Book 1: Capitalism at Work: Business, Government, and Energy
Chapter 4 Internet Appendix
4.1 Equilibrium versus Market Process
4.2 Entrepreneurship in Economics: From Unknown to Missing
4.3 Schumpeter, Drucker, and Hamel
4.4 Economic Calculation Revisited
4.5 Externalities and Economic Calculation
4.6 The Institutional Framework of Economic Calculation
4.7 Markets within a Firm
Bibliography: Chapter 4 Appendices
4.1 Equilibrium versus Market Process
Equilibrium—also called the evenly rotating economy (ERE) by economists wary of natural-science metaphors—is a theoretical construct, an imaginary construction. However, the real world offers examples of momentary equilibrium where the actions of buyers and sellers are coordinated. Supply equals demand for a time, and traders close the books before starting anew. But going from partial equilibrium to general equilibrium is another story entirely. General equilibrium, where all markets are in perfect alignment, is a grand leap that has no real world counterpart, not even for an instant. Economists enter a never-never land when they go from partial to general equilibrium analysis.General equilibrium is where optimality is reached and economic adjustment is not only over, it is unnecessary. Understanding this end state, however, is important to understanding where economic processes are headed. “There is no means of studying the complex phenomena of action other than first to abstract from change altogether, then to introduce an isolated factor provoking change, and ultimately to analyze its effects under the assumption that other things remain equal,” stated Ludwig von Mises (1966, 248). The process of seeking profits and avoiding losses is coordinating, or equilibrating toward equilibrium/ERE. “Economists find equilibrium a useful concept not because they expect it to be reached, but because it tells them the directions in which price and quantity will move” (Michaels, chapter 3).
However, a preoccupation with equilibrium/ERE can come at the expense of understanding the business world, the market process that tends to bring costs and selling prices into line and eliminate both pure profits (returns above the going rate of interest) and losses. Incessant changes in consumer demand and production possibilities prevent the steady, timeless state of equilibrium/ERE from finalization. So equilibrium/ERE should be seen as an aid to comprehending reality, and even to be a foil to reality, but not to be reality itself.
For many economists, equilibrium has become reality because that is much or all of the theoretical work that they do. The journals and classrooms have become so filled with static-state analysis that the economics of business uncertainty (Knightian uncertainty versus risk) has been lost. But without real world economics, the applied economist and historian cannot understand the actual business environment and develop case studies of success and failure, and, certainly, bankruptcy.
Methodological realism, or essentialism, makes disequilibrium economics, or the study of market process, the center of analysis. Knightian uncertainty, defined as uncertainty that cannot be managed away by the entrepreneur, has also been described as genuine, pure, or radical uncertainty. Economic terms in the imperfect-knowledge lexicon are alertness, anticipation, change, discontinuity,discovery, ignorance, intuition, judgment, novelty, revision, spontaneity, surprise,serendipity, and trial and error. Entrepreneurship, resulting in pure profits and losses, is inseparable from uncertainty in the passage of time.
The disequilibrium world has been described as change-always, evolving,kaleidoscopic, living, open-ended, and revolutionary. Entry, exit, mergers, and divestitures occur. There is product heterogeneity (differentiation). Information is incomplete and costly to acquire. Opportunities are unexploited and not even known to be available for exploitation. Real time is differentiated from timeless “Newtonian” time. There are innovators and inventions. There is improvement and deterioration. Asset values change. Intangibles matter. Brand names and advertising are important.
Equilibrium analysis, on the other hand, has been described as closed, static, and timeless. Ronald Coase described equilibrium as blackboard economics“since what they described could happen only on a blackboard” (1995: 239). Other terms for general or stationary equilibrium are the circular flow(Schumpeter, 1934: 10–11, 76) and, as mentioned, the evenly rotating economy(Mises, 1966: 246–47). Whatever the term, the imaginary construction is to be used with great care in understanding the direction of economic activity (Mises: 236–37, 247–48).
Purposeful human action is altogether different from the laws of nature (Knight: 1930). Thus metaphors such as equilibrium, disequilibrium, equilibrating, statics, and dynamics should be used with reservation. Diagrams of supply, demand, cost, and revenue curves are pedagogical devices that, strictly speaking, violate assumptions of human action and thus economics. The economist should acknowledge as much in journal articles, in books (including textbooks), and presentations.
4.2 Entrepreneurship in Economics: From Unknown to Missing
Entrepreneurship was slow to become the focus of economic theory despite the centrality of business to economics and entrepreneurship to business. Joseph Schumpeter credited Richard Cantillon (1680–1734) with first describing the entrepreneur and J. B. Say (1767–1832) with the notion of the entrepreneur combining resources in one entity (1954: 222, 555). Schumpeter also observed how Adam Smith had very little to say about capitalism’s prime mover: “[Smith] speaks occasionally of the undertaker, the master, the merchant—and, if pressed, would not have denied that no business runs by itself” (1954: 555). Alfred Marshall (1842–1924), the most revered economist of his time as author ofPrinciples of Economics (1890), focused upon the managerial role and not entrepreneurship (1954: 646).
Other economists worked on the edges of entrepreneurial theory before Schumpeter, Frank Knight, Ludwig von Mises, and Ronald Coase put entrepreneurship at the center of economic analysis. Yet the rest of the economics profession, with some exceptions, dissatisfied with the literary method, embraced unrealistic assumptions and technical analysis that for decades eclipsed the study of entrepreneurship and the theory of the firm (1991b: 61). Coase complained:
What is studied is a system which lives in the minds of economists but not on earth. I have called the result “blackboard economics”. The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a “black box”. And so it is (Coase: 1991a, 229). |
The mathematics of equilibrium theory was an unproductive detour. “In my youth it was said that what was too silly to be said may be sung,” Coase noted. “In modern economics it may be put into mathematics” (Coase: 1959, 185).
The sterility of mathematical economics has been noted by academics outside of economics in search of real-world comprehension. Complained Nassim Taleb:
There was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science. Someone in a great rush decided to introduce mathematical modeling techniques (culprits: Leon Walras, Gerard Debreu, Paul Samuelson) without considering the fact that either the class of mathematics they were using was too restrictive for the class of problems they were dealing with, or that perhaps they should be aware that the precision of the language of mathematics could lead people to believe that they had solutions when in fact they had none…. Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes—and they refused to accept the fact that no mathematics at all was probably better (Taleb: 177). |
But far from a political issue, economist Paul Krugman of Princeton (and an anti-market columnist of the New York Times) has stated:
Economists have always sought the rigor and clarity that comes from using numbers and equations to represent their ideas. And the economics of diminishing returns lend themselves readily to elegant formalism, while increasing returns—[Adam Smith’s] Pin Factory—are notoriously hard to represent in the form of a mathematical model (Krugman). |
The Austrian school of economics placed entrepreneurship at the center of its system—and no member of that school more so than Ludwig von Mises. InHuman Action (1949: 254), Mises defined the entrepreneur as “acting man exclusively seen from the aspect of the uncertainty inherent in every action.” The pure entrepreneur does not have to own capital; he or she can use the capital of others to speculate in the market by buying resources now to create a product that is sold later in the expectation of a profit. This person (or function) is that of the promoter, the pacemaker, the pioneer. “The driving force of the market, the element tending toward unceasing innovation and improvement, is provided by the restlessness of the promoter and his eagerness to make profits as large as possible,” Mises stated (1949: 256).
Mainstream economics—filling the textbooks with timeless and perfectly continuous curves of cost, revenue, price, and quantities—dismissed the realists. But leading business strategists grabbed the flag and reached a much wider audience. Strategist Peter Drucker complained: “In the equilibrium economics of a closed economic system there is no place for profit, no justification of it, no explanation of it” (1983: 110). Methodological formalism at the expense of realism polluted the educational curriculum. In a “salvo against the business schools,” Tom Peters and Robert Waterman, citing others, complained about an “overemphasis on quantitative methods” (1982: 35) at the expense of a broader liberal arts understanding of the world. The damage was confined, however, the two added, because “the business schools … aren’t running the country. Managers are” (1982: 36).
Mainstream economics—with little excuse—neglects the study of entrepreneurship. The term “entrepreneurship,” for example, is not found in the index of a popular economics textbook, Principles of Economics (South-Western, 2003), by N. Gregory Mankiw. Mark Blaug is correct. It is an intellectual scandal (87) that students learn so little about entrepreneurship despite the best efforts of Schumpeter, Knight, Mises, and Coase.
4.3 Schumpeter, Drucker, and Hamel
Peter Drucker, called by BusinessWeek “the man who invented management” (Byrne), praised Joseph Schumpeter as one of the two greatest economists of the century—the other being J.M. Keynes—and the one with the brighter future (Drucker: 124). “Schumpeter’s dynamic, growing, moving, changing economy,” Drucker argued, not only illuminates business reality, unlike the equilibrium-centered theory of Keynes. “Schumpeter’s economic model [is] the only one that can serve as the starting point for the economic policies we need” (Drucker: 111).
Gary Hamel and C. K. Prahalad in Competing for the Future acknowledged the “pioneers” in the business history and strategy field, three top names being Alfred Chandler, Michael Porter, and Henry Mintzberg (xix–xx). But the greatest praise was reserved for Peter Drucker, whom Hamel and Prahalad described as “both a pioneer and a latter-day guru” and “an unfailing beacon, lighting the way toward the management issues of tomorrow.” Among other things, Drucker “never lost sight of the fact that, for a theory or concept to be useful, it must ultimately be translated into the language and context of managers and managerial action,” Hamel and Prahalad explained (xxi).
Drucker, like Hamel, mentions Schumpeter only in passing. But their emphasis on revolution rather than continuous improvement is thoroughly Schumpeterian. Hamel’s (co-authored) introduction to the second edition of Competing for the Future presents the first-edition message in a much more aggressive, emphatic way. And Hamel’s Leading the Revolution (2000) takes revolution to higher heights. While his prior book drove Enron, Enron’s revolution-always genetics drove the latter book, which necessitated a second revised edition (2002) upon the company’s bankruptcy.
4.4 Economic Calculation Revisited
The argument of Ludwig von Mises that capitalism is economically rational and socialism is not can be grasped in three steps:
1. | Money prices, by creating a common index for goods and services, are a necessary (but not sufficient) condition for economic calculation; | |
2. | Meaningful prices emerge under capitalism where competition between property-owning entrepreneurs as buyers and sellers imparts scarcity values through the structure of production; and | |
3. | Nonmeaningful (nonscarcity) prices result under socialism where government ownership (a legal monopoly) precludes market entrepreneurship, and thus rivalrous selling and buying. |
Consumers under socialism can help set scarcity prices at retail by their decisions to buy or not buy, however imperfect the available options are as determined by the one retailer, the State. Such retail prices can offer a smidgeon of economic calculation at the wholesale level. But as the stages of production are removed from the final consumer, there is only the State as The Supplier and The Demander of resources, buying from and selling to itself. The true price of alternatives (wood versus stone, for example) cannot be established. The State can only make “vague valuations” as opposed to the market’s “exact valuations of value” (Mises: 1920, 122). Central planning boards have also peeked at capitalist markets elsewhere to get hints on pricing (Rothbard: 959–60; Boettke and Coyne: 81–82).
Under socialism, there are not entrepreneurs, only bureaucrats. There is no stock market because, when the state owns the firm in toto, an interest in a firm cannot be bought and sold. Other financial markets familiar to capitalist countries are also precluded by state management of the economy.
The market process, composed of activity within and between firms, is an institutional framework that encourages, but does not guarantee, improvement over time. The profit motive creates a tendency for good information to drive out bad. The general result is what F. A. Hayek called spontaneous order, an order that was designed by no one but created unintentionally by the actions of all (1967: 162, 96–105).
Hayek, a Nobel Laureate in economics, derived the economic calculation argument in a way that complemented that of Mises. Mises spoke of “the intellectual division of labor” in his original 1920 essay (102), noting that not even a genius could solve the economic calculation problem. Hayek posed the problem in informational terms, explaining that even a planning board of geniuses could not replicate what the market process engenders spontaneously. This is because the knowledge required for economic efficiency is decentralized andsubjective. Said Hayek in a famous passage of twentieth century economics:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality (1945: 77–78). |
Hayek’s argument that the free-market price system overcomes the division of knowledge is in tandem with Mises’s admiration of “the system of double-entry bookkeeping” for making “it possible to relieve the entrepreneur of involvement in too much detail” (1966: 304). Prices and accounting guide entrepreneurship and thus the economy as a whole.
4.5 Externalities and Economic Calculation
Mises’s argument about economic calculation in a free market assumes that prices reflect relative scarcity and economic value. Such private valuations would be in general accord with social ones, although private and social costs cannot be measured for comparison because of the subjectivity of value.
A. C. Pigou (1877–1959) introduced the notion of a diversion between private and social costs and benefits, spawning the subdiscipline of welfare economics. Pigou stated in The Economics of Welfare:
In general, industrialists are interested, not in the social, but only in the trade net product of their operations. Clearly, therefore, there is not reason to expect that self-interest will tend to bring about equality between the values of the marginal social net products [national dividend] of investment in different industries, when the values of social net product and of trade net product in those industries diverge (1920: 149). |
In a later edition of his book, Pigou added:
No “invisible hand” can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is, therefore, necessary that an authority of wider reach should intervene and should tackle the collective problems of beauty, of air and of light, as those other collective problems of gas and water have been tackled (1932: 195). |
Thus “certain specific acts of [government] interference with normal economics processes may be expected, not to diminish, but to increase, the dividend” (1932: 172).
Ludwig von Mises recognized externalities but not market failure. Unlike Pigou, Mises saw the absence of private property rights as a major cause of private actions that were not contributions to the general welfare. Thus less, not more, government intervention was prescribed. Stated Mises:
It is true that where a considerable part of the costs incurred are external costs from the point of view of the acting individuals or firms, the economic calculation established by them is manifestly defective and their results deceptive. But this is not the outcome of alleged deficiencies inherent in the system of private ownership of the means of production. It is on the contrary a consequence of loopholes left in this system. It could be removed by a reform of the laws concerning liability of damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership (1949: 653). |
In the 1980s, a new school of thought, free-market environmentalism, arose in opposition to the Pigou-inspired political environmentalism. The role of government was less to regulate than to improve the assignment and enforcement of private property rights to internalize externalities. Explained Terry Anderson and Donald Leal:
Government has an integral role to play in the definition and enforcement of property rights. In the absence of the rule of law, the incentives inherent in private ownership disappear and with them goes the potential for environmental stewardship. With clearly specified titles obtained from land recording systems, strict liability rules, and adjudication of disputed property rights in the courts, market processes can encourage owners to carefully weigh costs and benefits and to look to the future (2001: 5). |
In Misesian terms, economic calculation would be improved with better private property rights. This is particularly true when the imperfection of political solutions, government failure, discussed in chapter 5 of Capitalism at Work, is considered.
Negative externalities and political capitalism go together in the Enron story. Enron lobbied hard for both renewable-energy subsidies and carbon dioxide regulation to create a market in CO2-emissions trading. Ken Lay heralded “Enron’s moral and economic success” at “turning instances of evident ‘market failure’ into self-interested business solutions” (3). But what Enron saw as market failure might not have been so upon close examination, as discussed in Book 3.
4.6 The Institutional Framework of Economic Calculation
Economic calculation by market entrepreneurs requires a social framework conducive to the creation, use, and protection of private property. The institutional framework behind economic calculation has been specified and empirically measured in a study written by James Gwartney and Robert Lawson, together with William Easterly: Economic Freedom of the World: 2006 Annual Report.
Their index measures economic freedom in terms of five variables, within which there are 38 specific (sub)variables:
1. | The size of government in terms of expenditures, taxes, and enterprises | |
2. | The legal structure and security of property rights | |
3. | Access to sound money | |
4. | Freedom of international trade | |
5. | Regulation of credit, labor, and business (7). |
As measured by this index, the greater the economic freedom, the greater the wealth creation and income.
In the second of these five categories, legal structure and property-right security, the “key ingredients” are:
1. | The rule of law | |
2. | Security of property rights | |
3. | An independent judiciary | |
4. | Impartial court system (10). |
Institutional economists have recognized the importance of property rights (property titles) that are tangible and long-lived, socially and politically respected, transferable and capable of validation, and of credit-instrument quality. “A good legal system, like a Swiss army knife,” states Hernando de Soto, “has many more mechanisms than just the elementary ‘ownership’ blade” (216). “Effective legal institutions,” add Thorsten Beck and Ross Levine,
allow knowledgeable and experienced financial market participants to design a vast array of sophisticated private contracts to ameliorate complex agency problems…. Courts must enforce private contracts impartially and have both the ability and willingness to read complex contracts and verify technically intricate clauses that trigger specific actions (254). |
The international investment climate that Enron worked within had numerous property-right uncertainties, which led the company to manage uncertainty by employing the political means, specifically, two U.S.-government agencies: the Overseas Private Investment Corporation and the Import-Export Bank. Such government assistance, as will be seen in Book 3, did not prevent many Enron investments from turning sour, suggesting the limits of economic calculation in a market and political sense.
4.7 Markets within a Firm
Firms have traditionally been thought of as socialism writ small. Ronald Coase inThe Nature of the Firm (1937), for example, quoted Dennis Robertson, who described firms as “islands of conscious power in [an] ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk” (90–91).
At first blush, firms are hierarchical and centrally planned, terms commonly associated with the socialist economy. Frederick Taylor’s The Principles of Scientific Management (1911), the business bible of its day, saw greater industrial efficiency in tighter managerial control over employees. “The work of every workman is fully planned out by the management at least one day in advance,” Taylor instructed, “and each man receives in most cases complete written instructions, describing in detail the task which he is to accomplish, as well as the means to be used in doing the work” (17). “The task idea,” or blueprint management (which Taylor called “perhaps the most prominent single element in modern scientific management” [ibid.]), was certainly akin to command-and-control for the whole economy.
However, the planned firm and planned economy are quite different. Market economies work only because inefficient firms go bankrupt, an outcome that cannot happen with “the economy.” But the analogy between the firm and socialism fails for deeper reasons. Fundamentally, the firm is a nexus of voluntary contracts that are ultimately shaped by consumer decisions to buy or not buy. The socialist economy is based on coercion. The free-market firm is an infinitesimal part of the overall economy; socialism is the economy.
Moreover, there are incentives under capitalism for firms to demote command-and-control and rigid hierarchies where greater profits can be won. Profit centers deep in the organization create, in effect, firms within firms. “Identifying and efficiently creating profit centers at the lowest practical level can provide a substantial competitive advantage,” states Austrian-school-influenced entrepreneur Charles Koch. “Ideally, each plant should be a profit center and, if it makes more than one product, the profitability of each product should be tracked” (2007: 111). Such internal markets allow subsets of a firm to employ arm’s length transactions and keep “scorecards” to determine profitability and also the opportunity cost (next best opportunity) of the resource, such as outsourcing or selling a unit (Koch: 43, 111).
Ultimately, there is still one firm. Marketing (transaction) costs can become high where firms try to mimic markets. But there has been a surge in thinking of the limits of central planning and value of decentralized knowledge and decision-making within a firm (Cowen and Parker).
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