Free Our Markets
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Interventions such as minimum wage laws (wage rates being the prices of labor services), rent controls, subsidies to reduce mortgage interest rates (interest rates being the “price of time”), price ceilings on gasoline, price supports on milk and cheese, subsidies for alternative energy sources such as wind and ethanol—all these distortions of prices block communication and hinder coordination. In each case, the intervention brings about the kind of waste (though perhaps harder to detect) that occurred when Russ Sobel’s neighbor dried her hair, and his father used his electric shaver, with electricity that could have kept thousands of dollars’ worth of food from spoiling.
Every price has an important story to tell. Every single one should be left free. Good government will protect all people’s freedom to negotiate whatever prices they see fit for the purchase or sale of their property, in peaceful negotiation with others.
Though market prices are essential to human flourishing, they don’t guide us all by themselves. If we are to cooperate as well as possible in a society based on division of labor and exchange, we must use prices to discover how best to create value for others. That is, we must use prices to pursue profit and avoid loss, because profits—in a free market—come from creating value for other people. While that is not a generally held opinion, it is as true as arithmetic. To profit and loss, and to their all-important role in making the world a better place, we turn in the next chapter.
Chapter Two
Profit and Loss Guide Innovation
In a world of endless possibilities but limited resources with which to try out those possibilities; in a world where many people have business ideas but it’s not clear which of those ideas are sound and which unsound; in a world where no single person even knows how to make a pencil, much less predict what new products, processes, and technologies will best serve people’s needs a year or five years from now—in such a world, we need some means of sorting out the good ideas from the bad, for discovering which products and processes actually do serve us better than others.
We need free markets because free markets give us profit and loss, and profit and loss guide innovation. They are imperfect guides, to be sure, but they are the best available to us. Hence the second of three principles of spontaneous economic order that account for why we should free our markets:
In free markets, profit and loss help entrepreneurs discover the most value-creating uses of scarce resources by providing them feedback about how well they are serving others: profit rewards value creation; loss punishes value destruction.
This chapter explains what profit and loss are and what they signify. It lays out the indispensable role they play in innovation. It distinguishes admirable from blameworthy profit. It explains that profits are more important as guides to future action than as rewards for past action, and draws conclusions for public policy.
Opposing Views of Value, Exchange, and Profit
Let us take a moment at the outset to appreciate the astonishing creativity of market economies. Contemplate all the delightful goods and services we enjoy—if we live in the economically freer regions of the world. How did it all come to be?
Some who enjoy rock- and ice-climbing may value life in nature and scorn workaday, commercial enterprise. Yet their joyful recreation in the mountains is vastly enriched by their crampons and ropes, their high-friction-soled rock climbing shoes, their high-tech alloy ice axes, their pitons and carabiners, all of which are created through an immense network of enterprises in mining, manufacturing, metallurgy, chemistry, materials science, transportation, insurance, and the like. The luxurious wealth that is rock-climbing gear is provided for them by entrepreneurial industrial and commercial enterprise.
Closer to our daily lives, we have contact lenses, air conditioning, Tylenol, and hot showers. We have music, at minimal expense, that in both quality and variety far surpasses what kings and queens of old could enjoy. And we can listen as we go for a run, or fly through the air at 35,000 feet. When the snow flies in the winter and nothing is growing for hundreds of miles around, we have fresh grapes and kiwi fruit.
An academic, I revel in the immediate availability of information of all sorts via the Internet, and I shall be eternally grateful to the Microsoft programmers who gave me automatic formatting of footnotes in Word.
This abundance is astonishing, enriching, glorious.
What makes developed economies so creative? What guides that creativity in socially useful directions? We begin to answer these questions with the help of some basic economic principles.
How would you answer each of the following questions? Please think them through before going on; I’ll give my answers in the discussion that follows:
What determines something’s value? (economic value, not spiritual or moral value)
When a sale is made, who benefits and who loses, the buyer or the seller?
Can wealth be created simply through trade?
How much profit is too much?
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What determines the value of a product? For a long time economists had the answer wrong. They believed that the value of a good was determined by the labor that went into producing it, directly or indirectly. The great Adam Smith got this wrong in chapter five of The Wealth of Nations, where he said, “Labour, therefore, as it appears evidently, is the only universal, as well as the only accurate measure of value.”
Karl Marx picked up on Smith’s error and developed it into his labor theory of value, which underlies all of Marxian economics.
A crucial implication of the labor theory of value is that value is inherent in the good itself and, hence, is objective. It implies that a good’s value can be measured or calculated; it does not vary; it is fixed as a consequence of the labor that went into producing the good. The value is in the good itself.
The labor theory of value has been discredited in economics since the 1870s. Even most Marxists now reject it. A little thought will make clear that the labor theory of value must be wrong. A house that falls down is not a good house, regardless of how much work went into building it. As a professor, I run into the labor theory of value frequently when students who have failed tests plead for a passing grade on the grounds that “I studied so hard!” If the labor theory of value were true, then mud pies should be worth as much as apple pies, as long as the same amount of labor went into each.
Value is not determined by labor input, but by the judgment of the valuer. We say, accordingly, that value is subjective, determined by the person (the subject) doing the valuing, not the object being valued. A mud pie is not worth as much as an apple pie because people like eating apples and dislike eating mud.
An important implication of the subjective theory of value is that different people value things differently. Accordingly, when considering the value of something, it is wise to ask, “value to whom?” A pick-up truck is generally of more value to a Wyoming rancher than to a New York City accountant. Some people prefer pepperoni pizza to plain cheese; for others, it’s the reverse. For vegetarians, a hamburger has no value at all.
Of course, the same person will value the same thing differently in different situations. An obvious example is food. When we have just eaten, we put a much lower value on a nice meal than when we have not eaten all day. Value is subjective.
Here is a quick quiz to check the reader’s understanding of this principle: Suppose, one evening, you and your friend go into a Pizza Hut hungry and buy a large pepperoni pizza for $11.00. What is value of that pizza? Not the price, the value; the price is easy; it’s $11.00. But what is the value of the pizza? Please answer before reading on.
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If you answered that the value of the pizza is $11.00, then you fell into the trap. We can be certain that neither you nor the Pizza Hut values the pizza at exactly $11.00. If the pizza were worth exactly $11.00 to you and your friend, then you would not have bothered to give up your $11.00 for it. Why take the time to make a perfectly even trade? Similarly, if Pi
zza Hut valued the pizza at exactly $11.00, they would not take the trouble to produce and sell it for the identical $11.00 value in return.
We can be certain that the pizza is not worth $11.00 either to you and your friend or to Pizza Hut. We can be certain that the pizza is worth more than $11.00 to you and your friend, because otherwise you would not have given up $11.00 for it. Similarly, we can be certain that the pizza is worth less than $11.00 to Pizza Hut, or else they would not have accepted $11.00 for it.
The point is important: Voluntary exchange occurs only when both parties to the exchange expect to be made better off by it. It’s not a zero-sum game with a winner and a loser; it’s a positive-sum game in which both trading partners win. In an important sense, wealth is created through exchange, in that both parties to the exchange become better off in their own opinion—wealthier—as a result of the trade. You and your friend are better off (especially if you are ravenously hungry and would have paid $15 or $20 for the pizza if you had had to) and Pizza Hut is better off, because the overall cost to them of producing and selling one more pepperoni pizza is less than $11. Both buyer and seller gain. Wealth is created though trade, as long as the trade occurs in free and open exchange.
These different theories of value have decisive implications for how we understand the nature of exchange and of profit and loss. Marxists and others who hold the labor theory of value necessarily conclude that market exchange is a pernicious business in which some people exploit others. For those who hold the subjective theory of value, by contrast, market exchange means benefit for both parties involved.
If the value of a good were determined by the amount of labor needed to make it, as in the Marxian view, then that value would be objective and fixed, and the buyer and seller could not both gain. Their exchange would be zero-sum—the sum of their gains and losses must be zero. “One man’s loss is another man’s gain.”
On this view, profit is an ugly thing because it can result only from exploitation. To simplify slightly the Marxist viewpoint, profit is the difference between the objective, labor-determined value of the capitalist’s product and the wages he pays his laborers. Because the laborers who produced it are the sole source of the product’s value, the argument goes, laborers should be paid the whole value they create; but they aren’t.
Consider a simple example. Suppose you are the capitalist owner of a tractor factory. In a year, you buy $4 million worth of inputs—steel, tires, glass, copper wire, etc.—that your workers assemble into tractors that sell for $5 million. According to Marxist theory, your workers have created $1 million worth of new value. You pay them, however, only $900,000. Your $100,000 profit was created by the workers, but you did not pay them for it. Your profit means you exploited your workers. You live as a parasite, at others’ expense. Shame on you … if the labor theory were correct.
But it is not correct.
Next, consider the implications of the subjective theory of value. Because the value of a good is subjective—because different people value things differently—exchange is (except when we make mistakes) value-creating for both parties. As long as each person gives up what she values less for what she values more, exchange creates value for both trade partners. Each person gets more (according to her values) only when the other person also gets more (according to his different values). You and your friend benefit when you buy the $11.00 pizza; so does Pizza Hut.
In the tractor factory example, the wage rates the company must pay emerge from competition among workers for jobs and competition among various companies for workers’ services. The workers value their wages more than the time and effort they give the tractor company, and the tractor company values the workers’ time and effort more than the wages it pays. Both sides benefit from the exchange, whether the factory makes profits or losses. Notice that the wages to be paid are determined by contract long before the entrepreneur finds out whether he has made profit or loss on his enterprise for any period of time. His profit or loss is irrelevant to his wage bill (except that if losses go on too long, the wages must cease altogether).
Voluntary exchange is positive-sum. Wealth is created through trade, as long as we judge people’s wealth by their own subjective valuations. One man’s gain, in free and voluntary exchange, means another man’s gain. Hence profit is good. It results not from exploitation, but from creating new value for other people.
The Source and Meaning of Profit and Loss
Exactly what are profit and loss, and where do they come from?
To begin with, we should always keep profit and loss together in our thinking, like the two sides of a coin. Think of the market process not as a profit system, but as a profit-and-loss system. Think of business people not as profit makers, but as people who risk loss in the hope of profit; frequently they just make losses. The future is always uncertain; no one is guaranteed a profit.
Here’s the definition: Profit or loss equals yield minus cost:
Yield
– Cost
Profit or Loss
This is the broadest definition of profit or loss. In everyday terms, it is the difference between what we get out of an effort (its yield) and what we put into it (its cost). If that difference is positive, it’s profit; if it is negative, it’s loss. Note the general applicability of this definition: it can apply to everything we undertake. When we go to a movie with friends, the yield is the enjoyment of the film and the companionship; the cost is the next best use we could have made of that time and the money we paid for the ticket. If the movie and companionship are delightful, we profit from going to the movie. If the movie is poor and our companions are dull, we lose by going to the movie.
Yield comprises not just monetary yield. People care about innumerable things other than money; so in figuring yield, we must pay attention to non-monetary benefits. As a college professor I am paid less than I could earn in other professions; and if the money were all I got from teaching, I would not teach. A great part of my yield from teaching comes from its many non-monetary benefits: I get to think about interesting ideas, I get long vacations, I get to spread understanding of ideas I care about, and I get a captive audience six or eight times a week!
Profit and loss are concepts generally applicable to human experience, as is made clear by the many non-business activities to which we apply the terms. One classic use of the terms comes from the Bible, in which Jesus asks, “For what is a man profited, if he shall gain the whole world, and lose his own soul?” Jesus clearly considered such an exchange a losing proposition. Moving from the profound to the commonplace, when I ask my students if they have ever been in an unprofitable romantic relationship, many nod ruefully and others laugh. They all know what I mean. The yield of some relationships is just not as large as all we have to give up to maintain them.
Even for business owners, monetary return is rarely the whole of the yield they seek. Many business owners could make more money working at a salary for some other enterprise than they can make working for themselves. Nevertheless, they prefer working for themselves because the non-monetary satisfactions of being their own bosses and of following their own creative visions provide enough additional reward to make up for the money income sacrificed. Money is rarely the only object of human endeavor.
But money is important. Let us restrict our thinking about yield, for present purposes, to monetary yield. The money part of yield is total revenue, the money customers pay the enterprise for its product. Cost is total cost, everything they spend or otherwise give up (such as alternative uses of the owners’ time) to produce that product. Monetary yield represented by total revenue minus total cost equals profit or loss:
Total Revenue
– Total Cost
Profit or Loss
Let’s consider the elements of this difference one at a time. First, what determines an enterprise’s total revenue, its monetary yield, in a true free-market setting? In very general terms, what’s the source of an enterprise’s revenue?
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The size of the (monetary) yield is determined by the customers who buy; their valuations of the good or service determine the monetary yield to the entrepreneur. In other words, customers will pay for something only what it is worth to them (or less). What they’ll pay for the entrepreneur’s output is an approximation of the value of that product to them. In short, the entrepreneur’s total revenue reflects the amount of value she has provided her customers.
Significantly, the value of a product to the customers is almost always more than what they have to pay. At the going price, some people get what they consider a decent bargain; some get what they consider a good bargain; and others get what they consider a great bargain. (The difference between the most customers are willing to pay and the price they actually do pay is called consumer surplus.) This means the value the entrepreneur provides her buyers is usually substantially more than the revenue she receives. Hence, total revenue is a conservative indicator of the value the business provides to customers.
Now, what determines a business’s cost? To economists, all costs are properly understood as opportunity costs, the values of the best opportunities foregone when an action is taken. The cost of production, then, is the next best use of all the resources used in production; it is the value of what does not get produced instead.
Profit or loss expressed in terms of value, then, is the difference between the value an entrepreneur produces for customers and the value of the resources she uses in doing so:
Value of the output to customers