Classical and neoclassical theories of profit

The beginning of modern political economy is to be traced back to the Tableau économique of Francois Quesnay (1758), to Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations (1776), and to David Ricardo’s On the Principles of Political Economy and Taxation (1817). Prior to modern economic theories, as Deane puts it (1978: 1—2), the epochs of economic thought can be associated with classical Greek authors, medieval scholastics, and the mercantilists.

In ancient Greece,

[without wages and interest [. . .] there could not be a theory of prices in any modern sense. Prices derive in one way or another from production costs, and production costs were not a visible function in the slaveowning household. So it remained for Aristotle to ask only whether prices were just or fair, a concern that would be central to economic thought for most of the next two thousand years.

(Galbraith 1987: 13)

During the Middle Ages in Europe, the scholastics and the mercantilists developed the concept of a fair or just price or justum pretium, as they called it in Latin. The just price was conceived, by some, as the fair price that allows the buyer to maintain his or her status, or, by others, as the market price (on this, see, for instance, Hagenauer 1931; Schumpeter 1954 [1994]; De Roover 1958; Baldwin 1959; Deane 1978; Pasinetti 1986).

No systematic attempt to study profit was made before the 18th century (Deane 1978: 4; Pasinetti 1981; Galbraith 1987). The transition from the pre-theoretical to the theoretical level took place thanks to classical authors, who paid increasing attention to wages, profit, and capital. The industrial revolution was the phenomenon that drew the attention of economists to the study of profits and capital accumulation (see, for instance, Pasinetti 1981, 1986). In the 18th century, authors started developing some theories of value. As noted by Pasinetti (1986: 414), ‘[t]he approach to discussions on value changed dramatically towards the end of the eighteenth century.

From the ethical pronouncements on value, writers began to move on to theories of value’. Moreover,

Over most of the modern life of economics [...] the theory of value and the theory of distribution [. ..] have been the ultimate concern. It is still thought that economics came of age when these two matters were tackled systematically in the latter part of the eighteenth century.

(Galbraith 1987: 6)

In the 19th century, theorists ‘narrowed themselves down to a choice between two quite different and alternative routes. Namely, the “objective” route of a cost-of-production and, more particularly, of a labour theory of value’ (Pasinetti 1986: 414), which is to be identified with the classical school; ‘and the “subjective” route of a “marginal utility” theory of value’, or ‘pure exchange economy’ (Pasinetti 1986: 414), namely the theory that became to be known as neoclassical. What concepts of profit were proposed by the best minds of the last three centuries? Did economists share, from Adam Smith to David Ricardo, from Karl Marx to Léon Walras, a common theory of profit?

The old quest for the surplus

The first theories of profits were worked out in the 18th century, mainly through the contributions of the Physiocrats and the Classical.

On the one hand, the Physiocrats were interested in the study of public policy ‘with respect to trade and taxation; and to this end they fashioned the concept of an “economic order’” (Dobb 1973: 39-40). Accordingly, as claimed by Dobb (1973: 40), they were investigating on the ‘physiology of economic society - with procedures and rules of its own to which governmental policy must be adapted if not subordinated’. The economic system of the Physiocrats was made up of three social classes: landowners; agricultural workers, the sole productive class; and artisans, who produced manufactured goods from raw materials. The latter two classes existed at subsistence level: their output continually reproduced so as to maintain ‘productive consumption’ over time. The sole net product was derived from nature and it was considered a surplus, a profit to be transferred to landowners, who consumed the product received from the other two classes. Quesnay (1758) represents this conception of the economy in his famous Tableau économique. Following a traditional reading of the Tableau, nature, through agricultural activity, supplies the net product necessary to restore the initial situation so that the circular process of production can start all over again.

On the other hand, the origin of the classical school, as well as the founding year of political economy, may be traced back to 1751, albeit economics, at that time, was considered to lie within the field of moral sciences. It was in 1751 that Adam Smith was appointed to a teaching position in logic at the University of Glasgow, where he also held the Chair of Moral Philosophy from 1752 to 1764. Smith sought to build an economic theory ‘within the ambit of moral philosophy as a normative study of society’ (Deane 1978: 13), where economic norms are related to a ‘moral [. . .], a philosophical rather than a logical or mathematical discipline’ (Deane 1978: 13). The classical school conceived individual interests and competition as the pillars of a ‘well-ordered society’ where ‘each man works for others, while believing that he is working for himself’ (Dobb 1973: 41). The Classical as well as the Physiocrats were interested in normative economics, being ‘philosophic system-builders concerned to establish the nature of the laws underlying the total socioeconomic order - as it was and as it ought to be’ (Deane 1978: 5).

Classical authors, including Smith (see 1776), Jean-Baptiste Say (1821 [1971]), and David Ricardo (1817), conceived the society as divided into three social classes - namely laborers, capitalists, and landlords - and, accordingly, they studied the subdivision of national output into wages, profit, and rent. Therefore, ‘it is not too fanciful to argue that the roots of the [. . .] theory’ of profit ‘may be observed in the work of certain classical economists’ (Wood 1975: 10-11).

One of the first classical inquiries into the existence of profits was made by Smith in 1776 (see Meek 1954 on this regard). According to the classical thinker, ‘[i]n that original state of things, which precedes [...] the accumulation of stock, the whole produce of labour belongs to the labourer’ (Smith 1776 [1981]: 82). Once it accrues to specific individuals, a stock shall be used as a means to carry out productive activities and, ultimately, to make a profit (Smith 1776 [1981]: 66). Through the exchange of produced goods, profit shall be made by those who advanced the stock.

In exchanging the complete manufacture either for money, for labour, or for other goods, over and above what may be sufficient to pay the price of the materials, and the wages of the workmen, something must be given for the profits of the undertaker of the work who hazards his stock in this adventure.

(Smith 1776 [1981]: 66)

Hence, as turns out from the Wealth of Nations, laborers earn wages and the capitalists earn profits. ‘The revenue derived from labour is called wages. That derived from stock, by the person who manages or employs it, is called profit’ (Smith 1776 [1981]: 69). Profits are conceived as the excess of revenues over the costs sustained by the capitalist. ‘Though the manufacturer has his wages advanced to him by his master, he, in reality, costs him no expense, [. . .] wages being generally restored, together with a profit’ (Smith 1776 [1981]: 330). Wages and profits are conceived as revenues that differ the one from the other. ‘In the price of commodities [. . .] the profits of stock constitute a component part altogether different from the wages of labour, and regulated by quite different principles’ (Smith 1776 [1981]: 66).

In the Wealth of Nations, the price of products is always made of three components: wages, rents, and profits.

[T]he whole price of any commodity must still finally resolve itself into some one or other, or all of those three parts; as whatever part of it remains after paying the rent of the land, and the price of the whole labour employed in raising, manufacturing, and bringing it to market, must necessarily be profit to somebody.

(Smith 1776 [1981]: 69)

Being made of three parts, any price allows for the remuneration of the three social classes, which live on wages, profits, and rent. ‘In the price of flour or meal, we must add to the price of the corn, the profits of the miller, and the wages of his servants’ (Smith 1776 [1981]: 68). Yet, compared to wages and profits, rents appear to be of less importance: ‘[w]ages and profit accordingly make up, upon most occasions, almost the whole of their high price’ (Smith 1776 [1981]: 191).

Smith’s cogent contribution met with great success at the time of its publication in 1776. Nonetheless, another Scottish author had already advanced some ideas on profit a few years before. Indeed, James Steuart was one of the very first authors to write about the concept of profit. In Book II, Chapter VIII, of his Inquiry into the Principles of Political Economy (1767), Steuart classified profit into three categories, which he called ‘positive’, ‘relative’, and ‘compound’. Positive profit corresponds to an increase in the general wealth of society, whereas relative profit turns out to have an impact on the allocation of wealth between individuals:

Positive profit, implies no loss to any body; it results from an augmentation of labour, industry, or ingenuity, and has the effect of swelling or augmenting the public good. [.. .] Relative profit, is what implies a loss to somebody, it marks a vibration of the balance of wealth between parties, but implies no addition to the general stock.

(Steuart 1767: 206, Vol. 1)

Compound profit was conceived by Steuart as a combination of the other two, which may happen to exist both at the same time. ‘The compound is easily understood; it is that species of profit [. . .] which is partly relative, and partly positive. I call it compound, because both kinds may subsist inseparably in the same transaction’ (Steuart 1767: 206, Vol. 1). The work of James Steuart never attracted as much attention as the contributions of major classical political economists, such as Smith, Say, and Ricardo.

It must be observed that the division into social classes is a fil rouge of classical writings, where profit is usually conceived as the income of the capitalist class. Yet, profit acquires a broader sense in Jean-Baptiste Say’s Treatise on Political Economy, first published in French in 1803 - the English translation dates back to 1821. Profits, in the Treatise, are conceived as the revenues of each individual as well as the revenues of each social class. On the one hand, the national revenue is made up of the total revenues made by individuals. ‘The whole amount of profit derived by an individual from his land, capital, and industry, within the year, is called his annual revenue. The aggregate of the revenues of all the individuals, whereof a nation consists, is its national revenue’ (Say 1821 [1971]: 318). On the other hand, the total value of the product was thought to be subdivided into three portions, or three kinds of profit, each corresponding to the income of the class that receives it (see Say 1821 [1971]: 317). Landowners receive the ‘profit of land’ and at times they distribute it to the ‘farmer’. The capitalists, who advance or lend capital, receive their quota of income, which is called ‘profit of capital’. Workers receive an income called ‘profit of labour’.

Say argued that, through production, individuals make profits according to the value added by them to the product:

in whatever class of industry a person is engaged, he subsists upon the profit he derives from the additional value, or portion of value, no matter in what ratio, which his agency attaches to the product he is at work upon. The total value of products serves in this way to pay the profits of those occupied in production.

(Say 1821 [1971]: 68-9)

In individual terms, the profit of someone was conceived by Say as someone else’s loss (Say 1821 [1971]: 307). In this context, profits were conceived as the difference between income and expenditure: ‘[t]he profits of an individual are limited to the excess of his income above his expenditure, which expenditure, indeed, forms the revenue of other persons’ (Say 1821 [1971]: 318). Yet, throughout his life, Say was never able to provide a proper explanation of the laws underlying the existence of profit.

In the first decades of the 19th century, David Ricardo surged as one of the most influential classical economists. Ricardo, in the Foreword to his Principles of Political Economy (1817), argued that the object of investigation of economics is the determination of the laws governing the distribution of income. This was identified as ‘the starting point common to all the economic theories of income distribution’ (Pasinetti 2000: 188), from a perspective that goes beyond the physiocratic conception of the natural system, and according to which the product of nature was regarded ‘as “by far” less important than those connected with the process of production’ (Pasinetti 1981: 6). It should be observed that Ricardo’s intellectual contributions are contained in The Works and Correspondence of David Ricardo, edited by Piero Sraffa in collaboration with Maurice Dobb (1951-73 [2004]), as well as in Pierluigi Porta’s book from 1992. As Porta recalls (1992: x), the collection edited by Sraffa does not contain Ricardo’s Notes on Malthus’s Measure of Value, which were rediscovered in 1943, together with the Mill-Ricardo Papers. From the content of these papers, it emerges that Ricardo thought that goods do have an absolute value (see Porta 1992: x). Yet, failing to find it, Ricardo grew convinced of the ‘impossibility of attaining a perfect measure’ of value (Porta 1992: xiv).

A well-known interpretation of the Ricardian economic system is given by Pasinetti (1960). See also, among others, Davidson (1959), Barkai (1959, 1965), Samuelson (1959), Garegnani (1960 [1972]), and Casarosa (1978). However, Ricardo’s many interpreters have had difficulty in concisely stating his complete system, ‘and the reason lies in the peculiarity of some of the concepts he used which are not always defined in an unambiguous way’ (Pasinetti 1960: 78). Ricardo has a number of merits. For instance, he largely carried out a ‘differential theory of rent’ (Pasinetti 2000: 189) - although it had already been proposed by James Anderson in 1777 (Pasinetti 2000: 385) - the ‘principle of diminishing returns’ (Pasinetti 2000: 189), and a ‘subsistence theory of wages’ (Deane 1978: 62). In line with other classical economists, Ricardo also sought to study the relation between wages, profits, and rents.

Global output, in Ricardo’s analysis, is made of the aggregation of wages and profit. In particular, as stated by Garegnani (1960 [1972]: 9-10):

[t]he quota constituting wages is determined when [...] wages are fixed at a given level [...]: the excess constitutes profits. [...] The relationship between the value of such excess and the value of the entirety of goods attributed to workers as wages determines the rate of profit.

Interestingly, rents from land are not conceived on the same conceptual level as wages and profits - a peculiarity of the Ricardian system. Rents indeed are thought as included into profits: deriving from profits, rents are an income of distribution. As argued in An Essay on The Influence of a Low Price of Corn on the Profits of Stock, ‘[i]n treating on the subject of the profits of capital, it is necessary to consider the principles which regulate the rise and fall of rent; as rent and profits [. . .] have a very intimate connexion with each other’ (Ricardo 1815 [2004]: 9, Vol. 4). ‘Rent [. . .] is in all cases a portion of the profits previously obtained [...]. It is never a new creation of revenue, but always part of a revenue already created’ (Ricardo 1815 [2004]: 19, Vol. 4).

Following an intense exchange of opinions with Thomas Malthus, Robert Torrens, and Edward West, among others, Ricardo came to believe that the value of the product is made of two components. The first part of value corresponds to the labor bestowed in the product, and it is called wages. The second part of value corresponds to the value of capital, added by the capitalists and measured as accumulated labor. Indeed, in the Note on Absolute Value and Exchangeable Value (1823 [2004]), Ricardo argued:

[t]hat part of the value of a commodity which is required to compensate the labourer for the labour he has bestowed upon it is called wages, the remaining part of its value is retained by the master and is called profit. It is a remuneration for the accumulated labour which it was necessary for him to advance, in order that the commodity might be produced.

(Ricardo 1823 [2004]: 380, Vol. 4)

The classical concepts of profit never merged into a unitary theory, and over time, they were consigned to oblivion by the great majority of economists. In the second half of the 19th century, the theory of profit proposed by Karl Marx - the theory of surplus value - drew the attention of a great number of intellectuals.

An old impasse

In his Capital (1867 [1982]), Karl Marx investigated the nature of profit and the laws of its monetization. Yet, as it shall be observed hereafter, Marx was not able to explain the existence of monetary profits.

Marx rejected the idea that profit is made through exchange, as argued for instance by Adam Smith and Thomas Tooke. Indeed, in the Capital, the exchange of goods does not give rise to profit, but rather to the distribution of values. To support his argument, Marx provided the following example:

A sells wine worth £40 to B, and obtains from him in exchange corn to the value of £50. A has converted his £40 into £50, has made more money out of less, and has transformed his commodities into capital. Let us examine this a little more closely. Before the exchange we had £40 of wine in the hands of A, and £50 worth of corn in those of B, a total value of £90. After the exchange we still have the same total value of £90. The value in circulation has not increased by one iota; all that has changed is its distribution between A and B.

(Marx 1867 [1982]: 265, Vol. 1)

Being impossible for profit to arise from exchange, the subdivision of total income into wages and profit, a concept inherited by Marx from Ricardo, was sought out at another level. Indeed, Marx wrote: ‘[w]e have shown that surplus-value cannot arise from circulation [...]. [C]an surplus-value originate anywhere else than in circulation [. ..]?’ (Marx 1867 [1982]: 268, Vol. 1).

According to Marx (1867 [1982]: 317, Vol. 1), capital and profit are strictly related the one to the other (on this, see also Garegnani 1960 [1972]). The Prussian author conceived capital as subdivided into two parts. The first part, made up of the ‘means of production, i.e. the raw material, the auxiliary material and the instruments of labour’, was defined as ‘constant capital’. The second part was defined as ‘labour power’, made of ‘those mental and physical capabilities existing in the physical form, the living personality, of a human being, capabilities which he sets in motion whenever he produces a use-value of any kind’, and which, all together, were defined as ‘variable capital’ (Marx 1867 [1982]: 271, Vol. 1). To the eyes of Marx, when profit is made, capital comprises a constant part, a variable part, and profit itself. Therefore, profit would originate from capital and would feed it. Further on, we shall develop a critical assessment of the theory of surplus value, drawing on Cencini and Schmitt (1977).

What makes it impossible for profit to form through the circulation of goods is the ‘law of exchange’, a law shared by classical authors according to which heterogeneous products can be exchanged between each other only provided they have equal values. In particular, price and value are necessarily equal one to the other, for the price is the monetary expression of value. It is Marx himself who wrote this explicitly:

Price, taken by itself, is nothing but the monetary expression of value. [. . .] Looking somewhat closer into the monetary expression of value, or what comes to the same, the conversion of value into price, you will find that it is a process by which you give to the values of all commodities an independent and homogeneous form.

(Marx 1898 [1969]: 16, emphasis in original)

Therefore, the direct consequence of the law of exchange is that profit cannot form during the circulation of goods, since the exchange of equivalents gives rise to no monetary gain of any sort.

Given this state of things, Marx came to believe that the origin of surplus value lies in the productive process. ‘The value of a commodity is expressed in its price before it enters into circulation, and it is therefore a pre-condition of circulation, not its result’ (Marx 1867 [1982]: 260, Vol. 1).

In this context, human labor is conceived as the sole source of value. Wages correspond to a share of total output value, the remaining part being equal to monetary profit. Indeed, according to a ‘conventional view’ (on this, see Wood 1975: 11-12), both Ricardo and Marx, among others, conceived profit as a residual between output per capita and the subsistence wage. (On this, see, for instance, Robinson 1942; Kaldor 1956). This interpretation of the Capital, however, is not the only one to be found in economic literature; in this regard see, for instance, Wood 1975). Marx attempted to explain such division of the product into wage-goods and profit-goods, or monetary wages and monetary profit, by introducing a particular commodity: labor power.

Labor power was identified as a particular commodity sold by each worker in exchange for monetary wages. By spending wages, then, workers shall purchase subsistence goods they have themselves produced. Wages measure the value of those goods or revenue that shall be purchased by workers for their subsistence. Money is ‘in the hands of the worker as the money form of his wage, [.. .] i.e. as the money form of the revenue that he receives from the [. . .] sale of his labour-power’ (Marx 1867 [1982]: 515, Vol. 2).

Further, workers produce a stock of goods - profit-goods - that is gratuitously appropriated by the capitalists. Therefore, surplus value or profit was conceived by Marx as the ‘difference between total labor and labor absorbed by wages’ (Cencini and Schmitt 1977: 20, our translation). Since real wages represent that part of the total product that ends up in the hands of workers and allows for their subsistence, real profit is that part of the total product that ends up in the hands of the capitalists. ‘[T]his appropriation is permitted by the particular nature of the labor-power commodity’ (Cencini and Schmitt 1977: 19, our translation).

In the Capital, real profit forms during the productive process, whereas its monetary realization must somehow take place through the circulation of goods. Yet, Marx acknowledged that surplus value cannot form from the sale of profit-goods. The wage-fund, the capital used to pay out wages, is recovered by the capitalists once wage-income is spent by workers in the purchase of wage-goods. It follows that, since capital reproduces and maintains at a constant level, profit-goods are unsalable. Indeed, in this reproductive process, there is no way for monetary profit to form out of the expenditure of wages. ‘Thus the question is not: where does surplus-value come from? But rather: where does the money come from which it is turned into?’ (Marx 1867 [1982]: 404, Vol. 2). Although Marx made some further attempts to understand the nature of monetary profit, the problem was left unsolved.

From approximately the 1870s onwards, Léon Walras’s general equilibrium theory came to the fore as an alternative to classical economic theories. Walras’s theory marked the beginning of what, at the present time, is known as mainstream or orthodox economics. According to Pasinetti (1981: 12), the success of the neoclassical theory is likely to be due to the combination of two features of that time, namely Marx’s Capital and the ‘widespread social unrest’ in Europe. On the one hand, Marx’s vision of the capitalistic system as a transitory phase from the Middle Ages to a future socialist system had distanced economic theory from the Classical theory, which had ‘accepted the society in which they lived as part of the order of Nature’ (Pasinetti 1981: 12). On the other hand, *[i]t is worth recalling that the whole of Europe had just been under the impact of shivering revolutionary waves’, such as the formation of the first Socialist International in 1864, and ‘the first communist revolutionary attempt ever to be made (the Paris Commune, March-May 1871)’ (Pasinetti 1981: 13). These two features were likely to be perceived by the bourgeoisie as a threat to the capitalist system, and hence to the existence of the bourgeoisie itself. It should also be noted that, laying socio-political reasons aside, the success of the neoclassical theory was due to the failure of classical authors to carry out a convincing theory of value. At the end of the 19th century, the neoclassical theory seemed to be a breath of fresh air in economic ideas.