We examined how firms in a simple monetary economy adjust their prices in historical time according to the mismatch between supply and demand. Now we will start to turn our attention to how firms adjust the scale of their production.
Imagine you control the decisions of a corn-producing firm. As before, assume you wish to operate the firm such that, at the very least, it continues as an ongoing concern. Ask yourself: How would you decide how much corn to produce?
In a market economy, you need money. And if you want to ensure the firm continues as an ongoing concern then you need to pay attention to profit and loss.
Define the residual income of a firm as its total income from the sale of goods minus its input costs (over a period of time). For example, the total income of a corn-producing firm is the total price of any corn it manages to sell in the market, minus the cost of seed corn (to replace the sown corn), the cost of iron (to replace any tools that wear out) and the wages of farm hands. (The firm might also pay interest on loans, as a cost of production, but we postpone discussing this very important issue. Hopefully there’ll be a reward for waiting).
The firm’s residual income might be positive or negative depending on the prevailing price structure. A positive residual income means you sell corn at a higher price than its cost of production, whereas negative residual income means your corn sells at less than its cost.
But why are we talking about “residual income”? Why not simply talk about “profit” and “loss”?
The language of political economy is not neutral and often smuggles in ideological baggage. Sometimes we need to introduce a new distinction in order to see social reality more clearly.
The term “profit” is almost exclusively associated with a specific distributive rules that are part of the contractual structure of a capitalist firm and therefore deeply embedded in the societies we live in. “Profits” are what the capitalist owners of a firm receive (and “losses” are what the capitalist owners are liable for).
In fact, the term “profit” is so indissolubly bound up with capitalism that some Marxists automatically think that any kind of profit whatsoever is necessarily exploitative and therefore unacceptable. This attitude is the mirror image of pro capitalist ideologues who equate the use of money as a technology of coordination as necessarily implying or justifying capitalist property relations. Yet monetary economies predate specifically capitalist social relations by about two millennia.
So, in order to talk precisely about the economic phenomena, we need a new term for predistributive profit, i.e. the residual income that a firm receives independent of who owns the firm and who controls its distribution (e.g., to equity holders, or the government if it’s state-owned, or working members if it’s a co-op).
In this sense, all industrial profits (and losses) are created equally, since ultimately they consist of the residual income of firms. But their social meaning very much depends on how those profits (and losses) are subsequently distributed. Profit, in the form of residual income, is predistributively innocent, neither exploitative or socialised but merely a sum of money that is the difference between a firm’s revenue and its costs of production.
(Marx, who knew a thing or two about the theory exploitation, explicitly states, in Vol. 3 of Capital, that worker-owned cooperatives “overcome the antagonism between capital and labour” and should be considered “as forms of transition from the capitalist mode of production to the associated one”. Why? Because the residual income (profit) of a worker co-op is democratically distributed to its working members.)
We haven’t yet specified who owns the firm, and we haven’t specified any distributive rules. So, for the time being, we will talk about residual income (rather than profit).
Back to the main question: how do you decide how much corn to produce?
Well, if the firm has positive residual income, then you could go for broke, and spend all the firm’s stock of money on input goods, in order to produce as much as possible. This way, you’d convert all the firm’s cash into saleable goods to maximise income (and increase the chance that the firm continues as an ongoing concern). The problem with this strategy is that you operate in a competitive environment, and prices will change while production takes place. By the time you’re ready to sell to the market you might be in for a shock.
Similarly, if the firm has negative residual income, you could shut down all production, and stop producing corn altogether. This way, you avoid any loss of income and preserve the firm’s money stock. But, again, prices can change, and you might miss an opportunity to sell some corn and gain income.
A more reasonable, and balanced strategy, is to adjust how much corn the firm produces according to the level and sign of the firm’s residual income. You increase the scale of production if the firm is making a profit, and reduce the scale of production if it’s making a loss. We’ll step into the details, and consequences, of this adjustment process next time.