Reading: Lesson 4 – The Importance of Loss

Description: 

In Human Action, Ludwig von Mises writes, “The direction of all economic affairs is in the market society a task of the entrepreneurs. Theirs is the control of production. They are at the helm and steer the ship. A superficial observer would believe that they are supreme. But they are not. They are bound to obey unconditionally the captain's orders. The captain is the consumer. Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt, and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.”

In this lesson, students will read The Economics of Errant Entrepreneurs by Israel M. Kirzner and The Importance of Failure by Steven Horwitz. Students will then complete a research activity to find examples of entrepreneurs who benefited from their own failures. Finally, students will watch a video in which Milton Friedman explains the importance of loss.

 

Time Required:

45 min

 

Required Materials:

Internet connection, writing instrument 

 

Prerequisites:         

Module 3 – How Can Entrepreneurs Use Economics to Make Better Decisions?

Module 4 – How Does Trade Create Wealth?

Lesson 5.1 – Role of Prices

Lesson 5.2 – How Market Prices Emerge

Lesson 5.3 – The Function of Profits

5.4.A - Read the following article using the questions below to guide your discussion [15 min]:

Article: The Economics of Errant Entrepreneurs by Israel M. Kirzner (FEE.org)

“A profitable entrepreneurial venture benefits society in a way central to the logic of capitalist success. If an entrepreneur hires productive services for one million dollars and produces consumer goods that are bought for two million dollars, this means that services that might otherwise have produced goods judged to be worth not much more than one million have, in fact, produced goods that are much more valuable to market participants, as measured by money offered. An unprofitable venture, on the other hand, has harmed society insofar as it is likely to mean that it has used valuable, scarce social resources to produce goods worth less than other goods that could have been alternatively produced.”

Discussion Questions:  The Economics of Errant Entrepreneurs

1.  How does an unprofitable venture harm society?

1. Dr. Kirzner explains, “An unprofitable venture, on the other hand, has harmed society insofar as it is likely to mean that it has used valuable, scarce social resources to produce goods worth less than other goods that could have been alternatively produced….The truth is that each and every entrepreneurial error represents a tragic waste of resources.”
2. A profitable venture helps society as the entrepreneur creates value for himself or herself while creating value for others.

 

2.  What is the one benefit to society of unsuccessful entrepreneurial activities?

1. Members of society benefit from superior entrepreneurial judgment. When errant entrepreneurs fail to use resources in a way that people value, they suffer losses and are encouraged to put resources to a more valued use.
2. Dr. Kirzner explains, “…the one really valuable feature of unprofitable entrepreneurial endeavor lies in its crucially important role in stimulating profitable entrepreneurship. Only in a society where entrepreneurs are free to make errors, can we expect an outpouring of entrepreneurship to lift its economy to new, hitherto unglimpsed, heights of prosperity”.

 

3.  What does the author mean by the statement “As Henry Hazlitt taught us, the true costs of waste are always unseen – yet are nonetheless real and poignant”?

1. Every entrepreneurial error represents a waste of resources. When an entrepreneur is unprofitable, we never see what other more profitable ways those resources could have been used.
2. These resources are tied up in activities that do not maximize value for people and can no longer be used for more satisfying activities. We may never know what alternative products or jobs the unprofitable ventures kept from coming into existence.

4.  Briefly describe the role of profit and loss signals in the market to prevent and correct failure. How might this differ from the incentives government faces when it is shielded from profit and loss?

• The market provides incentives not to waste resources, and to quickly correct errors as they occur.
• The government does not operate using profit and loss signals from the consumers they purport to serve. As a result, resource waste is common and errors are rarely corrected. Moreover, failed government programs are often held as reasons for needing larger budgets to fund the program.

 

5.4.B - Read the following article using the questions below to guide your discussion [15 min]:

Article: The Importance of Failure by Steven Horwitz (FEE.org)

“More important than this individual learning process is the irreplaceable role failure plays in the social learning process of the competitive market. When we refuse to allow failure to happen, or we cushion its blow, we ultimately harm not only the person who failed but also all of society by denying ourselves a key way to learn how best to allocate resources. Without failure there’s no economic growth or improved human well-being.”

 

Discussion Questions:  The Importance of Failure

1.  Why is failure important? What is the importance of failure as discussed by the author in this article?

1. Failure is important because it enables the entrepreneur to learn from mistakes, correct mistakes, and find new knowledge and better ways of producing things.
2. The author explains “Failed entrepreneurial activity is just as important as successful entrepreneurial activity. Markets are desirable not because they lead smoothly to improved knowledge and better coordination but because they provide a process for learning from our mistakes and the incentives to correct them.”

 

2.  What are possible consequences of policies put in place to prevent or cushion business failure?

1. Prof Horwitz explains, “The subsidies, bailouts, stimulus packages, and other interventions that now increasingly characterize the US economy disrupt this [social learning] process.” Not allowing Chrysler and General Motors to fail during the recession prevented the market response to correct the misuse of resources. As a result, the companies continued making cars when their losses showed these resources could have been put towards producing something that provided value to people in society.
2. In addition, government interventions to prevent failure prevent new entrepreneurs from entering the market and doing things better. When companies fail, the physical assets of the failed company do not disappear. The stewardship of those scarce resources simply transfers to more responsible owners.
3. Finally, everyone in society bears the cost of these policies in the form of increased taxes and fewer varieties of goods and services of high value to consume. The author uses the example of Walt Disney – if the government didn’t let the Laugh-O-Gram Corporation fail, we would never have had the ‘Disney’ we know today.

5.4.C – Watch the following video and be prepared to answer the questions that follow [15 min]:

Video:(PenguinProseMedia, 2:05 min)

“Milton Friedman explains the necessity in a free market system of allowing unsuccessful businesses to go bankrupt without the government bailing them out. The free market is a system of profit AND loss where the consumer decides who wins, NOT the federal government.”

Discussion Questions: Milton Friedman – GM Auto Bailout

1.  Why is Milton Friedman so adamant about the Federal Government NOT bailing out big automobile manufacturers?

1. Milton Friedman repeatedly asserts the importance of loss in a free market economy. When referring to the free market, he states, “…the loss part is just as essential as the profit part and it’s a disgrace that we should be bailing out Chrysler. Chrysler ought to be allowed to go broke!”
2. He explains that losses are what “…gets rid of badly managed and poorly operated companies.”
3. When a company fails or shows losses, it’s up to the company to re-evaluate its products and/or processes in order to satisfy consumer demands.
4. It’s not up to taxpayers to cover the losses of failing companies (i.e. bailouts).

 

2.  What are the positive effects following the failure of a company that was not using resources in the way that served the wants and needs of people?

1. Milton Friedman explains that when a company goes bankrupt, the company does not simply disappear. On the contrary, the company’s assets are able to be directed toward more productive uses under new management.
2. It is not the government’s responsibility to “save” a company (big or small) from going out of business. Furthermore, government bailouts come at the expense of other people in society, and prevent scarce resources from being reorganized to better create value in the future.

Lesson Recap

 

• Failure is important because it enables the entrepreneur to learn from mistakes, correct mistakes, and find new and better ways of producing things.

 

• When entrepreneurs fail, it is harmful to society in that the resources involved are not being used in their most productive capacity; such failure can also prevent new, more productive uses from coming into existence.

 

• Failure does have a beneficial aspect. It allows entrepreneurs to learn from and correct mistakes and to identify better, more productive ways to use resources. Society benefits from such improved knowledge, as businesses are better able to create value for their customers. Additionally, when a company fails, its assets are able to be directed toward more productive uses.

 

• Government intervention to prevent failure is harmful in two ways. First, by not allowing businesses to fail, such intervention prevents business owners from learning from their mistakes and perpetuates inefficient, less-productive practices. Second, when a poorly-performing company stays in business, its assets are not able to be used by more effective owners.