Profits a powerful tool to keep firms focused

A simple insight we teach introductory economics students is that for-profit firms strive to maximize profit.

What is more important, however, is that all for-profit firms, from a roadside taco stand to the largest company, receive constant feedback as to how they are doing through the metric of profits and losses.

Economic losses send a clear signal that the firm is doing something wrong and gives it an incentive to change. Economic profits send a clear signal that the firm is doing something right.

Is this system perfect? Of course not! Signals can be misread. Lots of firms incur losses before they become profitable. Today’s profits can quickly erode because of changing conditions.

And of course, profits can be obtained illegally, fraudulently, unethically or by cajoling government to rig the market. Nevertheless, profits are a powerful tool keeping a firm focused and are a pretty clear signal of how well the firm is doing.

A major problem in public enterprises is there are no equivalent signals to profits and losses. Let us examine an area of intense public interests and scrutiny: higher education.

Over the last decade the main funder of public universities, state legislators, have demanded more accountability from the ivory tower. This demand for accountability has emerged for a host of reasons that are for the most part valid. The goal is to generate “better educational outcomes.”

But what exactly does that mean? What metric shall be used to measure “better?” What have emerged are two: the 4-year graduation rates of students and the number of science graduates.

In Indiana a large component of state funding rests on an institution’s “success” on these margins. Yet everyone knows there is much more to higher education than getting through in four years and being a science major. At best this is an imprecise and clumsy metric of success.

For-profit firms are constantly seeking out those margins. Increased profits are an indication that the right ones have been chosen, whereas declining profits or outright losses are an indication of the opposite.

In publicly funded enterprises the process is very different. A government agency thinks up margins of improvement. They then choose the ones that can be measured. They then reward the public enterprise by how well it performs on those margins.

However, because there is no profit mechanism in place how does anyone know whether the chosen margins are the best measures of success, poor measures of success or wrong measures of success? One is reminded of the Soviet nail factory directed to produce one ton of nails that produced a single, very large one-ton nail. Why not direct all faculty members to pass all students independent of performance and insert some ersatz science component in all courses?

Of course, the response of both bureaucrats and administrators is we need more detailed metrics, more studies (state funded of course) and a better managed process. Yet a more complex formula is likely to become unmanageable, open more ways to game the system, generate more unanticipated consequences. It will produce more one-ton nails.

There is simply no good way out of the problem — it is an inherent problem in any not-for-profit enterprise. Most all of us agree that many socially useful enterprises cannot or should not be run for profit.

The argument above is more an observation than a critique. The simple fact is the information given by profits can’t be given if there are no profits.

Cecil Bohanon is a professor of economics at Ball State University. Send comments to awoods@tribtown.com.