Chapter 5: Entrepreneurs and Economic Freedom

Entrepreneurs are risk-takers who engage in enterprises with the hope of making a profit. Those who start small businesses such as restaurants and shoe repair shops are entrepreneurs, as are those who improve existing services and products or create new ones.

Entrepreneurs of all types are important to our economic well-being, but the most dramatic progress comes from the ventures of a relatively few. These are the entrepreneurs who challenge the conventional vision of what is possible and turn one generation's fantasies into the next generation's necessities.

Every country and culture has men and women with the spirit of bold entrepreneurship, but this spirit alone will not result in economic progress. Market economies provide the freedom and discipline needed for entrepreneurship to flourish.

Achieving great success requires taking great risks—attempting things that few would dare and that most would consider impractical, if not impossible. Most such bold ventures do fail. The only way to discover what works and what doesn't is by turning people loose with the freedom to pursue their dreams.

Market economies allow the productive energy of entrepreneurs to be unleashed by ensuring that they are accountable to consumers.

Consumer Communication as Discipline

Consumers discipline entrepreneurs by letting them know what they think of projects as they develop, in ways that cannot be ignored.

First, the prices entrepreneurs pay for the inputs they use reflect the inputs' value in the production of other goods, and consumers communicate that value through the prices they are willing to pay for those goods. So entrepreneurs receive a clear message—one that hits them in their bank accounts—on the sacrifice their activities impose on consumers. Second, the price consumers pay for an entrepreneur's product communicates how much value they realize from her venture.

Of course, when an entrepreneur is getting started, her product won't be fully developed and on the market, so the only consumer feedback will be through the cost of the inputs. This is where entrepreneurial confidence is important. It helps the entrepreneur persuade others to help fund the project and motivates her to put up much of the money herself, with the expectation of a large return if the venture succeeds.

Often, entrepreneurs and venture capitalists fund good ideas—or what seem like good ideas—for a long time without generating enough revenue to cover cost. These undertakings often catch on eventually, with consumers rewarding entrepreneurs and investors with large profits, communicating that the new goods are worth more than the old goods being sacrificed.

But no matter how confident an entrepreneur, if consumers continue to indicate the project is worth less than its cost, she will eventually have to respond. A lack of sales is a powerful signal, forcing entrepreneurs to respond by acting as if they are saying, "Although I am convinced my venture is worth more than it costs, consumers are telling me the opposite. They are telling me they value other things that could be produced with the resources I am using more than they value what I am producing. So I will call off my venture to free up resources to produce more of what consumers value more."

Obstacles to Success

The market economy keeps entrepreneurs accountable to consumers by giving consumers the power to pull the plug on some ventures and encourage others. It is this accountability that makes entrepreneurial freedom possible and entrepreneurial ventures such a powerful force for progress.

Yet some object to the success of entrepreneurial ventures. Entrepreneurial activity always disrupts established ways of doing things, particularly when it makes consumers better off. Indeed, the greater the potential benefit from an entrepreneurial venture, the more likely it is to provoke opposition from those with a vested interest in the status quo.

Entrepreneurial success results from the most potent and ruthless form of competition—one that allows the new and improved to sweep away the old and threatens the existence of well-established and profitable firms. As economist Joseph Schumpeter pointed out, the most important competition is "from the new commodity, the new technology, the new source of supply, the new type of organization.competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives."

All competition is unpopular with producers because it forces them to remain vigilant to consumer interests. But it is the competition from successful entrepreneurs that, because it benefits consumers the most, poses the greatest threat and prompts the greatest reaction.

If established firms responded by trying to develop better and less expensive products or by passively going out of business, there would be no problem. But these firms commonly wield significant political influence because of the many jobs they provide and their long-standing support for powerful officeholders. When faced with either making painful changes or being driven out of business, firms often use their influence to hamper entrepreneurs' freedom to get their products and services to market.

Entrepreneurial Davids are able to slay the status quo Goliaths on the field of market competition, but the Goliaths have the advantage when the battle shifts to the political arena. Those with the better products can capture the patronage of large numbers of consumers in open competition, but they may not be able to mobilize large numbers of voters to overcome political barriers. So while the market makes it possible to tolerate the risk of entrepreneurial failure, the political process often has difficulty tolerating entrepreneurial success.

The political obstacles to successful entrepreneurs are more limited in the United States than in many other countries, thanks to the Constitution and public opinion. Still, organized interest groups have been able to use the political process to slow the introduction of technology and products. Consider the following examples.

• As motorized vehicles gained popularity, groups such as the Horse and Mule Association of America, the Master Horseshoer National Protection Association and the National Hay Association lobbied legislatures, with some temporary success in the 1920s, to limit the use of automobiles, trucks and tractors.
   
• In the 1920s and '30s, local retailers sought legislation restricting competition from lower cost chain stores. Today, many retailers lobby local governments to prevent, or at least delay, the opening of large discount stores such as Wal-Mart.
   
• Responding to dairy interests, many states once banned the sale of yellow margarine. Consumers had to tint their margarine at home, with coloring provided by the manufacturer. Such laws began to fall in the early 1950s but held on in Wisconsin until 1967.
   
• Despite the general enthusiasm for the Internet, many existing retailers have fought some types of e-commerce. In a number of states, it is illegal to use the Internet to buy out-of-state wine or purchase automobiles directly from manufacturers.

Economic Freedom

Centrally planned economies fail because they deny people the freedom to act on the information that only they possess to innovate, start businesses, and buy and sell. Substituting the direction of political authorities for the market choices of individual producers and consumers guarantees that economic decisions are made in an informational vacuum.

A productive economy requires using the information dispersed throughout the population, but this cannot be done unless individuals are free to interact in the marketplace. Destroy freedom, and you destroy the information flows necessary for sound economic decisions.

The connection between freedom and markets also runs the other way. Freedom depends on properly functioning markets as much as properly functioning markets depend on freedom.

The market protects freedom by establishing the only setting in which it can be tolerated. Freedom without accountability soon becomes license and cannot endure for long. The only freedom that can survive is one exercised in ways that take into account the concerns of others—freedom subject to the discipline of the marketplace.

In a market economy, I can tolerate your freedom to buy the clothes you prefer, eat the foods you like and pursue almost any objective you desire. When you use resources to pursue your objectives, you take my concerns, and those of others, into consideration. As discussed earlier, the price you pay for the things you buy reflects the value others place on them, so you buy them only as long as their marginal value to you is at least as great as their marginal value to others. Similarly, you can tolerate my freedom to pursue my objectives in the marketplace.

But when markets are undermined, so is the discipline necessary for freedom to survive. There is no mystery about why people are denied basic freedoms in countries where markets are suppressed. Freedom without discipline is unacceptable, and without markets, the discipline will come from central direction and bureaucratic red tape.

Even in primarily free market economies, market incentives aren't always operating, and when they aren't, bureaucratic limits on our freedom are imposed.

For example, excessive pollution results from not having markets to discipline waste emissions into the environment. If such markets existed, polluters would have to pay prices that reflect the cost their emissions impose on others, and this accountability would motivate polluters to voluntarily limit their discharges. But without markets for the right to pollute, we accept bureaucratic restrictions on polluting activities that we would consider unacceptable in most areas of our lives.

We all value freedom, and few want our own freedoms denied. But it is easy to lose our freedoms a little at a time, without noticing the loss.

First, many of the benefits we realize from freedom are the result of the freedom exercised by others. For example, most of us are not entrepreneurs and are not directly affected by government restrictions on entrepreneurial ventures that threaten well-established producers with new and improved products and technologies. Even though they receive most of the benefits from the progress fueled by entrepreneurs, few consumers object to these restrictions because they don't notice the loss of benefits they never had.

Second, it is always possible to provide very visible benefits to identifiable groups through restrictions on freedom. For example, the government greatly benefits a handful of U.S. sugar growers by restricting American consumers' freedom to buy sugar from foreign countries. Growers are fully aware of the millions of dollars in benefits they receive from these restrictions, and they use campaign contributions to show their appreciation to those in Congress who support them. The cost of these restrictions to consumers exceeds the benefits to sugar growers, but because it is spread over 270 million consumers, few ever notice it.

And even when a consumer does notice, he has no motivation to take political action to eliminate the restriction on his freedom. The cost of the action would greatly exceed the cost he would save from lower sugar prices, even if he succeeds. And because of the difficulty of organizing people to take action, success is unlikely.

Finally, every restriction on our freedom erodes market discipline a little more, making it just a little easier to justify further restrictions. If this destructive dynamic goes unrecognized, our freedom and prosperity can be gradually undermined.

Our Best Hope

No economic system is perfect, and market economies are no exception. A more extensive discussion than is possible here would explain why prices do not always communicate information accurately. An important reason for studying economics is to gain a better understanding of the economy's flaws. Then we can attempt to reduce them, even though we can never eliminate them entirely.

But another reason—maybe a more important reason—for most people to study economics is to gain an appreciation for the difficulty of the task faced by any economy and how impressively market economies perform that task. The goal of every economy is to generate the most value with the resources, skills and technologies available, while creating opportunities and incentives to expand these factors over time. This requires giving people the maximum degree of freedom to use the information that only they have, consistent with taking others' concerns into consideration.

No economic system does a better job than the market system of realizing the advantages of both individual freedom and social cooperation. But no matter how well the market works, people will still be dissatisfied with the outcomes it produces because they always reflect the unavoidable reality of scarcity. People will always want, and are easily convinced they deserve, more than is available.

Many of the criticisms of the market are really complaints about scarcity. Indeed, one reason the market is so effective at pushing back the limits of scarcity is that it forces us to face up to scarcity—and deal with it—through the information that market prices communicate.

Market economies address scarcity by keeping us informed and responsive to it. Understanding economics reduces the temptation to temporarily mask scarcity by restricting market communication. Our best hope for continued freedom and prosperity is the social cooperation made possible by communication through market prices.

—Dwight R. Lee

References Anderson, Terry L., and Donald R. Leal, Enviro-Capitalist: Doing Good While Doing Well (Lanham, Md.: Rowman & Littlefield, 1997). Atkinson, Robert D., "The Revenge of the Disintermediated: How the Middleman is Fighting E-Commerce and Hurting Consumers," Policy Paper (Washington, D.C.: Progressive Policy Institute, January 2001). Cox, W. Michael, "The Low Cost of Living," The Wall Street Journal (April 9, 1998). Cox, W. Michael, and Richard Alm, "Time Well Spent: The Declining Real Cost of Living in America," 1997 Annual Report, Federal Reserve Bank of Dallas. O'Driscoll, Gerald P., Jr., Kim R. Holmes and Mary Anastasia O'Grady, 2002 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Co., 2002). Read, Leonard E., "I, Pencil," The Freeman (December 1958, pp. 32-37). Schumpeter, Joseph A., Capitalism, Socialism, and Democracy (New York: Harper Torchbooks, 1950), originally published 1942. Smith, Adam, The Wealth of Nations, Modern Library ed. (New York: Random House, 1937), originally published 1776. About the Dallas Fed The Federal Reserve Bank of Dallas is one of 12 regional Reserve Banks in the United States. Together with the Board of Governors in Washington, D.C., these organizations form the Federal Reserve System and function as the nation's central bank. The System's basic purpose is to provide a flow of money and credit that will foster orderly economic growth and a stable dollar. The Reserve Banks also supervise banks and bank holding companies and provide certain financial services to the banking industry, the federal government and the public. The Dallas Fed serves financial institutions in the Eleventh District, which comprises the state of Texas, northern Louisiana and southern New Mexico. For more information on the Federal Reserve Bank of Dallas, visit our web site at www.dallasfed.org. About the Publication Free Enterprise: The Economics of Cooperation is published by the Federal Reserve Bank of Dallas. The views expressed are those of the author and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System. For additional copies of this publication, call 214-922-5254. Publications Director: Kay Champagne Editor: Monica Reeves Art Director/Designer: Patti Holland

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