Prof E's Blog

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The Economic Nature of Profit and Loss

The Emergence of Profit and Loss – Profit and loss emerge as entrepreneurs purchase factors of production in anticipation of future prices of consumer goods. If the future were perfectly predictable, profit and loss would not exist. They only exist because change is constant.

The Distinction Between Profits and Other Proceeds – Entrepreneurial profit is not interest. It is not wages for the labor of entrepreneurs. It is not monopoly gains. Entrepreneurial profit or loss is what is earned because of the quality of decision making. If you want to identify an entrepreneur, identify who would take a loss if things went badly.

Non-Profit Conduct of Affairs – In the absence of profit and loss, bureaucratic rules and regulations are the only viable alternative. This applies to governments as well as other non-profit organizations.

The Ballot of the Market – while entrepreneurs are the decision makers in the market, consumers have the final say, as they vote with their dollars for what they want.

The Social Functions of Profit and Loss – Profit and loss are the return on good (or bad…) entrepreneurial decision making – that is redirecting resources to their highest valued ends, in the minds of the consumers.

Profit and Loss in the Progressive and the Retrogressing Economy – in a progressing economy, profits are greater than losses, allowing for an accumulation of capital, which allows increased production. This requires real saving. An economy that is consuming capital will have greater losses than profits, and will retrogress.

The Computation of Profit and Loss – profit and loss are naturally psychological. However, in a monetary economy we can calculate them.

The Condemnation of Profit

Economics and the Abolition of Profit – Some, inspired by Marxism, have declared that profit should be abolished. If this is a purely moral claim, then economics has little to say about it. However, if the claim is that this would benefit workers and consumers, then economics can analyze whether this is true.

The Consequences of the Abolition of Profit – profit is what makes entrepreneurs accountable to the consumer. Abolition of profit would then turn entrepreneurs into unaccountable managers, resulting in chaos.

The Antiprofit Arguments – All the arguments against profit are

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Praxeology and Understanding: An Analysis of the Controversy in Austrian Economics – Austrian economics faces the challenge of skepticism. GLS Shackle has suggested that economic laws aren’t really useful because the economy is typified by patternless “kaleidic” change. Some Austrians have adopted this view as well on some level.

Praxeology: The Method of Economic Theory – Economic laws come from logically deducing from the action axiom, which is undeniable.

Ideal Types and “Exact Laws” – Praxeological laws are true regardless the specific content of people’s preferences or the specific circumstances in which they find themselves. The question is simply whether they apply in a specific case or not. This means that praxeological laws cannot be “exact” (in the sense of being numerically precise). We may use ideal types to fill in some “common sense” preferences and so on when doing historical work. However, Mises draws a sharp distinction between history and theory. Theory is purely the logic of choice. History allows for (and requires) consideration of specific preferences and interpretations of situations.

From Mises to Lachmann: Austrian Revisionism – Three thinkers led some Austrians to question the value of praxeological reasoning. (1) Hayek suggested that praxeology by itself provides very little real-world insight, and suggested supplementing it with “common sense” assumptions about the content of preferences. (2) Shackle focused on the importance of uncertainty – but in a radical form. In the strong form, Shackle’s view is that economics cannot deal with the “kaleidic” nature of the future. In this, Shackle confuses determinism in concrete application with determinism in logical patterns. (3) Lachmann emphasizes the need to deal with “divergent expectations”. Profit and loss provide good feedback for past expectations – but provide little guidance for future expectations.

Equilibration and Coordination – the praxeological understanding of equilibration is really just about the removal of a felt uneasiness. So, while we may never reach “equilibrium” (a state where there is no felt uneasiness), action is equilibrating in as far as it is successful. But, to be successful requires foresight. If the future is “kaleidic” (that is, basically unpredictable), then there is no reason to expect that action will generally be successful. The claim from Shackle and Lachmann is that human action is radically unpredictable. So, in as far as my action being successful requires the action of others, there is no reason to expect that it will be successful.

Implications of the Kaleidic Society – In short: praxeology can’t really “prove” that society isn’t kaleidic. Rather, what it can prove is that a kaleidic society is one where action doesn’t really happen in any meaningful sense. If the future is kaleidic, then one can’t really undertake purposeful behavior – that is, action – in any meaningful sense. Since there is no clear connection between our behavior and the effects of our behavior, we will never be able to remove any specific felt uneasiness except by pure chance. In addition, the advocates of the kaleidic view have failed to explain their own bothering to engage in economic theorizing. If the future is kaleidic, then engaging in economic research can’t be expected to serve any particular purpose. So, why do it? Rather, their own behavior suggests that those that claim to believe in a kaleidic future don’t actually believe in it in any practical sense.

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My brief summary:

Austrian economists Menger, Bohm-Bawerk, and Mises all had various philosophical influences.

Aristotle – influenced Menger through Bentrano. Against the German Historical School, which emphasized the interconnectedness of everything and denied the existence of any kind of universal economic laws that would apply across different societies, Bentrano emphasized the ability to separate pieces of reality in our analysis. Specifically, Bentrano separated the acts of the mind from the objects of those acts. In Menger, this showed up as people making judgments of value. So, value is not intrinsic to the good – or even to the mind. Rather, it is a matter of a judgment that the mind makes about the good. Aristotle also emphasized that true science is deductive – treating empirical science as a stand-in for true science until our understanding of the deductive structure develops sufficiently.

Occam – had a big influence on Bohm-Bawerk – especially in the need to trace all concepts back to their origin in perception. This led Bohm-Bawerk to reject mystical sorts of notions in social science and to be very concerned with clarity and thoroughness in the analysis. This is especially obvious in his criticism of Marx. Rather than settling at criticizing the labor theory of value (which would have been sufficient), Bohm-Bawerk criticized Marx more or less line-by-line.

Kant – Not as big an influence as you’d expect. He provided some of the Misesian language, but Mises doesn’t rely on Kant’s philosophical system.

The Logical Positivists – probably the biggest influence on Mises, but in the negative direction. Much of Mises’s more philosophical work was defending a deductive method against the logical positivists, who favored empirical methods as being the only real way to do “science”.

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Confession: Despite having been on the faculty for Mises University for a few years now, I haven’t actually done all the readings. Now, don’t get me wrong, I read the readings for when I was a student back in 2003 and 2004. But, things have changed a bit. So, I’ve decided to try to read through some of the Mises U readings this year – anything I’ve not read, or have too vague a memory of. Then, I’ll offer a (very!) brief synopsis here. So, here’s the first – which I had never previously read!

Anatomy of the State – Murray Rothbard

What the State isn’t – us.

What the State is – a regional monopoly on the use of force.

How the State preserves itself – creating vested economic interests, but ideology that supports the State as good or at least inevitable even moreso.

How the State transcends its limits – by controling the power of interpretation of its limits.

What the State fears – losing its power through conquest or revolution.

How States relate to one another – mostly through war. Though we used to recognize that war was between States rather than between peoples.

History as a race between social power and State power – sometimes the creative forces run ahead of the State – leading to an increase in freedom. Other times, the State catches up. We have yet to find a good method of limiting State power.

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I’m a bit of a weirdo when it comes to medicine. I will happily agree with basically anyone who says that the American medical system is messed up. The system is designed so that no one ends up actually comparing costs and benefits. Patients and doctors generally are trying to maximize benefits while insurance companies are trying to minimize costs, with no one really comparing the two against each other. The result is a system that gives mediocre performance on the whole, and does so very expensively.

I’m even willing to acknowledge that a reasonably designed socialized system might even perform better. Along that measure, the UK’s NHS is quite good. They evaluate cost per quality-adjusted life year (QALY). So, expensive routines that aren’t likely to extend or improve life aren’t likely to be approved. On the face of it, this seems like a reasonable system. Compare the cost of a treatment to the benefit. Obviously a good idea.

But, there’s a reason that I don’t advocate for socialized medicine. Preferences are subjective. How much is another year of life worth to you? I suspect everyone who reads that question will give a different answer. And there’s nothing special about years in your life. We each have different values we attach to everything. Some people believe that black licorice is very valuable. So valuable they’d even be willing to pay for the ability to eat it. Then there’s me. The subjectivity and diversity of preference is part of fundamental economic reality. What the market system allows us to do, rather brilliantly, is convert a vast array of subjective preferences into an objective number – price – that reflects the value of increasing the production of a good by an additional unit. This price can then be compared with the cost of increasing production by that unit, so that profit-seeking entrepreneurs produce just the right amount of the goods that are produced by the market.

Socialized systems cannot do this. They lack the necessary mechanism for reacting to individual preference. So, even if we assume perfect information about cost per QALY, the fact that we don’t have perfect information about each patient’s VALUE per QALY suggests that some patients will be over-served (if they place a low value on extending their life) and others will be under-served (if they place a high value on it).

To me, this is one of the lessons that Baby Alfie can teach us. The NHS simply could not account for the preferences of the people involved (the parents in this case). What they knew: treatment was expensive and unlikely to add QALY. So, it should stop.

I know it is uncomfortable – and to many feels borderline sociopathic – but when it comes to decisions about life and death, we have to consider both benefit and cost. For most of human history the reality was that death was not a financial choice. Staying alive was either cheap (buying basic food and shelter) or impossible (because we couldn’t effectively offset the effects of most diseases, old age, war, accidents, etc.). So, there was never really a point where a person would have to make a financial decision about life and death.

Today, though, things have changed. We have the technological ability to keep our bodies going for long periods of time. We can treat most diseases on some level. But, it’s often expensive. And worse, it’s expensive in monetary terms. So, someone has to decide: is it worth $3,000 per day to keep someone alive on life support?

It’s a difficult decision, no doubt. But, it must be made. The question is by whom? On the one hand, doctors are in a good position to estimate the odds of recovery. Naturally, if keeping someone on life support for a week is likely to lead to a full recovery so that the person will go on to live for another 30 years the calculation is a bit different than if the odds of ever recovering is basically zero.

However, doctors are not in a position to place a value on the person’s life – where the person’s family is in a much better position both to represent the person’s own decision, if they were in a position to make it themselves, and also to account for the impact of the person’s life on those around them. Easy? No. Heart-wrenching? Absolutely. But, is it better to ignore the subjectivity involved and impose a one-size-fits-all policy instead? I suspect not.