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NOTE Profit, Loss and the Entrepreneur

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Okay, well, let's begin our afternoon session, and I'd like to start off today by doing a little something different, so I've decided to give a pop quiz.

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Put all your notes and books away and get out a blank sheet of paper.

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I'm only kidding, but it was worth doing that just to see the fear in some people's eyes.

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Are you serious?

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Okay, well we're moving on now as we're in the middle of the week to some slightly more advanced topics and today this afternoon we'll examine the theory of profit and loss and the theory of the entrepreneur.

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One thing to notice, it's significant that we are using, that we have titled this lecture Profit, Loss and the Entrepreneur.

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There's a great deal of economic theory and a great deal of literature on profit, but much less on loss, and as we'll explain shortly, profit and loss are inextricably linked and there can be no theory of profit without a theory of loss, as we'll see.

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Also as you may be aware, entrepreneurship has become a very popular field of study, not only in business schools, but also in other departments and colleges and universities, one of the fastest growing specialty areas in economics, finance, management, and also in the humanities and social sciences.

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However, a lot of the literature on entrepreneurship, as we'll see in contemporary academic discourse, is not very closely tied to the economic theory of entrepreneurship, which we'll go over today.

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We'll talk about that relationship a little bit more.

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But I want to begin by reminding you of a little bit of economic methodology, a little bit about the approach and strategies that we use in doing economic analysis.

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We've emphasized throughout the week that our presentation here follows what we describe as causal realistic or causal realist analysis,

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Analysis, causal in the sense that we're studying purposeful human action and explaining economic phenomena in terms of the Aristotelian notion of cause and effect, and also that our analysis is realist in that we're not trying to explain hypothetical imaginary situations, but actual real world situations.

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Nonetheless, in causal realist analysis, we do make room for, in particular situations, what we call imaginary constructs. What Mises called imaginary constructs, what you might describe simply as sort of theoretical, abstract theoretical models.

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We might imagine a situation that we know is deliberately unrealistic, a situation that either could in principle obtain, but is very unlikely to obtain in the real world, or even more extreme, a situation that could not even conceivably exist in the real world.

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It's somehow logically contradictory.

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But yet, in imagining a world like that, it helps us to isolate in our thinking certain factors to separate one cause from another cause and helps us to understand the real world a little bit better.

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One of these important imaginary constructs is what Mises and Rothbard called the evenly rotating economy.

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And I think Joe will agree with me that that's perhaps not the best term for this particular imaginary construct, but we haven't come up with a better term as of yet.

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What Mises has in mind in the evenly rotating economy is a hypothetical state of affairs in which there is what I might describe here as action-like behavior.

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There are economic actors in this model, and they engage in what appears to be action.

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So there's buying and selling, there's production and consumption, there are economic transactions.

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This activity unfolds through time. So individual actors do have a notion of time.

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There does exist a positive time preference.

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The only thing that's different about this world from the real world is the complete

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absence of any uncertainty about the future. So people act, they buy and sell, but they

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know exactly what they will consume and produce in the future. When an entrepreneur engages

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in the process of production, he knows exactly what consumer demands will be in the future

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after production has taken place. So there's no possibility that an entrepreneur will lose

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If he knows that consumers will buy XYZ in the future, he would never engage in production unless he knew that he would be able to cover his costs with future revenues discounted by the rate of interest.

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Likewise, since there's no uncertainty, all producers, all entrepreneurs know what future market conditions will be.

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So competition among entrepreneurs assures that no entrepreneur can purchase factors of production in the present at a price lower than their discounted marginal revenue product.

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So there's no money left over for entrepreneurs to earn profit either.

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So there's no uncertainty in this world.

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What's the point of imagining a world like that?

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By the way, it's internally inconsistent in the sense that the very notion of human action implies some kind of uncertainty about the future.

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Man acts, in Mises' terminology, to eliminate some felt uneasiness.

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It's because he believes that the state of affairs will be more desirable in the future if he does act than if he doesn't act.

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Right? But if future conditions were predetermined, if he knew exactly what those conditions would be, then he would have nothing to gain by acting.

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Okay? But nonetheless, we presume that people do act or they engage in behavior that looks like action in the evenly rotating economy.

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Why do this? Why go through this exercise?

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Well, there's a very important analytical purpose, which we'll discuss in more detail in just a moment,

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and that is to distinguish conceptually the economic concept of profit from the economic concept of interest.

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The reason we need to engage in some abstract reasoning to do so is because in the real world, for a real world entrepreneur,

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business person, profit and interest look very similar. They both constitute dollars in your pocket.

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Okay, so the businessman or businesswoman goes home at the end of the day with some cash in his or her pocket.

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Well, is that profit? Is it interest? It could contain an element of both.

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And there's an important conceptual distinction between profit and interest that can only be understood using this kind of abstract reasoning.

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We cannot understand it simply by observing.

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Okay, so we want to disentangle profit and interest at a theoretical level.

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And in doing so, we will be able to uncover or isolate the function of entrepreneurship or the entrepreneur in the economy.

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So that's sort of our mission for this afternoon.

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Let's talk a little bit about the entrepreneur and the entrepreneurial function.

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Entrepreneurship and causal realist economic analysis is, as we've previously discussed, the deployment of resources in the present in anticipation of uncertain future receipts.

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So in the real world outside the evenly rotating economy, or ERE, the entrepreneur doesn't know with certainty what future consumer demands, for example, will be.

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And there is an element of uncertainty in making investments today that may or may not pay off at some point in the future.

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Now, describing the entrepreneurial function in these terms immediately brings to mind some key points.

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Highlight some key points first is that entrepreneurship is inextricably linked with the ownership of property.

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Okay, notice we describe entrepreneurship as the deployment of resources, resources that the entrepreneur already owns, let's say, or resources that the entrepreneur has to purchase.

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Okay, so the entrepreneur has to spend some money to hire factors of production before production can take place.

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Production is not an instantaneous affair. It takes place through the passage of time.

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And one cannot be an entrepreneur without some resources to invest.

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So there's an important sense in what entrepreneurship is a way of thinking about investment under conditions of uncertainty.

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We'll come back to that point just a little bit later.

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Also, this notion of entrepreneurship does not necessarily imply some of the attributes or characteristics that are often associated with sort of the real world entrepreneur, with Steve Jobs or Bill Gates or Henry Ford, right, people, for example, who have great imaginations, who are extremely creative, who are alert to opportunities for gain, who have personal charisma, can exercise leadership and so on.

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The entrepreneur in economic theory, as an individual, may possess those attributes, but they aren't necessary characteristics of entrepreneurship.

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What is economic profit or economic loss?

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It's the residual that accrues to the business owner, the entrepreneur who deploys these factors of production, after the factors of production have been paid.

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This is a very simple business person's notion of profit, right? Revenues minus costs, but notice there's an element of time and uncertainty. Revenues and costs are not realized at the same time. Costs must be expended in advance of revenues being received.

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So whatever is left over, after all the factors have been paid, discounted appropriately by the rate of interest, constitutes the entrepreneur's profit if revenues exceed costs, if discounted value of revenues exceeds costs, or it's an economic loss if revenues are not sufficient to cover costs.

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Notice that, as I said before, in the ERE, in this hypothetical construct, in the absence of uncertainty, all factors of production would be paid their discounted marginal revenue products and there would be no profit or loss.

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Profit and loss can only exist under conditions of uncertainty.

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The economist notion of profit, the idea of profit in economic theory does not always

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always translate in a perfectly unambiguous one-to-one relationship with the various notions

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of profit we find in the accounting profession.

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So there are different specific accounting measures that can be used to get a sense of

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net earnings or net income and exactly what things are included and what things are not

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How is that included? How is depreciation handled? Is it better, more useful to think of profit as a quantity, the level of profit? Or is it more useful to think of it as a ratio? So, net income divided by the total amount of capital invested and so on.

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The point is all of these accounting measures, or accounting measures such as these can be proxies for economic profit, but economic profit doesn't just appear as an item on the income statement.

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We have to use a little bit of judgment in inferring what actual profits are in dollar terms.

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and we have to use our discretion as to what accounting measure we use that we think is the best proxy for economic profit, okay?

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Now what do I mean by uncertainty? I've said that in the ERE there's no uncertainty, in the real world there is.

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Profit and loss only exist under conditions of uncertainty. What does that mean?

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Well, probably the best-known definition of uncertainty among economists comes from a famous formulation by Frank Knight, a Chicago economist from the early 20th century, who was one of the first economists to, in my judgment, correctly explain the theory of profit and distinguish profit from interest.

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Although some of Knight's other contributions are less congenial, his theory of competition, his theory of capital, for example.

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But I think Knight was correct on the theory of profit.

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And Knight famously distinguished between what he called risk and what he called uncertainty.

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So risk describes situations where the outcome of action is unknown,

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But the range of possible outcomes and the probabilities with which each outcome will obtain are known.

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A roulette wheel, for example. You don't know exactly what number will come up on the roulette wheel,

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but I know all of the numbers that could come up, and if it's a fair game where there's no cheating,

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I know the probability that any particular number will come up based on the design of how many slots there are in the wheel and so on.

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When I roll a die, I don't know what the number will be, but I know that it will be between 1 and 6 and each of those outcomes occurs with probability 1 sixth.

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Uncertainty, by contrast, for situations where not only do we not know what specific outcome we'll obtain, but we don't even know the range of possible outcomes or the probabilities with which each outcome we'll obtain.

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Okay? So risk applies only to very strictly limited situations. Okay? And one way that people have often thought of this is in terms of insurance. Right? If a particular outcome can be insured against, for example, I don't know if I'm going to have a car accident this afternoon. Right? But people in the insurance business who study

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and the probability of car accidents can make a pretty good prediction about the probability that an accident of a particular type will obtain under particular driving conditions in a particular geographic area given the characteristics of the driver and so on.

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They can quote me an insurance rate because they know throughout my lifetime approximately how many accidents I will have and so on.

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And the more details they know about me and my car and the places where I drive, the more precisely they can come up with an estimate.

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So I can insure myself against auto accidents, against my house burning down and so on.

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Right, but there's a more fundamental kind of uncertainty for which you cannot purchase any insurance.

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Okay, you know, say I'm, let's see, who is the most valuable player in the NBA this year?

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Who won the MVP award? I'm sorry?

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I'm sorry? It was Nowitzki. Okay, a European guy? I'm shocked. So suppose that Nowitzki wants to be the MVP every year, he can't go to Allstate or State Farm and take out an insurance policy that will pay him a certain amount of money if Steve Nash is the MVP next year or LeBron James or whoever. So simply isn't the kind of information available that would allow us to make a prediction about the

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The probability that one guy or another guy will be the MVP of the NBA.

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The way Mises described this distinction, and actually here, our Mises, Ludwig von Mises, was drawing on some ideas from his younger brother, Richard von Mises, who was a statistician at Harvard University, a well-known scholar in probability theory.

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The first distinction is between what Mises calls class probability and what he calls case probability.

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So class probability refers to situations where an event can usefully be aggregated

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or can be considered an element of a set of relatively homogeneous events, a homogeneous class of events,

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like an automobile accident.

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I mean, every automobile accident is unique in a sense, but automobile accidents share very many common features, okay?

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As opposed to cases, situations of what he called case probability, where the event itself is unique.

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Okay, there is no homogeneous class of events into which certain activities can be placed.

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Okay, so we don't have comparable, we don't have information necessary to come up with an expected value in quantitative terms.

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Okay, so my point in this digression is that what we're talking about in the theory of profit is not conditions of probabilistic risk.

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We're not saying that the entrepreneur knows with certainty that his profit will either be

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$100,000 or $150,000 or $200,000 with probabilities one-third, one-third and one-third,

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but he doesn't know exactly what his profit will be.

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We're not talking about a situation like that.

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We're talking about a situation where he has no information with which to construct a mathematical probability distribution

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over what his future earnings will be.

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It doesn't mean that the entrepreneur acts blindly, right?

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He does have a sense, he does have to make some kind of a forecast or estimate of what future market conditions will be,

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but that estimate, the process by which he arrives at that estimate cannot be modeled by the analyst, you know, in a mathematical formulation, okay?

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We can't formally model this decision process.

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And indeed what Knight described as judgment, Knight used the word judgment to describe

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situations in which individuals form estimates of what future conditions will be without

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the aid of some kind of formal decision model.

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So to exercise judgment is to make these, is to have these expectations or to make these

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forecasts without a formal decision model in which you can simply plug in numbers and

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Crank Out Unexpected Value, okay?

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Well, what are some common misconceptions about profit?

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What are some things that profit isn't?

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Profit is not, okay?

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Well, as we've just seen, profit is not interest,

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even though both profit and interest

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are monetary returns to the business owner, okay?

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The person who owns capital and deploys that capital

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and the production process is foregoing some present consumption in anticipation of being

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able to consume more in the future and thus is earning a return for foregoing that consumption.

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So interest is determined strictly by people's time preferences, the extent to which agents

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prefer present consumption over future.

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The owners of capital goods are using resources in longer production processes, they're deferring

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consumption and as a result of which earning a return for that foregone consumption.

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Profit by contrast is a return or a reward for the successful bearing of uncertainty.

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And you can think of loss as the penalty for unsuccessfully bearing uncertainty.

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Okay, so profit is not the same thing as interest.

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It is not the same thing as accounting income, because accounting income can include profit, interest, and, as I mentioned in the morning lecture, the entrepreneur's implicit wage.

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So economic profit would only be that part of accounting income that subtracts the entrepreneur's opportunity wage, what he could earn in his next best opportunity, and subtracts the interest payments that accrue to the business owner for the use of his capital.

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The part that is determined strictly by uncertainty-bearing is the part that is profit.

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And again, as I'm trying to emphasize, we're thinking of profit here as a functional category, not a line item.

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Although there are line items that we can use to try to approximate in dollar terms what the actual economic profit will be.

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There are other common misconceptions in the history of economic thought.

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Marx described profit as almost like an automatic return to capital.

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Anyone who owns capital automatically gets some profit that accrues to it.

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It's just sort of naturally.

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And in fact, you see this expressed still in some of the contemporary textbooks.

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Some of the textbooks, if they're not careful, will say, well, rent is the return to land,

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and wages are the return to labor and profit is the return to capital.

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That's incorrect.

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I mean, if you think about it, that can't be correct because things aren't sort of measured in the right units.

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It's like wages are dollars per hour or dollars per month, a monetary payment per unit of time.

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Well, the return to capital goods should also be dollars per unit of time, right?

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So if I use a machine in production, then I pay the owner of that machine a rental price,

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so many dollars per hour, for the right to use that machine.

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I mean, it can't be profit. It's not a dollar amount or a percentage.

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It's a rate per unit of time.

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Profit can't be the return to capital, and even more so, it can't be some sort of automatic, natural return to capital that you get simply by owning capital.

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Joe showed a couple of days ago the pictures of destroyed cities. Remember you had to play the game, bombing or rent control?

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The idea that capital automatically generates some kind of return is utterly refuted by the existence of abandoned factories.

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There are plenty of capital goods out there that are just trash, basically, that have little value over some minimal salvage value, let's say.

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If capital goods automatically, intrinsically generated some kind of return just by the nature of their existence, well, we wouldn't have any idle factories.

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We wouldn't have any old forklifts and digging machines stuck out in junkyards.

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They would be deployed in some use, earning their profit.

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But, of course, profit only obtains when resources are deployed by entrepreneurs in ways that satisfy future consumer wants.

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Moreover, profit is not simply a markup over production costs.

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Right? There's a popular misconception that, you know, business people, you know, you want to be in the business of building houses, so it costs a certain amount to build a house, and then you just add five percent.

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And that's your selling price. Well, I mean, right? We know from the theory of subjective value that the producer cannot arbitrarily set a selling price and receive that selling price on the market.

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It depends on the valuations of consumers, the degree to which they value the good or service being offered relative to the value of their cash balances, and moreover, the cost of production for the construction firm, the housing

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are contradicted by the theory of imputation that we studied this morning of how factors of production are valued and priced in the first place, okay?

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Something else to notice, it's sort of implicit in our discussion so far, but it's worth bringing out more explicitly that in a modern complex economy,

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Entrepreneurship is closely linked to the notion of resource heterogeneity, that land, labor and capital goods are not homogeneous, that they can be combined in different ways.

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Right? I mean, there's more than one way to skin a cat, there's more than one way to produce bottles of bottled water.

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There are alternative technologies that could be employed.

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There are different production methods. There's labor-intensive hand production.

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Somebody individually fills each bottle out of a jug.

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There are more automated capital-intensive methods of production with robots and machines.

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So there's some substitutability of capital and labor.

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Well, which method of production is the most cost effective means of producing bottled water?

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What leads to the highest profits for the entrepreneur?

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Well, that isn't given, that information is not given by nature.

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The task of the entrepreneur is to discover the appropriate or to figure out the appropriate combinations of resources that yield the highest economic value.

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And there's a nice quote from the Austrian economist Ludwig Lachmann who studied, was a colleague of Hayek's at the London School of Economics in the 1930s and wrote a very useful book called Capital and its Structure published in 1956 where he expresses the problem I think quite nicely.

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Lockton says, we are living in a world of unexpected change, a world of uncertainty, in other words, mighty in uncertainty.

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Hence capital combinations will be ever changing, will be dissolved and reformed.

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In this activity, in this activity, we find the real function of the entrepreneur.

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Okay, so the entrepreneur's function in a modern economy is to experiment with different combinations of factors of production

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to find those that produce the greatest amount of economic value and hence profit for the entrepreneur.

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We'll get into this a little bit more in the discussion of socialism and economic calculation, which is tomorrow.

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We won't discuss this in the theory of socialism and economic calculation, so strike that from the record.

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By the way, notice that given that resources are heterogeneous, we can't do this exercise in any way outside of a monetary economy.

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Because we need a common accounting unit, and so the entrepreneur can't sort of add up apples and oranges, so to speak,

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but can only calculate the difference between revenues and costs in monetary terms.

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Okay, so we're assuming a monetary economy.

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Why are profits and losses important?

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What is the significance of the profit system,

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the profit motive?

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Is it a good thing or a bad thing

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that entrepreneurs are motivated to increase their profits?

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Should profits be condemned?

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I think you can already anticipate

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what the answer to that question will be from this crowd.

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But we can think a little bit more systematically

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about the functions that the profit and loss system provide.

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And here, the classic reference is the article

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that you have in your reading list by Mises

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called Profit and Loss that was reproduced

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in his collection, Planning for Freedom.

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And if you haven't had a chance to read it yet,

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I certainly encourage you to do so.

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So one of the functions of profits and losses

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are providing feedback to entrepreneurs

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in their short-term and their long-term planning, right?

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So the entrepreneur, I think that I want to go

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into the business of selling bottled water.

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I know that it costs me this much to produce bottled water

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and I hope that I can sell them when the production run

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is completed for so many dollars per unit

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and I'll earn a nice economic profit.

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Once I go into production and then I put my products

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on the Market for Sale, I get some information about whether my forecast was accurate.

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Okay, hopefully I got it right or revenues exceed my expectations.

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If not, if revenues fall short of expectations, I end up with a loss.

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I have a sense of whether my actions created value or not.

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Okay. In the absence of profit and loss, it's extremely difficult for the manager,

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the person who assembles resources,

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to know whether resources were assembled correctly or not.

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Think of this kind of example.

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You hear often calls for government agencies

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to sort of reinvent themselves

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and to be more like private businesses.

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Some of you may be old enough to remember

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in the early 90s, Al Gore, Vice President Gore had a,

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or wasn't Vice President yet, a program he called Reinventing Government. This is before

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he got on the global warming shtick. It was all about how to make government agencies

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be more efficient, act more like businesses.

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Well, the problem here is, suppose you're running a government agency. Suppose you're

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running the Internal Revenue Service. Again, assume for the sake of argument that the Internal

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It's for the sake of argument that the Internal Revenue Service performs a legitimate function.

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This is an imaginary construct here.

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It's supposed to

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take audit tax returns

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and collect money and so on. How do

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the managers of the Internal Revenue Service know whether they're doing their jobs well or not?

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Like a private business person, they have to make some

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investment decisions, they have to hire labor, they have to rent facilities, they have to

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purchase capital goods, you know, the 20-year-old computers that they have, should they upgrade

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their computer system or not? Should they continue using the sort of obsolete technology

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that they supposedly have, or should they invest in newer, faster scanning machines?

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Should they go to more electronic filing? Should they encourage electronic filing at

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and discourage people from paper filing for greater economic efficiency.

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Well, on what basis does the manager, the director of the IRS, make such a decision, make such a determination?

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The private entrepreneur can say, well, if I use this older labor-intensive technology, it will cost me this much.

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If I use the more capital-intensive technology, it will cost me this much.

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What will my revenues be under each of those two scenarios, and I can estimate my profit, which will be the most profitable production technology.

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I make my decision, I deploy resources, and then I get feedback once I sell my output as to whether my anticipations were correct.

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Well, what if you don't have output that you sell?

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Government agencies don't sell their output on the market. They don't have a profit. They don't have a bottom line, so to speak.

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So they have no way of knowing for sure whether the decisions that they've made have been appropriate in satisfying consumer wants or not.

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I remember reading an article in the Wall Street Journal back about reforming the Los Angeles Police Department.

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This was shortly after the Rodney King riots, which took place in what year? I've forgotten now, early 90s.

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So there were calls to engage in some major reform of the police department.

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I remember reading an article in the Wall Street Journal about a bunch of management consultants and efficiency experts who were brought in to try to suggest reforms to the LAPD to make it more responsive to the end customer,

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to make it more efficient, more productive, and so on, lower costs, and it was perfectly clear that once these experts came in, it was extremely difficult for them to design mechanisms to bring about these efficiency enhancements because there was no market feedback for whether the changes were any good or not.

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When we think about, in a private firm, a manager employs a subordinate and can give that subordinate some discretion over making particular decisions and then make an assessment of whether that subordinate's actions are, how they're contributing to the bottom line.

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Are they increasing profits or decreasing profits? If they're increasing profits, I'm going to encourage those actions, I'm going to keep that person, promote that person and so on.

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Otherwise, I'm going to discourage those actions or fire the person.

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Take a city beat cop, a police patrolman.

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How do you know whether that patrolman's actions are contributing to overall performance of the police agency?

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Well, the private entrepreneur has a measure of overall performance, profit.

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The police department doesn't.

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Suppose you wanted to provide performance incentives for police officers.

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You want to give them a bonus for doing things that contribute to the overall mission of the agency.

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Well, what would your performance measure be?

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Maybe you could pay police on a per-arrest basis.

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Might set up some undesirable incentive effects.

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Well, I mean, the policeman's job is a very complicated one, with multiple dimensions to it.

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How do you assess which ones are more or less important?

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The point is, in the absence of market feedback, which government agencies lack,

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the kind of signals, the kind of feedback that's available to the entrepreneur are simply not available.

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So government officials, even if completely well-meaning,

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even if performing services that you might think are necessary and essential services,

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can never be economically efficient in the sense that a private entrepreneur's activities can be.

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The classic reference here is Mises' short book, Bureaucracy, published in 1944,

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which has not received the attention that it really deserves, I think, even among Austrian economists.

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Moreover, besides this sort of day-to-day or planning period by planning period feedback process,

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Process, there's also a more general feedback process for who's a good entrepreneur, right?

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So an entrepreneur whose forecasts of future market conditions, whose judgments about the

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future are consistently poor is not going to be an entrepreneur for long, will run out

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of resources, will not be able to acquire any additional resources and will eventually

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do something else, will not be an entrepreneur but be engaged in work for a wage or whatever.

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Okay, whereas those who are consistently good at the act of making entrepreneurial judgments, their activities will be successful, their businesses will flourish, and they'll continue to engage in entrepreneurial activity.

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Right, again, you don't have this with government agents.

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And you've all read plenty about this, nobody was fired after 9-11, people at NORAD and all these outfits that receive billions of dollars for radar control and to shoot down enemy planes and so on, I mean, whatever mistakes were made, and there were plenty of them, no one is held accountable, right?

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He said, well, wait a minute, but in a democracy, aren't government officials held accountable by the ballot box?

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Well, there's an extent to which that's true, but there's certainly some accountability in principle,

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but it's a much weaker form of accountability than the profit and loss system.

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In fact, you might sometimes hear people say, well, markets are like democracies.

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People vote with their dollars, so the market is sort of like a big democracy.

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Well, I mean, there's an element of truth there, but it would be more accurate to say that voting in a democratic political system is kind of a crude approximation of the market.

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The Market is the much more pure form of democracy if you want to use that term.

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Why? For example, because competition among consumers and producers in markets is not winner-take-all.

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In other words, if I prefer to drive a Ford and Salerno prefers to drive a Chevrolet,

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it isn't the case that we bid in the marketplace with our willingness to pay with our dollars

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And then whoever wins, that car, everybody has to drive that car.

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I mean, he can drive a Chevrolet and I can drive a Ford, right?

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Consumers can satisfy a variety of preferences.

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Unlike in political markets where you vote for a representative or a president

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and everybody is stuck with the person who gets the highest number of votes

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whether you want to be governed by that person or not, okay?

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So we don't have this kind of selection process in the absence of markets, so just as profit and loss in a market system provides this feedback, you can think of it as a mechanism for placing productive resources, productive assets, land, labor and capital, in the hands of those who can best use them, okay? Those who can best use those resources for the satisfaction of consumer wants, okay?

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Another important clarification is that you sometimes read, even in the economics literature, about concepts like a normal rate of profit.

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So some firms are earning excessive profits because they're earning more than the normal rate of profit.

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I mean, certainly in a crude statistical sense, we could calculate what was the average accounting profit of firms in the computer industry over a 10-year period, and we could say, oh, well, this one firm had accounting profits that were two standard deviations above the mean.

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If we want to call that excessive, okay, fine.

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But there's no fundamental intrinsic economic notion of excessive profits, because there's no sort of thing as normal profits.

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All profits are the result of uncertainty.

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No firm can assure itself some particular baseline level of profit simply by existing.

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No firms are guaranteed earning any profits in the absence of monopoly, which we'll be talking about tomorrow.

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But under market competition, there's no such thing as normal profit, so there can't be any notion of excessive profit.

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There's simply profits and losses.

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Again, those who hold the view that profit is some kind of automatic return to capital or that firms or entrepreneurs can guarantee themselves a normal rate of profit simply by engaging in some default activities have a very hard time explaining why so many firms go bust, why so many firms go bankrupt, why so many firms earn losses.

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So whenever you're thinking about profit or reading about profit, ask yourself, test what you're reading.

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If someone is offering you an account of profit or a theory of profit that doesn't simultaneously explain loss by the same mechanism,

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you should be suspicious that this is an inadequate or misleading or fallacious notion of profit.

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Even some Austrian economists might try to pull that one on you.

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Okay, let's distinguish a little bit more carefully between the entrepreneurial function and the managerial function.

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Here both entrepreneurs and managers exercise a kind of judgment over the deployment of resources.

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Notice that in the definition of entrepreneurship that we've offered here, entrepreneurship is inextricably linked with resource ownership, right?

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So the owner of capital goods performs the entrepreneurial function, yet as we all know, owners of capital goods frequently hire agents to manage those goods for them, okay?

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I may own my own business of, you know, producing this bottled water, but unless it's a very

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small operation where I can do everything myself, I have to hire some assistants, right?

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Not only laborers, sort of wage laborers, but I might hire some people that we would

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call managers, white collar employees, who will supervise and govern other employees,

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who will make decisions about operations and purchasing and sales and marketing and so

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on.

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Right?

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If I am the owner of the assets, I own the land, the factory, the capital goods and so on that are used in this production process,

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then I am exercising the entrepreneurial function even if I choose to delegate much of the day-to-day decision management to hired subordinates.

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Okay, terminology that I like to use,

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I like to think of two different kinds of judgment.

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What I call original judgment, or true judgment,

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or pure judgment, if you like,

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is that that is exercised by resource owners

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in their judgments or decisions

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about how their resources should be deployed.

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Okay, so owners of productive assets

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cannot, there's no way they can avoid exercising judgment,

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Right? Merely allowing your resources to lay idle is making decisions about how those assets will be used.

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So asset ownership implies original or pure or primary judgment, if you like.

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But resource owners can delegate decision authority to subordinates who exercise what we might call derived judgment.

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Okay, so if I hire Joseph Salerno to manage my bottled water plant, I'm not at the plant every day making operational decisions, but I hire him and ask him to do that for me.

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So he exercises a kind of judgment, but because he doesn't own the resources himself, unless I make him my partner or give him equity shares, assuming he's just a salaried employee,

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All of the judgment that he exercises is exercised on my behalf.

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It's kind of a derived or a delegated or a secondary kind of judgment.

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And I like to use the term for someone like that,

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describe that person as a proxy entrepreneur.

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So not a real entrepreneur because not a property owner,

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but someone who acts, sort of takes entrepreneurship-like actions

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So if you like, you can think of the entrepreneur's task in operating an organization that employs

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multiple people and managing this derived judgment, assigning derived judgment to the

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appropriate people, specifying what decision rights they have, evaluating their performance,

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Making Adjustments to the Degree of Delegation, and so on.

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A few comments about this. Some people find this notion...

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Some people have trouble with the link between entrepreneurship and ownership.

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Partly I think it's a semantic issue,

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because the way the term entrepreneur is used in popular literature,

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and I'm going to come back to this in a moment in more detail,

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Often, when people say entrepreneur, they mean a young person who starts a new business.

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Someone who's old and who has owned a business for years is not an entrepreneur.

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Entrepreneurship only applies to startups somehow.

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Well, that certainly isn't correct in the economic sense of entrepreneurship.

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You can be old, young. You can be new in the business.

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You can have been in the business for 50 years and still be acting entrepreneurially

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If you're making judgements about the future, if you're bearing uncertainty, okay?

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The other problem that people have is they think of ownership, they have sort of a stereotypical model of an absentee owner.

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Well, here's some wealthy person, you know, Peter Klein is some rich guy and he inherited some money from his uncle,

387
00:47:23.660 --> 00:47:30.660
and he owns a bunch of factories, but he doesn't go near the factories, he lets Joseph Salerno run the factories for him.

388
00:47:30.660 --> 00:47:44.660
How can you say that Klein is an entrepreneur? He doesn't do anything but sit around all day. Or better yet, he's a playboy. All he does is go to ski resorts and hang out with supermodels and this sort of thing. How can he be an entrepreneur?

389
00:47:44.660 --> 00:47:58.660
Well, again, it may be the case that Joseph Salerno is exercising most of the delegated judgment on a day-to-day basis. He's acting as a very strong and influential proxy entrepreneur.

390
00:47:58.660 --> 00:48:28.660
Remember, the point is, if I own the business, I hired him and I can fire him. I choose who will manage my assets on my behalf, and though I may very well say to Joe, look, I trust you, you figure out how to do it, I'm going to be off and I'll be in money, Carlo, at the casino, but I reserve the right to show up in my factory

391
00:48:28.660 --> 00:48:38.660
The fact that I choose not to intervene on a regular basis doesn't preclude me from intervening if I wanted to.

392
00:48:38.660 --> 00:48:48.660
And the key point is the fact that Joe is not the owner means that he doesn't behave in exactly the same way that he would if he were the owner.

393
00:48:48.660 --> 00:48:56.660
Even if de facto he has lots of discretion, he knows that I can take his discretion away if I want to.

394
00:48:56.660 --> 00:49:05.660
I want to. I can terminate his employment if I want to. So he doesn't manage the assets the same way he would if he actually owned them.

395
00:49:05.660 --> 00:49:14.660
This is a critical distinction between being an owner and a non-owner. A non-owner can exercise a kind of judgment, a kind of derived judgment,

396
00:49:14.660 --> 00:49:25.660
can be a proxy entrepreneur, but only an owner can exercise original judgment and be an entrepreneur in the true sense.

397
00:49:25.660 --> 00:49:40.660
As I mentioned, there are many different concepts of the entrepreneur and the entrepreneurial function in the literature, both academic and non-academic.

398
00:49:40.660 --> 00:49:50.660
In the economics literature, the entrepreneurial function has been described in ways that differ somewhat from the way that I've just laid it out.

399
00:49:50.660 --> 00:49:59.660
A very famous formulation from Joseph Schumpeter, first in his book on the theory of economic development, published in 1911.

400
00:49:59.660 --> 00:50:04.660
Schumpeter described the entrepreneur as a kind of innovator.

401
00:50:04.660 --> 00:50:16.660
That entrepreneurship is the act of introducing new goods and services, new production technologies, new combinations of resources that no one had previously thought of.

402
00:50:16.660 --> 00:50:22.660
Well, I mean, innovation is clearly an important aspect of economic performance. There's no doubt about it.

403
00:50:22.660 --> 00:50:30.660
But the function of the innovator is distinct from the function of the entrepreneur as laid out in causal realist analysis.

404
00:50:30.660 --> 00:50:38.660
This is a little bit of an aside on Schumpeter. My interpretation of Schumpeter is as follows.

405
00:50:38.660 --> 00:50:44.660
Schumpeter, of course, was trained in the Austrian tradition. He was a student of Boehm-Bawerk.

406
00:50:44.660 --> 00:51:14.660
Boehm-Bawerk's favorite student and Schumpeter was extremely brilliant, was very learned, there's actually a new biography of Schumpeter by the business historian Thomas McCraw that's getting a lot of attention now, I haven't read it yet, Schumpeter is an extremely interesting character in the history of economic thought, but Schumpeter though he was of Viennese descent and was trained in the sort of milieu of the Austrian School

407
00:51:14.660 --> 00:51:18.180
on the same time as Mises was a contemporary of Mises.

408
00:51:18.180 --> 00:51:21.540
Schumpeter was not really fully an adherent

409
00:51:21.540 --> 00:51:26.100
of the Austrian subjectivist causal realist program.

410
00:51:26.100 --> 00:51:28.020
Schumpeter was much more attracted

411
00:51:28.020 --> 00:51:31.180
to the mathematical system,

412
00:51:31.180 --> 00:51:34.060
general equilibrium theories of Leon Volra.

413
00:51:34.060 --> 00:51:36.280
So Schumpeter was really a Volrazian

414
00:51:36.280 --> 00:51:38.700
with a little bit of an Austrian influence.

415
00:51:40.340 --> 00:51:42.960
And if you know anything about the Volrazian model,

416
00:51:42.960 --> 00:52:12.960
The Volrasian General Equilibrium Model, it's a purely static kind of conception of the economy and Schumpeter, who had real world business experience in banking, although he's not very successful as a banker, he realized that he was living in a period of tremendous economic growth and tremendous technological and organizational innovation, yet Schumpeter was committed

417
00:52:12.960 --> 00:52:24.960
The Volrasian Static Model of General Equilibrium, and he realized that there was no way to incorporate economic growth, innovation and change in the Volrasian model.

418
00:52:24.960 --> 00:52:38.960
So what he did is he theorized that, well, there must be some exogenous shock to the system that brings the economy from one Volrasian general equilibrium to another.

419
00:52:38.960 --> 00:53:03.960
Okay, so the economy is just sort of sitting there in general equilibrium, then all of a sudden, as sort of a Deus ex machina, right, the inventor, the innovator, as a lone genius, Thomas Edison, Steve Jobs, comes up with some new idea, introduces it into the market, the old equilibrium is disturbed, and then gradually the economy reaches a new long-run general equilibrium.

420
00:53:03.960 --> 00:53:09.960
So entrepreneurship is the faculty that moves us from one long-run equilibrium to the next.

421
00:53:09.960 --> 00:53:16.960
There's an important sense in which entrepreneurship for Schumpeter was kind of a residual category.

422
00:53:16.960 --> 00:53:24.960
It's sort of that which explains innovation, because you can't explain innovation within a purely Volrasian framework.

423
00:53:24.960 --> 00:53:42.960
Another concept of the entrepreneur that is not as well known is one developed in a series of papers by Nobel laureate economist T.W. Schultz at the University of Chicago where he conceived entrepreneurship as not so much as innovation but as the response to innovation.

424
00:53:42.960 --> 00:54:00.960
So Schultz described entrepreneurship as a kind of adaptation. So ordinary people, consumers, small producers. Schultz was very interested in economic development and transformation from agriculture to manufacturing.

425
00:54:00.960 --> 00:54:11.960
So imagine a rural agricultural society in which technological innovation is introduced, hybrid seeds or improved farm implements or whatever.

426
00:54:11.960 --> 00:54:28.460
and he was interested in how ordinary farmers responded, which ones would adopt the new technology first, what would happen to the existing distribution of firms and incomes and so on when this new innovation is introduced into the system.

427
00:54:28.460 --> 00:54:43.460
So, Schultz, like Schumpeter, took the innovation itself as exogenous, but Schultz, unlike Schumpeter, thought that the key mechanism was how people respond to the innovation, how ordinary people respond.

428
00:54:43.460 --> 00:54:57.460
Probably the concept of entrepreneurship that is best known in the Austrian literature is the notion of alertness or discovery that comes out of Israel Kirzner's many writings on entrepreneurship.

429
00:54:57.460 --> 00:55:07.460
And Kirzner has placed great emphasis on an imaginary construct or an analytical fiction of what he calls the pure entrepreneur.

430
00:55:07.460 --> 00:55:11.460
What is the pure entrepreneur in Kirzner's writings?

431
00:55:11.460 --> 00:55:19.460
Well, the entrepreneur is sort of a fictional agent who does not invest resources,

432
00:55:19.460 --> 00:55:26.460
But rather is alert to profit opportunities that exist exogenously in the economy.

433
00:55:26.460 --> 00:55:34.460
Okay? So imagine a situation in which the economy is not in equilibrium.

434
00:55:34.460 --> 00:55:40.460
So there are some factors of production that are being offered for sale at prices below their DMRPs.

435
00:55:40.460 --> 00:55:45.460
Right? But not everyone is sort of aware of this.

436
00:55:45.460 --> 00:55:55.460
Okay, so some people, some agents in the economy have a special faculty, a special ability to perceive these kind of gaps.

437
00:55:55.460 --> 00:56:06.460
Gosh, if I buy these factors of production now at this price, I can resell the output later and earn some money.

438
00:56:06.460 --> 00:56:09.460
There's a profit opportunity that others have overlooked.

439
00:56:09.460 --> 00:56:15.460
You can think of the simplest case as being one of arbitrage, even in the absence of production, right?

440
00:56:15.460 --> 00:56:24.460
Apples are selling for, you know, a dollar a bushel in Auburn, and they're selling for a dollar fifty a bushel over in Opelika down the road.

441
00:56:24.460 --> 00:56:33.460
Well, I can go to Auburn and I can buy a whole bunch at a dollar, you know, I can pay a little more than a dollar, I can pay a dollar or one cent,

442
00:56:33.460 --> 00:56:41.460
Truck them over to Opelika, sell them for $1.49 and make a lot of money even once I've paid the transportation, you know, shipping costs.

443
00:56:41.460 --> 00:56:49.460
Here's an analogy that describes the Kirznerian system pretty well, I think.

444
00:56:49.460 --> 00:56:56.460
Some of you may have heard the joke about the economist and the $20 bill on the sidewalk. Have you heard that one?

445
00:56:56.460 --> 00:57:07.460
So the two sort of Chicago economists are walking down the street, and one of them stops and bends down to pick something up, and his friend says, what are you doing?

446
00:57:07.460 --> 00:57:16.460
He says, well, there's a $20 bill right there, I'm going to get it. And his colleague says, no, there's not. There's not a $20 bill on the sidewalk.

447
00:57:16.460 --> 00:57:24.460
The first guy says, what do you mean, it's right there. His colleague says, look, if there were a $20 bill on the sidewalk, somebody would have picked it up.

448
00:57:24.460 --> 00:57:29.460
The first guy says, yeah, I guess you're right, and he keeps on walking.

449
00:57:29.460 --> 00:57:37.460
So in the Chicago world, if we're always in perfectly competitive general equilibrium, there are never any $20 bills on the sidewalk.

450
00:57:37.460 --> 00:57:42.460
In other words, there are no profit opportunities that have not already been exploited.

451
00:57:42.460 --> 00:57:51.460
There is something to that. If you ever go to the big shopping mall around Christmas time,

452
00:57:51.460 --> 00:58:03.460
You don't even bother to drive by the front door and look for a parking space there, because you know there's not going to be one, right, because if there were a parking space, somebody would have immediately grabbed it, so you just go park in the back, at least I do.

453
00:58:03.460 --> 00:58:17.460
The Kirzner's perspective would say, wait a minute, that's not quite right. In Kirzner's model, there are $20 bills on the sidewalk, but not everybody can see them.

454
00:58:17.460 --> 00:58:22.460
Some people walk down the street, eyes front, they never bother to look down.

455
00:58:22.460 --> 00:58:29.460
And there are other people, not who are actively searching for $20 bills, but who, because they have better peripheral vision.

456
00:58:29.460 --> 00:58:36.460
They just happen to glance down and, hey, there's a $20 bill that nobody else saw, and they grab it and they pocket, they put it in their pocket.

457
00:58:36.460 --> 00:58:45.460
That, according to Kirzner, is where profit comes from, the seizing or exploitation of an opportunity for gain that other people have missed.

458
00:58:45.460 --> 00:58:51.460
Well, there are some problems with this account of entrepreneurial profit.

459
00:58:51.460 --> 00:59:00.460
The first is that there's no deployment of resources involved.

460
00:59:00.460 --> 00:59:08.460
In Kirzner's fiction of the pure entrepreneur, there's no uncertainty associated with the venture,

461
00:59:08.460 --> 00:59:14.460
and the entrepreneur does not have to own any capital, does not have to spend any resources to get the $20.

462
00:59:14.460 --> 00:59:19.300
$20. All he has to do is bend down and pick it up. So entrepreneurial opportunities are

463
00:59:19.300 --> 00:59:26.820
exploited costlessly in the Kirzner model. The problem with that is how do you explain

464
00:59:26.820 --> 00:59:36.180
entrepreneurial loss? How do you lose money if making money is seizing an opportunity

465
00:59:36.180 --> 00:59:39.180
that exists out there, okay?

466
00:59:42.260 --> 00:59:43.500
I mean, if you think about it,

467
00:59:43.500 --> 00:59:48.060
even in the most stylized sort of arbitrage transaction,

468
00:59:48.060 --> 00:59:50.380
even my story about the apples,

469
00:59:50.380 --> 00:59:53.700
in reality, there's a little bit of uncertainty there.

470
00:59:53.700 --> 00:59:56.160
Unless I can literally simultaneously

471
00:59:56.160 --> 00:59:58.060
buy and sell the apples, right?

472
00:59:58.060 --> 01:00:00.700
I buy the apples at $1.01 in Auburn

473
01:00:00.700 --> 01:00:05.460
and I truck them over to Opelika and oops, the price fell.

474
01:00:05.460 --> 01:00:09.940
Now they're only selling for 50 cents in Opelika and I've lost money.

475
01:00:09.940 --> 01:00:14.340
Right? So it's not clear to what extent we can imagine profit opportunities sort of

476
01:00:14.340 --> 01:00:18.900
existing, waiting to be seized, because we never know if a profit opportunity is

477
01:00:18.900 --> 01:00:20.620
really an opportunity or not.

478
01:00:20.620 --> 01:00:24.580
It may turn out to be a loss by the time it's exploited.

479
01:00:24.580 --> 01:00:28.260
In the Nightian model,

480
01:00:28.260 --> 01:00:33.120
the two guys are walking down the street, or you're walking down the street, you look down

481
01:00:33.120 --> 01:00:37.880
and you see something that might be a twenty dollar bill but you're not exactly sure.

482
01:00:37.880 --> 01:00:39.860
You see a little shade of green

483
01:00:39.860 --> 01:00:43.520
kind of buried under the dirt.

484
01:00:43.520 --> 01:00:46.280
There may be a twenty dollar bill there, there might not be.

485
01:00:46.280 --> 01:00:50.960
The only way to find out is to go and buy a shovel.

486
01:00:50.960 --> 01:00:53.120
Okay, you have to buy a shovel

487
01:00:53.120 --> 01:00:56.720
and you use it and you dig and if you were right and there's a twenty dollar bill

488
01:00:56.720 --> 01:01:01.780
there and the shovel costs less than twenty dollars, you have earned an entrepreneurial profit.

489
01:01:01.780 --> 01:01:11.780
If you're wrong, it's just a blade of grass, it's not money at all, or it's only a $1 bill and you spent $10 on a shovel, you just earned a $9 loss.

490
01:01:11.780 --> 01:01:20.780
So, Kirzner's model, unlike the model we've been describing here, does not incorporate uncertainty.

491
01:01:20.780 --> 01:01:25.780
It's not a model of uncertainty, profit as the result of bearing uncertainty.

492
01:01:25.780 --> 01:01:34.780
Now, in Kirzner's defense, I think Kirzner has largely been misunderstood and misread particularly in the entrepreneurship, applied entrepreneurship literature.

493
01:01:34.780 --> 01:01:41.780
And that is in the sense that Kirzner is really not trying to explain entrepreneurship at all.

494
01:01:41.780 --> 01:01:54.780
Rather, he is using the concept of entrepreneurship, as he defines it, the fiction of the pure entrepreneur, as a means of explaining the convergence to equilibrium.

495
01:01:54.780 --> 01:02:09.780
The key question for Kirzner is how do we know that markets that are not in equilibrium, not in long run equilibrium, how do we know that they converge to some kind of long run equilibrium state?

496
01:02:09.780 --> 01:02:16.780
Okay, so Kirzner accepts that we have sort of very short-term equilibrium prices, the ones that we've modeled here.

497
01:02:16.780 --> 01:02:24.780
What Mises calls the prices that emerge and what Mises calls the plain state of rest.

498
01:02:24.780 --> 01:02:30.780
So Kirzner acknowledges that these plain state of rest prices exist as kind of equilibrium prices.

499
01:02:30.780 --> 01:02:33.780
But he says those prices aren't all that interesting or important.

500
01:02:33.780 --> 01:02:48.780
The only prices that are interesting or important for being able to make any statements about the efficiency of resource allocation are the kind of long run equilibrium prices, what Mises calls the final state of rest prices.

501
01:02:48.780 --> 01:03:08.780
And Kirzner points out quite correctly that in the Volrasian system and even in the neoclassical Marshallian system, there is no explicit mechanism for guaranteeing that these plain state of rest short-term equilibrium prices converge to their long-term final state of rest values.

502
01:03:08.780 --> 01:03:18.780
And so Kirzner introduces the fiction of the pure entrepreneur as a means of explaining the tendency of these prices to converge, right?

503
01:03:18.780 --> 01:03:25.780
Because when outside the final state of rest there are profit opportunities out there.

504
01:03:25.780 --> 01:03:32.780
So if we assume that someone is out there seizing them or there's an incentive for people to recognize and seize them

505
01:03:32.780 --> 01:03:36.780
and thus bring the market towards a sort of long run equilibrium state.

506
01:03:36.780 --> 01:03:51.780
There's some controversy on this point, but the way I read Mises and Rothbard, this question of convergence from the plain state of rest to the final state of rest is not a terribly important question.

507
01:03:51.780 --> 01:04:01.780
So they don't accept the need for this mechanism to explain the convergence. They don't think this convergence actually happens in the real world.

508
01:04:01.780 --> 01:04:17.780
The point of the story is that Kirzner is not trying to explain profit per se, or to model the entrepreneur per se, but he simply invokes this concept as an instrument for explaining market clearing.

509
01:04:17.780 --> 01:04:22.780
So it's quite different from the kind of entrepreneurship that we're describing today.

510
01:04:22.780 --> 01:04:49.780
Unfortunately, as it turns out, possibly because Kirzner's stuff is interesting to read and his stuff has gotten considerable attention in the applied literature and business schools on entrepreneurship, many of them have read Kirzner's work, particularly his 1973 book, Competition on Entrepreneurship.

511
01:04:49.780 --> 01:04:53.780
I would say they've read it in a somewhat shallow way and said,

512
01:04:53.780 --> 01:04:56.780
aha, this guy's talking about the thing we're interested in.

513
01:04:56.780 --> 01:04:59.780
Yeah, we think that entrepreneurs are alert to opportunities,

514
01:04:59.780 --> 01:05:05.780
so we'll set up this whole applied research program in what they call opportunity identification

515
01:05:05.780 --> 01:05:08.780
or opportunity recognition.

516
01:05:08.780 --> 01:05:12.780
So there are whole research programs and courses and seminars

517
01:05:12.780 --> 01:05:16.780
devoted to teaching people how to recognize opportunities.

518
01:05:16.780 --> 01:05:21.780
What are the psychological characteristics of those who are good at being alert to profit opportunities?

519
01:05:21.780 --> 01:05:25.780
Can we train people to be more Kirznerian in this sense?

520
01:05:25.780 --> 01:05:30.780
Well, I think Kirzner, quite rightly, would reject that entire analysis as misguided.

521
01:05:30.780 --> 01:05:36.780
Kirzner's not trying to provide a positive theory of who identifies opportunities and how they do it,

522
01:05:36.780 --> 01:05:42.780
but rather invoking, as I said, this alertness as a purely instrumental construct.

523
01:05:42.780 --> 01:06:07.780
Okay, even worse than these alternative functional accounts of entrepreneurship, if you read the literature carefully, both the practitioner applied literature and the academic literature, you find that many people don't conceive of entrepreneurship as a function at all, but rather as something else, for example, as an occupational category.

524
01:06:07.780 --> 01:06:22.780
So in vast swaths of the entrepreneurship literature, the term entrepreneur, entrepreneurship is an occupational category. An entrepreneur is a person who is self-employed.

525
01:06:22.780 --> 01:06:30.780
So if you own your own small business, you're an entrepreneur, otherwise you're not.

526
01:06:30.780 --> 01:06:43.780
So, there's very little attention to sort of the entrepreneurial function of bearing uncertainty and so on, but rather looking at, you know, the choice to start your own business versus work for another company.

527
01:06:43.780 --> 01:06:48.780
So, this really comes out of the labor economics literature and occupational choice, right?

528
01:06:48.780 --> 01:06:55.780
There's a sort of long literature in labor economics about why do people choose this profession versus that profession,

529
01:06:55.780 --> 01:07:08.780
empirical work, trying to run regressions on the probability that someone will enter this vocation or that vocation as a function of age, income, education, family background, demographic characteristics and so on.

530
01:07:08.780 --> 01:07:18.780
So there's a big strand of empirical literature trying to predict who will become a self-employed business person and who will go and work for IBM as a function of various characteristics.

531
01:07:18.780 --> 01:07:31.780
There's another strand of literature that thinks of entrepreneurship in kind of a structural sense.

532
01:07:31.780 --> 01:07:41.780
The unit of analysis here is not the individual and not an economic function, but rather a kind of firm or a particular industry structure.

533
01:07:41.780 --> 01:08:00.780
So when you hear someone say that one firm is an entrepreneurial firm and this other firm is not an entrepreneurial firm, or they say this society is more entrepreneurial than that society, they have in mind what I call a structural notion of entrepreneurship.

534
01:08:00.780 --> 01:08:06.780
Apple is a very entrepreneurial company and IBM isn't, you'd hear people say.

535
01:08:06.780 --> 01:08:10.780
Well, what does that mean in terms of entrepreneurship as uncertainty bearing?

536
01:08:10.780 --> 01:08:16.780
It doesn't really mean anything. I mean, both firms are engaged in entrepreneurial acts.

537
01:08:16.780 --> 01:08:20.780
What people mean here is a small firm.

538
01:08:20.780 --> 01:08:26.780
Entrepreneurial firm is a small firm or a new firm. A big firm and an old firm is not entrepreneurial.

539
01:08:26.780 --> 01:08:31.780
I mean, again, that's sort of an arbitrary distinction in terms of the theory of entrepreneurship.

540
01:08:31.780 --> 01:08:40.780
I mean, you have this big literature in industrial organization on the evolution of firm and industry structure from more entrepreneurial to less entrepreneurial firms,

541
01:08:40.780 --> 01:08:43.780
how many startups are in this country versus that country.

542
01:08:43.780 --> 01:08:48.780
I mean, interesting applied work, but it really doesn't have anything to do with entrepreneurship, per se.

543
01:08:48.780 --> 01:08:57.780
Okay, so this is my point here, is that the occupational and structural concepts are not closely linked to the functional notions of entrepreneurship that we've been discussing.

544
01:08:57.780 --> 01:09:10.780
Okay, we'll stop in just a minute here. There's some interesting implications of the theory of entrepreneurship for the theory of the firm, the theory of the business firm, the theory of economic organization, right?

545
01:09:10.780 --> 01:09:32.780
Well, what is a firm anyway? Well, if you take a typical course in intermediate microeconomic theory, the firm is described as a production process or modeled mathematically with a production function, y is equal to f of x1, x2, x3, and so on.

546
01:09:32.780 --> 01:09:39.780
So there are a series of inputs that are stuck into this production process and output comes out the other end, okay?

547
01:09:39.780 --> 01:09:50.780
So a lot of the technical literature on scale and scope economies and different factor input combinations and so on is really,

548
01:09:50.780 --> 01:09:56.780
it's not so much a theory of the business firm, where we think of the firm as ownership of assets,

549
01:09:56.780 --> 01:10:00.780
but rather a theory of the plant or the production process.

550
01:10:00.780 --> 01:10:12.780
In some of the management literature, there's a very interesting work on what is sometimes called the knowledge-based or capabilities approach to the firm.

551
01:10:12.780 --> 01:10:17.780
It has a sort of Hayekian flavor that has attracted some Austrian economists.

552
01:10:17.780 --> 01:10:27.780
It's the notion that, well, the firm is best understood as kind of a stock of knowledge, shared beliefs, routines, capacities,

553
01:10:27.780 --> 01:10:32.980
that are not manifest in tangible property, but rather exist as a kind of tacit knowledge

554
01:10:32.980 --> 01:10:34.660
and Hayek's sense of tacit.

555
01:10:34.660 --> 01:10:40.980
Well, I mean, clearly there is tacit knowledge within teams of people in firms.

556
01:10:40.980 --> 01:10:44.180
Firms do have capabilities in a sense.

557
01:10:44.180 --> 01:10:51.380
But I think a more correct approach to the firm is to think of the firm in property rights

558
01:10:51.380 --> 01:10:52.380
terms.

559
01:10:52.380 --> 01:11:02.380
Okay, then what we call a firm is a stock of assets, alienable assets, that are owned by one or more entrepreneurs.

560
01:11:02.380 --> 01:11:08.380
Okay, a sole entrepreneur or a team of entrepreneurs is in a partnership or a joint stock company.

561
01:11:08.380 --> 01:11:19.380
Okay, so the difference between IBM and Apple is that IBM owns some machines and equipment and land and buildings and some trade secrets and so on, and Apple owns other ones.

562
01:11:19.380 --> 01:11:26.380
Okay, so that's the distinction between the two firms is they're physically distinct in terms of ownership relations.

563
01:11:26.380 --> 01:11:34.380
Right now, of course, firms can jointly own, just as entrepreneurs can pool their resources and jointly own assets,

564
01:11:34.380 --> 01:11:42.380
firms can engage in partnerships and joint ventures and so on that involve some shared ownership, but ownership is still the key.

565
01:11:42.380 --> 01:11:53.380
So the firm is defined as the entrepreneur, a group of entrepreneurs plus the alienable assets that the entrepreneur owns or that the entrepreneurs own.

566
01:11:53.380 --> 01:12:02.380
Ownership, as I mentioned previously when I was discussing Joseph Salerno as my hired manager, ownership conveys a kind of authority.

567
01:12:02.380 --> 01:12:15.380
Some of you may have heard the somewhat obscure Greek terms favored by Hayek in one of his articles called Taxis and Cosmos.

568
01:12:15.380 --> 01:12:22.380
Taxis and Cosmos. And he's trying to distinguish between two kinds of social institutions.

569
01:12:22.380 --> 01:12:39.380
But what Hayek calls taxis is an organization that is deliberately designed sort of from the top down, is set up deliberately by a specific individual or group of individuals to achieve a particular defined purpose.

570
01:12:39.380 --> 01:12:53.380
As opposed to a cosmos, which is sort of a broader kind of institution or set of institutions that emerges organically from the bottom up, step by step, without any sort of deliberate overall design.

571
01:12:53.380 --> 01:13:08.380
Great story about, Murray Rothbard used to tell that Hayek came to New York to deliver a lecture when he was writing this article, Taxus and Cosmos.

572
01:13:08.380 --> 01:13:13.820
of Business and Cosmos, and Murray Rothbard's wife, Joey, saw an announcement or a mailing

573
01:13:13.820 --> 01:13:19.100
or something, she says, look, look, Hayek's giving a lecture on taxis, you know, the yellow

574
01:13:19.100 --> 01:13:24.900
ones, that's what people in New York understand. But no, Hayek meant Texas. Menger used the

575
01:13:24.900 --> 01:13:33.900
terms organizations and organisms, isn't that it? No, that's not right.

576
01:13:33.900 --> 01:13:40.900
Organizations and Orders

577
01:13:40.900 --> 01:13:45.900
I just wrote something about this yesterday and I've already forgotten it. I've got early Alzheimer's.

578
01:13:45.900 --> 01:13:52.900
So Menger used the term organizations as what Hayek calls a taxis.

579
01:13:52.900 --> 01:13:57.900
And the term order, as in the phrase many of you have heard, spontaneous order, to describe a cosmos.

580
01:13:57.900 --> 01:14:03.900
What's my point? My point is that the firm is a taxis or an organization.

581
01:14:03.900 --> 01:14:12.900
In other words, there's a critical teleological distinction between the firm and the market, between organizations and markets.

582
01:14:12.900 --> 01:14:24.900
Yes, clearly there is some element of experimentation and change and trial and error and unintended consequences within a firm,

583
01:14:24.900 --> 01:14:30.900
But a firm is a deliberately designed institution with specific owners, property owners.

584
01:14:30.900 --> 01:14:39.900
Whereas markets and the common law and language and culture are not organizations in that same sense.

585
01:14:39.900 --> 01:14:44.900
There are no residual claimants who have specific property claims over them.

586
01:14:44.900 --> 01:14:51.900
And what I mean is it's misleading to think of the firm as not having some kind of authority.

587
01:14:51.900 --> 01:15:00.900
The firm is really associated with authority. Owners of assets have authority over how those assets will be used.

588
01:15:00.900 --> 01:15:09.900
There is hierarchy in a firm. It's very popular nowadays, especially in the so-called new economy or the knowledge economy,

589
01:15:09.900 --> 01:15:15.900
to talk about the flattening hierarchy, firms becoming more decentralized.

590
01:15:15.900 --> 01:15:24.400
and sort of hierarchy is an old outdated 1950s-era concept when people went to work wearing, you know, suits and button-down shirts and ties.

591
01:15:24.400 --> 01:15:33.400
Now it's casual, laid-back, decentralized, there's more delegation, less hierarchy.

592
01:15:33.400 --> 01:15:41.900
I mean, certainly there are different approaches in management and subordinates can be delegated more or fewer decision rights.

593
01:15:41.900 --> 01:15:48.900
But the fact of ownership conveys a kind of authority that cannot be fully delegated, okay?

594
01:15:48.900 --> 01:15:59.900
On this notion of the production function view of the firm, well clearly that isn't an explanation of what firms are and what activities firms undertake, right?

595
01:15:59.900 --> 01:16:07.900
Because a firm, a single firm can own many different production processes, each of which has its own production function, okay?

596
01:16:07.900 --> 01:16:17.900
Or a group of firms can jointly operate and manage a particular production process through a joint venture or franchising arrangement or whatever.

597
01:16:17.900 --> 01:16:25.900
So the production function approach doesn't tell us much about the firm, though it may tell us something useful about the production process itself.

598
01:16:25.900 --> 01:16:36.900
I'm going to stop there because it's 3.19 and let's see if we have any other questions.

599
01:16:36.900 --> 01:16:39.900
Anybody besides Dan have a quick, no, I'm kidding, Dan, please.

600
01:16:39.900 --> 01:16:51.900
I guess you had the one slide where you designated Schumpf-Kerrien, Krederian, and one other

601
01:16:51.900 --> 01:16:52.900
Yeah, Schulzian.

602
01:16:52.900 --> 01:17:14.900
I guess, I mean, you keep referring to your kind of view as causal realism, and that's the role that comes out to me when I read Kirzner's version of alertness, with your example of hiring out Professor Salerno to handle your finances,

603
01:17:14.900 --> 01:17:28.900
I see how the property ownership and authority is important in bringing about kind of your human action or your own personal satisfaction of your preferences.

604
01:17:28.900 --> 01:17:37.900
But I don't necessarily see how there's any connection between that process and market clearing or a general market process.

605
01:17:37.900 --> 01:17:59.900
But when Kirzner positions entrepreneurship as being that link to alertness, that you need the essential characteristic of alertness to draw a link between individuals just bringing about their own better state of affairs in comparison to markets clearing systematically.

606
01:17:59.900 --> 01:18:09.900
So what's the causal realism of your description with entrepreneurship having this ownership function and then bringing it out?

607
01:18:29.900 --> 01:18:32.700
that have to some kind of systematic process

608
01:18:32.700 --> 01:18:35.700
of market clearing, and if it doesn't have such a connection,

609
01:18:35.700 --> 01:18:37.780
how can it be called causal realist?

610
01:18:37.780 --> 01:18:41.540
Is that a summary, a fair summary of your question?

611
01:18:41.540 --> 01:18:44.820
Okay, well, first of all, I mean,

612
01:18:44.820 --> 01:18:49.700
you correctly repeated some of what I said, right, that,

613
01:18:49.700 --> 01:18:51.340
sorry, that sounds a little harsh.

614
01:18:52.280 --> 01:18:56.120
No, you're correct, and I tried to emphasize that point,

615
01:18:56.120 --> 01:19:01.120
that Kirzner's theory is a theory of the market process,

616
01:19:01.680 --> 01:19:04.740
not a theory of the entrepreneurial act.

617
01:19:04.740 --> 01:19:06.240
Whereas what's being described here

618
01:19:06.240 --> 01:19:10.000
is not a theory of the market process in that sense.

619
01:19:10.000 --> 01:19:11.460
Because the question is,

620
01:19:11.460 --> 01:19:16.460
under the theory of profit in Mises' profit and loss,

621
01:19:17.260 --> 01:19:20.600
where is the mechanism that explains the convergence

622
01:19:20.600 --> 01:19:24.000
from the plain state of rest to the final state of rest?

623
01:19:24.000 --> 01:19:26.720
and the answer is, it isn't there.

624
01:19:28.120 --> 01:19:30.160
And in causal realist analysis,

625
01:19:30.160 --> 01:19:35.160
there is no attempt to explain the tendency of markets

626
01:19:35.480 --> 01:19:37.920
to go from the plain state of rest

627
01:19:37.920 --> 01:19:39.480
to the final state of rest,

628
01:19:39.480 --> 01:19:42.840
because in Mises, that convergence never happens.

629
01:19:42.840 --> 01:19:46.040
That is not a process that takes place in the real world.

630
01:19:47.800 --> 01:19:52.800
That all real world prices are plain state of rest prices

631
01:19:52.800 --> 01:20:10.800
The final state of rest never obtains, so there's no need for a mechanism to explain a process by which we converge from the PSR to the FSR.

632
01:20:10.800 --> 01:20:18.800
In Mises, the only kind of process that's important in that sense is the selection process that we describe for entrepreneurs.

633
01:20:18.800 --> 01:20:29.800
The process of providing profit and loss feedback to select the bad entrepreneurs from the good entrepreneurs is the only market process in a sense that's needed.

634
01:20:29.800 --> 01:20:42.800
I think for some insight into this, because it's a somewhat subtle issue, look at Kirzner's article in the Cato Journal in 99, which is an explicit response to some of Joe's papers.

635
01:20:42.800 --> 01:20:45.360
I'm gonna ask Joe to comment on this in just a second.

636
01:20:45.360 --> 01:20:47.000
Kirzner essentially says, he says,

637
01:20:47.000 --> 01:20:52.000
well, Salerno is right to point out that for Mises,

638
01:20:52.560 --> 01:20:56.400
only the plain state of rest obtains in the real world

639
01:20:56.400 --> 01:20:59.600
and that Mises does not explain how or why

640
01:20:59.600 --> 01:21:03.520
final state of rest prices would obtain

641
01:21:03.520 --> 01:21:07.080
and that that's a flaw in Mises's exposition.

642
01:21:08.280 --> 01:21:10.640
Kirzner says, well, he says,

643
01:21:10.640 --> 01:21:24.640
It's right that Mises, Kirzner says the only reason that the plain state of rest is economically significant is because Mises builds his theory of consumer sovereignty on it.

644
01:21:24.640 --> 01:21:34.640
Kirzner recognizes that Mises' account of consumer sovereignty is based on Mises' belief about the significance of the prices that obtain in ordinary market transactions.

645
01:21:34.640 --> 01:21:41.640
But, Kirzner says, other than that, those prices aren't particularly important.

646
01:21:41.640 --> 01:21:54.640
We can't offer a systematic defense of the market economy, unless we can also explain how these plain state of rest prices tend toward their final state of rest positions.

647
01:21:54.640 --> 01:21:58.800
But that, to me, that's contradictory, right?

648
01:21:58.800 --> 01:22:03.000
Because if you can use these everyday prices to explain consumer sovereignty, why would

649
01:22:03.000 --> 01:22:10.760
you need to, why do you need to posit an additional mechanism that leads us to a state of affairs

650
01:22:10.760 --> 01:22:13.960
that is, again, an imaginary construct, a hypothetical construct?

651
01:22:13.960 --> 01:22:17.920
Joe, do you want to add a comment to that, since you've done some of the key writing

652
01:22:17.920 --> 01:22:18.920
in this area?

653
01:22:18.920 --> 01:22:31.920
The point is that when, or what Mises is driving at is that the entrepreneur, when he plans production, let's say he plans to introduce a new model car five years from now, he doesn't care what the final state of the rest is.

654
01:22:31.920 --> 01:22:38.920
There are many, many changes that are going to intervene between when he starts that plan and when the plan comes to fruition five years from now.

655
01:22:38.920 --> 01:22:46.920
All that he's interested in is what will be the state of supply and demand be five years from now when that car reaches the dealer?

656
01:22:46.920 --> 01:22:56.920
The market process is what happens in real time, in calendar time over those five years.

657
01:22:56.920 --> 01:23:01.920
He may be right, he may be wrong, he may have anticipated the future state of prices wrongly or correctly.

658
01:23:01.920 --> 01:23:10.920
If he's wrong, his capital will diminish and eventually if he doesn't change, his anticipation will continue to be incorrect.

659
01:23:10.920 --> 01:23:12.920
He'll go out of business.

660
01:23:12.920 --> 01:23:42.920
and my other entrepreneurs at the same time will be earning profit and will be expanding, so there is no, why do we need to focus on this mechanism that drives the economy after one change and or a number of gaps between prices, everything else stops and then people pick up these $20 bills and then everything is coordinated, that's not the way it happens in the real world, okay, the only reason why we need a plain state of rest notion is just to show

661
01:23:42.920 --> 01:23:50.540
and the

662
01:23:50.540 --> 01:23:56.120
final state of rest.

663
01:23:56.120 --> 01:24:02.520
So there is a, what Mises calls final state of rest analysis is kind of analogous to comparative

664
01:24:02.520 --> 01:24:08.900
statics in standard undergraduate economics and it does help us to understand some causal

665
01:24:08.900 --> 01:24:17.900
Relationships, but it isn't needed as some sort of overall theory of the market process, of the effectiveness of the resource allocation of the market and so on.

666
01:24:17.900 --> 01:24:29.900
So I guess the short answer to your question is that in the view that's being expounded here, Kirzner is trying to propose a solution to a problem that isn't really a problem.

667
01:24:29.900 --> 01:24:37.900
A problem that isn't a problem that we have to worry about.

668
01:24:37.900 --> 01:24:43.900
I refer you to the voluminous writings of Joseph Salerno on this particular topic.

669
01:24:43.900 --> 01:24:45.900
Yes?

670
01:24:45.900 --> 01:24:55.900
As you were listing the characteristics of your entrepreneur, I thought of another player in the economy,

671
01:24:55.900 --> 01:25:03.900
and it seemed, another name, and it seemed to fit over and over and over again, and that is venture capitalists.

672
01:25:03.900 --> 01:25:18.900
What is the difference between a venture capitalist, as conventionally understood, and what you say, after all, a venture capitalist is alert. He is the ownership of a single capital.

673
01:25:18.900 --> 01:25:22.900
A venture capitalist is an extremely important kind of entrepreneur.

674
01:25:22.900 --> 01:25:31.900
You're saying kind of entrepreneur, but is there a general category of which a venture capitalist is covered in one sector?

675
01:25:31.900 --> 01:25:37.900
I mean, someone who invests in publicly traded equities is also an entrepreneur.

676
01:25:37.900 --> 01:25:42.900
If by venture capitalist we mean someone who makes private equity investments,

677
01:25:42.900 --> 01:25:47.900
makes investments in ventures that are not publicly traded, then that would be another type.

678
01:25:47.900 --> 01:25:55.900
An angel investor, if you distinguish that from a venture capitalist, would be another kind of entrepreneur.

679
01:25:55.900 --> 01:26:00.900
So anyone who holds an equity interest, in a sense, is acting entrepreneurially.

680
01:26:00.900 --> 01:26:05.900
So a venture capitalist is one real-world manifestation of the entrepreneurial function.

681
01:26:05.900 --> 01:26:09.900
But there are other people who also perform a similar function who are not venture capitalists.

682
01:26:09.900 --> 01:26:16.900
But surely not any boulder of inequity in that if I own pre-shares in Microsoft, I'm not an entrepreneur, am I?

683
01:26:16.900 --> 01:26:18.900
Yeah, I would say you are.

684
01:26:18.900 --> 01:26:19.900
I am?

685
01:26:19.900 --> 01:26:21.900
Yeah, let me explain.

686
01:26:21.900 --> 01:26:28.900
This is kind of a, I don't want to say a trivial case, but technically speaking you are an entrepreneur

687
01:26:28.900 --> 01:26:47.900
Entrepreneur, because you do own assets that are put, that are put at risk. Okay? Now, in a practical sense, you're an entrepreneur in such a teeny-tiny sense, it's such a small part of your overall portfolio of activities that it really doesn't have any practical economic significance.

688
01:26:47.900 --> 01:27:17.900
Just as we could say, imagine, I was talking to you about Paris Hilton, suppose that just for fun, or as part of some reality show or something, they have a TV show where they make Paris Hilton be a waitress for one hour per month, and they film it for fun, and for that one hour she really is, they're paying her, they pay her $5 for doing that, and she gets tips or whatever. I mean, technically speaking, for one hour a month, Paris Hilton is a wage earner.

689
01:27:17.900 --> 01:27:23.900
Activities have a very economically significant effect, a practically significant effect on the labor market.

690
01:27:23.900 --> 01:27:29.900
No. Would we describe her? Oh yeah, Paris Hilton, she's that famous waitress. No.

691
01:27:29.900 --> 01:27:33.900
But again, technically speaking, she would be a laborer in a little teeny-tiny sense,

692
01:27:33.900 --> 01:27:36.900
just as you with your three shares of General Motors.

693
01:27:36.900 --> 01:27:45.900
I mean, you are, technically speaking, an entrepreneur. You're just not a very important one.

694
01:27:45.900 --> 01:27:50.700
No offence, I mean neither am I, neither are most of us.

695
01:27:50.700 --> 01:27:56.700
I'm not offended, I just find this crazy, because there's something missing from somebody

696
01:27:56.700 --> 01:28:02.700
who doesn't have more than three shares in major companies, and that's right for me.

697
01:28:02.700 --> 01:28:08.700
It's a very old-fashioned sort of investment.

698
01:28:08.700 --> 01:28:12.900
The distinction is between a general notion of entrepreneurship and what you're thinking

699
01:28:12.900 --> 01:28:22.900
You're thinking of specific psychological attributes, the drive for success, the creative impulse, the desire to leave the world in a different state in which you found it.

700
01:28:22.900 --> 01:28:33.900
Fine, that's all great, but it isn't necessary to possess those characteristics to act entrepreneurially in the sense of bearing uncertainty in the world outside the evenly rotating economy.

701
01:28:33.900 --> 01:28:40.260
economy. Again, if we were interested in doing applied work on entrepreneurs in history,

702
01:28:40.260 --> 01:28:44.900
I wouldn't spend a lot of time studying guys who own three shares of General Motors. Okay,

703
01:28:44.900 --> 01:28:51.900
but I mean technically they're entrepreneurs, but there's not very interesting ones. Yes?

704
01:28:51.900 --> 01:29:02.900
Well, in further comment to that question, you're focusing on numbers to re-share, so the question becomes then, how many shares would you have to own to be an entrepreneur?

705
01:29:21.900 --> 01:29:40.900
Here's Kirzner's element coming into it. He isn't just plunking down his money to buy free shares in a very well established company whose greatest time was rose was 25 years ago.

706
01:29:51.900 --> 01:30:21.900
Entrepreneur to Describe Something Else. That's fine. As it turns out, however, in my defense, if you look at the history of the word entrepreneur, as it first appeared in the French, in Richard Cantillon, really the notion of entrepreneurship as judgmental decision making under uncertainty is historically the more accurate term. It's only recently that the word entrepreneur has come to be associated with startups and systems.

707
01:30:21.900 --> 01:30:25.900
and the kind of things that you're describing.

708
01:30:25.900 --> 01:30:27.900
Again, it's just a semantic issue.

709
01:30:27.900 --> 01:30:29.900
And maybe Joe and I have talked about this before.

710
01:30:29.900 --> 01:30:33.900
Maybe it would be in our interest, purely for expositional purposes,

711
01:30:33.900 --> 01:30:37.900
to find a different word, not to use the word entrepreneur.

712
01:30:37.900 --> 01:30:40.900
It's just like the word liberal.

713
01:30:40.900 --> 01:30:46.900
We classical liberals or libertarians realize we've lost the word liberal to the left.

714
01:30:46.900 --> 01:30:57.900
Maybe the word entrepreneur is too difficult to get that word back, but again, it's just a semantic point, it's not a theoretical point.

715
01:30:57.900 --> 01:31:02.900
Okay, thank you very much.