The Driving Force of the Market

By: Peter_G_Klein

Entrepreneurship is one of the fastest growing fields within economics, management, finance, and even law. It's also becoming a popular subject at colleges and universities. Entrepreneurship courses, programs, and activities are springing up not only in business schools, but also in colleges of arts and sciences, engineering, education, social work, and even fine arts.

Surprisingly, however, while the entrepreneur is fundamentally an economic agent — the "driving force of the market," in Mises's phrase — modern economics maintains an ambivalent relationship with entrepreneurship. It is widely recognized that entrepreneurship is somehow important, but there is little consensus about how the entrepreneurial role should be modeled and incorporated into economics and strategy. Indeed, the most important works in the economic literature on entrepreneurship — Schumpeter's account of innovation, Knight's theory of profit, and Kirzner's analysis of entrepreneurial discovery — are viewed as interesting but idiosyncratic insights that do not easily generalize to other contexts and problems.

The same is true even for modern theories of firm strategy and organization, which recognize that entrepreneurship is important, but can't quite figure out how to work the entrepreneur into the standard models and analytical techniques. And yet, entrepreneurship is ultimately the main source of value creation at the firm level. Indeed, the firm's key strategic decisions — strategy formulation, market analysis, industry positioning, diversification, vertical integration and outsourcing, organizational design — are ultimately entrepreneurial decisions. But it is only very recently that the strategic-management field has realized the need for a closer relationship with entrepreneurship (e.g., the 2008 start-up of the Strategic Entrepreneurship Journal.)

The awkward relationship between mainstream economics and strategy and entrepreneurship makes sense in the context of the development of the neoclassical theory of production and the firm. The increasingly formalized treatment of markets, notably in the form of general-equilibrium theory, not only made firms increasingly passive, it also made the model of the firm increasingly stylized and anonymous, doing away with those dynamic aspects of markets that are most closely related to entrepreneurship. If any firm can do what any other firm does, if all firms are always on their production-possibility frontiers, and if firms always make optimal choices of input combinations and output levels, then there is nothing for the entrepreneur to do.

The Austrian School, by contrast, has given the entrepreneur a central role in economic activity, at least since the proto-Austrian contribution of Richard Cantillon. Key figures in the Austrian School, such as Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, and Murray Rothbard (1962) all emphasized the entrepreneur in their causal-realistic analysis of economic organization and economic change.

In The Capitalist and the Entrepreneur, I build on Mises's and Knight's theory of entrepreneurship to offer a new perspective on the economic theory of the firm. Entrepreneurship, in the Misesian sense, is the act of bearing uncertainty. In an ever-changing world, decisions must be made based on expectations of future events. Because production takes time, resources must be invested before the returns on those investments are realized. If the forecast of future returns is inaccurate, the expected profits will turn out to be losses.

This is, of course, true not only of financial investors, but of all human actors. If we knew for certain that our action would not change the future, we would not act, because action would be pointless. Moreover, human action typically carries some risk that the means chosen will not bring about the desired end. Where this is so, human actors are entrepreneurs.

At the same time, there is a particular case of entrepreneurship, one that is more important to the allocation of resources in a market economy: the capitalist-entrepreneur, who risks his money capital in anticipation of future events. The capitalist-entrepreneur is a property owner, who seeks to obtain, control, and deploy factors of production in particular combinations in pursuit of money profits. Successful capitalist-entrepreneurs make accurate forecasts of future prices and receive returns greater than their outlays. Those whose forecasts are less accurate earn losses. Capitalist-entrepreneurs who systematically make poor forecasts quickly find themselves unable to secure any further resources for investment, and they eventually exit the market.

"If any firm can do what any other firm does, if all firms are always on their production-possibility frontiers, and if firms always make optimal choices of input combinations and output levels, then there is nothing for the entrepreneur to do."

The book takes the position that the most interesting problems of economic organization relate to the intersection of the entrepreneurial and capitalist functions. The capitalist-entrepreneur performs what Mises called "economic calculation," linking the theory of the firm to the general problem of resource allocation in a complex dynamic economy that Mises raised in his famous 1920 article on socialism. Entrepreneurs deal with heterogeneous capital goods, connecting the theory of entrepreneurship to the Austrian theory of capital, a theory that has been applied primarily to the business cycle, but one that has far-reaching implications for business management as well.

Indeed, as Ludwig Lachmann put it in 1956, "We are living in a world of unexpected change; hence capital combinations … will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur." It is this "real function" that my book tries to elaborate.

The chapters in The Capitalist and the Entrepreneur deal with firms, contracts, entrepreneurs — in short, with the economics and management of organizations and markets. Chapter 1, "Economic Calculation and the Limits of Organization," shows how the economic-calculation problem identified by Mises helps understand the limits to firm size, an argument first offered by Rothbard in Man, Economy, and State. Along with chapter 2, "Entrepreneurship and Corporate Governance," it offers an outline of an Austrian theory of the firm, based on the Misesian concept of entrepreneurship and the role of monetary calculation as the entrepreneur's essential tool. "Entrepreneurship and Corporate Governance" also suggests four areas for Austrian research in corporate governance: firms as investments, internal capital markets, comparative corporate governance, and financiers as entrepreneurs.

Chapter 3, "Do Entrepreneurs Make Predictable Mistakes?" applies this framework to the problem of corporate divestiture, while chapter 4, "The Entrepreneurial Organization of Heterogeneous Capital," shows how Austrian capital theory provides further insight into the firm's existence, boundaries, and internal organization.

Management scholars, and some economists, are familiar with Israel Kirzner's concept of entrepreneurship as "discovery," or "alertness" to profit opportunities, typically seeing it as "the" Austrian approach of entrepreneurship. However, as I argue in chapter 5, "Opportunity Discovery and Entrepreneurial Action," one can interpret Mises differently. Indeed, I see Mises's approach to the entrepreneur as closer to Knight's, and the investment of resources under uncertainty, not discovery, as the hallmark of entrepreneurial behavior. This suggests a focus not on opportunities, the subjective visions of entrepreneurs, but on investment — on actions, in other words, not beliefs. Chapter 6, "Risk, Uncertainty, and Economic Organization," further discusses the Knightian distinction between "risk" and "uncertainty," or what Mises called "class probability" and "case probability."

Chapter 7, "Price Theory and Austrian Economics," challenges what I see as the dominant understanding of the Austrian tradition, particularly in applied fields like organization and strategy. Scholars both inside and outside economics tend to identify the Austrian School with Hayek's ideas about dispersed, tacit knowledge, Kirzner's theory of entrepreneurial discovery, and an emphasis on time, subjectivity, process, and disequilibrium. Despite renewed interest in the Mengerian tradition, the Austrian approach to "basic" economic analysis — value, production, exchange, price, money, capital, and intervention — hasn't gotten much attention at all.

Indeed, it's widely believed that the Austrian approach to mundane topics such as factor productivity, the substitution effect of a price change, the effects of rent control or the minimum wage, etc., is basically the same as the mainstream approach, just without math or with a few buzzwords about "subjectivism" or the "market process" thrown in. Chapter 7 suggests instead that the Austrians offer a distinct and valuable approach to basic economic questions, an approach that should be central to research by Austrians on theoretical and applied topics in economics and business administration.

A final chapter, "Commentary," collects some shorter essays on the nature and history of the Internet, the role of the intellectuals in society, the relationship between management theory and the business cycle, biographical sketches of Carl Menger and F.A. Hayek, and a note on Oliver Williamson's contributions and his relationship to the Austrian tradition.

I hope these essays will stimulate discussion, perhaps even generate controversy, both within and outside the Austrian tradition. Indeed, researchers in strategic management, organization theory, and (mainstream) entrepreneurship have been particularly receptive to Austrian ideas in recent years, and I expect Austrian thinking to have a significant impact in these areas, regardless of its fortunes within mainstream economics. Let the fireworks begin!

Peter G. Klein is associate professor and associate director of the Contracting and Organizations Research Institute at the University of Missouri and adjunct professor at the Norwegian School of Economics and Business Administration. He blogs at Organizations and Markets. See his webpage. Send him mail. See Peter G. Klein's article archives. Comment on the blog.

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