Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy—and may affect the aggregate level of output by changing the incentives that firms or individuals face—the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them. Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit

The Original Federal Reserve System Several monetary institutions appeared in the United States prior to the formation of the Federal Reserve System, or Fed. These were, in order: the constitutional gold (and bimetallic) standard, the First and Second Banks of the United States, the Independent Treasury, the National Banking System, clearinghouse associations, and the National Reserve Association. The Fed was the last such institution founded. Although it has endured, the present-day Fed would be unrecognizable to its founders. The original Federal Reserve Act became law in December 1913. The “Federal” in the title implied that the law applied to the whole country, and “Reserve” emphasized the new institution’s role as a reserve holder and reserve supplier for the commercial banking system. The twelve regional Federal Reserve Banks, according to the Federal Reserve Act, were “to furnish an elastic currency” by discount[ing] notes, drafts, and bills of exchange arising out of actual commercial transactions.. . . The time, character, and volume of sales of [this eligible] paper . . . shall be governed with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the country. Conspicuously absent in the title or anywhere else in the act were the words “central bank.” The primary reason for this omission was the term’s unpopularity with the populist wing of the Democratic Party. Republicans had accepted the label, but, after 1912, no longer controlled either Congress or the White House. Therefore, the new institution could not be a “central bank.” That term, many congressmen objected, implied monopolistic control by Wall Street bankers, who would keep interest rates “high” and conspire with speculators to cause panics. However, under Democratic sponsorship, the new institution could be an autonomous group of regional reserve-holding supercommercial banks, and the act passed through Congress in this guise. The U.S. banking and financial system at this time had recognizable faults that some bankers, financial experts, politicians, and economists thought needed correcting. The major monetary institution of the era was the self-regulating gold standard, which functioned much as was expected. However, the commercial banking system included both state banks—chartered by state governments—and national banks—licensed as such by the comptroller of the currency. Because of the overlap in regulatory jurisdictions, a plethora of regulations made banking operations difficult. Legal reserve requirements, for example, varied significantly at the state and national levels, and almost always made banking less flexible and more precarious. The banking system’s fragility appeared whenever some random and unforeseen financial shock put undue pressure on the banking system to provide “emergency” liquidity. The Federal Reserve System was the institutional answer to this perceived problem. Just as the gold standard worked through market forces to provide a proper quantity of gold-based money, so the new Federal Reserve Banks would augment the gold standard to ensure that the commercial banking system could issue the proper quantity of bank-created money in a timely fashion. The twelve regional Federal Reserve Banks were to be located in major cities. Each bank was to operate autonomously in its region. A Fed Bank had a board of directors and an executive structure similar to that of any commercial bank or business firm. Commercial banks in a Federal Reserve district could become members of the Federal Reserve if they fulfilled certain requirements, including buying stock in their regional Fed Bank according to a formula based on their capital value. The Fed Bank then paid them a statutory annual return of 6 percent on the value of this stock. Member commercial banks therefore became the “stockholders” of the Fed banks. Also included was a Federal Reserve Board located in Washington, D.C., and housed in the Treasury Department. Members of the board, appointed by the president, served staggered ten-year (later fourteen-year) terms. The

As an economic system, fascism is socialism with a capitalist veneer. The word derives from fasces, the Roman symbol of collectivism and power: a tied bundle of rods with a protruding ax. In its day (the 1920s and 1930s), fascism was seen as the happy medium between boom-and-bust-prone liberal capitalism, with its alleged class conflict, wasteful competition, and profit-oriented egoism, and revolutionary Marxism, with its violent and socially divisive persecution of the bourgeoisie. Fascism substituted the particularity of nationalism and racialism—“blood and soil”—for the internationalism of both classical liberalism and Marxism. Where socialism sought totalitarian control of a society’s economic processes through direct state operation of the means of production, fascism sought that control indirectly, through domination of nominally private owners. Where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically. In doing all this, fascism denatured the marketplace. Entrepreneurship was abolished. State ministries, rather than consumers, determined what was produced and under what conditions. Fascism is to be distinguished from interventionism, or the mixed economy. Interventionism seeks to guide the market process, not eliminate it, as fascism did. Minimum-wage and antitrust laws, though they regulate the free market, are a far cry from multiyear plans from the Ministry of Economics. Under fascism, the state, through official cartels, controlled all aspects of manufacturing, commerce, finance, and agriculture. Planning boards set product lines, production levels, prices, wages, working conditions, and the size of firms. Licensing was ubiquitous; no economic activity could be undertaken without government permission. Levels of consumption were dictated by the state, and “excess” incomes had to be surrendered as taxes or “loans.” The consequent burdening of manufacturers gave advantages to foreign firms wishing to export. But since government policy aimed at autarky, or national self-sufficiency, protectionism was necessary: imports were barred or strictly controlled, leaving foreign conquest as the only avenue for access to resources unavailable domestically. Fascism was thus incompatible with peace and the international division of labor—hallmarks of liberalism. Fascism embodied corporatism, in which political representation was based on trade and industry rather than on geography. In this, fascism revealed its roots in syndicalism, a form of socialism originating on the left. The government cartelized firms of the same industry, with representatives of labor and management serving on myriad local, regional, and national boards—subject always to the final authority of the dictator’s economic plan. Corporatism was intended to avert unsettling divisions within the nation, such as lockouts and union strikes. The price of such forced “harmony” was the loss of the ability to bargain and move about freely. To maintain high employment and minimize popular discontent, fascist governments also undertook massive public-works projects financed by steep taxes, borrowing, and fiat money creation. While many of these projects were domestic—roads, buildings, stadiums—the largest project of all was militarism, with huge armies and arms production. The fascist leaders’ antagonism to communism has

The European Union (EU) includes twenty-seven countries and 490 million people. In 2005, the EU had a $13 trillion (€11 trillion) economy, a single market, and for some member countries, a single currency. A growing number of political and economic decisions are made on a pan-European level in Brussels. The origins of the EU are usually traced to the European Coal and Steel Community (1952). Heavily regulated coal and steel industries of Germany and France were to be administered by a supranational authority. Economic benefits of supranational control over one sector of the economy were expected to lead to demands for supranational management of other economic sectors. But supranationalism, characterized by bureaucratic planning and regulation, could not produce economic growth. Ludwig Erhard’s free-market reforms in West Germany in the late 1940s (see german economic miracle) provided an alternative model for development, and the resulting economic growth made a strong case for Europe-wide liberalization. The 1957 Treaty of Rome created the European Economic Community (EEC). The EEC abolished internal tariffs and quotas and established a customs union. The treaty made provisions for the eventual liberalization of movement of labor, services, and capital. Despite the Treaty of Rome’s many imperfections, the economic interdependence between nations that it produced was believed to make future armed conflict less likely. As nineteenth-century French economic journalist

Positive externalities are benefits that are infeasible to charge to provide; negative externalities are costs that are infeasible to charge to not provide. Ordinarily, as Adam Smith explained, selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy. Externalities undermine the social benefits of individual selfishness. If selfish consumers do not have to pay producers for benefits, they will not pay; and if selfish producers are not paid, they will not produce. A valuable product fails to appear. The problem, as David Friedman aptly explains, “is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more than it would cost to produce” (Friedman 1996, p. 278). Admittedly, the real world is rarely so stark. Most people are not perfectly selfish, and it is usually feasible to charge consumers for a fraction of the benefit they receive. Due to piracy, for example, many people who enjoy a CD fail to pay the artist, which reduces the incentive to record new

There are many different measures of environmental quality, and most of those in use show that environmental quality is improving. For example, from 1970 to 2000, concentrations of carbon monoxide, a pollutant, fell by 75 percent in the United States and by 95 percent in the United Kingdom. From 1975 to 2000, nitrogen oxides declined by 35 percent in the United States and by 40 percent in the United Kingdom. The percentage of beaches in Denmark not complying with local or European Union regulations fell from 14 percent in 1980 to approximately 1 percent by 2000. Between 1969 and 1994, DDT and PCB contamination of fish fell by more than 80 percent. Indeed, it is difficult to find measures indicating that environmental quality is deteriorating in countries enjoying relatively high incomes. The correlation between environmental quality and economic growth is incontrovertible. Comparing the World Bank’s environmental sustainability index with gross domestic product per capita in 117 nations shows that richer countries sustain environmental quality better than poorer countries do (see Figure 1).1 Indeed, every systematic study of environmental indicators shows that the environment improves as incomes rise. When per capita incomes reach $4,000 to $8,000 (this would include countries such as Brazil, Ukraine, and Indonesia, for example), arsenic pollution, sulfur dioxide emissions, and deforestation decrease, while dissolved oxygen in streams, a necessary element for healthy aquatic plants and animals, increases. Nonetheless, alternate and more pessimistic views are widespread. For example, Paul and Anne Ehrlich, the modern counterparts of thomas robert malthus, write: Humanity is now facing a sort of slow-motion environmental Dunkirk. It remains to be seen whether civilization can avoid the perilous trap it has set for itself. Unlike the troops crowding the beach at Dunkirk, civilization’s fate is in its own hands; no miraculous last-minute rescue is in the cards.. . . [E]ven if humanity manages to extricate itself, it is likely that environmental events will be defining ones for our grandchildren’s generation—and those events could dwarf World War II in magnitude. (Ehrlich and Ehrlich 1996, p. 11.) Similarly, Harvard biologist Edward O. Wilson contends that “the wealth of the world, if measured by domestic product and per-capita consumption, is rising. But if calculated from the condition of the biosphere, it is falling” (2003, p. 42). From the Worldwatch Institute’s assertion that “the key environmental indicators are increasingly negative” to the World Wildlife Fund’s prediction that if we do not change our ways, human welfare will collapse by 2030, the view seems to be that the Earth’s environment is getting worse. The data, however, are inconsistent with this conclusion. Thanks largely to the pioneering work of the late economist Julian Simon and, more recently, to the work of statistician Bjørn Lomborg, abundant data show that we are not running out of resources, that we are not destroying our environment, and that the plight of human beings is improving rather than diminishing. Simon’s confidence in challenging Ehrlich’s pessimistic thinking came from his belief that people respond to scarcity by conserving on scarcer resources and by reducing waste and hence pollution. Doubting Simon’s logic and data, Bjørn Lomborg, a statistician and political scientist, set out to prove him wrong by examining reams of data on various environmental claims. These claims include: global forest cover is declining, finite resources are being depleted, global temperatures are rising due to human causes, and massive species extinctions are occurring. Consider Lomborg’s findings. Global forest cover has remained quite stable since the middle of the twentieth century. Even the Amazon forests are not declining at the alarming rates touted by doomsayers. Since the arrival of man, Amazon deforestation has been only about 14 percent, three percentage points of which have been replaced by new forests. High oil prices in 2004 and 2005 have caused many people to fear that we will run out of energy. Long-run trends, however, suggest that such claims are exaggerated. The pessimistic view comes from the assumption that no more oil will be found. But that assumption has been

When the Swedish Nobel Committee awarded the 2002 Nobel Memorial Prize in Economic Sciences to Vernon L. Smith, an economist at George Mason University, it simply affirmed what economists have long known: that experimental economics has arrived as a respected and powerful discipline within economics. The committee noted that the award was based on Smith’s “having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms.” But what exactly are market experiments, and what can researchers learn from them? Of what importance,

Is capitalism good? Should we admire hard workers who are motivated to make large profits? Does competition bring out the best in people? These questions juxtapose practices and institutions that economists study (capitalism, profits, competition) with concepts that ethicists use (good, admirable, best). Ethics studies values and virtues. A value is a good to be achieved or a standard of right to be followed, while a virtue is a character trait that enables one to achieve the good or act rightly. For example, a list of core goods might include wealth, love, and freedom. A corresponding list of virtues—or character traits—might include the productiveness that enables one to achieve wealth, the honesty that enables one to enjoy loving relationships, and the self-responsibility that enables one to live in freedom. Ethical issues connect intimately with economic issues. Take the economic practice of doing a cost-benefit analysis. You could spend one hundred dollars for a night on the town, or you could donate that one hundred dollars to the reelection campaign of your favorite politician. Which option is better? The night on the town increases pleasure. A politician’s successful campaign may lead to more liberty in the long term. We regularly make decisions like this, weighing our options by measuring their likely costs and likely benefits against each other. This connects economics directly to a major issue in ethics: By what standard do we determine what counts as a benefit or a cost? A list of competing candidates for the status of ultimate value standard includes happiness, satisfying the will of God, long-term survival, liberty, duty, and equality. Economists implicitly adopt a value framework when beginning a cost-benefit analysis. Different value commitments can lead to the same item being considered a cost from one perspective and a benefit from another. For example, those whose standard of value is increasing human happiness would count a new road to a scenic mountain vista as a benefit, while those whose standard is maintaining an unchanged natural environment would count it as a cost. The results of economic analysis also lead directly to ethical issues. For example, one result of the nineteenth- and twentieth-century debate over capitalism and socialism is a general consensus that capitalism is effective at producing wealth and socialism is effective at keeping people poor. Advocates of capitalism use these results to argue that capitalism is good; others might respond that “socialism is good in theory, but unfortunately it is not practical.” Implicit in the capitalist position is the view that practical consequences determine goodness. By contrast, implicit in the position of those who believe socialism to be an impractical moral ideal is the view that goodness is distinct from practical consequences. This connects economics to a second major issue in ethics: Is goodness or badness determined by real-world practical consequences or by some other means, such as revelations from God, faith in authorities or authoritative institutions, appeals to rational consistency, felt senses of empathy, or an innate conscience? The point for economic analysis, most of which is a matter of understanding and predicting the consequences of various actions, is that the relevance of economic analysis to policymaking depends, in part, on what one believes is the final source of value standards. So far, we have two questions of ethics that bear directly on economics: (1) What is the standard of good? and (2) How does one establish that something is good? A third relevant question of ethics is: Who should be the beneficiaries of the good? A common assumption of economic analysis is that individuals are rational and self-interested. The third question focuses on self-interest. Is self-interest moral, amoral, or immoral? Is morality a matter of individuals taking responsibility for their lives and working to achieve happiness? Or is morality a matter of individuals accepting responsibility for others and being willing to forgo or sacrifice for them? This is the debate in ethics between egoism and altruism. Strong forms of egoism hold that individuals should be self-responsible and ambitious in their pursuit of happiness, that they should treat other individuals as self-responsible trading partners, and that those who are unable to be self-responsible should be treated through voluntary charity. Strong forms of altruism argue the opposite, holding that morality is primarily a matter of helping those who are in need, that charity is more moral than trade, and that the most moral individuals will be motivated by a spirit of self-sacrifice. For example: Carly worked hard and earned $10 million by the time she was forty. She is now in semiretirement, enjoying the good life of travel, building her dream home, managing her investments, and spending time with her family and friends. Jane, by contrast, inherited $10 million at age forty, gave $9.9 million away to charity, and lives frugally on the remaining money. Which woman is more morally admirable? Or consider the debates over rent control and minimum wages. Economists, by a large majority, agree that such policies are not merely zero-sum, as their advocates intend, but rather negative-sum. In this encyclopedia, Walter Block (see rent control) argues that rent controls cause landlords a loss—and also cause housing shortages that harm some of the poorest renters the most. Linda Gorman (see minimum wages) argues that minimum wages cause employers a loss—but also destroy jobs for unskilled laborers. These unintended consequences are well known among economists, but there is little sign that rent controls and minimum wages will be abandoned anytime soon. Why so? In the case of rent controls, part of the explanation involves the political dynamics of urban areas, in which many voters are renters: renters believe that rent control is good for them, and politicians sometimes listen to their constituents. Yet another major part of the explanation has to do with an altruistic ethic that says that the self-interest of landlords and employers counts for little morally and may be sacrificed to help tenants and employees. The thinking is that landlords and employers are richer, and tenants and employees are poorer, and thus rich people should be willing to sacrifice profits to help out the poor if necessary. But if we cannot expect the rich to do the right thing voluntarily, then an altruistic ethic will help justify the government’s mandating the sacrifice by law. The moral difference between egoists and altruists on these economic policy issues is between those who see employers and employees as win-win trading partners and those who see employment as exploitation; and between those who see landlords and tenants as trading value to mutual benefit and those who see poor tenants vulnerable to being taken advantage of by rich landlords. Generalizing from debates over particular policies to evaluations of economic systems as a whole, Adam Smith’s famous statement about self-interest from The Wealth of Nations is directly relevant to our contemporary debates about the morality of capitalism: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Smith is working out a middle ground between traditional ethical theories that have been altruistic in principle and his new (at the time) economic theory that is optimistic about the power of egoistic individuals in a free market. Smith’s position is modern and egoistic in accepting that self-interest is natural and beneficial in making capitalism work well; at the same time Smith is traditionally altruistic in reserving his highest praise for those who take a disinterested perspective on their own interests and are willing to sacrifice their interests. Bracketing Smith’s view on one side is a traditional view of self-interest, one still held by most of capitalism’s contemporary opponents: Self-interest is amoral or immoral because it is essentially antisocial; and because it is based on self-interest, capitalism must be a system of conflict and zero-sum transactions. And because the good of society as a whole is the standard of value, it follows that self-interest and capitalism must be restrained or sacrificed. Smith’s economic insight is to see that self-interest and capitalism do not generate social conflict. His analysis led him to see that self-interested individuals would mostly engage in win-win transactions—that the profit motive, property rights, divisions of labor, competition, and other features of capitalism would lead to individual prosperity and social harmony. But Smith retained the traditional ethical belief that the good of society as a whole is the moral standard of value. Bracketing Smith’s view on the other side is the view—held by neo-Aristotelians and Ayn Rand, for example—that self-interest is moral and that what justifies capitalism is its protection and enabling of individuals in the pursuit of their individual lives and happiness. This position agrees essentially with Smith’s economic analysis of capitalism as a network of win-win transactions, but not with his primary ethical justification. Both ethical and economic analysis quickly become complex, and the three questions noted above provide a starting point for integrating the two fields. Our contemporary debates over environmental values and policies can help illustrate the complex interplay. Environmental debates are about two categories of human action: resource use and waste disposal. For example, whether we are running out of trees and whether we should drill for oil in Alaska are issues of resource use; and whether toxic chemicals are poisoning a water supply and whether greenhouse gases are causing global warming are issues of waste disposal. Some issues, such as recycling, are issues of both resource use and waste disposal. We end with the case of recycling of metal drink containers as a working example. Part of the motivation for recycling may be a belief that the world is running out of a natural resource—in this case, aluminum. In part this belief depends on strictly scientific information: How much aluminum is available from the Earth? How much are we currently using? As mining and processing techniques improve, what effect will that have on the available stock of aluminum? Depending on the scientific data, one might conclude that aluminum is becoming more plentiful or scarcer (see natural resources). Another part of the recycling issue integrates economic considerations. Recycling can increase the available stock of aluminum and save space in landfills, but it also has costs: the costs of making and installing recycling bins for empty cans, the monetary and pollution costs of having recycling trucks travel through neighborhoods and businesses to collect the recyclables, the time cost of putting the cans in the right bins, the cost of reprocessing the cans to extract the raw aluminum, and so on. Whether the benefits of recycling outweigh the costs depends on the results of number crunching by economists. Another part of the recycling issue turns on general political commitments. Given that using resources well and putting trash in its place are valuable, what social institutions should we rely on to achieve those values? Should recycling be voluntary and a matter of market incentives? Or should the government mandate recycling as part of a broader mandate to manage society’s resource use and waste disposal practices? (see tragedy of the commons and free-market environmentalism). Governing how we approach the above scientific, economic, and political issues is a set of presuppositions of ethical values. Those who think egoistically see the environment as a set of resources for humans to use for their benefit. Humans use the environment for a variety of economic and aesthetic purposes, and it is important to human health that certain standards of cleanliness are maintained. On that assumption, it makes sense to ask scientists to investigate the stock of resources and to develop techniques for extracting them. It also makes sense to ask economists to do cost-benefit analyses comparing mining and recycling to determine the most cost-effective methods of producing aluminum. The egoistic goal is to preserve, change, or use the environment in ways that increase human wealth, health, and experiences of beauty. By contrast, strong forms of altruism when applied to environmental issues dictate different scientific and economic priorities. Altruism with respect to the environment requires that humans subordinate or sacrifice their interests to the needs of other species or to the environment as a whole. Given this perspective, the environment is something to be preserved rather than used by humans. Human self-interested values are a lower priority than the well-being of other species or the environment as a whole. Scientifically, asking researchers to find out how much aluminum is available for our use then becomes a morally suspect activity. And economically, recycling then becomes not a matter of a practice worth doing if the cost-benefit numbers work out for us but rather a duty that humans should accept no matter what the economic consequences to themselves. About the Author Stephen Hicks is professor in the Department of Philosophy at Rockford College and Executive Director of the Center for Ethics and Entrepreneurship. In 1994–1995 he was a visiting professor of business ethics at Georgetown University in Washington, D.C. Further Reading   Hume, David. A Treatise of Human Nature. 1739–1740. Reprint. Oxford: Oxford University Press, 2000. In book III (part 1, section 1), Hume argues that there is no logical way to derive an “ought” from an “is.” This implies, for example, that there is no logical connection between normative ethics and descriptive economics. Mill, John Stuart. On Liberty. 1859 (many editions available). A defense of liberal society based on the argument that it realizes the utilitarian moral principle of the “greatest happiness for the greatest number.” Available online at: http://www.econlib.org/library/Mill/mlLbty.html. Mill’s Utilitarianism (1861) is his argument for the “greatest happiness” principle as the ultimate standard in ethics. Rand, Ayn. Capitalism: The Unknown Ideal. New York: Signet, 1967. A defense of capitalism on egoist grounds. Rand argues that what justifies capitalism morally is that it provides individuals with the liberty and property rights they need to survive and flourish self-responsibly. Sen, Amartya. On Ethics and Economics. London: Blackwell, 1989. Sen criticizes standard utilitarian defenses of free markets and discusses generally the kind of theoretical ethics needed to provide a basis for welfare economics. Smith, Adam. The Wealth of Nations. 1776 (many editions available). The classic early study of free markets, describing how the self-interested actions of unregulated individuals come to be coordinated to mutual benefit. Available online at: http://www.econlib.org/librarySmith/smWN.html   (0 COMMENTS)

To economists, efficiency is a relationship between ends and means. When we call a situation inefficient, we are claiming that we could achieve the desired ends with less means, or that the means employed could produce more of the ends desired. “Less” and “more” in this context necessarily refer to less and more value. Thus, economic efficiency is measured not by the relationship between the physical quantities of ends and means, but by the relationship between the value of the ends and the value of the means. Terms such as “technical efficiency” or “objective efficiency” are meaningless. From a strictly technical or physical standpoint, every process is perfectly efficient. The ratio of physical output (ends) to physical input (means) necessarily equals one, as the basic law of thermodynamics reminds us. Consider an engineer who judges one machine more efficient than another because one produces more work output per unit of energy input. The engineer is implicitly counting only the useful work done. “Useful,” of course, is an evaluative term. The inescapably evaluative nature of the concept raises a fundamental question for every attempt to talk about the efficiency of any process or institution: Whose valuations do we use, and how shall they be weighted? Economic efficiency makes use of monetary evaluations. It refers to the relationship between the monetary value of ends and the monetary value of means. The valuations that count are, consequently, the valuations of those who are willing and able to support their preferences by offering money. From this perspective a parcel of land is used with maximum economic efficiency when it comes under the control

An entrepreneur is someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit. An entrepreneur who takes the resources necessary to produce a pair of jeans that can be sold for thirty dollars and instead turns them into a denim backpack that sells for fifty dollars will earn a profit by increasing the value those resources create. This comparison is possible because in competitive resource markets, an entrepreneur’s costs of production are determined by the prices required to bid the necessary resources away from alternative uses. Those prices will be equal to the value that the resources could create in their next-best alternate uses. Because the price of purchasing resources measures this opportunity cost— the value of the forgone alternatives—the profit entrepreneurs make reflects the amount by which they have increased the value generated by the resources under their control. Entrepreneurs who make a loss, however, have reduced the value created by the resources under their control; that is, those resources could have produced more value elsewhere. Losses mean that an entrepreneur has essentially turned a fifty-dollar denim backpack into a thirty-dollar pair of jeans. This error in judgment is part of the entrepreneurial learning, or discovery, process vital to the efficient operation of markets. The profit-and-loss system of capitalism helps to quickly sort through the many new resource combinations entrepreneurs discover. A vibrant, growing economy depends on the efficiency of the process by which new ideas are quickly discovered, acted on, and labeled as successes or failures. Just as important as identifying successes is making sure that failures are quickly extinguished, freeing poorly used resources to go elsewhere. This is the positive side of business failure. Successful entrepreneurs expand the size of the economic pie for everyone. Bill Gates, who as an undergraduate at Harvard developed BASIC for the first microcomputer, went on to help found Microsoft in 1975. During the 1980s, IBM contracted with Gates to provide the operating system for its computers, a system now known as MS-DOS. Gates procured the software from another firm, essentially turning the thirty-dollar pair of jeans into a multibillion-dollar product. Microsoft’s Office and Windows operating software now run on about 90 percent of the world’s computers. By making software that increases human productivity, Gates expanded our ability to generate output (and income), resulting in a higher standard of living for all. Sam Walton, the founder of Wal-Mart, was another entrepreneur who touched millions of lives in a positive way. His innovations in distribution warehouse centers and inventory control allowed Wal-Mart to grow, in less than thirty years, from a single store in Arkansas to the nation’s largest retail chain. Shoppers benefit from the low prices and convenient locations that Walton’s Wal-Marts provide. Along with other entrepreneurs such as Ted Turner (CNN), Henry Ford (Ford automobiles), Ray Kroc (McDonald’s franchising), and Fred Smith (FedEx), Walton significantly improved the everyday life of billions of people all over the world. The word “entrepreneur” originates from a thirteenth-century French verb, entreprendre, meaning “to do something” or “to undertake.” By the sixteenth century, the noun form, entrepreneur, was being used to refer to someone who undertakes a business venture. The first academic use of the word by an economist was likely in 1730 by Richard Cantillon, who identified the willingness to bear the personal financial risk of a business venture as the defining characteristic of an entrepreneur. In the early 1800s, economists Jean-Baptiste Say and John Stuart Mill further popularized the academic usage of the word “entrepreneur.” Say stressed the role of the entrepreneur in creating value by moving resources out of less productive areas and into more productive ones. Mill used the term “entrepreneur” in his popular 1848 book, Principles of Political Economy, to refer to a person who assumes both the risk and the management of a business. In this manner, Mill provided a clearer distinction than Cantillon between an entrepreneur and other business owners (such as shareholders of a corporation) who assume financial risk but do not actively participate in the day-to-day operations or management of the firm. Two notable twentieth-century economists, Joseph Schumpeter and Israel Kirzner, further refined the academic understanding of entrepreneurship. Schumpeter stressed the role of the entrepreneur as an innovator who implements change in an economy by introducing new goods or new methods of production. In the Schumpeterian view, the entrepreneur is a disruptive force in an economy. Schumpeter emphasized the beneficial process of creative destruction, in which the introduction of new products results in the obsolescence or failure of others. The introduction of the compact disc and the corresponding disappearance of the vinyl record is just one of many examples of creative destruction: cars, electricity, aircraft, and personal computers are others. In contrast to Schumpeter’s view, Kirzner focused on entrepreneurship as a process of discovery. Kirzner’s entrepreneur is a person who discovers previously unnoticed profit opportunities. The entrepreneur’s discovery initiates a process in which these newly discovered profit opportunities are then acted on in the marketplace until market competition eliminates the profit opportunity. Unlike Schumpeter’s disruptive force, Kirzner’s entrepreneur is an equilibrating force. An example of such an entrepreneur would be someone in a college town who discovers that a recent increase in college enrollment has created a profit opportunity in renovating houses and turning them into rental apartments. Economists in the modern austrian school of economics have further refined and developed the ideas of Schumpeter and Kirzner. During the 1980s and 1990s, state and local governments across the United States abandoned their previous focus on attracting large manufacturing firms as the centerpiece of economic development policy and instead shifted their focus to promoting entrepreneurship. This same period witnessed a dramatic increase in empirical research on entrepreneurship. Some of these studies explore the effect of demographic and socioeconomic factors on the likelihood of a person choosing to become an entrepreneur. Others explore the impact of taxes on entrepreneurial activity. This literature is still hampered by the lack of a clear measure of entrepreneurial activity at the U.S. state level. Scholars generally measure entrepreneurship by using numbers of self-employed people; the deficiency in such a measure is that some people become self-employed partly to avoid, or even evade, income and payroll taxes. Some studies find, for example, that higher income tax rates are associated with higher rates of self-employment. This counterintuitive result is likely explained by the higher tax rates encouraging more tax evasion through individuals filing taxes as self-employed. Economists have also found that higher taxes on inheritance are associated with a lower likelihood of individuals becoming entrepreneurs. Some empirical studies have attempted to determine the contribution of entrepreneurial activity to overall economic growth. The majority of the widely cited studies use international data, taking advantage of the index of entrepreneurial activity for each country published annually in the Global Entrepreneurship Monitor. These studies conclude that between one-third and one-half of the differences in economic growth rates across countries can be explained by differing rates of entrepreneurial activity. Similar strong results have been found at the state and local levels. Infusions of venture capital funding, economists find, do not necessarily foster entrepreneurship. Capital is more mobile than labor, and funding naturally flows to those areas where creative and potentially profitable ideas are being generated. This means that promoting individual entrepreneurs is more important for economic development policy than is attracting venture capital at the initial stages. While funding can increase the odds of new business survival, it does not create new ideas. Funding follows ideas, not vice versa. One of the largest remaining disagreements in the applied academic literature concerns what constitutes entrepreneurship. Should a small-town housewife who opens her own day-care business be counted the same as someone like Bill Gates or Sam Walton? If not, how are these different activities classified, and where do we draw the line? This uncertainty has led to the terms “lifestyle” entrepreneur and “gazelle” (or “high growth”) entrepreneur. Lifestyle entrepreneurs open their own businesses primarily for the nonmonetary benefits associated with being their own bosses and setting their own schedules. Gazelle entrepreneurs often move from one start-up business to another, with a well-defined growth plan and exit strategy. While this distinction seems conceptually obvious, empirically separating these two groups is difficult when we cannot observe individual motives. This becomes an even greater problem as researchers try to answer questions such as whether the policies that promote urban entrepreneurship can also work in rural areas. Researchers on rural entrepreneurship have recently shown that the Internet can make it easier for rural entrepreneurs to reach a larger market. Because, as Adam Smith pointed out, specialization is limited by the extent of the market, rural entrepreneurs can specialize more successfully when they can sell to a large number of online customers. What is government’s role in promoting or stifling entrepreneurship? Because the early research on entrepreneurship was done mainly by noneconomists (mostly actual entrepreneurs and management faculty at business schools), the prevailing belief was that new government programs were the best way to promote entrepreneurship. Among the most popular proposals were government-managed loan funds, government subsidies, government-funded business development centers, and entrepreneurial curriculum in public schools. These programs, however, have generally failed. Government-funded and -managed loan funds, such as are found in Maine, Minnesota, and Iowa, have suffered from the same poor incentives and political pressures that plague so many other government agencies. My own recent research, along with that of other economists, has found that the public policy that best fosters entrepreneurship is economic freedom. Our research focuses on the public choice reasons why these government programs are likely to fail, and on how improved “rules of the game” (lower and less complex taxes and regulations, more secure property rights, an unbiased judicial system, etc.) promote entrepreneurial activity. Steven Kreft and Russell Sobel (2003) showed entrepreneurial activity to be highly correlated with the “Economic Freedom Index,” a measure of the existence of such promarket institutions. This relationship between freedom and entrepreneurship also holds using more widely accepted indexes of entrepreneurial activity (from the Global Entrepreneurship Monitor) and economic freedom (from Gwartney and Lawson’s Economic Freedom of the World) that are available selectively at the international level. This relationship holds whether the countries studied are economies moving out of socialism or economies of OECD countries. Figure 1 shows the strength of this relationship among OECD countries. The dashed line in the figure shows the positive relationship between economic freedom and entrepreneurial activity. When other demographic and socioeconomic factors are controlled for, the relationship is even stronger. This finding is consistent with the strong positive correlation between economic freedom and the growth of per capita income that other researchers have found. One reason economic freedom produces economic growth is that economic freedom fosters entrepreneurial activity. Figure 1 Economic Freedom and Entrepreneurship in OECD Countries, 2002 ZOOM   Economists William Baumol and Peter Boettke popularized the idea that capitalism is significantly more productive than alternative forms of economic organization because, under capitalism, entrepreneurial effort is channeled into activities that produce wealth rather than into activities that forcibly take other people’s wealth. Entrepreneurs, note Baumol and Boettke, are present in all societies. In government-controlled societies, entrepreneurial people go into government or lobby government, and much of the government action that results—tariffs, subsidies, and regulations, for example—destroys wealth. In economies with limited governments and rule of law, entrepreneurs produce wealth. Baumol’s and Boettke’s idea is consistent with the data and research linking economic freedom, which is a measure of the presence of good institutions, to both entrepreneurship and economic growth. The recent academic research on entrepreneurship shows that, to promote entrepreneurship, government policy should focus on reforming basic institutions to create an environment in which creative individuals can flourish. That environment is one of well-defined and enforced property rights, low taxes and regulations, sound legal and monetary systems, proper contract enforcement, and limited government intervention. About the Author Russell S. Sobel is a professor of economics and James Clark Coffman Distinguished Chair in Entrepreneurial Studies at West Virginia University, and he was founding director of the Entrepreneurship Center there. Further Reading Introductory   Gwartney, James D., and Robert A. Lawson. Economic Freedom of the World: 2002 Annual Report. Vancouver: Fraser Institute, 2002. Information about this book can be found online at: http://www.freetheworld.com/. Hughes, Jonathan R. T. The Vital Few: American Economic Progress and Its Protagonists. Exp. ed. New York: Oxford University Press, 1986. Kirzner, Israel M. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973. Information about Kirzner and his works can be found online at: http://www.worldhistory.com/wiki/I/Israel-Kirzner.htm. Kirzner, Israel M. “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature 35, no. 1 (1997): 60–85. Lee, Dwight R. “The Seeds of Entrepreneurship.” Journal of Private Enterprise 7, no. 1 (1991): 20–35. Reynolds, Paul D., Michael Hay, and S. Michael Camp. Global Entrepreneurship Monitor. Kansas City, Mo.: Kauffman Center for Entrepreneurial Leadership, 1999. Information about this book can be found online at: http://www.gemconsortium.org/. Rosenberg, Nathan, and L. E. Birdzell Jr. How the West Grew Rich. New York: Basic Books, 1986. Schumpeter, Joseph A. Capitalism, Socialism, and Democracy. New York: Harper, 1942. Schumpeter, Joseph A. The Theory of Economic Development. 1911. Cambridge: Harvard University Press, 1934. Information about Schumpeter and his works can be found online at: http://cepa.newschool.edu/het/profiles/schump.htm. Zacharakis, Andrew L., William D. Bygrave, and Dean A. Shepherd. Global Entrepreneurship Monitor: National Entrepreneurship Assessment: United States of America. Kansas City, Mo.: Kauffman Center for Entrepreneurial Leadership, 2000. Information about this book can be found online at: http://www.gemconsortium.org/.   Advanced   Bates, Timothy. “Entrepreneur Human Capital Inputs and Small Business Longevity.” Review of Economics and Statistics 72, no. 4 (1990): 551–559. Baumol, William J. “Entrepreneurship: Productive, Unproductive and Destructive.” Journal of Political Economy 98, no. 5 (1990): 893–921. Baumol, William J. The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism. Princeton: Princeton University Press, 2002. Blanchflower, David G., and Andrew J. Oswald. “What Makes an Entrepreneur?” Journal of Labor Economics 16, no. 1 (1998): 26–60. Blau, David M. “A Time-Series Analysis of Self-Employment in the United States.” Journal of Political Economy 95, no. 3 (1987): 445–467. Blomstrom, Magnus, Robert E. Lipsey, and Mario Zejan. “Is Fixed Investment the Key to Economic Growth?” Quarterly Journal of Economics 111, no. 1 (1996): 269–276. Boettke, Peter J. Calculation and Coordination: Essays on Socialism and Transitional Political Economy. New York: Routledge, 2001. Boettke, Peter J., and Christopher J. Coyne. “Entrepreneurship and Development: Cause or Consequence?” Advances in Austrian Economics 6 (2003): 67–87. Bruce, Donald. “Taxes and Entrepreneurial Endurance: Evidence from the Self-Employed.” National Tax Journal 55, no. 1 (2002): 5–24. Evans, David S., and Linda S. Leighton. “Some Empirical Aspects of Entrepreneurship.” American Economic Review 79, no. 3 (1989): 519–535. Hamilton, Barton H. “Does Entrepreneurship Pay? An Empirical Analysis of the Returns to Self Employment.” Journal of Political Economy 108, no. 3 (2000): 604–631. Holtz-Eakin, Douglas, David Joulfaian, and Harvey S. Rosen. “Sticking It Out: Entrepreneurial Survival and Liquidity Constraints.” Journal of Political Economy 102, no. 1 (1994): 53–75. Kreft, Steven F., and Russell S. Sobel. “Public Policy, Entrepreneurship, and Economic Growth.” West Virginia University Entrepreneurship Center Working Paper, 2003. This article and some related research can be found online at: http://www.be.wvu.edu/ec/research.htm.   (0 COMMENTS)