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50 Economics Classics: the Microtheory of Innovative Entrepreneurship

50 Economics Classics: the Microtheory of Innovative Entrepreneurship

The Microtheory of Innovative Entrepreneurship 

By William J. Baumol

‘The thing that’s wrong with the French,’ George W Bush is apocryphally said to have told former British prime minister Tony Blair, ‘is that they don’t have a word for entrepreneur.’

Entrepreneurship is the fourth ‘factor of production’ along with land, labour and capital. Yet because the activity of entrepreneurs is hard to quantify, a meaningful theory of entrepreneurship would long linger on economists’ to-do list.

While heavyweights such as John Stuart Mill and Alfred Marshall had things to say about entrepreneurship, it wasn’t until Joseph Schumpeter in the twentieth century that we had a theory that put entrepreneurs centre stage.

However, American economist William Baumol felt there was much left unsaid about entrepreneurs, and complained that mainstream economics, particularly the theory of the firm, had conveniently glossed over the species.

One cannot explain the huge differences in economic performance between time and place without thinking about the entrepreneur.

Baumol first made a distinction between entrepreneurs and managers. Managers make existing processes more efficient, but bring little new into being.

His second distinction was between two kinds of entrepreneurs. An entrepreneur who starts a business doing something many others are doing he called a ‘replicative’ entrepreneur. By contrast, the ‘innovative entrepreneur’ must be a leader – it is only an entrepreneur of this type who will be responsible for ‘revolutionary growth’ in an economy.

Conventional economics focuses on ‘market failures’ that hold back growth, including monopoly, negative externalities and poor public infrastructure. Yet Baumol argued the fixing of market failures in no way accounted for the massive growth in income between 1900 and 2000 (583% in the US, 1,653% in Japan, 526% in Germany). It was the productive innovations unleashed by entrepreneurs, that accounted for a significant portion of such growth.

Schumpeter believed the day of the innovating solo entrepreneur was waning, because big business was taking over the function of innovation. Baumol disagreed, noting that big companies are not good at the early stages of innovation.

Schumpeter told us that entrepreneurship extended well beyond technical innovation, and could involve the introduction of a new good, or a new quality of a good; the opening of a new market; the securing of a new supply of raw materials or half-manufactured goods; or shaking up the organisation of an industry, by creating a monopoly or breaking an existing one.

In Entrepreneurship: Productive, Unproductive, and Destructive Baumol asked: ‘What pushes entrepreneurs to focus on a particular combination of these activities, or single one out as the most promising?’

If entrepreneurs are simply ‘persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige,’ as Baumol puts it, then it follows that not all entrepreneurs will be doing things that add to society. They may be engaged in acts of ‘unproductive entrepreneurship’, such as building an organised crime network.

Baumol imagines an activity (‘A’) that normally would provide both a good payoff for the entrepreneur, and benefit society, but which is thwarted by legislation or social stigma. To save their social skin and stay within the law, entrepreneurs will naturally direct their efforts to another activity (‘B’) which may be less beneficial to society. By its direction of resources towards B, society loses.

Baumol’s theory of ‘contestable markets’ seeks to explain why growth in free market economies is always greater than in other kinds of political economy, even if a market is not perfectly competitive (ie, if there is an oligopoly in which a market is tied up by a small number of firms).

This is because, as Baumol said in an interview, ‘the oligopoly’s main weapon is not price, but invention, in which it is life and death for them. That competition drives them each to try and prevent the others from getting ahead of them in innovation.’

In a nutshell:

Economic growth rests on the development and implementation of new ideas, so it is surprising the extent to which entrepreneurship has been ignored by economics.

Final comments

Partly as a result of Baumol’s work, entrepreneurship is now an important part of ‘new growth theory’, which suggests that economies are driven to new heights through the power of ideas. However, it is also a fact that economic growth creates more consumption, which has knock-on environmental effects. Whereas conventional economics will focus on such failures, Baumol is more interested in the innovations that may transcend it. Just as the use of whale oil was replaced by crude oil as a global energy resource thanks to the diffusion of engineering innovations, so the world is likely to get gradually cleaner thanks to entrepreneurs seeking to profit from new energy technologies.

Copyright © Tom Butler-Bowdon, 2017. The above is an abridged extract from 50 Economics Classics, priced at £12.99, by Tom Butler-Bowdon, published by Nicholas Brealey Publishing.

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