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Economics For Individuals: Can We Really Identify Bubbles? Only In Hindsight.

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Everywhere we look, the world looks bubbly.

Politically, we may point to the anger bubbling among people who feel like they were robbed of power ‒ or their opponents who want to wield that power for their own, not exactly goodhearted purposes. Economically, we may point to the monetary extravagances of 2020, and whether we’ll ever get out from under this pandemic yoke.

Financially, the stock markets (and certain cryptocurrencies) are also thankful recipients for the epithet “bubble.” Last year, as the U.S. economy faltered some 4-5% ‒ much more than during the financial crisis and rivalled only by the Great Depression ‒ the S&P 500 index grew by 16.3%. Some notable stocks delivered returns in the hundreds of percent: the biotech company Moderna, +434%; Etsy, the online retail platform, +302%; Square, the fintech payment processor, +248%. The world’s largest company by market capitalization, Apple, saw its stock price increase by 77% (to which dividends added a few points’ additional return).

But none of them approached the bubbliest of all stocks: Tesla, the now-fourth largest component of the S&P 500. During 2020 it absolutely exploded in value, stating a return of over 700%.

How, you may ask, can the largest companies in the world be more valuable after a year when the economy they form part of collapsed, and the consumers and businesses who provide them with income streams lost their jobs or closed down?

Unless, say some, it’s a bubble.

Source: Yahoo Finance

Tesla’s Price-to-Earnings ratio, a common metric for valuing companies, is almost a thousand. If you’re not usually slinging P/E ratios, that’s a lot ‒ incomprehensibly so. Its market value as of Jan 15 is something like 25x its sales for 2020 ‒ way ahead of even some lofty fast-growing unicorns, even though sales of Tesla cars are growing much slower than these companies. We had individual days last year where Tesla’s market value increased by more than the entire market capitalization of other car companies.

If anything was ever a bubble, this is a grand candidate.

The classic definition of a financial bubble is that prices exceed “fundamentals.” We may talk about asset prices that are way above, detached, or separated from their fundamental values. A recent and wholly uncontroversial description runs

“A stock bubble occurs when sentiment or other market forces bid up the price of a security (or other asset) such that it becomes divorced from its economic prospects/free cash flow generating capability.”

Here’s one major problem that researchers in finance have dabbled with for decades, and that longs and shorts involved in whatever bubbly assets are vocally battling over: what, then, are the relevant fundamentals? How much cash flow can this asset really generate? What will this company’s future hold? How likely are its “economic prospects” to reach that?

This empty bubble definition merely pushes the dispute one step further and forces us to argue about what a relevant fundamental is.

As if that wasn’t enough, here’s another tricky idea to wrap your head around: we can only identify bubbles in hindsight. We can’t conclusively identify them until they’ve burst. Even worse: the accused bubbles that actually make it are never called “misidentified bubbles” ‒ they’re just successful ventures. Bubbles that make it are talked about as prosperous companies that prevailed against impossible odds, run by eccentric entrepreneurs who persevered when nobody else believed in them, or perhaps when only the wrong kind of people believed in them.

The fights over bubbles are boring battles over what constitutes fundamentals, intensified by a backward-looking selection bias for what constitutes past financial bubbles. Looking at the real world, without the help of accurate crystal balls, the only thing that separates a disastrous bubble from a company meeting its lofty expectations is its future success! Its promoters become validated or judged by the future only.

In a strange way, we reserve the derogatory term “bubble” only to those who don’t succeed.

The difference between Amazon, the online retail giant we all know, and Pets.com, the obscure 1990s startup that only financial nerds now talk about, is that Amazon succeeded. In hindsight, that’s obvious; from the point of view of 1999, it wasn’t. Widespread use of the internet was new and revolutionary, and nobody knew what it would bring.

Amazon was as much a part of the mad rush to internet-related financial investment as was Pets.com. Still, a thousand dollars invested in Amazon at the peak of its dot-com journey (December 1999) would have been worth $27,500 today. The same amount invested in Apple at the peak of its dot-com boom ‒ after increasing almost 400% between March 1999 and March 2000 ‒ would have been worth a whopping $95,000 today. If those are the ways of bubbles, do sign me up.

Then again, as a long-term Amazon stockholder you would have had to stomach a collapse of almost 95% between 2000 and 2001 when the hallucinatory promises of the early Internet companies finally evaporated. Apple shares didn’t regain their peak dot-com price until five years later.

Of course, around the dot-com bubble, nobody could have known what these tech giants would become. Or that of the myriad of other promising companies at the time, they would be market leaders two decades thence. Plenty of other companies were available, with similarly lofty promises of future success ‒ very few of which survive, other than as discouraging case studies in business schools and finance departments.

I’m sure that corporate historians can give lots of reasons for why Amazon and Jeff Bezos, even in the late ‘90s, had better potential than Pets.com and its founders whom nobody has heard of today. But was the difference between the world’s fastest IPO-to-insolvency and the world’s second company to be valued above $1 trillion, really that books were more marketable online than dog food?

Hardly: the business models were so similar that Amazon even owned 30% of Pets.com. In its short entry at Investopedia.com, Andrew Beattie writes:

“Given the choice between ordering online and waiting for delivery or walking into the nearest store to buy the product [pet food and toys] and take it home immediately, the majority of people preferred the latter. Granted, Amazon has made a gigantic business of doing just that today. Pets.com was perhaps a bit too early on this idea.”

Today, those preferences of convenience have flipped entirely. But I often argue that if you’re early in financial markets, you are wrong, and if you can’t hold the position long enough to be vindicated, you weren’t right in any meaningful way.

Whenever accusations of “bubbles” are thrown about, I think of these extraordinary stories and the grand selection mechanism that is financial markets. Amazon wanted to sell books online, with great potential and great service; Pets.com wanted to sell dog food. In the late 90s, both looked bubbly, but we only slapped “bubble” on the company that failed.

For the aspiring startup today, perhaps working away in the venture-cap lands of overpriced unicorns, the history of bubble allegations teaches you one thing: be right or be a bubble. Until the dust has settled, nobody can really tell.

Economics For Individuals: Does Twitter Have “Unimaginable Power”? Of Course Not. Only Its Users Do.

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Politicians are clueless about most things in the real world, and especially about economics. When they talk about the unimaginable power of Big Tech, they reveal their ignorance of economic principles, especially consumer sovereignty. The user is the boss, and they can overthrow any power by changing their allegiance.

Nick Saban added yet another national championship to his resume on Monday night. College football coaches, assistants, and agents everywhere celebrated. Why’s that? The answer is simple: Saban’s brilliance as a head coach raises the price of hiring every coach and assistant not Saban. Other schools, seeing what Saban has achieved, spend fortunes in a frequently fruitless search for the next Saban. Paraphrasing Warren Brookes, in every walk of life we’re blessed by the genius of the very few.

The Saban Effect reveals itself in the business world all the time. In a year when the shares of “Big Tech” companies soared, so did IPOs for much smaller ones. So did VC investments in even smaller tech firms. The three situations are related. Rising valuations for the Big Five or Six or Seven technology companies redound to the smaller ones. That’s because investors are relentlessly searching for the next “Big Techs.” What lifts the very few generates intense interest among investors in their eventual replacements. Stress replacements. Please read on.

The idea of replacements for today’s tech eminences brings us to the great Gerard Baker of the Wall Street Journal. His weekly opinion pieces are can’t miss, and this week’s was no exception. Writing about what happened at the Capitol last week, Baker made the essential point that in an effort to justify the doings after the “Save America” rally, “President Trump’s supporters have been working overtime on the moral-equivalence shift.” While he doesn’t need me to say it, Baker nailed it. Republicans, or Trump supporters don’t lift themselves by comparing what they do with the despicable actions of the other side. Better is it to always operate on a higher level. Republicans don’t break things, and don’t wreck the property of others. Period.

At the same time there was disagreement with one point Baker made. Explaining the undeniable uniqueness of Donald Trump, and why opportunists in the GOP won’t replace him, Baker observed that Trump “succeeded in large part because he spoke to the frustrations of so many Americans who have been disdained and discarded by a global elite that enjoys unimaginable power and privilege – and wields it for its own gain.” On this point Baker missed.

It seems his underlying argument was that pockets of elites, think Silicon Valley in particular, have enormous economic power that redounds to Silicon Valley. No.

Indeed, it’s worth asking where Donald Trump would be today had Twitter, Facebook, and other elite tech creations not been around in 2016. Their common use by the everyman is what helped make Trump a Republican presidential primary force, and an eventual White House occupant. These companies are big, and carry enormous valuations, precisely because their use is extensive among those with the smallest of small net worths. The elites of Big Tech didn’t and don’t disdain or discard the proverbial Trump supporter as much their size and market cap signal a powerful understanding of those who pulled the lever for the New Yorker. It’s arguable their understanding is better than Trump’s.

After that, the “unimaginable power” of top technology companies is surely not something the individuals at the top of those companies are aware of. For elites like Jeff Bezos, Mark Zuckerberg, Sundar Pichai, and Tim Cook, they know better than anyone that power in the commercial space is a highly ephemeral concept. And if they’re not aware of this truth, their investors are. Think about it.

When the 21st century began, Amazon was regularly referred to as Amazon.org, owing to its seeming inability to make online sales profitable. Zuckerberg was in high school when 2000 dawned, but the simple truth is that as late as 2006 then social media giant MySpace had more daily visitors than Google did. Facebook was still a site used by well-to-do college kids. Apple was near bankrupt in 2000, but more important is that ahead of the iPhone’s launch in 2007, it was dismissed by the seemingly unbeatable Blackberry (remember it?) as much less than imposing.

How things change. Today’s Big Tech elites are aware of this. That’s why they spend tens of billions each year in pursuit of new ways to meet the needs of existing and future customers. They’re not spending fortunes on a rather opaque tomorrow because they think their present power is secure. Quite the opposite. They know commercial history, and they know that a few wrong moves or missed opportunities will render them the AOLs and Yahoos of the 2020s. Remember them? Oh yes, they were the gold standard of a burgeoning internet when the 21stcentury began. Once again, how things change.

So while the suspension of Trump’s Twitter account, Facebook’s ejection of the 45th president, and Amazon’s role in the disappearance of Parler may have conservatives marveling at the power of tech firms bent on insulting them, rest assured that all three of the aforementioned moves have Twitter, Facebook and Amazon unnerved. It’s hard enough to stay on top, only to potentially offend a large block of U.S. users. If Amazon won’t host Parler, someone will, or will host another would-be vanquisher of Twitter. Somewhere out there the company that will knock Facebook off of its perch similarly exists. Amazon too. Bank on it.

Why is the above assertion a certainty? The answer is in the enormous valuations investors have placed on Big Tech. They signal dominance, but also an eventual end to same. Sectors pregnant with trillion dollar companies are quite a bit more pregnant with IPOs and VC rounds that will fund the replacement of today’s giants.

Translated, if you have a problem with “Big Tech” and elites more broadly, then you should cheer their success. Indeed, high achievement begets the very investment that will result in those on top being replaced at the top. Nick Saban knows this, and so do the businesses that conservatives are oddly calling for government to neuter. Such a view is backwards. Power that is “unimaginable” is by its very name ephemeral.

John Tamny is editor of RealClearMarkets.

Economics For Individuals: There Are No “Winner Takes All” Markets. Consumers Always Win, And There Are Billions Of Us.

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Twenty-twenty marks the twenty-fifth anniversary of a book that has had an expanding influence on the public conversation about market competition. Robert Frank and Philip Cook’s 1995 The Winner-Take-All Society argued that there are an increasing number of markets in which small differences in performance give rise to enormous differences in rewards. As John Kenneth Galbraith described it in a review of that book, the consequence is that “the one who wins gets it all.”

Since then, I have seen multiple articles that reflected the winner-take-all, “a few win at the expense of others” rhetoric as an accurate description of competitive markets, sometimes even accepting that its core claim was so well-established that it could be used as a scapegoat for an ever-expanding host of social problems.

However, even if technology has greatly increased the possible leverage or “amplification” of human talents (such as current worldwide markets for entertainers or large international businesses that multiply the economic impacts of superior corporate management), that leverage creates greater benefits for consumers, evidenced by consumers’ shifting of who and what they patronize toward what they consider better. Consequently, even if “star performer” incomes rise sharply compared to others, that doesn’t mean “the one who wins gets it all,” because that overlooks the far larger positive effects on consumers.

That selective blindness to consumer gains is crucial, since, as Leonard Read emphasized in “A Consumer Looks at Freedom” (in his 1971 book, Then Truth Will Out), people share most in common in their role as consumers. Consequently, consumers’ interests should be the focus of public policy, rather than the growing incomes of the producers who provided those greater benefits to consumers. For instance, Bill Gates got very rich from his software successes, but the gains to users enabled by using his products vastly dwarfed his gain, and those consumer gains negate any attempt to claim or insinuate that the rest of us lost in the process.

A competitive sports analogy adds to the analytical confusion about competitive markets (i.e., voluntary arrangements people make with one another). In Galbraith’s words, “As in sports, so generally in the modern economic world.”

When we judge sports from the perspective of those on, or hoping to be on, medal stands, the rewards seem to only go to a very few “winners,” even when their superiority may be minuscule (e.g., winning a race by only a hundredth of a second). That perspective can be interpreted as implying that most participants are losers. However, the victor celebrated on a medal stand or achieving far fatter earnings is substantially different from the victory for others that results from market competition.

For the competitor aiming for the medal stand, the relevant “output” rewarded is being better, regardless of how much better. But that view ignores the gains to others as a result of the competition. A more accurate analogy to the gains from competition in market arrangements is the improvement in results for customers.

That is, who won the race is far less important to consumers (who aren’t just watching the race) than the improvement in the results. If the result of the competitive process is that products or processes become 10 percent better in some dimension over time (as with longer distances, greater weights, faster times, etc.), those gains are largely passed on to consumers. And such gains are a result of the competitive process, whether party A or B supposedly “won it all.” The core question then becomes whether the competitive process at work produces better results than other mechanisms. And open market competition has no peers at producing better results.

Competition and emulation of what reveals itself in superior performance in the eyes of consumers make all of us able to achieve certain tasks better over time. Such increased capabilities mean more can be produced, and that increased production, in a world of scarcity, benefits the rest of us in society. That makes it a positive-sum game, not a zero-sum game. Society gains massively from the “positive externality” of increased and improved outputs created by competition, which makes overlooking that fact a means of massively misleading yourself.

Seeing through the surface of “winner take all” arguments requires that we keep our analytical eye on what others commonly overlook—the expansion of benefits for others as competition induces increased productivity. The rest of us are not losers when someone outcompetes rivals; we all win as consumers when any producer wins through better ways of doing things.

Instead of the usual misguided analogy between sports competition and market competition, we would benefit from a better description of the process. And in this perhaps Ludwig von Mises provided the clearest guidance on what he called the “catallactic competition” of markets in his monumental Human Action:

(Economic) competition must not be confused with prize fights and beauty contests…to discover who is the best boxer or the prettiest girl….Its function is to safeguard the best satisfaction of the consumers attainable under the given state of the economic data.

[This article first appeared at mises.org and has been adapted from a chapter in Gary Galles’s latest book, Pathways to Policy Failures (2020), published by the American Institute for Economic Research.]

Economics For Individuals: Save Like A Pessimist, Invest Like An Optimist.

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Why we chose this article: Morgan Housel writes thought-provoking, distinctive articles, often on the subject of individual economics. This one provides guidance to the kind of mindset that can prepare anyone for a thoughtful lifelong approach to personal financial management.

In 1984 Jane Pauley interviewed 28-year-old Bill Gates. “Some people call you a genius,” Pauley said. “I know that might embarrass you but …”

Gates deadpans. No emotion. No response.

“OK, I guess that doesn’t embarrass you,” Pauley says with an awkward laugh.

Again, zero reaction from Gates.

Of course he was a genius. And he knew it.

Gates dropped out of college at 19 because he thought a computer should be on every desk in every home. You only do that when you have relentless confidence in your abilities. Paul Allen once wrote about the first time he met Bill:

You could tell three things about Bill Gates pretty quickly. He was really smart. He was really competitive; he wanted to show you how smart he was. And he was really, really persistent.

But there was another side of Bill Gates. It was almost paranoia, virtually the opposite of his unshakable confidence.

From the day he started Microsoft he insisted on always having enough cash in the bank to keep the company alive for 12 months with no revenue coming in. In 1995 he was asked by Charlie Rose why he kept so much cash on hand. Things change so fast in technology that next year’s business wasn’t guaranteed, he said, “Including Microsoft’s.” In 2007 he reflected:

I was always worried because people who worked for me were older than me and had kids, and I always thought, ‘What if we don’t get paid, will I be able to meet the payroll?’”

Optimism and pessimism can coexist. If you look hard enough you’ll see them next to each other in virtually every successful company and successful career. They seem like opposites, but they work together to keep everything in balance.

What Gates seems to get is that you can only be an optimist in the long run if you’re pessimistic enough to survive the short run.

The best way for most people to apply that is: Save like a pessimist, invest like an optimist.

Let me try to convince you of each.

SAVE LIKE A PESSIMIST

John Littlewood was a mathematician who sought to debunk the idea of miracles being anything more than simple statistics.

Physicist Freeman Dyson explains:

Littlewood’s law of miracles states that in the course of any normal person’s life, miracles happen at the rate of roughly one per month.

The proof of the law is simple. During the time that we are awake and actively engaged in living our lives, roughly for eight hours each day, we see and hear things happening at a rate of one per second. So the total number of events that happen to us is about 30,000 per day, or about a million per month.

With few exceptions, these events are not miracles because they are insignificant. The chance of a miracle is about one per million events. Therefore we should expect about one miracle to happen, on average, every month.

The idea that incredible things happen because of boring, obvious, statistics is important, because it’s true for terrible things too.

Think about 100-year events. One-hundred-year floods, hurricanes, earthquakes, financial crises, frauds, pandemics, political meltdowns, economic recessions, and so on endlessly. Lots of terrible things can be called “100-year events”.

A 100-year event doesn’t mean it happens every 100 years. It means there’s about a 1% chance of it occurring in any given year. That seems low. But when there are hundreds of different independent 100-year events, what are the odds that any one of them will occur in a given year?

Pretty good, in fact.

If next year there’s a 1% chance of a new disastrous pandemic, a 1% chance of a crippling depression, a 1% chance of a catastrophic flood, a 1% chance of political collapse, and on and on, then the odds that something bad will happen next year – or any year – are … uncomfortably high.

Littlewood’s Law tells us to expect a miracle every month. The flip side is to expect a disaster roughly as often.

Which is what history tells us, isn’t it?

History is “just one damn thing after another” said Arnold Toynbee. Dan Carlin’s book The End is Always Near highlights periods – from pandemics to nuclear war – where it felt like the world was coming to an end. They exist in every era, every continent, every culture. Bad news is the norm.

Even during what we think were prosperous periods, like the 1950s and 1990s, there was a continuous chain of grief. Adjusted for population growth, more Americans lost their jobs during the 1958 recession than did in any single month during the Great Recession of 2008. The global financial system nearly fell apart in 1998, during the greatest prosperity boom we’ve ever seen.

The world breaks about once every ten years, on average. For your country, state, town, or business, once every one to three years is probably more common.

Sometimes it feels like terrible luck, or that bad news has new momentum. More often it’s just Littlewood’s Law at work. A zillion different things can go wrong, so at least one of them is likely to be causing havoc in any given moment.

Save like a pessimist means you acknowledge the cold statistics of how common bad news is. It’s common at the global, national, local, business, and personal level. Save heavily, knowing with certainty that you’ll need a cushion to deal with the next banana peel. Be a little bit paranoid, knowing the assumptions you hold today could break tomorrow, and you’ll need enough room for error to make it to the next round.

INVEST LIKE AN OPTIMIST

More people and businesses try to solve problems than fudge success or get into trouble. Not by much. But the odds tilt ever so slightly toward long-term progress amid frequent setback. It’s been happening for thousands of years: millions of people solving one problem and moving on to the next, bit by bit, experiment by experiment.

Since progress is cumulative (we don’t forget past innovations) but setbacks are temporary (we rebuild), the long-term odds tilt towards growth.

And that’s all it takes.

In blackjack, casinos usually have a 0.5% edge over players, which is enough to guarantee they’ll win over time. The best card-counters give themselves about a 2% edge over the house, which is enough to ensure they’ll win over time.

Same thing in the economy.

As long as more people try to get better than screw up, the long-term odds are in an economy’s favor. And that’s virtually always the case because the screw-ups – the declines, the recessions, and panics, the wars – fuel the problem-solving.

Once the odds are in your favor, compounding takes hold. And then …. boom.

Compounding is easy to underestimate because it’s not intuitive, even for smart people. Michael Batnick once explained it. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it’s 134,217,728).

If the odds are in your favor and you can keep them in your favor for a long time, you shouldn’t just be an optimist. You should be a ridiculous, full-blown, giddy optimistic.

Which is also what history tells us, isn’t it?

All good investing comes down to surviving an inevitable chain of short-term setbacks and disappointments in order to enjoy long-term progress and compounding.

Save like a pessimist, investing like an optimist.

Check out Morgan Housel’s book, The Psychology of Money.

Economics For Individuals:Let’s Talk Time Preference, Democracy And The Decline Through Which We Are Currently Living.

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One of the most important concepts in economics is time preference. It’s a bit hard to get one’s head around. A high time preference signifies presentism – an individual with high time preference wants everything now, now, now. An individual with lower time preference is willing to forego some present consumption, and to save and invest for the future, feeling that they will value future goods higher than present goods.

In societies that display, on average, a lower rather than a higher time preference, there will be more net investment, more capital formation and greater capital accumulation. Production becomes more sophisticated. Labor becomes more productive and wage rates rise. More people become saver-investors, and they identify more and more sophisticated and beneficial future-improving projects in which to invest. Future incomes rise more; the social time preference rate becomes lower and lower. This tendency has been called the process of civilization. 

The tendency will continue and civilization will progress unless there is interference in the freedom of individuals to exercise their property rights as saver-investors. One type of interference is crime: theft, fraud, or physical violence. To combat this, the saver-investor will divert some funds towards defense: safety products, insurance, security and the like. Although this use of funds is not as productive as other forms of investment, the diversion does not typically obstruct the process of civilization to a major degree. Criminals are usually in the minority and less sophisticated than their targeted victims.

This changes when property rights violations take the form of government interference. 

In Democracy, The God That Failed, Hans-Hermann Hoppe writes:

The distinctive mark of government violations of private property rights is that, contrary to criminal activities, they are considered legitimate not only by the government agents who engage in them, but by the general public as well.

Hence in these cases, a victim may not legitimately defend himself against such violations.

Government interventions that tend to increase the time preference of citizens include taxation of property and income (reducing the individual’s stock of present goods and therefore shifting focus to shoring up the present rather than investing for the future); government money-printing, which has the same effect as criminal counterfeiting; and any regulation concerning what the individual property owner may or may not do with his or her property.

Because of their perceived legitimacy, government violations affect time preferences n a fundamentally different fashion than criminal violations. Crime occurs only intermittently, but government institutionalizes violations into a predictable and unavoidable future pattern. The future-oriented actions of saver-investors become more constrained and everyone becomes more present-oriented. The natural tendency to build an accumulation of capital goods may come to a standstill or even be reversed. People become less farsighted. This is the process of decivilization. 

Politicians and the employees of democratic governments have no incentive to concern themselves about this process of decivilization. Their time preference is high. They are not the owners of government, but temporary caretakers. Their incentives are to take advantage of their position as much as possible and as quickly as possible in the short term. They will want to maximize current government income and increase current government power. Taxes will increase, more government money will be printed, more debt will be accumulated, and more government employees will be hired (and the kinds of people who take the jobs will exhibit high time preference and limited farsightedness).

The state will be increasingly transformed into a “welfare state”, where income redistribution is implemented via transfer payments, “free” goods (like healthcare), and “protective” laws, all directed at transferring income and wealth from low time preference / high productivity citizens to high time preference dependents. The future becomes more uncertain for producers, and those who have produced little or nothing are rewarded. More people will opt to join the latter group.

This trend of decivilization is inevitable in a democracy. When unproductive people, such as politicians and government employees, can aspire to powerful roles in a government that has a legitimate monopoly on the transference of income and wealth to reward and reinforce non-productivity, they will seize the opportunity it represents and exploit it to the fullest. When high time preference non-governmental workers can become recipients of present goods from government-authorized redistribution, as a payment for not producing, or a subsidy for low production, more people will join those ranks.

The only defense against this trend of decivilization is to change public opinion from legitimizing democracy and social-democratic government. Our theory of government is wrong. We must change it.

Entrepreneurship Is The One Institution We Can Rely Upon To Maintain A Prosperous And Civil Society.

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In this time of social unrest, Americans’ confidence in our institutions is in decline. A sample from Gallup’s frequent annual poll  includes these selected comparisons between 2019 (latest available data) and 2000.

% Confidence in Institutions (Great Deal + Quite a lot)
2019 2000
Congress 11 24
Big business 23 29
Newspapers 23 37
Banks 30 46
Small Business 68 57

Relatively few Americans declare confidence in political institutions, as represented by Congress. Roughly twice as many – but still less than a quarter of Americans – express more confidence in big business and banks. Newspapers, similarly, command only low levels of confidence. All the poll data from 2019 are lower than those from 2000, indicating across-the-board declines of confidence in institutions in general.

The Institution Of Entrepreneurship

Except for small business. Two thirds of Americans declare confidence in this institution, and that number is higher than in 2000. We can easily look beyond the structural definition of small business – which is, after all, defined by government statisticians gathering employment data – into the institution of entrepreneurship.

Entrepreneurs are those individuals who shoulder the task of making things better for the rest of society. They are society’s optimists. They recognize current conditions for what they are – and then imagine a future in which conditions are better. Then they sacrifice themselves to bring that future about, expending capital and labor now for the prospects of revenue in the future. That future is uncertain –  entrepreneurs do not know if their initiative will be as well-received by customers as they hope it will. They press on anyway, their goals being discovery and achievement and making a difference, more than profit.

In this sense, entrepreneurs perform the kind of social function that is badly needed in a time of lost confidence in institutions. Having little time for the rear view mirror and gazing intently through the windshield at the road ahead, they substitute sanguine imagination for everyone else’s dissatisfaction and disappointment with the status quo. They don’t dwell on past injustices, as so many young people seem inclined to do today; they’d rather concentrate on what is possible in the future. When they see barriers they dismantle them.

Solving The Problems Of Others

Entrepreneurs are problem solvers – and the problems they solve are those that their fellow citizens (all potential customers) deem most pressing. If you’re looking for a solution to a problem, seek out an entrepreneur rather than an elected official or bureaucrat.

Entrepreneurs’ problem-solving technique combines empathy with rigorous cause-and-effect thinking. Empathy is the entrepreneur’s tool to understand why people – why society – feels a certain way. What does dissatisfaction stem from? Why do people feel uneasy the way they do? Entrepreneurs take society’s pulse  and measure society’s level of pain. From this input, which is largely emotional, they try, as rigorously and logically as they can, to reverse-engineer a cause-and-effect chain. If dissatisfaction and pain are the outcomes, what are the causes? Entrepreneurs are not policy-makers like politicians, whose aim is to appease. They are obliging and accommodating collaborators whose aim is to please.

Entrepreneurial Creativity

Entrepreneurship is a profoundly human, social and creative activity that changes our world for the better. In contrast to the destruction that our current social justice warriors seek to impose, entrepreneurs create new economic value via a transformative act of human imagination. Their ingenuity is limitless.

What are the entrepreneurial actions that result from this creative societal problem-solving disposition? Entrepreneurs start firms, grow businesses, research and introduce innovations, lower customers’ costs and increase customers’ convenience. Their guiding principle is that whatever customers want, customers can have. The responsibility to improve life is given to the customer, in that they are tasked with communicating, as clearly as possible, what needs to be done and what needs to be provided and what needs to be changed to make them feel better. Entrepreneurs put their own private property at risk to create customer benefits that add up to social benefits for all. The customer is sovereign in this exchange – what they want is what is produced. If they stop wanting it, entrepreneurial production ceases.

Contrast this with political action. Politicians put none of their own private property at risk. In fact, they steal property from some citizens, through taxation and debt (which is a tax on future citizens), in order to redistribute it in some new form to a different set of citizens. They appease one group of citizens with the property of another group. Where the entrepreneur’s collaborative deal with customers is win-win (entrepreneurs make profits when customers approve their initiatives), the politicians’ deal always involves loss. The politician achieves office when an opponent loses an election, and makes policy that imposes loss on some part of the population. Politicians deal in losses, entrepreneurs deal in benefits.

Individual Action, Social Benefits

Society would be happier and healthier if we turned to entrepreneurs for all our solutions, and to politicians solely to protect the system of private property and freedom of contract that makes entrepreneurship possible. It would be healthier still if we were to encourage the spirit of entrepreneurship in a larger group: the spirit of service to fellow-citizens through innovative technological problem-solving. The measure of success for this system is what historian and economist Deirdre McCloskey calls “trade-tested betterment”. What she means by that is the customer-determined improvement in the quality of life (i.e., betterment) validated by customers buying or not buying what entrepreneurs offer as potential solutions to their problems and their pain (i.e. trade-tested).

If those who protest and complain today were themselves to adopt the entrepreneurial spirit in their own lives, they would find that they could not only build better platforms for progress, but also introduce more purpose, meaning and autonomy into their own lives. The entrepreneurial life is purpose-driven (solving others’ problems), a source of meaning (solving problems is more meaningful than carrying protest signs or throwing rocks) and the ultimate autonomous lifestyle (discarding dependency on employment wages or welfare payments).

Entrepreneurship is an American institution. Every immigrant who ever came here brought an entrepreneurial spirit: life will be better for me and others if I escape from the limitations of my current situation and join this open, betterment-demanding, property-protecting, innovation-welcoming country and see what I can do. The institutions that grew up with our innovating immigrants and their offspring are now largely decayed and decrepit. But entrepreneurship is one institution that there is no need to abandon. In fact, it’s necessary that we revive it.

 

 

How Entrepreneurs Build Beautiful Businesses.

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In his book, Narrative Economics, Robert Schiller, Nobel Prize-winning economist, tells us that the greatest influences on the nation’s economy come from the stories we tell ourselves about it.

A depression lasts longer when people tell themselves and each other that it’s going to be a long time before things turn around. Recoveries accelerate when people turn optimistic and tell each other that the good times are just over the horizon and will be back soon. Currencies lose their purchasing power when people tell each other prices are going up and its best to exchange cash for products now and not wait for the higher prices. Trade unions are vilified when people start talking about excessively high wages pushing up inflation. Schiller has a lot of stories, or narratives, as he calls them.

These are macroeconomic tales, about trends in GDP, and the price level. But the same is true at the microeconomics level. The reason why there is so much negativism about business, capitalism and free markets is that people are telling each other negative stories about business aggressiveness, unsustainability, lack of sympathy and general coldness. We’re angry at business, it seems.

One source of this anger are the business school instructors, and their textbooks and business biographies and histories that portray businesspeople as a warrior class and business competition as warfare. Invading industries, taking beachheads, fighting for market share. The Art Of War by Sun Tzu is often cited as the most popular business book, and a source of business strategies.

Another military metaphor is defensive – protecting your castle. “You need a “moat” — essentially, a barrier that can protect your business from potential encroaching forces”, says one writer in Medium.

The military narrative is a horrible metaphor for business. The blood and gore and destruction and operational chaos that war metaphors bring to mind have no place in our image of what businesses do and the service they provide. Customers buy products and services only if they believe that, by so doing, they’ll make their lives better in some way. Otherwise they wouldn’t buy. Businesses exist to generate this sense of betterment, of satisfaction, of well-being among their customers. If they are not good at it, they’ll lose the patronage of that customer to a business that pleases them better. Consequently, businesses are always trying harder to understand what will make their customers happy, and to perfect their own knowledge of how to deliver that happiness.

We need a new narrative of business formation and business action that is an alternative to the military metaphor, especially so that we can teach our kids in school that business is a channel for their aspirations, not a regimen to which they are to be subjected. We need a business-is-beautiful metaphor. That its purpose is to serve and to please and to make life better. That it’s the source of what’s good: income to nurture families, products and services to nurture life.

One business guru who is leading us in this direction is Per Bylund, a professor at Oklahoma State University’s Spears School Of Business. He writes about business owners and executives and managers building an island – an island that is inviting enough to attract visitors who will enjoy their time there, and perhaps become residents. An island that’s separate but well connected by bridges and ferries and transportation to bring people comfortably to and fro. Like any island, it’s unique. No two are the same.

Professor Bylund calls them “islands of specialization”, designed by entrepreneurs and their management teams to serve customers in a specialized way that will merit their patronage, keep them visiting, and make them loyal. His strategic advice to businesses has no military overtones.

“Aim to please” is his first principle of beautiful business. To attract people – customers – to the island is simply a matter of understanding what will please them. This requires empathy – understanding people, their hopes and dreams and desires and preferences, and catering to them. It’s a matter of discovery and translation. Business strategy, in this vision, is not aggression but deference: seeking to please others.

“Don’t copy – move beyond” is the next principle. The military metaphor sees competition as conducting wars over business territory, or fighting for customer attention. That’s a misconception of the economic concept of competition. In the economic way of thinking, there is no new value for customers when a firm merely copies what is already offered by others. Value emerges from what’s new and better and different. Smart entrepreneurial island builders assess the current landscape, predict where the customer will be in the future, and navigate to that place to build a new island.

Once they establish the new location, entrepreneurs build from strength. They distinguish what is unique about their resources that can be of benefit to customers. Much of the uniqueness is subjective – the owners’ or the business’s identity, their unique knowledge and expertise, their relationships and interconnections that can co-ordinate the assembly of specific solutions. It’s not about arraying more destroyers on the battle lines than the opponent; it’s arraying a set of uniquely desirable and attractive brand features and attributes that are attractive to the customer.

And the island builder keeps on building. Not for scale or market share or maximizing output. The direction of growth is to maximize value. Value is a feeling of satisfaction in the customer’s mind. Maximization, in this view, refers to higher levels of satisfaction, over a wider range of experiences, for more customers on more occasions. Maximization is not a quantitative or mathematical concept, to be compared with rivals to ascertain who is “winning”. It’s a qualitative concept – what quality of value has been experienced, and how can it be improved.

The four guiding principles – aim to please, in unique ways, based on your own identity and strengths, always thinking about the value that’s experienced by customers – lead to beautiful businesses. If you are developing visual island imagery in your mind’s eye as you read this, think of a balmy climate, vibrant flowers and trees, bubbling streams and distinctive animals and birds. Perhaps there’s an attractive resort hotel welcoming and catering to customer-guests. Let your imagination run free in conjuring up beauty – that’s what entrepreneurs do as the start, grow and sustain their businesses.

Per Bylund, PhD, is assistant professor of entrepreneurship and Records-Johnston professor of free enterprise in the School of Entrepreneurship at Oklahoma State University. His areas of research are entrepreneurship, management and economic organization. He is author and editor of four books.

Life is Good with Individual Economics

Individual Economics Shows Each One Of Us The Pathway To The Good Life.

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Everyone can benefit from a knowledge of economics. Economics is powerful science. To support that assertion, we could simply cite the $US86 Trillion global economy. It has grown and grown – 3000% in 200 years to cite one estimate by Professor Deirdre McCloskey – because we all learned, and started to talk to each other about, economics. The term the Professor prefers is not economics but “ values” – the ethics of commerce.

Now, that doesn’t sound much like the statistics and curves and lines and graphs of GDP projections, money supply, trade balances, employment participation rates and government policy prescriptions. Those, we are told today, are the proper subjects of economic study and the products of economic knowledge.

But we are being led astray by the consultants and bureaucrats and Federal Reserve employees who conduct that level of aggregate economics for their own purposes. Everyday Americans, both as consumers and producers, are helped in making good decisions by an entirely different brand of economics.

Individual Economics

Let’s call this brand of economics Individual Economics. The unit of analysis is the individual, not the grand aggregates of Gross Domestic Product and the like. Every individual plays two economic roles, as consumer and producer. In these roles, every individual is involved in transactions or exchanges. What individual economics has discovered is that, for an exchange to take place, each party to it must feel that they are benefitting. An exchange is mutually beneficial. Economics is never about exploitation, and always about shared betterment. “Give me that which I want, and you shall have this which you want, is the meaning” of every exchange, as Adam Smith, often quoted as the father of economics, put it. Economics is collaboration, and it’s what gives us the good life, rather than the dog’s life. (“Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog” as Adam Smith declared.) Or, as we might say, economics is more about the wealth of the individual than the wealth of nations.

Means and Ends

How does individual economics help us make the good decisions that result in wealth? Through a minute study of individual ends and individual means. Ends are goals, objectives, aspirations. It’s important to choose them wisely and not get misled by unachievable ambitions. No-one can choose for you. Economics can help you understand what’s possible, but it doesn’t constrain you. Where it really helps is on the subject of means – which means are the best ones to choose to reach the goals you have set for yourself. Economics helps with both cause and effect – identifying what is the most likely outcome of choosing one means versus another – and the analysis of opportunity cost: if I choose this means, what alternative choice am I giving up, and have I weighed all the consequences properly? In individual economics, the future is always uncertain, and we don’t try to predict; but we can achieve good decision-making using available information and sound decision processes.

As the consumer, you are the boss.

The captain of the economic ship is not the President, or the Chairman of the Federal Reserve, or a billionaire CEO like Jeff Bezos. The captain of the ship is the individual consumer. The consumer determines what is produced and what sells well. How? By buying or not buying. If the consumer buys a certain good, more of that good will be produced. If the consumer stops buying, the production line shuts down, the brand dies, the company closes. If the consumer never bought in the first place, even the most splashy new product launch with all its glitzy advertising and celebrity endorsements will fail. As individuals, we can exercise immense market power.

Not only do we have the power of life and death over brands and products, as individual consumers we are co-creators of the products that serve us. By exchanging information with producers, we influence their decisions about what to produce. The information we provide might be direct commentary, like leaving a Yelp or amazon review, or an indirect indication about what we’re interested in, such as the clickstream we leave on the internet.

The most powerful individual tool we have as consumers is dissatisfaction. If we express it, the entire entrepreneurial production system is geared to find out what we’re dissatisfied about and how to make us happier through innovation, better service, lower prices or some act of betterment. By being dissatisfied at all times, we can drive economic growth through innovative new solutions. Our power as consumers is undiminished.

As Producer, You Are A Do-Gooder.

We are all both consumers and producers. Through the complex global network of interconnected specialization, we all collaboratively contribute what we’re individually best at to the world production system. Together, we produce food and fertilizer, houses and furniture, laptops and computer chips, credit cards and financial services, healthcare, entertainment, schools and ships and cars and concrete. Individually, we produce the work and the thinking and collaboration and connecting that go into these outputs.

The purpose of all this production is betterment for others. If what you are producing improves their lives, they’ll buy, subscribe, join and click. If not, they won’t, and you and your collaborators will stop producing it and move on to something else that’s better received. The goal is not production for its own sake, but production to improve lives. All the feedback loops reinforce this virtuous circle. By producing, you are doing good. You’re a do-gooder. Try hard to produce more.

How you feel is what you get.

How do individuals decide what to consume and what to produce? The answer lies in the economic concept of subjective value.  We each produce and consume in order to experience value. Note the word experience. Value is a feeling. It’s in your own head. It’s unique to you. It’s idiosyncratic. What feels valuable to you today may not feel valuable tomorrow.

Despite what the business schools and business books tell us, corporations can’t create value or add value. That sounds like engineering, an objective science. Corporations – or at least the people working for them and the parts of the capital structure that come into contact with customers – can make it possible for individual consumers to enjoy a value experience. Will they succeed? It depends how the customer feels on any given day. Will corporations be successful in energizing their employees and harnessing their energy and commitment? It depends on how the employee feels.

Money has little to do with value. You can’t feel money. Money is not an experience.

Fitting In And Contributing.

We are individuals, pursuing our own ends, choosing our own means, producing and consuming according to our own values. But we are not atomistic loners. We are part of a system, comprising the interactions of many individuals each pursuing their own competent goal-oriented activities. We have learned over time that collaboration in these interactions is more productive for everyone than antagonism. In fact, the economic idea of competition is a collaborative concept: multiple producers rivalrously pursuing the best ideas to improve the lives of our fellow men and women.

Our economic actions are directed at identifying for ourselves the best way to fit in to the system – finding the most valuable specialization for which others will reward us. When we find this role, we are contributing to the system in the most productive way we can. It’s a generous act of imagination to identify the future value creation of which we are capable, and to prepare for it now. For some, the contribution is rewarded with great wealth, for others it’s social recognition, and for most of us it’s the quiet satisfaction that we did our best.

Out of all of these individual contributions, there emerges a growing economy – 3000% in 200 years – a flourishing society, and an elevated civilization. Our understanding of emergence is most important. These complex systems to which we all contribute – economy, society, civilization – can not be designed or planned or ruled or directed. They emerge as the consequence of the behaviors of each one of us.

The Idea Of Emergence.

Most academic and professional economists prefer to think of the economy as a machine, and themselves as engineers. They can compose equations that tell them how the machine can perform. If they modify the equations, they can make it perform better on paper, and if they modify the engine itself through government policy, they can make it perform better in practice.

All this is rubbish. The economy is simply all individuals, acting as producers and consumers, and interacting and exchanging with each other. Each individual in each interaction is making their own decisions based on their own values and preferences. Every one of us is different, and every transaction is different, and we’ll each feel differently tomorrow than we feel today. This can’t be modeled and government policy intervention can’t possibly result in predictable change, only in error and confusion.

How does the economic growth we prize so much – the 3000% in 200 years – happen? Through the process we call emergence. It just happens – as a result of the hard work and good intentions and personal choices of individuals. Scientists understand this phenomenon. Complex systems, they say, have emergent properties. It’s impossible to direct the outcome of complex systems, or to tinker with them to try to influence outcomes. All that can be done is to make sure they are working with beneficent general rules. The emergent growth of free-market economic systems results from the general rule of individuals being free to make their own choices, to try new ideas to innovate and improve, and to ‘truck, barter and exchange” as Adam Smith put it.

The Transition To Individual Economics.

The world, and each of us in it, would be much improved if Individual Economics were to become the dominant form to be taught in school and university, and to inform the efforts of every producer and every consumer. The opposite form – mainstream economics or government economics – is dominant today. We will attempt to influence this imbalance with more articles explaining the elements of Individual Economics.

We are not breaking new academic ground. There is a highly-researched, fully developed, historically significant form of economics known as Austrian economics, because of the geographical origins of its founders in Vienna. The Austrian school of economics is largely ignored today. People’s mental imagery immediately leaps to the country of Austria when Austrian economics is mentioned. So it’s appropriate for the Center For Individualism to re-christen this school with the term Individual Economics. We are all individuals, and so we are all Austrians.

 

 

Economics For Individuals:An Old Banana As Artwork Explains The Economic Concept Of Subjective Value.

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Recently, Miami art gallery Art Basel sold, for $120,000, a piece of art composed of a banana duct taped to a wall. At least one other identical piece sold for a similar amount. A third piece was priced at $150,000. The banana used in the display is a real banana, and on Saturday, a performance artist named David Datuna ate some of it.

Datuna’s stunt merely illustrated what everyone should have already known: the value of the artwork had almost nothing to do with the banana itself. Its value came not from the amount of labor that went into it or from the cost of the physical materials involved. A spokeswoman for the museum summed up the real source of the item’s value, noting, “He [Datuna] did not destroy the artwork. The banana is the idea.”

In other words, the people who purchased the art weren’t actually purchasing a banana and tape. The person who purchased the art was buying the opportunity to communicate to peers that he or she was rich enough to throw around $120,000 on a work of art that would soon cease to exist. This was a transaction that involved purchasing status in exchange for money. The banana was only a tiny part of the exchange.

Moreover, the transaction offered the opportunity for the gallery, the art seller, and the art buyer to all further increase their status by being the topic of discussion in countless news articles and discussions in social media. As was surely anticipated by the artists and everyone else in the banana sale, the media could be counted on to act as if this art was something new, outrageous, or exciting. “Art world gone mad,” the New York Post announced on its front page. Hundreds of thousands of commentators in various social media forums chimed in to comment on the matter.

One wonders, however, how many times this shtick can be repeated over and over until people lose interest. Apparently: many times. After all, this sort of art is not a new thing. For decades, avant-garde artists have been using garbage and other found objects to create art. And people with a lot of disposable income have been willing to pay a lot of money for it. It’s all basically an inside joke among rich people. And regular people have the same reaction over and over again.

But there’s absolutely nothing at all that’s shocking, confusing, or incomprehensible from the point of view of sound economics. Transactions like these should only surprise us if we’re still in the thrall of faulty theories of value, such as the idea that goods and services are valued based on how much labor and materials went into them. That’s not true of any good or service. And it’s certainly not true of art.

Is It Garbage or Is It Art?

In fact, two identical items can be valued in two completely different ways simply if the context and description of the objects changes.

According to the Daily Mail, a 2016 study suggests that people value ordinary objects differently depending on what they are told about the objects: “According to the new research, being told that something is art automatically changes our response to it, both on a neural and a behavioural level.”

In this case, researchers in Rotterdam, the Netherlands, told subjects to rate how they valued objects in photographs. When told that those objects were “art” people valued them differently.

In other words, the perceived value of objects could change without any additional labor being added to them, and without any physical changes at all.

The value, it seems, is determined by the viewer, and we’re reminded of Carl Menger’s trailblazing observations about value:

Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men.

One moment the viewer may think he’s looking at garbage, which he has likely learned is of little value. When told that said junk is really “art,” the entire situation changes. (Of course, we would need to see their preferences put into real action via economic exchange to know their preferences for sure.)

The change, as both Menger and Mises understood it, is brought about not by changes to the object itself, but by changes in context and in the subjective valuation of the viewer.

A glass of water’s value in a parched desert is different from that of a glass next to a clean river. Indeed, a glass of water displayed in a museum as art — as in the case of Michael Craig-Martin’s “An Oak Tree” — is different from water found in both deserts and along rivers. Similarly, the value of a urinal displayed in a museum as art — as with Marcel Duchamp’s “Fountain” — is different from a physically identical urinal in a restroom.

The Daily Mail article attempts to tie the researchers’ observations to the theories of Immanuel Kant on aesthetics. But, one need know nothing about aesthetics at all to see how this study simply shows us something about economic value: it is, to paraphrase Menger, found in the “consciousness of men.”

And it is largely due to this fact that centrally planning an economy is so impossible. How can a central planner account for enormous changes in perceived value based on little more than being told something is art?

Is a glass of water best utilized on a shelf in a museum, or is it best used for drinking? Maybe water is best used for hydroelectric power? Exactly how much should be used for each purpose?

When discussing the problems of economic calculation in socialism, Mises observed that without the price system, there simply is no way to say that a specific amount of water is best used for drinking instead of being used for modern-art displays. Nor is the fact that people need water for drinking the key to determining the value of water. (See the diamond-water paradox.)

In a functioning market, consumers will engage in exchanges involving water in a way that reflects how much they prefer each use of water to other uses. At some moments, some consumers may prefer to drink it. At other moments, they may prefer to water plants with it. At still other moments, they may want to contemplate an art display composed of little more than a glass of water. The price of water at each time and place will reflect these activities.

Without these price signals, attempting to create a central plan for how each ounce of water should be used is an impossible task.

Do we need to know why people change their views of an object when told they are art? We do not. Indeed, were he here, Mises would perhaps be among the first to remind us that economics need not tell us the mental processes that lead to people preferring different uses for different objects, although we can certainly hazard a guess. It’s unlikely that the buyer of the taped banana bought it because he or she planned to eat it.

But even if we are wrong about the buyer’s motivation, the fact remains that the buyer valued the banana at $120,000 for some reason — and the value was subjective to the buyer.

Similarly, we can’t know for sure why each individual values water for drinking over “art water” or vice versa. And a government planner or regulator — it should be noted — can’t know this either.

Economics For Entrepreneurs:Entrepreneurship Creates More Value For Everyone In Society. Economic Freedom Creates More Entrepreneurs.

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An entrepreneur is someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit. An entrepreneur who takes the resources necessary to produce a pair of jeans that can be sold for thirty dollars and instead turns them into a denim backpack that sells for fifty dollars will earn a profit by increasing the value those resources create. This comparison is possible because in competitive resource markets, an entrepreneur’s costs of production are determined by the prices required to bid the necessary resources away from alternative uses. Those prices will be equal to the value that the resources could create in their next-best alternate uses. Because the price of purchasing resources measures this opportunity cost— the value of the forgone alternatives—the profit entrepreneurs make reflects the amount by which they have increased the value generated by the resources under their control.

Entrepreneurs who make a loss, however, have reduced the value created by the resources under their control; that is, those resources could have produced more value elsewhere. Losses mean that an entrepreneur has essentially turned a fifty-dollar denim backpack into a thirty-dollar pair of jeans. This error in judgment is part of the entrepreneurial learning, or discovery, process vital to the efficient operation of markets. The profit-and-loss system of capitalism helps to quickly sort through the many new resource combinations entrepreneurs discover. A vibrant, growing economy depends on the efficiency of the process by which new ideas are quickly discovered, acted on, and labeled as successes or failures. Just as important as identifying successes is making sure that failures are quickly extinguished, freeing poorly used resources to go elsewhere. This is the positive side of business failure.

Successful entrepreneurs expand the size of the economic pie for everyone. Bill Gates, who as an undergraduate at Harvard developed BASIC for the first microcomputer, went on to help found Microsoft in 1975. During the 1980s, IBM contracted with Gates to provide the operating system for its computers, a system now known as MS-DOS. Gates procured the software from another firm, essentially turning the thirty-dollar pair of jeans into a multibillion-dollar product. Microsoft’s Office and Windows operating software now run on about 90 percent of the world’s computers. By making software that increases human productivity, Gates expanded our ability to generate output (and income), resulting in a higher standard of living for all.

Sam Walton, the founder of Wal-Mart, was another entrepreneur who touched millions of lives in a positive way. His innovations in distribution warehouse centers and inventory control allowed Wal-Mart to grow, in less than thirty years, from a single store in Arkansas to the nation’s largest retail chain. Shoppers benefit from the low prices and convenient locations that Walton’s Wal-Marts provide. Along with other entrepreneurs such as Ted Turner (CNN), Henry Ford (Ford automobiles), Ray Kroc (McDonald’s franchising), and Fred Smith (FedEx), Walton significantly improved the everyday life of billions of people all over the world.

The word “entrepreneur” originates from a thirteenth-century French verb, entreprendre, meaning “to do something” or “to undertake.” By the sixteenth century, the noun form, entrepreneur, was being used to refer to someone who undertakes a business venture. The first academic use of the word by an economist was likely in 1730 by Richard Cantillon, who identified the willingness to bear the personal financial risk of a business venture as the defining characteristic of an entrepreneur. In the early 1800s, economists Jean-Baptiste Say and John Stuart Mill further popularized the academic usage of the word “entrepreneur.” Say stressed the role of the entrepreneur in creating value by moving resources out of less productive areas and into more productive ones. Mill used the term “entrepreneur” in his popular 1848 book, Principles of Political Economy, to refer to a person who assumes both the risk and the management of a business. In this manner, Mill provided a clearer distinction than Cantillon between an entrepreneur and other business owners (such as shareholders of a corporation) who assume financial risk but do not actively participate in the day-to-day operations or management of the firm.

Two notable twentieth-century economists, Joseph Schumpeter and Israel Kirzner, further refined the academic understanding of entrepreneurship. Schumpeter stressed the role of the entrepreneur as an innovator who implements change in an economy by introducing new goods or new methods of production. In the Schumpeterian view, the entrepreneur is a disruptive force in an economy. Schumpeter emphasized the beneficial process of creative destruction, in which the introduction of new products results in the obsolescence or failure of others. The introduction of the compact disc and the corresponding disappearance of the vinyl record is just one of many examples of creative destruction: cars, electricity, aircraft, and personal computers are others. In contrast to Schumpeter’s view, Kirzner focused on entrepreneurship as a process of discovery. Kirzner’s entrepreneur is a person who discovers previously unnoticed profit opportunities. The entrepreneur’s discovery initiates a process in which these newly discovered profit opportunities are then acted on in the marketplace until market competition eliminates the profit opportunity. Unlike Schumpeter’s disruptive force, Kirzner’s entrepreneur is an equilibrating force. An example of such an entrepreneur would be someone in a college town who discovers that a recent increase in college enrollment has created a profit opportunity in renovating houses and turning them into rental apartments. Economists in the modern austrian school of economics have further refined and developed the ideas of Schumpeter and Kirzner.

During the 1980s and 1990s, state and local governments across the United States abandoned their previous focus on attracting large manufacturing firms as the centerpiece of economic development policy and instead shifted their focus to promoting entrepreneurship. This same period witnessed a dramatic increase in empirical research on entrepreneurship. Some of these studies explore the effect of demographic and socioeconomic factors on the likelihood of a person choosing to become an entrepreneur. Others explore the impact of taxes on entrepreneurial activity. This literature is still hampered by the lack of a clear measure of entrepreneurial activity at the U.S. state level. Scholars generally measure entrepreneurship by using numbers of self-employed people; the deficiency in such a measure is that some people become self-employed partly to avoid, or even evade, income and payroll taxes. Some studies find, for example, that higher income tax rates are associated with higher rates of self-employment. This counterintuitive result is likely explained by the higher tax rates encouraging more tax evasion through individuals filing taxes as self-employed. Economists have also found that higher taxes on inheritance are associated with a lower likelihood of individuals becoming entrepreneurs.

Some empirical studies have attempted to determine the contribution of entrepreneurial activity to overall economic growth. The majority of the widely cited studies use international data, taking advantage of the index of entrepreneurial activity for each country published annually in the Global Entrepreneurship Monitor. These studies conclude that between one-third and one-half of the differences in economic growth rates across countries can be explained by differing rates of entrepreneurial activity. Similar strong results have been found at the state and local levels.

Infusions of venture capital funding, economists find, do not necessarily foster entrepreneurship. Capital is more mobile than labor, and funding naturally flows to those areas where creative and potentially profitable ideas are being generated. This means that promoting individual entrepreneurs is more important for economic development policy than is attracting venture capital at the initial stages. While funding can increase the odds of new business survival, it does not create new ideas. Funding follows ideas, not vice versa.

One of the largest remaining disagreements in the applied academic literature concerns what constitutes entrepreneurship. Should a small-town housewife who opens her own day-care business be counted the same as someone like Bill Gates or Sam Walton? If not, how are these different activities classified, and where do we draw the line? This uncertainty has led to the terms “lifestyle” entrepreneur and “gazelle” (or “high growth”) entrepreneur. Lifestyle entrepreneurs open their own businesses primarily for the nonmonetary benefits associated with being their own bosses and setting their own schedules. Gazelle entrepreneurs often move from one start-up business to another, with a well-defined growth plan and exit strategy. While this distinction seems conceptually obvious, empirically separating these two groups is difficult when we cannot observe individual motives. This becomes an even greater problem as researchers try to answer questions such as whether the policies that promote urban entrepreneurship can also work in rural areas. Researchers on rural entrepreneurship have recently shown that the Internet can make it easier for rural entrepreneurs to reach a larger market. Because, as Adam Smith pointed out, specialization is limited by the extent of the market, rural entrepreneurs can specialize more successfully when they can sell to a large number of online customers.

What is government’s role in promoting or stifling entrepreneurship? Because the early research on entrepreneurship was done mainly by noneconomists (mostly actual entrepreneurs and management faculty at business schools), the prevailing belief was that new government programs were the best way to promote entrepreneurship. Among the most popular proposals were government-managed loan funds, government subsidies, government-funded business development centers, and entrepreneurial curriculum in public schools. These programs, however, have generally failed. Government-funded and -managed loan funds, such as are found in Maine, Minnesota, and Iowa, have suffered from the same poor incentives and political pressures that plague so many other government agencies.

My own recent research, along with that of other economists, has found that the public policy that best fosters entrepreneurship is economic freedom. Our research focuses on the public choice reasons why these government programs are likely to fail, and on how improved “rules of the game” (lower and less complex taxes and regulations, more secure property rights, an unbiased judicial system, etc.) promote entrepreneurial activity. Steven Kreft and Russell Sobel (2003) showed entrepreneurial activity to be highly correlated with the “Economic Freedom Index,” a measure of the existence of such promarket institutions. This relationship between freedom and entrepreneurship also holds using more widely accepted indexes of entrepreneurial activity (from the Global Entrepreneurship Monitor) and economic freedom (from Gwartney and Lawson’s Economic Freedom of the World) that are available selectively at the international level. This relationship holds whether the countries studied are economies moving out of socialism or economies of OECD countries. Figure 1 shows the strength of this relationship among OECD countries.

The dashed line in the figure shows the positive relationship between economic freedom and entrepreneurial activity. When other demographic and socioeconomic factors are controlled for, the relationship is even stronger. This finding is consistent with the strong positive correlation between economic freedom and the growth of per capita income that other researchers have found. One reason economic freedom produces economic growth is that economic freedom fosters entrepreneurial activity.

Figure 1 Economic Freedom and Entrepreneurship in OECD Countries, 2002

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Economists William Baumol and Peter Boettke popularized the idea that capitalism is significantly more productive than alternative forms of economic organization because, under capitalism, entrepreneurial effort is channeled into activities that produce wealth rather than into activities that forcibly take other people’s wealth. Entrepreneurs, note Baumol and Boettke, are present in all societies. In government-controlled societies, entrepreneurial people go into government or lobby government, and much of the government action that results—tariffs, subsidies, and regulations, for example—destroys wealth. In economies with limited governments and rule of law, entrepreneurs produce wealth. Baumol’s and Boettke’s idea is consistent with the data and research linking economic freedom, which is a measure of the presence of good institutions, to both entrepreneurship and economic growth. The recent academic research on entrepreneurship shows that, to promote entrepreneurship, government policy should focus on reforming basic institutions to create an environment in which creative individuals can flourish. That environment is one of well-defined and enforced property rights, low taxes and regulations, sound legal and monetary systems, proper contract enforcement, and limited government intervention.

About the Author

Russell S. Sobel is a professor of economics and James Clark Coffman Distinguished Chair in Entrepreneurial Studies at West Virginia University, and he was founding director of the Entrepreneurship Center there.

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