Formalism in Entrepreneurship Research Jerry Gustafson Coleman Foundation Professor of Entrepreneurship Beloit College Beloit, WI 53511
[email protected] 608-363-2343 Joshua Hall* Assistant Professor of Economics Beloit College Beloit, WI 53511
[email protected] 608-363-2376
*
Corresponding author.
Formalism in Entrepreneurship Research Efforts to apply more formal techniques, especially economic ones, to the study of entrepreneurship have increased in recent decades. We argue that formalism has done little to advance our understanding of either entrepreneurship or the entrepreneurial process. We detail the problems inherent in trying to formally model entrepreneurship and also discuss several aspects of entrepreneurial behavior that have been understudied in part because they are not amenable to formal analysis.
Introduction Economists frequently note, and bemoan, the lack of attention given entrepreneurship in neoclassical economic theory (Gustafson 1992; Johansson 2004; Baumol 2006). Only the Austrians have historically emphasized the importance of entrepreneurship (Kirzner 1997). The development of economic theory is marked by a handful of economists who did comment extensively on the importance of entrepreneurs and who assigned them a bewildering variety of functional roles (Baretto 1991). Since the classicists, however, most economists have thought of entrepreneurship, when they have needed to think of it at all, simply as a productive factor: that force which combines capital, land, and labor (see, for example, Schultz (1980)). This practice seems appealing since the residual return, profit, seems justifiably attributable to the risk-taking and decision-making of the business owner or manager. Neoclassicists have not been forced to a consideration of entrepreneurship, however, because under usual assumptions of complete knowledge, zero transactions costs, and perfectly elastic supplies of entrepreneurial effort, the behavior of the entrepreneur evaporates from the competitive model (Machovec 1995). Even so, economists continue to try to fit a square peg into a round hole and attempt to model
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entrepreneurship as some form of specialized human capital, to associate its supply with its rate of return, and to otherwise cram it into the model of static equilibrium. For example, in the well-known entrepreneurship and occupational choice model of Kihlstrom and Laffont (1979), entrepreneurs are merely individuals with a greater taste for uncertainty and risk.1 In these types of models, it is the fundamental attributes of individuals that determine whether they become entrepreneurs, not the presence of entrepreneurial opportunities or the idiosyncratic desire to see a product brought to market. The impulse to apply more formal economic techniques to the study of entrepreneurship is strong, as is evinced by the large number of papers since the 1970s that try to use the formal tools of equilibrium analysis to study entrepreneurship.2 We argue, however, that the use of formal theoretical equilibrium models does not advance our understanding of entrepreneurship.3 Formal economic theory has achieved its greatest successes in the precise and rigorous disclosure of conditions for and properties of equilibrium, a process that is a crucial aid to economic intuition (Krugman 1998). Mathematical exposition together with parallel developments in econometrics led not only to rigor and clarity but to testable hypotheses in much of economics. Just as it is reflexive that consideration of entrepreneurship be cast in a general equilibrium model, it would seem only natural that any worthwhile model of entrepreneurship be presented with the appropriate level of formal mathematical rigor. Most entrepreneurship scholars, of course, are not economists. Many of them share, however, in the quest for formal rigor and testable hypotheses. For their part, technique serves to signify the quality of research. As practitioners in a new field still in
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search of full academic legitimacy, entrepreneurship scholars often feel they must demonstrate command of the tools that are respected and accepted in the other social sciences. Whether reflexive and natural or not, abstruse methods are considered to be the path towards the arrival of the field of entrepreneurship as a mature discipline. We argue that such formalism is problematic. In the next section we begin with some thoughts on the problems with using formal mathematical equilibrium models to capture the entrepreneurial process. The third section reflects on the nature of entrepreneurship as we understand it in an attempt to focus attention on what formal methods cannot help us explain. The fourth and final section concludes.
Thoughts on Formal Models of Entrepreneurship Whatever the merits of these theoretical models of entrepreneurial behavior, the following may be reasonably be argued: the models bear no meaningful relationship to much of what we know of actual entrepreneurial behavior. Entrepreneurs are conspicuous for their tendency to make their own commitments, keep their covenants and to persist stubbornly in pursuing innovation as they wish to shape it. They are urgent about getting things done. They harbor and protect their recognition of opportunity. Their deepest urge is to preserve independence and control at all cost. Modeling their activity, as simple seekers of marginal gain wherever it may be found, seems off-key to say the least. Neither does it seem correct to view entrepreneurship as a productive factor. Entrepreneurial services are a flow, not a finite stock. It is clumsy to view these services as bid forth in quantity either according to existing market or uncertain subjective rates of return. They are a flow of characteristic behaviors designed to achieve for the actor non-
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pecuniary as much as pecuniary awards – emanating as much from the actors’ taste and style as from prices. When one reads the vast literature concerning the psychology of entrepreneurship, the motivation appears actually as much about consumption as production. And entrepreneurship is certainly not about equilibrium with its attendant notions of allocative efficiency; its essence is of change and vibrancy – so-called “dynamic efficiency.” It exists in an institutional environment which cannot be easily abstracted and concerns not only efforts to exploit existing institutional arrangements but efforts to promote institutional change, as well. Maximizing behavior implies a world of given constraints. But it is often the aim of the entrepreneur to change the structure of constraints.4 If these assertions are justifiable, then mathematical models of entrepreneurship seem to be hardly about entrepreneurship at all. Those interested in communicating the subject of entrepreneurship to the next generation of economists are likely to fail if what their models describe is not entrepreneurship. Why has the research of economists with respect to entrepreneurship taken the form it has? First, their methods have come largely to dictate the content of their analysis in all areas of inquiry (Boettke 1997). While mathematics was useful in being able to describe and define general equilibrium, it had the unintended consequence of changing how economists do economics (Boettke et al. 2003). Instead of using competitive equilibrium as a counterfactual “idealized state” in order highlight the positive contributions of real-world institutions, the use of mathematics in economics inverted this approach (Boettke 1997). After the formalist revolution in economics, economists began
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to see the complexity and institutional characteristics of real world markets as deviations from perfection – not as the subject of investigation. Gradually, the nature of the subject became the body of issues that submitted to mathematical techniques. Second, mathematical discourse is of particular value when there is substantial regularity of the phenomenon under investigation. If variables are tightly specified, if actions are routine and repetitious and if the parameters which specify a given environment are stable, then a limited number of relationships may describe and predict vast quantities of behavior. Great power is gained by viewing slightly disparate acts of consumption or production as essentially the same. The simplicity of the Walrasian system is a good example. Demonstration of regularity – of economic law – is often the point of theory. If regularity is absent, mathematics loses power as an expository mode. Finally, mathematics enhances several characteristics regarded as hallmarks of good theory. Theories are typically judged according to internal consistency, operationality, tractability, and robustness. A special value of mathematics in examining logical accuracy, ferreting out contradictions in implications, and exposing internal consistency is clear (Krugman 1998). Mathematical methods are likewise praiseworthy for their ability to separate tautology from hypothesis and to encourage the formulation of theoretical statements in terms suitable for empirical testing. Tractability – ease of use and manipulation and yielding of definitive conclusions – is often given as a major advantage of mathematical analysis. Once specified, variables and relationships may be subjected to mathematically defined operations which can yield unsuspected properties of a model, thereby increasing understanding of the underlying phenomenon. Robustness
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calls for testing the sensitivity of conclusions to changes in assumptions and conditions. Such assessment can be enormously aided by mathematics. Several other characteristics of good theory, however, are not enhanced by mathematical investigation. A theory may be judged according to its strategicness – does the theory concern a matter of pressing interest and importance for reasons external to the theory construction itself? Is it of instrumental as well as intellectual value? Second, a theory may be assessed according to its ability to explain. A theory should permit a plausible story to be told about why and how its conclusions, implications, and predictions arise. Explanation is of particular importance in theories which are policy relevant. Finally, a theory may be judged by its ability to permit interpretation. Economists have tacit knowledge about how economies work which is only partially disclosed by theoretical formulations. It is seldom self-evident what the meaning of a theoretical construct is until it is placed in the context of the web of informed intuition of the community of practitioners. Theories should, as McCloskey (1985) says, promote conversations about meaning. Mathematical methods may not enhance strategicness, explanation, and interpretation; they may actually impede them. It is fairly compelling that economists ignore many crucial issues in the interest of pursuing those which model well. Entrepreneurship is among these, although examples abound (say in economic dynamics, institutional change, income distribution, or other aspects of public economics). Since Milton Friedman’s (1953) essays on positive economics, which so stressed the importance of predictive validity, economists have been cavalier about explanation. Sometimes economists illustrate theory with stories of actual behavior and underlying
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motives; much more often behavior is explained in terms of the mechanics of mathematical operations which arise in the course of modeling. The degree to which mathematics discourages interpretation can be seen in the pages of any economics journal; when economists engage in critical reflection with each other, at issue is technique, rarely is it interpretation. Entrepreneurship is not a subject where mathematical techniques are at a comparative advantage. Fundamentally, entrepreneurship is not about equilibrium. It is true that a debate continues, framed originally by Schumpeter and the Austrians and emphasized by Kirzner, about whether entrepreneurial innovation disturbs equilibrium or merely exploits pre-existing opportunities necessary to achieve it. Either way, the existence of equilibrium is irrelevant to the entrepreneurial act: entrepreneurship is about change, perturbation, disequilibrium, dynamism. Since it is not about equilibrium, proofs of existence or examination of outcomes which follow in its wake are not of likely of power or relevance. Entrepreneurship is not a well-defined variable. Indeed, it is probably best understood, as most entrepreneurship scholars conceive it, as a cluster of activities including opportunity finding, opportunity exploitation, organization, strategic planning, commitment to goal achievement, etc (Timmons 1989, Hills et al. 1999). Furthermore, it is difficult to separate entrepreneurial behavior from its multiple social roles and functions. Little is known about what social conditions may cause or encourage it. Not much of entrepreneurial behavior is regular, repetitive, or routine. Entrepreneurial behavior is interesting precisely because of its idiosyncratic response to poorly recognized, often short-lived, unique, and even peculiar circumstances.
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Not only is entrepreneurship in economics vaguely defined, it is typically discussed in terms of a variety of emergent functional contributions (e.g., risk-taking, innovating, coordinating, arbitrating, etc.), rather than clearly motivated individual behavior. It is the behavior we wish to understand first, not emergent social function. What is required initially is not internally consistent and operational theories as much as a conversation about first principles. A clear understanding of the properties of the competitive market did not follow from DeBreu and others; it preceded and guided the working out of mathematical details. Similarly, the profession needs keener intuition and broader agreement about the nature of the behavior before getting to the general impact of entrepreneurship on economic systems. We need conjecture, speculation, tentative explanations and partial analysis before advancing to robust and tractable theorizing. We need more talk, in other words, in order to agree on what we are talking about. Finally, and probably most important, entrepreneurship cannot be explored by the typical mathematical techniques which analyze behavior in the context of a given environment, specified by stable parameters, and devoid of institutions. Perhaps what is most significant about entrepreneurial behavior is that it changes and shifts parameters, which lead to institutional change. Alone among economic actors, the entrepreneur alters the incentive scheme which characterizes an economy and so, wittingly or not, has a role similar to the exogenous policy maker.
A Conversation about Entrepreneurship If economists are not to explore entrepreneurship in the habitual ways of modeling general equilibrium, what are they to do? There is much to do even if the
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necessary tasks are not currently fashionable. The foregoing discussion raises the several issues each of which seems in need of closer attention. Perhaps a central problem plaguing entrepreneurship research is, as we have noted, the failure to distinguish between entrepreneurship as motivated behavior of particular economic actors versus the social impact or functions of that behavior. In economic theory, entrepreneurs are those who have speculated, coordinated, innovated, borne-risk, made decisions, engaged in arbitrage, etc. None of these functions are likely in the mind of the entrepreneur at work, valuable though their outcomes may be to society at large after the fact. We lack even a rough consensus about what entrepreneurship is and why persons engage in it, in spite of a deep appreciation of its myriad emergent effects. Second, whatever else entrepreneurship is, studies of individual entrepreneurship performed by scholars in social psychology and business make it clear that their main intention is not to maximize subject to given constraints (Collins et al. 1964; Ronen 1983; Timmons 1989). They find ways of altering or avoiding the current structure of incentives altogether. In so doing, they contribute to institutional change. They are thus a key source of economic dynamism and vibrancy. Third, entrepreneurship is both a product of culture and a source of cultural change. Entrepreneurs are successful, presumably in substantial part, because of a superior comprehension of the cultural context of economic processes. That comprehension includes a particular view of how the economy works, an ability to sense unmet needs, an awareness of the social consequences of technical change, and so on. An evaluation of entrepreneurship requires an appreciation of the substantial tacit knowledge
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which informs their behavior. Their role cannot be captured entirely by the outlines of a formal model. It requires interpretation which requires, in turn, the application of substantial tacit knowledge on the part of the economist. None of the following ideas offer prospect for useful mathematical analysis, but less formal consideration might be of great value. Here are our short comments on each. (1) Entrepreneurs seem to engage in entrepreneurship because they enjoy it and are, in any event, compelled to it. A near mountain of psychological studies of entrepreneurs makes clear that entrepreneurs are not drawn from ordinary profit-making activity by the prospect of higher returns from speculative, innovative, or risk-taking behaviors (Gartner 1988). Neither, as it is commonly supposed, is it the risk that they seek (Low and MacMillan 1988; Palich and Bagby 1995). Entrepreneurship is, in part, consumption behavior. Their tastes and values lead them to behavior which from a production viewpoint is scarcely consistent with the standard neoclassical assumptions about maximizing behavior.5 Consider entrepreneurship in the model of Becker and Stigler (1977), who set out to show that relative prices were responsible for a much broader range of behavior than is commonly thought. They purport to show that relative price changes induce behavior usually credited to changes in taste. Their argument was belligerently positivist, holding that economic empiricism could be extending well into the area of non-disputable tastes. Becker and Stigler posit a utility function whose arguments include holdings of other market goods, time, human capital, and other inputs into producing commodities which are the consumers’ objects of choice. Given such a reformulated utility function, it becomes possible that the devotion of time and other resources to a particular line of
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consumption can lower the costs and increase the quantity demanded of that commodity line. If so, we may have a case where increased consumption leads to still further increases stimulated not by changing tastes but instead by relative price changes. If so, the behavior appears as addiction; if the time and resources “spent” on the consumption line increases the human capital conducive to enjoyment of the activity, Becker and Stigler call the addiction “beneficial.” Music appreciation is given as an example; the more time one spends listening to music, the more one’s understanding of it goes up, which in turn lowers the cost of producing more satisfaction from listening to music. The accumulation of time spent listening to music, then can be explained not by the non-illuminating argument that learning has altered tastes, but by the lower cost and higher relative return which occurs as the learning takes place. The addictive behavior has an economic cause. This line of argument permits Becker and Stigler to show that the addictive behavior is more likely to occur the younger the consumer is at the point of initial exposure and the more elastic the demand for the activity in question. At first glance, the notion of beneficial addiction has rather startling appeal as a description of entrepreneurial behavior. It could possibly explain, for example, why so many entrepreneurs are recidivists.6 The “shadow price” of being an entrepreneur is low because individuals have engaged in the behavior before and thus each hour of time engaged in entrepreneurship yields a higher return. This example, however, illustrates part of the problem with formalism, namely that it often obscures the primary question at hand in its redefinition of the problem. While Becker and Stigler’s theory illustrates that repeat entrepreneurs have a greater
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return on each hour spent on each hour engaged in the entrepreneurial process, it does not explain it. After all, what made the individuals become entrepreneurs in the first place? Becker and Stigler’s theory would suggest that it was those individuals with the lowest price of engaging in entrepreneurial behavior. This again begs the question of why the price is lower for some people than others. Why do some people face an elastic demand curve for entrepreneurship and others do not? More to the point, if entrepreneurship is recognized as consumption behavior, one is driven to ask: what do they like about the entrepreneurial process? What causes individuals to pursue the activities which encompass entrepreneurship? Some have recently argued that it is genetic (Cicolaou et al. 2008)? What about heartbreak? Samuel Morse missed his wife’s funeral because of the slowness of mail delivery, inspiring him to develop the telegraph (Lee 2000). It seems to us that any theory that explains Morse’s actions as a rational response to a relative price change is missing the true explanation. (2) That question brings us to the second issue. Because they want intrinsically (and increasingly) to engage in the entrepreneurial process, entrepreneurs are willing to engage in behavior which from a production standpoint appears irrational.7 That process involves commitment to objectives which are undemonstrated, unproven, and where creativity – the production of value from nothing – is frequently of the essence. This process requires sacrificing, not maximizing, behavior. Entrepreneurs commit to an idea not only in expectation of a pay-off; they commit because they are charmed by the idea. As a result, entrepreneurs are willing to bear transactions costs to a degree far greater than the rational producer.
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Douglass North (1992) offers a comprehensive view of his attempts to understand the significance of transaction costs for real economies. He has shown how institutions may develop which reward privileged groups so as to either dramatically impede or allow economic development depending on whether they raise or reduce the costs of transacting. North argues convincingly that economic phenomena can be understood only within the context of a prevailing institutional framework and that a major shortcoming of economics is its failure to provide a theory of institutional change. It is clear throughout his work that North considers entrepreneurs to play a crucial role in institutional dynamics. He describes repeatedly how the maximizing behavior of firms (and political entrepreneurs) probe and test the prevailing institutionally-sanctioned incentives and, in the process, change them.8 But North curiously offers no particular theory of entrepreneurship. The closest he comes, perhaps, is to observe that the tasks of entrepreneurs consist of discovering markets, evaluating techniques, and managing employees, all of which require not only heavy investment in information but also tremendous tacit knowledge of the particular institutional context in which they operate (North 1992, 77). What is significant about entrepreneurs, which North ignores, is precisely their unique willingness to bear transactions costs. They resist allowing legal, political, and financial institutions to stand in their way.9 They surmount the burden of transacting by absorbing high costs personally rather than to pay market value for specialized services. In bearing these costs, to a degree belying theories of rationality, entrepreneurs also reduce the inertia such costs exert upon society at large. This extraordinary effort is justified more by their commitment to achieve than by expected returns. There is idealism
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in play; they intend to promote change in institutions and incentives. Their contribution to institutional change is not limited to emergent and unintentional outcomes of entrepreneurial maximizing behavior. Their brand of idealism may be overlooked since entrepreneurial vision, unlike prophetic vision, is often handsomely rewarded. In carving out a role for entrepreneurs as agents of institutional change, North has raised an issue far beyond the limits of this discussion. Here we have a missing link between an economy forever trapped within its own incentive structure with all agents maximizing and therefore never altering that structure. Furthermore, understanding this link requires an appreciation for perceptions, ideas, and tacit knowledge which lies outside of the formal modeling of behavior. As North (1992, 111) puts it: Social scientists have incorporated the costliness of information in their models, but have not come to grips with the subjective mental constructs by which individuals process information and arrive at conclusions which shape their choices…. Our preoccupation with rational choice and efficient market hypotheses has blinded us to the implications of incomplete information and the complexity of environments and subjective perceptions of the external world that individuals hold… This theme — that behavior takes place within a world of meaning rather than mechanics — is probably addressed most passionately in the work of Lavoie (1991), which brings forward the third issue. (3) Lavoie (1991) objects to the view that entrepreneurship is mere maximizing adjustment to pre-existing but heretofore unrecognized profit opportunities. Entrepreneurship instead incorporates radical change, an unanticipated break with the
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past, an injection of novelty and innovation which cannot be explained by mechanical adjustments to newly recognized opportunities and constraints. Entrepreneurs do not passively ‘notice,’ they actively and purposefully ‘discover.’ They are able to do so because of their imbeddedness in, and special sensitivity to, the extent culture. Culture is a complex of meanings that serves as a framework for shared understanding of concepts and social events. It is a language cum discourse, a ‘continuing conversation,’ to which events are referred to for interpretation. To summarize Lavoie roughly, entrepreneurs can discover and evaluate prospects for radical change because they tap deeply into this intersubjective world of discourse and sense its direction and possibilities for change. Entrepreneurs do not so much rationally exploit the world as they interpret it: Interpretation suggests the point the profit opportunities entrepreneurs discover are not a matter of objective observations of quantities, but a matter of perspectival interpretation, a discerning of the intersubjective meaning of a qualitative situation. Profits are not measured; they are “read.” Entrepreneurship, I argue, is primarily a cultural process. The seeing of profit opportunities is a matter of cultural interpretation. And like any other interpretation, this reading of profit opportunities necessarily takes place within a larger context of meaning, against a background of discursive practices, a culture. (Lavoie 1991, 36). Study of entrepreneurship, too, requires interpretation. It must provide a recognition and disclosure of the entrepreneur’s tacit knowledge which is difficult to formalize. Entrepreneurs are social as well as individual and their ability to see opportunity in their novel readings of situations comes from their unusual sensitivity to
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others’ thoughts and desires as they are transmitted through common culture. They are not isolated loners; indeed, their sensitivity to what others are looking for gives a public character to the decisions they make (Lavoie 1991, 49). The social nature of behavior is a connection to North’s theory of institutional change. Their choices are not merely individual but are aligned with their reading of others’ minds. They assume the authority to gain advantage by asserting the wishes of all. Concomitantly, they accept responsibility, both consciously and not, for altering institutional incentives that might obstruct such assertion. This behavior is heroic more than utilitarian, but not entirely so; as consumers, they like the process of provoking change, proving possibilities, and receiving the consequential approbation of others. If they profit, being proven right is the best reward of all.
Conclusion The three approaches of entrepreneurship as consumer behavior, as agency of institutional change, and as cultural interpreter offer the prospect of deepening the understanding of entrepreneurs as economic actors. None are developed sufficiently to guarantee tractability. None are mainstream. But each is strategic; each corresponds to a profile of entrepreneurship which makes sense in the context of studies of the subject, at least those by non-economists. They center on some questions we would like answered. None, clearly, yield easily to mathematical expression, at least for now. Until we improve our bearings it is best to encourage conversation and conjecture rather than to demand or expect mathematical rigor.
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Footnotes 1
Parker (2005) cites this as one of the “canonical” theoretical articles in the economics of entrepreneurship. One of the first major papers to put entrepreneurship in a static equilibrium occupational choice framework, Kihlstrom and Laffont (1979) has been cited 379 times as of November 2007, according to Google Scholar. 2 See, for example, Kihlstrom and Laffont (1979), Holmes and Schmitz (1990), Blanchflower and Oswald (1998), Gabszewic and Didier (2007), Clemens (2008). For an excellent overview and assessment of this literature, see Bianchi and Henrekson (2005). 3 Formalism, of course, has different definitions depending on the discipline and the methodological approach (Backhouse 1998). Here we use formalism primarily to refer to the use of mathematical techniques in entrepreneurship research, although our argument also spills over to the impact of mathematisation on methodological formalism. 4 In this context see the work of Holcombe (2007), especially chapter 2 on the difference between economic growth and economic progress. Growth is the result of increasing inputs into the production process (such as capital and labor) and technological advance, while economic progress is about changing the very nature of output and consumption opportunities. While entrepreneurs contribute to both economic growth and economic progress, it is entrepreneurs’ desire to change the way things are done that contributes to economic progess. 5 See, for example, the discussion in Shane et al. (2003). The authors discuss the importance of ego, goal setting, and independence on entrepreneurial motivation. 6 An interesting example of potential research into the psychology of entrepreneurs (although at the macro level) is by Koellinger et al. (2007). Using data from population surveys across 18 countries, the authors find that individuals’ confidence levels are a strong predictor of business start-up activity. They find evidence that higher levels of start-up activity might be the result of overconfidence within countries, based on the negative correlation between the level of confidence and the survival rate of new enterprises. 7 This is consistent with the literature showing that entrepreneurs tend to be very optimistic people (Cooper, Woo, and Dunkelberg, 1988). 8 Political entrepreneurship, of course, can be both productive and destructive. See, for, example, Holcombe (2002). 9 This is consistent with the literature showing, for example, that liquidity constraints may not be that important (Hurst and Lusardi 2004).
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