MICRO-ECONOMICS OF THE FIRM

Boris Johnston informed the Conservative Party conference a few weeks ago that he “has the guts to turn the UK into a dynamic high-wage economy”. But he said nothing about how he would achieve this economic miracle. Our PM is a past master when it comes to spouting his aspirations as if they are achievable policies – a habit that betrays a severe affliction: economic ignorance with no discernible wish to learn from past errors!

After all, if “high” wages represent the PM’s objective, why does he not simply inject still more counterfeit into the system and use it to raise the minimum wage and pay the workers whatever amount he considers high enough to satisfy his high-wage criterion. The recipients will not complain – until forced to recognise that they need even more, just to have enough to live on.

Wishing for something does not make it happen. Real economics is ordered by natural law, where method trumps luck and the exercise of reason is needed.

Economic calculation in the individual business

Boris wants high wages.  How do wages figure in the accounts of the firm? Within the limited focus of accountancy, wages are simply treated as just another cost of production. But in the wider world of economics, far from being a cost, wages represent Labour’s share of the value added by the whole business. It is part of the cause of production, rather than its cost. What a difference this shift in perception makes to one’s view of economic calculation!

Getting the basic terminology right is half the battle.

Production”, or everything produced, is the same as “output”.

“Productivity” is the “rate” at which output is produced, and is expressed in terms of a chosen metric – hence, “output per factory worker”, or “output per employee”, or “output per square metre of floor space”, or “output per machine”, or “output per hour/day/week etc”

“Gross revenue” is always a useful starting point for economic calculation because it’s the biggest number in the accounts of any business. It equates to “sales revenue” or, in a business providing services, its total receipts. Think about it: it’s the pot of revenue from which all payments must be met, starting with payments to the suppliers of everything purchased for use in our business, notably raw materials, components, energy, professional services – or, putting it simply, “all the payments that form part of other businesses’ sales revenue”. Only when these costs are deducted from our own sales (thereby avoiding double-counting) do we arrive at the value that we have added. You can call this our “product” - our “added value” (AV).

[If this exercise is undertaken for every business in the community, the total sum of their products, their total added value, would truly equate to “gross domestic product” (GDP), thus contrasting with the aberration that conventionally passes under that name.

Adding value is the firm’s raison d’etre

This critical number, added value, is utterly different from the accounting number called “profit” (whether “net” or “gross”). It is, quite simply, the sum of contributions made by all the factors of production to the productive process, each of which has a claim representing its share of the AV cake.

Wages represent the share of production attributable to labour - but, once again, nothing is as it appears once government statisticians get involved. For example, the “wages” figure that appears in the entity’s audited accounts includes things that the wage-earners themselves never actually receive - namely all the employment taxes, national insurance charges and any other statutory deductions, all lumped into “wages”. Remember: we are dealing here with reality - where “wages” are what employees actually receive and are free to spend – and that alone is what an AV statement should reflect in labour’s share.

“Gross” and “Net” are obfuscatory accounting fictions. If workers are paid their full wages there is no need for family income supplements, rent rebates, council tax rebates, free school meals, free milk or any family allowances. As I wrote in Management Today some 45 years ago, every government attempt to synthesize the twin objectives of fiscal needs and social justice must – and will - always fail.

Other factors of production

“Rent”, of course, is the share of AV due to the landlord for the use of the land on which the business stands. But just as wages means wages, land means land – not the buildings and other improvements standing on it, even if the accounts simply show one figure for rent without making the distinction – in which case estimation is always possible by reference to market stats or local authority records showing the “rateable value” of every plot in the borough. It’s the principle that matters, regardless of how accessible the actual numbers may be. By the same token, if the land is owned by the business and no rent is paid, a notional rent must be included in our economic calculation.

As for the share of added value representing a claim due to the use of “Capital”, this will obviously include interest paid by the business on sums borrowed and dividends paid to providers of share capital. Where business-owners have themselves provided its capital needs, an amount representing the income they have foregone should be entered as part of their share.

……..and Taxation

No AV presentation is complete without showing the government’s take, mainly in the form of taxation. The largest taxes featured will usually be corporate taxes and employment taxes. The latter are usually included in wages (incorrectly). The “pay-as-you-earn” system treats income tax and national insurance as if it is collected by the business from employees on behalf of the tax authorities, to whom it is handed over every month. The reality is that payment to the authorities is the legal liability of the employing business - in effect a penalty for the of crime of employing people.

Making the key adjustments

The AV statement must therefore take employment taxes out of Labour’s share; council taxes out of Land’s share; dividend/investment taxes out of Capital’s share; and VAT out of all payments to suppliers of goods and services – collected by the business from its customers as a punishment for daring to trade. Making these deductions reveals a picture of business ravaged by taxes disguised under other names; they should be shown, together with corporate taxes, as a separate total in the AV statement.

Sometimes “enterprise”, or entrepreneurship, is treated as a distinct factor of production. The well-drafted statement of added value will therefore identify profit as the share due the entrepreneur, representing (i) the reward for risking the loss of capital; (ii) the source of all savings and the seed-corn for investing in future innovation and growth; and (iii) the primary motivation for embarking on the enterprise in the first place.

Conclusion

In essence, the economics of the firm are not different from the economics of the nation. It’s just a question of scale. But it’s vital to understand what they have in common: both the firm and the nation function optimally when allowed to exercise their judgments, untrammelled by external intervention. Investment and Management are separate functions. The best recipe for a successful business is allowing investors to invest (passive) and managers to manage (active). This formula works on every level – and translates into minimal regulatory interference; free trade; rule of law; and a stable currency.

There you have it.