About Profits
Smith had no commercial experience
He simply did not think like a merchant or trader or capitalist. In numerous places this shows, and it leads him at times to make very odd pronouncements that make no sense.
It is important to recognise that in his great book_ The Wealth of Nations _Adam Smith is always the philosopher who treats profits as a category. ..No where in the book is the depiction of a transactional or trading profit (as distinct from annual profit) clearly set out. ..While many passages are so fuzzy that such may be imputed, yet this would credit Smith with something that really is not there.
Reading these, one might expect this is what Smith must mean, but why then is his language not explicit? …As he says himself .. “I am always willing to run some hazard of being tedious in order to be sure that I am being very clear.” [end of chapter 4 of Book One.]
Except, not when it comes to something as everyday as profits. Any explanation he offers of those is pretty well always wrong.
{note: _ He was even less interested in machinery, and thus missed its importance in producing the ‘opulence’ he attributed instead to the division of labour. ..[as do many Intro Economics textbook authors even today.] Where Smith wrongly led, many others have unthinkingly followed.}
Of course, he knows profits come from trade, yet he does not dwell on them because for him profit is an annual figure, ..a net figure from summing all the gains and losses. ..These may be from accident, spoilage, pilferage, low price, and so on. ..So he always speaks of annual profit and the rate of profit is always an annual affair. ..Nor ever prorated for a shorter time period. The necessity to do so evidently never occurred to him.
The following quotes come from Book One, Chapter Nine, the paragraph as indicated: [they are abridged or paraphrased].
“The lowest ordinary rate of profit must also compensate for the occasional losses to which every employment of capital is exposed. ..And so the gross profit, which does this, is larger than the net or clear profit. ..The interest that the borrower can afford to pay is in proportion to the clear profit only. ” __[para 18]
By proportion he means a slice thereof, a certain fraction. Smith organised things in categories and sub-categories, and so tended to think in proportions.
“The proportion that the usual market rate of interest ought to bear to the ordinary rate of clear profit varies as profit rises or falls. ..Double interest is in Britain reckoned by merchants a good or usual profit. ..Where the ordinary rate of clear profit is 8 or 10%, and business is carried on with borrowed money, it may be reasonable that half should go to interest.” __[para 22]
But what were these merchants speaking of: ..a trading profit or an annual one? ..If they are turning their capital but once in a year, then the two are the same. ..But if they turn their capital more often, then either they will earn multiple profits, else their mark~ups will be lower and the trading profit per transaction lower than the annual rate. ..These are not considerations Smith ever explores. Frankly, he seemed completely unaware of this distinction.
About Holland
Smith exhibited the same failing a few pages earlier…
“When the capitals of many rich merchants are turned into the same trade, their mutual competition tends to lower its profit [rate of] …and when there is a like increase of capital in all the different trades carried on in the same society, ..the same competition must produce the same effect in them all.” __[para 2]
“Holland, in proportion to its … population, is a richer country than England. Its government borrows at 2% and people of good credit at 3%.
The Dutch, it is well known, trade upon lower profits than any people in Europe, though the wages of labour are said to be higher than England’s. … The smallness of profits are a natural effect of its prosperity, ..of a greater capital being employed in it than before.” __[para 10] {italics added}
Smith faithfully conveys what he has heard: that the Dutch ..trade upon lower profits, ..but without apprehending its meaning. ..As they turn their capitals several times in a year, ..one’s annual profit will be several such trading profits combined, a concept Philosopher Smith is innocent of.
He clearly thought this was an annual figure ‘explained‘ by a large quantity of capital existing and its owners competing for good opportunities and lowering the rate. ..His observation of the rate was accurate; ..his interpretation clearly was not.
Retailing in a Great City
Smith in the following passage (in Book One, chapter X, para 37 — again, paraphrased) is purely observational, perhaps because he had no explanation to offer:
“Though the profits of capital both in the wholesale and retail trade are generally less in the capital city than in small towns, ..yet great fortunes are frequently acquired there from small beginnings. … In great towns trade can be extended as stock increases, and the credit of a frugal and thriving man increases much faster than his stock [capital].
“His trade is extended in proportion to the amount of both; ..the amount of his profits is in proportion to the extent of his trade; ..and his annual accumulation [of money] is in proportion to the amount of his profits.” [italics added]
{note:_ He used stock where today we would say capital, but for Smith they were the same thing: ..his merchandise stock (inventory) would be his capital, or trading capital to be more precise;… whilst the store’s fixtures, though also part of his capital are fixed capital. …
Perhaps due to his use of stock where capital would be appropriate, he simply forgot that “circulating capital” was involved and therefore several profits could be had on it in one year. This realisation never dawned on him.}
Notice that he had no explanation as to how a great fortune is made, even though he had all the elements stated.
Recall, merchants felt a profit of double the interest rate was usual, and here the merchant has borrowed to finance much of the inventory. ..Anyone with any business nous would recognise this as.. leveraging ..(gearing in British argot). Its absence is most telling: ..Philosopher Smith simply did not think like a merchant, trader, or capitalist.
As instance: ..Say inventory is financed half with borrowed funds at 5% and half with the merchant’s own capital, ..each set at 100 units, with the rate of expected profit double the interest rate or 10%. ..Say all goes well and after one year profits are 20, minus the interest paid of 5, for a clear return of 15 on the merchant’s own capital of 100 units. ..[Such a merchant could pay a higher rate of interest, and might be willing to, if he could not find another lender.]
The following very clearly shows Smith’s lack of business acumen: ..it is from Book 1, ch 6, paragraph 6 … Here he does attempt to explain profit.
“Let us suppose, where the common annual profits on manufacturing capital are ten percent, ..a manufacturer employs some workmen at a total annual expense of 300. ..Let us suppose, too, that the coarse materials annually wrought up cost only 700, ..so that the annual capital employed is 1000. ..At the rate of ten percent, therefore, the undertaker will expect a yearly profit of about 100.”
Here the annual capital employed is used in order to show the annual profit at its ten percent rate. [These figures may be any currency you want: pounds, dollars, euros, yen. Smith, of course, used pounds.] ..At best, this would be working capital, though even that is more than simply materials and wages.
But the workers would be paid weekly, the payroll being about 6 each week, and each payday one week nearer the year’s end. ..The average annual capital in use for wages for the year is then roughly half the workers’ annual total pay, here 150.
Similarly, unless all materials are bought at the start of the year, they will be got in batches throughout the year, worked up into product and sold, ..and the money received will help pay for another batch of materials. ..So the capital employed over an entire year on materials will be a fraction of the total expenditures on them.
Total capital needed is much less than depicted by Smith: ..say 150 for wages — ignoring the income stream in meeting payrolls — plus for materials perhaps 70, so likely even 200 in total would do for wages and materials both. ..Consequently, about 20 in annual profits would be ten percent on the capital employed, a fifth of what Smith stated.
Also, this is ‘working capital’ with no provision for offsetting the contribution of any fixed costs such as use of machinery or tools, expenses of an owned building, and so forth.
Though in many places he went into tedious detail, ..yet here offers a simplistic example that reflects his simplistic thinking on this matter. ..Philosopher Smith simply did not think like a capitalist, or merchant, or trader.
What Adam Smith did not know
About profits Adam Smith knew little, other than businessmen expected to have them. Any mention of profits was either of an annual one, typically ten percent, else remarkably fuzzy. ..He was oddly incurious as to what those in business did to enhance their profits (other than up prices — for which competition was the cure). He could be doctrinaire and naive all at once.
The following is paraphrased, italics added, from Bk 4, Ch 5, the Digression, ~60% in:
“Most manufacturers could not retail their own goods so cheap as a vigilant and active shopkeeper, whose sole business was to buy goods at wholesale and to retail them again.”
He often used the phrase vigilant and active in describing any specialist, whom he always believed could outcompete any others in that particular trade.
[note:_ By manufacturer he meant a craftsman and small scale production. ..Also, the liberty of an individual to do as he pleased was paramount to Smith and he rarely allowed it to be lessened (provided that individual was not infringing another’s ‘natural liberty’). …This is why Smith was so popular with those who wanted to make money however they could.]
“Manufacturers in many places were by law forbidden to sell their goods retail, an evident violation of natural liberty and therefore unjust. ..
“The law was intended to protect shopkeepers from being undersold and their trade ruined. But the manufacturer, had he been allowed to sell retail, could not have undersold a common shopkeeper: ..For whatever part of his capital he placed in his shop [as goods for sale] would be withdrawn from his workplace and a profit taken on them. Plus a second profit as a retailer for the capital in his shop.
“If ten percent was the ordinary [annual] profit both of manufacture and of retailing capitals, he must then have charged upon every piece of his own goods he sold in his shop two profits of ten percent each: For when he carried them from workplace to shop he must have valued them at the price he could have sold them for to a dealer or wholesaler.” _[Who would then supply ordinary shopkeepers.]
Surely this is not two distinct capitals but the same one in two places — why take two profits on it? ..Moreover, why would both be the annual figure? Also, where is the wholesaler’s profit, that the independent shopkeeper would be paying? His cost for those items would necessarily be more.
An explanation that makes sense of this — though it is rather odd — is to treat profit as a proportion (10%) and then add that to the item — which is mark~up, though Smith is unaware of it. ..Similarly, he knows nothing of turnover either.
As instance, say a retailer has a popular item that will turn ten times during the year: ..it could be marked up by two percent and yield twenty percent profit on that capital which keeps getting re~used.
An artisan producer with his own shop could undersell any independent shop, have a greater volume of sales, hence a lower mark~up, and in consequence an even lower price. ..Which is why a law existed to protect the independent shopkeeper from such competition.
Yet, Smith innocently observed:… “The dealer who employs his whole capital in one branch of business has an advantage of the same kind as the workman who applies his whole labour in one operation, which enables him to perform a much greater quantity of work.
“Likewise, the dealer acquires so easy and ready a method of transacting his business, of buying and disposing of his goods, that he then with the same capital can transact a much greater quantity of business.” {emphasis added, same page as above}
Smith was delighted to find such a wonderful instance of specialisation due to the division of labour. ..Yet, he makes no mention of the effect this has on the retailer’s profits, of the annual summing of many such trading profits. ..Instead, he drops this tale and wanders off on a different topic.
Clearly, though he valued the effects of trade, he did not delve into details, simply because he did not think like a dealer, trader, or capitalist. ..Smith remained a philosopher rather innocent of commerce. ..And thus he reached odd conclusions — such as saying the above law to protect independent shopkeepers was completely unnecessary.
Stout Defender of Grain Speculators
All quotes or paraphrasing are from book 4, chapter 5, the Digression on the Corn Trade, unless otherwise stated. (Corn in Britain means grain, and here would be wheat principally.)
“The unlimited, unrestrained freedom of the corn trade is the only effectual preventative of the miseries of a famine … [yet] in years of scarcity the inferior ranks of people impute their distress to the avarice of the corn merchant, who becomes the object of their hatred and indignation. … No trade more deserves the full protection of the law, and no trade requires it so much …” [emphasis added] {paragraphs7,8}
How he arrived at this conclusion, how indeed he argued the case of the much maligned speculating grain merchant, will be given farther on. ..But first, whatever the grain dealer may be to buyers, for Adam Smith he is the farmer’s friend, and what are friends for?
The farmer’s friend …
“The role of the corn merchant in support of the farmer is that of the wholesale dealer in support of the manufacturer.” {Think craft scale here.}
“The wholesale dealer, by taking the goods of the manufacturer off his hands as fast as he can make them, and sometimes even advancing their price to him before he has made them, enables him to keep his whole capital constantly employed in manufacturing, and thus to make a much greater quantity of goods than if he was to dispose of them himself to immediate consumers, or even to retailers.
“A large wholesaler has more capital than a number of small manufacturers, and it may interest him to aid some of them when losses and misfortunes might otherwise be their ruin.” … {paras18,19}
“A relationship of the same kind established between farmers and grain merchants would be attended with effects equally beneficial to the farmers.
“They would be able to keep their whole capitals constantly employed in cultivation. And in case of those setbacks to which farmers are prone, they would find their usual customer, the wealthy corn merchant, a person with the interest and means to support them, instead of having to be entirely dependent, as now they are, upon the forbearance of their landlord or the mercy of his steward.” … [italics added] {para20}
Quite the fairy tale, but a good farmer facing some general adversity, such as drought or too wet a season, severe insect infestation or crop disease, is most likely to be kept on as tenant by the landlord, whereas the wealthy grain merchant has no such interest, for the following year the land will still be farmed regardless, and the dealer’s interest is only in the grain and not with who may grow it.
Also, any large wholesaler is buying diverse goods of many works, some producing a better quality of goods than others. ..Plus, some items would be fairly unique to particular makers, whereas the dealer in grain is buying a commodity undifferentiated between suppliers and is thus indifferent as to its source. ..So, the comparison of grain dealer with wholesaler is a poor one.
Misdirection …
Methinks Adam Smith knew a grain dealer of good standing — perhaps a former student — and likely a younger son whose elder brother inherited a landed estate. And this caused him to be so very excessive in his defence of the excesses of that trade, having swallowed entire a self~serving narrative of that peerless person …as the following does suggest: _{all in paragraph8}
“It is in years of scarcity, when prices are high, that the corn merchant expects to make his principal profit. He is generally in contracts with some farmers to provide him for a certain number of years with a certain quantity of corn each year at a certain price. This contract price is settled according to what is supposed [estimated to be] the moderate and reasonable, that is, the ordinary or average price.
“Thus, in years of scarcity the corn merchant buys a great part of his corn for the ordinary price and sells it for a much higher. … [But] this extraordinary profit is no more than sufficient to put his trade upon a fair level with other trades… [Smith presumes.]
“…and to compensate the many losses which he sustains on other occasions, both from the perishable nature of the commodity itself, and from the frequent and unforeseen fluctuations in its price. ..This seems evident enough from this single [observation:] that great fortunes are as seldom made in this as in any other trade.” … [italics added]
Adam Smith obviously wished to believe all the foregoing, but offers no evidence that any of it may be true.
“The popular odium, however, that attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter it. … the inferior ranks of people impute their distress to the avarice of the corn merchant, who becomes the object of their hatred and indignation … [and who then] is often in danger of being utterly ruined, of having his magazines (storages) plundered and destroyed by their violence.” [emphasis added]
O woe! Let us weep for the greedy sod who deserves, says Mr. Smith, our gratitude for averting a possible famine!
But wait! ..What of an artificial local scarcity induced by sending a shipload or three off to some port in the Mediterranean where prices may be high due to local drought there? ..In fact, it often happened that some part or other along that sea’s coasts would have a short crop.
Smith did not consider such a tactic, that a clever and more daring corn merchant might attempt. Or if not himself, selling to an exporter who would. ..Yet, Smith would needs have defended it in principle, as he always championed “free trade”.
For as Smith, the true believer, put it:.. “The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle that it alone, without assistance, is not only capable of carrying the society on to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often encumbers its operations, though the effect of these obstructions is always, more or less, either to encroach upon its freedom, or to diminish its security.” [italics added] {para43}
The Beneficent Grain Merchant
Specifically applying this natural effort of individuals to grain merchants, here is what Adam Smith believed:
“Corn at no price can be so engrossed (captured) by the inland dealers as to hurt the people. … {para 24} … Nor does forestalling*, buying corn only to sell it in the same market soon after, hurt the people. [For] when a dealer does this, he must judge that the market cannot be so liberally supplied throughout the whole season (year), and so the price must rise. …If he judges wrong, he only hurts himself [assuming competition], but if he is right he renders the people a most important service: …” {para25}
[* Smith was mistaken here, as forestalling means buying grain from farmers directly and then keeping it from going to public sale, in order to induce higher prices getting established in that market.]
“By making them feel the inconvenience of a dearth earlier (scarcity = high price) than they otherwise might, he discourages consumption faster … [which] is for the best, as it divides the inconveniences of it equally as possible through all the months and weeks of the year. … Here the interest of the corn merchant makes him study to do this as exactly as he can — and no other person can have either the same interest, or the same knowledge, nor the same ability to do it so exactly as he, so this important operation of commerce ought to be entrusted entirely to him. In other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free. … [italics added] {para25}
It would, Smith believes, prevent a worse outcome… “It is in the interest of the people that their daily and weekly consumption be apportioned as exactly as possible to the supply of the season. .. And the interest of the dealer is the same. By supplying them as nearly as he can judge in this proportion, he is likely to obtain the highest price and the greatest profit.”
This is wonderful, these high prices? … “Thus without intending the interest of the people, he is necessarily led by a regard for his own interest to treat them in a year of scarcity much as the prudent master of a vessel is at times obliged to treat his crew. ..When he foresees that provisions are likely to run short, he puts the crew upon short rations. … {para3}
“The inland corn merchant from an excess of avarice might raise the price somewhat higher than required, yet the ensuing inconveniences suffered by the people does secure them from a famine before season’s end, which they might have been exposed to by a more liberal policy earlier.” [emphasis added] {para3}
Price is so NOT the sole effective means of rationing a short supply: ..it is pure dogma to say that price is. [See end of this item.] Rationing by quantity per customer of a set amount per month at an elevated, but not extortionate, price would surely have been perfectly possible.
After all, the population was not all that large in the mid 1700s and local distribution could well have been imposed by outside authority. “The market” and whatever prices it throws up is not the only means of distribution. ..Moreover, the rationed quantities could be of flour rather than of grain, rather easier to administer, there being relatively few millers. ..But Adam Smith the dogmatist would have vehemently objected to such a policy, as the next section shows.
Overblown Rhetoric .…
“Over the past three centuries anywhere in Europe, the cause of dearth has always been real scarcity occasioned mostly by weather, though in some particular cases by war.
“…And a famine has never arisen from any other cause than the violence of government attempting by improper means to remedy the inconveniences of a dearth.
“When the government orders all dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market (that is, they refuse to), or if they bring it thither it enables the people to consume it so fast as to produce a famine at the end of the season (that is, before next harvest).” … {para5&7} [italics added]
Which argument is factually wrong — indeed, it is pure rubbish. ..It is the splutter of the dogmatist unable to see clearly due to wearing ideological blinkers.
Famine means starvation, and the problem is not so much a failure to ration supply, as soaring prices placing food beyond the budgets of the lower layer of society, if not some higher up besides. ..Death from starvation itself, or by disease resulting from weakened condition, was always likely among the poor, who most bore the inconveniences of a famine.
In the Irish famine of 1740-1 about thirteen percent of the population died, many from dysentery and other diseases, and thousands emigrated. ..In the great famine of 1693-4 in France, an estimated tenth of the entire population perished. …And the problem was essentially price.
“When an artisan spent [typically] half his income on food for his family, he was in an impossible situation when the price of food quadrupled and his income ceased altogether.” < Unemployment was common that year.> “He was left with no recourse but charity — inadequate in the towns and non~existent in the country.”
From Pierre Goubert’s _ Louis XIV and Twenty Million Frenchmen_ English translation 1970; Vintage Books, New York; p 218.
Smith continues even more outrageously
“The popular fear of engrossing and forestalling may be compared with the popular terrors and suspicions of witchcraft. The unfortunate wretches accused of the latter were as innocent of the misfortunes imputed to them as are the grain dealers theirs. … The law that put an end to all prosecutions against witchcraft [1736] put it out of any man’s power to gratify his own malice by accusing his neighbour of that imaginary crime. … [emphasis added] {para26}
“This seems effectually to have put an end to those fears and suspicions, by taking away the great cause which encouraged and supported them. {That is, the laws against witchcraft.} ..A law that restores entire freedom to the inland trade in corn {apparently there were some restrictions} would likely prove as effectual in putting an end to the popular fears of engrossing and forestalling…” {para26}
Witches, Doctor Smith PhD? _This comparison is so utterly absurd as to be sickly funny. ..Witchcraft was yet a crime forty years’ earlier, while the last witch actually burnt to death in Scotland was in 1727, when Adam Smith was four years’ old. ..Clearly, this would have been an evocative analogy for his readers. _However, while witches don’t exist, greedy speculating grain dealers do. —And Adam Smith stoutly defended them.
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In response to the recent famine in Ireland, there was a proposal in 1741 by a Mr. T. A. Prior to erect granaries in Dublin and elsewhere ‘to prevent any scarcity of corn in the future.’
Two hundred years earlier (circa 1570) the respected Frenchman Jean Bodin had this to say in his Reply to the Paradoxes of Malestroit Concerning the Dearness of All Things …
“The export of wheat should be more wisely regulated than it is. For we witness dearness and intolerable famines for lack of foresight. … The way to regulate this is to have in each city a public granary, as they formerly had in well ordered cities, and each year the old wheat should be replaced. By doing this we should never have such high prices as we [now] see — for besides making provisions for bad years, we would also destroy the monopolies of merchants who store all the wheat … [then] fix the price at their leisure.”