In the previous post Paradox of Profits?, I mentioned how I view the paradox of profits as the confusion between production firms’ operating surplus (as defined in the SNA such as the 2008 SNA or earlier versions) and surplus on the financial account of the system of national accounts.

The paradox is highlighted by saying that at the beginning of the monetary ‘circuit’, firms inject an amount of money M and can only recover a maximum of M.

So let us think of an economy in which there is no money or banks initially and suddenly someone producers find a way to make cakes and the banking system opens simultaneously. This is admittedly an oversimplification but nonetheless useful.

Initially firms decide to make 100 cakes and price it $1 per cake. They hire labour and pay $60 as wages. For this, they borrow $60 from banks. Households is a mix of both labour and entrepreneurs.

Now households consume cakes worth $55.

Before proceeding, it is important to note that inventories will be valued at current costs. So even though firms have initially paid households $60 and recovered $55, they have still made a profit of $22. This is because 55 cakes were sold and cost $55 × 0.6 = $33.

So:

Profits = $22

I am neglecting the interest costs on loans but this is minor in comparison to the income generated by production so as to matter crucially.

That profits are $22 can be seen from the profits formula of the previous post:

F_f  = C + ΔIN − WB − r_lL

Having sold 55 units of cakes, firms have 45 units left in their inventory. But since inventories are valued at current costs, the multiplicative factor here is 0.6, so ΔIN  = $27. So,

$22 ≈ $55 + $27 − $60 − ε

After having paid their employees, firms started out with no bank balance but soon have $55 in bank deposits. They then pay back $33 of loans, leaving them with $22 of bank deposits. At this stage household hold $5 of deposits: they received $60 and consumed $55.

So total bank deposits is $27. This is equal to the value of inventories. This is also equal to the initial loan of $60 minus the repayment of $33. So firms’ inventories are backing the loan amount.

Firms are now in a situation to distribute dividends. It is clear that they don’t have trouble paying interest to banks. (In this example but not always the case).

Another production cycle starts. Dividends will buy more cakes and make more profits for firms. Fixed capital formation can also be added in the story without any problem.