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Capital Goods and the Firm

Mises Daily: Friday, October 05, 2012 by

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What Are Capital Goods?

In chapter 5 of Organizing Entrepreneurial Judgment, Nicolai Foss and Peter Klein articulate the real nature of capital goods. They explain how the treatment of capital goods has varied among different schools of economic thought, as well as the implications for the firm and the entrepreneur resulting from differing conceptions of capital goods. Foss and Klein (FK) argue that the Austrian School of economics offers the most realistic conception of heterogeneous capital and thus lays the best framework for developing a connection between a sound theory of entrepreneurship and a sound theory of the firm.

Capital Goods According to Modern Mainstream Economics

FK argue that modern economics unfortunately does not give much attention to capital goods. Therefore a satisfactory conception of capital goods is not found in the majority of the economics literature. FK note that the predominant treatment of production is the production-function view (PFV) that stems from the neoclassical school of economics. In this view, capital goods are a "homogeneous blob" or what is sometimes given the nickname "shmoo." This shmoo can be defined as an infinitely elastic, fully moldable factor that can be substituted costlessly from one production process to another.

Neoclassical economics treats the firm as a "black box" that transforms inputs of homogenous capital (shmoo) into output (finished goods) that are sold on the market. The PFV does not take the organization of the firm into account and assumes that the knowledge necessary for production is obvious and can be easily transferred. The PFV leaves one with a simple, unrealistic portrayal of the production process that brings goods to the market.

FK mention some key implications that the PFV has on the firm and the entrepreneur. Since the organization of production is inconsequential in the PFV, a theory of the firm (the entity that organizes production) is inconsequential according to this view. For the same reason entrepreneurs (ultimate decision-makers composing the firm) are not of any real importance in the PFV. The PFV takes a very non-complex view of the world and thus oversimplifies economic reality and completely diminishes the role of the firm and the entrepreneur.

Capital Goods as Heterogeneous Goods

When capital goods are viewed as heterogeneous instead of homogenous, we are left with entirely different implications for the firm and the entrepreneur. Capital heterogeneity means that different capital goods have varying physical features, uses, and attributes. This is directly opposed to the view of homogenous capital. FK note that many working toward a theory of the firm have already accepted the heterogeneous nature of capital in their writing. For instance, transaction-cost economics and property-rights theory conceive assets as having specific uses and recognize that, in an uncertain world, the firm must adapt and change how they use assets over time.

FK note that management scholars view firms as bundles of heterogeneous resources and believe the interaction among resources is what give certain firms competitive advantages over other firms. Likewise, the "old" property-rights theory advanced by Ronald Coase and Yoram Barzel recognizes that assets have various attributes (characteristics, functions, or possible uses of assets, as perceived by an entrepreneur).

FK note that the above views of capital heterogeneity can be best unified by the capital theory established by the Austrian School of economics. Austrian capital theory recognizes that there is a complex structure of production. The structure of production consists of countless stages within a very complex hierarchy. Demonstrating this with a house as a final consumer good can aid in understanding this. A finished, fully constructed house would be a consumer good, a good of the lowest order in the capital theory. Numerous goods such as wooden beams, drywall, heavy machinery, shingles, windows, etc., must be used in constructing the house. These are goods of a higher order. The goods necessary to produce the wooden beams, drywall, etc., are of an even higher order, and so on.

Austrian capital theory recognizes that different capital goods cannot be easily substituted for each other. A window cannot simply be used to do the same thing as a wooden beam. Substitution between capital goods is limited. This theory also asserts the reality that production takes time. Factors of production are committed in the present for the production of consumer goods that will not be sold until a time in the future.

Austrian economist Israel Kirzner claims that capital goods are heterogeneous because they play particular roles within an entrepreneur's production plan, thus establishing a link between entrepreneurship and capital goods. A given capital good has various attributes that may vary over time as circumstances change. Entrepreneurs do not have omniscient knowledge and therefore do not know all relevant attributes of their assets at any point in time. Thus they must make the best decisions they can (with limited information) with how they use and combine their assets. Entrepreneurs have the potential to create and discover previously unknown attributes of capital goods as time goes on. They also have incentive to own capital goods to acquire legal rights to the income generated by an asset as well as the attributes they create and discover.

Entrepreneurial Judgment in a Complex Capital Structure

FK tie in the theory of complex systems, most attributed to Herbert Simon and Stuart Kauffman, to complement the Austrian economist's view of the capital structure. The theory of complex systems asserts that in the real world we have systems composed of subsystems. There are different ways in which subsystems interact in a system. The capital structure can be thought of as a non-decomposable system in which the interactions among subsystems are essential. Suffice it to say, FK argue that when the capital structure is viewed this way, we can establish a metaphor for the capital structure as a "landscape" of combinations among capital goods.

This conception of a complex capital structure has multiple implications for the entrepreneur. For one, entrepreneurs will search the "landscape" in pursuit of the best, most profitable combinations of capital assets. This is not simply a process of trial and error. The entrepreneur uses his judgment to decide which goods are relevant to his production and how to combine the goods. The entrepreneur's experience influences his interpretation of the "facts" and thus helps guide him in his search. FK note that experiential knowledge can underlie innovative activity in established, mature firms and give them sustained competitive advantage, further challenging the notion that only new or small firms are entrepreneurial. Lastly the entrepreneur will experiment with the assets he has. He may do this in various ways such as mergers and acquisitions with other firms or trying out new combinations of his assets within his own firm.

FK make a strong case that scholars studying entrepreneurship and the firm should view capital goods as heterogeneous rather than homogeneous goods. In their view, the Austrian School's view of capital is most consistent with capital heterogeneity, most descriptive of the real world, and thus superior to alternative conceptions of capital held by mainstream economists. FK view capital heterogeneity as a crucial link in connecting a theory of the entrepreneur with a theory of the firm. Having laid the groundwork for a sound capital theory, FK explore entrepreneurship and the firm in their next chapter.

Entrepreneurship and the Economic Theory of the Firm

Beginning with chapter 6, Nicolai Foss and Peter Klein focus on actually making the connection between the theory of the entrepreneur and the theory of the firm. Specifically in chapter 6, FK dive into existing theories of the firm and the role for the entrepreneur within those theories. While FK critique the form of theories of the firm for crowding out the entrepreneur, they also focus on insights that can be pulled from these theories and how to build on them for a greater understanding of entrepreneurship within the firm.

Established Theories of the Firm

Neoclassical Theory

In earlier chapters of their book (touched on in my previous article), FK argue that neoclassical economic theory leaves much to be desired in understanding the firm. Within the neoclassical school, FK argue, "The firm is a set of cost curves, and the 'theory of the firm' is a calculus problem. There is nothing for an entrepreneur to do."

The firm becomes a "black box" in which input factors of production are transformed into an output of finished goods to be sold on the market. FK note that this treatment of the firm is unable to account for many real-world business practices (e.g., vertical and lateral integration, mergers, franchising, research joint ventures, etc.).

Coase's Theory of the Firm

Economist Ronald Coase saw that the neoclassical theory of the firm did not satisfactorily explain why firms come into existence. He emphasized that a firm comes into existence to reduce the transaction costs involved in production processes. Coase saw that there was a cost to discovering relevant prices for goods and secondly a cost for executing separate contracts for all the transactions necessary in coordinating production processes. The example of producing a house I used above demonstrates how complex production can be and the immense number of contracts that need to be made. Coase argued that inside the firm, the entrepreneur is able to reduce transaction costs by coordinating activities himself. He claimed that the main tasks in establishing a theory of the firm is to study the existence of the firm, the boundaries of the firm and the internal organization of the firm.

Coase's view of the entrepreneur contrasts with Frank Knight's view. To Coase, the primary role for the entrepreneur is to compare the costs of "organizing specified transactions in given governance structures." The main focus for Coase is whether the entrepreneur will contract with independent suppliers and distributors or hire employees to work under him. This is how he studies the boundaries of the firm. In contrast, Knight focuses on the quality and quantity of the assets owned by the entrepreneur. Knight is concerned with ownership boundaries (ownership of assets in total) more so than solely employment boundaries. One could imagine an entrepreneur in Coase's theory who does not own assets. Ownership is a must in Knight's conception.

Modern Organizational Economics

FK argue that there are four main strands in modern economics that contribute to a theory of the firm. They are transaction-cost economics, the nexus-of-contracts view, agency theory, and team theory. A common theme within these strands is a belief that economics must move beyond analysis done while assuming perfectly competitive markets to better understand the firm. FK also note that within all these theories, "relevant units of analysis can be matched to particular alternatives to satisfy some efficiency criterion."

FK give a simple example of game theory to demonstrate the framework in which the firm is analyzed in modern economics. I will draw heavily on their quotes in order not to misrepresent their analysis of the theory. In essence, game theory is a way to demonstrate that humans will not pick the utility-maximizing (most efficient, first-best) arrangement when making contracts with one another. In explaining game theory, FK state "agents who anticipate opportunism on the part of their contractual partner will refrain from taking efficient actions or making efficient investments." Essentially there are incentive conflicts that prevent the "most efficient" contracts from being made when two individuals are bargaining with one another. Much of this stems from fear within each individual that the other individual will not honor the agreement. Regarding how this relates to the firm, FK write "transferring a transaction or activity from a market to an organization context means that the agreement will be honored."

The Modern Theory of the Firm and Entrepreneurship

FK critique the modern theory of the firm for making some unrealistic assumptions that crowd out the role for the entrepreneur. One of them being that these theories make very strong assumptions about the cognitive powers of agents. The theories assume that cognitive homogeneity, correctness, and constancy are characteristic of all agents. Agents all have common knowledge about the structure of the theoretical "game" as well as payoffs and strategies within the game. This treats individuals as if they have an "identical model of the world."

A second critique is that everything is given in the model. All decision alternatives are given. There is no need for experimentation; no learning takes place; and there is no place for entrepreneurs to come up with new, innovative contractual or organizational forms. FK explain, "Players have identical, shared beliefs about other players' strategies and these beliefs are consistent with some equilibrium in the game."

These modern theories also leave little role for individual motivation. Behavior is almost entirely modeled as a response to some external force. Experience has proven that intrinsic motivation from within is particularly important for being a successful entrepreneur. These theories unfortunately neglect such motivation. These theories also neglect heterogeneity and unrealistically assume that firms possess the same capabilities.

FK also argue that behavior within and among firms should be analyzed as a process over time rather than by a moment-by-moment maximization problem. They write, "If firms are composed of heterogeneous, but complementary capital assets, with entrepreneurial judgment required to determine the best combinations, then firms are formed and reformed as processes of experimentation and learning, not moment-by-moment optimization." FK also note that these theories engage in "suppressing margins," which they define as "prohibiting the agent from knowing or doing certain things within a given interaction structure (typically, by choosing extreme values for some variables)."

For example, many of these theories assume that agents have either full knowledge of something or no knowledge at all on the subject. This kind of modeling uses an extreme "on-off" approach in which reality is not modeled very well. FK point out that under such constraints "agents are not allowed to exercise entrepreneurship to somehow circumvent the interaction problems caused by the suppression of margins."

Existing Links between the Entrepreneur and the Firm

FK are mainly critiquing the form of modern theories of the firm. This does not keep them from finding much constructive insight in these theories toward building a theory of the firm. While this chapter focuses on analyzing the form taken by modern theories, they close the chapter by noting some key insights provided by these theories. One is that an entrepreneur needs to transact with other individuals to exercise his judgment as embodied in a business plan. Additionally, "an entrepreneur must decide on contractual safeguards to protect entrepreneurial returns in designing the business model." They also note that these theories rightly deduce that the governance of a transaction may change over time.

The tone of FK's writing clearly conveys that they aim to work together with all economists in these fields to incorporate insights and build a sound theory of the firm that incorporates the reality of entrepreneurship. They see particular potential for incorporating the entrepreneur in the contractual approach to the firm. This is the focus of their next chapter.

Organizing the Firm

The last subject covered by FK is the internal organization of the firm. They argue that the organization of the firm is critical to how entrepreneurial judgment will be manifested at different levels of the firm. Ownership rights are foundational for this organization to occur.

Original and Derived Judgment

FK distinguish between original entrepreneurial judgment and derived entrepreneurial judgment within the firm. Original judgment is the judgment that belongs to the owner of the firm. The owner exercises original judgment in forming and executing a business plan. He has decisive control over the structure and goals of the firm. As a firm grows larger, the entrepreneur with original judgment will lack the information to make all firm decisions. At this point, the owner-entrepreneur delegates decision-making to other employees within the firm. FK call these employees with delegated powers "proxy-entrepreneurs." They are given the right to exercise derived entrepreneurial judgment over certain decisions. In other words, FK argue that the owner-entrepreneur makes "specifying decisions"; defined as a "set of formal and implicit contracts by which the entrepreneur delegates judgment to subordinates in the multi-person organization."

FK assert the truth, which has been underemphasized in the literature, that not all entrepreneurship is beneficial. Some entrepreneurial decisions are productive while others are destructive to the firm. Productive entrepreneurship results from employees using their discretion to create or discover new attributes of firm assets that add value to the firm. Destructive entrepreneurship occurs when employees use their discretion in efforts that reduce firm value.

Those with original judgment have the task of managing derived entrepreneurship. To expand derived entrepreneurial judgment to employees, the owner-entrepreneur will reduce constraints on employees. He then must manage the trade-offs between the productive entrepreneurship and destructive entrepreneurship of his employees. FK state some ways this occurs within businesses. Owners can give cash bonuses to their employees who add value to the firm through productive entrepreneurship. They can also give employees direct equity stakes or stock options to incentivize adding value to the firm. To constrain employees judgment, the owner-entrepreneur can do such things as set the "proxy-entrepreneur's" budget, determine which activities he's allowed to engage in, assign which people he is allowed to work with, and determine how he's allowed to use equipment.

Ownership and Internal Organization

FK explain that ownership rights are central to the internal organization of the firm. Ownership rights allow the owner-entrepreneur to make contracts with his employees and define how entrepreneurial judgment will be exercised throughout the firm. By loosening contractual constraints on how employees can use firm assets, the owner-entrepreneur expands the scope of entrepreneurship for lower-level employees. By tightening the constraints, he decreases the amount of entrepreneurial judgment his employees are allowed to exercise over firm assets.

To manage derived judgment efficiently, owners need to clarify two things up front. They must commit to rewarding employees for suggesting projects that the firm adopts. This gives employees incentive to seek out new and improved ways to use firm assets. If the firm does not commit to rewarding employees for finding better uses of assets, the employees will be less likely to take the time and energy to search for these uses as it will be too costly for them. Secondly, owners must communicate what types of projects they will adopt. This gives employees incentive to focus on searching for projects that owners want to pursue and thus makes the searching process more efficient.

Dispersed Knowledge, Authority, and Firm Organization

The last section of chapter 8 accounts for dispersed knowledge — most famously articulated by economist F.A. Hayek — and its implications for the firm. FK define dispersed knowledge as "knowledge that is not possessed by any single mind and which may be private, fleeting, tacit and subjectively held and is necessary for the effective allocation of resources." Thus, in a firm, management does not have all the knowledge to make the best allocation of resources. Critical knowledge is dispersed throughout the organization to lower-level employees.

FK argue that management deals with this reality by giving employees discretion. In large organizations, owners will typically set a structure for distributing discretion. Middle managers are delegated decision rights by owner-entrepreneurs. These middle managers then delegate decision rights to employees under them, and so. Thus, the firm is decentralized through this delegation of decision rights.

While management employs mechanisms to decentralize the firm in light of dispersed knowledge, authority is still retained by the owners for final decision-making. FK argue that a level of centralized authority is still necessary and beneficial even in light of dispersed knowledge. They argue it is better for employees to be constrained and guided to some degree rather than left to act solely according to their own judgment. FK point out a couple of reasons why. One is that a need for urgent coordination often arises. Authority, or the right to direct factors of production, must be exercised quickly in such urgent situations. Owners often have decisive knowledge in such cases. They can make a decision based on their information without involving other pieces of information. Therefore a hierarchy of authority is very beneficial when someone needs to make quick decisions with firm assets. The property rights held by the owner-entrepreneurs secure their right to make these final decisions.

Conclusion

To summarize FK's conclusion to chapter 8, tying together entrepreneurship and the firm allows for a dynamic and realistic understanding of how the internal organization of the firm is established and the effects it has on performance. The internal organization determines how derived entrepreneurial judgment will be exercised by employees as circumstances change. The owner-entrepreneur exercises original judgment in determining the amount of discretion his employees will have. Thus, entrepreneurship is exercised in some way at every level of the firm. The owners should not be mistaken as passive bystanders to the actions of the firm, for they are the ones who ultimately establish and adjust over time the structure for how entrepreneurship is to be exercised by firm employees.