We shall concentrate on the capitalist-entrepreneurs, economically the more important type of entrepreneur. These are the men who invest in “capital” (land and/or capital goods) used in the productive process….
The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest. Suppose the interest rate is 5 percent; Jones can buy a certain combination of factors for 100 ounces; he believes that he can use this agglomeration to sell a product after two years for 120 ounces. His expected future return is 10 percent per annum. If his expectations are fulfilled, then he will obtain a 10 percent annual return instead of 5 percent. The difference between the general interest rate and his actual return is his money profit (from now on to be called simply “profit,” unless there is a specific distinction between money profit and psychic profit). In this case, his money profit is 10 ounces for two years, or an extra 5 percent per annum.
What gave rise to this realized profit, this ex post profit fulfilling the producer’s ex ante expectations? The fact that the factors of production in this process were underpriced and undercapitalized—underpriced in so far as their unit services were bought, undercapitalized in so far as the factors were bought as wholes. In either case, the general expectations of the market erred by underestimating the future rents (MVPs [marginal value products]) of the factors. This particular entrepreneur saw better than his fellows, however, and acted on this insight. He reaped the reward of his superior foresight in the form of a profit. His action, his recognition of the general undervaluation of productive factors, results in the eventual elimination of profits, or rather in the tendency toward their elimination. By extending production in this particular process, he increases the demand for these factors and raises their prices. This result will be accentuated by the entry of competitors into the same area, attracted by the 10 percent rate of return. Not only will the rise in demand raise the prices of the factors, but the increase in output will lower the price of the product. The result will be a tendency for a fall in the rate of return back to the pure interest rate.
What function has the entrepreneur performed? In his quest for profits he saw that certain factors were underpriced vis-à-vis their potential value products. By recognizing the discrepancy and doing something about it, he shifted factors of production (obviously nonspecific factors) from other productive processes to this one. He detected that the factors’ prices did not adequately reflect their potential DMVPs [discounted marginal value products]; by bidding for, and hiring, these factors, he was able to allocate them from production of lower DMVP to production of higher DMVP. He has served the consumers better by anticipating where the factors are more valuable. For the greater value of the factors is due solely to their being more highly demanded by the consumers, i.e., being better able to satisfy the desires of the consumers. That is the meaning of a greater discounted marginal value product.
It is clear that there is no sense whatever in talking of a going rate of profit. There is no such rate beyond the ephemeral and momentary. For any realized profit tends to disappear because of the entrepreneurial actions it generates. The basic rate, then, is the rate of interest, which does not disappear. If we start with a dynamic economy, and if we postulate given value scales and given original factors and technical knowledge throughout, the result will be a wiping out of profits to reach an ERE [Evenly Rotating Economy; for more see chapter 5] with a pure interest rate. Continual changes in tastes and resources, however, constantly shift the final equilibrium goal and establish a new goal toward which entrepreneurial action is directed—and again the final tendency in the ERE will be the disappearance of profits. For the ERE means the disappearance of uncertainty, and profit is the outgrowth of uncertainty.
A grave error is made by a host of writers and economists in considering only profits in the economy. Almost no account is taken of losses. The economy should not be characterized as a “profit economy,” but as a “profit and loss economy.”
A loss occurs when an entrepreneur has made a poor estimate of his future selling prices and revenues. He bought factors, say, for 1,000 ounces, developed them into a product, and then sold it for 900 ounces. He erred in not realizing that the factors were overpriced and overcapitalized on the market in relation to their discounted marginal value products, i.e., to the prices of his output.
Every entrepreneur, therefore, invests in a process because he expects to make a profit, i.e., because he believes that the market has underpriced and undercapitalized the factors in relation to their future rents. If his belief is justified, he makes a profit. If his belief is unjustified, and the market, for example, has really overpriced the factors, he will suffer losses.
The nature of loss has to be carefully defined. Suppose an entrepreneur, the market rate of interest being 5 percent, buys factors at 1,000 and sells their product for 1,020 one year later. Has he suffered a “loss” or made a “profit”? At first, it might seem that he has not taken a loss. After all, he gained back the principal plus an extra 20 ounces, for a 2 percent net return or gain. However, closer inspection reveals that he could have made a 5 percent net return anywhere on his capital, since this is the going interest return. He could have made it, say, investing in any other enterprise or in lending money to consumer-borrowers. In this venture he did not even earn the interest gain. The “cost” of his investment, therefore, was not simply his expenses on factors—1,000—but also his forgone opportunity of earning interest at 5 percent, i.e., an additional 50. He therefore suffered a loss of 30 ounces.
The absurdity of the concept of “rate of profit” is even more evident if we attempt to postulate a rate of loss. Obviously, no meaningful use can be made of “rate of loss”; entrepreneurs will be very quick to leave the losing investment and take their capital elsewhere. With entrepreneurs leaving the line of production, the prices of the factors there will drop and the price of the product will rise (with reduced supply), until the net return in that branch of production will be the same as in every branch, and this return will be the uniform interest rate of the ERE. It is clear, therefore, that the process of equalization of rate of return throughout the economy, one that results in a uniform rate of interest, is the very same process that brings about the abolition of profits and losses in the ERE.
A real economy, in other words, where line A yields a net return of 10 percent to some entrepreneur, and line B yields 2 percent, while other lines yield 5 percent, is one in which the rate of interest is 5 percent, A makes a pure profit of 5 percent, and B suffers a pure loss of 3 percent. A correctly estimated that the market had underpriced his factors in relation to their true DMVPs; B had incorrectly guessed that the market had underpriced (or, at the very least, correctly priced) his factors, but found to his sorrow that they had been overpriced in relation to the uses that he made of the factors. In the ERE, where all future values are known and there is therefore no underpricing or overpricing, there are no entrepreneurial profits or losses; there is only a pure interest rate.
In the real world, profits and losses are almost always intertwined with interest returns. Our separation of them is conceptually valid and very important, but cannot be made easily and quantitatively in practice….Do profits have a social function? Many critics point to the ERE, where there are no profits (or losses) and then attack entrepreneurs earning profits in the real world as if they were doing something mischievous or at best unnecessary. Are not profits an index of something wrong, of some maladjustment in the economy? The answer is: Yes, profits are an index of maladjustment, but in a sense precisely opposed to that usually meant.
As we have seen above, profits are an index that maladjustments are being met and combated by the profit-making entrepreneurs. These maladjustments are the inevitable concomitants of the real world of change. A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment—specifically an undervaluation of certain factors by the market. By stepping into this situation and gaining the profit, he calls everyone’s attention to that maladjustment and sets forces into motion that eventually eliminate it. If we must condemn anyone, it should not be the profit-making entrepreneur, but the one that has suffered losses. For losses are a sign that he has added further to a maladjustment, through allocating factors where they were overvalued as compared to the consumers’ desire for their product. On the other hand, the profit-maker is allocating factors where they had been undervalued as compared to the consumers’ desires. The greater a man’s profit has been, the more praiseworthy his role, for then the greater is the maladjustment that he alone has uncovered and is combating. The greater a man’s losses, the more blameworthy he is, for the greater has been his contribution to maladjustment.
Of course, we should not be too hard on the bumbling loser. He receives his penalty in the form of losses. These losses drive him from his poor role in production. If he is a consistent loser wherever he enters the production process, he is driven out of the entrepreneurial role altogether. He returns to the job of wage earner. In fact, the market tends to reward its efficient entrepreneurs and penalize its inefficient ones proportionately. In this way, consistently provident entrepreneurs see their capital and resources growing, while consistently imprudent ones find their resources dwindling. The former play a larger and larger role in the production process; the latter are forced to abandon entrepreneurship altogether.
There is no inevitably self-reinforcing tendency about this process, however. If a formerly good entrepreneur should suddenly made a bad mistake, he will suffer losses proportionately; if a formerly poor entrepreneur makes a good forecast, he will make proportionate gains. The market is no respecter of past laurels, however large. Moreover, the size of a man’s investment is no guarantee whatever of a large profit or against grievous losses. Capital does not “beget” profit. Only wise entrepreneurial decisions do that. A man investing in an unsound venture can lose 10,000 ounces of gold as surely as a man engaging in a sound venture can profit on an investment of 50 ounces.
Beyond the market process of penalization, we cannot condemn the unfortunate capitalist who suffers losses. He was a man who voluntarily assumed the risks of entrepreneurship and suffered from his poor judgment by incurring losses proportionate to his error. Outside critics have no right to condemn him further. As Mises says:
Nobody has the right to take offense at the errors made by the entrepreneurs in the conduct of affairs and to stress the point that people would have been better supplied if the entrepreneurs had been more skillful and prescient. If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits? It is easy indeed to display foresight after the event.