Institutions and Entrepreneurship: Pushing the Boundaries
Abstract: New institutional economics (NIE) and Austrian economics (AE) both emphasize the role that institutions play in facilitating or impeding entrepreneurship and hence economic growth. In this paper, we discuss the complementarities between AE and NIE for advancing our understanding of the relationship between institutions and entrepreneurship. We argue that a subjectivist view of institutions, entrepreneurial microfoundations, and capital heterogeneity can enrich our understanding of within-country variation in entrepreneurial strategies, institutional evolution, and the relationship between institutions and production processes. We hope our discussion serves as an invitation both for further theoretical collaboration between the two camps and as a spur to applied research at the intersection of institutions and entrepreneurship.
JEL Classification: H35, L5, M13, 031, P14
Scott Burns ([email protected]) is assistant professor of economics at Southeastern Louisiana University. Caleb S. Fuller is assistant professor of economics at Grove City College.
We thank Ennio Piano, David Lucas, Jeff Herbener, Rosolino Candela, and Chris Coyne for helpful commentary. We are also grateful to two anonymous referees and the editor for insightful remarks. The standard disclaimer applies. Both authors shared equally in the writing of this paper.
New institutional economics (NIE) has made important contributions to our understanding of the relationship between institutions and entrepreneurship.1 NIE scholars stress the critical function that institutions—society’s “rules of the game”—play in constraining and enabling entrepreneurial action (North 1986; Baumol 1990; Murphy et al. 1991; Williamson 2000). Austrian scholars have also written extensively about institutions and entrepreneurship, work that predates the mid-twentieth-century advent of NIE. Beginning with Carl Menger’s ( 2007; 1883) analysis of the spontaneous emergence of social orders, as well as Ludwig von Mises’s ( 1990) and F. A. Hayek’s (1945; 1948) comparative analyses in the socialist calculation debate, Austrians have always been concerned with how choice generates institutions and how these institutions influence social outcomes in turn (Lavoie 1985; Langlois 1986, 1992, 165; Foss 1997; Garrouste 2008). Especially in the twentieth century, Austrians have also stressed the central role that entrepreneurs play as the “driving force” of the market process (Mises  1998; Hayek 1968; Kirzner 1973; Klein and Bylund 2014; Bylund 2019).
Given these overlapping themes, it is unsurprising that there has been some collaboration between the traditions. At the same time, it is also surprising that this exchange of ideas has not been more thoroughgoing. Numerous authors have suggested that there are gains from trade to be had from merging aspects of each tradition (see Langlois 1986, 1992; Boettke 1989; Foss 1994, 1997; Boettke and Coyne 2003, 2009; Sima 2004; Foss and Klein 2009; Manne 2014; Bylund and McCaffrey 2017; McCaffrey 2018; Piano and Rouanet 2020). These contributions represent promising movements in the direction of integration; nevertheless; we believe that there remain unseized profit opportunities from further integrating the two traditions to improve our understanding of the institutions- entrepreneurship link.
This paper identifies three areas where NIE literature on entrepreneurship may benefit from more thoroughly incorporating Austrian insights. The first deals with a recent puzzle in NIE literature: explaining within-institution variations in entrepreneurial strategy––that is, why some entrepreneurs abide by existing rules while others seek to alter or evade them. The second deals with a subject that prominent NIE scholars such as Douglass C. North (1994) contend has not been satisfactorily resolved: explaining why and how institutions evolve over time. The third area addresses an even less well-established but promising research stream: the interaction between institutions, capital heterogeneity, and entrepreneurial action.
Suggesting how long-established Austrian insights can enrich NIE thinking on entrepreneurship is not to imply that the influence should be unidirectional. As this paper will demonstrate, Austrians can also incorporate NIE ideas in several areas. These include extending well-developed Austrian notions of entrepreneurship beyond “productive activity” and the adoption of new approaches which emphasize the distinction between “economic” and “legal” property rights.
This article achieves three tasks. First, it demonstrates the overarching complementarity between Austrian economics and NIE, particularly for furthering understanding of the institutions-entrepreneurship “black box.” Second, it highlights existing work that points in the direction of synthesis. Third, it proposes future research avenues based on our proposed integration of the traditions. The objective here is not to provide a comprehensive overview of the ways that these traditions can benefit from each other, nor is it to provide a final word on the proposed research ideas. However, the hope is that this article will spur further collaboration between the two traditions that will help resolve ongoing puzzles in the entrepreneurship literature.
The article proceeds as follows. First, the elements of both Austrian economic (AE) and NIE that are crucial for better understanding institutions and entrepreneurship are reviewed. A discussion of the prior interaction between the two traditions follows, and some ways in which they can complement each other are suggested. The final section builds on that synthesis to identify concrete ways that Austrian ideas can inform our approach to questions at the intersection of institutions and entrepreneurship. In doing so, it also raises several questions which will hopefully inspire future research. The article concludes with implications.
AUSTRIAN ECONOMICS AND THE NIE–KEY THEMES FOR ENTREPRENEURSHIP
Austrian economics is marked by its subjectivist foundations. Of course, all contemporary economic traditions recognize the subjective nature of value, though the Austrian emphasis is the most thoroughgoing (Stringham 2010).2 A key aspect, though, of the Austrians’ encompassing subjectivism has been to show that each person evinces not merely different preferences, but also divergent knowledge and expectations. Unsurprisingly, then, Austrians have been the most systematic exponents of subjectivism within economics, an emphasis that extends to Austrian theorizing on entrepreneurship and management (Klein et al. 2008, 4).
The subjective nature of knowledge is likely the most widely recognized aspect of Austrian subjectivism. In his much-cited 1945 paper, Hayek argued that prices serve as knowledge surrogates since “local knowledge” is not given in its totality to any single mind; rather, it is dispersed throughout society in the minds of individuals.3 As Hayek emphasized, this knowledge “of the particular circumstances of time and place” can only be discovered in the context of a market economy.
Although Austrians have consistently integrated subjectivism with their theories of value, knowledge, expectations, and even capital (described below), they arguably have not applied it as thoroughly to institutions. This gap is puzzling given that many of the most seminal Austrian contributions (i.e., the emergence of money and law, the socialist calculation debate) either explained the origins of institutions or engaged in comparative institutional analysis (Menger  2007; 1883; Mises  1990,  1998; Hayek 1945, 1948). These contributions were deeply rooted in subjectivism, as they sought to explain real-world institutions in terms of the personal values and knowledge of the relevant actors. (The way that further application of subjectivism to institutions can provide answers and generate new research directions at the interchange of institutions and entrepreneurship is described below.)
The Austrian tradition is also widely recognized for its pioneering work on entrepreneurship and the central role accorded to entrepreneurs in driving the competitive market process (Mises  1998; Kirzner 1973; Boettke and Coyne 2003; Foss et al. 2008; Klein and Bylund 2014).4 Austrians eschew static general equilibrium models, with their assumptions of perfect information, which dominate neoclassical economics.5 Instead, they favor a dynamic, processoriented approach—one that emphasizes how entrepreneurs utilize their unique knowledge while responding to continuous profit and loss feedback. Mises ( 1998, 249) famously described the entrepreneur as the “driving force” of this process, the catalyst of change who drives the dynamism of the market economy. Whereas the defining feature of long-run equilibrium in the neoclassical approach is zero economic profits, Austrians place the ceaseless earning of profit and loss at the forefront of the dynamic market process (Mises  1951).
Austrians have advanced somewhat differing perspectives on the so-called market process. For Israel M. Kirzner (1973, 1996, 1997, 2009), the market process describes entrepreneurs’ ceaseless attempt to seize profits, which via arbitrage, continually drive disequilibrium states toward equilibrium. Continuous learning is key to this framework. Joseph T. Salerno (1993, 1994) argues for a narrower conception of market process that emphasizes how those less skilled at forecasting the future are continuously and systematically weeded from the marketplace. Arguably, both of these ideas find textual justification in Mises ( 1998,  1951), but what these varying conceptions share in common is that entrepreneurs, responding to profit and loss, are the primary drivers of this competitive process, once more standing in sharp contrast to general equilibrium models, where, based on the assumptions, the entrepreneur has no role to play.
A corollary of market process analysis is that entrepreneurial decision- making cannot be characterized by stochastic models, where outcomes are unknown but which are drawn from a known probability distribution. Instead, it is better characterized by the uncertainty described by Frank Knight (1921),6 where the distribution of possible outcomes is itself unknown. Entrepreneurs therefore act under conditions of uncertainty, drawing on their subjective knowledge to anticipate opportunities, a function eliminated by static equilibrium models that assume perfect information and thus preclude genuine uncertainty (Mises  1998, 249–56).
The speculative function of entrepreneurship is a universal human function, not a job title or characteristic of a subset of individuals (Klein 2008). This universal speculative element owes to the fact that action is future oriented, that the future is uncertain, and that all actions therefore confer either psychic profits or losses. At the same time, the Austrian tradition also designates a specific set of economic actors as “entrepreneurs,” in contrast to wage earners, landowners, or consumers. In the Austrian framework, entrepreneurship is the element which organizes and arranges the factors of production but is not a factor of production itself.
This basic conception of the entrepreneur has generated a flurry of literature attempting to demonstrate that “innovation” (Schumpeter 1934), “alertness” (Kirzner 1973; Sautet 2018), “judgement” (Foss and Klein 2012), or “creativity” (Alvarez and Barney 2007) is the essence of the entrepreneurial function. These debates have important implications for market theory and for integrating entrepreneurship with organizational economics, but they have less direct bearing on the interface between institutions and entrepreneurship that is central to NIE literature. We concur with Matthew McCaffrey (2018, 190) that “a major advantage of [William J.] Baumol’s argument is that its value does not depend on any particular theory of entrepreneurship.” To that end, entrepreneurship is here defined as “profit seeking”—a “big tent” description broad enough to capture all major conceptions. Additionally, the phrase “entrepreneurial action” is often used, because “discovery,” “judgment,” and “creation” all require subsequent action for there to be any real-world impact.
Austrians have also long stressed the heterogeneity of capital, an emphasis that begins with Menger’s ( 2007) development of an intricate capital—or production—structure. At least until the emergence of certain NIE concepts, Austrians were unique in stressing that capital is heterogeneous not only in form but also in function (Lachmann  1978; Lewin 1998; Garrison 2001). As Ludwig M. Lachmann ( 1978, 2) argued, heterogeneity in function, or “use,” refers to the multiple specificity of capital goods, meaning that “each capital good can be used for a limited number of purposes.” Capital goods also vary according to their complementarity with other capital goods, a point that is implicit in Hayek’s (1945) argument. Knowledge of the “particular circumstances of time and place” includes the degree to which capital goods (and labor) are substitutable for one another.
As with subjectivism, capital heterogeneity and entrepreneurship are inextricably linked. Entrepreneurs must continuously allocate capital goods to what they perceive is their most profitable use, which requires that they judge their complementarity (Mises  1998, 252-254; Lachmann  1978; Foss 2012).7 The heterogeneous attributes of capital goods must first be subjectively perceived and interpreted by entrepreneurs before they can be integrated into their production plans (Kirzner 1966). A key aspect of entrepreneurship, then, is exercising judgment over how to best combine and utilize heterogeneous capital goods (Foss et al. 2007). As Lachmann ( 1978, 16) notes, “As long as we disregard the heterogeneity of capital, the true function of the entrepreneur must also remain hidden.”
New Institutional Economics
NIE arose in the latter half of the twentieth century as an effort to revive core elements of classical political economy and to return institutions to the forefront of economic analysis. Rooted in Ronald H. Coase’s seminal contributions (1937, 1960), the term new institutional economics was coined by Oliver E. Williamson in 1975. NIE, which came to represent an amalgam of transaction cost, property rights, law and economics, public choice, and agency theorizing, blossomed around the time the Austrian tradition was experiencing its own revival, sparked by seminal publications (Rothbard [1962, 1970] 2009; Kirzner 1973), the famed South Royalton conference in 1974, and Hayek’s Nobel Prize in 1974. NIE scholars frequently addressed institutional issues that, with a few notable exceptions, were not systematically examined by Austrians in the decades between the Keynesian Revolution and the Austrian revival (Foss and Klein 2009). Coase and Williamson devised transaction cost theories of the firm and other organizations. Armen A. Alchian and Harold Demsetz (1972), Steven N. S. Cheung (1983), and Yoram Barzel (1997) offered somewhat differentiated transaction cost theories of the firm, while also seeking to explain how alternative property rights arrangements affect and are affected by economic activity.8 North and Baumol examined the role that society-wide institutions play in providing a framework for economic activity.
What unites these various strands of research is their focus on the role that institutions—the “humanly devised constraints that structure human interaction”—play in providing guideposts for human activity (North 1994, 360; Foss and Garzarelli 2007). Naturally, NIE’s emphasis on how institutions structure incentives has had an important influence on the emerging economics of entrepreneurship. This focus on the guiding role of institutions for entrepreneurial actors was most famously noted by Baumol (1990), who argues that what differs between nations is not the supply of entrepreneurial talent but its allocation between productive (e.g., innovation), unproductive (e.g., rent seeking), and destructive (e.g., crime) activities. This allocation is determined by the relative payoffs that a society offers to such activities, and these payoffs are determined by the prevailing institutions (Baumol 1990; Boettke and Coyne 2003; Boettke and Piano 2016; Lucas and Fuller 2017; McCaffrey 2018). The primary conclusion is that entrepreneurship is a proximate cause of growth but institutions are the fundamental cause.
Baumol’s classic 1990 paper has sparked a research program spanning both NIE and the “mainstream” entrepreneurship literature, with scholars deploying his framework to explain variation in the allocation of entrepreneurial activity across different nations—that is, why some nations have high rates of productive entrepreneurship while others have a larger share of unproductive activity (see, for instance, Coyne and Leeson 2004; Acs 2008; Aidis, Estrin, and Mickiewicz 2008; Sobel 2008; Bjørnskov and Foss 2008, 2016; Minniti 2008; Estrin et al. 2013; Stenholm et al. 2013). Furthermore, Baumol’s work opened the door to extending entrepreneurship beyond the application to “productive activity” found in the works of Mises, Murray N. Rothbard, and Kirzner. At the same time, his framework stands to be enriched by further incorporation of subjectivism, process, and heterogeneity––a project that is advanced in the final section of this article.9
FINDING COMMON GROUND: SYNTHESIZING AUSTRIAN AND NIE SCHOLARSHIP
What might a synthesis between the Austrian and NIE approach look like, specifically for furthering our understanding of the institutions-entrepreneurship nexus? To answer this question, one first must ask whether a synthesis is possible given the methodological differences between the two traditions. Certain strands of NIE are, indeed, deeply rooted in neoclassical economics, though it is generally seen as a relaxation of the stricter, more unrealistic assumptions of the neoclassical framework (Eggertsson 1990). Given that Austrians came to understand their unique identity in a sharp critique of core aspects of the emerging “neoclassical synthesis” during the socialist calculation debate, some may question whether such an integration is possible.10
To provide an overview of the Austrian assessment of NIE, we find it useful to follow Lance Edwin Davis and North (1971) in distinguishing between the “institutional environment” (society- wide rules that often arise spontaneously) and “institutional arrangements” (organizations that are usually the consequence of conscious design).11 Sometimes the distinction is described as being between “institutions” and “organizations,” though admittedly, this line is not always easy to draw and some have challenged its existence altogether (see, for example, Cheung 1983).
Most Austrian criticism of NIE has focused on institutions, specifically Coase (1960), the locus classicus of what, under Stigler’s influence, came to be known as the “Coase theorem.” Austrian scholars advanced the idea that Coase was hostile to private property rights because his work can be read as suggesting that courts could reallocate rights on the basis of perceived willingness to pay when transaction costs are prohibitive (Block 1977, 1995; Rothbard 1979, 1982; Lewin 1982; Cordato 2004; Hülsmann 2004). Additionally, Austrians have argued that courts striving for Kaldor-Hicks efficiency encounter insuperable difficulties, namely that subjective costs cannot be aggregated and that assigning property rights encounters the calculation problem (Rizzo 1980; Lewin 1982; Stringham 2001). Given the “Posnerian” wealth maximization appropriation of Coase, such criticisms are justifiable, yet they may also explain why there has been more synthesis of Austrian ideas with NIE thinking on “organizations,” rather than with “institutions” proper.
With a few notable exceptions, Austrian assessment of NIE contributions to organizations has been largely positive, beginning with Rothbard ([1962, 1970] 2009) and including Nicolai J. Foss and Peter G. Klein (2012). The first noteworthy exception is Donald J. Boudreaux and Randall G. Holcombe (1989), who argue that the Coasian equilibrium framework is in tension with Austrian concerns for disequilibrium, and the second is Per Bylund (2014), who argues that Coase (1937) was attempting to provide justification for central planning. In contrast to these misgivings, Klein and Foss develop a theory of the firm—a subject that has been the primary NIE focus from its beginning—by incorporating Austrian insights into a framework that is grounded in Coase (1937; Klein 1999; Foss and Klein 2009, 2012). Foss and Klein (2012) see the Austrian emphasis on the entrepreneur as necessary for a robust theory of organization, arguing that entrepreneurs establish firms because the judgment they exercise is noncontractible and can thus only be expressed by forming a firm.12
More recently, Ennio E. Piano and Louis Rouanet (2020) have argued that NIE scholars should incorporate insights bequeathed by the calculation debate. For their part, Austrian scholars ought to adopt a greater appreciation for the fact that private property rights are costly to establish and the corollary that, even in unhampered markets, not every asset will be privately owned due to the existence of transaction costs (Barzel 1997; Allen 2000; Piano and Rouanet 2020).13 Furthermore, Piano and Rouanet (2020) maintain that economic calculation over which property rights to establish can only occur in an institutional environment where some prices already exist and are free to arise. However, like Foss and Klein (2012), Piano and Rouanet (2020) develop their arguments in the context of organizational economics. Thus, one irony given the Austrians’ Mengerian origins is that in the last thirty years Austrian work in “institutio
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