Following up on my earlier piece Investment as Renting Money – a Four Factor Model I want to expand on certain points and eventually move towards models of money production, sectoral balances and system reproduction. One issue I wish to elaborate on in the next piece is depreciation and debt amortisation. The assumption was made of durable capital in the simple model to illustrate the theoretical separation of rents from ownership of capital goods from rents from ownership of invested money, even if the durability assumption was unrealistic. This did cause confusion if the comments received are any measure because of my failure to properly state this as a prior assumption and not stating the assumption an economic conception of depreciation of capital goods as continuous revaluation rather than the conventional accounting approach of assigning costs to capital goods ex-poste. I hope to set this out more clearly in the next post.
Today I want to deal with entrepreneurship and the firm. The first post made a distinction for rent of capital goods and money between cash flows and profit, treating factor returns as profit after payment of overhead costs. This made it easy to incorporate a business model of banking, and avoided problems of negative prices, but does create problems of exposition down the line. I now think it is better to treat issues of costs and profits at the level of the firm with factor returns seen as pure cash flows, this also makes it easier down the line to distinguish between marginal productivity at input prices and discounted marginal productivity at output prices. This leads to the following revised table of returns :
|Capital (physical means of production)
||Capital Goods Rent
||Loan Repayment (Interest+Principal)
Does entrepreneurial activity then gain a factor return?
It creates clear difficulties if it is treated so. Entrepreneurial activity is the act of combining factors of production at a particular time and place to produce a particular product or products. Depending on the minimisation of cost and the maximisation of revenues through exploiting the market opportunities the entrepreneur sees the business enterprise realise a profit or loss.
Where any or all of the factors of production are not owned by the entrepreneur then this is a cost to the entrepreneur which they will seek to minimise. (The combination of the factors of production being the means of production)
Where any or all of the factors of production are owned by the entrepreneur then this is a means of revenue to them which they will seek to maximise.
Only then when a factor of production is owned does it enable a share of profits from growth to the entrepreneur, otherwise it becomes an input price cost, of benefit to another.
It follows from this that profit, and the incentive to undertake entrepreneurial activity will be boosted by the extent to which entrepreneurs own the factors of production and hindered by the extent they are owned by others.
An entrepreneur then will realise a profit to the extent that they minimise costs of input commodity prices (both goods and services) and costs of factors of production they do not own and to the extent that they maximise revenues at these input prices over and above cost of production. This profit is then distributed fully to each of the factors. All costs are also distributed between the factors through intermediate stages of production so that all prices paid at all stages in production can ultimately be broken down into a price paid for a factor.
Each of these factors can return a cash flow but that does not mean it can automatically be used for consumption by its owner. Factors may be involved in business relationships themselves which mean that only net profits resolving to a factor or equity owner can be used for consumption. The classic example where being credit where only the profit on the loan is the net return to the factor owner. Equity being a share in the ownership of a combination of factors of production in the form of a firm.
In this approach then there is never an unexplained residual revenue not attributable to a factor and requiring a separate factor of ‘entrepreneurs return’ . The entrepreneur is successful to the extent that they secure a profit, pure and simple. Once a firm is financed any payment from the firm to an owner of a factor is a pure transfer payment.
Imagine then that an entrepreneur has an idea to import toys cheaply from abroad and sell them at high prices before christmas. They own no other factors of production, so they are forced either to save or to take out a loan.
This loan is purely used to purchase stock which they sell on the street. So the only factor returns are on credit and labour. If they make a profit after paying debt and for stock of goods and other expenses then this is purely a factor return to labour. So we can see the importance of Adam Smiths discussion in Wealth of Nations Book I of the importance of confusing labour with profits on stock etc. for the self employed.
Here there was no stock but if they then from their profits formed a firm which manufactured toys etc. bought land for a factory and advanced credit to retailers then it would be realising other non labour factor returns.
No one factor by itself can turn a profit, it always requires labour plus at least one other factor in a profit centre (which where formally constituted is a firm) to do so.
2) Entrepreneurship and Risk
One of the great debates in economics is whether entrepreneurs are risk takers. Schumpeter said they took no risk, this was borne by those advancing credit. Knight and later Drucker said they were the great risk takers in the economy.
This issue can be resolved through the four factor returns approach.
A creditor will bear considerable risk but is unlikely to grant a loan (except at high interest) collateral free or without the debtor bearing some risk. They may be required to bear a share of the risk by including some of their own savings. How do such savings gain a factor return? Such savings are a credit to the business enterprise enabling, in the toys example above, purchase of working capital – in this case inventory. We are referring to credit in the sense of the credit theory of money, a positive money balance which enables purchase of a good or service. Because the entrepreneur owned the enterprise there is no need to take out debt and no need to pay premium +interest. This avoided cost then becomes profit which resolves as a credit factor return to the entrepreneur. Here we have a familiar Austrian story of saving leading to capital formation but with a twist, distinguishing between factor returns to different owners of credit, and debt substituting for savings.
We can also deal with venture capital and equity in the same way. To the extent this is spent of fixed capital this is a capitalist factor return. To the extent it is spent on working capital this is a financiers factor return.
Any factor owner therefore can bear some risk, as each factor will have an opportunity cost. The opportunity cost to the entrepreneur above being the wages forgone in any previous employment they left.
3) Entrepreneurship and Innovation
Each and every decision to combine factors of production will involve a economic decision. A decision to buy at total input price at certain times and places and selling at an output price at another time and place. To what extent does this involve innovation?
For Schumpeter entrepreneurs are innovators first movers, creating new products and business models. These high profits then attracting a swarm of new entrants, and of course a switch of capital from old businesses to new. In his first writings on this in the 30s he stressed the first mover issue. In these cases though firms are likely to be small and though enjoying high rates of profit and growth will enjoy little market power and in proportion to the economy as a whole limited current earnings. As firms grow however they can gain market power, and through this position of monopoly/oligopoly gain additional profits. Other entrepreneurs in the swarm behind may offer little innovation but much competition. The long term success of innovators then is the extent they can expand their market power and continue innovation.
Firms then in the factors or production they command and the knowledge of the market and its future development they possess is a collection of potential economic resources which if combined efficiently and productively will realise a profit and grow and gain in market power. For further insight on this particular point see chapter III ‘The Productive Opportunity of the Firm and the ‘Entrepreneur’ in Penrose (1959) The Theory of the Growth of the Firm