Friday, October 13, 2006

A world of entrepreneurs

Any issue can usually be seen from different perspectives. Although all points of view might lead to many of the same conclusions from different directions they also make one judge differently what are the most relevant aspects. The focus can vary.

Economic issues can be perceived from roughly three distinct points of view: macroeconomic, microeconomic, and entrepreneurial. The macroeconomic approach is causal, trying to predict what is going to happen on the basis of what exists now and taking into account what has happened in the past. The microeconomic approach is intentional, trying to predict what is going to happen on the basis of what people desire and what means are available (or can be created). Finally, the entrepreneurial approach is neither causal nor intentional – it tries to explain how new things appear without a particular cause or without a preconceived plan. They all have a lot of things in common because they all use the same data and describe the same thing, but they focus on very different things.

The causal approach

One can think about the presence or absence of various incentives or deterrents and about how they affect the processes on the market. From this perspective, economic phenomena are strictly causal; the entire economic system has a lot of "dials" that one could tinker with – the entire system is described by a large set of more or less independent variables. These "dials" are modified either by government's actions or by the actions of various private individuals, firms or corporations.

This is a social or statistical approach, ignoring what particular individuals want. What one tries to do when thinks from this perspective is to unravel the relations, which are often feed-back relations, between various variables. For example one can say that a subsidy S for X would increase the quantity of X by a certain amount and decrease the quantities of A, B and C (because resources are redirected from them to X). X might be anything from education, health care or unemployed people to infrastructure in remote areas or oil drills. Finding out the nature of A, B and C (and possible D, E and so on) is trickier.

[Ignoring the side-effects A, B, C etc. has been famously identified by Henry Hazlitt as the most important source of economic errors. "In this lies the whole difference between good economics and bad," he wrote. "The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups."]
Such a macroeconomic causal perspective is usually used by governments, mass media and brokers. This is because they are interested in what happens in society at large. But, insofar, in order to develop such a statistical perspective, they have strongly, and controversially, relied on the idea of equilibrium. It is assumed that society is in a state of equilibrium and that when something is changed (and all other things are kept unchanged!) the entire economic system would gradually tend toward a new state of equilibrium. The models can only tell you the variable's equilibrium values. So, to the extent that the real economic system is not in equilibrium these models are approximate. For example, a macroeconomic model could predict the average gas price, but would be incapable of predicting the actual price one particular gas pump would ask.

As macroeconomic models got better and better one interesting thing rose to the surface: chaos. The models' formulas exhibit the fact that small changes in one variable could lead to widely different equilibrium end states. In other words, the economic system is less of a quit river and more of turbulent one.

Economists favoring the microeconomic perspective have hailed this discovery because it backs up what they have been always saying: that the individuals cannot be taken out of the picture. The individuals are the ones causing the small changes and their importance is felt even at the macroeconomic level.
"The chaos theorists are opposed to the common statistical technique of 'smoothing out' the data by taking twelve-month moving averages of monthly data – whether of prices, production, or employment," Murray Rothbard wrote. "In attempting to eliminate jagged 'random elements' and separate them out from alleged underlying patterns, orthodox statisticians have been unwittingly getting rid of the very real-world data that need to be examined."
Chaos theory was developed especially by a group of physicists at Los Alamos National Laboratory. At first, they were interested in meteorology and tried to figure out how to predict the weather, despite the chaotic behavior of the atmosphere. When the funding dropped in early 1990s, two of them, Doyne Farmer and Norman Packard, who were previously working on the modeling of the catalytic behavior of pre-biotic chemistry, decided to use their mathematical knowledge on the stock markets. They created the Prediction Company and, after 5 years of improving their mathematical models, they eventually won a million dollars in one day (8 April 1996) when all the other investors were taken by surprise.
"Everyone knows that prices in financial markets move up and down, but no one knows why or how," Doyne Farmer explained. "Economists claim these price moves are a 'random walk' that they are the unpredictable product of 'efficient markets' and that prices in these markets reflect the activity of rational, logical, and always equally well-informed investors."

"I don't know about you, but I'm not always a rational human being, and I think this is a pretty far-fetched view of the world. There are patterns in market data they appear more often than one would normally expect, and they reappear in the future. We monitor many inputs, continually evaluating which ones are relevant. We look for pockets of predictability, shifting regimes where order can be found emerging from what are otherwise highly chaotic time series."
In other words, they are looking for the appearance of economic turbulence. In a quiet pond the water molecules are moving completely at random in all directions – that's why there is no overall motion and the water looks still; but when there is a vortex, the molecules are caught in an emergent pattern of ordered motion – they all rotate together and give shape to that vortex. It might seem that a turbulent flow is more disordered than a quiet lake, but actually it is exactly the opposite! The Prediction Company approach finds similar turbulent order in the economic data. The orthodox statisticians average out the vortexes as if they weren't there.

The intentional approach

A different way of looking at economic phenomena is to look at the market from the consumer's point of view. Things happen as they do because various people want certain things and choose certain means for achieving what they want. The market is a process driven by demands (desires and needs). Thus, instead of looking at the past and present, one can try to make predictions based on the estimation of what people want for their future.

This approach, not surprisingly, is employed mostly by marketing research and by individual businesses. A firm has to decide how much to produce and what price to ask so it has to guess and, to the extent that is possible, influence the desires of the potential customers. But this view also offers a way to look at the entire economy and a way to explain where the chaos comes from.

Where does that economic turbulence come from? Why does that self-organization appear and what breaks the "random walk"? Why isn't the economic system in equilibrium? This ultimately means two things: What are the consequences of the fact that people don't just respond to incentives like Pavlov's dogs, but have goals. And, easier to answer, why do people want so many more things today compared to what they wanted a hundred years ago?
"The rich adopt novelties and become accustomed to their use. This sets a fashion which others imitate," Ludwig von Mises wrote. "Once the richer classes have adopted a certain way of living, producers have an incentive to improve the methods of manufacture so that soon it is possible for the poorer classes to follow suit [because an increase in the number of produced products lowers their price]. Thus luxury furthers progress. Innovation is the whim of an elite before it becomes a need of the public. The luxury today is the necessity of tomorrow. Luxury is the roadmaker of progress: it develops latent needs and makes people discontented."
But of course not every whim of a celebrity is elevated into a public desire. And maybe not every single public need has to start as a celebrity's caprice – although it's pretty hard to find actual examples when this hasn't been so.

Moreover, the methods for producing something can change. For example, solar panels are not a public desire right now because they are too expensive, but if a cheaper technology were invented, they would probably become a public desire (because having solar panels would make you independent of the official power grid and I suppose people would find that desirable). But who knows when such a cheaper technology would be invented and by whom? So, one is left with a big deal of uncertainty.

The division of labor and of knowledge

Besides the uncertainty factor that permeates every aspect of the market, there is the fact that everybody is different. And it isn't just that people look different, but they behave differently. The billiard balls for instance also look different but they behave the same. (See non-ergodicity.) This is one of the major causes behind that spontaneous order that messes up the equilibrium.

This is probably one of the least intuitive economic discoveries, brought to the attention of the world by Adam Smith in the 18th century, but still largely unknown to the general public. Most people believe that cooperation is possible only if people see each other as the same, if they come to believe that they have more things in common than things setting them apart. For some reason this is a highly intuitive opinion. But it is also wrong.

In reality, what makes cooperation possible is precisely the difference. You cooperate with somebody because he or she can do for you something that you cannot do yourself (or because you can do it only poorly). In other words, cooperation is an exchange of services – a process similar to trade which is an exchange of goods. In the same way as you don't buy what you already have, you don't cooperate with the behaviors you yourself have.

The social outcome of cooperation is the division of labor. Each individual specializes in what he or she can do best, and uses the services of others. For instance, Mr. A is a lawyer. He is good at defending himself in court. He does this better than any other thing. So, he specializes in it and starts defending other people as well – for instance he defends Mr. B who is an accountant. Mr. B is better at bookkeeping than at anything, including at defending himself in court. Maybe Mr. B could have been a better lawyer than Mr. A. Who knows? The point is he ended up being an accountant and he now hires Mr. A to defend him in court. Similarly, maybe Mr. A could have become a better accountant than Mr. B. But he didn't because he was better at being a layer than he was at being an accountant.

This is an idealization of course. But it explains why everybody in society becomes specialized and it allows us to understand why, in general, in such a society each individual is better of. On average, one gets better services than one could have had if one would have done everything for oneself (self-sufficiency is not a very efficient way of getting things done). Moreover, it explains why one can find a job for doing what he or she can do best although one is not the ultimate expert in that field. The division of labor doesn't promote the "survival of the fittest", but finds a place even for the least unfit.
"Society is joint action and cooperation in which each participant sees the other partner's success as a means for the attainment of his own," Mises wrote. "People do not cooperate under the division of labor because they love or should love one another. They cooperate because this best serves their own interests. Neither love nor charity nor any other sympathetic sentiments but rightly understood selfishness is what originally impelled man to adjust himself to the requirements of society, to respect the rights and freedoms of his fellow men and to substitute peaceful collaboration for enmity and conflict."
As you can imagine, the economists who adopt this microeconomic point of view have the tendency of being in favor of laissez-faire. This happens because they see the organization of society as the spontaneous outcome of multiple voluntary exchanges. The selfishness of individuals is not a destructive force, but the very engine of the social self-organization. Trying to interfere with this self-organization only messes things up.
"All this talk: the state should do this or that, ultimately means: the police should force consumers to behave otherwise than they would behave spontaneously," wrote Mises.
Moreover, besides the idea that one shouldn't even try to interfere with what people do voluntarily, they argue that even if one tries to do it, one has little chances of success. This is because, besides the division of labor, there exists an equally important division of knowledge. Together with the ability of doing some specialized work comes the know-how of that work, the knowledge of what is relevant.
"The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess," Friedrich Hayek wrote. "To put it briefly, [the economic problem of society] is a problem of the utilization of knowledge which is not given to anyone in its totality."
In other words, if one tries to fix the problems that arise on the free market by changing the "dials" of the economic system, one needs to take into account so much information that one simply cannot gather and process. And one would certainly need better models than that equilibrium model. "We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based," Hayek said in his Nobel Prize lecture in 1974, "a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed."

He calls the market a "communication system" because the prices, especially the high prices, act like signals for entrepreneurs telling them where the profits are. Since 1974 mathematicians have found out why this "communication system" is so difficult to model – it is chaotic. So, the irony is that economists have been making for almost a century all sorts of macroeconomic recommendations affecting the lives of millions of people based on models that are worse than the weather prediction models!

The entrepreneurial approach

The entrepreneurial approach is also microeconomic, but in a certain sense, it's the exact opposite of the intentional approach. In some other sense, it goes deeper within the individual's mind. While the previous view sees the individuals as a sort of maximizers that compute the best path toward their goals, this view sees individuals as trying to figure out what goals to pursue given the available means.

Historically it hasn't been very clear what exactly does it mean to be an entrepreneur. Economists usually considered the entrepreneur as the one that takes the risk and deals with the uncertainty. One way to understand this is to think about the interest rate a bank gives you. Part of that interest rate is due to the fact that there is a certain risk you will not get your money back. That risk is small so the interest rate is also small. But other activities are riskier and, consequently, have higher interest rates. Buying stock for instance is riskier than putting your money in a bank but a stock broker promises you a higher gain.

Similarly, you can see any profit as a kind of interest rate. Conversely, you can see lending your money to a bank as a type of investment (with a very low profit). The entrepreneurial side of humanity is thus, in this first approximation, that side in you that takes risks – that deals with uncertainty.
"Let's assume that all the uncertainty in the world is subsumed within the entrepreneur, and nobody else has any element of uncertainty," Israel Kirzner wrote. "The actions of everyone else are not human actions; they are the movements of robots. Neither the laborers, nor the capitalists [resource owners], nor the consumers are entrepreneurs. They are Robbinsian maximizers. ... In the real world, of course, no one performs a purely non-entrepreneurial function. The consumer is an entrepreneur, the capitalist is, and the laborer is too. They are all taking risks, taking leaps. They are all forgoing some opportunities for others."
According to this view, the entrepreneur gains some profit by noticing what others don't notice. Regular profits appear because the value of the products is higher than the value of the utilized resources (that's what "being efficient" means). But the entrepreneurial profits are just a reward for having the "guts" to take your chances or for having been more "alert".
"Pure entrepreneurial profit," Kirzner wrote, "is not a payment for something for which a price can be established; the entrepreneur is paid for overcoming ignorance through alertness. A person might say, you have no right to cash in on somebody else's ignorance. Now is everybody who makes a pure profit cashing in on somebody else's ignorance? In fact, yes. Full and equal knowledge is not a reality. If people could not cash in on other people's ignorance, there would be no such thing as pure profit."
According to this view, the Prediction Company's profits are nothing but "pure profits". But there is more than just than. One of the pioneering economists who emphasized the importance of entrepreneurship, Joseph Schumpeter, thought that the entrepreneurs are the reason why the market is never in equilibrium. He coined the term "creative destruction" in order to describe the impact entrepreneurs have on the market.
"The opening up of new markets and the organizational development from the craft shop and factory to such concerns as US Steel illustrate the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one," he wrote. "[The industrial mutation] must be seen in its role in the perennial gale of creative destruction; it cannot be understood on the hypothesis that there is a perennial lull."
Schumpeter's views have been taken further by Kirzner, who also brought the entrepreneur theory in line with Mises-Hayek approach, revealing the complementarity between the two views. They offer two perspectives on why the market is not in equilibrium.
"We have to recognize that when the entrepreneur discovers the automobile, he is not simply disrupting the calm," Kirzner said. "He is identifying what was in fact waiting to be introduced. Technological knowledge was being misapplied. Resources were being wasted on trains, carriages, and bicycles, when, in fact, what was waiting to be put together was this new gadget called the automobile. A person who recognizes this is responding to a preexisting, gaping hole in the market."
And yet, this is still not describing everything about the entrepreneur! This assumes that all the possibilities somehow exist in an abstract way and that the entrepreneur just moves in this space of predetermined possibilities. But in fact, the entrepreneur doesn't just move in a novel direction, he or she is actually creating the very possibility of moving in that direction. The entrepreneur often takes a leap in the dark, without a clearly determined end in mind.

In 1997, Saras D. Sarasvathy traveled through 17 states in US to talk to 30 entrepreneurs who had founded companies ranging in size from $200 million to $6.5 billion. Her conclusions, published in 2001, turned on their head many assumptions about how entrepreneurs think and act. She found that being an entrepreneur mainly means deciding to what ends to use the available means. "Starting with exactly the same product, the entrepreneurs in the study ended up creating companies in 18 completely disparate industries!" she wrote.
"All entrepreneurs begin with three categories of means:
  1. Who they are – their traits, tastes and abilities;
  2. What they know – their education, training, expertise, and experience; and,
  3. Whom they know – their social and professional networks.
Using these means, the entrepreneurs begin to imagine and implement possible effects that can be created with them. Most often, they start very small with the means that are closest at hand, and move almost directly into action without elaborate planning.

Unlike causal reasoning that comes to life through careful planning and subsequent execution, [the entrepreneur] lives and breathes execution. Plans are made and unmade and revised and recast through action and interaction with others on a daily basis.

Yet at any given moment, there is always a meaningful picture that keeps the team together, a compelling story that brings in more stakeholders and a continuing journey that maps out uncharted territories. Through their actions, the effectual entrepreneurs’ set of means and consequently the set of possible effects change and get reconfigured. Eventually, certain of the emerging effects coalesce into clearly achievable and desirable goals – landmarks that point to a discernible path beginning to emerge in the wilderness."

So, it isn't just that entrepreneurs disrupt the market as it is, they actually create it. Among the most interesting discoveries of Sarasvathy's study is that entrepreneurs are not driven by the desire to maximize their profits but think in terms of what losses are affordable. This sounds very odd if one views the entrepreneur as that heroic individual who is daring to take risks where others don't. In reality, the entrepreneur is the one that often tries something just for the sake of it, simply because it is an affordable loss, and then goes from there in any conceivable direction if things "click" one way or another with the customers.

This isn't very different from what we are doing all the time, and brings new meaning to Kirzner's idea that in order to understand the market all individuals have to be viewed as entrepreneurs (rather than like Pavlovian creatures reacting to incentives or like maximizers that just compute what are the best means).

The typical logic employed by economists is "To the extent that we can predict the future, we can control it", while the entrepreneurial logic is saying "To the extent that we can control the future, we do not need to predict it", Sarasvathy noted. As I argued on another occasion, the intuitive understanding of uncertainty has little to do with what you can predict via probability theory and more with what you can control. (If you assume that being rational means solving problems in probability theory than you are left with a bunch of paradoxes that seem to imply we are awfully irrational.) The notorious entrepreneurs don't just deal with uncertainty better, they literally have fewer uncertainties as they manage to use their skills to gain more control.

Thus, it is not surprising that Sarasvathy found that entrepreneurs rely more on personal connections and on developing "strategic partnerships" rather than on elaborate planning and that they generally don't think about the competition (at first competition might not even exist!) but more about how to do best what they themselves are doing.

Perhaps most importantly, the entrepreneurship thrives on contingency. While from an orthodox perspective randomness is something that messes up your plans, entrepreneurs usually welcome randomness as a kind of resource. When unexpected happens they try to incorporate it what they're doing and to change their plans accordingly – in other words the unexpected in an opportunity. In fact, due to the uncertainty of the whole entrepreneurial process and due to the impossibility to plan everything in advance one has to hope good surprises will be part of the journey.
"They believe in a yet-to-be-made future that can substantially be shaped by human action;" Sarasvathy wrote, "and they realize that to the extent that this human action can control the future, they need not expend energies trying to predict it. In fact, to the extent that the future is shaped by human action, it is not much use trying to predict it – it is much more useful to understand and work with the people who are engaged in the decisions and actions that bring it into existence."

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