The Difference between the Entrepreneur and the Capitalist and their functions in the maintenance of Consumer Sovereignty

ECON 3160 Life among the Econ Blog 1

The Difference between the Entrepreneur and the Capitalist and their functions in the maintenance of Consumer Sovereignty

Gregory T. Bogosian

            In popular parlance the terms “entrepreneur” and “capitalist” are used interchangeably to refer to the owners of private for-profit businesses. This often leads to the erroneous impression that the professional managers are the people who make the real decisions about how the firm shall be run and the owners are parasites who survive by taking money from the business without earning it. The neoclassical theory of the firm exacerbates this impression by assuming that the firm makes decisions as though it were a living sapient organism of a single mind. Austrian economics distinguishes between the capitalist and the entrepreneur in a way that dispels this notion. Austrian economics defines the capitalist as the owner of either financial or physical capital. Austrian economics defines the entrepreneur as the person who decides to what purpose the factors of production shall be used. Equivalently and more to the point, the Austrian school defines the entrepreneur as the party who decides what factors of production shall be used in what industry. The terms “capitalist” and “entrepreneur” do not refer to individuals. Rather they refer to functions served in the economy. The functions of the capitalist and the functions of the entrepreneur can be served by the same individual simultaneously. Nevertheless, these functions are normally served by different people. The person who owns the capital is not necessarily the person who decides what product the capital will be used to make. The Austrian school calls the money that capitalists earn interest. In finance the term “interest” denotes the percentage fee on money loans, but in Austrian economics the definition of “interest” is broader. In Austrian economics the term “interest” denotes any money that someone makes by supplying either financial or physical capital. When someone uses their own capital in a business venture they are supplying that capital to themselves. So the money they earn is still called interest. The money that the entrepreneur earns is called profit. Profit in finance and accounting denotes the difference between a firm’s revenue and that firm’s cost. In Austrian economics profit denotes any gain financial, intellectual, spiritual or otherwise. In Austrian economics entrepreneurial profit denotes the money that the entrepreneur earns by moving factors of production from relatively less valuable uses to relatively more valuable uses. In other words, the entrepreneur makes economic gain by redirecting things away from purposes that the consumer desires less and towards purposes that the consumer desires more.

            The mechanism by which the entrepreneur redirects resources towards more useful purposes is by purchasing those resources at prices that one would know are too low if one knew what price the product could be sold for by the time the inputs were processed into the product.  Their profit is the difference between the current costs of the inputs, or resources, and the future cost of the output, or product. In both Austrian and Neoclassical economics cost is not the nominal price of the item that the entrepreneur pays for it. Rather, cost in the economic sense is opportunity cost, the value of the next best alternative forgone in pursuing a particular purpose. An entrepreneur earns an economic profit if their revenue exceeds the opportunity cost of their inputs. They suffer an economic loss if their revenue is less than the opportunity cost of their inputs. If their revenue exactly equals the opportunity cost of their inputs, then they earn an economic profit of zero, neither a profit nor a loss. Zero economic profit is called a normal profit. Normal profits only occur in the neoclassical model of perfect competition, never in real life. In real life economic profits and losses are inevitable because  the constant emergence of new knowledge changes the opportunity cost of every input. If an entrepreneur is earning an economic profit by using one combination of inputs to produce one product, and other entrepreneurs are not prohibited from doing the same, then other entrepreneurs will imitate the methods of the entrepreneur earning the profit so that they may also gain a share of the profit. This process of imitation moves resources into the use which earns the economic profit, biding up the price of the inputs and biding down the price of the output until  the spread disappears and profit is zero. Then new information changes the opportunity costs of the various inputs by alerting another entrepreneur to a new source of economic profit and forcing all other ends back into economic loss. In this way economic profit drives entrepreneurs to use every combination of inputs for the purpose that the consumer values most. The use of every combination of inputs for the use that the consumer values the most is called consumer sovereignty. The most obvious criticism of this notion is that it seemingly proves that the entrepreneur is exploiting the rest of society by acting on relevant knowledge that remains unknown to all others until after the fact. This is fraud in the same sense that insider trading on the stock market is fraud. The problem with this criticism is that even if the entrepreneur had a psychic vision that allowed them to know exactly what the spread between the inputs and the output would be by the time the product was brought to market, which does not happen in real life because there is no such thing as psychic visions, the entrepreneur could still not share such knowledge with the rest of the world even if they wanted to do so. There is no way to prove to others that there is a positive spread between present inputs and future outputs in advance. The only way to know for certain which uses of which inputs will yield a profit is trial and error. It cannot be predicted with any certainty whether the spread on the present inputs and future outputs of any new entrepreneurial venture will prove to be positive and yield entrepreneurial profits or be negative and yield entrepreneurial losses.

            So what the entrepreneur must do to profit is not fraud because their decisions are not based on secrets that would make everyone else deny them that profit if they knew those secrets. Rather, the entrepreneur’s decisions are based on intuition that can only be shown to be true or false by acting on that intuition. The obvious criticism of this statement is that it reduces what the entrepreneur does to gambling in the form of allocating resources based on guesswork for economic gain. Most of us intuitively want to say that there is a better way to make decisions that affect the whole of our society than guesswork. This criticism is more effective than the first criticism because there is a degree of truth in it. Entrepreneurs do make decisions despite their inability to predict the outcome of those decisions with certainty. So entrepreneurial activity is like gambling in that very important sense. The difference between entrepreneurial activity, as the Austrian school understands it, and gambling is that entrepreneurial activity yields information about the preferences and relative priorities of the consumer that cannot be gained any other way. If the preferences and priorities of the consumer were already known, then there would be no entrepreneurial activity because profit would always be zero. Thus there would be no incentive to be an entrepreneur. The entrepreneur discovers more useful purposes for society’s existing resources through experimentation, not experimentation in the sense that it is scientifically rigorous but rather experimentation in the sense that it discerns the merits of ideas by testing them.

            Opportunity cost compels the capitalist to supply capital to the end that the consumer prefers most of all competing ends in the same way that it compels entrepreneurs to combine the factors of production to fulfill the end that the consumer prefers most of all competing ends. The capitalist earns interest on their capital by supplying it to entrepreneurs who will devote it to useful purposes and turn a profit. Profits and losses allow the capitalist to serve as the mechanism of economic Darwinism in which the capitalist redirects their capital from entrepreneurs who lose money to entrepreneurs who gain money. This process roots out inept entrepreneurs. Inept capitalists give their capital to inept entrepreneurs who accidentally wipe out that capital through their losses. Capitalists and entrepreneurs in cooperating in pursuit of their own material gain serve as the agents of market place natural selection in which the inept capitalists and entrepreneurs are rooted out by the competent capitalists and competent entrepreneurs. This economic competition ensures that only the most competent capitalists and entrepreneurs serve the interests of the consumer. The ultimate function of the market is to show the consumer who is best equipped to serve them. Thus the relevant question about capital is not whether the pecuniary gain of capital owners is inherently parasitic because it is not parasitic so long as economic natural selection persists. Rather, the relevant question about capital is whether there are enough capitalists and enough entrepreneurs who can communicate with and do business with each other for capital markets to be sufficiently competitive. The questions of whether there are any obstacles to the acquisition and deployment of capital or obstacles to assembling new combinations of factors of production or devoting existing combinations to new purposes that prevent capitalists or entrepreneurs from fulfilling their social function are also critical to the health of any market economy. It is the answer to these questions that determines whether the forces of the market continue to compel capitalists and entrepreneurs to serve the interests of the consumer in their own quests for financial gain.

Government Intervention

"Raising the minimum wage would equally help Americans who live in Republican and Democratic districts, rural and metropolitan. It would also pump money into the economy and save billions in taxpayer dollars by reducing the number of low-wage workers receiving federal assistance. It seems an obvious thing to do." - Raymond C. Offenheiser from Why raise minimum wage?

Ludwig Von Mises would disagree with this statement because he believes that societies need government to protect life, liberty, and property and anything it does beyond this is a violation of its boundaries.  When the government intervenes in matters such as the market, specifically the wages of workers in this case, it creates unintended consequences since it put its hands on an issue that it was never intended to solve.

According to Mr. Offenheiser, here is what would happen if the minimum wage were raised:

• Stimulation of the economy: since workers would have more money in their pockets, they would turn around and spend it, sending more money through the economy
• Less dependence on social programs: since workers would have more money, they would slowly rely less and less on the government
• More jobs: the workers would spend more which would result in businesses earning more money and would therefore be able to hire more people
• Equal distribution of wealth

     According to Mises, if the government sets a price floor on minimum wage, it results in unintended consequences because, though the idea that consumers will spend their extra money is nice, it is not always the case.  When a poor person receives a higher paycheck, is their first instinct to go and spend that money?  Or to save it?  It depends on the individual of course but applying logic to this scenario, Mises recognizes the very real possibility that when people who have been living on a very tight income begin earning more income, their tendency is to save that money.  Unless the increase is a profound amount, such as half a million dollars or the lottery, people lean towards saving their money.  Unfortunately, the minimum wage cannot be increased to half a million dollars.  An increase in the minimum wage would not stimulate the economy because realistically, people save extra income.
     In response to the assertion that a higher minimum wage would reduce dependency on government programs Mises argues that an increase in itself is a reliance on the government.  People waiting for the government to give them higher paychecks is clearly dependence on the government, simply in another form.
     Mises argues that an increase in minimum wage would not result in an influx of jobs.  He believes that markets are self-correcting, if untouched by excessive government involvement, and that government intervention in this case would result in the opposite of the expected outcome.  Raising the minimum wage and hoping that the workers spend the extra $3 per hour instantly to support the economy is unrealistic.  Even if it were the case, businesses also tend to save so if they experienced higher profits, the first move would most likely not be to hire a bunch of new employees.  It would be something more along the lines of investing, improving advancements and technologies, or saving.  Raising the minimum wage would mean that businesses would have to let people go.  It is the same scenario as when a business cannot sell a product because it costs them too much.  Do they keep that product or do they trash it?  With labor, the same concept applies.  If it costs more to keep that labor that isn't producing more output for that raised cost, they will be let go.
     Lastly, Mises disagrees with the assertion that a raise in minimum wage will level out income inequality because he realizes that in a capitalistic market system, the rich are rich because they invested time, money, energy, and hard work into an innovation that the masses benefit from.  The poor are poor because they have not made such investments, or if they have, it was not as big of an investment.  If everyone got paid the same amount, innovation would go extinct.  Why would the inventor of the iPhone go through all the tedious, difficult, tumultuous travails that come with creating a cell phone if his income matched that of the cashier at 7/11?  It is much easier to punch a few buttons and put money in a drawer, so if everyone got paid the same, everyone would do the same amount of work.  Mises says that the government sticking its hands into this aspect of the market will not level out the income "inequality."  It will result in more people not having an income at all.
     In all of these examples, the government actually creates a new problem without solving the original one.  This is Mises' view towards government intervention: although it sounds nice, it never satisfies.

The 2014 Nobel Prize For Economic Sciences: Jean Triole and "The Pretence of Knowledge"

F. A. Hayek

Jean Tirole

     It's been 40 years since F. A. Hayek delivered his acceptance speech for the Nobel prize in the science of economics. Earlier this month, the annual award was once again decided on; this time for Jean Tirole of France. Perhaps by evaluating the reasons for Tirole's victory on the basis of Hayek's critical acceptance speech; "The Pretence of Knowledge," (in addition to some of his other work) we can, in a crude way, see if Hayek's work has had any influence on their shared discipline.

     Upon first glancing over the reasons the Royal Swedish Academy of Sciences gave for Tirole's victory, one can hardly be blamed for thinking that Hayek's acceptance speech has fallen on deaf ears. After all, the press release announcing the decision to award Tirole is titled; "The Science of Taming Powerful Firms" (because of his work on the regulation of industries dominated by a few powerful firms - a form of "control" over society Hayek discouraged using in the closing remarks of his now famous speech on the limitations of economic knowledge). Yet, despite this potentially glaring contradiction in overall principle, I believe there is reason to think that Hayek's work has had at least some impact on Tirole's analysis of market failure and competition.

     In the paper "Competition as a Discovery Procedure," Hayek opens by criticizing macroeconomists' methodology by accusing them of "investigat[ing] competition primarily under assumptions which, if they were actually true, would make competition completely useless and uninteresting." One assumption of these models frequently criticized by Hayek is that of homogeneity (as far as the products offered by firms, information the firms possess, and the various industries firms exist in). In other words, Hayek questions the value of neo-classical economics' competitive analysis (and the policies these analysis give birth to), because homogeneous assumptions reflect, in no conceivable fashion, the reality of competition.

     It would appear that Tirole (to some extent) agrees with this criticism. According to the above linked press release, Tirole's work has gone some way towards weening policy makers and economic researchers off of the idea that "general principles for all industries" exist and can be acted on. Rather than treating all firms and industries alike (i.e., adhering to a set of assumptions regarding homogeneity), Tirole's work emphasizes carefully adapting research, as well as policy regulations, to "every industry’s specific conditions" (as opposed to resorting to common, often harmful, "solutions" like price-caps, price-setting, and the prevention of mergers).

     On the one hand, if Hayek were still around today, he would likely be disappointed to see that the "pretense to knowledge" he criticized all those years ago seems to be alive and well in economics and public policy decisions... On the other hand, he might derive some small satisfaction from seeing that those decisions are more and more often being guided by attempts to understand society's "fine structure" rather than it's aggregated, or homogenized, "coarse" one.