The Science of Everything Podcast - Episode 16: Profits and Competition

Episode Date: March 5, 2011

A discussion of the importance of the profit motive and freedom of competition in the efficient operation of a market economy. Includes an overview of the uniformity of profit principle, and an examination of how competition serves as both an opportunity and a disciplining agent for entrepreneurs and firms, thus promoting useful innovations while weeding out bad ideas.

You're listening to The Science of Everything podcast, Episode 16, Profits and Competition. This episode continues on from episode 12 on the price system, and so I'd advise listening to that episode before listening to this one. So in this episode, I'm going to talk about the profit motive and the uniformity of profit principle, how the uniformity of profit principle helps to increase the efficiency of the free market economy, and also how freedom of competition in a free market economy promotes innovation, entrepreneurship, but whilst also maintaining discipline upon entrepreneurs and businesses in the activities that they undertake.

This is all the continuation of how a free market economy can operate to efficiently allocate the resources in an economy and generate a large amount of wealth without any central planner controlling the entire system. So first of all, I'm going to talk about the profit motive, and before we do that, I have to define what are profits. Well, the rate of profit is simply the difference between, sales revenues and costs, divided by the amount of capital that is invested in a particular industry. So, profit itself is just the difference between revenues and costs. So the amount of money

that you take in in your business, minus the amount of money that you have to pay in order to buy inputs, pay labor, rent, all those sorts of things. So that difference is simply profit. That's a fairly common sense principle. The rate of profit takes that total net amount of profit and divides it by the amount of capital that is invested. So that's the total value of all the assets that you have embodied in your business. It would include things like buildings that you own, computers, machinery, other things like that. And the rate of profit is an important concept because it's really the rate of profit that is, that determines that is the driving force of the uniformity of profit principle. It doesn't matter so much the total

amount of profit that's made. It's the amount of profit relative to the amount of capital that is invested. So you could earn, you could only have a very small amount of invested capital, but if you're earning a very large profit on that relative to the amount of capital you have invested, then that is going to be very lucrative business activity and that's going to attract more investment. And vice versa, you could have a very large investment capital, but only a relatively low rate of profit earnings relative to that large capital size, and so that's going to be a not very lucrative business activity. So the key point is the rate of profit, which is profits relative to the size of invested capital.

Okay, so this leads us to the uniformity of profit principle. And this principle states that in a free, free market, there is a tendency towards the establishment of uniform rate of profit on capital invested in all the different branches of industry. Now, I just want to note that this is only a tendency. It's not saying that there always will be an exactly identical rate of profit earned on all capital throughout the economy. That's obviously not the case because an economy is never in equilibrium. It's always moving, that there are always changes and reallocations of resources. So it's only a tendency, but it's a tendency that works very well.

and is self-correcting in relatively quick, short amount of time, and so it's still very useful to look at. Now, what does this actually mean? What does it mean there's a uniform rate of profit across different branches of industry? Well, you can think of it as that when an investor or a business or anything like that is trying to decide what to do with its money, it can choose between investing in cars, the automobile industry.

It could invest in supermarket chains, bookstores, service industry, education, literally anything that is done, the economy is a potential avenue of investment. And so then the choice of the investor is, how do I pick where to invest? What's the best use of my money? Now, clearly, the investor, or the investment bank, or the corporation, whatever it is exactly, wants to maximize the amount of profits that they earn, or the amount of return they have on their investment. And so what they're going to do is they're going to look at the rate of profit, or the rate of return that they earn,

on that investment. So this is where the rate of profit becomes a crucial compensation. So this is where the rate of profit becomes a crucial concept because it doesn't really matter the total amount of profit that they earn, because that's going to be dependent upon the size of the investment that they make. A big investment will yield more profit than a smaller investment, other things being equal. But they're going to look at the rate of profit. And so this will lead to a tendency then for new investments to be directed towards industries providing the highest rates of profit or the highest earnings. So that means that there's the biggest gap between revenues and expenditures relative to the size of capital

that has been invested in that industry. And of course, this analysis is taking tax rates and other regulations and relative riskiness in the different industries to be constant. Because obviously if you have different tax rates and that's going to affect the pre-tax profit that you have to earn to compensate for that. And if some activities are more riskier than others, you're going to have to earn a premium to compensate for that risk. But we're just simplifying that out of the analysis for the moment. So just ignore taxes and risk and those other things like that. So how does the uniformity of profit principle come about? Okay, so it's fairly obviously that investors are going to seek the highest rate of return,

but why does that necessarily mean that all branches of industry and the economy are going to have the same amount of returns in the long run? The reason for this is because of the concept of diminishing marginal product. Now, this essentially means that as you get more capital invested in a particular industry, or even in a particular business, the relative productivity of that additional capital diminishes. In economics, the term marginal refers to sort of on the edge at the margin. So the average productivity of capital in a particular industry may be very high, but an additional unit of capital added to that industry might not be very particularly useful. So we said that in that case there is a low marginal product or marginal utility of capital.

Product just refers to the amount that is produced. So marginal product refers to the extra units of output that are produced as a result of extra capital that's added, the extra units of capital at the margin that are added to the industry, ignoring all the capital that's already been invested in that industry because that's kind of irrelevant to the analysis of what happens at the margin at the edge. Now, marginal product tends to decrease because if you have the same amount of labor, the same number of workers, the same skill set of those workers and the same levels of technology, so holding all other things constant, if you just keep adding more and more capital, that's eventually you're going to run into diminishing returns. This is a general concept in economics, that the first units of something, whether it's an ice cream or a computer or,

car or anything are going to be much more useful than the 100th unit or the thousandth unit of that good holding other things constant. You can think of it like the, I think I discussed this in the earlier podcast, but the first computer that a business purchases may have a huge effect on their productivity because now they don't have to keep all their records by hand and they can type things in and so on. But the second computer, well maybe now they can have two people working at the same time and that improves productivity a little bit, but it doesn't make as big a difference as the first computer. And by the time they get to the fifth computer, you know, well maybe they don't really need that and it's just kind of a backup in case one of the other

computers stops working and they have to get it fixed. So, you know, that's a little bit of an increase in productivity because now they don't have that downtime waiting for their third and fourth computer to be fixed, but it doesn't happen that often. So it's only a very small increasing productivity. So that illustrates the point that is as you get more and more of something, of an investment good in particular, so that could be a computer or machinery or anything like that. As you get more and more of it, the marginal product decreases. It becomes a less less useful. That doesn't mean that it's not useful. The marginal units are not useful at all. They're just not as useful as earlier units. So how is this in any way relevant to the uniformity

of profit principle? Well, the reason is that the marginal product of capital invested in an industry is related to the marginal revenue that that capital generates when it's invested. So think of it as a... This is easiest to understand it in the context of a factory that's purchasing extra machines. The revenue that the factory earns will be proportional in in our example here to simply the amount of goods that it produces. Let's call them widgets. So the amount of widgets that this factory produces is really the sole determinant of its revenue, of its incomes. So as this factory purchased more machines, it produces more widgets and so earns more income. However, because of the law of diminishing marginal product, each new machine that

it purchases produces less output than the previous machine, produces fewer widgets. And so the earnings or the revenue generated by each new machine decreases as the factory purchases more and more machines. So therefore, revenues go down, revenues don't go down, but marginal revenues go down, or revenues per new machinery, piece of machinery, go down as you get more and more machinery in the factory. And that could be because you only have a certain number of workers or a certain amount of space in the factory, etc., etc. The exact reasons for diminishing marginal product differ between industries. And diminishing marginal product doesn't apply all the time. It may be that within a particular factory or even in an entire industry at a given time, there's no real diminishing marginal

product. But it generally does apply. The law of diminishing marginal product generally does apply throughout the economy as a whole, sort of over a broad spectrum and over a long enough period of time. Eventually, as you just get more investment in an industry, the revenues generated by that extra investment are going to go down, just because the simple idea that you are going to, you will always use investment funds for the most urgent or the most useful purpose first. So if a supermarket got more investment funds, they would use it to do whatever activity would most increase sales. And then after that activity is done, they would use any additional investment funds for the activity that increased sales by the second most amount and so on and so on. And so there's always, or almost always

going to be this diminishing effect, diminishing marginal product, and therefore diminishing marginal revenue of capital invested in an industry. And so because, going back to our full, factory example, every new machine that the factory purchases represents a capital investment. You know, it costs money to buy that machine, and that machine is owned by the factory. And so it represents investment in that industry. It's money that has been used to purchase an asset that then is used to produce revenues. So that is an instantiation of investment. So the point is, as investment in that factory increases, the marginal product of its machines

goes down and therefore the marginal revenue of the machines of the machinery goes down and therefore the marginal revenue of per investment of capital in the industry also decreases and if the revenue is going down but costs are staying the same and costs are staying the same because each piece of machinery is the same as the same as each piece of machinery. It's just producing less revenues because of the use of the machinery. Yeah the costs are the same but with lower revenues profits of course go down same costs smaller revenues fuel profits it's a fairly simple algebra there and with fewer profits, or with a relatively lower profit rate, the profit earnings per capital investment for that industry or that factory or whatever are going to decrease. So that's why profits tend

to diminish as more and more funds are invested in that industry. Industries can almost always make use of those extra capital funds, but because of the law of diminishing marginal product, that extra investment will produce less revenue than before, and less revenue means less profit, and therefore the extra investment produces lowers the rate. of profit in that industry. It also works the other way around. If you withdraw capital from that industry, normally the way that happens is not by physically destroying machinery or whatever, but it's more like you just let capital depreciate and don't offset that depreciation. But anyway, if you withdraw capital from that industry, the relative effectiveness of the capital that does

remain goes up. And so you have the sort of inverse marginal product principle and the rate of profit increases. So more capital into an industry means a higher rate of, sorry, means a lower rate of profit and less capital in an industry means a higher rate of profit. Okay, now if we combine this with the fact that investors will always seek out industries with the highest rate of profit to maximize their earnings, we can see how the uniformity of profit principle is derived. Basically, suppose you had industry A and industry B, actually to make it more concrete, we'll say the automobile industry and the agricultural industry. Let's say the agricultural industry has too much capital in it, so it has a relatively low rate of profit because of that

finishing marginal product, the problem we discussed before. And conversely, the automobile industry has a relatively high rate of profit because of the relatively low capital that's been invested in it. As a result, investors will withdraw capital from agriculture, or more realistically, they'll just allow that capital that is in agriculture to depreciate and invest more capital into the automobile industry. As that happens, capital stocks of automobile industry will increase relative to those in agriculture, and the margin, revenues of those capital in the automobile industry will go down whilst those in agriculture will go up and therefore the rate of profit in the automobile industry will diminish and the rate

of profit in agriculture will increase until and this process will continue until rates of profit are about equal to each other at which point the investors will stop withdrawing their funds from agriculture and moving them into automobiles and just kind of keep it level or channeled the same amount of funds into both industries so there's no relative change and that's where where the uniformity of profit principle arise. Profit will be withdrawn from overcapitalized, I'm sorry, not profit. Capital will be withdrawn from overly capitalized industries, driven by an artificially low rate of profit in those industries,

into undercapitalized industries directed by the relatively high rates of profit in those industries. So high rates of profit are a sign or an indication that an industry is undercapitalized, and so they serve to direct more capital to that industry. This is another example of what we saw in the previous podcast where prices serve both as information and an incentive. So the low rates of profit in undercapitalized industries serve as a sign or a source of information that those industries are relatively undercapitalized, but they also serve as the incentive to transfer that capital to that industry because people who do so will earn higher profits. And there's a negative feedback loop in there, so as more capital is invested in that industry, the rate of profit goes down. and so the inflow of capital tends to diminish.

So once again, we see how prices serve to regulate the economy and keep industries balanced relative to each other. So this uniformity of profit principle ensures that industries have the relative right amounts of capital in them, and there isn't too much investment in one industry and not enough investment in another industry. Because if there was such an imbalance of investment, rates of profit would go up or down, and capital would be redirected accordingly. Now, remember that this is an oversimplification in some sense, because I've neglected the impact of taxes, as I mentioned. Also, I've neglected the existence of the potential for asset bubbles or other such things to artificially inflate the rate of profit that one can earn in an industry.

And I'm going to save that discussion for another podcast, because it's a very interesting issue. However, asset bubbles are relatively rare. Well, it's hard to know exactly how common they are, but particularly large ones are certainly rare. They do happen. We had the housing bubble a couple of years ago, and before that it was the dot-com boom, and there have been others in the past. But those sort of big ones don't happen particularly often. So for most industries, most of the time, the uniformity of profit principle is a good explanation of the dynamics of investment and earnings within that industry. I should also point out a couple of extra things. First of all, the uniformity of profit principle also benefits from not just diminishing marginal product of capital, but also the simple fact of the demand curve sloped downwards. In other words, if an industry has too much capital, it will tend to be producing too much a product, and therefore the price of its output will tend to fall. Or people won't be willing to pay very much for that large amount of output, for those extra units of output, you know, because of diminishing marginal utility of those extra units.

If suddenly the automobile industry started producing 10 times as many cars as they did at the moment, they would have to dramatically reduce the price of many of those cars, because people wouldn't be willing to pay the same amount for those 10 times as many cars, those extra units as they would be for the current number of cars, you know, because one car is very useful, a second car is quite useful, a fifth car is probably not that useful for most people. That's an example of diminishing marginal utility. Diminishing marginal utility means that as the output of a particular good gets, increases relative to other goods, not in an absolute sense, of course, but just relative to other goods, then people will be willing to pay less for that relatively abundant

good, and therefore the price of it will have to fall, and as the price of it falls, of course, revenues go down, costs stay the same because there's been no change in the manufacturing process, it's just a demand issue. So with constant costs and diminishing revenues, you get a reduction in the rate of profit, and therefore that complements the diminishing marginal product effect in producing the uniformity of profit principle. The uniformity of profit principle can also work kind of in reverse in that if industries or particular businesses are heavily overcapitalized, they may actually make losses whereby some of the capital that they produce is just so unproductive or people, the market is just so saturated with whatever that they produce, with whatever they

produce, that they are unable to cover their costs, and so their capital stock actually, so they actually make losses. The thing about this is that as they're making losses, where does that loss money come from? It has to come from somewhere. It comes out of their capital. If costs exceed revenues, then the capital stock of that business or that industry is being depleted.

And remember that the whole problem in the first place was that this industry had too much capital, so it was overproducing, so it had to sell at a low cost, et cetera, and so it was making losses. So the very fact of being overcapitalized produces losses, which in turn offsets the effect of being overcapitalized. So this is a negative feedback mechanism, and this also happens in undercapitalized industries. Undercapitalized industries would tend to earn very high rates of profit on their investment. Very high rates of profit are typically reinvested. Well, they almost certainly would be because it would be silly to, investment somewhere in an industry where you'd earn a lower rate of profit. And so as these

high rates of profit are reinvested in that industry, that reinvestment represents an increase in the capital stock of that industry. So once again, this is a negative feedback mechanism whereby low capital stocks lead to high profits, which lead to increases in capital stocks. It's a very efficient mechanism, on the whole, of course. Okay, now, I want to move on from the uniformity of profit principle and just talk about profits in a bit more of a general sense, how they promote efficiency and innovation. Now, the key point here is that because private businesses get to keep the differences between receipts and expenses or revenues and expenses, there is a strong incentive for them to constantly keep costs as low as possible. Because obviously, they lower the costs with constant revenues, the more profits they make, and they want to maximize profit.

Now, that might sound like a bad thing trying to keep costs as low as possible. Doesn't that mean, like, cutting corners and taking risks and keeping wages as low as possible and things like that? Well, yes and no, because a business will always try and cut as many corners as it possibly can in terms of, in order to keep costs low, but they won't cut any more than they are able to because, you know, if they produced a really poor quality good, no one would buy it. Or if they pay their workers too low wages or have such horrible conditions in their factories or offices, no one will work for them or hardly anyone will be willing to work for them. So there's a natural offsetting mechanism to sort of prevent firms from economy. anonymizing too much and reducing quality too much because they simply won't be able to get either the workers or won't be able to sell their goods if they do that. Now, once again, it is more complicated than that because there are problems with information. Consumers don't always know how good

quality goods that they're getting. Workers don't always know exactly how safe the conditions they're working in are or what options they have in other industries. And so it certainly doesn't work perfectly, but it does generally work very well. And we can see this if we compare it to say how government enterprises work whereby if you go to a government office of some kind you'll generally have to wait in a queue for a ridiculously long amount of time. This was very evident in the Soviet Union when all shops were run by the government and there were queues everywhere. This is particularly evident in the Soviet Union when all shops and businesses were run by the government and they were queues everywhere. Service quality was very poor because there was no incentive to attract

customers and to keep them happy because people who worked at the stores or even the managers of of the stores didn't get to, didn't, were not motivated by the profit motive. They were paid essentially a salary and, or maybe they had some incentive mechanisms, but it generally wasn't related to profits that the business earned. And so, yeah, there are a wide variety of pieces of evidence to show that the profits, profits do promote efficiency whilst also placing constraints on the business not to cut corners too much. But anyway, going back to the more theoretical instance, when a firm exchanges, say they manage to introduce a new mechanism or a new method of production or organization or anything like that that enables them to replace a more expensive input into production or a more

expensive machine or more expensive worker for a cheaper worker or a cheaper machine or a cheaper process of making the good. When they do that, that benefits the economy. Obviously it makes that the good that they're making cheaper because it costs less to produce. But it's not just that. It actually, the process of replacing a more expensive for a less expensive input or a more expensive worker for a less expensive worker benefits the economy as a whole. It increases the total efficiency of the economy. Why is this? Well, the reason is as follows. The price or cost of an input or a worker that a business has to pay is going to be related to the marginal utility or the marginal product of that good, of that input or worker in their next most beneficial use. the higher the product of that good slash worker in their next most productive use, the higher that is, then the higher the price the business will have to pay in order to get the services of that good or that worker. And so if the first business manages to replace an expensive worker with a cheap worker, it means that the next most beneficial use of that worker or good is less valuable,

therefore less expensive than the next most beneficial use of the worker that they previously used. So that may sound quite abstract and hard to follow, but think of it like this. Suppose that we developed a mechanism where instead of having to hire a whole bunch of engineers, highly qualified engineers to run some factory, we managed to simplify the processes or introduce new technologies or whatever, which permitted us to hire just technicians with lower levels of training to do the work. What does that represent? Well, the engineers, who previously were doing the job, would have cost a lot more to hire than the technicians, obviously.

But the reason for that, the fundamental reason for that difference in expense is because the engineers, if they weren't working for this business, they could go and work at some other business and do something almost as equally important and earn almost the same wage, because their skills are highly valued. So the production that these engineers are giving up is quite valuable to work at firm A instead of firm B. Whereas the technicians, their skills are not as valued. And so whatever they would be doing, if they weren't working for this firm A, the first firm we were talking about, would be less valuable. And so the firm A would have to pay only a lower wage in order to attract them,

away from whatever other firm would be hiring them instead. And so this illustrates the fact that if a firm manages to replace an expensive input or an expensive worker for a cheaper one, they're actually freeing up resources that the economy can use to do something else. And so that is always beneficial because it's increasing the productive capacity. of the economy. And we see that in the form of lower prices for the goods that are being produced. That's not just because the business is cutting corners or something. It actually means something. The lower price for that good means that the firm is using less resources from the economy.

It's reducing, because whenever a firm produces anything, that takes resources. I'm not talking about coal or something. I'm talking about labor and capital and machinery and things like that. So whenever that firm produces something, it diminishes the total stock of available resources in the economy by a certain amount. And the amount of resources that it sort of pulls away from that pool, if you like, that the economy has to draw from, is that the size of that pull of resources is proportional to the price of the good. So if the amount of resources that is being pulled out of that pool is to reduce, the price of the good also will be reduced. but that is reflecting the reduced costs of producing that good, or the reduced drain upon resources from the economy that that represents.

So hopefully you were able to understand that. It's a bit of an abstract concept. You may need to think about it for a bit. But anyway, I want to move on now to looking at profits and innovation, and this will certainly lead into our discussion of freedom of competition. Now, businesses are always motivated by the prospect of earning above average profits, and this can be done by introducing new technologies or new products that people hadn't thought of before, or just anticipating changes in consumer demand,

introducing improved products, etc. Now, any businesses that managed to do this before other businesses, will be able to earn a lot of revenues, either through higher prices for new goods that no one else had thought it before, or for lower prices of existing goods, and then lots of people will buy their product as opposed to another product, etc. So any business that manages to do any of these things will earn very high profits, not just lots of profits, but a high rate of profit. and because firms want to maximize their profits, firms private businesses are going to be constantly

trying to seek ways of anticipating changes in demand or introducing new goods that people want or reducing production costs, etc. They're highly motivated by earning this above average rate of profit. The trouble is, though, that you can't just do this once because any time a given firm introduces, say, a really new product or a new technology, another business is very shortly going to copy that method. Even if you have a patent on sale, something, patents don't last forever. They only last for, I don't know, seven years, 20 years, depends on exactly what it is, but they only last for a couple of decades at most. And even within that time, generally, there are ways of reverse engineering a patented product

or good or whatever so that you can, so that other businesses can essentially do the same thing, but it's sufficiently different so that you don't infringe upon the patent. Or maybe you'll just give the other business an idea of a different avenue that they can go down. But the point is that you can't just rest on your laurels once you've invented a new good or a new technology because very soon someone else will imitate that and you'll lose your competitive advantage and you'll go from earning above average profits to earning average profits once again. So if you want to, if in business you want to keep earning above average profits, you have to keep innovating and introducing better and better goods, newer goods, anticipating changes

in demand and all that stuff. And that is one of the biggest reasons why a capitalist free market economy is able to continually innovate and continually experience technological advances and economic growth because of the innovations promoted the potential to earn above average profits. And you can't take that incentive away, because if you do, the, well, why would people, why would businesses spend so much time and effort to continually try and improve production and introduce new and better goods? They just wouldn't be the same motivation. Now, there's a question of all about intrinsic motivations and reward from doing the job itself.

Yes, those things are all important, but someone may enjoy tinkering with electronics, or whatever and inventing things, but that's not the whole story. The key point of it is that it's the most important thing in a sense, if that is if your new technology that you've just invented, your awesome little robot or whatever that you just built, is going to benefit other people is if it's standardized, if a mechanism for mass producing it is established, if it's packaged and arranged in a way that's convenient

and attractive to lots of people, and if it's advertised that lots of people know about it, there are lots of steps beyond just inventing a technology or process towards actually getting it. it out so that lots of other people can enjoy it and benefit from it. That process of going from invention to mass consumer good is an expensive one, and generally it's not so much the one that is going to provide the biggest intrinsic rewards to people. Like, people might invent things just for the fun of it, but they're not going to start mass producing them and developing

it into a mass consumer good, you know, that's sufficiently durable and safe and useful and all those other things, unless they have that motivation of high profits. So that's the key thing. It's not even so much that the profit motive is motivating inventors to invent things or people to come up with new poems or whatever, all the kind of things that people might want to do. It's more that the profit motive provides the incentive to take those raw ideas and those raw products and apply them and introduce them

so that everyone can enjoy them and everyone can purchase them and that they become a mass-produced good. And this leads me into the next part of the podcast about, of competition because entrepreneurs, those who introduce these new innovations and new ways of doing things, new goods, require economic freedom, the freedom to purchase goods and to set up their own businesses and do new things, et cetera, if they are going to be entrepreneurs, that they have to have this freedom. In the Soviet Union, you really couldn't be an entrepreneur other than on the very, very smaller scales, because you weren't allowed to buy and sell property or capital goods or

make investments or anything like that. It just wasn't possible. Economic freedom didn't exist in that sense. I'm just going to put some names forward here of examples of famous entrepreneurs who have introduced new goods and new ways of doing things that have certainly improved life and made the economy more efficient. Donald Trump, Bill Gates, Steve Jobs, Henry Ford, Michael Dell, Walt Disney, Howard Hughes, Howard Schultz, Andrew Carnegie, Joyce Hall, Ray Kroc, Rupert, Murdoch, Oprah Winifrey, John D. Rockefeller, Thomas Edison, George Easton, and James Watt. All of these people would not have been able to do what they did had it not been for

economic freedom. And it's particularly important to give people the freedom to, you know, try out new things and introduce new innovations, because by definition, a new innovation is something that goes against the conventional wisdom of the time. Most people expected things like the steam engine or the electric light bulb or the television or the automobile not to work when they were first introduced. But it turns out that they did work. And only by letting 100 flowers bloom, so to speak, and allowing different people to try different things, be able to, you know, find out what works and what doesn't. So that is why free markets are able to generate the type of technical and economic progress, because we allow, those type of free markets

allow everyone who thinks they have a good idea to try out their good idea. And it's not just that, though, there's also a selection mechanism that selects only the best ideas, or generally only the best ideas, and weeds out all of the bad ideas. Because it is true, most new ideas, most innovations are bad. Most entrepreneurs fail. Most new businesses fail. And that's for a reason, because most ideas are bad. Most ideas that challenge conventional wisdom, go against conventional wisdom for a reason, because they're not good ideas. But a few of them are good ideas. So in this sense, the process of economic progress and economic freedom is much like natural selection. In natural selection, natural selection is driven by random mutations in the DNA of organisms

that produce differences in various phenotypic traits of that organism or that species. Most such mutations are harmful and make their organism less fit, less able to survive and reproduce. But a few of those mutations, just by chance, make the organism more fit, make it better. And evolution selects out, or natural selection, selects out those few beneficial mutations, and thereby producing evolution, which allows organisms to become more, better adapted to their environment over time. And it's the same thing in economies. The very few new ideas or innovations that are good are selected out, by the profit and loss motive, the facts of profit and loss.

Entrepreneurs who produce a good that no one wants or who produce, who use an inefficient process will not be able to make profits, and so will eventually go out of business. Whereas those few entrepreneurs who produce a very desirable product or have a very efficient method of production will earn very high rates of profit, and then they can then use those high rates of profit to reinvest in their own industry, or in their own business, excuse me, thereby expanding their activities and permitting them to, to grow. And so the successful businesses, which correspond to the useful practices, the good ideas are able to grow, and the bad ideas are weeded out because they make losses and go out of

business. The fact of economic freedom also increases the chances or the abilities for innovation, because there's not just one mechanism for obtaining funds. Even if the Soviet Union, they did have economic freedom, the only place you would have been able to go to get the capital to invest in your project would have been the Soviet government, because they essentially owned everything. So basically, you know, that's one, maybe a few different branches of the bureaucracy that you can approach to try and get approval for your project. And even if the government doesn't own everything, but you have to have a permit to do any business activity, that's a government official or maybe at most a few different branches of the officialdom that you have

to approach to get approval to do something. The whole point, though, of a free market is that you don't have to get approval from any one person or any one agency to do something. All you have to do is raise the necessary funds to begin investing in whatever it is, whatever project you have. And so that could take the form. of convincing, say you need a million dollars, you could convince a single millionaire to give you that million dollars, or you could convince 10 rich people to give you $100,000, or you could convince just one million ordinary people to give you $1 each, or any combination of these mechanisms. So there are a whole plethora of different ways of raising capital and

achieving the goal you want, achieving your ends, in a free market economy, and that ability to do, to have multiple avenues of approach to a particular problem, permits much greater flexibility in terms of the amount of innovations that can be implemented in the amount of different ways that we can try to do things. Another important factor of free market economy is how entrepreneurs and businesses in general are disciplined. So it's all very well that we give freedom for entrepreneurs and innovators to introduce new ideas,

but we also need to restrict that because we can't just have resources being wasted in many frivolous crackpot schemes. First of all, entrepreneurs have to pay for the inputs that they use, and the prices that they pay for those inputs reflect the value of those inputs in the production of other goods. So if you're an innovator and you have this great idea which requires the use of large quantities of diamonds, you're going to have to pay a lot of money to buy those diamonds,

and that large sum of money reflects the fact that people highly value diamonds for other uses. And so if you want to use them for something, you have to pay a proportionate fee to offset that usefulness that you're taking away from other people by using all those diamonds yourself. And so if, in fact, your use of diamonds is not very beneficial. No one really likes it. It's not very helpful to anyone. Then you're going to make a loss.

You're going to go out of business, and you're going to stop doing that. However, if people do like that use of diamonds, then you're going to make a profit and continue in your business and expand your business. So that's one way that entrepreneurs are restrained by the price they have to pay for their inputs, which reflects the marginal utility of those inputs in other alternative uses. Second of all, of course, the price that consumers are willing to pay for the entrepreneurs' product communicates how much value the consumers place in the product that the entrepreneurs are producing. And so by these two mechanisms operating together, the entrepreneur is restraining their activity. So it doesn't really matter how confident the entrepreneur is that their idea is a great

one. Of course, they all think that it's a great idea. All that really matters is how much consumers value whatever it is that they're producing relative to the prices that the entrepreneur has to pay for the inputs required to produce those goods. So, and in effect, to everyone else in the economy votes on how good the entrepreneur's idea is. And the way they vote is by their buying and selling activities which set the prices for the entrepreneur's product and the inputs that the entrepreneur requires to produce that product. And through voting in this way, consumers effectively can vote as to whether the entrepreneur will stay in business or whether they'll go out of business.

And a similar restrictive or restraining mechanism operates on firms, as I mentioned before, competition for consumers or for customers forces businesses to, well, not only to keep prices low and to keep their goods attractive and working. but it forces firms to maintain nice stores to have friendly staff to treat customers well, etc. As I mentioned before, this was not an issue in communist countries, and so you had very rundown stores, very sparse, very shoddy products, rudder-niritable shopkeepers, etc. And a similar mechanism operates to keep employers on as relative to employees.

Of course, as I mentioned before, this mechanism doesn't work perfectly because of imperfect information, imperfect competitions, but generally it works pretty well. You can't just pay your workers three cents an hour because they won't work for you. They'll go and work somewhere else. businesses compete with each other for finite supplies of labour and for other inputs too, and thereby they are forced to treat their workers at least reasonably well to at least pay them reasonably well, etc. The very reason that people in, say, third world countries, China or wherever else,

are paid such low wages is because the competition for workers in those countries is relatively low. There aren't too many other businesses wanting to hire workers there, at least relative to the large population of people that there are. And so the businesses are able to pay low wages. Nike and whoever else is hiring workers in those such countries. But if economic growth continues in those places, then you'll get more and more businesses setting up and more economic activity, the competition for those workers will increase and their wages will go up. So hopefully you've got a reasonably good overview of the profit motive, freedom of competition, how these things are

important to maintaining the dynamism and efficiencies of a free market economy. If you want to contact me in regards to this podcast, you can email me at Fodds12 at gmail.com. please keep listening and invite others to listen likewise to the podcast. I'd love to get more listeners, and I'll talk to you next time.