Rate of profit
Encyclopedia
In economics
and finance
, the profit rate is the relative profitability
of an investment project, of a capitalist enterprise, or of the capitalist economy as a whole. It is similar to the concept of the rate of return on investment.
In Marxian political economy
, the rate of profit (r) would be measured as
where surplus-value corresponds to unpaid labor in the production process or to profits, interest, and rent (property income).
and capital at market value
. Historical cost is the original cost of an asset at the time of purchase or payment. Market value is the re-sale value, replacement value, or value in present or alternative use.
To compute the rate of profit, replacement cost of capital assets must be used to define the capital cost. Assets such as machinery cannot be replaced at their historical cost but must be purchased at the current market value. When inflation occurs, historical cost would not take account of rising prices of equipment. The rate of profit would be overestimated using lower historical cost for computing the value of capital invested.
On the other side, due to technical progress, products tend to become cheaper. This in itself should raise rates of profit, because replacement cost declines.
This, however, means that replacement cost of capital per worker invested, now calculated at the replacement cost necessary to keep up with the competition, tends to be increased by firms more so than sales per worker before. This squeeze, that investments per worker tend to be driven up by competition more so than before sales per worker have been increased, causes the tendency of the rate of profit to fall
. Thus, capitalists are caught in a prisoner's dilemma
or rationality trap.
This "new" rate of profit (r'), which tends to fall, would be measured as
For example, he must invest:
Now, it is assumed that during the year the capitalist can produce and sell commodities at a total price of 300 €. Volume of sales, therefore, is 300 €.
From volume of sales costs of the year must be deducted. Costs of circulating capital
are expenses for “production material” and for labour power, both of them are consumed in production during the year (that is the definition of “circulating capital”):
In total, costs are 275 €.
Sales of 300 € minus costs of 275 € gives a profit of 25 €. 25 € in relation to an initial capital investment of 500 € gives a rate of profit of 5 %. From year to year capital can grow at a rate of 5 %, if all profits are invested or accumulated.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
and finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, the profit rate is the relative profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
of an investment project, of a capitalist enterprise, or of the capitalist economy as a whole. It is similar to the concept of the rate of return on investment.
In Marxian political economy
Political economy
Political economy originally was the term for studying production, buying, and selling, and their relations with law, custom, and government, as well as with the distribution of national income and wealth, including through the budget process. Political economy originated in moral philosophy...
, the rate of profit (r) would be measured as
-
-
- r = (surplus-value)/(capitalCapital (economics)In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
invested).
- r = (surplus-value)/(capital
-
where surplus-value corresponds to unpaid labor in the production process or to profits, interest, and rent (property income).
Historical cost vs. market value
The rate of profit depends on the definition of capital invested. Two measurements of the value of capital exist: capital at historical costHistorical cost
In accounting, historical costs is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of...
and capital at market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
. Historical cost is the original cost of an asset at the time of purchase or payment. Market value is the re-sale value, replacement value, or value in present or alternative use.
To compute the rate of profit, replacement cost of capital assets must be used to define the capital cost. Assets such as machinery cannot be replaced at their historical cost but must be purchased at the current market value. When inflation occurs, historical cost would not take account of rising prices of equipment. The rate of profit would be overestimated using lower historical cost for computing the value of capital invested.
On the other side, due to technical progress, products tend to become cheaper. This in itself should raise rates of profit, because replacement cost declines.
A prisoner's dilemma
If, however, firms achieve higher sales per worker the more they invest per worker, they will try to increase investments per worker as long as this raises their rate of profit. If some capitalists do this, all capitalists must do it, because those who do not will fall behind in competition.This, however, means that replacement cost of capital per worker invested, now calculated at the replacement cost necessary to keep up with the competition, tends to be increased by firms more so than sales per worker before. This squeeze, that investments per worker tend to be driven up by competition more so than before sales per worker have been increased, causes the tendency of the rate of profit to fall
Tendency of the rate of profit to fall
The tendency of the rate of profit to fall is a hypothesis in economics and political economy, most famously expounded by Karl Marx in chapter 13 of Das Kapital Vol. 3. It was generally accepted in the 19th century...
. Thus, capitalists are caught in a prisoner's dilemma
Prisoner's dilemma
The prisoner’s dilemma is a canonical example of a game, analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so. It was originally framed by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W...
or rationality trap.
This "new" rate of profit (r'), which tends to fall, would be measured as
-
-
- r' = (surplus-value)/(capitalCapital (economics)In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
to be invested for the next period of production in order to remain competitive).
- r' = (surplus-value)/(capital
-
Numerical example
At the beginning of a "year" (possibly another length of time period, in this case other numerical values will arise) the capitalist has to invest an amount of capital.For example, he must invest:
- 100 € for wages (variable capital v)
- Furthermore he must invest for constant capitalConstant capitalConstant capital , is a concept created by Karl Marx and used in Marxian political economy. It refers to one of the forms of capital invested in production, which contrasts with variable capital...
c:- 100 € for “production material”
- 100 € for “instruments” (life span 2 years)
- 100 € for “machines” (life span 4 years)
- 100 € for “equipment” (life span infinity).
- In total he invests at the beginning of the year 500 €.
Now, it is assumed that during the year the capitalist can produce and sell commodities at a total price of 300 €. Volume of sales, therefore, is 300 €.
From volume of sales costs of the year must be deducted. Costs of circulating capital
Circulating capital
Circulating capital refers to physical capital and operating expenses, i.e., short-lived items that are used in production and used up in the process of creating other goods or services. This is roughly equal to Intermediate consumption. It includes raw materials, intermediate goods, inventories,...
are expenses for “production material” and for labour power, both of them are consumed in production during the year (that is the definition of “circulating capital”):
- 100 € wage costs (variable capital) – see assumption above.
- 100 € expenses for material – see assumption above.
- costs of fixed capitalFixed capitalFixed capital is a concept in economics and accounting, first theoretically analysed in some depth by the economist David Ricardo. It refers to any kind of real or physical capital that is not used up in the production of a product and is contrasted with circulating capital such as raw materials,...
(depreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
).
- Fixed capital are those means of production, which are in use for more than one year: The capitalist must take into account, that “instruments” and “machines” do not live forever, but must finally be replaced after usage. From sales he must take aside certain sums of money (depreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
) to be able to replace “instruments” and “machines” at their end of life. For “instruments”, the depreciation expense per year is 50 € (100 € purchase cost divided by lifespan of 2 years, straight-line depreciation assumed) and for “machines” 25 € (100 € purchase cost divided by 4 years). For “equipment” there is no depreciation expense, because, in this example, it is assumed, that equipment hold forever, there is no wear and tear for equipment.
In total, costs are 275 €.
Sales of 300 € minus costs of 275 € gives a profit of 25 €. 25 € in relation to an initial capital investment of 500 € gives a rate of profit of 5 %. From year to year capital can grow at a rate of 5 %, if all profits are invested or accumulated.
See also
- ProfitabilityProfit (accounting)In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Return on capital
- Capital accumulationCapital accumulationThe accumulation of capital refers to the gathering or amassing of objects of value; the increase in wealth through concentration; or the creation of wealth. Capital is money or a financial asset invested for the purpose of making more money...
- Tendency of the rate of profit to fallTendency of the rate of profit to fallThe tendency of the rate of profit to fall is a hypothesis in economics and political economy, most famously expounded by Karl Marx in chapter 13 of Das Kapital Vol. 3. It was generally accepted in the 19th century...
- Okishio's theoremOkishio's theoremOkishio's theorem is a mathematical theorem formulated by Japanese economist Nobuo Okishio. It has had a major impact on debates about Marx's theory of value...