When we were kids, we played a game called Hot 'N Cold. The way the game works is like this: The players agree on an object, say a quarter, that will be hidden someplace in a room. Somebody is chosen to be "it" and is led outside while the door is closed him. Back inside, the other players hide the object, maybe on the seat of a chair, in a planter, on top of the stereo system. The player who was taken outside the room is then brought back in. His job is to find the hidden object.

The only information he has to go on are the "hot" and "cold" clues of the other players. If the player who is "it" is searching the room far away from where the object is hidden, the other players say things like, "Brrrr! You're freezing and you're going to catch cold if you aren't careful," "Put a parka on, Chump", and "Frostbite! Frostbite!" As "it" gradually moves closer, the other players tell him he's "getting warmer." When he gets really close to the object, they say things like "You're starting to sweat, baby" and "Watch out! You're going to burn yourself!"

Besides being revealing about our incredibly deprived childhoods, this game serves as a beautiful picture of how a free-market economy operates (we confess that we didn't necessarily make this connection when we were kids). Think of "it" as the firm. The firm's job is to combine resources in such a way that it will make society better off. It doesn't have a clue about the best way to do that. Despite the best efforts of its production engineers and market consultants, it is led into the "room" not knowing what combination will produce the best result for society. Profits are like the "hot" and "cold" signals described above. When a firm does a poor job of combining resources to make a product--either because it is taking resources that are really valuable in other activities, or because the product it produces isn't much wanted by consumers--it earns negative profits. That's the economy's way of saying "Brrrr! You're freezing."

Alternatively, as it hits on a better combination of resources, either by improving its product or economizing on inputs, it starts to earn a reasonable rate of return on its investment. That is, the economy says, "You're getting warmer." Every now and then there is a firm that develops a new good or service, and it earns incredible profits--say McDonald's perfects the concept of fast food, or Microsoft develops an incredibly powerful operating system called MSDOS. What does the economy say then? "Hot dog! You're burning out of control, baby!"

In a world of darkness and uncertainty, profits are the consumers' way of telling firms when they get it right. There are many different ways of producing a product, many different ways of improving a product so that consumers will like it more (derive more happiness from it). And what makes this all difficult for firms is that oftentimes consumers don't know themselves what they will like before they experiment with it. Nor do consumers know how long they will like it. Pet rocks, bell bottoms, and Teenage Mutant Ninja Turtles were all "products" that produced huge profits for their inventors that were relatively short-lived. Frisbees, blue jeans, and the Beatles are products that have continued to produce happiness for consumers long after their initial introduction. Who could have guessed how much happiness these products would have produced at the time of their introduction? Or for how long consumers would continue to find pleasure in them?

But profits also play another important role. When one firm earns exceptional profits from hitting on the right combination of resources to please consumers, an inevitable reaction occurs. Other firms try to copy the winning combination. Imitation--copy catting. That is one of the great trademarks of free-market/capitalism. The rise of McDonald's sets in motion forces that spawn competitors producing like products, such as Burger King and Wendy's. Apple Corporation's menu-driven operating system gives rise to Microsoft's Windows and Windows 95. Dodge Caravan gives rise to Ford Windstar. There was a time when salad bars were only to be found in health food restaurants. Now they're everywhere.

One can picture the whole economy as an enormous room filled with firms roaming around, each trying to find where consumers have "hidden" the object that will produce the most happiness for society. When consumers tell one firm that "they're hot," a flock of other firms swarm over to where that firm is and try to copy--and improve--what that first firm is doing. It's like the whole economy is one huge game of Hot 'N Cold.

Both of these functions of profits are well-illustrated in the story of Maury Tate, the main character in the article excerpt which began this chapter. In 1987, Maury Tate was a full-time, professional rodeo rider. He had a family friend sew colorful materials into his rodeo shirts. When his fellow competitors saw Tate's shirts, they offered to buy them. Tate would literally sell the shirt off his back to another rider who liked what Tate was wearing. One thing led to another, and soon Tate found himself the owner of a company that was producing shirts for national chain stores. Tate just happened to hit upon a combination that pleased consumers. But then something else happened. Soon he found that his weren't the only shirts that offered colorful western-style looks. Everybody starting to produce them. Levi started to produce similar looking shirts. And Wrangler's. Even Sears, Wal-Mart, and Target. Each day, thousands of firms try to mimic what Maury Tate did by accident. They assemble resources, drawing them away from other parts of the economy, hoping to combine them in a way that will make them the next big success in the economy's hit parade.

This perspective of the world as being a world of "darkness and uncertainty" is a controversial perspective with far-reaching consequences. It differs with most conventional textbook presentations of how the economy operates. It is customary, for example, for economics textbooks to represent firms as being fully cognizant of the revenues and costs they would experience at every possible level of production. Armed with this knowledge, the major task of firms is merely to choose the level of output that maximizes total profits. Rarely is there a sense of the lack of information that characterizes most firm decision-making. There is little to no mention of the role of the entrepreneur.

In fact, most textbooks represent a view of the economy in which firms settle down to what is called "long-run equilibrium." That's where there is no more impetus for change in an industry. Each firm produces the same products and quantity as the year before. Further, all the firms in the industry are completely identical. Each earns zero economic profits. There are no new firms who enter this industry, and no old firms who depart.

Contrast this world with the picture of the economy that is represented by your local paper's Business section. What kind of world is this? This is the world of bankruptcies and business mergers. Of new products. Of firms that were the leader in their fields last year, but are now trying to compete with new entrants who are threatening to take away their market share this year. It is the world of Lee Iaccocca, of Bill Gates, of Robert Crandall. It is a world in which automobile corporations report record earnings one year, and multi-billion dollar losses the next. Where firms try to "redesign" themselves to fit changing business environments. It is a jungle out there! Each firm scrambling, trying to figure out what it is that consumers want this year. Nothing is certain, everything is risky. Where is this world in the standard economics textbook?

On one extreme, we have a picture of an economy in which everything is known. The most difficult task facing firms is to choose the level of output which will maximize profits. On the other extreme, we have a picture in which the economy is characterized by great uncertainty, in which firms grope and stumble in the dark trying to find out what will please consumers. It turns out that which worldview one subscribes to has important implications for public policy.

Suppose one believes that lack of information is a serious problem facing the economy. Then one is inclined to try to place as many resources as possible under the control of profit-maximizing firms. One sees the entrepreneur as the driving force of the economy, and a key agent for improving society's happiness. One supports minimizing regulations which restrict firms from pursuing profit-increasing combinations of resources. One becomes a proponent of the FREE-MARKET; one advocates leaving as many resource allocations to the price system as possible.

On the other hand, suppose one believes that lack of information is not a serious problem. In this case, the informational role played by profits is relatively unimportant. An economic planner can decide what and how much to produce, just as well as any firm. In fact, the economic planner can probably do it better. After all, he or she can produce the good without "wasteful competition." This is the worldview which underlies much of GOVERNMENT REGULATION of consumer safety, for example. It is also the worldview of economic policy makers who believe that government spending can be used to stimulate economic growth. Here the question of what to produce is not considered a problem. It is assumed that those in charge of disbursing the funds will know what it is that consumers want--and how the rest of the economy will respond to the government's intervention. In this case, one is a proponent of an ACTIVIST GOVERNMENT, a government that tends to use planners, regulations, taxes, subsidies, and the like to direct resources to various uses.

Two very different worldviews--two very different policy positions. Which worldview is right? In the end, it's a matter of one's best judgement. That's because the fundamental element--information--is unseen. Nobody can know just how much unknown information is out there. Despite our best efforts to remain scientifically neutral and unopinionated, you've probably been able to figure out what our worldview is. How about yours? Think about it....Anybody for a game of Hot 'N Cold?