The Microtheory of Innovative Entrepreneurship

William J. Baumol

• Publisher: Princeton University Press
• Year: 2010
• Print ISBN: 9780691145846
• eBook ISBN: 9781400835225
• Topic: Economics
• Subtopic: Entrepreneurship
• Index: Economics

An authoritative look at the microeconomics of entrepreneurship

Entrepreneurs are widely recognized for the vital contributions they make to economic growth and general welfare, yet until fairly recently entrepreneurship was not considered worthy of serious economic study. Today, progress has been made to integrate entrepreneurship into macroeconomics, but until now the entrepreneur has been almost completely excluded from microeconomics and standard theoretical models of the firm. The Microtheory of Innovative Entrepreneurship provides the framework for introducing entrepreneurship into mainstream microtheory and incorporating the activities of entrepreneurs, inventors, and managers into standard models of the firm.

William Baumol distinguishes between the innovative entrepreneur, who comes up with new ideas and puts them into practice, and the replicative entrepreneur, which can be anyone who launches a new business venture, regardless of whether similar ventures already exist. Baumol puts forward a quasi-formal theoretical analysis of the innovative entrepreneur's influential role in economic life. In doing so, he opens the way to bringing innovative entrepreneurship into the accepted body of mainstream microeconomics, and offers valuable insights that can be used to design more effective policies. The Microtheory of Innovative Entrepreneurship lays the foundation for a new kind of microtheory that reflects the innovative entrepreneur's importance to economic growth and prosperity.

CHAPTER 1

Entrepreneurship in Economic Theory: Reasons for Its Absence and Goals for Its Restoration

Man is not the only animal who labors; but he is the only one who improves his workmanship.

—Abraham Lincoln, “First Lecture on Discoveries and
Inventions,” 6 April 1858

The direction of all economic affairs is in the market society a task of the entrepreneurs. Theirs is the control of production. They are at the helm and steer the ship. A superficial observer would believe that they are supreme. But they are not. They are bound to obey unconditionally the captain’s orders. The captain is the consumer.

—Ludwig Von Mises (1940, 270)

If we are interested in explaining what Trygve Haavelmo once described as the “really big dissimilarities in economic life,” we must be prepared to concern ourselves with entrepreneurship. For the really big differences are usually those that correspond to historical developments over long periods of time, or to the comparative states of various economies—notably, those of the developed and the underdeveloped areas. It has long been recognized that the entrepreneurial function is a vital component in the process of economic growth. Thus, we are led to suspect that if we ignore the entrepreneur, we are prevented from explaining a very substantial proportion of historic growth in developed countries and its distinction from that of other lands. Those who concern themselves with development policy have apparently been driven to similar conclusions. If we seek to explain the degree of success of those economies that have managed to grow significantly in comparison to those that have remained relatively stagnant, we find it difficult to do so without taking into consideration differences in the availability of entrepreneurial talent and in the motivational mechanism that drives them on. Those who design plans to stimulate development devote a substantial proportion of their energies to providing the means for training and encouraging entrepreneurs. The entrepreneurs also are present in institutional and applied discussions of a number of economic arenas other than development. For example, their absence is sometimes cited as a significant source of the difficulties of a declining industry, and a balance-of-payments crisis is sometimes discussed in similar terms. Thus, those who study either macro or micro problems reserve a substantial place for innovative entrepreneurship within their analyses.

Whether or not they are assigned star roles in such discussions, entrepreneurs, in practice, play no minor role. In fact, the innovative entrepreneurs are among the most intriguing and elusive characters in the cast of characters that constitute economic analysis. They have long been recognized as occupants of the apex of the hierarchy that determines the behavior of the firm and, thereby, bears a heavy responsibility for the vitality of the free enterprise society. This is no recent phenomenon: in the writings of the classical economists, entrepreneurs appeared at least occasionally, though they remained a shadowy entity with no clearly distinguished form or function. Only Schumpeter, and to some degree, Say, succeeded in infusing entrepreneurs with life, assigning them the task of innovation as a specific area of activity that is commensurate with their acknowledged importance. In more recent years, the accumulating facts underscore the significance of their role,¹ but, at the same time, they have disappeared from the theoretical literature. In discussions of the doctrinal history of entrepreneurship theory, the consensus view now seems to be that there once was a theory of entrepreneurship found in the writings of the classical economists, but with the advent of neoclassicism, the entrepreneur was exorcised from that literature.²

However, a review of the literature should lead to some modification of these views, particularly those about the earlier period. First, the set of authors who constitute the “usual suspects” hardly includes all of the superstars of the classical arena. Neither Smith nor Ricardo typically is listed as a significant contributor on the subject. Instead, they frequently are replaced in this role by Cantillon and Say. Second, careful perusal of what these early authors have written on the subject should lead to the conclusion that, as far as theory—particularly of the neoclassical variety—is concerned, “There is no there, there.” The writings offer us brief descriptions of the activities of the entrepreneur, such as organizing new firms and undertaking risky investments. But that surely is no more theoretical than a theory of labor that tells us carpenters are laborers and use saws to cut lumber. The material is brief—strikingly so—because, arguably, it contains nothing that can reasonably be taken to constitute operational theory.

This is not mere quibbling about the true definition, or connotation, of the word “theory.” Rather, this highlights an important point about what we have a right to expect from work that qualifies as “theory.” In the academic literature, the term is taken to mean two interrelated things. First, it can be interpreted to refer to a formalized and deliberately oversimplified version of some phenomenon, which, in its simplicity, reveals that phenomenon’s basic working mechanism. Second, a theory is interpretable as a machine that can be used to generate operational theorems, which can assert that an increase in the magnitude of one variable—the relevant interest rate, for instance—will, other things remaining equal, lead to a new equilibrium in which the magnitude of another variable—say, investment by firms—decreases.

I will argue that Schumpeter and a few others who have been working since the appearance of his writings have created the beginnings of an operational theory of entrepreneurship. However, impediments created by the very nature of this topic, at least so far, have limited what we are able to provide by way of theory. Indeed, these handicaps have all but prevented a formal mathematical analysis, up to this point. Still, I aim to show that now we can provide a theory of innovative entrepreneurship that is at least as powerful as the theory of labor and wages, for example. If it is desirable for students of entrepreneurship to ground their learning in theory, there already exists substantial material with which to get them started.

First, however, we will look briefly, and rather superficially, into the doctrinal history and then consider whether the absence of the innovative entrepreneur from much of standard microtheory is, indeed, a needless failing of this body of analysis. After that, I will outline specifically what we can hope to obtain from a theory of entrepreneurship. Then we will examine the obstacles that impede it. Finally, we will turn to the most significant part of the discussion: what has already been accomplished in this arena, and what directions for future work appear to be most promising. Later chapters will turn to the substance of my immodest claim that this book provides at least the beginnings of a theoretical structure that can fit entrepreneurship into the mainstream microtheory of value that has long been the focus of microeconomic analysis.

ENTREPRENEURSHIP: ORIGINS AND EARLY WRITINGS ON THE TOPIC

Until the twentieth century, writings in English referred to entrepreneurs as “adventurers” or “undertakers” (see, e.g., Marshall 1923, 172). The term “entrepreneur” was introduced by Richard Cantillon in the translation into French (suspected to have been carried out by Cantillon himself) of his great work (1755, 54). However, his original English text continues to use the appellation “Undertaker.”³

These early writings were more descriptive than theoretical. Cantillon’s discussion in chapter 13, for instance, is brief, focusing on entrepreneurs who create new firms that may not be innovative, such as “wholesalers in Wool and Corn, Bakers, Butchers, Manufacturers and Merchants of all kinds” (51). Like Knight, Cantillon’s main point is the risk involved in the entrepreneur’s task:

These Undertakers can never know how great will be the demand in their City, nor how long their customers will buy of them since their rivals will try all sorts of means to attract customers from them. All this causes so much uncertainty among these Undertakers that every day one sees some of them become bankrupt. (51)

Writing nearly a century later, J. B. Say offers a similarly brief, but richer, discussion. In contrast to Cantillon, Say seems interested primarily in innovating entrepreneurs and, among them, he focuses on three types of “producers”: scientists, entrepreneurs, and laborers. Using locks as an example, Say describes the scientist as the investigator of “the properties of iron, the method of extracting from the mine and refining the ore,” while entrepreneurs deal with “application of this knowledge to an useful purpose,” and the third group, the workers, actually make the product (1827, 20). According to Say, any successful economy needs all three: “Nor can [industry] approximate to perfection in any nation, till that nation excel in all three branches” (21). Thus, Say blames poverty in Africa, for instance, on that continent’s lack of scientists and entrepreneurs. He is careful to note, however, that even with abundant scientific knowledge, a lack of entrepreneurs, alone, can undercut prosperity, for without the entrepreneur, “that knowledge might possibly have lain dormant in the memory of one or two persons, or in the pages of literature” (22).⁴ Say also gives us a hint of Schumpeter’s analysis, which I will summarize briefly later in this chapter. “In manufacture . . . if success [in innovation] ensue[s], the adventurer is rewarded by a longer period of exclusive advantage” (24). Finally, Say mentions the spillovers of innovation, which, he proposes, justify their governmental financing:

The charges of experiment, when defrayed by the government . . . [are] hardly felt at all, because the burthen is divided among innumerable contributors; and the advantages resulting from success being a common benefit to all, it is by no means inequitable that the sacrifices, by which they are obtained, should fall on the community at large. (25–26)

Before Joseph Schumpeter’s breakthrough, the theory of entrepreneurship was touched upon by economists like J. S. Mill, Alfred Marshall, and (a bit later) Frank Knight. Generally, their focus was not on innovative entrepreneurship;⁵ they emphasized management’s role in directing going concerns, rather than in establishing new firms. Today, however, these discussions would hardly be considered theory. Rather, they usually are narratives containing illuminating observations. For example, they assert that the entrepreneur’s payment is a residual after other inputs are compensated and that compensation is determined by the entrepreneur’s ability and the supply of entrepreneurship in the market. They also note that the occupation is risky and that entrepreneurs employ themselves, so that unlike other inputs, there is no demand function for their services. Beyond this, however, they offer little.

ABSENCE OF THE ENTREPRENEUR FROM STATIC THEORY OF THE FIRM AND PRODUCTION

Contrast even these limited observations with the entrepreneur’s almost total lack of place in modern formal theory. Look for the innovative entrepreneur, or the entrepreneur of any sort, in the index of some of the most noted of recent writings on value theory, in neoclassical rent theory, or on activity analysis models of the firm.⁶ The references are scanty—if not totally absent. Expunged from the discussion, the entrepreneur has become as invisible as Ralph Ellison’s famous character.

It is not difficult to explain the entrepreneur’s absence. Consider the nature of the model of the firm. In its simplest form (and in this respect, the more complex, sophisticated models are no better), the theoretical firm must choose among alternative values for a small number of rather well-defined variables: price, output, investment in plant and equipment, and perhaps advertising outlay. In making these choices, management is taken to consider the costs and revenues associated with each candidate set of quantities, as described by the relevant functional relationships, equations, and inequalities. Explicitly or implicitly, the firm then performs a mathematical calculation that yields optimal (i.e., profit maximizing) values for all of its decision variables. These values, which the theory assumes to be chosen, are taken to constitute the business decision. Matters rest there, at the values selected by the optimization process, and will remain so forever, or until exogenous forces lead to an autonomous change in the firm’s environment. Until there is such a shift in one of the relationships that define the problem, the firm implicitly is taken to replicate its previous decisions, day after day, year after year.

The innovative entrepreneur is excluded from this model, which leaves no room for enterprise or initiative. As a result, the management group becomes a passive calculator that reacts mechanically to changes imposed on it by fortuitous external developments over which it does not attempt to exert any influence. One encounters no clever ruses, ingenious schemes, brilliant innovations, charisma, or any of the other stuff of which outstanding entrepreneurship is made. There simply is no way in which these elements can fit into this model.⁷

Nor can the practical pertinence of the decision variables make the difference in carving out a place for the entrepreneur. Already there are maximization models in which, instead of prices and outputs, the decision variables are the firm’s real investment program, its financial mix (the proportion of equity and debt in its funding), or the attributes of a new product to be launched by the company. These decisions seem to smell more of the ingredients of entrepreneurship. But though such models may serve their objective well, they take us not a whit further in the analysis of innovative entrepreneurship, for their calculations remain mechanistic and automatic and call for no display of innovative initiative. Here it is important to emphasize that the timeless nature of these models has nothing to do with the invisibility of the entrepreneur. Professor Griffith Conrad Evans (1924) long ago constructed a model based on the calculus of variations in which the firm considered the consequence of its decisions for the time path of prices. In a number of more recent models, the firm chooses an optimal growth rate, rather than a stationary, once-and-for-all output level. But none of these alternatives helps matters. In all of these models, the businessmen are automaton maximizers, and automaton maximizers they remain.

This suggests why our body of theory, as it has developed, offers us no promise of being able to deal effectively with a description and analysis of the entrepreneurial function. Because maximization and minimization constitute the near ubiquitous foundation of the microtheory, the theory is deprived of the ability to provide an analysis of entrepreneurship.

There are at least two very good reasons why the entrepreneur virtually is never mentioned in modern theory of the firm and distribution. The first, and less significant, reason is summarized in what I call “Baumol’s Third Tautology.” According to this view, innovation is an entirely heterogeneous output—production of yesterday’s invention is today’s mere repetition. By such reasoning, there are no commeasurable items that can be added up, compared in magnitude, or otherwise quantitatively manipulated as, for example, we can add together the outputs of some commodity in different months of the year and analyze the effect of changes in prices on these totals. Simply put: in an analysis of entrepreneurial activities, there are none of the homogeneous elements that lend themselves to formal mathematical description, let alone the formal optimization analysis that is the foundation of the bulk of microeconomic theory.

The more critical explanation of the absence of the entrepreneur is that in mainstream economics, the microtheory generally is composed of equilibrium models in which, structurally, nothing is subject to change. By definition, however, this excludes innovative entrepreneurs. They are absent from such an innovationless model because they do not belong there—there is no task for them to carry out. This has been argued definitively by Schumpeter (1936) and Kirzner (1979), who demonstrated that sustained equilibrium is not tolerated by innovative entrepreneurs—any more than they tolerate sustained disequilibrium. Here Schumpeter’s key insight is that the entrepreneur’s occupation, in itself, is the search for profitable opportunities to upset any equilibrium—which is exactly what any innovation, in the broadest sense, entails. The rest of the story is told by Kirzner, who recounts that the entrepreneur, with her cri...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of Figures and Tables
• Preface: The Innovative Entrepreneur in Dynamic Microtheory
• Introduction: Bringing Entrepreneurship and Innovation into the Theory of Value
• Chapter 1: Entrepreneurship in Economic Theory: Reasons for Its Absence and Goals for Its Restoration
• Part I: Pricing, Remuneration, and Allocation of the Agents of Innovation
• Part II: Welfare Theory: Technology Transfer, Imitation, and Creative Destruction
• Part III: Institutions, Payoffs, and the Entrepreneur’s Choice of Activity: Historical Origins
• Notes
• References
• Index