The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates….
[T]he … process of industrial mutation—if I may use that biological term— … incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.
For example, consider how we light our buildings. Only one hundred fifty years ago the primary source of light was whale oil lamps. The discovery that petroleum could be refined into kerosene destroyed the role of whale oil in lighting and, with it, large portions of the whaling industry. (By some accounts the advent of kerosene sank the whaling centers of New England into recession for two generations.) This destruction was creative—it resulted from the creation of a lamp fuel that was cheaper and burned brighter and cleaner than whale oil.
Of course kerosene’s role in lighting was creatively destroyed, too, by the development of electric lighting, in its own turn cheaper, brighter, and cleaner still. What will creatively destroy electric light bulbs and fluorescent tubes? We can’t say, of course, but we should expect it before too long. As of this writing, light-emitting diodes (LEDs) look like the leading contender.
Consider telecommunications. Fifty years ago, when someone in the United States called someone in Australia, the signal of her voice was carried by copper wire—tons and tons of copper torn from the mountains of Peru and Utah and Montana—stretching in a cable across the Pacific. The call could be made, but quality was poor; there were delays and clicks as repeaters amplified the steadily degrading signal.
Now, when we make a phone call to Australia, the signal of our voice is carried either by an optical fiber cable or by microwave. Optical fiber cables are also stretched across the Pacific, but they carry thousands of times as many calls as copper for their weight, and they are made of cheap and abundant sand. Microwave communication requires even less physical stuff: we just bounce the signal off a satellite floating in geosynchronous orbit. Whether the signal is carried by optical fiber or microwave, the call is much cheaper, there are no notable delays, and the quality is almost perfect. Telecommunication via optical fibers and microwaves are creatively destroying communication via copper cable.
Innovation, then, beyond the discovery of how best to use known resources for known ends, is discovery of new and better resources, or new ways to use them, or formerly unknown ends. Profit and loss feedback continuously motivates and guides entrepreneurs who seek to innovate.
Profit and loss feedback are not just helpful to human advancement; they are indispensable. Or, rather, perhaps society could advance without profit and loss, but it could only do so much more slowly. The reason has to do with scarcity and uncertainty.
Resources for experimentation are scarce. Lots of people have ideas for new products and processes, but most of those ideas probably won’t work, and we don’t have unlimited free capital to invest in any and every idea. There is not enough capital to go around. Machinery, energy, and human talent invested in one idea are unavailable to invest in another idea; only some ideas can get tried out.
At the same time, just what are the best new ideas—best in how they satisfy others’ wants—cannot be known ahead of time.
As some wag has said, “The future is hard to predict because it hasn’t happened yet.” The future is uncertain; it is unpredictable, though not unimaginable. In consequence, profits are never assured, because businesspeople can never be certain that their ideas will work. They must try to figure out, to imagine, to project what will work; what will work well enough and at low enough cost so that the price it earns will cover that cost.
Human beings simply don’t know for sure what products and processes will fit well into the ever-unfolding future. The following quotations should help to make this clear:
“This ‘telephone’ has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us.” – William Orton, president of Western Union, 1876
“The wireless music box has no imaginable commercial value. Who would pay for a message sent to nobody in particular?” – one of David Sarnoff’s associates in response to his urgings for investment in radio in the 1920s
“Who the hell wants to hear actors talk? The music—that’s the big plus about this.” – H.M. Warner of Warner Brothers on the prospect of sound tracks in movies, 1927
Note the date on the next one; the comment must have been made by summer, because things changed in the fall:
“Stocks have reached what looks like a permanently high plateau.” – Irving Fisher, Professor of Economics, Yale University, 1929
“Computers in the future may weigh no more than 1.5 tons.” – Popular Mechanics, forecasting the relentless march of science, 1949
“We don’t like their sound, and guitar music is on the way out.” – Decca Records, rejecting The Beatles, 1962
“So we went to Atari and said, ‘Hey, we’ve got this amazing thing, even built with some of your parts, and what do you think about funding us? Or we’ll give it to you. We just want to do it. Pay our salary, we’ll come work for you.’ And they said, ‘No.’ So then we went to Hewlett-Packard, and they said, ‘Hey, we don’t need you. You haven’t got through college yet.’” – Apple Computer Inc. founder Steve Jobs on attempts in 1974 to get Atari and HP interested in his and Steve Wozniak’s personal computer.
“What would I do? I’d shut it down and give the money back to the shareholders.” – Michael Dell, CEO of Dell Computer, before a crowd of several thousand IT executives, when asked what could be done to fix Apple Computer, 1997
All these remarkable quotations show that even people in the best position to judge what sorts of products and processes to try often get it wrong. Who was better able to assess the prospects of a satellite phone system than Motorola? Yet they misjudged. More than one major publishing house rejected J.K. Rowling’s idea for the Harry Potter series. Think what a dreadful misjudgment that was. In general, it’s just very difficult to determine what enterprises will really create value for others: over half of all new businesses fail within the first five years. Human beings are woefully ignorant about what to do today to improve our standard of living tomorrow. Because we just don’t know, we have to experiment.
Profit and loss guide the experimentation. An entrepreneur with an exciting new idea peers into an uncertain future and applies her judgment about likely developments in consumer tastes, production technologies, labor costs, shipping costs, and all the other considerations she expects to affect the success or failure of the project she is considering. Based on past and present prices she estimates future prices of everything relevant and thereby estimates the project’s profit or loss. That calculation, backed up by varying measures of wishful thinking or lack of faith, by greed for gain or fear of loss, and by plain old hunches, determines whether the entrepreneur goes ahead with the effort, tying up scarce and precious productive resources of human talent, machinery, energy, materials, office space, and the like in the inescapably uncertain venture.
We want entrepreneurs to take risks because, when the risks pay off, we all benefit from the new products and lower costs: think of the iPhone, iPod, iPad, eBay, miracle rice, automatic formatting of footnotes, EZ Pass, Lasik surgery, digital photography, and containerized shipping. But we don’t want entrepreneurs to waste society’s resources on foolish risks. The lure of profit encourages entrepreneurs to take risks, while the fear of loss discourages them from taking imprudent risks.
Most of the time in a market economy, where entrepreneurs must continually pass the market’s test of performance to hold onto their position as entrepreneurs, projects expected to make losses are left unattempted. Projects expected to make profits cannot all be attempted (in
a world of scarce resources), so entrepreneurs compare the best prospects with one another, weighing expected profit with relative risk.
In this way, forward-looking profit-and-loss calculations guide entrepreneurs to discover which among an infinity of possible endeavors promises best to create new value for customers.
The consuming public needs some means of sorting out the good ideas from the bad. We need a feedback system that tells entrepreneurs when they are creating value and when they are destroying it, and motivates them to do more of the former and less of the latter. By piling up losses, a new product or process—like Iridium—shows that it’s unlikely to serve society well; and its backers are thereby “told” to stop wasting resources on it. On the other hand, when a new product or process serves the public well at low cost, profit rewards its backers and encourages them to develop it further.
These reactions from the market are society’s indispensable guidance system for economic activity.
Economic development is an evolutionary process. All evolution consists of variation and selection. In the natural world, variation occurs though genetic mutation and sexual recombination, producing all the wondrous variety of creatures we observe, both across and within species. The means of selection, of course, is reproductive success, or “survival of the fittest.”
The economic world works the same way. Entrepreneurial innovation provides the variation—the myriad new products, materials, production techniques, and approaches to management, marketing and business organization. These changes can be great or small, ranging from introduction of an entirely new product such as the personal computer to little refinements such as a more comfortably shaped mouse.
The all-important means of selection is profit and loss. Through profit and loss, society sorts out the good ideas from the bad, those goods and services that satisfy us at acceptable cost from those that don’t. Profit and loss are society’s crucial means of guiding human creative energies in directions that actually satisfy people’s wants and needs.
The profit and loss system of a free market is ultimately directed by consumers. In a free market, only those goods and services for which consumers willingly pay, directly or indirectly, get rewarded. Through profit and loss we say yes to cell phones and no to Iridium.
In a society based on private ownership and freedom of association, profit and loss in their broad senses determine the fortunes of non-profits and even informal associations as well as those of for-profit enterprises. Consider churches. Like corporations, they must generate enough value for their “customers”—parishioners—to induce them to support the enterprise. If they don’t, they fail. A weak and uninspiring church, or one in an area losing population, may not be able to attract enough productive resources from its congregation. If people don’t come to church and put money in the plate to pay for an inspiring pastor, if they won’t contribute their time and effort to the church’s activities, the church will fail. Straight economic reasoning applies: If a church does not create enough value for its members—in fellowship, inspiration, service to the greater community and the like—to exceed the value of the next best use of parishioners’ time, effort, and money, the church will make losses and fail. By contrast, successful churches provide their congregations with spiritual and social benefits and opportunities to serve the greater community in satisfying ways. For these benefits their parishioners will gladly donate time, effort, and money. The church creates more value than it consumes; it profits and thrives.
The same reasoning applies to private-sector non-profits such as schools, soup kitchens, recreational sports leagues, symphony orchestras, fan clubs, medical clinics, environmental protection organizations, drug and alcohol treatment centers, summer camps, the Boy Scouts, book clubs, and the myriad other kinds of voluntary associations and enterprises that people create for themselves in pursuit of some shared vision of the good life. In a free society, these succeed and flourish when, in the broad sense, they are profitable for those concerned—when they create benefits for the targeted population greater than the opportunity cost of the resources used. When they make losses—when supporters believe the benefits created fall short of the value that could be created using the time and money another way—they weaken and eventually disappear.
Discovery of Capable Entrepreneurs
Evolutionary selection operates not just at the level of goods and processes, but also at the level of the entrepreneurs generating those goods and processes. This is the third kind of discovery guided by profit and loss. In the words of Ludwig von Mises,
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.
Those entrepreneurs who make good decisions, or even those who are just lucky, will be rewarded with profit. They may then invest that profit in still other new production activities. Accordingly, those who generally serve the public well get the chance to try again.
In our time, Bill Gates and the late Steve Jobs are notable examples of such successful entrepreneurs. Bill Gates started with Microsoft DOS (disk operating system) for early personal computers. It was a good product that earned him profit. He reinvested that profit in improved versions of DOS, then the new Windows operating system and other programs such as Word and Excel. The success of each new product and version has meant more profits that he has invested in still more improvements and other new products.
The story of Steve Jobs is similar. Each good investment he made in his extraordinary career at Apple meant profits that Jobs used to develop new products and improve existing ones. He admitted that sometimes he made mistakes, causing losses that reduced his investable funds; the Lisa computer comes to mind. But by and large he made good decisions, investing scarce capital resources in products that surprised and delighted consumers. Each time he did so, the consumers rewarded him with profits that he used to work further wonders.
By contrast, those who serve us poorly and thus make losses see their funds available for reinvestment shrink. If they make losses big enough for long enough, they are left with nothing to invest at all. They join the rest of us earning wages or salaries.
Mises describes this process as a kind of ongoing election:
The consumers by their buying and abstention from buying elect the entrepreneurs in a daily repeated plebiscite as it were. They determine who should own and who not, and how much each owner should own.… The ballot of the market elevates those who in the immediate past have best served the consumers. However, the choice is not unalterable and can daily be corrected. The elected who disappoints the electorate is speedily reduced to the ranks.
Note that while the consumers’ judgment—their “election”—of entrepreneurs is decisive in a free market, it is not instantaneous. Entrepreneurs must therefore look into the uncertain future and try to foresee consumers’ eventual judgments. Their personal stake in the outcome motivates them to peer into the future as discerningly as possible. Whether a given enterprise will become profitable or not can remain uncertain a long time. But always the prospect of profit or loss motivates entrepreneurs to try to make correct judgments for the long term. Those who believe that their enterprises will eventually increase value for consumers have an incentive to invest more and more money and time into it until it does, even though they first make losses for a long time. Through its first many years of existence, Amazon made losses while the enterprise gobbled up the huge quantities of investment necessary to build it. Nevertheless, the entrepreneurs investing in it believed enough in Amazon’s prospects of eventual success that they continued to support it. Those who held on, at least until this writing (2013), have been rewarded.
In contrary cases, when entrepreneurs with their own money at stake become convinced that their enterprise will never provide benefits to customers in excess of its costs, they have an incentive to cut their losses by closing it down, even if they have already sunk a frightful amou
nt of money into it. Remember Iridium.
Market-based Profit v. “Legal Plunder”
This chapter has sung the praises of the profit-and-loss system: Trade creates wealth. Profit results from creating new value. The more profit the better for society. In each case we have added a crucial proviso: as long as that profit is made in a free market. The underlying discipline of the free market’s basic institutions—private property and freedom of exchange—will direct profit-seeking activities in socially useful, mutually-beneficial directions. (Part II develops this idea.)
When government intervenes, however, or property is not privately owned, or property rights are not protected, profit may come from seizing wealth rather than creating it. In those circumstances, where governments transfer property from those who own it to those who don’t, or restrict freedom to engage in mutually agreeable exchange, or fail to enforce contracts; or where government ownership allows one party to pollute, despoil, or deplete what “everybody owns,” then profit can be made at others’ expense. Such profit-making merits not praise but condemnation.
The crucial factor for distinguishing the good kind of profit from the bad is consent of the parties involved. In a (classical) liberal society, in which governments, in Jefferson’s words, “prevent men from injuring one another, … leave them otherwise free to regulate their own pursuits of industry and improvement, and … [do] not take from the mouth of labor the bread it has earned,” people interact with one another only when they find it mutually beneficial. Hence any exchange occurs only when both parties (expect to) benefit. The interactions are by what Franz Oppenheimer calls “the economic means”—free and voluntary exchange.
In contrast to the economic means are what Oppenheimer calls “the political means” of transferring goods without the consent of those concerned: taxing, restricting, granting monopolies, licensing, subsidizing, and the like. When political means are used, it is not necessary to get the consent of those one deals with; those possessing governmental power simply compel others. In such circumstances, those we interact with may not find the interaction beneficial to them; they may find it harmful.
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