THE “CHARACTER” OF PROFIT AND LOSS:

ENTREPRENEURIAL VIRTUES

JUAN PABLO COUYOUMDJIANESCUELA DEL GOBIERNO

UDD (SANTIAGO DE CHILE)

MICHAEL C. MUNGERPPE PROGRAM

DUKE UNIVERSITY

CICERO, DE OFFICIIS (BOOK III, CHAPTER 15)

Quintus Scaevola, the son of Publius, when he asked to have the price of an estate that he was buying named once for all, and the seller had complied with his request, said that he thought it worth more, and added a hundred thousand sesterces. There is no one who would say that this was not the act of a good man; but men in general would not regard it as the act of a wise man, any more than if he had sold an estate for less than it would bring. This, then, is the mischievous doctrine, — regarding some men as good, others as wise…

TWO ARISTOTELIAN/THOMISTIC CONCEPTSVirtue--a habit of right action, cultivated as an intentional product of reasoned reflection, in a social setting. Right action balances between vices, which are deficiencies or excesses of the particular virtue. (Liberality is a virtue, lying between parsimony and prodigality).

Character--a collection of traits of a person, both in terms of visible actions and the internal motivations that cause those actions. Character results from the repetition of choices in a variety of settings, as a product of right reason. Virtues are individual habits of right action; character is the overall set of virtues and vices exhibited by a person.

STANDARD STORY

• Mandeville: Private Vices, Publick Benefits• So, entrepreneurs (for example) are vicious (act out of the

vice of self-interest), but we should allow the vice because of the good consequences market action can have for the public good

TWO KINDS OF “ENTREPS ARE VICIOUS” ARGUMENTS

1. Intent--Entrepreneurs act out of self-interest. To be sure, profit-seeking might in principle have good consequences, but these are incidental to the narrow selfishness of the pursuit itself. Virtue as a character trait is a habit of right action, cultivated as an intentional product of reason. To be good, on this account, a person must intend good, rather than produce material benefits as a side-effect. Not harmful, but not virtuous. At best, following Aquinas, something to be tolerated, even promoted, but not virtuous. (Thanks to Dr. Karen Vaughn)

TWO KINDS OF “ENTREPS ARE VICIOUS” ARGUMENTS2. Exploitation--Profits are per se exploitative and illegitimate. The successful entrepreneur, judged on the merits of commercial activity, must earn positive profits. But then only an unsuccessful entrepreneur could possibly be innocent of exploitation. If virtues are features of excellence in character, this implies a contradiction: One could be an excellent entrepreneur, and make profits, or one could be virtuous, and go bankrupt, but never both.

ENTREPRENEURSHIP

Israel Kirzner (distinguished for me by Boettke): (1)Optimization: Convergence toward (though never fully achieving) a “single price.” Arbitrage. (2) Alertness: “Seeing around corners”

Alertness and profit-seeking is a discovery process, but at a higher level than prices. Prices work out the value of existing resources; profits reveal the values of products/resources that exist only in the imagination of the entrepreneur.

STEVE JOBS

“You can't just ask customers what they want and then try to give that to them. By the time you get it built, they'll want something new.” (Inc., 1989).

“But in the end, for something this complicated, it's really hard to design products by focus groups. A lot of times, people don't know what they want until you show it to them.” (Business Week, 1998).

PROFIT

• Distinguish “profit” and “rent-seeking” (Profits: mutual benefit; rents are transfers; rent-seeking is

resources consumed in securing transfers…)• Both result in accounting profits. But the underlying action

depends on whether you hire more engineers, or more lobbyists!• If exchange is (eu)voluntary, and the person making the exchanges earns part of the surplus, and that is intentional, the result is mutual benefit.

Profits and Rent-SeekingProfits: The excess of revenues from selling a product after costs are subtracted. If the exchange is voluntary, each person buying the product must think s/he is better off. Entrepreneurs seek profits, and therefore try to create value.Rent-seeking: A competition for an artificial prize or benefit created either by (a) taking money from taxpayers and trying to "give it away" or (b) a restriction on competition that allows an artificial increase in prices for products sold. Political entrepreneurs seek rents. No value is created.

“THEOREM”

If part:

Exchanges are euvoluntary

Profits are the excess of revenues over costs in a market without artificial constraints

Then part:

Entrepreneurship is always virtuous. It is the habit of alert seeking of exchange opportunities, embedded in a character of forbearance of rent-seeking opportunities.

How Do Markets Choose?How Do Polities Choose?

In economics, things happen at the margin. The majority is always wrong. (JK Galbraith)

What does that mean? Consider three mechanisms for motivating and choosing…Markets: Profit TestRent-seeking: Rent/Subsidy TestPolitics: Appeal to the Median Voter

Markets “Choose” Using Price• Signals, information about scarcity• Incentives, when combined with private ownership• Absence of price system/information is a big reason

that "real" socialism has always failed, everywhere it has been tried.

• Conversely, even welfare states can be fairly successful, if they rely on theprice system. They use prices and private property for production, and then have a welfare state system financed by taxes. Relatively little public ownership of production in Norway, Finland, Denmark, Sweden (Volvo, Ericsson, Nokia)

Three Stories: Profits and Virtue?

• The Itinerant Padre• The Verger• The Mancgere

The Itinerant Padre

The Verger

The Mancgere

The Mancgere

The roots of the English word “monger,” a common merchant or seller of items are quite old. In Saxon writings of the 11th century, described in Sharon Turner’s magisterial three-volume History of the Anglo-Saxons (1836), we find a very striking passage where a merchant (mancgere) defends himself on moral grounds.

The Mancgere“I say that I am useful to the king, and to ealdormen, and to the rich,

and to all people. I ascend my ship with my merchandise, and sail over the sea-like places, and sell my things, and buy dear things which are not produced in this land, and I bring them to you here with great danger over the sea; and sometimes I suffer shipwreck, with the loss of all my things, scarcely escaping myself.”

“What things do you bring to us?”“Skins, silks, costly gems, and gold; various garments, pigment, wine,

oil, ivory, and orichalcus, copper, and tin, silver, glass, & suchlike.”“Will you sell your things here as you brought them here?”“I will not, because what would my labour benenfit me? I will sell

them dearer here than I bought them there, that I may get some profit, to feed me, my wife, and children.”

EntrepreneurshipWhat is an entrepreneur? “A person who organizes and operates a business or businesses, taking on financial risk to do so.” What is a political entrepreneur? A political entrepreneur uses government funds in business, which greatly reduces any financial risks to the “entrepreneur.”So, an entrepreneur might make iPods, selling a product to consumers for full price. A political entrepreneur might make solar panels, in effect “selling” the product to the government, because of the subsidies. The whole point of the subsidies is that—without the bump from taxpayers, at gunpoint—nobody would buy the product. Not only do political entrepreneurs lobby to receive federal funds, they often work to pass laws that hinder their competitors. Thus, political entrepreneurs, one could argue, are really not entrepreneurs at all. In most respects, they resemble government bureaucrats. Their “research and development” teams aren’t scientists, but lobbyists.

Profits and Rent-Seeking

Market entrepreneurs are those who build their businesses with private funds, using either their own money or funds from investors. They succeed by giving the public useful goods or services at a good price. They hire engineers and salespeople, to sell to people.Political entrepreneurs, on the other hand, lobby government officials to award federal funds to their business enterprises. They hire lobbyists, to sell to Congress.Which group benefits society the most?

In the early 1800s, the great technological innovation of the day was the steamship. First working steamship was…built by John Fitch, in 1787. He got a patent in 1790.http://vimeo.com/48744782#You have likely learned it was Robert Fulton. Fulton's boat was the first commercially successful steamship. In 1807, Fulton and some investors built the first commercial steamboat, the North River Steamboat (later known as the Clermont), which carried passengers between New York City and Albany, New York. The Clermont was able to make the 150 mile trip in 32 hours. This compared favorably to 2 days by horse-drawn coach, because the steamship could also carry a large amount of heavy cargo.

Robert Fulton--entrepreneur when he used steam power to provide quick/cheap transport. But he became a political entrepreneur when he got a monopoly from NY legislature to carry all steamboat traffic in NY thirty years.Fulton insisted that his monopoly meant that no one else could ferry passengers to New York City from neighboring states, but an enterprising businessman named Thomas Gibbons wanted to break Fulton’s monopoly. In 1817 Gibbons hired young Cornelius Vanderbilt to run steamboats between Elizabeth, New Jersey and New York City. On the mast of Gibbons’ ship, Vanderbilt hoisted a flag that read: “New Jersey must be free.” For 2 months, Vanderbilt defied capture as he speedily transported passengers and lowered fares. Too fast!

The actions of Gibbons and Vanderbilt led to the landmark Supreme Court case Gibbons v. Ogden (1824), in which the Supreme Court struck down the Fulton monopoly: Only the federal government, not the states, could regulate interstate commerce.

Cornelius Vanderbilt went on to develop his wn steamship company, and once again, he had to compete against a government subsidized political entrepreneur, Edward Collins. Collins’ company eventually went bankrupt, after wasting millions of tax-payer dollars. Vanderbilt’s line proved to be faster, safer, and much cheaper for consumers. Once again, the government had tried to pick a winner in a new business enterprise and had failed. Vanderbilt is the classic example of an entrepreneur, a market entrepreneur.

The career of Cornelius Vanderbilt shows us what to expect from market entrepreneurs. He was born on Staten Island, New York, in 1794. His great-great-grandfather had immigrated in 1650 as an indentured servant, and by the time Cornelius was born the family operated a ferry in New York Harbor. Cornelius quit school at age 11 to work on his father’s boats and began his own ferry service five years later. In 1817 Thomas Gibbons hired him to run a ferry between New Jersey and New York City.

Profits and Rent-SeekingProfits: The excess of revenues from selling a product after costs are subtracted. If the exchange is voluntary, each person buying the product must think s/he is better off. Entrepreneurs seek profits, and therefore try to create value. (Vanderbilt)Rent-seeking: A competition for an artificial prize or benefit created either by (a) taking money from taxpayers and trying to "give it away" or (b) a restriction on competition that allows an artificial increase in prices for products sold. Political entrepreneurs seek rents. No value is created. (Fulton)

"PROFIT TEST"

• Are more people willing to pay, a sufficient amount, to cover the costs of production and distribution?

• Is this a "good" thing? Consider the….

The All-Time Greatest Product!

• The. Pet. Rock.

Gary Dahl: Pets are too much work. So Pet Rocks (1975) were ordinary gray stones bought at a builder's supply store. They were marketed like live pets, in custom cardboard boxes, complete with straw and breathing holes for the "animal." The fad lasted about six months, ending after a short increase in sales during the Christmas season of December 1975. Although by Feb 1976 they were discounted due to lower sales, Dahl sold 1.5 million Pet Rocks and became a millionaire.

A thirty-two page official training manual titled The Care and Training of Your Pet Rock was included, with instructions on how to properly raise and care for one's new Pet Rock (notably lacking instructions for feeding, bathing, etc.). The instruction manual was the real product: it was full of gags, puns and jokes. It contained several commands that could be taught to the new pet. While "sit" and "stay" were effortless to accomplish, "roll over" usually required a little extra help from the trainer. "Come," "stand" and "shake hands" were found to be near-impossible to teach, but "attack" was easy: Throw it hard.

The owners also found that potty-training their pet rocks was fairly simple, given that they were, in fact, rocks. Dahl's biggest expense was the die-cutting and manufacture of the boxes. The rocks only cost a penny each, and the straw was nearly free. For the initial run of booklets, Dahl had a printing job for a client and "tacked" the pet rock booklet onto the main job. This resulted in a batch requiring only a cut and trim, at almost no cost except some labor.Dahl made a small fortune. But a lot of people sued him for "patent infringement" or stealing their idea.

Seriously.

2001 Update: Handy USB, Added Functionality

How do Decide?

• If firms have to make positive net revenues, after costs, or "profits"…

• What do politicians or political choices need?• The middle, but a particular kind of "middle."• The mean, or average?• The mode?• The median?THE MEDIAN

In the late 1950s, MITI (the Japanese Ministry of International Trade and Industry) decided to rationalize and streamline the Japanese automobile industry. The goal was to realize economies of scale in design and production, and increase the number of cars that Japanese companies would export to the U.S. and elsewhere.

It was decided that just two auto companies (Toyota and Nissan) would get government financial support. All other companies were told that they should direct their energies to motorcycles, or blenders, or perhaps those new televisions. Costs would fall as each company produced more cars. The logic was undeniable: fewer producers, lower costs.

But there was one strange loner, named Soichiro. He was an odd prickly person, and wouldn't listen to MITI, or anyone else. Soichiro's company sold excellent high-performance motorcycles, and he thought his engines and manufacturing procedures would work well in automobiles. In 1959, in spite of the bleating of MITI, Soichiro's company introduced the S360 sports car.

Today, you have likely heard of the company led by an oddball, a guy who refused to comply with the dictates of the central authority. By the mid 1950s, the company had come to be known by Soichiro's last name…

Two Steves

In 1976, there were two Steves, in a garage. One worked for Hewlett-Packard, and the other for Atari, in California. The Atari guy, Steve Jobs, had the garage, and the two Steves worked on a revolutionary machine. Or so they hoped. Near the end of 1976 the Steves, Jobs and Wozniak (the HP guy), released into the market a metal box attached to a TV screen, and tried to charge $666.66 for each one. The contraptions were called Apple I's.

AppleSuppose we had taken a vote at that point on this "personal computer" thing. Most people would have guessed that there was no future in these silly, overpriced boxes. ($666.66 is more than satanic; it is also $2,350 in 2006 dollars. This for a paper weight with no fixed memory and 16k of RAM.) No government agency would have funded the thing, unless Jobs / Wozniak were also big campaign contributors. And no grass roots wave of support, since no one even knew who the Steves were or what they were trying to accomplish.

AppleBut Jobs and Wozniak were out at the extreme of opinions about computers and the future. They moved out of the garage in 1976, and in 1980 they rolled out the $3,495 Apple III (that's about $9,000 today!). Clearly, this company had no future. Of course, they had not received, or risked, any public money, so it was no one's problem but theirs. Their hunch, their money, their loss.

AppleThen, the Steves held a public stock offering of stock later in 1980. And against all expectations, they became instant millionaires, selling 4.6 million shares. That's a lot of shares; is Median Joe a risk taker, after all? Not really; suppose that each sale was for just one share, to 4.6 million people. That would still mean that more than 97% of the U.S. population thought the stock was a bowzer. And in fact just a few people bought any shares at all, though these few oddballs bought heavily, making a "yes" bet when everyone else was betting "no."

AppleThen, the Steves held a public stock offering of stock later in 1980. And against all expectations, they became instant millionaires, selling 4.6 million shares. That's a lot of shares; is Median Joe a risk taker, after all? Not really; suppose that each sale was for just one share, to 4.6 million people. That would still mean that more than 97% of the U.S. population thought the stock was a bowzer. And in fact just a few people bought any shares at all, though these few oddballs bought heavily, making a "yes" bet when everyone else was betting "no."

Losers: The conventional wisdomBusiness editor at Prentice Hall said, in 1957: ""I have traveled the length and breadth of this country and talked with the best people, and I can assure you that data processing is a fad that won't last out the year." Microchip invented 1968--engineer at IBM's Advanced Computing Systems was puzzled: "But what ... is it good for?" Ken Olson, founder of computer giant DEC (1978): "There is no reason anyone would want a computer in their home."

Let's give DEC's Olson his due: He was right, in a very unimportant way. For years, few did want home computers. If we had put it to a vote, computers would have lost, with more than 95% of population voting "no." But we didn't vote. We left it up to the individuals at the extremes. By 1985, only 5% of American households had voted "yes," with people having some kind of access to personal computers.In economics, the margins matter.In politics, the middle matters.

Finally, in 2005, 25 years after the margin recognized the value of PCs, the majority changed its mind. More than 60% of households had at least one computer, with more having access at work or libraries. Those who bet "yes" on personal computers early on, won. And eventually most of the rest of us came along, free riding on the correct guess. None of the skeptics had to risk anything on the success of the computer, and were free to wait until all the up-front costs of development were paid by others. And had PCs flopped, none of the skeptics would have lost any money. It would just have been "I told you so!" time.

Three Ways to Choose

• Markets, profit test, allocate based on price. Lots of mistakes, but encourages innovation. Operates at the margin.

• Political entrepreneurship, rent-seeking. Allocate based on subsidies, lots of mistakes, rarely direct resources toward productive uses (if different from profits). Best you can hope for is guess what will be profitable.

• Democratic choice: Median voter. Operates at the middle, never at the margin. Sharply discourages innovation.

PROBLEM: SUSTAINABILITY

Owner/manager has fiduciary duty to earn accounting profits. Can a manager of good character behave virtuously, if rent-seeking opportunities are available?

Depresssed share prices, stockholder lawsuits, market for mangers, increase accounting profits.Hostile takeover, replace virtuous managers with rent-seekers.

CONCLUSION?

Perhaps disturbing….Vicious behavior by corporations, bad character of corporate managers is actually a government faiure!

Simple calculus problem: if there are opportunities for rent-seeking (price controls, barriers to entry through increased accounting regulations, tariffs/quotas, artificial licensing requirements, etc.), then the rational manager will equate the marginal profitability of investing in engineers and lobbyists. Rent-seeking will always be grater than zero for the rational manager.

This is true whenever the state offers rent-seeking opportunities. So the REAL question is this:

Can politicians be virtuous? Can the members of the legislature demonstrate good character and forbearance in service of “publick benefits”?