The entrepreneur and the firm

We have now considered in some detail the contribution of those economic theorists who have given the entrepreneur a place of importance in their thinking. There are clearly many different conceptions of the entrepreneur, but complex and subtle as are some of the arguments and distinctions that we have encountered, a few fundamental points seem particularly relevant for the theory of the firm. Entrepreneurs are concerned with the process of coordination. It is time and change which give rise to the possibility of entrepreneurial profit. This is so whether we emphasise alertness, imagina­tion, skill in making judgemental decisions, willingness to bear uncertainty or energy to overcome resistance as the ultimate source of entrepreneur­ship. In Chapter 1, much space was devoted to the proposition that a world of perfect information required no firms and that the firm was an institu­tional response to uncertainty. Clearly, therefore, at this very fundamental level the entrepreneur and the firm are closely associated. Both are con­cerned with managing change.

It is important to remember that the entrepreneur is not a prisoner in the firm, and it is interesting that most of the theoretical work in the Austrian school concentrates, as we have seen, on intermediation in the market. This, though, is simply because these theorists are particularly interested in uncovering the ultimate source of entrepreneurial profit, and wish to emphasise their view that all economic life can be seen as a changing network of exchange relationships. Thus, as we saw in Chapter 2, the firm itself can be viewed as a set of contracts with a central authority; contracts so framed as to reduce the transactions costs associated with exchange in the market. Those who spot that possibilities for profitable collaboration exist, who put together the necessary set of contracts between themselves and the collaborating agents, and thus establish a new enterprise or firm, are acting as entrepreneurs in the same way as the middleman in our earlier example. The difference between simple arbitrage and setting up a firm is one of the degree of complexity and the type of contract involved rather than any difference of economic principle. In both cases, resources are real­located, and if the reallocation makes it possible for everyone to benefit thereby the entrepreneur stands to gain a pure entrepreneurial profit. Entrepreneurship is central, therefore, to the establishment of new enter­prises. As Knight recognised, A considerable and increasing number of individual promoters and corporations give their exclusive attention to the launching of new enterprises, withdrawing entirely as soon as the prospects of the business become fairly determinate’ (p. 257).

1. The Small Entrepreneurial Firm

Casson’s supply curve of entrepreneurs is not easy to estimate empirically, but in recent years a significant amount of academic research has attempted to investigate the factors determining the establishment of new entrepreneurial firms. As we saw above, the position of the supply curve is expected to depend upon the prevailing return to normal employment, the judgemental qualities of the population and the information flows which they encounter, and access to finance (especially private wealth or some other means of surmounting the hazards associated with the capitalist- entrepreneur relationship).

In the United Kingdom, for example, Storey and Johnson (1987) have studied regional variations in entrepreneurship. The authors construct an ‘entrepreneurship index’ for each region. Factors such as the percentage of small firms in a region or the proportion of the population in managerial groups can be associated with the accumulation of relevant knowledge and experience on the part of potential entrepreneurs. Educational informa­tion, such as the proportion of the population with degrees, may correlate with the ability of people to draw up and act upon simple business plans. Savings per head, house price indices, and measures of the house-owning population are related to access to capital. Indices of ‘entry barriers’ attempt to measure the height of the capital ‘qualification’ which would have to be surmounted by new entrepreneurs in the industries of the region. Storey and Johnson find that variation between the regions in new firm for­mation rates in manufacturing cannot be explained simply by differing industrial structures. ‘Fertility’, that is the propensity for new firms to be set up, was a more important factor than regional industrial structure. Further, government policies to encourage small firm formation were not equally effective in all the regions.27 Indeed, ‘the entrepreneurship index performs remarkably well in predicting the regional take-up of small firms policy’ (p. 170).

In another paper, Storey and Johnson (1987b) concentrate on the oppor­tunity cost side of the decision to become an entrepreneur. They use an index of labour shedding as a measure of local labour market conditions. Unemployment may reduce the opportunity costs of becoming an entre­preneur although it may also have adverse effects on asset values – both human and physical. Using data on new manufacturing firms in Northern England between 1965 and 1978 they found that it was not the lure of high profitability that influenced new firm formation so much as local labour market conditions.28

Other work focuses on the entrepreneur’s problem of obtaining finance. In the United States, Evans and Leighton (1989) and Evans and Jovanovic (1989) find that switches out of employment into self-employment are more likely to occur as family assets rise. They argue that this evidence is consis­tent with the existence of binding financial constraints deriving from the contractual hazards discussed earlier. Blanchflower and Oswald (1991) also use a neoclassical supply and demand framework to investigate this issue. Data from the National Child Development Study in the United Kingdom were used to estimate the probability of a person being self-employed. The role of gifts or inheritance proved to be significant. ‘A gift or inheritance of £5,000 approximately doubles a typical young individual’s probability, ceteris paribus, of setting up his or her own business’ (p. 22).

At the macroeconomic level, King and Levine (1993) propose a model of the connection between finance, entrepreneurship and growth. In their work, financial intermediaries specialise in evaluating prospective entre­preneurs and thus overcoming the adverse selection problem. Some people have the capacity to be successful entrepreneurs and others do not. Expenditure of resources in the activity of assessment is capable of distinguishing competent from incompetent entrepreneurs. When compe­tent entrepreneurs and potentially successful projects have been identified, the intermediaries raise finance and diversify risk. They do this by provid­ing equity capital in the manner of venture capitalists. The hypothesis is that a more developed financial system will facilitate entrepreneurship and hence will be associated with higher levels of national income and with a higher growth rate. King and Levine use data from over eighty countries for the years 1960-89 to evaluate this hypothesis. Their proxies for the degree of development of the financial system include the ratio of liquid liabilities (currency plus interest and non-interest-bearing liabilities) to GDP, the rel­ative size of central bank assets to total bank assets and the proportion of credit advanced to private enterprises rather than the government sector. Econometric analysis indicated strong links between these characteristics of the financial system and overall productivity growth and growth in per capita output.

Small businesses rely heavily on the banks for the provision of finance. It has been argued that the problems of information asymmetry which con­front entrepreneur and financier will depend to some extent on the nature of the banking system. More discussion of this issue can be found at the end of Chapter 9 in the context of corporate governance. Here we merely note that the commercial banks in the United Kingdom have not traditionally been seen as appropriate sources of venture capital or long-term industrial investment.29 They developed as deposit-taking institutions that would provide relatively short-term finance on good security. No very deep knowl­edge of particular industries or entrepreneurial prospects was required in this system on the part of banks. Quite different traditions evolved in other countries with respect to the channelling of savings to investment opportu­nities. Stanworth and Gray (1991, p. 70) write that ‘by retaining a more sep­arate and isolationist role from industry in the UK, the banks may be less able to provide this transformation process than are their counterparts in other countries’. Entrepreneurs require appropriate supporting institutions. Reid and Jacobsen (1988, p.6) in their study of the small entrepreneurial firm in Scotland, however, do not see the policies of commercial banks as representing a significant barrier to the raising of outside finance by new small firms. Further discussion of the finance of the entrepreneur can be found in section 8 of Chapter 4, where the role of instruments of debt com­pared with instruments of ownership is specifically investigated.

Once the enterprise is established, the scope for entrepreneurship does not cease. In principle, the continuation of the same arrangements, the monitoring of the inputs and routine management are not entrepreneurial activities, but continuing change elsewhere is likely to involve a continuous process of adaptation by the firm, and no firm is likely to survive for long without the exercise of some entrepreneurial talent. It is in this context that Casson’s approach has most to commend it. All firms require entrepre­neurs, and a significant problem is how to make the most of available talent in the making of judgemental decisions. One of the most obvious problems faced by closely owned businesses is what happens when the sons or daugh­ters of the founder lack their parent’s business acumen. Indeed, the growth of transferable shares and limited liability can be seen as a response to this very problem.30

The entrepreneur and the proprietor of a business enterprise are not syn­onymous. Clearly, the single owner of the classical capitalist firm who sup­plies the capital and performs routine managerial tasks may also exercise entrepreneurial skills, but the owner is not necessarily an entrepreneur. Neither should we think in terms of a single entrepreneur associated with each firm. Especially in larger firms, entrepreneurship, alertness to new opportunities, may exist throughout the organisation. Indeed it is possible to regard ‘the firm’ itself as a ‘coalition’ of entrepreneurs.

2. The Firm as a Coalition of Entrepreneurs

Wu (1989) has developed the idea that markets can evolve over time to permit trade in commodities, labour and capital, but that ‘all the services provided by entrepreneurs are nontradeable’ (p. 103). Moral hazard is such a severe problem with entrepreneurial services that a market can never exist and ‘entrepreneurs must take the initiative to organise production through non market means, that is, by organising a firm’ (p.232). In the era of the medieval guilds, a craftsman would supply capital labour and entrepre­neurial talent together. Gradually, however, separate markets in labour and capital developed. For several centuries, entrepreneurship was still associ­ated with the provision of capital, but the development of the joint-stock company has permitted further specialisation. Pure entrepreneurs are taking control of production while capitalists become providers of funds. ‘The long historical evolution toward functional specialisation among the factors of production had reached its destination’ (p. 224).

For Wu, a firm is a coalition of entrepreneurs which agrees a production policy, an organisational structure, and a rule for sharing the residual profits. The entrepreneur’s reward is the result of bargaining within the firm over a share of the surplus. This does not mean that pure entrepreneurs can easily set up a new firm. Start-up firms in risky industries cannot be founded by pure entrepreneurs because of the difficulty of raising funds. Such firms will require innovator-entrepreneurs with private sources of finance, but established firms can generate a sufficient reputation in the market to attract finance, and hence can be managed by pure entrepreneurs.

Further reference to this conception of the firm and the role of the entre­preneur is made in Chapter 8 in the context of corporate governance. It is clearly a controversial view because it implies that market evolution and the power of reputation is enough to overcome the hazards associated with the relationship between entrepreneur and financier. It is also heavily influenced by ‘Austrian’ ideas. The main resources harnessed by each firm are the entrepreneurial talents of the coalition. These will be highly ‘coali­tion specific’ and the surplus generated by the mutual efforts of the entre­preneurs will not necessarily be competed away in the long run. Thus, Wu’s approach has affinities with those who emphasise the importance of the generation of ‘competitive advantages’ within the firm – advantages which cannot be replicated at low cost and derive from the special experience and make-up of a given coalition.

If the firm is a vehicle for the exercise of entrepreneurship we have to get used to the idea that a significant proportion of the income received by those who work in the firm is entrepreneurial profit. This applies not merely to those who have Board appointments, and possess the more obvious claims to profits such as stock options and deferred pension rights, but also to those who work throughout the organisation. The means by which people lay claim to these profits is important. In Chapter 6, for example, we will look at the structure of hierarchies. Promotion can be seen as a way of inducing effort. It might also be part of the mechanism whereby the pure surplus of the organisation is distributed between the entrepreneurs who created it. The important thing is that entrepreneurs have the means of transferring their insights into personal gain. To consider the mechanisms by which this can be accomplished requires us to investigate in much more detail the nature of property rights and the way that different types of organisation reflect different structures of rights.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.

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