Earlier (in Chapter 7) we saw how the price system could be used to signal where a new building would produce the greatest social happiness. If 2000 square foot homes are selling for $160,000 in suburban Detroit and $120,000 in Ann Arbor, Michigan, then greater happiness would be produced if a new home were built in Detroit rather than Ann Arbor. Note, however, that we have never said whether or not a new home should be built; we have only stated where the new home generates the most happiness. Deciding if society should build a new home is somewhat more complex.

Building a new home diverts a lot of valuable resources from other happiness-producing activities. The cement that will be poured to lay the new home's foundation could have been used to build swimming pools in suburban Atlanta. The carpet used to line the floors of the new home could have been used for a new apartment complex in Duluth, Minnesota. The wiring and electrical materials that will be employed in the walls of the new home could have been used for building electrical components in the dashboards of new Chevy pickups. How can we know that the private contractor (the firm) will make the right decisions in taking these resources away from these other activities and diverting them towards the production of a new home?

Let's first think of how we would want firms to behave in an ideal world. If we could fill out a job description for our firms, we would put down "maximize society's happiness." This is admittedly a little vague, so we'll try to be more specific. Since firms are resource owners, we'd like them to DIRECT RESOURCES FROM LOW-VALUED USES TOWARD HIGH-VALUED USES.

Just our luck! The firms in the real world don't give any thought to doing what is best for society. In a free market economy, firms are interested in only one thing...PROFITS. Making more money, maximizing their incomes, that is what interests firms. But is profit lust a good thing? Shouldn't people come before profits? Before answering these questions, let's examine this thing called profits. While we promised that we would not resort to fancy formulas and high-level mathematics, here's one equation that will prove absolutely crucial for appreciating what firms do.

Profits are the difference between revenues and costs. Now think. How are a firm's revenues determined?

Or, more simply, a firm's revenue is its total dollar income. What information is contained in a firm's revenues? We already know the information contained in the price of output goods. The price of an output good tells us the gain in happiness that society receives from having one more unit of the output good. If we multiply this by the number of output units sold, we see that REVENUES PROVIDE A MEASURE OF HOW MUCH TOTAL HAPPINESS THE FIRM CREATES FOR SOCIETY THROUGH ITS PRODUCTION OF GOODS AND SERVICES.¹

To complete the story, compare revenues with the cost side of the firm's accounting sheet.

In our example of Reginald Buford the kumquat farmer, total costs equalled the price of the land ($23,000), plus Reginald's own cost for his labor, ($20,000), for a total cost of $43,000. Of course, this was a simplistic example. A more realistic description of costs would include kilowatts of electricity, hours of secretarial assistance, tons of cement, and many other types of inputs.

Consider the information contained in a firm's COSTS. We know from our previous hard work that the price of an input good tells us the loss in happiness that society suffers from having one less unit of the input good. When a firm chooses to employ a given input, say a ton of cement, it deprives the rest of the economy of the use of that input. For example, if the price of cement is $600 per ton, we know that consumers will be foregoing approximately $600 in happiness because that cement will no longer be available to produce alternative goods such as swimming pools and shuffleboard courts. If 150 tons of cement are required to build ten new homes, then the firm's cement costs will be $90,000 ($600 X 150). The economic interpretation of those costs is that building those two homes has resulted in $90,000 less happiness elsewhere in the economy because that cement is no longer available to produce other things. Applying this logic to all the firm's costs, we see that COSTS PROVIDE A MEASURE OF THE TOTAL LOSS IN HAPPINESS THE FIRM CAUSES FOR SOCIETY BY WITHDRAWING RESOURCES FROM OTHER USES.²

And now, for the pièce de résistance...(drum roll, please). Look what happens when we put revenues and costs together to obtain profits. If revenues tell us the gain in happiness from the goods and services supplied by the firm, and costs tell us the loss in happiness caused by using up resources to produce those goods and services, then PROFITS PROVIDE A MEASURE OF SOCIETY'S NET GAIN IN HAPPINESS GENERATED BY THE FIRM AS IT TRANSFERS RESOURCES FROM OTHER USES TO THE PRODUCTION OF ITS OWN GOODS AND SERVICES. Incredibly, profits provide the ultimate measure of whether a given firm is making society better or worse off.

Meditate for a moment on the human drama that is represented by the following home builder's income statement.

Most people would just look at this income statement and see a bunch of numbers and not realize the amazing story that it represents. But we know better. These numbers represent a chapter in the saga of humanity's never ceasing struggle to carve out a better life from an inhospitable world. It is the story of a firm that made the world a happier place. By redirecting resources such as cement, labor, wood, etc. away from LOWER VALUED USES, and using them instead for the HIGHER VALUED USE of building homes, this--dare we say, heroic?--firm produced an increase in society's happiness of $100,000. Once we understand what's going on, reading firms' income statements becomes a moving, emotional experience. It almost makes us want to run out and become accountants (if only we had the personality for it!).

The supply curve represents the horizontal summation of each firm's marginal cost curves. As such, the height of the supply curve at any given quantity represents the marginal cost of producing that particular unit. As discussed previously, the height of the demand curve represents the willingness to pay of the marginal consumer for that particular unit. Thus, the distance between the demand and supply curve represents the difference between the marginal consumer's willingness to pay and the marginal costs of production for that particular unit of the good. When summed over all the units of the good produced in the market, one obtains the area in the graph below, which should be familiar as the "welfare gain" associated with the market, otherwise identified as the sum of "consumers' and producers' surplus."

 The claim in this chapter is that a firm's profits measure the net gains in happiness from a given resource transfer. The key assumption needed to justify this claim is that the willingness to pay of the marginal consumers associated with the firm's output must be equal to the price of the good. However, as long as the firm comprises a small component of the market, then it is a "price taker," which means that the demand curve facing the firm is horizontal at the market price. This is the situation represented in the graph below.

The shaded area--that is, the area between the firm's demand curve, representing the willingness to pay of its consumers, and the firm's marginal cost curve--identifies the firm's profits from production. It also identifies the welfare gains received by society from the marginal firm's production. Once one recognizes that every unit of production represents a "resource transfer," then it should be seen that the claim of this chapter is a straightforward deduction of conventional welfare theory.

Students sometimes raise the objection that since all firms are supposed to earn zero economic profits in long run equilibrium, this must imply that firms add nothing to society's happiness. There are two sources of confusion represented by this objection. First, firms can earn economic profits in the short run. In fact, the "long run," as it is used in economics, represents a theoretical ideal that is never realized. Second, there is an important distinction between marginal and total. Profits measure the marginal contribution of the firm to society's happiness. Marginal contribution means that we hold the production of other firms constant. Assuming the classical microeconomic definition of long run equilibrium, then any particular firm in long run equilibrium contributes zero gain to society's happiness at the margin. This is different from saying that the total output produced by all firms in an industry adds nothing to society's happiness.