? The Role of the Entrepreneur | Where Does Profit and Loss Come From?

What is the role of the entrepreneur? What does he do on the market? Where does his profits come from? What is loss?

▪ Who is an entrepreneur?

“In order to succeed in business a man does not need a degree from a school of business administration. These schools train the subalterns for routine jobs. They certainly do not train entrepreneurs. An entrepreneur cannot be trained. A man becomes an entrepreneur in seizing an opportunity and filling the gap”.¹ – Ludwig von Mises

In the previous video, we’ve said that the consumer is king on the market and not the entrepreneur. Now Mises tells us, that entrepreneur cannot be trained. So what is this weird market role? What are the functions of an entrepreneur and where does his profits or losses come from?

Although we cannot be trained to be an entrepreneur, we can definitely become one. Today we will talk about the entrepreneur’s role, and maybe understanding this role will help you discover the entrepreneur in you, or at least look kindly on the useful function he has on the market.

The task an entrepreneur has is to correctly guess what future consumer preferences would be, the future demand. None of us knows the future and therefore entrepreneur actions always have an element of uncertainty. It’s not easy to correctly predict future needs, so not everyone is good at it. The market is a result of peoples’ actions. Peoples’ preferences change a lot, and therefore, their actions change. That’s why the market is constantly changing. An entrepreneurs role is to correctly predict these changes and allocate factors of production where they will satisfy peoples’ needs best.

▪ Where does the profit come from?

We would be naive of course, If we said that the entrepreneur does this because he is a great philanthropist. If after our last video someone felt bad for entrepreneurs, who has to comply with the consumer’s every whim, then don’t feel bad, because they are not doing it for free. They do it to make a profit. Where does profit come from?

The entrepreneurial profit comes from this: An entrepreneur sees a difference between the prices of factors of production, which he wants to use in a process of production, and the prices he expects consumers will pay in the future for his product. Let’s clarify this a bit. An entrepreneur sees, for example, that some material is cheap in comparison to the expected price of a product, he wants to produce using it. The entrepreneur notices, that this material can be used in a better way than before and the consumer will appreciate this new use more, so he will pay more for the final product. The reward for a correct prediction is a profit, which is the difference between the price of factors of production he used and the price of the final product that consumer has bought. Dr Matt Machaj says this in the subject:

“A skillfully acting entrepreneur is the one who can notice factors of production, for which he can pay relatively less, and then will be able to transform them into something more valuable. An entrepreneur bears the costs, to draw back the factors of production from alternative uses. A confectioner needs to draw back the factor of production (the flour) from the baker, to make donuts. But for his decision to be justified, his costs have to be lower than the income – he has to make a profit. Entrepreneurial profit indicates the success in managing the uncertainty problem: correctly predicting consumer preferences and their purchase decisions”.²

▪ What if he is wrong?

While talking about profits, we cannot forget profit’s ugly cousin, loss. It’s very possible that an entrepreneurs predictions will be wrong, that the consumers won’t want to buy his product in the predicted quantities or at predicted price.

Dr Machaj gives us a visual example once again:

“Loss indicates that an entrepreneur is wasting resources. Let’s go back to the flour example: If a confectioner makes donuts, which are bought by too few people, the loss informs him, that the flour he used for his donuts could be successfully used to bake bread, which turns out to be more desired by consumers”.³

As we can see, entrepreneurial loss is bad for the consumers, because the factors of production could be used better elsewhere. With profit, the opposite is true. Profit indicates, that the entrepreneur uses factors of production in a right way, to the benefit of the consumers. Consumers are the ones who decide about profits, because they have the power. Their interest in product and by trying to outbid the other, they raise its price. We’ve presented this process in the Price Discovery video.⁴

▪ Role of an entrepreneur

Some people accuse the entrepreneurs of only caring about the profits. But seeing where the profits come from, we can say that they accuse entrepreneurs of only caring about satisfying consumer needs. Economic calculation is only a tool, which allows one to evaluate the efficiency of a particular business activity. If I make a profit, it means that I did something right, if I make a loss, it means I’ve made a mistake. When the loss occurs, I need to change something or do something else, because I’m wasting scarce resources. Without economic calculation, without information about profit or loss, an entrepreneur wouldn’t know if his business activities are effective.

You can now say: “Ha! Got you! You talk about market effectiveness and it turns out, that the factors of production can be wrongly priced by the market – hence the entrepreneurial profit!”. You would be right. This price discrepancies are due to constant market changes – and so the data changes very often. And the entrepreneurs are the ones on the market who are responsible for elimination of these discrepancies. Let us see how.

When an entrepreneur notices that factors of production can be used in a better way and he buys them, increasing the demand, that causes their prices to go up. He then produces the final good and makes high profits. Other entrepreneurs see that and they follow his lead, further increasing prices of under-priced factors of production. At the same time they increase the supply of the final good, which lowers its price. Consumers are happy with lower prices. But lower prices leads to lower profits so the entrepreneurs have an incentive to seek yet another innovation and cost reduction.

▪ Summary

Thanks to the entrepreneurs we have innovative products which are available only to the few very rich people at first. But also thanks to the entrepreneurs, the supply of this luxury product increases, its price falls, and they are becoming available to more and more people with lower incomes. A car or a computer were once the type of luxuries unavailable to the average-earning person. Now almost everyone has a car and computer, despite the fact that they are way better than they were before. Matt Machaj explains it like this: First there is an innovation, which leads to the creation of a new product. Then the product passes market test and the consumers take interest in it. Then there is a surge in supply, new competition arises, which ultimately leads to price decline.

By their actions, entrepreneurs adjust the prices to every data change, which is the cause of price discrepancy and a new chance to make a profit. If there weren’t any changes in the economy, the entrepreneurs wouldn’t be necessary or useful. But we live in a world that is constantly changing, and that’s why we – the consumers – need entrepreneurs as a market role.

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