II On the Neoclassical Theory of Entrepreneurial Behavior

Since the mid-twentieth century neoclassical formulations of entrepreneurial behavior have been embodied in more comprehensive theories of production, of the firm in perfectly competitive market structures, or of firm formation in a competitive equilibrium context. It was sheer hyperbole for Baumol (1968: 66 - 67) to claim that in the “neoclassical model” the “theoretical firm is entrepreneurless - the Prince of Denmark has been expunged from the discussion of Hamlet”. Baumol’s position was motivated by the neoclassical conception of the entrepreneur as a functionary and as another factor of production separate from the standard triumvirate: land, labor and capital. The traditional production function describes an engineering relationship between inputs and outputs rather than a behavioral phenomenon. Entrepreneurship, like other inputs, is a deployable scarce resource. Some writers in the neoclassical tradition refer to specific entrepreneurial inputs as a type of human capital viz. “entrepreneurial ability” or “business acumen”(Evans and Jovanovic 1989: 810). However as Blaug (1996: 440-41) argued, “the strange disappearance of the entrepreneur from the center stage of economic theory” may be attributed to intractable analytical difficulties with the marginal product of the entrepreneurial input given its indivisibility and its nonstandardized, heterogeneous character. Since

Walras’s contribution in the late nineteenth century an overarching conception of end-state equilibrium has circumscribed the notion of the neoclassical entrepreneur as a decision maker within the ‘firm as production function’ approach. In a world of uncertainty (understood as calculable risk), and given the entrepreneur’s decisions take place with optimally imperfect information (following Stigler 1961), a theory of profit has been appended to the neoclassical model of the firm as a production function that sustains a minimalist entrepreneurial role. Entrepreneurs are only distinguished from other factor inputs by assuming they act as residual profit claimants given their special risk-bearing appetite (Blaug 1996: 444). Risk averse agents remaining in the firm are designated as administrators, employees or laborers.

In sophisticated models in the neoclassical tradition, such as the Khilstrom and Laffont (1979: 720) general equilibrium model of firm formation, entrepreneurs contribute managerial and organizational skills (“entrepreneurial ability”). Unlike risk averse laborers, entrepreneurs bear the risks associated with production. We now list concisely those features of this neoclassical approach that have implications for the behavior of entrepreneurs.¹

1. Entrepreneurs have equal access to the same risky ideas or technology and receive all the profits of risk-taking.

2. All entrepreneurs are risk neutral, so that a unit of entrepreneurial labor is homogeneous in respect of risk attitude.

3. While entrepreneurial labor inputs are deployable they are not deployable in infinitesimal amounts.

4. Entrepreneurs are the firm’s principal decision makers and enjoy free entry to the industry concerned.

5. Since risk attitude is potentially affected by firm size, the model’s range of applicability is to entrepreneurial behavior in “small businesses and farms”(Khilstrom and Laffont 1979: 749); in short it is restricted to an atomistically competitive economy.

6. Entrepreneurs are always and everywhere maximizers (or optimizers in that they may act as cost minimizers as well).

In elaborating on the dynamics of firm entry and exit the neoclassical approach identifies an equilibrium outcome. When an inefficient equilibrium outcome is investigated “it takes three forms: risks are maldistributed, firms are operated at the wrong levels and there is an inappropriate number of firms”(ibid: 721). Institutional impediments such as a dearth of risk-sharing opportunities can lead to an inefficient allocation of risks. Stock market institutions and venture capital financing arrangements are not incorporated in these models. Crucially, the referents used for theory construction and evaluation is the existence, stability and efficiency of competitive equilibrium. It is against these outcomes that the neoclassical theory of entrepreneurial decision making must be judged.

Khilstrom and Laffont (1979: 720) explicitly address entrepreneurs’ decision styles, a matter taken for granted in most other work in the neoclassical tradition where individual behavior is set in the form of “expected utility maximizing”. By this postulate it is proposed that the entrepreneur will maximize the subjective expected utility of profits derived from risk bearing. Moreover, neoclassical entrepreneurs obey the standard von Neumann-Morgenstern axioms of decision making under uncertainty (preference completeness, consistency, independence). They are idealized, representative entrepreneurs rather than real entrepreneurs, just as the firms in which they behave are hypothetical and representative. And entrepreneurs have a systematic response to uncertainty, use probabilistic calculating procedures, can easily be turned into good Bayesian learners and act comfortably in strategic decision making contexts by calculating their actions according to their competitors’ possibilities (Laville 2000b: 421). Whatever nuance may have been appended to the model in the later twentieth century there is no escaping Baumol’s (1968: 68) original observation that neoclassical entrepreneurs are “automaton maximizers” and automaton maximizers they have remained.²

Some specific (often tacit) neoclassical behavioral assumptions in respect of entrepreneurial behavior have not hitherto been widely appreciated in the literature. An entrepreneur:

7. lists all alternative opportunities for allocating resources in an equilibrating manner in existing markets;

8. finds opportunities evenly (randomly) distributed in the market and these have the same value for all who search for them;

9. determines all the possible consequences of acting upon an opportunity;

10. makes comprehensive comparative evaluations of each set of consequences and selects between different opportunities and

11. has access to information required initially to perceive alternative opportunities and their consequences, though the standard marginalist tools are applied to information as with other commodities.

As a result of applying (7) through (11), entrepreneurs will arrive at optimally imperfect decisions when considering whether or not to exploit a profit opportunity which reveals itself as a marked divergence between revenue and costs in market disequilibrium states. There is nothing in the five foregoing implications suggesting that what has been constructed is a separate theory of the entrepreneurial decision process in which opportunities are generated and then exploited, not to mention a theory that may directly be tested empirically. It is one thing to postulate a certain human decision algorithm within a firm situated in a competitive equilibrium context, and quite another to assume that entrepreneurial decisions, as an empirical matter, are coordinated in an equilibrium pattern. Neoclassical entrepreneurial behavior is differentiated from the behavior of consumers and laborers: entrepreneurs are a class of agents with a stable attitude to risk. All individuals in this class are equally and instantly capable of exploiting known profit opportunities. In an important sense not only is instantaneity asserted; the entrepreneurial class is always preserved in neoclassical models. No particular individual stands out.

The idealized decision processes of entrepreneurs are imagined to be exactly the same as the other maximizing agents and the theory of optimization establishes precisely what objective function is to be computed. While the neoclassical treatment of the costs of information search, information acquisition and opportunity identification is just another application of marginalist analysis, the burden of computation itself is usually set aside (Mongin and Walliser 1988; Conlisk 1996: 686-90). So, too, is “the question of why maximizing … is the appropriate computation”(Laville 2000a: 127); it is a question which is never posed in the limited, modern neoclassical literature on entrepreneurship. This should be scarcely surprising given the cameo role played by entrepreneurial decisionmaking in the general equilibrium theory of firm formation.