Tuesday, July 22, 2014

You can't maximize costs and profit

In the principles of microeconomics class I am currently teaching we just covered the perfect competition and monopoly models. In the beginning of the lecture I explain to them that the goal of a firm is to make a profit. Profit is defined as total revenue minus total costs i.e. Profit = TR - TC. This is pretty basic stuff. After all, a firm won't be in business for long if their total costs exceed their total revenue on a regular basis.

The idea of maximizing profit is common sense for any business owner, yet the federal government has convinced many people that the goal of a government program is to maximize costs, not profit or net benefit. For example, in February of 2014 President Obama signed an executive order mandating that federal contractors be paid no less than $10.10 per hour. This is consistent with his repeated (and misguided) call for an increase in the federal minimum wage to $10.10 per hour.

Also in February, the Obama administration announced new TIGER grants for transportation projects. This program aligns with one of his other often repeated goals of creating jobs via infrastructure spending. From whitehouse.gov:

The President explained that "one of the fastest and best ways to create good jobs is by rebuilding America’s infrastructure -- our roads, our bridges, our rails, our ports, our airports, our schools, our power grids. We’ve got a lot of work to do out there, and we’ve got to put folks to work."

These programs make it clear that Obama stands firmly behind paying government workers more and creating jobs. And this also means that Obama is not interested in maximizing the profit, or net benefit, of these government initiatives for the taxpayers who are funding them. Remember, Profit = TR - TC. Paying workers more and paying more workers are both COSTS. If you increase costs and total revenue does not change profit must be going down, not up.

One of the things I tell my students and one concept that you learn in economics training is that MAXIMIZING PROFITS and MINIMIZING COSTS for a given level of output are the SAME THING. So when Obama raises costs by creating jobs (hiring more workers) and then paying each worker more than the market rate he is necessarily lowering the net benefit of the project to the taxpayer. What would a private sector employer say if she was shown a cost benefit analysis with the labor costs on the benefits side? Hopefully she would fire that worker and hire another one who is competent. Yet somehow the national dialogue has become such that creating jobs and paying workers more is a good thing for the taxpayer i.e. it is a benefit.

One of the fundamental objectives of economics as a science is to come up with the most efficient way to allocate scarce resources. Yet many on the left, including some economists, and even some on the right have come to the absurd conclusion that using more resources than necessary to create a given level of output makes society better off. If increasing costs and wasting scarce resources can really make us better off than there is little reason for economics as a discipline to exist. It does not take specialized training to learn how to waste stuff.

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