Kirzner, Entrepreneurship & the Market Approach to Development

Entrepreneurship and the Market Approach to Development by Israel M. Kirzner

It is beginning to be realized that the vast literature on growth and development conceals a yawning gap. This void refers to an understanding of the role of the entrepreneur in economic development, both at the theoretical level, and at the level of past and prospective economic history. The entrepreneur, Professor Baumol remarks1 , has “virtually disappeared from the theoretical literature.” In a penetrating essay on the entrepreneur's role in economic development, Professor Leibenstein discovers that “received theory of competition gives the impression that there is no need for entrepreneurship.”2

In the literature dealing more narrowly with growth models3 , this hiatus is almost complete and hardly surprising in view of its predominant concern with macroeconomic relationships.4 In contrast, the literature dealing with development proper gives some attention to entrepreneurship, although little effort has been devoted to formulating a clear theoretical understanding of the entrepreneurial role. Discussion has revolved primarily around the possibilities of an “entrepreneurial climate” emerging in hitherto primitive economies; around whether the motivation to seek profits is as weak in underdeveloped countries as frequently assumed; around the feasibility of relying upon foreign entrepreneurs, and similar issues.1 However valuable, these discussions appear either to lack an explicit theoretical framework within which to examine the relevant issues, or, at best, to be founded rather shakily on the theory of entrepreneurship in development as expounded by Schumpeter in his justly famous work.2 Frequent, somewhat vague references to Schumpeterian innovators and entrepreneurs are apparently considered sufficient to indicate the theoretical background that is being assumed. Consequently, the real function of the entrepreneur in a developing market economy seems often to have been poorly understood, and the plausibility of rapid development under alternative economic systems to have been accepted uncritically.

This paper will attempt to reconsider the role of the entrepreneur in the theory of the developing market economy. Schumpeter's approach, for all its brilliant and valuable insights, will be criticized at a fundamental theoretical level, both to the notion of entrepreneurship itself and to capitalusing production. Finally, I will attempt to outline the far-reaching implications of these criticisms for the economic policy of developing nations.

Decisions and Decisions

At the heart of microeconomics lies the individual decision. The decision is usually conceived of as an “economizing” decision, i.e. one in which the individual—whether consumer, producer, or resource owner—seeks to achieve his ends to the furthest extent possible within the constraints imposed by the available means. It involves buying where price is lowest, selling where price is highest, balancing the marginal gain from each proposed step against the associated marginal sacrifice, and so on. This essentially allocative, efficiency-oriented, economizing type of decision, is the subject of exhaustive analysis in the theory of price. The theory of the market explores the extent to which economizing decisions of many independent market participants can be carried out simultaneously. The conditions necessary for all such decisions to dovetail together, so that none need be disappointed, constitute the conditions for market equilibrium. The market process enables a state of affairs in which the conditions for equilibrium are absent to lead towards the state of equilibrium.

The essential feature of the “economizing” decision, and the feature which renders it amenable to analysis, is its “rationality” or, more helpfully, its purposefulness. But this purposefulness is viewed exclusively as imposing upon the utilization of means, the importance assigned to the various relevant ends. In particular these ends and means are viewed as given and known, the act of decision-making being seen as essentially calculative, as though the resulting action were already implicit in the relationship between given ends and means.

But economists cannot confine their attention to this narrow notion of the decision. Attention must also be paid to an element in decision-making which cannot be formalized in the allocative, calculative terms. Purposefulness in human decision-making manifests itself along a dimension which is ignored in the analysis of “economizing” decision-making. In addition to the exploitation of perceived opportunities, purposive human action involves a posture of alertness towards the discovery of as yet unperceived opportunities and of their exploitation. This element in human action—the alertness towards new valuations with respect to ends, new availability of means,—may be termed the entrepreneurial element in the individual decision.1 Awareness of this element in human action leads to the recognition that knowledge by the outside observer of the “data” surrounding a decision-making situation is not sufficient to yield a prediction of the decision that will be made. The calculation by the observer of the optimum choice (relevant to the data) may be profoundly irrelevant. The crucial question concerns what knowledge of the data is possessed—effectively possessed—by the decision-maker. In fact the essence of the “entrepreneurial” decision consists in grasping the knowledge which might otherwise remain unexploited.

Equilibrium, Disequilibrium, and Entrepreneurship.

It is not difficult to understand the traditional neglect by economists of this entrepreneurial element. Much economic analysis was developed against the background of an assumed world of perfect knowledge. The theory of perfect competition and more generally the theory of market equilibrium were developed in terms of perfect knowledge. Decisions were seen as strictly economizing decisions. Indeed, the world of perfect knowledge precludes the entrepreneurial element in decision-making.

Most importantly, for a market to be in equilibrium perfection of knowledge emerges as the essential condition. Equilibrium simply means a state in which each decision correctly anticipates all other decisions being made. In such a situation decision-making involves nothing more than the calculation of the optimum course available to the chooser, within the constraints imposed by the (correctly) anticipated decisions of others. No room exists for the entrepreneurial element.

In contrast, a disequilibrium market means a state of affairs in which decisions do not correctly anticipate all the other decisions being made. Clearly scope exists here for exercise of the entrepreneurial alertness to opportunities for more advantageous decisions than those currently embraced.

It is here that the appropriateness of this concept of an “entrepreneurial element” in the individual decision becomes apparent. It is well known that in price theory the “entrepreneur” has no place in the state of equilibrium. Only in disequilibrium are there opportunities for entrepreneurial profit, for the purchase of inputs at a cost lower than the revenue obtainable from the sale of their potential output. In equilibrium all profits have been squeezed out, costs and prices have become fully adjusted. To imagine all decisions correctly anticipate all others is to assume away all opportunities for capturing a margin between resource costs and product revenues. For the existence of such a margin is inconsistent with the knowledge assumed of resource sellers, concerning the higher product revenues, and of the knowledge assumed of product purchasers, concerning the lower resource costs. The perfection of knowledge, which rules out the “entrepreneurial element” in the individual decision, also rules out all entrepreneurial profit opportunities. The imperfection of knowledge that obtains in the disequilibrium market creates the price divergences between resource costs and product revenues which constitute the opportunities for profitable entrepreneurship in the more usual sense. And the exploitation of entrepreneurial opportunities for profit involves precisely that element in decision-making which we have termed the entrepreneurial element. To win pure entrepreneurial profits, it is necessary to perceive price divergences that have gone unnoticed. What is required is an alertness to the existence of opportunities that have been overlooked—because their continued existence must mean they have been overlooked.

Entrepreneurship-Equilibrating or Disequilibrating?

All this is elementary enough, although not always clearly perceived, and is not inconsistent with the framework within which Schumpeter develops his entrepreneur-innovator. While, unlike Schumpeter, we have couched our discussion primarily in terms of decisions (and the knowledge possessed by decision-makers of others' decisions), our analysis can easily be seen to correspond to Schumpeter's discussion of the entrepreneurless circular flow and of the way the entrepreneur injects change into the system.

But the emphasis in Schumpeter's presentation, (quite apart from its failure to stress the importance to decision-makers of knowledge of the decisions of others), slurs over an important aspect of entrepreneurial activity. In Schumpeter it appears that the entrepreneur acts to disturb an existing equilibrium situation. Entrepreneurial activity disrupts the continuing circular flow. While each burst of entrepreneurial innovation leads eventually to a new equilibrium, the entrepreneur is presented as a disequilibrating force. “Development ... is ... entirely foreign to what may be observed in ... the tendency towards equilibrium.”1

In contrast, our discussion indicates that the existence of an as yet unexploited opportunity for entrepreneurial profit means that the existing state of affairs, no matter how evenly it seems to flow, is a disequilibrium situation. It is a situation in which some decision-makers are at least partly ignorant of the decisions being made by others. This situation is bound to change and the existence of profit opportunities is the leaven that gives rise to the fermentation of change. Thus in our discussion the entrepreneur is seen as the equilibrating force. More precisely we see the entrepreneur as bringing into mutual adjustment those discordant elements which constitute the state of disequilibrium. His role is created by the state of disequilibrium and his activities ensure a tendency towards equilibrium. While it is true that without him a disequilibrium state of affairs might continue indefinitely (so that one could hardly insist upon calling the situation one of disequilibrium), nonetheless it is important to recognize that the changes he initiates are equilibrating changes, i.e. away from the maladjusted state of affairs which invites change, towards the state of affairs in which further change is unnecessary or even impossible.

This contrast, between Schumpeter's vision of the entrepreneur as a spontaneous force pushing the economy away from equilibrium and our view of the entrepreneur as the prime agent in the process from disequilibrium to equilibrium, is particularly important in the context of economic development. We must first, however, explicitly extend our discussion of entrepreneurship to the multiperiod level, in which Schumpeter's exposition suffers further.

Single Period Equilibrium and Intertemporal Equilibrium

In an analysis confined to single period decisions, equilibrium means the state of affairs in which all the single-period decisions made correctly anticipate the other such decisions being made. Entrepreneurship, in single-period analysis, consists in grasping profit opportunities to buy and sell at different prices in a disequilibrium market within the same period.

In an analysis extending to multiperiod decisions, the notion of equilibrium is more complex. In such an analysis decisions extend to plans to buy or sell in the future. A man invests now in his education, intending to sell in the future the skills he is learning. Another man erects a shoe factory now intending to buy regular supplies of leather during future periods of time. The equilibrium that would result from perfect dovetailing of these multiperiod plans must be an intertemporal equilibrium. Plans made today must fit not only with plans by others today, but also with plans made in the past and other plans to be made in the future.1 A state of disequilibrium will exist wherever any plan being made at any date fails to dovetail with other relevant plans (of whatever date) in the entire system being considered. A man who erects a shoe factory and who discovers in later periods that shoe leather is unobtainable, or that consumers no longer wish to buy shoes, made his decision in ignorance of the plans of others on which his own depended. A man who educates himself in a profession for which later demand is lacking, has made a plan based upon incorrectly anticipated plans of others.

Clearly entrepreneurship has its place in the intertemporal market in an analogous way to that occupied in the simpler single-period analysis. Where existing plans do not satisfy the conditions for intertemporal equilibrium, the relevant ignorance by the decision-makers has created opportunities for entrepreneurial profit which can be grasped by those who are able to “see” what others fail to see. These opportunities, (available to market participants with that alertness we have identified as the entrepreneurial element in individual decision-making), consist in the availability of resources today, at prices lower than the present value of the prices at which outputs can be sold in the future. This difference between buying prices and selling prices is similar to entrepreneurial profit in simpler contexts. This profit margin is the result of the failure by those selling the resources today (at the low prices) to perceive the possibilities for selling at higher prices in the future. Entrepreneurial alertness to these opportunities will capture this difference as profit and thereby generate the universal tendency towards the elimination of profit. Their buying and selling activities in the intertemporal market will tend to bring resource prices of one date into line with output prices of later dates (until only pure interest will be left separating them).

Thus, in the multiperiod context (as in the single-period analysis), the entrepreneur finds scope for his specific role in opportunities for the profitable use of resources which others have not perceived. We see him tending to bring about the exploitation of production possibilities which no one has yet noticed. These insights may be extended very smoothly to encompass capital-using production plans.

Entrepreneurship and the Use of Capital

Everyone knows that economic growth and development requires capital. Our discussion of the entrepreneurial role in the context of the intertemporal market will help us to understand the relation between the entrepreneur and the capitalist.

We have seen that intertemporal production opportunities involve the acquisition of inputs at one date and the subsequent sale of products at a later date. In the context of capital-using production we say that the producer “locks up” resources in the form of capital goods, or goods in process, until the completion of the period of production. For such time-consuming, capital-using productive processes it is necessary for someone to forgo the alternative outputs available by using the inputs in less time-consuming processes of production. That is, someone must perform the capitalist role. If the input sellers (say, laborers) are not willing to wait for payment (wages), someone else must advance the funds for the purchase of the inputs and wait until the end of the productive process for the return of his investment. The producer who borrows the funds to finance his capital-using process of production finds it worthwhile to undertake the commitment necessary to persuade the capitalist to invest. The more productive processes of production, insofar as these involve more investment of capital, will be undertaken only to the extent that the producer “sees” the profitability of these processes. All this is trivial enough. But it focuses attention on the role of the entrepreneur in a way that is important for our purposes.

The technical availability of profitable capital-using methods of production and of savings to provide the necessary capital, is not sufficient to ensure that these methods will be undertaken. They constitute an opportunity for intertemporal exchange which may never be exploited if no one is aware of it. If, at any time, such an opportunity remains as yet unexploited, it offers opportunity for entrepreneurial profit. An entrepreneur will be able to borrow capital, buy resources, and produce output at a market value that will more than repay the capitalist's investment together with the interest necessary to persuade him to advance the capital funds. Only in intertemporal equilibrium (which, in the context of capital accumulation certainly does not mean a stationary state), will capital-using methods of production yield no surplus over the resource costs plus interest. In the world of imperfect knowledge—and in the multiperiod context lack of prescience is hardly a rarity—the harnessing of capital to more productive processes of production must involve entrepreneurial recognition of an opportunity that has hitherto gone unperceived.

Entrepreneurship is necessary in economic development, therefore, for the quite pedestrian purpose of ensuring a tendency towards the adoption of the socially advantageous long-term capital-using opportunities available. So far from being a kind of exogenous push given to the economy, entreprenounial innovation is the grasping of opportunities that have somehow escaped notice. So far from Schumpeter's “spontaneous and discontinuous change in the channels of the flow,” disturbing and displacing “the equilibrium state previously existing,”1 the development generated by entrepreneurial activity is to be seen as the response to tensions created by unfulfilled opportunities, by the unexploited information already at hand.

Schumpeterian Development—A Criticism

We have brought the discussion to a point where out dissatisfaction with Schumpeter's view of the role of entrepreneurship in development emerges in clear focus. Samuelson has captured the spirit of the Schumpeterian vision with an admirably apt metaphor. “The violin string is plucked by innovation; without innovation it dies down to stationariness, but then along comes a new innovation to pluck it back into dynamic motion again. So it is with the profit rate in economic life.”2 Development is initiated by innovators who are generating new opportunities. The Schumpeterian innovators stir the economy from its sluggish stationariness. The imitators compete away the innovational profits, restoring the stationary lethargy of a new circular flow, intil a new spurt of innovational activity emerges to spark development once again.

In spite of the brilliance and power of the Schumpeterian analysis, our own view of entrepreneurial development is quite different. For us entrepreneurship is an equilibrating force in the economy, not the reverse. Our entrepreneur, whether at the single period level or at the multiperiod level, is seen as fulfilling existing opportunities, as the one who generates the tendency towards the satisfaction of the conditions for equilibrium consistent with available information. His role is to fulfil the potential for economic development that a society already possesses.

We may present our dissatisfaction with the Schumpeterian scheme as follows. At all levels of human action, whether in the market economy or the centrally planned economy, we must distinguish two separate problems associated with ensuring that the best possible course of action will be adopted. The first concerns the discovery of the best available course of action, and is essentially a matter of calculation from the relevant data. The second problem is how to ensure that this best course of action—which can be carried out—will be carried out. At the level of the individual decision, economic analysis has all too frequently assumed that the second problem will take care of itself. The decision-maker is simply assumed to seek the optimum position. In other words the analysis overlooks the need for the entrepreneurial element in the individual decision, assuming the relevant ends and means are known. But, as soon as one recognizes the problem of ensuring that the individual “sees” the optimum course of action, the importance of this entrepreneurial element, of ensuring alertness to and awareness of “the data”, becomes apparent.

When we consider the economic prospects of developing societies, the same two problems present themselves, and again we find the second problem ignored. The first problem is the discovery of the best course of economic development available to the society. In principle, it is a matter of calculating, of comparing alternative possiblities consistent with available resources and technology, in the light of relevant scales of value (whether of individuals or of planners, and including the relevant time preferences). No matter how elaborately this kind of calculation is carried out, the solutions obtained relate only to the first problem of determining what is best in the light of what is possible. We are still left with the second problem—of ensuring that the opportunities thus perceived will be fulfilled. No matter the form of economic organization, laissez-faire or central planning or some attempted mixture, the second problem must be faced: what can ensure that the opportunities that exist be “seen” and embraced? It is here—in the market case—that the entrepreneurial element comes in.

In the market system the existence of opportunities is signalled by profit opportunities in the form of price differentials. Now signals may not always be seen—but the kernel of market theory is that a tendency exists for them to be seen. The profit incentive is viewed as the attractive force. It is a force which not only provides the incentive to grasp the opportunities once perceived, but which ensures a tendency for these opportunities to be perceived. Entrepreneurship is seen as the responding agency; the alertness of the entrepreneur to profit possibilities is seen as the social mechanism ensuring the capture by society of the possibilities available to it. What the “entrepreneurial” element in individual decision-making is to the individual, the entrepreneur himself is to the market economy. All this is missing in the Schumpeterian scheme.

The literature on growth and development consists of careful, elaborate discussions of what possibilities exist for raising the productivity of labor, for increasing the volume of resources, for the accumulation of physical and human capital, for gains through foreign trade, foreign capital, and so on. The problem of entrepreneurship in this literature seems to be treated in much the same way as are economic resources in general. Although a difference is recognized between the entrepreneur and the manager, the former still appears to be treated as an element that extends the range of possible opportunities-rather than the element needed to ensure a tendency towards the fulfilment of opportunities available in principle without him. Schumpeter's picture of the entrepreneur as the initiator and author of development seems to be at least partly responsible for this failure to grasp the real significance of entrepreneurship. (In this regard Leibenstein makes a valuable distinction between allocative efficiency and “X-efficiency”, and recognises entrepreneurship as being concerned with the latter rather than with the former.1) )

Our objections to Schumpeter may be summed up. The Schumpeterian view of development is one of spontaneous, disjointed change. The circular flow from which such change occurs is one in which intertemporal plans seem to be somehow suppressed, so that changes, say, in the capital intensity of production, are associated specifically with entrepreneurial activity. This view directs attention from the possibility of intertemporal equilibrium in the sense of an economy fully adjusted—with no scope for entrepreneurship—to a definite pattern of increasingly capital-intensive activity. The role of the entrepreneur to ensure a tendency towards the fulfilment of such a pattern is thus suppressed. Instead of entrepreneurs responding to intertemporal profit possibilities (through alertness to possibilities of commanding additional capital resources), the entrepreneur is pictured as creating profits (“the child of development”2) ). Instead of entrepreneurs grasping the opportunities available, responding to and healing maladjustments due to existing ignorance, the entrepreneur is pictured as generating disturbances in a fully adjusted circularly-flowing world in which all opportunities were already fully and familiarly exploited.

The Implications of the Criticism

Does this criticism of the Schumpeterian view make much difference, or is it another way of seeing the same thing? There are strong grounds for insisting that our criticism does indeed have important implications.

The great neglected question in development economics concerns the existence of a social apparatus for ensuring that available opportunities are exploited. Its solution requires a social apparatus for ensuring that the decision-makers become aware of the existence and attractiveness of these opportunities. We have noticed that the market possesses exactly such an apparatus in the freedom with which it permits entrepreneurs to exploit opportunities for profit of which they become aware. Profit, in the market system, is not merely the incentive to lure entrepreneurs into grasping the opportunities they see, it is the incentive upon which the market relies to ensure that these opportunities will be seen in the first place. One of the major arguments in favor of a market approach to economic development consists precisely in this crucially important element of the system. Whatever advantages the price system possesses as a computer, facilitating an optimum intertemporal allocation of resources, these advantages depend utterly on the entrepreneurial element we have identified. And it is precisely such an element which appears to be lacking in alternative systems of social economic organization.1 It is here, we submit, that Schumpeter's scheme fails us.

For Schumpeter's picture of economic development depends, after all, upon entrepreneurship. Yet, despite having within his grasp this enormously important insight, Schumpeter lets it go. His picture fails to bring out the power of entrepreneurship to ensure a tendency towards the fulfilment of socially desirable opportunities. His picture fails to throw into relief how the tension generated by the existing maladjustments draws the corrective entrepreneurial activity. His picture fails to reveal how it is the market which permits all this to occur. On the contrary, the entrepreneurship around which Schumpeter builds his system is in principle equally applicable to the centrally planned economy.1 The notion of circular flow and the possibility of its disturbance through creative spontaneous decisions are in principle entirely relevant to the non-market economy. What the Schumpeterian picture of innovational development fails to explain is that the existence of a possibility is not enough, that a social mechanism is needed to ensure that possibilities are perceived and embraced. Schumpeter fails to show how the non-market economy can grapple with this central problem.

Schumpeter's brilliant insights into the nature of innovation and entrepreneurship thus need to be recast into an ex ante mold. Instead of seeing only changes which the entrepreneur has wrought, we must focus attention on the opportunities which were waiting to be grasped by the entrepreneur. Instead of identifying the profits captured ex post by the entrepreneur, we must focus attention on the profit possibilities which serve to attract the entrepreneur. Instead of seeing how the entrepreneur has disturbed the placid status quo. we must see how the status quo is nothing but a seething mass of unexploited maladjustments crying out for correction. Instead of seeing entrepreneurship as jerking the system out of equilibrium, we must see it fulfilling the tendencies within the system towards equilibrium. My belief is that only such a theoretical scheme can be helpful in the great policy questions that face the developing countries of the world.

[1]W.J. Baumol, “Entreprensurship in Economic Theory”, American Economic Review (May, 1968)p.64.

[2]H. Leibenstein, “Entrepreneurship and Development”, American Economic Review (May, 1968), p. 72.

[3]For a survey see F.H. Hahn and R.C.O. Matthews, “The Theory of Economic Growth: A Survey”, Economic Journal, (December, 1964).

[4]Even Hicks' Capital and Growth (Oxford, 1965), in which the price theoretic implications of formal growth theory are pursued, is not concerned at all with entrepreneurship.

[1]For a sampling of this literature see P. T. Bauer and B.S. Yamey, The Economics of Under-developed Countries, (Chicago, 1957), Chapter VIII: M. Abramovitz, “Economics of Growth”, in A Survey of Contemporary Economics, Vol. II, (Irwin, 1952), pp. 157-162; H.G. Aubrey, “Industrial Investment Decisions: A Comparative Analysis”, Journal of Economic History, (December, 1955); N. Rosenberg, “Capital Formation in Underdeveloped Countries”, American Economic Review, (September, 1960), pp. 713-714; G.F. Papanek, “The Development of Entrepreneurship,” American Economic Review, (May, 1962).

[2]See J.A. Schumpeter, The Theory of Economic Development, (Harvard, 1934).

[1]See I.M. Kirzner, “Methodological Individualism, Market Equilibrium, and Market Process”, Il Politico, 1967.

[1]Schumpeter, op.cit., p. 64.

[1]F.A. Hayek, The Pure Theory of Capital, pp. 22f; I.M. Kirzner, An Essay on Capital, p. 30; Market Theory and the Price System, pp. 311-320.

[1]Schumpeter, op. cit., p. 64.

[2]P.A. Samuelson, Economics, (7th Edition), p. 725.

[1)]See H. Leibenstein, “Allocative Efficiency vs. X-Efficiency”, American Economic Review, (June, 1966) “Entrepreneurship and Development”, American Economic Review. (May, 1968).

[2)]Schumpeter, op.cit., p. 154.

[1]See on this the masterful passage in Hayek, Individualism and Economic Order, pp. 201-203.

[1]Schumpeter, op.cit., pp. 138ff.