8. The Entrepreneur and The Profit and Loss System

8. THE ENTREPRENEUR AND THE PROFIT AND LOSS SYSTEM

SUGGESTED ACTIVITIES

1. To call attention to the inevitability of change in the world, have each student recall major changes affecting his or her personal life and family since the start of their respective careers in school. In other words, ask each to list significant changes since they were five or six years old. Remind them that the world holds over two billion persons, each of whom is also always facing and trying to cope with changes from time to time. Here are the types of events they will probably mention:

a. Changes affecting members of their family— births, marriages, deaths, etc.

b. Residential moves

c. Parental changes in occupation

d. Shifts in personal ideas, values, activities, interests, friends, jobs, purchases, etc., due to growing up, growing bigger and making different personal contacts

e. Substantial acquisitions, losses, accidents, thefts, etc. of automobiles, furniture, appliances or other belongings

f. Neighborhood changes—homes, stores, offices, other buildings or highways newly constructed or demolished

g. Changes affecting the student and his family due to news events, world affairs, acts of nature (fire, flood, earthquake, etc.)

2. Have the students read at least the first few pages of Percy L. Greaves, Jr.’s “Why Speculators?” (Reading No. 34). Then discuss the three categories of purposive human actions—(a) gambling, (b) scientific and (c) speculative. Every conscious action a person takes is of one of these three types. Have each student name at least one action he has taken of each type:

a. As a gambler—when he could know nothing in advance of the results of the action except that he had some chance to win or lose. It is gambling to play the lottery, bet on the spin of a roulette wheel or on the toss of a coin.

b. As a scientist—when he could know in advance the results to expect from his action. A person acts as a scientist when he performs a mechanical act according to established procedures. He acts scientifically when he turns the key to start his automobile engine, steps on the gas, releases the brake, sets it in motion and steers it in a specific direction. He acts scientifically when he bakes a cake according to a proven recipe or moves a pencil across paper to make a line. In each case he knows in advance what the consequences of his action will be.

c. As a speculator—when he could have only partial knowledge and understanding on which to base his decision and action. A person acts as a speculator when he makes the decision whether or not, and also when, where, how and why, he will act—be it to drive a car, bake a cake, or draw lines on paper. A person is acting as a speculator also when he relies on another person to respond in a certain way under certain conditions.

3. As we have seen, changes are continually taking place in the lives of every one of us. Each of us is always on the lookout for new ideas which may be helpful in adjusting to these changes. Every one of us acts on such new ideas every day in the attempt to cope with changes affecting our own personal lives. Inventors try to develop their new ideas into tools or new techniques. Producers look for new ideas enabling them to offer consumers better, cheaper, or better-and-cheaper, goods and services. Public relations men and advertising agencies try to take advantage of new ideas in announcing innovations to the world. New inventions, new commodities and new services are often described in newspapers and magazines. Radio and TV ads frequently offer new goods or services, new combinations of goods and related services or special new prices for goods and services already on the market. New products, new production techniques and new distribution methods are often discussed in corporation annual reports. Barron’s, Business Week, Fortune and The Wall Street Journal also print frequent articles on industrial innovations. Once the students are alerted to look for such items they will see them often in newspapers, magazines and TV ads. If some students started files on new businesses, products or inventions—as suggested in Unit 1—they may already have a collection of such clippings.

4. It was suggested in Unit 1 that the students might interview the owners or officials of some local business. Perhaps they encountered some who were articulate and who would be willing to discuss their business ventures with the class. If so, here are several questions to ask which will help to make the discussion pertinent:

a. What factors had to be taken into consideration before deciding to go into business locally? Why was their particular type of enterprise selected? What investigations were made, if any, as to the potential market for goods or services to be produced, the availability of raw materials and suitable workers, and/or means of transport for bringing in needed supplies and shipping out the finished products?

b. Where did they locate the materials, tools, machines and equipment needed for the business? How were potential costs estimated? Were large sums of capital required to get started and to tide them over the early months and years of operations until a clientele could be developed? Did they use their own savings? Or did they borrow— from friends, other savers or banks? Were their early estimates of costs accurate? If not, why not? Did outside factors upset their calculations?

c. Were governmental rules or regulations (federal, state or local) significant factors in the decision as to what, where and when to go into business? Were any permits or licenses needed? How did government regulations affect their operations and income? Must they still cope with governmental red tape, inspections and other federal, state and/or local restrictions? Have new and higher taxes been levied since they started in business? What effect has inflation had on the firm’s operations?

d. Is their money income greater, about the same, or less, than they could earn as employees elsewhere, or by investing their savings in a bank, corporation stocks or bonds? Does the enterprise yield its owner/entrepreneur or manager a “psychic profit” in addition to any money income earned because he or she is “boss” and more or less runs the show, so to speak—subject of course to the sovereignty of consumers?

5. Students who have read books about individual entrepreneurs or business firms might turn in their reviews at this time and/or report to the entire class. If they read or discuss their reviews in class, everyone would learn something about several different enterprises. Each student reviewer should be asked to explain (a) why his or her particular entrepreneur was not satisfied, (b) what ideas they had for improving their respective situations, (c) why they thought their ideas would help, (d) how they succeeded, if they did, in accomplishing their goals. Ask each student to mention especially whether or not his or her entrepreneur had to accumulate savings or borrow before embarking on any particular projects. Did the entrepreneurs encounter obstacles? Were they finally successful in overcoming them, avoiding losses and eventually making profits?

6. Did any students in the class take part in the Junior Achievement program? If so, they might tell of their experiences. How did they get the idea for their enterprise, obtain raw materials, tools and workers, cope with problems that arose in the course of production, find customers and succeed in competing for sales on the market? Did they wind up with profit or loss? What mistakes, if any, do they believe they made? What would they do differently another time?

7. If the students have received their annual reports from the companies to which they wrote (as suggested in Unit 7), ask them to look in their respective reports for answers to the following questions:

a. What products does their company produce?

b. To whom does it try to sell—individuals or firms?

c. What raw materials and factors of production does it use?

d. Can they discover from the report where—in this country or abroad—the suppliers of these raw materials and factors of production are located?

e. What can they learn from the company’s report about where its money came from and how it was used to carry out its operations, during the previous year?

The teacher will find help in interpreting a typical annual report in the text which follows.

8. This Unit discusses not only “entrepreneurial (business) profit,” the excess of an enterprise’s money income over outgo, but also “psychic profit,” the subjective or psychological gain from an action. Psychic profit depends on the personal (subjective) values of the individual actor. Psychic profit is the extra value of something over and above the value to the person involved of what he gave in trade. One student might enjoy a rock concert so much that it seemed worth more than the value to him or her of the money he or she paid for the ticket—the extra value was a source of psychic profit. Another student may have won an award for athletic prowess—the pleasure, sense of pride and recognition it brought were sources of psychic profit, having nothing to do with money. Still other students, who spent summer vacations on the road or in Europe, may have exciting memories, memories more valuable to them than the value to them of the money spent. These memories are sources of psychic profit. Psychic profit is not for sale, and it cannot be tabulated or measured. To demonstrate psychic profit to the student, ask each to write a short paper, or tell the class about, some personal experience that furnished pleasure or enjoyment over and above the student’s subjective (personal) valuation of the money spent on the activity, event or purchase.

9. The automobile industry in the United States furnishes an excellent example of the role of “consumer sovereignty” in directing entrepreneurial activities and determining profits (or losses). Students interested in cars might study the history of the industry, looking for evidence of the “economic power” of consumers. Special attention should be called to the fact that purchases and refusals to purchase on the part of consumers—each deciding in the light of conditions and available alternatives—were responsible, for instance, for the following:

a. the failure in the early decades of this century of dozens of small automobile manufacturers, each of which was producing its own make of car

b. the gradual concentration of automobile production in the hands of a few large firms who were able to take advantage of mass-production assembly line techniques to reduce unit costs and so earn higher profits per sale

c. huge “box office receipts” and therefore profits for Henry Ford when he developed and sold thousands of his inexpensive but sturdy Model T’s

d. higher wages on factory jobs to induce many workers to leave the farms and permit automobile manufacturers to increase output to keep up with consumer demand

e. losses for the Ford Company in the 1920’s when it resisted new consumer demands for more luxurious cars than its Model T and again in the 1950’s when it misjudged consumer demand for large cars and introduced the Edsel

f. pressure on U. S. manufacturers in the 1960’s to introduce small economy cars in the attempt to maintain sales in competition with small foreign-make autos

g. shutting down in 1974-1975 of many automobile plants when the prospects for selling their future output at prices which would cover production costs seemed slim.

EXPLANATORY TEXT

So far the class has covered several basic economic concepts—purposive human action and personal (subjective) values (Unit 3), private property, specialization and exchange (Unit 4), the way all individuals are interconnected through the market (Unit 5) and how each of us helps to determine prices (Unit 6). The class has also learned how some people, if not prevented from owning and accumulating private property, will start saving for “rainy days” which then enables inventors and producers to develop tools and machines to use in increasing production (Unit 7). This Unit deals with the reasons certain processes are preferred to others, who makes production decisions, what influences their choices, why production takes place as it does and why some things are produced and not others.

1. What are the different categories of actions? When an individual acts in the attempt to accomplish his most urgent goal of the moment, he or she may know a great deal, very little or practically nothing about the results his action will have. Thus, purposive human actions may be classified according to the information available to the individual actor. From this point of view, three different types of action may be recognized:

a. Scientific actions are based on known facts, proven knowledge, experience or experiments. Persons act as scientists when they know in advance the results an action will produce. If they lack sufficient knowledge, or make mistakes, the results of their actions will not be those expected. But the fault would then rest on human ignorance or error, not on the scientific method. The more people can learn about the universe, the laws of the physical sciences, cause and effect, the more successful they may be in acting as scientists. It is a scientific action to carry out a mechanical action according to proven techniques. For instance, a person acts as a scientist when he follows the correct method to start an automobile and puts the car in motion in a certain direction. A person who bakes a cake according to a proven recipe is acting scientifically. A man who manufactures a product—combining raw materials and labor in such a way as to obtain known results—is also acting as a scientist. A scientific action is an action, the consequences of which—barring accidents, ignorance and human error—may be known in advance

b. Gambling is an action about which nothing can be known in advance as to the results expected except that the person who gambles has certain chances of winning or losing. No amount of study, experiment or reasoning will improve the odds of a pure gamble. The results of gambling depend on chance alone. A person acts as a gambler if he bets on a lottery, the toss of a coin or the spin of a roulette wheel. It should be noted that most persons who buy stock on the market or bet on horse races are not merely gamblers but speculators, at least insofar as they do not select shares of stock or race horse blindly, but try first to learn something about the potentials of the corporation or horse and jockey, as the case may be

c. Speculations are based on partial knowledge and understanding as to what the results will be. All entrepreneurial decision-making actions are speculations. As a matter of fact, most purposive human actions are speculative, at least in part. On the one hand, few apparently scientific actions can be carried on, in this changing world, under such precisely controlled conditions that their exact results may be scientifically predicted. On the other hand, few persons are anxious to engage very often in really pure gambling; if a person wants to be at all successful in accomplishing any specific goal, he cannot permit his plans to depend on chance alone. Thus, everyone tries to find out as much as possible about the results an action is likely to have under the circumstances. Inevitably many factors will remain unknown, some even unknowable, making the outcome of an action somewhat uncertain. Thus most purposive choices, decisions and actions are speculative in character. Driving a car, baking a cake or manufacturing may be scientific in themselves but deciding whether or not to drive, bake or manufacture is in each case a speculation. Once that first decision is made, still further speculations are called for as to when, where and how to drive the car, bake a cake or manufacture a product. A farmer speculates on the weather and the potential market for his crop when it ripens, etc. A young man speculates if he invites his girl friend for a ride; he cannot predict the outcome on the basis of his technical skill in driving nor on his understanding of her interests and character. The young lady also speculates if she accepts his invitation—on the basis of her knowledge of his driving skill, her understanding of his views, motives, etc. Many unknowable factors may alter the results of their speculations—the behavior of other motorists, possible mechanical failures, weather, his reaction to her, her responses to him, etc.

Speculators try to use all the scientific knowledge available to them in a situation, as a tool to facilitate their speculations. But no amount of science can ever reveal the future. Thus, as pointed out above, almost every action involves some uncertainty. We must frequently make decisions on the basis of partial knowledge. In this sense, every one of us is a speculator when we act and make decisions. Hence, economics may be said simply to be the study of speculations and their consequences.

2. How does change affect the purposive actions of individuals? The goal of acting men, as we have seen, is to solve as best they can the “economic problem” (Unit 4). They seek to satisfy as many of their wants as possible within the limits of their abilities, energies, time and other available resources. The fact that it is possible to bring about changes enables people to make plans and to act (Unit 2). However, changes often complicate a situation, upset plans already made and may even turn an action intended to help into a catastrophe. Thus, in everything we do we must always try to take into consideration changes which may occur in the future, as well as changes which occurred in the past.

Conditions in the physical world are never static. Changes are always taking place—from night to day, summer to winter, calm to storm, heat to cold, drought to flood, and so on. In addition to changes brought about by such natural causes, countless other changes are taking place at every moment throughout the world as a result of the conscious and purposive actions of men. People alter the face of the earth by cutting down some trees for firewood, paper pulp and lumber, and planting other trees for purposes of landscaping and to harvest as a resource for production in the future. They blast rocks, drill holes and level mountains to extract building blocks, gravel, petroleum, coal, iron, etc. They build highways, dams, canals, automobiles, private homes, stores, apartments, skyscrapers, and so on. They are continually planting, harvesting, tearing down, building up, transforming and moving physical things around.

People are also always changing their ideas, concepts, philosophies and values. Their knowledge and understanding vary. As a result, their purposes and goals are forever shifting too. In trying to satisfy their various personal (subjective) values, therefore, every one of us must always deal with changeable and ever-changing factors.

Actions taken in the attempt to cope with physical changes and shifting ideas are necessarily always based on partial knowledge only. Thus they are speculations and the acting individuals are speculators. Speculators, as distinguished from gamblers, have some knowledge on which to base their actions. They use whatever pertinent scientific and historical information is available. They try to learn what they can by observing, studying and analyzing past experiences. They use reason, logic and psychology to try to interpret and understand the present situation and to anticipate as best they can the changes likely to occur in the future. But the future remains unknown and unknowable. Thus, a speculative action, by definition can never be a “scientific action.” Every one of us is a speculator in the sense that we make decisions, take actions and run certain risks in the hope of coping with changes while trying to accomplish specific ends and anticipate the likely results of our speculations.

In the field of economics, speculators are often called “entrepreneurs.” Entrepreneurs in this sense are the persons responsible for production decisions. They undertake speculative projects at some risk to themselves in the attempt to serve consumers through the market. Their special role is to try to cope with past changes affecting the market and bring about other changes, so as to counteract the undesirable effects of past changes and avoid possible harm from future changes. Thus, entrepreneurs are continually juggling, adjusting, adapting and rearranging factors of production, goods and services, in the hope of improving conditions. When they succeed they contribute to solving the “economic problem” by helping to reduce the gap between what we have and what we want.

3. Just what do entrepreneurs do? The word “entrepreneur” is French. Translated literally it means “under-taker,” i.e., someone who undertakes a project. Thus entrepreneurs are idea men and decision makers. We are all entrepreneurs in the sense that we all have ideas, make decisions and undertake projects whenever we act. However, when most people think of entrepreneurs they have in mind persons acting in a more limited capacity—in business and on the market. The chief role of such producer-entrepreneurs is to speculate on the basis of knowledge and resources available to them in the attempt to cope with ever-changing market conditions so as to supply consumers with the various things they want.

Every action starts with an idea. Also, as we have seen, every action involves change. Both as (a) idea men and (b) decision makers, entrepreneurs are deeply concerned with change. Not only do previous changes make actions appear desirable but also the purpose of every action is to effect further change. To entrepreneurs as idea men, past changes are data, data which they “feed” into their “mental computers,” their minds, in the search for new ideas which may result in improvements. As decision makers, entrepreneurs speculate. They make plans, take steps to carry out their ideas and bring about new changes which they hope will make things better.

Entrepreneurs often make long-term plans to be carried out, step by step, over extensive periods of time. They must always try to be realistic and to consider things the way they are. They consider the world as a tremendous “smorgasbord” of various raw materials, semi-finished factors of production and products, completed consumers’ goods, data, technological knowledge and various types of available workers. The countless physical things in existence at any instant are inert and lifeless without any meaning unless and until individual acting human beings with ideas, values and goals discover ways to use them.

The economist, Israel Kirzner, has described this complex of goods and services as it exists in the world at any instant as a “half-baked cake.” Some things exist as original raw materials, untouched by human hands. Some have been moved or partially transformed from their natural state. Some have become “semi-produced” factors of production or products. Some are now “idle resources,” having been fabricated for a special purpose and then discarded as mistaken or worthless, or at least not expected to be valuable enough to future consumers to warrant completion. Some things which were formerly valued have been physically damaged (by fire or flood, for instance) or rendered less valuable on the market than formerly due to shifts in ideas, consumer demands, technology and production. Still others are considered completed products and are up for sale on the market. The role of the entrepreneur in the economy is to consider this “half-baked cake” or “smorgasbord” of miscellany and to use it as best he can to serve consumers.

Entrepreneurs speculate. They seek to reassemble and rearrange what they consider usable in the “smorgasbord” or “half-baked cake” of existing goods and services, to adjust and adapt things to suit future conditions better than they otherwise would. They try to salvage what they can from existing materials and factors of production, shift them to more urgent uses, insofar as they may be “convertible” or “semi-convertible,” so as to create new and different goods and services in the hope of developing things of greater value to consumers on the market. Thus, entrepreneurs are always looking for clues as to what products consumers will be wanting in the future.

Entrepreneurs watch for changes that may be occurring, or expected to occur as a result of natural as well as market phenomena. All such changes affect available supplies, the ideas people hold, their values, knowledge, wants, ends and, thus, prices and production also. Entrepreneurs then speculate, in the light of these changes and their anticipations of the future. They look for opportunities to buy, transport, transform, process and offer on the market goods and services that will please consumers better than other products. They speculate by trying to discover supplies of raw materials, factors of production and labor that may be relatively cheap to purchase in their present state, but which may be transformed into new products and transported to new locations so that they will be more highly valued.

4. How are entrepreneurs rewarded (penalized) for their success (failure) in adjusting to change?

But it is only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavor to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods. ... He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By . . . directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

The Wealth of Nations (Random House, Modern Library Giant Edition, 1937), p. 423

In the broadest sense of the word, profit is simply the gain derived from an action, a speculation. Thus, every one of us always aims at profits. Profit—or its opposite, loss—is a psychic, or mental, phenomenon. The person who acts decides on the basis of his or her own personal (subjective) values and goals whether an action was a success or failure, as compared with available alternatives. Psychic profit may stem from reducing some dissatisfaction or “felt uneasiness,” or from accomplishing a positive goal. Psychic profit is the extra bonus value of something one receives in trade over and above the value to the trader of what was given in exchange.

Producer-entrepreneurs, like everyone else, speculate in the hope of gaining psychic profits and avoiding psychic losses. However, to stay in business over an extended period of time, entrepreneurs must also take in money from their customers—at least enough to cover all expenses. To determine monetary or entrepreneurial (business) profit or loss, entrepreneurs calculate the total money cost of producing and/or reproducing an item and subtract them from the enterprise’s total money income. To earn an entrepreneurial profit, money income must exceed money outgo. Any excess of money income over outgo is monetary or entrepreneurial (business) profit.

The more popular a product is with consumers, the greater will be its producer’s “gate” or “box office receipts,” and the better will be his or her chances for entrepreneurial profit. The drive for entrepreneurial profit, therefore, pressures producers into trying to please consumers. Thus, entrepreneurs are always eager for any clues they may glean by observing the behavior of consumers.

In a free market, consumers are sovereign. As producer-marionettes, entrepreneurs dance on strings, so to speak, at the direction of consumer-puppeteers whose purchases and refusals to purchase indicate likely ways to earn entrepreneurial (business) profits. But consumers can be mighty fickle. Their ideas, like everything else in the world, are always changing. As situations change, so do their ideas, values, needs and buying habits. They will purchase a particular good or service only so long as they continue to consider it useful from their respective personal (subjective) points of view. As soon as they learn of something better, cheaper, or better-and-cheaper for their purposes— all things considered—they change their buying habits. They may reject further purchases of things they had been buying, switch to entirely different products, buy more of some things, less of others, make purchases more or less frequently and/or economize in line with the old New England maxim:

Use it up

Wear it out

Make it do

Go without.

Entrepreneurs are always trying to adjust through the market to changes that occur—good ones and bad ones alike. If they earn profits in the process of making adjustments, they are helping others. For instance, if property is destroyed— as it frequently is by fire, flood, earthquake, etc.— some entrepreneurs may try to fill the gap. Entrepreneurs who manufacture such items as bricks and steel beams, will be eager to increase shipments into the stricken area in the hope of profit. No one need order them to do so; their desire for profit guides them. But the result of their efforts is to better satisfy consumer needs and improve the situations of people in the devastated areas who want to repair buildings and highways. Whether they profit (or lose) from their enterprise will depend on their success (or failure) in pleasing consumers. Only if buyers are ready to pay higher prices than the entrepreneurs spent in producing and offering the bricks and steel beams on the market will the entrepreneurs earn profits.

Take another example. Suppose a chemist announces a new medicine expected to destroy a common virus. Surely consumers would buy it if it were available, they knew about it and were convinced it would be effective. Should an entrepreneur decide that many people would find the new medicine helpful and buy it if they could, he may try to speculate in its production. He must then explore ways to manufacture this new chemical compound at costs below the price he expects consumers will be ready to pay for it. He must search for relatively inexpensive sources of chemicals, plant equipment, machinery, containers and workers. To obtain the needed materials, he will have to offer high enough prices to induce their present owners to sell to him. To persuade the workers he needs to shift to his employment, he will have to offer them opportunities they prefer to their present occupations. Then he must master the manufacturing process and tell potential buyers about the new medicine and its healing powers. His chance for profit starts with persuading buyers to try it. If the new medicine helps these new customers they will benefit almost immediately, but the entrepreneur will profit only if he continues to satisfy many customers again and again, so as to cover his initial investment, production costs, and then some. If the costs of supplying this new product to the market are more than customers will pay for it or if the producer/entrepreneur fails to please enough customers, the speculation will result in entrepreneurial losses. Shifts in consumer purchases are “grist for the mill” of entrepreneurial decisions and the source of their profit or loss.

The opportunities to earn huge “gates” or “box office receipts” that come with fame and popularity have attracted thousands to compete in the fields of sports and entertainment. Some few have made the “Big Time.” Many more have failed. As soon as one star athlete or performer falls from public favor, newcomers are ready to take over the leading roles. The situation in production is similar. Many strive for the generous entrepreneurial profits with which consumers reward their favorites, but only a few ever reach the top. Those who succeed in business remain at the top only so long as they adapt successfully to the constantly shifting whims of consumers and retain their favor by satisfactorily supplying some of their various wants.

5. How do consumers exercise their sovereignty on the market? On a free market where individuals are in a position to seek their own personal (subjective) values and goals, they give profits to the producers of the products they want most and deny profits to others whose products they reject. The largest “gates” or “box office receipts” and thus the best chances for profit go to the producers whose products are most popular. If their sales decline, however, so will their “gate” or “box office receipts” and also their chances of profit. Thus each of us, as a consumer, influences production to some extent by expressing our own personal (subjective) values through our purchases and refusals to purchase products on the market:

. . . the market with its prices is the steering mechanism of the free enterprise system. . . . The only forces determining the continually fluctuating state of the market are the value judgments of the various individuals and their actions as directed by these value judgments. The ultimate factor in the market is the striving of each man to satisfy his needs and wants in the best possible way. Supremacy of the market is tantamount to the supremacy of the consumers. By their buying, and by their abstention from buying, the consumers determine not only the price structure, but no less what should be produced and in what quantity and quality and by whom. They determine each entrepreneur’s profit or loss, and thereby who should own the capital and run the plants. They make poor men rich and rich men poor. The profit system is essentially production for use, as profits can be earned only by success in supplying consumers in the best and cheapest way with the commodities they want to use.

Ludwig von Mises, Planning For Freedom (Libertarian Press, 1952/1962/1974), pp. 15 and 73

Profits come and go, reflecting consumer demand. No entrepreneur, no matter how successful he or she may have been in the past, can retain wealth on a free market unless the goods or services he or she produces stay in favor with consumers. No one can compel consumers to buy their products on a free market. Even big steel magnates, automobile manufacturers or “chocolate kings” dangle like marionettes while consumers pull the strings:

A “chocolate king” has no power over consumers, his patrons. He provides them with chocolate of the best possible quality and at the cheapest price. He does not rule the consumers, he serves them. The consumers are not tied to him. They are free to stop patronizing his shops. He loses his “kingdom” if the consumers prefer to spend their pennies elsewhere. Nor does he “rule” his workers. He hires their services by paying them precisely that amount which the consumers are ready to restore to him in buying the product.

Ludwig von Mises, Human Action (3rd ed., Regnery, 1966), p. 272

Entrepreneurial profits are not mark-ups added to costs for the benefit of producers. Profits are indications that entrepreneurs have produced something consumers valued more than the total cost of supplying it to the market. Consumers are always weighing the relative importance to them of the various personal (subjective) values, wants, goals and other opportunities. By their purchases and refusals to purchase, they signal entrepreneurs as to what they, as consumers, want more easily accessible. They help entrepreneurs decide how to speculate, what to produce and how to produce it. If the entrepreneurs succeed in producing things consumers value highly out of less valued resources and factors of production, the difference between their relatively low costs of production and the relatively high prices satisfied customers pay for their product will swell the size of their “gate” or “box office receipts” and provide them with entrepreneurial profits. How much profit an entrepreneur will earn and for how long will depend on the whims of consumers. The moment consumers change their minds, so do their buying patterns change. Thus entrepreneurs earn profits only so long and insofar as they anticipate consumer wants correctly and fumish them with things they want to have and to use.

NOTE: Incidentally, this understanding of the sovereignty of consumers reveals the error in the Communist slogan calling for “production for use and not for profit.” In a market economy, the two are precisely the same. When consumer purchases and refusals to purchase determine profits and also, as a result, the pattern of production, production for profit must be production for use also—and vice versa. The desire of entrepreneurs to avoid entrepreneurial losses and to earn profits by serving consumers assures (a) that “production for profit” will be useful to consumers and (b) that “production for use” will be profitable to entrepreneurs.

6. Is there a limit to the profit an entrepreneur can earn in a free market economy? There are two possible answers to this question. In one sense, there is no limit to the profit an entrepreneur may earn on a free market. But in another sense, there are very definite limits in the real world to the profit any entrepreneur CAN earn. The sky may be the limit as far as the profit he may receive from his “gate” or “box office receipts”—so long as he continues to have ideas, make decisions, act and offer on the market goods or services consumers want which he can produce for less than consumers are willing to pay. But the ability of any single entrepreneur to do this consistently over an extended period of time and to keep on steadily earning profits is very definitely limited by: (a) his fallibility as a human being, (b) potential competition from other entrepreneurs and (c) consumer sovereignty.

The possibility of unlimited, permanent and increasingly rising profits is unrealistic, for there is a continual tendency for profits to disappear in the real world. Once an entrepreneur finds a way to make a profit and expands production, his efforts to buy more materials and tools and to hire more workers tend to raise their value on the market and thus their prices and his costs of production. Moreover, if competition is open and free and there are no restrictions or barriers to prevent newcomers from entering the field, an entrepreneur’s very success is likely to make his situation more precarious by attracting competition. The newer entrepreneurs will try to offer something similar at a lower price, or something they hope potential customers will consider better at the same price, or something they hope consumers will recognize as both better and cheaper. Thus consumers soon benefit. But the greater numbers of entrepreneurs seeking to produce and offer similar goods or services (a) intensify competition for customers and (b) tend to increase production costs for all competing producers including the pioneering entrepreneur. It becomes more difficult for any of them to continue producing as cheaply and earning the same relatively high profits as before.

Consumers are quick to switch to different goods and services the moment they discover something they consider better, cheaper, or better-and-cheaper than what entrepreneurs had previously been offering them on the market. Their fickleness, their changeability and the frequency with which they alter their ideas, wants and values increase the uncertainty with which entrepreneurs must cope and further limit the chances of entrepreneurs for continuous profits. Thus, consumers play the decisive role in determining an entrepreneur’s “gate” or “box office receipts.” There may be no ceiling on the entrepreneurial profit a successful entrepreneur may earn in a free market economy, if he keeps on satisfying consumers and producing the goods and services they want for less than they are willing to pay. But in real life, under free and open competition, entrepreneurial profits are subject to strict limitations— limitations imposed by (a) the human fallibility of a specific entrepreneur, (b) the likelihood of new entrepreneurs coming into the field and (c) consumer sovereignty.

Every entrepreneur must always do his best to keep abreast of changes and new developments. No matter how thoroughly familiar he may be with the technology of his production process or how well he understands the vicissitudes of the market at the time, sooner or later unanticipated changes will occur restricting the chances of the less energetic and less far-sighted entrepreneur in the competition for customers. The moment an entrepreneur relaxes his efforts, makes a mistake, miscalculates and fails to satisfy consumers as well as before, his profits will start to decline. If he fails to earn enough to cover expenses, he may in time have to go out of business completely.

7. What information about a corporation’s entrepreneurial activities and its profits (or losses) may be found in a typical annual report? Most corporations with offices in this country are required by law to publish annual reports, disclosing certain financial data. Most corporations also include in their annual reports additional statistics and textual material to keep their stockholders, each of whom is a part owner in the company, advised of the firm’s products, output, sales, research, competition, plans, future prospects, and so on. Compare and contrast the information offered in the annual reports of several different firms—the various types of statistical data, the manner in which they are presented, as well as the textual material describing the corporation’s activities.

Each student should examine the annual report he receives for evidence of the entrepreneurial activities described in this Unit. Look for specific examples of (a) new ideas the firm is developing, (b) to adjust, adapt or rearrange the ingredients of the existing “half-baked cake,” (c) so as to cope with changes that occurred in the past, (d) bring about further changes (e) reduce their costs of production (f) increase their sales and the size of their “gate” or “box office receipts,” (g) improve market conditions, and thus, hopefully, (h) yield entrepreneurial profits. What goods and services does each corporation produce? Where does it get its raw materials? Does it do research to develop new ideas? What kinds of tools, machines, plants and equipment are needed for its production? Whence come the savings it invests? Does the annual report mention plans for converting some factors of production to different uses from those originally intended? Does it reveal anything about the corporation’s employees? What types of specialized workers does it hire? Does the corporation have to deal with unions? How have government rulings, regulations, controls, taxes and inflation affected the company’s operations? Does the annual report indicate that the corporation has been flexible in adjusting to changes and shifts in consumer demands? Did the corporation earn an entrepreneurial profit during the last year? If it suffered losses, are these explained as the result of unforeseen changes or uncertainties? Does the corporation have plans which it hopes will yield profits in the future?

Each student should also analyze the statistics in his annual report. One of the basic tables in a corporation’s annual report is the “balance sheet” showing the firm’s assets, normally appearing on the left hand side of the page, and its liabilities and net worth at the right, all as of a specific date. The entries on a balance sheet represent estimated market values in terms of money. The items printed in annual reports are usually simplified into several broad categories. The list of assets shows the firm’s total holdings in the form of cash, securities, accounts receivable, property of various kinds (land, equipment, buildings, etc.) and inventories of other items. On the right hand side are shown the firm’s liabilities—notes, debts, accounts payable, taxes due, and so on—as well as the firm’s net worth, i.e., the difference (plus or minus) between total assets and total liabilities. The corporation’s net worth is equal to the equity of all stockholders, i.e., the estimated money value of the shares they own.

Many firms supplement the simplified balance sheet published in their annual report with detailed notes about individual entries. Considerable information may be found here concerning the business of the corporation and the raw materials, tools, equipment, plants, land, etc., in its inventories. Various other financial reports are also frequently included. Perhaps the most helpful for understanding a firm’s activities is the “operating statement,” itemizing total money income (by source) and total money outgo (by purpose) during a definite period of time. Some firms also report earnings and holdings over several years to show changes that have taken place in their operations. Some firms include diagrams to help stockholders visualize the corporation’s financial situation. For instance, total assets, liabilities and net worth may be portrayed in pie-shaped diagrams, with each type of asset or liability represented as a segment, reflecting the relationship it bears to the total “pie.” Other charts might give total money income, or outgo, over a period of time, so that the proportion received from, or spent on, each operation may be seen at a glance.

The students should be encouraged to study their annual reports carefully. By examining the statistics, tables and charts, they will be able to learn quite a bit about the entrepreneurial role of their particular firm, its success (or failure) in coping with change, rearranging the goods and services available at various prices so as to improve conditions by providing consumers with things they consider better, cheaper, or better-and-cheaper than what they had before.

SUMMARY

The world is an economic smorgasbord, a hodgepodge of natural resources semi-produced and produced factors of production, some more, some less convertible than others. The countless physical things in existence at any given moment are inert and lifeless without any meaning or value unless and until individual acting human beings with ideas, values and goals recognize uses for them. It is acting, thinking, reasoning persons who give meaning and value to physical objects.

As consumers we determine the prices at which goods and services will be traded and help entrepreneurs to recognize where the chances are best for making sales, for expanding their “gate” or “box office receipts” and thus for earning profits.

The goal of every entrepreneur is to conceive of some way to provide consumers with something he can produce for less than they will be willing and able to pay for it. Once he believes he has such an idea, he makes plans and takes actions over a period of time. He searches for the raw materials and factors of production he will need among the goods and services currently available on the economic smorgasbord. He tries to acquire these ingredients at prices below the values he expects them to have later, after he has reassembled, transformed and/or transported them to make the new product he plans to offer consumers on the market. As a result of the fact that such entrepreneurial ideas, plans and actions are always taking place, the whole economy is in a state of continual flux.

The purpose of every entrepreneurial idea is always to try to make a profit by adjusting, adapting and producing changes in the existing complex of goods and services so as to bring about improvements and, thus, to serve consumers better. Sparked by the hope of profits over many years, entrepreneurs have developed ideas for using available materials and labor, made plans, speculated and taken actions to bring about countless big and little changes. Some produced what consumers wanted and, as a result, earned profits. For various reasons, others wasted factors of production and so incurred losses. Gradually in this way, step-by-step, the purposive actions and choices of unnumbered individuals transformed the world’s natural resources from the wilderness it was just a few centuries ago into the amazing smorgasbord of material goods and services that exist today. The ingredients of the economic “half-baked cake” at any instant are always the products of the world’s resources plus changes due to natural causes as well as those arising out of the purposive efforts of all entrepreneurs in the past and of individual choices.

GLOSSARY WORDS

(For definitions, see glossary, pp. 223ff.)

Assets

Balance sheet

Consumer sovereignty

Convertible factor of production

Entrepreneur

Entrepreneurial profit

Equity

Gambling

“Idle resources”

Inconvertible factor of production

Liabilities

Loss

Net worth

Operating statement

Profit

Psychic profit

Scientific action

Speculation

Footnotes

1 Adam Smith (1723-1790) was perhaps the first to develop economics, or political economy, as an intellectual discipline. For more on the significance of his work, see Unit 13.

1On coming to Paris for a visit, I said to myself: Here are a million human beings who would all die in a few days if supplies of all sorts did not flow into this great metropolis. It staggers the imagination to try to comprehend the vast multiplicity of objects that must pass through its gates tomorrow, if its inhabitants are to be preserved from the horrors of famine, insurrection, and pillage. And yet all are sleeping peacefully at this moment, without being disturbed for a single instant by the idea of so frightful a prospect. On the other hand, eighty departments have worked today, without co-operative planning or mutual arrangements, to keep Paris supplied. How does each succeeding day manage to bring to this gigantic market just what is necessary—neither too much nor too little? What, then, is the resourceful and secret power that governs the amazing regularity of such complicated movements, a regularity in which everyone has such implicit faith, although his prosperity and his very life depend upon it? That power is an absolute principle, the principle of free exchange. (1845)

Free Market Economics: A Syllabus