Thursday, March 26, 2009

Notes from the train

I finished reading Prophet of Innovation during my train ride, and thumb-typed the following on the way:

I am starting to understand the fourth division of the factors of production: entrepreneurship. While the other three are necessary for the continuation of existing productive structures, the creation of new ones requires the entrepreneur, and successful entrepreneurship is rewarded by profits. The rewards of capital are necessary for the maintenance of capital, the rewards of labor maintain labor. Potential profits are the spur of innovation, and actual profits are evidence of success.

The rewards of land, on the other hand, maintain nothing, and it is from there that the funds of mischief can be found, and it is there that public funds can be safely and justly appropriated.
When I was taking economics classes, I was surprised to learn that my teachers spoke not of three factors of production, but four, with the additional one being "entrepreneurship", "profit" being the name for that particular revenue stream. I wondered: what differentiates "entrepreneurship" from other forms of labor (which can take both physical and mental forms) that it gets its own category? Sure, the entrepreneur's "wage" is more dependent on the success or failure of a business than the hourly or salaried worker, but that's no different than the independent laborer who works directly with marginal land.

But according to Schumpter (or at least, according to his biographer) the entrepreneur isn't just any businessman, and economic profit isn't just any revenue stream. It's an exceptional revenue stream, the result of being among the first to engage in some vital new enterprise. It's a huge, but temporary revenue stream, a sudden reward for innovation that dwindles as competitors enter the market. The entrepreneur doesn't make changes that modestly improves efficiency; he introduces new products, services, and modes of business organization that alter the landscape, people's ways of life, in fundamental (and in the long term, highly beneficial) ways.

Land, Labor, and Capital were the only terms needed by the early economists, before the art of finance matured to the level where the entrepreneur and the financier could be separate entities: banks make loans to entrepreneurs so they can try their ideas. The banks then collect interest (which is most likely the sum of the rewards of both capital and land), or they lose the money if the entrepreneur defaults. But if the entrepreneur is correct, revenues can greatly exceed labor costs and bank obligations (including the opportunity cost of working for himself instead of someone else)... and the entrepreneur himself collects a tidy sum, which is rightly called "profit".

This was a new phenomenon when economics got its start, and I think Joseph Schumpter is recognized as the first economist to formally recognize the role of the entrepreneur in the capitalist economy. Wages, interest, rent: these provide for the maintenance of the status quo. But profit: that is what spurs men to wrack their brains and work ridiculously long hours in an effort to do what none have done before. The freedom to do this, and to reap the rewards, is the thing that makes a national economy great.

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