Economics of Entrepreneurship and Enterprise

Notes on the Economics of Entrepreneurship & Enterprise*

edited by Tim Wakeley

 

1. Introduction

Developing a deeper understanding of the economics of entrepreneurship and enterprise is one of the cornerstones of a pluralist education in economics. 
The market economy is a dynamic system in which enterprising individuals and firms are continually challenged to take on the uncertain activities of developing new goods, services, and business models and improving existing ones, in order to create superior value for customers and outdo each other.  In private enterprise the promise of future profit provides the incentive to take on the myriad obstacles this inherently uncertain activity brings with it, while in not-for-profit organisations the incentive to become more efficient is an important factor contributing to enhanced survival prospects.
Several perspectives on entrepreneurship have been developed in the economics literature.  In what follows we present a brief overview of six perspectives, each of which should be seen as a piece of a more coherent whole and each of which is essential in taking steps towards a deeper understanding of the fabric of the real world economy.

2. Six Perspectives on the Economics of Entrepreneurship & Enterprise

2.1 The Mainstream Perspective on the Entrepreneur

The mainstream treatment of the entrepreneur is intimately bound up with the mainstream theory of the firm. Essentially the theory of the firm examines how scarce factors of production, which fall into one of three broad categories — land, labour, and capital — should best be used in the production of goods and services for society. Within this framework, the entrepreneur is identified as the fourth factor of production.
Mainstream economics presumes that people are always looking out for, readily perceive, and act upon opportunities for improving their positions as much as possible. One implication of this presumption is that everybody has what it takes to be an entrepreneur. In other words, mainstream theory treats entrepreneurs as if they were a resource with an infinite supply. If something is in infinite supply economists tend not to pay much attention to it because economics focuses on how best to use scarce resources. It is partly for this reason that mainstream economics has not developed a specific theory of the entrepreneur. This is not to say that entrepreneurship has no part to play in the mainstream theory of the firm, it is just that its role is trivial.
In the mainstream theory entrepreneurs are the founders, the owners and the managers of the firm all rolled into one and are responsible for organising the other factors of production so that the firm can produce a good or service to sell to customers. They reside in a fictitious world where economic agents have full information about:

•        the availability of factor inputs
•        the quality of factor inputs
•        the variety of ways in which factor inputs can be combined
•        buyers’ demand for the firm’s product.

As a result, the practical questions that would face and challenge a boundedly rational real world entrepreneur effectively become automatic choices.
In particular, two things are glossed over in this theory of the firm. The first is the question of how the business opportunity which led to the founding of the firm was recognised in the first place; here mainstream economics simply assumes that business opportunities will be automatically recognised and acted upon. The second is how the entrepreneur decides on the best way to organise and utilise the productive resources under her or his control. The assumption here is that if two entrepreneurs had access to the same quantity and quality of factor inputs, then we should expect both entrepreneurs to utilise and organise these factors in an identical way within their respective firms. In other words, the rival firms would not only be as efficient as each other, but each firm would be expected to operate at optimum efficiency.
It is only fair to point out that the mainstream theory of the firm was never intended to be a platform from which a detailed understanding of the competitive process could be developed. It is instead a small part of a much bigger equilibrium theory of competitive markets. It is worth noting, however, that, despite this, it has been used in the field of strategic management to offer advice to firms as they seek to gain a competitive edge (often called competitive advantage) over their rivals and this has had important implications for actual business decisions and behaviour; since the theory posits that any two entrepreneurs will make identical and optimal decisions for any given bundle of factor inputs it follows that a firm can only obtain an edge over its rivals if it has ownership/access to factors of production that are not available to its rivals for some reason. In other words, competitive advantage derives from the ownership of unique physical assets rather than unique intellectual assets such as superior skills, knowledge and imagination.
Casual empirical observation suggests that this view of the source of competitive advantage is incomplete because the variable quality of decisions made inside actual organisations seems, quite clearly, to make a difference to their fortunes. One economist who took this point seriously was Harvey Leibenstein, who suggested that organisations will not necessarily use resources as efficiently as the mainstream theory of the firm implies.

 

2.2 The Entrepreneur and the Inefficient Organisation

Harvey Leibenstein coined the phrase ‘X-inefficiency’ to describe the key feature of his theory of the inefficient organisation.

X-inefficiency occurs when an organisation is underutilising its resources for some reason and, as a result, its costs (per unit of output) are higher than they should be.

In other words, an X-inefficient organisation is not fulfilling its potential. This opens up scope for it to obtain an improvement in its position, as it were, ‘for free’.
One of the principal reasons why the firm may not be fulfilling its potential is the nature of labour employment contracts. Labour employment contracts are incomplete: while a typical employment contract describes the hours of work for which the employee will be rewarded it cannot specify the level of effort that the employee will put into her or his job. Consequently the effort level of employees is a discretionary variable (in other words, it is up to the individual) and there is scope for the productivity of the labour force to be less than its inherent potential.
It should be noted that managers, as employees of the firm, are also a part of the labour force hired by the entrepreneur. This means that a crucial role for the entrepreneur is to hire ‘good’ managers who are able to motivate the workforce to produce effort at or close to its maximum potential. Of course the entrepreneur has no unique way of knowing if a manager is putting in maximum effort although various options are open to her or him to try to bring this about. One option is to offer profit sharing incentives (this could also be offered to the non-managerial workforce) but getting the balance right here is something of an art – the more of the profit that is offered to others the less will be left for the entrepreneur. The fundamental message from this analysis is that entrepreneurs have to possess the skill to motivate and inspire effort in others.
A further implication of the X-inefficiency approach is that entrepreneurs should be aware of inefficiencies in rival firms because such inefficiency offers scope for a better-run operation to be competitively superior. Awareness of business opportunities is a feature of the entrepreneur that has been discussed in great detail by a group of non-mainstream economists who are known collectively as the Austrian school. Friedrich von Hayek and Israel Kirzner exemplify this approach.

2.3   The Austrian Perspective on the Entrepreneur

The Austrian analysis of the entrepreneur is intimately associated with the quest for a deeper understanding of how markets work. Austrian economists take as their point of departure the notion that market equilibrium is the end result of the economic process and, as such, it is a relatively uninteresting phenomenon. The implication of their view is that economists ought to devote most of their time and energy to developing a deeper understanding of the disequilibrium processes that generate eventual equilibrium outcomes, because it is only when a market is in disequilibrium that active decisions are being taken by suppliers and demanders. The Austrian theory of the entrepreneur is developed in this disequilibrium context.
If a market is in equilibrium it implies that entrepreneurs and their customers have arrived at a state of the world where neither group has any incentive to change their trading behaviour. From an entrepreneur’s perspective this means that no further profit opportunities remain to be exploited in the market.
Hayek describes the equilibrium state as one where everyone has full information about potential trading opportunities and where everyone has acted optimally in the light of this information. Disequilibrium behaviour is therefore exemplified firstly by the acquisition of useful knowledge and, secondly, by its communication. For example, an entrepreneur may have acquired some useful knowledge that enables her or him to obtain a particular good at a cost that is lower than is being achieved by rival entrepreneurs, but unless this fact is communicated to customers (in the form of lower asking prices) they are unlikely to switch their custom away from the low-cost entrepreneur’s rivals.
For Hayek the disequilibrium market process can usefully be described as a process of discovery. For example, the entrepreneur discovers if asking prices and product quality are appropriate, while customers discover who is able to supply them with goods of acceptable quality at prices that offer them value for money.
Kirzner picks up Hayek’s theme and points out that disequilibrium situations can arise because of interspatial (geographical) differences between suppliers and demanders. For example, for much of the 1990s the most popular Japanese motorcycles were available to the motorcycle riding public in continental Europe and other countries of the world for prices that were considerably lower than those paid by UK customers. Awareness of this fact led a few enterprising UK-based motorcycle retailers to purchase motorcycles from these markets, rather than through official manufacturer’s channels, and this led to a burgeoning growth in so-called parallel imports into the UK. The upshot of this was that official imports were dramatically reduced in price. This process of buying cheap and selling on is generally given the name arbitrage. According to Kirzner anyone who partakes in this practice is an entrepreneur. In fact the key characteristic of the entrepreneur for Kirzner is alertness to such potential sources of profit.
Another source of disequilibrium arises because of intertemporal differences between supply and demand. The entrepreneur who is alert to this situation undertakes to obtain or produce goods or services in advance of buyers demanding the product. In its extreme form the entrepreneur may have no idea what demand for the product will be. In this situation the entrepreneur must necessarily exercise some kind of foresight (which may be based upon gut instinct or an educated guess) and as result she or he takes something of a gamble; the entrepreneur in this situation takes a truly heroic decision in the sense that she or he faces uncertainty rather than calculable risk.
It will be clear from the discussion of Hayek’s and Kirzner’s ideas that Austrian economics is concerned with explaining movements towards equilibrium in markets that already exist as a result of the actions of individuals who are alert to profit opportunities. This view contrasts with that of Joseph Schumpeter who constructed an entire theory of economic development around the contention that the entrepreneur is a destroyer of equilibrium situations.

 

2.4   Schumpeter on the Entrepreneur as Innovator

Schumpeter is very clear about what entrepreneurs do. In essence they are the primary agents of economic development and change and they think up ways of putting scarce resources to new uses. They do this by carrying out one or more of five broad activities;

•   introducing new goods or a new quality of good

•   introducing new ways of producing goods

•   opening up new markets (usually overseas)

•   discovering new sources of supply of raw materials or partly-manufactured goods

•   reorganising the structure of an industry (for example, by creating a monopoly or breaking up a monopoly situation)

Each of these activities is an example of innovation.
Schumpeter is very precise about the meaning of innovation, in particular he is careful to distinguish between invention, innovation and imitation. Invention is an activity which can be thought of as more in the realm of the creation of scientific knowledge than business, although this is not necessarily the case, and it provides a possible source of raw material upon which entrepreneurial individuals can draw as they seek out business opportunities (one might think of the scientific knowledge that underpins everyday commercial products such as the light bulb, the motor car, and the aeroplane). Innovation on the other hand refers to the very first commercial application of what up to that point has remained non-commercialised knowledge. The first person to do this is called the entrepreneur.
Schumpeter points out, “to produce means to combine materials and forces within our reach” and that the same materials may well be used in different ways. He describes these potential alternatives as new combinations and identifies the entrepreneur’s role as the discovery and commercialisation of new combinations.
The second person in the market is not an entrepreneur on Schumpeter’s definition because the first person has already shown the way. The second and subsequent entrants/adopters are simply imitators.
Schumpeter’s discussion also suggests that a particular person should only be described as an entrepreneur at the point when she or he first introduces their innovation. The subsequent activity of running and managing the resulting business is not entrepreneurship in Schumpeter’s view – it is instead the more routine job of business administration. However, Schumpeter also points out that an entrepreneur does not necessarily have to be a business proprietor; it is quite plausible within his definition of entrepreneurship for a manager employed by a firm to carry out an entrepreneurial act and, in fact, given the prevalence of large corporations within the developed economies of the world this implies that continued business success may well depend upon the development of entrepreneurially inclined executives. This phenomenon is known as intrapreneurship.
Schumpeter draws a clear distinction between entrepreneurs and capitalists. Capitalists are the providers of finance; they lend money to entrepreneurs and as such Schumpeter is adamant that entrepreneurship is not about bearing the financial risks associated with novel actions. This is a point of contention. One problem with Schumpeter’s view is that, by definition, the outcome of innovative activity is uncertain and it may be very difficult to persuade third parties to invest in unproven activities. Be that as it may, his fundamental point is that the act of providing credit to finance innovation is not, in his view, how we can recognise who is and who is not an entrepreneur. This is important in Schumpeter’s theory of economic development because, among other reasons, it allows him to analyse the existence of entrepreneurship in economic systems other than capitalism.
The most significant and coherent analysis of entrepreneurship in economics apart from that of Schumpeter is arguably that provided by the British economist Mark Casson. Casson’s theory is part of a more encompassing theory of how economies work and it analyses the role played by the entrepreneur in the coordination of scarce resources in a world where information and knowledge are imperfect.

 

2.5   The Entrepreneur as a Specialist in Coordination

Casson begins his detailed analysis with a very precise definition:

 “…an entrepreneur is someone who specializes in taking judgemental decisions about the coordination of scarce resources.”

Three key points arise out of this definition. The first point is that the entrepreneur is a specialist at what she or he does. From an economics perspective when somebody specialises in an activity they do so because they have a comparative advantage. Casson argues that the core capabilities of the entrepreneur (which are the source of her or his comparative advantage) are very difficult or impossible to learn — in fact he argues that some of these capabilities are more or less innate. Furthermore, he suggests that these innate capabilities are unevenly distributed throughout the population and that they are scarce.
In order to pinpoint which core capabilities are identified exclusively with Casson’s decision-making entrepreneur we first have to understand a little bit of detail about how decisions are made generally. Table 1 summarises the typical stages in decision-making and the correspondent qualities (capabilities) that are required by the decision maker.

Activities	Qualities
First stage: formulation of the decision problem Specification of the objective Specification of the options Specification of the constraints Derivation of the decision rule	Self-knowledge (or knowledge of the principal’s objectives) Imagination Practical knowledge Analytical ability
Second stage: generating the data Data collection Data estimation	Search skill Foresight
Third stage: execution of the decision Application of the data to the decision rule Initiation of the implementation process	Computational skill Communication skill (in formulating instructions)

Table 1. Decision-making activities and the qualities they require
(Source: The Entrepreneur, Mark Casson, 1982, Oxford, Martin Robertson, p.29)

Of the qualities listed in the right-hand column of Table 1 Casson identifies two as essential for the successful entrepreneur, namely, imagination and foresight. Imagination is required in order to perceive of alternative ways in which resources can be utilised — it might also be called vision. Foresight is a complement to imagination and entrepreneurs especially need it because there may well be a shortage of suitable data to collect as a result of the novelty of the alternatives conjured up at the imagination stage. If possessed on their own these qualities will not make a successful entrepreneur; ideally the entrepreneur should possess all of the qualities (i.e. be a generalist). However, Casson argues that the nature of the other qualities is such that they are perhaps less difficult to hire in than the two essential ones and it may therefore be possible to employ other people who possess the requisite ‘missing’ qualities. He does not suggest that this task is an easy one because of difficulties with identifying these qualities in people. Furthermore, if the ‘hiring in’ route is followed, the successful entrepreneur will be required to possess two extra qualities that do not appear in Table 1. These are delegation skills and organisational skills.
The second important point highlighted by Casson’s definition is the judgemental nature of the decisions that the entrepreneur makes. Judgemental decisions are those for which the decision-maker does not have objective criteria to guide her or his choice. In other words, if two different people were asked to make a decision to recommend a particular course of action and no objective data or solution concept were available, they would have to exercise their respective judgemental skills and in so doing they would, in all likelihood, arrive at two different recommendations. On the other hand, if the same two people were asked to ‘recommend’ an answer to the mathematical question, ‘what is 10 + 10?’ they would be able to apply an objective decision rule and both would arrive at the same answer. In short, judgemental decisions involve different perceptions of problems and issues, different interpretations and possibly access to different information.
Typically, an entrepreneur can be thought of as someone who judges situations and opportunities differently from the majority of other people — in essence, it is this difference of opinion that allows the entrepreneur to act when others will not do so. This brings us on to the third important point highlighted in Casson’s definition: when an entrepreneur coordinates scarce resources she or he essentially reallocates them to alternative uses. In other words, Casson’s approach is consistent with the Austrian and Schumpeterian notion that the entrepreneur is an agent of change. Unlike Schumpeter, however, Casson is very clear that entrepreneurship is an ongoing function rather than a one-off act of innovation. His argument in support of this contention is that entrepreneurs essentially spend most of their time looking out for new information that makes the current allocation of resources appear to be inefficient.
Casson goes on to develop the implications of his definition in some detail and, at the risk of oversimplifying his argument, we can say he makes the point that in order to execute a reallocation of scarce resources (i.e. to carry out the role of coordination) the entrepreneur must have control over these resources. In a capitalist system this is achieved by taking on ownership of the relevant resources, in other words the entrepreneur has to buy or hire them. This observation is compatible with a number of activities including:

•        starting up a new firm;
•        taking over an inefficient established firm;
•        and acting as an arbitrageur.

Casson augments his theory with an analysis of the crucial role played by the entrepreneur in the setting up of markets. Essentially he develops the theory that entrepreneurs are market makers and in so doing provides important insights into the nature of this important institution. Casson’s insights have particular resonance for the nascent entrepreneur because they provide a good deal of practical advice about the obstacles to trade. In fact his market making theory suggests that an entrepreneur may need to develop or have access to qualities in addition to those associated with decision-making.
The purpose of a market is to allow buyers and sellers to trade with each other. Two simplifying assumptions in mainstream economics are that markets spontaneously arise and that they are costless to use, but Casson points out that markets do not simply appear out of the ether; they are constructed by human action, in particular by entrepreneurs. There are six main obstacles to trade and each arises because of a lack of information. Overcoming each of the six obstacles in turn can be thought of as taking the steps required to allow a successful trade to take place or, as Casson puts it, each step is designed to take transactors from a state of mutual isolation towards the successful completion of a trade. The six obstacles to trade are:

1.  The need for the potential buyer and seller to find each other.

2.  The need for each party to communicate reciprocal wants.

3. The need to negotiate a price.

4.  The need to exchange custody of the goods in return for payment.

5.  The need to screen for quality of the goods (in other words, are the goods up to the promised specification?).

6.  The need to be able to enforce compensation if the goods are revealed not to be of the promised specification.

Casson’s chief point is that if entrepreneurs wish to sell their goods then they have to take the initiative in constructing mechanisms to overcome these obstacles to trade — customers have little or no role to play here — and, as a result, the costs of setting up a market are borne by the entrepreneur in the first instance. Furthermore these are sunk costs that typically have to be made in advance of any trading activity and which continue to be incurred ahead of the receipt of sales revenue.
These sunk costs include resources devoted to product development and copyrighting, highly specific tooling and other equipment, signs, logos, and other marketing expenses, and the foregone use of the entrepreneur’s time from alternative activities. They make the entrepreneur vulnerable, given the uncertainties associated with subsequent revenue.
The strong implication of this perspective is that entrepreneurs need to possess or to acquire excellent bargaining skills if they are to recover upfront investments and correspondingly make a profit from their superior ability at making judgemental decisions.  Casson does not see entrepreneurial profit as a residual but instead as earned income since entrepreneurs have to perform their function actively rather than sit back and let the other factors of production do all of the work.

2.6 The Entrepreneur as a Constructor of Connections

The theory of the entrepreneur as a constructor of connections takes as given the notion articulated by Kirzner, Schumpeter, Leibenstein and Casson that entrepreneurial individuals spend much of their time looking out for profit opportunities. The perspective takes its cue from the work of the philosopher-economist George Shackle who proposed that most thoughts, including new ideas, are based upon a limited set of elements that are capable of being combined in new ways. A non-economic example of this is the alphabet; its 26 letters have been, and still are being, combined into an enormous, and growing, pool of words. The implication of Shackle’s proposition is that profit opportunities are constructed initially as possibilities in the minds of entrepreneurs and this construction entails recognising connections between hitherto unconnected elements. The fundamental insight of this perspective is that profit opportunities are not things that lie around waiting to be found; the entrepreneur has to construct them actively. If entrepreneurs are to survive in business — in other words if they are going to make successful connections — they will also need to possess some understanding of how their potential customers make mental connections.
From the Shackle perspective, the creation of new products does not entail the creation of something from scratch but new connections between existing elements (i.e. ideas, capabilities and technologies). An informal examination of the catalogues of modern consumer electronics firms such as Sony will reveal that innovation tends to entail new combinations of a multiplicity of technologies. Each new product feature, such as a PlayStation II’s capacity to read DVDs, builds upon existing technologies, and the products of supposedly ‘different’ industries may end up as elements of other products—as with the incorporation of audiovisual entertainment systems in cars. Some technologies, such as LCD systems, soft touch keypads and memory chips, may be added to an astonishing variety of products and their growing ubiquity makes it easier to apply them in yet more applications, as users can employ the same skills in all manner of different contexts. All it requires is that an entrepreneur dreams up the possible connections or is prepared to back financially an inventor who sees them sooner.

3  Final Comments

         There is no single coherent theory of the economics of entrepreneurship and enterprise.  This should not be surprising.  Equally it should come as no surprise that the mainstream approach plays down its role, since entrepreneurship cannot be understood easily within the equilibrium framework and it certainly does not sit comfortably with the notion of the fully informed rational decision maker (homo economicus).  In order to understand entrepreneurship we need to explicitly recognise differences between decision makers.  By adopting a pluralist perspective we open ourselves up to the insights that alternative theories offer and set ourselves the task of reconciling them.  This is not as difficult as it may seem; the theories of entrepreneurship discussed here are complementary - each one illuminates different aspects of this multifaceted activity and contributes to a deeper understanding of the dynamics and institutions which make up the fabric of society.

Further Reading

Mark Casson (2003) The Entrepreneur: An Economic Theory (Second Edition), Cheltenham, Edward Elgar.

Peter E. Earl (2003) ‘The entrepreneur as a constuctor of connections’, pp. 113–130 of Roger Kopple (ed.) Austrian Economics and Entrepreneurial Studies: Advances in Austrian Economics, Volume 6, JAI/Elsevier, Amsterdam.

Israel Kirzner (1979) Perception, Opportunity, and Profit: Studies in the Theory of Entrepreneurship, Chicago, University of Chicago Press.

J. Stanley Metcalfe (2004) ‘The entrepreneur and the style of modern economics’, Journal of Evolutionary Economics, 14, 157-175.

Richard Swedberg (ed.) (2000) Entrepreneurship: the Social Science View, Oxford, Oxford University Press.