In what might be called the “Economics 1.0” view of the world we think of the process of producing some good or service as a simple “Sneetch Machine.” Someone gets some land and uses that land along with some workers and some machines to produce some output. The financial flows in this sort of a static system are easy to follow. Workers get wages. Owners of machines receive rents. And with those wages and rents the workers and “capitalists” buy the goods and services produced from those Sneetch Machines. It’s a tidy circular flow of activity that has been used since at least the time David Hume articulated it a few decades before Adam Smith wrote The Wealth of Nations.

Where profits fall in this world is a bit of a mystery. Do they come from the fact that owners of the Sneetch Machines somehow exploit workers? Do they accrue to owners simply by virtue of them owning capital? What of the inventors of capital? What of the users of capital? The old theories don’t seem to even have a place to accommodate technological change and innovation.

To make more sense of economic activity, and the process of dynamic growth, let’s think about what a simple example tells us. Suppose I currently work as a line-cook making $20,000 per year. I also have $30,000 in the bank earning 5% per year and own a small storefront that I rent out for $10,000 per year. I decide that I have enough of that life, and I want to open a chocolate lasagna shop. So I cash the CD from the bank, I borrow another $40,000 to pay some start-up costs of equipment and materials, I use my own building and I work for myself and get to work making chocolate lasagna. I expect that I will sell $90,000 worth in my first year. Would this be a good idea?

From an economic standpoint, we want to compare this person’s expected revenues (note the inherent risk in the entrepreneurial process – we forego known wages and rents and venture into the unknown prospects of selling) with his total costs – not just his explicit money costs, but also the value of all sacrificed opportunities that he incurs in order to run his businesses.

In this case, my explicit costs are$30,000 that is cashed out of the bank plus $40,000 that I borrowed plus the interest of 5% on that $40,000. Thus, an accountant would see that I am spending $72,000 on the enterprise. He might even say that if I earn $90,000 for the year, that this would be a good deal. But remember, working for yourself, and using your own building and using your own cash is not free, it is very costly. Thus, for a correct understanding of how profitable this venture is, you’d also want to subtract the $20,000 per year “wage costs” you must “pay” to yourself (i.e. by making lasagna, you are giving up the chance to work as a line cook) and you would want to subtract the $10,000 per year in “rental costs” that you pay to yourself (i.e. by using that office space, you are not earning rent on it) and then you’d also have to subtract the interest that you are paying yourself (i.e. by cashing out the $30,000 from the bank, you are forgoing the $1,500 of interest you could have been earning).

Taking all of the direct and indirect (opportunity) costs of production into account, we’d see that your total revenues are $90,000 but your total economic costs are $72,000 in explicit costs plus $31,500 in implicit costs, leaving you with an annual economic loss of $13,500. While the accountant might tell you that your business is a good idea, to an economist it is just the opposite.

If you estimate that your revenues would have been $115,000, then this would have been a good idea, as your annual economic profit from running the lasagna shop would be $11,500. But here is where Economics 2.0 comes in. What exactly does this $11,500 “profit” mean? What it is, is the annual return to my entrepreneurial effort. What this is telling me is that by taking the risk and becoming an entrepreneur, I am better off by $11,500 per year (with some probability, since the revenues are expectations at the time you decide to go for it) than if I employed all of the “Economics 1.0” factors of production in their typical uses. There is nowhere in the traditional model to account for this! In the language of inputs and outputs, the right way to think of production is that not only does it require land, labor and capital (human and physical) but it also requires another “input” and that input or ingredient is the ability of the entrepreneur to implement his vision, to make a recipe from the other ingredients by adding his ideas and his energy to the entrepreneurial process. Thus, an economic profit is a “payment” to the new “factor of production” (i.e. ingredient) called entrepreneurship. Just as the wage is the market return for participating in the labor market and the equipment rental is the market return for participating in the “capital” market, and property rents are the market returns for participating in the land market, so too are profits the market return for applying your entrepreneurial effort to the discovery process.

If you work for someone else, or rent out your capital instead of employing it yourself, your “profits” would be zero. If you decide to take the risks and employ all of the other “ingredients” on your own, then you may either make a profit or a loss, and those profits and losses are extraordinarily important “prices” which signal to all economic actors whether it makes sense to launch a new venture or innovate in some way, or whether it makes sense to sit on the sidelines and leave your labor and capital out there for others to take advantage of.

Whatever you think about whether someone “deserves” to make or lose tons of money as an entrepreneur, the importance of the price signal that such prices express is undeniable. Following these signals, and comparing the “returns” one might get on being an entrepreneur with doing something else is the reason we see new business creation, technological advancement and innovation. The progressives among us seem to think that if we “just got rid of profits from the system” that we’d improve the fairness of our world and still get all the goodies that we get today. There are not enough people in the world who would become entrepreneurs for the “fun of it” though there are still quite a good many of them.