Lecture 3 Classical Theories of Entrepreneurship Understanding Schumpeter

Lecture 3 Classical Theories of Entrepreneurship: Understanding Schumpeter, Kirzner & Knight Vartuhi Tonoyan & Michael Woywode April 1, 2008 © Vartuhi Tonoyan 2008 All rights reserved. No reproduction, copy or transmission of these slides may be made without written permission 1

1. Who Is an Entrepreneur? Classical Theories of Entrepreneurship: Understanding Schumpeter, Kirzner & Knight 1. 1. ‘The Theory of Economic Development’ (Schumpeter 1934) 1. 2. ‘Entrepreneurial Discovery & Competitive Market Process: An Austrian Approach’ (Kirzner 1997) 1. 3. Comparison between Kirznerian & Schumpeterian Opportunities 1. 4. ‘Risk, Uncertainty and Profit’ (Knight 1921) 2

1. 1. ‚Theory of Economic Development‘ by J. A. Schumpeter (1911, 1934) Joseph Alois Schumpeter developes „The theory of economic development“ („Theorie der wirtschaftlichen Entwickling“) in 1911 - interested to know how capitalism administers existing structures, but, also, how it creates and destroys them - economic development is a dynamic process: it is a disturbing of the economic status quo! - entrepreneurs do not operate within conventional technological constraints to make small changes, but develop new technologies & products that make changes to the existing economic paradigm 3

1. 1. ‚Theory of Economic Development‘ by J. A. Schumpeter (1911, 1934) 1) Entrepreneur as „innovator“ „The nature of entrepreneurial function lies in the discovery of new economic opportunities“ 2) Entrepreneur as a ‚disequilbrium force‘ Through a „creative destruction“ the entrepreneur brings economy out of the equilibrium - The‚creative destruction theory‘ is built upon dynamic, deliberate entrepreneurshial efforts to change market structures (cf. with a static concept of market equilibrium in neo-classical models) - Entrepreneur is the core of the ‚creative destruction theory‘ (but he is fully absent from neo-classical models) 4

„Creative destruction“ occurs when an entrepreneur sets up a new business, using innovations to enter an existing market dominated by a few large enterprises The innovative new firm grows through a dual process of i) increasing overall demand for the products (or services) ii) taking market share from existing suppliers While a new firm expands overall economic activity, it re-distributes wealth by destroying existing market structure and thus shifting market shares from existing large firms to itself The creation of innovations and new wealth combined with the destruction of market structures is called a „creative destruction“ process 5

5 Types of Innovation by Josef Schumpeter 1. the introduction of a new good or quality of a good Example: a new accounting software (see also Case Studies) 2. the introduction of a new method of production –“something yet untried in industry“ Example: new surgical devices; new methods of car production 3. the opening of a new market Example: the introduction of Chinese snack crackers in Europe/US 4. the utilization of a new source of supply for raw materials or intermediate goods Example: the discovery of oil as a new raw material 5. the carrying out of new organizational forms of industry Example: the Internet made possible the organization of economic activity without bricks and mortar locations 6

Examples of New Products Introduced by New Enterprises into the Market • Air conditioning • Laptop • Cellophane • Biosynthetic insulin • Tape recorder • Soft contact lenses • Anti-baby pill • Microprocessor • DNA ‚fingerprint‘ • Polaroid camera • Internet browser Source: Prof. Dr. Michael Fritsch, Seminar „Entrepreneurship“, http: //www. wiwi. unijena. de/uiw/index. html 7

Distinction between „arbitrage-entrepreneur“ & „innovative entrepreneur“ Personal Traits of a Dynamic & Innovative Entrepreneurial traits are not teachable; only a small percentage of individuals has entrepreneurial abilities the entrepreneur (opposed to a manager or resource owner) has the „view“ & „the intuition“ to do the right things he has the power to create something new he has the power to overcome scepticism and hostility from his or her surrounding environment (Ripsas 1998) Schumpeter (1912: 138) viewed entrepreneurs as individuals who not only try to secure high incomes and wealth, but also pursue noneconomic goals, such as - striving toward a powerful position in the society pleasure in being creative wish for success 8

3 Sources of Schumpeterian Opportunities Source: Shane (2003: 23) 9

1) Technological change makes it possible to allocate resources in different and potentially more productive ways (Casson 1995) Example: Before the invention of Internet, resources were allocated by the use of facsimile, letter & phone communications. The invention of the electronic mail & Internet has reduced the firm transaction costs, making the ways of production more effective Empirical evidence: - Examining self-employment rates in the US during 1952 -1980, Blau (1987) finds that an increase in the rate of technological change led to an increase in self-employment - Shane (1996) finds that the rate of technological change (measured as annual number of new patents issued) had a positive impact on the number of organizations per capita in the subsequent year during 1899 -1988 - Klevorick et al. (1995) shows that industries with closer ties to science have higher number of self-employment 10

2) Political and regulatory changes (political turmoil, de-regulation & privatization) make it possible to re-allocate resources to new uses in ways that are either more profitable or re-distribute wealth from one member of society to another Examples: The US government‘s de-regulation of the electric utility, telecommunications, airline, trucking, railroad and banking industries created new markets and changed the way profits were made (Shane 2003: 25 -27) Empirical evidence: - Kelly (1988) finds that the rate of airline formation in the US increased after the de-regulation of the airline industry - Carrol & Huo (1986) find that political turmoil (and change) during 1800 and 1925 had positive effects on the formation of new firms in the newspaper industry in the US 11

3) Socio-demographic changes are important sources of opportunity since - they transfer information about ways on how to allocate resources in different and potentially more productive ways - they create the potential for scale economies necessary for some types of entrepreneurial activities and - they generate additional demand (Shane 2003: 28 -29) Types of socio-demographic changes 3. a) urbanization 3. b) population dynamics 3. c) educational infrastructure 12

3. a) Urbanization - Communication is greater in more densely populated areas, thus facilitating the transmission of information about entrepreneurial opportunities in urban areas - Urbanization also increases the number of entrepreneurial role models, facilitating information transfer from observation - Urbanization means higher demand because of the population number - It also creates the potential for the scale economies Empirical evidence: - Schiller & Crewson (1997) find that being in an urban area increases the likelihood of entering self-employment for men in the US - Examining self-employment among African-Americans, Boyd (1990) finds that being located in the city center increases the probability of would-be selfemployed 13

3. b) Population dynamics Population size: the fixed cost necessary for the opportunity to occur is amortized over more demand in places with larger populations, making opportunities that would not exist in places with lesser population possible in places with greater population Population growth: Population growth increases the likelihood that scale economies will be achieved. It also generates demand growth Population mobility: By moving, people carry the information that makes opportunities possible from one location, where an opportunity has been recognized and acted upon, to another location, where it has not been recognized or exploited yet 3. c) Educational infrastructure Educational institutions conduct scientific research that results in the creation of new knowledge which is the basis for some entrepreneurial opportunities (e. g. „academic spin-offs“) 14

1. 2. Entrepreneurial discovery & competitive market process: An Austrian approach (Kirzner 1997) Israel Meir Kirzner developes a concept of economics of e-ship, emphasizing the role of the entrepreneurial discovery („entrepreneurial alertness“) and the competition among entrepreneurs as equilibrating forces of the economy 1) Kirzner‘s criticism of neo-classical microeconomics i) the constrained maximization pattern is imposed upon individuals ii) prices and products/resource qualities are taken as given to each decision makers & are independent of the decisions made iii) neglect of the entrepreneur in neo-classical theory 2) Emphasis on entrepreneur in the Austrian school The neo-classical decision maker operates in a world of given price and output data. In contrast, the Austrian entrepreneur operates to change price/output data. In this way, the entrepreneurial role drives the everchanging process of the market 15

„In this neo-classical context, there is no room for entrepreneurship in the sense that no opportunities for pure profit can possibly exist, “. . . and „that the model precludes all Knightian uncertainty that might affect the character of the individual decision“ Moreover, „boldness, imagination and drive are characteristics which are simply irrelevant to individual decision making. . . “ Cornerstones of the Austrian entrepreneurial discovery theory a) the entrepreneurial role b) the role of discovery c) rivalrous competition 16

3. a) the entrepreneurial role The role of the entrepreneur is to fill market shortages, whittle away surpluses and eliminate quantity gaps, thus bringing the market into the equilibrium „Each market is characterized by opportunities for pure entrepreneurial profit. These opportunities are created by earlier entrepreneurial errors which have resulted in shortages, surplus, misallocated resources. The daring, alert entrepreneur discovers these earlier errors, buys where prices are nudged higher, high prices are nudged lower; price discrepancies are narrowed in the equilibrative direction. Shortages are filled, surpluses are whittled away; quantity gaps tend to be eliminated in the equilibrative direction. . . 17

3. b) the role of discovery Market imperfection is corrected through the responsiveness of alert and imaginative entrepreneurs who discover profitable opportunities The Austrian approach „postulates a tendency for profit opportunities to be discovered and grasped by routine-resisting entrepreneurial market participants“ Whereas earlier plans had overlooked available profit opportunities (. . . where some buyers buy goods at high prices, that were being sold elsewhere in the same market for lower prices), subsequent plans can be expected to reflect discovery of the profit opportunities implicit in (and constituted by) the earlier plans (ibid: 70)“ „Without knowing what to look for, without deploying any deliberate search technique, the entrepreneur is at all times scanning the horizon ready to make discoveries. Each such discovery will be accompanied by a sense of surprise (at one‘s earlier unaccountable ignorance)“ 18

3. b) the role of discovery (cont. ) „ Such natural alertness expresses itself in the boldness and imagination“ of the entrepreneurs. „Entrepreneurial alertness refers to an attitude of receptiveness to available opportunities“ 3. c) rivalrous competition The Austrian school emphasizes a dynamically competitive character of entrepreneurs in the market. In being alert to opportunities and in grasping them, entrepreneurs are competing with other entrepreneurs. This benefits consumers. Moreover, there is a discovery potential in rivalrous competition among entrepreneurs „. . . the rivalrous process we encounter in the everyday business world, in which each entrepreneur seeks to outdo his rivals in offering goods to consumers recognizing that because those rivals have not been offering the best possible deals to consumers, profits can be made by offering consumers better deals (ibid: 73)“. 19

1. 3. Comparison between Kirznerian & Schumpeterian Opportunities Source: Shane (2003: 21) 20

1. 4. ‘Risk, Uncertainty and Profit’ (Frank H. Knight 1921) Frank Hyneman Knight (1885 -1972), a founder of the Chicago school („laissez-faire proponent“), provides theoretical underpinnings for profit in his book on „Risk, Uncertainty and Proft“ Profit exists because actual (imperfect) competition in a modern industrial economy differs from perfect competition in one essential regard: competitors in the former face a world of uncertainty; competitors in the latter do not. In the face of uncertainty, competitors have to become entrepreneurs: they have to use their critical judgment to decide whether to engage in business activity or not. However, the uncertain world is not simple but rather finicky; success may not be repeated and it could not be replicated or taught (!) 21

Uncertainty is a central aspect of entrepreneurship for Knight He viewes gambles as risky, if the probabilites of outcomes are known („the probability of getting a six in throwing a die is one in six“), and uncertain, if the probabilities of outcomes are unknown („Knightian uncertainty“) Situations are risky, if the decision making is faced with unknown outcomes but known ex-ante probability distributions An entrepreneur as someone who undertakes uncertain investments for which the future returns and the associated probability distribution are unknown. An entrepreneur thus has unusually high level of uncertainty bearing “It is this true uncertainty which accounts for the peculiar income of the entrepreneur (Knight 1921)”. 22

But, where does this uncertainty come from? Entrepreneurs face uncertainty from the unknown availability of natural resources, technological change and fluctuating prices. Although factor prices are contractible and certain, output prices (and thus profits) are not The decision to become an entrepreneur (versus “laborer”) depends on the risk-adjusted relative rewards in each sector “The laborer asks what he thinks the entrepreneur will be able to pay, and in any case will not accept less than he can get from some other entrepreneur, or by turning entrepreneur himself. In the same way, the entrepreneur offers to any laborer what he thinks he must in order to secure his services (Knight 1921: 273). ” 23

Summary: Constituing Parts of Entrepreneurship • Opportunity recognition („Erkennen von Gelegenheiten“) • Creativity, boldness & imagination • Alertness to available opportunities • Initiative • Power to overcome scepticism and hostility • Striving toward self-fulfilling („Streben nach Selbstverwirklichung“) • Striving toward a powerful position in the society • Personal responsibility • Risk-taking & uncertainty bearing • Power to create something new (innovation) • Establishment of a new organization (enterprise) 24

Required Readings 1. Chapter on „The Role of Opportunities“ from S. Shane (2003) ‚A General Theory of Entrepreneurship: The Individual. Opportunity Nexus‘, pp. 18 -36 2. Kirzner, I. M. (1997) „Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach“, Journal of Economic Literature 35: 60 -85 25