3. Entrepreneurship, Institutions and Economic Growth
Author: Frederic Sautet (Mercatus Centre, George Mason University)
The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.
F. A. Hayek
Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.
Adam Smith
3.1 Introduction
Austrian economists understand economics as a multidisciplinary research programme, which sees the economic problem as a problem of coordination of individuals' plans under radical uncertainty. In this context, institutions, culture, anthropology, law, history and political economy are fundamental to understanding the nature of the social order.
This paper provides a brief view of growth and social change taken from the perspective of the entrepreneurial process and Austrian economics in order to establish the following chain of argument:
- Economic performance (i.e. growth) depends on capital accumulation.
- Capital accumulation is the result of entrepreneurial profit discoveries.
- Entrepreneurship is a function of the institutional makeup of a society.
- Institutions (or rules) will foster entrepreneurship if their effects on (a) the noticeability and (b) the exploitability of profit opportunities are limited over time.
In order to limit the effects on the noticeability and exploitability of profit opportunities, institutions must constrain the government in its possibility to renege on its commitments.
3.2 A bit of Crusoe economics…
Economics was born out of the recognition that individuals use scarce means in order to achieve ends that are most of the time mutually exclusive. Thus the very fact of the relative scarcity of means and the impossibility to achieve all ends simultaneously both at the individual level (e.g. I cannot be in Paris and Wellington at the same time) and at the collective level (e.g. we cannot all live in the same house) implies that there will be a limited number of ends that we can achieve in our lives.
Growth has to do with being able to gradually reduce the relative scarcity of means in order to achieve more ends. An illustration using "Crusoe economics" will help understand this claim.
As in the story, assume that Crusoe is alone on his island. His goal is to capture fish in order to eat. At this stage he only has his bare hands to go fishing and thus it may take hours before he can catch any fish. If he could use something to help him catch a fish, he could improve his chances. Assume that he finds some thin vines in the forest and decides to make a net. A net will improve his chances of catching fish for a given unit of time. The net is what allows Crusoe to reduce the scarcity of means in order to achieve the end of fishing (and eating).
Capital goods can reduce the relative scarcity of means to allow us to achieve more ends and thus satisfy more needs while sacrificing fewer alternatives in the process.
By using a net, Crusoe improves his chances of catching more fish per unit of time and thus he will have more time to spend pursuing other alternatives.9
It is because Crusoe is able to use better means that he sacrifices fewer alternatives to achieve his ends. The means that are used in order to achieve ends are called "capital goods". The process of using better means to gradually reduce relative scarcity is called "capital accumulation".10
Capital goods are akin to a time machine, they are "stored-up" labour, land and time. By storing up labour, land and time, they get us closer to the achievement of the end sought after. They are intermediate way stations on the road to the attainment of one's own end and the consumer's goods into which they are transformed (e.g the net is turned into fish over time). Capital goods allow us to free up resources (e.g time) to achieve more ends than we would have done otherwise.
What separates rich countries, nations, regions and communities from poor ones is the level, structure and quality of capital accumulated which transports individuals in time. Poor countries are poor in terms of capital accumulation. The basic question to understand growth is thus: what makes the process of capital accumulation possible?
3.3 Subjectivism and capital goods
Attempting to provide a response to the above question involves knowing the principles that underlie the economic approach. One of the principles that the Austrian approach holds is methodological subjectivism. This refers to the idea that individuals perceive and experience reality and that one cannot objectively know (i.e. as an external observer) this inner experience. Utility, for instance, is a subjective phenomenon and there is no objective measure of utility that one could establish.11 The objectivity of economic theory lies in the recognition of the subjective dimension of human action.
A first implication of methodological subjectivism is that capital goods are heterogeneous. The use of aggregates such as "capital", "output", etc overlooks the issue of subjective value and perceptions. What matters to the economist is the perspective of the acting individual who values capital goods.
Capital accumulation is therefore accumulation of capital goods that are useful to individuals in the circumstances in which they are placed and with respect to the ends they want to achieve. In the Austrian approach, capital accumulation does not refer to some aggregate notion of capital. Every capital good is thus specific to the end that an individual wants to pursue in the circumstances in which he finds himself. If circumstances change and an individual realises that he can use his capital goods to pursue other ends, then he will reallocate his portfolio of assets to these new specific ends.
A second implication of methodological subjectivism is that there are no "natural resources". Methodological subjectivism implies that any resource is a resource because it is valued as such by the human mind. It is only with regard to ends that individuals want to pursue that means will come to be valued. In other words, by valuing means with respect to the ends that they can help achieve, the human mind introduces information in the natural world. Thus so-called natural resources are resources in so far as they have been recognised and valued by the human mind as potential means. They are not resources by virtue of some intrinsic property they might have. This stands in contrast to some popular explanations of economic growth, which consider natural resources as a given.
3.4 Crusoe, capital accumulation and entrepreneurship
There are thus two issues that are necessary for capital accumulation to take place:
- One must save in order to accumulate;
- Capital accumulation is not an automatic process.
With regard to (a). To make a net Crusoe needs his labour, time, thin vines, etc. Crusoe has to set aside these resources in order to make a capital good that will be helpful to achieve his end (eating fish) in a better way. Instead, he could have spent his time catching fish with his bare hands or resting on the beach. In other words, accumulation is possible only if the means used to achieve ends are not consumed immediately but are set aside for greater consumption later.
With regard to (b) the decision to save resources in order to make a capital good is not an automatic process for Crusoe. It involves two steps:
- The discovery and recognition that another way of doing things is possible. This is the "eureka": Crusoe realises that vines can be used to make a net. This step involves sheer human creativity and ingenuity;
- Associated with the first step is the judgment that Crusoe must make between pursuing this new possibility and doing what he already knows (e.g. using his bare hands). Crusoe will only set aside resources to make a net if he believes that it will help him achieve his end in a better way. Thus in the investment into making a capital good is a judgement of relative success with regard to the alternatives (i.e. a sufficient return on investment). This success is not guaranteed a priori: it is a judgement about the future.
The discovery and the judgement of future conditions are what constitute the entrepreneurial function in human action. In a monetary economy, the phenomena of discovery and judgement are guided by the existence of pure profit (see below).
The issues of savings and capital accumulation have been explored in neoclassical economics for a long time. However entrepreneurship has been largely ignored because neoclassical economics does not allow for the phenomenon of discovery. The contention of the entrepreneurial approach is that at the most essential level, neoclassical economics is not in a position to explain the phenomenon of growth.
Neoclassical economics operates in a "closed universe". In this paradigm, genuine novelty (and therefore change) is excluded. This has been recognised by some neoclassical economists such as Kenneth Arrow: "Subtle observation is not needed to see that we have had great changes in our technological knowledge. The need for economic analysis is to explain steady or even accelerating rates of growth in advanced economies. Neoclassical economics without increased knowledge should lead to diminishing rates of growth, even apart from Malthusian considerations and exhaustible resources. While dissemination of existing information can certainly account for some gains in productivity, it is clearly necessary for sustained growth to have information new to the entire system, not merely learned from others. Where does this new knowledge come from?" (Arrow 1994: 7)
What has neoclassical economics resorted to in order to explain new knowledge? Neoclassical economics has only posited growth in order to explain growth. This is true of the work of Solow (1956), which posits the unknown factor, and this is also true of endogenous growth theories where one resorts to externalities and increasing returns.
Crusoe economics is rich in explanations to understand human action. It shows that:
- In order to improve his lot, Crusoe must produce capital goods.
- These capital goods are the result of discoveries and judgments about the future: this is the entrepreneurial function.
- Judgements about the future imply uncertainty (e.g the vines may not resist to water as much as he hoped).
- Crusoe's time preference will be revealed by his decision to save resources in order to build the net (i.e. the forgone consumption of leisure must be compensated by more consumption in the future than would have otherwise taken place): advancing the means of production is the capitalist function.
- In the absence of an objective measure of utility, it is difficult for an external observer to measure the growth that may result from the use of the net, as one must assume an objective measuring rod: catching fish or time at the beach.
3.5 Entrepreneurship and the market process view in a nutshell
First of all, the market process view recognizes that not all states of the future can be known (even probabilistically speaking) and that action takes place within the radical uncertainty of the future. This means that the present state of the world does not determine its future. A corollary of this proposition is that genuine change exists.
An open-ended world means that equilibrium can never be achieved as there are always unnoticed opportunities for profit. From this perspective, the economic problem is a problem of coordination of individual plans. Thus what matters to understand the market system is what lies outside a situation of (hypothetical) equilibrium where all the plans mesh (Kirzner 1973).
The entrepreneurial function is this human capacity of imagining what the future may be like by discovering opportunities for profit. In a world in disequilibrium, price discrepancies overlooked by other participants exist and arbitrages are possible. Most price discrepancies are inter-temporal, that is, if discovered they lead to arbitrages over time. In inter-temporal arbitrages, an entrepreneur discovers a profit opportunity based on the fact that current prices of inputs are, seen from the future state of the market, too low. Pure profit represents the difference between the price at which the output will be sold in the future and the current inputs prices taking into account the opportunity cost of capital.
The market is in a constant state of flux and the future is radically uncertain. Therefore, there is no profit that is certain; every entrepreneurial discovery is speculative until the profits are realized. However, entrepreneurial discoveries occur because entrepreneurs are guided by the existence of pure profits. Profits act as a compass that guides entrepreneurial activity towards the most desired outcomes. Profits act as a lure that awakens entrepreneurial senses.
The nature of knowledge is important to the context in which discoveries take place. Knowledge can be explicit or tacit and will depend on the local circumstances of time and place (Hayek 1948). While knowledge plays an important role, there is nothing deterministic about entrepreneurial discovery, which is why they are discoveries. Entrepreneurs are alert to profit opportunities but do not necessarily discover them (Kirzner 1973).
One doesn't invest in entrepreneurship, as it is not a resource that is deployed to achieve some ends. By their very nature, discoveries are costless; there is no resource that is given up in the act of discovery.
Austrian economics stipulates that the true human dimension in human action is the possibility of creation. Ultimately, entrepreneurship is about the introduction of radical novelty in the universe. It is the possibility for human beings to be, as Thomas Aquinas explained in the Summa, second causes.
Schumpeter's distinction between invention and innovation (Schumpeter, 1947) is important as it shows the role of profit in signalling which inventions are desired by others from those that aren't. Profit guides entrepreneurs towards what is desired by others.
In an open-ended world, monopoly pricing loses its relevance, as the structure of the market does not matter. What is important is entrepreneurial pure profit, which is transient. Also the issues around the optimality of investment and externalities are not seen as economic problems (in the usual sense of the term) but rather as institutional ones (e.g the definition of property rights).
3.6 Shumpeterian creative destruction
In recent years, neo-Schumpeterian theories have become more recognised because of the theory of creative destruction. However, Schumpeter was not the first one to talk about entrepreneurship and technical change. The reason why his theories have had a lot of appeal for many neoclassical economists is because he has tried to reconcile two different approaches. While Schumpeter was educated in Austria and studied under Böhm-Bawerk, he was influenced by Walrasian general equilibrium theory. His understanding of the entrepreneurial role comes not from the recognition of radical uncertainty but from the incompatibility of equilibrium theory with change.
Schumpeter (1939, 1942) starts his inquiry into the nature of economic change with a general equilibrium characterised by an absence of profit and loss and a zero interest rate. In the Walrasian equilibrium, consumers' tastes, technology and resources are given. These are the parameters of the equilibrium, i.e. this is a closed universe. Schumpeter examined each of these in turn.
As Schumpeter assumed that there is no time preference, he cannot assume that economic change would come from a change in the saving rate that would free up resources for production. Similarly, a change in other preferences is unlikely because consumers are passive individuals who merely react to prices and quantities. Resources cannot be the source of change, as land and labour cannot change (or only slowly over long periods of time). Schumpeter endorses this Walrasian assumption. Thus the only possible source of change was technology and this is associated, in Schumpeter's system, with the role of the entrepreneur.
Thus Schumpeter saw the entrepreneur as a "destroyer" of the existing equilibrium; a disruptive force that introduces new technology into the system. In Schumpeter's view, the entrepreneur destroys a state of equilibrium to replace it with another one.
While appealing because it tries to deal with novelty and entrepreneurship, there are many problems with Schumpeter's theory. First of all, Schumpeter neglects to give a rationale for entrepreneurial behaviour. In the absence of profit, it is difficult to see why the entrepreneurial function would take place in a world in equilibrium. This is the profound difficulty of neoclassical economics that in order to have genuine change, one needs the possibility of pure profit and disequilibrium, which is by assumption ruled out.
Secondly, in Schumpeter's equilibrium model there is no time preference, thus there can be no saving to finance entrepreneurial activity either. This is why Schumpeter saw the role of banks not as financial intermediaries but as credit creators. Moreover, the disruption that entrepreneurs create comes with changes in prices and thus profit and losses may appear. In order to obtain a return to equilibrium, Schumpeter must postulate a type of entrepreneurial activity where the profits realised by the new industry are counter-balanced by the losses made by the old industry. Eventually, the innovative period comes to an end and the economy settles down in a new equilibrium with a higher price level as the result of the inflationary bank credit. In fact, by describing a theory of innovation, Schumpeter described a theory of cycles. This is why entrepreneurial activity only occurs at certain moments and not all the time, as in the market process view where entrepreneurs constantly strive to capture profit opportunities.
While Schumpeter was correct in associating change with the entrepreneurial function, he only focussed on technological change. The real issue is entrepreneurial activity as such (i.e. the discovery of pure profit opportunities); not so much technological change, for the latter is a consequence of the former. Entrepreneurship can be seen as a much broader phenomenon, that of discovering the new means-ends framework under which individuals will operate. This encompasses, for instance, the discovery of deeper preferences that were genuinely unknown to individuals and this does not necessarily relate to technological change. Schumpeter's view is a construct that tries to account for the existence of economic change, inflation and cycles, taking general equilibrium as a point of departure and arrival. It is a dynamic approach to break out of the Walrasian box, not a truly dynamic approach of the market. 12
3.7 Entrepreneurship and the nature of incentives
Schumpeter's contribution makes one important point, which is to realise that a general theory of the market is also an explanation of the growth process (i.e. of social change). In other words, growth is not an issue in itself (i.e. separated from the rest of market theory). In fact, market process theorists would argue that if one understands market processes, then one also understands growth processes, as the two are inseparable. There is no such thing as "growth economics" separated from the rest of economic theory; there is only a general theory of markets and empirical differences in the institutional and cultural contexts.
While I gave a brief explanation of what entrepreneurship is about in the Austrian view, I have not provided a response to the above question: what makes capital accumulation possible?
From the above discussion on market processes, one can deduce that Austrian economics sees the entrepreneurial function in human action as the key engine to change and thus growth. Austrian economics understands the entrepreneurial function not as confined within some individuals who start companies, but as a propensity that any individual can display at any moment. The basic question is to understand why while the entrepreneurial function is supposed to be a universal trait of human nature it does not seem to lead to the same results across all places in the world.
Understanding the incentives to entrepreneurship provides an essential clue to the question. Kirzner (1985) makes the distinction between "already perceived alternatives" and "unnoticed opportunities". In other words, if discovery exists, then there must be a period before the discovery has been made, that is, a period where the opportunity is truly unnoticed and where it is not part of the choice set of the individual.
In the traditional approach, incentives refer to already perceived alternatives, that is, alternatives that are part of the individual's choice set. What matters to market process theory is to understand the nature of the incentives that will encourage the entrepreneur to notice what was previously overlooked. This type of incentive takes place in an open universe where undiscovered potential courses of action exist. Thus, it does not refer to the inducement to undertake a course of action that has already been perceived but to the inducement to discover a certain course of action.
As we saw above, pure entrepreneurial profit is what is left once all the costs (including interest) to a course of action have been taken into account. Profit is the compass that directs entrepreneurial alertness. The lure for profit is the basic incentive that makes entrepreneurial discoveries possible.
Thus if one could remove pure entrepreneurial profits from the economy, the incentives to provide the goods that already exist would not be changed. However, it would affect the incentive related to the discovery of hitherto unknown courses of action. Pure profit provides an incentive only in the second sense of the term discussed above: it affects the noticeability of undiscovered courses of action.
3.8 Institutions and the generation of knowledge
The primary condition for entrepreneurial discovery is the existence of pure profit. Moreover, what also matters to the existence of entrepreneurship is the possibility to exploit discovered opportunities for profit.
Discovery and exploitation are two sides of the same entrepreneurial coin. If entrepreneurship is the ultimate cause of social change, this means that the issue of growth is basically an institutional problem: the problem of identifying the necessary institutional conditions for entrepreneurship to take place. In other words, entrepreneurship is a function of the institutional makeup of a society.
One of the main aspects of the competitive market process is its "decentralised" nature. Precisely because information is dispersed, the decentralised aspect of competition allows each individual not only to apply his/her own explicit knowledge to the recognition of the new data in the market, but also his/her own tacit knowledge. Through this process, knowledge that is tacit is used in ways that could not have been effected under a different institutional arrangement since none of this knowledge could have been organised and centralised. Paradoxically, the economic problem finds its root in the decentralised nature of knowledge (i.e. radical ignorance is due to the dispersion of knowledge) but it is also through the decentralised nature of knowledge that it finds its solution (i.e. the entrepreneurial competitive process). The market system, through the entrepreneurial competitive process, is able to create and disperse knowledge that could not be organised by a single mind.
This leads us to one of the core issues of market process theory: the influence of institutions on the generation and dispersion of knowledge. The idea is that different patterns of institutions will produce different patterns of knowledge because they will affect the incentives for entrepreneurial discovery in different ways. That is why the differences among institutions are so important. What the theory of entrepreneurial competition teaches us is that the decentralised structure of the market produces knowledge that would be impossible to produce in a different institutional environment. It is not only that the market system marshals knowledge in a more efficient way than any form of government planning; it is essentially that the knowledge produced in the market system would simply not exist under central planning. The entrepreneurial process of competition will tend to solve the Hayekian knowledge problem (i.e. the idea that the knowledge necessary to make individuals' plans dovetail is not possessed by anyone) because it creates knowledge that would not be available otherwise (Hayek 1948).
This claim is valid at the systemic level, e.g. the market system versus central planning; but is also valid at more micro levels, where specific institutions, such as the structure of multidivisional firms, can be shown to produce knowledge that would not exist in their absence. Market process theorists thus argue that the superiority of the market system resides in its capacity to produce knowledge that would not be available under different institutions. The versatility of the market system allows individuals to use their explicit and implicit knowledge to turn discovered information into useful knowledge.
One issue that is often raised is the "cornerstone hypothesis", that is, the idea that some cultures can be a barrier to the adoption of institutions that foster entrepreneurship and economic change (see Harper 2003 for an analysis of the concept). Culture is often part of that "thick" description of the world that anthropologists and historians like to gather but that most economists reject in favour of "thin" descriptions that can be treated statistically. The legitimacy of a particular institutional makeup is likely to be related to the culture of a people. Whether institutional changes stick or not will depend, among other things, on culture (Boettke 2001a).
However, culture is only part of the story, as Rabushka (1987) and Olson (1996) have argued. If culture was always primordial in the adoption of institutions, one wouldn't have seen the cases of the two Germanys (East and West) and the three Chinas (Mainland China, Hong-Kong and Taiwan). In these cases, peoples with strong similar cultural heritage have adopted different institutional fabrics. Thus while culture is vital to understanding the context in which entrepreneurship occurs, it is not the only cause for adopting institutions.
3.9 Public Choice and Institutional Design
Before addressing the issue of policy, two important issues need to be mentioned. The first one is what Barry Weingast (1995) calls the paradox of government. The second one is the limits of democracy.
The paradox of government is the idea that a government strong enough to establish limits to its powers is usually strong enough to break those very bonds. The basic problem is one of ex ante commitment and ex post predation. In other words the constitutional constraint that a people must establish is one that will tie the ruler's hands; i.e institutions, which stop the state from reneging on its promises.
As I argued above, in order for entrepreneurship to take place, entrepreneurs must be able to exploit discovered opportunities. If an entrepreneur decides to participate in the economy, once she has entered, the government can benefit from confiscating her profits. Therefore unless the ruler's hands are tied, a non-desirable social outcome will follow: that where entrepreneurs do not enter the market. The temporal dimension of institutions is essential to the success of policy because the most important part of entrepreneurship for economic performance takes place in time. The simple decision tree derived from Boettke (2001b) shows that commitment is most fundamental to entrepreneurial activity (see appendix). Because modern production processes happen through time, unless the institutional structure limits ex post expropriation, no entrepreneurship and long-term investments will occur.
This brings us to my second point on the limits of democracy. The market system and entrepreneurial competition can bring huge transitory profits to some actors in the economy and this raises the incentives for public expropriation. The question is whether majoritarian Parliamentary systems are capable of keeping the commitment that governments must make in order to create the institutional strata for entrepreneurship to flourish. Public choice economics argues that there are strong reasons to think that this is not the case because: (a) politicians and bureaucrats do not have the public interest at heart but their own self interest; (b) voters are rationally ignorant; (c) bureaucracies waste resources and finally (d) representative democracy will tend to favour rent seeking by some organised groups at the expense of the rest of the population (the "dispersed costs, concentrated benefits" story).
Bounded rationality and self-interest with guile apply to policy makers as well. Even more so, radical uncertainty is also a fact of reality that governments have to live with. Politicians and policy makers are ignorant of many of the consequences of their own actions in government. Policy failure, that is the existence of a conflict between actual and intended outcome, is a clear possibility. As policy failures create the need for more intervention, the mixed economy becomes a "self-ordering and self-sustaining process embodying a powerful internal dynamic that tends to cycle the system between relatively free markets, on the one hand, and collectivist central planning and inevitable crisis on the other" (Ikeda 1997: 28). This is the slippery slope problem (Rizzo and Whitman 2003). The issue is one of comparative institutional analysis: which institutions will (a) provide the environment for entrepreneurship and capital accumulation to take place and (b) protect the citizenry against itself (because it is ignorant of both what politicians want to do and of the impact of policies) and against the government (i.e. the slippery slope problem). Weingast (1995) has argued that the best constitutional framework for economic development and performance is what he termed "market-preserving federalism".
3.10 Policy implications
While understanding why some rules are adopted and others are not is essential, it is not the focus of this last section. Here I would like to focus on the above proposition that "entrepreneurship is a function of the institutional makeup of a society".
As we saw above, the fundamental incentives for capital accumulation are twofold:
- Incentives that affect the noticeability of undiscovered courses of action.
- Incentives that affect the exploitability of discovered profit opportunities.
The first type of incentives relate to the rules that affect pure profit. These rules relate primarily to taxation but also to other forms of regulation that may reduce pure profit: regulation of competition that affect the freedom of contract, regulation of trade, industrial policy, regulation of labour, inflation, etc.
The second type of incentives relates to the commitment that governments must make with regard to the consistency of their policies. This means that constitutional constraints should extend into the policy domain:
- Fiscal constitution: to limit taxation and balance the budget.
- Regulatory constitution: to limit industry regulation (including competition law) and to require compensation for regulatory takings.
- Monetary constitution: to have and maintain an independent monetary policy (or a currency board or even free banking).
- Trade constitution: to have and maintain free trade with all countries.
Because it reduces the noticeability and exploitability of profit opportunities, "interventionism both increases the level of discoordination within the system and makes it more difficult to eliminate this discoordination" (Ikeda 1997). What matters is the speed and responsiveness of the market to discoordination situations: the market is an error-correcting mechanism where entrepreneurs tend to spot overlooked opportunities.
The institutions that foster entrepreneurial incentives are those of a free market system traditionally understood based on the rule of law. These institutions are subsumed under the laws of property, contract and tort in traditional English Common Law (i.e. abstract and general rules), to which one should add the idea of monetary responsibility.13
3.11 Conclusions
As I stated in the introduction, I have tried to establish in the paper the following chain of argument:
- Economic performance (i.e. growth) depends on capital accumulation;
- Capital accumulation is the result of entrepreneurial profit discoveries;
- Entrepreneurship is a function of the institutional makeup of a society;
- Institutions (or rules) will foster entrepreneurship if their effects on (a) the noticeability and (b) the exploitability of profit opportunities are small over time;
- In order to limit the effects on the noticeability and exploitability of profit opportunities, institutions must constrain the government in its possibility to renege on its commitments.
In his 1974 Nobel Lecture (Hayek 1989), Hayek warned us against the "scientistic error". This is the view that economists should imitate as closely as possible the procedures that we learn in the physical sciences. Knowledge of physics has helped us develop the practice of engineering and the design of complex machines. The fallacy is the idea that the same should be done with economics: it should inspire the engineering of society.
What the entrepreneurial understanding of the economic system teaches is that we cannot engineer growth. Growth is the result of a spontaneous order that cannot be designed. The true use of reason resides in understanding that much more than what we can comprehend makes the social order possible. The reliance on general and abstract rules (in the establishment of social orders) is not an abandonment of reason, but rather an essential insight into its limited powers (Hayek 1973). What we can try to do, in spite of the conflicting goals that individuals may have (e.g have the cake and eat it too) is to influence the adoption of an institutional framework that enhances entrepreneurship and capital accumulation (i.e. the competitive process).
3.12 Appendix
Decision tree with two players: the government A and an entrepreneur B, and two periods. The issue is for the entrepreneur to participate in legal market activity or do something else (such as undeclared work). If the entrepreneur chooses not to participate he only makes 2 and the government makes 0. While if he chooses to participate, his income will depend on the behaviour of the government. If the government commits, then the government will receive 3 and the entrepreneur will make 6. If the government reneges on its promise to commit then the entrepreneur receives nothing and the government gets 5.
The incentives for the government are to renege in the second period, while the incentives for the entrepreneur are not to participate if he anticipates that the government will renege. Post-contract opportunism on the part of the government is what destroys entrepreneurial behaviour and reduces total wealth (5 instead of 9). The rules of the game must provide the right incentives for entrepreneurs to enter the market, discover opportunities for profit and exploit them. Solving the ex ante and ex post commitment problem is necessary to the flourishing of entrepreneurship.
3.13 References
Aquinas, Thomas (1981) Summa Theologica, Thomas More Publishing
Arrow, Kenneth (1994) "Methodological Individualism and Social Knowledge", American Economic Review, 84 (2), 1-9
Boettke, Peter (2001a) "Why Culture Matters" Reprinted in Calculation and Coordination, London: Routledge
Boettke, Peter (2001b) "Credibility, Commitment and Reform" Reprinted in Calculation and Coordination, London: Routledge
Harper, David (2003) Foundations of Entrepreneurship and Economic Development, London: Routledge
Hayek, Friedrich (1948) "The Use of Knowledge in Society" Reprinted in Individualism and Economic Order, Chicago: University of Chicago Press
Hayek, Friedrich (1973) Law, Legislation and Liberty, volume I: Rules and Order, Chicago: University of Chicago Press
Hayek, Friedrich (1989) "The Pretence of Knowledge" American Economic Review, 79 (6), 3-7
Ikeda, Sanford (1997) Dynamics of the Mixed Economy, London: Routledge
Kirzner, Israel (1973) Competition and Entrepreneurship, Chicago: University of Chicago Press
Kirzner, Israel (1985) Discovery and the Capitalist Process, Chicago: University of Chicago Press
Lucas, Robert (1988) "On the Mechanics of Economic Development", Journal of Monetary Economics, 22(1)
Olson, Mancur (1996) "Big Bills Left on the Sidewalk: Why Some Nations are Rich, and Others Poor", Journal of Economic Perspectives, 10(2), 3-24
Rabushka, Alvin (1987) The New China, Boulder, CO: Westview Press
Rizzo, Mario and Douglas G. Whitman (2003) "The Camel's Nose is in the Tent: Rules, Theories and Slippery Slopes", UCLA Law Review, 51(2) , 539-92
Robbins, Lionel (1932) An Essay on the Nature and Significance of Economic Science, London: Macmillan
Rosen, Sherwin (1997) "Austrian and Neoclassical Economics: Any Gains from Trade?" Journal of Economic Perspectives, XI (4), 139-152
Rothbard, Murray (1987) "Breaking out of the Walrasian Box: Schumpeter and Hansen" Reprinted in The Logic of Action II, Cheltenham: Edward Elgar
Schumpeter, Joseph (1939) Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, New York: McGraw-Hill
Schumpeter, Joseph (1942) Capitalism, Socialism and Democracy, New York: Harper and Brothers
Schumpeter, Joseph (1947) "The Creative Response in Economic History" Reprinted in Schumpeter, J. (1997) Essays, New Brunswick: Transaction Publishers
Solow, Robert (1956) "A Contribution to the Theory of Economic Growth", Quarterly Journal of Economics, 70(1), 65-94
Weingast, Barry (1995) "The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development" Journal of Law, Economics and Organizations 11: 1-31
Back to Top