4. Profits and Interest

Entrepreneurial action is action taken due to uncertainty.  If an entrepreneur expects increased demand for a given product, he will invest in factors of production of that product hoping to make a psychic profit, which, other things being equal, is a monetary profit.  He will need to save money first before investing it in production factors, and then invest, and then wait for the profits to (hopefully) materialize later.  To truly benefit from the entrepreneurial action, he will have to gain more in return than he could have by simply renting out the money for the same period of time. 

For example, with an interest rate (rental price of money) is 10%, a $10,000 cash balance can be exchanged for $11,000 in one year’s time.  If $10,000 in invested in a production process and yields $10,500 in the year, then the investment would have been error.  The price spread (difference between income and expenditures, $500) would have to have been greater than the interest income ($1000) for the business to have been profitable. 

Note that in accounting, any positive price spread implies a profit, but in economics, a profit requires the price spread to be greater than the foregone interest income.  Other things being equal, businesses making an economic loss (even if it is an accounting profit) will eventually have to be liquidated and their resources diverted to alternative and more productive uses.

Now imagine a fictitious mental construct called an evenly-rotating economy (ERE).  In the ERE, all value scales and production processes are fixed and repeat themselves in a perfectly predictable manner.  The ERE is the final end state toward which the economy would tend if all disturbing influences (changes in value scales and natural resource supplied) were held at bay. 

With no uncertainty in the ERE, there can be no profits or losses, since profits come from predicting uncertainty more accurately than other individuals.  However, the law of time preference still applies in the ERE, so capitalists will still earn on interest on their investments.  In the ERE, all businesses will yield a “profit” (in the accounting sense) exactly equal to the interest rate, regardless of the product or the stage in production.  (This is barring psychic influences – for example a particularly disliked line of production may yield a slightly higher profit, and a particularly favored line will yield a slightly lower profit)

The role of the capitalist then is to give up present satisfactions - with his saved up funds, he provides an “advance” to labor, landowners and capital goods owners (or buys the land or capital goods outright) – in exchange for future ones.  His income therefore is due to the universal fact of time preference.  The pure interest rate is the interest rate that would be established in the ERE, where there is no uncertainty.  It would be determined entirely by the premium individuals place on present goods over future goods.