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A commenter on this post asked me to say a bit more about how effective the price signals of profits and losses are in guiding useful entrepreneurial action. Briefly, here is the good question he asks:

I wonder about these price signals in the discovery process. I see two distinct situations: where I am copying someone else’s recipe, and where I am inventing my own recipe. The first we can say there’s a clear price signal. But in the second, I’m not so sure. The fact that business is booming for your new idea of chocolate lasagne does not say anything about how well I will do with my raspberry goulash. And it becomes even less clear when we think about investing in recipes – this is a non-linear process.

Here is a very brief attempt to answer.

Generally, this whole entrepreneurial process is messy and uncertain. This is one reason why I was even hesitant to write it down the way I did in the former post – it gives the whole process the appearance of something far more orderly than really occurs. In terms of the first situation, that’s why we see “good deals” get competed away very rapidly. And this has wide applications. For example, if we try to make farmers better off by providing them with crop supports, we may not be making them better off – competition will quickly emerge to “copy that recipe” so the price of land and other “ingredients” in the farming process will be bid up by new entrants until it is no more profitable to be a farmer than whatever else we might have chosen. If the farmers are the landowers and the factor owners, then this would work to their benefit.

You can see why there is a desire for patent protection based on how “easy” it is to copy an existing recipe. Economists, including myself, are divided about the desirability of patents and, if we grant their desirability, the optimal structure. I don’t think it lends itself to simple economic or ideological thinking.

On the second point, I think this is why the price signals are even more important than the first. It’s not that the prices themselves for your new venture are obvious to you, they are not. Indeed, you may not have any clue about its possible success until well after you’ve taken the risk. But the chance to make profits is a reason we are free to test all sorts of new ideas in the first place. But this then is also why losses are desirable. They tell us whether that new idea, like raspberry goulash (that COULD be yummy, but it sounds as awful as my lasagna idea!) is “worth doing.” And the possibility of losses prevents most of us from taking risks that are completely outlandish in the first place. Finally, those losses encourage the movement of ingredients and brainpower out of those losing ideas and into possibly better ideas far faster than if losses were insulated against.

Unfortunately, many of these ventures will fail, and fail miserably. Some due to bad luck, others due to bad timing, others due to bad management, others because the idea was bad. If it was clear a priori that any of these would happen, most folks would avoid it. But we have to accept this heuristic process in a world of limited knowledge, it’s the best we can do. Without these profit and loss signals working, we would never expect to see regular discovery and economic growth. I wished the world were different, but it might also be a less interesting world too.

2 Responses to “Returns to Recipes, Part II”

  1. Michael says:

    http://www.tasteofhome.com/Recipes/Community/Sweet-Raspberry-Goulash

    http://www.grouprecipes.com/42007/olive-gardens-chocolate-lasagna.html

    They sound okay to me!

    Another point to make would be that there is a great confusion, even among economists, between economic and accounting profits. But, it would be difficult to determine whether a raspberry goulash company would succeed (accounting wise) in part because of all the other factors that go into a business. But as long as I enjoy making and eating the raspberry goulash, I would consider that economically profitable.

  2. Harry says:

    Wintercow, being the orderly professor he is, no doubt has filed this away for future lectures, et cetera. Well put.

    The progressives, certain in their capabilities both concrete and metaphysical, have no such constraints. Repeated failure does not deter them, nor do capitalist price signals.

    All of a sudden ethanol has gotten a reputation as bad social engineering. Big surprise!

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