[This paper was originally written for ECON 3499 - Independent Study in Austrian Economics]
Two Theories of the Entrepreneur in Austrian Economics
The role of the entrepreneur is one of the most pivotal elements in the economic theories of the Austrian School. The entrepreneurial nature of the market cited by Austrians is alone sufficient to distinguish their theories from orthodox economics. Instead of a set of static equilibrium models with pristine assumptions, the Austrians elucidate an emergent market revolving around the dynamic actions of entrepreneurs in an uncertain environment, a perpetual state of disequilibrium. Professors Joseph Schumpeter and Israel Kirzner, two of the most prominent entrepreneurial theorists, both agree on the fundamental role of the entrepreneur in the market process, and that economics ought to focus on disequilibrium. However, they interpret the function and purpose of the entrepreneur in two starkly contrasting ways. Schumpeter argued that it is a small cluster of entrepreneur-innovators that cause disequilibrium in the market with revolutionary new inventions, and that this unstable process will ultimately morph capitalism out of existence. Kirzner both incorporates the entrepreneurial nature of the market to a broader range of human action, and takes an optimistic approach, arguing that the entrepreneur instead alleviates disequilibrium and brings the market closer to equilibrium and economic harmony.
The traditional models of economics chronically undervalue the role of the entrepreneurship (if it is considered at all), and instead offer various static conditions of equilibrium, which are then analyzed and compared. In every equilibrium model, an “end-state” is achieved with the heroic assumptions of perfect knowledge, zero transaction costs, given consumer demands and a stock of goods, and no change in any “exogenous” variables (consumer tastes, production time, risk, weather conditions, etc.). The vector of prices and quantities which are found in these conditions are thus analyzed for their allocative efficiency and public policies are drawn from comparisons of equilibria. However, this model, outside of an abstractly fantastic Garden of Eden, fails to provide any substance in the real world, due to such notions as time, uncertainty, and change, simply being defined out of existence.
It is the Austrian theory of the entrepreneur that incorporates precisely these elements, and necessarily provides a highly accurate description of real world market conditions. To the Austrians, because of the ever evolving nature of economic conditions and interactions, the market is a process. Schumpeter and Kirzner both heavily chastise orthodox economists for their preoccupation with the mythical “perfect competition” and agree on the evolutionary nature of the market:
Capitalism…is by nature a form of economic change and not only never is but never can be stationary…The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process. (Schumpeter, p.82)
[S]ince we are dealing with a process whose every element takes considerable time in revealing its true features and ultimate effects, there is no point in appraising the performance of that process ex visu of a given point of time… (Schumpeter, p.83)
[T]he efficiency of the price-system in [the Austrian] approach, does not depend upon the optimality (or absence of it) of the resource allocation pattern at equilibrium; rather it depends on the degree of success with which market forces can be relied upon to generate spontaneous corrections in the allocation patterns prevailing at times of disequilibrium. (Kirzner, p.6)
The reason that the market is not an end-state but a process is due to the constant flux of economic “data,” the incessant changes of consumer desires, social conditions, ideas, and various other phenomena.
However, beyond the simple though profound observation that an entrepreneurial element exists in and is inherent to a market economy, Schumpeter and Kirzner’s theories diverge substantially. For each, the men and women who may be called “entrepreneurs” are very different, serve different purposes, and their actions promote two very different outcomes for an economic and social framework.
Professor Schumpeter argued that it is merely those few great innovators and inventors who advance a revolutionary departure from the norm that deserve the title of “entrepreneur.”
To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and that define the entrepreneurial type as well as the entrepreneurial function. This function does not essentially consist in either inventing anything or otherwise creating the conditions which the enterprise exploits. It consists in getting things done. (Schumpeter, p.132)
To Schumpeter, it is the entrepreneurial actions of these exclusive few that create the change in the “data of economic action” (Schumpeter, p.82). In an unlikely world without such entrepreneurs, the economy would follow a perpetually “circular flow” pattern similar to the neoclassical models. The purpose of the entrepreneur is to upset this monotonous circular flow with avant-garde activity, to:
revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply of materials or a new outlet for products, by reorganizing an industry and so on. (Schumpeter, p.132)
the history of the productive apparatus…is a history of revolutions. (Schumpeter, p. 83)
In brief, it is the purpose of the entrepreneur to introduce disequilibrium into a naturally equilibrated pattern of “normal” economic actions. Schumpeter also observed the business world around him, discovering that “competition” as economists describe in their theoretical models does not match the business colloquialism of “competition:”
But in capitalist reality as distinguished from its textbook picture, it is not that kind of 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 which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. (Schumpeter, p.84, emphasis added)
Thus, Schumpeter deduced that all businesses must compete with each other due to the entrepreneurs’ unceasing introduction of radical innovations that steal market power away from apathetic and routine businesses.
Professor Kirzner offers a much more inclusive definition of entrepreneurship. He places the idea of entrepreneurship into the broad realm of praxeology, in the Misesian tradition. Ludwig von Mises asserted that all human action is necessarily entrepreneurial because it is speculative; decisions to act are made based on an expectation that one can improve one’s state of affairs by pursuing a goal. Kirzner follows this approach in a general sense, positing that any individual can potentially become an entrepreneur, though in a unique sense. In order to conclude this, Kirzner first elucidates his account of the market process, which he describes as the “acquisition of market information through the experience of market participation,” (Kirzner, p.13). Since there is apodictic uncertainty in the world, it is only by “testing the market,” through trial and error, that an individual gains marginal information on present market conditions with which they can use to improve their utility.
The market process, then, is set in motion by the results of the initial market-ignorance of the participants. The process itself consists of the systematic plan changes generated by the flow of market information released by market participation – that is, by the testing of plans in the market. (Kirzner, p.10)
The “pure” entrepreneur is he who observes a potential opportunity for arbitrage—to buy low and sell high to reap a profit—and acts on this before anyone else:
The entrepreneurial element in the economic behavior of market participants consists…in their alertness to previously unnoticed changes in circumstances which may make it possible to get far more in exchange for whatever they have to offer than was hitherto possible. (Kirzner, p.15)
The act of arbitrage necessarily breeds competition, since all individuals ceterus paribus are enticed by profit. Subsequent interactions in the market will reveal the profitability of the initial entrepreneur’s action, and newcomers will imitate the action:
The systematic alteration in decisions between each period and the succeeding one renders each opportunity offered to the market more competitive than that offered in the preceding period – that is, it is offered with fuller awareness of the other opportunities being made available, against which it is necessary to compete. (Kirzner, p.11)
Thus, entrepreneurs must always appeal to the incentives of other participants to accept their product over their rival’s, and anticipate (and act upon) other unforeseen opportunities for profit. If they remain stagnant, their profits will dwindle into losses as more innovative entrepreneurs bid away all the consumers.
Additionally, for Kirzner, the act of introducing a new product does not make one an entrepreneur as Schumpeter believed, but instead it is:
the ability to see where new products have become unsuspectedly valuable to consumers and where new methods of production have, unknown to others, become feasible. [It] consists not of shifting the curves of cost or of revenues which face him, but of noticing that they have in fact shifted. (Kirzner, p.81)
Schumpeter only saw the result of an entrepreneurial action, of a new product or production process entering the market and forcing all other businesses to react to it. Kirzner noticed the impetus for it, that the entrepreneur has noticed the potential for introducing this new product or process to the market.
Professor Schumpeter recognized the entrepreneurial function as a powerful force that “sets and keeps the capitalist engine in motion,” but also warned that its immense potential would cause its own downfall, (Schumpeter, p.83).
Industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. (Schumpeter, p.83)
Schumpeter believed that this evolution, this “perennial gale of creative destruction” that emerged in the context of capitalism will run out of control and ironically overwhelm the capitalist system. Capitalism will morph out of its present state through the actions of entrepreneurs who will create a new society, perhaps socialism. In this context, he attributed this process, perhaps naively or abruptly, as the cause of the regular business cycle fluctuations:
This kind of activity is primarily responsible for the recurrent “prosperities” that revolutionize the economic organism and the recurrent “recessions” that are due to the disequilibrating impact of the new products or methods. (Schumpeter, p.132)[1]
It is thus easy to conclude that Schumpeter classified entrepreneurship in capitalism as fascinating and important, but more importantly, violently unstable.
Professor Kirzner, on the other hand, appraises the entrepreneurial function as a beneficent one. Instead of the Schumpeterian entrepreneur introducing disequilibrium to initial equilibrium, the Kirznerian entrepreneur dissipates disequilibrium by guiding the economy to equilibrium. Of course, the theoretical final equilibrium is never reached, but only groped at, since conditions are always and everywhere changing. The entrepreneurial actions bring the market participants into “dovetailing” patterns of continual transactions at a uniform price:
In this process the plans of consumers and of resource owners are gradually brought into greater and greater consistency with one another. Consumers’ initial ignorance of the kinds of commodities technologically possible with currently available resources and of the relative prices at which these commodities can in principle be produced gradually diminishes…The new knowledge is acquired through changes in the prices of resources and of products, brought about by the bids and offers of the entrepreneur-producers who are eagerly competing for the profits to be won by discovering where resource owners and consumers have (in effect) underestimated each other’s eagerness to buy or sell. (Kirzner, p.18)
This is a sharp contrast to Schumpeter, for whom entrepreneurs introduce a bit of chaos into the system by doing something new and radical, moving away from the circular flow of equilibrium. Kirzner’s theory demonstrates that Schumpeter falsely interpreted the entrepreneur’s actions backwardly, that in truth:
The crucial element in entrepreneurship is the ability to see unexploited opportunities whose prior existence meant that the initial evenness of the circular flow was illusory – that, far from being a state of equilibrium, it represented a situation of disequilibrium inevitably destined to be interrupted. (Kirzner, p.127)
Israel Kirzner and Joseph Schumpeter both made grand contributions to economic theory by calling attention to the role of the entrepreneur through a distinctly Austrian lens. Though they both agree on the underappreciated significance of the entrepreneur, they profoundly disagree on their role in creating or restoring equilibrium, and in their role as the cause or the effect of uncertainty and dynamism in the market. Overall, Schumpeter presents a more chaotic, if not negative view of the entrepreneur, while Kirzner praises the equilibrating harmony that the entrepreneur brings to the market process.
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Works Cited:
Kirzner, Israel. Competition & Entrepreneurship. University of Chicago Press. (Chicago, IL.: 1973).
Schumpeter, Joseph A. Capitalism, Socialism, and Democracy. 2nd Ed. Harper & Brothers Publishers. (New York, NY: 1947).
Footnotes:
[1] The use of Schumpeter’s vivid language in his descriptions of this process is also instructive. Schumpeter does not merely describe how an innovative product replaces an obsolete one, he asserts that a new product is created as another is destroyed. He also seemed to use many violent or chaotic metaphors to describe the process of replacement and emergence of new industries, at the expense of others.
