E. Profits and losses are the green and red lights of the system, by which customers signal “go” or “stop”
Two other signaling components of a free-market system are profits and losses. Profits and losses tell entrepreneurs whether their ideas are succeeding or failing. So, if entrepreneurs represent the engine of the competitive market process, then profits and losses are the green lights and red lights, signaling “go” or “stop.”
Even in a free market, our knowledge is imperfect and incomplete. In the absence of perfect coordination of the independent plans of decision makers, opportunities for improvement in products and services are always present. Profits are an excellent incentive for such improvement.
On the other hand, losses can stop everything, forcing a business model to be reassessed and another option tried. Entrepreneurs invent, create, envision the future, produce things, feed people, save lives, and enhance others’ well-being by risking their money and time. If their ideas do not work, they can lose everything. Once losses set in, the process must change or be terminated.
Recognizing what the consumer wants and calculating the costs of making it available, while still earning a profit, is no easy task. Profits are the rewards, losses are the pain. Even good ideas might not align properly with what people want, and therefore losses might be incurred. Yet losses are as important as profits. Cleansing an economic system, losses remove what consumers do not want and signal producers to change, improve, or fail. Businesses must be constantly attentive to consumer preferences. The system of profits and losses encourages enterprises to cast their bread upon the waters of uncertainty with the hope that it might return with rewards. But this is risky, because the system requires entrepreneurs to give first and get later, maybe. Risking personal money and time with the hope of profitability drives the whole process.
But if the hope of making and keeping a reasonable profit is taken away (through higher tax rates, for example), then fewer people will take risks, and the economy will falter.
Business profit is the incentive that permits people to believe with a good deal of confidence that market forces work. Do people always guess right? No, there are lots of mistakes and unforeseen costs. In fact, many people fail and have to try again. But over the long run, those who succeed continually produce goods and services that consumers value, and thus they increase a nation’s GDP.