 Now we move to the second of the main principles that I see as being with foundations of why human beings need free markets in order to flourish. And that has to do with profit and loss. The idea is that profit and loss provide necessary, indeed, indispensable feedback to business people to help them discover how to use their resources and their talent in ways that serve other people. Profit and loss feedback is necessary to the discovery of what to do new and different better, how to use resources so as to make other people better off. That's the point of this lecture. There are three parts to it. First of all, I'm going to talk about what profit and loss are, second I'm going to talk about their role in guiding discovery, their role in guiding innovation, and finally I'm going to make the case that they're necessary for this purpose, that there's nothing that humanity has to put in the place of profit and loss feedback, even though by the way it is a sort of a kluge imperfect trial and error process. We just don't have anything better to put in its place. So those are the three main topics. One other topic there is I'll make the claim that profit and loss aren't to be understood so much as a reward for past action as a guide to future action. And that's a response sometimes to people who say it's not fair that some people make such profits. So that's what's coming up. First of all, what are profit and loss? First of all, what they are not. People have the idea that when someone makes a profit, somebody else must make a loss, that one man's loss is another man's gain, that the world is a zero sum world, so if somebody is profiting, somebody else must be worse off after all, where did the money come from? Instead of that view, the view I'll present to you is that profit is an indication of benefit to others, because a healthy economy is a positive sum game in which there is mutual exchange to mutual benefit. But let's look at the first sort of negative take on profit. In the Marxist view, profit is a, this is a simplification, but not a distorting simplification. Profit in the Marxian view is the difference between the value of the labor that workers put into a product and the wages they get paid. According to the labor theory of value, which Marx held, as did Adam Smith, the source of value is labor. So what profit is, is the consequence of the labor is not being properly compensated for their labor? Take a simple example. Suppose a, let's imagine a tractor factory, and suppose I'm the proprietor, the capitalist owner of the tractor factory, and in a year I sell a million dollars worth of tractors, and you guys are my laborers who built the tractors. Where did that million dollars come from? Came from the sweat of your brows, because you're the ones who built the tractors, I just sat in my air conditioned office. And if I pay you only $900,000 total in wages, I make a $100,000 profit, because you created a million dollars worth of labor that I only paid you $900,000 for. I ripped you off. The capitalist is a parasite on the, on the work of the laborers. It's a mistaken view based in the, the old labor, discredited labor theory of value. Instead, we're gonna look at profit as an indication of new value created for other people. But let's take a moment more on that tractor example, tractor factory example. In real life, I, the capitalist, have to pay you that $900,000 to get you to work at all, right? And am I guaranteed, do I know there'll be a profit at the end of the year? Do I know how much I'll sell my tractors for, or how many I'll sell? No, I don't know. So really the, the profit is not so much a consequence of, of, of the labor. Profit is what's, is, what's the new value created after the labor has been compensated. All right, with that, let's get, let's look at the, at this, this idea of profit, what profit and loss are. Now the first thing I would say to you is always keep those two together. Don't think, I recommend to anyone listening or to this, from now on for the rest of your life. Don't think of the market economy as a profit system. Think of it as a profit or loss system. Because profits are never guaranteed. Profits and losses are two sides of the same coin. Profit can best be defined as yield minus cost. This is from Ludwig Mies' article, Profit and Loss. Yield minus cost, what you get out of a project versus what you had to put into it. If it's positive, it's profit. If it's negative, it's loss. A more useful definition for economic and commercial purpose isn't yield, which is general and includes all sorts of psychic benefits also. Let's leave those to the side and define profit or loss as total revenue minus total cost, all right? That's familiar, total revenue minus total cost. Once profit is the difference between the total revenue that they take in versus the cost of all the resources that they put in in order to create the product. You're with me so far, right? Okay, now let's think about where revenue comes from. Who pays a business its revenue? Where does a business's revenue come from? It's customers. It's customers, of course. And why do the customers pay that revenue into the business? Because they value what the business is selling. Because they value the product. So where does total revenue come from? What's the source of the total revenue? It's the value to the customers. So total revenue is an indication of value to the customers, okay? What about cost? What do we mean by cost? The total cost of an endeavor. It's also a measure of subjective value of what the inputs could be used for otherwise. Good for you, it's the inputs. It's always best to think of cost as opportunity cost as we talked about. And opportunity cost is the next best alternative. So in a commercial setting, the cost is the value of the input resources in their next best alternative use. You're with me? Yeah. All right, now let's think about what that implies about profit or loss. If profit is a difference between the value created for customers and the inputs and the value of the inputs in their next best alternative uses, then profit is an indication of new value created for other people. Because in order to make a profit, you take resources worth a certain amount. Let's, in round number, you take $100,000 worth of resources and turn them into products that are worth $120,000 to other people. Making a profit on this view is a profoundly creative act. It's an indication of new value created for other people. Because you take a bundle of input resources that were worth less in their next best alternative and turn them into a bundle of products that are worth more, it's a great thing. On that view, how much profit is too much, by the way? There's no amount that's too much. No such thing, no amount of profit is too much. The more profit, the better. As long as that profit is made in voluntary exchange in an open competitive economy, because that profit indicates new value being created for other people. That's the first of three main subtopics. The second is this, the social role of profit and loss. What do profit and loss do for us? You gave the answer a moment ago, you gave a part of it. They're a signal to entrepreneurs about whether or not they are creating value for other people. Whether or not they're using resources in a way that satisfy others' wants and needs. They help entrepreneurs discover how to make the world a better place. It shows business people which projects to pursue and which to abandon. It helps them discover which processes to use and which to avoid, because one is more efficient than the other. Again, all this is true as long as the prices in which they're calculating are free market prices that reflect the real value of resources, okay? If prices are market prices, telling the truth about the availability and urgency of need for various goods and services, then profit and loss will guide us in how to use those goods and services. Now I want to break this down into two kinds of discovery. The first is the more textbook one will take more quickly. And that is the discovery of how to use known resources for known ends. To me what's much more fun and exciting about the discovery process of a market economy is the discovery of resources that we didn't even know were resources. The discovery of new ends, new products, completely new processes. This innovation is one of the main ways in which mankind advances in its standard of living and that process needs profit and loss to guide it also. This process of innovation creating new goods and processes was given a very colorful name by the great economist Joseph Schumpeter. Does any of you know? Creative destruction. Creative destruction. The process of creative destruction whereby the discovery or the development of a new product or a new process. The creation of that new product or process destroys old ways of satisfying similar kinds of human wants. Profit and loss guide this as we'll see. But let's think a little bit more about the process of creative destruction. Take the way we light our buildings. 200 years ago, what technology did we use? Whale. People in this part of the world. Whale oil, yeah. Whale oil lamps and candles. Very expensive, but they did the job. What creatively destroyed that technology? Electricity. Pardon, not electricity yet. I want one more between them. Kerosene. Kerosene. Because people discovered that this petroleum gunk that used to be a nuisance coming out of our streams could be refined into kerosene. It made a better, cheaper, cleaner burning fuel than whale oil. And so the development of the petroleum industry with kerosene leading the way creatively, the creation of that destroyed much of the fixed capital of the whaling industry. I'm told that some areas of the New England Coast went into recession for two generations while they made the transition from whaling to whatever else they moved to. So that's a kind of creative destruction. What technology creatively destroyed the use of kerosene in lamps? Electricity. Electricity. In particular, electricity driving what sorts of devices? Incandescent light bulbs. Incandescent light bulbs and fluorescent tubes. Now I'm delighted to be able to say that when I first started to give this lecture, I had no idea what would creatively destroy incandescent bulbs and fluorescent tubes. But I was confident that eventually something would. I have to confess that even though I teach this stuff, I'm astonished at how rapidly it seems to be happening. Because there's a new technology arising now, which seems fair to creatively destroy incandescent bulbs and fluorescent tubes. What am I thinking of? LEDs. LEDs. LEDs. When I go to the hardware store now to replace my incandescent bulbs, it isn't going to be with new incandescent bulbs, and it certainly isn't going to be with compact fluorescent lamps. It's going to be with LED bulbs that are now available. Something like 12,000 times the life. They're much more expensive. But they're expensive at the point of purchase, but they're less expensive to operate over time. That's creative destruction. And profit and loss guide this. Because it's not clear exactly which technologies are going to be the best, and so we need profit and loss to guide it. That gets me into the third part of this lecture, which is why we have nothing better than profit and loss to put in its place for providing this guidance. And the reason for that, the reason why, is in a word, human ignorance. People don't really know for sure what the best technologies will be. Let me give you some neat quotations that illustrate this. Here's a popular mechanics magazine knowledgeable about technologies. In 1949, forecasting the relentless march of science, computers in the future may weigh no more than 1.5 tons. And they're certainly talking about computers with less processing power than our iPhones. Thomas Watson, chairman of IBM in 1943, I think there is a world market for maybe five computers. This one is a Western Union internal memo in 1876. What did Western Union do? What was their business? A telegraph. Telegraph. They were the big telecommunications company. This internal memo said, this telephone, in scare quotes, has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us. And the biggest telecom company in the country didn't invest in the telephone until they had lost their lead. Others were ahead of them. This is a great one from H.M. Warner of Warner Brothers in 1927. Who the hell wants to hear actors talk? He didn't anticipate the value of the script. Now, in fairness to him, he was saying it's the music that's really going to be the payoff, because he was paying orchestras in every theater around the country to play the music to go with the films. And the soundtrack would get rid of the orchestras. There are a number of these terrific ones. I'll just give you a couple more. This is 1962, Deca recording company, rejecting a band. With the comment, we don't like their sound, and guitar music is on the way out. Who were they turning down in 1962? Beatles. The Beatles. And finally, Michael Dell of Dell Computer, before a crowd of several thousand IT executives in 1997, when he was asked what could be done to fix Apple computer, which was having on hard times, maker of the Macintosh, he said, what would I do? I'd shut it down and give the money back to the shareholders. Apple's never gone anywhere. It's now the largest capitalized country, a company. Is it still the number one market cap company? I think it is. Now, the point of all this is that even people in the best position to know what to invest in, what products to produce, what processes to use, don't really know. It has to be discovered. People are ignorant. And that ignorance, combined with the limitation on our investment capital, there just aren't enough free resources to build parallel telecommunication systems. We have to find some way to decide which ones we do invest in. And the market process I suggest is that kind of an evolutionary system. It's like evolution in biology. All evolution is variation and selection. There needs to be some sort of new trials, some variation, which in biology is mutation, sexual recombination, which creates new critters. And then the means of selection is natural selection, reproductive success, survival of the fittest. We need a similar process in the commercial economy. What is the system of what's the source of variation in a market economy? What goes in those two boxes? What's the source of variation? We've been talking about it. Just different people who have different minds and different ideas for different products. What do we call those who do that innovation? Entrepreneurs. Entrepreneurs. So entrepreneurial innovation. And what's the means of selection among these different entrepreneurial innovations? Profit and loss. Profit and loss. The entrepreneurs say, satellite phone system. 66 low earth orbit. Satellites, that'll be the thing. Others say, let's go for cell phones. And who ultimately decides? Ultimately the customers. The customers do. Customers do. In the words of Ludwig Mises, profit and loss are the instruments by means of which the consumers pass the direction of production activities into the hands of those best fit to serve them. So profit and loss are the consumers' means of guiding the productive profit seeking efforts of business people. Now for that reason, we're almost finished. Just a couple more points. For that reason, we need to look at profit and loss as their main purpose being not to reward people, but to guide people. Yes, it's true that profit and loss rewards Steve Jobs and Bill Gates and Warren Buffett for their entrepreneurial acumen. But that's not so much the main purpose. The main purpose isn't really to reward them. And people who are upset at the high profits made by people who are, in some cases, brilliant. But in other cases, just lucky. Think of movie stars and certain pop stars. They make these great profits. They have really deserved them. So people are uncomfortable with big profits. And that's understandable. But when they say these profits should be minimized or taxed away or prevented, they're missing the key point, which is that we need the profits, that system, to tell people what to do. Because it's in the hope of making a profit for themselves that entrepreneurs work so hard to see what will really serve my fellow man. So profit and loss are best understood. Their function in society is best understood as guiding future actions. The reward for past actions is just sort of a necessary side point to that. OK? Now, the final point before I wrap up. I've been singing the praises of profit, saying that the more profit, the better. And the people who make profits have created value for others. That's true as long as the profits are made in free market exchange. Because profits can also be made in a very ugly way by using political power and coercion. For example, are there some companies who have made nice profits because they have tariff protection? There sure are. But tariff protection just makes it illegal for their customers to buy from their potential competitors. Are there companies who have made big profits by getting bailed out with millions of taxpayer dollars? There certainly are. Are there companies that have made profits with massive subsidies for green energy, for example? There certainly are. Those kinds of profits made not by voluntary exchange with consumers, but by using the power of government to get a special advantage. I do not think are good profits. That's what Frederick Bastiat colorfully calls plunder. That point's clear. Good profit made in open market exchange. Bad profits are made with the help of Uncle Sam or local governments who give you a special advantage over your customers or your competitors. All right then, to sum up, the market process leads to improvements in the human condition by guiding discoveries of how best to satisfy others' wants. Profit and loss is the crucial selection system in that profit. The more profit, the better. The policy implications, don't punish profitable companies and don't bail out companies that have made losses. Let the consumers speak via profit and loss.