Monday, November 29, 2010

Engines of Prosperity: Entrepreneurship

A couple of weeks ago, I began a series explaining what economics teaches us about the causes of prosperity (see here, here, and here). Because capital accumulation increases productivity of land and labor, the size of the capital stock is positively related to economic expansion. In order for economic progress to continue over time, however, it is important not to waste capital that has already been accumulated. Capital must not be consumed by being sunk in unproductive uses. This is why entrepreneurship is the third major contributor to economic development.

If the capital stock is unwisely employed, it will shrink over time, resulting in a decline in the standard of living. Merely because a capitalist sits on a pile of capital that he is ready to invest does not guarantee that he will have an equivalent or larger pile of capital to invest a year from now. He could invest his present capital to produce goods that are unwanted and fail to reap enough revenue to maintain his capital stock.

Capital accumulation, per se, does not guarantee success in any business venture. As Austrian economist Ludwig von Mises explained in Human Action (p. 295),
Capital does not ‘beget profit’. Profit and loss are entirely determined by the success or failure of the entrepreneur to adjust production to the demand of the consumers. 
Capital is accumulated out of savings. Savings is income held back from consumption. If income declines, then savings declines, if there is not an accompanying decrease in time preference (and there is no reason to think that there would be merely due to economic losses).

Capital accumulation over time, therefore, also depends upon the wise use of capital. Waste is possible, because production decisions in the present are based on a forecast of uncertain future market conditions. If the producer forecasts incorrectly, he will use his capital to make something people do not want and he will not be able to sell his output at prices he anticipated would cover his costs. His income falls and his capital is consumed. Successful entrepreneurship is needed to reap profits that are the result of the wise use of capital.

Entrepreneurship is necessary because in the market division of labor people produce goods more for the market than directly for themselves. As my friend Jeff Herbener notes, they must therefore forecast the subjective values of other people. The entrepreneur performs the valuable social function of dealing with uncertainty, coordinating diverse land, labor, and capital goods owned by numerous people, and directing production into the most socially valuable ends. A society that wants to flourish economically, must embrace social and legal institutions that allow entrepreneurs to perform their function.

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