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of its product than the opportunity cost of the resources required to make the good. Thus, a
firm will earn a profit only if it is able to produce a good or service that consumers value more
than the cost of the resources required for their production.
Consumers will not purchase a good unless they value it as much, or more, than the
price. If consumers are willing to pay more than the production costs, then the decision by the
producer to bid the resources away from their alternative uses will have been a profitable one.
Profit is a reward for transforming resources into something of greater value.
Business decision-makers will seek to undertake production of goods and services that
will generate profit. However, things do not always turn out as expected. Sometimes business
firms are unable to sell their products at prices that will cover their costs.
Losses
(?)
occur when
the total revenue from sales is less than the opportunity cost of the resources used to produce a
good or service. Losses are a penalty imposed on businesses that produce goods and services
that consumers value less than the resources required for their production. The losses indicate
that the resources would have been better used producing other things.
Suppose, in Bulgaria (where the currency is the Bulgarian Lev, BGN), it costs a shirt
manufacturer BGN 20,000
per month to lease a building, rent the required machines, and
purchase the labor, cloth, buttons, and other materials necessary to produce and market one
thousand shirts per month. If the manufacturer sells the one thousand shirts for BGN 22 each,
he receives BGN 22,000 in monthly revenue, or BGN 2,000 in profit. The shirt manufacturer
has created wealth—for himself and for the consumer. By their willingness to pay more than
the costs of production, his customers reveal that they value the shirts more than they value the
resources required for their production. The manufacturer’s profit is a reward for increasing the
value of resources by converting them into the more highly valued product.
On the other hand, if the demand for shirts declines and they can be sold for only BGN
17 each, then the manufacturer will earn BGN 17,000, losing BGN 3,000 a month. This loss
occurs because the manufacturer’s actions reduced the value of the resources used. The shirts
—the final product—were worth less to consumers than the value
of other things that could
have been produced with the resources. We are not saying that consumers consciously know
that the resources used to make the shirts would have been more valuable if converted into
some other product. But their combined choices provide this information to the manufacturer,
40
along with the incentive to take steps to reduce the loss.
In a market economy, losses and business failures work constantly to bring inefficient
activities—such as producing shirts that sell for less than their cost—to a halt. Losses and
business failures will redirect the resources toward the production of other goods that are
valued more highly. Thus, even though business failures are
often painful for the owners,
investors, and employees involved, there is a positive side: They release resources that can be
directed toward wealth-creating projects.
The people of a nation will be better off if their resources—their land, buildings, labor,
and entrepreneurial talent—produce valuable goods and services. At any given time a virtually
unlimited number of potential investment projects are available to be undertaken. Some of
these investments will increase the value of resources by transforming them into goods and
services that consumers value highly relative to cost. These will promote economic progress.
Other investments will reduce the value of resources and reduce economic progress. If we are
going to get the most out of the available resources, projects
that increase value must be
encouraged, while those that use resources less productively must be discouraged. This is
precisely what profits and losses do.
We live in a world of changing tastes and technology, imperfect knowledge, and
uncertainty. Business owners cannot be sure what the future market prices will be or what the
future costs of production will be. Their decisions are based on expectations. But the reward-
penalty structure of a market economy is clear.
Entrepreneurs
(?)
who produce efficiently and
who anticipate correctly the goods and services that attract
consumers at prices above
production cost will prosper. In contrast, business executives who allocate resources
inefficiently into areas where demand is weak will be penalized with losses and financial
difficulties.
While some criticize the business failures that accompany the market process, this
reward-penalty system underlies the prosperity that markets provide. Interestingly, many of the
entrepreneurs
who initially failed, eventually succeed in a big way. Steve Jobs provides an
example. After leaving Apple in 1985, Jobs founded neXT, a firm that he thought would
produce the next generation of personal computers. The company struggled. But, Jobs learned
from the experience. He returned to Apple in 1997 and soon introduced the iPhone, the iPad,
41
and other innovative products that succeeded spectacularly in the marketplace.
The bottom line is straightforward: Profits direct
business investment toward
productive projects that promote economic progress, while losses channel resources away from
projects that are counterproductive. This is a vitally important function. Economies that fail to
perform this function well will almost surely experience
stagnation
(?)
, or worse.
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