"I try to be tolerant," said mouse Karl quite intolerantly, "of the open, competitive market. But one thing wrong with it is that it doesn't work very well. If widget output is greatly increased, widget prices crash and profits turn into losses. In a world of scarcity, it is a ridiculous economy in which great output means disaster for producers."
Mouse Adam tried to tolerate the intolerance. "Losses for widget producers," he said gently, "are evidence of bad use of the community's resources and incentive to shift some of those resources to better uses."
Karl was offended. "Look," he snarled, "we want more goods, producers produce goods, so producers should not be penalized when they produce more."
"Losses certainly are misfortunes for producers," Adam agreed. "But we should recognize what they reflect and what they imply from the standpoint of the economy."
"A loss," snapped Karl, "means simply that some unlucky character is losing his shirt because his costs are greater than his receipts."
"But what do the costs and the receipts measure?" asked Adam. "Business receipts are a measure of the worth of the product in the eyes of the buyers. Anyone paying two dollars for a widget is saying that he prefers the widget to two dollars' worth of any other good."
"Obviously," said Karl, "people pay two dollars for widgets only because they consider the widget to be worth the money. But what do costs reflect?"
"Costs," replied Adam, "reflect the value of other goods which could have been produced by the resources embodied in the widgets. To produce widgets, labor and other inputs must be bid away from other uses. Inputs derive their value from the value of the outputs they produce. The price which must be paid for inputs is a measure of the most valuable alternative good which is not produced when we make widgets."
Karl's beady little eyes sparkled with comprehension. "So," he said, "if business receipts indicate the value of our product and business costs indicate the value of the best alternative product, and if receipts are smaller than costs, then the community prefers that the resources we are using here be used elsewhere. They consider some other good to be worth more than widgets at the margin, so widget production should be cut and the output of the other good increased."
"You are a pretty smart mouse," commended Adam. "A loss is a sign that the resources of the community are misallocated. We would be better off by shifting inputs from widgets to something of greater value. And, in an adaptable market, that will happen. Widget producers, with their losses, will not find it feasible to compete for the previous amount of inputs against profit-making competitive producers. And owners of inputs will have incentive to sell their services to the highest bidder. So-with no five-year plan decreed by an economic czar-resources will shift to where the community values them most."
"I conclude," said a now wiser Karl, "that the market works."
Reflection for Thought and Discussion:
1. When would an increase in widget production increase the total revenues of widget producers and when would it decrease their total revenues?
2. Even though we want more goods in a world of scarcity, why are losses and consequent output reductions an important part of an efficient economy?
3. What would be required to guarantee that no decision maker ever made losses?
4. Without profits or losses to guide him, how would a central planner know which industries to expand and which industries to contract?