Business and Economic Change

0:00So, Bob is kind of a tough act to follow, so I hope none of you think that this lecture is going to be funnier than the last one, because as far as the morning lectures go, we definitely peaked and now we're on the down-out. So, the title is Business and Economic Change, but I could just as well have called it Profit and Loss, because profit and loss are the key concepts, and pretty much everything that I'll be saying relates to them. Now when economic conditions are bad, like they have been for the past few years, we start to hear more about preserving and encouraging economic growth as a way of getting out of trouble. But we also hear all sorts of anti-business rhetoric, too, about greed and evil businessmen and so on. So it becomes a little bit confusing because we think, well, pick a side, what should we do? Is business good or bad or what have you?

0:51So, what I want to talk about is first a little bit about how the economy changes and grows naturally in a free economy and then I'll talk about some of the problems we see when the market is not allowed to function freely and hopefully I'll get to say some things about common misconceptions people have about how markets work. So, one of Mises's great contributions to economics was to develop a theory of the entrepreneur to explain how economies change and develop over time, and as we'll see, it's all due to entrepreneurs. So what are entrepreneurs and what do they do? Well, when you have an advanced division of labor, like Bob was talking about, with millions or billions of workers and a practically infinite number of ways to produce different things, there's a huge problem which emerges.

1:38That is, somebody has to decide what to produce and where to produce and how and so on. And that someone is the entrepreneur. Usually when we think of entrepreneurs, we tend to think of people who start new businesses, especially small businesses. But really, entrepreneurs exist at every level of the economy, from local businesses all the way up to large corporations that sell raw materials and other inputs that we as consumers never even see. So the key to understanding entrepreneurship is in understanding that when we talk about entrepreneurs, we really aren't talking about individuals necessarily, we're talking about a function, a certain kind of business activity that individuals engage in. Bob talked about the division of labor and about how free economies encourage people to develop their special skills, and the division of labor is actually at the core of the idea of entrepreneurship.

2:31Because in entrepreneurial theory, we say that some individuals specialize in guiding the process of economic change. And there's one skill in particular which is more important than most others, and that's the skill of predicting future wants of consumers. The economy changes and grows because some individuals, entrepreneurs, are willing to introduce innovations and new and more efficient ways of producing things. So what entrepreneurs do is to take resources and use them for projects which will only come to fruition in the future so that they don't necessarily know whether or not they'll be successful. There's always some uncertainty in the future, so even the best entrepreneurs can't be completely sure that they'll succeed, but they still take risks with their property just for the chance to make a profit.

3:16Entrepreneurs buy resources which they use to produce, including human labor, and it's because they direct the process of production to satisfy consumers that we say that entrepreneurs drive the economy. They help to bring about economic progress. Now, most mainstream economists don't ever really think about entrepreneurship, the entrepreneurial function, because economists tend to think about economics in a very abstract way that's not very realistic, to make a long story short. But Austrian economists focus on the way individual behavior brings about economic change. It's a much more realistic approach. So because entrepreneurs need to invest in business, they need to buy machines and equipment, pay workers and so on, they have certain costs. And when they sell their product, whatever it might be, they bring in revenues.

4:03So of course when the revenues are greater than the expenses, they earn profits, and if not, they earn losses. This idea is extremely simple, but it's also extremely powerful when we really think about what it means. And what it tells us is that in order for entrepreneurs to earn revenue, they need to produce something that people actually want to buy. If they do that, if they satisfy enough people, they earn more than their costs, but if not, then they lose money. So profit and loss are an indication of the level of satisfaction of consumers. Research. Large profits show that many individuals are willing to buy and that individuals consider themselves better off buying the products of the entrepreneur, while losses show that people aren't interested or aren't interested because prices are too high, and so losses show that the entrepreneur is wasting resources by producing things that nobody wants.

4:51As Mises liked to point out, the market in this way is like a democratic political system, but even more so because every day the consumers decide who owns the economy's resources and how many resources they own, as Mises put it, Each ballot of the consumers adds only a little to the elected man's sphere of action. To reach the upper levels of entrepreneurship, he needs a great number of votes repeated again and again over a long period of time, a protracted series of successful strokes. He must stand every day a new trial, must submit anew to re-election, as it were. This idea is called consumer sovereignty or individual sovereignty, and it's critical when explaining how the market works, especially to people who think that owning capital automatically entitles you to profits, or that owning resources and earning profits somehow isolates you from the community.

5:45But really, profits demonstrate a harmony with the interests of the community. They demonstrate that people are being satisfied by what's being produced. Especially today, we constantly hear about, we hear expressions like giving back to the community when businessmen donate to charity, for example. But this implies that under normal circumstances, businesses take something away from the community. But profitable businesses do exactly the opposite. They provide services that people want. They allow people to engage in mutually beneficial transactions with each other. And the community is better off because of it. If you're interested in this sort of thing, by the way, there's a great essay by Mises called Profit and Loss It's available downstairs, and I would urge you to read that because Mises lays out the principles of profit and loss and entrepreneurship very simply and clearly. It's a fantastic little book and Also, Bob has a good chapter on entrepreneurs in his book for high school students, so you can look at that as well

6:41But I'm really out of shape, so I can't hold up his book though But contrary to popular belief, profits aren't permanent. Even the most amazing entrepreneurs don't earn profits forever, because competitors imitate each other and come up with their own versions. And the more imitators that enter the market, the more profits are gradually bid down. There's this idea that once a business is established and gets large enough that it necessarily earns profit, as if it becomes sort of a self-sustaining mechanism. But this is completely false. Because profits and losses are earned every day in the economy, even successful entrepreneurs can't stop trying to innovate to keep the customers happy. Competition keeps firms on their toes. So past success doesn't mean very much, and it doesn't guarantee future profits. Even the largest and most successful firms have to constantly change in order to survive in the market.

7:33market. Now I'm kind of a film geek so all my examples tend to do with the film industry. I considered coming up with some examples that were maybe more relevant to this crowd and I thought no I'm not going to do that. I'll just do what I want and so you'll have to bear with me. But an example of sort of how the mighty have fallen in business recently would be someone like the A corporation like the MGM Movie Studio, which just went bankrupt, even though they own a lot of potentially lucrative assets, they own the rights, for example, to the James Bond franchise, which is the second most successful film series of all time, after Harry Potter, but the point is that in recent years, MGM hasn't been able to produce movies which people actually want to see. And so, even though it owns these assets, which might make money in the future, because of bad decisions, they have no money right now, and so they're trying to sell off everything they have in order to stay open.

8:30They're also selling, by the way, half shares in the two film adaptations of The Hobbit they're producing. So if you're a Tolkien fan and you have some extra money, you might want to look into that. So profits don't just tell entrepreneurs if they're successful or not, though. Another function which they have, which is just as important, is that prices allow entrepreneurs to see the cost of every decision they make. Make, entrepreneurs can look at their balance sheets and income statements and tell from them what it costs to make certain decisions. It tells them what they could have done so they can compare that to what they actually did. And this accounting enables entrepreneurs to decide between different ways to produce. Being able to see the opportunity costs of an action, what Dr. Thornton was talking about, that is what you could have done, and then comparing different possibilities is necessary for entrepreneurs to produce anything because they have all these different options.

9:26So it becomes a serious problem then when profit and loss accounting is falsified somehow because it changes the perceptions of entrepreneurs and gives them the wrong idea about the state of the market. The principal way that this happens is through inflation when it can appear that firms are extremely profitable when in fact they might be making losses in terms of the real value placed on their services by consumers. But also this problem of calculation that hints at the great problem of socialism, which Mises talked about, which involves the impossibility of allocating resources properly in any society without private property and market prices. And now that's a whole lecture by itself, so I won't get into it, but the punch line is that without a way to measure the opportunity cost of production, a socialist economy simply can't function.

10:12Okay. So the lesson here is that you can't survive in the free market without constantly innovating in Satisfying Consumers. And competition leads to consumer satisfaction, but also to social cooperation in general. Because in order to make themselves better off, as Dr. Thornton was pointing out, or no, it was you, it was Bob, sorry. People have to exchange with each other, even if they really wouldn't want to. So some people in society can be completely greedy or selfish, for example, but in order to satisfy their own selfishness, they first have to benefit other people by producing And this is what the economist Adam Smith was talking about when he introduced his famous metaphor, the invisible hand. We don't really use this term anymore because it sounds sort of mysterious and magical, right, like the invisible hand.

11:00I mean, if you try and have an argument with somebody over economic policy and say, well, the invisible hand will solve everything, I mean, it just makes you look crazy. I mean, imagine if you had a conversation about physics like that and you said, well, the ball moves a certain way when it strikes the other ball of all because the invisible hand made it that way, like the men in the white coats would come, right? And they'd give you a PhD in economics. But just because we don't use the terminology anymore, it doesn't mean that the idea isn't important, because it is. In fact, it's maybe one of the most important ideas in all of economics, and it's so important to a sound understanding of the market to realize that the profit and loss system and everything that it entails is the greatest mechanism for Social Cooperation Ever Created.

11:46So just a quick sort of side note about taxes. Obviously, taxing profits then has extremely negative effects. It discourages innovation and destroys the incentive to produce because when you tax profits, entrepreneurs have very little to work toward. And also at the same time, when you tax profits, that doesn't do anything to diminish your losses, so it eliminates the amount of success you can have, So why on earth would you ever produce anything if you knew from the outset that you couldn't really succeed but that you could lose everything, right? So that's a serious problem with tax and profits. But the bottom line on entrepreneurs is that entrepreneurs take risks and for that they sometimes receive an income.

12:32Greed has nothing to do with entrepreneurial profit or at least it doesn't magically produce profit. Only satisfying consumers can make a firm profitable. and that's why you know free market profits are so important because they show us who is using resources to satisfy the consumers and who's just wasting them. It's entrepreneurs who drive the economy who constantly innovate and try to improve consumer satisfaction and the income they receive is a sign of how well they do that. So now I want to talk a little bit about when entrepreneurs are in losses. Related to the idea of loss is the problem of bankruptcy and from what we've said we can realize that when we talk about Bankruptcy is the most important kind of economic adjustment because it takes resources which are being wasted by entrepreneurs and businesses and it allows them to be bought up by other people who can put them to better use, that is entrepreneurs who can try to do a better job of satisfying customers so we should be happy when we see firms go bankrupt because we know now that the

13:39The resources they were wasting could be put to better use elsewhere, and this applies to people as well. It's not that we should be happy that individuals become temporarily unemployed because the business they work for closes. What we should be happy about is that bankruptcy allows labor to switch from unproductive to productive tasks. It enhances the division of labor by shifting individuals from producing things people don't want to things that people do want. So it encourages people to develop socially useful skills. The bankruptcy example I'm using right now is Blockbuster. So at one time Blockbuster was one of the leading names in entertainment, but now they've been completely pushed out. And a huge part of the reason for that is because until recently Blockbuster was not very innovative. They were focused entirely on their physical store locations and anticipated that the need for these kind of stores would always be there.

14:31But of course companies like Netflix and iTunes and Redbox come along and they made rental stores pretty much a thing of the past and so Blockbuster only got into the online stuff very late, they never got into it like Netflix did so by the time they really started to take the competition seriously it was just too late and so a series of bad decisions, of bad forecasts cost them their business. In fact even though they were successful at times, even during the good times Blockbuster's business strategy was extremely risky and vulnerable to competition and innovation because it depended on late fees for a huge portion of its revenue, about 16%, I think. So when other companies did away with late fees and found innovative ways, especially through the internet, of providing the same or better service at a better price, Blockbuster became much more unattractive to consumers.

15:21And you might think that maybe anyone could see this coming, but the point is that nobody acted on it until the last few years. Anybody could have come up with the idea, but it was the entrepreneurs, like the guys who started Netflix, who were the ones who acted on the idea and capitalized on Blockbuster's mistakes and for that they now earn the profits that used to go to Blockbuster. So again here Blockbuster didn't anticipate that other businesses might develop an innovative way to revolutionize the industry and they've paid for their failure to anticipate future conditions so now they have to liquidate as many of their assets as they can and their holdings are being bought up by individuals who will put them to other uses which consumers value more highly. And this sort of bankruptcy and then resource adjustment is exactly what happens when markets are allowed to operate freely.

16:09There's a constant cycle of renewal in the economy as old and inefficient firms disappear and are replaced by new and innovative ones that are more capable of adapting themselves to changes in the economy. The economist Joseph Schumpeter called this process creative destruction, which is kind of a catchy way to describe how the economy is always in a sort of competitive revolution, always pushing towards increases in efficiency and productivity. So in the same way that business success is good because it shows that people are getting what they want, business failure is actually good too because it shows that entrepreneurs have realized their mistakes and the businesses are trying to make a better use of scarce resources. So that's a brief description of how free market entrepreneurs and businesses operate.

16:55So now I'm just going to talk about how government intervention affects business. This is a huge topic, so I can't say very much, but hopefully I can give you a small picture of some of the problems that arise from interfering with profit and loss. As we all know, or at least as I think we all know, we don't live in a truly free economy. We have government intervention in basically every industry and every part of our lives. So our analysis is a little bit different when we move from a free market to what we live under, a sort of interventionist economy. A lot of the time when we think about government intervention, we think about it as if the government is only doing something to business. That is, government is preventing business from succeeding and hampering the economy, getting in the way, and so on.

17:42And this is the picture, for example, that you see in novels of Ayn Rand, for example, where the evil government always wants to destroy the good entrepreneur, and so on. And this, of course, does happen. All government intervention hurts somebody in the economy. But there's another side to this as well, because government doesn't just do things to business, it does things for business as well, that is, it grants monopoly privileges. And these privileges benefit some firms at the expense of the rest of the economy. And of course businesses, especially large businesses who can afford it, know that it's possible to get support from the government, so they invest huge amounts of resources to try to suppress competition through all kinds of regulations. Economists sometimes call this rent seeking. So it's very common for the government and business to collude, to restrict competition and secure market share for one or a few firms who happen to have the ear of the legislators.

18:36Actually, more realistically, who happen to have the pocket of the legislator. But when you can legally suppress the competition, of course you can earn profits which would not otherwise have been available to you. The market has a much more difficult time penalizing you for failing to provide for the consumers There are a million different ways this can happen, laws like tariffs and quotas, prevent international competition, a little bit about what Bob was talking about. This is an obvious example, but there are much more subtle methods too, such as the monopoly which is granted to prescription drug companies through intellectual property laws, which prevent competitors from mass producing certain medicines, keeping the price or Minimum Wage Laws, for example, which price certain workers out of the market and reduce competition with, say, union workers who get to keep their wages artificially high.

19:32And the list goes on and on. A good rule of thumb is that whenever you see people agitating for a law to intervene in the market for an ostensibly humanitarian cause, you can bet that first, it hurts the people that it's supposed to help, to help, and then second, there's usually a large business or group of businesses behind it who support it, who stand to gain from it at the expense of their smaller competitors. But the most significant recent example of intervention in the profit and loss mechanism is the too big to fail argument that we heard around the time of the bailouts. This idea is that there are so many resources which are controlled by certain large firms that we need to prevent them from going bankrupt to keep the economy stable. But of course, it's exactly because so many resources are tied up in companies like GM, for example, that they need to go bankrupt.

20:25So this huge amount of prudential productive power can be given to somebody who wants to produce a product people actually want. And this is actually even truer of larger institutions like the banks than it is about GM, but I think Mr. French will probably have more to say about banking. But protection against bankruptcy in this way just protects bad economic decisions. It rewards mismanagement. And it punishes good management by keeping inefficient producers in the market alongside the innovative and productive ones. So when government prevents bankruptcy, it necessarily means that resources which were being wasted already are further prevented from being put to their most urgent uses. In fact, it would actually be more logical to say from this point of view that businesses would be too small to fail because smaller businesses use relatively few resources.

21:16Now, I'm not saying that small businesses should be protected from competition, because the same logic applies to them as well. well but my point is that it's the large failed businesses that need to be eliminated the most because they control the greatest amount of resources and even if there was an economic justification for keeping failed businesses in the market there's a practical side to protection as well that is protections are very hard to get rid of once they're in place because the business is getting protected always want to keep their protection and so they build up political support networks which make it very difficult to change And of course, once a firm gets protection from competition, there's also no clear point at which we can say, well, before the company was weak, but now it's stable enough to compete, so we can just allow competition again.

22:04So firms who want to get protected can keep making the same claim over and over and over again that they're not strong enough. so in fact protecting industries actually makes it less likely that they'll ever become healthy and capable of competing because once you have protection you don't have much incentive to really innovate or increase efficiency right because nobody can take away your share of the market all right well so this brings me to the last problem I want to talk about along sort of the same lines the problem of moral hazard moral hazard actually has a misleading name Moral hazard has many definitions, but the simplest way to describe the principle is to say that when you don't bear the cost of your own actions because you can shift them to somebody else, you behave differently, maybe more recklessly, than you otherwise would, whether that means that you spend more money or do risky things because you don't bear the cost, the point is that you behave differently.

23:08differently when you have little or no responsibility. The example of this which has been in the news in the last few years is compulsory health insurance. When people believe that insurance companies will pick up the bill for their accidents, they start paying less attention to their health and well-being. It's not that people are evil or that insurance is bad or anything, it's just that when there's some kind of intervention and as a result more people are insured than otherwise would be or have more comprehensive health insurance policies than they otherwise would. You see an increase in many different types of risky behavior. So when you have compulsory health insurance, it essentially means that individuals will have insurance who wouldn't have it otherwise, and this sets this process in motion. So paradoxically, trying to protect people and improve the quality of health care through compulsory legislation like this, assuming protecting people was the goal, but that's another issue, But paradoxically, trying to improve health care actually increases the amount of health problems people have

24:08because they pay less attention to their own health than the health of others. Maybe a more relevant example for this crowd would be car insurance, compulsory car insurance. For those of you who are new drivers, statistically speaking, you have a higher likelihood of getting in an accident than most adults. But let's assume that you're all very good, safe drivers. But think about how your driving habits might change, maybe without you even knowing it. If every time you got into an accident, you never had to pay for it. If every time you got into a fender bender, the insurance company just rolled a new car off the belt for you, right? With compulsory car insurance, even very good drivers are put in this moral hazard world, where you have this perverse incentive to drive carelessly because the cost of crashing is lower than it should be.

24:58So I think the relevance of this for business should be pretty obvious when businesses earn losses but are protected from bankruptcy, it just encourages irresponsible behavior, it relieves businesses of the cost of failure, it socializes the cost of failure, and it makes it much easier for businesses not to learn from their mistakes and to keep doing what it was that got them in trouble in the first place. The example of this, which I mentioned before, is the bailout of firms like GM, who produced a poor product and have been rewarded by being relieved of the cost of their failure. Again, I don't want to talk too much about banking, but I just want to point out briefly that when you have an organization like the Federal Reserve, which acts as the so-called lender of last resort, There's an implicit promise to banks and other prominent institutions of this, relating to this moral hazard problem, this implicit promise that they'll be rescued if their businesses start to collapse.

25:52And this breeds careless and sometimes even extremely reckless behavior, like for example, the lending to people with very bad credit that we saw in the housing boom. So, even though I've only said a little bit about this problem, I want to emphasize that moral hazard is one of the most important problems in economics. In fact, one of my graduate school professors used to say that moral hazard is more important than all the other problems of economics put together, which is probably an exaggeration, but not by much, because we see it everywhere, especially when we look at government intervention, welfare economics and areas like this. Okay, so the last thing that I want to say, and I'm afraid this is going to be confusing, I hope not, but so I've tried to give some examples of the basic principles of profit and loss, but the examples themselves, the real-world examples, aren't perfect because we live in a regulated economy.

26:48It's difficult to find practical examples of what happens on a free market because there aren't any free markets. So even though examples like MGM and Blockbuster and so on give us an idea of how the market operates, these companies aren't purely competitive. A lot of free market economists talk about companies that innovate and eliminate the competition and they might praise Walmart or Apple or other popular companies because they make profits and they wanted to defend these corporations as if they existed in a sort of free market vacuum independent of all the government intervention that's going on. But the problem is we can't make this distinction very clearly or absolutely, because intervention affects everyone in the market, whether you want it to or not.

27:34And even though we as teachers want examples of how the market works, we have to be very careful not to sort of just praise the free market when we see something that we like being produced, and then criticize the government on the other hand when we see something we You don't like being produced and saying, oh, well, that's just the product of intervention. That wouldn't happen on a free market. And the reason I'm pointing this out is just to note that it's very easy when, for example, you debate other people who don't understand the virtues of the free market, it's very easy to get trapped into defending people and institutions that really shouldn't be will be defended from the perspective of free market economics.

28:20Okay, so, the punchline. Key points. In a free market, entrepreneurs drive the economy by attempting to anticipate the future wants of consumers. Entrepreneurs take risks in order to earn profit, which is never guaranteed. Profits are a sign of success by entrepreneurs and the satisfaction of consumers. Losses are a sign of waste and inefficiency. Bankruptcy is beneficial for society because it moves resources from unproductive to productive industries. And protecting businesses and preventing bankruptcies wastes more resources and encourages future waste. So what I've tried to point out is the immense importance of earning profits in a free economy and a few of the socially beneficial effects profits have.

29:06I also can't emphasize enough the healthy role of loss and bankruptcy. So to close, I just want to pose some rhetorical questions to you, which are to ask, if it's true that in business, protection against bankruptcy is so harmful to society, then what should we think about government and its agencies, which are of their nature, organizations which do not pass the market test, strictly speaking? And what should we think of government organizations which are, practically speaking, permanently protected from failure, bankruptcy, and elimination from society? So thank you for listening. Thank you very much.