In the previous chapter we discussed a number of currents in the modern theory of the firm, explaining why they struggle to come to terms with the entrepreneurship phenomenon. In this and the next chapter we rely more constructively on select insights from these theories to piece together a theory of the entrepreneurial firm. We organize our discussion around the three classic themes in the theory of the firm: existence (or emergence), boundaries, and internal organization. The present chapter deals with existence and boundaries.

Coase (1937) explained the firm as a means for economizing on transaction costs, a theme elaborated by Williamson (1975, 1985, 1996). Alchian and Demsetz (1972) viewed the firm as an (albeit imperfect) solution to the free-rider problem in team production (see also Holmström, 1982), and agency theorists have subsequently provided important contributions to the understanding of contracts within the firm (e.g., Holmström and Milgrom, 1991; Roberts, 2004). The “new” property-rights approach of Oliver Hart and his colleagues and students adopted the emphasis on specific assets and investments of Klein et al. (1978) and Williamson (1985) and gave it a new twist by showing how incentives to invest in relationship-specific assets vary with ownership arrangements (Grossman and Hart, 1986; Hart and Moore, 1990). Resource-based theories emphasize the need to generate and internalize tacit knowledge, and while they are mainly theories of firm performance (financial-market returns, innovation, etc.), they do have implications for economic organization (Kogut and Zander, 1992; Langlois and Robertson, 1995; Conner and Prahalad, 1996).

Preface

Entrepreneurship, long neglected by economists and management scholars, has made a dramatic comeback in the last two decades. As the economic theory of the firm flourished following the rediscovery and reworking in the 1970s of Coase’s path-breaking “The Nature of the Firm” (1937), the new field of “strategic entrepreneurship” has also begun to take off, along with a parallel rebirth of entrepreneurship studies in economic growth and development, sociology, and anthropology.

As management and organizations researchers with a particular and decade-long interest in entrepreneurship, we obviously welcome all these new developments, just as we have been heavily influenced by modern work on the theory of the firm. And yet, we think both sets of literature have missed important insights from the other. This book is written to fill the gap, proposing and developing an entrepreneurial theory of the firm that focuses on the links between entrepreneurship and management.

Entrepreneurship is one of the fastest-growing subfields in management research, and is increasingly appearing in economics, sociology, anthropology, finance, and even law. Entrepreneurship became a Division (specialized interest group) within the Academy of Management in 1987 and now has its own subject code (L26) in the Journal of Economic Literature classification scheme. Research and policy organizations such as the World Bank, the US Federal Reserve System, the European Commission, the United Nation’s FAO, the OECD, agencies involved in agricultural and rural development, and others show a growing interest in studying and encouraging entrepreneurship. The Kauffman Foundation has substantially increased its funding for data collection, academic research, and education on entrepreneurship.

Entrepreneurship is also becoming one of the most popular subjects at colleges and universities (Gartner and Vesper, 1999; Solomon, Duffy, and Tarabishy, 2002). Entrepreneurship courses, programs, and activities are emerging not only in schools of business, but throughout the curriculum. In 2008 US colleges and universities offered over 2,200 entrepreneurship courses at over 2,000 schools (Cone, 2008), over 600 schools offered majors in entrepreneurship, and an additional 400 with concentrations in entrepreneurship (Kuratko, 2008). The number of Ph.D. programs conferring degrees in entrepreneurship has also increased in the last 20 years (Katz, 2007) and the number of refereed academic entrepreneurship journals have risen in impact factor ratings among peer-reviewed management journals (Gatewood and Shaver, 2009). While the field remains a minority specialization among business school faculties (Katz, 2003), during the 1990s the number of entrepreneurship positions increased by over 250 percent and the number of candidates nearly doubled (Finkle and Deeds, 2001). Besides the usual business school offerings, courses in Social Entrepreneurship, Family Business Management, Technical Entrepreneurship, Performing Arts Entrepreneurship, and the like are popping up in colleges of arts and sciences, engineering, education, social work, and even fine arts.

The theory of entrepreneurship and the theory of the firm should be treated together. And yet, the important connections between these two bodies of literature have been largely overlooked. This is our book’s basic motivation.

How, then, are entrepreneurs and firms connected? Do entrepreneurs need business firms to carry out their function? Or, do firms need entrepreneurs to survive in the competitive market process? And if there is a role for the entrepreneur in the firm, what is it, exactly? Where in the firm does entrepreneurial activity mainly take place? How does the organization of the firm influence entrepreneurial actions? Are business firms run by entrepreneurs, or rather by hired managers? How does firm organization (e.g., the allocation of residual income and control rights) affect the quantity and quality of entrepreneurial ideas? Can entrepreneurship be a property of a managerial team – or is it strictly an individual phenomenon?

The entrepreneurship literature in economics and management is biased towards start-up firms. And yet, profit opportunities are imagined, evaluated, and captured by existing firms. Employees often play a key role for developing and pursuing business opportunities (Baumol, 1994; Bhardwaj, Camillus, and Hounshell 2006). In fact, modern firms increasingly encourage “intrapreneurship,” “autonomous strategic initiatives,” and “corporate venturing” at all levels of the organization (e.g., Day and Wendler, 1998; Yonekura and Lynskey, 2002; Covin and Miles, 2007; De Clercq, Castaner, and Belausteguigoitia 2007). Clayton Christensen’s Innovator’s Dilemma (1997), one of the most influential business books of the last two decades, deals with the difficulties facing established firms that try to innovate.

To foster entrepreneurial attitudes and behavior, managers must give employees significant discretion. The need for such entrepreneurial attitudes is partly driven by deep-seated changes, sometimes placed under the rubric of the “knowledge economy” (Foss, 2005). Thus, greater variability in the environments firms confront, more emphasis on innovation as a competitive tool, an increased need to source heterogeneous knowledge inputs, and so on call for an increased reliance on decision-making within firms that is not only fast, but also adaptive and intelligent. This amounts to an increase of delegation of discretion to employees at all levels in order to make them exercise responsible judgment. Cowen and Parker (1997: 28) cogently summarize this line of thinking:

As we argued in the previous chapter, the key construct that links entrepreneurship and the theory of the firm is entrepreneurial judgment. But what is judgment, exactly? So far we have treated judgment in a highly formal and abstract way, as that which generates profit and loss. Here we are consistent with other approaches to the entrepreneurial function: Schumpeter takes entrepreneurship to be that which generates economic growth, while Kirzner treats it as that which causes markets to equilibrate. In all of these cases, entrepreneurship itself is largely a black box; it is invoked, instrumentally, to explain a particular set of phenomena.

Judgment, to be more specific, is residual, controlling decision- making about resources deployed to achieve some objectives; it is manifest in the actions of individual entrepreneurs; and it cannot be bought and sold on the market, such that its exercise requires the entrepreneur to own and control a firm. To simplify, we have collapsed into this notion the acts of creating and evaluating opportunities, and deciding on which resources need to be assembled, how they need to be combined, etc. to realize the opportunity. We have made the point that judgment is a meaningful notion of decision-making that is intermediate between decision-making via formalizable rules and pure luck or random behaviour (see Casson, 1982). It is the kind of decision-making that concerns unique business investments for which it is difficult, or even impossible, to assign meaningful probabilities to outcomes, or even to specify the set of possible outcomes itself (Shackle, 1972; Zeckhauser, 2006). When confronted with such a situation, individuals will reach different decisions, even if they share the same objectives and the data are presented to them in exactly the same manner, because they have access to different information, interpret the data in different ways, and so on (Lachmann, 1977; Casson and Wadeson, 2007). In Bayesian terms, priors are diffuse, and updating rules may differ.

In the preceding chapters we have highlighted the entrepreneurial function, arguing that the entrepreneurship literature needs to go beyond its current preoccupation with the discovery and evaluation of opportunities, and consider more fully the exploitation of these opportunities through resource ownership and control. The judgment view explicitly highlights this aspect of entrepreneurship, and therefore points to the role of the entrepreneur as an investor, an owner with skin in the game. But we have not yet explored the context in which judgmental decision-making takes place. Some perspectives in entrepreneurship research – notably network perspectives (Greve, 2003; Hoang and Antoncic, 2003; Sorenson and Stuart, 2005) and the effectuation view (Sarasvathy, 2008) – strongly emphasize the contextual aspects of entrepreneurship, albeit in very different ways.

In the previous chapter we discussed the epistemological and ontological contexts of judgment as seen by Knight (1921) and Mises (1949). However, we said little about the more concrete contexts, those of markets for inputs and outputs, and even inputs and outputs themselves. In this chapter we argue that the judgment view is naturally aligned with a specific view of capital, one that is often associated with the Austrian school of economics, but also has a strong similarity to certain key perspectives in modern management research, notably the resource-based view of strategy and, to some extent, transaction-cost economics. These perspectives highlight the heterogeneity of capital assets, the benefits of combining them in complementary bundles that generate competitive advantage, and the hazards associated with investments in assets that depend on particular exchange relationships to maintain their value.

In Knight’s (1921) view, firm organization, profit and loss, and entrepreneurship are inextricably linked. These phenomena arise as an embodiment, a result, and a cause, respectively, of commercial experimentation – a view founded on a particular ontology of the world as essentially open-ended and not deterministic (1921: chapter 7). Few economists have followed Knight in linking the firm, profit and loss, and entrepreneurship, especially from his philosophical starting points. And yet, as we noted in the beginning of this book, there are many good reasons to treat the theory of entrepreneurship and the theory of the firm together. Such a synthesis informs many foundational questions in economics, business strategy, and public policy: Can we meaningfully address entrepreneurship without considering the organization in which such entrepreneurship takes place? How does the structure of the firm influence entrepreneurial actions? How does firm organization (e.g., the allocation of residual income and control rights) affect the quantity and quality of entrepreneurial ideas? And so on. To answer these, we need to bring the theory of the firm and entrepreneurship literatures into close contact. And yet, the important connections between these two bodies of literature have been largely overlooked. We seek to identify and establish some of those connections in this and the next two chapters.

In bringing together entrepreneurship and the theory of the firm we hope to convince scholars in both fields that there are significant gains from trade. We start by reviewing extant theory of the firm, asking why these gains were not recognized, evaluated, and exploited. Economics, and hence the economic theory of the firm, developed throughout the twentieth century in a particular way, one that effectively excluded the entrepreneur from the organization and the market – not because the insights of Schumpeter, Knight, Mises, and other thinkers on entrepreneurship are unimportant or not subject to clear, precise, systematic presentation and development, but because the increasingly formal and stylized treatment of economic phenomena made it difficult to incorporate judgment and creativity, bounded rationality, unforeseen contingencies, and so on.

Introduction

The preceding chapters have outlined an entrepreneurial theory of the firm built upon Knightian uncertainty and Austrian capital theory. The theory regards entrepreneurship as an active, owning, controlling agency, the function of assembling, configuring, and reconfiguring bundles of heterogeneous resources under conditions of “true” uncertainty, with strong implications for our understanding of the nature, emergence and boundaries of the firm. It also shows how entrepreneurial judgment about resources is distributed throughout the multi-person firm, as the owner’s original judgment is shared with employees who exercise derived judgment on the owner’s behalf.

This notion of the entrepreneurial firm is implicit in some of the earliest systematic treatments of economic problems, including Cantillon’s (1755) landmark essay, was incorporated by some Classical and Austrian economists, but gradually fell out of favour, losing out to the stylized abstraction of the neoclassical “firm,” a production function that is analytically tractable but descriptively vacuous and silent on the key problems of economic organization and entrepreneurship. The transaction cost, agency-theoretic, property-rights, resource-based, and capabilities theories of the firm that emerged in the 1970s, 1980s, and 1990s breathed new life into the theory of the firm, explicating many important problems of firm behavior and performance, but even these did not bring the entrepreneur back into the story. Likewise, entrepreneurship studies became established as a separate field, focusing on start-ups, small-business management, and innovation, but the entrepreneur remained absent from other, mundane topics in economics and management.