Traditional neoclassical microeconomics presents a very lengthy and rigorous treatment of business firms operating in markets with different levels of competition. Economics professors test their students’ knowledge about this material mostly with equations, graphs, and mathematical conditions. While these models are neat and tidy, they to a large extent completely ignore the real driving force behind markets—entrepreneurship. This is unfortunate. Entrepreneurs are the ones who actually create these markets. They are the individuals who operate and take the actions within markets to bring them closer to efficiency and make decisions on firm resource use. We pride ourselves on being a discipline that employs methodological individualism, yet we fail to do this when it comes to the behavior of ‘firms’ in markets. Firms don’t behave, entrepreneurs do!
Most Principles of Economics textbooks do not even have the word entrepreneurship in the index. Can you believe it? That’s right, four or five chapters of your principles book are devoted to ‘the theory of the business firm,’ and the book don’t even mention the individual actor who started and runs the business firm, or their role in the economy at large. Check the index of the textbook on your shelf—I dare you.
In this article I attempt to help briefly introduce those elements that are missing from standard textbook theory, but that are critical to understanding real-world product markets. To better frame this discussion, let me introduce four scholars in economic theory who have significantly furthered our understanding of entrepreneurship: Israel Kirzner, Joseph Schumpeter, F.A. Hayek, and William Baumol. Their insights form the basis of my discussion.
Let’s begin with something that is harder than it first appears—defining entrepreneurship. Entrepreneurs are agents of change. We typically define entrepreneurs as individuals who organize, manage, and assume the risks of a business or enterprise. They perform a function beyond simply providing financial resources for the firm and assuming financial risk (which is something venture capitalists do). Joseph Schumpeter defined entrepreneurs in terms of their role—introducing new combinations of resources. In fact, Schumpeter believed someone simply managing a business was not an entrepreneur as they were no longer performing the entrepreneurial function. Even in public discourse, individuals who, for example, open yet another franchise of Subway are viewed differently than someone like Elon Musk or Steve Jobs. So the first definitional difficulty is whether all business owners should or shouldn’t be considered entrepreneurs. But the issue runs much deeper.
In contrast, modern work by authors such as William Baumol allows us to frame this much more broadly, as individuals can be entrepreneurial and creative in many sectors other than private markets. There can be political entrepreneurs, legal entrepreneurs, military entrepreneurs, academic entrepreneurs, and social entrepreneurs (among other types). Entrepreneurial individuals are agents of change—individuals who come up with new ways of doing things and implement them. These activities are not limited to the for-profit marketplace business sector. They even happen in sports.
American football had been played for decades prior to anyone attempting a forward pass. In the Yale versus Princeton game in 1876, Yale’s Walter Camp threw the football forward to a teammate as he was being tackled, and the play resulted in a touchdown. Despite protests by the opposing team, the referee actually tossed a coin to make his decision and allowed the touchdown to stand. Walter Camp is an entrepreneur, albeit not in the for-profit market sector creating a business. For over a century now individuals have been exploiting and improving Walter Camp’s innovation much as we have done with the automobile or other private market innovations.
An example of political entrepreneurship is the case of the gerrymandering of political districts. A creation of Massachusetts Governor Elbridge Gerry, it was the first-time political district boundaries were significantly manipulated to alter the outcomes of elections. This too is now widely used as a tool for political gain. In the legal arena, creative attorneys frequently come up with new ways of litigating cases. In 1999, for example, the plaintiff’s attorney litigating the case of Bower v. Westinghouse in the West Virginia courts was able to creatively argue that individuals who showed no current physical injury should be given lump sum damage awards from a nearby manufacturing plant for future medical monitoring in case they started developing problems. Now jokingly known as the “Ford F-150 rule” because large groups of individuals have spent their checks on new pickup trucks, the creative thinking of one attorney has opened the door to hundreds of new lawsuits representing class actions of uninjured parties to seek transfers through the legal process from surrounding business entities. There are similar examples of groups through history pioneering innovations in lobbying (‘rent seeking’) and securing government favors, transfers, or protections for the first time that many others now routinely receive.
Some take the narrow, traditional definitional stance of entrepreneurship being about managing, organizing, and taking the risks of a business enterprise. Some even exclude simply managing or owning a business in favor of only including true innovation. But entrepreneurship can be more broadly viewed as consisting of creative people who see and discover opportunities for personal gain that others have overlooked, which is the basic role stressed by Israel Kirzner in his conception of entrepreneurship.
In private markets, these opportunities for profit or gain are acted upon by the entrepreneur, and the resulting profit (or loss) is the reward (or punishment) for whether the entrepreneur has increased (or decreased) the value of the resources under his or her control. This is Adam Smith’s invisible hand principle at work. In other arenas such as political or legal entrepreneurship the link between personal gain and social gain is not so clear—some of these types of entrepreneurial activities can actually be unproductive or destructive at a societal level.
Institutions Affect the Allocation of Talent
Whether the talented and entrepreneurial individuals in a society choose to undertake innovative, wealth-creating activities in the private sector versus spending their time in activities that may simply transfer around or even destroy wealth has critically important implications for the prosperity and growth of a state or country. This choice, made by these individuals, is largely determined and influenced by the differential rates of return to the activities. In areas where it is lower cost and/or higher return to devote time and effort to private entrepreneurial activities that create wealth, we get more of these ‘productive’ activities. In areas where it is lower cost and/or higher return to devote time and effort to plundering others through the legal or political process (or even military conquest) we get more of these ‘unproductive’ activities.
Based on the work of Baumol and others we now know that differences in measured rates of private sector entrepreneurship are largely due to the different directions entrepreneurial energies are channeled by prevailing economic and political institutions, through the rewards and incentive structures they create for entrepreneurial individuals. This is precisely why institutions matter so much for growth and prosperity. They channel the effort of entrepreneurial individuals. More bluntly, the level of economic freedom affects the allocation (and productivity) of entrepreneurial talent.
“In areas with high levels of economic freedom—with secure property rights, a fair and balanced judicial system, contract enforcement, and effective limits on government’s ability to transfer wealth through taxation and regulation—creative individuals are more likely to engage in productive market entrepreneurship.”
In areas with high levels of economic freedom—with secure property rights, a fair and balanced judicial system, contract enforcement, and effective limits on government’s ability to transfer wealth through taxation and regulation—creative individuals are more likely to engage in productive market entrepreneurship. In areas with low levels of economic freedom, these same individuals are instead more likely to engage in attempts to manipulate the political or legal process to capture transfers of existing wealth through unproductive political and legal entrepreneurship. This reallocation of effort occurs because the institutional structure affects the relative financial and personal rewards to investing entrepreneurial energies into productive market activities versus investing those same energies instead into unproductive activities to transfer wealth.
Invention vs. Innovation and The Profit & Loss System
There is a difference between invention and innovation. While invention is the creation or discovery of a new product or process, which can be done by scientists in a laboratory, innovation is the successful introduction and adoption of a new product or process in the commercial marketplace. Innovation is basically the economic application of inventions. For example, while the electric vacuum cleaner was invented by a department store janitor in 1908 named James Spangler, it was his cousin, William Hoover who successfully innovated and commercially produced and marketed the product. Henry Ford did not invent the automobile, but he did bring the assembly line innovation that made it possible to mass produce them at a price within reach of the average family. Similarly, Ray Kroc innovated franchising, not McDonald’s itself. That was invented by Richard and Maurice McDonald in California.
According to Kirzner this discovery process of innovation is incentivized by profit. The large rewards that await successful innovators give them motivation to work harder, think deeper, and spend the time and effort to discover innovations. This is why, despite having thousands of well-trained engineers, the 1970s cars produced under socialist systems (such as the Trabant) were dismal in comparison to their counterparts produced under capitalism. Without the lure of profit, and the feedback of the profit and loss system, the pace of innovation is not as rapid. This is also why policies such as price controls, high taxes, and burdensome regulations that reduce the profitability of new ventures are destructive to progress—they reduce the reward to innovation. In fact, the argument that high potential profits are what incentivize a more rapid pace of innovation is precisely the argument usually used to defend having a government patent system that grants monopoly power to new ideas. But, importantly, not all inventions are profitable business ideas—there is a difference.
Joseph Schumpeter viewed this process as one of entrepreneurs searching for new combinations of resources. “What if we combine this ingredient, with this other ingredient, in this location, with this marketing strategy…. Does this work?” There are almost an infinite number of new possible combinations of productive resources. If you have ever been to one of those make your own pizza places where you pick the toppings, you know there are many possible different pizzas you could make. If you only picked three toppings from a set of 50 ingredients, there are almost 20,000 different possible three-topping pizzas you could make! The Hawaiian pizza, consisting of cheese, pineapple, and ham is one of them, and its invention is often credited to a Canadian named Sam Panopoulos.
Not all new combinations are worth producing, and it is the profit and loss system that gives entrepreneurs quick feedback about whether they have stumbled onto a ‘good’ or ‘bad’ idea. A good idea is a new combination of resources that produces more value for consumers than the opportunity cost of the resources required for its production. Bad ideas result in losses that then cause business failure which in turn frees up those resources to flow into other new entrepreneurial experiments. Making matters even more complex, the profitability of different opportunities changes constantly through time. Something that is a profitable idea today may not be tomorrow.
The outcomes of this process are by and large unpredictable and unknowable in advance. Hayek stressed that markets and competition are a discovery process. He likened it to the process of competition in a sporting event, such as a football game. The game itself is how we know which team is better. The process produces knowledge that we wouldn’t know without the competition taking place. Thus, the equilibrium prices, optimal firm sizes, best quality mixes, etc., are things that are discovered through marketplace competition directed by the profit and loss signals sent by consumer demands and by others vying to employ those same resources for different purposes.
Entrepreneurship: Equilibrating or Disequilibrating?
The views of Kirzner and Schumpeter regarding the role of entrepreneurship are often contrasted. In particular, Kirzner’s entrepreneur was more of an arbitrageur who looks for places where they can buy low and sell high, so to speak. These are the types of entrepreneurs one envisions behind those models in economics textbooks. You know the model. It’s the one where under perfect competition, the presence of economic profits leads new firms to enter. These new firms result in prices falling until zero economic profit equilibrium is restored. Seeing that lumber is cheap in Oregon and expensive in Idaho, an entrepreneur may buy it and then resell it for a profit. These actions help move markets closer to equilibrium as prices subsequently adjust. Thus, Kirzner’s entrepreneur is often seen as an equilibrating force in an economy. He or she discovers previously unnoticed (or newly created) profit opportunities and acts on them within existing markets.
In contrast, Schumpeter’s entrepreneur is constantly searching for new combinations of resources and producing new products—creating new markets. Schumpeter’s entrepreneur sees a world of horses and buggies and introduces the automobile. The actions of these entrepreneurs are disruptive and disequilibrating. They make new markets that didn’t previously exist. Schumpeter used the term “creative destruction” to refer to this process by which new goods and services replace old ones. Blockbuster Video, the once dominant firm in the movie rental industry, has been replaced with Netflix streaming movies. Cell phones have replaced dozens of items such as portable music players, paper address books, and digital cameras. If you have visited your local mall recently, you likely know many of those stores are largely in the process of being replaced by online merchants such as Amazon.
But this process of replacement creates enemies. Taxi drivers worldwide have protested Uber, and in many localities have successfully limited, regulated, taxed, or blocked the firm’s entry. Mom and pop stores fought the coming of Wal-Mart. These disruptions create political tension. Those in danger of being replaced turn to government for assistance to block their competitors. That is, the very entrepreneurs who benefitted from the economic system of free market capitalism now turn on it and ask government to impose barriers against the ability of others to do the same. Societies that put up with economic churning, allowing for freedom of entry and exit, are the ones that prosper through time. Those that try to slow this process are the ones that stagnate.
We also know that most disruptive innovations come from small startup firms. Harvard business professor Clayton Christensen popularized this idea in The Innovator’s Dilemma, but it has been pointed out many times by other authors including Schumpeter and Baumol. Basically, large existing firms are good at incremental improvements to existing products—making existing products better, cheaper, faster, etc.–using highly educated workers and large R&D departments. New firms, however, are the ones that enter and revolutionize industries and provide the disruptive innovations and breakthroughs—and many of the entrepreneurs who do this do not have fancy educational backgrounds. They are the odd, creative individuals, the ‘outside the box’ types.
Conclusion and Implications for Policy
In the end, entrepreneurship is about creative people discovering things, whether they be profit or arbitrage opportunities within existing private markets (the view of Kirzner), new combinations of resources that create entirely new markets and destroy old ones (the view of Schumpeter), or opportunities for gain in other non-market areas such as the political or legal arena (including Baumol’s unproductive entrepreneurship). This discovery process of market competition between entrepreneurs, as Hayek stressed, must be undertaken in a decentralized manner with trial and error based on local knowledge and information. It can’t be centrally planned. It can be, however, promoted.
Failing to understand the true nature of entrepreneurship leads to bad policy. Attempts to promote entrepreneurship by creating government funded and managed venture capital funds, or government subsidized business incubators mostly fail, and fail badly. The reason is that they grow government and its involvement in areas where there were no market failures to begin with. We have no shortage of office space, business consultants, or venture capital firms and banks. Let the market do its job! To promote entrepreneurship we don’t want to grow government, we want to grow economic freedom. Raising taxes to fund a commissioner of entrepreneurship education is not the path to prosperity. Growing government results in more unproductive entrepreneurship attempting to secure political favors (and accordingly less entrepreneurship in productive private markets).
Productive entrepreneurship is best fostered by having limited government; low taxes; reasonable regulations; a fair and balanced judicial system that fairly enforces contracts and property rights; freedom of entry and exit; and market-based and determined unregulated pricing, profits, and losses. If we want more entrepreneurship, we need to work to lessen the government tax and regulatory burdens faced by first-time entrepreneurs starting a small business.
I once heard my local chamber of commerce president say “it’s a shame half of all new businesses fail within a few years”. But I want to live in a world where everyone who has an idea for a new private business—even a very marginal one—can roll the dice and try out their idea at low cost in the marketplace, risking their own assets or those of their willing investors. With more rolls of the dice, we stumble onto more of those one in a million ventures such as Apple, Amazon, or Netflix. I want a world where we maximize the number of these attempts by making it easy and low cost to open a new business—by removing artificial costs and barriers. In my world, with all these experiments the rate of business failure would be high, but that isn’t what matters. Lots of business failures with lots of business startups is a healthy economy in my book! As Hayek tells us, we have to use this process to discover what works. There is no way to plan it in advance. Bring on the failures! They are the route to true entrepreneurial discovery.