Entrepreneur

The term entrepreneur, which most people recognize as meaning someone who organizes and assumes the risk of a business in return for the profits, appears to have been introduced by Richard Cantillon (1697-1734), an Irish economist of French descent. The term came into much wider use after John Stuart Mill popularized it in his 1848 classic, Principles of Political Economy, but then all but disappeared from the economics literature by the end of the nineteenth century.

The reason is simple. In their mathematical models of economic activity and behavior, economists began to use the simplifying assumption that all people in an economy have perfect information (see Information). That leaves no role for the entrepreneur. Although different economists have emphasized different facets of entrepreneurship, all economists who have written about it agree that at its core entrepreneurship involves judgment. But if people have perfect information, there is no need for judgment. Fortunately, economists have increasingly dropped the assumption of perfect information in recent years. As this trend continues, economists are likely to allow in their models for the role of the entrepreneur. When they do, they can learn from past economists, who took entrepreneurship more seriously.

According to Cantillon's original formulation, the entrepreneur is a specialist in taking on risk. He "insures" workers by buying their products (or their labor services) for resale before consumers have indicated how much they are willing to pay for them. The workers receives an assured income (in the short run, at least), while the entrepreneur bears the risk caused by price fluctuations in consumer markets.

This idea was refined by the U.S. economist Frank H. Knight (1885-1972), who distinguished between risk, which is insurable, and uncertainty, which is not. Risk relates to recurring events whose relative frequency is known from past experience, while uncertainty relates to unique events whose probability can only be subjectively estimated. Changes affecting the marketing of consumer products generally fall in the uncertainty category. Individual tastes, for example, are affected by group culture, which, in turn, depends on fashion trends that are essentially unique. Insurance companies exploit the law of large numbers to reduce the overall burden of risks by "pooling" them. For instance, no one knows whether any individual forty-year-old will die in the next year. But insurance companies do know with relative certainty how many forty-year-olds in a large group will die within a year. Armed with this knowledge, they know what price to charge for life insurance, but they cannot do the same when it comes to uncertainties. Knight observed that while the entrepreneur can "lay off" risks much like insurance companies do, he is left to bear the uncertainties himself. He is content to do this because his profit compensates him for the psychological cost involved.

If new companies are free to enter an industry and existing companies are free to exit, then in the long run entrepreneurs and capital will exit from industries where profits are low and enter ones where they are high. If uncertainties were equal between industries, this shift of entrepreneurs and of capital would occur until profits were equal in each industry. Any long-run differences in industry profit rates, therefore, can be explained by the different magnitudes of the uncertainties involved.

Joseph A. Schumpeter (1883-1950) took a different approach, emphasizing the role of innovation. According to Schumpeter, the entrepreneur is someone who carries out "new combinations" by such things as introducing new products or processes, identifying new export markets or sources of supply, or creating new types of organization. Schumpeter presented an heroic vision of the entrepreneur as someone motivated by the "dream and the will to found a private kingdom"; the "will to conquer: the impulse to fight, to prove oneself superior to others"; and the "joy of creating."

In Schumpeter's view the entrepreneur leads the way in creating new industries, which, in turn, precipitate major structural changes in the economy. Old industries are rendered obsolete by a process of "creative destruction." As the new industries compete with established ones for labor, materials, and investment goods, they drive up the price of these resources. The old industries cannot pass on their higher costs because demand is switching to new products. As the old industries decline, the new ones expand because imitators, with optimistic profit expectations based on the innovator's initial success, continue to invest. Eventually, overcapacity depresses profits and halts investment. The economy goes into depression, and innovation stops. Invention continues, however, and eventually there is a sufficient stock of unexploited inventions to encourage courageous entrepreneurs to begin innovation again. In this way Schumpeter used entrepreneurship to explain structural change, economic growth, and business cycles, using a combination of economic and psychological ideas.

Schumpeter was concerned with the "high-level" kind of entrepreneurship that, historically, has led to the creation of railroads, the birth of the chemical industry, the commercial exploitation of colonies, and the emergence of the multidivisional multinational firm. His analysis left little room for the much more common, but no less important, "low-level" entrepreneurship carried on by small firms. The essence of this low-level activity can be explained by the Austrian approach of Friedrich A. Hayek and Israel M. Kirzner. In a market economy, price information is provided by entrepreneurs. While bureaucrats in a socialist economy have no incentive to discover prices for themselves (see Socialism), entrepreneurs in a market economy are motivated to do so by profit opportunities. Entrepreneurs provide price quotations to others as an invitation to trade with them. They hope to make a profit by buying cheap and selling dear. In the long run, competition between entrepreneurs arbitrages away price differentials, but in the short run, such differentials, once discovered, generate a profit for the arbitrageur.

The difficulty with the Austrian approach is that it isolates the entrepreneur from the firm. It fits an individual dealer or speculator far better than it fits a small manufacturer or even a retailer. In many cases (and in almost all large corporations), owners delegate decisions to salaried managers, and the question then arises whether a salaried manager, too, can be an entrepreneur. Frank Knight maintained that no owner would ever delegate a key decision to a salaried