Economic Piece by Josh L. Ascough
Most mainstream presentations of the market economy place a focus on the incentive effects of profit and loss; known as the profit incentive. While it is undeniable, that profits incentivise market activity towards making good decisions about the allocation of resources, it is far too narrow a lane for looking at profits and the price mechanism.
Profits and prices are not a key function of the market economy for the incentives alone; these factors of the market economy have an epistemological nature to them; not just for the short term, current consumption and production, but in future consumption and interest too.
Information and knowledge are not centrally organised and distributed goods. To assume such a state would be to assume it possible for human beings to be omniscient; to hold perfect information for any given time period, and a state of perfect equilibrium. If we look at the Austrian understanding of the market process and the entrepreneur, this gives us a clear insight into the Subjectivist theory; this includes the standard of value being subjective, but also the step prior to the arrival of value, that being information. The profit and loss network works in a similar way, as described by Professor Steve Horwitz:
“Profit and loss are like the pleasure and pain signals sent by our nerve endings. If we didn’t feel the pain of our hand on a hot stove, we wouldn’t know that we were burning ourselves.” (Horwitz, Austrian Economics, pp. 49-50).
Without the price mechanism, we would hold no means of understanding the relative scarcity of goods and services, and have no methodology of passing on information in terms of where supply is needed; whether it is needed, and neither for passing information about where demand is; if it exists, for the particular final consumption good, or the capital goods of higher order.
To get back to the entrepreneur, The Austrian school of Economics places a high emphasis on the role of the entrepreneur, as well as the entrepreneurial process in the confines of the subjectivist theory.
The Misesian approach to the entrepreneurial process and how it relates to the theory of subjectivism, is that at any time market forces can face an absence of information (not knowing what we don’t know), and that this creates a disequilibrium. This mutual ignorance between buyers and sellers creates opportunities for the entrepreneur to acquire pure profit. If ‘A’ is selling oranges for $6 a bag, yet I value the oranges at no higher than $4 and I am subject to an absence of information because I do not know of ‘B’, who is selling oranges for $2 a bag, the entrepreneur has an opportunity for pure profit and to eliminate this absence of information. If he himself as an external observer is aware of the opportunity, he will buy oranges from ‘B’ for $2 a bag and sell to me in the middle for $3 a bag.
There is also the possibility that my ignorance is not an absence of information, but a matter of rational ignorance, or optimal ignorance. Suppose I am aware that I can acquire oranges from ‘B’, but the cost of transportation I deem as too great, or the time to get to seller ‘B’ does not fit within my time preference of having the oranges for current consumption. I have made a rational decision to remain ignorant.
If the entrepreneur has accurately perceived the information that I was ignorant of, then, ceteris paribus, that knowledge will be transferred to the market; informing consumers of an alternative choice they were absent of knowing, and competitors of the missed opportunity for profit. As explained by Jesus Huerta de Soto:
“The entrepreneurial creation of information implies its transmission in the market. Indeed to transmit something to someone is to cause that person to generate in their own mind part of the information which other people have created or discovered beforehand.” (de Soto, The Austrian School, p. 22).
These unnoticed opportunities play a key role in the economic world, because as stated, knowledge and information are not, and cannot be a centralised body, because at no time can one person or everybody know everything; such an approach would render knowledge and information; as translated into prices and profits, as static.
On the subject of interest, the time preference of consumers provides signals of information to the entrepreneur in terms of whether people hold a need-want for current consumption, or future consumption. The lower interest rates (due to real savings, not the artificial decrease by central banks), gives a means of knowledge to the entrepreneur that it is more profitable to create a future alternative to what is currently provided on the market, or to develop a new area of the market which had unexplored opportunities for pure profit, due to a previous absence of information, or optimal ignorance on the part of buyers and sellers. As Professor Israel Kirzner notes:
“Ever since Bohm-Bawerk, Austrian capital-and-interest theory has revolved around the concept of “roundaboutness.” This insight-that production takes time-focusses attention on intertemporal allocation of resources, on intertemporal rates of exchange, and on the structure over time of the stock of capital in the economy. Because the passage of time permits us to witness the successive initiation of time-consuming processes of production (and their subsequent successive completion), a cross-section of production activities at a given date will reveal a wide array of processes of production arrested at different stages towards completion, embodying stocks of resources invested already for a wide array of lengths of past time.” (Kirzner, Austrian Subjectivism and the Emergence of Entrepreneurship Theory, p. 112).
What happens when there are political forces which alter these signals? If an intervention of price controls or a “cap” on profits is brought into effect, then not only does this effect the incentives, but it skews the information being sent to market participants by giving false signals as to the quantity available to consumers, and to the profit seeker, as to how accurate he is interpreting knowledge and information. As Mises noted in his book Liberalism:
“But once the supplies already on hand at the moment of the government’s intervention are exhausted, an incomparably more difficult problem arises. Since production is no longer profitable if the goods are to be sold at the price fixed by the government, it will be reduced or entirely suspended. If the government wishes to have production continue, it must compel the manufacturers to produce, and, to this end, it must also fix the prices of raw materials and half-finished goods and the wages of labor.” (Mises, Liberalism, p. 52).
As further controls are put in place, additional inaccurate signals of information are sent out to market participants, to which we are then left in a situation where we not only have an absence of information, but the information we are aware of is false, and so we are operating under an absence of efficiently perceived information; a blindness of externally imposed ignorance. These interventions stifle knowledge, and holt the movements of information; creating an institutional blockage of information.
This makes the existence of a government bailout much more onerous than simply creating bad incentives for a failed business or bank; it is a punishment of consumers, for the business’s or bank’s failure to accurately interpret market activity.
The entrepreneurial process, prices, and profits are seldom irrational. They are epistemic; a means of acquiring knowledge about the value judgements and time preferences of our fellow man. They provide signals of information; if a man makes a profit he has been informed that he perceived the information accordingly, if he makes a loss he recognizes he misread said signals and miscalculated, or misinterpreted the information (or lack thereof) he had available. Any and all regulations, controls and artificial changes of these areas by government, merely obstruct our ability to utilise market signals efficiently; usually at great peril.
- Steve Horwitz: Austrian Economics: Capital and Calculation (pp. 49-50).
- Israel Kirzner: Austrian Subjectivism and the Emergence of Entrepreneurship Theory: The Modern Austrian Subjectivism (p55).
- Steve Horwitz: Austrian Economics: Market Process and Spontaneous Order (p. 23-24).
- Jesus Huerta de Soto: The Austrian School: Knowledge and Entrepreneurship (p. 22).
- Israel Kirzner: Austrian Subjectivism and the Emergence of Entrepreneurship Theory: Capital and Interest Theory (p. 112).
- Ludwig Von Mises: Liberalism: Liberal Economic Policy (p. 52).