But why would entrepreneurs wish to increase the amount of consumer goods? Because of consumer demand. Entrepreneurs are greedy and if they see a demand they see the opportunity for profits and the only manner to achieve this is through an expanded production. Thus they acquire more capital goods in order to expand said production of consumer goods.
Please note that up to this point we have not mentioned competition. All the above mentioned processes work without the need for an existing competition. They operate assuming a monopoly. This is yet another reason why monopolies are nothing to be afraid of. Although it is true that in a monopolistic situation an entrepreneur will optimize profits thus only manufacturing sufficient consumer goods to maximize profits, it is also true that they will increase manufacturing capacity in order to increase the number of sales. Higher sales mean higher profits. Despite the fact that entrepreneurs will attempt economic calculations in order to produce the exact amount of product to maximize profits, we must always remember that all economic calculations are best guesses only. Entrepreneurs will invariably over or under shoot. The end result of this process is that over time prices of consumer goods will tend to decrease, although not as fast and not as low as under competition.
Now we have to include competition. There are two kinds of competitions; direct and indirect. Direct competition is the classic one where we compare two similar products with similar properties but different prices. Indirect competition occurs when dissimilar products compete for our disposable income. If we purchase product A we won't have enough money to purchase product B. If we blow all our disposable income in marbles we won't have enough money to buy Lego.
The consequence of these facts is that even in a situation of absolute monopoly, the monopoly owner is still under the pressure of competition. This person must produce products so appealing that people will purchase them and not others. In other words, these products must fulfill a really important need far better than under a theoretical monopoly (i.e. no competition) but these products must also be sold at a price that makes them appealing to potential customers above and beyond other unrelated products. For example, the manufacturers of exotic (and unique) chesses cannot charge any price they want even for the most exclusive ones because they are competing with wine manufacturers, also producing exclusive and exotic wines.
This indirect process tends to lower prices far beyond what plain monopoly processes will do. However, eventually all goods are copied and thus they all face direct competition to one degree or another. It is this direct competition that drives prices down to an absolute minimum. Think about it. If you have two identical products which one would you buy? The cheapest, right? Thus direct competition drives prices to their absolute minimums. And what are those minimums? Manufacturing costs. Entrepreneurs can't sell cheaper than what it costs them to manufacture said goods because their motivation is profit. No profit no motivation and herein lies their problem. They know that eventually all their goods will cease to produce profits. The production of profits is only temporary and ephemeral (i.e. it vanishes over time). But entrepreneurs are greedy. What can they do about this? Simple. They develop new products which can then sell at higher profits. But new products imply new tools to reduce our uneasiness which translates as higher standards of living.
It is for this reason that competition is yet another process which enhances our standards of living, but the most important fact is that competition operates on the basis of greed, this is selfishness. Competition works because people are greedy. Attempting to dismantle greed only leads to higher prices because greed is in our very nature, selflessness is not. Selflessness leads to lack of incentives which produces less consumer goods which creates lower standards of living. The truth is that greed has a very bad reputation due to ethical and religious perspectives, perspectives that are obviously utterly clueless about real-life economics.
This is what Romans used to ask when on trial. Who benefits? Socialism and communism doctrines have been tremendously successful in selling the idea that entrepreneurs "exploit" workers. We talked about this issue in our previous lesson and explained why this is rubbish, but we didn't show the complete picture. Today we are going to do just that.
Let's recap. To begin with, entrepreneurs take huge risks in the marketplace. They are betting all their capital to their economic calculations, which are guesses at best. Workers, on the other hand, take very little risk. Their wages are almost risk-free. This is one of the reasons why entrepreneurial profits are so high when compared with wages.
The second issue is what is called a "survival bias". This is a well-known statistical phenomenon that neither socialists nor communists ever mention. What these people do is to compare successful entrepreneurs versus workers' wages, yet they conveniently "forget" that for every single successful entrepreneur there are many more failed ones. The typical ratio of successful entrepreneurs to failed ones is about 4 to 6 (depending upon countries and time in business). For every 4 successful ones there are 6 failed ones. Now, when an entrepreneur fails all the capital is wiped out. There are no second chances. No other companies and no other capitals. The entrepreneur must start from scratch. A worker, on the other hand, still possesses marketable skills, however basic they may be. This is yet another reason why entrepreneurial profits are so much higher than workers' wages.
The third reason is that entrepreneurial profits are constantly threatened by competition enabled through capital accumulation. The more effective the competition, the lower the profits and the higher the capital accumulation of consumers which is the enabler of more competition. Entrepreneurs must remain on guard and creative at all times. This is yet another reason why entrepreneurial profits are so much higher than workers' wages.
The fourth reason is that all those critics focus on personal wealth and not on distributed wealth. They are comparing the wealth of one rich entrepreneur against one poor worker. Although this reflects reality, this does not reflect the whole of reality. For that we need a deeper analysis.
Distribution of wealth
The basis of socialism and communism is the forced redistribution of wealth in order to reach "equality". Fair enough. The question is then, how badly is this wealth distributed to begin with? because it is easy to compare a rich entrepreneur versus a poor worker. However, the entirety of the wealth created by the entrepreneurial activity is not represented by either amount of wealth. What we need to look at is all the wealth created by the entrepreneurial activity and who received it.
Imagine a person who finds a treasure map. This person labours for years following clues, hiring guides, translating obscure texts and so on until finally she finds a large coffer full of ancient gold coins. This person then proceeds to take a fistful of coins for herself, pays two coins to each former employee and then distributes the remaining coins randomly among the world's population. Yes, this person is rich by comparison to her employees, but she is poor by comparison to all the gold that she gave away. This is exactly the scenario representing entrepreneurs. The only difference is that while gold coins are easy to imagine, wealth created by entrepreneurs is difficult to estimate, although not impossible. It is an issue of image, not reality. The problem is the false image created by socialists and communists, not with market reality.
But what is the logistics of this distribution of wealth? How does it work?
To begin with, every single consumer of a product produced by an entrepreneur benefits permanently from the product. The needs of consumers are satisfied. Their uneasiness is quenched and thus their standards of living rise.
Then we have the effects of competition. Consumers quench their uneasiness at cheaper and cheaper prices. This drop in prices is also permanent. Which means that consumers retain more of their wages thus their savings and their disposable income grows. This means that their standards of living also raised.
Then we have the people working for entrepreneurs. They receive a fixed salary but the costs of consumer products are also falling, in the same manner as they are falling for everybody else. Which means that workers also benefit immensely. The total wealth spared must be estimated as the difference between the original price of a product minus the price under competition times all the customers who bought the product.
For example, let's assume that Elias makes a unique gadget called "The Approximator". Elias is the first in the market with it and as such he enjoys a monopoly. The original price of the gadget is 100 Morlocks (yes, very expensive). Elias' profits are 10000 Morlocks / year while his worker's wages are 100 Morlocks / year (100 : 1). Over time other competitors appear in the horizon and the price begins to fall. We can summarize an oversimplification of the price history as follows:
Year 0: (100 - 100) x 10000 buyers = 0 Morlocks saved
Year 1: (100 - 90) x 10000 buyers = 100000 Morlocks saved
Year 2: (100 - 80) x 10000 buyers = 200000 Morlocks saved
Year 3: (100 - 70) x 10000 buyers = 300000 Morlocks saved
If we now calculate how many Morlocks were saved in total over 4 years, they equal to 0 + 100000 + 200000 + 300000 = 600000 Morlocks!
Now let's compare.
Total Elias' profits over 4 years = 40000 Morlocks
Total workers' wages over 4 years = 400 Morlocks
Total wealth saved to consumers over 4 years = 600000 Morlocks
See the difference now?
Elias may be a rich person by comparison to his worker but Elias is not rich by comparison to all the wealth that was saved to consumers through the action of the free market. Let's be clear. This example is an arbitrary and oversimplified estimate, its intention simply being to illustrate the type of thinking that socialists and communists never bother mentioning. The 600000 saved Morlocks are real, they are not fictitious. We know this because they do exist in the bank accounts of all the clients who bought "The Approximator". These savings are not imaginary, they are very, very real.
And so now you tell us who benefited the most from Elias' entrepreneurial activity. Elias, his worker or their customers?
This process is the exact equivalent a thinking in terms of all customer's and Elias' worker going up over time. This is so because their purchase capacity has been increased. In economic terms we would say that the marginal productivity of their labour and their wage rate went up.
Note: please see the Glossary if you are unfamiliar with certain words.