Lecture Five:  The Market Process - Entrepreneurship

 

Main Sources used:  Israel Kirzner, Competition and Entrepreneurship; Ludwig von Mises, Human Action; Frank Knight, Risk, Uncertainty and Profit.

 

The Entrepreneur in Mainstream Economics (or lack thereof)

 

Even in mainstream microeconomics there is an individual decision maker. 

 

Usually the decision is what Hayek called “economizing” – that is someone is trying to improve his position within the constraints imposed by the available means.

Could include:

 

Buying at the lowest price offered

Selling at the highest price possible

Balancing marginal benefit with marginal cost

 

 

All of this assumes purposeful human action (or in mainstream terms – rationality).

 

But this purposefulness is limited in a sense:  Particular ends and means are viewed as given and known, the act of decision-making being seen as essentially calculative, as though the resulting action were already implicit in the relationship between given ends and means.

 

So for the decisions above:

 

Buying at the lowest price offered  - prices are given to the consumer.

Selling at the highest price possible – prices are given to the supplier.

Balancing marginal benefit with marginal cost – marginal benefit and marginal cost are known by the decision-maker.

 

According to Austrian economists (and fellow travelers) - economists cannot confine their attention to this narrow notion of decisions.

 

Purposefulness in human decision-making is very broad.  Much of it is ignored in the analysis of “economizing” decision-making.

 

 In addition to the exploitation of perceived opportunities, purposeful human action involves alertness towards the discovery of as yet unperceived opportunities and of their exploitation.

 

 

 

Kirzner's Entrepreneur:

 

Entrepreneurship:  This element in human action—the alertness towards new valuations with respect to ends, new availability of means,—may be termed the entrepreneurial element in the individual decision.

 

As Kirzner puts it, “I will argue that there is present in all human action an element which, although crucial to economizing activity in general, cannot itself be analyzed in terms of economizing, maximizing, or efficiency criteria.  I will label this, . . . the entrepreneurial element.” (Kirzner, p. 31)

 

The crucial question concerns what knowledge of the data is possessed by the decision-maker.

 

In fact the essence of the “entrepreneurial” decision consists in grasping the knowledge which might otherwise remain unexploited.

 

Kirzner again, “It reflects not merely the manipulation of given means to correspond faithfully with the hierarchy of given ends, but also the very perception of the ends-means framework within which allocation and economizing is to take place.” (Kirzner, p. 33).(my emphasis)

 

“Economizing behavior – or, more accurately, its analysis – necessarily skips the task of identifying ends and means.” (Kirzner, p. 34)

 

Kirzner’s “pure entrepreneur” is “a decision-maker whose entire role arises out of his alertness to hitherto unnoticed opportunities.” (Kirzner, p. 39 – his emphasis).

 

Other Austrian economists would disagree with this definition – and say that we can’t separate the alertness from an action taken because of the alertness.  One does not become an entrepreneur until they act upon the discovery.  More on this alternative, yet also “Austrian,” theory later.

 

 

 

 

Equilibrium, Disequilibrium, and Entrepreneurship.

 

Perfect Knowledge assumption:  It is not difficult to understand the traditional neglect by economists of this entrepreneurial element. Much economic analysis was developed against the background of an assumed world of perfect knowledge. The theory of perfect competition and more generally the theory of market equilibrium were developed in terms of perfect knowledge. Decisions were seen as strictly economizing decisions.

 

Economizing, then, is appropriate in a world of perfect knowledge.  But when knowledge itself becomes an interesting factor in the market process to be analyzed – we have to look beyond economizing.

 

Equilibrium is a place of:

 

Perfect knowledge

No action – no desire for action

 

All participants know the “equilibrium” price, for example.

No room exists for the entrepreneurial element.

 

In contrast, a disequilibrium market means a state of affairs in which perfection has not been achieved.  This leaves room for entrepreneurial alertness to opportunities for more advantageous decisions than those currently embraced.

 

It is here that the appropriateness of this concept of an “entrepreneurial element” in the individual decision becomes apparent.

 

It is well known that in price theory the “entrepreneur” has no place in the state of equilibrium. Only in disequilibrium are there opportunities for entrepreneurial profit, for the purchase of inputs at a cost lower than the revenue obtainable from the sale of their potential output. In equilibrium all profits have been squeezed out, costs and prices have become fully adjusted.

 

So in equilibrium, all decisions correctly anticipate all others (since all decision makers have the same information and the information is “perfect”).  This assumes away all opportunities for capturing a margin between resource costs and product revenues.

 

The perfection of knowledge, which rules out the “entrepreneurial element” in the individual decision, also rules out all entrepreneurial profit opportunities.

 

 The imperfection of knowledge that obtains in the disequilibrium market creates the price divergences between resource costs and product revenues which constitute the opportunities for profitable entrepreneurship in the more usual sense.

 

And the exploitation of entrepreneurial opportunities for profit involves precisely that element in decision-making which we have termed the entrepreneurial element.

To win pure entrepreneurial profits, it is necessary to perceive price divergences that have gone unnoticed.

 

What is required is an alertness to the existence of opportunities that have been overlooked—because their continued existence must mean they have been overlooked.

 

 

 

 

 

Is Entrepreneurship-Equilibrating or Disequilibrating?

 

All this is basic enough, although not always clearly perceived.  Or perhaps not found to be important or interesting.

 

In the management literature you sometimes run across Schumpeter’s “creative destruction” idea (Schumpeter was from Austria but is not considered an Austrian economist).

 

Schumpeter’s analysis seems to see the entrepreneur as shocking the market out of an existing equilibrium.  It is as if we are in equilibrium but then new knowledge is discovered and this moves us out of the equilibrium. 

 

“. . each burst of entrepreneurial innovation leads eventually to a new equilibrium situation, the entrepreneur is presented as a disequilibrating, rather than equilibrating force.” (Kirzner, p. 73). (his emphasis)

 

In contrast, Kirzner’s analysis indicates that the existence of an as yet unexploited opportunity for entrepreneurial profit means that the existing state of affairs, no matter how evenly it seems to flow, is a disequilibrium situation.  Perfect knowledge does not exist.

 It is a situation in which some decision-makers are at least partly ignorant of the decisions being made by others. This situation is bound to change and the existence of profit opportunities is the catalyst that gives rise to the change.

 

So according to Kirzner the entrepreneur is seen as the equilibrating force.  Although, not necessarily actually reaching an “equilibrium” situation.

 

 The entrepreneur adds to the knowledge base.  In that sense, he is adding value and also helping resources move to more desirable places.  Kirzner considers this “equilibrating.”

 

 

 

Single Period Equilibrium and Inter-temporal Equilibrium

 

In an analysis confined to single period decisions, equilibrium means the state of affairs in which all the single-period decisions made correctly anticipate the other such decisions being made. Entrepreneurship, in single-period analysis, consists in grasping profit opportunities to buy and sell at different prices in a disequilibrium market within the same period.

 

In an analysis extending to multi-period decisions, the notion of equilibrium is more complex.

 

 In such an analysis decisions extend to plans to buy or sell in the future. A man invests now in his education, intending to sell in the future the skills he is learning. Another man builds a shoe factory now intending to buy regular supplies of leather during future periods of time. The equilibrium that would result from perfect dovetailing of these multi-period plans must be an inter-temporal equilibrium. Plans made today must fit not only with plans by others today, but also with plans made in the past and other plans to be made in the future.

 

A state of disequilibrium will exist wherever any plan being made at any date fails to dovetail with other relevant plans (of whatever date) in the entire system being considered. A man who builds a shoe factory and who discovers in later periods that shoe leather is unobtainable, or that consumers no longer wish to buy shoes, made his decision in ignorance of the plans of others on which his own depended.

 

A man who educates himself in a profession for which later demand is lacking, has made a plan based upon incorrectly anticipated plans of others.

 

Clearly entrepreneurship has its place in the inter-temporal market in an analogous way to that occupied in the simpler single-period analysis.

 

Where existing plans do not satisfy the conditions for inter-temporal equilibrium, the relevant ignorance by the decision-makers has created opportunities for entrepreneurial profit which can be grasped by those who are able to “see” what others fail to see.

 

 

 

These opportunities, (available to market participants with that alertness we have identified as the entrepreneurial element in individual decision-making), consist in the availability of resources today, at prices lower than the present value of the prices at which outputs can be sold in the future.

 

 This difference between buying prices and selling prices is similar to entrepreneurial profit in simpler contexts. This profit margin is the result of the failure by those selling the resources today (at the low prices) to perceive the possibilities for selling at higher prices in the future. Entrepreneurial alertness to these opportunities will capture this difference as profit .

 

Thus, in the multi-period context (as in the single-period analysis), the entrepreneur finds scope for his specific role in opportunities for the profitable use of resources which others have not perceived.

 

We see him tending to bring about the exploitation of production possibilities which no one has yet noticed. These insights may be extended very smoothly to encompass capital-using production plans.

 

 

 

 

Entrepreneurship and the Use of Capital

 

We will delve into capital and interest theory in detail later.  And inter-temporal decisions are key to the Austrian analysis of capital and interest.

But now let’s look at how entrepreneurship fits in with the use of capital (as per Kirzner).

 

Everyone knows that economic growth and development requires capital (well, I think everyone knows that – maybe not).  Our discussion of the entrepreneurial role in the context of the inter-temporal market will help us to understand the relation between the entrepreneur and the capitalist.

 

    Entrepreneur vs Capitalist:

 

So, as stated, inter-temporal production opportunities involve the acquisition of inputs at one date and the subsequent sale of products at a later date.

 

In the context of capital-using production we say that the producer uses resources in the form of capital goods, or goods in process, until the completion of the period of production.

Remember – capital goods produce consumer goods – but this takes time.  It is not instantaneous! 

 

For such time-consuming, capital-using productive processes it is necessary for someone to forgo the alternative outputs available by using the inputs in less time-consuming processes of production.  In other words, there are obviously opportunity costs involved here.

So someone must perform this capitalist role.  Forgo producing more consumer goods today to invest in capital goods, for example.  The capitalist provides the capital.

 

 

 

If the input sellers (say, laborers) are not willing to wait for payment (wages), someone else must advance the funds for the purchase of the inputs and wait until the end of the productive process for the return of his investment.

 

The producer who borrows the funds to finance his capital-using process of production must find it worthwhile to undertake the commitment necessary to persuade the capitalist to invest. The more productive processes of production, insofar as these involve more investment of capital, will be undertaken only to the extent that the producer “sees” the profitability of these processes.

 

 All of this is easy enough. But it focuses attention on the role of the entrepreneur in a way that is important for this analysis.

 

The technical availability of profitable capital-using methods of production and of savings to provide the necessary capital, is not sufficient to ensure that these methods will be undertaken.

Just because there is savings and there are potentially profitable methods of production available – does not mean the process of production will take place.

 

They constitute an opportunity for inter-temporal exchange which may never be exploited if no one is aware of it.

 

 

 If, at any time, such an opportunity remains as yet unexploited, it offers opportunity for entrepreneurial profit.

 

So the hope is that the entrepreneur will be able to borrow capital, buy resources, and produce output at a market value that will be more than enough to repay the capitalist's investment together with the interest necessary to persuade him to lend the capital funds.

The moving of capital to more productive processes of production must involve entrepreneurial recognition of an opportunity that has (as of yet) gone unperceived.

 

Entrepreneurship is necessary in economic development.  It is necessary for markets to change.

 

So far from being a kind of exogenous push given to the economy, entrepreneurial innovation is the grasping of opportunities that have somehow escaped notice - but is most certainly endogenous!!

 

 

 

 

The Implications of the Theory

 

If the role of the entrepreneur is not overlooked but instead brought to the forefront of our analysis – then we must ask:  what institutions foster this “alertness” to new opportunities?

 

What ensures that decision-makers become aware of the existence and attractiveness of these opportunities?

 

Obviously, there must be an environment of freedom to become alert to the opportunities for profit.

 

So profit, in the market system, is not merely the incentive to get entrepreneurs to take action on these potential opportunities, it is the incentive upon which the market relies to ensure that these opportunities will be seen in the first place.

Whatever advantages the price system possesses as a “calculator” that allows for inter-temporal allocation of resources, these advantages depend utterly on the entrepreneurial element the Austrian economists emphasize. 

 

Therefore Kirzner will say that any policy that blocks profit opportunities also blocks entrepreneurship.

 

Can you think of examples?

 

 

 

 

 

 

 

A Critique and Alternative “Austrian” View

 

Other Austrian economists disagree with Kirzner’s view of the entrepreneur. 

 

    Entrepreneurship as Action Under Uncertainty or Judgment

 

Following economists Richard Cantillon, Frank Knight and Ludwig von Mises (in Human Action, for example) and other Austrian economists want to interpret or define entrepreneurship not as alertness or discovery, but as action under uncertainty, or what Frank Knight called judgment.

 

The argument is that the Kirznerian notion of alertness:

 

 

 In this context, the theory criticizes Kirzner‘s denial that the entrepreneur must own capital.

Also:

 

 

Under this view, entrepreneurship is judgment in relation to the most uncertain events, such as starting a new firm, defining a new market, and the like.

In other words, there is no market for the judgment that entrepreneurs rely on and, therefore, exercising judgment requires the person with judgment to purchase and organize factors of production—in other words, to start a firm.

They can’t simply sell their alertness or judgment – they must act upon it themselves.

 Judgment thus implies asset ownership, for judgmental decision making is ultimately decision making about the employment of resources.

 

 

 

 

    Mises’s Entreprener: 

Rather than an equilibrator, Mises‘s entrepreneur is a resource allocator.

Mises begins with the marginal productivity theory of distribution developed by his Austrian predecessors. In the marginal productivity theory, laborers earn wages, landowners earn rents, and capitalists earn interest.

Their incomes depend upon the marginal productivity that they bring to the production process.

Any excess (deficit) of a firm‘s realized receipts over these factor payments constitutes profit (loss). Profit and loss, therefore, are returns to entrepreneurship.

In a hypothetical equilibrium without uncertainty (what Mises calls the evenly rotating economy), capitalists would still earn interest as a reward for lending, but there would be no profit or loss.

Outside the evenly rotating economy, however, factors may be priced above or below these equilibrium values, and shrewd entrepreneurs can acquire factors for less than their discounted marginal revenue products, leading to profit. Less capable entrepreneurs will overpay for factors, or choose inefficient factor combinations, or produce the wrong products, among other errors, and earn losses.

 

Mises clearly associates entrepreneurship with uncertainty-bearing: “The term entrepreneur as used by [economic] theory means: acting man exclusively seen from the aspect of the uncertainty inherent in every action.” (Mises, p. 254).

Of course, all human action involves uncertainty.

Hence capital owners, landowners, and even laborers (who own their own minds and bodies) act as entrepreneurs under conditions of uncertainty.

Kirzner does not deny that business people, resource owners, financiers, traders, and the like exercise judgment, or that they possess boldness, creativity, and imagination, only that they need not exercise these functions to be alert to previously unknown profit opportunities.

 

But this view says no – they must also ACT.

It seeks to explain not only discovery, but action, focusing on combining abstract processes of imagination and creativity with action on real markets.

This view suggests that an emphasis on entrepreneurial action under uncertainty, focusing on investment, real prices, and the resulting profits and losses, provides richer insights into the market.

It also suggests that the institutional environment becomes even more important than Kirzner makes it.

Kirzner wants to make sure that profit opportunities are not limited – because that will limit the alertness and discovery of these opportunities.

But this view would also analyze how the actual actions of entrepreneurs are also limited or extended.  How does the institutional environment change investment decisions, decisions as to whether or not to start a firm, expand a firm, etc.  All of this is included in the definition of entrepreneurship.

 

Putting Them Together

If we put all of these ideas together – then the Austrian entrepreneur is someone who becomes alert to an opportunity, makes a judgment about the opportunity, and acts upon the opportunity, thereby bearing the uncertainty under which the action is taken, and thereby also allocating resources in new directions.

Entrepreneurial Process:

Alertness – Judgment – Action – Bearing Uncertainty – Changes Resource Allocation

So –  MORE KNOWLEDGE IS GENERATED THAT WAS PREVIOUSLY UNKNOWN.  EVEN IF IT IS KNOWLEDGE REGARDING WHAT NOT TO DO!

Any institutional arrangement (rules, etc.) that affects any part of our entrepreneurial process will either hinder or help the process.  If entrepreneurship is an integral part of the outcome of markets – and those outcomes are seen as good – then it is important to discuss these institutional arrangements.  Institutions, for example, that might lead to a:

 

DO ICE FIVE