profit, and these should not be confused with the economic senses above:

(1) net profit is the residual after the calculation of total revenue (the inflow of money coming into the firm, which is usually total sales revenue and sometimes other revenue) minus all explicit costs including (1) costs of production (wages to labour and other salaries, cost of capital goods and raw materials, rent), (2) interest on money loans (often considered part of fixed costs), and (3) depreciation. Net profit can be calculated before or after tax. Net profit after tax may be a return to the capitalist owners of the firm, or held as retained earnings, or a combination of both.

(2) gross profit is net profit before depreciation and interest are deducted.

To illustrate the difference between “economic profit” and “accounting profit,” the crucial concept here is the difference between (1) explicit costs and (2) implicit costs:

(1) explicit costs are the actual money costs of production, or expenditure.

(2) implicit costs are the opportunity costs of engaging in a given activity. In other words, it is a measure of what is sacrificed for engaging in a given activity.

BIBLIOGRAPHY
Naples, M. I. and N. Aslanbeigui. 1996. “What does Determine the Profit Rate? The Neoclassical Theories presented in Introductory Textbooks,” Cambridge Journal of Economics 20.1: 53–71.