ECONOMICS AND PEOPLE

Antony Davies, Ph.D.Duquesne University

UNIT 2PART 1

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PART 1:ECONOMICS AND

INDIVIDUALS

UNIT 2:PROFIT, LOSS, AND

DISCOVERY

This unit is divided into several sections. Start with the Introduction. Then proceed onto each section. You can click on a link below to navigate to the section where you had recently left off. IntroductionSection 1: The Nature of ValueSection 2: The Nature of ProfitUnit Summary & Assignment

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

In the previous unit, we learned the importance of thinking in terms of first principles rather than in terms of issues in order to avoid logical contradiction (see Unit 1, Part 3 for further discussion of logical contradictions).

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

In this unit, we will apply this style of thinking to investigate the nature of profit. Most people think of profit as the difference between a company’s revenue and its costs.

In fact, profit is simply “net benefit.” A company’s profit is objectively measurable, but there are many other forms of profit that are less noticed (though just as real) because they are measured subjectively.

For example, the happiness you get from eating ice-cream minus the price to purchase the ice-cream and the possible concern over getting fat equals your profit.

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

Profit (in this basic sense) is the motivation for all human activity, regardless of the economic system and social order.

Even selfless acts are profit-motivated. For example, if you believe that it is your moral responsibility to give to the poor and that you feel this so strongly that you give away half of your possessions, then the economist would say that you incurred a profit.

The subjective benefit you received (in this case, the satisfaction or peace in knowing that you behaved morally) exceeds the subjective value (to you) of that which you gave away. If not, you wouldn’t have given away your possessions!

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

This may sound like a depressing view of humanity – that everyone, even the selfless, are really selfish profit seekers.

If that is your view, then you don’t yet understand profit. In this unit, we will explore the nature of profit and show that profit is not a sign of exploitation and division but a sign of creation and community.

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

One view holds that profits are, if not immoral, then highly suspect because when one makes a profit, one makes it at the expense of another.

By extension, this view also holds prices as suspect because prices are the mechanism by which one obtains profit.

According to this view, there is a cycle wherein greed motivates sellers to charge high prices, high prices generate profit at the expense of buyers, and the quest for profit encourages further greed.

Price ProfitGreed

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

An alternate view holds that profits are the reward for creating value. By extension, prices are signals that communicate what goods and services society values most.

According to this view, there is a cycle wherein the value consumers place on things determines prices, prices generate profit, the quest for profit encourages producers to innovate, and the innovation generates more value for consumers.

Value Price Profit

Innovation

UNIT 2: PROFIT, LOSS, ANDDISCOVERY

MICRO-LECTURE

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SECTION 1THE NATURE OF VALUE

Take a few moments to answer the following questions:

What determines something’s value?

When a sale is made, who benefits and who loses, the buyer or the seller?

Can wealth (value) be created simply through exchange?

How much profit, in your opinion, is too much?

ACTIVITY

The two alternate views of profits arise from two opposing theories as to the nature of value.

Labor theory of value

What makes something valuable is the labor that went into the thing’s production.

Subjective theory of value

What makes something valuable is that someone desires the thing.

What makes something valuable is the labor that went into the thing’s production.

The labor theory of value is appealing because it recognizes that value derives from labor. An object, unto itself, has no value. The value comes about when you add labor to the object.

For example: Carving wood into a chair makes the wood valuable.One might argue that the wood itself has value as a source of fuel. But, in order to be used as fuel, someone must go out and collect the wood, split it, and season it – again, labor is required to transform the wood into something of value.

What makes something valuable is the labor that went into the thing’s production.

The logical implication of the labor theory of value is that an object’s value is objective – that is, the value is the same for everyone.

For example, suppose that the wage rate is $1 per hour. If it takes 50 hours of labor to transform wood into a chair, then the value of the chair is $50.

Notice what happens when the woodworker goes to sell the chair…

What makes something valuable is the labor that went into the thing’s production.

If the woodworker charges more than $50 for the chair, then the woodworker cheats the customer.

Woodworker Customer

$60

Value = $50

What makes something valuable is the labor that went into the thing’s production.

But, if the customer pays less than $50 for the chair, then the customer cheats the woodworker.

Woodworker Customer

$40

Value = $50

What makes something valuable is the labor that went into the thing’s production.

The labor theory of value implies that every transaction is a zero-sum game.

When the woodworker sells the chair, he loses a chair worth $50 in exchange for gaining money. When the customer buys the chair, he gains a chair worth $50 in exchange for losing money. If the price is $50, both the woodworker and the customer are as well off after the transaction as they were before. If the price is above $50, the woodworker is better off after the transaction while the customer is worse off. If the price is below $50, the woodworker is worse off after the transaction while the customer is better off.

Through the eyes of the labor theory of value, the world is a bleak place wherein every transaction either results in neither party being better off or involves the exploitation of one party at the expense of the other.

Fortunately, the labor theory of value is inconsistent with reality. A simple thought experiment demonstrates the inconsistency.

Suppose that it takes you 2 hours to collect apples, make a crust, and bake an apple pie. It also takes you 2 hours to collect dirt, mix it with water to make a fine mud, and create a mud pie.

According to the labor theory of value, both the apple pie and the mud pie have the same value because each required 2 hours of labor to produce.

But, put a $2 price tag on each and see which sells. The fact that no one wants the mud pie but many would want the apple pie indicates that there must be more to value than simply the amount of labor that goes into a product.

What makes something valuable is that someone desires the thing.

The subjective theory of value holds that an object’s value is determined by the person.

For example, the chair is valuable to both the woodworker and the customer because of the happiness each gets from looking at a nice piece of furniture and having a comfortable place to sit.

If it is easy for the woodworker to make another chair, then the value of the chair will be low for him. If the customer badly needs a place to sit, then the value of the chair will be high for him.

What makes something valuable is that someone desires the thing.

The logical implication of the subjective theory of value is that an object’s value is subjective – that is, the value may be different for different people.

For example, suppose that the woodworker can make another chair with relative ease so the value of this chair to the woodworker is $20. Suppose also that the customer is in need of a chair but that it would be extremely difficult for the customer to make one himself. So, the value of this chair to the customer is $60.

Notice what happens when the woodworker sells the chair for $40…

What makes something valuable is that someone desires the thing.

The woodworker is $20 better off because he gives up a chair that he values at $20 in exchange for $40 cash.

Woodworker Customer

$40

Value$20

What makes something valuable is that someone desires the thing.

Meanwhile, the customer is also $20 better off because he gave up $40 cash in exchange for a chair that he values at $60.

Woodworker Customer

$40

Value$20

Value$60

What makes something valuable is that someone desires the thing.

The subjective theory of value implies that every transaction is a positive-sum game.

In the absence of coercion, the woodworker will only sell the chair if the price exceeds the woodworker’s subjective value of the chair, and the customer will only buy the chair if the price is less than the customer’s subjective value of the chair.

By definition, if the transaction occurs, both parties are better off.

Take a few minutes to reflect upon coercion and answer the following questions (if necessary, go back and view the definition of coercion in the glossary).

• Suppose that the woodworker lied to the customer by telling the customer that the chair was made of a rare expensive wood when, in fact, the chair was made of a cheap and common wood. Assuming that the customer believed the woodworker’s lie, would the lie constitute coercion?

ACTIVITY

Take a few minutes to reflect upon coercion and answer the following questions (if necessary, go back and view the definition of coercion in the glossary).

• Alternatively, suppose that the chair is made of a cheap and common wood but that the customer (for whatever reason) erroneously believes that the chair is made of a rare expensive wood. The customer does not reveal his belief to the woodworker and the woodworker makes no claim as to what type of wood is in the chair. Does the customer’s erroneous belief constitute coercion?

ACTIVITY

How can a chair – something that exists objectively – have a value that is subjective? Certainly, one of the two parties is wrong about the chair’s true value!

The chair is an objective reality. But, value does not come from the chair. It comes from the person experiencing the chair. The “experience” of the chair might come from sitting in it, or looking at the fine workmanship, or smelling the aroma of the wood with which it was made.

The experience can come from storing the chair safely so as to produce the satisfaction of knowing that you have a fine chair should you ever need one, or so as to produce the sense of security from knowing that you can sell the chair later when it is an antique for more than you paid for it.

WAIT!

What makes something valuable is that someone desires the thing.

The experience of the chair is specific to the person’s needs, tastes, and beliefs. Therefore the value of the chair is different for different people – that is subjective value.

There are two powerful implications to the subjective theory of value:

• In the absence of coercion, exchange usually benefits both the buyer and the seller.

• The profit the seller makes corresponds to happiness the buyer receives.

The profit the seller makes corresponds to the happiness the buyer receives.

Bill Gates is one of the richest people in the world. As of 2010, he is worth over $50 billion. To put that number in perspective, in the time it will take you to read this slide, he will have earned about $1,000 in interest.

• Assuming the labor theory of value is correct, consider what his accumulation of this wealth implies about the people who bought his software.

• Assuming the subjective theory of value is correct, consider what his accumulation of this wealth implies about the people who bought his software.

ACTIVITY

What you should have noticed by now is that the subjective theory of value implies that profit is one part of the benefit created from a transaction. The other part is the happiness the buyer gets from receiving a good that is (subjectively) worth more than the money the buyer paid.

One reason profit is sometimes viewed as bad is that profit can be explicitly seen and counted, while happiness cannot. Because of this, it appears to the untrained eye that only the seller benefits from a transaction. This is falling back into the error of the labor theory of value.

Instead, profit (when generated in a non-coercive environment) is a sign that both buyers and sellers are better off – that society has improved.

  Labor Theory of Value Subjective Theory of Value

Exchange zero-sumwin / lose

positive-sumwin / win

Profit or Loss profit = (labor) value – wages

profit = new value created

Market Relationships

exploitationparasitism

mutual benefitsymbiosis

THEORIES OF VALUE AND VIEWS OF THE MARKET

SECTION 2THE NATURE OF PROFIT

The two theories of value imply two different views of profit.

Implications of Profit in the Subjective Theory of Value

Implications of Profit in theLabor Theory of Value

Obtained via mutual agreement Obtained via coercionWealth is created Wealth is transferredRelationship between buyer and seller is a symbiosis

Relationship between buyer and seller is parasitism

Transactions build community relationships

Transactions destroy community relationships

Economics is about getting ahead by working with others

Economics is about getting ahead at the expense of others

As sellers seek profit, they are constantly looking for ways to harness resources for the good of society. They do this, not out of altruism, but out of self-interest. What is fascinating is that (assuming a non-coercive environment) sellers end up behaving as if they were motivated by altruism.

Value Price Profit

Innovation

What is innovation?Who does the innovating?

Entrepreneurs are people who are skilled at finding new and better ways to do things, and who think up new and better goods and services.

Some entrepreneurs work for existing companies, helping these companies to improve their goods and services. Some entrepreneurs create new companies to provide new products or to provide old products in better ways.

ENTREPRENEURS

Some entrepreneurs who founded new companies:

• Andy Grove founded Intel.• Jerry Yang founded Yahoo.• Sergey Brin founded Google.• Pierre Omidyar founded eBay.• Frederick Smith founded Federal Express.• Bill Gates founded Microsoft.• Steve Jobs founded Apple Computer.

ENTREPRENEURS

Not all entrepreneurs are successful. Not all ideas are good ideas, and even good ideas can be introduced at the wrong time or the wrong place. Even good ideas introduced at the right time and the right place can be poorly executed.

As a result, like aspirants to professional sports, most entrepreneurs fail. But the cost to society of hundreds of failed entrepreneurs can easily be outweighed by the benefit to society of the success of one.

So who are entrepreneurs?

ENTREPRENEURS

What attributes are common among entrepreneurs?

• They are usually people with a higher tolerance for risk.• They are usually people who generate novel ideas.

These attributes can also describe the insane.

Entrepreneurs can be dangerous as well as beneficial.

ENTREPRENEURS

Good Risk vs. Bad Risk

• Good risk (or “prudent” risk) is risk that is justified by the potential reward.

• Bad risk (or “imprudent” risk) is risk that is not justified by the potential reward.

ENTREPRENEURS

Good Ideas vs. Bad Ideas

• Good ideas create more value than they consume.

• Bad ideas create less value than they consume.

ENTREPRENEURS

Since we can’t see into the future, we will not be sure whether risks are prudent or imprudent, and we will not be sure whether an idea is good or bad.

ENTREPRENEURS

Who should make the decision to allocate society’s scarce resources to a new idea?

REFLECTION

ExampleSuppose you live in 1900, before the automobile. Someone suggests to you that society should expend resources to develop and produce automobiles.

Here are some things you, living in 1900, would likely consider:

Anticipated Benefits• Cars will be faster than horses.• Cars will be fun to drive.• Cars will be more comfortable than horses.

Anticipated Costs• Iron smiths will become unemployed (lesser need for

horseshoes).• Saddlers will become unemployed.• Horse breeders and traders will become unemployed.• Farmers will make less money on grain (fewer horses to feed).

REFLECTION

ExampleSuppose you live in 1900, before the automobile. Someone suggests to you that society should expend resources to develop and produce automobiles.

Given the costs and benefits that you anticipate, you might argue that society should not expend resources to develop and produce automobiles because the costs may outweigh the benefits. The problem is that you, being a finite human, are unable to anticipate all of the ramifications of this new idea. For example, in 1900, you would have failed to anticipate:

• The creation of new industries needed for the support and maintenance of cars (gas stations, car mechanics, parts stores, etc.).

• The creation of new industries to sell products that make cars more useful (computer aided navigation, fast food restaurants, etc.).

REFLECTION

Given that we are finite humans, how do we make the best decision as to whether or not to commit society’s resources to a new venture?

There are two possible answers:

• Government makes the decision• Entrepreneurs make the decision

When government makes the decisions, we call this a command economy (or a centralized economy).

When entrepreneurs (and investors) make the decisions, we call this a market economy (or a free market).

REFLECTION

We cannot perfectly anticipate the future and so always run the risk of making poor decisions. There are two ways we can make poor decisions: we can commit resources to projects that do not benefit society, or we can fail to commit resources to projects that do benefit society.

Consider the pros and cons of having government make the decision (a command economy) and of having entrepreneurs make the decision (a market economy).

ACTIVITY

Pros ConsGovernment(motivation)

In theory, concerned with achieving what is socially optimal.

In practice, concerned with achieving what is politically expedient.

Government(capabilities)

Has the ability to coerce and so can direct adequate resources to prudent activities.

Has the ability to coerce and so can direct too many resources to imprudent activities.

Entrepreneurs(motivation)

Concerned with making a profit. In a non-coercive environment, the quest for profit also generates value for customers.

Concerned with making a profit. In a coercive environment, the quest for profit leads to exploitation of customers.

Entrepreneurs(capabilities)

Cannot coerce and so may be unable to direct too many resources to imprudent activities.

Cannot coerce and so may be unable to direct enough resources to prudent activities.

WHO SHOULD DECIDE TO WHAT PROJECTS SOCIETY SHOULD COMMIT ITS RESOURCES?

• If government chooses where society should commit resources, there is less incentive to identify and correct mistakes because those who control the resources (the bureaucrats and politicians) are not those who bear the cost of the wasted resources (the taxpayers). In fact, those who benefit from the mistake have an incentive to convince the public that no mistake exists and to lobby government not to correct the mistake.

WHAT HAPPENS WHEN WE MAKE A MISTAKE?

• If entrepreneurs choose where society should commit resources, there is greater incentive to identify and correct mistakes because the entrepreneur (and the entrepreneur’s investors) directly bear the cost of mistakes.

WHAT HAPPENS WHENWE MAKE A MISTAKE?

When entrepreneurs decide where resources should be committed, the flow of resources is directed by profit and loss.

Prudent choices are rewarded with profits and profits encourage other entrepreneurs to make similarly prudent choices.

Imprudent choices are rewarded with losses and losses encourage other entrepreneurs to avoid similarly imprudent choices.

PROFIT AND LOSS

Humans are imperfectly informed and imperfectly motivated, regardless of whether they work in government or in industry. What makes a market economy allocate resources better than a command economy is that in a market economy those who make decisions must live with the consequences (both good and bad) of those decisions while in a command economy those who live with the consequences of decisions are usually not those who make the decisions.

CONCLUSION

In this unit, you learned that value is measured subjectively and that, as a result, a non-coercive transaction between two people benefits both people. You learned that profit accrues to the seller but that happiness accrues to the buyer. Because profit is easily measured while happiness is not, it appears that only the seller benefits. In fact, profit is an indicator of value provided to society.

UNIT SUMMARY

You also learned that profit serves as an incentive to encourage entrepreneurs to take prudent risks and to divert resources to prudent uses. Meanwhile, loss serves as an incentive to discourage entrepreneurs from taking imprudent risks and from diverting resources to imprudent uses.

UNIT SUMMARY

Finally, you learned that humans (whether working in government or in industry) will make mistakes. The power of a market economy is that people have incentives to identify and correct mistakes quickly. The incentives come from the fact that those who make decisions are also those who live with the consequences of those decisions.

UNIT SUMMARY

Pick two firms that produce comparable products. One firm must be a private firm (preferably one that has competitors) and the other firm must be a public firm. For example, among U.S. firms, one could pick the U.S. Postal Service and Federal Express.

For each firm, answer the following questions (in each case, report the average for the previous five years):

1. What is the firm’s annual profit?

2. How many units of product does the firm produce annually?

3. What is the typical price the firm charges?

ASSIGNMENT, PART 1

In your opinion, which firm represents a better use of society’s resources and why?

Post your thoughts onto the JPIC 220 Wiki.

ASSIGNMENT, PART 2

HOW TO POST ONTO WIKI1. Click on the Wiki discussion link above.

2. Sign into Wikispaces so that you are able to post via the “Sign In” link.

3. Type your response in the reply box at the bottom of the page.

Read the following articles, which are available on the JPIC 220 ERes site at the Gumberg Library. To access these articles, click on the links below. You may be prompted to enter a password ( JPIC ).

Akst, Daniel. "Graduates Take Heed." Wall Street Journal (Eastern Edition) 11 June 2004: W13. ProQuest. Web. 22 June 2010.

Boudreaux, Donald. “Afterward to I, Pencil.” 1999. Library of Economics and Liberty. <http://www.econlib.org/library/Essays/rdPncl2.html>.

Read, Leonard E. "I, Pencil: My Family Tree as told to Leonard E. Read." 1999. Library of Economics and Liberty. <http://www.econlib.org/library/Essays/rdPncl2.html>.

ASSIGNMENT, PART 3

A zero-sum game is an interaction in which a gain to one party equals a loss to the other party.

A positive-sum game is an interaction in which both parties gain.

Coercion occurs when someone forces another to perform (or not perform) an action. Coercion can also occur when one misrepresents reality so as to cause another to perform (or fail to perform) an action.

A private firm is a firm that is not owned by the government. Private firms are funded through private investors and profits.

UNIT 2 GLOSSARY

A public firm is a firm that is funded, at least in part, by tax revenues or whose liabilities are (either explicitly or implicitly) guaranteed by the government.

The U.S. Postal Service is a government organization that delivers mail and packages. The USPS is funded partly through user fees (e.g., postage) and partly through tax revenues.

Federal Express is a private company that delivers packages. It competes with the U.S. Postal Service (a public firm), United Parcel Service (a private firm), DHL (a private firm), and other firms.

UNIT 2 GLOSSARY