Profits, Losses, and Entrepreneurship

I'm just back from my intro class, where we're on the "Profit and Loss" chapter of Heyne, Boettke and Prychitko.  As is often the case, teaching something leads me to see nuances of it that I never have before.  One of the great joys of teaching is when you come across a new insight on the fly, as you're in front of a class.  I'm not a musician but it has to be something like when you spontaneously see a new way to play a solo in a jazz piece while you're playing it. 

The little insight today was about what the current politicization of the economy might do to the effectiveness of entrepreneurship.  Taking a Kirznerian view that prices, profits, and losses help "activate" the alertness of (potential) entrepreneurs, it's easy to make the point that when the economy gets more politicized, more people will seek "profits" or "wealth-enhancement" (why did Smilin' Bob just pop into my head?) through the political process.  This has plenty of problems of its own.

But there's another point here too:  to the extent that public policy taxes profits more heavily and subsidizes losses more fully, it undermines the ways in which profit and loss signals make it in entrepreneurs' interest to notice what it is in their interest to notice, to paraprhase Kirzner.  Put differently, in a world of "flattened" profits and losses, entrepreneurs will make more of both Type I and Type II errors.  They will not notice as many "true" profit opportunities (errors of omission) and they will "over-notice" the "false" opportunities (errors of comission).  Notice that this is not the same thing as seeking wealth through politics.  Rather this is describing what will happen in the marketplace.  We will see both more active "discoordination" of plans and more "lack of" coordination of plans as a result of the "flattening" of profits and losses. 

So from a Kirznerian perspective, penalizing profits and subsidizing losses weaknens the effectiveness of any given level of entrepreneurial alertness by reducing its signal reception capacity for potentially profitable activities and making it less resistant to potentially loss-inducing ones.

When we add this set of market inefficiencies to those created by the shift from markets to politics, we have an even bigger mess on our hands.

Comments

[Joe Strummer]

This is a good point, but it's a point that isn't just about the future politicization of the economy, but the past as well.

To take a recent example, when government plays in the credit markets, it creates a lot of Type II errors, chief among them in whatever asset market that is experiencing a bubble. So a ton of people now unemployed invested a lot of time, money, and energy exploiting various real estate ventures - from construction, to flipping, to remodeling etc. - most of which were just mal-investments. That was a Type II error, regarding rising prices in real estate caused by cheap credit (among other factors) as indicative of genuine demand.

This was largely the result of very cheap credit to reinflate the tech bubble after its collapse in 2000.

But I'm a little curious as to what would count as non-politicization. Some things are obvious political intrusions into the economy. Other things are not so obvious, but let me give one example.

Bankruptcy law generally permits, following a successfully completing of the process by the debtor, that creditors take a hit to any debts still owed down to the secured value of the collateral. This is called a cramdown. But BK law doesn't permit that for two of the most important assets owned by consumers: primary homes, and automobiles (purchased within 910 days of the BK filing).

The effect of this provision in the BK code is to make it cheaper to lend to homeowners, and lower the interest rates - ceteris paribus - on loans backed by mortgages.

But this provision in the BK code was simply a sop to the mortgage industry who lobbied hard for it in the 1970s, on the premise that it would encourage home ownership.

My question is: is this a simply a rule of the game and "non-political"? Or is it the politicization of the economy (through a preferential BK loophole) that creates Type II errors (overlending in the real estate market?

[Ivan Pongracic, Jr.]

"As is often the case, teaching something leads me to see nuances of it that I never have before. One of the great joys of teaching is when you come across a new insight on the fly, as you're in front of a class. I'm not a musician but it has to be something like when you spontaneously see a new way to play a solo in a jazz piece while you're playing it."

Amen to that, Pete! And an excellent insight. The entrepreneurial errors due to distortions of both incentives and information are a fundamental part of the Austrian business cycle story, and a very intuitive one - we really need to push that insight and explain it better to the public. I'm sure Pat Gunning will agree... ;)

[Ivan Pongracic, Jr.]

Damn, I meant: "Amen to that, STEVE!!" Sorry.

[Peter G. Klein]

Steve, this is something that has always puzzled me about Kirzner's framework. Profit opportunities are treated as exogenous, right? In other words, what Kirzner offers is an account of equilibration _conditional_ on a given set of profit opportunities. An economy with price controls, bailouts, etc. offers a different set of profit opportunities than an economy without them. (I mean pure entrepreneurial profit opportunities, a la Kirzner, not opportunities for rent-seeking or other forms of political entrepreneurship.) Even in a highly interventionist economy, there are opportunities for entrepreneurial profit, and Kirzner's theory says those opportunities will tend to be exploited, moving prices and quantities closer to their equilibrium values. Now, we have all kinds of theories to tell us why the zero-profit equilibrium under interventionism is inferior to the zero-profit equilibrium under laissez-faire. But those theories are not part of Kirzner's account of entrepreneurship per se, are they? In other words, on pure Kirznerian grounds, in what sense can we say that interventionism hampers entrepreneurial activity?

I ask because if we grant that Kirzerian coordination works better under free markets than interventionism, then we may also have to grant that Kirznerian coordination works better with thick rather than thin markets, with fewer externalities, with less asymmetric information, with better educated or more experienced entrepreneurs, with one initial distribution of wealth or another, and so on. But then we're incorporating into the Kirznerian story some account of the _preconditions_ to entrepreneruship, which Kirzner argues is outside the story. If entrepreneurship is sui generis, an uncaused cause, then how can we say it's stymied by intervention?

[Rafael Guthmann]

Klein,
Do you mean, like in the situation where a profit opportunity of 10 dollars is cut down to 5 dollars because taxes of profits, entrepreneurs would discover and exploit the profit opportunity in the same way, the market process would work with the same degree of robustness? Well, if the discovery is costless in itself but the act of transacting to exploit the profit is costly, them larger profit opportunities will make the market process work faster.

"coordination works better (...) with less asymmetric information"

But if information is symmetric (this "information" is defined in the austrian sense?) I though that we can have 2 possible cases: If everybody knows everything we have walrasian equilibrium, if everybody has the same imperfect knowledge, then entrepreneurial action will only occur when somebody discovers something that nobody knows, yet.

[Rafael Guthmann]

"If entrepreneurship is sui generis, an uncaused cause, then how can we say it's stymied by intervention?"

Maybe because, while entrepreneurial alertness is given. It is not fully harnessed with increasing intervention?

But, if taxes on profits result in a weakening of the market process what about a pure profit subsidy that makes the market process works "faster"? A subsidy (like, 20%) on pure profit (assuming that it is possible to isolate pure profit in accounting) would not make the competitive process more dynamic?

[Peter G. Klein]

Rafael, you're missing my point, which is not that "the market process would work with the same degree of robustness," but that there's nothing in Kirzner's theory of entrepreneurial discovery per se to tell us exactly how this would work. For instance, Kirzner offers no argument that a $10 profit opportunity is seized more quickly, or more accurately, than a $5 profit opportunity, any more than he says a person with a college degree seizes opportunities more accurately than a person without one (or vice versa).

Pete B. points me (privately) to "The Perils of Regulation" and "Taxes and Discovery," but I think the argument presented in those essays involves a non-sequitur. As Dan Klein has pointed out, the concept of coordination in Kirzner is only weakly connected to Kirzner's statements about the welfare properties of markets.

[Rafael Guthmann]

"For instance, Kirzner offers no argument that a $10 profit opportunity is seized more quickly, or more accurately, than a $5 profit opportunity"

I had interpreted that you thought that there is nothing in Kirzner's theory that implied that variation in the magnitude of profit opportunities would alter the market process. Now I see what you mean.

Do you think it is a field with needs more work on, with the potential for the discovery of important insights?

[Dave Prychitko]

"For instance, Kirzner offers no argument that a $10 profit opportunity is seized more quickly, or more accurately, than a $5 profit opportunity, any more than he says a person with a college degree seizes opportunities more accurately than a person without one (or vice versa)."

I agree with Peter here. For years I've thought this is a part of Kirner's pure theory that doesn't map well with what we "know to be true" about taxes and discovery in actual market processes.

[Current]

Surely whether an entrepreneur acts as one depends on a marginal decision.

If it is not profitable enough to make it worthwhile the entrepreneur will do something else.

[Peter G. Klein]

Current, I think Dave and I are agreeing with you here, just pointing out that Kirzner doesn't offer an argument for this. The specific welfare implications Kirzner draws from the discovery perspective don't seem to follow from the theory. Pete, Steve, Frederic, can you help?

[Steve Horwitz]

Short comment: I think the problems Peter and Dave and others have identified are real ones when one tries to apply Kirzner's PURE theory to the real world. Given the particular problem Kirzner was trying to solve, his arid approach might make sense. But it doesn't help us all that much in understanding the factors that affect real-world entrepreneurship and the consequences that follow from it.

[David Andersson]

Rizzo's introduction to the 2nd edition of "The Economics of Time and Ignorance" is perhaps the best treatment of the problems inherent in Kirzner's approach. If I'm not mistaken, there is also a very interesting critique of Kirzner's theory with Peter G. Klein as one of the co-authors.

Rizzo focuses on Kirzner's static conception of time, i.e. Kirzner's exogenous variables cannot remain exogenous for time-consuming entrepreneurship (innovation, speculation).

[Current]

The problem here is that entrepreneurship theory must be embedded in an overall economic theory.

To make a good account of it today it's necessary to write about the supporting ideas that immediately surround it.

Entrepreneurship theory must change as those surroundings change. Also, different aspects of the surroundings must be dealt with as the concerns of the Economics profession change.

I think increased use of hypothetical examples would help these problems.