Understanding Capitalism: Profit, Loss, and the Economic Structure of Society

[Music] Welcome to the Hillsdale College online courses podcast. I am Jeremiah Rean. And I'm Juan Davalos.

We're back to lecture two today. Profit loss and the economic structure of society. Yeah, that's right.

And in this lecture, Dr Steele talks about how the capitalist system rewards and punishes those who participate in it. And the more free, the more voluntary the society is, the clearer signals that producers can get from their consumers. Uh he he starts and this is in our trailer for the course actually.

He starts by talking about how there's this misconception that uh businesses need to give back uh and that profit is a bad thing. He says no, profit is the marker that you're doing something useful for other human beings. People are willing to part with the fruits of their labor, their money, in order to buy your good or service because they think it's going to make their life better.

That's the way they signal approval. And if you make bad decisions, if you're if you don't balance your books properly, if you don't use good suppliers, or if you make a product that people don't want, you are punished, so to speak, with loss. It's a very simple system, and the less interference in the market that there is, the clearer those signals are for producers.

It works a little bit different in the nonprofit world because for example what we do here at Hillsdale is we teach and uh that's you know teaching costs money obviously but we have a mission to teach as many Americans as we can the things that are necessary for virtue and happiness and we give it out for free. So, what Juan's saying to put a fine point on it is if you like what we're doing and want to reward us, then make a donation so we can keep doing it. And if you don't like what we're doing uh and want to punish us, then don't give us a donation.

But I ask you not to do that. Please uh listen and learn with Dr Charles Steele in lecture two of understanding capitalism, profit loss, and the economic structure of society. [Music] Welcome to lesson two of understanding capitalism.

In this lesson, we'll study interaction, cooperation, and how the capitalist system will coordinate and organize human behavior. From the outset, we'll note that there are two fundamental ways in which humans can interact. One is through what we call hegemonic bonds.

The other through contractual bonds or relationships. The hegemonic bond is hierarchical. There is one decision maker who commands or tells the others what to do.

It is a top- down system. The other is the contractual bond in which there are two decision makers equal in rights and decisions are voluntary. Each has the opportunity to make an offer and accept or reject.

The market is a metaphor for the system of voluntary and contractual relations among people. In capitalism, organization is largely voluntary without compulsion. This is the basis of production, the basis of exchange.

It's the basis of the firm, the corporation, and other voluntary organizations. Fundamental to this are property rights as the fundamental constraints. In economics, we tend to distinguish between two concepts of rights.

The first is what we call de facto rights. In fact, de facto. These are the actual abilities of individuals to use assets.

This is the key to market behavior. We distinguish that from dere rights. Those are rights in law.

rights that are protected and enforced by a third party, typically government. Capitalism works best when these two sets of rights are integrated, when they dovetail. What people actually own and control is also backed up by force of law.

These property rights are an external constraint. They're the fundamental constraint of capitalism. Of course, we could speak of a person's morals and ethics as a sort of internal constraint.

that will be reflected in his or her choices. But protected private property rights are the fundamental external check on behavior. Why do property rights matter so much?

Well, property rights means that exchanges of property, including labor, will be mutually voluntary. We're constrained by each other's rights. We cannot simply command one another.

Exchange is always two-party. Voluntary trade means that each party is free to accept or reject the offer made by the other. A person will accept a trade or an exchange only if he thinks it makes him better off as he sees it.

Therefore, under voluntary exchange, both parties benefit. Now, true, people can make mistakes, but in general, we learn and we act to make ourselves better off because it's in our interest to do so. Now contrast this with the involuntary exchange, the hegemonic relationship.

In this case, there is nothing to make a systematic tendency for mutual gain. To the contrary, such exchanges can easily be what economists call zero sum, where one person's gain is another's loss. These can even be destructive where a small gain by one party forcing the exchange is accompanied by severe losses and harm on the others.

Let me give an example. Let's go back to our story of the running shoes and the money. Suppose that I have $100 and someone has a set of new running shoes for sale.

If I decide that I value the shoes more than the money, I'll make the offer. If this person values the money more than the shoes, they'll accept it. We make a mutually beneficial exchange.

Both are better off in our own eyes. On the other hand, it's possible that we could have a zero sum transaction. I could simply decide that I want the shoes, I take them.

The other party's loss of the shoes is my gain. Even worse, this could be a destructive exchange. I might go up to the window of the running shoe store, smash the window, grab the shoes, and have done much more damage.

It could be destructive. Now, of course, involuntary exchanges could be mutually beneficial. So, for example, taxation is an involuntary exchange in which the taxpayer is compelled to give up funds in return for government services.

These services might consist of things like police protection or national defense. These might make the taxpayer better off, but there's nothing systematic to ensure this. Government officials might as easily spend on things contrary to the taxpayers's interest and well-being.

Yet, the taxpayer cannot simply refuse the exchange. The capitalist system based in private property rights is a system of voluntary exchange. And this is a fundamental reason why the system makes people better off.

It is why capitalist societies are more prosperous with higher living standards than alternative systems. Now a critic might object. Are these truly voluntary exchanges?

What about a person who is compelled by his needs to work? For example, a laborer who takes a job because he needs to eat. Isn't that an involuntary exchange?

Well, notice that this is a very different definition of involuntary and compulsion. Compulsion properly refers to human relations to one person or one group forcing others to be a party to an exchange against their will. The objection that has just been made here refers instead to scarcity and the limits of reality.

Only in a hypothetical utopia where all imaginable needs are costlessly met for everyone, where every need is satisfied without work or effort, could the standard posed by that challenge be satisfied. And that's not our world. Voluntary and involuntary refer to relationships among human beings, whether both parties agree to an exchange or whether one uses force to impose his will on the other.

What about error? This is a second objection one might make to the claim that voluntary trade is mutually beneficial. If people make mistakes, might not voluntary exchanges prove to not be mutually beneficial?

Well, that can be true. We do make mistakes and we can suffer regret. However, man's self-interest, his reason, and his ability to learn will tend to direct him away from mistakes.

But that raises another interesting point. People do make mistakes. We're not perfect in our judgment and knowledge.

So what does this imply? Under the capitalist system, this triggers a set of events that will tend to correct mistakes. As we shall see when we discuss the roles of profit, loss, and entrepreneurship.

Now, human cooperation, we know, is necessary for men to flourish. This is a part of man's nature. We are social beings.

But how is this cooperation coordinated in a system of voluntary relations? Under capitalism, we often say that our actions are coordinated by the free market and prices. The free market is a metaphor for individuals who are free to organize their activities on a mutually voluntary basis as they choose, including production and trade.

They agree on rates of exchange of goods and services usually expressed in terms of money. These are what we call prices. Prices are the ratios at which people agree to exchange in terms of money.

These ratios are important signals of the relative values different people place on goods and services. They coordinate our interactions and our behavior. Well, how do prices coordinate?

Let's imagine for a moment a purely hypothetical imaginary world where everyone's activities are perfectly coordinated. Each of us has correctly anticipated what everyone else is doing. In such a world, prices perfectly reflect the values that each person places on different goods and services.

We economists call that hypothetical situation a state of equilibrium. And it is a very useful model or tool for studying economic questions. But it fails to answer what happens in a capitalist market economy when people have failed to correctly anticipate others actions.

When they make errors and when they engage in exchanges they later regret or they fail to grasp opportunities they later wish they had pursued. That is to say, what happens in our world, not the hypothetical world of equilibrium. As the great economist Joseph Schumpeter observed, studying equilibrium misses the most important feature of capitalism, its dynamism, entrepreneurship.

It also misses the meaning of entrepreneurial profit and loss and the pricing process. Incomplete knowledge and uncertainty is always present for each of us. We make mistakes.

It's part of the human condition. It's part of our nature that our knowledge is limited. When we act, we act to make our future better, but we do so under uncertainty.

The future is not known. We do not have complete understanding of cause and effect relations in the world, and we don't know for certain everything that others will do, and we don't know all the opportunities that might in principle be available. Well, if that's true for us, it is certainly true for entrepreneurs in the commercial realm.

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In economics, we often say that prices are important information signals, but it's quite subtle what this actually means. What is important is the pricing process. and how this process guides our actions and how this drives the capitalist system to create more wealth to generate systematic economic growth.

So understanding it is essential for understanding the nature of entrepreneurial profit and loss and their vital social meanings and importance. So how does entrepreneurship work? It's not enough to simply say supply and demand determine price.

We need to explain how human action generates these prices and then is guided by them. Suppose you enter a supermarket, for example, and you observe a price label for a can of soup, let's say $2. That is not actually a price.

It's an offer by the store to sell at a certain ratio of dollars per can. The offer becomes a price only if someone accepts the offer. If no one accepts the offer or if insufficient numbers of people do so, the store will need to reconsider its offer.

Reducing what it requests until it can move its inventory. Conversely, if the offer results in the shelves being quickly cleared out, the store owner may realize his offer was unnecessarily low. Entrepreneurship is the discovery and pursuit of previous mistakes and previously untapped opportunities.

So imagine an individual who notices a disequilibrium that is unmet needs or resources that are being mismployed creating less value than they might or perhaps some opportunity that others are missing. This individual has spotted an opportunity for entrepreneurship. For example, a person sees agricultural land and labor being used to produce grain.

The price of grain is low, but those same resources could be devoted to the production of another good, for example, wool. This person observes that those factors are creating low value in grain production, but he could buy them cheaply and switch them to raising sheep for wool, which he thinks will command a higher price. In doing so, he'll make a profit.

So, the entrepreneur bids the land and labor away from grain production. And if his judgment is correct, he earns a profit. But notice what else he has done.

He's taken resources that were creating little value and used them to create a lot more value. Those resources that were undermployed were in a sense wasted. He has reduced waste and in doing so he has made consumers, buyers better off by meeting their more highly valued needs.

Now, of course, this requires a kind of foresight. The entrepreneur does not know with certainty what the future prices will be. His estimates are forecasts of future demand and prices.

He appraises resources or factors of production, estimating what he can do with them and what they will bring in the future. If a project appears profitable, he'll bid resources away from other uses. Of course, expectations for the future are uncertain.

The entrepreneur could be right, in which case he earns profit, the difference between what it cost and the value of his revenue. But he could be wrong, overly optimistic, and the goods and services he provides will bring less than the factors he used to make them. He takes losses.

His production is in the eyes of consumers and customers less valuable than the factors he uses to make them. He has made an error. Well, he'll correct it or he will go bankrupt.

He cannot sustain losses forever. Thus, note the social role of profit and loss. The potential for profit leads entrepreneurs to seek out unmet needs, misallocated resources, new ways of combining resources to meet needs, invention and innovation.

If the entrepreneurs expectations and appraisements are correct, he earns profit. That's the difference between cost and revenue, a reward that benefits him, but also he benefits consumers and other buyers whose needs are now better met. Profit actually signals mutual gain, a win-win situation.

It is in fact beneficial to consumers when firms are profitable. It indicates success at putting factors of production to better uses and the creation of value in the economy. Conversely, if the entrepreneur proves to be wrong, he or his firm take losses.

This shuts down mistaken lines of production. It's a signal that resources are creating less value than the entrepreneur started with. Loss informs him and signals him to change course.

Capital markets, labor markets, and markets for resources and production goods facilitate this. So, let's think further about how this pricing process works. Suppose there's a set of resources, potential inputs into a production process.

I contemplate them and I estimate I can produce a set of goods that will sell for say $1 million. You, on the other hand, have a project that you estimate can produce $1. 5 million worth of goods.

In this case, you will bid those resources away from me because you've noticed or created a more valuable employment for them. In this way, in the capitalist system, factors will tend to flow to the uses that create the most value for consumers and they will tend to go to the people who can create the most with them. This explains the dynamism of the capitalist system and why it produces more for everyone than any alternative.

This explains systematic economic growth. Contrast this with an alternative. Sometimes it is said that a government agency can provide goods more cheaply because it doesn't have to make a profit.

For example, this is sometimes said about health insurance. Well, this is a false idea and a confusion. Profit comes from creating goods and services that are more valuable than it costs to make them.

It isn't an extra cost that is tacked on to price. To the contrary, government enterprises run by bureaucrats and administrative agencies do not have profit signals to encourage value creation, nor do they have loss signals to shut down wasteful lines of activity. Government projects typically are funded by taxes and they continue whether they create value or not.

If they run over budget, it's a call for greater appropriation in future budgets. Private enterprise and entrepreneurship in the market system are the things that make capitalism so productive. Let's note one other feature.

In several important ways, capitalist system is a moral system. It has embedded in it a particular ethic. First, as we've seen, it is built on individual rights.

Relations are contractual. They're voluntary. No one is compelled to give up their property.

These exchanges are voluntary. So each individual has been left free to pursue his best interest to flourish as he understands it. That freedom is a moral principle.

Now of course this does not require or assume selfishness in the sense of only caring for oneself. As Aristotle points out, ownership of private property enables one of the greatest pleasures available. that of voluntary sharing with others.

And this is far easier to do and more common in a society with a growing economy than in one with a poor or stagnating economy. We'll explore this further in a later lesson. Second, let's briefly note that entrepreneurial profit is earned in an important sense.

The person who engages in successful entrepreneurship has discovered or invented a way to create more value. Profit is an incentive and a signal, but it is also a justly acquired reward paid voluntarily by buyers. The economist Israel Kursner has called this the finders keepers ethic.

Hence, we see entrepreneurial profit is beneficial from the standpoint of the consumer and morally justifiable. This is key to understanding why capitalism generates such prosperity. In our next lesson, you'll see in more detail why organizing society and commerce in this way leads to creation of value far exceeding alternative systems.

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