• The term "profit" has been used with a variety of different meanings.

  • The most common definition is total revenue minus total cost.

  • A synonym would be net revenue.

Incomes established in advance by contract

• Wage is the payment to people for their labor service, established by a contractual agreement.

  • No one would say a worker's wage is also profit.

  • A great deal of uncertainty has been removed by this contractual agreement.

  • The same holds true for rent and interest.

• Wage, rent, and interest are three important forms of earned income in a market economy.

  • They represent a price: wage rate is the price for labor services, rental rate for rental property, and interest rate for credit.

Profit: income that can be positive or negative

• Profit is the fourth form of earned income in a market economy.

  • It's the residual between revenues and costs.

• A negative profit is a loss.

• Unlike the wage earned, the entrepreneur seeking profits can never be sure that their efforts will be profitable.

  • The search for profit means accepting greater uncertainty.

Calculating profit: what should be included in costs?

• Recall that cost means the next-best forgone opportunity.

  • Monetary expenses do not capture the total costs of production.

• Part of the cost of doing business is the owner's own labor cost.

  • Owners sacrifice the next-best job opportunity to be their own boss.

  • That forgone wage might not appear on a ledger, but it will remain in mind and influence choices.

• The issue is, then, what shall be included in the total costs of production?

  • Accountants measure the explicit costs of production.

  • In the economic way of thinking, expenses don't capture total costs of production.

• The expected amount of residual influences entrepreneurial decisions.

  • Example in the book: Ann Trepreneur, secretary to a pizzeria.

Uncertainty: a necessary condition for profit

• Business decisions are influenced by the presence (or absence) of economic profit.

• Profits exist, and continue to exist, without being reduced to zero by competition, because of uncertainty.

  • If there was a way for a firm to get into a line of business that guaranteed profits, wouldn't so many people move into that line of business that competition would reduce the profit to zero?

  • People see profits being made, but aren't sure how to cut into those profits.

  • In a world of scarce information, the existence of such profits might not even be widely known.

• Nominal wages, rents or interest will never be negative as long as they live up to their contracts.

  • But an entrepreneur's profit can be negative, even if all contracts have been met.

• Profit or loss is the consequence of uncertainty.

The entrepreneur

• But earning profits is not simple speculation, people don't just sit around and bet on the outcome of other people's activity.

  • They try to organize things differently.

• Their incentive is the belief that a particular reorganization will return revenues greater than its cost.

  • The term for such people is entrepreneur.

  • The English equivalent is undertaker.

  • Entrepreneurs are people who undertake to reorganize a segment of the social world

• They accept the responsibility for the outcome, they say "I'll take the profit or loss."

• Entrepreneurs claim the residual, what is left after all prior agreements have been honored.

• What Adam Smith called a commercial society, and what other people misleadingly call a capitalist society, can be referred to as an enterprise society.

• If you want to be the boss, you have to be the residual claimant.

• Residual claimants are crucial actors in any society characterized by extensive specialization and exchange.

  • Example: long lines at post offices but not at grocery supermarkets, because of the influence of residual claimants.

Entrepreneurship and the Market Process

• Entrepreneurial activity is the driving force within market processes.

  • It takes three forms: arbitrage, innovation, and imitation.

  • It tends to correct for errors in the market process.

• Arbitrage: buy goods at a low price and sell them at a higher price.

  • Example: syrup in New Jersey and Vermont.

    • Price differentials are sign of genuine errors being made by buyers and sellers.

    • Entrepreneurs find opportunities and fix these errors.

  • The unintended consequence is that it generates useful information and furthers plan coordination.

  • Entrepreneurial arbitrage further integrates local markets into a national market, the converging of market prices.

  • It tends to reallocate goods, shifting them from lower-valued uses to higher-valued uses.

• Innovation: always on the lookout for better ways to satisfy consumer demand.

  • In the search for economic profit, entrepreneurs seek less costly ways of combining scarce resources into something valued more highly by consumers.

• Entrepreneurs engage in the imitation of previous trailblazing entrepreneurs.

The role of monetary calculation

• Markets create information.

  • Market prices are key to estimating whether a particular business endeavor will combine scarce resources in a more efficient and profitable manner.

• The everyday entrepreneur’s calculation of expected profit provides useful information to decide whether or not to engage in arbitrage or launch a new enterprise.

  • The entrepreneur’s realized profit or loss will further inform about the accuracy of entrepreneurial foresight.

  • Calculation in the market process helps people discover what consumers want.

Beware of experts

• The key to an efficient market process is open entry and exit.

  • Comparative advantage can and often does change over time.

• Governments, nor anyone else, can decide who successful entrepreneurs will be.

  • Open entry allows claims to be tested. It allows potential pioneers to test the judgments of previous pioneers and other authorities.

• Entrepreneurship is society’s source of change.

  • Entrepreneurs are the people who perceive gaps between what is and what might be, and opportunities to profit from closing those gaps.

• Closed markets stifle competition.

Entrepreneurial speculation

• Speculators even out the flow of commodities into consumption and diminish price fluctuations over time.

  • Example: if corn will be scarce in the future, speculators will store some now to save later.

  • Grain speculators, Smith argued, reduce the suffering that poor harvests cause by inducing consumers to start economizing early.

• Futures markets allow people to allocate their risks and deal with uncertainty as they best see fit.

• Professional speculators are our distant early warning system.

  • They help us to hedge (an investment to counter or minimize the risk of adverse price movements in an asset or security).

• While middlemen tend to coordinate market exchanges across regions, speculators tend to coordinate market exchanges through time.

Summary

The summary available in the book:

• Profit is defined as total revenue minus total cost. Accounting profit includes only the explicit costs (such as expenses) when determining total cost. Economic profit can be usefully defined as total revenue minus total cost if we include all opportunity costs in our calculation of total cost.

• Profit arises from uncertainty. In the absence of uncertainty, any differences between expected total revenue and expected total cost would be competed away, and profits would become zero.

• The possibility of an economic profit encourages entrepreneurial activity. Entrepreneurs undertake to reorganize some part of the social world in the belief that the reorganization will create benefits greater than its costs. The entrepreneur’s profit is the residual: whatever is left over after paying all those whose cooperation had to be secured in order to complete the entrepreneur’s project. The system of residual claimancy facilitates social cooperation by enabling people to agree among themselves on who will take responsibility for each aspect of a common project.

• A system of private property rights, market exchange, and money gives rise to monetary calculation: the ability to use market prices as signals to evaluate the potential profitability of one’s actions. It allows entrepreneurs to calculate the expected effects of their decisions.

• Entrepreneurship itself takes three forms: arbitrage, innovation, and imitation. Entrepreneurial innovation and imitation are essentially sophisticated versions of arbitrage: attempts to buy scarce resources at a perceived low price and recombine and sell them at a perceived higher price.

• The entrepreneur’s profits tend to disappear when “the truth gets out.” Once the entrepreneur’s activity has shown how a profit can be made, the revenue available to the entrepreneur or any imitator will decline. If scarcity of a key resource prevents others from imitating the entrepreneur, competition for that resource will raise its price until expected total cost equals expected total revenue.

• Uncertainty is a fact of life. Everyone who makes a decision in the absence of complete information about the future consequences of all available opportunities is a speculator. So everyone is a “speculator” in a world of uncertainty.

• Professional speculators—those who feel they have a comparative advantage in taking risks—coordinate markets through time.

• Futures markets provide people the opportunity to allocate their exposure to risk. Hedgers reduce their exposure by entering into a futures contract with speculators, who seek to increase their exposure to risk.

• People who think they know more than others about the relationship between present and future scarcities will want to buy in one time period for sale in the other. If they are correct, they will make a profit on their superior insight, and also transport goods through time from periods of lesser to periods of greater scarcity. If they’re wrong in their predictions, they will perversely move goods from periods of greater to periods of lesser scarcity and suffer the penalty of a personal loss on their transactions.