WEBVTT NOTE 8.01. Entrepreneurial Profit and Loss 1 00:00:00.000 --> 00:00:06.000 Chapter 8, Production, Entrepreneurship and Change 2 00:00:06.000 --> 00:00:11.000 1. Entrepreneurial Profit and Loss 3 00:00:11.000 --> 00:00:17.000 Having developed in the previous chapters our basic analysis of the market economy, 4 00:00:17.000 --> 00:00:22.000 we now proceed to discuss more dynamic and specific applications, 5 00:00:22.000 --> 00:00:27.000 as well as the consequences of intervention in the market. 6 00:00:27.000 --> 00:00:36.000 In the evenly rotating economy, there are only two ultimate categories of producers' prices and incomes. 7 00:00:36.000 --> 00:00:45.000 Interest, uniform throughout the economy, and wages, the prices of the services of various labor factors. 8 00:00:45.000 --> 00:00:53.000 In a changing economy, however, wage rates and the interest rate are not the only elements that can change. 9 00:00:53.000 --> 00:01:00.560 Another category of both positive and negative income appears. Entrepreneurial, Profit and 10 00:01:00.560 --> 00:01:08.240 Loss. We shall concentrate on the capitalist entrepreneurs, economically the more important 11 00:01:08.240 --> 00:01:15.960 type of entrepreneur. These are the men who invest in capital, land and or capital goods 12 00:01:15.960 --> 00:01:22.800 used in the productive process. Their function is, as we have described, the advance of money 13 00:01:22.800 --> 00:01:29.900 Money to Owners of Factors and the Consequent Use of the Goods until the More Nearly Present 14 00:01:29.900 --> 00:01:32.660 Product is Later Sold. 15 00:01:32.660 --> 00:01:37.020 We have worked out the laws of the ERE in detail. 16 00:01:37.020 --> 00:01:40.720 Factor prices will equal DMVP. 17 00:01:40.720 --> 00:01:46.180 Every factor will be allocated to its most value-productive uses. 18 00:01:46.180 --> 00:01:50.560 Capital values will equal the sums of the DMVPs. 19 00:01:50.560 --> 00:01:57.720 The interest rate will be uniform and governed solely by time preferences, etc. 20 00:01:57.720 --> 00:02:04.980 The difference in the dynamic real world is this, none of these future values or events 21 00:02:04.980 --> 00:02:06.440 is known. 22 00:02:06.440 --> 00:02:11.320 All must be estimated, guessed at by the capitalists. 23 00:02:11.320 --> 00:02:18.220 They must advance present money in a speculation upon the unknown future in the expectation 24 00:02:18.220 --> 00:02:30.020 In the real world, then, quality of judgment and accuracy of forecast play an enormous 25 00:02:30.020 --> 00:02:34.500 role in the incomes acquired by capitalists. 26 00:02:34.500 --> 00:02:42.120 As a result of the arbitrage of the entrepreneurs, the tendency is always toward the ERE. 27 00:02:42.120 --> 00:02:51.120 In consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives. 28 00:02:51.120 --> 00:02:57.120 The capitalist entrepreneur buys factors or factor services in the present. 29 00:02:57.120 --> 00:03:00.120 His product must be sold in the future. 30 00:03:00.120 --> 00:03:09.120 He is always on the alert then for discrepancies, for areas where he can earn more than the going rate of interest. 31 00:03:09.120 --> 00:03:31.120 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. 32 00:03:31.120 --> 00:03:39.620 If his expectations are fulfilled, then he will obtain a 10% annual return instead of 5%. 33 00:03:39.620 --> 00:03:47.120 The difference between the general interest rate and his actual return is his money profit, 34 00:03:47.120 --> 00:03:51.120 from now on to be called simply profit, 35 00:03:51.120 --> 00:03:57.120 unless there is a specific distinction between money profit and psychic profit. 36 00:03:57.120 --> 00:04:07.120 In this case, his money profit is 10 ounces for two years, or an extra 5% per annum. 37 00:04:07.120 --> 00:04:17.120 What gave rise to this realized profit, this ex post profit, fulfilling the producer's ex ante expectations? 38 00:04:17.120 --> 00:04:25.120 The fact that the factors of production in this process were underpriced and undercapitalized, 39 00:04:25.120 --> 00:04:32.800 underpriced insofar as their unit services were bought, undercapitalized insofar as the 40 00:04:32.800 --> 00:04:40.480 factors were bought as wholes, in either case the general expectations of the market aired 41 00:04:40.480 --> 00:04:46.480 by underestimating the future rents, MVPs, of the factors. 42 00:04:46.480 --> 00:04:53.360 This particular entrepreneur saw better than his fellows, however, and acted on this insight. 43 00:04:53.360 --> 00:04:59.340 He reaped the reward of his superior foresight in the form of a profit. 44 00:04:59.340 --> 00:05:06.300 His action, his recognition of the general undervaluation of productive factors, results 45 00:05:06.300 --> 00:05:13.820 in the eventual elimination of profits, or rather in the tendency toward their elimination. 46 00:05:13.820 --> 00:05:19.780 By extending production in this particular process, he increases the demand for these 47 00:05:19.780 --> 00:05:22.980 factors and raises their prices. 48 00:05:22.980 --> 00:05:29.540 This result will be accentuated by the entry of competitors into the same area, attracted 49 00:05:29.540 --> 00:05:32.900 by the 10% rate of return. 50 00:05:32.900 --> 00:05:38.820 Not only will the rise in demand raise the prices of the factors, but the increase in 51 00:05:38.820 --> 00:05:42.540 output will lower the price of the product. 52 00:05:42.540 --> 00:05:48.980 The result will be a tendency for a fall in the rate of return back to the pure interest 53 00:05:48.980 --> 00:05:50.660 rate. 54 00:05:50.660 --> 00:05:54.500 What function has the entrepreneur performed? 55 00:05:54.500 --> 00:06:00.860 In his quest for profits, he saw that certain factors were underpriced vis-à-vis their 56 00:06:00.860 --> 00:06:03.580 potential value products. 57 00:06:03.580 --> 00:06:09.780 By recognizing the discrepancy and doing something about it, he shifted factors of production 58 00:06:09.780 --> 00:06:17.140 – obviously non-specific factors – from other productive processes to this one. 59 00:06:17.140 --> 00:06:24.700 He detected that the factors' prices did not adequately reflect their potential DMVPs. 60 00:06:24.700 --> 00:06:31.020 By bidding for and hiring these factors, he was able to allocate them from production 61 00:06:31.020 --> 00:06:37.180 of lower DMVP to production of higher DMVP. 62 00:06:37.180 --> 00:06:44.420 He has served the consumers better by anticipating where the factors are more valuable. 63 00:06:44.420 --> 00:06:50.560 for the greater value of the factors is due solely to their being more highly demanded 64 00:06:50.560 --> 00:06:58.380 by the consumers, that is, being better able to satisfy the desires of the consumers. 65 00:06:58.380 --> 00:07:04.500 That is the meaning of a greater discounted marginal value product. 66 00:07:04.500 --> 00:07:11.180 It is clear that there is no sense whatever in talking of a going rate of profit. 67 00:07:11.180 --> 00:07:18.420 There is no such rate beyond the ephemeral and momentary, for any realized profit tends 68 00:07:18.420 --> 00:07:24.380 to disappear because of the entrepreneurial actions it generates. 69 00:07:24.380 --> 00:07:30.500 The basic rate, then, is the rate of interest, which does not disappear. 70 00:07:30.500 --> 00:07:37.020 If we start with a dynamic economy, and if we postulate given value scales and given 71 00:07:37.020 --> 00:07:43.680 in original factors and technical knowledge throughout, the result will be a wiping out 72 00:07:43.680 --> 00:07:49.860 of profits to reach an ERE with a pure interest rate. 73 00:07:49.860 --> 00:07:56.300 Continual changes in tastes and resources, however, constantly shift the final equilibrium 74 00:07:56.300 --> 00:08:04.100 goal and establish a new goal toward which entrepreneurial action is directed, and again, 75 00:08:04.100 --> 00:08:10.500 The final tendency in the ERE will be the disappearance of profits. 76 00:08:10.500 --> 00:08:19.860 For the ERE means the disappearance of uncertainty, and profit is the outgrowth of uncertainty. 77 00:08:19.860 --> 00:08:26.660 A grave error is made by a host of writers and economists in considering only profits 78 00:08:26.660 --> 00:08:28.700 in the economy. 79 00:08:28.700 --> 00:08:31.940 Almost no account is taken of losses. 80 00:08:31.940 --> 00:08:39.200 The economy should not be characterized as a profit economy, but as a profit and loss 81 00:08:39.200 --> 00:08:41.000 economy. 82 00:08:41.000 --> 00:08:47.020 As Frank H. Knight put it, one thing I miss in discussion generally in the field is any 83 00:08:47.020 --> 00:08:55.940 use of words recognizing that profit means profit or loss, and is in fact as likely to 84 00:08:55.940 --> 00:08:58.300 be a loss as a gain. 85 00:08:58.300 --> 00:09:03.700 Professor Knight's great contributions to profit theory are in sharp contrast to his 86 00:09:03.700 --> 00:09:07.700 errors in capital and interest theory. 87 00:09:07.700 --> 00:09:14.540 A loss occurs when an entrepreneur has made a poor estimate of his future selling prices 88 00:09:14.540 --> 00:09:16.140 and revenues. 89 00:09:16.140 --> 00:09:22.640 He bought factors, say, for 1,000 ounces, developed them into a product and then sold 90 00:09:22.640 --> 00:09:25.180 it for 900 ounces. 91 00:09:25.180 --> 00:09:31.880 He erred in not realizing that the factors were overpriced and overcapitalized on the 92 00:09:31.880 --> 00:09:38.920 market in relation to their discounted marginal value products, that is, to the prices of 93 00:09:38.920 --> 00:09:41.520 his output. 94 00:09:41.520 --> 00:09:48.680 Every entrepreneur, therefore, invests in a process because he expects to make a profit, 95 00:09:48.680 --> 00:09:55.920 is because he believes that the market has underpriced and undercapitalized the factors 96 00:09:55.920 --> 00:09:58.760 in relation to their future rents. 97 00:09:58.760 --> 00:10:02.520 If his belief is justified, he makes a profit. 98 00:10:02.520 --> 00:10:09.800 If his belief is unjustified, and the market, for example, has really overpriced the factors, 99 00:10:09.800 --> 00:10:12.420 he will suffer losses. 100 00:10:12.420 --> 00:10:16.480 The nature of loss has to be carefully defined. 101 00:10:16.480 --> 00:10:24.480 Suppose an entrepreneur, the market rate of interest being 5%, buys factors at $1,000 102 00:10:24.480 --> 00:10:29.480 and sells their product for $1,020 one year later. 103 00:10:29.480 --> 00:10:33.520 Has he suffered a loss or made a profit? 104 00:10:33.520 --> 00:10:37.520 At first, it might seem that he has not taken a loss. 105 00:10:37.520 --> 00:10:45.720 After all, he gained back the principal plus an extra 20 ounces for a 2% net return or 106 00:10:45.720 --> 00:10:46.720 Gain 107 00:10:46.720 --> 00:10:53.600 However, closer inspection reveals that he could have made a 5% net return anywhere on 108 00:10:53.600 --> 00:10:58.220 his capital, since this is the going interest return. 109 00:10:58.220 --> 00:11:04.360 He could have made it, say, investing in any other enterprise, or in lending money to consumer 110 00:11:04.360 --> 00:11:05.680 borrowers. 111 00:11:05.680 --> 00:11:10.240 In this venture, he did not even earn the interest gain. 112 00:11:10.240 --> 00:11:17.620 The cost of his investment, therefore, was not simply his expenses on factors, 1,000, 113 00:11:17.620 --> 00:11:25.600 but also his forgone opportunity of earning interest at 5%, that is, an additional 50. 114 00:11:25.600 --> 00:11:30.320 He therefore suffered a loss of 30 ounces. 115 00:11:30.320 --> 00:11:37.360 The absurdity of the concept of rate of profit is even more evident if we attempt to postulate 116 00:11:37.360 --> 00:11:39.320 a rate of loss. 117 00:11:39.320 --> 00:11:44.440 Obviously, no meaningful use can be made of rate of loss. 118 00:11:44.440 --> 00:11:51.160 Entrepreneurs will be very quick to leave the losing investment and take their capital elsewhere. 119 00:11:51.160 --> 00:11:57.480 With entrepreneurs leaving the line of production, the prices of the factors there will drop, 120 00:11:57.480 --> 00:12:03.960 and the price of the product will rise, with reduced supply, until the net return in that 121 00:12:03.960 --> 00:12:09.880 branch of production will be the same as in every branch, and this return will be the 122 00:12:09.880 --> 00:12:13.860 uniform interest rate of the ERE. 123 00:12:13.860 --> 00:12:19.460 It is clear, therefore, that the process of equalization of rate of return throughout 124 00:12:19.460 --> 00:12:26.440 the economy, one that results in a uniform rate of interest, is the very same process 125 00:12:26.440 --> 00:12:32.840 that brings about the abolition of profits and losses in the ERE. 126 00:12:32.840 --> 00:12:41.780 A real economy, in other words, where line A yields a net return of 10% to some entrepreneur, 127 00:12:41.780 --> 00:12:50.680 and line B yields 2%, while other lines yield 5%, is one in which the rate of interest is 128 00:12:50.680 --> 00:12:52.200 5%. 129 00:12:52.200 --> 00:13:00.080 A makes a pure profit of 5%, and B suffers a pure loss of 3%. 130 00:13:00.080 --> 00:13:06.540 A. Correctly estimated that the market had underpriced his factors in relation to their 131 00:13:06.540 --> 00:13:09.280 true DMVPs. 132 00:13:09.280 --> 00:13:16.560 B. Had incorrectly guessed that the market had underpriced, or at the very least, correctly 133 00:13:16.560 --> 00:13:23.280 priced, his factors, but found to his sorrow that they had been overpriced in relation 134 00:13:23.280 --> 00:13:26.620 to the uses that he made of the factors. 135 00:13:26.620 --> 00:13:33.540 In the E.R.E., where all future values are known and there is therefore no underpricing 136 00:13:33.540 --> 00:13:39.540 or overpricing, there are no entrepreneurial profits or losses. 137 00:13:39.540 --> 00:13:43.340 There is only a pure interest rate. 138 00:13:43.340 --> 00:13:50.740 In the real world, profits and losses are almost always intertwined with interest returns. 139 00:13:50.740 --> 00:13:57.580 Our separation of them is conceptually valid and very important, but cannot be made easily 140 00:13:57.580 --> 00:14:01.500 and quantitatively in practice. 141 00:14:01.500 --> 00:14:06.300 Let us sum up the essence of an evenly rotating economy. 142 00:14:06.300 --> 00:14:12.740 It is this, all factors of production are allocated to the areas where their discounted 143 00:14:12.740 --> 00:14:16.600 marginal value products are the greatest. 144 00:14:16.600 --> 00:14:20.380 These are determined by consumer demand schedules. 145 00:14:20.380 --> 00:14:25.880 In the modern world of specialization and division of labor, it is almost always the 146 00:14:25.880 --> 00:14:33.700 consumers alone who decide, and this in effect excludes the capitalists, who rarely consume 147 00:14:33.700 --> 00:14:37.500 more than a negligible amount of their own products. 148 00:14:37.500 --> 00:14:44.440 It is the consumers, then, given the natural facts of stocks of resources, particularly 149 00:14:44.440 --> 00:14:50.340 labor and land factors, who make the decisions for the economic system. 150 00:14:50.340 --> 00:14:56.860 The consumers, through their buying and abstention from buying, decide how much of what will 151 00:14:56.860 --> 00:15:03.860 be produced, at the same time determining the incomes of all the participating factors. 152 00:15:03.860 --> 00:15:07.620 And every man is a consumer. 153 00:15:07.620 --> 00:15:14.100 One obvious exception to this rule occurs when either capitalists or laborers have strong 154 00:15:14.100 --> 00:15:19.660 preferences or dislikes for a particular line of production. 155 00:15:19.660 --> 00:15:27.180 The equilibrium rate of return in the ERE for a strongly disliked line will be considerably 156 00:15:27.180 --> 00:15:34.460 higher than the uniform rate, and the equilibrium rate of return for a strongly liked line will 157 00:15:34.460 --> 00:15:36.020 be lower. 158 00:15:36.020 --> 00:15:41.660 These preferences, however, have to be strong enough to affect the investment or productive 159 00:15:41.660 --> 00:15:48.600 actions of a considerable number of potential investors or laborers in order to register 160 00:15:48.600 --> 00:15:55.920 Do profits have a social function? 161 00:15:55.920 --> 00:16:02.800 Many critics point to the ERE, where there are no profits or losses, and then attack 162 00:16:02.800 --> 00:16:08.760 entrepreneurs earning profits in the real world as if they were doing something mischievous 163 00:16:08.760 --> 00:16:11.320 or at best unnecessary. 164 00:16:11.320 --> 00:16:17.960 Are not profits an index of something wrong, of some maladjustment in the economy? 165 00:16:17.960 --> 00:16:25.680 The answer is yes, profits are an index of maladjustment, but in a sense precisely opposed 166 00:16:25.680 --> 00:16:27.840 to that usually meant. 167 00:16:27.840 --> 00:16:34.800 As we have seen, profits are an index that maladjustments are being met and combated 168 00:16:34.800 --> 00:16:38.020 by the profit-making entrepreneurs. 169 00:16:38.020 --> 00:16:43.620 These maladjustments are the inevitable concomitants of the real world of change. 170 00:16:43.620 --> 00:16:52.440 A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment, 171 00:16:52.440 --> 00:16:57.700 specifically an undervaluation of certain factors by the market. 172 00:16:57.700 --> 00:17:03.540 By stepping into this situation and gaining the profit, he calls everyone's attention 173 00:17:03.540 --> 00:17:09.640 to that maladjustment and sets forces into motion that eventually eliminate it. 174 00:17:09.640 --> 00:17:16.120 If we must condemn anyone, it should not be the profit-making entrepreneur, but the one 175 00:17:16.120 --> 00:17:18.360 that has suffered losses. 176 00:17:18.360 --> 00:17:25.200 For losses are a sign that he has added further to a maladjustment, through allocating factors 177 00:17:25.200 --> 00:17:31.520 where they were overvalued as compared to the consumer's desire for their product. 178 00:17:31.520 --> 00:17:38.080 On the other hand, the profit-maker is allocating factors where they had been undervalued as 179 00:17:38.080 --> 00:17:41.160 as compared to the consumer's desires. 180 00:17:41.160 --> 00:17:46.660 The greater a man's profit has been, the more praiseworthy his role. 181 00:17:46.660 --> 00:17:53.480 For then, the greater is the maladjustment that he alone has uncovered and is combating. 182 00:17:53.480 --> 00:18:00.360 The greater a man's losses, the more blameworthy he is, for the greater has been his contribution 183 00:18:00.360 --> 00:18:02.600 to maladjustment. 184 00:18:02.600 --> 00:18:08.000 We may make such value judgments, of course, only to the extent that we believe it is 185 00:18:08.000 --> 00:18:17.300 good to correct maladjustments and to serve the consumers, and bad to create such maladjustments. 186 00:18:17.300 --> 00:18:23.240 These value judgments, therefore, are not at all praxeological truths, though most people 187 00:18:23.240 --> 00:18:26.000 would probably subscribe to them. 188 00:18:26.000 --> 00:18:33.980 Those who prefer maladjustments in serving consumers will adopt the opposite value judgments. 189 00:18:33.980 --> 00:18:38.180 Of course we should not be too hard on the bumbling loser. 190 00:18:38.180 --> 00:18:41.660 He receives his penalty in the form of losses. 191 00:18:41.660 --> 00:18:46.100 These losses drive him from his poor role in production. 192 00:18:46.100 --> 00:18:51.820 If he is a consistent loser, wherever he enters the production process, he is driven out of 193 00:18:51.820 --> 00:18:54.700 the entrepreneurial role altogether. 194 00:18:54.700 --> 00:18:57.620 He returns to the job of wage earner. 195 00:18:57.620 --> 00:19:04.260 In fact, the market tends to reward its efficient entrepreneurs and penalize its inefficient 196 00:19:04.260 --> 00:19:06.300 ones proportionately. 197 00:19:06.300 --> 00:19:13.100 In this way, consistently provident entrepreneurs see their capital and resources growing, while 198 00:19:13.100 --> 00:19:18.040 consistently imprudent ones find their resources dwindling. 199 00:19:18.040 --> 00:19:23.020 The former play a larger and larger role in the production process. 200 00:19:23.020 --> 00:19:27.720 The latter are forced to abandon entrepreneurship altogether. 201 00:19:27.720 --> 00:19:33.940 There is no inevitably self-reinforcing tendency about this process, however. 202 00:19:33.940 --> 00:19:40.140 If a formerly good entrepreneur should suddenly make a bad mistake, he will suffer losses 203 00:19:40.140 --> 00:19:41.660 proportionately. 204 00:19:41.660 --> 00:19:48.020 If a formerly poor entrepreneur makes a good forecast, he will make proportionate gains. 205 00:19:48.020 --> 00:19:52.820 The market is no respecter of past laurels, however large. 206 00:19:52.820 --> 00:20:00.820 Moreover, the size of a man's investment is no guarantee whatever of a large profit or against grievous losses. 207 00:20:00.820 --> 00:20:08.820 Capital does not beget profit. Only wise entrepreneurial decisions do that. 208 00:20:08.820 --> 00:20:20.820 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. 209 00:20:20.820 --> 00:20:29.320 Beyond the market process of penalization, we cannot condemn the unfortunate capitalist who suffers losses. 210 00:20:29.320 --> 00:20:34.320 He was a man who voluntarily assumed the risks of entrepreneurship 211 00:20:34.320 --> 00:20:40.320 and suffered from his poor judgment by incurring losses proportionate to his error. 212 00:20:40.320 --> 00:20:44.320 Outside critics have no right to condemn him further. 213 00:20:44.320 --> 00:21:01.320 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. 214 00:21:01.320 --> 00:21:09.320 If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits? 215 00:21:09.320 --> 00:21:14.320 It is easy indeed to display foresight after the event.