The increase of stock, which raises wages, tends to lower profit.
If you’ve gotten this far, you may have picked up on some general themes that Adam Smith writes about. Two of the most prominent are the interrelated concepts of supply and demand and competition. For example, we discussed how some employments (e.g., garbageman) were naturally less agreeable and thus were more supply-constrained and wages were less bid down by competition than other employments. Profits of stock are another example of the power of these forces. The greater the supply of capital, the greater the competition between capitalists for opportunities, and the lower the profits of stock.
For example, let’s take the fictitious town of Podunk. Podunk was formed when 50 settlers moved there. The main hub of commerce was Main Street where there was a barber, a grocer, and a general store. However, at the start, there was very little capital to go around. Concretely, the barber only had one pair of scissors; the grocer and the general store manager had tiny shops which they could manage themselves. Since capital was so scarce, profits could be high. For example, since the barber had the only pair of scissors in the town, when someone wanted to borrow them he could make them pay a hefty sum. However, over time, they acquired more capital through their profits and their wages. The barber was able to save up enough money to go to the neighboring town and purchase another pair of scissors. Now that they had more capital, they had a need for laborers to employ that capital. This naturally rose demand for wages without a corresponding increase in supply, thus raising wages. In addition, since there was an increase of supply of capital in the market, naturally the price (the profit) of that capital diminished. Capital became more cheap.
Still, it’s not true that capital will become uniformly more cheap. That is, not all uses of capital are created equal; some will garner more profits than others. The primary natural cause of inequalities in profits is the “risk or security” of the business.
This should be pretty self-evident. Let’s say the average return on capital in the market is 10%. That is, for every dollar put it, on average the capitalist is pulling $1.10 out after a year. If there’s an endeavor where there’s a 20% chance of losing all your capital (e.g., carrying products by boat through hazardous waters), profits may need to be much higher to compensate for this higher level of risk. The amount of profit premium will be proportional to (a) the level of risk and (b) whether the average capitalist is risk-averse or risk-seeking. Risk-averse capitalists drive up the profit premium; risk-seeking capitalists bring it down.
Adam Smith also brings up an unnatural cause of high profits. This is the enforcement of laws that constrain supply. In Smith’s time there were ‘corporations,’ which were essentially trade groups that came together to collude and constrain supply. E.g., there could be a ‘Podunk Cobbler Corporation,’ which would have all the cobblers in Podunk as members. Smith describes how these corporations would raise the profits of stock for capital that was employed in towns:
The aim in establishing all corporations and most corporation laws is to prevent his reduction of price, and consequently of wages and profit, by restraining the free competition that would most certainly cause it. In many parts of Europe in earlier times all that was needed to establish a corporation was the permission of the town corporate—the self-governing town—in which it was established. In England a charter from the king was also needed, but the purpose of this seems to have been to extort money from the subject rather than to defend the common liberty against oppressive monopolies. . . . The government of towns-corporate was altogether in the hands of traders and artificers, and it was obviously in the interests of every particular class to ‘prevent the market from being overstocked’, as they commonly express it, which is actually to keep it always understocked. Each class was. . . . obliged to buy the goods they needed from others within the town at a higher price than they otherwise might have had to pay; but in recompense for this they were able to sell their own just as much dearer; so that in the mutual dealings of the different classes within the town none were losers by these regulations. But in their dealings with the country they were all great gainers; and the whole trade that supports and enriches every town consists in its dealings with the country.
In today’s world, although explicit collusion is much rarer, laws can still have a large impact on the profits of stock. Healthcare in the US is the canonical example here. The arcane set of laws and regulations dealing with healthcare are arcane, which adds large barriers to entry. This helps explain why the pharmaceuticals and biotech industries generated the highest average return on invested capital from 1963 to 2004.
