LESSON 9 Entrepreneurship and Competition

In this lesson you will learn:

• The role of entrepreneurs in a market economy.
• How competition guides entrepreneurs.
• Why workers tend to get paid the full value of what they contribute.

Entrepreneurship

The entrepreneur is the driving force of a market economy. It is the entrepreneur who judges that something is missing in the market, and decides to start a new business or develop a new product. The entrepreneur uses savings (either personal or borrowed from capitalists¹) to hire workers, rent land and equipment, and purchase raw materials, electricity, semi-finished goods, and other inputs. The entrepreneur then gives instructions to the hired help to use the tools, machinery, and inputs to produce goods and services which in turn are sold to customers.

The customers of a particular business may be other entrepreneurs or the final consumer. For example, one entrepreneur might open a bakery, where he uses a large oven, flour, water, and a bunch of teenagers to produce crusty French bread for local families. But there is another entrepreneur whose business is the production of industrial-scale ovens, and his customers are other entrepreneurs such as the baker and the owner of a restaurant.

Revenues are the money that customers pay to the entrepreneur for his products and services. Expenses are the money that the entrepreneur must pay out to workers, suppliers, landlords, and others in order to continue producing his goods and services. When revenues are higher than expenses, the entrepreneur earns a monetary profit. If expenses are higher than revenues, the entrepreneur suffers a monetary loss. Although entrepreneurs may be motivated by factors other than monetary profits and losses, when people refer to a “successful business” they mean one that is profitable.² On the other hand, if someone appeared to be running an operation year in and year out, constantly suffering monetary losses with no apparent end in sight, then the operation would probably be a hobby or a charity, rather than an actual business, and the would-be entrepreneur would actually be a consumer.³

The Contribution of the Entrepreneur

“What distinguishes the successful entrepreneur and promoter from other people is precisely the fact that he does not let himself be guided by what was and is, but arranges his affairs on the ground of his opinion about the future. He sees the past and the present as other people do; but he judges the future in a different way”

—Ludwig von Mises, Human Action, p. 582.

Competition Protects Customers

If entrepreneurs are the driving force in a market economy, competition is what regulates and motivates them. Competition ensures that entrepreneurs constantly strive to provide customers with goods and services at the quality they want for the lowest possible price.

In a pure market economy every transaction is voluntary. No matter how rich a particular entrepreneur becomes, he can’t literally force a customer to buy his products. Customers always have the option of taking their business elsewhere, meaning that even the most successful entrepreneurs must continually earn their patronage day in, day out.

The competitive process unfolds through a process of imitation and innovation. An insightful entrepreneur surveys the status quo and has a good idea to improve on the way that other entrepreneurs are currently serving their customers. The idea might be grand, such as the invention of a completely new product. But often the innovation is quite modest, such as switching to a plastic (and unbreakable) ketchup bottle, or changing the system of passenger seating for airline flights. Many innovations also occur on the production side, when an entrepreneur discovers a cheaper source of raw materials, or discovers a use for by-products that were previously thrown out. When magnified in large-scale operations, even tiny reductions in expenses can translate into huge differences in profits.

The story does not stop there. When a particular entrepreneur comes up with a successful innovation, he earns relatively high profits. Other entrepreneurs see his success, and they begin to imitate it—while looking for further ways to make slight modifications and introduce yet more innovations. The business world never sleeps. Even those firms that are “on top” in their respective industries are constantly researching new ways to stay ahead of the competition. Over time, there is a tendency for businesses to produce goods and services of rising quality and falling prices.

The ultimate beneficiaries of the competitive process are not the entrepreneurs, but their customers. When a particular entrepreneur makes a successful innovation and earns extraordinary profits, the success is temporary. Over time, his competitors discover how to lower their expenses, or improve the quality of the product, as he has done. Many critics of the market economy are horrified at the huge “markups” that sometimes occur, meaning that there is a large gap between the price an entrepreneur charges for a product, versus the money he himself had to pay to produce the item. But so long as there is competition, monetary profit (and hence “markups”) will be whittled away, as competitors try to gain market share by offering a similar product at a slightly lower price. Only by constantly introducing further innovations can a particular entrepreneur enjoy a steady stream of monetary profits.

In practice, most entrepreneurs are motivated by the desire to earn monetary profits. Yet in a market economy, the only way to earn profits is to serve customers (while keeping expenses down). One of the most beautiful aspects of a market economy is that it harnesses some of the most selfish, ambitious, and talented people in society, and makes it in their direct financial interest to worry at night about pleasing others. Entrepreneurs drive the market economy, but competition among entrepreneurs keeps them honest.

Competition Protects Workers

In the previous section we saw that competition protects consumers from arbitrarily high prices. If a particular entrepreneur is charging his customers a large markup relative to his expenses, in a free market he can’t prevent a competitor from offering the same product at a slightly lower price to win over his customers. In the long run, competition ensures that customers do not “overpay” for the goods and services they desire. Customers are charged a “fair” price for products and services, in the sense that at the moment of sale, some of the brightest minds in society had not yet come up with a way to deliver those items at lower prices—even though they would have reaped financial rewards from doing so.⁴

On the other side of the business, competition protects workers from arbitrarily low wages. It is true that a particular worker—especially with a family to feed—may not have much “bargaining power” and will have to accept a very low wage if that’s the only offer available. Yet in a pure market economy, a tight-fisted employer can’t prevent a competitor from coming along and offering a slightly higher wage to win over the underpaid employees and drive the tight-fisted entrepreneur out of business. In the long run, competition ensures that employers do not “underpay” for the labor services—and other resources—that they must hire or purchase in their operations.

In order to judge whether an employee is getting paid a “fair” wage, we need to understand the employee’s actual contribution.⁵ After all, some employees are more productive (and hence valuable) than others, so it makes sense that different employees will be paid different wages. How then does an employer decide what he’s willing to pay a potential new hire?

Economists say that the employer should try to calculate the marginal productivity of the potential new worker. This means that the employer should look at his total business output, with and without the new worker. Then the employer uses this information to calculate how much extra revenue his operation will bring in, because of the additional output. These calculations provide a ceiling, an upper limit of how much the employer would be willing to pay for the new worker.

Of course, in practice the employer will try to pay less than the marginal productivity of a potential new worker—just as in practice he will try to charge his customers a large markup. But competition ensures that he can’t get away with “underpaying” employees for very long, just as it prevents him from “overcharging” his customers for very long.

For example, suppose Rita owns a restaurant that is very busy. Rita notices that a major bottleneck in her operation is the cleaning of a table after the customers leave. At any given time, there are several tables in the restaurant that are dirty, meaning the hostess has to ask incoming customers to wait a few minutes before being seated. Rita realizes that it makes sense for her to hire an additional busboy to help the current busboy clean tables and get them ready for new customers.

Rita finds a candidate, Bob, who has had previous experience as a busboy at a busy restaurant, and who seems to be very courteous and responsible. Rita estimates that if she offers Bob the busboy position, after a week of getting used to the new job his presence will allow her restaurant, on average, to serve an extra 2 tables per hour. (Perhaps instead of there being 4 dirty tables at any time, now there are only 3, and each group of diners takes an average of 30 minutes to order their food, eat the meal, and leave.) If the typical table of patrons pays $26 to Rita for a meal that costs her $20 to prepare—not counting the paycheck she gives to Bob—then Rita would be willing to pay Bob up to $12 per hour.

Of course, Rita would hope to hire Bob for less than $12 per hour. But if she offered him only $4, then Bob would surely be able to sell his services to a competitor restaurant for, say, $5 per hour. Ultimately, the only logical stopping point would occur when Bob was being paid according to how much extra money his services brought in to the employer.⁶ Competition among entrepreneurs provides a tendency for workers to be paid for their contributions.

Lesson Recap...

• Entrepreneurs are the driving force in a market economy. They hire workers and buy resources, in order to produce goods and services for sale to the consumers.
• Competition pushes entrepreneurs to produce goods and services that their customers value, and to charge the lowest possible price for the level of quality that the customers desire.
• Competition also pushes entrepreneurs to pay workers the full value of their contribution to the business. If they underpay, then another employer—who only wants to make more money himself—can offer higher pay and entice the worker away.

NEW TERMS

Entrepreneur: The person in a market economy who hires workers and buys resources in order to produce goods and services.

Revenues: The amount of money customers spend on an entrepreneur’s output during a period of time.

Expenses: The amount of money an entrepreneur spends on labor, raw materials, and other inputs during a period of time.

Monetary profit: The amount by which revenues are greater than expenses.

Monetary loss: The amount by which expenses are greater than revenues.

Competition: The rivalry that exists between entrepreneurs who have the option of hiring the same workers and buying the same resources, in order to produce goods and services to be sold to the same customers.

Marginal productivity: The increased revenues that result from hiring an extra worker.

STUDY QUESTIONS

1. Why is the entrepreneur the “driving force” of a market economy?
2. *In the real world, why are all capitalists also entrepreneurs?
3. What motivates and regulates entrepreneurs in a market economy?
4. How does the competitive process unfold through “imitation and innovation”?
5. How does competition protect workers?