Everyone abhors failure, and rightfully so. No one wants to fail. Students want to succeed at their school work, employees want to succeed in their jobs, and athletes want to succeed on the playing field. Business people are the same. No firm tries to be unsuccessful; all businesses try to satisfy their customers in order to make profits. The inability to succeed means the loss of jobs, paychecks, and often, happiness. Yet economists recognize failure as essential to economic progress.
Those unfamiliar with economics look with shock and disbelief at those individuals who profess that efforts to guarantee success and prevent bankruptcy undermine economic growth and exacerbate economic problems. People tend to see only the short-run, immediate pain associated with failure and not the indispensable function of the failures allowed by economic freedom. Failure should be seen as a blessing in disguise; it directs the economy away from wasteful and unproductive activities, and toward greater prosperity. Policymakers who try to ensure economic success through legislation seem not to understand that an economy without failure cannot progress.
To understand why business ventures fail, it is important to appreciate economic scarcity. The dictionary defines scarcity as an insufficient amount or supply; shortage. There is a limit to the amount a society can produce and consume at any one time. Hence, people must make choices. Scarcity makes the prices of commodities such as land, labor, and materials so high that the less efficient producers cannot succeed. Resources tend to be allocated to produce the goods and services in greatest demand and away from the production of those less demanded.
Why Entrepreneurs Fail
The lack of sufficient capital for the success of all business ventures explains why so many entrepreneurs fail and why entire industries disappear. The open market rewards only those whose discovery, invention, or idea satisfies urgent demands. Consider Alexander Graham Bell and the invention of the telephone, or Henry Ford and the introduction of the mass-produced automobile or, more recently, Steve Jobs, the founder of Apple Computers, and Bill Gates, creator of Microsoft Corporation. When an invention is of great benefit to society, the entrepreneur will be rewarded handsomely. However, if through the free market a society decides that the benefits gained by an invention do not justify its cost, it will fail to attract consumers.
For all the new economic successes, there are many busts. In 1995 alone, 832,415 businesses filed for bankruptcy protection with the federal government. Even established companies experience failures from time to time. A few well-known and ill-fated new products include the Edsel, New Coke, Crystal Pepsi, the 8-track cassette, and Beta VCRs. These products were either replaced by better substitutes, or never proved beneficial enough to consumers to warrant long-term production. Some products did well for a time and then passed, ignominiously, into the dustbin of the economy: the hulahoop, silent movies, the typewriter, and so on. The bright side of these ill-fated ventures is that their failure resulted in the reallocation of capital and other resources to the production of other, more desired goods.
Some industries, once among the world’s largest, have succumbed to market forces. The market and the needs of people evolve continuously. Industries that fail to change are punished.
Not even corporate giants can be complacent about the demands of consumers. In 1909 the Central Leather Company was the seventh largest company in the nation. However, plastics and other synthetic materials eventually became the equivalent of, or better substitutes for, leather at lower prices; consequently, Central Leather went bankrupt. Like Central Leather, the Pullman Company was once huge. With the development of the airline industry and the construction of a national highway system, however, consumers found more attractive alternatives to traveling by railroad. As a result, Pullman fell from its perch as a corporate giant. Other forgotten industrial superstars include American Woolen, American Locomotive, and American Molasses. Economists Dwight Lee and Richard McNown observe that the firm that appears to control the market today may find itself an obscure has-been in the future, because of new technologies or the whims of a fickle consumer.
Too often, people see only the immediate, visible impact of business failure. Government frequently enacts laws that benefit narrow special interests without consideration of the detrimental effects on society as a whole. In other words, public policy- makers often disregard secondary consequences. As Henry Hazlitt observed, The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.
A Missed Connection
Government bureaucrats regularly miss the connection between failure and progress. They believe that an economic miracle can be produced through an abundance of rules and regulations designed to spare society the growing pains of failure. Ironically, efforts by legislators to limit or reduce the number of losers in an economy usually have the unintended consequence of reducing the number of winners. Government reduces the number of successes achieved by taxing, regulating, or otherwise restraining those who prosper.
All government responses to failure have one thing in common—to the extent that they prevent some, they cause others. Government allocates resources to one activity by reducing the resources available for other activities. The incentives which operate in the political arena seldom, if ever, outperform market incentives in leading people to employ resources in their most valuable uses.
The former Soviet Union and the other socialist nations of the world provide the clearest illustration of the tragic consequences of this phenomenon. Enormous human suffering has occured in these countries. They may have been founded on the sincere and compassionate belief that the government could relieve suffering by providing an equitable and comfortable life for all citizens, but in reality the opposite occurred. By attempting to suppress economic disarray, central planners impeded economic progress. In most instances, the citizens of socialist nations are no better off, or perhaps even worse off, than they were 50 years ago. By Western standards, people in socialist eastern Europe, China, Cuba, and Russia drive obsolete automobiles (or ride bicycles), live in crowded, inefficient homes that lack the modern amenities enjoyed by many poor Westerners, and do without the educational and career opportunities of people living in capitalist nations. Socialist countries exchanged their economic progress for a guarantee against personal and business failure.
In a recent study, James Gwartney, Robert Lawson, and Richard Stroup found a direct relationship between the amount of economic freedom a country has and the subsequent amount of economic progress it enjoys. This linkage was drawn from a 20-year comparison of 102 countries. The authors ranked each nation according to an index of economic freedom and compare this to the change in GDP per person. Those with a consistently high amount of economic freedom throughout were also among the highest in terms of GDP per person. Countries with the lowest ratings actually had a declining GDP per capita.
The freest economies include Hong Kong, Switzerland, Singapore, the United States, Canada, and Germany. The least-free include Nicaragua, Iran, Venezuela, Morocco, Panama, Greece, and Brazil. In this study, economic freedom signifies the protection of property rights, voluntary military service, no price or production controls, relatively little public spending, and monetary stability. The empirical evidence gathered suggests that over the long term the freer the economy, the more success it will enjoy.
Even the countries of semi-capitalist Western Europe have tried for several decades to isolate themselves from economic failure. Yet, ironically, the more they attempt to regulate and prevent failure, the more failure they suffer. These countries have generous national welfare systems for their citizens and extensive government regulation to support national industries. Western Europeans believed, and in many cases still believe, they could alleviate the inequities of the market. With the fall of communism and an increasingly open global market, European companies, because of their governments’ efforts to control capitalism, have found themselves increasingly unable to compete with more efficient American and Asian firms.
Consider the European aerospace industry. A consortium, Airbus, produces jumbo jets and competes with the American firms Boeing and McDonnell-Douglas. But this entity, the pride of the public sector, is leaning toward privatization. Airbus, traditionally a government-subsidized marketing co-op, has been unable to match its rivals in price and efficiency.
Similarly, European banking, another industry traditionally under heavy government control, is moving away from the status quo. Several prominent European banks have announced their intentions to become private firms. Pressured by competition from the economically freer nations, the less efficient European industries realize the critical need to change or be destroyed.
This phenomenon also occurs in the United States, which is among the most economically free nations in the world. And here, too, attempts to prevent economic failure often have detrimental long-term consequences. Many American industries and businesses lobby the government for legislation to protect their narrow interests from the rigors of the market. Examples include subsidies for farmers, tariffs for steelmakers, and bailouts for Chrysler. But these policies simply prevent the free movement of capital from industries where it is less valuable to those where it is more valuable. Government taxation, regulation, and tariffs to reduce the chances of failure for certain groups penalize the entire society.
History has proved that the most successful nations are those that give their citizens the freedom both to fail and to succeed. It is ironic that people have regularly risked their lives to live in a capitalist world, thus risking economic failure. East Germany in 1961 was forced to build the Berlin Wall to prevent East Germans from living under capitalism. More recently, Cubans have fled their communist nation to live in the United States where, paradoxically, the government makes less grandiose promises of security.
People throughout the world vote with their feet and overwhelmingly choose to live in capitalist nations where they are free to fail. Perhaps the greatest tragedy of the twentieth century has been that sincerely compassionate efforts to eliminate failure have often resulted in only more failure. The people of the world need to realize that to achieve success, failure must also be risked.
5. James Gwartney, Robert Lawson, and Walter Block, Economic Freedom of the World, 1975-1995 (Vancouver: The Fraser Institute, 1996); see also “Economic Freedom: Of Liberty and Prosperity,” The Economist, January 13, 1996, pp. 21-23.
Mr. Ragan is a student, and Dr. Block a professor of economics, at the College of the Holy Cross in Worcester, Massachusetts.