Interview: Nicolai J. Foss and Peter G. Klein on “Organizing Entrepreneurial Judgment”

Nicolai Foss and Peter Klein are interviewed on the contents of their 2012 book “Organizing Entrepreneurial Judgment: A New Approach to the Firm”. The book is worth the time to read.

A brief discussion of the Foss and Klein book can be found in Section 3.2 of  "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective". Journal of Economic Surveys, forthcoming.

A few questions:

Question: The aim of your book is, as you state, to define a program for research in the intersection of the theory of the firm and entrepreneurship. What is wrong with current theory in these fields?

Klein: Until the 1980s, the economic theory of the firm was a branch of neoclassical production theory. “Firms” were highly stylized, abstract units that convert inputs into output – everything economically relevant about the firm could be expressed as a production function. There was little interest in why firms exist, how firms are governed and managed, why some firms perform better than others, and so on. Any behaviors not consistent with “perfect competition” were regarded as efforts to exploit monopoly power. Basically, the theory had little to do with business firms as they actually exist.

Things got better with the emergence of agency theory, transaction cost economics, and the economic analysis of property rights. Even these approaches, however, are fairly static and “closed,” with little room for entrepreneurship and uncertainty. There was a standalone academic discipline of entrepreneurial studies, but it was mainly descriptive and focused on startup companies and self-employed individuals. Even today, the theory of firm doesn’t incorporate entrepreneurs, and much of entrepreneurship theory abstracts from the firms that entrepreneurs establish and operate.

Question: What are those “neglected insights” you want to revitalize?

Foss: In this book we pick up on a number of themes associated with less conventional thinkers in economics, notably Frank Knight and his seminal book, Risk, Uncertainty and Profit from 1921. In fact, our book may well be described as “Knightian.” What we appreciate in Knight is his emphasis on uncertainty rather than risk as characteristic of most business decisions and not just the major ones. Someone has to shoulder the uncertainty (it is uninsurable) associated with setting up an enterprise and because these ideas are often not fully or clearly articulable, the result is that entrepreneurs set up firms, bearing responsibility for any profits or losses the venture make. However, Knight’s ideas go much beyond start-ups.

Another source of inspiration is the Austrian school of economics. In the book we put much emphasis on resource heterogeneity and all the many problems of measuring, monitoring, combining, coordinating and so on that arise in a world of heterogeneity. All management problems are caused by such heterogeneity in conjunction with uncertainty. This is something mainstream economics still has to embrace.

Question: You make the point that “problem-solving activities in firms have many of the features of experimental activity“. This view radically contrasts with the typical microeconomics textbook view whereby firms face a simple optimization problem (maximizing profits subject to known constraints) ....

Foss: True. But economics simply has to accommodate the fact that the choice of production methods, the combination of resources, the sourcing of knowledge and so on are not “data”.Hayek was very explicit about this in a brilliant essay from 1948 (“The meaning of competition”). Firms may be groping towards optimum resource combinations, but they are really tracking a moving target, because of shocks to technology, tastes, policies, and so on. And to the extent that they succeed in tracking the target it is because of sound managerial judgment. I must say, though, that I see many of the younger applied microeconomists, such as Nick Bloom and John van Reenen, adopting this basic view. They need to make sense out of the managerial function.

Question: You have a very interesting chapter on internal organization and intrapreneurship (entrepreneurship within firms), where you disagree with the trendy claim in the tech start-up world “that authority and traditional firm organization are fading under the impact of delegation of decision rights to entrepreneurial employees who control critical knowledge.” Why?

Foss: Well, the “trendy claim”, as you call it, has some truth to it. There is evidence of increased delegation, particularly in fast moving industries, and it is also evident that there is a tendency to shift decision rights to employees that are high in human capital. Some of my empirical work with my CBS colleague Keld Laursen speaks to this issue. However, authority has efficiency advantages that just don’t disappear like that. First, authority economizes on the costs of transmitting knowledge: Rather than telling someone why he should carry out a task, how it fits into the big picture, and so on, the holder of authority simply tells someone to get it done. Second, bosses often have superior knowledge, in which case they should give direction. Third, there is a need for someone to operate and maintain reward systems.

For another approach that explains why this "trendy claim" may not be true for all firms see "Simple models of a human-capital based firm: a reference point approach". Journal of the Knowledge Economy, forthcoming.