Entrepreneurs as Surrogate Forward Traders of Goods and Services, Seen from the Viewpoint of New Institutional Economics

Only a few goods are traded forward,¹ because, as Hicks (1946, p. 139) explains, ‘[…] it is uncertainty of the future and the desire [of the consumer] to keep one’s hands free to meet that uncertainty, which limit the extent of forward trading under capitalism.’ Most forward markets for consumer goods fail.² The cause is—from the perspective of New Institutional Economics (NIE)—the presence of positive transaction costs, imperfect individual foresight and bounded individual rationality. The unspoken assumption of classical economics is that private firms and their managers or entrepreneurs serve as surrogate futures traders of goods and services. They decide ‘today’ what, where and how much will be produced for ‘tomorrow’ and, in that context, what, etc., factor inputs should be bought ‘today’ for that purpose. The reason the price mechanism is superseded by ‘the firm’, whose ‘entrepreneur-coordinator’ directs production, is transaction costs or the ‘cost of using the price mechanism’ (Coase 1937, p. 390) and, according to the reading of Williamson (1975, p. 4), ‘[Knightian] uncertainty and, implicitly, bounded rationality’.³ The latter two include the costs of adapting to unforeseen events and of repairing errors resulting from bounded rationality. Anyway, transaction costs, imperfect foresight and bounded rationality require suitable institutional arrangements and ‘[…] some authority (an “entrepreneur”) to direct the resources’ such that ‘certain marketing costs’ are saved.⁴ Coase continues:

The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the [forward] market transaction which he supersedes, because it is always possible to revert to the open market if he fails to do this. (Coase 1937, p. 392, emphasis added)

However, the last line of the above reference is at variance with the fact that most futures markets for goods and services fail. Since there are (practically) no forward markets, the Coasian entrepreneur-coordinator cannot compete with them. Instead, he competes with the multiplicity of entrepreneurs of other firms—the standard problem of industrial organisation.

The purpose of this paper is to illustrate—in an argumentative style—that once we refrain from the usual neoclassical assumptions and integrate transaction costs, imperfect foresight and bounded rationality into present neoclassical (spot and futures) market theory, we get a more realistic perception of the decentralisation of intertemporal economic decision making. The non-existing futures markets for goods and services are replaced by firms which are led by ‘entrepreneur-coordinators’. They may be seen as surrogate forward traders of goods and services who bridge present and future engagements by using the services of financial markets and financial firms. We claim that the ‘more realistic assumptions’ of NIE lead to a better perception of what takes place behind the veil of ‘money and finance’ than the present neoclassical theory and its financial counterpart. It might also help to better understand aspects of the financial crisis of 2008.

Standard market theory deals with spot markets and their equilibrium, as illustrated by the ‘Marshallian Cross’.⁵ Its general equilibrium version is provided by Hicks (1946, p. 140) in the form of his ‘pure spot economy’, which contains no forward markets but assumes that individuals form expectations about future prices and take them into account in their spot market decisions. Hicks basically describes the theory that underlies Keynes’ General Theory by using his temporary equilibrium theory that explains only pure spot market equilibria.

Different from Hicks’ pure spot economy approach, Arrow (1953) and Debreu (1959) described a fully-fledged multi-period general equilibrium model that incorporates risk, though not (Knightian) uncertainty. The first step from a pure spot economy to Arrow-Debreu’s time-state preference theory is comparatively simple: goods and services are now characterised not only by their physical nature and the location at which they are available, but also by the point of time at which they are available and the state of the world on which their exchange contract is contingent (Debreu 1959, pp. 28 and 98).⁶ The probabilities of the various states of the world are assumed as known a priori. In this sense, people possess perfect foresight and thus ‘full information about the nature and consequences of their choice’.⁷ Furthermore, consumers are assumed to act perfectly rationally in the sense that they maximise their individual utility⁸ subject to their endowment.⁹ Individual utility functions are stable, well-ordered time-state preference orders over the set of all individual consumption plans (bundles of commodities)—weighted by their related individual state preferences (the individual attitudes towards risk). Finally, competition is perfect, transaction costs are zero, money is irrelevant—and there are firms. They perfectly hedge both their sales and their factor expenses; as a consequence, the profits of firms are certain. There is no room for [Knightian] entrepreneurs. Firms are profit-maximising automatons, with their profits being distributed to consumers who own shares of firms. Risk behaviour within this time-state preference economy is reflected only by the risk behaviour of consumers.¹⁰

This is no longer true under NIE conditions, i.e., positive transaction costs, incomplete foresight (we do not know all possible future events, let alone their statistical properties) and bounded rationality. Textbooks, like Hirshleifer (1970), mention of these three properties only positive transaction costs in the sense of positive costs of using the market, and speak of ‘incomplete’ instead of ‘complete’ markets for time-state claims (Hirshleifer 1970, p. 264 ff). However, we prefer to at least accentuate also incomplete foresight (Knightian uncertainty). Arrow (1970) explicitly refers to it in his discussion of time-state preference theory by arguing that the establishments of a new business or the investments in technical progress are ‘[…] by their very nature leaps into the unknown’ (1970, p. 135). He continues:

In any economic system, capitalist or socialist, there is a responsible agent to whom the burden of any given risk falls in the first instance. In a capitalist world […] the owner of a business typically is supposed to assume all the risks of uncertainty, paying out the unexpected losses and enjoying the unexpected gains. (Arrow 1970, p. 135)

It is about here that the support of the institutions of money, money loans and, importantly, the diverse forms of limited liability enter. The latter implies a termination of the chain of personal liabilities—as in the case of equity ownership or bankruptcy—which amounts to a disruption of what classical economists since David Hume¹¹ view as the ‘natural’ (i.e., determined by self-interest) control mechanism of the capitalist economy. Arrow (1970, p. 139) explains it as society’s answer to the progress-impeding fact that not all risks ‘which it would be desirable to shift¹² can be shifted through the market’.¹³ Of course, this interruption of the ‘natural’ capitalist control mechanism has to be filled by some appropriate ‘made’ (or designed) control mechanism such as corporate boards, securities and exchange commissions, financial regulators, bankruptcy courts, the judiciary in general, etc. At those interfaces, the (impersonal) control mechanism of market competition is interrupted and must be replaced by (personal known) members of supervisory boards that might invite monopolistic practices.¹⁴ It is against this background that we interpret the economic and political activities of entrepreneurs, the leading managers of private firms, being surrogate futures traders of goods and services. They bridge present and future through an on-going decision process that is coordinated by means of a complex system of market and non-market organisations (like firms, supervisory boards, government agencies, etc.). For convenience, four kinds of decisions are distinguished here: spot market decisions (purchase of inputs); non-market decisions (transformation of inputs into outputs); future market decisions (adapting output to expected sales, influencing sales through marketing, political manoeuvres, etc.); and financial decisions, i.e., decisions on how to financially bridge present and future actions.¹⁵

The problem of bounded rationality, raised by Simon in 1957, took a bit longer to seep through into the microeconomics of institutional analysis.¹⁶ It might sound like a bad joke to some people, but legal rules and legal practice provide examples of how society allows for our cognitive limits. An example is contracts. Those reaching into the future may be unavoidably incomplete. The standard technique to deal legally with the difficulties created by ‘gaps’ in such incomplete contracts is to apply certain accepted principles, e.g., the common judgment as to what is ‘reasonable’. The most famous example of this technique in Anglo-American law is the use of the standard of due care in cases of negligence.

For obvious reasons, a judge is not free to decide cases according to his whims. He has to apply some principle that, ideally, is understandable, re-constructible, and predictable. Unavoidably, bargaining is pervasive. And this process seems to obey some implicitly or explicitly agreed upon principles. In any case, the rational lawmaker knows that additional rules will evolve over time. Changes will come about partly by the extension of judge-made law, or through the writing of individual contracts, and partly through the generation of informal rules. (Furubotn and Richter 2005, p. 22)

Summing up: in the world of NIE, markets for time-state claims are generally open-ended or ‘incomplete’. As a result, market-promoting institutions like money and money loans and non-market institutions like firms, limited liability, supervisory boards or bankruptcy courts are important. Non-markets are helpful not only because of transaction costs but also because not all risks that would be desirable to shift can be shifted through the market. Given that, ‘[…] the economic problem of society is mainly one of rapid adaptation to change in the particular circumstances of time and place’ (Hayek 1945, p. 524), the search for a governance structure of non-market institutions, managed by qualified entrepreneurs, may improve the adaptability of the economy to an uncertain and changing environment, and, in this sense, contribute to its ‘adaptive efficiency’.¹⁷ But what about its ‘allocative efficiency’ (or Pareto efficiency)?¹⁸ The answer is that Pareto efficiency is a foreign word in NIE. It is the result of an (as-if) optimisation-under-constraints exercise that is based on assumptions that contradict the premises of NIE.¹⁹ The existence of transaction costs, incomplete foresight and bounded rationality has institutional consequences that cannot be answered by neoclassical optimising procedures. Thus, under NIE conditions, the advantages of ‘more market’—an increase in risk shifting by means of financial innovations—is not necessarily welfare improving. On the contrary, it may invite moral hazard (opportunistic actions of the counterparty)²⁰ on a scale that by far outweighs the advantages of ‘more market’. The financial crisis of 2008, which followed a rising wave of asset securitisation and risk shifting, illustrates this point.

As we have seen, the costs of using the market and the problems of incomplete foresight and bounded rationality help to understand not only why there are firms but also why there are only a small number of forward markets for goods and services. In this case, it appears preferable to restrict ourselves to a study of the institutional economics of a pure spot market economy based on Hicks’ (1946, p. 140) temporary equilibrium analysis. By assumption, prices or sales of future goods or services are only expected, not known. In addition, because of Knightian uncertainty, not all kinds of goods and services available in the future are known today. The firm, under the leadership of its ‘entrepreneur-coordinator’, is now the institutional answer not only to the costs of using the market but also to the problems of incomplete foresight and, according to our understanding, of bounded rationality. The Knightian entrepreneur replaces Coase’s entrepreneur-coordinator.

At this point, it is advisable to consider some of Knight’s views, including his idea to compare the evolution of hierarchical organisations under uncertainty with the evolution of biological organisms:

When uncertainty is present and the task of deciding what to do and how to do it takes the ascendancy over that of execution, the internal organization […] is no longer a matter of indifference or mechanical detail. Centralization of this deciding and controlling function is imperative, a process of ‘cephalization’, such as has taken place in the evolution of organic life, is indispensable, and for the same reasons as in the case of biological evolution. (Knight 1921, p. 268 ff., emphasis added)

It is tempting to digress into the history of economic thought, like the ideas of David Hume (1739/40) concerning the origin of justice and property, Carl Menger’s (1883) organic interpretation of social phenomena, or the differences and similarities with the much referred to entrepreneur of Joseph Schumpeter (1911). Yet we do not want to get involved here in the history of economic thought.²¹ All we wish to do is point out that not only the proper design of institutions, and manning them with capable people, but also entrepreneurial leadership (authority) as described by Knight is society’s best answer to the imponderables of life. Numerous organisational questions arise that are absolutely foreign to the neoclassical theory of the firm, such as the problem of the separation of ownership and control as in the case of a joint stock company (corporation). All these ‘made’ disruptions of the ‘natural’ control mechanism of capitalism require a ‘made’ replacement in the form of some kind of ‘manual’ control mechanism—such as a board of directors that has the task to, inter alia, supervise entrepreneurial decision making. Consequently, NIE scholars started to view the firm in an entirely different way, viz., as ‘one form of legal fiction which serves as a nexus for contracting relationships’ among individuals [emphasis in the original].²² As a consequence, the core theme of the theory of the firm switched from its neoclassical engineering perspective to the institutional (legal) perspective of corporate governance. The problem concerned is that, with uncertainty present, ‘[…] the primary problem or function is deciding what to do and how to do it’—not the execution of activities (Knight 1921, p. 268). Consequently, professional managers, in their capacity as Knightian entrepreneurs (or ‘surrogate forward traders of goods and services’), need sufficient leeway. In actual fact, corporate law gives executives—for a limited period of time—full ownership rights in the corporation.²³ To avoid managerial exploitation of the firm’s resources, management is subjected to the control of the corporation’s board of directors—not of its shareholders (the owners of the firm). The latter may be understood as a legal answer to Olson’s (1965) logic of collective action.²⁴

By their nature, economists emphasise the need to keep an eye on the economic incentives slumbering in legal or administrative control mechanisms such as corporate governance (e.g., Vives 2000). Thus, corporate governance is treated from various angles, e.g., with a focus on aspects of the forces of internal or external competition, ²⁵ the role of strategic manoeuvres between insiders (like management, supervisory board) and outsiders (stockholders, taxpayers),²⁶ and the influence of too much personal closeness between members of the supervisory and executive board.²⁷

In short, referring to entrepreneurs as surrogate forward traders of goods and services implies viewing the core problem of the firm not simply as how to adjust production to given input and commodity prices but rather as how to plan and decide under conditions of uncertainty.