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Entrepreneurs, the Firm, and the Knowledge Problem

October 15th, 2008

Standard treatment of entrepreneurship as it relates to so-called absentee ownership/capitalists, is that these people (the capitalists) provide a valuable service in the allocation of goods and services across a market. For example, the Rothbardian treatment is that an entrepreneur’s success stems from prior success as a result of superior business acumen; the market weeds out those prospective entrepreneurs who are not as able to allocate scarce resources, as their counterparts. Salerno notes that entrepreneurial profit arises when others make mistakes in their allocations. Therefore loss is a purely personal responsibility, and profit is fleeting; the result of error on behalf of one’s competitors1. It follows, that willingness to bear risk, moving into the uncertain future in hopes of profit, sets entrepreneurs apart from the general, risk-averse population.

This treatment is oft-criticized by many left-libertarians, left-anarchists, etc. One objection which I fielded several years hence, was the notion that the Firm suffers from the classic Hayekian Knowledge Problem: the corporation is a centrally-planned quasi-economy.

At that time, I could not answer to the objection, but mustered instead, something along the lines of, “Well, they’re entrepreneurs, and they have to pass a market-test. A centrally planned economy does not have to pass a market test.”

Some might object that most firms don’t really have to pass a market test2, either. In the current economy, the prior success, on which the foundations of capitalist wealth are built is more often than not the result of some government meddling and therefore, object the left-libertarians, imagining any large business the magnitude of those with which we’ve become familiar, in a free market, is laughable. Atomistic competition in a free market doesn’t tolerate the profits required for absentee ownership.

This simplification of Rothbard’s treatment appears to suffer from a regression problem: from whence comes the prior success, the profits of which permit one to be an effective entrepreneur?

What has happened, is that our definition has silently changed: we’ve gone from Entrepreneur as Risk-Bearer, to entrepreneur as rent seeker resulting form a haphazard equivocation of two very different economic states: the current state, and the free market. Without making value judgments, if we are talking about the current state, then the objection (at least in terms of economic theory) doesn’t hold water. If we are discussing in context of a free market, we need only demonstrate that the normal profits accruing to entrepreneurial success could permit investment in new ventures, and therefore that the so-called “absentee” owner, is not so much an abomination of free market principles3 as he is often made out to be.

In addition to a willingness to bear risk, the prototypical entrepreneur must also have a longer time preferencethan others. Time preference is the rationale by which one agrees to defer consumption in the present for a greater consumption at some time in the future. So, the entrepreneur earns normal profits on his investments, which he invests in accordance with his time preference. A successful entrepreneur will still direct production and provide the valuable functions of allocating resources across an economy, and directing investment to its most valuable opportunity.

It should go without saying, that these analyses are predicated on sound money and free-markets. In a free market, entrepreneurial loans will be real loans, representing the accumulated savings and deferred consumption, not fiat paper promises backed by fraud and violence. If these conditions do not hold, we can throw the preceding paragraphs out the window.

In a rather convoluted and roundabout manner, we can return to the initial objection against the firm, which as the legend goes, suffers to some extent, from the Hayekian Knowledge Problem. This objection is valid as an argument contra any state-capitalist apologist, but suffers from a similar equivocation error as the objection to Rothbard, above. If we are discussing organization and production in the context of a free market, the basis of this objection (that the Corporation does not face the market test) is null.

Profits and losses would no longer be subsidized in a free market, so we can expect profits to be smaller (representative of opportunity costs), and hence more difficult to accrue in the ginormous amounts required to develop firms the sizes of which we see at present (cf., “economies of scale” that we learn about in school are essentially a fiction).

Since the fictional economies of scale are counterbalanced by very real diseconomies of scale,
firms in a free market would stand in stark contrast to megalithic entities, the profits of which often dwarf the entire domestic production of the smaller nation states in the world. Indeed, the organizational structure of the market as a whole would tend to be much flatter than at present, and the smaller, more agile firms comprising it would be far less susceptible to the Knowledge Problem.

Notes

1. This simple but sometimes counter-intuitive proposal can be illustrated thusly: if all entrepreneurs accurately predict demand, and satisfy their customers, the resultant competition for customers drives profit down to the hypothetical opportunity cost.

2 Corporations are able to borrow at preferential rates, receive different tax-status than individuals (i.e., they can write-off their expenses!) and are often shielded from liability, etc.

3. Some suggest that so-called passive income (e.g., from entrepreneurship) is an abomination. Setting aside the debate over how such things might arise, IMO, absentee “ownership” ceases to exist in-fact, and entrepreneurship would instead be directed by conditional loans. Investor/entrepreneurs would have a valid claim against the production which they assisted by financing.

no third solution

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