TCS Daily

Entrepreneurs of the World Unite! You Have Nothing to Lose but Your Guilt!

By Tim Worstall - October 8, 2004 12:00 AM

Entrepreneurs of the world unite! You have nothing to lose but your guilt!

According to a new paper, y'all owe me $2.5 million. Or at least have benefited that much from my activities as an entrepreneur. It seems fair that I should capture all the value I have created, doesn't it, rather than the pitiful portion that I actually have? Thus the rather Marxist call to action.

It is difficult to distill down to a pithy nugget some thousands of pages of turgid impenetrable prose yet I think you will recognize that this is what is at the heart of "Das Kapital": the system is unfair. The whine of the idiotarian the world over, a hum that rises to a buzz at those gulags of dis-education, the liberal arts colleges, to a cacophony in the faculty rooms of those concentration camps devoted to the torturing of reality. The unfairness is that the laborer does not receive the full value of the product of his labor. How can he, when the capitalist is receiving profit?

Very well, I am an entrepreneur and in a new paper by William Nordhaus I am told that I receive some 2.2% of the value that I produce. The other 97.8% goes to y'all in the general populace (or as a past girlfriend from the Deep South would say when referring to the plural y'all, y'all y'all).

To see how unfairly I am being treated, think of it this way. If every laborer's wages rose by 15-20% then profits would disappear and in our Marxist dream universe they would not be exploited. For myself and other entrepreneurs to be similarly fairly treated our wealth would have to rise by 45 times. Not a percentage, that number: we should be getting 45 times the wealth that we do in order to -- as Marx posited the laborer should -- capture the value of our work.

A Raw Deal

I've lived and worked in a country recovering from the application of the idiocy that was the real world implementation of Marx's philosophic maunderings so no, I'm not suggesting a wholesale re-ordering of the economy so that my fellow class members get what is rightfully ours. As a factor of production, the entrepreneur class (and yes, we have been considered for decades to be a factor of production to go alongside the more traditional land, labor and capital) is getting a raw deal and it's about time that the world in general realized it. What I really want is a more robustly Anglo-Saxon two-fingered (perhaps middle-fingered for the colonial cousins) response to criticism of the wealth that the more successful among us accumulate. That pitiful 2.2% of the wealth that we create.

The actual paper under discussion is "Schumpeterian Profits in the American Economy: Theory and Measurement", which doesn't sound like one of those must read airport novels packed with busty heroines and lusty lawyers. It is both a duller read and a vastly more important and entertaining document. It's from William Nordhaus of Yale and published by the National Bureau of Economic Research (NBER) as working paper 10433.

Now we already know that Nordhaus is one of the good guys. It is his work with the DICE and RICE models which has been so important in outlining the economic costs and benefits of the Kyoto Treaty. That is, lots of costs and no benefits, whatever your view of the realities of global warming and whether we're causing it.

The original purpose of this paper appears to have been twofold: to try and explain the late 90's stock market bubble and to test a hypothesis of Alan Greenspan (known as the Greenspan Effect) about the interaction of productivity growth, aggregate demand and the wealth effect and how they affect consumption. Slightly ho hum geeky stuff to most of us and the explanation that the internet boom was due to a misreading of the appropriability of Schumpeterian profits and subsequent depreciation rates would not, out there in the real world, get that many people excited. I wouldn't recommend it for use as a babe magnet next time you're out for a quiet drink for example.

Why Capitalism Works So Well

What the Professor actually finds is a great deal more interesting, showing us why the returns to capital over the decades have been so close to the costs of capital, despite the innovativeness of the American economy, plus my above number, that innovators only get 2.2% of the wealth that they create through their innovation.

There's two little explanations that you need here. Just like the Red Queen, words mean what I want them to mean and I am equating innovator and entrepreneur -- not too much of a stretch as innovation is what entrepreneurs do, just as being entrepreneurial is what innovators do. The second is the definition of "Schumpeterian profits" which in the paper are defined as "...only the profits that exceed the risk-adjusted return to innovative investments." So we're not talking about the usual returns to capital, only those above and beyond them, those that arise from the new technologies, gidgets, methods of organization that are introduced by our innovators and entrepreneurs. I'll leave out the calculations and arguments of the paper (both calculus and graphs are used, ugh) and provide you here with the conclusion:

"The present study develops a technique for estimating the size of Schumpeterian profits in a market economy. It shows that innovational profits depend upon the appropriability of innovations as well as the rate of depreciation of profits from the innovations. Using data from the U.S. non farm business section, I estimate that innovators are able to capture about 2.2 percent of the total social surplus from innovation. This number results from a low rate of initial appropriability (estimated to be around 7 percent) along with a high rate of depreciation of Schumpeterian profits (judged to be around 20 percent per year). In terms of the rate of profit on capital, the rate of profit on the replacement cost of capital over the 1948-2001 period is estimated to be 0.19 percent per year.

"One reaction to these numbers is that the rate of Schumpeterian profits is implausibly low given the enormous innovativeness of the American economy. Another reaction is that it clears up at least part of a puzzle about the profitability of American capitalism. Some observers have wondered why the rate of profit on corporate capital is so low. Indeed, over the last four decades in which we have careful measurement, the rate of profit after tax on non financial corporations averaged 5.9 percent per year, which was very close to the cost of capital over that period. How could the rate of profit be so low, it might be asked, given that the denominator omits several important assets (such as land and intangible investments) and the numerator includes important sources of profits (such as monopoly power and Schumpeterian profits)? At least part of this puzzle is resolved here by the finding that only 20 basis points of the rate of return to capital was due to Schumpeterian profits."

In the course of trying to explain a stock market bubble and testing the Greenspan Effect our scholar has actually managed to explain away one of the great puzzles -- why is the profit rate so low? -- and similarly reveal a great truth about why capitalism works. Seriously, it is as fundamental as that: why does the whole system, this oddity of economic organization we call capitalism, why does it seem to make the whole society so stinking rich? We know very well that voluntary exchange, free markets, property rights and so on encourage innovation, that the freedom to launch meat flavored ice cream for dogs is misused, appears wasteful, can be and is lambasted as less logical than a proper planned approach by the wise men and women in our legislatures. Yet why is it that it works? How is it that this cornucopia of riches falls down around us as technology marches ever on? The answer is that just about all the benefits of the heavy lifting done by those who design, dream up and launch new items go to society in general, those toilers at the entrepreneurial coalface getting just 2.2% of the wealth that they create.

That's a pretty big result from an initially modest question. Science can work in these wonderful ways as we know, for after all, Sir Alexander Fleming discovered penicillin while conducting an experiment in not cleaning up the lab. We've found out something interesting, the why of how it all works, which is great. Yet then we come to the next question, what do we actually do with this new information? Are there any policy implications, something we should change about the system so as to get more, an even better allocation of resources? I think it's pretty obvious that society is getting a bargain here, 98 bucks worth of value for the $2 the innovator keeps, so surely we would like to encourage more of this sort of trade?

Just in case anyone thinks I'm getting a little too excited here, I refer you to Don Boudreaux's take on the matter and I trust that the Chair of the George Mason economics department is sufficient authority, permission perhaps, for me to be excited. (One line is "The smallness of this figure is astounding" which is enough to get this monkey dancing.)

Swinging wildly from the scientific to the personal it might surprise some regular readers here that I do not spend all of my time in dark alleys chatting up dubious economic propositions. Out there in the big wide world I have a day job, running my little company which deals with a small set of the more weird and exotic metals. This is where I get that headline $2.5 million from, the value that y'all get from the innovations that we provide. There's no great product that you will have heard of, nothing really to excite the imagination. We've had a little to do with the design of an electrolyte for solid oxide fuel cells, aided researchers into the welding of aluminum, made some experimental products, simply pottered along as a small company in our own sweet manner. Until now there's been no real way for us to measure what good we do to the wider world, until, of course, we got this 2.2% number. For if the numbers work one way, that entrepreneurs only get 2.2% of the value they create, then if you know the value of the 2.2% then you can backtrack to the grander number, which is how I got to the one above. As you can see, yes, we really are a very small company. In fact, the only measurable effect that I can point you to is this photo-montage of the world at night, where we have a part in the supply chain of fully 50% of the light visible. Yes, there is a little bit of prime-monkey chest beating in showing that image and knowing that I have had a hand in fully 50% of the light visible from space but I must ask you one thing, don't tell any astronomers, they don't like light pollution.

Moving away from such disturbingly personal revelations just what is it that we should do to encourage more innovation and entrepreneurship? As Boudreaux notes it looks like something of a bargain. The bargain of the millennium I think, for where else can you get, on average, for decade after decade, a return of 45:1. Don't forget, this isn't in one or other invention, one or other innovator. This is the average across all of the non-farm economy from 1949 to 2000. That includes every piece of innovation, from the Mac to the PC Jr, Spaceship One to the Ford Edsel, New Coke to Snapple. Society as a whole made 45 times as much out of the efforts of the innovators as they themselves did. It is simply a no brainer that society wants to have more of this sort of bargain.

The first and most obvious thing is that we do not want a government program to encourage innovation. Allowing the people who brought us the Department of Housing and Urban Development into the process will simply destroy the goose laying the golden egg. Similarly I'm dubious about trying to change the tax system to foster it. We would again be letting the politicians in to define just what was innovation. I think that you can imagine what the likes of Hilary would consider to be innovational, productions of the Vagina Monologues in kindergartens perhaps? So no, other than a few minor changes at the margin (what is it with the insane US system for taxing stock options? It positively discriminates against people holding onto the stock, exactly the opposite of what you actually want them to do.), no changes in public policy or taxation. So, what? Surely I haven't forced you to read all this way just to say I don't know have I? Fortunately, no, I do have a solution.

Malefactors of Great Wealth, Party On

Allow me to restate the problem. We now know that innovation and entrepreneurial activities are hugely profitable for the wider society, almost all of the gains going to that society, not the initiators. We wish to encourage more such activity but have ruled out structural changes because the pols will undoubtedly screw it up. Could, therefore, those who have been successful, those who have innovated and won, please start looking like they enjoy it? Could we have rather less whingeing about the burdens of great wealth and rather more exuberant partying? More champagne and decent cigars? As we already know the first and most basic truth about economics is that incentives matter. What incentive is there to struggle to launch a new company or product if having reaped the rewards of doing so one is brow beaten by society into apologizing for the wealth, forced into making grants to puerile non-entities, funding pressure groups on this or that fashionable matter. Where's the incentive for the next generation in that? Far better that those who have won launch into rip-roaring enjoyment of the things that money can buy, create a little envy so as to gee up those making the great decision of life. Whether to work for a salary and pay 20-30% of their income to the rest of us or to innovate and give 98% away?

Further, a more robust response to those who criticize said enjoyment. There is a useful Anglo-Saxon verb, one that can be conjugated in a number of ways and dependent upon context has a multitude of meanings. The next time someone whines at Bill that he's too rich I want him to come back with "**ck off, so, I've got $40 billion but the rest of you have had $1.6 trillion out of me." Actually, I can't imagine Bill saying that, maybe Larry instead. Definitely Larry.

In fact, in more detail, I want the self-made rich to live up to the standards of Tug McGraw; "I spent 90% of my money on booze and women. The other 10% I just wasted." The three most famous (barring Trump, I refuse on the grounds of taste, mine not his lack of it, to include him here) self-made men in the US today are Larry, Moe and Curly. So here are the instructions for them, the work they now have to do to encourage more to follow the lonely path of the innovator.

Larry, that Russian fighter plane of yours is pretty cute but you really aren't thinking big enough. You should have at least a squadron if not an entire wing. When you return from leading the strafing run on Redmond I want you, cigar clenched at a jaunty angle in your teeth, magnum of Dom Perignon in hand, to introduce the bevy of Penthouse Pets who are your pilots to an adoring world with the phrase "Y'know, they're nekkid under their clothes" before reminding the audience that several of them are pregnant by you and you're working on the rest.

Moe, this curing malaria thing is all very well and I wouldn't want you to stop but it just isn't what is going to arouse the juices of the next generation's ubergeek. Melissa might be a little put out by your taking to traveling with Brittney Spears but I'm sure she'll come round once you explain that it's all for the good of the future society, incentivization and all that. Also, instead of that little lakeside house you've got, you need to do a Hearst. There must be three or four castles left in Europe that he didn't ransack.

Finally, Curly, I know you're from the mid-west but what is it with this "I eat Big Macs" shtick? If a man with your sort of wealth desires a hamburger he sends the second under-chef to Japan to pick up 100lbs of Kobe beef. Upon his return, the first under-chef chooses the finest 4 ounces, subsequently ground and cooked by your personal beef chef, the bread carefully toasted by the baker. The remainder is fed to the pigs who will provide next quarter's breakfast bacon, all under the watchful eye of an Entertainment Today reporter.

It is with these sorts of actions, flagrant and flamboyant enjoyment of wealth, that we will encourage the next generation of innovators and entrepreneurs and as the good Professor Nordhaus has been able to point out to us, for every $2.20 that they get to spend on wine women and song the rest of us get $ 97.80. A stunning bargain for all concerned.

One final point. If my little business should grow and prosper, I promise not to do a Tug. Not a single cent will be wasted.

The author is a TCS contributor. Find more of his writing here.


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