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A decision theory model for entrepreneurial acts.

Entrepreneurship is becoming a focal point in much of the popular press as well as in academia. New journals are appearing to deal with questions of entrepreneurship. But the vast majority of these journals deal with managerial or psychological aspects of entrepreneurship. Economic theory has yet to make a concerted effort at explaining entrepreneurship, either its role in economic development or its determinants. There are of course some very important individual efforts such as that of Casson (1982) and that of Suarez-Villa (1989), but the profession does not appear to have taken much of an interest in these questions.

An often repeated phrase among economists discussing entrepreneurship is that "there is no economic theory of entrepreneurship." (See, for example, Casson, 1982; Rosen, 1986; Shapiro, 1986; Kilby, 1971.) But the entrepreneur is central to economic development in the view of Schumpeter (1934) and in the writings of many economic historians. For example, Cole (1968-69, p. 9) writes:

The essential basic (economic) unit is, of course, the entrepreneur or entrepreneurial group seeking to 'initiate, maintain, and aggrandize' a business institution aimed at the achievement of monetary or other gains in an economy or business world that gives an appreciable amount of freedom to such actors. Too often entrepreneurship is viewed merely as a psychological capacity like musical or poetical talent.

A complete economic theory of entrepreneurship is a vast and complex task which only Casson has attempted with much success. The initial act of defining the term "entrepreneurship" is itself a difficult task.

Much in the literature examining entrepreneurship appears to be guided by the presumption that, like crime, entrepreneurial acts represent deviant social behavior. Entrepreneurial acts are often presumed to be linked to the entrepreneur's unique motivation and unique personal, familial, and psychological traits (see, for example, McClelland, 1969, or Hagen, 1962). Such a view limits both explanations and predictions of entrepreneurial acts as well as policies to encourage such acts. Rather than relying on hypotheses addressing unique personal characteristics and social conditions or the preference for risk, it is possible to examine the extent to which economic motives are important in the decision to become an entrepreneur.

The definition of an entrepreneurial act used here derives from the Austrian view suggested by Schumpeter (1971, p. 57):

The carrying out of new combinations we call 'enterprise'; the individual whose function it is to carry them out we call 'entrepreneurs'. . . . But whatever the type, everyone is an entrepreneur only when he actually 'carries out new combinations' and loses that character as soon as he has built up his business, when he settles down to running it as other people run their businesses.

Following Schumpeter we define the entrepreneurial act as the act of carrying out new combinations. Such an act may include any of the following and may be performed by individuals, business firms, groups, or even communities (Schumpeter, 1934, p. 77):

1. making up for market deficiencies (input or output)

2. connecting different markets

3. creation or expansion of firms

4. creation, expansion, or modification of markets.

Thus there is a continuum of entrepreneurial acts from the creation of an imitative firm to the production of a new product or use of a new technology or new organizational form.

The model of entrepreneurial acts used here is applied to the start-up of a new firm (also referred to as a business birth), but such a model can easily be generalized to any other entrepreneurial act. This model must also be recognized as a partial model only. We are here looking at the "economic" (in the traditional sense of the word) rationale for entrepreneurship but remain fully cognizant that there are sociological, cultural, and psychological factors that are important. Thus, the model developed here deals with only one part of the whole.

This model is similar to the migration model of Todaro (1969) and to the entrepreneurial decision model of Casson (1982). An individual's decision upon whether to become an entrepreneur will be based upon a comparison of the expected reward to entrepreneurship and the reward to the best alternative use of his time (Casson, 1982, p. 335).

There are obvious alternative models to the model that follows. Occupational choice decision models have been demonstrated by such researchers as Boskin (1974) stressing human capital, and by Ehrlich (1973) stressing risk. Such decision models and the economic rationale behind them can be seen in Harris (1973) and Becker (1968). This model and its rationale are consistent with Casson's (1982) model of entrepreneurship and with Todaro's (1969) model of migration, as well as most general occupational choice models. The model chosen here is conceptually similar to the Todaro (1969) model of migration and is much simpler than the more elegant decision theory models, but the behavioral implications are very nearly the same. A good alternative which yields similar results is Ehrlich's (1973) model of illegitimate versus legitimate behavior. One need only substitute entrepreneurial activities for illegitimate behavior and wage labor for legitimate behavior to derive such a model.

THE MODEL

Any entrepreneurial act has the potential of increasing or decreasing the wealth and psychic well-being of the entrepreneur. Entrepreneurial acts are, by their very nature, subject to risk and uncertainty. There are two obvious alternatives to entrepreneurial acts. The individual may pursue leisure or work as wage labor. In order to simplify the model of the decision to become an entrepreneur, it is assumed here that the choices facing the potential entrepreneur are to either become an entrepreneur or to perform wage labor. In models such as that of Erlich it is normally also assumed that wage labor is riskless. Testing this model we have found that such an assumption is far too limiting. Thus, the alternative to the entrepreneurial act is here assumed to be wage labor, but wage labor is not assumed to be riskless.

The essence of the model is to assume that the potential entrepreneur examines the expected net benefits of entrepreneurship versus the expected gains from wage labor. The decision to start a business depends upon the expected net gain in wealth, beyond that gain which would be expected from non-entrepreneurial activities. The expected net gain is determined by the difference between: (a) the product of the probability of success and the average income of entrepreneurs; and (b) the product of the probability of employment times the average incomes of non-entrepreneurs (wage labor).

The probability of success as an entrepreneur should be positively correlated with the degree of investment in human capital on the part of the potential entrepreneur. Such human capital investment certainly includes the level of formal education but should also include on-the-job training specific to the kind of entrepreneurial venture the individual may pursue. Young and Francis (1991) found that founders of small manufacturing firms tended to have previous work experience in similar small firms. Such on-the-job training may, in fact be more important than formal education in that such training not only familiarizes the potential entrepreneur with processes and organizational functions but also involves the individual in a network with suppliers and buyers who deal with such firms. It also means that the new entrepreneur may benefit from recent research and development that was conducted at the firm where he was employed and may use such research and development results at the firm he founds.

The probability of success should also be positively related to net business growth in the aggregate. This does not mean that all firms are directly tied to overall economic growth but the chances of success for most firms should, ceteris paribus, be greater when the economy is strong. This is not only because there are likely to be more orders for all kinds of goods, it also is because the likelihood of obtaining financing and operating credit are far better during growth periods.

The individual's perception of the probability of success should also be positively related to the relative concentration of local firms in similar or allied industries. The existence of such firms provide agglomeration economies in terms of the availability of skilled labor, already existing networks for inputs and networks for sales.

The probability of success at time (t) is represented as |P.sub.e~(t) and is a function of the amount of training and experience (E(t)) held by the potential entrepreneur and the amount of time the potential entrepreneur has devoted towards becoming an entrepreneur. That is, the individual who has a higher level of education and who has worked in a similar business to the one he is about to start is more likely to be successful at the endeavor.

The probability of wage employment at time (t) is represented as |P.sub.w~(t) and is a function of the general health of the economy, the individual's current employment status, the industry (and its health) in which the person is currently employed (if currently employed), the specific occupation of the individual, the individual's human capital, and the individual's tenure and experience.

Letting |Y.sub.e~(t) represent the average income of an entrepreneur and |Y.sub.w~(t) represent the average income of a non-entrepreneur (wage labor) with similar human capital endowments, then the expected income of the potential entrepreneur at time (t) is dependent upon his probability of success and the income which would accrue to him if successful:

E(|Y.sub.e~(t)) = (|P.sub.e~(t)) * (,|Y.sub.e~(t)) (1)

This is not the sole basis of the decision, however. The potential entrepreneur must evaluate E(|Y.sub.e~(t)) relative to his expected opportunity costs E(|Y.sub.w~(t)), where:

E(|Y.sub.w~(t)) = (|P.sub.w~(t)) * (|Y.sub.w~(t)) (2)

He must also subtract the actual money costs and net psychological costs C(0). The costs of becoming an entrepreneur include both money costs and the money equivalent of psychological costs involved in the start-up of the venture. Such costs include the venture capital, and such psychological factors as the fear of personal embarrassment and loss of self-esteem, and the potential fear of having to find alternative employment. Those costs which take place in time period 0 are designated as |C.sub.0~.

Finally, his expected net gain must be evaluated over his planning horizon and discounted with an appropriate discount rate (r) representing the potential entrepreneur's time value of money. If the resulting net present value for entrepreneurial activities N|V.sub.e~(0) is greater than zero then the potential entrepreneur will undertake the venture. If N|V.sub.e~(0) is negative he will not undertake the activity. Thus

|Mathematical Expression Omitted~

BEHAVIORAL IMPLICATIONS

The expected addition to wealth for the potential entrepreneur is dependent upon both his probability of success and the differential in income between entrepreneurial ventures and wage labor. This includes both the actual money income and the money equivalent of psychic income.

An increase in the probability of success, ceteris paribus, will result in an increase in the incentive to start an entrepreneurial venture. Increases in the probability of success and the differential between entrepreneurial income and wage income will depend upon the attitude toward risk on the part of the potential entrepreneur. The risk-averse individual should be more affected by increases in the probability of success while the risk preferrer will be less inclined to increase entrepreneurial activity from an increase in the probability of success and in the extreme may even engage in less entrepreneurial activity because of the increase in the probability of success. Conversely, the risk avoider will be more affected by increases in the differential between entrepreneurial income and wage income.

Schumpeter (1934) discusses waves of innovation as being critical in the business cycle and as the motive force in capitalism. How do such waves come about and why do they eventually slow nearly to a halt in some industries? In the early period of innovation P(t) is very small. There is little chance for success, but in the event of success |Y.sub.s~ is extremely large relative to the wage from labor. Thus (E(|Y.sub.e~(t))) - (E(|Y.sub.w~(t))) will also be relatively large. Many imitative entrepreneurs will enter the field. As they do, competition will ensue and E(|Y.sub.e~(t)) will decline. As information diffuses and competitors begin to eat away at the monopoly advantages of the first entrepreneurs and as it becomes easier to obtain both materials and information, |P.sub.e~(t) will increase. This leaves E(|Y.sub.e~(t)) relatively large until finally the market begins to become crowded relative to demand growth. At this point, either because |P.sub.e~(t) and |Y.sub.e~(t) have declined enough or because of general economic improvements in the economy (due in at least some part to the entrepreneurial activity itself), |Y.sub.w~(t) will have risen. N|V.sub.e~ thus begins to approach zero or actually turns negative and new entrepreneurs and some existing ones cease such activity, bringing the wave of innovation to a halt.

Another set of interesting implications concerns minority entrepreneurs. One of the implications of research such as that of Bates (1985) and of Fratoe (1988) is that two major problems for minority entrepreneurs are (1) the lack of role models and (2) the concentration of minorities in very-low-income businesses. Because minorities also suffer from generally low incomes in non-entrepreneurial fields as well as lower levels of education and training than non-minorities, those who do choose to start business ventures may do so in light of low probabilities of success, as in the case of many retail and low-skill service businesses. Thus, |P.sub.e~(t) * |Y.sub.e~(t) is very low, but |P.sub.w~ * |Y.sub.w~(t) is also very low so the net present value may still be greater than zero. Those minority entrepreneurs who are more risk-averse may also be led to ventures with much higher probabilities of success but very low incomes in the event of success--thus |P.sub.e~(t) * |Y.sub.e~(t) is still greater than |P.sub.w~ * |Y.sub.w~(t).

Finally consider high income individuals. Since |P.sub.e~ * |Y.sub.e~(t) is very high, such individuals would require very large expected returns. To be induced to become entrepreneurs either both |P.sub.e~(t) and |Y.sub.e~(t) would need to be relatively high or, in the event that |P.sub.e~(t) is low, |Y.sub.e~(t) would need to be very high. This would indicate that such upper income earning individuals would tend to be concentrated in high-return industries such as high-technology firms.

CONCLUSIONS

An initial test of this model using aggregate data has been encouraging. It does lend evidence to the presumption that the entrepreneurial decision is at least partially attributable to economic motivation and can be characterized by a standard kind of decision model underpinned by the theory of utility maximization. Research into psychological motivation of entrepreneurs is still important, but the economic factors should not be ignored. The results also indicate that using a model assuming that wage and salary labor is riskless may be too naive and that the risks associated with wage and salary employment are as much a factor as the risks associated with the entrepreneurial venture.

Because of the increasing stress on using the development of entrepreneurs as a regional development tool, this sort of research should be of increasing importance to regional economists as well as to the economics profession in general. Since entrepreneurship is not a purely psychological phenomenon, policy makers can influence the level of entrepreneurship. Such encouragement should attempt to reduce the costs of starting a business by providing increased access to venture capital and perhaps increasing community support of entrepreneurial ventures. Additionally, policy makers can increase the probability of success through such programs as small business development workshops and small business assistance.

REFERENCES

Bates, T. (1985). Entrepreneur human capital endowments and minority business viability. The Journal of Human Resources, 20(4), 540-554.

Becker, G. S. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 78(2), 526-536.

Boskin, M. J. (1974). A conditional logit model of occupational choice. Journal of Political Economy, 82(2), 389-398.

Casson, M. (1982). The entrepreneur: An economic theory. Totowa, NJ: Barnes and Noble.

Cole, A. H. (1968-69). Meso-economics: A contribution from entrepreneurial history. Explorations in Entrepreneurial History, 2nd Series, 6(1), 3-33.

Ehrlich, I. (1973). Participation in illegitimate activities: A theoretical and empirical investigation. Journal of Political Economy, 81(30), 521-565.

Fratoe, F. A. (1988). Social capital of black business-owners. Review of Black Political Economy, Spring, 33-50.

Hagen, E. E. (1962). On the theory of social change: How economic growth begins. Homewood, IL: Dorsey Press.

Harris, J. R. (1973). Entrepreneurship and economic development. In L. P. Cain & P. J. Uselding (Eds.), Business enterprise and economic change, pp. 141-172. Kent, OH: Kent State University Press.

Kilby, P. (1971). Hunting the heffalump. In P. Kilby (Ed.), Entrepreneurship and economic development, pp. 1-40. New York: The Free Press.

McClelland, D. C. (1969). Motivating economic achievement. New York: The Free Press.

Rosen, S. (1986). Economics and entrepreneurs. In J. Rosen (Ed.), Entrepreneurship, pp. 301-310. Lexington, MA: Lexington Books.

Schumpeter, J. (1934). Capitalism, socialism, and democracy. New York: Harper and Row.

Schumpeter, J. (1971). The fundamental phenomenon of economic development. In P. Kilby (Ed.), Entrepreneurship and economic development, pp. 43-70. New York: The Free Press.

Shapiro, H. N. (1986). Entrepreneurial concepts, definitions, and model formulations. In. J. Rosen (Ed.), Entrepreneurship, pp. 75-99. Lexington MA: Lexington Books.

Suarez-Villa, L. (1989). The evolution of regional economies: Entrepreneurship and macroeconomic change. New York: Praeger.

Todaro, M. P. (1969). A model of labor migration and urban unemployment in less developed countries. American Economic Review, 59(1), 138-148.

Young, R. C., & Francis, J. D. (1991). Entrepreneurship and innovation in small manufacturing firms. Social Science Quarterly, 72(1), 149-162.

Charles A. Campbell is Associate Professor of Economics at Mississippi State University.
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Author:Campbell, Charles A.
Publication:Entrepreneurship: Theory and Practice
Date:Sep 22, 1992
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