Does a novice entrepreneur need to understand the quantum mechanics of a product he is selling?

 

I have been pondering on an idea of late, and have decided to put it on paper. It coalesces around the idea of absolute knowledge from the side of the entrepreneur in every day business activities.

Before we start, lets make a few assumptions that we will delve into and therefore try to answer the question in the heading. Lets assume that person “A” decides to open a bakery (I wanted to give an example of a sofa manufacturer, but since I ate a nice bun this morning, lets stick with whole grain products shall we). Before he even considers opening a bakery, he must ask himself one crucial question: According to my time preference, am I able to generate a return higher than or at least equal to the opportunity cost of a similar investment? If the answer is “Yes”, he will ask subsequent questions and make further assumptions.

We will assume that person “A” will need idle retail space for his bakery. He will need to hire staff for production, sales, accounting, maintenance. He will need to find suppliers, a customer base etc.

Lets assume also, that he can hire skilled bakers, people that have been employees in other firms or idle workers with knowledge in the craft of baking bread.

Lets further assume that he has a vision of a product but doesn’t have any background in design or mechanics of designing a product (the input tools, shapes, special ingredients). He can than hire someone that does know.

And to keep this mental exercise short, we shall also assume that he understands that he may fail and lose everything, and that he may also succeed and reap the benefits of his endeavor.

Does the novice entrepreneur need to understand how bread rises in the oven? Does he need to know how long does it takes for the bread to be baked? Does he need to know the chemical processes taking place in the oven? Does he need to know how the alarm system at the front door using motion sensor technology detects burglars during the night? Well, frankly, not necessarily.

You see, the market has an ingenious built-in system of solving problems that require fine tuning and specialization. Entrepreneurs, that are seeking for the next best thing to satisfy desires and consumer wants, “paste” together various resources and makes assumptions on those actions. He is either rewarded or punished for his actions. Punishment might seem rather harsh in the form of bankruptcy, but it the “invisible mechanism” that gives out signals if person “A” is doing something right or wrong. If person “A” manages to put together correctly the pieces of the puzzle, he will get the correct picture – a profit, which is nothing more than a time component of receiving additional future goods, that would not have been created if not for the entrepreneurs efforts.

Without person “A” and without this “signal” (profit), nobody would really know for sure if certain human actions of resource usage were productive or not. Person “A” is rewarded for taking risk, providing employment and indirectly, accomplishing the goals of his employees in the process in the form of salaries and their own time preferences.

So, unlike in todays world, where person “A” is thought of as being an exploiter, and a social pariah, he is the social champion, the provider of goods and bearer of good news.

Government run sport events, aka The Olympics

 

I wanted to write a post concerning the current Olympic games that are being held in London, but before I did, I wanted so see if there was any economics, reasonable to comment on and maybe give a positive or a negative response. SO, instead of giving my own thoughts regarding the games, a 2002 article from mises.org will suffice, and I will give my own comment for the current games.

This article was written by Christopher Wesley:

“I didn't watch any of the Winter Olympics that recently concluded in Salt Lake City, but it was hard not to hear of the controversies that defined them.  Early in the games, the tempest over the judging of the figure-skating competition dominated the news, after gold medals were awarded, first to the Russian pair, and then to the Canadian pair two days later.  Similar controversies arose in speed skating, skiing, and hockey.

The question is whether judging is actually as impartial as possible or whether pressure is being placed upon judges to effect specific results that are in line with the desires of both image-conscious politicians and revenue-conscious Olympic organizers, be they on Olympic committees or television network boards.

Needless to say, no one is happy with the situation.  The Russian team has threatened to boycott the 2004 Olympic Games to be held in Athens, Greece.  Winners now wonder if the metal in their medals has been debased, given the uncertainty implied in the judging process.  While everyone concedes that there must be some element of subjectivity in refereeing any sport, the very notion that every effort to allow results to be determined in the field of play are not being taken threatens to delegitimize future Olympics competitions for an entire generation.

The hullabaloo created by this turn of events is heartening.  It illustrates the inherent attraction of the human person to competition, and the disgust felt when the results of competition have been determined in an a priori manner, showing that the best efforts of egalitarians over the course of several decades to squash this spirit through reeducation have failed.  

The free-enterprise system is based in part on this characteristic of the human person.  It focuses the drive to compete in a way that maximizes the benefits derived by consumers in the form of better products offered in a wide variety and at ever lower prices.  

This explains why, just as many are outraged at the suggestion that judges may have been taking cues from network executives or bribes from home country bureaucrats, so many were sickened byreports that, in 1996, Enron executives received a $1-billion, taxpayer-subsidized loan to keep the firm in business for an extra year or two.  Absent this intervention in the competitive process, the market very well may have shut down Enron sooner than later, before it could do any more damage.  

In the same way, the average sports fan would rather have the competitive process, as much as possible, determine whether Country A's hockey team proceeds to the next level and whether it is told to unlace its skates and go home.  If Country A benefited from any other factor, then its continued presence in the games calls into question the results of other forms of competition as well.  

Of course, this situation is nothing new to an economist.  Since people are self-interested, it is essential that no one person, firm, or state be allowed to set the terms under which competition takes place, whether the competition is in the marketplace or the sports arena.  To allow otherwise would be to allow the reappearance of mercantilism.

Mercantilism describes state intervention in the competitive process in order to bring about specific results that support its goals.  This system defined global trade patterns at least until the end of the eighteenth century, after which time the classical liberal economists of the 1800s--the champions of individual freedom and private property--did their best to crush mercantilist doctrines.  However, neomercantilist thought had emerged by the end of the late 1800s, and in the twentieth century, the continued acceptance of this doctrine complemented the growth of the nation state.

In other words, some bad ideas just won't go away, especially if belief in them supports the expansion of state power.  

When mercantilism is practiced successfully, it serves to expand the power of the state while smashing the incentives of the human person to express any creativity and ingenuity outside of any non-state-approved venues.  Why would anyone have wanted to compete with Enron in the late 1990s for the loyalty of consumers, knowing that the state was actively pursuing a strategy that forbade the firm from failing?  For that matter, why would anyone from a politically insignificant country want to compete in the Olympics if he thought that the results of competition were biased in favor of rivals from other countries?  

In the sports industry, fixing outcomes is detrimental to the bottom lines of the firms that finance competition, and efforts are made to provide a sufficient amount of private regulation to minimize problems resulting from the desire to predetermine outcomes.  None of us will watch the Super Bowl, or any of the Super Bowl-related commercials, if we think it is likely that the result has been previously decided.  Such beliefs directly effect revenues.

Unfortunately, the same analysis can't be said to apply to the Olympics, which is largely a state-sponsored, mercantile event.  When the state heavily finances any project, including the training of Olympic athletes or the staging of Olympic games, its efforts seem foolish or wasteful when its intended results do not come about.  This applies as much to taxpayer funding of curling events as it does to both the corrupt AmeriCorp and the FreedomCorp programs, none of which would receive much attention from private investors in a truly republican society.

The solution to these problems is to remove state influence from all aspects of Olympic competition.  Let private clubs compete among each other for the right to represent their countries, and let private firms stage the events.  Until the Olympics becomes a completely private enterprise, we can expect many years of such controversies, as well as a waning interest in the results of Olympic competition.”

I would have to agree on Mr. Wesley’s points. No games in modern times are unbiased against the competing athletes, or against host nations. In 1980, The USA boycotted the games in Moscow, and the Soviets retaliated four years later. I am no expert in these matters, but the question that pops to mind is: Who decides which sports are going to be represented by the games? What is the quota per country per discipline. I can guarantee that because of this quota, not all athletes, even if they made the “norm” get into the discipline they wanted. Such crazy things happen, as individuals that have learned how to swim a couple months prior the Olympics, are allowed into the games, because it goes along the line of “it is important to be a part of the games, medals are a bonus”.

I wonder, how people of an impoverished country feel, if some individual was granted a pass to the Olympics and gifts funded from tax payer money?

The thing gets worse, as they are in these games, when athletes allegedly from Greece got to spend insurmountable amounts of money at the governments expense. (I have seen this news update, but cannot find the news feed, I will post when I finds it). The Olympics are usually touted as a being a huge boost to the country's’ GDP and an investment for the future. New aquatic centers, gyms will be built for the young to qualitatively fill out their time. If this were the case, Greece should be booming.

They did host the 2004 summer Olympics didn’t they?

Regulated leverage, or imposing endogenous market regulation?

Before I start writing todays post, I am glad to announce that I have successfully mastered a milestone in the CFA program, and passed the Level I exam. Due to future career prospects I may get with having passed this exam, I have decided to enroll in the second leg of the curriculum.

The former chairman and CEO of Citigroup appeared on CNBC to share his views on the ailing economy and about prospects for future reform concerning the banking industry. Since I am unable to embed the video file in this blog post, I will write out the main tenants of his monologue.

Sandy Weill said:

- break up investment and commercial banking

- manage a system that will not allow excessive leverage, somewhere in the 15 to 18x debt to risk adjusted capital

- force banks to book derivatives on their balance sheets and not manage risks off balance sheet

- protect taxpayer funds from having to bailout TBTF banks

Now, with all due respect to Mr. Weill, who also stated that the biggest banks were also the main providers of capital and growth in the global economy in the past two decades, he is putting the cart before the horse on some of these issues.

To be fair, he did state that investment and deposit banking should be broken up. I put commercial because in the mainstream, the two coincide with one another. But the problem with this reasoning is that somehow deposit taking and making commercial loans will make the investment banking business much to tied up with the former and the latter will be in a constant conflict of interest which will force the government through regulatory measures to force financial institutions to construct “Chinese” walls between departments so no kickbacks may occur and no hefty commissions be generated. To Mr. Weill’s point, it is not the commingling between these activities that cause the problems, but the fraudulent nature of loan origination that occurs in todays economy through secondary deposit creation.

His second point deals with leverage. Leverage as an instrument of magnification, may boost returns that may not be generated without the debt standing behind it. But capping this somewhat arbitrary number will again not solve the problem. Especially when banks, in response to a low yield environment must be forced to generate returns sufficient enough to satisfy customer needs, as well as not losing their revenue base to alternative investment vehicles or pools of funds. Also, on this point, different industries operate on different degrees of leverage. (To make a point, there is a difference between operating leverage, which shows the effect of fixed assets and gross profits on revenue, as well as financial leverage, which shows the difference that operating profits have on net income).  

Now, in respect to derivatives, I do agree that these instruments, as like any other that abide to commercial law, must be placed on the balance sheet as a source (asset) and flow (income) to the company. The problem with derivatives, is that, any change in price stemming from the contract (variation of the instruments fair value), and especially if the instrument is booked as AFS under IFRS, doesn’t show as an unrealized gain or loss in the income statement, but rather as a change in the OCI component at shareholder’s equity. That is point one, and point two, if companies, wish not to keep it on their books, in the form of a SPE, they can do whatever they want; but if there are guarantees and contingencies, they ought to be represented as a liability when calculating financial ratios.

And finally, to protect taxpayer funds, why bailout anybody? Why the need for this made up TBTF notion? They are a drag to the economy and should be allowed to reorganize and selloff unsound units and business ventures.

But all in all, someone that sat at a ranking position should have had the courage to speak out regarding these problems in foresight, and not in hindsight.