Notes 1 Economic Calculation and the Limits of Organization

^†Published originally in Review of Austrian Economics 9, no. 2 (1996): 51–77.

¹For overviews of the new institutional economics and the theory of the firm, see Coase (1991); Holmström and Tirole (1989); Langlois (1994b); Furubotn and Richter (1997); Williamson (2000); Ménard and Shirley (2005), and Brousseau and Glachant (2008). For surveys of related empirical work see Shelanski and Klein (1995); Klein (2005), and Macher and Richman (2008).

²The framework of transaction cost economics has already made it into textbook form: Kreps (1990b, pp. 744–90), Rubin (1990), Milgrom and Roberts (1992), Acs and Gerlowski (1996), Brickley, Smith, and Zimmerman (1997), and Besanko, Dranove, and Shanley (1998).

³Foss and Klein (2010) summarize some of this literature.

⁴For critiques of instrumentalism see Rizzo (1978) and Batemarco (1985). For references to the interpretative literature on Milton Friedman’s 1953 essay on “positive economics”— the source of most economists’ views on method—see Boland (1979), Caldwell (1980), and Musgrave (1981); all reprinted in Caldwell (1984) along with De Marchi (1988).

⁵For examples of the “standard account” of the calculation debate see Schumpeter (1942, pp. 172–86) and Bergson (1948). My discussion of the “revisionist view” follows Hoff (1949), Salerno (1990a), and Rothbard (1991).

⁶Other works that made arguments similar to that of Mises include N. G. Pierson’s “The Problem of Value in the Socialist Community” (1902) and parts of Max Weber’s Economy and Society (1921).

⁷It would no doubt be gratuitous to point out that since the collapse of central planning in Eastern Europe the writer of that comment has changed his mind, writing that although fifty years ago, it was felt that Lange had decisively won the argument for socialist planning, “now it turns out, of course, that Mises was right” (Heilbroner, 1990, p. 92).

⁸Lange actually claimed years later that even market socialism would be made obsolete with the advent of high-speed computers, which could instantly solve the huge system of simultaneous equations for the central planner. “Were I to rewrite my [1936] essay today my task would be much simpler. My answer to Hayek and Robbins would be: So what’s the trouble? Let us put the simultaneous equations on an electronic computer and we shall obtain the solution in less than a second. The market process with its cumbersome tâtonnements appears old-fashioned. Indeed, it may be considered as a computing device of the pre-electronic age” (Lange, 1965, pp. 401–02). Obviously, Lange did not have much experience with a computer. Also, during his time as chairman of the Polish Economic Council in the 1950s, Lange never tried to put market socialism into practice (see Lange, 1958).

⁹We tend to forget just how old the idea of socialism is, that it is not a twentieth-century invention; the subtitle of Alexander Gray’s famous book The Socialist Tradition (1946) is “Moses to Lenin.”

¹⁰Mises does devote a section of the 1920 paper to “Responsibility and Initiative in Communal Concerns,” but he clearly considers this a secondary problem for socialist planners, not the primary one. In the book-length treatment, Socialism (1922), Mises discusses the incentive problem in greater detail (pp. 163–84).

¹¹Rothbard (1962, pp. 612, n. 56) notes that the implicit transfer price may be somewhat more or less than the existing market price, since the entry of either the buying or the selling division into the external market may bid the price up or down slightly. Unlike Hirshleifer (1956), then, Rothbard does not require the external market to be perfectly competitive for a market-based transfer price to be economically meaningful. For Rothbard, “thin” markets are adequate: all that is necessary to have a genuine “external market” is the existence of at least one other producer (seller) of the intermediate good. (Of course, if external prices are perfectly competitive, then the economy must be in a competitive general equilibrium, in which information is perfect and all contracts are complete, and in which there is thus no need for firms.) Rothbard does not discuss the potential “holdup” problem that follows from relationship-specific investment under bilateral monopoly (Klein, Crawford, and Alchian, 1978), which should be considered a cost of reliance on an external market with a single supplier.

¹²This does not mean that because external prices are necessary for large firms to function efficiently, firms will necessarily become larger where external markets are “thick” or better developed. On the contrary, large firms typically arise precisely where external markets are poorly developed or hampered by government intervention; these are the kinds of circumstances that give entrepreneurs an advantage in coordinating activities internally. However, such firms are still constrained by the need for some external market reference.

¹³Lavoie briefly notes the Rothbard analysis in his Rivalry and Central Planning (1985, p. 62n). Fritz Machlup, in a comment on Rothbard’s 1976 essay, says he is “intrigued” by the analogy between the central planner’s problem and the firm’s problem, calling it “an issue I have tried to sell in several of my publications... but unfortunately not with sufficient success” (Machlup, 1976a, p. 114). He cites an early book (Machlup, 1934, esp. pp. 209–14) and a later article (Machlup, 1974, esp. pp. 42–45 and 52–54), both published in German, on the problem of “artificial” transfer prices. The argument is also foreshadowed by Hayek in Prices and Production (1931, p. 63) in a discussion on vertical integration.

¹⁴This line of reasoning has interesting implications for the study of innovation. Since the innovating firm is more likely to be using unique intermediate goods, particularly in industries where few of the relevant manufacturing capabilities exist in the market (Langlois and Robertson, 1995), innovation carries with its benefits the cost of more severe internal distortions. Economic calculation is then another obstacle the innovator must overcome.

¹⁵Mises (1944, p. 32) recognized the problem of allocating overhead costs, mentioning this as a possible exception to the notion that divisional accounting costs can reflect “true” costs.

¹⁶Nor do all Coasian perspectives deny the importance of specialized knowledge lines in determining a firm’s capabilities or “core competence.” Transaction cost economics, for example, simply holds that the need for ex post governance of contracts in the presence of relationship-specific investments, and not “tacit knowledge” per se, is the most useful way to think about the boundaries of the firm. For the case that Austrian economics is more compatible with the capabilities literature (for substantive, not only methodological, reasons), see Minkler (1993b) and Langlois (1994a).

¹⁷See also Tullock (1969).

2 Entrepreneurship and Corporate Governance

^†Published originally in Quarterly Journal of Austrian Economics 2, no. 2 (Summer 1999): 19–42. A Spanish translation, “Función empresarial y control de la dirección de le empresa,” appeared in Libertas 16, no. 31 (October 1999): 3–49.

¹The new institutional economics is reviewed and critiqued in Furubotn and Richter (1997), Klein (2000), Williamson (2000), Ménard and Shirley (2005) and Brousseau and Glachant (2008).

²Mises (1949, p. 254) defines the entrepreneurial function broadly, referring to “the aspect of uncertainty inherent in every action.” He quotes the English idiom: “There’s many a slip ’twixt cup and lip” (p. 254). He defines entrepreneur-promoters more narrowly, as uncertainty-bearers “who are especially eager to profit from adjusting production to the expected changes in conditions, those who have more initiative, more venturesomeness, and a quicker eye than the crowd, the pushing and promoting pioneers of economic improvement.” He laments that the same word, “entrepreneurship,” has been used both for the general concept of uncertainty-bearing and the narrower role of the bold, active, creative, business person.

³For surveys of the literature on corporate governance see Gilson (1996); Shleifer and Vishny (1997) and Zingales (1998).

⁴What Knight (1921) would describe as “risk,” rather than “uncertainty.”

⁵Williamson (1975, 1985, 1996) attributes contractual incompleteness to cognitive limits or “bounded rationality,” following Simon’s (1961, p. xxiv) interpretation of human action as “intendedly rational, but only limitedly so.” Other economists are more agnostic, assuming only that some quantities or outcomes are unobservable (or not verifiable to third parties, such as the courts), in which case contracts cannot be made contingent on these variables or outcomes.

⁶This is the sense in which Kreps (1990a) understands “corporate culture.”

⁷As noted in chapter 1 above (pp. 18–21), some Austrians have questioned the Coasian, contractual approach as an appropriate basis for an Austrian theory of the firm. I do not share these concerns, however, seeing Coase’s framework as a general heuristic that can accommodate various notions of the origins of internal and external transaction costs, including those emphasized in the Austrian literature.

⁸See chapter 5 below for further discussion of this point.

⁹Of course, bondholders, as well as equity holders, are partly entrepreneurs, since even bondholders bear some default risk.

¹⁰For more on Misesian entrepreneurship and its various interpretations, see chapter 5 below.

¹¹One distinction between entrepreneurship (as uncertainty bearing) and management is that managerial functions can be purchased on the market: innovation can be outsourced to R&D labs; strategic planning can be contracted out to consultants; corporate identities, both internal and external, can be developed and communicated by outside specialists; and so on.

¹²Similarly, Rothbard’s claim is not that because external prices are necessary for large firms to function efficiently, firms will tend to become large where external markets are “thick” or better developed. On the contrary, large firms typically arise precisely where external markets are poorly developed or hampered by government intervention; these are the kinds of circumstances that give entrepreneurs an advantage in coordinating activities internally (Chandler, 1977). However, such firms are still constrained by the need for some external market reference.

¹³Such a process is described explicitly in the 1977 Annual Report of Fuqua Industries, a diversified firm with interests in lawn and garden equipment, sports and recreation, entertainment, photofinishing, transportation, housing, and food and beverages:

Fuqua’s strategy is to allocate resources into business segments having prospects of the highest return on investment and to extract resources from areas where the future return on investment does not meet our ongoing requirements.... The same principle of expanding areas of high return and shrinking areas of low return is constantly extended to product lines and markets within individual Fuqua operations. Only with a diversified business structure is the application of this modern fundamental business investment policy practical.

Another highly diversified firm, Bangor Punta Corporation, explains that the role of its corporate headquarters is “to act as a central bank supplying operating units with working capital and capital funds” (1966 Annual Report).

¹⁴Myers and Majluf (1984) show that if the information asymmetry between a standalone firm and potential outside investors is large enough, the firm may forego investments with positive net present value rather than issue risky securities to finance them.

¹⁵For more on the relationship between Thornton and McNamara, see Shapley (1993), and Byrne (1993).

¹⁶Chapter 1 of Bureaucracy, on profit management and the sources of entrepreneurial profit, contains a remarkably lucid account of economic calculation under capitalism and its impossibility under socialism. “To the entrepreneur of capitalist society a factor of production through its price sends out a warning: Don’t touch me, I am earmarked for another, more urgent need. But under socialism these factors of production are mute” (Mises, 1944, p. 29). Mises also provides a very Coase-like discussion of the make-or-buy decision, though without citation (p. 33).

3 Do Entrepreneurs Make Predictable Mistakes?

^†Published originally in Quarterly Journal of Austrian Economics 4, no. 2 (Summer 2001): 3–25. Reprinted in Nicolai J. Foss and Peter G. Klein, eds., Entrepreneurship and the Firm: Austrian Perspectives on Economic Organization (Aldershot, UK: Edward Elgar, 2002).

¹On the gains from mergers, acquisitions, and other restructurings, see also the surveys by Jensen and Ruback (1983), Jarrell, Brickley, and Netter (1988), Roll (1988), Romano (1992), and Andrade, Mitchell, and Stafford (2001).

²Jensen (1986, 1993) argues similarly that diversifying acquisitions resulted from widespread agency problems in corporations, though he does not recommend any regulatory response: “The legal/political/regulatory system is far too blunt an instrument to handle the problems of wasteful managerial behavior effectively” (1993, p. 850). Instead, he advocates alternative forms of organization such as leveraged buyout associations and venture capital funds (see especially Jensen, 1989).

³Servaes (1996) also finds that conglomerate firms in the 1960s were valued at a discount relative to specialized firms. However, Matsusaka (1993) and Hubbard and Palia (1999) show that market participants rewarded conglomerate acquisitions during this period, and Klein (2001) offers valuation evidence consistent with the event-study results.

⁴Other empirical studies of asset sales and restructurings include Hite, Owens, and Rogers (1987); Lang, Poulsen, and Stulz (1994); John and Ofek (1995); and Schlingemann, Stulz, and Walkling (2002). These papers look at divestitures more generally, and not only at divestitures of previously acquired assets.

⁵Sanchez, Heene, and Thomas (1996, p. 28) suggest that the same is true for networks and alliances.

In a dynamic market context, longevity of interfirm alliances is not necessarily an indicator of successful collaboration. A succession of short-term alliances by a firm, for example, may suggest that the firm has a superior ability to learn from its partners, or that it may have superior ability to quickly reconfigure its chain of firm-addressable resources in response to changing competitive and market conditions.

Mosakowski (1997) also offers an experimentation theory of diversification (without looking at subsequent divestitures).

⁶Chapter 2 above argues that financial-market entrepreneurship is a particularly important form of entrepreneurial activity, though it has received little attention in the Austrian literature.

⁷Jensen (1993) argues that internal control mechanisms are generally weak and ineffective, while external control mechanisms—where allowed to function—are typically superior.

⁸Two popular explanations for multiproduct economies of scope center on internal capital markets and strategic resources. According to the internal-capital-markets hypothesis, as expressed by Alchian (1969), Williamson (1975), Gertner, et al. (1994), and Stein (1997), internal capital markets have advantages where access to external funds is limited. The central office of the diversified firm can use informational advantages, residual control rights, and its ability to intervene selectively in divisional affairs to allocate resources within the firm better than the external capital markets would do if the divisions were stand-alone firms. In the resource-based view, the firm is regarded as a stock of knowledge, establishing a range of competence that may extend across multiple product lines. Excess profits or supranormal returns are seen as rents accruing to unique factors of production (Montgomery and Wernerfelt, 1988) and firms diversify because they have excess capacity in these unique factors.

⁹This raises the question of why, if managers were sufficiently entrenched to make inefficient acquisitions in the first place, would they not remain sufficiently entrenched to hold on to poorly performing targets, rather than divest them and risk revealing their underlying objectives? Boot (1992, p. 1402) argues that an entrenched manager will not divest because the external market will take divestiture as an admission of failure and a bad signal of his ability. The argument that divestitures indicate agency problems thus assumes a change in corporate control between the original acquisitions and the later divestitures.

¹⁰See chapter 6 below for details on Mises’s approach to uncertainty.

¹¹This is Malkiel’s (1990, p. 58) explanation for the conglomerate boom: “the major impetus for the conglomerate wave of the 1960s was that the acquisition process itself could be made to produce growth in earnings per share.... By an easy bit of legerdemain, [conglomerate managers] could put together a group of companies with no basic potential at all and produce steadily rising per-share earnings.” For a more balanced discussion of the bootstrapping practice see Lynch (1971, pp. 55–56).

¹²However, in our sample, all targets are themselves publicly traded corporations, so lack of media exposure is unlikely to be a problem.

¹³Mosakowski (1997) suggests that younger firms face greater uncertainty, or a higher level of “causal ambiguity,” about the best use of their resources, which implies that firm age could also be a proxy for match-seeking behavior.

4 The Entrepreneurial Organization of Heterogeneous Capital

^†Published originally in Journal of Management Studies 44, no. 7 (November 2007): 1165–86.

¹For related treatments along the same lines, see Casson (1982) and Langlois and Cosgel (1993).

²In Kirzner’s treatment, entrepreneurship is characterized as “a responding agency. I view the entrepreneur not as a source of innovative ideas ex nihilo, but as being alert to the opportunities that exist already and are waiting to be noticed” (Kirzner, 1973, p. 74, emphasis in original)

³This contrasts with Schumpeter’s and Kirzner’s conceptions of entrepreneurship, in which entrepreneurship can be exercised without the possession of any capital goods. On this contrast, see Foss and Klein (2005).

⁴Contracts might still be incomplete because contracting parties have different, subjective expectations about the likelihood of various contingencies affecting the value of the (homogeneous) capital asset. Agents may also differ in their ability to learn about possible uses of the capital good. In other words, Knightian uncertainty plus bounded rationality could drive contractual incompleteness even in a world without capital heterogeneity. However, the neoclassical world of shmoo capital is characterized by parametric uncertainty, common priors, and hyperrationality

⁵Resources that are initially homogeneous could become heterogeneous over time, through learning by doing or co-specialization of human and physical capital. Here we refer to conditions of permanent homogeneity.

⁶Penrose’s approach, unlike modern resource- and knowledge-based approaches, did emphasize one important element of economic organization, namely the rate of growth of the firm.

⁷Foss and Foss (2005) link the property rights approach to the resource-based view, demonstrating how the more “micro” approach of the property rights approach provides additional insights into resource value. See also Kim and Mahoney (2002, 2005) for similar arguments.

⁸Clearly, this notion of subjectively perceived attributes of capital assets is related to Penrose’s (1959) point that physically identical capital assets may yield different services, depending on, for example, the nature of the administrative framework in which they are embedded.

⁹In this chapter we do not distinguish between “discovery” and “creation” as alternative conceptions of the entrepreneurial act (Alvarez and Barney, 2007). Chapter 5 below discusses this distinction in detail.

¹⁰Of the several dozen papers on Austrian economics and the theory of the firm (including, for instance, the papers collected in Foss and Klein, 2002), only a few deal with Austrian capital theory (see Chiles, Meyer, and Hench, 2004; Lewin, 2005; Yu, 1999; and various papers by the present authors)

¹¹Hayek’s 1974 Nobel Prize in economics was awarded for his technical work on the business cycle and not, as is commonly believed, for his later work on knowledge and “spontaneous order.” For a modern restatement of Austrian business cycle theory, see Garrison (2000).

¹²For overviews see Strigl (1934), Kirzner (1966), and Lewin (1999).

¹³Hayek’s Prices and Production (1931) emphasized the relationship between the value of capital goods and their place in the temporal sequence of production. Because production takes time, factors of production must be committed in the present for making final goods that will have value only in the future after they are sold. However, capital is heterogeneous. As capital goods are used in production, they are transformed from general-purpose materials and components to intermediate products specific to particular final goods. Consequently, these assets cannot be easily redeployed to alternative uses if demands for final goods change. The central macroeconomic problem in a modern capital-using economy is thus one of intertemporal coordination: how can the allocation of resources between capital and consumer goods be aligned with consumers’ preferences between present and future consumption? In The Pure Theory of Capital (1941) Hayek describes how the economy’s structure of production depends on the characteristics of capital goods durability, complementarity, substitutability, specificity, and so on.

¹⁴Penrose (1959) also emphasizes the subjectivity of the firm’s perceived opportunity set (Kor and Mahoney, 2000). In her approach, entrepreneurs must learn how best to deploy their productive resources; because learning is idiosyncratic, firms with similar stocks of physical resources may differ in their strategic opportunities. Our emphasis on subjectively perceived attributes of capital assets may be seen as an example of a Penrosian perceived ‘opportunity’ set. Kirzner’s concept of entrepreneurial “alertness,” by contrast, is not a learned skill, but a talent or ability that is not subject to further explanation.

¹⁵We note in passing that the understanding of management may also be furthered by beginning from heterogeneous capital assets and the need for coordination they imply. From a resource-based view, Mahoney (1995) argues that an important function of management is the coordination of such assets.

¹⁶See the discussion in chapter 2 above on “Firms as Investments” and “Financiers as Entrepreneurs.”

¹⁷For a fuller analysis of this point see Foss and Foss (2002).

¹⁸The alert reader will notice that while we enthusiastically endorse Kirzner’s contributions to the Austrian theory of capital, our own conception of entrepreneurship differs substantially from his. Chapter 5 below explores this distinction in greater detail.

¹⁹In contrast, our emphasis on understanding economic organization in a dynamic context has obvious parallels to Langlois’s (1992) notion of “dynamic transaction costs.”

²⁰See Shook, Priem, and McGee (2003) for ideas on empirical research on the behavioral aspects of entrepreneurial judgment.

5 Opportunity Discovery and Entrepreneurial Action

^†Published originally as “Opportunity Discovery, Entrepreneurial Action, and Economic Organization” in Strategic Entrepreneurship Journal 2, no. 3 (2008): 175–90.

¹Kirzner is careful to distinguish alertness from systematic search, as in Stigler’s (1961; 1962) analysis of searching for bargains or for jobs. A nice example is provided by Ricketts (1987, p. 58): “Stigler’s searcher decides how much time it is worth spending rummaging through dusty attics and untidy drawers looking for a sketch which (the family recalls) Aunt Enid thought might be by Lautrec. Kirzner’s entrepreneur enters a house and glances lazily at the pictures which have been hanging in the same place for years. ‘Isn’t that a Lautrec on the wall?’”

²Exceptions include Ekelund and Saurman (1988), Harper (1995), Sautet (2001) and Holcombe (2002). Kirzner (1973, pp. 39–40) concedes that in a world of uncertainty, resource owners exercise entrepreneurial judgment in allocating their resources to particular uses. But he goes on (1973, pp. 40–43) to introduce the analytical device of “pure entrepreneurship,” the act of discovery or alertness to profit opportunities by those with no resources under their control, and claims that this function, rather than uncertainty-bearing, is the “driving force” behind the market economy.

³In Kirzner’s treatment, entrepreneurship is characterized as “a responding agency. I view the entrepreneur not as a source of innovative ideas ex nihilo, but as being alert to the opportunities that exist already and are waiting to be noticed” (Kirzner, 1973, p. 74). Of course, as Kirzner (1985b, pp. 54–59) himself emphasizes, the actions of entrepreneurs in the present affect the constellation of possible profit opportunities in the future. “[Alertness] does not consist merely in seeing the unfolding of the tapestry of the future in the sense of seeing a preordained flow of events. Alertness must, importantly, embrace the awareness of the ways the human agent can, by imaginative, bold leaps of faith, and determination, in fact create the future for which his present acts are created” (Kirzner, 1985b, p. 56). However, Kirzner (1985b, p. 57) continues, the only opportunities that matter for equilibration are those that do, in fact, “bear some realistic resemblance to the future as it will be realized.”

⁴It is useful here to distinguish between broad and narrow notions of (Knightian) entrepreneurship. All human action involves judgment, and in an uncertain world, all action places some assets at risk (at minimum, the opportunity cost of the actor’s time). In Mises’s terminology, human action is the purposeful employment of means to bring about desired ends, which may or may not be realized. In this sense, we are all entrepreneurs, every day. Of course, this broad concept of entrepreneurship is not particularly operational, or empirically important. Economics and organization theorists, therefore, tend to focus on a narrower concept of entrepreneurship, namely the actions of the businessperson—the investment of tangible resources in pursuit of commercial gain. In the discussion that follows, I focus on this narrower, commercial notion of entrepreneurship.

⁵The foregoing description applies primarily to what Kirzner calls the “pure entrepreneur” (see footnote 2 above). As he explains, flesh and blood entrepreneurs do not correspond exactly to this ideal type (they can simultaneously be laborers, capitalists, consumers, etc.)—and they do more than simply discover costless profit opportunities. However, in Kirzner’s framework, the attributes of real-world entrepreneurs defy systematic categorization.

⁶Incidentally, the occupational choice literature cited above treats opportunities, implicitly or explicitly, as objective. Agents are assumed to compare the expected benefits of employment and self-employment, meaning that the set of possible entrepreneurial outcomes must be fixed, and the probability weights assigned to individual outcomes known in advance.

⁷Here I follow Gul and Pesendorfer’s (2005, p. 1) more general critique of neuroeconomìcs, namely that cognitive psychology and economics “address different questions, utilize different abstractions, and address different types of empirical evidence,” meaning that the two disciplines are in essentially different, though potentially complementary, domains. In other words, understanding the cognitive processes underlying entrepreneurial behavior may be interesting and important, but not necessary for the economic analysis of the behavior itself.

⁸Miller (2007) distinguishes further between opportunity recognition, opportunity discovery, and opportunity creation.

⁹The concept of “opportunity imagination” calls to mind Boulding’s (1956, p. 15) notion of “image,” defined as “the sum of what we think we know and what makes us behave the way we do.” Human action, in Boulding’s framework, is a response to the actor’s (subjective) image of reality. This does not mean that images are completely detached from reality, but that reality is altered, or interpreted, by the actor’s subjective beliefs. Penrose’s (1959) concept, of the firm’s subjective opportunity set also reflects entrepreneurial imagination in this sense (Kor, Mahoney, and Michael, 2007).

¹⁰In his defense, Kirzner’s (1997) remarks appear in the context of defending the equilibrating tendency of the market, against the Walrasian picture of instantaneous market adjustment. Still, the defense could perhaps be made equally well without reference to the discovery metaphor.

¹¹To go from judgment to an explanation for market efficiency requires assumptions about the tendency of entrepreneurial judgments to be correct. Mises’s (1951) explanation is based on a kind of natural selection, namely that market competition rewards those entrepreneurs whose judgments tend to be better than the judgments of their fellow entrepreneurs. Of course, one needn’t go as far as Friedman (1953) in assuming that the result is “optimal” behavior, in the neoclassical economist’s sense of optimality, to defend the effectiveness of this selection process.

¹²In Foss, Foss, and Klein’s (2007) terminology, the entrepreneur-owner exercises “original” judgment, while hired employees, to whom the owner delegates particular decision rights, exercise “derived” judgment as agents of the owner. This implies that top corporate managers, whose day-to-day decisions drive the organization of corporate resources, are acting only as “proxy-entrepreneurs,” except to the extent that they themselves are part owners through equity holdings.

¹³Lachmann (1956) does not require the entrepreneur to own the assets he recombines; see chapter 4 above for a more detailed argument that ownership, as residual rights of control, is a necessary part of this entrepreneurial function. Consider also Marchal’s (1951, pp. 550–51) explanation of the economic return to the entrepreneurial function:

[E]ntrepreneurs obtain remuneration for their activity in a very different manner than do laborers or lenders of capital. The latter provide factors of production which they sell to the entrepreneur at prices which they naturally try to make as high as possible. The entrepreneur proceeds quite otherwise; instead of selling something to the enterprise, he identifies himself with the enterprise. Some people doubtless will say that he provides the function of enterprise and receives as remuneration a sum which varies according to the results. But this is a tortured way of presenting the thing, inspired by an unhealthy desire to establish arbitrarily asymmetry with the other factors. In reality, the entrepreneur and the firm are one and the same. His function is to negotiate, or to pay people for negotiating under his responsibility and in the name of the firm, with two groups: on the one hand, with those who provide the factors of production, in which case his problem is to pay the lowest prices possible; on the other hand, with the buyers of the finished products, from which it is desirable to obtain as large a total revenue as possible. To say all this in a few words, the entrepreneur, although undeniably providing a factor of production, perhaps the most important one in a capitalist system, is not himself to be defined in those terms.

Marchal expresses, in strong terms, the view described in chapter 4 that entrepreneurship is embodied in asset ownership (i.e., in the creation and operation of the firm). The entrepreneur is not merely an idea man, but rather an owner, who exercises judgment over the capital assets he owns and manages. This contrasts with Kirzner’s analytical device of the “pure entrepreneur” who owns no capital. (I thank John Matthews for the reference to Marchal.)

¹⁴Ironically, the notion of capital as a homogeneous fund owes its popularity to Knight (1936).

¹⁵Earl’s (2003) “connectionist approach” to entrepreneurship also focuses on coordination, but here the emphasis is on coordination among market participants, not within organizations. See also Koppl and Langlois (2001) and Langlois (2002).

¹⁶See the discussion in chapter 2 above on “firms as investments” and “financiers as entrepreneurs.”

¹⁷Spender (2006, p. 2) argues that “Penrose’s model of managerial learning [is] an accessible instance of the epistemological approach proposed by Austrian economists such as Hayek, Kirzner, and Schumpeter.”

¹⁸See Cook and Iliopoulos (2000) and Cook and Chaddad (2004) for details.

¹⁹Cook, Burress, and Klein (2008) document the emergence of a cluster of newgeneration cooperatives in the tiny community of Renville County, Minnesota.

6 Risk, Uncertainty, and Economic Organization

^†Published originally in Jörg Guido Hülsmann and Stephan Kinsella, eds., Property, Freedom, and Society: Essays in Honor of Hans-Hermann Hoppe (Auburn, Ala.: Ludwig von Mises Institute, 2009), pp. 325–37.

¹O’Driscoll and Rizzo (1985) adopt the terms “typical events” and “unique events” to get at this distinction.

²Hence the use of the term “case probability” is misleading; what Mises really means is “case non-probability,” or perhaps “case judgments without probabilities.” Confusingly, Mises also argues elsewhere that “[o]nly preoccupation with the mathematical treatment could result in the prejudice that probability always means frequency” (Mises, 1949, p. 107). Van den Hauwe (2007) argues, in contrast to Hoppe, that Mises’s position is in some ways closer to Keynes’s.

³One might also include Shackle’s notion of “self-destructive, non-seriable” decisions. See G.L.S. Schackle, Decision, Order, and Time in Human Affairs (Cambridge: Cambridge University Press, 1961).

⁴Bayesian updating can also be applied to objective prior probabilities, presumably to give guidance to the decision maker in cases where repeated trials to determine the new ex post probability are not possible. The “Monty Hall paradox” is a classic example.

⁵See also Buchanan and Di Pierro (1980).

⁶Demsetz (1983) compares Kirznerian alertness to luck.

⁷See chapter 7 below.

7 Price Theory and Austrian Economics

^†Published as “The Mundane Economics of the Austrian School” in Quarterly Journal of Austrian Economics 11, nos. 3–4 (2008): 165–87.

¹Admittedly, Hayek’s 1968 assessment of the Austrian School’s influence is harder to reconcile with his own insistence (Hayek, 1937, 1945, 1946) that neoclassical economists had failed to appreciate the role of knowledge and expectations. Hayek remained ambivalent on this point; in an unfinished draft for the New Palgrave Dictionary, written around 1982 (and reprinted in Hayek, 1992, pp. 53–56), Hayek describes indifference-curve analysis as “the ultimate statement of more than half a century’s discussion in the tradition of the Austrian School,” adding that “by the third quarter of the twentieth century the Austrian School’s approach had become the leading form of microeconomic theory.” But he goes on to identify the school’s “main achievement” as clarifying the differences between “disciplines that deal with relatively simple phenomena, like mechanics, ...and the sciences of highly complex phenomena.”

²Koppl urges Austrian economists to join what he calls the “heterodox mainstream,” a body of literature embracing bounded rationality, rule following, institutions, cognition, and evolution, or BRICE. Austrians have “an opportunity to contribute to the heterodox mainstream of today and join, thereby, the emerging new orthodoxy of tomorrow” (Koppl, 2006, pp. 237–38).

³My focus here is economic theory, not methodology, so my point is different from Rothbard’s (1995) argument that Misesian praxeology, not the alternative Popperian, evolutionary epistemology of the later Hayek or the “radical subjectivism” of Lachmann, is the proper starting point for Austrian economics.

⁴Interestingly, the third- and fourth-generation Austrians were thoroughly steeped not only in the writings of their Viennese predecessors, but also those of the Anglo-American Mengerian price theorists. Hayek (1963a, p. 32) notes that “in the early post-war period the work of the American theorists John Bates Clark, Thomas Nixon Carver, Irving Fisher, Frank Fetter, and Herbert Joseph Davenport was more familiar to us in Vienna than that of any other foreign economists except perhaps the Swedes.” Hayek quotes a letter from Clark to Robert Zuckerkandl in which Clark praises Zuckerkandl’s Theory of Price (1899), saying “[n]othing gives me greater pleasure than to render full honor to the eminent thinkers, mainly Austrians, who were earlier in this field than myself, and who have carried their analysis to greater lengths” (Hayek, 1939a, p. 39) Hayek adds that “at least some of the members of the second or third generation of the Austrian School owed nearly as much to the teaching of J. B. Clark as to their immediate teachers.” Salerno (2006) discusses Clark’s influence on Mises.

⁵Lachmann cites Hicks (1939), Lindahl (1939), and Lundberg (1937) as the main exponents of process analysis, though these theorists are not usually included in the contemporary “market process” tradition.

⁶Morgenstern (1935) also deals with expectations and their role in the formation of economic equilibria.

⁷By the 1950s, Hayek tells us,

I had... become somewhat stale as an economist and felt much out of sympathy with the direction in which economics was developing. Though I had still regarded the work I had done during the 1940s on scientific method, the history of ideas, and political theory as temporary excursions into another field, I found it difficult to return to systematic teaching of economic theory and felt it rather as a release that I was not forced to do so by my teaching duties. (1994, p. 126)

Throughout his career at the London School of Economics from 1932 to 1949, Hayek’s main teaching obligation had been the required graduate course in economic theory. Of course, he did produce his first important work in classical liberal political economy, The Road to Serfdom, in 1944.

⁸See Klein (1997) and Klein and Orsborn (2009) on the differences between Menger’s account of institutions and Hayek’s understanding of spontaneous order. Klein (1997) argues that Menger’s notion of coordination is closer to Schelling’s (1978) than Hayek’s.

⁹See also Klein and Selgin (2000).

¹⁰Machlup (1958, p. 57) seems to have the FSR in mind when he writes:

To characterize a concrete situation “observed” in reality as one of “equilibrium” is to commit the fallacy of misplaced concreteness. At best, the observer may mean to assert that in his opinion the observed and duly identified situation corresponds to a model in his mind in which a set of selected variables determine a certain outcome, and that he finds no inherent cause of change—that is, that he believes only an outside disturbance, not in evidence at the moment, could produce a change in these variables. This, of course, is a personal judgment, meaningful only if the variables are fully enumerated and the assumptions about their interrelations are clearly stated.

¹¹Though specific Austrian writings are not identified, a footnote refers to “relevant sections” of Mises (1949), Rothbard (1962), Kirzner (1973, 1979, 1985b) and High (1980, 1982, 1986) as “neoclassical Austrianism.”

¹²See also Marget (1938–42, vol. 2), Kirzner (1963, pp. 105–35) and Salerno (1994a, pp. 97–106).

¹³For additional discussion see Cowen and Fink (1985), Gunning (1989), and MacKenzie (2008).

¹⁴Just as Mises’s (hypothetical) FSR results from a sequence of PSRs, Marshall’s “normal equilibrium” is brought about by a series of market-day equilibria (De Vroey, 2002).

¹⁵Inexplicably, she accuses Rothbard (1962) of confusing the FSR and ERE, though without providing any specific page reference (Vaughn, 1994, p. 82, n 35). She also says Mises “seemed to confuse his two [sic] distinct notions of equilibrium.”

¹⁶Kirzner (2000) argues for a more nuanced appreciation of Hayek’s commitment to “plan coordination,” arguing (against O’Driscoll, 1977) that Hayek was ambivalent on the proper notion of coordination in economics. For more on concepts of coordination see Klein (1997) and Klein and Orsborn (2009).

¹⁷De Vroey (2002, pp. 406–07) argues that Marshall, too, regarded his market-day equilibrium construct as both realistic and practical, i.e., not requiring an underlying adjustment process:

Two adjustment processes are present in Marshall: the adjustment toward market-day equilibrium and the adjustment toward normal equilibrium. In my view... the former should be interpreted as proceeding instantaneously, whereas the latter (to be called intertemporal adjustment) arises across several trading rounds....

The stationary equilibrium concept of equilibrium is in accord with the common-sense understanding of equilibrium—i.e., it is a point of rest. It is implied that this point does not need to be effectively reached; it suffices that reacting forces are triggered whenever it is not reached. Equilibrium is thus viewed as an attractor.... Note also that in this line of thought, assessing the existence of equilibrium or disequilibrium amounts to making a statement about reality.

¹⁸Note that Clark (1907, p. 96) describes simple FSR analysis or comparative statics—e.g., if the supply increases, the price will fall, ceteris paribus—as obvious, as what he calls a “commercial fact.”

¹⁹And these FSR prices are only “efficient” in perfectly competitive markets; any degree of asymmetric information renders economic outcomes inefficient (Grossman, 1980).

²⁰Adds Boettke (2005):

Why is all this important? Well as Franklin Fischer pointed out in his very important book The Disequilibrium Foundations of Equilibrium Economics (1983) that unless we have good reasons to believe in the systemic tendency toward equilibrium we have no justification at all in upholding the welfare properties of equilibrium economics. In other words, without the sort of explanation that Kirzner provides the entire enterprise of neoclassical equilibrium is little more than a leap of faith.

If one rejects the neoclassical equilibrium concept as a welfare benchmark, though, this justification is unnecessary.

²¹Caldwell (2004, p. 333) argues that Austrians accept “the simple (although unrealistic) models used for basic economic reasoning,” such as supply-and-demand analysis, at least for market-level predictions. But Menger’s analysis, while “abstract,” is not “unrealistic” in the sense of Walras’s or Marshall’s models of market exchange. In Long’s (2006) terminology, Austrians reject “precisive abstraction,” in which false assumptions are deliberately included to simplify the analysis, while embracing “non-precisive abstraction,” in which certain characteristics of the situation are simply not specified. In other words, the “basic economic reasoning” of the Austrians is different from the basic economic reasoning of neoclassical economics.

8 Commentary

^†Published originally on Mises.org, June 12, 2006.

^†Published originally as a review of Yochai Benkler, The Wealth of Networks: How Social Production Transforms Markets and Freedom, reviewed in The Independent Review 13, no. 3 (Winter 2009).

^†Published originally on Mises.org, November 16, 2006.

¹See also Pasour (2004) and White (2005) on the influence of government spending on research in agricultural economics and monetary economics, respectively.

²For more on the professionalization of economics see Bernstein (2001).

³On Litton see also Sobel (1984, pp. 68–72). On the relationship between Thornton and McNamara see Shapley (1993) and Byrne (1993).

^†Published originally as “Management Theory is Not to Blame,” Mises.org, March 19, 2009. See also Agarwal, Barney, Foss, and Klein (2009) for further details.

^†Published originally as the Foreword to Carl Menger, Principles of Economics (reprint edition, Auburn, Ala.: Ludwig von Mises Institute, 2006).

^†Published originally as “F. A. Hayek: Austrian Economist and Social Theorist,” in Randall G. Holcombe, ed., Fifteen Great Austrian Economists. Auburn, Ala.: Mises Institute, 1999, pp. 181–94.

⁴Hayek (1994), and the introduction by Stephen Kresge.

⁵Hayek’s father was a physician and botanist. One grandfather, a statistician, was a friend of Eugen von Böhm-Bawerk; the philosopher Ludwig Wittgenstein was a second cousin.

⁶Hicks (1967, p. 204) noted, in reference to Hayek’s first (1931) English book, that “Prices and Production was in English, but it was not English economics.”

⁷In addition, Hayek (1963b, p. 60) cited his own “tiredness from controversy”; he had already engaged the market socialists on economic calculation, Knight on capital theory, and Keynes on money.

⁸For more on Hayek’s failure to respond to the General Theory see Caldwell (1995), especially pp. 40–6. Hayek (1963b, pp. 60–61; 1966, pp. 240–41) also believed that an effective refutation of Keynes would have to begin with a thorough critique of aggregate, or “macro” economics more generally. Caldwell (1988) suggests another reason: it was during this time that Hayek was losing faith in equilibrium theory and moving toward a “market process” view of economic activity, making it difficult for him to engage Keynes on the same terms in which they had debated earlier. McCormick (1992, pp. 99–134) and Blaug (1993, pp. 53–55) propose an entirely different reason: Hayek couldn’t respond because the Austrian capital theory, on which the cycle theory was built, was simply wrong.

⁹On the emigration of the Austrian economists see Craver (1986).

¹⁰However, at Chicago Hayek was considered something of an outsider; his post was with the Committee on Social Thought, not the economics department, and his salary was paid by a private foundation, the William Volker Fund (the same organization that paid Mises’s salary as a visiting professor at New York University).

¹¹By this time, Hayek (1994, p. 126) said, “I had... become somewhat stale as an economist and felt much out of sympathy with the direction in which economics was developing. Though I had still regarded the work I had done during the 1940s on scientific method, the history of ideas, and political theory as temporary excursions into another field, I found it difficult to return to systematic teaching of economic theory and felt it rather as a release that I was not forced to do so by my teaching duties.”

¹²The proceedings of the South Royalton conference were published as The Foundations of Modern Austrian Economics (Dolan, 1976). A follow-up volume appeared two years later: New Directions in Austrian Economics (Spadaro, 1978). For perspectives on the Austrian revival see Rothbard (1995), and Vaughn (1994). Salerno (1996b) argues that the Austrian revival should be dated not from 1974, but from 1962–63, when Rothbard published Man, Economy, and State (1962), America’s Great Depression (1963a), and What Has Government Done to Our Money? (1963b), the works that sparked the younger South Royalton participants’ interest in Austrian economics.

¹³Lucas (1977) cites Hayek as a leading exponent of pre-Keynesian business-cycle theory. Grossman and Stiglitz (1976) and Grossman (1980; 1989) argue that contrary to Hayek, market prices are not “sufficient statistics” for changes in tastes and technology. This literature tries to test the “informative content” of price signals, and contends that in general only perfectly competitive prices convey useful information. Farrell and Bolton (1990) claim that Hayek overstates the coordinating properties of decentralized market exchange. Hayek’s 1945 paper is also frequently cited in the new institutional literature emphasizing process and adaptation, although coordination through markets is seen as only one type of desirable coordination. See, for example, Williamson (1991c).

¹⁴Hayek ultimately rejected Böhm-Bawerk’s “average period of production” as a useful concept, though he had used it earlier in Prices and Production (1931). See Hayek (1994), p. 141, and White (1996)

¹⁵Hayek thought the more important case was when the market interest rate was kept constant despite a rise in the natural interest rate. In his writings, however, he focused on the expositionally easier case when credit expansion lowers the market interest rate below an unchanged natural rate.

¹⁶For most of his career Hayek viewed a system of fractional-reserve banking as inherently unstable, endorsing a role (in principle) for government stabilization of the money supply. In later writings, beginning with The Constitution of Liberty (1960) and culminating in Denationalisation of Money (1976), he argued in favor of competition among private issuers of fiat money. See White (1999).

¹⁷Anticipating modern cycle theories, Hayek (1939b) recognized that the behavior of the cycle depends on expectations about future price and interest rate movements. As Garrison and Kirzner put it (1987, p. 612), for Hayek “prices are signals, not marching orders.” But Hayek did not believe agents could know the real structure of the economy, to correctly distinguish movements in interest rates generated by changes in consumers’ intertemporal preferences from those generated by changes in the money supply.

¹⁸For general overviews of Hayek’s macroeconomic views see O’Driscoll (1977), and Garrison and Kirzner (1987). For expositions and interpretations of the Austrian tradecycle theory, particularly as it relates to modern cycle theories, see Garrison (1978, 2000); Beilante and Garrison (1988); van Zijp (1993); and Foss (1994b), pp. 39–55.

¹⁹Hayek’s use of an argument from ignorance as a defense of the market is unusual. Modern economists typically require assumptions of hyperrationality—complete and perfect information, rational expectations, perfect markets, and so on—to justify market allocations as “efficient.” In the new microeconomics literature on information and incentives, theorists like Joseph Stiglitz have used deviations from these assumptions of perfection to reach a verdict of market failure and to provide a rationale for government intervention (see note 13 above). For Hayek, by contrast, the fact that agents are not hyperrational is an argument not against individual freedom, but against state planning and social control.

²⁰Earlier Hayek (1933b, p. 27) had used “organism” and “organization,” borrowed from Mises, to distinguish the two; this is the distinction cited by Coase in his famous 1937 article, “The Nature of the Firm.”

²¹On the relationship between the socialist calculation debate and the theory of the firm see chapter 1 above.

²²For more on spontaneous order see Fehl (1986). Vanberg (1994) argues that Hayek’s notion of spontaneous order via group selection is incompatible with methodological individualism.

²³Wieser’s have generally been considered a personal contribution, by Hayek himself and others. For a contrary view, see Ekelund (1986).

²⁴For Hayeks I and II see Hutchison (1981), pp. 210–19; for the “transformation” see Caldwell (1988). The secondary literature contains some debate about whether Hayek’s 1937 article “Economics and Knowledge” represents a decisive break with Mises in favor of a Popperian “falsificationist” approach, one holding that empirical evidence can be used to falsify a theory (though not to “verify” it by induction). For the case that 1937 is a crucial turning point see Hutchison (1981, p. 215) and Caldwell (1988, p. 528); for the reverse see Gray (1984, pp. 16–21) and Garrison and Kirzner (1987, p. 610). Hayek (1992, pp. 55–56; 1994, pp. 72–74) himself supported the former interpretation, maintaining that it was indeed Mises he had hoped to persuade in the 1937 article. If true, Hayek’s attempt was remarkably subtle, for Mises apparently welcomed Hayek’s argument, unaware that it was directed at him.

²⁵Margit von Mises (1984, p. 133) recalls of her husband’s seminar in New York that he “met every new student hopeful that one of them might develop into a second Hayek.”

²⁶Hayek’s writings on socialist economic calculation are collected in Hayek (1997). See Caldwell (1997) for an overview.

²⁷For more on the complex and subtle Mises–Hayek relationship see Klein (1992, pp. 7–13) and the references cited therein.

²⁸Kirzner (1995, p. 1244), for example, writes that Mises’s and Hayek’s critiques of socialism “are simply different ways of expounding the same basic, Austrian, insight.... To fail to see the common economic understanding shared by Mises and Hayek, is to have been needlessly misled by superficial differences in exposition and emphasis. To compound this failure by perceiving a clash, among modern Austrians, of ‘Hayekians’ versus ‘Misesians,’ is to convert an interpretive failure into a dogmengeschichtliche nightmare.” For more on the de-homogenization debate see Herbener (1991, 1996), Salerno (1994a, 1996b), Hoppe (1996), Boettke (1998), and Yeager (1995). Rothbard (1994, p. 559) identifies three “distinctive and often clashing paradigms within Austrian economics: Misesian praxeology; the Hayek–Kirzner emphasis on the market as transmission of knowledge and coordination of plans—rather than the Misesian emphasis on continuing coordination of prices; and the ultra-subjectivism of [Ludwig] Lachmann.”

Interestingly, Hayek himself sought to de-homogenize his work from that of free-market thinkers with whom he disagreed methodologically. In an interview in the 1980s he described Milton Friedman as a “logical positivist,” who “believe[s] economic phenomena can be explained as macrophenomena, that you can ascertain cause and effects from aggregates and averages [Friedman] is on most things, general market problems, sound. I want him on my side. You know, one of the things I often have publicly said is that one of the things I most regret is not having returned to a criticism of Keynes’s treatise, but it is as much true of not having criticized Milton’s [Essays in] Positive Economics, which in a way is quite as dangerous a book.” Quoted in Hayek (1994), pp. 144–45.

²⁹On puzzlers and masters of their subjects see Hayek (1975). Along with himself, Hayek named Wieser and Frank Knight as representative puzzlers, and Böhm-Bawerk, Joseph Schumpeter, and Jacob Viner as representative masters of their subjects. As Hayek (1975, p. 51) recalled, “I owed whatever worthwhile new ideas I ever had to not being able to remember what every competent specialist is supposed to have at his fingertips. Whenever I saw a new light on something it was as the result of a painful effort to reconstruct an argument which most competent economists would effortlessly and instantly reproduce.”

^†Published originally on Mises.org, October 14, 2009.