Per Bylund’s Tweet Stream Explains The Concept Of Economic Cost And How It Directs Investment To The Highest Return Projects.

/0 Comments/in /by
The concept of economic cost seems to confuse people. It is not the price you pay for a good, but the reason you pay it. The cost of one action is the value you could otherwise have gained, from taking another action. In other words, if you have $100 and you have the choice to buy two goods, each at a price of $100, you’ll naturally choose whichever is more important (valuable) to you. The cost of it is not the $100, which you give up to purchase it, but the value of the other good, which you can no longer purchase.
That other good is the opportunity foregone by your action, the ‘true’ cost of your action–the economic cost. Why does this matter? Because our actions are intended to create value, and we always aim to maximize that (subjectively understood) value. The economic cost concept brings to our attention what we *actually* give up to get a value, and thus why we choose a certain course of action.
An economy, which is a system of economizing on scarce resources, is the systematic allocation of resources to maximize value. It is not about minimizing price paid, which is something different. It is about value. While this may seem like an academic point, the implications are enormous. Those who are ignorant of this concept focus on the outcome of action only–the “net gain”–rather than the cost. Doing so means we end up wasting enormous resources while not getting the value that was well within reach.
Examples of this include arguing that there were massive gains from, for example, World War II or the US space program in the 1960s. Both were enormously wasteful, but also generated tangible benefits. WW2 led to the discovery of artificial rubber, freeing us from costly and time-consuming rubber production. Yes, that’s a benefit. And there were plenty of technologies developed as part of the space program. Those were also benefits. But at what economic cost? That’s the real issue: what *other* benefits did we never see because we instead pumped in enormous resources into war and the space race? What other discoveries and innovations were within reach had those resources been used differently?
The WW2 example should be obvious, since the war itself was hardly productive. But the space program is exactly the same issue: what opportunities did we, as a society, forego because the government preferred to invest billions of dollars into the prestige program of beating the Russians to the moon? We don’t know what we didn’t get, of course. But this doesn’t mean we cannot say whether it was the right thing to do. The fact is that in a market system entrepreneurs compete with each other not to minimize cost, but to produce value. Naturally, this means *net* value: what actual benefit is provided in the eyes of the consumer. The entrepreneurs don’t know what consumers will value, but they bet their livelihoods on what they think will benefit consumers most. The result is a variety of goods and services from which consumers can choose, and they will choose what is the best option from their point of view.
What is not produced cannot be chosen. But what is not produced also does not seem to be worth it to the numerous entrepreneurs engaging in value facilitation for consumers. Note that this is not a matter of whether entrepreneurs can “afford” the capital investment needed. It is about the rate of return: whether the value is high enough above the outlays necessary to produce the good/service (the production cost). With a sufficiently high ROI, relative to other possible and attempted projects, entrepreneurs can always find the funds needed: investors are looking for a return on their funds, after all. So the argument that “only the government can” invest in something because it requires capital is bogus. It asserts problems that don’t exist, and often fails to properly apply the concept of economic cost (as in the examples above).
Economic cost tells us what is expectedly most important to people, regardless of the capital investment magnitude. Higher ROI means greater value, which means a higher price can be charged–and more profit earned. This is where economic cost is essential to understand the workings of the economy. Because if a project envisioned by an entrepreneur appears to be highly profitable, regardless of initial investment needed, s/he will pursue it. This means, at the same time, that other entrepreneurial projects, which are expected to provide a lesser return on investment, will *not* be pursued.
What matters for society and the economy is that the greater value is pursued, because it makes all of us better off. This is why, through competition, the swift weeding out of entrepreneurs with projects that do not actually produce much value is important: they literally waste our resources because the value foregone–the projects that were not undertaken because the resources were bound up in these lesser projects–is higher than the value produced. It is an economic loss regardless of what benefits came out of it.
Consequently, we can conclude that the space program, just like war, was a wasteful act. The government stepped in because no entrepreneur was willing to undertake it, which is because its expected ROI (if any) was much lower than other projects entrepreneurs could pursue. We don’t know what we lost, but it could have been cures for nasty diseases, doing away with poverty, or whatever. The fact that consumers were not expected to spend their own money on the space program, and the fact that no entrepreneurs expected that they would, at
least not to the extent necessary, means it was not considered valuable enough. Its economic cost was expected to be higher than the economic value!
Now, does this mean that nothing good came out of the space program? Of course not. There were innovations and technologies discovered that have served us well. But they were, at the time of investment, either not expected (at all) or not expected to sufficiently serve people. There are certainly examples of flukes that ended up creating beautiful things (like Arpanet becoming the Internet), but who in their right mind would argue that we should waste resources on grand government projects because there might be unintended consequences that we’d benefit from? Considering the economic cost, what we could have gained from that investment was expected (by everyone!) to be higher than the project pursued by the government.
That’s the reason the government did it: Government is in the business of wasting scarce resources at high economic cost, i.e. without sufficient expected value. No matter how one looks at it, this is wasteful.
Unless, of course, one ignores the concept of economic cost: the higher-value opportunities that are foregone–lost–because we’re instead pursuing the lower-valued ones.
To simplify, it is a matter of picking the low-hanging fruits first, because there is much higher return–greater “bang” for the buck–from doing so. It makes no sense climbing to the top branches “in case” there is some other and unexpected benefit from putting in the extra effort.

Is There A Philosophy Of Entrepreneurship? Yes, There Most Certainly Is. It Starts With Ethics.

/0 Comments/in /by

Mainstream economics today does not believe in ethics, or does not count ethics as a part of its program. Instead, it is based on the concept of “rationality”, asserting that both individual human action and economic policy at the government level are determined by mathematical calculations and valuations of costs and benefits. Specifically, the ends that are pursued can be “maximized” by optimally assigning the available means. The result of this approach is that ethical principles lose relevance as guides to human behavior. They are not optimal. They do not help to maximize the beneficial consequences of human action.

However, mainstream economics is a failure. The mathematical calculations are impossible. The economic process is driven by the innate creative capacity of human beings, constantly discovering new ends and means, giving rise to new flows of knowledge and information, making it impossible to calculate the future consequences of different human actions and/or political decisions. This is precisely why socialism and government intervention and central planning fail.

The entrepreneurial approach to economics does not try to calculate or predict outcomes. It recognizes that social affairs evolve spontaneously as a result of the participation of a very large number of human beings who act in very varied ways in different specific circumstances of time and place. They are guided by ethical principles that act as a sort of “automatic pilot” for behavior and therefore for human freedom.

Entrepreneurship consists of the innate capacity for all human beings to appreciate or discover the opportunities for gain that arise in their surroundings and to act to take advantage of them. Entrepreneurship is the human capacity to continually create and discover new ends and means that have a higher value. The ethical approach is not to redistribute what exists, but to stimulate creative entrepreneurship that is best adapted to the betterment of society. One axiom for such stimulus is that all human beings have a natural right to the fruits of their own entrepreneurial activity.

The market economy arises from this creative entrepreneurial capacity of human beings. In the dynamic creation of new knowledge and new opportunities arising from the interaction of thousands of human beings, it’s impossible to calculate costs and benefits. All human beings need a moral framework of principles to guide them towards the behaviors they should follow in order for there to be social coordination as well as individual betterment. This coordination process is both spontaneous and dynamically efficient. Therefore, justice and effective markets are not two values to be traded-off, but two sides of the same coin. Only justice can lead to efficiency, i.e. social coordination, and what is efficient can not be unjust. Moral principles of behavior and economic efficiency mutually strengthen and support each other.

Consequently, we can conclude that the most just society is the one that most forcefully promotes the entrepreneurial creativity of all the human beings who compose it. To do this, it is indispensable for each human being to be certain that he or she will retain ownership rights to the results of their entrepreneurial activity. Any system that expropriates these rights is immoral.

Mainstream economics disagrees. It focuses on the results of the social process, rather than the moral behaviors and rights of those who participate in it. It is a static analysis – it takes an historical moment in time when goods and services are given and fixed, and focuses solely on the distribution of them. But entrepreneurial impetus means that there is never a static moment in time. Production and distribution are taking place simultaneously, with continuous change.

The only way to impose the static concept of social justice on the dynamic entrepreneurial market is to stop it – to coercively prevent the free practice of entrepreneurship and the creativity and coordination that makes civilization possible. From an ethical point of view, the moral principle that all human beings have a natural right to the results of their own creative entrepreneurial activity is violated. Social justice is essentially immoral.

Free markets driven by entrepreneurship are the only just markets. And it is perfectly compatible for this entrepreneurial creativity and spirit also to be used voluntarily to seek, discover and alleviate any situations of urgent need into which other human beings may have fallen.

Adapted from The Ethics Of Capitalism, Jesus Huerta De Soto, Journal Of Markets And Morality, Fall 1999.

Interview on The Libertarian Christian Podcast

/0 Comments/in /by

Check it out! A few weeks back I joined Doug Stuart to discuss my book, The Interconnected Individual, and why we should look forward to the exciting new economic realities of the future.

Click Here to listen to the full podcast on the Libertarian Christian Institute’s website.

Entrepreneurs Change The World For The Better By Thinking Exclusively About How To Offer New Value To Consumers.

/0 Comments/in /by

Original Article by Per Bylund.

Politics is hardly an effective force for bringing about positive change in society. Instead, real change, and especially such that changes people’s lives for the better, comes from elsewhere. It comes from business, and specifically from innovators, entrepreneurs, and pioneers in the market. And very often it does so despite politics and the state — or even in direct conflict with it.

While technology often gets the credit for achievements of the market place, this is too much of a simplification. It is not technology per se that produces the changes and improvements; it is but a common (and eye-catching) means. The real change is brought about through entrepreneurship, specifically through what Ludwig von Mises called the entrepreneur-promoters: the pioneers, the disrupters, the creative destroyers.

These innovative and trailblazing entrepreneurs are often thought of as creators of something new. For example, it is easy to see the immense change brought to the market for personal transportation by new and innovative players like Uber and Lyft. By providing a new type of transportation — ride-sharing — these entrepreneurial firms placed themselves outside of the existing regulatory framework for taxi cabs. And thus they broke new ground and forced deregulation of the often guild-like taxi industry.

Ride-sharing is an obvious and important example of the enormous change that entrepreneurship can have on society — for the better, by providing new goods and services, and thus improving people’s lives. This is the power of the market. But that is too limiting a definition of disruptive entrepreneurship. Such change can also be brought about by incumbent business firms who pursue new and innovative business models.

A Membership-Based Auto Industry

An example of such is the recently advertised change in how automobile manufacturer Volvo intends to do business. While other automobile manufacturers are stuck, partly due to protective regulation, with producing automobiles sold through a vast dealership network, Volvo intends to stop selling automobiles. Yes, you heard that right.

The new program, Care by Volvo, is a flat-rate membership in which you are provided access to your automobile — with maintenance, service, and even insurance included. While this seems like an interesting twist on the face of it, it is a new business model that has the potential to revolutionize the automobile industry. Drivers no longer need to own their cars, and they also, as a result, do not need to worry about anything with the usage of their car. There is an immense convenience gain.

But think one step further. If a Volvo membership, rather than owning an automobile, means you have the right to a vehicle, this could change everything. Imagine going out of town, and being provided with an identical (or, if you prefer, different) Volvo when you arrive at your destination airport. The Care by Volvo program is effectively competing with the rental car business.

Further imagine that “your” Volvo is a self-driving car, as automobiles will soon be, and your leaving town means not only that you can be picked up at the airport by your preferred car, but also that the car in your driveway, or which dropped you off at the airport, can be used by others.

The future that Volvo likely envisions is one in which there is no need for ownership of automobiles because they can provide the transportation service without hassle everywhere and always. The gain is not only that resources become better utilized as automobiles no longer are parked for long stretches of time in one’s driveway or garage, but also that consumers no longer have to make capital-intensive investments in something as banal as personal transportation.

With much more efficient use of transportation resources, one can imagine how automobile manufacturers such as Volvo not only take on rental car agencies and taxi cabs, but also (out)compete public transportation systems like buses, trains, and subways.

Rather than automobile manufacturing being a stagnated industry “of the past,” and under threat from the anti-oil movement, Volvo’s business model innovation can completely change the playing field and revolutionize the entire transportation sector of the economy. (And I haven’t even mentioned how Volvo also envisions soon offering only electric vehicles .)

The driving force here is obvious: entrepreneurship. But the disruption is not from a new player, but from a player thinking anew. The step for Volvo going from a lease-or-sell model to membership is not a huge one in terms of the production or distribution process. The difference lies in how they imagine best serving their customers, and by thinking of their customers first – or the actual value of what they do – they realized they should think differently about their business. Their dealership locations become member care facilities.

By explicitly thinking of and making consumer value the purpose and goal of their business, Volvo has recreated themselves. As a result, they could disrupt the automobile industry. And in the process, they may erase the boundary between different industries involved in providing the value of personal transportation: automobile manufacturing, car rentals, taxi cabs, public transportation.

This is an entirely predictable evolution. The only reason these are considered different industries in the first place is that they started out offering different types of services based on the technology of the day. But what they really do is not to provide technological solutions to consumers, but to provide value. By recognizing this simple but often forgotten fact, artificial boundaries dissolve and more value is attainable for both businesses and consumers. Herein lies the power of business and entrepreneurship to change the world: by serving the rest of us.

Per Bylund is an assistant professor of entrepreneurship & Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship at Oklahoma State University. Website: PerBylund.com.

Interview on Power Trading Radio

/0 Comments/in /by

Check out my recent appearance with John O’Donnell on Power Trading Radio where we discuss my most recent book, the Economics for Entrepreneurs Podcast and more.

Where’s The Profit In Digital Innovation? It’s In Reduced Transaction Costs.

/in /by

Economists tend to use weird and unhelpful language. One of their terms is Transaction Costs and these things are really important. They’re the reason why firms exist at all, and they’re the reason why the new digital platforms like amazon.com and Uber get to be so big and grow so fast and assume such great prominence.

Let’s see if we can unpack the language.

When a consumer or a customer buys a service, they pay a price in money. Let’s call this the final price, after all discounts and savings and haggling, it’s the amount of cash you part with or the amount on the cheque that you write.

But the final price does not reflect the total cost to you, the buyer. There are a lot of other costs involved in many transactions, some of which we think about and try to compute, some of which we are not conscious of or don’t compute.

The High Price We Pay For Transaction Costs.

Since we have already mentioned Uber, let’s use the purchase of a taxi ride to illustrate transaction costs. If you are in the big city on a dark rainy night and you’d like to get a taxi ride to a destination several blocks away, you might compute the expected price in your head as $15 plus a tip, and decide that it represents a good value to you. You stand in the rain and the wind at the edge of the sidewalk waving at passing yellow cabs, feeling like an idiot and getting yourself and your clothes wet, thinking that there may be a visit to the dry cleaners in your future. Eventually you think you’ve snagged one, but just as it pulls to the curb a burly and brutish-looking guy runs up, pushes you out of the way, yelling “This one’s mine” and you are left disappointed and disheveled. Eventually, after waiting much longer than you had planned and worrying about being late for your appointment, you do get in the cab. It’s uncomfortable, cramped, dirty and doesn’t smell very nice. Nor does the driver. He mumbles to you in a foreign sounding accent you can’t understand. Does he recognize the address you’ve given him? He seems to be taking a long way round. Should you argue? Safer not to, probably. Eventually, you arrive. The fare is higher than you thought. You consider giving no tip but fear the confrontation this may bring on, so you demur. You take out some bills, negotiate some change, then you get out feeling wet and badly treated, and you consider a stiffer drink than you had originally planned.

These inconveniences of time, discomfort, fear and undesirable aesthetics are transaction costs. The cab ride cost $15 or $20 plus tip plus all of these transaction costs. Its value to you must be greater than the money price plus transaction costs for you to feel as though you got a good deal – that’s the essence of a voluntary market transaction, that both parties feel better for having made the exchange. Odds are that you don’t feel that way. There must be a better alternative.

Smartphones And Software Sharply Reduce Transaction Costs.

Now there is: Uber. You install the software on your smartphone. On the next similar occasion, you initiate a transaction. The software knows who you are (you’ve pre-entered the information), and it knows where you are, by the magic of GPS. It finds you a car and a driver, and gives you a rating that suggests to you that you can trust the driver and will have a good experience. The car comes to you, and you can track its incoming progress. No-one pushes you out of the way, asserting they have a prior claim. After minimum time in the rain (perhaps you have to run from the doorway to the car, but no standing), you are safely ensconced, feeling good, and on your way. You pay with one tap (you’ve already entered your payment information and the system has verified it). You arrive on time. You are unstressed, happy to be at your destination, and can get by on a regular sized alcoholic beverage.

Uber has saved you a significant amount of transaction cost. The money price of the ride may be higher, yet you feel you received good value and you’d repeat the experience.

Triangulation, Transfer And Trust.

In his new book, Tomorrow 3.0, Transaction Costs And The Sharing Economy, Michael Munger tries to wrap up these transaction costs in a catchy alliterative expression of three T’s: triangulation, transfer and trust. The affectation is a bit forced, but let’s go with it.

Triangulation refers to information about who you are, who the Uber driver is, the location of the pick-up and of the destination (and the car’s location as it makes its way to you). It’s about getting two parties to the exchange together. Munger also includes making an agreement on a price in his definition of triangulation, which you can also do with the software. All of this is easier / better / more comfortable with Uber.

Transfer refers to the way of transferring the service and the payment for it that is immediate, convenient and as invisible as possible. Software, and the pre-registration of a payment mechanism (your credit card) and the in-built processing capability make transfer easy and safe.

Trust is the way the software creates a feeling of assurance, anticipating honest dealing, with both sides living up to expectations, and performance of the terms of the contract. Both parties can anticipate that their expectations will be met by a trustworthy service provider and a trustworthy customer.

When all of the potential transaction costs are eliminated or highly reduced, the value received for the final price plus transaction costs is much higher in the consumer’s perception.

The Entrepreneurial Opportunity.

Munger’s major point is that there are tremendous amounts of entrepreneurial value creation available in the reduction of transaction costs. He refers to the sharing economy and paints the picture of  future where, if transaction costs are sufficiently reduced, no-one will need to own anything, and we’ll all get by on entrepreneurially-facilitated sharing. Need an electric drill to make a hole to hang a picture? Click on an app, have the drone or robot deliver the drill in a secure package to which you have the unlocking software code, use it for a couple of minutes, and send it back. Same with cars (don’t own one, borrow or rent one for a while), lawnmowers, perhaps even some clothes (like specialized formalwear).

Who is creating these low transaction cost experiences? Entrepreneurs. They see consumers saying, “I wish it were easier to ……..” or “I wish I had XXXX here right now” or “I really disliked my last experience with YYYY”, and they immediately think of ways to solve those problems and meet those needs. They can design an app, assembling the code from Github or by hiring an app developer on Upwork, go to market, and quickly find out whether they can sell the low transaction service improvement.

The new era of low transaction cost digital service provision is, in Munger’s telling, a revolution, as significant as the Industrial Revolution in the nineteenth century. Each of us as consumers will have the opportunity to lead more convenient, more efficient, and safer lives. And each of us as entrepreneurs – from Uber drivers to coders – will thrive by delivering new value creation through transaction cost reduction.