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1. Peter G. Klein | Mises Academy 20121 | Profit, Loss, and the Entrepreneur
Peter G. Klein
University of Missouri
August 16, 2012
Austrian Microeconomics
Profit, Loss, and
the Entrepreneur

2. 2 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
The evenly rotating economy
► Recap: imaginary constructs in causal‐realist analysis
► The imaginary construction of the evenly rotating economy
(ERE)
 Passage of time
 “Action‐like” behavior
 No uncertainty
► Purpose of the ERE
 Distinguishing profit from interest
 Isolating the function of entrepreneurship

3. 3 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
The entrepreneurial function
► Entrepreneurship: deployment of resources (in the present) in
anticipation of (uncertain) future receipts.
 Implies property ownership
 May or may not imply imagination, creativity, alertness, leadership, etc.
► Profit (loss): residual accruing to business owner after factors of
production have been paid.
 In the ERE, all factor prices would equal their DMRPs  no profit or loss
► Laborers: earn wages
► Landowners: earn rents
► Capitalists: earn interest
 Profit and loss can thus only exist under conditions of uncertainty.
 Note on profit measurement, profit rates, etc.

4. 4 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Uncertainty versus risk
► Frank Knight (1921) on risk and uncertainty
 Risk: possible outcomes and probabilities are known
 Uncertainty: probability distribution is unknown
► Richard (and Ludwig) von Mises on probability
 Class probability: event is part of a class of
similar, repeatable events
► Games of chance
► Insurance
 Case probability: event
constitutes a unique case
► Understanding

5. 5 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
What profit is not
► Interest
 Interest: reward for foregoing consumption
 Profit: reward for successfully bearing uncertainty
► Accounting income
 Accounting income includes profit, interest, and the entrepreneur’s
implicit wage
 Economic concept of profit as a functional category, not a line item on
the income statement
► An automatic “return to capital”
► A markup over production costs

6. 6 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Entrepreneurship and resource heterogeneity
► Austrian capital theory: heterogeneous, subjectively perceived
resources
► Lachmann (1956) on heterogeneity: “We are living
in a world of unexpected change; hence capital
combinations . . . will be ever changing, will be
dissolved and reformed. In this activity, we find the
real function of the entrepreneur.”
► Note: given resource heterogeneity, profits and
losses can only be calculated in a money terms.
Ludwig Lachmann

7. 7 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
The capitalist and the entrepreneur
► The business firm: intersection of the
capitalist and entrepreneur functions
► Insights from Austrian economics
 Capital resources are heterogeneous
 Production takes time
 Entrepreneurs perform economic
calculation
 Market competition selects for
entrepreneurial skill

8. 8 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Social functions of profits and losses
► Provides feedback to entrepreneurs in
short‐ and long‐run planning
Establishes a selection process for
entrepreneurship, placing productive
resources under the custody of those
who can best use them to satisfy
consumer wants.
► Note: no such thing as “normal profits,” “excessive profits,” etc.

9. 9 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Mises’s entrepreneur‐promoter
► A special class of entrepreneur
 Economics “also calls entrepreneurs those who are especially eager to
profit from adjusting production to the expected changes in conditions,
those who have more initiative, more venturesomeness, and a quicker
eye than the crowd, the pushing and promoting pioneers of economic
improvement” (Mises, 1949, p. 255).
 Mises’s suggested term for these: promoter
► Characteristics of the promoter
 Owns and invests financial and/or physical capital
 Is particularly alert to profit opportunities
 Exhibits creativity and leadership
 A more loosely defined, historically contingent
concept than the pure, functional entrepreneur

10. 10 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Entrepreneurs and managers
► Original and derived judgment
 Original judgment – can only be exercised by resource owners.
 Derived judgment – exercised by subordinates who are delegated
specified decision rights, acting as “proxy entrepreneurs.”
► Economics of organization: art of managing derived judgment

11. 11 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Alternative perspectives on the entrepreneurial function
► Israel Kirzner: entrepreneurship as alertness to
opportunities
 Similar to Mises’s promoter, but without capital
 Entrepreneurship (necessarily?) “pierces the fog”
of uncertainty”
 Focuses not on profit and loss, but on equilibration
► Joseph Schumpeter: entrepreneurship as the introduction
of new products, processes, markets
 An “Austrian” addition to Walrasian general equilibrium
 Sees the entrepreneur as a disequilibrating force
(“creative destruction”)
► Mises: closer to Knight’s view of
entrepreneurship as judgmental decision‐
making under uncertainty

12. 12 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Alternative concepts of entrepreneurship
► Occupational concepts
 Entrepreneur = self‐employed individual
 Labor economics literature on occupational choice
 Psychological studies of the entrepreneur’s characteristics
► Structural concepts
 Unit of analysis: the firm or industry
 Entrepreneurial firm = new or small firm
 IO literature on industry evolution
► Note: little relationship to functional approaches

13. 13 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
Implications for the theory of the firm
► Neoclassical view: firm as production function
► Austrian view: firm as ownership of assets
 The firm is the capitalist‐entrepreneur (or a group of capitalist‐
entrepreneurs) plus the alienable assets he owns.
 Ownership conveys authority
 Firms can own many, or no, production processes (functions).

14. 14 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
The theory of the firm
► Why do firms exist?
 Transaction costs of market exchange (Coase 1937)
 Entrepreneurial judgment is non‐contractible (Knight, 1921)
► What determines the boundary of the firm?
 Internal and external transaction costs
 Entrepreneurial talent
 Need for economic calculation (Rothbard)
► How should the firm be organized?
 Costs and benefits of delegation (Foss, Foss, and Klein, 2007)

15. 15 | Profit, Loss, and the Entrepreneur Peter G. Klein | Mises Academy 2012
The limits to the firm
► Incremental limits: indivisibility in the entrepreneurial judgment
► Ultimate limit: need for external markets for all internally
transferred factors
 The vertical stages of production
 Divisional profit and loss
 Need for market‐based transfer prices
► Calculational chaos
 As external markets disappear, “islands of noncalculable chaos swell to
the proportions of masses and continents. As the area of incalculability
increases, the degrees of irrationality, misallocation, loss,
impoverishment, etc., become greater” (p. 548).
► Relationship to socialist calculation debate