Lesson 1, Topic 1
In Progress

1.3 The Evolution of Entrepreneurship Thought

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This section includes an overview of how entrepreneurship has evolved to the present day.

The following timeline shows some of the most influential entrepreneurship scholars and the schools of thought (French, English, American, German, and Austrian) their perspectives helped influence and from which their ideas evolved. Schools of thought are essentially groups of people who might or might not have personally know each other, but who shared common beliefs or philosophies.

  • The Earliest Entrepreneurship

The function, if not the name, of the entrepreneur is probably as old as the institutions of barter and exchange. Butonly after economic markets became an intrusive element of society did the concept take on pivotal importance. Many economists have recognized the pivotal role of the entrepreneur in a market economy. Yet despite his central importance in economic activity, the entrepreneur has been a shadowy and elusive figure in the history ofeconomic theory (Hebert & Link, 2009, p. 1).

Historically those who acted similarly to the ways we associate with modern day entrepreneurs –

namely those who strategically assume risks to seek economic (or other) gains – were military leaders, royalty, or merchants. Military leaders planned their campaigns and battles while assuming significant risks, but by doing so they also stood to gain economic benefits if their strategies were successful. Merchants, like Marco Polo who sailed out of Venice in the late 1200s to search for a trade route to the Orient, also assumed substantial risks in the hope of becoming wealthy (Hebert & Link, 2009).

The entrepreneur, who was also called adventurer, projector, and undertaker during the eighteenth century, was not always viewed in a positive light (Hebert & Link, 2009).

  • Development of Entrepreneurship as a Concept
  • Risk and Uncertainty

Richard Cantillon (1680-1734) was born in France and belonged to the French School of thought although he wasan Irish economist. He appears to be the person who introduced the term entrepreneur to the world. “According to Cantillon, the entrepreneur is a specialist in taking on risk, ‘insuring’ workers by buying their output for resalebefore consumers have indicated how much they are willing to pay for it” (Casson & Godley, 2005p. 26). The workers’ incomes are mostly stable, but the entrepreneur risks a loss if market prices fluctuate.

Cantillon distinguished entrepreneurs from two other classes of economic agents; landowners, who were financially independent, and hirelings (employees) who did not partake in the decision-making in exchange for relatively stable incomes through employment contracts. He was the first writer to provide a relatively refined meaning for the term entrepreneurship. Cantillon described entrepreneurs as individuals who generated profits through exchanges. In the face of uncertainty, particularly over future prices, they exercise business judgment. They purchase resources at one price and sell their product at a price that is uncertain, with the difference representing their profit (Chell, 2008; Hebert & Link, 2009).

Farmers were the most prominent entrepreneurs during Cantillon’s lifetime, and they interacted with “arbitrageurs” – or middlemen between farmers and the end consumers – who also faced uncertain incomes, and who were also, therefore, entrepreneurs. These intermediaries facilitated the movement of products from the farmsto the cities where more than half of the farm output was consumed. Cantillon observed that consumers were willing to pay a higher price per unit to be able to purchase products in the smaller quantities they wanted, whichcreated the opportunities for the intermediaries to make profits. Profits were the rewards for assuming the risks arising from uncertain conditions. The markets in which profits were earned were characterized by incomplete information (Chell, 2008; Hebert & Link, 2009).

Adolph Reidel (1809-1872), form the German School of thought, picked up on Cantillon’s notion of uncertainty and extended it to theorize that entrepreneurs take on uncertainty so others, namely income

earners, do not have to be subject to the same uncertainty. Entrepreneurs provide a service to risk- averse income earners by assuming risk on their behalf. In exchange, entrepreneurs are rewarded when they can foresee the impacts of the uncertaintyand sell their products at a price that exceeds their input costs (including the fixed costs of the wages they committo paying) (Hebert & Link, 2009).

Frank Knight (1885-1972) founded the Chicago School of Economics and belonged to the American School of thought. He refined Cantillon’s perspective on entrepreneurs and risk by distinguishing insurable risk as something that is separate from uncertainty, which is not insurable. Some risks can be insurable because they have occurred enough times in the past that the expected loss from such risks can be calculated. Uncertainty, on the other hand, is not subject to probability calculations. According to Knight, entrepreneurs can’t share the risk of loss by insuring themselves against uncertain events, so they bear these kinds of risks themselves, and profit is thereward that entrepreneurs get from assuming uninsurable risks (Casson & Godley, 2005).

  • Distinction between Entrepreneur and Manager

Jean-Baptiste Say (1767-1832), also from the French School, advanced Cantillon’s work, but added that entrepreneurship was essentially a form of management. Say “put the entrepreneur at the core of the entire processof production and distribution” (Hebert & Link, 2009, p. 17). Say’s work resulted in something similar to a generaltheory of entrepreneurship with three distinct functions; “scientific knowledge of the product; entrepreneurial industry – the application of knowledge to useful purpose; and productive industry – the manufacture of the item by manual labour” (Chell, 2008, p. 20).

Frank Knight made several contributions to entrepreneurship theory, but another of note is how he distinguished an entrepreneur from a manager. He suggested that a manager crosses the line to become an entrepreneur “when the exercise of his/her judgment is liable to error and s/he assumes the responsibility for its correctness” (Chell, 2008, p. 33). Knight said that entrepreneurs calculate the risks associated with uncertain business situations and make informed judgments and decisions with the expectation that – if they assessed the situation and made the correct decisions – they would be rewarded by earning a profit. Those who elect to avoid taking these risks choosethe relative security of being employees (Chell, 2008).

Alfred Marshall (1842-1924), from the English School of thought, was one of the founders of neoclassical economics. His research involved distinguishing between the terms capitalist, entrepreneur, and manager. Marshall saw capitalists as individuals who “committed themselves to the capacity and honesty of others, when he by himself had incurred the risks for having contributed with the capital” (Zaratiegui & Rabade, 2005, p. 775).An entrepreneur took control of money provided by capitalists in an effort to leverage it to create more money; but would lose less if something went wrong then would the capitalists. An entrepreneur, however, risked his ownreputation and the other gains he could have made by pursuing a different opportunity.

Let us suppose that two men are carrying on smaller businesses, the one working with his own, the other chiefly with borrowed capital. There is one set of risks which is common to both; whichmay be described as the trade risks of the particular business

… But there is another set of risks, the burden of which has to be borne by the man working with borrowed capital, and not by the other; and we may call them personal risks (Marshall, 1961, p. 590; Zaratiegui & Rabade, 2005, p. 776).

Marshall recognized that the reward capitalists received for contributing capital was interest income and the reward entrepreneurs earned was profits. Managers received a salary and, according to Marshall, fulfilled a different function than either capitalists or entrepreneurs – although in some cases, particularly in smaller firms, one person might be both an entrepreneur and a manager. Managers “were more inclined to avoid challenges, innovations and what Schumpeter called the ‘perennial torment of creative destruction’ in favour of a more tranquil life” (Zaratiegui & Rabade, 2005, p. 781). The main risks they faced from firm failure were to theirreputations or to their employment status. Managers had little incentive to strive to maximize profits (Zaratiegui & Rabade, 2005).

Amasa Walker (1799-1875) and his son Francis Walker (1840-1897) were from the American School of thought,and they helped shape an American perspective of entrepreneurship following the Civil War of 1861-1865. Thesescholars claimed that entrepreneurs created wealth, and thus played a different role than capitalists. They believedthat entrepreneurs had the power of foresight and leadership qualities that enabled them to organize resources andinject energy into activities that create wealth (Chell, 2008).

(c ) Entrepreneurship versus Entrepreneur

Adam Smith (1723-1790), from the English School of thought, published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776. In a departure from the previous thought into entrepreneurship and economics, Smith did not dwell on a particular class of individual. He was concerned with studying how all people fit into theeconomic system. Smith contended that the economy was driven by self-interest in the marketplace (Chell, 2008).

Also from the English School, David Ricardo (1772-1823) was influenced by Smith, Say, and others. His work focused on how the capitalist system worked. He explained how manufacturers must invest their capital in response to the demand for the products they produce. If demand decreases, manufacturers should borrow less and reduce their workforces. When demand is high, they should do the reverse (Chell, 2008).

Carl Menger (1840-1921), from the Austrian School of thought, ranked goods according to their causal connections to human satisfaction. Lower order goods include items like bread that directly satisfy a human wantor need like hunger. Higher order goods are those more removed from satisfying a human need. A second order good is the flour that was used to make the bread. The grain used to make the flour is an even higher order good. Entrepreneurs coordinate these factors of production to turn higher

order goods into lower order goods that more directly satisfy human wants and needs (Hebert & Link, 2009).

Menger (1950 [1871], p. 160) established that entrepreneurial activity includes: (a) obtaining information about the economic situation, (b) economic calculation – all the various computationsthat must be made if a production process is to be efficient, (c) the act of will by which goods of higher order are assigned to a particular production process, and (d) supervising the execution ofthe production plan so that it may be carried through as economically as possible (Hebert & Link,2009, p. 43).

  • Entrepreneurship and Innovation

Jeremy Bentham (1748-1832), from the English School of thought, considered entrepreneurs to be innovators. They “depart from routine, discover new markets, find new sources of supply, improve existing products and lower the costs of production” (Chell, 2008).

Joseph Schumpeter’s (1883-1950) parents were Austrian, he studied at the University of Vienna, conducted research at the University of Graz, served as Austria’s Minister of Finance, and was the president of a bank in the country. Because of the rise of Hitler in Europe, he went to the United States and conducted research at Harvard until he retired in 1949. Because of this, he is sometimes associated with the American School of thought on entrepreneurship (Chell, 2008).

Whereas Menger saw entrepreneurship as occurring because of economic progress, Schumpeter took the oppositestance. Schumpeter saw economic activity as leading to economic development (Hebert & Link, 2009). Entrepreneurs play a central role in Schumpeter’s theory of economic development, and economic development can occur when the factors of production are assembled in new combinations.

Schumpeter (1934) viewed innovation as arising from new combinations of materials and forces. He provided thefollowing five cases of new combinations.

  1. The introduction of a new good – that is one with which consumers are not yet familiar – or of anewquality of good.
    1. The introduction of a new method of production, that is one not yet tested by experience in the branchof manufacture concerned, which need by no means be founded upon a discovery scientifically new, and can also exist in a new way of handling a commodity commercially.
    1. The opening of a new market that is a market into which the particular branch of manufacture of thecountry in question has not previously entered, whether or not this market has existed before.
    1. The conquest of a new source of supply of raw materials or half-manufactured

goods, againirrespective of whether this source already exists or whether it has first to be created.

  • The carrying out of the new organisation of any industry, like the creation of a monopoly position or the breaking up of a monopoly position (Schumpeter, 1934, p. 66).

Another concept popularized by Schumpeter – in addition to the notion of new combinations – was creative destruction. This was meant to indicate that the existing ways of doing things need to be dismantled – to be destroyed – to enable a transformation through innovation to a new way of doing things. Entrepreneurs use innovation to disrupt how things are done and to establish a better way of doing those things.