Revolution

Notes on Kirzner's Competition and Entrepreneurship

These are my notes on Israel Kirzner's Competition and Entrepreneurship for an economics project in college.


Market Process

Market theory (also called price theory or microeconomic theory) tries to explain relationships among observed market phenomena. Two alternative approaches to market theory are the orthodox neoclassical theory (developed mainly by Marshall, Robinson, Chamberlin and Walras) and the Austrian market process theory (developed by Mises, Hayek and Kirzner).

The objective of orthodox theory is to determine market equilibrium, generating numerical values for prices and quantities at which transactions are made. Orthodox theory analyzes the effects of exogenous change and policies in terms of their effects on equilibrium. Equilibrium is the "one set of planned activities" that allows all planned transactions to be carried out. (p. 4)

The objective of market process theory is to "understand how the decisions of individual participants in the market interact to generate the market forces which compel changes in prices, in outputs and in methods of production and the allocation of resources." (p. 6)

Market participants make decisions (plans), many of which anticipate other participants' actions. With imperfect knowledge, at the end of a given period, many individuals will find that their plans could not be carried out (too optimistic) or were carried out but failed to take advantage of more beneficial opportunities (too pessimistic). Through market participation, individuals see others' actual decisions (often in the form of prices), gaining knowledge that causes them to revise their plans. This market process ("series of systematic changes in the interconnected network of market decisions" p. 10) occurs even without change in the "data" or underlying conditions of trade.

With perfect knowledge, individual plans will be made so that none fail (from being too optimistic or pessimistic). The market process ceases (no adjustments occur), and equilibrium exists.

Opportunuties (offers) to buy and sell are available in the market. An individual (buyer or seller) accepts the offer he believes is the best available, and at the same time realizes that others will accept his offer only if they believe it is the best available to them. The market process in inherently competitive, as individuals try to make their offers better than everyone else's. This competition forces individuals "to gravitate closer and closer to the limits of their ability to participate gainfully in the market." (p. 12)

With perfect knowledge, everyone knows which offer is best, so that competition ceases, and equilibrium exists.

With imperfect knowledge, profit opportunities exist in the market. All such opportunities consist of price differentials; a good (or bundle of inputs) can be bought at a lower price than it (or its product) can be sold. Entrepreneurship is alertness to unnoticed price opportunities. Entrepreneurs exploit these opportunities, and through competition with each other, eliminate them. The market process is inherently entrepreneurial because individuals learn from their participation in the market.

With perfect knowledge, there is no scope for competition or entrepreneurship. The theory of perfect competition, which assumes perfect information, has no relation to competition (the process), except possibly as the result of competition, after the process has completed its course.

Production

Production is the conversion of resources (inputs, factors, producer goods) into products (outputs, consumer goods). In a market with production, individuals can be grouped into resource owners, producers and consumers. Producers are entrepreneurs who buy resources from resource owners and sell them (in the form of a product) to consumers. Even if a producer owns one of the resources himself, he must 'buy' that resource from himself in the form of opportunity cost (what he could sell it for in the market). Production is arbitrage (entrepreneurship), the exploitation of price differences.

Production is inherently entrepreneurial and competitive, and cannot be monopolized. The situation of a single seller then must be analyzed taking into account whether the position is the result of offering the best opportunities to the market or the result of monopolized resource ownership. Monopolized resource ownership can be the result of competitive entrepreneurial activity.

Entrepreneurship

Entrepreneurship requires no resources to be initially owned, and 'pure' entrepreneurship (a mental tool) is exercised only in the absence of resource ownership.

Orthodox theory interprets human behavior as economizing (maximizing, allocative, "Robbinsian"). Individuals apply given means to given ends, and the best course of action is implied in these data. Changes in the means and ends are exogenous.

Market process theory interprets human behavior as human action, a wider view which includes the perception of means and ends. The orthodox individual is a mere calculator. "Mises' homo agens, on the other hand, is endowed not only with the propensity to pursue goals efficiently, once ends and means are clearly identified, but also with the drive and alertness needed to identify which ends to strive for and which means are available." (p. 34)

The entrepreneurial element of every human action is "alertness to possibly newly worthwhile goals and to possibly newly available resources." (p. 35) With perfect knowledge, the entrepreneurial element would be unnecessary, but in the real world, knowledge is imperfect.

Economic analysis can be simplified by separating decisions into entrepreneurial and economizing elements. 'Consumers' and 'resource owners' economize, and 'entrepreneurs' display alertness (in real life, of course, an infividual will fall into all the categories).

'Producers' are both entrepreneurs and economizers at different stages of production. If the producer contributes an input (for example, managerial skills), he is economizing. In deciding which inputs to hire and which outputs to produce, he is an entrepreneur. As entrepreneur the producer decides what he believes to be cost and revenue functions; as economizer the producer uses those judgments to select a production process. The initial decision to purchase inputs is entrepreneurial; once the inputs are acquiredm the decision to actually produce (or to change the initial plan instead) is the decision of a resource owner.

Profits result from resource ownership or from entrepreneurship. Owners' profit results from an exchange, and is the difference between the value of what is received and the value of what is given up. Entrepreneurial profit is the difference between the price paid and the price received; nothing is given up. Profit is usually the result of more than one decision, and so can be viewed as either owners' or entrepreneurial depending on which decision is being analyzed.

Capitalists are resource owners. A production process that takes time requires capital, that is, resources advanced by owners who agree to receive payment (with interest) at a later date.

Orthodox theory concentrates on the "firm" as the decision-maker in production, and firm's behavior maximizes profit. In market process theory, the firm is the result of a partially-completed entrepreneurial decision, being basically an entrepreneur who has already acquired some resources. "Profit-maximization" is not used to interpret firms' behavior. The producer as resource owner maximizes the value of his resources, but as entrepreneur is alert to new uses for his resources.

The corporation poses a problem for orthodox theory because 'control' (managers) is separated from 'ownership' (capitalists or stockholders), so that profit may not be maximized. In market process theory, there is no problem. If the managers receive only their wages, they are hired resources; if they in addition extract other (possibly nonmonetary) benefits from their position, they are acting also as entrepreneurs; if instead, they steal benefits, then revenue will not cover costs and they will be fired.

Entrepreneurship is not merely the possession of knowledge of price differences; such knowledge can be hired, in which case the one who does the hiring is the entrepreneur. Hiring itself can be hired (a personnel manager), in which case the one who hires the hirer is the entrepreneur. The enterpreneur is the one with the ultimate knowledge, the one who does the ultimate hiring, the one who decides to bring all the inputs together to produce an output.

Entrepreneurship is the ability of individuals to learn from market participation. This alertness to opportunities sets the market process in action, generating changes in individual plans, eliminating price differentials.

Other Theories of Entrepreneurship

"Naive profit theory" associates entrepreneurship with risk-bearing. It is simply an input, and profits are its wages, resulting from having no contractual claim to income. This definition leaves alertness (learning, deciding to produce) unexplained.

Schumpeter's theory sees the entrepreneur as an innovator. The innovator acts in equilibrium, disturbing it with innovations and creating opportunities. Schumpeter recognizes that entrepreneurship is not an input and that profits are not wages.

In market process theory, the market is already in disequilibrium, so that the opportunities already exist, and the entrepreneur notices (not creates) them. To Schumpeter, 'imitators' restore equilibrium (through price competition) after the innovator's disturbance (through quality competition). In market process theory, both imitators and innovators are equally entrepreneurial, and both push a disequilibrium world closer to equilibrium. Schumpeter's main mistake is to believe that opportunities for innovation could exist in an equilibrium world, with perfect knowledge of products and production processes.

Knight's theory is that profit is compensation for uncertainty-bearing. "Profit is the residual, if any, left for the entrepreneur after he pays out the contractual incomes agreed upon for the factors he hires." (p. 82) Knight's view neglects the fact that every entrepreneurial venture is believed to be profitable by the entrepreneur who starts it. Knight's theory ignores "the active, alert, searching role" of the entrepreneur. (p. 83)

Market process theory is derived mainly from Mises' concept of entrepreneurship. Mises (in Human Action, pp. 253-5, 288) sees all profit as arbitrage. "Profit opportunities arise when the prices of products on the product markets are not adjusted to the prices of resource services on the factor markets. ... The entrepreneur notices this price discrepancy before others do." (p. 85)

Competition

In orthodox theory, competition and monopoly are situations; the theory models various market structures in equilibrium, labeling them 'competitive' or 'monopolistic.' The model of perfect competition is "the situation in which every market participant does exactly what everyone else is doing, in which it is utterly pointless to try to achieve something in any way better than what is already being done by others, and in which, in fact, it is not necessary to keep one's eyes open to what the others are doing at all." (p. 90) An obstacle to competition is any deviance from the assumptions of the perfect competition model.

The layman's definition of competition is the opposite, a rivalrous process of trying to do better than one's competitors. The market process theory's definition of competition is closer to the layman's; competition is "the active process of offering the market opportunities which one believes are better than those others are able or willing to offer." (p. 96)

In market process theory, an obstacle to competition is anything that prevents participants from offering opportunities to the market (restricted entry). The only possible barriers to entry are the use of force (including government restrictions) and monopolized access to some resource. Pure entrepreneurship is always competitive because it requires no resources.

In orthodox theory, monopoly is a firm's monopoly over a product. The concepts of the firm and the industry are essential, and substitutability of products raises problems. Monopoly is present whenever a firm faces a downward-sloping demand curve. Monopoly is inefficient because it causes a smaller output to be produced than perfect competition would. Welfare appraisal requires looking at immediate allocation of resources.

In market process theory, monopoly is a resource owner's monopoly over a resource. The mere fact that a producer is the sole producer of a given product, or that a producer faces downward-sloping demand, does not imply monopoly. A sole producer without sole access to a resource is under as much competitive pressure as anyone else. A monopolist could even face horizontal demand (for example, if he does not realize that the product produced with his monopolized resource is a superior one). At the entrepreneurial level, the demand curve is not a given, and so its shape is irrelevant. The industry and the firm are irrelevnt to competition and monopoly, and competition and monopoly are irrelevant to the firm (which is an economizer).

Monopoly is inefficient in market process theory is it causes a resource to be underutilized. Welfare appraisal must consider the long-term effects of the monopoly on the market process. Monopoly does not capture profits, but rents. The monopolist need not product using his resource; he could instead hire out to the market (receiving a higher price than if he were not a monopolist).

Quality is an economic variable as much as price and quantity. Product differentiation may exist at any point simply because the market is not in equilibrium (just as more than one price may exist at one time), and not because of any lack of competition (as is claimed by orthodox models of imperfect competition). The orthodox model of monopolistic competition is inherently flawed because it assumes both product differentiation (leading to profits) and free entry (which should eliminate profits).

The results of assessing monopoly often depend on whether the short- or long- run is examined. Monopoly can result from initial endowments created by the institutional setting (for example, in nonslave societies each individual has a monopoly over his labor), in which case profits and disadvantages should be attributed to the institutions. Monopoly can be the result of entrepreneurial effort, in which case profits can be attributed either to the monopoly position (short-run view) or to the entrepreneurial effort (long-run view). A quasi-monopoly can be the result of an entrepreneur being the first to exploit an opportunity when entry takes time; in this case the entrepreneur has a temporary monopoly while others begin to assemble the resources to compete, and this monopoly can be viewed the same way as the entrepreneurially-gained monopoly.