Profit and Loss Guide Entrepreneurial Discovery

Howard Baetjer: Now we move to the second of the main, the principles that I see as being the foundations of why human beings need free markets in order to flourish. That has to do with profit and loss. The idea is that profit and loss provide a necessary, indeed [00:00:30] indispensable feedback, to business people. To help them discover how to use their resources and their talent in ways that serve other people. Profit and loss feedback is necessary to the discovery of what to do new and different, better, how to use resources so as to make other people better off. That’s the point of this lecture.

[00:01:00] There are three parts to it. First of all I’m going to talk about what profit and loss are. Second I’m going to talk about their role in guiding discovery. Their role in guiding innovation. Finally I’m going to make the case that they’re necessary for this purpose. That there’s nothing that humanity has to put in the place of profit and loss feedback. Even though, by the way, it is a sort of a kludgy, imperfect trial [00:01:30] and error and process. We just don’t have anything better to put in its place. Those are the three main topics. One other topic there is I’ll make the claim that profit and loss aren’t to be understood so much as a reward for past action, as a guide to future action. And that’s response sometimes to people who say, “It’s not fair that some people make such profits.” That’s what’s coming up.

First of all, [00:02:00] what are profit and loss? First of all, what they are not? People have the idea that when someone makes a profit somebody else must make a loss. That one man’s loss is another man’s gain. That the world is a zero sum world so if somebody is profiting somebody else must be worse off. After all, where did the money come from? Instead of that view, the view I’ll present to you is that profit is [00:02:30] an indication of benefit to others. A healthy economy is a positive-​sum game in which there is mutual exchange to mutual benefit.

Let’s look at the first negative take on profit. In the Marxist view, this is a simplification but not a distorting simplification. Profit in the Marxian view is the difference between the value of [00:03:00] the labor that workers put into a product and the wages they get paid. According to the labor theory of value, which Marx held as did Adam Smith, the source of value is labor. So what profit is is the consequence of the laborer’s not being properly compensated for their labor.

Take a simple example. Let’s imagine a tractor [00:03:30] factory. Suppose I’m the proprietor, the capitalist owner of the tractor factory. In a year I sell a million dollars worth of tractors and you guys are my laborers who built the tractors. Where did that million dollars come from? It came from the sweat of your brows because you’re the ones who built the tractors. I just sat in my air conditioned office. If I pay you only 900 thousand dollars total in wages, I make a 100 thousand dollar profit because [00:04:00] you created a million dollars worth of labor that I only paid you 900 thousand dollars for. I ripped you off.

The capitalist is a parasite on the work of the laborers. It’s a mistaken view based in the old labor, discredited labor theory of value. Instead we’re going to look at profit as an indication of new value created for other people. [00:04:30] But let’s take a moment more on that tractor factory example. In real life, I the capitalist, have to pay you that 900 thousand dollars to get you to work at all, right? Do I know there’ll be a profit at the end of the year? Do I know how much I’ll sell my tractors for or how many I’ll sell? No, I don’t know. Really the profit is not so much a consequence of the labor, [00:05:00] profit is what’s the new value created after the labor has been compensated.

With that let’s look at this idea of what profit and loss are. The first thing I would say to you is always keep those two together. Don’t think, I recommend to anyone listening to this, from now on for the rest of your life, don’t think the market economy is a profit system. [00:05:30] Think of it as a profit or loss system because profits are never guaranteed. Profits and losses are two sides of the same coin. Profit can best be defined as yield minus cost. This is from Ludwig Mises’ article, Profit and Loss. Yield minus cost. What you get out of a project versus what you had to put into it. If it’s positive it’s profit. If it’s negative it’s loss.

[00:06:00] A more useful definition for economic and commercial purpose is yield, which is general and includes all sorts of psychic benefits also. Let’s leave those to the side and define profit or loss as total revenue minus total cost. That’s familiar.

Total revenue minus total cost. Ones profit is the difference between the total revenue that they take in versus the cost of all the resources that they put in [00:06:30] in order to create the product. You’re with me so far, right?

Now let’s think about where revenue comes from. Who pays a business its revenue? Where does a businesses revenue come from?

Student: Its customers?

Howard Baetjer: Its customers. Of course. Why do the customers pay that revenue into the business?

Student: Because they value what the business is selling them.

Howard Baetjer: Because they value the product. So where does total revenue come from? What’s [00:07:00] the source of the total revenue? It’s the value to the customers. Total revenue is an indication of value to the customers. What about cost? What do we mean by cost? The total cost of an endeavor.

Student: It’s also a measure of subjective value of what the goods, what the inputs could be used for otherwise.

Howard Baetjer: Good for you. It’s the input. It’s always best to think of cost as opportunity [00:07:30] cost, as we talked about. Opportunity cost is the next best alternative. In a commercial setting the cost is the value of the input resources in their next best alternative use. You’re with me?

Student: Yeah.

Howard Baetjer: Now, let’s think about what that implies about profit or loss. If profit is the difference between the value created for customers and the inputs, and the value of the inputs in their next best [00:08:00] alternative uses, then profit is an indication of new value created for other people. In order to make a profit you take resources worth a certain amount, let’s in round numbers you take a hundred thousand dollars worth of resources, and turn them into products that are worth 120 thousand dollars to other people. Making a profit on this view is a profoundly creative act. It’s an indication [00:08:30] of new value created for other people. You take a bundle of input resources that were worth less in their next best alternative, and turned them into a bundle of products that are worth more. It’s a great thing.

On that view, how much profit is too much by the way?

Student: There’s no amount that’s too much.

Howard Baetjer: No such thing. No amount of profit is too much. The more profit the better. As long as that profit is made in voluntary [00:09:00] exchange, in an open competitive economy. That profit indicates new value being created for other people. That’s the first of three subtopics. Main subtopics. The second is this, the social role of profit and loss. What do profit and loss do for us? You gave the answer a moment ago. You gave a part of it. They’re a signal to entrepreneurs about whether or not they are creating value for [00:09:30] other people. Whether or not they’re using resources in a way that satisfy others wants and needs.

They help entrepreneurs discover how to make the world a better place. It shows business people which products, which projects to pursue and which to abandon. It helps them discover which processes to use and which to avoid. Because one is more efficient than the other. Again all this is true as long as the prices in which they’re calculating [00:10:00] are free market prices that reflect the real value of resources.

If prices are market prices telling the truth about the availability and urgency of need for various goods and services, then profit and loss will guide us in how to use those goods and services. I want to break this down into two kinds of discovery.

The first is the more textbook one. We’ll take more quickly. That is the discovery of how to use [00:10:30] known resources for known ends. To me what’s much more fun and exciting about the discovery process of a market economy is the discovery of resources that we didn’t even know were resources. The discovery of new ends. New products. Completely new processes. This innovation is one of the main ways in which mankind advances in its standard of living and that process [00:11:00] needs profit and loss to guide it also.

This process of innovation creating new goods and processes was given a very colorful name by the great economist, Joseph Schumpeter. Does any of you know?

Student: Creative destruction.

Howard Baetjer: Creative destruction. The process of creative destruction, whereby the discovery or the development of a new product or a new process, that the [00:11:30] creation of that new product or process destroys old ways of satisfying similar kinds of human wants. Profit and loss guide this as we’ll see. But let’s think a little bit more about the process of creative destruction.

Take the way we light our buildings. 200 years ago what technology did we use?

Student: Whale oil lanterns.

Howard Baetjer: Whale oil lamps and candles. Very expensive [00:12:00] but they did the job. What creatively destroyed that technology?

Student: Electricity.

Howard Baetjer: Not electricity yet. I want one more between them.

Student: Kerosene.

Howard Baetjer: Kerosene. People discovered that this petroleum gunk that you know used to be a nuisance coming out of our streams, could be refined into kerosene. It made a better, cheaper, cleaner burning fuel than whale oil. So the development of the petroleum industry with [00:12:30] kerosene leading the way, creatively, the creation of that destroyed much of the fixed capital of the whaling industry. I’m told that some areas of the New England coast went into recession for two generations while they made the transition from whaling to whatever else they moved to. That’s a kind of creative destruction.

What technology creatively destroyed the use of kerosene in lamps?

Student: Electricity.

Howard Baetjer: Electricity. In particular, electricity driving [00:13:00] what sorts of devices?

Student: Incandescent light bulbs.

Howard Baetjer: Incandescent light bulbs and fluorescent tubes. Now I’m delighted to be able to say that when I first started to give this lecture I had no idea what would creatively destroy incandescent bulbs and fluorescent tubes, but I was confident that eventually something would. I have to confess that even though I teach this stuff I’m astonished at how rapidly it seems to be happening. Because there’s a new technology arising now which seems [00:13:30] fair to creatively destroy incandescent bulb with fluorescent tubes, what am I thinking of?

Student: LEDs.

Howard Baetjer: LEDs. When I go to the hardware store now to replace my incandescent bulbs it isn’t going to be with new incandescent bulbs and it certainly isn’t’ going to be with compact fluorescent lamps, it’s going to be with LED bulbs that are no available. Something like 12 thousand times the life. They’re much more expensive. They’re expensive [00:14:00] at the point of purchases but they’re less expensive to operate over time. That’s creative destruction. And profit and loss guide this because it’s not clear exactly which technologies are going to be the best. So we need profit and loss to guide it.

That gets me into the third part of this lecture which is why we have nothing better than profit and loss to put in its place for providing this guidance. The reason for that, the reason why is, in a word, human [00:14:30] ignorance. People don’t really know for sure what the best technologies will be. Let me give you some neat quotations that illustrate this.

Here’s Popular Mechanics magazine, they’re very knowledgeable about technologies. In 1949 forecasting the relentless march of science, “Computers in the future may weigh no more than 1.5 tons.” And they’re certainly talking about computers with [00:15:00] less processing power than our iPhones. Thomas Watson, Chairman of IBM in 1943. “I think there is a world market for maybe five computers.” This one is a Western Union internal memo in 1876. What did Western Union do. What was their business?

Student: They wired [crosstalk 00:15:21]-

Student: Telegraph.

Student: Oh, telegraph.

Howard Baetjer: Telegraph. They were the big telecommunications company. This internal memo said, “This ‘telephone’,” in scare quotes, “has too many short [00:15:30] comings to be seriously considered as a means of communication. The device is inherently of no value to us.” The biggest telecom company in the country didn’t invest in the telephone until they had lost their lead, others were ahead of them. This is a great one from HM Warner of Warner Brothers in 1927, “Who the hell wants to hear actors talk?” He didn’t anticipate the value of the script. Now in fairness to him [00:16:00] he was saying it’s the music that’s really going to be the payoff because he was paying orchestras in every theater around the country to play the music to go with the films. And the soundtrack would get rid of the orchestras. There are a number of these terrific ones. I’ll just give you a couple more.

This is 1962, Decca recording company rejecting a band with the comment, “We don’t like their sound and guitar music is on the way out.” Who were they turning down in 1962?

Student: Beatles?

Howard Baetjer: The Beatles. [00:16:30] Finally, Michael Dell of Dell computer. Before a crowd of several thousand IT executives in 1997 when he was asked what could be done to fix Apple computer, which was having on hard times, maker of Macintosh. He said, “What would I do? I’d shut it down and give the money back to the shareholders.” Apple’s never going anywhere. It’s now the largest capitalized company in the … [00:17:00] Is it still the number one market company? I think it is.

Student: I think so.

Howard Baetjer: Now the point of all this is that even people in the best position to know what to invest in, what products to produce, what processes to use, don’t’ really know. It has to be discovered. People are ignorant. That ignorance combined with the limitation on our investment capital, there aren’t enough free resources to build parallel telecommunication system. We have to find some way to decide [00:17:30] which ones we do invest in. The market process I suggest is that kind of an evolutionary system.

It’s like evolution in biology. All evolution is variation and selection. There needs to be some sort of new trials, some variation which in biology is mutation sexual recombination which creates new [00:18:00] critters. Then the means of selection is natural selection. Reproductive success. Survival of the fittest. We need a similar process in the commercial economy. What’s the source of variation in a market economy? What goes in those two boxes? What’s the source of variation? We’ve been talking about it.

Student: Different people who have different minds and different ideas for different products.

Howard Baetjer: Sure, what do we call those who do that innovation.

Student: Entrepreneurs.

Howard Baetjer: Entrepreneurs. [00:18:30] Entrepreneurial innovation. What’s the means of selection among these different entrepreneurial innovations?

Student: Profit and loss.

Howard Baetjer: Profit and loss. The entrepreneurs say, “Satellite phone system! 66 low earth orbit satellites, that’ll be the thing.” Others say, “Let’s go for cell phones.” Who ultimately decides?

Student: Ultimately it’s the customers.

Student: We do.

Student: We all do.

Howard Baetjer: The customers do. In the words of Ludwig von [00:19:00] Mises, “Profit and loss are the instruments by means of which the consumers pass the direction of production activities into the hands of those best fit to serve them.”

Profit and loss are the consumers’ means of guiding the productive profit-​seeking efforts of business people.

Now for that reason, we’re almost finished just a couple more points, we need to look at profit and loss as [00:19:30] their main purpose being not to reward people but to guide people. Yes, it’s true that profit and loss reward Steve Jobs and Bill Gates and Warren Buffett for their entrepreneurial acumen, but that’s not so much the main purpose. The main purpose isn’t really to reward them.

People who are upset at the high profits made by people who are, in some case brilliant but in other cases lucky, think of movie stars and certain pop [00:20:00] stars. They make these great profits, they haven’t really deserved them. So people are uncomfortable with big profits. That’s understandable but when they say these profits should be minimized or taxed away or prevented, they’re missing the key point which is that we need the profits, that system, to tell people what to do. It’s in the hope of making a profit for themselves that entrepreneurs work so hard to see, “What [00:20:30] will serve my fellow man?” So profit and loss are best understood, their function in society, is best understood as guiding future actions.

The reward for past actions is a necessary side point to that.

Now the final point before I wrap up. I’ve been singing the praises of profit. Saying that the more profit the better and the people [00:21:00] who make profits have created value for others. That’s true as long as the profits are made in free market exchange because profits can also be made in a very ugly way. By using political power and coercion.

For example, are there some companies who have made nice profits because they have tariff protection? There sure are. Tariff protection just makes it illegal for their customers to buy from their potential competitors. [00:21:30] Are there companies who have made big profits by getting bailed out with millions of taxpayer dollars? There certainly are. Are there companies that have made profits with massive subsidies for green energy, for example? There certainly are. Those kinds of profits, made not by voluntary exchange with consumers but by using the power of government to get a special advantage, I do not think are good profits. That’s what Frederic Bastiat [00:22:00] colorfully calls plunder. That points clear. Good profit made in open market exchange. Bad profits are made with the help of Uncle Sam or local governments who give you a special advantage over your customers or your competitors.

Then to sum up. The market process leads to improvements in the human condition by guiding discoveries of how best to satisfy [00:22:30] others wants. Profit and loss is the crucial selection system in that profit. The more profit the better. The policy implications, don’t punish profitable companies and don’t bail out companies that have made losses. Let the consumer speak via profit and loss.