Lesson 6 of 8
The signal that a plan was wrong
A profit here is not mainly a reward. It is the market reporting that resources were in the wrong place, and a loss is the same message, louder.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A pure profit appears where resources were worth more in another arrangement than in the one they were in. It marks a misallocation that has just been corrected.
- A loss carries the same information in the other direction, and it is the harder half: it says resources already committed were pointed at something people did not want.
- The signal only works if it is allowed to arrive. Anything that suppresses either side removes information, and on this account that is the cost, whatever else the intervention achieves.
In ordinary usage profit is what a business earns and loss is what it suffers. In this tradition both are first of all messages, and who receives the money is a separate question from what the number tells everybody.
What each outcome reports
Profit
- These resources were worth more here than where they were.
- Somebody earlier had them in the wrong place.
- The gap has now been closed by whoever noticed.
- The signal disappears once acted on.
Loss
- These resources were worth less here than elsewhere.
- The commitment that put them here was mistaken.
- Continuing means continuing the mistake.
- The signal persists until the resources move.
A reward can be argued about. A report cannot be argued with, only ignored.
Why profit is a report and not only a reward
Kirzner's two-price case makes the point cleanly. The gain from buying at the lower price and selling at the higher one is not payment for effort, for capital or for risk, since the example has none of those. It is what the gap was worth, and the gap existed because resources were not where people valued them most.
So the size of a pure profit is a measurement of how badly something was misplaced. Taking it is what removes it: buying more where the price was low pushes it up, selling more where it was high pushes it down, and the signal consumes itself.
Loss is the half that does the work
Profit tells somebody that something can be done. Loss tells somebody that something already done should stop, and that is much more expensive information, because the resources have already been committed to a particular arrangement.
This is where the previous course rejoins. Capital goods are specific, so a loss is not a signal that money should move; it is a signal that a specific combination of things, in a specific place, was built for a demand that was not there. The next lesson is entirely about why that is expensive.
The condition the signal depends on
If profit and loss are information, then their informational value depends on their being allowed to occur and to be read. A subsidy, a guarantee or a price control does not only transfer money; on this account it removes a reading.
This track states that as a consequence of the theory and stops there. Whether a particular intervention is worth its informational cost is a policy question with other considerations in it, and no lesson here takes a position on one.
Check yourself
On this account, what does a pure profit measure?
- The effort the entrepreneur expended
- How far resources were from where people valued them most
- The risk that was borne
Show the answer
Answer: B.
In Kirzner's two-price case there is no effort, capital or risk in the example, and the gain is exactly the size of the gap that had been left unclosed.Why is a loss the more expensive signal?
- Because losses are usually larger
- Because the resources have already been committed to a specific arrangement
- Because losses are reported later
Show the answer
Answer: B.
A profit points at something not yet done. A loss reports that something already built was built for a demand that was not there, and specific capital cannot simply be moved.What does the account imply about suppressing either outcome?
- That it always makes an economy poorer
- That it removes information, whatever else it achieves
- That it has no effect on allocation
Show the answer
Answer: B.
The informational claim is that the signal has to be allowed to arrive. Whether a particular intervention is worth that cost is a separate question this track does not take a position on.Sources
- Kirzner, How Markets Work: Disequilibrium, Entrepreneurship and Discovery, Institute of Economic Affairs, Hobart Paper 133, 1997, on pure profit as what an unexploited price gap is worth and on its being removed by the act of taking it.
- Hayek, 'The Use of Knowledge in Society', American Economic Review, 1945, sections VI and VII, on the price system as a mechanism for transmitting the consequences of dispersed knowledge.
- Lachmann, Capital and Its Structure, 1956, chapter 1, on why committed capital goods cannot be freely redeployed, which is what makes a loss costly.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Both firms in the example are invented with round figures. They describe no company and no transaction.
- Reported accounting profit is not the pure profit of this argument. An accounting figure contains returns to capital, to labour and to earlier decisions, and separating them is not something a filing does.