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THE VISIBLE HAND

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ECONOMICS AND ENTREPRENEURSHIP MAY BE TWINS BUT THEY ARE NOT IDENTICAL TWINS

Prof. Henry M. Bwisa ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it )

 

In recent times I have had occasion to read research proposals by PhD students of entrepreneurship from my own university €“ The Jomo Kenyatta University of Agriculture and Technology and other universities. A good number of the proposals fail to make the fine distinction between economics and entrepreneurship. Yes, economics and entrepreneurship are both about creation of wealth. They both deal with the firm, the process of production and profit. They both feature factors of production with entrepreneurship being regarded as a fourth factor of production. The scholars regarded as founders of modern entrepreneurship are themselves economists. To this end the two €“ entrepreneurship and economics - may be regarded as twins. They are however not identical twins.

This short paper identifies the economics theory of the firm with its market forces sub-theory as a key aspect of divergence between economics and entrepreneurship. The paper starts by looking at the classical economics, and in particular the contribution of Adam Smith, in relation to entrepreneurship before zeroing in on the theory of the firm. It then covers Schumpeter€™s and Kirzner€™s contributions to entrepreneurship before concluding with lessons learned. The main objective of this paper is to provoke scholarly debate on convergences and divergences between economics and entrepreneurship.

CLASSICAL ECONOMICS

Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill.  Adam Smith's €œThe Wealth of Nations€ in 1776 is usually considered to mark the beginning of classical economics. He is credited with the term €œinvisible hand€ which he used to describe the natural force that guides free market capitalism competition for scarce resources. Economics heavily (or should it be entirely?) borrows from this invisible hand. 

According to Adam Smith, in a free market each participant will try to maximize self-interest, and the interaction of market participants, leading to exchange of goods and services, enables each participant to be better off than when simply producing for oneself. Adam Smith further said that in a free market, no regulation of any type would be needed to ensure that the mutually beneficial exchange of goods and services took place, since this "invisible hand" would guide market participants to trade in the most mutually beneficial manner. Economists have loyally and obediently accepted these teachings and continue to advocate for price decontrols. As we shall see shortly the issue of invisible hand also known in economics theory as market theory and also as price theory marks a striking divergence between economics and entrepreneurship. 

ECONOMICS

Economics is highly theoretical.  Just to remind the reader a theory is a general statement of cause and effect, action and reaction.  Theories involve models, and models involve variables. A model is a formal statement of a theory.  Models are descriptions of the relationship between two or more variables. Using the ceteris paribus, or all other things held constant, assumption economics studies the relationship between two variables while the values of other variables are held unchanged. The ceteris paribus device is part of the process of abstraction used by the economists to focus only on key relationships as though other relations did not matter. This helps understand complex phenomena without necessarily reflecting the reality.

Virtually all economic models attempt to abstract from complex human behaviour in a way that sheds some very useful insight into a particular aspect of that behaviour.  However the process inherently ignores important aspects of real-world behaviour. This makes economics modelling process a very good art and mathematical exercise. Let us take an example €“ the economists€™ equilibrium model.

THE GENERAL EQUILIBRIUM MODEL

The general equilibrium theory is a branch of theoretical neoclassical economics. It studies economies using the model of equilibrium pricing and seeks to determine under which circumstances the assumptions of the general equilibrium will hold. The theory dates to the 1870s particularly to the work of French economist Leon Walras. This theory seeks to explain the behaviour of supply, demand and prices in a whole economy with several or many markets, by seeking to prove that equilibrium prices for goods exist and that all prices are at equilibrium.

ACKNOWLEDGEMENT

It should be acknowledged that the concept of an economic equilibrium is fundamentally very complex and subtle.  The goal is to derive the outcome when the agents described in a model complete their process of maximizing behaviour.  Determining when that process is complete, in the short run and in the long run, is an elusive goal as successive generations of economists rethink the strategies that agents might pursue.

At its simplest, however, we often find equilibrium at the intersection of two or more lines.  The explanation is given as: suppose line A represents the optimizing behaviour of one group of agents, and suppose line B represents the optimizing behaviour of another group of agents.  Then, the intersection of lines A and B is the equilibrium where both groups of agents are optimizing.

The classic example in economics is supply and demand.  The supply curve shows the quantity supplied at a given price by profit-maximizing firms.  The demand curve shows the quantity demanded at a given price by utility-maximizing consumers.  The intersection of the supply curve and the demand curve is the point that maximizes both profits and utility

Price of market balance: 

P - Price

Q - Quantity of good

S €“ Supply curve

D €“ Demand curve

P0 - Price of market balance

A - Surplus of demand - when P<P0

B - Surplus of supply - when P>P0

 

 

Economics illustrated

 

The economics €œin the long run€ equilibrium model

According to economists, should the price of a good increase for any reason more people will start producing this good. They do this out of self interest, tempted by the high sales price, but it also benefits society as a whole since the larger supply will make the goods available to more buyers and this will drive the price down again. According to economics theory the invisible hand (NOT A HUMAN BEING!!) puts more resources into producing goods for which there is a shortage, as evidenced by high profit margins, at the expense of goods for which there is a surplus, as evidenced by low or negative profit margins. And the invisible hand keeps doing these adjustments continuously without anyone planning or ordering that society should produce more of what it needs and less of what it doesn't need.  

We filter from the above said that the neoclassical theory of the firm that forms the basis of the shown competitive general equilibrium model has no place for the entrepreneur. In economics textbooks, the €œfirm€ is a production function or production possibilities set; a €œblack box€ that transforms inputs into outputs. The firm is modelled as a single actor, facing a series of decisions that are portrayed as uncomplicated: what level of output to produce, how much of each factor to hire, and the like. Scrutinized very closely these €œdecisions,€ are not really decisions at all; they are mere mathematical calculations, implicit in the underlying data.

OBSERVATIONS

Two key observations about the shown equilibrium model cannot go unnoticed. One €“ the model uses a demand curve. The curve is based on a law that states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good.  The factors that should be held constant include:

i) Price of a substitute

Substitutes are goods in competitive demand and act as replacements for another product. For example, a rise in the price of Zain mobile phone services should cause a substitution effect away from Zain towards Safaricom or other competing services. 

ii) Price of a complement

A complement tends to be bought together with another good. Two complements are said to be in joint demand. Examples include: fountain pen and ink, DVD players and DVD's,. A rise in the price of a complement to Good X should cause a fall in the demand for X. For example a decrease in the cost of flights from Nairobi to Mombasa would cause an increase in the demand for hotel rooms in Mombasa and also an increase in the demand for airport-based taxi services both in Nairobi and Mombasa.

iii) Income of consumers

Most of the things we buy are normal goods, that is, more is bought when income rises. When an individual's income goes up, their ability to purchase goods and services increases even when there are no changes in prices and this causes an outward shift in the demand curve. When incomes fall, there will be a decrease in the demand for most goods.

iv) Tastes and preferences

Tastes can often be volatile leading to a change in demand. An example would be demand for British beef during the mad cow disease outbreak. Advertising is designed to change the tastes and preferences of consumers and thereby causes a change in demand. Thus Kenyan blue band and coca cola advertising creates more appetite in children who in turn ask their parents to buy the items. The Kenyan banking and TV industries, as other industries, use heavy advertisement to try to influence consumer preferences.

v) Interest rates

Many goods are bought on credit using borrowed money and therefore the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Central Bank of Kenya decides to raise interest rates - the demand for many goods and services may fall. Examples of "interest sensitive" goods include new furniture and motor vehicles. The demand for new homes is affected by changes in mortgage interest rates.

These examples are designed to show that in reality not many things are held constant. In fact the only constant is change. Consequently much as the law of demand helps us understand complex behaviour it may not be realistic.

The second observation is that the equilibrium situation is based on perfect competition conditions. A perfectly competitive market may have several distinguishing characteristics, including:        

 i.            Infinite Buyers/Infinite Sellers €“ Infinite consumers with the willingness and ability to buy the product at a certain price, Infinite producers with the willingness and ability to supply the product at a certain price.      

 ii.            Zero Entry/Exit Barriers €“ It is relatively easy to enter or exit as a business in a perfectly competitive market.     

 iii.            Perfect Information - Prices and quality of products are assumed to be known to all consumers and producers. With perfect knowledge, there is no scope for competition or entrepreneurship. The theory of perfect competition, which assumes perfect information, has no relation to competition (the process), except possibly as the result of competition, after the process has completed its course.    

iv.            Transactions are Costless - Buyers and sellers incur no costs in making an exchange.       

v.            Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.    

vi.            Homogeneous Products €“ The characteristics of any given market good or service do not vary across suppliers

In general a perfectly competitive market is characterized by the fact that no single firm has influence over the price of the product it sells. These conditions are clearly unrealistic in many economies. So the equilibrium is an ideal situation difficult to realize. If this does not make sense to you then allow me paraphrase my argument. The model of perfect competition is the situation in which every market participant does exactly what everyone else is doing, in which it is utterly pointless to try to achieve something in any way better than what is already being done by others, and in which, in fact, it is not necessary to keep one's eyes open to what the others are doing at all. Is this a reality? Let me now provoke debate by suggesting that since the government of Kenya decontrolled prices in the late 1980s early 1990s the country has not witnessed an equilibrium price in any single product on the market.  

ENTREPRENEURSHIP

Let us now look at the entrepreneur€™s response to the issues outlined above. In doing so I want to advance the philosophy that €œevery entrepreneur is a business person but not all business people are entrepreneurs€.

The entrepreneur is an actor in microeconomics, and the study of entrepreneurship reaches back to the work of Richard Cantillon and Adam Smith in the mid-16th century, but was largely ignored theoretically until the late 19th and early 20th centuries and empirically until a profound resurgence in business and economics in the last a half a century or so. That explains why the modern theory of the firm is void of an entrepreneur as a unit of analysis.

In the 20th century, the understanding of entrepreneurship owes much to the work of economist Joseph Schumpeter in the 1940s and other Austrian economists such as Israel Kirzner, Carl Menger, Ludwig von Mises and Friedrich von Hayek.

SCHUMPETERIAN ENTREPRENEURSHIP

To Schumpeter, an entrepreneur is a person who is willing and able to convert a new idea or invention into a successful innovation. Entrepreneurship employs what Schumpeter called "the gale of creative destruction" to replace in whole or in part inferior innovations across markets and industries, simultaneously creating new products including new business models. In this way, creative destruction is largely responsible for the dynamism of industries and long- term economic growth. Innovations in the information and communications technology (ICT) industry are glaring examples of modern day constructive destruction. Indeed it can be claimed that the difference between developed and developing nations is very much in their level of entrepreneurship.

Despite Schumpeter's early 20th-century contributions, traditional microeconomic theory did not formally consider the entrepreneur in its theoretical frameworks (instead assuming that resources would find each other through a price system). The €œincreasingly rigorous analytical treatment€ of markets, notably in the form of general equilibrium theory, not only made firms increasingly €œpassive,€ 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 (O€™Brien, 1984). In particular, the development of what came to be known as the €œproduction function view€ (Williamson, 1985; Langlois and Foss, 1999) €” roughly, the firm as it is presented in intermediate microeconomics textbooks with its fully transparent production possibility sets €” was a deathblow to the theory of entrepreneurship in the context of firm organization. If any firm can do what any other firm does (Demsetz, 1991), 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 no room for entrepreneurship

Probably the best-known concept of entrepreneurship in economics is Joseph Schumpeter€™s idea of the entrepreneur as innovator. Schumpeter€™s entrepreneur introduces €œnew combinations€€” new products, production methods, markets, sources of supply, or industrial combinations €” shaking the economy out of its previous equilibrium through a process Schumpeter termed €œcreative destruction.€ The entrepreneur-innovator is introduced in Schumpeter€™s ground-breaking Theory of Economic Development (1911) and developed further in his two-volume work, Business Cycles (1939). Realizing that the entrepreneur has no place in the general-equilibrium system of Walras, whom Schumpeter is said to have greatly admired, Schumpeter gave the entrepreneur a role as the source of economic change. €œ[I]n capitalist reality as distinguished from its textbook picture, it is not [price] competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization . . . competition which commands a decisive cost or quality advantage and which strikes not at the margins of profits and the outputs of existing firms but at their foundations and their very lives€ (Schumpeter, 1942: 84).

If classical economists equated an entrepreneur to a capitalist then Schumpeter carefully distinguished the entrepreneur from the capitalist (and strongly criticized the neoclassical economists for confusing the two). His entrepreneur need not own capital, or even work within the confines of a business firm at all. While the entrepreneur could be a manager or owner of a firm, he is more likely to be an independent contractor or craftsman. In Schumpeter€™s conception, €œpeople act as entrepreneurs only when they actually carry out new combinations, and lose the character of entrepreneurs as soon as they have built up their business, after which they settle down to running it as other people run their businesses€ (Ekelund and Hébert, 1990: 569). It is important that before we lose this strand of thought we reflect on the reason many Kenyans give for not owning a business as lack of start up capital and relate the same to the above philosophy that every entrepreneur is a business person but not all business people are entrepreneurs.

There is a rather tenuous relationship between the entrepreneur and the firm he owns, works for, or contracts with. Entrepreneurship is exercised within the firm when new products, processes, or strategies are introduced, but not otherwise. The day-to-day operations of the firm need not involve entrepreneurship at all. More-over, because Schumpeterian entrepreneurship is sui generis, independent of its environment, the nature and structure of the firm does not affect the level of entrepreneur-ship. Corporate R&D budgets, along with organizational structures that encourage managerial commitment to innovation (Hoskisson and Hitt, 1994), have little to do with Schumpeterian entrepreneurship per se.  

KIRZNER€™S ENTREPRENEURSHIP

Professor Israel Kirzner€™s theory of entrepreneurship uses the methods of Austrian Economics to explain the function of the man who perceives and pursues economic opportunities in the face of uncertainty. Kirzner describes alertness as the fundamental quality of the entrepreneur. Alertness is the entrepreneur€™s ability to perceive new economic opportunities that no prior economic actor has yet recognized. The entrepreneur might foresee demand for a new product that has not hitherto been manufactured; he might then decide to manufacture that good himself. Alertness may also involve the entrepreneur€™s detection of arbitrage opportunities on the market: opportunities to sell the same factor of production for a higher price than he bought it. The entrepreneur€™s alertness detects arbitrage opportunities by recognizing that certain factors of production are underpriced; he then proceeds to act on this knowledge to earn profit.

Kirzner posits that the entrepreneurial function is possible due to the presence of sheer ignorance on the part of some economic actors. Sheer ignorance, in Kirzner€™s definition, consists of not only not knowing a given piece of information but also of not knowing that one does not know it.

The entrepreneur constantly remedies sheer ignorance and corrects sheer error. Through his alertness, the entrepreneur foresees economic developments that other actors have overlooked; he also recognizes where the other actors€™ lack of information has created mistakes in the price structure and hence arbitrage opportunities for him.

We here summarize Kirzner€™s above line of argument and particularly in relation to the equilibrium model to mean that entrepreneurship is alertness to unnoticed price opportunities. Entrepreneurs exploit these opportunities, and through competition with each other, eliminate them. The market process is inherently entrepreneurial because individuals learn from their participation in the market.

Many analysts see an apparent contradiction between Schumpeter and Kirzner on equilibrium. Whereas Schumpeter says the entrepreneur disrupts the equilibrium Kirzner says the entrepreneur restores equilibrium. Rather than contradiction I see complementarity, dialectics and even synergy. Thus Schumpeter€™s theory sees the entrepreneur as an innovator. The innovator acts in equilibrium, disturbing it with innovations and creating opportunities. Kirznerian theory takes over when the disequilibrium is created. An alert entrepreneur notices the disequilibrium and acts on it in the direction of restoring it.

Let us start with an equilibrium situation and two entrepreneurs €“ the Schumpeterian and Kirznerian. The equilibrium means that there is a status quo in the market. Schumpeter€™s innovative entrepreneur dissatisfied with homogeneity brings in new combinations including product differentiation. This constructively destroys the equilibrium and influences consumer preferences. After introduction the Schumpeterian entrepreneur grows and starts to earn entrepreneurial profit which is defined in economics as compensation for the expertise and successful effort of a skilled businessperson. Kirzner€™s alert entrepreneur notices the opportunity to share in the entrepreneurial profit and realizes the opportunity. Competition is created and as the Schumpeterian entrepreneur reaches maturity the Kirznerian entrepreneur enters growth. This tends to push back the market to equilibrium as postulated by Kirzner.  But the Schumpeterian entrepreneur refuses to enter decline and keeps innovating and before the new equilibrium is achieved new combinations are created. This Schumpeter-Kirzner-Schumpeter-Kirzner or S-K-S-K process continues causing economic growth. This is illustrated in the business life cycle adapted from the textbook product life cycle and diagrammed below.

 

 

BUSINESS LIFE CYCLE

 

We can also take off from Kirzner€™s standpoint. The market is already in disequilibrium, so says Kirzner. Therefore opportunities already exist, and Kirzner€™s alert entrepreneur notices (not creates) them. Kirzner€™s could be any of the many non-innovative entrepreneurs such as imitators. The €˜imitators€™ restore equilibrium (through price competition). The innovative entrepreneurs start disrupting the equilibrium (through quality competition). Both imitators and innovators are equally entrepreneurial, and both act on the equilibrium. They supplement and complement one another. 

LESSONS

1.      The first lesson we ought to learn is that entrepreneurship is distinctive form economics although they may have a common root in the social science family.

2.      In real life prices of substitutes and complements of goods do change and so do incomes, tastes and preferences of consumers. Interest rates do not remain constant for a long time. That these conditions do not remain constant means that the law of demand which holds only when they are held constant cannot be realistically applied in entrepreneurship.

3.      The real life characteristics are such that there are many more buyers of a good than there are sellers giving the sellers an upper hand in price determination. At the same time there exist barriers of entry into many businesses and there is imperfect information on the market. In many cases sellers withhold certain information as the case happens in cartels. Transaction costs are often high and cases are known where firms do not necessarily aim at maximizing profits and entrepreneurial business people employ innovation to differentiate their products and services. The real life situation is therefore void of the characteristics of a perfect market which is supposed to give birth to the micro economics equilibrium model.

4.      While the Schumpeterian entrepreneur disrupts the equilibrium the Kirznerian entrepreneur engages in its restoration. Together the two defeat the static characteristics of a perfect market model as they destroy the homogeneity of the product by converting it into product differentiation. The innovating entrepreneur tends to be monopolistic in that he/she possesses intellectual property naturally or artificially protected from others. This leads to imperfect knowledge on the market and creates room for the entrepreneur to influence prices. The entrepreneur therefore becomes the €œvisible hand€ as opposed to Adam Smith€™s €œinvisible hand€. 

My proposal for debate: Economics is the theoretical aspect of entrepreneurship and entrepreneurship is the practical aspect of economics.

REFERENCES

Demsetz, Harold. 1991. €œThe Theory of the Firm Revisited,€ in Oliver E. Williamson and Sidney G. Winter, eds. 1993. The Nature of the Firm, Oxford: Blackwell.

Ekelund, Robert B., Jr., and Robert F. Hebert. 1990. A History of Economic Thought and Method, third edition. New York: McGraw-Hill

Hoskisson, Robert F., and Michael A. Hitt. 1994. Down scoping: How to Tame the Diversified Firm. New York: Oxford University Press 

Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago: University Press of Chicago.

Langlois, Richard N. And Nicolai, J. Foss. 1999. €œCapabilities and Governance: The Rebirth of Production in the Theory of Economic Organization,€ KYKLOS

O€™Brien, Dennis. 1984. €œThe Evolution of the Theory of the Firm,€ in idem. 1984. Methodology, Money and the Theory of the Firm, Vol. 1. Aldershot.

Schumpeter, Joseph A. 1911. The Theory of Economic development: An inquiry into Profits, Capital, Credit, Interest and the Business Cycle. Translated by Redvers Opie. Cambridge, Mass., Harvard University Press, 1934

Schumpeter, Joseph A. 1939. Business cycles: A theoretically Historical and Statistical Analysis of the Capitalist Process. Ney York: McGraw-Hill

Schumpeter, Joseph A. 1942. Capitalism, Socialism and Democracy. New York: Harper & Row

Williamson, Oliver E. 1985. The Economic Institutions of Governance. New York: Free Press.

 

Last Updated ( Friday, 08 January 2010 13:19 )  

THOUGHT

Entrepreneurship is the practice of starting new organizations or revitalizing mature organizations, particularly new businesses generally in response to identified opportunities. Entrepreneurship is often a difficult undertaking, as a vast majority of new businesses fail.

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