Thursday, 11 December 2014

Book award to Foss and Klein

This is from the website of the Society for the Development of Austrian Economics
2014 FEE Prize for the best book in Austrian economics is awarded to Nicolai Foss and Peter G. Klein’s Organizing Entrepreneurial Judgment

Comments read by Virgil Storr, Vice President of the SDAE, during the presentation of the 2014 FEE Prize for the best book in Austrian economics:

In Organizing Entrepreneurial Judgment: A New Approach to the Firm, Nicolai Foss and Peter G. Klein bridge the gap between studies of entrepreneurship and the theory of the firm. Despite both concepts becoming increasingly appreciated and studied by contemporary scholars in economics and management, Foss and Klein show that the existing theoretical and practical literature too often fails to adequately connect these theories. Seeking to correct this failing and drawing on insights from Austrian economics, Foss and Klein examine entrepreneurship as judgment decisions made by management under conditions of uncertainty. They show that these judgments are drivers of the economy and keys to understanding firm performance and organization.

For meaningfully adding to the Austrian literature on entrepreneurship and applying Austrian insights about entrepreneurship to the theory of the firm, the prize committee determined that Organizing Entrepreneurial Judgment: A New Approach to the Firm is deserving of the 2014 FEE Prize for the best book in Austrian Economics.
In a working paper of mine I say this about the Foss and Klein book (footnotes removed),
Foss and Klein 2012

A second recent approach to the firm that doesn't fit well into the Foss, Lando and Thomsen classification, but which also emphasises the entrepreneur, is that of Foss and Klein (2012) (FK). FK see their work as offering a theory of the entrepreneur centred around a combination of Knightian uncertainty and Austrian capital theory. While such a basis places their work outside the conventional theory of the firm, FK see themselves ``not as radical, hostile critics, but as friendly insiders" (Foss and Klein 2012: 248).

To understand the FK theory first consider the one-person firm. For FK it is the incompleteness of markets for judgement that explains why an entrepreneur has to form their own firm. Here ``judgement" refers to business decision making in situations involving Knightian uncertainty, that is, circumstances in which the range of possible future outcomes, let alone the likelihood of any individual outcome, is unknown. Thus decision-making about the future must rely on a kind of understanding that is subjective and tacit, one that can not be parameterised in a set of formal, explicit decision-making rules. But then how can we tell great/poor judgement from good/bad luck? A would-be entrepreneur may not be able to communicate to others just what his ``vision" of a new way to satisfy future consumer desires is in such a manner that other people would be able to assess its economic validity. If the nascent entrepreneur can not verify the nature of his idea then they are unlikely to be able to sell their ``expertise" across the market - as an consultant or advisor - or become an employee of a firm utilising his ``expertise" due to adverse selection/moral hazard problems and thus he will have to form his own firm to commercialise this ``vision". This reasoning for the formation of a firm is not entirely without precedence. Working within a standard property rights framework Rabin (1993) and Brynjolfsson (1994) show that an informed agent may have to set up a firm to benefit from their information for adverse selection and moral hazard reasons respectively. In addition to this the inability to convey his ``vision" to capital markets will limit an entrepreneur's ability borrow to finance the purchase of any non-human assets the entrepreneur requires. This means the the entrepreneur can not be of the Kirznerian penniless type. Non-human assets are important because judgemental decision making is ultimately about the arrangement of the non-human capital that the entrepreneur owns or controls. Capital ownership also strengthens the bargaining position of the entrepreneur relative to other stakeholders and helps ensure the entrepreneur is able to appropriate the rents from his ``vision".

Turning to the multi-person firm FK argue that the need for experimentation with regard to production methods is the underlying reason for the existence of the firm. Given that assets have many dimensions or attributes that only become apparent via use, discovering the best uses for assets or the best combination of assets requires experimenting with the uses of the assets involved. Thus entrepreneurs seek out the least-cost institutional arrangement for experimentation. Using a market contract to coordinate collaborators leaves the entrepreneur open to hold-up, collaborators can threaten to veto any changes in the experimental set-up unless they are granted a greater proportion of the quasi-rents generated by the project. By forming a firm and making the collaborators employees, the entrepreneur gains the right to redefine and reallocate decision rights among the collaborators and to sanction those who do not utilise their rights effectively. This means that the entrepreneur can avoid the haggling and redrafting costs involved in the renegotiation of market contracts. This can make a firm the least-cost institutional arrangement for experimentation.

With regard to the boundaries of the firm, FK argue that when firms are large enough to conduct activities exclusively within its borders - so that no reference to an outside market is possible - the organisation will become less efficient since the entrepreneur will not be able to make rational judgements about resource allocation. When there are no markets for the means of production, there are no monetary prices and thus the entrepreneur will lack the information they need about the relative scarcity of resources to enable them to make rational decisions about resource allocation and whether entrepreneurial profits exists. This implies that as they grow in size, and thus do more internally, firms become less efficient due to the increasing misallocation of resources driven by the lack of market prices. But the boundaries of firms seem to be such that firms stop growing before outside markets for the factors of production are eliminated and market prices become unavailable. So while this idea can explain why one big firm can not produce everything it seems less able to tell us why the boundaries of actual firms are where they are. Real firms seem too small for the lack of outside markets and prices to be driving large efficiencies.

For FK the internal organisation of a firm depends on the dispersion of knowledge within the firm. The entrepreneur will typically lack the information or knowledge to make optimal decisions. So the entrepreneur has to delegate decision-making authority to those who have, at least more of, the necessary information or knowledge. In doing this the firm is able to exploit the locally held knowledge without having to codify it for internal communication or motivating managers to explicitly share their knowledge. But the benefits of delegation in terms of better utilising dispersed knowledge need to be balanced against the costs of delegation such as duplication of effort - due to a lack of coordination of activities, moral hazard, creation of new hold-up problems and incentive alignment.

The things that sets the FK apart from the mainstream is the importance given in their theory to the entrepreneur and that they develop their theory utilising a combination of Knightian uncertainty and Austrian capital theory. But, unlike Spulber (2009), the questions they set out to answer are standard in that they want to explain the existence, boundaries and organisation of the firm.
  • Brynjolfsson, Erik (1994). `Information Assets, Technology, and Organization', Management Science, 40(12): 1645-62.
  • Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press.
  • Rabin, Matthew (1993). `Information and the Control of Productive Assets', Journal of Law, Economics and Organization, 9(1) Spring: 51-76.
  • Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.

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