The Economic Role of the Entrepreneur Nitesh

8/21/2019 The Economic Role of the Entrepreneur Nitesh

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The Economic Role of theEntrepreneur

Daniel F. Spulber

Northwestern UniversityJune 2!

AbstractEntrepreneurs play a central role in the economy by establishin" firms# which

in turn create mar$ets an% or"ani&ations. The paper presents a %ynamic theory of

the entrepreneur. 'n in%ivi%ual en"a"es in entrepreneurial activities before the firmis establishe% an% then becomes an owner after the firm is establishe%. ( refer to thechan"e is the in%ivi%ual)s role from entrepreneur to owner as the foun%ational shift.*efore the foun%ational shift occurs# the ob+ectives of the startup enterprise cannotbe separate% from those of the entrepreneur. 'fter the firm is establishe%# by%efinition# its ob+ectives are separate from those of its owners. The foun%ational shiftis important because it helps to e,plain the interconnections between the financial#labor an% technolo"y %ecisions of the startup enterprise an% the consumption#human capital# an% innovation %ecisions of the in%ivi%ual entrepreneur. Theentrepreneur faces three types of competition. (n type-(competition# the entrepreneur

competes with other entrepreneurs to establish the most efficient new firm. (n type-(( competition# the entrepreneur competes with %irect e,chan"e between consumersthe newly-establishe% firm must create efficiencies of e,chan"e that consumerscannot achieve on their own. (n type-((( competition# the entrepreneur competes withe,istin" the newly establishe% firm must offer innovations an% efficiencies thatcannot be achieve% by a%+ustin" or e,pan%in" incumbent firms.

//////////////////////////////// 0 Elinor 1obbs Distin"uishe% rofessor of (nternational *usiness# 3ana"ement 4Strate"y# 5ello"" School of 3ana"ement# Northwestern University# 26 Sheri%anRoa%# Evanston# (7# 82!. E-mail9 +ems:$ello"".northwestern.e%u ( "ratefullyac$nowle%"e the support of a research "rant from the Ewin" 3arion 5auffmanFoun%ation.


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Introduction

Entrepreneurs are ma+or contributors to economic "rowth# %evelopment# an%

prosperity see Schramm ;28a< an% *aumol# 7itan# Schramm ;2=


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structure of transactions# thus %epen%s on the actions of entrepreneurs. The

%iscussion %raws upon the microeconomic analysis in

2

Spulber ;2!< in which not only entrepreneurs# but also firms# mar$ets# an%

or"ani&ations are en%o"enous.

>et# as in%ivi%uals# entrepreneurs are %istinct from firms. ( present a

%ynamic theory of the entrepreneur. 'n in%ivi%ual en"a"es in entrepreneurial

activities before the firm is establishe% an% then becomes an owner after the

firm is establishe%. ( refer to the chan"e is the in%ivi%ual)s role from

entrepreneur to owner as thefoun%ational shift. *efore the foun%ational shift

occurs# the ob+ectives of the startup enterprise cannot be separate% from

those of the entrepreneur. (n%ivi%uals choose to become entrepreneurs base%

on the personal rewar%s offere% by mar$et opportunities an% "enerate% by

their capabilities. 'fter the firm is establishe%# by %efinition# its ob+ectives are

separate from those of its owners. The foun%ational shift is important because

it helps to e,plain the interconnections between the financial# labor an%

technolo"y %ecisions of the startup enterprise an% the consumption# human

capital# an% innovation %ecisions of the in%ivi%ual entrepreneur.


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*ase% on the mo%el of the entrepreneur# ( consi%er the three main types of

competition face% by entrepreneurs. (n type-( competition# entrepreneurs compete

with each other to establish firms. The many personal attributes of entrepreneurs

that are critical inclu%e preferences# income# wealth# +u%"ment# $nowle%"e# ability#

i%eas# an% opportunity costs. (n type-(( competition# entrepreneurs compete with

%irect e,chan"e between consumers. Entrepreneurs will be successful in

establishin" firms only if firms provi%e transaction benefits that cannot be achieve%

by consumer or"ani&ations. (n type- ((( competition# entrepreneurs compete withestablishe% firms since the entrepreneurialstart-up must provi%e incremental

economic benefits that incumbents are unable or A

unwillin" to provi%e. To a%% value# the entrepreneur must launch a firm that

can offer scarce capacity# more effective or"ani&ations# better mar$ettransactions# more efficient technolo"ies# or %ifferentiate% "oo%s an% services.

The "eneral theory of the firm presente% here contrasts substantially with

neoclassical economics.6 (n neoclassical "eneral e@uilibrium theory# firms an%

mar$ets are "iven e,o"enously. Firms are %escribe% by the pro%uction technolo"y.

3ar$ets are "iven for practically every "oo%# location# time an% state of the worl%#an% operate costlessly. Br"ani&ations are missin" from the neoclassical framewor$.

3ost si"nificantly# because firms are "ivens# the entrepreneur has no economic

function. 's Cilliam *aumol ;28< observes# the entrepreneur is mentione% virtually


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never in the mo%ern theory of the firm an% observes that The more critical

e,planation of the absence of the entrepreneur is that in mainstream economics the

theory is "enerally compose% of e@uilibrium mo%els in which# structurally# nothin" is

chan"in". *ut# this

6 The entrepreneur has playe% practically no part in neoclassical economics for two

main reasons. First# firms alrea%y are "iven e,o"enously# so no entrepreneur is

nee%e% to establish them. Secon%# entrepreneurs play little part in neoclassical

economics since mar$ets alrea%y e,ist in stan%ar% mo%els. 3oreover# mar$ets attain

an e@uilibrium by means of the invisible auctioneer# so that firms are not nee%e% to

create or mana"e mar$ets. Neoclassical economics is silent on entrepreneurs

because they serve no purpose since firms are confine% to pro%uction. Chen firms

ma$e mar$ets# entrepreneurs are nee%e% to provi%e the mar$et-ma$in" mechanism.

e,clu%es the entrepreneur by %efinition# see also *aumol ;6GGA


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his path-brea$in"economic treatise. The theory of the entrepreneur has

un%er"one cycles of revival an% ne"lect throu"hout the history of economic

thou"ht. Jean-*aptiste Say ;6!6# 6!I2< provi%es the first comprehensive

%iscussion of the entrepreneur in economic analysis# emphasi&in" the effects

of the entrepreneur)s reputation# +u%"ment# an% ris$ bearin" on profit.

Entrepreneurs are central to Fran$ 5ni"ht)s ;6G=6< %iscussion of ris$#

uncertainty# an% profit. 5ni"ht emphasi&es both the supply of an% %eman% for

entrepreneurship. Joseph Schumpeter ;6GA# p. =I< i%entifies

entrepreneurship as the fun%amental phenomenon of economic

%evelopment. The carryin" out of new combinations we call enterprise) the

in%ivi%uals whose function it is to carry them out we call entrepreneurs.)

Schumpeter ;6GA# p. 88< further observes that new combinations are# as a

rule# embo%ie%# as it were# in new firms which "enerally %o not arise out of the

ol% ones but start pro%ucin" besi%e them.

2 Dan Johansson ;2< stu%ies h.D. pro"rams an% te,tboo$s in economics

an% fin%s that re@uire% h.D. courses in microeconomics# macroeconomics#

an% in%ustrial or"ani&ation an% the relate% te,tboo$s completely e,clu%e the

concept of the entrepreneur. Johansson conclu%es that there is a nee% for

economics h.D. trainin" base% on theories that incorporate entrepreneurship

an% institutions.


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I

These classical themes are %evelope% further in the mo%ern literature on the

entrepreneur. 3ar$ Hasson)s ;6G!2# p. 2A< %iscussion emphasi&es interme%iation by

entrepreneurs9 an entrepreneur is someone who speciali&es in ta$in" +u%"mental

%ecisions about the coor%ination of scarce resources# see also Hasson ;2A


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%escriptions# an% no confi%ence that restitution will be ma%e for %efault. Hasson

;6G!2# p. G=< points out that For information flows as comple, as those re@uire% for

the operation of a mar$et# social convention is usually unable to provi%e the %e"ree

of structure re@uire%. Kreater sophistication is calle% for an% this necessitates the

use of purpose-built or"ani&ations. 'mon" these purpose-built or"ani&ations

are mar$et-ma$in" firms.8

*aumol ;6G8!< emphasi&es the function of the entrepreneur as locatin" new

i%eas# puttin" them into effect# an% e,ercisin" lea%ership. *aumol ;28< ar"ues that

the innovative entrepreneur relies on price %iscrimination to raise fun%s for

innovation.

*aumol ;6GGA< presents theoretical mo%els that e,amine the innovative

activities of the entrepreneur# see also *aumol ;22# 28


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1.The Economic Role of the Entrepreneur

'n entrepreneur is an in%ivi%ual who establishes a firm. *ecause of their

importance in the mo%ern economy# entrepreneurs shoul% be at the heart of

microeconomics. Entrepreneurs set up firms in response to economic incentives. (n

turn# firms create an% operate mar$ets that provi%e mechanisms of e,chan"e for

consumers. Firms also create an% mana"e or"ani&ations that provi%e internal

coor%ination an% mar$et interactions. The actions of entrepreneurs are the essential

force that helps to %rive the economy towar%s e@uilibrium. This process is illustrate%

in Fi"ure 6.

Entrepreneurs are en%o"enous to the economy in the "eneral theory of

the firm. The entrepreneur is# before anythin"# a consumer. The consumer

becomes an=

entrepreneur by choosin" to establish a firm. Honsumers brin" to the tas$ of

entrepreneurship their +u%"ment# $nowle%"e# an% technolo"y. Honsumers

%eci%e to become entrepreneurs base% on their personal characteristics an%

their +u%"ment of available mar$et opportunities. Entrepreneurs act rationally

an% purposefully base% on ma,imi&in" their net benefits.

' firm is %efine% to be a transaction institution whose ob+ectives are separate

from those of its owners. 'll firms involve some combination of mar$et mechanisms

an% or"ani&ational structures. ' mar$et is a transaction mechanism that brin"s


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buyers an% sellers to"ether. ' mar$et can be a store# a web site# a matchma$er# or

an auction. 'nor"ani&ation is a mechanism for mana"in" nonmar$et transactions

insi%e the firm# inclu%in" those between owners an% mana"ers# between mana"ers

an% employees# an% between employees# an% for mana"in" the firm)s mar$et

transactions. 'n or"ani&ation can involve hierarchies# bureaucracies# "roups# teams#

an% networ$s.

7u%wi" von 3ises ;6GG!# p. 2II


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Honsumers

Entrepreneurs


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Entrepreneurs establish firms

Firms

Firms create an% mana"e mar$ets an% or"ani&ations

3ar$ets an% Br"ani&ations

Honsumers an% firms interact throu"h mar$et mechanisms an%or"ani&ationsEconomic E@uilibria

Figure 1 Microeconomics with endogenous entrepreneurs, firms,

markets and organiations

G

The connection between the entrepreneur an% mar$et ma$in" can be

illustrate% by the e,ample of 'ma&on.com. Entrepreneur Jeff *e&os establishe% the

firm which in turn create% a vast set of online mar$ets for a wi%e ran"e of pro%ucts.

These pro%ucts were "roupe% into such broa% cate"ories as ;6< boo$s# music# an%

movies# ;2< toys 4 vi%eo "ames# ;A< consumer electronics# ;< computer an% office#

;I< tools an% automotive# ;8< foo% an% househol%# ;=< home an% "ar%en# ;!< clothin"


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an% +ewelry# ;G< health an% beauty# ;6< $i%s an% baby# an% ;66< sports an% fitness.

Cithin these broa% cate"ories were over pro%uct cate"ories containin" many

thousan%s of pro%ucts from many manufacturers. These represente% thousan%s of

mar$ets where 'ma&on brou"ht to"ether buyers an% sellers. 'ma&on serve% tens of

millions of buyers an% over one million sellers. 'ma&on also offere% start-up sellers

an alternative to heavy liftin"# by provi%in" web hostin" an% transaction

interme%iation.

The connection between the entrepreneur an% or"ani&ations can be

illustrate% by the e,ample of (ntel. Entrepreneurs *ob Noyce an% Kor%on

3oore establishe% the firm which in turn create% an or"ani&ation that ha%

more than G# employees within forty years of its foun%in". The firm was

structure% aroun% five "roups9 three "roups were base% on the company)s

technolo"y platforms for mobility# the %i"ital enterprise an% %i"ital home#

another "roup was concerne% with %i"ital applications in healthcare# an%

another "roup %ealt with worl%wi%e %istribution. The firm ha% a worl%wi%e

networ$ of R4D laboratories# the firm)s researchers focuse% on a%vance%

computin"# communications# an% wireless technolo"ies. The firm operate%

manufacturin" plants for pro%ucin" microprocessors# component assembly#

an% @uality testin"# an% con%ucte% research on manufacturin" processes.6


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(n%ivi%ual members of the society establish firms to facilitate# formali&e#

an% enhance economic relationships. The social an% economic ori"ins of the

firm shoul% be reflecte% in the structure of the economic theory of the firm.

Rather than bein" "iven e,o"enously# firms arise en%o"enously because

consumers choose to become entrepreneurs. Honsumer characteristics are

the "ivens an% firms are the result of consumer %ecisions. The e,istence of

firms# their purpose# an% their or"ani&ational structure %epen% on the

%ecisions of the entrepreneur.

The entrepreneur establishes a firm to achieve a %esire% economic

ob+ective. 's with any type of man-ma%e instrument# the firm au"ments the

abilities an% capacity of the entrepreneur who creates it. The in%ivi%ual

becomes an entrepreneur because establishin" a firm allows him or her to

accomplish somethin" that otherwise coul% not be %one as effectively.

Honsumers have preferences over consumption bun%les. They own

en%owments of "oo%s an% services. They own pro%uction technolo"ies an%

can carry out manufacturin" usin" those technolo"ies. Honsumers also

possess i%eas# capabilities# s$ills# blueprints# transaction metho%s# an% other

types of intellectual property. Honsumers can invent new technolo"ies an%

can e,chan"e them. Honsumers also have the capacity to perform various

activities# actin" as inventors# investors# mana"ers# an% wor$ers.


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(n the theory of the firm with en%o"enous entrepreneurs# the e,o"enous %ata

of the mo%el are the characteristics of consumers. The characteristics of

entrepreneurs# inclu%in" preferences an% income have been stu%ie% e,tensively an%%ata is available to66

e,amine their %ecisions to establish firms.I (n a%%ition# the consumer %ecision

%epen%s on $nowle%"e of pro%uction an% transaction technolo"ies an% ownership of

intellectual property# such as patents# copyri"hts# in%ustrial processes# bran%s# an%

tra%emar$s. The consumer)s e%ucation# trainin"# an% e,perience are li$ely to

influence the %ecision to become an entrepreneur. The in%ivi%ual)s access to

information about mar$et opportunities is critical to ma$in" business %ecisions. The

consumer)s abilities# interests# creativity# an% business +u%"ment can enter into the

%ecision to become an entrepreneur.

3ar$et opportunities open to the in%ivi%ual are crucial to the %ecision to

become an entrepreneur. The entrepreneur combines his capabilities with mar$et

opportunities. 8

I Reynol%s ;2< reviews the National anel Stu%y of U.S. *usiness Startups#

which provi%es an e,tensive an% %etaile% statistical overview of new businesses an%

the personal characteristics of entrepreneurs. The personal information that is


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stu%ie% inclu%es all of the usual %emo"raphic %ata such as a"e# se,# ethnic

bac$"roun%# e%ucation# an% househol% income. (n a%%ition# interviews an%

@uestionnaires are use% to obtain information about the entrepreneur)s motivation#

e,pectations# $nowle%"e# career e,periences# competitive strate"y# %ecision-

ma$in" style# an% ris$ preferences.

8 Shane ;2A# p. < %efines entrepreneurship as an activity that involves

e,ploitation of opportunities. Shane emphasi&es that entrepreneurship involves

interaction between the in%ivi%ual characteristics of entrepreneurs an% the set of

mar$et opportunities. 1e stresses the effects on opportunities of chan"es in

technolo"y# re"ulation an% public policy# an% social an% %emo"raphic con%itions.

Shane ;2A# p. 6!< observes that the62

The interaction between the entrepreneur)s characteristics an% the menu of

mar$et opportunities recalls a tra%itional framewor$ in the fiel% of

mana"ement strate"y. The mana"er of the firm e,amines the firm)s

opportunities an% competitive threats. The mana"er then consi%ers the firm)s

stren"ths an% wea$nesses. The mana"er formulates a competitive strate"y by

ma$in" the best match between the firm)s characteristics an% the choice of

opportunities.= The entrepreneur ma$es a similar choice by ma$in" the best

match between his own personal characteristics an% mar$et opportunities.


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The entrepreneur establishes a firm that involves the best combination of his

personal talents an% en%owments an% the menu of available opportunities.

Such a combination will ma,imi&e the entrepreneur)s profit.

e,amination of opportunities that are available to the entrepreneur is a central

but lar"ely overloo$e% aspect of entrepreneurship.

= The notion that both e,ternal analysis an% internal analysis are vital for strate"y

ma$in" %raws upon 5enneth R. 'n%rews ;6G=6# p. !


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is useful in un%erstan%in" the entrepreneur)s %ecision problem. 't the

be"innin"# nature reveals information to the consumer# inclu%in" the

consumer)s preferences# en%owment# technolo"ical $nowle%"e# an%

intellectual property. (f the consumer %eci%es to establish a firm# the consumer

becomes an entrepreneur an% creates a startup. The in%ivi%ual plays the role

of the entrepreneur only up to the time that the firm is establishe%. Chen the

startup becomes a firm# a foun%ational shift occurs# the consumer)s role

chan"es from that of an entrepreneur to that of an owner of the firm. Thissection e,amines the %ynamic theory of the entrepreneur. The %ynamic theory

of the entrepreneur is illustrate% in Fi"ure 2.

Nature reveals Entrepreneur creates startup Foundational shift$consumer)s type

Entrepreneur becomes

an owner

M///////////////////////M/////////////////////////////M//////////// . Honsumer 6. Entrepreneur 2. Bwner

Figure ! A d#namic theor# of the entrepreneur$ the foundational shift.

6


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!.1The Foundational %hift

's Schumpeter ;6GA< points out# bein" an entrepreneur is not a

lastin" con%ition. The entrepreneur ta$es time to establish a firm. 5aplan#

Sensoy# an% Strmber" ;2I


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or"ani&ations have ob+ectives that are often not separable from the interests of

consumers who establish# own# mana"e# or are members of the or"ani&ation.

Kenerally# consumer or"ani&ations ma,imi&e the benefits of their members# so that

the or"ani&ation)s ob+ectives are not separate from the consumption interests of its

members.6I

Chat ma$es the foun%ational shift so important is the contrast between

the economic role of the entrepreneur an% the economic role of the firm. Chat

"ives content to this seemin"ly strai"htforwar% %istinction is the

characteri&ation of the firm. ' firm is %efine% to be a transaction institution

whose ob+ectives are %istinct from those of its owners.! Thus# consumer

or"ani&ations such as clubs# buyers) cooperatives# wor$ers) cooperatives#

merchants) associations# nonprofits# an% basic partnerships are not firms. Theseparation criterion %istin"uishes a firm from consumer or"ani&ations. ' firm

a%%s value to the economy because the separation of ob+ectives "ives it

capabilities that consumer or"ani&ations cannot achieve.

The entrepreneurial startup enterprise %oes not satisfy the separation

criterion. The ob+ectives of the startup "enerally are not separable from those of the

entrepreneur who is the owner of the startup. The entrepreneur)s consumption

ob+ectives are closely tie% to the entrepreneur)s ob+ectives in mana"in" the startup.

The entrepreneur provi%es financin" so that the entrepreneur)s personal bu%"et


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constraint is interconnecte% with the startup)s costs. The entrepreneur)s

consumption ob+ectives are also interconnecte% with the ob+ectives of the startup

because the entrepreneur provi%es labor an% mana"ement effort to the startup.

Separation of ob+ectives only occurs when the firm is establishe% an% the

entrepreneur becomes an owner.

Honsumers choose to become entrepreneurs base% on two primary consi%erations9

personal characteristics an% mar$et con%itions. (n%ivi%ual characteristics of the consumer

that affect the %ecision to start a firm inclu%e the consumer)s preferences an% en%owments.

references are important because the entrepreneur may %erive "reater

! See Spulber ;2!


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*efore turnin" to the implications of separation for entrepreneurship# it

is useful to consi%er the con%itions un%er which separation occurs. Fisher

;6G8# 6G=# 6GA< a%%resse% the separation of the firm)s investment

%ecisions from the owners) consumption an% savin" ob+ectives. The firm)s

optimal investment %ecisions are in%epen%ent of the preferences of its owners

an% in%epen%ent of how the investment is finance%. The firm)s owners are

only affecte% by the firm)s %ecisions throu"h their wealth. They carry out their

consumption an% savin" %ecisions throu"h pro%uct mar$ets an% financialmar$ets. Fisher)s separation theorem is in the neoclassical tra%ition an%

re@uires price-ta$in" behavior by bothconsumer-owners an% firms. The Fisher

separation theorem assumes that there are no transaction costs an% that

there e,ists a complete set of competitive mar$ets.

The Fisher Separation Theorem %epen%s on price ta$in" behavior by firms

an% consumers an% the presence of neoclassical mar$ets for consumer "oo%s#

investment "oo%s# an% financial capital. The Fisher Separation Theorem provi%es a

foun%ation for the stu%y of the firm)s investment %ecisions. The firm is owne% by

consumers who have preferences over current an% future consumption bun%les. The

Fisher Separation6=

Theorem shows that the firm)s investment %ecisions are in%epen%ent of the

consumption %ecisions of its owners. Honsumer-owners receive a share of the


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present value of the firm)s profits. 'ccor%in"ly# consumer-owners unanimously

a"ree that the firm shoul% ma,imi&e the present value of profits.

The Fisher Separation Theorem further shows that the firm)s

investment %ecisions are in%epen%ent of how the firm finances its investment.

The level of investment ma,imi&es the present value of profits# so that the

efficient investment level e@uates the mar"inal return to investment to the

mar"inal cost of investment. (nvestment mi"ht be finance% from an initial

en%owment of fun%s or throu"h borrowin"# or in some other manner such as

issuance of securities. This will not affect the investment %ecision in Fisher)s

framewor$.

The Fisher Separation Theorem is plante% firmly in the neoclassical

tra%ition. (t e,plains why firms ma$e investment %ecisions an% why consumers

%o not. (t provi%es a foun%ation for the stu%y of investor %ecisions in financial

mar$ets. 1owever# the Fisher mo%el maintains the neoclassical assumptions

that mar$ets are establishe% an% operate without costs. This section

ree,amines the Fisher separation analysis when there are transaction costs.

Honsi%er a consumer who lives for two perio%s an% consumes the same "oo% in

each perio%. 7et c an% C represent the amounts of consumption "oo% consume% in the two

perio%s. The consumer)s preferences are represente% by the separable utility function

;6


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where Q is the consumer)s rate of time preference. The function u(c) is %ifferentiable#

increasin" an% concave. The consumer has an initial en%owment of the

consumption

6!

"oo% e@ual to P that is available in the first perio% an% an en%owment O that is

available in the secon% perio%. There is a mar$et for the consumption "oo% in each

perio%. The consumer can purchase or sell the "oo% in either perio%. 7et p be the

price of the "oo% in the first perio% an% let P be the price of the "oo% in the secon%

perio%. The consumer ta$es the prices of the "oo%s as "iven e,o"enously. The

consumer has access to a capital mar$et an% can borrow money or save money at

interest rate r # also ta$en as "iven e,o"enously. Suppose that the consumption "oo%

is not storable. The consumer)s bu%"et constraint e,presse% in present value terms

is

;2 c . The consumer

ma,imi&es utility sub+ect to the bu%"et constraint so that first an% secon%

perio% consumption solve

;A


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Suppose that the consumer owns a firm. The firm is %escribe% by its pro%uction

function as in the neoclassical mo%el. The input to the pro%uction function is the

consumption "oo% in the first perio% an% the output of the pro%uction function is the

consumption "oo% in the secon% perio%. The input to pro%uction is K an% the output

of the pro%uction process is Q. The investment level K results in a capital stoc$ of

e@ual amount that only provi%es services for a sin"le perio% before bein" use% up.

ro%uction involves a one-perio% la" so that output only is available in the secon%

perio%. The

6G

ma,c # C

pro%uction function is Q = f(K), which is %ifferentiable# increasin"# an%

concave# an%f(0) = 0.

Honsi%er the financin" an% investment %ecisions of the firm. (f the firm has no

initial en%owment# it can fully finance investment by borrowin" money atinterest rate r.

The firm)s investment %ecision will be the same re"ar%less of whether it has an initial

en%owment of money. The firm purchases K units of the consumption "oo% at

price p to invest in pro%uction. The firm)s investment %ecision will be the same

re"ar%less of whether it has an initial en%owment of the consumption "oo%. The firm

sells its output in the secon% perio% at mar$et price P . The firm)s profit in present-

value terms is

;< O

Pf ;K <4 pK .

6 P r


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The firm)s optimal investment %ecision e@uates the mar"inal revenue pro%uct

of investment to the per-unit cost of investment#

;I< Pf'(K**) = p(1 + r).

The per-unit cost of investment is the purchase price of the consumption "oo%

times the cost of borrowin". The profit-ma,imi&in" investment is shown in

Fi"ure A.

Honsi%er a Robinson Hrusoe economy in which the consumer owns the

firm. Suppose further that there is no capital mar$et so that there is nopossibility of borrowin" or len%in" money. Suppose further that there is no

possibility of buyin" or sellin" the consumption "oo%. Then# the consumer will

mana"e the firm to ma,imi&e the consumer)s benefit sub+ect to the pro%uction

function. The consumer solves

u;c < P 6 P6 ! u;C <

sub+ect to C = f(" ! c) + # an% c $ " . The optimal consumption c 0 solves2

;8<u;c <

O f ;% 4 c


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Q

O 6PQP r 4 pK

Q = f(K)

Q**

K** K


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Figure & 'rofit(ma)imiing in*estment b# a price(taking firm.22

C

u;c < P 6 P6 ! u;C < O U

Q = f(K)

C 0


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K 0 c " K

Figure + ptimal in*estment in the Robinson -rusoe econom#.

Honsi%er now the situation in which a consumer owns the firm but both the

consumer an% the firm have access to pro%uct an% capital mar$ets. The firm)s investment

%ecision is in%epen%ent of the preferences of its consumer-owner. The consumer-

ownerwishes to obtain the "reatest present value of profit so the firm chooses the profit-

ma,imi&in" investment. Then# ta$in" the firm)s profit as "iven# the consumer ma,imi&es

2A

utility sub+ect to the consumer)s en%owment plus the firm)s profit. The

consumer problem is

ma,c # C u;c < P

6U ;c <

6 P !

sub+ect to

;=<

pc P 6 PC O p% P P P .

P r

6 6 P r

The consumer)s first-or%er con%ition is

;!<

u;c 0<

O

p

.

u;C 0


30/79

The consumer)s secon%-perio% consumption is e@ual to

C* = (1 + r)(p/P)(" ! c*) + # + (1 + r)(1/P)%.

The Fisher Separation Theorem %emonstrates that the consumer is better off

lettin" the firm choose the profit-ma,imi&in" investment instea% of the utility-

ma,imi&in" investment. This is %epicte% in Fi"ure I. The consumer has a %ifferent

consumption profile in the Robinson Hrusoe economy from that in the mar$et

economy. Cith initial en%owment P# the consumer invests K 0 an% consumes c 0 = " !

K 0 an% C 0 = f(" ! K 0 ) in the Robinson Hrusoe economy. The consumer in the mar$et

economy consumes c* = " ! K* an% C* = (1 + r)(p/P)K* + (1 + r)(1/P)%*. The

consumer in the case %epicte% in Fi"ure I has a hi"her amount of consumption in

the first perio% in the mar$et economy as compare% to the Robinson Hrusoe

economy# since the consumer uses less of the initial en%owment# K* < K 0 . (n the

case shown# the consumer consumes less in the secon% perio% in the mar$et

economy as compare% to the Robinson Hrusoe economy but is still better off. The

benefits of a%%itional consumption in the first perio% outwei"h2

the benefits of less consumption in the secon% perio%. The a%%itional

consumption in the first perio% occurs because the firm purchases more of the

investment "oo% in the mar$et than the consumer supplies to the mar$et K* <

K 0 < K**. The firm invests more in the mar$et economy than in the Robinson

Hrusoe economy in the case shown in Fi"ure I. The consumer supplies less

of the en%owment of the investment "oo% in the mar$et economy than in the


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Robinson Hrusoe economy in the case shown in Fi"ure I. This illustrates how

the mar$et for "oo%s an% the mar$et for capital investment allow the

%ecouplin" of the firm)s investment %ecision an% the consumer)s savin" an%

consumption %ecisions.2I

Q U mar

U auar

O 6PQP r 4 pK

Q**

Q = f(K)


32/79

Q0

Q*

6 PP r 0

K* K 0 K** " K

Figure The Fisher %eparation Theorem shows that the firm/s optimal

in*estment decision is independent of the preferences of a consumer(owner.

The Fisher Separation Theorem %epen%s critically on the e,istence of three types of

mar$ets9 for the investment "oo%# for the consumption "oo%# an% for financial capital. This

%epen%ence is obscure% in the stan%ar% presentation by the triple nature of the "oo% that

can be use% for investment# consumption an% financial transactions. The Fisher 28

Separation Theorem %epen%s also on the absence of transaction costs. Not

only are mar$ets establishe% e,o"enously# but neither the consumer nor the

firm face abi%-as$ sprea% in their mar$et transactions. '"ain# the consumer is

ma%e better off when consumer %ecisions an% firm %ecisions are separate%

because of the presence of outsi%e opportunities. *oth the consumer an% the

firm reali&e "ains from tra%e throu"h their mar$et transactions with other

unobserve% consumers an% firms. These "ains from tra%e are achieve%

without transaction costs.


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The Fisher Separation Theorem e,plains why consumption an% firm

investment %ecisions can be separate% but %oes not i%entify an economic role

for the firm. The framewor$ is neoclassical with the firm bein" fully %escribe%

by its pro%uction technolo"y. *oth the consumer-owner an% the firm are price

ta$ers. The firm chooses an investment an% output plan ta$in" prices as "iven

an% the consumer solves a consumption-savin" problem. The %ecision of the

consumer an% the firm are separable because both the consumer an% the firm

reali&e "ains from tra%e with other tra%in" partners. The consumer wants thefirm to ma,imi&e its profit because the consumer is only intereste% in the firm

as a source of income. The consumer ma$es consumption an% savin"

transactions an% the firm ma$es sales an% investment transactions in

establishe% mar$ets.

!.&0efore the Foundational %hift

The entrepreneur)s ob+ectives are closely connecte% to those of the

startup. The startup thus is %istinct from an establishe% firm. The

interconnection between the2=

entrepreneur)s ob+ectives has important implications in five main areas9

investment# employment# effort# innovation# an% business strate"y.


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In*estment The entrepreneur investment %ecisions are combine% with

hisconsumption-savin"s %ecisions. These ob+ectives are closely connecte% because

the entrepreneur contributes to financin" the start-up# alon" with family an% frien%s.

These effects are %ue to imperfections in the relationship between the entrepreneur

an% sources of financial capital# which may result from asymmetric information. The

%ecision about the %ate at which to launch the firm also %epen%s on the

entrepreneur)s own consumption ob+ects. The entrepreneur)s reali&ation of income

from the pro+ect %epen%s on the timin" of the establishment of the firm. '"ain#asymmetric information plays a fun%amental role because of %ifficulties outsi%e

investors face in %eterminin" the value of the prospective firm. Hontracts with

venture capitalists are a means of provi%in" information to the capital mar$ets for the

(B. The entrepreneur is a party to contracts with venture capitalists an% others

involve% in the startup enterprise.

*efore the foun%ational shift occurs# transaction costs often are the

most important type of costs incurre% by the entrepreneur. The entrepreneur

learns about the in%ustry an% ma$es contacts with potential customers an%

suppliers. There are substantial transaction costs associate% with search#

communication# ne"otiation an% formin" relationships with prospective

customers an% suppliers. The entrepreneur incurs transaction costs in

assemblin" the pro%uctive inputs an% technolo"y nee%e% to establish the firm.2!


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Emplo#ment The entrepreneur)s effort %ecisions are combine% with his labor

mar$et %ecisions. These ob+ectives are closely tie% because the entrepreneur

contributes to the mana"ement an% labor of the startup. 's with financin"# the

entrepreneur)s hirin" %ecisions can be base% on personal relationships# with family

an% frien%s compensate% throu"h informal arran"ements. 'symmetric information

prevents the entrepreneur from ma$in" full use of the labor mar$et to hire wor$ers

an% mana"ers# thus re@uirin" the entrepreneur to %o much of the initial wor$ or to

obtain a%%itional labor inputs throu"h contracts with venture capitalists. 'symmetricinformation also may affect the entrepreneur entrepreneur)s ability to reali&e returns

from his i%eas throu"h an employer# which can lea% to the %ecision to @uit the +ob

an% create a startup.

Effort Due to the entrepreneur)s participation in financin" the startup an%

provi%in" mana"ement an% labor to the startup# the entrepreneur)s labor-

leisure %ecisions are not separable from the employment %ecisions of the startup.

The entrepreneur)s labor- leisure tra%eoffs are affecte% by income effects which

%epen% on his investment in the startup an% anticipation of earnin"s from

establishin" the firm. This may e,plain why many researchers emphasi&e the

entrepreneur)s personal en+oyment# creativity# %rive# preferences# attitu%e towar%

ris$# rate of time preference. The entrepreneur)s preferences an% other


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characteristics %rive effort %ecisions so that the consumption ob+ectives of the

entrepreneur are not separable the employment %ecisions of the startup.

The entrepreneur often %evotes si"nificant effort to raisin" financial capital

from ban$s an% investors. Financial transaction costs are thus part of the

entrepreneur)s costs.

2G

(n a%%ition# the entrepreneur)s costs inclu%e the effort an% resources %evote% to

information "atherin" an% learnin". To establish the firm# the entrepreneur is li$ely to

re@uire information about the nee%s an% characteristics of potential consumers# the

availability an% features of alternative pro%ucts# the technolo"y re@uire% to

manufacture the pro%uct# an% the business metho%s involve% in supplyin" the

pro%uct. The entrepreneur must "ather other types of mar$et $nowle%"e inclu%in"

the prices of comparable pro%ucts an% the prices of pro%uctive inputs nee%e% to

provi%e the "oo%. The entrepreneur may nee% to purchase the technolo"y use% to

provi%e the "oo%.

The entrepreneur ta$es into account the opportunity cost of his time# "iven

his s$ills an% other abilities. The entrepreneur will spen% time researchin" an%

%evelop the i%ea of the business. The entrepreneur may nee% to %evote time an%

effort to %evelopin" the s$ills nee%e% to un%erstan% an% apply the technolo"y. The


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entrepreneur will invest time in the process of settin" up the business an% formin"

the or"ani&ation.

The entrepreneur)s personal satisfaction can offset some of the costs

incurre% to establish the firm. The entrepreneur may %erive consumption benefits

from establishin" the firm. The process of establishin" a firm can be creative#

entertainin"# informative an% en+oyable. Then# the per-perio% costs of establishin"

the firm reflect the entrepreneur)s costs net of the benefits of bein" an entrepreneur.

The costs of establishin" a firm reflect the consumer-entrepreneur)s i%iosyncratic

pro%uctivity an% costs of effort. The costs also inclu%e the entrepreneur)s use of

resources# labor an% capital.

Inno*ation The entrepreneur)s innovation %ecision is combine% with a

technolo"y mar$et %ecision. 'symmetric information about the entrepreneur)s

i%easA

prevents full use of the mar$et. This helps to e,plain why the entrepreneur

chooses to embo%y the technolo"y in the new firm rather than to license the

technolo"y to other in%ivi%uals or to other firms. This applies to new pro%ucts#

new processes# new business metho%s# an% new forms of or"ani&ation. The

innovation %ecisions of the entrepreneur are closely tie% to the entrepreneur)s

personal $nowle%"e# information# an% intellectual property.


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0usiness %trateg# The close tie between the entrepreneur)s

consumption ob+ectives an% the ob+ectives of the startup pro+ect %o not allow

for the separation of ownership an% control. The entrepreneur)s choice of mana"ement strate"y ? rate of "rowth# what mar$ets to serve# what suppliers

to contract with ? reflect the limitations an% constraints from the

entrepreneur)s other %ecisions.

The entrepreneur must %evise a business plan to "ui%e the new enterprise

an% to attract investment. Typically# the business plan inclu%es the entrepreneur)s

vision of the business an% a %escription of the ob+ectives of the new enterprise. The

business plan also features a strate"ic analysis of the mar$ets that will be serve% by

the firm an% the competitors that will be encountere%. The entrepreneur formulates a

competitive strate"y an% e,amines potential sources of competitive a%vanta"es for

the new business.

The plannin" process also inclu%es an e,amination of what pro%uction

technolo"y will be use%# what types of pro%ucts an% services the business e,pects

to provi%e# an% how the firm will mar$et# sell an% %istribute its offerin"s. The

business plan features a preliminary or"ani&ational structure for the new enterprise.

The business plan inclu%esA6

pro+ecte% costs an% revenues an% a financial analysis of the capital resources

nee%e% to establish the firm. The entrepreneur bears the costs of preparin" the

business plan.


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!.!After the Foundational %hift

The foun%ational shift# from entrepreneur to owner# is what ma$es the

firm such a valuable economic actor. Cith separation of ob+ectives# the firm

pursues activities that ma,imi&e its profit. The foun%ational shift allows the firm

to provi%e limite% liability for its owners. Establishin" a firm provi%es an

a%%itional actor to the economy that au"ments the variety of potential

transactions. For e,ample# the firm can serve as an interme%iaries between

buyers an% sellers. The firm is a transaction institution with capabilities that

%iffer from those of consumer or"ani&ations. *ecause firms ma,imi&e profits#

they can select %ifferent allocations an% contracts than consumer

or"ani&ations that ma,imi&e the avera"e benefits of their members.

The entrepreneur)s costs of establishin" the firm shoul% be %istin"uishe%

from the costs of the firm itself# which start to be incurre% once the firm be"ins its

operation. The entrepreneur incurs costs %urin" the perio% that he is establishin" the

firm. The entrepreneur necessarily bears ris$ in practice because of the %elay

between the time that he be"ins to establish the firm an% the time the firm be"ins to

operate. This time la" intro%uces uncertainty about the firm)s profit. The %ynamic

nature of the entrepreneur)s activity implies that startin" a firm is a type of

investment.

The transaction costs of establishin" a firm limit entry an% re%uce the erosion

of profit by competitive entry. 3oreover# costly transactions mean that competitors


40/79

will encounter %ifficulties %iscernin" an% in imitatin" entrepreneurial innovations.

EconomicA2

frictions re%uce the prospect of perfect competitive challen"es. Economic

frictions further provi%e opportunities for entrepreneurs to establishin" mar$et

ma$in" firms that earn rents from miti"atin" transaction costs.

The entrepreneur acts in pursuit of entrepreneurial profit. The rewar% of

the entrepreneur is a share of the economic value of the firm. (n turn# the

firm)s economic value %epen%s on its provision of transaction efficiencies that

the economy cannot attain otherwise. 'ccor%in"ly# consumer-

entrepreneurs choose to establish firms if an% only if %oin" so increases

transaction benefits net of transaction costs in comparison with the best

institutional alternative. The firm is an economic actor that is %istinct from the

entrepreneur once the foun%ational shift ta$es place.

'fter the firm is establishe%# the consumer)s role un%er"oes the

foun%ational shift from entrepreneur to owner of the firm. From the point of

view of theconsumer-owner# the firm becomes a financial asset at the %ate

that it is establishe%. 's an owner# the consumer obtains ri"hts of resi%ual

control over the firm)s activities. The consumer also obtains resi%ual returns

e@ual to the firm)s revenues net of e,pen%itures inclu%in" %ebt payments an%

resi%ual claims of other owners.


41/79

The consumer-owner wishes the firm to ma,imi&e profit so as to increase the

owner)s income rather than ma$in" %ecisions to benefit the owner as a consumer.

's a conse@uence of the Fisher Separation Theorem hol%s# the entrepreneur

receives the rewar%s of ownership after the firm is establishe%. 'fter the foun%ational

shift# the consumer no lon"er acts in the economic capacity of an entrepreneur#

havin" complete% the tas$ of establishin" the firm. The owner of the firm can %ivest

his share of the firm or AA

%irect the firm)s activities usin" ri"hts of resi%ual control. The firm acts un%er

the authority %ele"ate% to it by its owners.

The entrepreneur may supply essential inputs# such as the

entrepreneur)s reputation# talents# creativity# an% other uni@ue services# on a

contractual basis once the firm has become establishe%. 'lthou"h the owner

may e,ercise consi%erable control over the firm# the firm "enerally is

%istin"uishe% from the owner)s personal bu%"et an% personal activities. 'fter

the foun%ational shift occurs# there is a separation of the owner)s consumption

%ecisions from the firm)s %ecisions.

The entrepreneur can maintain a connection to the firm after the foun%ational

shift by remainin" as an owner an% also by performin" such functions as mana"er#

consultant# supplier# or customer. The entrepreneur can still be creative an%

innovative as an owner an% mana"er# or the entrepreneur can %ele"ate these %uties


42/79

to mana"ers an% employees. 'fter the foun%ational shift# the entrepreneur can

choose to en% all economic ties to the firm by %ivestin" the ownership share. Even

after %ivestin" his ownership share# the consumer can maintain other economic

relationships with the firm.

'fter it is establishe%# the firm is a new economic actor. The firm plays

various economic roles as a seller of outputs# a buyer of resources# a borrower of

finance capital# an employer of wor$ers an% a party to contracts. The firm is an

interme%iary that matches buyers an% sellers an% ma$es mar$ets. The firm)s

mana"ers choose "oals# strate"ies to achieve the "oals# an% means to implement

strate"ies. 'lthou"h it acts un%er %ele"ate% authority# the newly-establishe% firm is

an a%%itional %ecision ma$er in the economy.

The entrepreneur %oes not earn money %irectly. The entrepreneur often

%oes not earn anythin" while he is establishin" the firm because theentrepreneur receivesA

payments by becomin" an owner of the firm. The entrepreneur is rewar%e% base%

on the @uality of his pro%uct. 's in professions such as science an% art# the

entrepreneur earns money in%irectly by creatin" somethin" new. This in%irect

payment may e,plain why entrepreneurs say that they %o not %o it for the money. Bf

course# entrepreneurs also may en+oy the creative process involve% in %esi"nin" the

firm an% seein" it ta$e shape.


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The return to bein" an entrepreneur is a share of the value of the firm

at the time it is establishe%. The value of the firm is affecte% by mar$et

%eman% an% supply con%itions an% by transaction benefits an% transaction

costs. Hompetition with other firms is a ma+or %eterminant of the firm)s value.

The motivation of the entrepreneur is to obtain the value of the firm. The value

of the firm %epen%s on the entrepreneur)s mar$et $nowle%"e# or"ani&ational

%esi"n# an% intellectual property.

Chen the Fisher Separation Theorem applies# the firm)s %ecisions are

separate from the consumption %ecisions of its consumer-

owners. Theconsumer-owner receives the firm)s profit base% on his ownership

share of the firm. The consumer also ma$es consumption %ecisions that are

in%epen%ent of the firm)s profit ma,imi&ation %ecisions. The entrepreneur)s

profit is e@ual to a share of the value of the firm# %iscounte% to account for thetime it ta$es to establish the firm# less the costs that the entrepreneur incurs in

establishin" the firm. The entrepreneur)s profit is the consumer)s incentive to

become an entrepreneur. The entrepreneur only be"ins to receive a return

after the foun%ational shift ta$es place.

The entrepreneur obtains the value of the firm by becomin" an owner of the

firm at the time the firm is establishe%. 's an owner# the entrepreneur receives the

firm)s profit by remains an owner of the firm over time an% thereby receivin" the

resi%ualAI


44/79

returns from the firm)s operation. 'lternatively# the entrepreneur can reali&e the value

of the firm by sellin" the firm to others after it is establishe%. The entrepreneur also

can form contracts with potential buyers that allow the firm to be sol% before it is

establishe%.

The theory of investment yiel%s insi"hts into the entrepreneur)s problem. The

entrepreneur may e,perience a%+ustment costs in establishin" the firm. The faster

the firm is establishe% the "reater the costs of establishin" the firm. The

entrepreneur may face a tra%eoff between the hi"h cost of rapi%ly establishin" a firm

an% the cost of %elay in obtainin" the value of the firm. 's in any stan%ar%

investment problem# the entrepreneur can choose the amount to invest in the firm.

3ore "enerally# the entrepreneur chooses the characteristics of the firm that he

plans to establish# which in turn affect the value of the firm an% also %etermine the

costs of establishin" the firm.

The entrepreneur)s profit can be "enerali&e% easily to incorporate uncertainty

about the future value of the firm. The entrepreneur may wish to %elay establishin"

the firm as a means of learnin" more about the mar$et. (f the start %ate %epen%s

ran%omly on the stream of e,pen%itures ma%e to establish the firm# the

entrepreneur)s problem resembles a stan%ar% research an% %evelopment ;R4D<

problem.G The entrepreneur can choose the optimal level of investment at each %ate

that reflects the tra%eoff between the cost of investment an% the for"one return %ue

to the e,pecte% %elay in establishin" the firm. The entrepreneur must ma$e


45/79

%ecisions that %etermine the mar$et activities an% or"ani&ational %esi"n of the firm.

The entrepreneur)s profit %epen%s the entrepreneur)s strate"y an% on the intensity of

competition.

G This can be mo%ele% as in the patent race literature# see Rein"anum ;6G!6#

6G!2< an% see Rein"anum ;6G!G< for a survey.A8

&.T#pe(I -ompetition$ -ompetition between Entrepreneurs

Entrepreneurs compete with each other by %eterminin" whether or not toestablish

a firm. Entrepreneurs consi%er their costs of establishin" a firm an% the

relative value that their firm will a%% to the mar$et. They compare the costs of

establishin" a firm an% the value a firm will a%% with those of other

entrepreneurs. 's a result# some consumers will choose not to establish a firm

because of the competitive activities of other entrepreneurs.

Entrepreneurs also compete by pro,y in the mar$et. (f there are

multiple new firms that compete in the same in%ustry# entrepreneurs will ta$e

this into account when %eci%in" whether or not to establish a firm.

Entrepreneurs also will consi%er pro,y competition in %esi"nin" the firms that

they establish.

Not all consumers choose to become entrepreneurs# an% not all

entrepreneurs successfully establish firms. The entrepreneurial process helps


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to %etermine what will wor$ best in the mar$et place. Entrepreneurs effectively

con%uct economic e,periments that test the relative effectiveness of the

pro%uction an% transaction technolo"ies. Entrepreneurs who compete toestablish firms perform the valuable function of comparin" an% selectin" the

best technolo"ies.

Entrepreneurs compete to establish firms so that they effectively

compete for final customers. Entrepreneurs who compete to enter the mar$et

also implicitly compete for inputs. Scarce inputs not only inclu%e resources#

labor# an% capital# but also pro%uction an% transaction technolo"ies. (n a

competitive settin" with full information# the most efficient entrepreneurs

obtain resources to establish firms.A=

Entrepreneurs compete with each other by %eci%in" whether or not to

establish firms. Entrepreneurs ma$e their establishment %ecisions base% on

information about the characteristics of competin" entrepreneurs.

Entrepreneurs only establish firms if they believe that the e,pecte% value of

the firm they set up will be sufficient to +ustify the costs of establishin" the firm.

'ccor%in"ly# an entrepreneur must evaluate the potential contribution the new

firm will ma$e in competition with the firms that other entrepreneurs plan to

establish.


47/79

Hompetition between entrepreneurs %epen%s on many factors that can

be summari&e% by %ifferences in in%ivi%ual preferences an% en%owments. (n

terms of preferences# entrepreneurs can %iffer in terms their %e"ree of ris$

aversion# rate of time preference# an% %isutility of effort. (n terms of

en%owments# entrepreneurs can %iffer in terms of ability# creativity# +u%"ment#

information# an% wealth. 'lso# since consumers own technolo"y# they can

have %ifferent en%owments of pro%uction technolo"y or transaction metho%s.

Spulber ;2!< presents a "eneral e@uilibrium mo%el of entrepreneurial

competition an% applies it to a%%ress various %ifferences between entrepreneurs.

The mo%el can incorporate %ifferences in entrepreneur preferences# inclu%in" ris$

aversion# rate of time preference# an% %isutility of effort. The mo%el can inclu%e

%ifferences in entrepreneur en%owments# such as technolo"y# information# an%

wealth. The e@uilibrium analysis of entrepreneurship shows how consumers %eci%e

whether or not to becomeA!

entrepreneurs. The mo%el e,amines the effects of the si&e of the economy an% the

effects of %eman% an% cost parameters on the e@uilibrium number of

entrepreneurs.6

The mo%el of the economy with en%o"enous entrepreneurs can be e,ten%e% to

"enerali&e the type of firms establishe% by the entrepreneur. The entrepreneur can choose

between %ifferent types of or"ani&ation ? sole proprietorship# partnership# corporation.


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oblete an% Spulber ;2=< e,amine an e@uilibrium mo%el with homo"eneous

entrepreneurs who choose between %ifferent or"ani&ational forms. ' sole proprietorship

functions efficiently# while a partnership is sub+ect to free ri%in"# an% a corporation is sub+ect

to moral ha&ar% by a HEB. The type of firm that emer"es in e@uilibrium will be a sole

proprietorship when investment costs are low# a partnership when investment costs are in

an interme%iate ran"e# an% a corporation when investment costs are hi"h. The wealth of

entrepreneurs also affects the or"ani&ation of the firm. Chen en%owments are hi"h#

entrepreneurs will establish sole proprietorships# when en%owments are in an

6 Spulber ;2!< presents a series of "eneral e@uilibrium mo%els that

e,amine many types of competition between entrepreneurs. The mo%el

consi%ers monopolistic competition between firms after they are establishe%#

as in Di,it an% Sti"lit& ;6G==< an% 7ancaster ;6G!


49/79

will corporation corporations.

+.T#pe(II -ompetition$ -ompetition between Entrepreneurs and "irect

E)change between -onsumers

Type-(( competition refers to the contribution of the entrepreneur incomparison

with %irect e,chan"e# that is# e,chan"e between consumers without interme%iation

by firms. (f firms %o not contribute sufficiently to economic efficiency there is no nee%

for entrepreneurs to establish firms. For entrepreneurs to establish firms# there must

be sufficient "ains in economic efficiency for the value of the firm to cover the costs

of establishin" a firm. Then# there will be an incentive for entrepreneurs to set up

firms.

Honsumers can un%erta$e a variety of economic activities without the

nee% for firms. *ecause consumers own pro%uction technolo"ies an%

transactions technolo"ies.# they have the option of en"a"in" in autar$ic

pro%uction. Honsumers can %evelop inventions an% put them into pro%uction

without the nee% for firms. Honsumers can create economic transactions

without the nee% for centrali&e% mar$ets. Honsumers can transact %irectly with

each other throu"h search# ne"otiation# barter# spot transactions# an%

contracts. 'lso# consumers can form or"ani&ations without the nee% for firms.

For e,ample# consumers can form buyers) cooperatives# sellers) cooperatives#

wor$er cooperatives# an% basic partnerships.


50/79

The entrepreneur competes with %irect e,chan"e by establishin" a firm that

creates or"ani&ations an% mar$ets. The entrepreneur will create value if the firm

provi%es interme%iate% transactions that improve upon %irect e,chan"e. The firm)smar$et ma$in"

activities shoul% improve efficiency in comparison to %ecentrali&e% e,chan"e

activities of consumers# inclu%in" search# bar"ainin"# an% a%verse selection. The

firm)s or"ani&ation shoul% improve efficiency in comparison to consumer

or"ani&ations# such as buyer cooperatives# wor$er cooperatives# an% basic

partnerships. The or"ani&ation establishe% by a firm improves efficiency when it

alleviates "overnance costs associate% with free ri%in"# moral ha&ar%# an% a%verse

selection in or"ani&ations.

The entrepreneur %oes not en"a"e in hea%-to-hea% competition with

%irect e,chan"e because it is the firm# once it is in operation# that must

conten% with %irect e,chan"e between consumers. The entrepreneur

competes with %irect e,chan"e by pro,y# that is# throu"h the firm that he

establishe%. The entrepreneur)s contribution is to anticipate the nee% for the

firm as an interme%iary an% as an or"ani&ation. The entrepreneur has an

incentive to establish the firm only if the firm will a%% value relative to %irect

e,chan"e.


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There are many forms of type-(( competition between entrepreneurs an%

%irect e,chan"e. Firms create mar$ets by settin" up an% mana"in" allocation

mechanisms# inclu%in" poste% prices an% auction mar$ets. Firms provi%e services

as interme%iaries an% %esi"n mar$et microstructure# see the analysis presente% in

Spulber ;6GG8a# b# 6GG!# 6GGG# 22a#b# 2A


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contractin" hub re%uces transaction costs throu"h stan%ar%i&ation an% scale

an% avoi%s the comple,ities of multilateral contractin" between many

in%ivi%uals.

The firm)s or"ani&ation also provi%es an alternative to consumer

or"ani&ations. (t is the autonomy of the firm that %istin"uishes it from consumer

or"ani&ations such as consumer cooperatives# wor$er cooperatives an% basic

partnerships. The firm provi%es transaction efficiencies throu"h relational contracts#

%ele"ation of authority# incentives for performance# monitorin"# communication an%

information "atherin"# see the %iscussion of contracts an% of a"ency in Spulber

;6GGG


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The entrepreneur establishes a new firm if the entrant offers

improvements in mar$et transactions# or"ani&ational transactions# pro%uction

technolo"y# or pro%ucts. E,istin" firms can a%%ress technolo"ical chan"e by

intro%ucin" their own new transaction metho%s# pro%uction processes# or new

pro%ucts. Entrepreneurs compete with establishe% firms in terms of incentives

for mana"erial performance. 'll other thin"s e@ual# a new firm must offer

"reater efficiency if incentives for performance an% opportunities to monitor

performance are "reater than within a establishe% firm. Btherwise# anestablishe% firm coul% offer the same pro%ucts by e,pan%in" or %iversifyin".

Establishe% firms also can offer or"ani&ational innovations by restructurin"

their firm to increase its efficiency. The entrepreneur must offer innovations

more effectively than e,istin" firms.

The entrepreneur)s establishment %ecision thus results in a more

efficient or"ani&ation of the in%ustry. The entrepreneur)s entry %ecision plays

an important economic role by %isplacin" less efficient incumbents an%

stimulatin" innovation by e,istin" firms. (n the absence of %eman% "rowth an%

capacity constraints on e,istin" firms# %isplacin" incumbents re@uires

innovation. *ut# innovation in itself is not enou"h. The entrepreneur must offer

innovations that create a%% value that what incumbents can offer. This

e,plains the "reat emphasis on innovation in economic %iscussions of the

entrepreneur# particularly by Schumpeter.A


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.1Entr#

Entrepreneurs compete with e,istin" firms throu"h their newly-

establishe%firm. The entrepreneur establishes a firm only if it a%%s value incompetition with e,istin" firms. *ein" newly establishe%# the entrepreneur)s

firm necessarily is an entrant# an% the entrepreneur %evises the firm)s strate"y

towar%s incumbents. The entrepreneur)s competitive role ceases once mar$et

entry ta$es place.

Hompetition between entrepreneurs an% establishe% firms can be

mo%ele% usin" the plethora of (n%ustrial Br"ani&ation mo%els of entry# see for

e,ample Spence ;6G==


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mar$etin"# con%uctin" mar$et research# an% obtainin" financin". Firms also must

ma$e irreversible investments in R4D to %evelop new pro%ucts an% pro%uction

technolo"ies.

The empirical in%ustrial or"ani&ation literature on entry she%s li"ht on the

entrepreneur. Keros$i ;6GGI< provi%es a useful overview of %ata an% results in this

area#

an% fin%s that entry appears relatively easy but survival is not. Ease of entry calls

into @uestion many empirical stu%ies that su""est the presence of hi"h barriers to

entry. The importance of entry as a means of intro%ucin" innovations helps to

reconcile these opposin" observations. Keros$i su""ests that entry may be

imperfect as a means of short- term price competition. 1owever# entry is a valuable

mechanism for intro%ucin" pro%uct an% process inventions# with the best pro%ucts

an% processes selecte% throu"h competition between firms once they are

establishe% an% operatin" within the in%ustry. Empirical analysis of entry thus

supports the view of the entrepreneur as innovator.

Entrepreneurs can apply creative entry strate"ies an% innovations to

surmount potential a%vanta"es of incumbent firms. Krowin" mar$et %eman%

or chan"es in consumer tastes "enerate opportunities for entry. Technolo"ical

chan"e allows entrants to arran"e novel transactions# intro%uce new pro%ucts#

or lower pro%uction costs. *ayus an% '"arwal ;2=< in a stu%y of the


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computer in%ustry fin% that technolo"y strate"ies employe% after entry are

critical for firm survival.

(f the incumbent an% entrant offer %ifferentiate% pro%ucts# price competition

ten%s to be re%uce%. *oth the incumbent an% entrant will have the opportunity to

earn profits inpost-entry competition. *ecause a lower price than a competitor

causes only some customers to switch their purchases# the incumbent an% the

entrant will not have an incentive to en"a"e in an all-out price war. Since the

incumbent an% the entrant earn positive profits in competition after entry# it is more

li$ely that the entrant can earn a sufficient mar"in above operatin" e,penses to

recover the sun$ costs of entry. Bther factors that lessen price wars are customer

switchin" costs# customer bran% loyalty# %ifferent convenience features# an%

imperfect information. (f these factors are present# theI

entrant can e,pect a re%uction in the severity of post-entry competition#

allowin" for the recovery of sun$ costs. Therefore# with pro%uct %ifferentiation

an% other factors# sun$ costs are less li$ely to be a barrier to entry.

(f the entrepreneur establishes a firm that will offer a %ifferentiate%

pro%uct# the firm)s value is "reater an% the entrepreneur has a better chance

of recoverin" costs incurre% in establishin" the firm. 'n entrant coul% offer

pro%ucts that %eliver sufficiently "reater value to the customer than %o the


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pro%ucts of establishe% companies. (n return# the entrant will earn mar"ins

that allow for the recovery of sun$ costs incurre% in enterin" the mar$et.

Kenerally# with technolo"ical chan"e# the nee% to sin$ cost is not an

insurmountable barrier to the entry of new competitors. (f an entrant employs

new technolo"ies to re%uce its operatin" costs# it can en+oy a cost a%vanta"e

over an incumbent operatin" out%ate% technolo"y. Even if the incumbent an%

entrant compete on price# an entrant with an operatin" cost a%vanta"e over

the incumbent will earn positive mar"ins that allow for the recovery of sun$

costs.

3oreover# sun$ costs nee% not be an entry barrier because the

entrants sun$ cost is a matter of strate"ic choice. The entrepreneur ma$es

various %ecisions about how much to spen% on plannin"# mar$etin"# R4D an%

so on. The choice of pro%ucts# pro%uction processes an% transaction metho%s

impact the new firm)s costs. The entrant can serve %ifferent sets of customers

than the incumbent# thus chan"in" the entrants nee% for %istribution facilities

an% mar$etin" e,pen%itures.

The entrepreneur can a%opt %ifferent pro%uction or %istribution technolo"ies

than incumbent firms# often %rastically chan"in" the mi, of investment an% operatin"

costs.8


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For e,ample# entrants into telecommunications employ wireless systems with lower

sun$ cost in facilities in comparison with incumbents that operate tra%itional wireline

systems.

Even with similar pro%ucts an% technolo"y# an entrepreneur can re%uce the

ris$ associate% with ma$in" investment commitments in a variety of ways. The

entrepreneur can lessen the ris$ of post-entry competition for formin" contracts with

customers before irreversible investments are ma%e. The entrant can compete with

the incumbent for customers before %eci%in" to enter the mar$et an% then only incur

entry costs if the customer contracts will "enerate sufficient revenues. The company

can fin% out if their pro%uct will be successful before ma$in" substantial investments

in facilities. For e,ample# aircraft manufacturers such as *oein" an% 'irbus si"n up

prospective customers on a contin"ent basis before startin" a pro%uction run on an

aircraft.

The success of the contractin" strate"y also %epen%s on the level of

transaction costs. Efficiencies in contractin" can miti"ate the impact of entry

costs an% entrepreneurs can use contracts as an entry strate"y when there

are substantial costs to establish the firm. (f the transaction costs of contactin"

with customers are relatively low in comparison with sun$ costs of entry# thentestin" the waters throu"h contracts is worthwhile. The entrepreneur can use

contracts to establish prices an% customer or%ers before the establishe% firm


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operates in the mar$et thus re%ucin" the ris$ of irreversible investments an%

avoi%in" price wars after entry.

.!Transaction -osts

The entrepreneur enters the mar$et if it offers more efficient transactions

than incumbents. ' firm that performs transactions with "reater efficiency than its

competitors=

has transaction a%vanta"e# see Spulber ;22# 2A


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processin" e@uipment such as computers# cash re"isters# bar co%in"

an% point-of-sale terminals. These cost economies nee% not translate into

barriers to entry. 's with pro%uction cost a%vanta"es# the entrant can apply

innovations in transaction technolo"y to pro%uce transactions at a lower costs.

For e,ample# an entrant coul% apply new types of enterprise software# point-

of-salee@uipment# or communications %evices# as means of lowerin"

transaction costs.

Transaction technolo"ies such as bac$-office information technolo"y

orpoint-of- sale systems can involve substantial sun$ costs. Entrants may

perceive an entry barrier if incumbent firms may have ma%e substantial

irreversible investments in such transaction technolo"y. 1owever# sun$ costs

in transaction technolo"y can be overcome by continue% innovations.

3oreover# entrants can pursue %ifferent %istribution channels that lower

transaction costs.!

' critical transaction a%vanta"e for a firm stems from i%entifyin"

innovations an% brin"in" them to mar$et faster than competitors. 1owever#

incumbent firms that achieve success from such a strate"y often buil% their business by pro%ucin" pro%ucts base% on a particular "eneration of

technolo"y. The successful incumbent has an incentive to stic$ with a

particular "eneration of technolo"y to provi%e service to its installe% base of


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customers. The incumbent may choose to incrementally improve its pro%ucts

since continually chan"in" their basic technolo"y woul% involve substantial

investment an% costs of a%+ustment. 's a result# entrants can "ain a

transaction a%vanta"e by embracin" later "enerations of technolo"y.

'n entrepreneur may believe that the incumbent firm has a transaction

a%vanta"e resultin" from supplier an% customer relationships that are %ifficult

to %uplicate. 3oreover# the establishe% firm may have e,perience in

coor%inatin" its supplier an% customer transactions. For entrants to overcome

such a%vanta"es# it is necessary to offer %ifferent types of transactions that

improve upon e,istin" types of e,chan"e. For e,ample# 'ma&on.com was

able to enter the retail boo$ business by sellin" throu"h the (nternet even

thou"h establishe% boo$stores ha% lon"-stan%in"relationships both with

customers an% with publishers.

(f the entrepreneur establishes a firm with innovative transactions# the sun$

costs of establishin" the firm nee% not be a barrier to entry. Throu"h innovative

interme%iation between buyers an% sellers# the entrant can earn operatin" profits

after entry. *y re%ucin" transaction costs# the entrant will earn returns that allow the

entrepreneur to recover sun$ costs. 'ccor%in"ly# entrants can ma$e investments in

information technolo"y#G


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communications systems# customer support# supplier connections# an% bac$

office processes# that are recovere% throu"h transaction a%vanta"es over

incumbents.

.&-ompetition and Inno*ation

Entrepreneurs compete with establishe% firms to be innovators. (n

particular# suppose that an inventor ma$es a %iscovery of a new pro%uction

process# pro%uct %esi"n# or transaction metho%. 1ow shall the %iscovery beintro%uce% into the mar$et Entrepreneurs an% establishe% firms are

alternative mechanisms for intro%ucin" the invention to the mar$et. *oth

entrepreneurs an% establishe% firms can serve as interme%iaries between the

inventor an% users of the invention.

The entrepreneur can start a new firm to commerciali&e the invention. 'lternatively# an establishe% firm can employ the invention to improve or

replace its e,istin" processes# pro%ucts# or transaction metho%s. The $ey

@uestion is why woul% new firms be nee%e% for innovation.

(n many cases# a new firm is nee%e% because no e,istin" firm is available.

The invention opens a completely new line of business that %oes not correspon% to

the activities of any establishe% enterprise. Bften# the new line of business while

relate% to the activities of e,istin" firms is sufficiently %istinct that establishe% firms

lac$ the $nowle%"e an% resources to employ the invention. 'lso# it may be that the


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%iversification re@uire% to employ the invention woul% %istract the company)s

mana"ers an% employees from their e,istin" activities thus overcomin" any potential

economies of scope.

' new firm may be nee%e% for innovation if e,istin" firms %o not correctly

+u%"e the economic value of the invention. 's is often the case in practice# the

mana"ers of I

e,istin" firms may un%erestimate the competitive threat pose% by the invention. This

mana"ement problem commonly is referre% to a mana"ement myopia. 66 The mana"ers of

e,istin" firms follow such a narrow %efinition of their mar$et that they fail to i%entify

technolo"ical chan"es that create pro%ucts that are substitutes in %eman%. Thus# mana"ers

of fa, machines %o not see the value of e-mail since they believe that they are in the fa,

machine business rather than in the communication business. Similarly# mana"ers may not

un%erstan% the impact of technolo"ies that create substitute pro%uction processes or

improve% transactions. For e,ample# 7evitt ;6G8< notes that nei"hborhoo% "rocery store

chains believe% that supermar$ets %i% not pose a competitive threat.

The entrepreneur)s incentive to a%opt an invention may %iffer from that

of the establishe% firm. 'rrow ;6G82< i%entifie% a %isplacement effect face% by

a monopolist. The firm earnin" a profit operatin" a business evaluates an

invention on the basis of its incremental contribution to profit# in contrast to a

competitive in%ustry that has a &ero profit benchmar$. This same analysis


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woul% apply to an entrepreneur who evaluates an invention %e novo in

contrast to a profitable incumbent.

The vast literature on R4D yiel%s insi"hts into entrepreneurial innovation.

Entrepreneurs can compete with establishe% firms throu"h R4D. 'n entrepreneur

that obtains an invention before an incumbent coul% establish a firm that %isplaces

the e,istin" firm. This can be analy&e% usin" mo%els of racin" to invent in which the

winner obtains an e,clusive monopoly patent an% enters the mar$et# see

Rein"anum ;6G!G< for a survey. Kans an% Stern ;2< loo$ at a race where there is

only one winner but licensin" an% imitation are feasible# see also Salant ;6G!< an%

5at& an% Shapiro ;6G!=


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These e,amples consi%er competitions with a sin"le winner. 1owever# even if

inventions are scientifically uni@ue# %ifficult to copy# or protecte% by patent# there are

alternative inventions that are substitutes in %eman%. 's E%mun% 5itch ;2# p.

6=A< co"ently observes patents that confer monopoly mar$et power are rare.

5itch %iscusses elementary an% persistent errors in the economic analysis of

intellectual property notin" particularly the incorrect assertion that e,clusivity in

intellectual property confers an economic monopoly. (n the same way# copyri"hte%

wor$s compete with each other# see Kol%stein ;6GG2< an% >oo ;2oo ;2


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lasers# or chemical processes. Different inventions can be use% to %evelop

new pro%ucts with competin" features. These inventions yiel% pro%uct

innovations that are substitutes in %eman% within such cate"ories asappliances# electronic "a%"ets# automobiles# cameras# fabrics# or me%icines.

The presence of competin" inventors provi%es entrepreneurs with a

means of competin" with e,istin" firms. *y obtainin" inventions in the mar$et

for i%eas# entrepreneurs intro%uce innovations that compete with the e,istin"

pro%ucts or the innovations of establishe% firms. Shane ;26< fin%s that an

invention is more li$ely to be commerciali&e% by an entrepreneur than by an

establishe% firm the "reater is the innovation)s importance# impact an% patent

scope. 1ellman an% uri ;2< show that venture capital financin" favors

innovators over initiators an% ten%s to spee% the time to mar$et for new hi"h-

tech ventures.

James 'nton an% Dennis >ao ;6GGI< loo$ at entrepreneurs who are

employees of firms# %iscover a si"nificant invention# an% then leave to start a new

firm. The employee has three options9 $eep silent an% leave to start a new firm#

reveal the invention to the employer in hopes of a rewar%# or ne"otiate a rewar% with

the employer before revealin" the invention. Dealin" with the employer also can

result in a new firm is the form of aspin-off. 1ere "eneral inventions result in spin-

offs while specific inventions lea% tostartup-ups. Thomas 1ellmann ;2I< uses

a multi-tas$ incentives mo%el an% shows how the choice of or"ani&ational structure


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of new ventures ;start-ups# spin-offs# an% internal ventures< %epen%s on corporate

policies towar% employee inventors an% the allocation of intellectual property ri"hts.IA

.+Incenti*es

Economists an% mana"ement researchers contrast the incentives of

entrepreneurs with those of mana"ers. The profit of the entrepreneur is the

%iscounte% value of the firm when establishe% minus the costs of establishin" the

firm. (n contrast# the mana"er receives contractual incentives that are base% on the

measure% performance of the firm. The entrepreneur acts to ma,imi&e his profit#

while the mana"er often respon%s to incentives %esi"ne% by the owners of the firm.

>oram *ar&el ;6G!=< ar"ues that the entrepreneur ta$es the role of the resi%ual

claimant because his actions are more costly to monitor than those of other factors

of pro%uction.

Kromb an% Scharfstein ;2I< consi%er a partial e@uilibrium mo%el in

which an investor owns two potential pro+ects that %epen% on mana"erial

ability. The pro+ects must be complete% one after the other. The mana"er must

%evote effort to improve the chances the first pro+ect will be successful. The

outcome of the pro+ects provi%es information about the mana"er)s ability. They

interpret the first pro+ect as that of an establishe% firm# an% they interpret

outsourcin" of the secon% pro+ect as an entrepreneurial firm. The %istinction

between e,istin" an% new firms has to %o with %ifferent labor-


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mar$et incentives for mana"ers# with hi"her-ability mana"ers preferrin" to

become entrepreneurs.

The incentives of entrepreneurs an% mana"ers %iffer because their tas$s

%iffer. The entrepreneur is concerne% with %efinin" the new firm# which is by

%efinition a mar$et entrant. The mana"er who wor$s for an establishe% firm# ta$es

into account the potential continuation of e,istin" business. The entrepreneur is

buil%in" an or"ani&ation an% wor$s in%epen%ently. (n contrast# the mana"er of an

establishe% firm is part of anI

e,istin" hierarchy# often with bureaucratic inertia# ris$ aversion an%inefficiencies that are

observe% in many lar"e business or"ani&ations# see Harl Schramm ;28b


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creatin" an% mana"in" mar$ets an% or"ani&ation# the economy pro%uces e@uilibrium prices

an% transactions. Thus# the entrepreneur helps the economy to achieve e@uilibrium.

The concept of the foun%ational shift helps to e,plain the interconnections

between the financial# labor an% technolo"y %ecisions of the startup enterprise an%

the consumption# human capital# an% innovation %ecisions of the in%ivi%ual

entrepreneur. The foun%ational shift has important implications for law an% public

policy. The novel implications have to %o with the situation before the foun%ational

shift occurs when there is an absence of separation between the ob+ectives of the

startup an% those of the entrepreneur. The entrepreneur contributes to the financin"

of the startup enterprise an% faces the ris$ of personal ban$ruptcy. The entrepreneur

contributes effort an% mana"ement to the startup enterprise which affects his labor

mar$et %ecisions# personal income# an% ta, liability. The entrepreneur contributes

i%eas to the startup enterprise an% is concerne% with the personal %imensions of

intellectual property. The entrepreneur is aII

party to contracts with venture capitalists an% others who help form the startup

enterprise. These interconnections also affect the in%ivi%ual)s incentives in

ma$in" the transition from entrepreneur to owner. The personal %imensions of

the entrepreneur)s economic relationships raise le"al an% public policy

@uestions.


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(n type-( competition# entrepreneurs compete with each other to

establish firms. Entrepreneurs are successful in competin" with each other

base% on their personal characteristics# inclu%in" preferences# wealth#

capabilities# +u%"ment# information# an% %iscernment of opportunities. (n type-

(( competition# entrepreneurs compete with %irect e,chan"e because the firms

they establish create an% mana"e mar$ets an% or"ani&ations. The mar$et an%

or"ani&ational transactions of successful firms enhance the efficiency of

transactions in comparison with %irect e,chan"e between consumers. (n type-((( competition# entrepreneurs compete with establishe% firms# offerin" new

capacity# technolo"ical innovations# more efficient transactions# an% improve%

incentives for performance.

The entrepreneur)s actions illuminate the main issue in the theory of

the firm why %o firms e,ist The entrepreneur chooses to establish a firm

only if %oin" so creates sufficient economic value. The entrepreneur fin%s it

worthwhile to incur the transaction costs of establishin" a firm only if the val

The Economic Role of the Entrepreneur Nitesh

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