The Capitalist and the Entrepreneur
Important extracts. Editing to come later.
"...the production-function approach is unsatisfactory, because it isn't useful for understanding a variety of economic phenomena. The black-box model is really a theory about a plant or production process, not about a firm. A single firm can own and operate multiple production processes."
"In Coase's words, "Why does the entrepreneur not organize one less transaction or one more?" Or, more generally, "Why is not all production carried on in one big firm?"" Coase, 1937, pp. 393–94
The distinction between calculation and incentives is important because the modern economics literature on organizational design—from transaction cost explanations of firm size, to public choice theories of bureaucracy, to recent work on market socialism and the “soft budget constraint” (Kornai, 1986)—focuses primarily on incentive problems (possibly encouraged by Lange’s famous warning about bureaucracy). Incentive theory asks how, within a specified relationship, a principal can get an agent to do what he wants him to do. Mises’s problem, however, was different: How does the principal know what to tell the agent to do? That is, just what activities ought to be undertaken? What investments should be made? Which product lines expanded and which ones contracted? The ideas developed in the calculation debate suggest that when organizations are large enough to conduct activities that are exclusively internal—so that no reference to the outside market is available—they will face a calculation problem as well as an incentive problem.
In this sense, market-socialist proposals are mostly irrelevant to the real problems of socialist organization. This is the case Mises himself sought to make in his critique of market socialism in Human Action (Mises, 1949, pp. 694–711). There he complained that the market socialists—and, for that matter, all general equilibrium theorists—misconceive the nature of “the economic problem.” Lange, Lerner, and Taylor looked primarily at the problem of consumer goods pricing, while the crucial problem facing a modern economy concerns the capital structure: namely, in what way should capital be allocated to various activities? The market economy, Mises argued, is driven not by “management”—the performance of specified tasks, within a framework given to the manager—but by entrepreneurship, the speculation, arbitrage, and other risk-bearing activities that determine just what the managerial tasks are. It is not managers but entrepreneurs, acting in the capital and money markets, who establish and dissolve corporations, create and destroy product lines, and so on. These are precisely the activities that even market socialism seeks to abolish. In other words, to the extent that incentives are important, what socialism cannot preserve are high-powered incentives not in management, but in entrepreneurial forecasting and decision making.
Mises’s prime concern was that entrepreneurs cannot be asked to “play speculation and investment” (Mises, 1949, p. 705). The relevant incentive problem, he maintains, is not that of the subordinate manager (the agent), who takes the problem to be solved as given, but that of the speculator and investor (the principal), who decides just what is the problem to be solved.
Lange, Lerner, and Taylor see the market through a strictly static, neoclassical lens, where all the parameters of the system are given and only a computational problem needs to be solved. In fact the market economy is a dynamic, creative, evolving process, in which entrepreneurs—using economic calculation—make industries grow and shrink, cause new and different production methods to be tried and others withdrawn, and constantly change the range of available products. It is these features of market capitalism, and not the incentives of agents to work hard, that are lost without private property ownership.
Without market prices for these goods, the firm must rely on relatively costly and inefficient methods of generating its own accounting prices, to perform internal calculations. This does not mean that because external prices are necessary for large firms to function efficiently, firms will necessarily become larger where external markets are “thick” or better developed. On the contrary, large firms typically arise precisely where external markets are poorly developed or hampered by government intervention; these are the kinds of circumstances that give entrepreneurs an advantage in coordinating activities internally. However, such firms are still constrained by the need for some external market reference.
"...all else equal, firms able to use market-based transfer prices should outperform, in the long run, firms using administered or negotiated transfer price."
In short, “at least some modern theories of the firm do not at all presuppose the ‘closed’ economic universe—with all relevant inputs and outputs being given, human action conceptualized as maximization, etc., that [some critics] claim are underneath the contemporary theory of the firm” (Foss 1993, p. 274). Stated differently, one can adopt an essentially Coasian perspective without abandoning the Knightian or Austrian view of the entrepreneur as an uncertainty-bearing, innovating decision-maker. Nor do all Coasian perspectives deny the importance of specialized knowledge lines in determining a firm’s capabilities or “core competence.” Transaction cost economics, for example, simply holds that the need for ex post governance of contracts in the presence of relationship-specific investments, and not “tacit knowledge” per se, is the most useful way to think about the boundaries of the firm. For the case that Austrian economics is more compatible with the capabilities literature (for substantive, not only methodological, reasons), see Minkler (1993b) and Langlois (1994a).
Of prime importance, then, is the problem of corporate governance: How do owners of financial capital structure their agreements with those who receive that capital, to prevent its misuse?
Because the owner delegates certain functions to managers, a central focus of the theory of the firm becomes the problem of corporate governance: how do suppliers of capital structure their arrangements with managers in a way that maximizes their returns?
Economists now increasingly recognize the importance of the capitalist in the direction of the firm’s affairs. In the introduction to his influential book Strong Managers, Weak Owners, Mark Roe (1994, p. vii) makes the point succinctly: Economic theory once treated the firm as a collection of machinery, technology, inventory, workers, and capital. Dump these inputs into a black box, stir them up, and one got outputs of products and profits. Today, theory sees the firm as more, as a management structure. The firm succeeds if managers can successfully coordinate the firm’s activities; it fails if managers cannot effectively coordinate and match people and inputs to current technologies and markets. At the very top of the firm are the relationships among the firm’s shareholders, its directors, and its senior managers. If those relationships are dysfunctional, the firm is more likely to stumble.
For more complex transactions, such as the purchase and installation of specialized equipment, the underlying agreements will typically be incomplete—the contract will provide remedies for only some possible future contingencies. Williamson (1975, 1985, 1996) attributes contractual incompleteness to cognitive limits or “bounded rationality,” following Simon’s (1961, p. xxiv) interpretation of human action as “intendedly rational, but only limitedly so.” Other economists are more agnostic, assuming only that some quantities or outcomes are unobservable (or not verifiable to third parties, such as the courts), in which case contracts cannot be made contingent on these variables or outcomes.
“[T]hose who confuse entrepreneurship and management close their eyes to the economic problem” (Mises, 1949, p. 704).
In a free market, any advantages that may be derived from “central planning” ...are purchased at the price of an enhanced knowledge problem. We may expect firms to spontaneously expand to the point where additional advantages of “central” planning are just offset by the incremental knowledge difficulties that stem from dispersed information. (Kirzner, 1992, p. 162)
Henry Manne’s essay, “Mergers and the Market for Corporate Control” (1965), responded to Berle and Means by noting that managerial discretion will be limited if there is an active market for control of corporations. When managers engage in discretionary behavior, the share price of the firm falls, and this invites takeover and subsequent replacement of incumbent management. Therefore, while managers may hold considerable autonomy over the day-to-day operations of the firm, the stock market places strict limits on their behavior.The central insight of Manne’s paper is also found in Mises’s Human Action (1949), in the passage distinguishing what Mises calls “profit management” from “bureaucratic management” (pp. 300–07).
In the ownership perspective, as developed by Gabor and Pearce (1952, 1958), Vickers (1970, 1987), Moroney (1972), and others, the firm is viewed as an investment.
It is not that the entrepreneur’s knowledge substitutes for the knowledge embodied in market prices. To evaluate the merit of a proposed investment, the central management of a diversified conglomerate still relies on market prices to calculate expected (money) benefits and cost. Internal accounting does not substitute for money prices; it merely uses the information contained in prices in a particular way. When capital-goods prices are distorted—for example, because of financial market regulation—then the entrepreneur’s additional knowledge is that much more valuable. So under those conditions we would expect an increase in M-form corporations, allocating resources via internal capital markets. During the 1960s, that is exactly what we observed.
According to Roe (1994), the phenomenon he calls “strong managers, weak owners” is an outgrowth not of the market process, but of legal restrictions on firm ownership and control. In the US, for example, banks and other institutions are forbidden from owning firms; antitrust laws prohibit industrial combinations like the Japanese keiretsu; and antitakeover restrictions dilute the effects of the takeover mechanism. Laws that require diffuse ownership create what Roe terms the “Berle–Means corporation,” in which “fragmented ownership shifts power in the firm to managers” (p. 93)
"...the main task performed by a market system is not the pricing of consumer goods, but the allocation of capital among various branches of industry."
"...the black-box approach to the firm that dominated neoclassical economics omits the critical organizational details of production."
What he calls asset specificity refers to “durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments are much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated” (Williamson, 1985, p. 55).
Kirzner’s (1966) refinement that defines capital assets in terms of subjective, individual production plans, plans that are formulated and continually revised by profit-seeking entrepreneurs (and Edith Penrose’s, 1959, concept of the firm’s “subjective opportunity set”).
Williamson’s work can be construed as a frontal attack on the perfectly competitive model, particularly when used as a benchmark case for antitrust and regulatory policy