Tuesday, October 4, 2011

The Paradox of Profit-Pt. 2

We have already seen how from the individual perspective the absolute profits of the capitalist (i.e. profits beyond those necessary to repay the capitalist's investment plus some necessary return to stimulate the investment in the first place) represent unearned returns from the productive process which is maintained solely by the input of labor power. Now let us turn and consider the paradox of profit from the perspective of the firm; from the institutional side.

Here we are viewing the productive enterprise, the business firm, as an autonomous entity whose goal is to maximize revenue and ensure continued operation into the future. Let us say that we have a firm that needs to raise money to update its facilities or expand its operations. There are two ways that the firm can raise this money: either it can take a loan from a bank, or it can sell shares of stock to private investors. In the first case the firm takes the money from the loan, invests it in increasing productivity, and then repays the loan plus interest from the returns of that investment. Once the loan has been repaid, the firm itself retains the continuing benefits of its increased revenue.

In the second case, that of selling stock, what the firm is doing is creating a continuing ownership right for the sake of gaining access to a fixed amount of capital input. In this case, the firm sells shares of stock in the company (either newly created shares or old shares held by the company), uses the additional capital to invest in increased productivity, then over time repays the stockholders for their investment. This repayment takes the form of dividends, which, from the firm's perspective, differ from loan payments to a bank in that shares of stock can never be "payed off." That is, after the stockholders have received back, in the form of dividends, the full amount of their initial stock purchase, plus the amount that a bank would have charged for a loan of the same size, the stockholders continue to demand and receive dividends.

Herein lies the paradox. In exchange for a fixed amount of capital, the firm consigns itself to a conceivably never-ending stream of resource expenditure in the form of dividends. And what is more, these expenditures by the firm are totally unproductive, since they drain the company's balance sheet while adding nothing to production. If a firm sells one million dollars worth of stock and pays dividends on that stock such that the buyer receives his full purchase price back in ten years time, after twenty years time the stockholder will have received two million dollars in return for his initial investment of one million (other things being equal, of course). It is obvious that no firm would ever consider taking a twenty year loan from a bank at one hundred percent interest, but this is just what happens in the case of stocks. Also quite apparent is the fact that the actual cost to the firm of the capital gained by selling stock continues to increase over time.

Let us suppose that our imaginary investor decides to sell his stock in the company after twenty years. Unless the investor sells his stock back to the company, the obligation to pay dividends to the new owner of the stock remains, despite the fact that this time the firm has received no additional capital input and despite the fact that the initial investment represented by the stock has already been re-payed, and that at a large premium. The only way for the firm to finally extinguish the debt of continual dividend obligations is to buy back the stock itself. But in this case the scenario is no better for the firm. Assuming the stock price has remained the same, they must now pay one million dollars to recover the ownership interest which has already cost the firm one million dollars (dividends during the second ten year period during which the stock was privately held). Here the paradox becomes explicit; the firm has, in essence, paid three million dollars for the use of one million: a net loss of two million dollars.

The unresolved question now is, given this situation, why would any firm opt raise money through the sale of stock rather than through a bank loan? The simple answer is that, in reality, a firm's purpose is not to produce useful goods and services, or to provide jobs for its employees, or to improve and develop its local community; but rather to create a continual stream of unearned revenue that can be captured by those with the wherewithal to purchase the ownership rights. The solution to this mystery lies in the internal make up of the firm itself and the ways in which relations between the different participants are structured. For, despite what we have assumed here, firms are not autonomous entities trying to maximize their own revenue and ensure their own continued existence. They are an amalgam of different groups of individuals, with different, and often opposing, interests. The havoc and irrationality created by this system will be the topic of a future post.