‘although entrepreneurs can..make errors, there is no tendency for entrepreneurial errors to be made.’
Isreal M. Kirzner Journal of Economic Literature, Volume 35, Issue 1 (mar. 1997), 60-65
With the greatest respect for Kirzner, who has given us many insights into market process and entrepreneurship, this statement is incorrect. There are such tendencies, and such tendencies are endogenous to the business cycle.
It is trivial to call a directionality in rising prices, a rising price must one day fall (falling prices are more difficult, they can fall to and below zero – a scrapping cost for outmoded goods). What is hard is calling when, getting the timing right.
What rules do market participants use to determine well to buy and sell? Im considering here the non-professional investor, acting without the benefit of sophisticated models.
Let us consider the two main theories for this, both based on different axiomatic foundations.
The Neo-classical – that decision under uncertainty is the choice that maximises the expected value of a utility function (See Savage 1954 The Foundations of Statistics. New York, Wiley.)
The Austrian – human action is rational but ex-poste the actor may discover they have made an entrepreneurial error. So economics is not a theory of choice or decision making but on the social processes of coordination, which depends on the awareness the actors show in the exercise of entrepreneurship (see De Soto Socialism, Economic Calculation and Entrepreneurship, Edward Elgar 2010).
The problem is that both theories leave bad decisions unexplained; placed outside the field of analysis of ‘core’ economics.
The kind of bad decisions that saw many Albanian’s investing in a pyramid scheme, that led to economic collapse in 1996. The kind of bad decisions that see people all over the world taking out credit to get in on housing bubbles, just before they pop.
If such actions are seen as outside the core concepts of economics then economics can tell us nothing.
Of course many decisions are not made on the basis of the calculation of a utility function, in fact outside the blackjack card counter at a casino very few are. To explain the ‘deviations’ from rationality and the ‘bias’s’ of decision making we have behavioural economics and behavioural finance. But it is putting lipstick on a pig, but it does not explain the commonality and universality of decisions that vary from the maximising ideal.
The Austrian approach is less flawed – bad decisions are made by those who believe them to be rational – but it tells us nothing about – for example – why in periods of ‘golden’ growth most actors make good decisions, and why in periods of bubble and crisis decisions are bad ones. We often have a disjunction. When the entrepreneur profits they are a hero – they got it right. But when, despite factors beyond their control there are losses and a downturn – they got it wrong – but they contend the market gets in right in driving failures to the wall. We have a mish-mash here of methodological individualism and hinting at some form of emergent process, which acts above individual will, to restore economic prosperity.
Austrians cannot have it both ways, they lack a coherent theory of how multiple decisions are made with economic consequences. Entrepreneurship is seen as an impenetrable black box of the not yet foreseen and unknown. It tells us nothing about economic change other than it is seemingly unknowable and unpredictable.
Consider a third new approach – the Decision Analysis approach promoted by LiCalzi and his co-writers (see Decision Analysis using Targets instead of Utlity Functions Decisions in Economics and Finance, 2000)
This approach extends the satisficing concept of Simon (1955)
the agent should establish some target t and then pick the first action d which meets the target
This simple target-based model is not complete because there may be uncertainty about the target itself. For example commercial firms must usually viewtheir customers’requirements as uncertain…Hence, we relax the assumption of a known target and replace t with a random consequence T . The ensuing target-based decision model prescribes that the agent should choose an action d which maximizes the probability v(d) = P(Xd T ) of meeting an uncertain target.
LiCalzi shows that aiming for a probabalistic target in this way both satisfys Savages and von Neumann and Morgenstern’s axiomatization. Indeed rather than using the wooly ‘language of utility’ it enables use of the more objective ‘language of targets’ – indeed the ‘indifference curve’ between two different decisions can be interpreted (after Pratt, Raiffa and Schlaifer (1995)) , as ‘indifference probabilities’. No understanding by the agent of cardinal utility, or indeed ordinal utility, is needed, only of whether one event is more likely than another.
But if faced by a decision between multiple options all that is needed is an assessment that one is most likely. It does not require a-priori a subjective construction of a probability function.
Entrepreneurial decisions, at their most simplistic, are decisions about which choice will make the most profit. But that doesn’t necessarily require a subjective maximising function, simply a decision choice about which option is likely to make the most. When time and information is available it might be appropriate to calculate a maximising function, such as through operational research methods such as the travelling salesman for delivery of goods, but most decisions are not made that way, they are a special case of decision making under full information. Most decisions are made on experience and gut instinct. Indeed we know from psychological research that most decisions are not even made from a range of options at all. The experience of the decision maker will be used to rule out certain courses of action in advance. See my article on action script decision theory – the decision maker has an idea how things work based on the knowledge that has been gained from experience. S/he compares the possible action against what is known to work.
Consider the herding instincts and madness of crowds of markets. Some may have a simplistic decision rule – my mate has bought a house at a low price, that price rose, they made lots of money, I can too. In the language of Minsky this could be called a ‘Ponzi investor’.
Many see that as a deviation from the rational actor presumed in neo-classical theory and look down their noses at Minsky’s ideas as a result. But as it is the simplest economic decision rule does not make it irrational. For many getting into a market at the right time and right price it was a very rational decision. But at a decision rule it is incomplete. Others with more experience of real estate markets might add to the decision rule ‘unless that capital value of the house exceeds a valuation dependent on rental yields’ that is one based on economic fundamentals. But these will always be in the minority in any market involving many actors who are not professional investors.
This of course is one of the reasons why the housing market is inclined to bubble behaviour to a greater extent than other markets, and why the distribution of different decision rules need to be at the core of an explanatory and predictive economics. Markets do have differential tendencies to entrepreneurial error, errors which, upon study, found to be systemic and predictable to a considerable degree.
Put at its most simplistically a market based on a crude rising price rule will rise exponentially until budget constraints are met, when they are people will borrow until liquidity constraints are reached, then the market will turn. Interest rate changes explain the changes to the point of inflection, but not the causes of malinvestment. Austrian theories of the business cycle are one step removed from the agent based process of crowd following that drives the cycle. They gloss over the systemic entrepreneurial errors.
There is not enough space in this article to examine the parallel process of falling prices, of the meta-decision of when to invest, and the process of homeostatis when there are multiple decisions of multiple actors. I will return to these.
[Note: This should not be read as making any assumption either way in arguments about ‘socialist calculation’, it is at a higher level of analysis]