Costs and the Entrepreneurial Mindset

We often hear that profits get a bad rap. But costs are just as often cause for complaint. Many economists treat costs as friction that can create market failures.  For example, barriers to entry are blamed for monopolies.  Private solutions to externalities are often deemed impossible if transaction costs are too high.  Public goods must be provided by government if the cost of making the good excludable is too high.  

However, much economic research shows that costs are not the friction they are often supposed to be.  For example, Harold Demsetz described the substantial ambiguity about what a “barrier to entry” even is and how to measure them for antitrust purposes.  Ronald Coase famously noted that transaction costs do not seem to be much of a problem in solving externalities.  Similarly, Coase pointed out that public goods are often provided by private means.  Elinor Ostrom spent many years showing how costs weren’t an insurmountable barrier in solving common pool resource problems.

And yet, despite all this evidence and multiple Nobel Prizes, costs in principles, intermediate, and even advanced economics textbooks and discussions are presented as something that causes market failure.  I don’t know why there is such this disconnect between theory and evidence.  I suspect part of it is the dominance of the Marshallian line of thought that treats costs as objective rather than subjective.  But that is a conversation for another time.

Instead, I argue that costs are not a friction but rather a lubricant for the market process.  In a similar manner to how profits act as a signal to entrepreneurs, costs can as well.  In a typical economics class, students are taught that profits act as a signal for potential market participants.  If there is profit to be had, firms will enter the market until profit returns to a normal level.  If there are losses, firms will exit the market.  Profit signals that more resources should go to this market.  Losses signal that fewer resources should do to this market.  So far, so good.

But most textbooks stop there.  The role of costs and revenue in determining profit are left purely mathematical.  Profit is total revenue minus total cost.  Total revenue is known (or estimated).  Total costs are known (or estimated).  Therefore, profit is known (or estimated). And that is that.  If costs exceed revenue, then firms will not enter the market.  Thus, if entry costs are sufficiently high, then a firm will not enter a market even if firms already in the market are earning extra-normal profits.

I take issue with this story.  I think high barriers to entry and transaction costs signal opportunity to the entrepreneurial mind.  If there is a way to break down these barriers, to reduce costs, that an unprofitable situation becomes profitable.  Thus, the role of the entrepreneur is not to simply coordinate resources within a firm (as he is often treated in textbooks).  Rather, the role of the entrepreneur is to find ways to reduce costs.  The innovation, the churn, the advancement of the market process comes from the entrepreneur looking for ways to reduce costs and turn a profit.  Costs do not prevent the market from functioning: they create the very incentive for the market to thrive!  

Human history, and much economic research over the past century, has shown how insignificant a barrier costs truly are.  Even industries that are well-protected from competition by governments still face pressures as people constantly find ways around the barriers to entry to compete.  Simply because there are (presumably) high costs to enter a given industry does not imply that the market has failed or will fail.  Market “frictions” (even things like sticky wages) do not imply market failure or a role for government.  Same with transaction costs.  Rather, they shout to the entrepreneur that there are opportunities if these barriers can be overcome.  They are a signal the market uses to function.  If we are to meaningfully talk about market failure and government intervention, we need to talk more about incentives rather than costs.  High costs are neither necessary nor sufficient to declare market failure.