the entrepreneurial economy ii

8/2/2019 The Entrepreneurial Economy II

1/65

The Entrepreneurial Economy II: Risk, Uncertainty,

and Innovative Entrepreneurship

Massimiliano Amarante

Universite de Montreal

y

Onur Ozg ur

Universite de Montreal

z

Edmund S. Phelps

Columbia University

x

November 1, 2011

Abstract

This is the second of a series of papers in which we address the questions How do capitalist

systems generate their dynamism and Why a capitalist economy is inherently di

erent from a

centrally planned one. We believe that, in order to study these issues, we must thoroughly

reconsider the role played by entrepreneurs and


2/65

nanciers in actual economies. Although it

is widely accepted that entrepreneurs are at the wheel of the free-market capitalist innovation

machine, mainstream microeconomic theory is mostly silent about them (Baumol, 2002). We

provide here a novel theoretical model of an economy with innovative entrepreneurship in the

spirit of Knight (1921). Innovating entrepreneurs need


3/65

nancing. Ordinary consumers are

incapable of assessing their likelihood of success. Financiers, though, take chances in those

projects systematically, hence channel resources from the part of the economy where the only

concern is risk and risky assets are priced on the asset markets, into the part where the concern

is uncertainty and agreements take the form of bilateral contracts between entrepreneurs and


4/65

nanciers. Equilibria with e


5/65

cient bilateral contracts Pareto dominate those without and in turn

We would like to thank Max Stinchcombe for very useful

conversations. Part of this research was done while

Ozg ur was visiting the Economics Department at the Universite Laval. He would like to thank YannBramoulle and

Bernard Fortin for organizing the visit. He is grateful for


6/65

nancial support to \La Chaire du Canada en Economie

des Politiques Sociales et des Ressources Humaines" at Universite Laval, CIREQ, CIRPEE, IFM2, and

FQRSC.

y

Department of Economics and CIREQ; e-mail: [email protected]

z

Department of Economics, CIREQ, and CIRANO; e-mail: [email protected]

x

Department of Economics and The Center on Capitalism and Society; email: [email protected]

12 Amarante, Ozg ur, Phelps

are dominated by the social planner's allocation. A central authority's (CA) planned allocations

will not agree with those of the market if either (i) the degree of ambiguity of CA is too high, or

(ii) there is fundamental disagreement among entrepreneurs and


7/65

nanciers regarding the joint

likelihood of competing innovations. Under mild regularity conditions, it is welfare improving to

tax capital to subsidize


8/65

nanciers. Finally, equilibria in capitalist economies under uncertainty

are characterized by their dynamism, generating higher levels of entrepreneurial activity relative

to centrally planned economies.

Journal of Economic Literature Classi


9/65

cation Numbers: C62, D51, D53, D81, P1, P51.

Keywords: Ambiguity, capitalist systems,


10/65

nancial contracts, entrepreneur, innovation, Knightian

uncertainty.Innovative Entrepreneurship 3

1 Introduction

An economy's economic system and the choice of the economic institutions that constitute it is

critical to the major economic policy issues of the past two decades: the \transition" in the east-

ern European countries, which raised the question of whether it was Anglo-Saxon capitalism or

Continental corporatism to which they ought to \transit"; the ongoing and worsening slowdown in

western continental Europe, where disagreement has broken out over whether the causes lie largely

in the over-grown welfare state or instead in the lingering corporatism of many of its economic

institutions and public-policy mentality; and the accounting and corporate scandals in the U.S.,

which raise questions of how e

ective and reliable are America's corporate institutions in driving

entrepreneurs to innovate and how much further damage to entrepreneurship might result from

some of the corporate reforms enacted in the name of improving things.

To help with these issues economists must study the mechanisms of entrepreneurship and in-

novation in capitalist economies: the role of entrepreneurs in seeing commercial possibilities for

developing and adopting products that exploit new technologies; the role of entrepreneurs in con-

ceiving and developing new products and methods; the role of


11/65

nanciers in identifying entrepreneurs

to back and to advise; and the incentives and disincentives for entrepreneurship inside established

corporations. This means studying both the entrepreneur as a micro actor and the entrepreneurial

economy as an interactive system.

We start from the view that capitalism as an economic system/organization of economic insti-

tutions is relatively well suited to engender economic dynamism that is, a

ow of innovative

ideas from the economy's entrepreneurs that are ample and well-conceived, that are well-chosen

for testing and development by the economy's


12/65

nanciers, well-developed and well-launched by its

managers, and well-received by prospective users. Succinctly put, capitalism is viewed as a means

to an entrepreneurial economy that is, one producing new models, which lead to novel commercial

ideas and to diverse and competing beliefs (see for e.g. Baumol, Litan, and Schramm, 2007).

One question to be investigated asks how the relatively capitalist systems function, how they

work, to generate their dynamism. From observation and intuition we can see that a predominantly

capitalist economy has mechanisms and institutions that appear to support and foster a supply of

innovative ideas from entrepreneurs; it also has


13/65

nancial institutions that appear to aid in the4 Amarante, Ozg ur, and Phelps

selection of entrepreneurial projects to be developed and tried out on the market in the matching

of entrepreneur to


14/65

nancier; it also has institutions possibly facilitating the adoption (di

usion)

of newly marketed products/techniques; even institutions a

ecting the rate at which


15/65

nal users

(consumers etc) try the new things.

But this is not satisfactory. There are gaps in our knowledge here. One is theoretical. The

analytical apparatus of supply curves for


16/65

rms and demand curves for consumers (or other


17/65

rms),

the central authority calculating the market-clearing prices, is not helpful in explaining the oper-

ation of the capitalist systems|not at their core, at any rate. The investment banks and other

suppliers of


18/65

nance may have supply curves but the entrepreneurs want as much


19/65

nancing as they

can get. And each entrepreneurial project is a di

erent good, so we need as many prices as there

are projects


20/65

nanced. Which entrepreneur gets what? And which project is the marginal one, with

the rest going begging?

Fortunately, the fact that each entrepreneur's idea is idiosyncratic, thus unique, does not by

itself preclude a manageable and attractive model of equilibrium, provided we are willing to accept

the supposition of a rather simple setting. Irving Fisher and the late James Tobin imagined a

setting in which a large number of entrepreneurs, each with a project, and a large number of


21/65

nanciers, each with a pile of liquid capital, get into the same place to settle the value to be put on

each project. They showed that, theoretically, the capital market would


22/65

rst


23/65

nance the project(s)

with the highest perceived value per dollar of investment cost, then the next-highest, and so forth

until there were no more projects with hopes of a positive rent with a perceived value-to-cost

ratio (Tobins Q ratio) greater than one. Such a Fisher-Tobin equilibrium may exist even if the

pro


24/65

tability of each project o

ered is a matter of uncertainty the radical kind of uncertainty that

Frank Knight (Knight, 1921) pointed to, in which no one knows or can know the probabilities of

the various imaginable outcomes or even knows all of the possibilities there may be.

Unfortunately, there is a complication that, it appears, may (but in many actual cases might

actually not) get in the way of that simple equilibrium story: it could thus get in the way of a

manageable and attractive model of the operation of capital markets|even a simple market where

all the entrepreneurs


25/65

nanciers actually meet and interview. The source of the trouble lies in the

point that, generally speaking, each entrepreneur's idea presents some ambiguity|the


26/65

nanciersInnovative Entrepreneurship 5

can see only dimly what each idea is, what it involves, and even more dimly what its merits are.

Hence, although each


27/65

nancier may fall under a group of like-minded


28/65

nanciers each of whom views

the entrepreneurs' proposals the same way, such a group might rank the projects di

erently from

the way the


29/65

nanciers in one or more other groups do.

Not all scholars saw entrepreneurs' ideas that way. In the view of the early 20th century German

school, when a navigator or scientist has made a discovery, some entrepreneurs (it does not matter

which ones act and which do not) at once deduce the commercial applications, which are bankable

propositions. In Schumpeter (1911), little is changed except that it is the entrepreneur who makes

the discovery. But it is like


30/65

nding a $5 bill in the woods: the banker immediately knows its value.

The breakthrough was M. Polanyis tacit knowledge (\We can know more than we can tell."),

followed by Hubert Dreyfus, later Gary Klein. Like


31/65

ghter pilots, entrepreneurs cannot explain

their own decisions and thinking; the


32/65

nanciers can understand even less.

A usable model of the intersection of the entrepreneurs' projects and the


33/65

nanciers' capital

necessitates seeing whether disagreements in


34/65

nanciers' rankings could be a barrier to a coherent

story and, if it's yes, seeing whether there is an attractive and useful fallback position|some

disagreement but not any arbitrarily disagreement. Although a workable model of equilibrium in

this rather abstract market for entrepreneurs' ideas may be possible where the analysis might start

with a relatively general model in which no structure is imposed on the rankings, if the rankings

are su


35/65

ciently di

erent, there would be no stability in the results|no equilibrium can be said to

exist. (For example, the values placed on the projects may depend on the order in which they are

auctioned.)

In the current paper, to get around this di


36/65

culty, we build a model of a more structured sort in

which each


37/65

nancier prefers to back the idea of an entrepreneur whose \thinking", or model, seems

to be like his|thinking with regard to which industry is the best bet, swinging for the fences or not,

etc. The insight here, which originates with Hayek and M. Polanyi, is that everyone in a capitalist

system carries around a sort of personal model of the economy|at any rate, some piece of it. Thus

the \capital market" is a sort of matching process that matches a


38/65

nancier to an entrepreneur whom

the former sees as having a model compatible with his own model. In short, capitalism is portrayed

as producing a profusion of ideas representable as competing models of the economy (or a piece of6

Amarante, Ozg ur, and Phelps

it). Capitalism is more than the goods, which is why it's hard and avoided. We are convinced this

is worth doing: Entrepreneurship, innovation and capitalism will make it into economics classrooms

only with the arrival of abstract, formal representations.

1 When those arrive, capitalism|and its

entrepreneurs etc. will get a huge boost. And in policy deliberations, consequences of a policy

move that would otherwise be unanticipated will be more likely to be caught beforehand. Finally,

in Baumol's own words, we see this paper as our contribution to the attempt of bringing back the

Prince of Denmark (read innovative entrepreneurship) into the discussion of Hamlet (read micro

growth theory) (see Baumol, 1968, p.66).

1.1 Related Literature

The existing body of work on entrepreneurship in economics is mainly concerned with the nature

and the function of entrepreneurs in the economy. The term \entrepreneur" is known to have

been introduced by Cantillon (1775) who thought of entrepreneurs as speculators, risk takers,

arbitrageurs, and not as innovators. Although much later, Kirzner's (see Kirzner, 1979, 1985)

entrepreneur shares the same characteristics with Cantillon's: Succesful entrepreneurs are people

who are more alert, who notice, and bene


39/65

t from opportunities that are in principle available to

everyone (Parker, 2009). In contrast, Say's entrepreneur is an innovator. He is not shy to argue that

te absence of entrepreneurs in the economy can undercut prosperity and development (Say, 1828).

Baumol tells us that up until Schumpeter's breakthrough, economists, such as J. S. Mill, Alfred

Marshall, and Frank Knight touched upon the theory of entrepreneurship. However, their main

concern was management's role in directing going concerns rather than in establishing new


40/65

rms

for innovation (Baumol, 2010). Finally, Schumpeter (Schumpeter, 1911) brings a fresh voice to

the entrepreneur. He regards entrepreneurial activities as the primary cause of business cycles, by

making discontinuous changes, altering the ongoing paradigm and driving economic development

(Schumpeter, 1939).

1

Baumol's early writings point to the fact that the theoretical


41/65

rm in economics is entrepreneurless (see Baumol,

1968). More recent writings of Baumol (see Baumol, 2010) argue that although there is an invaluable

body of empirical

work being accumulated on the subject of innovative entrepreneurship, formal theory is still virtuallynonexistent;

one cannot even


42/65

nd the word entrepreneur' in most successful economic textbooks.Innovative Entrepreneurship 7

Most celebrated modern theories of entrepreneurship stands on the premise that entrepreneur-

ship is the outcome of an occupational choice process, in which the outside option is usually taken

as paid employment. Lucas (1978) uses heterogeneous ability to explain varying observed en-

trepreneurial occupational choices, in a model where individuals knew their abilities. Jovanovic

(1982) relaxes this latter assumption in a dynamic model where entrepreneurs learn about their

abilities over the long run and this dynamic learning process induces an equilibrium entry, growth,

and exit behavior across cohorts of individuals. Kihlstrom and La

ont (1979) use heterogeneous

aversion to risk to generate the heterogeneous selection into occupational choices.

Entrepreneurs also take the center stage in macroeconomic theoretical models, (i) as generator,

accumulator of wealth that promotes growth and further entrepreneurship, e.g., Evans and Jo-

vanovic (1989), Banerjee and Newman (1993), Aghion and Bolton (1997), Acemoglu et al. (2006),

Berger and Udell (1992), and Newman (2007), (ii) as entities adapting their actions to advances in

technology, exogenous (Calvo and Wellisz, 1980) or endogenous (Aghion and Howitt, 1992, 1997),

and (iii) as promoters and exploiters of knowledge spillovers in the new endogenous growth theory,

e.g., Romer (1986) and Schmeidler (1989).

A current debate in the literature is whether patents and temporary monopoly pro


43/65

ts are

necessary to give entrepreneurs the incentive to undertake innovation activities. A literature on

`patent races' argue that


44/65

rms compete against each other for the right to monopoly pro


45/65

ts, while

rendering previous products obsolete as observed by Schumpter. In Aghion and Howitt (1992),

for example, imperfect competition is needed for entrepreneurs to be willing to conduct research.

Lucas (1978) and Romer (1986) suggest that either a complicated set of taxes and subsidies or

allowing monopoly power and relative pro


46/65

ts is necessary to let innovators internalize the unpriced

\spillovers" they generate with their innovative ideas, so that they are fully rewarded for their

incremental contribution to aggregate productivity. Boldrin and Levine respond to that claim

by arguing that monopoly is neither needed for, nor a necessary consequence of innovation. In

particular, intellectual property is not necessary for, and may hurt more than help, innovation and

growth (see e.g. Boldrin and Levine (2004a,b, 2005a, 2008, 2009)).

We depart from the existing literature in the way \uncertainty" is modelled. In the existing

theory, following the Bayesian tradition, uncertainty is modelled as Risk. It is an old idea, dating8

Amarante, Ozg ur, and Phelps

back to at least Knight (1921), that some|and, perhaps, the most relevant|economic decisions

are made in circumstances where the information available is too coarse to make full sense of the

surrounding environment, where things look too fuzzy for having a probability distribution over a

set of relevant contingencies. In such situations, Risk Theory is simply of no use. This distinction

between Risk and Ambiguity was fully appreciated by Knight (1921), who attempted to build a

theory of entrepreneurship and pro


47/65

t based on it. We adhere to this view. In fact, our main claim

is that, granted the presence of Ambiguity, the main di

erences between a decentralized economy

and a centrally planned one could be explained by the dierent ways each type of economy deals

with Ambiguity.

The study and the usage of uncertainty and probabilistic methods go a long way in economics

(see Lippmann and McCall, 1981). When it comes to distinguishing between risk and uncertainty,

Knight (1921) receives the credit. The modern de


48/65

nition of risk is any situation where the likeli-

hoods of possible events are precisely measured by a unique objective probability. Uncertainty or

ambiguity as suggested by Ellsberg (1961) refers to situations where events likelihoods are unknown.

In the classical Arrow-Debreu model, at an economys equilibrium there is nothing uncontroversial

about the way one deals with uncertainty.

Decision theorists have developed several models to deal with this problem, all of which stipulate

that the behavior of agents facing Knightian uncertainty is described not by a single probability

but rather by a set of those (Amarante (2009), Bewley (2002), Schmeidler (1989), Gilboa and

Schmeidler (1989), Ghirardato et al. (2004), and Klibano

et al. (2005). An important special case

of variational preferences is the so-called multiplier model of Hansen and Sargent (2007). See also

Hansen and Sargent (1999, 2001). Though originally not motivated by the Ellsberg paradox and

ambiguity, the \model uncertainty" literature due to Hansen and Sargent falls within the scope of

the literature on decision making under ambiguity. As argued by Ghirardato (2010), both decision

models they employ are special cases of models in the ambiguity literature: the \multiplier model"

is a special case of variational preferences (Maccheroni et al., 2006), and the \constraint model"

is a special case of Maxmin Expected Utility by Gilboa and Schmeidler (1989) For good surveys

of this fast-growing literature see Mukerji (1997), Marinacci and Montrucchio (2004), Mukerji and

Tallon (2004), Ghirardato (2010), and Gilboa and Marinacci (2010). For a few (by no means

anInnovative Entrepreneurship 9

exhaustive list) applications of this framework to general equilibrium, asset pricing, and contracts

see Dow and Werlang (1992), Mukerji (1998), Mukerji and Tallon (2001), Epstein and Wang (1994),

Epstein and Schneider (2008), Easley and O'Hara (2009) and Rigotti and Shannon (2005),

There is one paper that comes closest to the current one regarding the question it asks and the

formalism it uses: Rigotti, Ryan, and Vaithianathan (2011) (RRV henceforth). RRV studies the

occupation choice of a continuum of agents between an old safe technology and a new technology

whose return is uncertain. In equilibrium, the fractions of agents who are most ambiguity tolerant

select into the new technology, get matched up with another agent to form a


49/65

rm. Moreover,

within a new


50/65

rm, the more tolerant one assumes the residual ambiguity while providing the less

ambiguity one with a


51/65

xed wage contract. RRV terms the former the \entrepreneur" and the latter

the \worker" type.

There are many important distinctions between RRV and the current model. First of all,

our main objective is to understand what it is that makes free-market capitalist economies better

habitats to engender economic dynamism, relative to other economic systems. To that e

ect, in

contrast to RRV, heterogeneity, plurality of innovations (read as many new technologies, innovations

as the number of entrepreneurs) is crucial for us. RRV does not study


52/65

nancing of innovations. We

do because we believe that a crucial di

erence between centrally planned and capitalist systems

might reside in the latter's ability to deal with Knightian uncertainty when it comes to channelling

credit toward ambiguous innovations. We also focus, as in RRV, on ex-ante e


53/65

cient contracts

between matches of entrepreneurs and


54/65

nanciers. However, we show that the general equilibrium is

necessarily ine


55/65

cient when there are multiplicity of innovations being


56/65

nanced. Finally, in contrast

to RRV, we study the question of whether it is Pareto improving to subsidize innovation and to

create a


57/65

nancier class to boost the dynamism in the economy. The answer turns out to be true

under mild regularity conditions.

Overall, the current paper is the


58/65

rst model of its kind that studies both the entrepreneur

and the


59/65

nanicer as micro actors and the entrepreneurial economy as an interactive system. The

remainder of the paper is organized as follows. Section 2 introduces the general class of economies

we are interested in along with the fundamental roles played by entrepreneurs and


60/65

nanciers as

micro actors. Section 3 presents an economy with entrepreneurial innovation and provides the

main10 Amarante, Ozg ur, and Phelps

results of the paper for that economy, mainly, equilibrium existence, characterization of bilateral

contracts between entrepreneurs and


61/65

nanciers, (in)e


62/65

ciency of equilibria and welfare comparisons

across economic systems. Section 4 contains the arguments regarding the feasibility of welfare

improving subsidies and a general conjecturere. Finally, Section 5 discusses possible future research

and concludes.

2 The Environment

2.1 Entrepreneurs and Financiers as Micro Actors

This section introduces formally the main ingredients of the class of economies we study. There are

two dates, denoted by t = 0; 1. There is a single all-purpose good that can be used for consumption

or that can be invested in productive technologies and which serves as a numeraire.

The economy is populated by individuals who can each be of three possible types: ordinary

consumers, innovative entrepreneurs, or


63/65

nanciers. Let C, E, and F be the sets of each type of

individuals respectively; let I := C [ E [ F be the set of all agents.

There is no uncertainty at date 0. We distinguish between two sorts of uncertainty at date

1, namely, risk, and ambiguity (Knightian uncertainty). Let

p := f1; : : : ; Sg denote the


64/65

nite set of publicly known states of the world. All agents agree on the likelihood of these publicly

observed states, and hence hold the same belief, represented by the probability distribution p on

p. The second sort of uncertainty, namely ambiguity, is created by entrepreneurs' innovations,

whose discussion we postpone until when we describe what we mean by innovation below.

Agents have streams of endowments of the consumption good, denoted by wc; we, and wf , for

consumers, entrepreneurs, and


65/65

nanciers respectively, contingent on the realizations of the publicly

known states in

p. More precisely, for i 2 I, let wi

:=

wi;0;(wi;1(s))

s2

2 R

S+1

+ . We assume for

simplicity that agents invest at date 0 before the resolution of uncertainty and consume at date 1

ex-post. In order to consume in the next period, agents need to invest in one of the following set

of possibilities:

Asset market: There exists a complete set of Arrow securities for contingent consumption

at date 1. At date 0, agents can trade in these securities that pay contingent on the publicly

the entrepreneurial economy ii

Documents