September 30, 2015

Entrepreneurs, Profits, and the Social Welfare: Profit AND Loss

By In Blogs, Brian Jacobson

Profit and Loss (see part 1, part 2, and part 3 of this series)

Nearly forgotten today by both its critics and proponents is that capitalism is a system of profit AND loss. Any act of government intervention preventing losses from occurring or from companies going under is just as destructive to economic development as taxing and confiscating “excessive” profits. The attempts of central banks and central planners alleviating the market from losses slows down the metabolism of capitalism that allows capital and labor to be metabolized and converted into a new profitable venture. When one firm cannot fail it means another cannot take that capital and start. Advocates of capitalism may stand to gain a lot by focusing on educating the general public that capitalism is a system of profit and loss. The area of losses has been as or if not more distorted through state cronyism and manipulation of the markets than profits, perhaps because avoiding losses even for billionaires appears to be a much more populist move. It might even be said that the Austrian Theory of the Business Cycle, as a theory of misallocation, is a theory of the consequences of preventing of losses through cheap debt by artificially suppressed interest rates. I doubt any of the GOP contenders or Bernie Sanders is going to harp on government’s refusal to let banks, car makers, or the housing industry fail. Instead they will say they profited too much (Democrats) or they weren’t allowed to profit enough(Republicans).

As Rothbard noted “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.”[1] Few take an economic of account of losses and the dynamic function and value they bring to the market. Those who incorrectly anticipate consumer desires and do not use resources in a needed and efficient manner to produce a cheap quality commodity suffer losses, and through these losses themselves, the capital is removed from their hands and transferred to entrepreneurs who more accurately anticipate future prices of goods in comparison to their present price and arrange their production process accordingly. This is what led von Mises to his conception of “consumer sovereignty”. While entrepreneurs and producers are at the helm and steer the ship they are not free to set its course. Steer to far off course and they will be removed. “They are not supreme, they are steersmen only, bound to obey unconditionally the captain’s orders. The captain is the consumer…The producers do not produce for their own consumption but for the market. They are intent on selling their products. If the consumers do not buy the goods offered to them, the businessman cannot recover the outlays made. He loses his money. If he fails to adjust his procedure to the wishes of the consumers he will very soon be removed from his eminent position at the helm.”[2]

Losses are how consumers impose mutiny. Those who make losses in their production efforts are those who, in the markets eyes, have been weighed, measured, and found wanting. The consumer is no easy boss according to Mises “They are no easy bosses. They are full of whims and fancies, changeable and unpredictable. They do not care a whit for past merit. As soon as something is offered to them that they like better or that is cheaper, they desert their old purveyors. With them nothing counts more than their own satisfaction. They bother neither about the vested interests of capitalists nor about the fate of the workers who lose their jobs if as consumers they no longer buy what they used to buy.”[3]

In this Mises considers the market is the truest democracy. Every penny is a ballot cast. The consumers “by their buying and by their abstention from buying;’ decide who should own the capital and run the plants.” It is the truest form of democracy because these decisions they make only for themselves. Because a majority of people eat at one kind of restaurant does not mean that the others are closed and all must eat at that restaurant but a proportionate amount of each restaurant exists according to how many consumers wish to eat there.

Consumer Sovereignty or Consumer-Driven Production

While Mises developed this idea he called “consumer sovereignty” his disciple Murray Rothbard would later object to the use of the word sovereignty, which he deemed to be bringing political vocabulary into the sociological realm:

“The term “consumers’ sovereignty” is a typical example of the abuse, in economics, of a term (“sovereignty”) appropriate only to the political realm and is thus an illustration of the dangers of the application of metaphors taken from other disciplines. “Sovereignty” is the quality of ultimate political power; it is the power resting on the use of violence. In a purely free society, each individual is sovereign over his own person and property, and it is therefore this self-sovereignty which obtains on the free market.”[4]

He did however agree with the concept behind Mises’s phrase:

“We have seen that in the free market economy people will tend to produce those goods most demanded by the consumers. Some economists have termed this system “consumers’ sovereignty.” Yet there is no compulsion about this. The choice is purely an independent one by the producer; his dependence on the consumer is purely voluntary, the result of his own choice for the “maximization” of utility, and it is a choice that he is free to revoke at any time…the individual is sovereign over his own person and actions and over his own property…To earn a monetary return, the individual producer must satisfy consumer demand, but the extent to which he obeys this expected monetary return, and the extent to which he pursues other, nonmonetary factors, is entirely a matter of his own free choice.”

Thus the idea main idea be saved by advocating the position of consumer driven production; the trend the that producers will make those goods most desired by consumers. Consumer demand determines what is produced, and therefore determines profits and losses. Our culture obviously favors the consumer (unless we’re talking about trade) and usually holds that he is a constant victim of producers and capitalist. Objectors to consumer sovereignty most always conceive of profit as automatically derived phenomenon of production. The obvious falsehood can be seen by examining those rather unsavory products which are produced. As Mises notes:

“It is irrelevant to the entrepreneur, as the servant of the consumers, whether the wishes and wants of the consumers are wise or unwise, moral or immoral. He produces what the consumers want. In this sense he is amoral. He manufactures whiskey and guns just as he produces food and clothing. It is not his task to teach reason to the sovereign consumers. Should one entrepreneur, for ethical reasons of his own, refuse to manufacture whiskey, other entrepreneurs would do so as long as whiskey is wanted and bought. It is not because we have distilleries that people drink whiskey; it is because people like to drink whiskey that we have distilleries. One may deplore this. But it is not up to the entrepreneurs to improve mankind morally. And they are not to be blamed if those whose duty this is have failed to do so.”

What then is a loss?

Mises explains then what it truly means praxeologically when there is losses made on a product: “What does it mean when we say that the production of a certain commodity A does not pay? It is indicative of the fact that the consumers are not willing to pay the producers of A enough to cover the prices of the required factors of production, while at the same time other producers will find their incomes exceeding their costs of production. The demand of the consumers is instrumental in the allocation of various factors of production to the various branches of manufacturing consumers’ goods. The consumers thus decide how much raw material and labor should be used for the manufacturing of A and how much for some other merchandise. It is therefore nonsensical to contrast production for profit and production for use. With the profit motive the enterpriser is compelled to supply the consumers with those goods which they are asking for most urgently. If the enterpriser were not forced to take the profit motive as his guide, he could produce more of A, in spite of the fact that the consumers prefer to get something else. The profit motive is precisely the factor that forces the businessman to provide in the most efficient way those commodities the consumers want to use.

The Importance of Losses: Ferreting Out Inefficiency

Thus one of the key roles profit and loss play at a more general level is to shift capital away from incompetent entrepreneurs to more able entrepreneurs. Through losses financing and capital leaves the hands of those who make continuous and grave errors in their use of production factors. While those who are successful in recognizing maladjustments in the market through their profit accumulation gain more control and influence over markets and accumulate more capital. Those who succeed and those who fail as entrepreneurs are rewarded proportionately. Any attempted intervention to prevent profits or losses loosen the grip of consumers influence over the production process:

“One of the main functions of profits is to shift the control of capital to those who know how to employ it in the best possible way for the satisfaction of the public. The more profits a man earns, the greater his wealth consequently becomes, the more influential does he become in the conduct of business affairs. Profit and loss are the instruments by means of

which the consumers pass the direction of production activities into the hands of those who are best fit to serve them. Whatever is undertaken to curtail or to confiscate profits impairs this function. The result of such measures is to loosen the grip the consumers hold over the course of production. The economic machine becomes, from the point of view of the people, less efficient and less responsive.”[5]

The profit motive (with its risk of losses) is what actually entices the entrepreneur and the producer to serve the consumers wishes  and to ensure scarce resources are not wasted but directed to their most efficient uses. Just as profit then is an act of good judgment in recognizing maladjustment in factors so Rothbard notes of entrepreneurial loss “a loss occurs when an entrepreneur has made a poor estimate of his future selling prices and revenues…He erred in not realizing that the factors were overpriced and overcapitalized on the market in relation to their discounted marginal value products, i.e., to the prices of his output.”[6] As was pointed out in part two of this series, profits are index that maladjustment has occurred. Not simply that but as Rothbard points out they are an index “that maladjustments are being met and combatted by the profit-making entrepreneurs.”[7] By this very act the profit-making entrepreneurs effects the first step in eliminating this maladjustment and therefore the possible profit. So why so much bad rap for people who make profits? “If we must condemn anyone,” says Rothbard “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 consumers’ desire for their product.”[8] Those who make losses are the ones who exacerbate the problems and impose a further misallocation of resources upon the social order. Rothbard is quick to note that we should not be too hard on the man though. He pays for his mistakes quite literally, and if frequent enough he returns to being a wage earner and selling his labor. It would be wrong to impose any more punishment on the failed entrepreneur than the market already has. Mises makes an interesting point about grumbling against entrepreneurs, their failures, or the current state a certain market. “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. In retrospect all fools become wise.”[9]

This possibility of losses was the risk and uncertainty he took on in beginning his venture. He was the victim of “the inevitable concomitants of the real world of change.”[10] The constant change and uncertainty that makes profits possible is the very thing that makes losses possible.

(see part 1, part 2, and part 3 of this series)

[1] Murray Rothbard, Man, Economy, and State with Power and Market, 512.

[2] Ludwig von Mises, Bureaucracy, 20.

[3] Ibid, 21.

[4] Murray Rothbard, Man, Economy, and State with Power and Market, 630.

[5] Ludwig von Mises, Profit and Loss, 23.

[6] Murray Rothbard, Man, Economy, and State with Power and Market, 512.

[7] Ibid, 515.

[8] Ibid.

[9] Ludwig von Mises, Profit and Loss, 14.

[10] Ibid.

Written by Brian Jacobson

Brian Jacobson works as a quality technician for a manufacturing company in St. Louis, Mo where he lives with his new bride. He studied biblical and theological studies at Reformation Bible College under R.C. Sproul in Orlando, FL. He’s an Old-School Presbyterian who enjoys the simple means of grace, Machen, and living the high life on a budget. Follow him @briankjacobson on Twitter.