0:36 Intro. [Recording date: November 14, 2011.] Profits; and you want to use three stories that you've chosen to illustrate the role of profit and error. Get us started. I'm going to start with a joke, because it's never a bad thing to do that. This is a joke I think most economists tell most intro economics students, and yet it's awfully useful. There's an economist--a neo-classical economist--and an entrepreneur walking along a street. The entrepreneur glances down and finds a $20 bill. Being an expansive sort of fellow, he says: "We're walking together. Let's split the $20 bill. We both saw it." And the economist says: "No. Actually, in equilibrium there couldn't possibly be a $20 bill because somebody would have picked it up. So, no thank you." The entrepreneur shakes his head, picks it up, puts it in his pocket and keeps the whole $20. It's a real knee-slapper. I tell that joke also, but I tell it with a psychologist, and I put the joke in quotes. Well, you mean it's supposed to be funny. Well, it's a gest. That's correct. It's a jibe, even, at economists who believe that profit opportunities disappear. The thing is that today we are going to talk about profits. The question is: What is the source of profits? And the neoclassical economist would say it's a nonsense question because there is generally no such thing. The only way you could have profits is a rate of return that's above the competitive rate of return; and as we all know, if we make the assumptions necessary for competitive equilibrium, there will be no profits. They will all be driven down to zero because price is driven to the cost of production. Now that's one of the genius things about competitive economics. That's certainly right. The question is: Why is it in the real economy we see profits? And why do they seem so important? And the reason I was interested in this was because it seems that profits have kind of become a bad word. It's something that the people involved in Occupy Wall Street and around the country are angry about. Yeah, I agree. Profits have always received a mixed welcome from the populace at large. It depends where they come from. Remember the movie Wall Street in 1987, the first Oliver Stone Wall Street: Gordon Gecko gives this iconic speech: "Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures. The essence of the evolutionary spirit. Greed in all its forms--greed for life, money, love, knowledge--has marked the upward surge of mankind." Gecko is not the hero of that movie. I hope you are reading that. Yes. Good. Maybe you liked it enough to memorize it. It's an evil speech, because capitalism does not celebrate greed. Capitalism takes greed as a given and celebrates consumer sovereignty. So, anything that starts with "greed is good" is wrong. It's a mischaracterization of capitalism. No one has ever believed that. What capitalism does is try to harness greed and use it for the good of consumers. We've talked about this before, but the idea that somehow the Wealth of Nations is about greed being good because it gets channeled by competition's help to consumers is not a Smithian idea. It's a caricature of Adam Smith. He obviously understood that people are self-interested, but he saw greed the way we use it in everyday language to be not a virtue. It is not a virtue; and one of the reasons I'm sympathetic with the Occupy Wall Street protesters is: We have created a society which under some circumstances has confused profits with rents. So, profits are what you do when you produce something that somebody else wants to buy and you do it at a low enough price that you can make more revenues than it costs you to make it. Rents are when you invest in government policies for protection, for price floors, for barriers to entry that actually are more profitable in an accounting sense, but produce nothing for the society. You should clarify another expression you used earlier. When economists talk about 0 profit, we don't mean that you don't have any left over. Want to clarify that? Sure. Economists and accountants argue about this all the time. And you can just imagine how exciting that is! I think it's a new reality TV show coming out on cable: accountants versus economists. And they'll both argue in technical language about what profits are. For the account profits are the amount of money you make over labor costs and the cost of materials. For economists, you have to include in your costs the rate of return that you would get on your capital. So, a zero-profit condition means that the person who has invested their money gets exactly the opportunity cost rate of return on that capital. Meaning? If the rate of return is 10%, I've got $1000, I'm making $100 profit. It's just that that's the profit I would get from investing it somewhere else. The next best alternative. We call that zero profit. A zero profit means I'm doing no better with my assets than I could do with them elsewhere. And that would include my time. So an entrepreneur who starts a business and is able to pay himself a salary of, say, $3000 because that's what's left over after paying all the costs and taking in the revenue--those are negative economic profits because he presumably could have done something more valuable with his or her time that would pay more than $3000. You might choose to stay in that field if you had enough of a cushion and you loved doing that enough, but in general we would say that's not going to be a going concern. So, the accountant and the tax man say: You are making $3000 profit. The economist would say: No, you probably could make $5000. Or $50,000 as an employee somewhere else. And that's your opportunity cost, and therefore you have negative economic profits. That's a loss to the economist, but profits to the accountant.

7:14 So, that's the story when profits earned through pleasing customers are good. And when not earned, say by getting some special privilege, are bad. Anything else to say? I think it is important, and the reason I wanted to start with that, as you pointed out, hilarious joke, that we need to recognize what the source of profits are. The source of profits is correcting errors. The economy around us is full of errors. And what I mean by errors is a maladjustment, a divergence between what we are actually producing and what we "should" produce in order to use the stuff that we have--our mental resources, physical capital, labor--to produce the highest possible level of satisfaction of what the public wants. So, there's this unobservable thing that nobody knows and nobody can know, and that is: What is it that a consumer-sovereignty oriented society would produce? How are we going to allocate our resources? There's all sorts of mistakes in the way we are allocating resources. If we not making iPods, if we are not making things that people want to buy, even if they don't know that they want to buy it. The genius of Steve Jobs was to say: Here's the way people want to buy these things. They don't know it, but if we do it, we correct this mistake. I can make a lot of money and people will be able to get the music they want in a very cheap and easy way; and they can listen to it on the street. And he could have been wrong. In which case he would have lost a lot of money. He was wrong about the Apple II--it was a disaster. So, he had a history of some really bad mistakes. But you are constantly trying to correct mistakes, not in the sense of: Oh, you've said 4+4=9. It's not a mistake anybody could recognize. It's a mistake that resources are misallocated now, and I can allocate them in a way that will produce more value for the society than it costs to produce it. Profits come from correcting mistakes. And where does that lead us? In trying to illustrate this I have the three little stories that we've talked about before, but I think it would be nice to link them in the podcast today because I think they have a nice unifying theme. Before you do that, I just want to add one footnote to the economist and the companion walking along the street, where the companion sees the $20 bill and gets excited and the economist says: Don't bother; if it were really there, somebody would have picked it up already. And although, of course, there has to be a first person, and that's what the economist is relying on. That's the sort of paradox of zero profits. You've claimed that there aren't any profit opportunities in equilibrium--to the extent such a thing exists--but you have to recognize that the reason there aren't is that somebody has to have been the first person to see it. I think the value of that story, and I'm going to make a little plea for it, is that so many times people think they have inside information or they know there is a bargain or they have a great stock they want to buy or they think they can make a lot of money; and that joke about the economist walking down the street is a very useful cautionary tale. Because your first thought should be, and this is wonderful advice: Be careful. It probably isn't there. Someone probably picked up that $20 bill before you saw it, and it's an illusion. Or worse: someone's trying to sell you something by implying there is such a thing. I'm really amazed at how many of my colleagues, quite politically left, actually had 100% of their money invested in the stock market in 2007, 2008; and now they can't retire. They thought it was a sure thing. We are very prone to the sure thing psychologically; it's so exciting to get a free lunch. When someone says, it hasn't gone down, or this goes up 10% every year, or the average is 10% for the last 100 years; you can't lose money on it--think of that story. I don't know if we've ever talked about this but there's this story that at lunch at the U. of Chicago faculty club, some time back in the 1960s--George Stigler used to tell this story--that there was this arbitrage opportunity, meaning two goods of the same quality were selling for different prices. Which means you can buy the cheap one and resell it at the place where it would be more expensive; and it's a sure thing. You can't lose. I think it was a ton of wheat in the United States and a ton of wheat in England. This is an embarrassing story; we won't name all the names; but George Stigler told the story that they got all excited. They bought the wheat in the United States, a contract prepared to sell it in London; only to discover that a ton in England is not the same as a ton in the United States. George Stigler used to summarize that by saying: It's the most expensive lunch I ever had. Of all people, a Chicago economist should have realized that there's no free lunch; there are not $20 bills lying around. But if you are lucky, you might be the first person to find such a thing. Isn't it interesting that the problem is that hard. One Christmas in the 1970s I got a thing called a Pet Rock. And it was a rock in a box. If you had come to me and said you had an investment opportunity--we are going to put rocks in boxes and sell them to people and we're going to sell millions--I'd have said: I don't think so. I'm going to leave that $20 bill on the ground, thank you. Every once in a while. If you think you have inside information, you are almost certainly wrong. If Bernie Madoff comes to you and says: I can make triple the return and there's no risk--it's a lie. It's not true. So, the question is: Why does anyone ever invest? Why is it that people take these chances when we all know, if we think about it, you're not going to; although secretly we think we are God's special snowflake. And in fact, no, I can probably guess.

13:43 You proposed to me that we discuss three stories, three that we have talked about in the past in various amounts of detail. And now we've set this in the frame of profit and correcting errors. So, let's start with the first story. Tell us the story. We'll do it chronologically. I'm a very egotistical person, and I Google myself 8 or 10 times a day. You're God's special snowflake. But it was harder for me to Google myself in the 11th century. But I did find a way to Google myself in the 11th century by trying to find out what was the etymological origin of my name, which is Munger. So, a few hundred years ago it was Monger. In Anglo-Saxon in the 11th century, it was the the word Mancgere, which meant merchant, just the lowest sort. And it turned out that there was a mention of the mancgere in translation by a woman named Sharon Turner in a 3-volume history of the Anglo Saxons, which was published in 1836. But this is from 1050; it was a psalter, that you would sing psalms from, but they also had stories, character stories. And this was in the Northern Hanseatic League. A trading organization. A bunch of city states loosely affiliated by trade, but it was pretty dangerous. So, the mancgere introduces himself in the psalter by saying--and you can tell he's defensive, he's not calm about this--I say I am useful to the King, to the elderman, to the rich, and to all people. I ascend my ship with my merchandise and I sail for the sea-like places. Sounds like it should be Monty Python. And I sell my things and buy dear things which are not produced in this land; and I bring them to you with great danger over the sea. And sometimes I suffer shipwreck, with the loss of all my things, scarcely escaping myself. And in the interlocutor asks: What things do you bring us? Skins, silk, costly gems, gold, various garments, pigment, wine, he goes on. Will you sell your things here as you brought them here? And it sounds like asking if was going to change them. And he says: No, not only am I not going to change them; I will not, because then what will my labor benefit me? I will sell them dearer here than I bought them there, that I may get some profit to feed me, my wife, and children. So, what he's doing is traveling, pretty far, at considerable risk to himself, bringing back stuff that he thinks people want to buy. Is he changing them in any way? No, there's no production. Parasite. There's no pretense that he is doing anything but being a parasite. I'm a mancgere and I'm okay; I sleep all night and I sail all day. So, this is 1050, a thousand years ago. It's a remarkable document because it's timeless. It's exactly the way an economist would defend the role of a merchant, and in particular one whose--you could gussie it up and call him a retailer, but he's not even a retailer. He's just a middleman of the most uncreative sort on the surface. He provides transportation services, I suppose you could say. But he's not saying: I'm charging for transportation. He's saying: I'm going to charge the most that I can get, because otherwise what would my labor get me? And the defensiveness hasn't changed either. Not long after this, Thomas Aquinas--the sentiment had been there for a while--had asked in, I think, Question 74 of Summa Theologica: Is it a sin to sell something for more than it is worth? And it's important that we take some of the parts of Aquinas's objection about the just price doctrine. Is it a sin to sell something for more than it is worth? Well, suppose that he sold something for gold that in fact was just iron. That would be fraud; that you can't do. Suppose it was coercive; suppose I didn't have enough information to know what it was you were selling. All of those things might be a sin; we might now say they should be illegal. So, let's put all those things aside. Let's suppose that all he has done is made a very large profit, more than it cost him to transport the stuff by a lot. He went and bought the stuff, he brings it to you; he represents precisely what it is; and asks me how much are you going to pay for it? A number of people are clustered. They are lined up because all of them want this, and they bid against each other. He ends up making a huge profit. Has he committed a sin? Or in modern terms, has he done something that we would now say that we were going to make illegal? He's brought back an orange from the Orient and people don't get oranges in 1050. He's brought back spices that mean the spoilt meat that I eat in my soup actually doesn't taste so bad. Might not make you sick. So, the question is: Has he behaved evilly? And Aquinas sort of goes back and forth on this; and he makes an exception for a just price on people, primarily merchants; and he says: Well, they are not behaving morally, but they are not behaving immorally. This is just a region of our civil life where the usual questions of our morality don't apply. That's a tepid endorsement but you could do worse. It's sort of monstrous, but we'll make an exception. What are you going to expect? These people are traders. Always there has been this idea, in some ways in Confucianism--not so much in Islam. Mohammed was a trader, so trade was okay in the Islamic world; and that's part of the reason why the Islamic world flourished for a long time--between 800 and 1200 there was a lot of trade in the Islamic world, before really there was in Europe. The question is: what is the status of the trader? And here's the argument that I would want to make. The fact that this man, the mancgere, is making profits is prima facie evidence that he is making a huge benefit to people who are voluntarily buying the stuff that he brought back--provided that there's no fraud and no coercion. He's doing a huge public service. He should have been celebrated rather than this tepid endorsement--yeah, you know how traders are.

20:36 It's an incredible thing. That attitude really hasn't changed. I don't know where it comes from exactly. Some of it's maybe cultural; some, in some dimension hardwired into us. When I talk to my students about this--and this illustrates another example of the difference between economic profit and accounting profit--economists tend not to care about historical price, what you paid for the good originally, but rather what replacement cost is. And when I first moved to Washington, D.C. the house I wanted to buy in the neighborhood I wanted to buy, it's public information, I was able to see that the owner, who had bought the house about 25-35 years before I had--he had paid one tenth of what he was charging me. And if I had gone to him and said: You know, I think 5 times what you paid for it would be plenty. That would be enough to motivate you to take care of the house. He would say: Well, I can get 10 times, and that's the market price. And in that situation nobody is outraged that the owner of the house is gouging me, because that's what houses of "comparable" amenities and size and location tend to earn for the seller. And so no one objects to the fact that he was charging what everyone else was charging. Now, one of the things that's unusual, and we've talked about this a lot in previous podcasts--if you've got the only orange, somehow it does feel different than if there are 40 orange sellers, all of whom have gone to the trouble of going to get them. Which is what a grocery store is doing. They've incurred costs; we understand they are entitled to a profit. But they don't earn the profit because of competition that they might earn if there were only one grocery store. It raises the question: Does anybody earn profits? There's a big question in philosophy about desert, and I've become interested in this. The word "desert" is complicated. There are a number of forms of the word "desert," as you probably know. One is the sweet stuff, that we are going to ignore. I think it's the same word. It's the same root--what you are entitled to. Dessert with two s's means to clear the table. You de-serve, middle French, des serve, with two s's. To clear the table after the meal, and that's why we have sweets. There is a very similar word, deservir, with one s, that means something of virtue or merit--I deserve it. The strange thing is, French is a very irregular language and deserte is to deserve, that is to merit reward or punishment. So, I'd always assumed that they were the same; but they're actually completely different. And that's also different from the idea of deserting or leaving, which is also middle French; and that's deserver, with an e [N.B. Pity me, the typist, yet?! Hope I got this close to right.--Econlib Ed.] which means to leave. So, the water has left the desert--you leave your military unit. So, it's actually three different words for very similar English words. So, the phrase "just deserts"--I actually did some research on this--the second word has one s, not two. But there's 4 million instances on Google with two s's. So, just desserts, with two s's, should be like a cake shop--we don't sell pizza. But "just desert" means I justifiably expect to get to keep that. So, the question, and you've raised it very well, is: We can split the difference. Sure, you deserve some profit, you deserve some part of the increase of the value of the house. But not that much--that's too much. And so you don't deserve all of the profits that you have gotten because you haven't earned them. So, the question that John Rawls raised in the Theory of Justice and elsewhere was: Why would any of us think that we deserve any of the character or effort or intelligence that lead us to perform well? So, suppose that we make a theory of desert in the sense that you deserve this because you own in some sense your own talents. Well, Rawls says you got those from your parents. You won a genetic lottery. Those are morally arbitrary. We may decide to keep some of it, but only what is necessary to motivate you to do what's good for society. The things that you know, that you do, your character--those are collectively held. They are not privately owned, according to that theory of desert. That's a very discomforting idea, isn't it? It's widely held. That's the basis; you really set this up perfectly. I think a lot of people, maybe not for a house, but, say you are making too much profits. So, we are going to have an excess profits tax. These oil companies, these other kinds of companies that are making big profits--they don't need that much. We'll take away half, and that will still motivate them to do what they should do. We recently did a podcast with Steven Kaplan on the top 1% and he had this remarkable statistic that in a recent year the top 25 hedge fund managers earned in total $25 billion in that year. And it's a skewed distribution, so the top 5 earned more than $5 billion. But the average of the top 25 was a billion apiece. Surely that is more than enough, right? I think that would be the average person on the street's response. And it might be true. If you start from the premise that all our talents and character are collectively owned because they are morally arbitrary, then the only reason that anyone gets to keep profits is to motivate them to do what we want them to do for the public good. So, I just made an argument saying profits are actually a sign that I am doing something for the collective. I am creating value. The mancgere is doing something that makes people better off. Well, my opponent might concede that but say: Okay, but then we'll only give them enough profits to motivate them to do what we should want them to do. We don't have to give them the full amount.

27:37 And as an economist, I have two thoughts on that. I don't know how persuasive they are to non-economists. But my first thought is, once you give the power to the state to allocate the rewards you are not going to be in the world of justice like you hope. You are going to be in the world of rent seeking and power. My second thought is, so okay, I'm willing to admit that people would still be hedge fund managers--assuming they do something valuable, which I think many of them do. Not all financial folks are doing productive things these days, but many do. And you'd say: I concede the point that a billion is too much in the sense that less than that would still motivate them to do a good job. How would you pick the number that you think was the right number, and how would you enforce it? It is really interesting that most of us think, if we are defenders of capitalism--no one that I know would defend the greed claim. What we defend instead is that what the price system does is provide information about the scarcity of resources so that it's easier for us to correct mistakes. I say: Wait, you are using tin for this? It's much more valuable over here. I will buy the tin from you, sell it over here, and correct a mistake that makes everybody, including me, better off. The person I bought it from is better off because he's not using the tin but he's got more money than he would have made. The other guy who values the tin more creates something more valuable. And I make a profit for doing it. Well, the response, yes but you don't need all of that, implies that somebody else has this information about how much it takes and they have this information about where the resource should be directed. So, the price system provides both information and decentralized motivation for people constantly to be looking around. A number of people who have studied entrepreneurship, because that's what that is, entrepreneurship--entrepreneurs correct the errors in allocations of resources, and profits are what they are looking for. They are looking for opportunities to correct allocations of resources. So, Israel Kirzner and others have called this awareness. What I'm looking for is a way to figure out how I can correct a misallocation of resources; I'm constantly looking around. Entrepreneurship rests on awareness. Well, I think the best answer to Rawls and the people who say these are morally arbitrary--I suppose that it is, and that's why I wanted to have the second story about "The Verger," because "The Verger" illustrates how morally arbitrary some of these features are. But the Nozickian answer--that is, Robert Nozick's answer to Rawls--was of course, it's too high a standard. It's silly to say that you deserve this all the way back to some kind of primeval having created something so fundamental that the society couldn't do without it. But we could settle on something intermediate, which is: You are entitled to it because as a liberal society we are going to adopt a value of personal autonomy. It can be overcome--you commit a crime, you lose your autonomy. But it's a pretty high bar to say unless you do something that harms other people, you own yourself. You own your own labor. And that definition of autonomy would mean while I don't deserve the profit in some moral sense, I'm entitled to it in the sense that we accept that in a market society people who take certain actions and create value get to reap the rewards. So, it's a question of ownership and property, not moral desert. It's a misrepresentation to insist you would have to deserve it if property and entitlement get you to the same place. I think underlying that--the easiest way for me to think about this is Steve Jobs, since he's such a dramatic example. Underlying that idea is the reason I'm entitled to it is the presumption I'm helping others, not just myself. If life were a zero-sum game and by engaging my skills, say as a warrior, I was able to amass wealth and goods by plunder, we'd say that's not moral. The fact that you were born stronger than I am, that you had better weapons because you had inherited them through your family or created them through gifts that bestowed by nature or God, that's irrelevant. It's ultimately got to come down to the fact that you makes folks better. So, I look at Steve Jobs; he dies and his estate is reportedly worth about $6.6 billion; $4.4 billion of that is Disney stock that he got from selling Pixar to Disney; $2.2, roughly half, came from what most people think of when they think of Steve Jobs, which is the profits from his Apple stock at the time of his death that he owned. Part of it's death--death has some reputational effects. Before he died, people complained he didn't give enough of it away. He wasn't charitable enough, didn't do enough for human beings. It's clear to me he did a remarkable lot for human beings. He gave us, to some extent, Pixar; he wasn't the only one, of course, but he gave us those remarkable visual treats. And then he transformed the music and information business through the iPod, the iPad, and the Mac computer. Those are just glorious gifts from which we benefited. So, his $6.6 billion is a fraction of his total contribution to the world. A trivial fraction. So, we got most of it. He got a lot. So, when somebody says he got too much--yes, he would have done it anyway for a much smaller share. But I think the reason we celebrate the man is we realize that the pie got bigger by so much more than that $6.6 billion that we say: That's okay. As it turns out. We couldn't have known that in advance. I wrote some articles a time ago. He tried several times at first to sell his computers to Hewlett Packard (HP) and they said: Are you kidding? Nobody's ever going to buy this. It was that awareness. Yes, he also made some mistakes. But overall the things he created, it's a huge amount of value. Many people now who are saying he got too much are reading about his death on something that would not exist if he had not lived. They are looking at a device that would not exist. Ironic. He had certain gifts; he used them to the fullest. His sister delivered a rather extraordinary eulogy that was reprinted. She chronicled among many other things his relentless work effort. Many people are given great gifts and they don't pursue them. My eighth grade teacher, Miss Keneen [sp?] used to say: It's better to have a half-gallon capacity and fill it to the top than to have a gallon capacity and only fill it up to a quart. She's right. Many gifted people don't use their gifts; and many people who have average gifts use them with such ferocity and intensity that they still make an important contribution that's greater than that of the gifted person.

35:34 Why did Steve Jobs do that? Why did he work so hard? He can't really claim any credit for having been born with the character and raised by his parents with the character. The drive. It still should be collectively owned if you are going to insist on a theory of desert. That's why I think a Nozickian entitlement theory makes a lot more sense. Insisting on desert means nobody ever owns or deserves anything. We're making collective decisions; we've raised two problems with that. One is the incentive problem that you raised, where we'd constantly be litigating about whether I get anything, or arguing with Congress. The second is information. How would anybody know any of these things? If we had to decide them collectively we would have looked at personal computers and said: No, nobody wants that. And turned it down. We wouldn't have any. Ex ante. It's a very deep point. It's hard to remember and hard to appreciate it, that ex ante, the knowledge isn't there. And the process--that James Buchanan piece I've cited here--it's the process that creates the knowledge. The knowledge isn't given to the participants. We often, and this is like the $20 bill--John Stuart Mill, in 1848, in his Principles of Political Economy, tried to make a distinction between production and distribution. He said: production, we have to do obviously through something like capitalism, because that produces the most; that's the way of organizing society, and production that's most efficient. But it's not like that with distribution. The things once there, mankind, individually or collectively, can do with them as they like. They can place them at the disposal of whomsoever they please, and on whatever terms. So, we can divide the benefits from capitalist production as we want. And the problem with that, the things once there. He's assuming that which has to be proved--that we wouldn't have iPods unless Steve Jobs had had enough autonomy to make that decision, partly in search of profits. He was motivated by profits, but not solely. He was motivated by fame. Commitment to an artistic vision, a thousand things. But still, we can't assume that the things were there. We can't just say: Production is one stage, but distribution is entirely separate. The maladjustments that will come from not having the incentives to capture the profits from things that I create will metastasize back into our distribution decisions. I agree with that, but I also have to concede, and I'm curious what your thoughts are on this--I think the incentive effects are of unknown magnitude. Economists who want to defend low rates of taxation and small levels of government will often invoke large incentive effects of taxation as a way of saying: If we raise taxes too high, people won't do creative stuff, and we need this for incentive reasons. I don't know if that's true; and I don't think there's any good evidence for it other than our armchair theorizing. Which is real; I think there is an effect. But I don't think hedge fund managers without a billion dollars would work a lot less hard. Other than to say that they would go into other investment opportunities. So, the market's a funny thing. If it has all these related payments that do matter to the participants, it's obvious that if you lower the wage to lawyers, fewer people go to law school and may become something else. But if you lowered the after-tax wages of all high-skilled activity, it's not obvious to me that the world would be a dramatically poorer place. I think it might be; it's a risky procedure. But my main argument against confiscatory taxation--I don't mean literally but high tax rates--isn't so much the efficiency effects but the power effects. The distortions that are going to occur. I don't think those two elements can really be separated. The incentive problem and the distortions that come from having to argue about it all the time, and I would say agnostic position, where we just don't know enough to set prices right, means that we are often going to accept levels of profits in some areas that just look obscene and in fact cannot be justified on any sort of moral claim.

40:04 [Spoiler Alert--Econlib Ed.] Let's move on to our second story, which is Somerset Maugham's short story, "The Verger". Published a couple of times, once as "The Man Who Made His Mark," in 1929; but then it was republished in 1936 in a magazine called Cosmopolitans under the name "The Verger." A verger is a kind of helper, a lay helper for the priest or the vicar because these are Anglican churches in England. He worked in St. Peter's, in Neville Square, and his name was Foreman. Started when he was 17; now 37, so he had been working there for 20 years. And had done a great job. Was very committed but he'd done a great job and he had a little house out back and he got paid in food. So he was basically paid in kind, and had committed his life to St. Peter's. They had a new vicar and they had representatives of the lay committee that helped the vicar at St. Peter's, and it turned out one day that Foreman, the Vicar, had never learned how to read or write. He had left school early, and then had hooked on as Verger when he was 17, and had never learned. The Vicar was appalled at this: This is the modern church. We can't have people like this that work for us--it's embarrassing. So, they called him in and they said: Look, you've done a great job, we're really sorry, but we are going to have to let you go. And he was disconsolate. He couldn't believe he'd been let go after all this loyalty, 20 years. No one doubted he'd done a great job. In fact, he asked: What of my work is inadequate? Well, nothing; but you can't read and write. And we can't have that sort of person here; we need to have someone who is more sophisticated, more able to deal with the increasingly sophisticated parish here at St. Peter's. I want to emphasize: This is a short story; this is fiction. My memory of the story is that it was just embarrassing; they felt it was unseemly. He clearly could do all the things the job required, but they felt they should get someone who looked better because he could read and write. And it would be embarrassing if it came out. They thought it would be embarrassing for the Church and for other people. They weren't really worried about him. They were mostly worried that it would be embarrassing for the Church. And so what happens? He's not happy. He's not a drinking man, but he does think he'd like to have a cigarette. Looks up and down this long street of houses, and there's no tobacconist. And he thinks: That's odd, there's no tobacconist on this whole long street. He has a little bit of money saved up because he had no expenses the whole time he'd been living there; and he rents a place, buys a few supplies, and opens a tobacco shop. And works really hard; and before long is able to open another tobacco shop. And his rule is pretty simple--he can't read or write, but he walks around neighborhoods and the place where there is no tobacconist for 3 or 4 blocks, he opens one. It's very small. It's the Starbucks model. With very low costs. He's going to hit 'em where they ain't, as Willie Keeler said about baseball. He ended up with 10 tobacco shops. And after a period of 15 years he had saved up 100,000 pounds--gigantic fortune. From his profits. He had saved up from the excess of his revenues over his costs, 100,000 dollars, and those were profits. Those were evidence that people found the products that he was selling cheap, convenient; and it was repeat business in the sense that they kept coming back. In some ways, tobacco is tobacco; but it was low-priced and it was low-cost because I could just walk half a block instead of four blocks to another tobacconist. He had made a large amount of money on very small increments by giving people what they wanted. Now maybe it's unfortunate that this is tobacco; it's not okay that this is tobacco now. But when he wrote it, it was a more beautiful, inspiring story. At the time, yes. Tobacco was an okay thing to sell; in fact, movie stars would smoke on screen. And athletes would sell them and advertise them. Well, he's worried about having all this cash--at the time, it was a fortune. So, he goes to the bank to deposit it, and the man at the bank is very impressed that he managed to save all of this just from simple profits just from this simple trade. And gives him some forms to sign. And the ex-verger says: I'm sorry, I can't read or write; I'll need to get somebody to read these for me. And the banker is incredulous, and says: You have amassed this fortune; you can't read and write; imagine what you could have done if you could read and write. And Foreman says: Well, I know the answer to that. I would be the Verger at St. Peter's.

45:36 It's a little Somerset Maugham humor. Economist and the stock brokers. It's an unusual Somerset Maugham story because it ends with that little punchline. It is sort of a shaggy dog joke. You might see it coming, but you also might not. Well, this guy doesn't deserve profits in the sense that he did something very simple. He can't even read or write. He is not someone like Steve Jobs, who sort of transcended genius. This is a guy who said: You know, I think I can make some money. And he had no vocation for selling tobacco. He didn't pick it. He's like the mancgere in that way. The only reason he picked this was he thought he could make profits from doing it. He had no deeper motives to say: All right, I want to help people. It was tobacco. He was selling cigarettes and pipe tobacco and supplies. And made a pretty large fortune simply by filling a need that no one was aware of. And that's the hard thing about profits--if you are aware, you make a guess about what it is that people would like. And if you are right, you make profits. I am motivated to do something that no one else has even noticed. So, it's not a policy question we are debating in Congress where we pick A or B. We don't know that B exists. We don't know that C exists. This alternative has not even been raised. It's something new. So, here's what I challenge my students with, if I used that in my class. Maybe I should; it's a great story. So he creates, he discovers, implicitly knowledge that wasn't there before, which is there aren't enough tobacconists in this location, where he has put his 10 shops. Now that he's done that, that's done. So, what we should do is we should take away his franchises and run them through the government as state-owned tobacco shops, and lower the price to a place where--again, neglecting the fact that people now say tobacco is a bad thing, but we do this literally with alcohol, although we don't always lower the price--we're going to take this knowledge that he's created; we are going to lower the price, and we are going to give people the benefit of this discovery. It's already been done; he got some profit out of it; and now that's enough. Let's not let him continue to exploit people. Because he's charging more than it costs him; and we know that because he's making profits. A lot, over time. And so, we can do a public service by nationalizing his tobacco shops and running them for the benefit of the people instead of the benefit of this illiterate. Because this guy--maybe he's okay, but he has gotten what he deserves and at this point he is behaving immorally by charging a price that's actually higher than it needs to be in order to sustain the service. They are ill-begotten; in fact, this is again the efficiency argument--I'm going to argue it's run amuck--but the argument would be: He's already created the value and he's had enough; let other people do it. Now, the standard argument against that is: Well, that will discourage people in the future. And the response would be: Well, not much, because he's got to make 100,000 pounds. We didn't take it all from him. We didn't say: You get nothing. We're just going to take the future benefit. He's got enough. I've got an argument against that, but what's yours, Mike? Fundamentally what we've already talked about is the problem of autonomy as a presumption. And we've talked about the John Stuart Mill observation that the things, once there, we somehow think, if you accept the argument you just made, that we know enough to be able to say how much is enough. The autonomy claim is the one that I think I find more persuasive, because otherwise you are in the position of power, where the government would say: We are going to take it. He would hire a lawyer, and everyone at every point in time is trying to justify their property. That sort of tenuousness--I mean, maybe the government operating it would be at lower cost. Maybe it wouldn't. Subjecting him to a continued profit test means that he is actually providing the service that people want at a cost that's lower than the amount they are willing to pay for it. Once the government starts to provide it, we no longer have that information. I think the last point is the key point, which is: Maybe there are going to be new ways of providing tobacco more cheaply. Maybe there's new products to be provided. All those incentives would be destroyed. And we have no idea. And we shouldn't look. Or, maybe there shouldn't be tobacco shops there after a while--which turned out to be the case, as tobacco was decided, found to be harmful--we don't have to make that decision. The consumers are going to stop buying there because they are going to be cutting back on the tobacco. Why not have a shop every 12 blocks instead of every 3? All those decisions, all that information that's dispersed is solved by letting people pursue profit. And of course we'd also say: Well, let's let new tobacco shops open that might drive the price down. And mean that he won't make as much money down the road. We'd expect him to make money in the beginning; he found something that wasn't there. But other people might compete and open a shop across the street. He might, because he has 10 shops, be able to do what Walmart has done and take advantage of economies of scale in purchasing. We don't have enough information. The fact that profits are earned or not earned is a really important piece of information; and it provides motivation. So both the decentralized incentives to act in certain ways and the information about scarcity is something that you are giving up if you say we are going to have the government operate this. And it's a very difficult argument to persuade people of. Because the argument you gave makes so much sense. Okay, we know; now we can do it at a lower price; now we are going to cut out the middleman and there's not going to be any profits. It's always tempting. And of course tobacco smokers really find it appealing. We always have to remember it's a bootlegger-and-baptist argument. The direct beneficiaries of this are going to describe the benefits for society at large but they just might want a cheaper smoke.

52:24 Do you want to talk about The Padre? We've talked about it several times, and in fact it was in a conversation with you that I first realized what an interesting example it was. The way that it worked was a man named Radford, an economist, was captured by the Germans and put into a prison-of-war camp in 1944. And they got these Red Cross packages once a month; and they all had exactly the same contents. So, we're in a sort of thought-experiment world where everyone has the same endowments but different preferences. And it might be that for a while I noticed that you didn't eat your tinned carrots because you don't like them and were going to throw them away; and I said: I'll tell you what. Why don't you just give those to me? And Radford said they quickly, very soon after capture people realized it was both undesirable and unnecessary, in view of the limited size and equality of supplies, to give away or accept gifts. Good will developed into trading as a more equitable means of maximizing individual satisfaction. Isn't that amazing? Good will developed into trading as a more equitable means of maximizing individual satisfaction. Otherwise, I might say, every month: I expect you to give me can of carrots. But somebody else would actually give you one cigarette for the can of carrots, where I was expecting them for free. So if I give you something, it's a one-time thing. But since this is repeated, over and over, every month we get the Red Cross package, we think that trade is more equitable than good will. I think that is a remarkable observation. That is a remarkable observation. It reminds me of the person who collects something. Might be knick-knacks that have a particular animal--there are people who collect dog items or pig items or whatever it is. And after a while everyone realizes this is easy now: I can find an easy knick-knack/gift they have for them, I just have to locate this theme. Sports, or whatever it is. Of course, sometimes a person gets tired of that, decides to drop the hobby. And they never buy another one for themselves. But they keep getting those gifts. Oh, another pig! Oh, that's great! But anyway, sorry: Carry on. So Radford then describes what he says was a priest with a sharp eye for exchanges. Stories circulated with a Padre who started off 'round the camp with a tin of cheese and 5 cigarettes. And returned to his bed with a complete Red Cross personal to his original cheese and cigarettes. So, what this guy did was he started out with a small amount of stuff; bought low, sold high. And ended up with a complete Red Cross package, which was of considerable value--some amount of cigarettes, some beef, some marmalade, some chocolate. Produced nothing of value. All he did was extract stuff from other folks. Take and take and take. He should be beaten. Well, less for everyone else. You can't deny that. Because the claim is: He not only got a different mix of stuff. He has the same mix he started with, plus everything else. Which because there is a fixed amount, there is no production in this society. Which is why it is interesting in this experiment. He clearly extracted stuff from folks. And yet he was probably doing good in the camp. That certainly not the view. That was certainly not someone you should emulate. This was someone who was evil. They called it "sharp practices." When I was talking to this, I thought it was kind of cool. Your reaction to it made me realize this is absolutely fundamental to a significant question in philosophy. I've actually written two papers about it since. And it's the Rawls/Nozick debate. The problem goes like this. How can there be a justification for redistributive taxation, taking from the wealthy and giving to the poor, if every individual transaction that made me rich actually creates benefits for the poor? Now, fraud--that would be a problem. Coercion--I hold a gun to your head and make you engage in a transaction--that would be a problem. But the premise of this example seems to be the Padre went up to a bunch of different people and said: I have something; I'll give it to you if you give me something. And in every instance--in every instance--the partner in the trade thought he would be made better off. And if we allow that subjectively people are autonomous, and informed--and in this case, they are. Because they know what's in the tin. They know it's not fraud. He made every single person better off. So the fact that he made significant profits was actually evidence that he had performed a brokering function. There was a person, A, let's call them, who would like to exchange at a certain price; and there is another person, B, who would be willing to take that price and give A something that he wants. And they've never met. The Padre acted as middleman or go-between, making both A and B better off. And implicitly letting them trade via him. But he took his own little slice. But the slice by definition has to be less than the total value or benefit that is created by the transaction between A and B if it happened. He can only make money if A is better off and B is better off. He takes some slice, but they both have to be better off. By definition, if it's a voluntary transaction.

58:17 And so, to take the analogy with the Verger: It's obvious how to make this camp better off. We ban the Padre. We just get A and B together without the Padre's slice. And there's even more for A and B. Because they would have gotten the slice. The slice reserved for the Padre. Who did nothing. He did nothing except be a parasite. But the problem with that is, A and B can't find each other. It's a big camp. Furthermore, as Radford points out: This was a symptom of sort of a new camp where prices were not yet unified. Actually, what happened was that the Verger--forgive me, the Padre--the thing that he did, if prices were high in one part of the camp, he would go and sell a bunch of stuff, driving the price down. And he would take it to the place where prices were low. And that's where he would buy what he sold. By buying low and selling high actually drove the price together. He picked up the $20 bill. There was no $20 bill any more. So, they did find each other. They found each other by posting prices on a bulletin board. But the Padre had business eventually. Yes. But you want to pick up the $20 bill. That's what entrepreneurship does. It means that there are no mistakes; there is no misallocation. If I eat a tin of carrots, when there is somebody out there who will give me chocolates for it but I don't know it, that's a misallocation. If I give my carrots and get my chocolate, we are both better off. All that the Padre did was correct errors. He picked up the $20 bill. It's true that after his activities, there was no more to pick up. But the question is: Why would that ever be a justification for saying you have too much money, that's evil, that's a prima facie evil and we're going to take it and give it back? Because he was motivated by the profits. The reason that he did this was he wanted to collect that little slice.