[Chapter 5 of Per Bylund’s new book How to Think about the Economy: A Primer.]
Why do we produce? For the simple reason that nature doesn’t automatically satisfy all of our needs and wants. Wild animals, grains, and berries are not enough to sustain the world population. Computers, airplanes, and hospitals do not grow on trees.
In other words, the means available to us are scarce. When we have more uses for something than we can possibly fulfill with what we have available, we must economize. That is, we need to make choices and consider the tradeoffs. It then makes sense to be careful in how resources are used so we don’t waste them or use them for the wrong things.
There are two important strategies for dealing with scarcity. First, there is rationing, which means we limit our use of a resource so that it lasts longer. This is a common and appropriate strategy for any specific resource that is finite. For example, someone with only limited water and food—and no hope of gaining access to more—would benefit from restricting their drinking and eating to stay alive longer. However, this strategy, while intuitive, is typically inappropriate for society at large, and especially, markets.
The better strategy is production, which economizes value. Simply put, production allows us to satisfy more wants with the resources available—it creates more “bang” for the “buck” rather than only spreading out the “buck.”
Production to Overcome Scarcity
Production alleviates the burden of scarcity by creating better means. It creates more value by changing, manipulating, and improving what nature provides. Because we engage in production, we can satisfy many more wants—and more highly valued wants—than would otherwise be possible.
The better we become at production, the more and better suited the means that are available to us. This is what “economic growth” means. The “larger” an economy is the more productive it is, which means it is better at satisfying consumer wants. It creates more value.1
Many consider bread to be a valued means of satisfying hunger. Whether or not we love bread, most of us find it more satisfying than munching on raw wheat and yeast and washing it down with water. Therefore we mix wheat flour and yeast together and make it into bread: the additional value of the bread justifies its production. We gain value even though it means that we use additional resources—oven, electricity, manpower—and must wait for the dough to rise and then bake.
It is easy to jump to conclusions and assume that the bread is valued more than the ingredients because additional resources were used to make it. This is false. It is the other way around: we choose to invest the resources—ingredients, manpower, time—because we expect the bread to give us greater satisfaction. By dedicating resources to making bread, including gaining the knowledge and expertise necessary to do it, the economy’s capability to produce value increases. The investment makes us better off not only because we get bread, but because we gain the ability to bake bread. For as long as bread is a valued good and the ability to bake it is retained, the investment creates more value.
It is the expected value of the bread that makes the investment worth pursuing. If it were the case that something is worth more because we use more resources to produce it, then we are not actually economizing. Why use fewer resources if using more makes the good more valuable? We would then be better off the more resources we used. This is, of course, nonsense. We economize because using more resources than necessary is wasteful. We can produce more valuable output using those inputs if we avoid wasting them.
However, resource use and value output often correlate—they seem to go hand in hand, at least after the fact. The reason is that the expected value justifies the costs. In other words, if we aim to produce something that we expect to be of great value, then we can afford to use resources to produce it. In contrast, if we aim to produce a good that will be of only limited value, then we cannot justify using nearly as many resources. The costs are chosen based on the expected value that is being produced. This means that a premium or luxury product is not more expensive to buy because it is produced using rare, expensive materials—it was produced using rare, expensive materials because the good is more expensive to buy. Value determines cost, not the other way around.
This sounds backward, so let’s illustrate by again considering making bread. Bread is a consumption good, so it is easy to understand its value: it directly satisfies a want—it makes us better off because it satisfies hunger and tastes good. People may value bread differently, but they all value it for offering them some personal satisfaction. But what about the things that were needed to make the bread? The flour, yeast, water, oven, and electricity are not directly enjoyed by consumers but are merely means used to produce the final good. They only indirectly satisfy consumers by making it possible to make bread.
These resources have value because they contribute to making bread. We can easily see this if we add resources that do not contribute to the consumer experience. Imagine if the baker buys a car engine and places it in the bakery. It’s a cost to the bakery. But does it add value to the bread? The answer is: not at all. The engine does not increase the bread’s value for consumers. Consumers do not value the bread higher and are not willing to pay a higher price for it just because the baker purchased an engine. Similarly with different types of flour or different ovens, which do contribute to the output. Consumers value the output, not the inputs. If they value wheat bread and rye bread equally, then it doesn’t matter which flour the baker uses—so the cheaper would be the more economizing choice.
We can easily see this if we consider the opposite case. Imagine there is a baker and that people enjoy the bread this baker offers. Thus, the bread has value and so do the bakery and the ingredients the baker uses to make the bread. Now imagine that everyone suddenly stops wanting bread, so the baker can no longer sell it. What is the value of his bread? Zero. What would be the value of the baker’s oven? The value of the oven falls too, perhaps to zero.
It is important to say “perhaps to zero,” because it depends on what other uses bread ovens can be used for. If its use is only for making bread, then it no longer has a valued use. Why would anyone want a bread oven when nobody wants bread any longer? They wouldn’t, so the oven is useless and has no value. But it may have scrap value if its materials (steel, glass, and so on) can be recycled and used for other purposes. The oven’s value would then fall to the scrap value because that is now its highest-valued use.
This does not only apply to the oven’s materials. If the oven can be used for something other than baking bread, then it might still have value higher than scrap. But the value would fall. Why? Because the reason it was used in baking and not something else is that baking was the higher-valued use. Indeed, the baker purchased or constructed the oven because it contributed to creating value. Economizing means we choose the higher-valued use because we get more value out of the resources. But this changes over time. If baking is no longer a valued use, the oven’s value drops. Its value cannot be higher than its new best use in producing something else which is valued. If someone thinks of a better use for ovens than baking bread, then the oven is of higher value to that person than it is to the baker. We would then expect that person to, all else equal, offer and buy the oven from the baker at a price that is higher than the baker’s valuation of it.
This simple example shows that the so-called means of production do not have value in themselves but only in terms of how they contribute to producing a valued consumer good. All productive resources have value only because they contribute to creating goods that consumers want. This is also true for something so distant from a consumer good as an oil tanker. Its value does not come from the resources used to make it but from how it is used in and contributes to valued production of consumer goods. And, of course, resources are used to make the oil tanker because it is expected to contribute to valued consumer goods. The expected value of the outcome that the oil tanker makes possible justifies the cost to produce it.
Capital and Production
Production efforts are made to create goods for consumption, which directly satisfy wants, but not all production is of consumer goods. The oven used to bake bread is an example, as is the production of flour, yeast, and the bakery. The oven was constructed with the intention of supporting bread production. The oven, in other words, makes (or was at least intended to make) it easier to make bread and thus our productivity increases.
These “means of production” that only indirectly satisfy consumer wants are called capital, or capital goods. A consumer who buys bread does not care if the baker has an oven. Consumers generally care only about the consumer good and how well it satisfies their wants—not what or how much capital is used in the process of producing it.
But while his customers do not care, the baker certainly does. With the oven, more bread can be produced with less work. The effect of using capital is more output per unit of input, typically and especially labor, which means more wants can be satisfied using the same amount of resources. For the baker, this means more bread can be baked at lower cost. The purpose of capital and why it is used and created is that it increases our productivity. We get more valued output for the invested inputs.
Productivity is not only a matter of how much of something can be produced, but also what can be produced. Indeed, economic productivity is not a technological measure of units of output—it is a measure of value. Capital makes the production of certain types of goods possible, an often overlooked but very important role.
Let’s revisit the baker again. Imagine that there is no oven, but that it is possible to bake flatbreads by placing the dough on a flat rock over an open fire. This baker spends his days baking flatbread this way. It is a worthwhile undertaking because flatbreads satisfy consumer wants better than the ingredients on their own. And there are enough consumers who prefer flatbread to other types of simple bread that do not require ovens. In other words, baking flatbread is a productive use of the baker’s labor, the flour, the rock, and the fire.
But an oven would make it possible for the baker to make new types of bread, which we (and, importantly, the baker) would expect to be of even greater value to consumers. Suppose a simple oven can be made from arranging flat rocks on top of the fire. Investing in gathering the rocks and arranging them in this way increases the value of the baker’s bread-baking efforts. The rocks make an unsophisticated oven, but the baker can now produce other types of bread that consumers are expected to value more highly than flatbreads.
The rocks, arranged in this particular way, make a capital good: an oven. By spending time and effort to arrange the rocks over the fire, the baker has created new capital, that promises to increase the value for consumers. If things work out as planned, the result will be increased value output.
We often think of capital goods as durable. It is true that rocks last a long time, but this does not mean the oven will. In fact, use will eventually wear it down. For the oven to remain useful, repeated or continuous investments must be made to it, such as replacing broken rocks. If this is not done, the usefulness of this capital will fall over time and eventually lose its value as the oven becomes useless. We say that we “consume” capital by using it. This applies to all capital but at different rates: some capital lasts longer and is more durable and may require less maintenance.
In addition to maintaining the oven itself, other supportive investments—such as keeping the fire going and grinding flour—must also be made to keep the capital useful. The whole capital structure requires continued investments. In fact, the oven is not useful unless the other capital necessary to produce bread is kept functional. All capital goods deteriorate with use and time. In other words, capital is added to increase productivity but is itself used up in producing consumer goods. We need constant reinvestments to keep capital useful and of value.
The oven made of rocks is of course not nearly as effective as our modern-day ovens. But it might be the best the baker can do at the time. To produce a longerlasting and more effective oven, the baker would need access to steel and advanced tools that may not yet exist. Even if the baker figured out how such a modern oven could work, it may not be worth his time or effort to figure out how to turn rock into iron, iron into steel, and then make an oven out of it. He is a baker, after all. But someone else could do it. And someone else did, because today we do have modern, highly effective steel ovens.
Modern ovens are the result of centuries of investments in new and improved capital, refined designs, better materials, and more effective production technologies. We take this long and complex history for granted. But, this historical production cycle has led to the modern appliances that now are available in our neighborhood stores. The same is true for everything we can buy: every good is a refined piece of nature that was created for a single purpose—to provide us as consumers with want satisfaction.
All of those efforts that create materials, tools, machines, etc., are investments in capital that enhance production and allow us to satisfy more and more varied wants more effectively. Together, all this capital is arranged into a productive structure, that spans the whole economy, that allows us to effectively create a multitude of different goods that satisfy consumer wants.
We refer to the amount of capital, used in different combinations (such as the oven made from rocks and the fire) that allow society to produce distinct goods and services, as the economy’s capital structure. This structure, as well as everything it comprises, was created. The production of new capital adds to the structure by adding or improving productive capabilities; maintenance investments extend existing capital’s usefulness; and divestments and reallocations shift capital to the production of other goods, refining, adjusting, and changing the structure and thus the economy’s productive capability. These actions, which bring about continuous change to the capital structure, are carried out by entrepreneurs.
The Role of the Entrepreneur
Entrepreneurs are in the business of creating our future. They do this by creating new goods or refining and improving production. In both cases, they bring about changes to the capital structure by either changing the use of existing capital or creating new capital. The aim in both is to create more value for consumers. If they are successful entrepreneurs get paid in profits. However, time and risk play an important role in this process.
Like the baker, who created a simple oven out of rocks and thereby could provide consumers with new types of bread, entrepreneurs imagine and bet that they can better satisfy consumers. This means they make investments to change things, seeking to create more value by increasing value productivity. They produce goods because they believe those goods will better serve consumers and, therefore, will be in great demand. When such an investment is successful, consumers get more value at lower cost, part of which entrepreneurs keep as profit. When it fails, which means consumers do not approve of what entrepreneurs offer, the investment loses value and may be lost completely.
The major problem entrepreneurs face is that the value of production effort is not known until it is completed. It is only when the finished good is sold that the entrepreneur learns if the investment was worthwhile—if consumers want the good. In contrast, costs are known and incurred long before the good is completed and offered for sale. Note that these costs are not merely the inputs that make the output, such as the flour, yeast, and water that are turned into bread, but also the capital needed: the oven, the bakery, etc. Even in those cases when an entrepreneur takes orders and is paid before producing the actual good, some costs are incurred as part of the not-yet-produced good. Those costs include such things as setting up the business, experimenting with capital, figuring out how to make an oven, developing a recipe or blueprint for production. Investments must be made to produce the good, which can then be sold.
This problem is often referred to as uncertainty bearing. Entrepreneurship is the economic function of bearing the uncertainty of creating future goods: production without knowledge of whether it is value creative and profitable or will it incur a loss. It is the potential for profit that justifies undertaking production and bearing the uncertainty of entrepreneurial investment. It is the possibility of suffering losses that moderates those efforts and forces entrepreneurs to be responsive to consumer wants. And entrepreneurs must be responsive, because consumers are sovereign in their choices to purchase and use goods, which means only consumers determine the value of goods.
Because the value of any good is unknown—cannot be known—before it is used, entrepreneurs invest in production based on what they imagine consumers will value. The baker created the oven because he imagined the new types of bread would serve consumers better. The higher expected value justified the cost of developing and building the oven. By undertaking this endeavor, the baker changed what is and can be produced in the economy. Indeed, the actions of entrepreneurs direct overall production by refining and adjusting the economy’s capital structure. In establishing productive capability and determining what goods can and will be produced, entrepreneurship drives the market process. All goods produced and made available to us, whether they end up successful and profitable or not, are the results of entrepreneurial undertakings—entrepreneurs’ uncertainty bearing.
However, while this is the outcome and implication of their efforts, individual entrepreneurs are not in the business of adjusting the capital structure for overall efficiency or the social good. Entrepreneurs invest in particular productive capabilities in pursuit of profits. But it is very difficult to figure out what consumers will find valuable, which means entrepreneurship is fraught with failure. The entrepreneurs’ task is in fact made even more difficult in markets where it is not enough to produce something valuable, but they must outdo each other in terms of value. Entrepreneurs compete to serve consumers in the best possible way.
Entrepreneurs Make Mistakes
The future is very difficult to predict, but this is what entrepreneurs attempt to do: they invest in creating the future in hope that consumers will find it valuable. And they do so while competing with the visions of other entrepreneurs. So it should be no surprise that there is an extremely high rate of failure.
This may seem inefficient or wasteful, but it is not. It would be if what consumers value were known, because with such knowledge of the future, production can be easily streamlined for efficiency. Entrepreneurship, however, solves another problem. Value is in the minds of consumers—it is not known beforehand, but consumers experience it when they use a good to satisfy wants.
Very often, consumers do not themselves know how to best satisfy their wants. Instead, entrepreneurs imagine a good they think, based on their own ingenuity, experience, and understanding, will serve consumers. To provide greater value than the goods already offered for sale, and therefore have a chance to earn profits, entrepreneurs must step ahead of consumers and introduce to them a valuable solution that they perhaps had not considered. As Henry Ford is thought to have said: “If I had asked people what they wanted, they would have said faster horses.”2 Indeed, most people probably thought they simply wanted faster horses, but Ford imagined that horseless buggies would offer higher value to consumers—and he was able to offer automobiles at prices that consumers would buy.
The fact is that consumers, whether or not they can say what goods they want, always choose between the goods offered to them. That’s when consumers exercise their sovereignty: entrepreneurs cannot force consumers to buy anything, they can only produce goods that consumers value and therefore choose.
The calculus for a consumer is simple but difficult for entrepreneurs to foresee and meet. First, the good has to offer value by satisfying some want that the consumer has. If what the entrepreneur offers has no value to the consumer, then it is not a good.
Second, the good must offer a better, more valuable means to satisfy a want than other goods offering to satisfy that same want. If it does not, then the good is ineffective and of lesser value for satisfying that want. Consequently, the entrepreneur must offer it at a lower price to make it worthwhile to the consumer.
Third, the good must offer value that exceeds the goods that promise to satisfy other wants. Entrepreneurs compete for the consumers’ money.
Fourth, the good must offer enough value for the consumer to buy it now rather than choose to hold on to their money and buy something else in the future.
The entrepreneur must provide value in accordance with all of these layers of consumer valuation.
Needless to say, entrepreneurs attempt to do something extremely difficult. They do so because they believe they will profit in some way in the end. But whether or not they do, their attempts to create value provide a crucial service to other entrepreneurs and the economy overall (we will discuss economic calculation in chapter 7). As they compete based on their own knowledge and imaginations—how they expect to best be of service to consumers—they create knowledge for the economy overall. Entrepreneurs’ discoveries of what consumers value, identified by profits, guide new entrepreneurs in their efforts. Similarly with losses, which suggest to other entrepreneurs that they should try something different. Consequently, every attempted entrepreneurial undertaking can take advantage of the knowledge and experiences of previous entrepreneurs. This makes entrepreneurial value production cumulative: successes are augmented and become stepping stones for future production; errors are weeded out.
It would be wrong to disparage failing entrepreneurs, however. Even though they were unsuccessful and suffer losses, they provided the economy with an invaluable service by making information available on what does not work. This is valuable information for all other entrepreneurs. As entrepreneurs fail, the resources—capital—that they invested become available to other entrepreneurs, who can then increase their own production or try something new.
In sum, entrepreneurs serve consumers by creating our future. They do this by trying ideas for new, imagined goods and, based on their expected value, paying wages to workers and developing new capital. When entrepreneurs err in their choices, they personally suffer the loss of those investments. That loss is the totality of the investments they made in production: wages paid to employees and prices paid to capital suppliers.
1. Note that this is not about creating stuff but satisfying wants. An economy that produces more goods does not necessarily produce more value than an economy that produces fewer goods. It could simply be more wasteful. What matters is the value of the goods produced, not their number or size—and certainly not the quantity of resources that were used to produce them. Production is the process of creating value; productivity is the measure of value produced per unit of input.
2. This quote is oft repeated and makes a vital point about entrepreneurship and production, but it is doubtful that Ford actually said this.