Quasi-Rents and Profit Opportunities
When entrepreneurs allocate their alertness during a recession, their choice has some specific characteristics. Recessions reveal many previous mistakes, embodied in misallocated factors of production.
This might, for example, mean that factories built and equipped during the boom are unprofitable in their intended uses, that they have to be shut down, and that the workers who were trained to operate the factory equipment have to find new employments. Awareness of these factors allows entrepreneurs to see new, related profit opportunities, channeling their alertness toward corresponding factor reallocations.The argument that entrepreneurs shift alertness during the recession, however, rests on the assumption that reallocation of the existing factors is more profitable than, let’s say, creation of brand-new factors of production. This higher profitability comes with the sunk-cost character of the previously misallocated factors. While the factors employed in unprofitable production processes do not make enough revenues to cover their own amortization, they are still useful, even though it does not pay to replace them once they wear out (in the case of capital) or to train new workers (in the case of labor). What matters is whether the difference between the return of the factors and the variable cost is sufficient to attract an owner or employer. This difference is also known as quasi-rent, which Alchian (2006, 577) defines as “the portion of the revenue from the use of some equipment in excess of current operating cost and which covers at least some of the initial, past investment cost of having produced that equipment.”
How much of this quasi-rent the prospective owner or employer has to pay for a capital good or for hiring labor is, of course, negotiable, and it is somewhere between zero and the quasi-rent. But the negotiability also means that the profit coming from hiring the labor or owning the capital is also flexible and might stretch—within the given quasi-rent constraint— enough for the project to compete with the alternative entrepreneurial projects. It is this flexibility that incentivizes entrepreneurs during a recession to be more alert to exploring new uses of the existing misallocated factors rather than to producing new factors of production.[1]
Let me illustrate with an example of a machine that makes rubber soles for shoes.
Assume the same machine can be repurposed to make chewing gum. Let's say the owner built the machine at a cost of $1000, expecting the present value of the variable costs to be $100 and the present value of the revenues to be $1100. While he could use the machine for making chewing gum, the fixed and variable costs would be the same but the present value of the revenues would drop to $500.Let's say that contrary to the owner's expectations, nobody wants new shoes and the expected revenues from selling shoes drop to zero. The owner goes out of business and puts the machine up for sale. Since it can still produce chewing gum and the expected demand for the gum is unchanged, the machine is going to sell at a positive price. The quasi-rent associated with chewing gum production is $400, and the price of the machine can thus range between one cent and $400. It will end up being low enough within the range to attract an entrepreneur with sufficient profit to divert her attention from other activities.
Can one say that all entrepreneurial attention will be diverted from starting new projects that include brand-new factors of production during the recession? Of course not, but entrepreneurs have an incentive to divert their attention more than they otherwise would have. Again, the necessary underlying assumption is that the existing capital goods and existing employees with their human capital are substitutes for rather than complements to new investments.
Fig. 2.1 The initial equilibrium, Eι, shows the allocation of entrepreneurial alertness between new investment and restructuring of the existing factors of production (Source Author’s creation)