Thursday, July 30, 2009

Why Profit Motive Is The Best Way To Ensure The Public Good

My good friend Jackie Danicki has a great post up on why people who talk about "public ownership" are stark raving mad.

Lots of things are owned by the government or state - roads, schools, hospitals, etc. Just because they’re paid for by taxpayers does not mean we own them - coercing “investment” from the public is merely a guaranteed funding model carried out with legally-backed force. (That is to say, if you don’t pay for the government’s stuff, you go to jail and/or they take your money. It ain’t an opt-in payment mechanism.)

If you claim this mad arrangement is ownership, then you must also believe that we as individuals “own” our data on Google or Facebook. Or that we “own” our data through the TSA and other government databases.

I'd like to riff on the same topic, but rather than discuss why "public ownership" is bad, I'm going to focus on why the profit motive is the best way to ensure the public good. Gordon Gekko, eat your heart out.

1) The most direct way of earning profits is to create value for others.

At HBS, we learned that you create value by selling goods and services to a market whose willingness to pay exceeds your own cost to serve. Because commerce is almost always a matter of voluntary choice (unlike the government, legitimate businesses don't have the power to compel obedience through violence), businesses can only succeed if they serve the needs of others.

2) The value of a business depends on the long-term value it creates.

While there are many ways to value a business, the single best way is via a discounted cash flow analysis. This means projecting the future cash flows of a business and then discounting those flows to determine the net present value of the business.

This means that businesses that sell goods that harm their customers will generally be less profitable than those who sell goods that benefit their customers. The latter class of companies have a much easier time building long-term value.

3) The role of government is to provide the rule of law and account for externalities.

There are definite exceptions to the rules of thumb above. For example, the government can grant monopolies and compel consumption; these allow some companies to generate enormous profits even if they don't create value (e.g. Russian oil companies). That is why government should take a passive, rather than active role, focusing on providing a consistent and fair set of rules for commerce.

At the same time, economists admit that there are situations in which externalities arise that aren't accounted for in the buyer-seller relationship. This is the lesson of the Tragedy of the Commons. Things like pollution are externalities that need to be accounted for by a third party, such as the government. (My more libertarian friends would point out that this problem can also be solved by better assignment of property rights, but I'm not that eager to don an oxygen meter to pay by the breath.)


To sum up, the profit motive drives businesses to create value for their customers and consider the long term benefits of their goods and services. The invisible hand safeguards the public good far more efficiently and effectively than any government agency.

(Seriously, why would anyone allow the U.S. Congress to direct the U.S. economy? I wouldn't trust those jokers to run a hot dog stand without going to the taxpayers for a bailout in less than a month.)

The government plays an important role by providing a level playing field and accounting for externalities, but it needs to focus on playing referee rather than coach.


Darrell said...

Though I agree with everything you write...I wonder if your definition of externalities has broadened since the financial crisis hit. When market excesses end in a downward spiral and confidence disappears, shouldn't the government step-in as the lender of last resort and take actions to restore confidence? And in some cases, shouldn't it prevent the downfall of companies who's failure presents a systemic risk? Perhaps limiting the government to playing the role of referee is too limited a role when the market stops functioning normally.

Foobarista said...

The problem is that the more the government does, the more "externalities" it creates. In the banking system, many of the "banking externalities" arise because of the available of FDIC-insured bank deposits available to backstop investment banking trades.

We still haven't dealt with this. You will know that we have when the government forces Citibank and Bank of America to separate their consumer bank parts from their investment bank parts.