1991

Opportunity Costs, Profits and Entrepreneurship [1991 SAJE v59(1) p86]

E. C. PASOUR*(1)IN A RECENT NOTE, Afxentiou (1988) draws attention to the importance of opportunity costs in the theory of the firm. Using anequilibrium analysis, he shows that when resources are valued at their opportunity costs, any expected abnormally high rate ofreturn leads to an instantaneous appreciation of asset values so that the rate of return is brought into equality with the equilibriumrate. If the price of corn increases, for example, expected profitability of production on unusually fertile land does not increase. Thisis because the price increase will bring about an increase in land prices, so that the expected rate of return is no higher than that onland of average fertility. Afxentiou (1988:98) concludes that profits are analytically impossible as long as opportunity costs areused in appraising the performance of economic activity.The purpose of this note is to demonstrate that the use of opportunity cost in economic analysis does not necessarily imply theabsence of profit opportunities or of profits. The analysis contrasts the conventional equilibrium analysis with the entrepreneurialmarket process under real world conditions of uncertainty and imperfect information.

1. Opportunity Costs and the Zero Profit TheoremThe opportunity cost of any action represents the expected value of opportunities foregone as a result of that action. Thus, cost asit influences choice is based on the decision maker's anticipations.*(2) Economic profit, in conventional analysis, is considered tobe the return in excess of normal profits which are the returns necessary to cover opportunity costs. Therefore, economic profit inthe traditional theory of the firm is total revenue less economic (opportunity) costs (Hirshleifer, 1988:163).Conventional firm theory focuses on final equilibrium positions. This emphasis has profound implications for the analysis ofeconomic activity.

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In equilibrium, all entrepreneurial opportunities have been exploited and there are no profit opportunities.*(3) This situation ischaracterized as the zero-profit theorem which holds that in long-run competitive equilibrium there are no economic profits(Hirshleifer, 1988:203). Friedman (1976: 147) shows that this theorem holds, as in the above example of corn production onunusually fertile land, even when some firms own more productive resources. Furthermore, Afxentiou (p. 94) demonstrates thatex ante profits are zero when there are specialized assets as long as market information is transmitted accurately and speedily,even if the firm is not a price taker. That is, even if firms have monopoly power, competition results in a capitalization of returns intohigher asset values (and costs) until the expected rate of return is comparable to that of other investments of similar risk. Thus, inthe conventional equilibrium approach, ex ante or expected profits are zero. However, this is not surprising since, by definition,there are no profit opportunities in equilibrium. The key assumption in obtaining this result is that the capital market is efficient inrevaluing assets so that expected returns are equal to expected costs.

2. Uncertainty and Ex Post ProfitsKnight (1964) and Friedman (1976) demonstrate that profits arise because of uncertainty. In the Knight-Friedman approach, profitis the residual (positive or negative) accruing to the entrepreneur after paying contractual costs for hired factors and imputing areturn to the expected entrepreneurial rent (Knight, 1964:308).Consider the example of a prospective tomato producer whose estimated costs per acre, excluding entrepreneurial return, are asfollows:Expected pre-harvest contractual costs ..........................................................$2, 400Expected harvesting and marketing contractual costs ...............................$2,200Expected yield is 20,000 pounds and expected price is $.30 per pound.If costs and returns are as expected and if the imputed return to entrepreneurship were $1,400, returns ($6,000) would equal costs($6,000) and there would be no profits. This is the "normal" profit situation and under perfect competition, only normal profits areto be expected.

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Ex post, costs and returns are unlikely to match those expected, since economic conditions cannot be perfectly anticipated. Forexample, if the yield, in fact, turns out to be 25,000 pounds, ceteris paribus, profits would be $1,500, an unanticipated returnarising from uncertainty. In this Knight-Friedman approach, the anticipated return to entrepreneurship is the motivating forcebehind the firm's decision, and profit or "pure profit" is viewed purely as an ex post consequence of uncertainty (Friedman, 1976:

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future market conditions, there would be no profits and Afxentiou's conclusion follows that profits and opportunity costs areincompatible. In the Knight-Friedman approach, however, it is perfect foresight rather than the use of opportunity costs inanalysing economic activity that implies the absence of profits.

3. Profits, Losses and the Entrepreneurial Market ProcessIn the conventional equilibrium analysis, there are no profit opportunities and, consequently, no scope for entrepreneurial activity.Under real world conditions, however, markets are not in equilibrium because people are not fully informed about future events andadjustments are not instantaneous. Thus, in the changing world of reality, the lack of market co-ordination provides scope forprofit-seeking entrepreneurial activity (Kirzner, 1973). That is, profit opportunities arise because constantly changing economicdata create new discrepancies in economic co-ordination. And entrepreneurs act to exploit the perceived opportunities that arisefrom this lack of economic co-ordination.Profits and losses, as Mises emphasizes, are generated by success or failure in adjusting the course of production activities to themost urgent demands of consumers (Mises, 1974:109). After the fact, some ventures yield higher than expected returns and someyield lower, but in an uncertain world, there is no way to determine ex ante which ventures will prove successful. If theentrepreneur assesses market conditions more accurately than others, the total costs of production (when factors are valued attheir opportunity costs) may be less than the income that the entrepreneur receives - this difference is the entrepreneurial profit(Mises, 1974:109). Here the emphasis is on profit as the motivation for entrepreneurial activity. The profit-seeking decisionmaker, alert to profit opportunities, expects to obtain a higher than "normal" rate of return. The expected profit, the motivating forcein the market process, is unlikely to be equal to the returns actually

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realized because of uncertainty. This difference between the general or normal return and the actual return is profit (or loss) in theKirzner-Mises analysis (Rothbard, 1970:464).*(4) Although uncertainty is fully recognized in this approach, emphasis is placed onthe relationship between expected profits and entrepreneurial incentives (Kirzner, 1973).Profits may arise in the entrepreneurial market process analysis of economic activity when economic activity is evaluated on thebasis of opportunity costs. Indeed, if the entrepreneur is to be motivated to act, he must expect returns to exceed opportunitycosts. That is, expected returns from the decision maker's standpoint are necessarily higher than opportunity cost, the value ofthe best sacrificed alternative. Otherwise, there would be no economic incentive to engage in entrepreneurial activity. If exp ectedopportunity costs are equal to expected returns from a prospective entrepreneurial venture, only normal profits would be in storeand there would be no financial incentive to undertake that particular economic activity rather than the sacrificed alternative. Stateddifferently, the lure of normal profits provides no motivation for entrepreneurial action. It is the higher than normal expected rate ofreturn from a particular business venture that motivates the decision maker to engage in risk-taking entrepreneurial activity.Consider the above example of tomato production. A higher than prevailing rate of return yielding an entrepreneurial profit of$1,500 on the crop might arise because the entrepreneur expects product price to be $.375 rather than $.30 per pound. If theproducer's insight about tomato price proves to be correct, he would, ceteris paribus, realize a profit of $1,500. In this situation,the profit opportunity arose because the producer perceived a profit opportunity more accurately than other potential producersand reaped the advantage of the superior foresight.*(5) Entrepreneurial activity

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generally tends to eliminate such profit opportunities because factor prices will be bid up, and new entrants will be attracted untilthe expected rate of return is no higher than from other investments of comparable risk.Profit in an entrepreneurial sense is the gain derived from action. However, if entrepreneurs were to anticipate correctly the futurestate of the market there would be no profit opportunities and, consequently, neither profits nor losses. In this situation, the pricesof factors would be fully adjusted to tomorrow's product prices. In reality, entrepreneurial profits hinge on the success of thedecision maker in anticipating future conditions more correctly than other entrepreneurs (Mises, 1966:293). Here, as in theFriedman-Knight analysis, uncertainty about future demand and supply conditions is the ultimate source of profits and losses.However, there is a subtle difference between profits in the Kirzner-Mises entrepreneurial profit and loss analysis and profits in theKnight-Friedman approach. In the Knight-Friedman analysis, pure profit is an unanticipated return that has no influence onentrepreneurial activity. In the Kirzner-Mises analysis, in contrast, expected profits provide the motivation for entrepreneurship, thedriving force of the market process.

ConclusionsEntrepreneurs seek profits but the ex post result may be profits or losses, depending upon how well the future state of the market isanticipated. If all entrepreneurs were to anticipate market conditions correctly, there would be no profits (or losses). In this

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situation, profits cannot arise because any excess return leads to an increase in asset values such that the rate of return is broughtinto line with the equilibrium rate. In this sense then, as Afxentiou (1988) emphasizes, profit is a contradiction when input values arebased on opportunity costs. However, there is an unrealizable assumption in this situation - perfect foresight. In the real world,profit opportunities are created through discrepancies between expected prices and outlays and those later "fixed on the markets"(Mises, 1966:294.) Therefore, the ex ante (and ex post) rate of return can be above the going rate because markets are notperfectly co-ordinated. From the standpoint of the entrepreneur, there is no inherent contradiction between opportunity costs andprofits in real world markets where economic conditions are constantly changing.In market equilibrium, returns from any action equal opportunity cost, the value of the sacrificed alternative, and there are noprofits. It is only in equilibrium, however, that the expected return from the prospective action

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is equal to the value of the foregone opportunity. Indeed, if the anticipated value of the foregone alternative were equal to theprospective returns from an action, there would be no economic incentive to undertake that activity. It is only in "perfect markets"that profits disappear when resources are valued on the basis of opportunity costs. The conclusion is that there is noincompatibility between the use of the opportunity cost principle and the emergence of entrepreneurial profits under real worldmarket conditions characterized by uncertainty and costly information.This note does not suggest that Afxentiou's (1988) analysis of conventional micro-economic theory is incorrect. It does suggest,that the alleged incompatibility between opportunity costs and profits does not arise when the analysis focuses on theforward-looking entrepreneurial market process rather than on conditions of market equilibrium that are rooted in perfectcompetition. Indeed, there is neither profit opportunity nor reason for entrepreneurial activity in this zero profit situation. Therefore,the incompatibility of profits and opportunity costs in the conventional theory of the firm arises from the assumptions of perfectcompetition rather than from the use of opportunity costs in analysing economic activity.

ReferencesAFXENTIOU, P.C. (1988). Opportunity Costs: Some Issues. 1988 SAJE v56(1) p94.BUCHANAN, J. M. (1969). Cost and Choice. Chicago: Markham Publishing Company.FRIEDMAN, M. (1976). Price Theory. Chicago: Aldine Publishing Company.HEYNE, PAUL (1987). The Economic Way of Thinking. 5th ed. Chicago: Science Research Associates, Inc.HIRSHLEIFER, J. (1988). Price Theory and Applications, 4th ed. Englewood Cliffs, New Jersey: Prentice Hall.KNIGHT, F. (1964). Risk Uncertainty and Profit. New York: Augustus M. Kelley.KIRZNER, I.M. (1973). Competition and entrepreneurship. Chicago: University of Chicago Press.MISES, L. (1966). Human Action. 3rd ed. Chicago, Illinois: Henry Regenry Company.MISES, L. (1974). Profit and Loss, ch. 9 in Planning for Freedom. South Holland, Illinois: Libertarian Press.PASOUR, E.C., Jr. (1987). Marginal Cost Pricing: Implications for Public Utility Regu- lation, Journal of Public Finance and PublicChoice (1):45-51.ROTHBARD, M. (1970). Man, Economy and State. Los Angeles: Nash Publishing Company.SCHULTZ, T.W. (1988). Investment in Entrepreneurial Ability, Scandinavian Journal of Economics Vol. 82:437-448.

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Endnotes1 00Professor of Economics, North Carolina State University

2 Thus, opportunity cost is inherently subjective (Buchanan, 1969). This fact has profound implications for the economic analyst andfor economic regulation, but exploration of these issues is beyond the purview of this paper (Pasour, 1987).

3 The entrepreneur is seldom discussed in economic theory and there is increasing awareness that entrepreneurship is not wellhandled in conventional theory (Kirzner, 1973; Schultz, 1980)

4 Opportunity cost is based on anticipations and, therefore, necessarily forward looking (Buchanan, 1969:43). This choice-basedconception of cost has important implications for profit as it influences economic activity. Since profit is defined as expectedreturns less opportunity costs, profit as it influences firm activity also is subjective and forward looking. Thus, neither cost norprofit as they motivate entrepreneurial decisions can be measured by someone other than the decision maker because there is noway that subjective experience can be observed directly. Furthermore, this ex ante choice-influencing concept of profit may bearlittle relationship to ex post accounting measurements of profit. However, it is the ex ante rather than ex post measure of profitthat is relevant in assessing the compatibility of opportunity costs and profits.

5In some cases entrepreneurial profits result from luck rather than foresight. Such profits often are referred to as "windfalls" (Heyne,1987:233). However, all entrepreneurial activity is speculative and there is no valid way to differentiate "windfalls" from otherprofits.

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