The Rise and Fall of Businesses | Basic Economics by Thomas Sowell | Ch. 5

Starting in chapter 5, Thomas Sowell begins the second part of the book, talking about Industry and Commerce. In this particular chapter, Sowell explains the purpose of businesses, the cycles they go through, and how they affect society at large.

Chapter Summary

The first thing to understand about business isn't just the money-making aspect that most people think of. Instead, we must accept the idea that businesses go through cycles. Some succeed, some fail, and many do not make it in the shifting tides of an evolving society. Thus, profits and losses play an essential role in the area of business.

Profit rates often change with the times. When a business is first to make a new product, they are often able to make larger profits. But those larger profits will attract new investors into other companies to make competing products. When this happens, competition drives prices down, and thus profit margins (i.e. the difference between what the item sells at and what it costs) often decrease. Sometimes, these prices go so low, that some companies won't make a profit, and go bankrupt. If the industry is to survive, the supply and demand levels must balance so that businesses can eventually profit again.

This has happened in virtually every industry, from steel production to airlines. Remember CDs? That industry took over vinyl, before being replaced largely by music players (e.g. iPods), which were largely replaced by smartphones. These technological changes are often what come to mind when we think about industries changing across time. And while businesses are often presented to us in impersonal ways, we must remember that every business is run by real human beings who must adapt to these changes.

Yet, sometimes, these changes are social. The main example given is A&P, a grocery chain in the United States that was once the largest retail chain in the world. But, after World War 2, when automobiles and suburban populations boomed in the United States, because A&P was located in central neighborhoods where walking to the local grocer was the norm, other chains became more popular. A&P's management never adapted, and as population shifted away from its stores, it slowly lost business, until today, where it is almost unheard of in a world of Walmart and Amazon.

There are a couple key things here. First, while profit is important, loss in businesses is what drives change in economics. This is because loss is what actually forces companies to either adapt or lose out to other competitors.

Second, it's important to realize that, even when the businesses fail, customers who have free choice are the ones who benefit over the long term. This is because all consumers benefit from the lower prices made possible by “the more efficient allocation of scarce resources which have alternative uses”. When governments control prices, either to save a business or appeal to consumers, the public is tricked with false knowledge about the underlying costs of goods and services (see Ch. 4).

No central entity has the ability to coordinate the vast amounts of information and knowledge required to make economies work. Instead, it requires individuals with their own specialties, attempting to make the best choices possible with the information that they have. Since businesses are made up of these individuals who are attempting to make the best choice possible for their locale, they know when to cut prices, how to compete, and how to adapt. If they don't, then their inevitable fall paves the way for consumers to get better prices from competitors.

Businesses also must adapt to economic changes. Examples of economic changes include things like the development of credit cards or an economic recession. As with social changes, businesses must learn to adapt to shifts in the economic landscape, or fall into irrelevance. Given the similarity, Sowell here drives home a point:

What is important is not the success or failure of particular individuals or companies, but the success of particular knowledge and insights in prevailing despite the blindness or resistance of particular business owners and managers.

This is an incredibly important insight. Free markets aren't about businesses controlling everything in society. Instead, it's the fact that, the freer the market is, the more we can allow prices to tell consumers accurate information about costs, so that ideas and innovation can freely drive society forward, even when businesses fail. In this free society, a farm boy can go to Detroit to build Ford Motor Company and change the face of transportation in the world, forever. Because investors are looking for financial winners, it's not about whether that person has an academic degree or even if they have lots of money themselves. It's simply about inspiration and, eventually, results.

A free society can always tap into its diverse population, and the real winners will come on top, rather than relying on central human authority to determine which ones will make it. Such central planning will inevitably make mistakes.

Finally, businesses must inevitably adapt to leadership changes. This includes cycles where businesses compete to be the best of their genre of competition. No business is guaranteed to be at the top of their category for any amount of time. In fact, there are often times when a very successful older business fails because they don't understand the change in environment for their businesses, and thus don't adapt.

Additionally, as people get older or more experienced, typically, they move on from the businesses they began or were a part of in their youth, and into other industries or even competing enterprises. When the leaders in a business change, they often bring different insights, leadership abilities, focuses, and other things into the picture.

In this way, a free market economy weeds out individuals and businesses who don't use the scarce resources of a society well. Losses are the way that economies force introspection. In other words, people must look at what they've done, and see if they can adapt or leave. Even in a business which has gone public (i.e. has public stock offerings), investors who have a controlling stake in the business will oust inefficient managers for better ones.

My Thoughts

I think that one of the most important things we can learn in life is to not take things too personally. Often, when we go get a job, or start a business, or even do generous work like starting non-profits or community gatherings, when these things fail, it's easy to take these things personally. It's easy to believe that, because I didn't get the job (or got fired), I'm somehow worthless. Or perhaps my startup business failed within two years, and somehow, it means I'm a failure.

But these things aren't true. Unlike what society presents to us, work, jobs, and money cannot tell us what our value is as human beings. Instead, our value comes simply because we are human beings, and what we can do by simply being human can lend value to society. We can't give out what we don't have, but we also can't stop giving out of what we already are. Since we are all intrinsically valuable, what we give has value, whether or not it is accepted.

When we step back and look at things this way, the idea of loss and business cycles become much less emotional, and just a simple principle we can use to understand economics and situations in society, both past and present.

Cryptocurrency and Business

A lot of what the crypto industry has gone through, especially since 2017 with ICOs and 2020 with DeFi, can be seen through the lens of business cycles. Hundreds, if not thousands, of cryptos have come and gone, and the ones that adapt to the very quick evolution of blockchain have stayed, while others have gone.

And it's not all about technology, either. After all, Bitcoin is the oldest coin, with the most basic tech of all of them, and yet has stayed on top all this time. I think it has done so because of its legacy, and until a token comes where its advantages and ease of use completely outstrip Bitcoin, there just won't be anything to take its place.

But I don't think that means that Bitcoin (or whatever crypto one is a fan of) will stay at the top forever. Instead, what I quoted above from Sowell is incredibly important: the whole point of a free market is so that the best ideas come to the top.

I believe the rise in governance protocols in crypto is going to be the next step for blockchain. And this principle is sure going to have effect. The cryptos that will succeed are the ones in which the best ideas (e.g. apps, protocols, etc.) come out on top.

We can already see this in Ethereum. Despite that particular chain's slow transaction rate and constant network congestion, because it allows basically anyone to develop on it, it has become the biggest elephant in the DeFi space. Lots of people are trying to copy it, but it is the number of developers on Ethereum's platform that gives it the advantage. So while the freedom of Ethereum has allowed for pointless apps like Cryptokitties, it has also led to the development of the likes of MakerDAO and Compound, which are pioneering the new industry of DeFi.

That's it for this chapter! See you in the next one!