–Value of resources in their next best use
Profit or Loss
The arithmetic is simple, isn’t it? But look what a profoundly important insight about enterprise it reveals: Entrepreneurs make profits by increasing the value available from resources, that is, by creating value. On the other side of the coin, entrepreneurs make losses by destroying value.
Again, let’s illustrate with an example. Suppose Alice comes up with an idea for a new line of women’s sportswear. She goes into business producing it. She incurs a variety of costs. Among other things, she must rent space, purchase cloth and thread, rent or purchase sewing and cutting machines, buy electricity, and hire people to help her. All of these productive resources could be used to produce other things whose value is reflected in the price she must pay for these resources. For each resource she uses, she must outbid other entrepreneurs who would like to use them for other purposes. Her space could be used to house some other business; the cloth and thread could be used to produce some other kinds of clothing; the sewing and cutting machines could be used to produce sheets, upholstery, or whatever; the electricity could be used for myriad other purposes; and the skills and energy of the people she hires could also be used in all sorts of ways. Don’t forget alternative uses of Alice’s own talent and energy; the most valuable service she could provide some other employer is the cost of Alice’s being in business for herself.
The cost of Alice’s sportswear, then, is the value to consumers of the best other things that might have been produced with the resources Alice uses on sportswear instead.
Now suppose Alice’s total cost in a year is $100,000, but her customers pay her $120,000 for her sportswear. She makes a $20,000 profit. How? By taking resources worth $100,000 in their next best uses and transforming them into sportswear worth … $120,000! Alice has created $20,000 worth of new value for other people. She has put those resources to a higher-valued use than their best (known) alternatives. Her actions are profoundly creative. Her $20,000 profit is a consequence of her creating at least $20,000 worth of new value for her customers.
So now, how much profit is too much?
No amount. There can’t be too much profit if it’s made in a free market.
Suppose Alice were to make far more profit than $20,000. Suppose she had taken $100,000 worth of resources and transformed them into sportswear worth, say, $500,000. (I don’t know how she would do that; using some miraculous new technology, perhaps.) Would her now $400,000 profit be “too much” in some meaningful sense? How could it be? Too much for whom? Her profit means she has produced for consumers far greater value out of existing scarce resources than others expect to be able to produce. That creativity is a great thing, not a bad thing. It serves others.
Or suppose that Alice manages to partner with Harry Potter, who waves his wand and conjures the sportswear out of thin air, so that her cost is zero. Suppose he conjures up sportswear for which people will pay Alice $120,000, but Alice uses no scarce resources of buildings, machines, electricity, labor, etc. in doing so. Her profit would be the entire $120,000 she gets paid. Would that be bad for others? Of course not. In that case, we would have sportswear we willingly pay $120,000 for without having to give up any other goods that we would have had to give up if Alice required scarce resources in order to produce.
The more profit, the better for society, as long as that profit is made in a free market.
Next, consider loss. Suppose Alice takes resources worth $100,000 in other uses and transforms them into sportswear for which people will pay only, say, $70,000. She thereby makes a loss of $30,000. What does this loss mean? It means she has destroyed $30,000 worth of value to others. In place of a variety of other goods and services worth $100,000 to us consumers, we now have sportswear worth only $70,000. Our society is $30,000 worse off than we would have been if Alice had never tried her enterprise.
The huge losses that some companies make represent huge losses to society overall. Consider the dramatic true story of Iridium, a satellite phone company that went bankrupt in 1999. Their concept was wonderful: A person with an Iridium phone could call from anywhere in the world to anywhere in the world. The phone would beam a signal up to one of a ring of satellites in low-earth orbit. Computers in the satellites would beam the signal around the ring to a satellite over the person being called and down to his Iridium phone, or to a receiving tower located near him, with the call completed over land lines.
The money cost of the Iridium system was estimated at between $5 billion and $7 billion. The company actually developed communications satellites, put up sixty-six of them, designed and debugged the software to run the system, built ground towers, negotiated with governments around the world for permission to build those towers and run land lines, and so on. It was a tremendous undertaking. All the resources they used—the time and energy of the satellite designers and manufacturers, the rocketry for launching, the time and expertise of the software designers, the computers, the construction of the ground towers, the time and expertise of the negotiators—all these resources could have been used producing other things that you and I would have valued. Instead they were used to produce the Iridium system.
In the end, the system could attract only a few thousand customers, instead of the millions it needed to turn a profit. The phones were very expensive; they were large and heavy (“like bricks”); and they performed poorly indoors. More important, the people at Iridium grossly underestimated the rates of growth and improvement of their main competitor—cell phones. Iridium could not compete. Around the time of bankruptcy in 2000 they were even preparing to de-orbit the satellites, letting them fall into the atmosphere and burn up, rather than clutter the space around Earth with useless junk.
Iridium was a stunning technical success, but a staggering economic failure. Their losses were in the multiple billions. Why? Because they destroyed value. They took resources valued at between $5 billion and $7 billion in other uses and transformed them into satellite phone services valued at only a few million. It was a minor tragedy.
Profit, then, is a consequence of the entrepreneur’s creating new value; loss is the consequence of the entrepreneur’s destroying value. More profit means more new value created. In the same way that prices reflect information about how badly people need things and how easy (or hard) it is to produce those things, profit and loss reflect information about how much value people have created or destroyed. Accordingly, there is simply no such thing as too much profit, as long as that profit is made in voluntary, free-market exchange. The more profit, the better.
Most Profits are Fleeting
The benefits of profit and loss in a market economy are heavily weighted toward consumers, not businesses, because of competition. Competition is the consumer’s friend. In a free market, when one company finds a way to make large profits, competitors quickly arise who seek to earn some of those profits for themselves by imitating or improving on the strategy of the innovator.
Consider Alice from our example above (without the help of Harry Potter). When she introduces her new line of attractive sportswear she earns profits because customers are willing to pay a price substantially above her cost of production. But then what happens? To the extent that Alice has success, she will attract competitors who make similar sportswear and offer it for sale at around the same price. That competition will cut into Alice’s sales; she will have to respond by lowering her price a little. But if her competitor is making some profit he can lower his price a little also. The competition tends to go on until Alice and her competitor just can’t afford to lower their prices any further, because they are charging just what it costs, or a razor-thin margin above.
Meanwhile the consumers benefit from more choices and lower prices. So it is for most products and processes: the companies that produce or use them make profit for a while, and then prices are pushed down by competition, benefiting the consumers and eliminating profits on that product or process.
But entrepreneurs are endlessly ingenious and innovative, so they come up with still new products and processes and the cycle begins again.
The pattern is clear in the computer and telecommunications industries over the last decades: Consumers have benefitted from ever better, faster, cheaper, lighter, smaller computers, smart phones, laptops and tablets; and ever faster, higher band-width, more mobile and widespread telecommunications. The companies that have produced these have made profits, but those profits are very short-lived. As I write these words Research in Motion (RIM), the maker of the Blackberry, once the leading smartphone, is in trouble. So is Nokia, once the leading manufacturer of cell phones. At present, the Apple iPhone is the leading smartphone, but Google is doing its best to take away Apple’s market share with its Android technology. Apple’s iPad is the leading tablet, but Amazon offers the Kindle Fire, and Microsoft has just brought to market the Surface. The profits, or losses, to be made on all these products as time passes are uncertain and certainly temporary, but their benefits to consumers are certain and lasting.
And competition squeezes profits and lowers prices for consumers not just in high-tech products. Both Michael Rothschild’s Bionomics and Russell Roberts’s novel, The Price of Everything, describe in some detail the extraordinary innovations that producers in search of profits have made over the years in the production of an ancient product, the hen’s egg. The innovations have driven down and down the inflation-adjusted price of eggs to consumers; but again, the profits producers earned have been temporary, because all big egg producers imitate the best practices of others as well as they can, and compete on price.
It is true that there are some products that are assured profits, at least for a while, because there are no substitutes, or substitutes that are few and imperfect. Actors and actresses have monopolies on their personal good looks; great athletes have monopolies on their extraordinary skill, grace, and strength. Hence they can charge astonishingly high prices for their performances with very limited competition to bring down the prices their customers pay. But these are exceptions that prove the rule. The main beneficiaries of profit and loss are consumers, not producers.
The Social Role of Profit and Loss
Clear now on what profit and loss mean, we turn to the indispensable role they play in helping people innovate—discover new and better ways of satisfying human wants—in a world where resources are scarce and the future is uncertain.
Because productive resources such as human talent, machinery, energy, and raw materials are scarce, whenever we use resources to produce one thing, we thereby give up all the other things we could have used those resources to produce instead. (The value of the most valuable bundle of those other things foregone is called the opportunity cost, as we have seen.) In order to live as prosperously as possible, therefore, we need to put resources to their most valuable uses.
But just what the most valuable uses are at any time and place is uncertain, both because of the limitations on what any one individual can possibly know (remember that no one even knows how to make a pencil) and because the future is inherently uncertain.
There would be no need for profit and loss if the world were not uncertain—if everyone could know for sure the most value-creating use of every resource at every time and place, and know that her action was perfectly fitted with the actions of everyone else with every other resource. We could all simply take the action that we directly perceive to be the most value-creating. But we can’t have such omniscience, so we need profit and loss to help us discover what to do to get the greatest possible value out of our scarce resources. There are three categories of discovery, the first is ordinary, the second and third are dramatic.
Discovery of the Best (Known) Uses of (Known) Resources
For illustration of the first kind of discovery, which we have already touched on in another context, let’s do another thought experiment: Suppose you are a farmer with a field that’s good for crops that grow down in the soil, such as carrots and potatoes. It is nearly planting season, so you need to decide what to plant in that field—how best to use that resource. To keep it simple, suppose you can grow equal quantities of carrots or potatoes in that field, say, one thousand bushels of one or the other. Suppose, as shown in Table 2.1, you expect that the market price for carrots at season end will be, say, $80 per bushel. You can’t know that for certain, of course; prices fluctuate constantly. You must use your experience and judgment to interpret past and current prices for clues about what prices to expect at harvest time. Suppose you also expect the cost of producing carrots—for wear and tear on your machinery, for paying your farmhands, and for fertilizer and pesticides—to be about $70 per bushel. Hence you expect a profit of around $10 per bushel or $10,000 in all if you plant carrots.
You make the same kind of calculation for potatoes. Suppose that you expect the price of potatoes at season end to be lower, at around $60 per bushel, but you expect costs to be lower still, at around $45 per bushel. Your expected profit for potatoes, then, is $15 per bushel or $15,000 in all.
Note that all this calculating is in terms of market prices (including wages, the price of labor services) which communicate, as we saw in the last chapter, the vastly dispersed and specialized knowledge, experience, and judgment of all the participants in the markets for carrots and potatoes, and for farm machinery, fertilizer, pesticides, farm labor and the rest. The price you must meet for each resource is the most some other farmer (or other enterpriser) will pay for the machinery, fertilizer, and so on, based on his judgment of the value he can create for his customers with it. That is, their market prices give a pretty good indication of the opportunity cost of your use of all these resources.
Expected Profit or Loss on Different Crops
Carrots
Potatoes
Expected Revenue
$80,000
$60,000
Expected Cost
$70,000
$45,000
Expected Profit or Loss
$10,000
$15,000
Given these expected costs and prices and your expected output of a thousand bushels of either crop, what would you plant?
You would plant potatoes, of course, because you expect potatoes to give you a profit of $15,000 instead of the $10,000 you expect from carrots, as shown above. That greater profit, if it comes to pass in reality, would be a consequence of your creating more new value for your customers growing potatoes than growing carrots. Accordingly, growing potatoes would be best for your customers just as it would be best for you. Indeed, as we have seen, it would be best for you because it would be best for your customers: it would give them the greatest difference between the value (to them) of the food you grow for them, as reflected in its price (at least $60,000 worth) and the value (to them) of the next best other things they could have had from those resources instead, as reflected in their various prices ($45,000).
Note that even though you expect you can provide $20,000 more value to your customers growing carrots in your field instead of potatoes ($80,000 worth as opposed to only $60,000 worth), you expect you can do that only by giving up an even greater value—$25,000 worth—of other things that could be produced with those resources instead ($70,000 worth as opposed to only $45,000 worth). In a world of scarce resources, the trick is not to produce whatever is most valuable regardless of cost, but to produce whatever will give customers the greatest increase of value. That increase (or decrease if it’s a loss) is reflected in profit and loss calculations.
Calculations of expected profit or loss, based on expected market prices, are indispensable for helping entrepreneurs try to discover how best to use scarce resources to satisfy the wants of others.
Of course entrepreneurs’ forward-looking estimates of profit and loss are not their only means of discovering the most value-creating uses of scarce resources in an uncertain world. That discovery also occurs through backward-looking calculations of the actual profits or lo
sses they make on their different projects. Businesses tally up their actual revenues based on the prices at which they were actually able to sell, tally up their actual costs based on the prices they actually had to pay for productive resources, and subtract. In reading the profit or loss on that bottom line they discover whether they have used scarce resources well or badly, whether they have created or destroyed value. Then (if they have enough cash flow to continue in business at all) it’s back to their entrepreneurial judgments: What does the profit or loss mean? Why was it different than expected? How might losses be cut, or profits increased? Should we try to improve the product to increase the value to customers or try to cut costs by improving our production methods? Or some of both?
Realized profit or loss never tells an entrepreneur what to do next, of course; it only makes clear the past project’s success or failure in creating value for others. But that feedback from the market, that discovery of whether past efforts have created value or not is essential in guiding entrepreneurs as they try to judge what to do next.
Innovation: Discovery of the New and Better
So far in this section we have talked about discovery of how best to use our scarce resources to get as much as possible of the things we want, when we know both what we have and what we want. It is discovery of how best to use known means to achieve known ends.
The second, more dramatic kind of discovery that profit and loss direct is discovery of previously unknown ways of satisfying human wants: new products, new resources, new productive techniques, tools, and processes. This is innovation, discovery of real novelty that helps us make more out of life. For innovation also, profit and loss are indispensable.
The great economist Joseph Schumpeter coined a famous term for this kind of discovery: “creative destruction.” He meant the destruction of goods, processes, and enterprises that once served people well, by means of the creation of new goods, new processes, and new enterprises that serve people better. Schumpeter wrote:
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