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(Excerpt from chapter 17 of Mises: The Last Knight of Liberalism, pp. 770–73.)

It was through the writings of Carl Menger and Eugen von Böhm-Bawerk that Mises had come to understand the market economy as a rational social order in which all factors of production are geared toward the satisfaction of consumer wants. Not only the allocation of the production factors, but also the incomes of the owners of these factors ultimately depended exclusively on their relative contribution to the satisfaction of human wants. All values, all prices, as Frank Fetter had put it, depend on a daily referendum in the market democracy.

But in none of his predecessors did Mises find a satisfactory account of the process through which the structure of production was brought in line with consumer preferences. His fellow Böhm-Bawerk seminar member, Joseph Schumpeter, had brilliantly shown how entrepreneurs drive the market. According to Schumpeter’s Theory of Economic Development, entrepreneurs are innovators who constantly interrupt the smooth operation of an inert economy.

Schumpeter had a point. Innovation does play a central role in the market economy. But how does this fit with the Mengerian picture of the market economy as a rational social order? Was there a contradiction between the Schumpeterian notion that entrepreneurs reap profits for innovation and the Mengerian insight that all incomes depend on consumer wishes? In Nationalökonomie, Mises reconciles Schumpeter with Menger. From Schumpeter, he adopted the idea that entrepreneurs are the motor of the market process. But they cannot earn a profit for innovation per se — only for innovations that improve the satisfaction of consumer wants.

Entrepreneurs constantly adjust the structure of production to what they expect will be the future preferences of consumers. The different entrepreneurs act in effect as advocates for different consumer needs. Based on their estimates of what they expect to obtain for an imagined product in the future, they go to the factor markets where they compete with other entrepreneurs, bidding up prices for the available factors of production—workers and material supplies. This pricing process determines the incomes of all factors of production, and it ensures that only the most important investment projects (“important” in terms of future consumer spending) will be realized.

The driving force of entrepreneurship is the profit motive. Profit is the specific remuneration a person receives for bearing uncertainty. In the market economy, entrepreneurs act with due caution and responsibility because they are personally liable for any wrong decisions. Loss is the punishment for unsuccessful entrepreneurship. Profit and loss are together the measure of entrepreneurship.

Are all businessmen entrepreneurs? Are all entrepreneurs businessmen? If not, how could entrepreneurs be distinguished from “regular” businessmen and other market participants? Mises answered these difficult questions by defining entrepreneurship as a social function, namely, as the function of assuming responsibility for the uncertainty of the future. The entrepreneur in Mises’s theory is not a person but a role played by people — and it is not at all limited to businessmen. Ultimately anyone can be an entrepreneur to the extent that he assumes the repercussions of uncertainty. Profits and losses do not only determine the income of businessmen, but also of wage-earners and capitalists. They always come mixed with specific factor incomes such as wages and interest.

One of the great problems Mises had to solve in this theory was to give a precise definition of profit and loss. In particular, he had to distinguish profit and loss from interest. His solution was that profit and loss were the results of human error. In other words, profits and losses can only exist in situations of disequilibrium. In contrast, money interest ultimately springs from time preference and has nothing to do with whether the market participants make good or bad decisions. Money interest exists both in general equilibrium and in disequilibrium, whereas profit and loss exist only in the latter case.

But then this line of argument makes it necessary to clarify the precise meaning of general equilibrium, as well as its role in economic analysis. Mises argued that general equilibrium — which he called the stationary economy (stationäre Wirtschaft) — is a purely methodological device. It is an imaginary construct (Gedankenbild) that has no counterpart in the real world. Its only purpose is for the definition of profit and loss.