Thursday, May 10, 2007

Emergence of profit and loss by uncertainty

Mises writes in Profit And Loss "If all people were to anticipate correctly the future state of the market, the entrepreneurs would neither earn any profits nor suffer any losses. They would have to buy the complementary factors of production at prices which would, already at the instant of the purchase, fully reflect the future prices of the products".

I tried to construct some kind of proof for this. Please look at the above three figures as I explain.

Let's suppose we have a market for rice and sushi does not yet exist. An entrepreneur is considering inventing sushi. She needs rice to make sushi. What price results in the market for rice? If we can answer this question, we can understand what Mises says "the total costs of production depends on the prices for the product" and we can understand what Kirzner writes how uncertainty fuels entrepreneurship.

Please look at the graph on the left. It shows the relationship between sushi and rice in our entrepreneur's future envisioned market. The first curve (left curve) bulging out reflects the production possibilities curve for rice and sushi. If I give up a certain amount of rice in society, I relieve resources to produce sushi.

The straight line curving down is the budget curve. The amount of rice and sushi cannot exceed beyond the boundary of this curve. This represents the scarcity of resources.

Finally the last curve (right curve) bulging in reflects what is called the indifference curve. Please focus on the solid curve and ignore the dotted one for now.It represents how changes in the consumption for rice and sushi reflects people's welfare. Along this curve people are indifferent to the changes in sushi or rice consumption. In the beginning of the curve, you have large decreases in sushi consumption (the curve is sloping down) corresponding to small increases in rice consumption. Yet, there is no change in society's happiness or welfare.

What consumption, then, would society achieve with rice and sushi. Given the production possibilities curve (bulging out), budget curve (straight down), and the solid indifference curve (bulging in), what would be the resulting consumption of rice and sushi?

Point B reflects the amount of sushi and rice optimally consumed in society for three reasons. It lies along the production possibilities curve, meaning it is possible to produce that amount of sushi for a given amount of rice represented at point B. This point does not exceed the budget curve, so society has enough resources to produce both rice and sushi at that point. Finally it is along the indifference curve, where welfare is possible to achieve.

So what does this mean for the entrepreneur? To answer this I need to first introduce the middle and right curves. They show the supply and demand for both sushi and rice. As we already know these curves reflect the equilibrium price of these two products. I know nothing in real markets is at equilibrium, but please bear with me.

How do these three curves relate? Look at the left curve's point B. It reflects an optimal amount of sushi and rice produced and consumed given all the information in the three curves. This consumption is reflected in the curve B in both the middle and right curves.

Remember in the left graph, we only focused on the bold indifference curve. This represents that we are CERTAIN about how the market will value the composition of sushi and rice consumption. Mises and Kirzner would argue in this situation there is no profit or loss. So now answering the final question, how does uncertainty foster an emergence of profit or loss?

Now we look at both the dotted indifference curve and the bold indifference curve
from the left graph. The dotted curve represents another possible reflection of so
ciety's value for sushi and rice. In our scenario now, we are not certain of which indifference curve. They are both possible. So what would be the result of this uncertainty on the market for sushi and rice that represents a potential emergence of profit and loss for the entrepreneur?

Along the dotted curve we see that it intersects the production possibilities curve at two points A and C. For the dotted indifference curve, these are the only two possible consumption optimums for sushi and rice. Notice for point A that the amount of rice demanded is less than for point C. Yet, for point C the amount of sushi demanded is less than for point A. The resulting supply/demand curves show the result of this.

For A, the equilibrium price for rice is lower than for point C. Thus the input prices for sushi production is lower for A than for C. On the right curve, we see that the equilibrium price for sushi is higher for A than for C.

Thus, under conditions of A we have profit because the price of sushi exceeds the price of rice. For conditions of B, we have neither profit or loss. For conditions of C, we have loss because the equilibrium price of sushi is less than that for rice.

These resulting differences were due to the differences in the position of the two indifference curves. In an entrepreneurial setting, we are uncertain as to the view of society's value on sushi and rice. We are uncertain as to whether society's value is reflected in the dotted curve or the bold curve. This uncertainty is what drives the emergence of profit and loss. Q.E.F. :-)

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