I am hard-pressed to think of a more fitting time for the book Organizing Entrepreneurial Judgment: A New Approach to the Firm by Nicolai Foss and Peter Klein to be read. The book’s aim is to integrate the study of entrepreneurship with the theory of the firm under economic analysis. Nationally and globally we are at a pivotal moment in which people need to understand how businesses function and the entrepreneurial abilities necessary for continued economic progress. Without further ado, I give you chapter 1 of the book.
Chapter 1. The Need for an Entrepreneurial Theory of the Firm
Foss and Klein (FK) lament from the start the schism that has been erected in economic science between the firm and the entrepreneur. They argue that, for a full understanding of the firm, one must understand the entrepreneurs who make decisions within the firm; while for a full understanding of the entrepreneur, one must understand the environment of the firm in which he acts. Their effort is to make the needed connection where a substantial gap currently exists between the firm and the entrepreneur.
The Theory of the Firm in Economics
FK give evidence to show that “the economic and managerial analysis of the firm is a vibrant area of research and application.” At the same time, “the theory of the firm as a contractual or organizational entity … is … a relatively new development” that emerged in the 1970s. The authors argue that it was Ronald Coase who first propelled the theory of the firm.
Entrepreneurship
FK also note that there has been a considerable push in the study of entrepreneurship within the past decade as economists have seen the entrepreneur more worthy of inspection in order to understand technological progress. FK pose the question “What is entrepreneurship?” Typically economists have either defined entrepreneurship in terms of either (1) an outcome or a phenomenon (self-employment, startups) or (2) a way of thinking or acting (creativity, innovation, alertness, etc.).
Why Entrepreneurship and the Firm Belong Together
FK contend that “economic theories of the firm are particularly well equipped to understand not only the “exploitation,” but also the discovery and even the evaluation of entrepreneurial activities.” They see a need for a further and fuller explanation for “why entrepreneurs choose certain ways for organizing their activities.” They point out that economic models that treat entrepreneurship as a variable in an equation are not sufficient for such an explanation. They add that management research has oversimplified the issue by defining entrepreneurship exclusively as “the creation of new firms.” FK point out that experience shows that entrepreneurial activity occurs in established, mature firms. These firms act entrepreneurially when seizing new opportunities through acquiring other companies, starting a new product, diversifying their funds, and so on.
FK adopt Frank Knight’s conception of entrepreneurship as judgmental decision-making. When understood this way, entrepreneurship helps explain how a firm actually transforms opportunities into realized profits. For it is the entrepreneurs, making decisions according to their best judgment, within the firm that make this happen. Furthermore, FK suggest that systematic differences in firm-level performance are due to the varying degrees of room entrepreneurs are given to exercise their judgment as well as delegate judgment to employees under them.
An Overview of Our Narrative
FK break away from the economics analysis that has left a legacy of an incomplete understanding of entrepreneurship. Entrepreneurship is not restricted to boldness, imagination, or creativity. Neither is entrepreneurship merely alertness to profit opportunities, a belief most attributed to economist Israel Kirzner.
Rather, FK adopt entrepreneurship as “judgmental decision-making under uncertainty,” the view most commonly associated with economists Frank Knight and Ludwig von Mises. In this sense, all humans demonstrate entrepreneurship in action. But FK focus on entrepreneurship within the firm. Entrepreneurs exercise judgment in attempting to employ the firm’s resources in the most profitable way. This is necessary at each step of the firm’s development, not only at its inception. A firm has a limited amount of capital goods it can own. Different capital goods have different attributes and serve different purposes. The entrepreneur must choose which goods to acquire and how to arrange them.
In chapter 1, FK convincingly argue that the firm and the entrepreneur cannot be treated as islands unto themselves. For a full understanding of the economic reality of our world, one must understand both the firm and the entrepreneur and how they relate — how they are connected. Why do entrepreneurs form certain kinds of firms and not others? How does a firm’s structure encourage or discourage entrepreneurial activity? FK aim to address such questions by integrating the firm and entrepreneurship. Chapter 2 will present the reader with a more detailed explanation of entrepreneurship to strengthen the groundwork for understanding the connection.
Chapter 2. What Is Entrepreneurship?
FK dedicate the second chapter of their book to putting forth the best definition of entrepreneurship. Although entrepreneurship studies is one of the fastest growing fields in colleges and universities around the world, FK argue that there is still much work to be done in defining the entrepreneur and clarifying how he relates to the firm. They explain that both in the economics and strategic-management literature, a realistic understanding of entrepreneurship has been crowded out by neoclassical economics with its assumptions of perfect competition and production functions, which treat the firm as acting according to a predetermined path.
Yet in real life, entrepreneurs within different firms are not in perfect competition and do not have accurate production curves that they can passively follow. Rather, they must take actions that they feel will lead to the best outcomes for the firm.
FK draw on the Austrian School of economics’ view of heterogenous capital goods and an active, thinking entrepreneur to establish their definition of entrepreneurship. They explore seven different conceptions of entrepreneurship, discussing each and how they connect entrepreneurship with the firm. FK conclude that a judgment approach to entrepreneurship is the most fitting and sound approach to the subject. In the following I will summarize their discussion of these seven approaches:
1. Entrepreneurship as Small-Business Management
In this approach, entrepreneurship is strictly linked with firms that qualify as small businesses. FK state, “it deems ‘entrepreneurial’ virtually all aspects of small or new business management, while excluding the identical tasks when performed within a large or established business.” This structural approach to entrepreneurship is one of the weakest according to FK yet still holds influence among colleges and universities today.
2. Entrepreneurship as Imagination or Creativity
When defined by personal, psychological characteristics such as imagination and creativity, entrepreneurship becomes “a specialized activity that some individuals are particularly well-equipped to perform.” Using this conception, entrepreneurship has no observable connection to the theory of the firm. The services of imaginative or creative people could be purchased when necessary by the firm. This conception leaves one wanting further explanation as well. FK pose the question that if a founder of a firm does not have a strong sense of imagination or creativity, then is he really not an entrepreneur?
3. Entrepreneurship as Innovation
This conception of entrepreneurship was championed by economist Joseph Schumpeter. He argued the entrepreneur introduces “new combinations” of ideas and resources and dynamically shakes up the economy out of its previous equilibrium state. Schumpeter called this process “creative destruction.” The entrepreneur is the source of economic change. In this conception, entrepreneurship is only demonstrated within the firm when it introduces new products, processes, or strategies. The regular day-to-day operation of the firm has nothing to do with entrepreneurship. The firm’s nature and structure has no effect on the level of entrepreneurship. Thus the connection between entrepreneur and firm is weak.
4. Entrepreneurship as Alertness to Opportunities
This conception is most attributed to economist Israel Kirzner. FK argue it has come to influence management literature on entrepreneurship more than any other. “Opportunities” have come to be defined as “situations in which resources can be redeployed to create value through various forms of arbitrage.” Entrepreneurs are characterized as having special knowledge or insight that no one else has. According to the conception, entrepreneurs only need to be aware of profit opportunities. They do not need to own assets. Since they are merely exercising privileged knowledge, they are neither facing uncertainty nor necessarily bearing any risk. FK explain, “In Kirzner’s formulation, the worst that can happen to an entrepreneur is the failure to discover an existing profit opportunity. Entrepreneurs either earn profits or break even, but it is unclear how they suffer losses.” In this conception, entrepreneurs do not need a firm to be entrepreneurs.
5. Entrepreneurship as the Ability to Adjust
This is the approach of Nobel Prize–winning economist Theodore Schultz. This approach assumes that innovation is occurring in the economy and measures entrepreneurship by how people adjust to large changes in the economy. Entrepreneurship is defined as “the ability to reallocate one’s resources in response to changing circumstances.” Schultz argued that entrepreneurial ability is a resources with an actual market price and quantity. By this conception, it is not only implied but overtly asserted that entrepreneurship could simply be purchased by firm management. Management could purchase the services of entrepreneurs during times of great change. Beyond that, there is no real connection between the entrepreneur and the firm.
6. Entrepreneurship as Charismatic Leadership
This conception is heavily influenced by Max Weber. Entrepreneurship is defined as “the ability to articulate a plan, a set of rules, or a broader vision, and impose it on others.” Successful entrepreneurs must be excellent communicators and generate a following. FK’s main critique of this conception is that it speaks only to one personal characteristic and says nothing about the physical assets that an entrepreneur controls. It says nothing of how he makes decisions about those assets.
7. Entrepreneurship as Judgment
This is the view that FK come to adopt. Entrepreneurship is defined as “judgmental decision-making under conditions of uncertainty.” Judgment is defined as “decisive action about the deployment of economic resources when outcomes cannot be predicted according to known probabilities.” In this conception, the entrepreneur is an active, creative agent. He is not passively identifying opportunities that he is aware of, but rather creating new opportunities by his judgment. Decision-making under uncertainty is the qualifying function of entrepreneurship whether it involves imagination, creativity, and leadership or not. FK argue that there is no market for this judgment and therefore entrepreneurs must establish firms as vehicles to perform their function in the economy. The definition of judgment implies that entrepreneurs own and manage assets. FK draw most heavily from economists Frank Knight and Ludwig von Mises to explain entrepreneurship as judgment.
To conclude my summary on chapter 2, I will quote a passage from FK that explains how an understanding of entrepreneurship as judgment links entrepreneurship with the firm and gives a fuller understanding of both:
The firm … is the entrepreneur and the assets he owns, and therefore ultimately controls. The theory of the firm is essentially a theory of how the entrepreneur exercises his judgmental decision-making — what combinations of assets will he seek to acquire, what (proximate) decisions will he delegate to subordinates, how will he provide incentives and employ monitoring to see that his assets are used consistently with his judgments, and so on.
In chapter 3, we will explore more deeply the contrast between entrepreneurship conceived as opportunity discovery and entrepreneurship as judgment.
Chapter 3. Entrepreneurship: From Opportunity Discovery to Judgment
Chapter 3 takes a detailed look at the opportunity-discovery view of entrepreneurship put forth by Kirzner (as we discussed above) and compares and contrasts it with the views of those in the Austrian School of economics.
Kirzner is an economist within the tradition of Austrian economics and has had perhaps the largest influence on the management literature on entrepreneurship. A popular definition for entrepreneurship research among those in the field is “the scholarly examination of how, by whom, and with what effects opportunities to create future goods and services are discovered, evaluated, and exploited.” The opportunity as explained by Kirzner has become the unit of analysis for many studying entrepreneurship. FK put forth a different approach to entrepreneurship within the Austrian School that they see as superior to Kirzner’s and also provide the history of thought regarding the entrepreneur within the school.
The Austrian School of Economics and the Entrepreneur
Carl Menger is considered the founder of the Austrian School of economics. He described the entrepreneur as a coordinating agent who is both a capitalist and a manager. The entrepreneur owns resources and decides how they will be used. Menger emphasized that entrepreneurs bear uncertainty and take purposeful, decisive action according to the knowledge they have. John Bates Clark and Frank A. Fetter are economists who followed in Menger’s approach to economics. Clark believed the entrepreneur must also be the owner of a business. Fetter saw uncertainty-bearing as the key entrepreneurial function. He asserted that an entrepreneur organized and directed production while possessing superior foresight. It is clear that the Austrian School did not start with an emphasis on the entrepreneur as an opportunity discoverer.
While those in the Austrian tradition have always seen the entrepreneur as having a central role in economic affairs, two different strands emerged within the Austrian tradition that led to different conceptions of the entrepreneur. Friedrich von Wieser and F.A. Hayek branched off in emphasizing knowledge, discovery and market process. Wieser saw the entrepreneur as owner, manager, leader, innovator, organizer, and speculator. Hayek emphasized that knowledge is dispersed to individuals throughout the economy. He argued that market competition makes the best use of this dispersed knowledge and brings it to light. Influenced by this strand of thought, Kirzner argues that a competitive market is superior because it best generates entrepreneurial discoveries.
Economists Eugen Böhm-Bawerk, Ludwig von Mises, and Murray Rothbard are considered to compose a different branch of thought than Wieser and Hayek. They emphasize monetary calculation and decision-making under uncertainty. Mises emphasized that the entrepreneur has an anticipative understanding of an uncertain future. Rothbard critiqued Kirzner for not emphasizing the role of entrepreneur as uncertainty-bearer. He also questioned Kirzner’s notion that the entrepreneur need not own any resources to perform his function. Rothbard asked, “In what sense can an entrepreneur even make profits if he owns no capital to make profits on?”
Understanding Kirzner’s Concept of Entrepreneurship
FK take the time to clarify Kirzner’s position on entrepreneurship. It should be understood that Kirzner is making theoretical abstractions in his explanation of the entrepreneur. Kirzner himself has made much effort to emphasize this. FK show him respect in clarifying this themselves. Kirzner does admit that real-world businessmen who own and allocate resources may be somewhat entrepreneurial.
However, Kirzner makes abstractions to establish that the “pure” entrepreneur is an individual who only performs a discovery function. He discovers new resource uses, new products, new markets and new possibilities for arbitrage. Entrepreneurship is the act of grasping and responding to profit opportunities. The pure entrepreneur is one who owns nothing at all. Kirzner is not arguing that this is how entrepreneurship is manifested in the real world. In fact, Kirzner uses the abstract notion of market equilibrium to define the entrepreneur. Market equilibrium is, in essence, an imaginary construct in which individuals have perfect knowledge and resources are dispersed perfectly according to everyone’s preferences. Therefore profits and losses do not exist in market equilibrium. Kirzner argues that the entrepreneur’s main effect is to push the economy closer to market equilibration. He is an equilibrator.
Kirzner’s approach has been much debated within the Austrian School of economics, which is known for taking into account the real causes and effects of human action in the world we live in. Austrians are averse to focusing on theoretical abstractions that draw economics away from the study of real-world phenomena. Thus Kirzner’s conception of the entrepreneur is by no means the dominant one among Austrians. In fact, many question whether market equilibrium is meaningful or useful in explaining entrepreneurship. FK argue that Mises did not see the critical market process as a movement towards market equilibrium. Rather, Mises emphasized that the preferences and decisions of consumers eliminate unsuccessful entrepreneurs from the market. Mises emphasizes that the entrepreneur is a resource allocator, not an equilibrator. Good entrepreneurs earn profits while less capable ones earn losses. They attempt to anticipate the future demands of consumers and to satisfy them.
Evaluation
Kirzner’s explanation of entrepreneurship should be recognized for what it is; an abstract metaphor to help explain why markets clear. His focus is on the abstract, aggregate effects of acts of alertness. The abstract “entrepreneurial opportunity” is Kirzner’s unit of analysis. He does not take uncertainty into account.
A full understanding of Kirzner’s entrepreneur raises considerable doubt as to whether those studying entrepreneurship in the real world should focus on Kirzner’s conception or not. Those studying entrepreneurship should seriously consider the alternative explanations presented by the Austrian School: by economists such as Menger, Fetter, Mises and Rothbard. They make human action the unit of analysis, not abstract “opportunities.”
FK state,
It is the real-world, flesh and blood entrepreneur, who not only bears uncertainty in his judgments about deploying the resources he owns and controls but is also alert, creative, and leader — and not some abstract, hypothetical discoverer — who is the “driving force of the market.”
It is questionable whether Kirzner’s conception helps us understand the real-world entrepreneur.
Chapter 4 will give a fuller explanation of the judgment approach to entrepreneurship within the Austrian School, which FK argue to be the best approach.
