Schumpeter’s Innovators

Originally published on September 7th, 2010.

This week we’ve celebrated the birthdays of two heroes, Ayn Rand (Feb. 2nd) and Ronald Reagan (Feb. 6).  

But today marks the birthday of another world-changing leader in the annals of liberty, Joseph Schumpeter, born on February 8th, 1883.

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No one did more to create the popular imageof the heroic entrepreneur than the Moravia-born economist Joseph Schumpeter (1883-1950), who was for many years aprofessor of economics at Harvard University.

Best known for his book Capitalism, Socialism, and Democracy (1942), Schumpeter wrote that: “Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary.  The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”

This endless generation of new goods and services and methods means, at the same time, the continual elimination of old goods and services and methods. From these observations came Schumpeter’s most famous statement: “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.”

According to Schumpeter, the process of creative destruction is (or at least historically has been) brought about by the entrepreneur. “The function of the entrepreneur is to reform or revolutionize the pattern of production by exploiting a new 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 goes on to sketch out the moral portrait of the entrepreneur by insisting that the business of entrepreneurship is nobly arduous and even dangerous. “To undertake such new things is difficult and constitutes a distinct economic function, first, because they lie outside the routine tasks which everybody understands and, secondly, because the environment resists in many ways that vary, according to social conditions, from simple refusal either to finance or to buy a new thing, to physical attack on the man who tries to produce it.”

Entrepreneurship, consequently, is the work of a few heroes. “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.”

But Schumpeter believed that the need for heroic businessmen of this cast will eventually dwindle,  just as the need for charismatic military leadership has given way to rational and professionalized generalship. “It is much easier now than it has been in the past to do things that lie outside familiar routine—innovation itself is being reduced to routine. Technological progress is increasingly becoming the business of teams of trained specialists who turn out what is required and make it work in predictable ways.”

Moreover, because entrepreneurship is the revitalizing source of new recruits to the bourgeoisie, the business class too will eventually vanish, with businessmen becoming mere paid administrators of “the perfectly bureaucratized giant industrial unit.”

KNIGHT’S GAMBLERS

Far less well known to the general public is the work on entrepreneurship done by another professor, Frank H. Knight (1885–1972), a founder of the so-called Chicago school of economics, to which Milton Friedman and George Stigler later belonged. Knight’s principal work on entrepreneurship is presented in his book Risk, Uncertainty, and Profit (1921), which grew out of his Ph.D. dissertation. His key distinction in that volume was between a “risk,” which has a known probability, and an “uncertainty,” which does not.

Thus, the chance of my becoming incapacitated during the coming year can be calculated very closely, based on my age and health history, and an insurance company could know how much to charge a large group of men like me in order to provide disability insurance while still being very confident of making a profit.  On the other hand, my chance of writing a best-selling book during the coming year is not calculable. Even if I and others believe that I have a splendid idea for a book, there is no way of knowing whether I can execute it.  I have no track record in writing books.

Suppose, therefore, that I want to shift to someone else my uncertainty about the success of my book in the same way that I shift my risk of illness to the insurance company. I can go to a publisher and propose that he pay me to write my book. The publisher, for his part, would agree to get the book printed, advertised, and distributed to bookstores—in exchange for keeping the net revenue that it earned. Under this arrangement, what he gets over and above his costs will be his entrepreneurial profit, and it will be his rightly in return for bearing all the uncertainty of the venture.

Knight put it like this: “So we get a general picture of a society in which entrepreneurs hire the productive services, give them directions, and assure the workers or property owners an income, larger or smaller, according to their worth to the enterprise; what each adds to its total value-output. The entrepreneurs competitively hire the other productive services in the market… [But the entrepreneurs’] income, his profit, is not received as the price of anything. Market competition fixes the prices he pays and those he receives. The former, his costs of production, may add up to more or less than the resources actually turn out to yield, what the product will sell for. If less, the entrepreneur makes a profit; if more, he takes a loss.”

And why, according to Knight, do entrepreneurs characteristically undertake their peculiar function? Does his analysis yield any psychological or moral portrait of the entrepreneur similar to Schumpeter’s heroic maverick? Yes.

In Knight’s view, the entrepreneur performs two basic types of actions: “He makes the decisions and he takes the risks—the two are inseparable. Whoever makes the responsible decisions automatically assumes the risk involved in which those decisions turn out to be correct or more or less in error.” These actions are driven by two general motives: “Entrepreneurs are paid for their efforts and losses—like outright gamblers as a class—by the excitement of the game, and by pride in bossing rather than being bossed.” In short, Knight’s entrepreneur seeks thrills and authority.

KIRZNER’S ARBITRAGEURS

A third leading theorist of entrepreneurship is Israel Kirzner (1930– ), now an emeritus professor of economics at New York University. Kirzner has built on the insights of Ludwig von Mises to produce a theory of entrepreneurship compatible with the so-called Austrian school of economics. Like Knight, Mises believed that the entrepreneur thrives on uncertainty. But he put one kind of uncertainty at the core of his theory: the future demands of consumers. As Kirzner elaborates in his book Competition and Entrepreneurship, this kind of entrepreneurship may be thought as a form of arbitrage.

In the usual case of arbitrage, a person sees a discrepancy in the prices offered in two different markets. For example, people who are looking for ready cash may be willing to sell their gold jewelry cheaply, while people who are looking to hold gold as a hedge against inflation may be willing to pay dearly for it. If these two parties are, for some reason, unaware of each other’s existence, an arbitrageur can step in, buy the gold jewelry from the needy and sell it to the investors for a much higher price, pocketing the difference.

According to Kirzner, entrepreneurs do much the same thing. They see that various factors of production are being sold at certain prices, and they see that those factors, if properly employed to make certain goods, could be sold for a price that would more than repay the costs of purchase and manufacture. Thus, the entrepreneur’s profit comes from difference between (on the one hand) the price for which the finished goods can be sold, and (on the other) the combined cost of the factors of production and the costs of production.

What makes this case of arbitrage peculiarly entrepreneurial, Kirzner says, is that “at the time of the production decision the product prices do not yet exist except as anticipations. The entrepreneur guesses that future product prices will not be fully adjusted to today’s input prices.”

A key point of Kirzner’s theory, as he emphasizes, is that entrepreneurship is fundamentally competitive—though not necessarily against other entrepreneurs. The entrepreneur begins by looking at the present prices of inputs, and those prices are set by the demand being generated from all buyers who want to own the inputs. The entrepreneur is willing to compete against that entire body of would-be buyers and offer a slightly higher price for at least some of the inputs, presumably because he sees the means of turning the inputs into more valuable products than his competitors do.

This is why Kirzner says that the only attribute required of the entrepreneur is “alertness.” Indeed, we may say that “alertness” is all that the entrepreneur contributes to the entire process of production. After all, he need not possess the capital with which to buy inputs (he can borrow that) and he need not control the managers, or workers, or machinery needed to produce the outputs he envisions (those can be hired). But this alertness is obviously different from the alertness of the ordinary arbitrageur, who simply sees an existing discrepancy in prices. The entrepreneur is alert to what might be.

WHAT IS COMMON?

As the great bard of entrepreneurship, Schumpeter’s permanent value seems to lie more with his imagery than with his theories. For him, entrepreneurship meant a few far-seeing innovators smashing up the place. Unfortunately, in his eyes, innovation was now becoming rationalized and professionalized and by that very fact it was ceasing to be the work of entrepreneurs, which was necessarily heroic.  

What Schumpeter failed to understand, I believe, is that much good innovation (such as he saw around him) can take place as ordinary technological improvement, but it takes place within the larger cycles of revolutionary innovation that are necessarily driven by rare geniuses. The former is not to be dismissed or demeaned, but it cannot replace the latter. Thus, the Schumpeterian entrepreneur we shall always have with us (so long as the free society lasts).

Knight’s entrepreneur is, in a small way, a reflection of Schumpeter’s, although it should be noted that Knight’s work came before Schumpeter’s. There remains something of the hero about Knight’s little entrepreneur as he confronts his irreducible uncertainty, having no sure and rational guide but only his own well-honed habits of judgment.

Israel Kirzner, however, is less emphatic about the need for the entrepreneur to operate in utter uncertainty: After all, when Henry Bessemer discovered his process of producing incredibly cheap steel, he was in no serious doubt about the future demand for his product.  Thus, Kirzner stresses instead the fundamental principle that the entrepreneur believes his judgment is superior to that of his most direct competitors. In that sense, Kirzner’s entrepreneur is very close to the speculator, and he resembles the Schumpeterian entrepreneur mainly in challenging the common herd.

What is common to these views of the entrepreneur, we may describe thus:  He is the responsible decision maker, and he plays his role successfully when he makes a correct decision in a situation presenting no obviously right course.

ПРЕДПРИНИМАТЕЛЬСКАЯ ЖИЗНЬ

In his essay “Life: Your Adventure in Entrepreneurship,” Kelley described what he called an entrepreneurial

attitude toward life. This attitude, he said, “is in part a sense of self-ownership, a conviction that one’s life is one’s own, not something for which one must answer to some higher power. In part, it is a willingness to set the terms of one’s life—to form convictions, to choose goals and values, and to make decisions—by one’s own judgment, without dependence on others. And in part it is a spirit of self-reliance, initiative, and alertness to opportunity, a belief that life is what you make of it.”

How does this description of “the entrepreneurial life” correspond with the several notions of the entrepreneur described above? More to the point, is this outlook a useful guide to living? In two ways, I think that it is. But in three crucial ways, I think that it is not.

First, Kelley is certainly correct that, as the entrepreneur is the ultimate decider economically, so the individual human is the ultimate decider metaphysically. That is simply inescapable. Whether a person is a Pragmatist setting his own moral rules or a devout Christian following the Ten Commandments, his is the decision in every choice, and he must bear the primary consequences.

Secondly, as we have seen, alertness to opportunity belongs to the very essence of the entrepreneur, and I would certainly agree that it is also an essential element of living well. Happiness does not come easily to humans, and opportunities for happiness are—alas—far more easily seen in retrospect than in the moment. “Of all the sad words of tongue and pen, the saddest are these: It might have been.” Thus, alertness to opportunity is an undoubted virtue.

But I have three objections to using entrepreneurship as a model for life. There is no doubt, no doubt at all, that we should admire the entrepreneur as an economic actor. But I believe we should realize that his situation does not represent the general human condition.

To begin with: Entrepreneurs risk only money, and generally they risk only the capital at stake in a limited liability corporation. In life, we risk everything. Life has no bankruptcy court in which we can limit our losses. For that reason alone, in his private life, the individual must grant the virtues of caution and prudence a higher priority than the entrepreneur typically does.

Secondly, entrepreneurs profit by embracing uncertainty, but human happiness—unless one is a thrill-seeker—is not the product of embracing uncertainty. It is the product of minimizing uncertainty. Human happiness is rightly pursued by exercising consistently and relentlessly the best-known, most-trustworthy means of producing happiness, which we call “virtues.” Some uncertainty of result will remain, of course, but that is a matter for resignation, not celebration.

Lastly, life is not inherently competitive, as entrepreneurship is. Man’s fundamental means of survival is rational production, the tools for which are internal to the individual. Thus, metaphysically, man is capable of surviving on his own (which some social insects apparently are not). But the task of living is so great that men need every aid they can obtain. Most especially, they need the aid of other men. They need the institutional aid offered by civil and political society, and they need the intellectual aid offered by education and tradition. Thus, the pursuit of human happiness, unlike the pursuit entrepreneurial profit, is fundamentally a matter of cooperation.

None of which is to say that I have a deep objection against comparing human life to a science or an art or a business—or to entrepreneurship. But we should recognize that, in the end, all such metaphors are limited.

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