Profit at the outset of the neoclassical theory
There is a fundamental difference between classical and neoclassical theories: classical authors generally considered labor to be the only factor of production and, broadly speaking, to be excluded from the product market; in the neoclassical theory, labor is one among many other productive inputs, and it becomes a good like any other. From 1874 onwards, indeed, labor is no longer thought to be the sole factor of production, and, as well as other productive factors, it is given a price. All productive factors, including labor, are thereby conceived as if they were commodities. Thus, Walras undertook a fusion between the product market and the market for productive inputs. This means that, in the neoclassical theory, there is no causal relationship between labor and products. Money - the ‘numéraire’ - is also conceived as a commodity to be exchanged in the same way as any other product. Also, a fusion does occur between production and exchange. In the classical theory, production precedes exchange, for the value of output is thought to be created within the productive phase. In the neoclassical theory, the prices of productive factors as well as product prices are made to depend on the interaction between supply and demand during the exchange phase (Schmitt 1986: 107).
The neoclassical theory is based on the concept of economic equilibrium, within which price determination takes place. Following Walras (1874 : 225), the hypotheses underlying equilibrium in exchange are as follows: the demand for and the supply of production factors (‘productive services’) are equal, their price being stationary; and the demand for goods equals the supply of goods, their price being stationary. A third characteristic concerns instead equilibrium in production: the selling price of goods and the costs of productive factors are equal. Walras viewed equilibria as ‘ideal’ states, both because, in his opinion, the selling price of a product is never equal to its production cost, and because the supply and demand of factors and products are never equal.
With respect to his predecessors from the classical school, Walras introduced something of an innovation into his profit analysis: first and foremost, profit has a tendency to disappear. Let us consider the concept of equilibrium and its implications with regard to profit. Walras believed that the ‘normal’ state of things is to be found in equilibrium, a situation ‘towards which things spontaneously tend under a regime of free competition in exchange and in production’ (Walras 1874 : 224). In this theoretical economic state,
if the selling price of a product exceeds the cost of the productive services for certain firms and a profit results, entrepreneurs will flow towards this branch of production or expand their output, so that the quantity of the product [on the market] will increase, its price will fall, and the difference between price and cost will be reduced.
(Walras 1874 : 225)
A search for maximum benefits drives the producer-seller to sell goods to the buyer-consumer. Yet general economic equilibrium theory does not allow for the existence of profit. In fact, the hypothesis that underlies the neoclassical model of general equilibrium, and according to which companies operate in conditions of perfect competition, implies that selling prices are equal to production costs: since there is no positive margin between the selling price and the cost of production, it is impossible for profit to form (see, for instance, Ullmo 1969: 8-9).
Walras’s theory had an enormous influence on the generations of economists succeeding him. Marshall was an example of this. Despite differences in interests, the technique used by neoclassical authors in all periods differs in no fundamental way from that employed by Walras and, earlier still, by Cournot: the technique of differential calculus applied to economics (see Hicks 1934: 338). One of the most important hypotheses that usually underlies the neoclassical models is to assume that an economy operates in a state of perfect competition. According to Walras, if the equilibrium is perfectly competitive, profit disappears. The entrepreneur is remunerated for managing the productive process. Marshall (1920 : 138-9) identified such remuneration as the reward of the organization (see Hicks 1934: 338).
Over the 20th century, Walrasian price theory was extended to various fields of application. Among the most eminent formalizations of economic equilibrium theory, applied to utility theory, are those of Mosak (1944), Arrow and Debreu (1954), and Debreu (1959) (see also Pasinetti 1986 and Mas-Colell, Whinston, and Green 1995). These are known as pure exchange, or pure preference models, employed in the framework of the subjective theory of value to represent a pure exchange economy, in which price determination takes place during the exchange phase. Other economists, including Pasinetti (1981,1986), prefer to call it a pure utility or pure preference economy, since it is a single individual’s search for maximum utility or satisfaction that motivates the exchange. Such an optimization problem is set in every microeconomic test to establish the minimum expenditure necessary to buy a basket of goods that will provide an individual with a given level of satisfaction or utility.
It is worth mentioning that, once the model is solved, it would appear that relative prices are determined. Whereas ‘[t]o determine also the absolute level of prices, one should at this point go on to introduce money’ (Pasi-netti 1986: 418). However, this issue is likely to deserve further study. Some authors argue that, in the neoclassical theory, the general level of prices, so-called absolute or monetary prices, is indeterminate - in other words, the total value of production remains indeterminate - and that relative prices cannot be determined, either (see, for instance, Schmitt 1984, 1996a; Cen-cini 1982, 2001, 2015; Schmitt and De Gottardi 2003).
Profit and interest: a comment
The existence of profit allows companies to pay interest to capital owners (see e.g. Ullmo 1969: 28). According to Adam Smith, interest is that part of profit necessary to remunerate the owner of capital.
The revenue or profit arising from stock naturally divides itself into two parts; that which pays the interest, and which belongs to the owner of the stock, and that surplus part which is over and above what is necessary for paying the interest.
(Smith 1776 : 657)
Generally speaking, all economists share the idea that interest is the remuneration of the owner of the capital. Such a remuneration is legitimated by the fact that society benefits from the increase in physical production that is enabled by the use of capital. However, some questions remain controversial.
First, although it is a common belief that profit and interest are bounded together, economists disagree with regard to the nature of this relationship. Obstacles arise as soon as a definition of profit is attempted. In fact, without finding a shared answer, economic theory puts the question as to whether profit belongs to the capitalist, understood as the owner of the mediums provided to run the company’s activities; to the entrepreneur, understood as the figure managing business activities or providing the funds and mediums to run them; or to the company, an abstract entity. It is, in fact, very difficult to clarify this matter, notwithstanding the contributions of notable researchers into interest, among whom are Smith, Ricardo, Walras, Wicksell, Bohm-Bawerk, Myrdal, Ohlin, and Keynes. In order to explain the role of the capitalist, the entrepreneur, and the company, the nature of the income made by each of them must be investigated. That is, it might be of high importance to establish whether their incomes are newly created, i.e. production incomes, or whether they are derived or distributed incomes, i.e. of substitution. In other words, it might be necessary to investigate how
profit forms in the hands of companies, entrepreneurs, and capitalists. Such an investigation is an old and controversial one in economic theory.
According to classical authors, or at least according to the English classical school, it is considered an established fact that profit is positive. So far as classical economists are concerned, the existence of a positive profit allows interest to be paid to the capitalist-entrepreneur-company. It is thereby company profit that allows the payment of interest to the capitalist. Walras believed that the classical reasoning in this regard is mistaken.
The theory of interest, especially that of the English School, [. . .] fails to distinguish between the figure of the capitalist and the figure of the entrepreneur. [. . .] That is why the term profit, as they use it, signifies simultaneously interest on capital and profit of enterprise.
(Walras 1874 : 423)
According to the neoclassical theory, a distinction needs to be drawn between the capitalist, understood as the individual who receives interest on capital, and the entrepreneur-company. To the eyes of Walras, interest is the profit of the capitalist. ‘Profits in the sense of interest charges on capital is defined as “a remuneration for the abstinence of the capitalist who has saved the capital”’ (Walras 1874 : 423). From this viewpoint, the role of the entrepreneur coincides with that of the company and should be distinguished from that of the capitalist. Walras maintained that the surplus profit of the entrepreneur-company system is null, since the profit of one individual corresponds to the loss of another.
So far as profit is concerned, in the sense of profit of enterprise [...], the English School fails to see that it is the correlative of possible loss, that it is subject to risk, that it depends upon exceptional and not upon normal circumstances, and that theoretically it ought to be left to one side.
(Walras 1874 : 423)
Walras’s reasoning has been applied to the neoclassical theory of production and growth, according to which the ‘cost’ of capital coincides with the profit-interest of the capitalist. In this theoretical environment, entrepreneurcompany’s profit is considered nil.
Thus, classical and neoclassical theories do not draw a net distinction between the roles of the capitalist, of the entrepreneur, and of the company. In point of fact, even minimal reasoning and observation of our daily reality should be enough to raise doubts regarding the classical and neoclassical theories of profit and interest. It is by no means rare for the entrepreneur to be a company manager who receives a wage-income, or a company shareholder who receives dividends. It is true, of course, that dividends originate in profit. But such profit does not belong directly to the entrepreneur.
Generally speaking, entrepreneurs benefit only when some measure of profit is distributed to them through the payment of dividends. It is therefore reasonable to suppose that the figures of the entrepreneur and of the company should be conceptually differentiated one from the other. At first sight, the entrepreneur’s income would appear to belong to the production income category, inasmuch as it is wage-income; on the other hand, recipients of dividends, including the entrepreneur, receive an income that is most probably a substitution income, since it derives from profit. What has been noted for the entrepreneur applies equally to the capitalist, who might well be either a manager or simply a company shareholder. The interest received by the capitalist may well derive from profit, being thus a distributed income as well as dividends. However, the origin of profit as company income is still to be explained. By failing in this, classical and neoclassical theories alike fail to satisfy the need to explain the nature of incomes accruing to the entrepreneur, to the capitalist, and to the company.