WEBVTT NOTE Business and Economic Change 1 00:00:00.000 --> 00:00:11.000 So, Bob is kind of a tough act to follow, so I hope none of you think that this lecture is going to be funnier than the last one, because as far as the morning lectures go, we definitely peaked and now we're on the down-out. 2 00:00:11.000 --> 00:00:27.000 So, the title is Business and Economic Change, but I could just as well have called it Profit and Loss, because profit and loss are the key concepts, and pretty much everything that I'll be saying relates to them. 3 00:00:27.000 --> 00:00:37.000 Now when economic conditions are bad, like they have been for the past few years, we start to hear more about preserving and encouraging economic growth as a way of getting out of trouble. 4 00:00:37.000 --> 00:00:43.000 But we also hear all sorts of anti-business rhetoric, too, about greed and evil businessmen and so on. 5 00:00:43.000 --> 00:00:51.000 So it becomes a little bit confusing because we think, well, pick a side, what should we do? Is business good or bad or what have you? 6 00:00:51.000 --> 00:01:11.000 So, what I want to talk about is first a little bit about how the economy changes and grows naturally in a free economy and then I'll talk about some of the problems we see when the market is not allowed to function freely and hopefully I'll get to say some things about common misconceptions people have about how markets work. 7 00:01:11.000 --> 00:01:23.000 So, one of Mises's great contributions to economics was to develop a theory of the entrepreneur to explain how economies change and develop over time, and as we'll see, it's all due to entrepreneurs. 8 00:01:23.000 --> 00:01:38.000 So what are entrepreneurs and what do they do? Well, when you have an advanced division of labor, like Bob was talking about, with millions or billions of workers and a practically infinite number of ways to produce different things, there's a huge problem which emerges. 9 00:01:38.000 --> 00:01:44.000 That is, somebody has to decide what to produce and where to produce and how and so on. 10 00:01:44.000 --> 00:01:46.000 And that someone is the entrepreneur. 11 00:01:46.000 --> 00:01:53.000 Usually when we think of entrepreneurs, we tend to think of people who start new businesses, especially small businesses. 12 00:01:53.000 --> 00:01:57.000 But really, entrepreneurs exist at every level of the economy, 13 00:01:57.000 --> 00:02:05.000 from local businesses all the way up to large corporations that sell raw materials and other inputs that we as consumers never even see. 14 00:02:05.000 --> 00:02:20.000 So the key to understanding entrepreneurship is in understanding that when we talk about entrepreneurs, we really aren't talking about individuals necessarily, we're talking about a function, a certain kind of business activity that individuals engage in. 15 00:02:20.000 --> 00:02:31.000 Bob talked about the division of labor and about how free economies encourage people to develop their special skills, and the division of labor is actually at the core of the idea of entrepreneurship. 16 00:02:31.000 --> 00:02:38.000 Because in entrepreneurial theory, we say that some individuals specialize in guiding the process of economic change. 17 00:02:38.000 --> 00:02:46.000 And there's one skill in particular which is more important than most others, and that's the skill of predicting future wants of consumers. 18 00:02:46.000 --> 00:02:55.000 The economy changes and grows because some individuals, entrepreneurs, are willing to introduce innovations and new and more efficient ways of producing things. 19 00:02:55.000 --> 00:03:05.000 So what entrepreneurs do is to take resources and use them for projects which will only come to fruition in the future so that they don't necessarily know whether or not they'll be successful. 20 00:03:06.000 --> 00:03:16.000 There's always some uncertainty in the future, so even the best entrepreneurs can't be completely sure that they'll succeed, but they still take risks with their property just for the chance to make a profit. 21 00:03:16.000 --> 00:03:29.000 Entrepreneurs buy resources which they use to produce, including human labor, and it's because they direct the process of production to satisfy consumers that we say that entrepreneurs drive the economy. They help to bring about economic progress. 22 00:03:29.000 --> 00:03:43.000 Now, most mainstream economists don't ever really think about entrepreneurship, the entrepreneurial function, because economists tend to think about economics in a very abstract way that's not very realistic, to make a long story short. 23 00:03:43.000 --> 00:03:51.000 But Austrian economists focus on the way individual behavior brings about economic change. It's a much more realistic approach. 24 00:03:51.000 --> 00:04:00.000 So because entrepreneurs need to invest in business, they need to buy machines and equipment, pay workers and so on, they have certain costs. 25 00:04:00.000 --> 00:04:03.000 And when they sell their product, whatever it might be, they bring in revenues. 26 00:04:03.000 --> 00:04:08.000 So of course when the revenues are greater than the expenses, they earn profits, and if not, they earn losses. 27 00:04:08.000 --> 00:04:14.000 This idea is extremely simple, but it's also extremely powerful when we really think about what it means. 28 00:04:14.000 --> 00:04:22.000 And what it tells us is that in order for entrepreneurs to earn revenue, they need to produce something that people actually want to buy. 29 00:04:22.000 --> 00:04:28.000 If they do that, if they satisfy enough people, they earn more than their costs, but if not, then they lose money. 30 00:04:28.000 --> 00:04:32.000 So profit and loss are an indication of the level of satisfaction of consumers. 31 00:04:32.000 --> 00:04:33.000 Research. 32 00:04:33.000 --> 00:04:37.200 Large profits show that many individuals are willing to buy and that individuals consider 33 00:04:37.200 --> 00:04:41.360 themselves better off buying the products of the entrepreneur, while losses show that 34 00:04:41.360 --> 00:04:46.080 people aren't interested or aren't interested because prices are too high, and so losses 35 00:04:46.080 --> 00:04:51.920 show that the entrepreneur is wasting resources by producing things that nobody wants. 36 00:04:51.920 --> 00:04:57.000 As Mises liked to point out, the market in this way is like a democratic political system, 37 00:04:57.000 --> 00:05:01.960 but even more so because every day the consumers decide who owns the economy's resources 38 00:05:01.960 --> 00:05:10.360 and how many resources they own, as Mises put it, 39 00:05:10.360 --> 00:05:14.460 Each ballot of the consumers adds only a little to the elected man's sphere of action. 40 00:05:14.460 --> 00:05:20.560 To reach the upper levels of entrepreneurship, he needs a great number of votes repeated again and again over a long period of time, 41 00:05:20.560 --> 00:05:23.360 a protracted series of successful strokes. 42 00:05:23.360 --> 00:05:29.160 He must stand every day a new trial, must submit anew to re-election, as it were. 43 00:05:29.160 --> 00:05:45.160 This idea is called consumer sovereignty or individual sovereignty, and it's critical when explaining how the market works, especially to people who think that owning capital automatically entitles you to profits, or that owning resources and earning profits somehow isolates you from the community. 44 00:05:45.160 --> 00:05:53.160 But really, profits demonstrate a harmony with the interests of the community. They demonstrate that people are being satisfied by what's being produced. 45 00:05:53.160 --> 00:06:01.160 Especially today, we constantly hear about, we hear expressions like giving back to the community when businessmen donate to charity, for example. 46 00:06:01.160 --> 00:06:07.160 But this implies that under normal circumstances, businesses take something away from the community. 47 00:06:07.160 --> 00:06:12.160 But profitable businesses do exactly the opposite. They provide services that people want. 48 00:06:12.160 --> 00:06:16.160 They allow people to engage in mutually beneficial transactions with each other. 49 00:06:16.160 --> 00:06:19.160 And the community is better off because of it. 50 00:06:19.160 --> 00:06:23.680 If you're interested in this sort of thing, by the way, there's a great essay by Mises called Profit and Loss 51 00:06:25.240 --> 00:06:28.400 It's available downstairs, and I would urge you to read that because 52 00:06:29.200 --> 00:06:35.840 Mises lays out the principles of profit and loss and entrepreneurship very simply and clearly. It's a fantastic little book and 53 00:06:36.200 --> 00:06:41.280 Also, Bob has a good chapter on entrepreneurs in his book for high school students, so you can look at that as well 54 00:06:41.920 --> 00:06:44.820 But I'm really out of shape, so I can't hold up his book though 55 00:06:44.820 --> 00:06:57.820 But contrary to popular belief, profits aren't permanent. Even the most amazing entrepreneurs don't earn profits forever, because competitors imitate each other and come up with their own versions. 56 00:06:57.820 --> 00:07:01.820 And the more imitators that enter the market, the more profits are gradually bid down. 57 00:07:01.820 --> 00:07:11.820 There's this idea that once a business is established and gets large enough that it necessarily earns profit, as if it becomes sort of a self-sustaining mechanism. 58 00:07:11.820 --> 00:07:23.820 But this is completely false. Because profits and losses are earned every day in the economy, even successful entrepreneurs can't stop trying to innovate to keep the customers happy. Competition keeps firms on their toes. 59 00:07:23.820 --> 00:07:33.820 So past success doesn't mean very much, and it doesn't guarantee future profits. Even the largest and most successful firms have to constantly change in order to survive in the market. 60 00:07:33.820 --> 00:07:41.100 market. Now I'm kind of a film geek so all my examples tend to do with the film 61 00:07:41.100 --> 00:07:46.300 industry. I considered coming up with some examples that were maybe more 62 00:07:46.300 --> 00:07:51.420 relevant to this crowd and I thought no I'm not going to do that. I'll just do 63 00:07:51.420 --> 00:07:56.380 what I want and so you'll have to bear with me. But an example of sort of how 64 00:07:56.380 --> 00:08:00.140 the mighty have fallen in business recently would be someone like the 65 00:08:00.140 --> 00:08:30.140 A corporation like the MGM Movie Studio, which just went bankrupt, even though they own a lot of potentially lucrative assets, they own the rights, for example, to the James Bond franchise, which is the second most successful film series of all time, after Harry Potter, but the point is that in recent years, MGM hasn't been able to produce movies which people actually want to see. And so, even though it owns these assets, which might make money in the future, because of bad decisions, they have no money right now, and so they're trying to sell off everything they have in order to stay open. 66 00:08:30.140 --> 00:08:36.140 They're also selling, by the way, half shares in the two film adaptations of The Hobbit they're producing. 67 00:08:36.140 --> 00:08:40.140 So if you're a Tolkien fan and you have some extra money, you might want to look into that. 68 00:08:40.140 --> 00:08:48.140 So profits don't just tell entrepreneurs if they're successful or not, though. 69 00:08:48.140 --> 00:08:55.140 Another function which they have, which is just as important, is that prices allow entrepreneurs to see the cost of every decision they make. 70 00:08:55.140 --> 00:08:59.900 Make, entrepreneurs can look at their balance sheets and income statements and tell from 71 00:08:59.900 --> 00:09:02.820 them what it costs to make certain decisions. 72 00:09:02.820 --> 00:09:05.780 It tells them what they could have done so they can compare that to what they actually 73 00:09:05.780 --> 00:09:06.780 did. 74 00:09:06.780 --> 00:09:11.380 And this accounting enables entrepreneurs to decide between different ways to produce. 75 00:09:11.380 --> 00:09:16.640 Being able to see the opportunity costs of an action, what Dr. Thornton was talking about, 76 00:09:16.640 --> 00:09:20.500 that is what you could have done, and then comparing different possibilities is necessary 77 00:09:20.500 --> 00:09:26.220 for entrepreneurs to produce anything because they have all these different options. 78 00:09:26.220 --> 00:09:31.320 So it becomes a serious problem then when profit and loss accounting is falsified somehow 79 00:09:31.320 --> 00:09:35.080 because it changes the perceptions of entrepreneurs and gives them the wrong idea about the state 80 00:09:35.080 --> 00:09:36.760 of the market. 81 00:09:36.760 --> 00:09:40.020 The principal way that this happens is through inflation when it can appear that firms are 82 00:09:40.020 --> 00:09:45.040 extremely profitable when in fact they might be making losses in terms of the real value 83 00:09:45.040 --> 00:09:49.340 placed on their services by consumers. 84 00:09:49.340 --> 00:09:53.240 But also this problem of calculation that hints at the great problem of socialism, which Mises 85 00:09:53.240 --> 00:09:59.460 talked about, which involves the impossibility of allocating resources properly in any society 86 00:09:59.460 --> 00:10:02.420 without private property and market prices. 87 00:10:02.420 --> 00:10:05.180 And now that's a whole lecture by itself, so I won't get into it, but the punch line 88 00:10:05.180 --> 00:10:10.540 is that without a way to measure the opportunity cost of production, a socialist economy simply 89 00:10:10.540 --> 00:10:12.700 can't function. 90 00:10:12.700 --> 00:10:14.060 Okay. 91 00:10:14.060 --> 00:10:17.300 So the lesson here is that you can't survive in the free market without constantly innovating 92 00:10:17.300 --> 00:10:19.300 in Satisfying Consumers. 93 00:10:19.300 --> 00:10:24.300 And competition leads to consumer satisfaction, but also to social cooperation in general. 94 00:10:24.300 --> 00:10:27.580 Because in order to make themselves better off, as Dr. Thornton was pointing out, or 95 00:10:27.580 --> 00:10:31.340 no, it was you, it was Bob, sorry. 96 00:10:31.340 --> 00:10:36.440 People have to exchange with each other, even if they really wouldn't want to. 97 00:10:36.440 --> 00:10:40.560 So some people in society can be completely greedy or selfish, for example, but in order 98 00:10:40.560 --> 00:10:44.580 to satisfy their own selfishness, they first have to benefit other people by producing 99 00:10:44.580 --> 00:10:54.580 And this is what the economist Adam Smith was talking about when he introduced his famous metaphor, the invisible hand. 100 00:10:54.580 --> 00:11:00.580 We don't really use this term anymore because it sounds sort of mysterious and magical, right, like the invisible hand. 101 00:11:00.580 --> 00:11:06.580 I mean, if you try and have an argument with somebody over economic policy and say, well, the invisible hand will solve everything, I mean, it just makes you look crazy. 102 00:11:06.580 --> 00:11:13.580 I mean, imagine if you had a conversation about physics like that and you said, well, the ball moves a certain way when it strikes the other ball 103 00:11:13.580 --> 00:11:16.100 of all because the invisible hand made it that way, 104 00:11:16.100 --> 00:11:18.520 like the men in the white coats would come, right? 105 00:11:18.520 --> 00:11:20.420 And they'd give you a PhD in economics. 106 00:11:21.500 --> 00:11:24.340 But just because we don't use the terminology anymore, 107 00:11:24.340 --> 00:11:27.180 it doesn't mean that the idea isn't important, 108 00:11:27.180 --> 00:11:28.100 because it is. 109 00:11:28.100 --> 00:11:32.260 In fact, it's maybe one of the most important ideas 110 00:11:32.260 --> 00:11:34.620 in all of economics, and it's so important 111 00:11:34.620 --> 00:11:36.060 to a sound understanding of the market 112 00:11:36.060 --> 00:11:38.480 to realize that the profit and loss system 113 00:11:38.480 --> 00:11:41.560 and everything that it entails is the greatest mechanism 114 00:11:41.560 --> 00:11:43.800 for Social Cooperation Ever Created. 115 00:11:46.920 --> 00:11:51.620 So just a quick sort of side note about taxes. 116 00:11:51.620 --> 00:11:53.740 Obviously, taxing profits then 117 00:11:53.740 --> 00:11:55.560 has extremely negative effects. 118 00:11:55.560 --> 00:11:56.800 It discourages innovation 119 00:11:56.800 --> 00:11:59.040 and destroys the incentive to produce 120 00:11:59.040 --> 00:12:00.200 because when you tax profits, 121 00:12:00.200 --> 00:12:03.080 entrepreneurs have very little to work toward. 122 00:12:03.080 --> 00:12:05.820 And also at the same time, when you tax profits, 123 00:12:06.760 --> 00:12:08.960 that doesn't do anything to diminish your losses, 124 00:12:08.960 --> 00:12:11.200 so it eliminates the amount of success you can have, 125 00:12:11.200 --> 00:12:20.200 So why on earth would you ever produce anything if you knew from the outset that you couldn't really succeed but that you could lose everything, right? 126 00:12:20.200 --> 00:12:32.200 So that's a serious problem with tax and profits. But the bottom line on entrepreneurs is that entrepreneurs take risks and for that they sometimes receive an income. 127 00:12:32.200 --> 00:12:40.200 Greed has nothing to do with entrepreneurial profit or at least it doesn't magically produce profit. Only satisfying consumers can make a firm profitable. 128 00:12:40.200 --> 00:12:43.320 and that's why you know free market profits are so important because they 129 00:12:43.320 --> 00:12:47.480 show us who is using resources to satisfy the consumers and who's just 130 00:12:47.480 --> 00:12:51.240 wasting them. It's entrepreneurs who drive the economy who constantly innovate 131 00:12:51.240 --> 00:12:57.280 and try to improve consumer satisfaction and the income they receive is a sign of 132 00:12:57.280 --> 00:13:01.460 how well they do that. So now I want to talk a little bit about when 133 00:13:01.460 --> 00:13:05.320 entrepreneurs are in losses. Related to the idea of loss is the problem of 134 00:13:05.320 --> 00:13:09.320 bankruptcy and from what we've said we can realize that when we talk about 135 00:13:09.320 --> 00:13:39.320 Bankruptcy is the most important kind of economic adjustment because it takes resources which are being wasted by entrepreneurs and businesses and it allows them to be bought up by other people who can put them to better use, that is entrepreneurs who can try to do a better job of satisfying customers so we should be happy when we see firms go bankrupt because we know now that the 136 00:13:39.320 --> 00:13:44.320 The resources they were wasting could be put to better use elsewhere, and this applies to people as well. 137 00:13:44.320 --> 00:13:51.320 It's not that we should be happy that individuals become temporarily unemployed because the business they work for closes. 138 00:13:51.320 --> 00:13:57.320 What we should be happy about is that bankruptcy allows labor to switch from unproductive to productive tasks. 139 00:13:57.320 --> 00:14:03.320 It enhances the division of labor by shifting individuals from producing things people don't want to things that people do want. 140 00:14:03.320 --> 00:14:08.320 So it encourages people to develop socially useful skills. 141 00:14:08.320 --> 00:14:12.200 The bankruptcy example I'm using right now is Blockbuster. 142 00:14:12.200 --> 00:14:16.440 So at one time Blockbuster was one of the leading names in entertainment, 143 00:14:16.440 --> 00:14:21.880 but now they've been completely pushed out. And a huge part of the reason for that is because until recently 144 00:14:21.880 --> 00:14:27.680 Blockbuster was not very innovative. They were focused entirely on their physical store locations 145 00:14:27.680 --> 00:14:31.000 and anticipated that the need for these kind of stores would always be there. 146 00:14:31.000 --> 00:14:35.280 But of course companies like Netflix and iTunes and Redbox come along 147 00:14:35.280 --> 00:14:45.580 and they made rental stores pretty much a thing of the past and so Blockbuster only got into the online stuff very late, they never got into it like Netflix did 148 00:14:45.580 --> 00:14:53.580 so by the time they really started to take the competition seriously it was just too late and so a series of bad decisions, of bad forecasts cost them their business. 149 00:14:53.580 --> 00:15:04.080 In fact even though they were successful at times, even during the good times Blockbuster's business strategy was extremely risky and vulnerable to competition and innovation 150 00:15:04.080 --> 00:15:09.080 because it depended on late fees for a huge portion of its revenue, about 16%, I think. 151 00:15:09.080 --> 00:15:14.080 So when other companies did away with late fees and found innovative ways, especially through the internet, 152 00:15:14.080 --> 00:15:21.080 of providing the same or better service at a better price, Blockbuster became much more unattractive to consumers. 153 00:15:21.080 --> 00:15:28.080 And you might think that maybe anyone could see this coming, but the point is that nobody acted on it until the last few years. 154 00:15:28.080 --> 00:15:33.080 Anybody could have come up with the idea, but it was the entrepreneurs, like the guys who started Netflix, 155 00:15:33.080 --> 00:15:37.880 who were the ones who acted on the idea and capitalized on Blockbuster's mistakes 156 00:15:37.880 --> 00:15:43.800 and for that they now earn the profits that used to go to Blockbuster. 157 00:15:43.800 --> 00:15:46.500 So again here Blockbuster didn't anticipate that other businesses might 158 00:15:46.500 --> 00:15:49.440 develop an innovative way to revolutionize the industry 159 00:15:49.440 --> 00:15:53.040 and they've paid for their failure to anticipate future conditions 160 00:15:53.040 --> 00:15:56.080 so now they have to liquidate as many of their assets as they can and their 161 00:15:56.080 --> 00:15:58.760 holdings are being bought up by individuals who will put them to other 162 00:15:58.760 --> 00:16:02.880 uses which consumers value more highly. 163 00:16:02.880 --> 00:16:09.480 And this sort of bankruptcy and then resource adjustment is exactly what happens when markets are allowed to operate freely. 164 00:16:09.480 --> 00:16:17.580 There's a constant cycle of renewal in the economy as old and inefficient firms disappear and are replaced by new and innovative ones 165 00:16:17.580 --> 00:16:21.680 that are more capable of adapting themselves to changes in the economy. 166 00:16:21.680 --> 00:16:26.780 The economist Joseph Schumpeter called this process creative destruction, 167 00:16:26.780 --> 00:16:32.180 which is kind of a catchy way to describe how the economy is always in a sort of competitive revolution, 168 00:16:32.180 --> 00:16:37.500 always pushing towards increases in efficiency and productivity. 169 00:16:37.500 --> 00:16:42.140 So in the same way that business success is good because it shows that people are getting what they want, 170 00:16:42.140 --> 00:16:46.740 business failure is actually good too because it shows that entrepreneurs have realized their mistakes 171 00:16:46.740 --> 00:16:51.700 and the businesses are trying to make a better use of scarce resources. 172 00:16:51.700 --> 00:16:55.780 So that's a brief description of how free market entrepreneurs and businesses operate. 173 00:16:55.780 --> 00:17:00.420 So now I'm just going to talk about how government intervention affects business. 174 00:17:00.420 --> 00:17:05.100 This is a huge topic, so I can't say very much, but hopefully I can give you a small picture 175 00:17:05.100 --> 00:17:10.580 of some of the problems that arise from interfering with profit and loss. 176 00:17:10.580 --> 00:17:12.980 As we all know, or at least as I think we all know, 177 00:17:12.980 --> 00:17:16.740 we don't live in a truly free economy. We have government intervention in 178 00:17:16.740 --> 00:17:21.060 basically every industry and every part of our lives. 179 00:17:21.060 --> 00:17:25.060 So our analysis is a little bit different when we move from a free market to 180 00:17:25.060 --> 00:17:29.460 what we live under, a sort of interventionist economy. 181 00:17:29.460 --> 00:17:36.460 A lot of the time when we think about government intervention, we think about it as if the government is only doing something to business. 182 00:17:36.460 --> 00:17:42.460 That is, government is preventing business from succeeding and hampering the economy, getting in the way, and so on. 183 00:17:42.460 --> 00:17:51.460 And this is the picture, for example, that you see in novels of Ayn Rand, for example, where the evil government always wants to destroy the good entrepreneur, and so on. 184 00:17:51.460 --> 00:17:56.460 And this, of course, does happen. All government intervention hurts somebody in the economy. 185 00:17:56.460 --> 00:18:04.460 But there's another side to this as well, because government doesn't just do things to business, it does things for business as well, that is, it grants monopoly privileges. 186 00:18:04.460 --> 00:18:10.460 And these privileges benefit some firms at the expense of the rest of the economy. 187 00:18:10.460 --> 00:18:21.460 And of course businesses, especially large businesses who can afford it, know that it's possible to get support from the government, so they invest huge amounts of resources to try to suppress competition through all kinds of regulations. 188 00:18:21.460 --> 00:18:24.460 Economists sometimes call this rent seeking. 189 00:18:24.460 --> 00:18:30.460 So it's very common for the government and business to collude, to restrict competition 190 00:18:30.460 --> 00:18:36.460 and secure market share for one or a few firms who happen to have the ear of the legislators. 191 00:18:36.460 --> 00:18:40.460 Actually, more realistically, who happen to have the pocket of the legislator. 192 00:18:40.460 --> 00:18:47.460 But when you can legally suppress the competition, of course you can earn profits which would not otherwise have been available to you. 193 00:18:47.460 --> 00:18:53.460 The market has a much more difficult time penalizing you for failing to provide for the consumers 194 00:18:53.460 --> 00:19:03.720 There are a million different ways this can happen, laws like tariffs and quotas, prevent 195 00:19:03.720 --> 00:19:07.520 international competition, a little bit about what Bob was talking about. 196 00:19:07.520 --> 00:19:11.320 This is an obvious example, but there are much more subtle methods too, such as the 197 00:19:11.320 --> 00:19:15.240 monopoly which is granted to prescription drug companies through intellectual property 198 00:19:15.240 --> 00:19:20.080 laws, which prevent competitors from mass producing certain medicines, keeping the price 199 00:19:20.080 --> 00:19:32.080 or Minimum Wage Laws, for example, which price certain workers out of the market and reduce competition with, say, union workers who get to keep their wages artificially high. 200 00:19:32.080 --> 00:19:46.080 And the list goes on and on. A good rule of thumb is that whenever you see people agitating for a law to intervene in the market for an ostensibly humanitarian cause, you can bet that first, it hurts the people that it's supposed to help, 201 00:19:46.080 --> 00:19:55.080 to help, and then second, there's usually a large business or group of businesses behind it who support it, who stand to gain from it at the expense of their smaller competitors. 202 00:19:55.080 --> 00:20:06.080 But the most significant recent example of intervention in the profit and loss mechanism is the too big to fail argument that we heard around the time of the bailouts. 203 00:20:06.080 --> 00:20:16.080 This idea is that there are so many resources which are controlled by certain large firms that we need to prevent them from going bankrupt to keep the economy stable. 204 00:20:16.080 --> 00:20:25.080 But of course, it's exactly because so many resources are tied up in companies like GM, for example, that they need to go bankrupt. 205 00:20:25.080 --> 00:20:31.080 So this huge amount of prudential productive power can be given to somebody who wants to produce a product people actually want. 206 00:20:31.080 --> 00:20:40.080 And this is actually even truer of larger institutions like the banks than it is about GM, but I think Mr. French will probably have more to say about banking. 207 00:20:40.080 --> 00:20:47.080 But protection against bankruptcy in this way just protects bad economic decisions. It rewards mismanagement. 208 00:20:47.080 --> 00:20:56.080 And it punishes good management by keeping inefficient producers in the market alongside the innovative and productive ones. 209 00:20:56.080 --> 00:21:08.080 So when government prevents bankruptcy, it necessarily means that resources which were being wasted already are further prevented from being put to their most urgent uses. 210 00:21:08.080 --> 00:21:16.080 In fact, it would actually be more logical to say from this point of view that businesses would be too small to fail because smaller businesses use relatively few resources. 211 00:21:16.080 --> 00:21:22.080 Now, I'm not saying that small businesses should be protected from competition, because the same logic applies to them as well. 212 00:21:22.080 --> 00:21:25.960 well but my point is that it's the large failed businesses that need to be 213 00:21:25.960 --> 00:21:31.800 eliminated the most because they control the greatest amount of resources and 214 00:21:31.800 --> 00:21:34.600 even if there was an economic justification for keeping failed 215 00:21:34.600 --> 00:21:37.720 businesses in the market there's a practical side to protection as well 216 00:21:37.720 --> 00:21:42.640 that is protections are very hard to get rid of once they're in place because the 217 00:21:42.640 --> 00:21:47.120 business is getting protected always want to keep their protection and so they 218 00:21:47.120 --> 00:21:50.640 build up political support networks which make it very difficult to change 219 00:21:50.640 --> 00:22:04.640 And of course, once a firm gets protection from competition, there's also no clear point at which we can say, well, before the company was weak, but now it's stable enough to compete, so we can just allow competition again. 220 00:22:04.640 --> 00:22:10.640 So firms who want to get protected can keep making the same claim over and over and over again that they're not strong enough. 221 00:22:10.640 --> 00:22:16.160 so in fact protecting industries actually makes it less likely that they'll ever 222 00:22:16.160 --> 00:22:19.760 become healthy and capable of competing because once you have protection you 223 00:22:19.760 --> 00:22:23.120 don't have much incentive to really innovate or increase efficiency right 224 00:22:23.120 --> 00:22:28.960 because nobody can take away your share of the market all right well so this 225 00:22:28.960 --> 00:22:34.200 brings me to the last problem I want to talk about along sort of the same lines 226 00:22:34.200 --> 00:22:38.600 the problem of moral hazard moral hazard actually has a misleading name 227 00:22:38.600 --> 00:23:08.600 Moral hazard has many definitions, but the simplest way to describe the principle is to say that when you don't bear the cost of your own actions because you can shift them to somebody else, you behave differently, maybe more recklessly, than you otherwise would, whether that means that you spend more money or do risky things because you don't bear the cost, the point is that you behave differently. 228 00:23:08.600 --> 00:23:13.300 differently when you have little or no responsibility. 229 00:23:13.300 --> 00:23:16.820 The example of this which has been in the news in the last few years is compulsory 230 00:23:16.820 --> 00:23:18.360 health insurance. 231 00:23:18.360 --> 00:23:21.440 When people believe that insurance companies will pick up the bill for their 232 00:23:21.440 --> 00:23:25.720 accidents, they start paying less attention to their health and well-being. 233 00:23:25.720 --> 00:23:29.240 It's not that people are evil or that insurance is bad or anything, it's just that 234 00:23:29.240 --> 00:23:33.160 when there's some kind of intervention and as a result more people are insured 235 00:23:33.160 --> 00:23:34.500 than otherwise would be 236 00:23:34.500 --> 00:23:39.020 or have more comprehensive health insurance policies than they otherwise would. 237 00:23:39.020 --> 00:23:42.780 You see an increase in many different types of risky behavior. 238 00:23:42.780 --> 00:23:45.740 So when you have compulsory health insurance, it essentially means that 239 00:23:45.740 --> 00:23:48.880 individuals will have insurance who wouldn't have it otherwise, 240 00:23:48.880 --> 00:23:51.540 and this sets this process in motion. 241 00:23:51.540 --> 00:23:54.640 So paradoxically, trying to protect people 242 00:23:54.640 --> 00:23:58.780 and improve the quality of health care through compulsory legislation like this, 243 00:23:58.780 --> 00:24:02.100 assuming protecting people was the goal, but that's another issue, 244 00:24:02.100 --> 00:24:08.360 But paradoxically, trying to improve health care actually increases the amount of health problems people have 245 00:24:08.360 --> 00:24:12.260 because they pay less attention to their own health than the health of others. 246 00:24:12.260 --> 00:24:19.000 Maybe a more relevant example for this crowd would be car insurance, compulsory car insurance. 247 00:24:19.000 --> 00:24:25.440 For those of you who are new drivers, statistically speaking, you have a higher likelihood of getting in an accident than most adults. 248 00:24:25.440 --> 00:24:29.600 But let's assume that you're all very good, safe drivers. 249 00:24:29.600 --> 00:24:34.600 But think about how your driving habits might change, maybe without you even knowing it. 250 00:24:34.600 --> 00:24:38.600 If every time you got into an accident, you never had to pay for it. 251 00:24:38.600 --> 00:24:45.600 If every time you got into a fender bender, the insurance company just rolled a new car off the belt for you, right? 252 00:24:45.600 --> 00:24:51.600 With compulsory car insurance, even very good drivers are put in this moral hazard world, 253 00:24:51.600 --> 00:24:58.600 where you have this perverse incentive to drive carelessly because the cost of crashing is lower than it should be. 254 00:24:58.600 --> 00:25:11.600 So I think the relevance of this for business should be pretty obvious when businesses earn losses but are protected from bankruptcy, it just encourages irresponsible behavior, it relieves businesses of the cost of failure, it socializes the cost of failure, 255 00:25:11.600 --> 00:25:19.600 and it makes it much easier for businesses not to learn from their mistakes and to keep doing what it was that got them in trouble in the first place. 256 00:25:19.600 --> 00:25:30.600 The example of this, which I mentioned before, is the bailout of firms like GM, who produced a poor product and have been rewarded by being relieved of the cost of their failure. 257 00:25:30.600 --> 00:25:40.600 Again, I don't want to talk too much about banking, but I just want to point out briefly that when you have an organization like the Federal Reserve, which acts as the so-called lender of last resort, 258 00:25:40.600 --> 00:25:52.600 There's an implicit promise to banks and other prominent institutions of this, relating to this moral hazard problem, this implicit promise that they'll be rescued if their businesses start to collapse. 259 00:25:52.600 --> 00:26:05.600 And this breeds careless and sometimes even extremely reckless behavior, like for example, the lending to people with very bad credit that we saw in the housing boom. 260 00:26:05.600 --> 00:26:13.600 So, even though I've only said a little bit about this problem, I want to emphasize that moral hazard is one of the most important problems in economics. 261 00:26:13.600 --> 00:26:19.600 In fact, one of my graduate school professors used to say that moral hazard is more important than all the other problems of economics put together, 262 00:26:19.600 --> 00:26:29.600 which is probably an exaggeration, but not by much, because we see it everywhere, especially when we look at government intervention, welfare economics and areas like this. 263 00:26:29.600 --> 00:26:37.600 Okay, so the last thing that I want to say, and I'm afraid this is going to be confusing, I hope not, but 264 00:26:37.600 --> 00:26:41.600 so I've tried to give some examples of the basic principles of profit and loss, 265 00:26:41.600 --> 00:26:48.600 but the examples themselves, the real-world examples, aren't perfect because we live in a regulated economy. 266 00:26:48.600 --> 00:26:53.600 It's difficult to find practical examples of what happens on a free market because there aren't any free markets. 267 00:26:53.600 --> 00:27:02.600 So even though examples like MGM and Blockbuster and so on give us an idea of how the market operates, these companies aren't purely competitive. 268 00:27:02.600 --> 00:27:22.600 A lot of free market economists talk about companies that innovate and eliminate the competition and they might praise Walmart or Apple or other popular companies because they make profits and they wanted to defend these corporations as if they existed in a sort of free market vacuum independent of all the government intervention that's going on. 269 00:27:22.600 --> 00:27:30.260 But the problem is we can't make this distinction very clearly or absolutely, because intervention 270 00:27:30.260 --> 00:27:34.200 affects everyone in the market, whether you want it to or not. 271 00:27:34.200 --> 00:27:39.740 And even though we as teachers want examples of how the market works, we have to be very 272 00:27:39.740 --> 00:27:45.020 careful not to sort of just praise the free market when we see something that we like 273 00:27:45.020 --> 00:27:49.060 being produced, and then criticize the government on the other hand when we see something we 274 00:27:49.060 --> 00:27:53.700 You don't like being produced and saying, oh, well, that's just the product of intervention. 275 00:27:53.700 --> 00:27:58.520 That wouldn't happen on a free market. 276 00:27:58.520 --> 00:28:04.020 And the reason I'm pointing this out is just to note that it's very easy when, for example, 277 00:28:04.020 --> 00:28:10.060 you debate other people who don't understand the virtues of the free market, it's very 278 00:28:10.060 --> 00:28:16.820 easy to get trapped into defending people and institutions that really shouldn't be 279 00:28:16.820 --> 00:28:20.820 will be defended from the perspective of free market economics. 280 00:28:20.820 --> 00:28:24.820 Okay, so, the punchline. 281 00:28:24.820 --> 00:28:27.820 Key points. 282 00:28:27.820 --> 00:28:33.820 In a free market, entrepreneurs drive the economy by attempting to anticipate the future wants of consumers. 283 00:28:33.820 --> 00:28:38.820 Entrepreneurs take risks in order to earn profit, which is never guaranteed. 284 00:28:38.820 --> 00:28:43.820 Profits are a sign of success by entrepreneurs and the satisfaction of consumers. 285 00:28:43.820 --> 00:28:46.820 Losses are a sign of waste and inefficiency. 286 00:28:46.820 --> 00:28:52.820 Bankruptcy is beneficial for society because it moves resources from unproductive to productive industries. 287 00:28:52.820 --> 00:28:59.820 And protecting businesses and preventing bankruptcies wastes more resources and encourages future waste. 288 00:28:59.820 --> 00:29:06.820 So what I've tried to point out is the immense importance of earning profits in a free economy and a few of the socially beneficial effects profits have. 289 00:29:06.820 --> 00:29:11.820 I also can't emphasize enough the healthy role of loss and bankruptcy. 290 00:29:11.820 --> 00:29:41.820 So to close, I just want to pose some rhetorical questions to you, which are to ask, if it's true that in business, protection against bankruptcy is so harmful to society, then what should we think about government and its agencies, which are of their nature, organizations which do not pass the market test, strictly speaking? And what should we think of government organizations which are, practically speaking, permanently protected from failure, bankruptcy, and elimination from society? So thank you for listening. 291 00:29:41.820 --> 00:29:43.820 Thank you very much.