"The need for profit drives up costs"

I recently saw the claim that the government might be able to deliver health care more cheaply than the private sector because "the need for profits [in the private sector] drives up costs." And I have seen it a number of times in the past.

Well, like Hayek, I am not adverse to the idea that modern Western societies are wealthy enough that we can afford to guarantee everyone some minimal level of health care, and that as a matter of equity we might want to do so. Probably the best way to do that is simply to issue health insurance vouchers to anyone making under $X0,000 per year. Of course this produces some market distortions, of course some people will spend the money foolishly on a scam insurance agency, etc.: but the world is not perfect, right? There aren't any perfect solutions.

In short, I am not opposed to the goal of people who want to offer a base level of health care everyone in United States. But one's means should be suited one's goal, correct?

And "eliminating profit" as a way of "reducing costs" is a nonsensical path to follow. First of all, suppliers in a market cannot raise their prices simply because their costs are high. Imagine a big flea market in Washington Square Park, where there are many people selling tie-dye T-shirts, generally for $10 each. You browse through the various offerings, and are surprised to find one vendor selling seemingly identical T-shirts for $15 each.

"Why do your shirts cost more than everyone else's?" you ask him.

"You see," he explains, "I'm a heroin addict, and I had to buy a $50 bag just to cope with coming to this flea market. So you see, my costs are higher than those of the other vendors."

Only those suffering from "idiot compassion" would be likely to pay this higher price because of this vendor's addiction. Higher costs do not elicit higher prices on the market.

The mistaken idea that higher costs do elicit higher prices is perhaps more understandable when we consider what would happen if the cost of dyes rose precipitously, so that every vendor at next month's flea market was unwilling to part with their shirts for under $15. If someone sees that vendors are still selling some shirts (though a smaller number), they might be tempted to say, "You see, the higher costs drove up the price!"

But we must break what is going on two parts. Higher costs certainly drove up the asking price for tie-die T-shirts: given the new cost of dye, defenders cannot get at least $15 dollars for their shirts, they would just as soon stay home. But those higher costs certainly did not compel anyone to pay this new higher price. In fact, what the lower sales volume reveals to us is that under the new market conditions, only those purchasers for whom tie-dye T-shirts were already worth $15 each are now in the market. In other words, it is not the higher costs that enable vendors to sell T-shirts at $15 each, it is the fact that these T-shirts are worth $15 to some people that enables them to do so.

To confirm this point, imagine that he died became so expensive that vendors could not sell these shirts for under $10,000 each. At that price, we would surely expect their sales to be zilch.

But an even more important is that profits are not cost at all. People who make the claim in the title of this post maybe thinking  of the cost of the capital necessary to provide healthcare, instead of profits. But government provision cannot eliminate such costs, although it may shift them around. If the rental cost for a building used to house a doctor's office is $10,000 per month, the government can either pay that same rent to the owner of the building, or it might seize the building outright, with no compensation. But in the latter case, the cost of providing the building has not gone to zero: it has simply been imposed entirely upon the former owner the building. Perhaps someone thinks such redistribution of costs is just, but it is fatuous to represent it as "lowering costs." Furthermore, even after seizing the building for no compensation, the government still ought to, if it wants to be economically rational, account for the opportunity cost of not employing the building in some other use.

But true profits (as opposed to payments to owners of capital goods) arise when someone discerns how to deploy existing resources more economically than they are currently being employed. Perhaps all of the existing vendors at the Washington Square Park flea market are using dyes produced by process X. But, through entrepreneurial alertness, I notice that dyes produced by process Y are cheaper than those produced by process X, can you create T-shirts equally attractive to those produced by the X process dyes, but instead are being employed in a less remunerative line of manufacturing. So I by the process Y dyes, produce T-shirts using them, and undercut my competition at the park.

Profits, therefore, far from being a factor "driving up costs, and therefore prices," instead are a factor driving down costs. And ultimately, the new conditions of supply created by the search for profit will draw more suppliers into T-shirt market, thus lowering prices.

And lest you think I am merely defining profit in some wacky, idiosyncratic way, let me quote Wikipedia: "Economic profit does not occur in perfect competition in long run equilibrium." Economic profits are not the returns to capital, which do exist in long-run equilibrium, or the evenly rotating economy. Profits are only earned  out-of-equilibrium, by better adjusting the (non-equilibrium) employment of the factors of production to more closely reflect consumer preferences.


  1. While I agree with everything else in the post I'm not convinced it actually disproves "the need for profits [in the private sector] drives up costs." (if "costs" mean the cost to the end user).

    Take your definition "Profits are only earned out-of-equilibrium, by better adjusting the (non-equilibrium) employment of the factors of production to more closely reflect consumer preferences.". When entrepreneurs do this they typically will (for a while) be able to sell their product above the long term equilibrium price for it. In theory at least a non-profit organization might discover the same optimization but choose to set the price to not take advantage of the entrepreneurial profits available.

    Using you Example: You discover process Y and can produce cheaper t-shirts. Until others also adopt process Y you make entrepreneurial profit by selling t-shorts above their long run equilibrium price. A state funded t-shirt collective could discover the same process but immediately reflect the lower costs in the sale price.

    Of course its very likely that the possibility of entrepreneurial profit will drive process improvements and lead to long term reductions in costs. But there would be nothing illogical for a proponent of state-produced t-shirts to claim that they could discover the same process improvements as the private sector and at at any point in time offer lower prices because of the absence of entrepreneurial profits.

    1. "But there would be nothing illogical for a proponent of state-produced t-shirts to claim that they could discover the same process improvements as the private sector and at at any point in time offer lower prices because of the absence of entrepreneurial profits."

      Hmmm... OK, but:

      1) Usually these people aren't actually talking about profits at all: they are talking about the returns to capital. And state enterprises have to account for that somehow if they are to do honest accounting.
      2) And as you note, without the lure of profit, state enterprises usually don't innovate very much. So, in the real world, we get lower costs due to the search for profit, not higher costs.

      But I grant we can IMAGINE a State enterprise acting as you posit.

  2. Instead of ACA, they should have banned employers from providing health insurance, phasing it out over a couple years. This would have created a real market, rather than a pool dominated by people who are sure losers from insurance companies' perspective.

    But that would have taken real political courage, and made the ultimate goal of single payer health care that much less likely.


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