A few months ago I suffered my worst computer crash ever [something must have fried the motherboard]; the 3-year-old box was beyond hope. The only way for me to recover was to purchase a new box at Best Buy on a Sunday evening, then return home to install applications and retrieve data from the backups I’d made.
The point of my computer-crash experience: A pleasant surprise unfolded for me at Best Buy. A new box with everything I wanted cost me just a few hundred bucks. Without a doubt, the suppliers made a profit on that Best Buy transaction, and I was happy to hand over my money, fully aware that some percentage of that few hundred bucks was “profit” for the corporations on the other side of the deal. I didn’t care; those companies had become very good at offering better equipment at a lower price every year, and I was happy to accept the offer.
I wonder why so many people think “profit” is a dirty word? I'm sure politics has a lot to do with it, but in any case, I think of profit as a tip I gladly hand over to the businesses who have learned how to supply what I want at a price I can afford. It’s my way of saying to those businesses, “Thank you for supplying a product of this quality at this price; you're offering me a better value than your competitors are. I’m voting with my dollars, and this time your product is the winner.”
In fact, that’s what millions of consumers are thinking, consciously or subconsciously, when they shop at Wal-Mart, or Target, or Best Buy, or Home Depot, or Starbucks. [Believe it or not, it’s also one of the two things I’m thinking when I buy a tank of gasoline at the Chevron or ExxonMobil station; the other is a thought on which I believe I hold a monopoly: “I wish the price of gasoline were at least a dollar a gallon higher; two dollars would be better.” I explained my rationale in "The argument for oil independence" near the end of this ANWR article two years ago.]
Profit isn’t a dirty word; it’s our personal thank-you to effective businesses. What’s more, each of us gets to define “effective” as we see fit: some of us think Target is more effective than Wal-Mart at delivering the value we’re looking for, but others of us think it’s the other way around. Some think Starbucks’ combination of coffee, prices, atmosphere, and conversation is better than that at Charlie’s Diner; others prefer Charlie’s Diner. In all cases, however, we are voting (or abstaining) with our dollars. If a business is doing its job effectively, we tend to vote with our dollars for it to stay in business; if it isn't, we vote against it, or abstain.
It’s easy, and lazy, to assume that the businesses on the receiving end of our dollars are static, immovable, price-fixing fat cats. Businesses that act that way sooner or later get their clocks cleaned by competitors. Businesses get big not by fixing prices on unchanging products, but by continually inventing new products and services, and by continually lowering prices on the successful ones throughout their product life cycles.
Decades ago, the Boston Consulting Group explained the process to us with a chart they called the “Experience Curve.” It’s a simple way to illustrate how “getting smarter” enables effective businesses to reduce prices. Here it is:
The first thing that happens is innovation: somebody or some company invents a new product or service that displaces an old one. It’s expensive to do that, so the price has to be higher in the beginning. Subsequently, if enough people vote for the new product with their dollars. . .
• the supplier gains experience, which
• lowers the cost of production, which
• enables the supplier to reduce the price, which
• attracts more people to buy the new product.
The low-cost producer obviously has the competitive advantage at any point in the product’s life cycle; the other companies are playing catch-up. (A famous example: Henry Ford's price reductions on the Model-T.) Competition and the experience-curve process continue to keep the price falling—until somebody or some company invents a new product or service that displaces the old one. That starts the process all over again at the beginning.
The late management guru, Peter Drucker, said this about innovation and profit:
Joseph Schumpeter insisted that innovation is the very essence of economics and most certainly of a modern economy. . . In the economy of change and innovation, a profit, in contrast to Karl Marx's theory, is not a "surplus value" stolen from the workers. On the contrary, it is the only source of jobs for workers and of labor income. The theory of economic development shows that no one except the innovator makes a genuine "profit"; and the innovator's profit is always quite short-lived.
The “experience curve” for a given product or service enables effective
companies to remain profitable while reducing prices. Smaller profit per unit times a rapidly expanding unit sales volume yields rapidly expanding profits. Innovation
resets the whole curve, and keeps our quality of life improving.
Those are two of the primary dynamics in the microeconomic world of business management, and in our growing macroeconomy. Those
dynamics are overlooked or misunderstood by those who think “profit” is
a dirty word. It isn't; instead, it's a small premium we gladly pay for innovation, and for price reductions through efficiency improvements.
That's the way I think about the money I'm shelling out whenever I buy a hot dog from the street vendor, and whenever I buy a computer at the electronics store—two profitable businesses that earn my dollars by offering the right product at the right place, right time, and right price.
One might be thinking, “What about gasoline prices? They definitely do not behave like the chart above. Chevron and ExxonMobil profits don’t conform to that curve, they go up and down like an elevator; what gives?”
Well, the chart above illustrated the supply side’s minimum price to stay in business. What was missing was the demand-side effect on price: suppliers will of course accept a higher price when customers will offer it. This chart should clear it up: