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NOTE Profit, Loss and the Entrepreneur

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What I want to do before I start is to draw your attention to an interesting article in yesterday's paper about the University of Alabama seeking a big tuition increase.

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And let me just read you the first few paragraphs.

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It says the University of Alabama is asking trustees to approve steep tuition hikes, despite the fact that it's going to be getting 17% more in state funds.

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University officials said the tuition raise is needed for Alabama to become one of the top institutions in the southeast.

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And then they go on and point out that the change would include an 8.5% raise for in-state tuition, up to around $5,200.

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And out-of-state students would face an even steeper increase, if this is approved, an increase of about 13.2% to over $15,000.

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What are they implicitly assuming about the demand for an Alabama education?

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That the demand curve is inelastic.

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That is that this big increase in tuition, while it's going to discourage some enrollments, will not discourage enough to cause total revenue to fall.

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So it's an inelastic demand curve. The point being that, a point I made yesterday, or I guess it's actually the day before, that state institutions, state-owned institutions, tend to price in the inelastic range.

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You never find profit-maximizing entrepreneurs doing this unless they've made a mistake in estimating what their demand curve will be.

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And this results really in a short-run waste of resources because the university becomes too big.

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If it raised tuition and got into the elastic range, quantity demanded would fall, enrollments would fall off, their total costs would fall,

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and these resources would be better used in other parts of the economy.

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So it's inefficient, but yet it's done continually. Now why is that? How do we explain that?

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Well, first of all, always ask the question, as I said yesterday, who benefits from these low prices of subways and state universities and so on.

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Well, the administration, the people in charge whose salaries depend on the size of their institution and the number of faculty in their institution,

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They certainly benefit. So the greater the enrollments are, the larger the institution is, the higher the salaries are, the more people under them they can hire.

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So in other words, it's called empire building. So they'd rather, if they could, they'd rather have a zero price, a zero tuition, okay, if they could get the state to finance all of the students that would come at zero tuition through taxes.

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Now, the politicians, why would the politicians consent to having lower prices when that means that they have to raise taxes to support the difference between the cost of educating the student and the tuition that's paid.

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Even after this raise in tuition by Auburn, there's still going to be tremendous amount of tax monies coming to the university.

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Well, again, the politicians are seeking to be re-elected and they want to appeal to people that are vitally interested in a particular issue, that is an issue that people consider to be a voting issue.

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So parents and students who are voting age who are intending to come to the University of Alabama are vitally interested in having a lower tuition.

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So the benefits are concentrated on this smaller group in Alabama and outside of Alabama, but they don't vote, a small group within Alabama, and who are willing to vote for people that will give them lower tuition.

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Whereas taxpayers in Alabama are a much larger group, right?

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And so the costs are dispersed and are smaller for each individual in this larger group who are victimized by these lower tuitions and higher levels of tax support.

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So that's, I think, an explanation of why consistently governments tend to price services that they provide in the inelastic range of their demand curve.

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All right, well, what I want to do now is to finish up the discussion that began yesterday regarding case studies in price controls.

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And there was one other point I wanted to make about rent controls before I get into another case of maximum price controls, and that is when you have a shortage, one other type of behavior you begin to see among landlords is that they begin to rigorously enforce the lease.

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In other words, if you rent an apartment and you read the fine print in the lease, basically you can't do anything after 10 o'clock at night except breathe in your apartment. You can't have overnight guests that are unrelated. You can't play the television at any sort of volume or your stereo. You can't, for example, repair your car in the parking lot or even wash your car in the parking lot. You may not be able to have pets. There are a lot of clauses in there.

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The various clauses in the lease generally are not enforced on a free market, where supply equals demand.

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They're usually in there to protect tenants, most of the tenants, from an unruly tenant who might have pets that he allows to roam freely and attack other tenants,

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or similarly his own children that are unruly and annoy other tenants, or people who are out there late at night fixing their cars and making a racket.

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So it makes it easier for them to evict, okay. If they were to actually enforce these sort of fascist provisions in the lease, they would experience a lot of vacancies, right.

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Because supply teams don't have to go to that apartment building, they'll find other apartments. So it's really competition that determines how rigorously the lease is enforced.

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Now what happens, however, if there's a big shortage of apartments? People put up with anything, okay.

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And I have had personal experience with this. When I lived in southern New Jersey, which is actually much more rural than northern New Jersey, in fact it's below, part of it's below the Mason-Dixon line, believe it or not.

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And there's an interesting sign as you're driving down a highway, major highway, it's going to southern New Jersey, there used to be a sign, a big sign with the top half of New Jersey more or less black and dripping sort of with oil,

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and the bottom half is Emerald Green and it says we don't want your industry, farmers of South Jersey.

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The people in South Jersey called themselves South Jerseyans.

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In any case, there was a real individualistic lot.

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After the wage and price control freeze that Nixon had imposed on the economy ended in 1975,

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many towns kept price controls and many towns in northern New Jersey kept rent controls, for example.

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In southern New Jersey, they didn't, okay, they just lapsed. So when I lived in southern New Jersey, I read the lease, I was teaching a small school there, read the lease and said you couldn't have pets, you couldn't repair your car, all of the usual things.

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And I had a couple of cats, so I was a little worried about it, and so one of my neighbors came over and said, look, don't worry, because I was trying to figure out how to hide them, she said, don't worry about it, they don't really enforce it.

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I really enforce it. As long as your pets don't make a mess on the property and are quiet and so on, they're not going to enforce that part of the lease.

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And also, I would see people during the day out there washing their cars and so on and repairing their autos.

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So I figured, well, that's great. So a few years later, I get a job at Rutgers, which is northern New Jersey.

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I move up to northern New Jersey. There's still rent controls.

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And, you know, so I have cats. So cats were out running around when the moving men were moving things in.

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And one of the neighbors came over and said, you better hide those cats.

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And I said, why?

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She said, well, because it's in the lease, if you look at it.

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And so I said, really?

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So did they enforce it?

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She says, oh yes, not only did they enforce it,

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they had the manager of the complex had like a little Gestapo group of kids

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that ran around during the day and looked in people's windows

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and reported back on whether or not they had pets.

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So they began, you know, and then at night I would see people out there with flashlights

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The parking lot. They were rigorously enforcing the lease. If you didn't like it, you can leave. There's a shortage of apartments. There's someone else on the waiting list.

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So you tend, that's very interesting. So what happens is that people with children, people with pets, people, you know, as I mentioned yesterday, there's also racial and religious discrimination.

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Discrimination. These types of people find it much more difficult to find apartments when you have rent control and there are shortages.

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They can be easily turned away without the landlord suffering any sort of monetary loss.

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And to bring this home, I give my class, when I teach this, an example of, it's not so politically correct anymore, but I don't think there's anything wrong with it,

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The lecherous landlord will only rent, let's say, the blonde females between 18 and 25.

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It's the only group he's going to rent to.

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So let's assume he can get $1,000 per month for the apartment.

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and let's say he has 20 units

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and where there are no rent controls on a free market where supply is equal to demand

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let's say he would have five vacancies

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because it takes a while to find exactly that small group of people he wants to rent to

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so I'm obviously exaggerating this

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for Effect. So he indulges his preferences. If he indulges his preferences for a certain group of people he wants to rent to, what's going to happen? He has five vacancies, which means that he loses $1,000 a month, and in one year that will work out to be times 12, so that will work out to be $60,000. He loses $60,000 in income if he wants to discriminate according to his preferences.

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Now let's take a rent control situation, where there's huge shortages, such as New York City.

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Would he lose that? So in other words, the higher the cost, the less he's likely to indulge his preferences.

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He may very well, on a free market, not indulge it. Say, it's not worth $60,000 for renting to pretty young females, or whatever his preferences are.

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However, when there is a shortage and people are desperate for apartments, he can simply turn people away until he finds the people that he wants.

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So it's much more likely that he'll indulge his preferences.

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He'll have many fewer vacancies. He might only have one or two, if any.

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And so he won't lose much income, especially if the rents are much below a thousand dollars.

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So in other words, it's the law of demand operating.

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As the cost of renting to only a certain group falls, which it does under rent control, what happens?

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People are going to engage in more of that sort of activity.

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Activity. So I think that's a good example that leads you to see that, even in the case of preferences and prejudices, that rent controls have an effect that you don't really, or that no one who endorses them would find desirable.

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And there was another article that I looked at and I meant to discuss in more detail. I'll briefly mention it to you. In France, after World War II, there were rent controls and the French were paying in Paris something equal to about one dollar or eleven packs of cigarettes per month. That was the rent. The rent controls had been put in during World War I. They hadn't been changed.

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Needless to say, hardly any Paris, hardly any new building in Paris after World War I.

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Okay, so now we're talking 1946, 1947 after World War II.

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There was a massive shortage. The only way you'd get an apartment was if someone died.

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So, when the soldiers returned and they married and so on after World War II, they needed apartments,

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because they were living with the in-laws, which isn't a great way to start a marriage, and so they needed apartments.

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So the full-time job of the wife while the soldier went to work or the former soldier was at work earning a living was to go and sit in parks where old people congregated and to focus in on the most sickly looking older person and then follow them home and find out where they live and then go to the landlord or to the superintendent and give them a big bribe and tell them this is an exchange for letting me be the first one to know when that person dies

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And then the landlord would let them know and then he would help, basically if you got there first, you got it.

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So as soon as the person died, you know, they'd be pushing the body aside, moving their furniture in.

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So no one in their wildest imagination believed that rent controls would lead to turning part of the population of France into ghouls.

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You know, just hovering around waiting for people to die.

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But in fact, that's indeed what did happen.

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This sort of behavior on a reduced scale also occurs in New York, as has just been pointed out, where people look in the obituaries to find the addresses of people that have died and then possibly even go attend the wakes and so on to meet the family so that they can pay them a bribe and get the apartment.

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I don't know if that's an apocryphal story or if that's true, but I do know that there's key money paid in New York, it's illegal, but you can pay a non-refundable deposit for the key.

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The landlord says, well, you've got to give me $3,000 for this key, and it's not refundable, so they keep it, it's a pretty transparent bribe.

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Let me now talk about another case of controls, and that is organ donations, which people don't usually think is an economic issue, but in fact it most definitely is.

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And I have an actual diagram with figures that are accurate, at least from 1995, I believe, yeah, 1995, let me see if I can get this centered and then focused in.

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In 1995, by the way, in 1984, let me just backtrack a moment, in 1984 in the United States, the Transplant Act of 1984 was passed and it makes it a felony to buy or sell organs, okay?

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So in effect that means that there is a zero price, P equals zero.

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Now, for family reasons or for altruistic reasons, people sign donor cards. Most of the organs that are transplanted are cadaveric, they come from dead bodies, but there's a proportion of donations among family members.

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So in the case of kidneys, there were 10,000 kidneys donated in 95, and yet 40,000 people needed transplants, were on a waiting list.

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Regarding hearts, the numbers were 2,400 and 6,400.

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What occurred, of course, was that some of those people between A and B, both kidneys and hearts, died while they were on the waiting list.

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I have the numbers here. 731 of those waiting for heart transplants out of the 4,000 that didn't get them died.

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And for kidney transplants out of the 30,000 patients on the waiting list, over 1,300 died.

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For lung and liver transplants, 290 and 674 patients died respectively while they were waiting for organs.

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Now how did the government meet this crisis that had begun to develop since 1984?

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There's another reason why it began to develop because in 1986, cyclosporine, a drug which was designed to inhibit organ and tissue rejection was allowed onto the market.

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And there's also an increasing sophistication in tissue matching and in surgical techniques.

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So success rates for transplants dramatically increased.

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So you began to get a big increase in demand for transplants, but yet there was no change in it.

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Well, there was no big increase in the supply curve or even in the quantity supply.

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So, this is simply a shortage caused by price control, price control of zero.

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It's interesting, and there's all ethical arguments, there's a number of ethical arguments against it.

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Why should an individual benefit from another individual's misfortune?

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Let's say the equilibrium price is $75,000 for a kidney.

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So the attitude is how dare someone accept $75,000 for a kidney that's taking advantage or exploiting someone else's misfortune.

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Well, let me put it to you the following way.

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Do the surgeons that participate in the transplants, do they get paid?

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Yeah, they sure do.

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Sure do. Hospitals get paid. The drug companies that supply cyclosporine and other drugs get paid. Yes, everyone else that participates in the transplant surgery get paid.

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But no one raises any ethical questions about that. They're all getting paid as a result of this person's misfortune. In fact, anytime you go to a doctor, anytime you have any sort of surgical procedure, they're exploiting your misfortune.

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That's simply scarcity, okay? It's a scarcity of good health in the world, okay?

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So that ethical argument doesn't hold up praxeologically.

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Yes?

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Right. That's an interesting point Mila brings up. That is that in some places, if someone has a rare form of cancer, for example, or another rare disease, they'll take some of that person's tissue and put it in their mouth.

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They'll take some of that person's tissue without informing the person of that and use it for experimentation and, you know, come up with new drugs and so on and possibly a big sum of money from successful research.

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I mean, it's a long period of time that you put that person under, that person is put under for a longer period of time than he or she would be,

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and that impairs their immune system, puts them at more risk, just to take this free tissue.

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Okay, so that's fine to do, if indeed that exists, not to inform people, and to take a part of their body, even though it's not a vital organ, for experimentation.

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But yet, to pay someone who will donate the organ, will more people sign donor cards? Let's put it that way.

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What will happen to quantity supplied if donor cards are permitted to be signed, or rather, if you can pay someone now to sign a donor card, which embodies an agreement to turn over their organs to this organ bank post-mortem, after they die, would more people do it at 10,000? Of course, quantity supplied increases as the price rises.

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And in fact, there's been surveys done. People's reluctance to designate themselves legally as organ donors can be attributed partly to procrastination, I'll do it later, and partly to an anxiety harbored by some potential donors that in the event of an accident, emergency room medical treatment might be less aggressive for accident victims whose drivers license or stamp organ donor. In matters of one's own life, most people tend to be quite reluctant to take risks for free. That's a fact.

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Would they overcome that reluctance at $50,000? Perhaps. And more would overcome it at $75,000.

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So what you would get then is a greater number of people, the difference between QE and QS, able to get transplants.

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And you would have fewer debts. The people that do not pay the higher price aren't necessarily people that can't afford to.

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They may be people who have a very short life expectancy even with the donation and don't want to go through the discomfort associated with that donation.

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Or they might be people that just don't like surgery and would rather stay on dialysis.

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But the point is, like any other good on the market, it's not the rich people that get all of the good.

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The rich people don't have all of the luxury cars.

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Some people will forego other things, some middle-income people or even lower-income people will forego many other things

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and other things because a luxury car ranks highly on their value scales, or their family will help them purchase it and so on, okay?

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Same thing is true with organs, okay?

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You're going to have them distributed to those who value them highest vis-a-vis other goods and money on their value scales, okay?

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There was one other point I wanted to make.

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Oh, predictably enough, a black market has, of course, grown up, and let me read you part of an article on this.

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They're talking about an individual. They say he was desperate for a kidney transplant, but getting a donated kidney he was told could take 10 years.

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That's when this individual's name is Teiti, Moshe Teiti. He decided to pay a broker $145,000 to buy a kidney.

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And he said he was in terrible shape, and it didn't matter what it cost. He wanted to live like a human being, as he puts it here.

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In any case, now this is a later article, this is 2001 or 2002 here, there are nearly 49,000 people in the United States waiting for kidneys, so the waiting list has gone up.

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The only major organs that can be wholly harvested from a living person. More than 2,500 Americans died last year waiting for kidney transplants, so the number of deaths have gone up significantly too, from 1,700.

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These numbers, along with desperate economic conditions in the third world,

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has given rise to a secret underground industry that is also fueling an explosive ethical debate.

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The people that are debating it, are involved in the ethical debate, are people in academia,

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people whose organs aren't failing. They're the ones that are debating on whether this is right or not.

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Within days of paying $145,000, Tady got a call from the broker,

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The Market is operating. The market is getting around all these government regulations.

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I mean, they're sending surgical teams on airplanes, and so on, okay?

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Buying and selling organs is prohibited in almost every country, and yet it's happening almost everywhere.

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It says most of the people that are selling their kidneys are from poor countries, okay?

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For example, in the former Soviet Republic of Moldova, one woman told ABC News, she sold one of her kidneys for just $1,500, okay?

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She did it to buy food for her children, okay?

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And then, oh, and then they talk a little bit about the ethical debate.

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The idea that organs can be bought and sold used to appall Dr. Michael Friedlander.

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But then some of his patients started getting into the market.

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I'm seeing patients who were in dialysis treatments as Friedlander.

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Some of them were in very bad condition and suddenly two or three weeks later coming back well transplanted,

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very happy and a completely different state of health.

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So, you know, these aren't just back alley operations where people are dying from them.

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The market is providing here, even though it's a black market, at least in many cases, a service that is successful.

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Most physicians and medical ethicists say that buying and selling kidneys is wrong, period.

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What does that mean, is wrong, period?

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They take into account the fact that not only the people getting the money are benefiting,

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Okay, but also the people getting the organs are benefiting, okay, that the woman that gets the fifty, it's interesting, it's really the poor that are always the good ones and the rich that are always the bad ones, so when a poor person sells an organ for fifteen hundred dollars, like this woman in Moldova, she's the exploited one, okay, the one that's selling the kidney, alright. So it seems to me, this is a physician talking, it seems to me a violation of the very nature of what medicine is about, explains Nancy Scheper-Yews.

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to suggest that the poor should be allowed to dismantle themselves bit by bit with the help of the medical profession.

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They're hardly doing that. That's absurd.

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How is it any different from Alex donating a kidney to a relative?

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How is that different from a surgeon participating in that procedure,

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from a surgeon participating in a procedure in which someone is selling the kidney?

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So I'm not even making an ethical judgment on it. What I'm saying is that, praxeologically, that they can't establish a difference between the two.

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They're both voluntary. They're both done in a way that improves the utility of both parties participating.

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Both donor and recipient and buyer and seller, both are better off. Whatever these ethicists, bio or medical ethicists, think.

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Okay, now let me get into, and I'll go through fairly rapidly, the case of price floors.

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Okay, that is a case where the price is set below which it's illegal to sell the good.

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Again, I start off with the milk example, but I'll use the wheat example, and let me zoom out on this.

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Okay. In this case, again, we're talking about gallons of milk.

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What happens is that Congress may pass a law that is designed to ensure that farmers have stable incomes,

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To fix a price at which farmers can sell the product, let's say $8, and have stable incomes.

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Incomes tend to, crops tend to change rapidly. There's a volatile supply in agricultural markets.

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That's usually one of the arguments that's used to get the consumers to support these price floors.

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They'll say something like, well, you know, today milk is very cheap, it's $2.

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But that's so low that farmers are going to lose money and eventually they're going to go out of business and then the price of milk is going to go up to $13 per gallon and, you know, babies will be starving, they won't have milk, okay?

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And then at that high price, the next year, there's going to be a lot more milk on the market to push the price down to $1 and more farmers are going to go out of business and then the price will shoot up to $15.

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So there's going to be a disorderly market with prices shooting up and down, okay?

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That's the argument that's often made to get taxpayers and other non-farmers to support consumers and so on, to support higher prices for milk.

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They say, look, at $8, farmers can earn a nice profit and they'll stay in the market and the price of milk will be stable, okay, from year to year.

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So that's an argument.

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Notice what happens here. You have all of the effects coming into play, although in reverse, that you did with price ceilings.

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At $8, notice that there's a given stock of milk on the market initially in the short run, 13 million gallons per week, and people only want 7 million.

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So suddenly you have a surplus. And as that surplus builds, it hangs over the market.

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What can happen is that farmers have an incentive to start violating the law and selling the milk on the black market to get something for it.

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So the government will step in and say, all right, what we'll do is anything you do not sell at $8, we will purchase at $8.

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That's called a price support. We'll support the price by buying up the surplus at $8.

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Now, as farmers adjust to this over time, as dairy farmers adjust, what they begin to do is at $8, it's profitable to produce milk, you get more people entering the industry and existing farms growing and increasing the supply of milk.

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So there's a long run supply curve. So the surplus gets worse and worse over time.

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The supply grows from, let's say, 13 million gallons to 22 million gallons per day, per week.

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And so now you have a huge surplus of milk. The difference between 22 million gallons quantity supplied and quantity demand of 7 million gallons.

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So this is very costly. The government has to buy up the milk. In milk programs that we have in the United States, farmers are forced to turn these surplus milk into butter and cheese, and then it's frozen, okay, it's stored and frozen, and then eventually, after two or three years, it will go bad anyway, so it's given away to, you often see these giveaways of free cheese and free butter and so on, it's given away to poorer people, okay.

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And other things happen. For example, as more and more land is used in farming, let's say cattle farming, and more machinery and so on, the price of all of these things begin to go up.

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So the price of farmland rises and the farmers benefit from that.

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Now, let me deal now with a real example here, or example I have more information about.

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Now, and there certainly are milk price supports, and that example is the wheat, okay, the case

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of wheat.

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But we price supports, let me make sure I have this.

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Hold on one second.

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I don't need a diagram for the time being. What I'll do is I'll just put up the other diagram with the price, but we'll use the wheat example.

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Wheat generally tends to be around $2 to $3 per bushel, and let's say the government set the price support at $5, or we can use $8 as an example.

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So what you're going to get is, in the long run, you have this huge surplus of wheat and the government's going to have a lot of pressure on it to deal with the surplus.

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For example, in the 1950s, what it tried to do was to give the wheat away to foreign countries in foreign aid.

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There was a law passed in 1954, public law number 480, which identified poor countries such as India.

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This is India. So they began to sell it cheap or give it away free to India, right?

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Now notice what happens there. In India, local people buy food from their local farmers, okay?

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They buy rice and other things. Now they're getting free wheat or very, very cheap wheat from abroad.

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So they begin to ship their demand, because they're rational, to the free or cheap food.

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The demand for the local food from the local farmers, agricultural products from local farmers in India, falls.

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Now, what happens to those farms? They go out of business.

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Now, what happens in a year in which the U.S. has a bad crop?

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That is to say that the supply curve shifts back to, you know, 7 million.

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And there isn't any excess wheat that the government has to get rid of.

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Well, then there's a famine in India.

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so after a while the US stopped these programs of giving direct

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you know large quantities of food to third world countries

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so then they figured out another way of doing it

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well actually before that they began to store the wheat

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in more full ships from World War II that were

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moored in the Hudson River

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and they just left it there and it rotted

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and that became a political scandal

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late fifties early sixties

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Well, people are starving in the United States and around the world, and you're allowing all this wheat to rot.

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At one point, the Canadian government, to get rid of its surplus of eggs, permitted 28 million eggs to rot, okay?

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So this politically does not look good, so you want to find another way to get rid of it.

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Well, you can give it away domestically to poor people, so that's why we had programs such as food stamps,

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School breakfasts, school lunches, free school breakfasts, free school lunches.

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It was to get rid of these surpluses.

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But of course poor people also buy food.

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So what happened to the demand for the food?

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The demand for food shifted to the left because they were getting it free and that increased the surplus.

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So government really, the US government was desperate to get rid of the surpluses.

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One of the things they actually tried was that government scientists experimented with a technique to use wheat in place of gravel to mix asphalt.

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Of course, it failed abysmally. It's for paving roads. They were going to use wheat in paving roads. That failed.

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So then, of course, you come to out-and-out monopoly. What you do then is to get rid of the wheat, the surplus, which is politically embarrassing, you forcibly shift the supply curve back.

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So you begin to tell farmers, you give them acreage allotments. You say from now on you can only devote 80% of your acres to wheat or 60% or whatever it is.

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So you force them to restrict the supply. Now a couple things happen here. Farmers are profit motivated. Their incentives to earn profits as high as possible.

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When you do that, how are they going to respond? Well, they're going to take their worst acres out of production, so it's not going to decrease as much.

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It's not going to decrease, let's say you mandate 40 percent taken out of production, 60 percent acres remaining in production.

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The weed output will not decrease by 40 percent, but by much less, so you're still going to have surpluses.

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Secondly, farmers are going to say, you know what, I'll just farm the 60% of the land that I'm permitted to farm with wheat more intensively.

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I'll buy more and better equipment, more fertilizer and so on.

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So the supply curve again tends to creep to the right, reestablishing the surplus.

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So then the government introduces market quotas, and market quotas set how much the farmer is permitted to bring to market.

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It's a straight cartel arrangement that farmers can bring more than a certain amount per harvest to market.

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And that, they hope, will push back the supply to equal demand.

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Farmers don't like this type of thing. In fact, some farmers rebelled against this. Some citrus farmers rebelled against this.

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There's a famous guy, he's a libertarian, who challenged the Sunkist cartel, which is sort of a government-mandated selling cartel.

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Somehow Sunkist controlled it, and I don't think he won.

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Then the farmers get deficiency payments if the prices fall. For example, allow the price to be set at the equilibrium, let's say $5 a bushel.

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The price falls below that, let's say to $3. Well, we'll pay farmers 2x for dollars for every bushel they sell so that they have $5 per bushel.

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So there you get rid of the surplus. So there's other, you know, other things to be said about this.

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But one thing I want to point out is that guess who benefits the most, large farmers or small farmers?

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The large farmers, first of all, just the point of view of increasing the prices, okay, through these various schemes.

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If, for example, you have a farmer that is selling a hundred thousand bushels of wheat, okay, that's the large farmer.

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And you have a large farmer and you have another farmer, a small farmer selling 5,000 bushels, and let's say the government sets the price support at $5 so that it's $2 higher than the $3 equilibrium price.

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Well guess who gets $2 more per bushel? Well they both do actually, but guess who benefits more?

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A large farmer earns $200,000 of additional income.

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The smaller farmer earns only $10,000.

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Some people have called these farm programs welfare programs in reverse,

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because what they do is they, in effect, tax consumers,

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particularly those consumers who spend the largest proportion of their incomes on food.

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And who are they?

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Who are they? Is the guy who earns a million dollars a year spending a very large portion of his income on food? Not likely.

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It's the guy who earns $20,000. So basically, you burden poor consumers with higher prices, you tax them, and then that money is redistributed mainly to large farmers, large wealthy farmers.

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That's why it's a welfare program in reverse. How do you get rid of all of these farm surpluses?

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Now, not only do we get screwed as consumers here, having to pay higher prices, but also as taxpayers, we have to pay for the deficiency payments, we have to pay to store the surpluses and so on.

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So taxpayers and consumers in general lose and farmers, especially wealthier farmers, are the ones that gain.

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Also, if the price of food were allowed, of things like peanuts and sugar and milk and wheat and cotton, a non-food agricultural crop,

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if the price of these things were allowed to be determined by the free market, food and clothing would have a lower price,

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and so you wouldn't need food stamps, or there would be less of a justification, let's say, for food stamps.

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Oh, here was, I was just going to show you the diagram of the wheat market. Let me just do that.

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Okay, so that's, put it up a little further.

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Okay, there's a short one supply curve there. There's an initial surplus of two million between seven and nine million bushels.

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Supplies nine, seven million is the quantity demanded at five dollars.

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and over time though farmers expand more people move into that area and what you

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get then is an increase in quantity supplied to 11 million in the long run

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and a larger surplus. Let's move on to the next topic which is on

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and Entrepreneurship, Profits and Losses.

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So now we're moving away from price determination. We've shown how prices are determined and how government interference with price determination distorts the market and makes things less efficient.

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Now we want to talk about how prices guide entrepreneurs in making their production decisions.

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So much of economics is about production decisions made under the calculation that is permitted by prices.

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So the driving force in production is the entrepreneur.

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And let me give you a definition of the entrepreneur.

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And then we'll talk about his role in more detail and about the role of profits.

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Now remember, before we actually define the entrepreneur, remember that all action takes place under uncertainty.

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It's all aimed towards the future. In order to act successfully, people have to forecast the future.

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The more successful they are in forecasting the future, the more successful their actions will be.

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So that therefore, there is always an entrepreneurial element in every action, including action in your daily lives and actions in business.

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So every action has an entrepreneurial element.

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So when you decide on a college major, you will make an entrepreneurial decision regarding what you expect the salaries to be in that major versus salaries that you're going to be earning if you took other majors.

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Or if someone moves from the northeast to the southeast thinking that the job market is better here and gets a job but then loses the job pretty quickly and can't find another one, that person has acted as an entrepreneur but has made an unsuccessful decision.

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Turns out the costs are greater than the benefits.

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So everyone acts as an entrepreneur, but when economists use the term entrepreneurship, we mean something much more specific.

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We don't mean the labor of making decisions that are risky, or the landowners making certain decisions that are risky, we mean a specific individual, the promoter entrepreneur.

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Now, Mises calls him the promoter entrepreneur, Rothbard calls him the capitalist entrepreneur, we'll just call him the entrepreneur, but keep in mind that when we're talking about the entrepreneur,

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In other words, we mean this narrower conception of someone who earns his or her income from allocating production to future needs or future demands.

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Or to put it another way, the capitalist entrepreneur is a person who attempts to take advantage of the fact that there's continual change in the economy

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Resources, at any given moment of time, there are resources in the economy that are undervalued, that are not being used in their highest valued use from the point of view of future consumer demand.

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So that person seeks to earn a living from adjusting resources, from moving them from undervalued to higher valued uses.

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So what is the specific function of this entrepreneur? Well, this entrepreneur determines the employment of the factors of production.

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With his capital and investment in various lines of production, he is making decisions how to use the scarce factors out there in the economy.

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And all entrepreneurs compete against one another to get control of these factors of production.

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And that's what determines, as we'll see in the next lecture, determines the prices, wages, rents and so on, of the various capital goods, types of labor and natural resources.

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Now, one thing to keep in mind, the entrepreneurial function, and I'll repeat this later on in more detail, is not a factor of production.

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The entrepreneur is not a factor of production. It's a pure decision-making function.

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It's a decision about how to use the factors of production.

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So it's an intellectual function, purely intellectual function.

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Many books, almost all books will say that, well, entrepreneurship is a type of labor, therefore it's a factor of production.

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Here's an indicator that it's not a factor of production.

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Every type of labor earns a positive return. We call that a wage.

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Every type of capital good earns a capital value or a rent if it's hired out.

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Every natural resource earns rent. However, an entrepreneur can either earn a positive

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or a negative income. He can earn a positive profit or he can lose. But no other factor

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of production can earn a negative income. So entrepreneurial income is something different.

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It's not a return to a factor of production, otherwise it would have to be positive. Since

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it sometimes can be negative, it's a return to a decision. If the choice is correct or

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or more correct than other choices being made by entrepreneurs, it's going to return something positive.

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If it's incorrect, then there will be a loss.

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Now when we say that the entrepreneur determines or decides upon the employment of factors of production, what do we actually mean by that?

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It means that he determines what to produce, what good to produce, exactly what qualities that good will have, where to produce it,

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There's a lot of technology to use, there's many different ways to produce an automobile, for example, all the way from putting it together by hand, and some collectible automobiles can be built that way, or some luxury automobiles can be built that way, all the way to having a completely robotized factory, you know, produced in the car. So there's many different ways of doing it. The entrepreneur wants to choose the most cost-effective way.

345
00:48:28.420 --> 00:48:33.420
After taking an investment in the factors of production, which have to be transformed eventually into a final consumer's good,

346
00:48:33.420 --> 00:48:39.420
it means that his decision, he will not know whether his decision is successful or not until some point in the future.

347
00:48:39.420 --> 00:48:44.420
It could be a year, it could be five years down the road, or even ten years down the road.

348
00:48:44.420 --> 00:48:49.420
That means that entrepreneurs must anticipate future market conditions.

349
00:48:49.420 --> 00:48:55.420
If you want to, let's say GM wants to come up to develop a new model car,

350
00:48:55.420 --> 00:49:01.420
The supply and demand for that car today, or that type of car today, or something similar today, is not relevant.

351
00:49:01.420 --> 00:49:04.420
In fact, there might not be any similar type of product today.

352
00:49:04.420 --> 00:49:16.420
So prices today are some kind of a guide, but what he's interested in, what he must do, is to forecast or anticipate what supply and demand conditions are going to be five years from now when that car comes onto the market.

353
00:49:16.420 --> 00:49:32.420
So he's going to have to be able to really, at least on a general level, predict or better yet forecast what consumer value scales will be like and what competitors will be doing in the meantime.

354
00:49:32.420 --> 00:49:50.420
Now, what he must also do, since he has to pay his cost of production in advance, he pays the cost now, or as the production process goes along, but he has to usually make a big fixed investment initially, he must compare that to estimated prices.

355
00:49:50.420 --> 00:49:56.420
So he must estimate what prices will be five years in the future, or four years in the future, or next month.

356
00:49:56.420 --> 00:50:03.420
In any case, it's the future prices of the output that are compared to the present prices or the cost of production.

357
00:50:03.420 --> 00:50:07.420
The present prices are the factors of production or the cost of production.

358
00:50:07.420 --> 00:50:12.420
So when you add up all the prices of factors of production, those are your costs.

359
00:50:12.420 --> 00:50:18.420
And that involves what we might call appraisement.

360
00:50:26.420 --> 00:50:39.740
He must place, appraising means placing a cardinal number, a price, deriving that from people's value scales, from available resources and so on.

361
00:50:39.740 --> 00:50:48.620
And that's what the market does. The market continually generates, based on people's value scales, cardinal prices that can be used to calculate profits and losses.

362
00:50:48.620 --> 00:50:54.260
So the entrepreneur, knowing all of this qualitative information, that's not enough.

363
00:50:54.260 --> 00:51:09.780
Okay, he can know what the man's going to be in the future. He can know what supplies will be. He still has to have some cardinal number. He has to arrive at some cardinal number that he can compare to his cost of production.

364
00:51:09.780 --> 00:51:21.460
And he can be better or worse at forecasting future market conditions and appraising future market prices. If he's worse at it, he's going to lose money. If he's better at it than other entrepreneurs, no one's perfect at it, by the way.

365
00:51:21.460 --> 00:51:32.660
By the way, if every entrepreneur knew perfectly what the prices of every good would be in the future,

366
00:51:32.660 --> 00:51:35.060
what would happen to the prices of the factors of production today?

367
00:51:35.060 --> 00:51:40.860
If, for example, everybody knew that a certain type of automobile would sell for $30,000 in two years,

368
00:51:40.860 --> 00:51:45.760
what would the prices or the costs of producing that good be today?

369
00:51:45.760 --> 00:51:51.460
Well, everybody would rush in and they'd be willing to bid up to how much for the factors of production?

370
00:51:51.460 --> 00:51:57.460
Up to $30,000 minus the rate of interest over two years, okay?

371
00:51:57.460 --> 00:52:02.560
Because they're not getting paid for two years, so there's a time preference factor here, and that's reflecting the rate of interest.

372
00:52:02.560 --> 00:52:10.060
So it's the same as if I held up a $20 bill. If I held up a $20 bill right now and I asked you, I'll sell it to the highest bidder, okay?

373
00:52:10.060 --> 00:52:14.060
Well, you're the entrepreneurs out there. The $20 bill is what you see in the future, okay?

374
00:52:14.060 --> 00:52:21.060
If everyone perfectly knew, if you trusted me, for example, if you didn't realize I was from New Jersey and my last name ended with a vowel,

375
00:52:21.060 --> 00:52:24.060
and you trusted me, then I would give you the $20 bill.

376
00:52:24.060 --> 00:52:30.060
What would you bid for that $20 bill? What would you predict right now would be the final bid?

377
00:52:30.060 --> 00:52:35.060
Very, very, very close to $20.

378
00:52:35.060 --> 00:52:42.060
The person who would put the least amount of value on their time and effort of getting up out of their seat and coming up here

379
00:52:42.060 --> 00:52:48.560
It might be $19.50, $19.75, whatever it would be, okay?

380
00:52:48.560 --> 00:52:51.360
Well, that's what would happen. That's called the evenly rotating economy.

381
00:52:51.360 --> 00:52:57.860
We'll talk a little bit more why that's important, though very unrealistic, in fact, unrealizable construct, okay?

382
00:52:57.860 --> 00:53:01.860
We do assume sometimes that producers know, for certain problems in economics,

383
00:53:01.860 --> 00:53:05.060
producers know exactly what prices will be in the future, okay?

384
00:53:05.060 --> 00:53:08.660
What that allows us to do is to show a world in which there's no uncertainty.

385
00:53:08.660 --> 00:53:11.760
And in that world, there is no profits. That's what I was getting at.

386
00:53:11.760 --> 00:53:22.960
Because every entrepreneur will bid, they'll all bid against one another and they'll bid the prices of the cost of the factors of production up to the level of the future prices minus the interest rate, okay?

387
00:53:22.960 --> 00:53:33.160
So, what that allows us to do, this construct which we call the evenly rotating economy, in which people's value scales are constant, resources are constant and technology never changes,

388
00:53:33.160 --> 00:53:37.660
that allows us to separate two types of return that entrepreneurs tend to get.

389
00:53:37.660 --> 00:54:07.660
their return as capitalists who advance their money now and which is based on time preference and their return as entrepreneurs who are operating under uncertainty right so we look at a world where there's no change and we find that there are no profits which then tells us you can deduce from that that in fact profits come from uncertainty it comes they come from from forecasting continual changes in supply and demand okay and being more right than other entrepreneurs in doing that

390
00:54:07.660 --> 00:54:11.660
A few other things about entrepreneurs.

391
00:54:11.660 --> 00:54:14.660
Let me use an example.

392
00:54:14.660 --> 00:54:18.660
When Stephen Jobs, who was one of the founders of Apple,

393
00:54:18.660 --> 00:54:25.660
when he began to make investments to bring his product to market,

394
00:54:25.660 --> 00:54:29.660
there were no personal computers on the market,

395
00:54:29.660 --> 00:54:33.660
or no small computers on the market that he could look to for prices.

396
00:54:33.660 --> 00:54:46.660
He had to appraise that future price of what this Mac, for example, would sell for, based on his experience of the past, based on hunches about how businesses will react to a small computer and so on.

397
00:54:46.660 --> 00:54:51.660
And he did so in a way that was successful, at least initially.

398
00:54:51.660 --> 00:54:59.660
Also, the entrepreneurial role implies that the person owns some capital.

399
00:54:59.660 --> 00:55:29.660
You either have to have the capital necessary to put that idea into effect, or you have to go convince someone else that you have a good idea and get capital from that person, but usually in order to get backing, to get outside financial backing, you yourself need to put up some resources, you yourself have to risk something, so for the most part entrepreneurs are also capitalists, that's why we call them capitalist entrepreneurs,

400
00:55:29.660 --> 00:55:47.660
Also, remember since all production is for the future and you're paying the factors of production, land, labor, natural resources, in advance, if you turn out to be wrong, you're the one who bears a sole loss.

401
00:55:47.660 --> 00:56:13.660
and loss. That is, you've already paid the costs. So think of it this way. When GM lost 10.6 billion dollars last year, and we brought this up, how much did the workers lose in producing the cars that were sold for low cost? They lost nothing. They were paid in advance. They were paid every two weeks before the cars were actually produced.

402
00:56:13.660 --> 00:56:17.660
Now, as a result of those bad decisions, some of those workers may lose their jobs.

403
00:56:17.660 --> 00:56:23.660
That has nothing to do with them getting paid for producing the goods that lost money.

404
00:56:23.660 --> 00:56:28.660
The entrepreneur bears the sole risk in production.

405
00:56:28.660 --> 00:56:34.660
And for the same reason, he gets whatever is left over after he has paid the factors of production.

406
00:56:34.660 --> 00:56:39.660
So, he bears the sole risk, that is, sometimes he's called the residual claimant.

407
00:56:39.660 --> 00:56:46.660
he gets what's left over after all the factors have been paid

408
00:57:09.660 --> 00:57:29.660
The labor may lose his or her job as a result of bad decisions by the entrepreneur, but the point is, during that production process, the labor got paid what he or she contributed to production.

409
00:57:29.660 --> 00:57:34.660
Now, by the way, when the labor gets laid off, the labor is pretty nonspecific.

410
00:57:34.660 --> 00:57:41.660
The labor can find another job, but the entrepreneur, and I'm not saying you should feel sorry for entrepreneurs that lose money.

411
00:57:41.660 --> 00:57:44.660
They've wasted scarce resources. They've produced the wrong things.

412
00:57:44.660 --> 00:57:49.660
But when they lose money, they've lost their capital, and they've lost their reputation.

413
00:57:49.660 --> 00:57:58.660
That is, it's going to be much more difficult to raise additional capital for another venture.

414
00:57:58.660 --> 00:58:12.660
Now, let's just talk a little bit about the entrepreneur and the manager, because sometimes, especially in the modern economy, it's difficult to pinpoint who the entrepreneur actually is, or who the decision maker actually is.

415
00:58:12.660 --> 00:58:23.660
So let's look at the managerial function. Remember, the entrepreneur determines the general plan for the factors of production, but he knows that over time things may change.

416
00:58:23.660 --> 00:58:33.660
And that, especially if it's a big firm that he creates, he can't take Bill Gates. He can't be everywhere to make small adjustments to these changes.

417
00:58:33.660 --> 00:58:40.660
So he hires managers. And managers are basically junior partners of the entrepreneur.

418
00:58:40.660 --> 00:58:48.660
In one way they operate like entrepreneurs, but in another very important way they could never be called the entrepreneur.

419
00:58:48.660 --> 00:58:55.660
They may actually make day-to-day decisions about how the firm is operating.

420
00:58:55.660 --> 00:59:00.660
How does the entrepreneur oversee those decisions?

421
00:59:00.660 --> 00:59:07.660
Well, because of accounting, double entry bookkeeping accounting, or double entry accounting,

422
00:59:07.660 --> 00:59:15.660
the entrepreneur can evaluate the performance of every department, every division,

423
00:59:15.660 --> 00:59:42.660
and the supervisors and so on. They can evaluate the managers' performance and one way to motivate the managers is to make them people who share in the profits by giving them bonuses, that is, you can make their salary to some extent depend on bonuses or by paying them partly in shares of stock.

424
00:59:42.660 --> 00:59:46.660
So, the better they perform, the higher their bonuses are.

425
00:59:46.660 --> 00:59:53.660
However, why does this not supplant the entrepreneurial role?

426
00:59:53.660 --> 00:59:56.660
The worst that can happen to the managers is that they don't get a bonus.

427
00:59:56.660 --> 01:00:00.660
They still get a salary, they still get paid, they can be fired.

428
01:00:00.660 --> 01:00:04.660
What can't happen to the manager that can't happen to the entrepreneur?

429
01:00:04.660 --> 01:00:08.660
Right, they can never lose money, they can never lose capital.

430
01:00:08.660 --> 01:00:13.660
They can participate in the profits, but they can't lose money.

431
01:00:13.660 --> 01:00:18.660
So it's sort of like the following example.

432
01:00:18.660 --> 01:00:25.660
Let's say, well actually let me get to someone who sort of criticizes this view, John Kenneth Goldbrave,

433
01:00:25.660 --> 01:00:30.660
the left-wing economist, the late John Kenneth Goldbrave, who just recently passed away in his 90s.

434
01:00:30.660 --> 01:00:35.660
He coined a term back in the 70s called the technocracy,

435
01:00:35.660 --> 01:00:48.660
Meaning the scientists, engineers and managers that sort of got together and wrested control of the firm effectively away from the stockholders and the entrepreneurs.

436
01:00:48.660 --> 01:00:52.660
And he claimed they ran it for their own benefit.

437
01:00:52.660 --> 01:00:56.660
And yes, they would just try to earn a small profit as if it's easy to earn a profit of any size.

438
01:00:56.660 --> 01:01:04.660
They would earn a small profit to keep the stockholders happy, the entrepreneur investors happy, but they really control the firm for their own benefit.

439
01:01:04.660 --> 01:01:20.660
Well, there's a number of things wrong with that. First of all, let me just give you an example that Murray Rothbard used to use, and that is, let's say one of the Rockefellers works in New York and on weekends or a couple of times a month goes up to his estate in upstate New York.

440
01:01:20.660 --> 01:01:33.660
New York, and he hires a head gardener or head landscaper who is in charge of landscaping the entire estate.

441
01:01:33.660 --> 01:01:37.660
Now, if you are observing this, we think this guy is completely in charge of everything.

442
01:01:37.660 --> 01:01:41.660
He's determining what sort of shrubbery to put in, what sort of grass to use and so on.

443
01:01:41.660 --> 01:01:44.660
He's laying out the whole design of the estate.

444
01:01:44.660 --> 01:01:57.660
So, it seems as if he controls it. Is he the ultimate decision maker? Of course not. One day Rockefeller could come up there and say, this is terrible. You're fired. Just get someone else.

445
01:01:57.660 --> 01:02:09.660
And there are similar mechanisms that operate in the modern corporate firm. For example, you have a board of directors that can fire the managers. They represent the interests of the stockholders.

446
01:02:09.660 --> 01:02:18.660
Yes, it's true the individual stockholders, though that's not true of the larger ones, but these small individual stockholders have really no knowledge of what's going on from day to day.

447
01:02:18.660 --> 01:02:26.660
Nor do they have any sort of an incentive to collect all that information, because it's very costly to collect that information if they think there's something wrong.

448
01:02:26.660 --> 01:02:29.660
It's very difficult to organize all these small stockholders.

449
01:02:29.660 --> 01:02:36.660
But there are some large stockholders that will always be looking over the shoulder of the managers.

450
01:02:36.660 --> 01:03:06.660
Managers. If they don't like something, especially if one of them sits on the board of directors, they can have them fired. There's also proxy fights where large stockholders will call for a vote on the board of directors and they'll collect votes, proxies from smaller stockholders and you can throw them out, the managers out that way, fire the board of directors, put in new directors and new managers. But there's a way that even

451
01:03:06.660 --> 01:03:13.360
Small stockholders can have a direct effect on the firm, on the policies that the managers are following if they don't like them.

452
01:03:13.360 --> 01:03:17.160
And that is simply voting with your feet. You can sell your stock.

453
01:03:17.160 --> 01:03:25.060
So if you think that the firm isn't performing very well, there'll be a mass movement of sales of stock on the stock market.

454
01:03:25.060 --> 01:03:38.620
So if the market, the total price of the firm on the stock market pays something like 8 billion dollars,

455
01:03:38.620 --> 01:03:47.660
and suddenly people become dissatisfied with the way the firm is being operated,

456
01:03:47.660 --> 01:03:51.820
they start selling their stock, the price of stock falls,

457
01:03:51.820 --> 01:03:59.920
So the firm's value falls, let's say it falls by 25% to 6 billion dollars.

458
01:03:59.920 --> 01:04:02.820
That opens up the firm to a hostile takeover.

459
01:04:02.820 --> 01:04:06.420
Someone says, you know what, with the resources that that firm controls,

460
01:04:06.420 --> 01:04:11.720
the factors of production that are in effect that firm,

461
01:04:11.720 --> 01:04:17.220
I can buy it at 6 billion and I believe I can increase profits in that firm to such an extent

462
01:04:17.220 --> 01:04:26.820
that stocks will rise by, let's say, 50% and the value of the firm will be $9 billion.

463
01:04:26.820 --> 01:04:35.320
So that person will then launch a hostile takeover and in the process benefiting the remaining stockholders by bidding the prices up.

464
01:04:35.320 --> 01:04:45.420
So maybe he'll get the firm at $7 billion, bid the prices up, offer $7 billion for it and then increase the profits

465
01:04:45.420 --> 01:04:50.220
and as a result bring about an increase in value, let's say nine billion.

466
01:04:50.220 --> 01:04:55.020
So that person would then earn a huge profit. This is called the market for corporate control.

467
01:04:55.020 --> 01:05:02.120
It happens all the time. When some firms merge with other firms,

468
01:05:02.120 --> 01:05:06.420
they may do it in a way that's hostile, it might be a hostile takeover.

469
01:05:06.420 --> 01:05:10.220
Unfortunately, the Congress made it much harder to have hostile takeovers.

470
01:05:10.220 --> 01:05:40.220
Back in the 1960s, the Harrison Act, I don't know what the full name of that act is, but Senator Harrison was a crooked senator from New Jersey who got caught in an Arab scam, remember that scam where they had FBI agents dressed up as Arabs bribing some congressmen and senators, so he was caught up in that, but anyway, the law that was passed really benefited the managers and intended to entrench them more,

471
01:05:40.220 --> 01:05:46.820
And basically what it said was that you can't just go in and buy up the firm, buy up the stock and take over the firm.

472
01:05:46.820 --> 01:05:52.780
You have to give notice that you're doing that. There's a certain waiting period. You can buy 10% of the stock at a certain period.

473
01:05:52.780 --> 01:05:58.900
So during that time, the managers know they have time to sort of get their house in order.

474
01:05:58.900 --> 01:06:03.020
So if you got rid of that, the market would operate much more efficiently.

475
01:06:03.020 --> 01:06:09.460
And these managers would be very, very frightened of running the firm in a way that benefits themselves.

476
01:06:09.460 --> 01:06:13.660
There are other incentives to do that, right?

477
01:06:13.660 --> 01:06:19.900
Raising costs lowers the profits that consumers, that stockholders get, but benefits the managers.

478
01:06:19.900 --> 01:06:23.700
Because look, the managers would like to have a private Learjet at their disposal.

479
01:06:23.700 --> 01:06:30.300
They would like to have a chauffeur-driven limo, not just for themselves, but to bring their children to school.

480
01:06:30.300 --> 01:06:34.020
They would like to have access to expensive country clubs.

481
01:06:34.020 --> 01:06:38.740
They would like to hire two pretty secretaries instead of one efficient secretary.

482
01:06:38.740 --> 01:06:45.140
They would like to have very high piled carpeting and expensive art on the walls.

483
01:06:45.140 --> 01:06:50.940
What's to prevent them from doing all those things and raising costs and lowering profit?

484
01:06:50.940 --> 01:07:02.140
That's an agency problem where your agent is acting against your interests.

485
01:07:02.140 --> 01:07:09.140
Okay, yes, Mila?

486
01:07:11.740 --> 01:07:17.340
Yeah, hostilities are important. They're the most important. I mean, it's, you know, proxy fights. I don't hear much about them

487
01:07:17.340 --> 01:07:21.660
anymore.

488
01:07:21.660 --> 01:07:25.520
Board of Directors have become more

489
01:07:25.520 --> 01:07:26.540
vigilant

490
01:07:26.540 --> 01:07:27.740
over managers

491
01:07:27.740 --> 01:07:30.260
in the last, you know, last decade or so.

492
01:07:30.260 --> 01:07:35.260
So that's become more effective. But you're right, you have to keep the market open, okay?

493
01:07:35.260 --> 01:07:40.260
Proxy fights aren't as effective as hostile takeovers. Yes?

494
01:07:48.260 --> 01:07:57.260
It contributes, I would say this, laws inhibiting hostile takeovers contribute to corporate scandals, yes.

495
01:07:57.260 --> 01:08:27.260
It was interesting, in the 1980s, when we began to have this phenomenon of hostile takeovers, people were writing letters to the Wall Street Journal, the New York Times, and so on, saying things like, this is a horrible thing, it's forcing American business to focus on short-term profits and short-term movements in the stock market, whereas Japanese managers can take the long-term view. Who are signing these letters? The managers, the existing managers of American firms.

496
01:08:27.260 --> 01:08:57.260
The Stock Market represents what people think today of the stream of profits in the future from the current managers, so it does reflect the long-term, no one knows the long-term for sure, so it reflects what people think of how that firm is being managed for now and for the long-term, because the stream of profit is discounted into the, well actually the price of the stock is discounted,

497
01:08:57.260 --> 01:09:02.260
and the discounted stream of the firm's earnings.

498
01:09:02.260 --> 01:09:08.260
Okay, all right, let's talk a little bit about profit and loss because I've been using the term.

499
01:09:08.260 --> 01:09:11.260
And let me give you a very simple example.

500
01:09:11.260 --> 01:09:18.260
Okay, profit, which we'll represent as pi, is always equal to total revenue.

501
01:09:18.260 --> 01:09:24.260
Okay, the number of units sold times the price per unit minus total cost.

502
01:09:24.260 --> 01:09:32.260
There's two different ways of defining costs, accountants define costs differently than economists do.

503
01:09:32.260 --> 01:09:35.540
So let me give you an example here.

504
01:09:35.540 --> 01:09:41.660
Let's say you have a small firm, it's a landscaping firm, and it's owned by a single individual.

505
01:09:41.660 --> 01:09:48.820
And in a given year, it returns $140,000 in monetary revenue.

506
01:09:48.820 --> 01:09:56.620
and the money costs that are laid out are $100,000.

507
01:09:56.620 --> 01:10:04.420
So the accountant, okay, forgetting about the appreciation, the accountant would figure the net earnings or the profit of the firm at $40,000.

508
01:10:04.420 --> 01:10:07.320
That would be the accounting profit.

509
01:10:07.320 --> 01:10:09.120
The economist, however, would want to know more.

510
01:10:09.120 --> 01:10:17.820
The economist would want to know, has the owner contributed any resources to the firm that he himself owns?

511
01:10:17.820 --> 01:10:25.420
And if he has, they must have an imputed or implicit price assigned to them, okay, because they have an opportunity cost.

512
01:10:25.420 --> 01:10:28.320
They could be used in other lines of production on the market.

513
01:10:28.320 --> 01:10:39.820
So let's say that the owner manages the firm himself, okay, and let's then say, we then have to ask the question,

514
01:10:39.820 --> 01:10:44.020
what's the value of his managerial labor for the year?

515
01:10:44.020 --> 01:10:50.020
Well, it's the opportunity cost of that labor. He could, let's say, go to work for another small firm as a manager at $50,000.

516
01:10:50.020 --> 01:11:07.020
That's the going rate. So let's say that what we call his implicit wages, so implicit salary or whatever you want to call it, salary, that's $50,000.

517
01:11:07.020 --> 01:11:22.020
Well, yeah, I am. What do we do over here? So, implicit wages, let's say, 50,000.

518
01:11:22.020 --> 01:11:28.020
He also owns, let's say, a dump truck that he uses in the landscaping business.

519
01:11:28.020 --> 01:11:34.020
And that also has to have an opportunity cost, and that also has to be accounted for.

520
01:11:34.020 --> 01:11:39.020
And let's say he could lease that out, so there's an implicit rent. He could lease it out for $5,000.

521
01:11:39.020 --> 01:11:45.020
So there's an implicit rent. So that resource that he contributes is worth $5,000.

522
01:11:45.020 --> 01:11:50.020
And finally, let's assume that he finances the business himself.

523
01:11:50.020 --> 01:11:55.020
That is, he has $100,000 of capital himself. He doesn't have to borrow.

524
01:11:55.020 --> 01:11:59.020
But yet, there is an opportunity cost of the capital invested.

525
01:11:59.020 --> 01:12:04.020
And that is what he could have earned, let's say, on a risk-free certificate of deposit.

526
01:12:04.020 --> 01:12:14.020
So let's say, for simplicity, he could have earned, make it simple, he could have earned 10 percent.

527
01:12:14.020 --> 01:12:26.020
So that's $10,000 of foregone interest, implicit or foregone interest.

528
01:12:26.020 --> 01:12:37.720
Okay, now, adding that into the out-of-pocket costs, it's another $65,000 of implicit costs that represent the opportunity costs of the resources that he contributes to the firm.

529
01:12:37.720 --> 01:12:49.420
So, an economist would calculate profit, okay, total cost $165,000, total revenue $140,000, as equal to negative $25,000.

530
01:12:49.420 --> 01:12:50.920
He's actually lost money.

531
01:12:50.920 --> 01:12:53.420
Now, is that meaningful?

532
01:12:53.420 --> 01:13:00.120
People will often say, well, he didn't really lose that. Well, yeah, he did. In a meaningful sense, in a sense that affects his actions.

533
01:13:00.120 --> 01:13:06.920
That is, if he had to do over again, what he would have done was this. He would have gone to work for another firm for $50,000.

534
01:13:06.920 --> 01:13:14.020
He would have leased his truck out to someone else for $5,000, and he would have left his money in the certificate of deposit at 10%.

535
01:13:14.020 --> 01:13:22.620
At the end of the year, he would have had his full $100,000 in principal, and he would have had $65,000 in income from the resources that he owned.

536
01:13:22.620 --> 01:13:26.820
He would have had in effect what? $165,000.

537
01:13:26.820 --> 01:13:28.620
So, he has lost money.

538
01:13:28.620 --> 01:13:32.220
He has not earned any sort of pure profit.

539
01:13:32.220 --> 01:13:37.100
Now, what if instead of total revenue being $140,000, it was $165,000?

540
01:13:37.100 --> 01:13:43.300
Then we would say that he earned a normal rate of return on all his resources, including his capital.

541
01:13:43.300 --> 01:13:45.940
But he did not earn any what?

542
01:13:45.940 --> 01:13:47.380
Did not earn any profit.

543
01:13:47.380 --> 01:13:50.700
Even though he earned $10,000 on the $100,000 investment,

544
01:13:50.700 --> 01:13:56.200
That's an interest return. That's the result of time preference.

545
01:13:56.200 --> 01:14:09.400
He hasn't earned anything here. There's no extra revenue left over that would indicate that he has moved lower value resources to higher value uses.

546
01:14:09.400 --> 01:14:22.400
If you earn $200,000, then the $35,000 over and above all implicit costs and the capital that he invested, that would be pure profit.

547
01:14:22.400 --> 01:14:38.400
To the extent that people own resources, including their own labor and capital, that they contribute,

548
01:14:38.400 --> 01:14:41.900
What I'm saying is that you cannot just look at the out-of-pocket costs.

549
01:14:41.900 --> 01:14:45.900
You have to look at the value of all resources used.

550
01:14:45.900 --> 01:14:55.900
Let me have, I think, a very good example of the social function and the source of profit.

551
01:14:55.900 --> 01:15:04.900
Now, very quickly, the source of profit is the fact that some of these resources are being used in lower-valued uses from the point of view of consumers.

552
01:15:04.900 --> 01:15:12.900
So if he earns $200,000, then what he's done is taken resources worth $165,000 and found a better use for them.

553
01:15:12.900 --> 01:15:21.900
He's been against other entrepreneurs for these various things, for the labor, for the tools that are used in his operations, for the gasoline and so on.

554
01:15:21.900 --> 01:15:30.900
And he's moved them to, maybe he's got a different idea about how to landscape, and so he's put this idea into effect and it's more valuable to consumers.

555
01:15:30.900 --> 01:15:36.900
If you hadn't stepped in, resources would have been wasted, and so that's the social function of profit.

556
01:15:36.900 --> 01:15:49.900
And the example I want to give you, it's actually a marvelous example of a great entrepreneur,

557
01:15:49.900 --> 01:15:59.900
a stroke of entrepreneurial genius by this woman that used to work for IBM.

558
01:15:59.900 --> 01:16:23.900
So, this is a woman, her name is Tamima Edmark, okay, who invented something that allowed women to, I guess, braid their hair or make ponytails and so on, it's called topsy-tail, okay, very simple implement, she became a millionaire as a result of it.

559
01:16:23.900 --> 01:16:34.900
So let me read you a little bit of this article. It was August of 1989 and Tamima Edmark was a Dallas-based IBM mainframe saleswoman. Good thing she got out of that.

560
01:16:34.900 --> 01:16:47.900
And she thought her long blonde ponytail looked a little drab. Edmark found she could braid her ponytail by using a makeshift device consisting of a plastic loop and a knitting needle.

561
01:16:47.900 --> 01:16:57.900
She was on to something with her hair gadget, Ed Mark, then 32, plunked down $5,000 to patent what she called Topsy Tail.

562
01:16:57.900 --> 01:17:11.900
She called on a couple companies in New Jersey to help her make and market this product. They turned her down.

563
01:17:11.900 --> 01:17:26.900
So she decided to make it herself. She paid for a mold with $9,000 in savings. She was still working for IBM at the time. She found a plastics maker who would produce as many topsy-tails as she needed for about $0.50 apiece.

564
01:17:26.900 --> 01:17:35.900
So they're at about $0.50 apiece plus you have to allocate some of the overhead $9,000 in mold to that. So she's making them for $0.60, $0.70 apiece, whatever it was.

565
01:17:35.900 --> 01:17:39.900
Then she started advertising in a small hairstyling magazine.

566
01:17:39.900 --> 01:17:44.900
The first ad, which was in April 1991, brought in orders worth $1,000.

567
01:17:44.900 --> 01:17:50.900
And she would fill them herself, stuffing these topsy-tail things into envelopes at home at night after work.

568
01:17:50.900 --> 01:17:56.900
By the end of 1991, she was moving 200 units a month at $10 each.

569
01:17:56.900 --> 01:18:00.900
They're costing her 60, 70 cents. She's selling them at $10 each now.

570
01:18:00.900 --> 01:18:12.900
While in New York on IBM Business, she persuaded Glamour magazine editor, it's a big woman's fashion magazine, her name was, the editor was named Melissa Phaidor, to try Topsy Tail, okay.

571
01:18:12.900 --> 01:18:25.900
Within three weeks, well, it was then featured in a February 1992 issue. Within three weeks, Ed Mark had $100,000 worth of orders and had to enlist her cleaning lady to help her stuff 400 envelopes each week.

572
01:18:25.900 --> 01:18:32.900
She got a big break, however, when IBM fired her, along with three quarters of their Dallas mainframe sales office.

573
01:18:32.900 --> 01:18:40.900
She had a $25,000 early retirement package, and she lived off this money while she began hawking her product to retailers.

574
01:18:40.900 --> 01:18:47.900
She had gone to trade shows and hair salons, but that was a small time. She had her own promotional video.

575
01:18:47.900 --> 01:18:55.900
But she did find out that the sales dramatically increased whenever women saw how easy the plastic device was to use.

576
01:18:55.900 --> 01:18:58.900
So she wanted to make a television commercial.

577
01:18:58.900 --> 01:19:08.900
After several false starts, she found a small TV products firm in New Jersey that promoted things like kitchen gadgets and sunglasses.

578
01:19:08.900 --> 01:19:18.900
The company agreed to put together a two-minute commercial, manage top details, television marketing and print advertising and retail distribution.

579
01:19:18.900 --> 01:19:19.900
So the company was going to do all that.

580
01:19:19.900 --> 01:19:27.900
All Ed Mark had to do was appear in the commercial and sell them enough product at a price reputed to be about a dollar apiece to meet the demand.

581
01:19:27.900 --> 01:19:33.900
So her cost was a dollar and so that's what she was going to do.

582
01:19:33.900 --> 01:19:40.900
So the strategy worked. On her own, Ed Mark had sold 250,000 topsy-tails at $10 a piece in 20 months.

583
01:19:40.900 --> 01:19:44.900
Remember, that was costing her less than a dollar, so she's already making a lot of money.

584
01:19:44.900 --> 01:19:53.900
In the first six months after her commercial hit the networks, in December 1992, she sold $3.6 million at about $15.

585
01:19:53.900 --> 01:20:01.900
And let's see what her costs were.

586
01:20:01.900 --> 01:20:13.900
The costs were down to 22 cents and she sold them at $15 a piece, $3.6 million. You do the math. She's a multi-millionaire.

587
01:20:13.900 --> 01:20:25.900
What did she do? She took a piece of plastic and a knitting needle that was worth 22 cents in other functions that entrepreneurs are only willing to pay 22 cents for, consumers in general.

588
01:20:25.900 --> 01:20:32.900
and she combined them in a new way and turned them into something that was worth to consumers $15.

589
01:20:32.900 --> 01:20:37.900
That's the entrepreneurial profit right there.

590
01:20:37.900 --> 01:20:45.900
She paid what entrepreneurs were paying, she didn't lowball anybody, she went out and bought these factors of production,

591
01:20:45.900 --> 01:20:53.900
combined them in a different way according to a different idea and sold them for a price much above the per unit cost.

592
01:20:53.900 --> 01:21:01.900
That's where all profits come from. That's just an extreme example, which I think is a very good example.

593
01:21:01.900 --> 01:21:08.900
Profits come from continually readjusting production, using factors of production in new and novel ways.

594
01:21:08.900 --> 01:21:11.900
They can be the same factors. You don't have to have the new technology.

595
01:21:11.900 --> 01:21:17.900
You should have any new technology, which is just a new idea about how to combine these factors.

596
01:21:17.900 --> 01:21:24.900
She had a forecast that there were many women out there that were like her and that wanted something very quick in the morning, working women, that would enable them to do their hair in a way that was simple, quick, but looked good. And she was right.

597
01:21:47.900 --> 01:22:17.400
The question is, what would happen if the person lost money in the first year and many start-up businesses do lose money in the first couple of years, but then his business caught on and he began to earn pure profits after that?

598
01:22:17.400 --> 01:22:26.400
Well, that's just the course of doing business. He forecast that eventually, it's going to take a while before his reputation is built up and that therefore he will earn entrepreneurial profits.

599
01:22:26.400 --> 01:22:33.400
So he forecast correctly. Let me just end with this example. I'll take some questions. Not examples. Well, real world examples.

600
01:22:33.400 --> 01:22:49.400
Does anyone remember the Blair Witch Project, that movie? That was made for $40,000 and its total revenue that it generated was,

601
01:22:49.400 --> 01:23:05.400
It was made for $60,000. It generated $50 million worth of revenues.

602
01:23:05.400 --> 01:23:13.400
The people who made it hired unknown actors. They used a very cheap setting in Maryland.

603
01:23:13.400 --> 01:23:33.400
in Ireland, and they use a technique, these shaky handheld cameras that were cheap but worked very well for the movie, and now there was a couple of millions more spent on advertising, they got some firm to advertise for them, but they still made millions and millions of dollars.

604
01:23:33.400 --> 01:23:45.400
The first example I wanted to give is The Passion of Christ, which was a picture made by Mel Gibson, and people claimed, oh, you know, it's not going to make any money, there was huge criticisms of it.

605
01:23:45.400 --> 01:23:56.400
He made it for 40 million. I think he said 40, maybe it would come to a little bit more than that. And worldwide, it garnered $500 million in revenues.

606
01:23:56.400 --> 01:24:09.400
Did he exploit anybody? No, he simply took resources that anybody could have purchased, cameras and actors and so on, and combined them in a different way, in a way that better satisfied consumer wants than anything else that was out there at the time.

607
01:24:09.400 --> 01:24:15.400
Now somebody could have come out with probably even a better movie that somebody could have made that would have tracked people away from his movie.

608
01:24:15.400 --> 01:24:21.400
But the point is that the world isn't perfect. People are making mistakes. As long as you're better than the other entrepreneurs, you're going to earn profit.

609
01:24:21.400 --> 01:24:29.400
I'll stop here. There are a few other things I'll say in the next lecture about this, but I'll take some questions in about five minutes.

610
01:24:29.400 --> 01:24:35.400
Questions? Comments? You're making me cold.

611
01:24:35.400 --> 01:24:39.400
Okay. Thank you.