Chapter 8, Production, Entrepreneurship and Change
1. Entrepreneurial Profit and Loss
Having developed in the previous chapters our basic analysis of the market economy,
we now proceed to discuss more dynamic and specific applications,
as well as the consequences of intervention in the market.
In the evenly rotating economy, there are only two ultimate categories of producers' prices and incomes.
Interest, uniform throughout the economy, and wages, the prices of the services of various labor factors.
In a changing economy, however, wage rates and the interest rate are not the only elements that can change.
Another category of both positive and negative income appears. Entrepreneurial, Profit and
Loss. We shall concentrate on the capitalist entrepreneurs, economically the more important
type of entrepreneur. These are the men who invest in capital, land and or capital goods
used in the productive process. Their function is, as we have described, the advance of money
Money to Owners of Factors and the Consequent Use of the Goods until the More Nearly Present
Product is Later Sold.
We have worked out the laws of the ERE in detail.
Factor prices will equal DMVP.
Every factor will be allocated to its most value-productive uses.
Capital values will equal the sums of the DMVPs.
The interest rate will be uniform and governed solely by time preferences, etc.
The difference in the dynamic real world is this, none of these future values or events
is known.
All must be estimated, guessed at by the capitalists.
They must advance present money in a speculation upon the unknown future in the expectation
In the real world, then, quality of judgment and accuracy of forecast play an enormous
role in the incomes acquired by capitalists.
As a result of the arbitrage of the entrepreneurs, the tendency is always toward the ERE.
In consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives.
The capitalist entrepreneur buys factors or factor services in the present.
His product must be sold in the future.
He is always on the alert then for discrepancies, for areas where he can earn more than the going rate of interest.
Suppose the interest rate is 5%. Jones can buy a certain combination of factors for 100 ounces. He believes that he can use this agglomeration to sell a product after two years for 120 ounces. His expected future return is 10% per annum.
If his expectations are fulfilled, then he will obtain a 10% annual return instead of 5%.
The difference between the general interest rate and his actual return is his money profit,
from now on to be called simply profit,
unless there is a specific distinction between money profit and psychic profit.
In this case, his money profit is 10 ounces for two years, or an extra 5% per annum.
What gave rise to this realized profit, this ex post profit, fulfilling the producer's ex ante expectations?
The fact that the factors of production in this process were underpriced and undercapitalized,
underpriced insofar as their unit services were bought, undercapitalized insofar as the
factors were bought as wholes, in either case the general expectations of the market aired
by underestimating the future rents, MVPs, of the factors.
This particular entrepreneur saw better than his fellows, however, and acted on this insight.
He reaped the reward of his superior foresight in the form of a profit.
His action, his recognition of the general undervaluation of productive factors, results
in the eventual elimination of profits, or rather in the tendency toward their elimination.
By extending production in this particular process, he increases the demand for these
factors and raises their prices.
This result will be accentuated by the entry of competitors into the same area, attracted
by the 10% rate of return.
Not only will the rise in demand raise the prices of the factors, but the increase in
output will lower the price of the product.
The result will be a tendency for a fall in the rate of return back to the pure interest
rate.
What function has the entrepreneur performed?
In his quest for profits, he saw that certain factors were underpriced vis-à-vis their
potential value products.
By recognizing the discrepancy and doing something about it, he shifted factors of production
– obviously non-specific factors – from other productive processes to this one.
He detected that the factors' prices did not adequately reflect their potential DMVPs.
By bidding for and hiring these factors, he was able to allocate them from production
of lower DMVP to production of higher DMVP.
He has served the consumers better by anticipating where the factors are more valuable.
for the greater value of the factors is due solely to their being more highly demanded
by the consumers, that is, being better able to satisfy the desires of the consumers.
That is the meaning of a greater discounted marginal value product.
It is clear that there is no sense whatever in talking of a going rate of profit.
There is no such rate beyond the ephemeral and momentary, for any realized profit tends
to disappear because of the entrepreneurial actions it generates.
The basic rate, then, is the rate of interest, which does not disappear.
If we start with a dynamic economy, and if we postulate given value scales and given
in original factors and technical knowledge throughout, the result will be a wiping out
of profits to reach an ERE with a pure interest rate.
Continual changes in tastes and resources, however, constantly shift the final equilibrium
goal and establish a new goal toward which entrepreneurial action is directed, and again,
The final tendency in the ERE will be the disappearance of profits.
For the ERE means the disappearance of uncertainty, and profit is the outgrowth of uncertainty.
A grave error is made by a host of writers and economists in considering only profits
in the economy.
Almost no account is taken of losses.
The economy should not be characterized as a profit economy, but as a profit and loss
economy.
As Frank H. Knight put it, one thing I miss in discussion generally in the field is any
use of words recognizing that profit means profit or loss, and is in fact as likely to
be a loss as a gain.
Professor Knight's great contributions to profit theory are in sharp contrast to his
errors in capital and interest theory.
A loss occurs when an entrepreneur has made a poor estimate of his future selling prices
and revenues.
He bought factors, say, for 1,000 ounces, developed them into a product and then sold
it for 900 ounces.
He erred in not realizing that the factors were overpriced and overcapitalized on the
market in relation to their discounted marginal value products, that is, to the prices of
his output.
Every entrepreneur, therefore, invests in a process because he expects to make a profit,
is because he believes that the market has underpriced and undercapitalized the factors
in relation to their future rents.
If his belief is justified, he makes a profit.
If his belief is unjustified, and the market, for example, has really overpriced the factors,
he will suffer losses.
The nature of loss has to be carefully defined.
Suppose an entrepreneur, the market rate of interest being 5%, buys factors at $1,000
and sells their product for $1,020 one year later.
Has he suffered a loss or made a profit?
At first, it might seem that he has not taken a loss.
After all, he gained back the principal plus an extra 20 ounces for a 2% net return or
Gain
However, closer inspection reveals that he could have made a 5% net return anywhere on
his capital, since this is the going interest return.
He could have made it, say, investing in any other enterprise, or in lending money to consumer
borrowers.
In this venture, he did not even earn the interest gain.
The cost of his investment, therefore, was not simply his expenses on factors, 1,000,
but also his forgone opportunity of earning interest at 5%, that is, an additional 50.
He therefore suffered a loss of 30 ounces.
The absurdity of the concept of rate of profit is even more evident if we attempt to postulate
a rate of loss.
Obviously, no meaningful use can be made of rate of loss.
Entrepreneurs will be very quick to leave the losing investment and take their capital elsewhere.
With entrepreneurs leaving the line of production, the prices of the factors there will drop,
and the price of the product will rise, with reduced supply, until the net return in that
branch of production will be the same as in every branch, and this return will be the
uniform interest rate of the ERE.
It is clear, therefore, that the process of equalization of rate of return throughout
the economy, one that results in a uniform rate of interest, is the very same process
that brings about the abolition of profits and losses in the ERE.
A real economy, in other words, where line A yields a net return of 10% to some entrepreneur,
and line B yields 2%, while other lines yield 5%, is one in which the rate of interest is
5%.
A makes a pure profit of 5%, and B suffers a pure loss of 3%.
A. Correctly estimated that the market had underpriced his factors in relation to their
true DMVPs.
B. Had incorrectly guessed that the market had underpriced, or at the very least, correctly
priced, his factors, but found to his sorrow that they had been overpriced in relation
to the uses that he made of the factors.
In the E.R.E., where all future values are known and there is therefore no underpricing
or overpricing, there are no entrepreneurial profits or losses.
There is only a pure interest rate.
In the real world, profits and losses are almost always intertwined with interest returns.
Our separation of them is conceptually valid and very important, but cannot be made easily
and quantitatively in practice.
Let us sum up the essence of an evenly rotating economy.
It is this, all factors of production are allocated to the areas where their discounted
marginal value products are the greatest.
These are determined by consumer demand schedules.
In the modern world of specialization and division of labor, it is almost always the
consumers alone who decide, and this in effect excludes the capitalists, who rarely consume
more than a negligible amount of their own products.
It is the consumers, then, given the natural facts of stocks of resources, particularly
labor and land factors, who make the decisions for the economic system.
The consumers, through their buying and abstention from buying, decide how much of what will
be produced, at the same time determining the incomes of all the participating factors.
And every man is a consumer.
One obvious exception to this rule occurs when either capitalists or laborers have strong
preferences or dislikes for a particular line of production.
The equilibrium rate of return in the ERE for a strongly disliked line will be considerably
higher than the uniform rate, and the equilibrium rate of return for a strongly liked line will
be lower.
These preferences, however, have to be strong enough to affect the investment or productive
actions of a considerable number of potential investors or laborers in order to register
Do profits have a social function?
Many critics point to the ERE, where there are no profits or losses, and then attack
entrepreneurs earning profits in the real world as if they were doing something mischievous
or at best unnecessary.
Are not profits an index of something wrong, of some maladjustment in the economy?
The answer is yes, profits are an index of maladjustment, but in a sense precisely opposed
to that usually meant.
As we have seen, profits are an index that maladjustments are being met and combated
by the profit-making entrepreneurs.
These maladjustments are the inevitable concomitants of the real world of change.
A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment,
specifically an undervaluation of certain factors by the market.
By stepping into this situation and gaining the profit, he calls everyone's attention
to that maladjustment and sets forces into motion that eventually eliminate it.
If we must condemn anyone, it should not be the profit-making entrepreneur, but the one
that has suffered losses.
For losses are a sign that he has added further to a maladjustment, through allocating factors
where they were overvalued as compared to the consumer's desire for their product.
On the other hand, the profit-maker is allocating factors where they had been undervalued as
as compared to the consumer's desires.
The greater a man's profit has been, the more praiseworthy his role.
For then, the greater is the maladjustment that he alone has uncovered and is combating.
The greater a man's losses, the more blameworthy he is, for the greater has been his contribution
to maladjustment.
We may make such value judgments, of course, only to the extent that we believe it is
good to correct maladjustments and to serve the consumers, and bad to create such maladjustments.
These value judgments, therefore, are not at all praxeological truths, though most people
would probably subscribe to them.
Those who prefer maladjustments in serving consumers will adopt the opposite value judgments.
Of course we should not be too hard on the bumbling loser.
He receives his penalty in the form of losses.
These losses drive him from his poor role in production.
If he is a consistent loser, wherever he enters the production process, he is driven out of
the entrepreneurial role altogether.
He returns to the job of wage earner.
In fact, the market tends to reward its efficient entrepreneurs and penalize its inefficient
ones proportionately.
In this way, consistently provident entrepreneurs see their capital and resources growing, while
consistently imprudent ones find their resources dwindling.
The former play a larger and larger role in the production process.
The latter are forced to abandon entrepreneurship altogether.
There is no inevitably self-reinforcing tendency about this process, however.
If a formerly good entrepreneur should suddenly make a bad mistake, he will suffer losses
proportionately.
If a formerly poor entrepreneur makes a good forecast, he will make proportionate gains.
The market is no respecter of past laurels, however large.
Moreover, the size of a man's investment is no guarantee whatever of a large profit or against grievous losses.
Capital does not beget profit. Only wise entrepreneurial decisions do that.
A man investing in an unsound venture can lose 10,000 ounces of gold as surely as a man engaging in a sound venture can profit on an investment of 50 ounces.
Beyond the market process of penalization, we cannot condemn the unfortunate capitalist who suffers losses.
He was a man who voluntarily assumed the risks of entrepreneurship
and suffered from his poor judgment by incurring losses proportionate to his error.
Outside critics have no right to condemn him further.
As Mises says, nobody has the right to take offense at the errors made by the entrepreneurs in the conduct of affairs and to stress the point that people would have been better supplied if the entrepreneurs had been more skillful and prescient.
If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits?
It is easy indeed to display foresight after the event.