Uncertainty, Competence and the Theory of the Firm
(Some crucial omissions and misunderstandings of the current debate)
by Angelo Fusari
Istituto di Studi e Analisi Economica (ISAE)
Piazza dell’Indipendenza, 4, 00185 Roma, Italy
Email Tel. 06 44482877
Paper presented at the
second meeting of the European Network on the Economics of the Firm (ENEF), Erasmus University, Rotterdam, 8-9 September 2005
Abstract: This essay aims in particular at remedying one of the major failing of the current state of the analysis on uncertainty, competences and innovation: the lack of a measure of radical uncertainty and of tension in the use of entrepreneurial skill. It shows the possibility of those measures and their importance for the explanation of investment, innovation and some other crucial variables. The shaped model of the firm also flanks transaction costs with productive expenses and emphasizes the monitoring role of profit rate as expression of the firm’s results. Some FIML estimates at the industry level are provided.
Keywords: Entrepreneurship, Competence, Uncertainty, Innovation, Decision-making, Estimations
Introduction
This paper considers the problem of the firm in the perspective of general economics much more than in that of business schools. In fact, it seems to us that a major shortcoming of the good deal of work performed by those schools is the lack of coordination with general economics. In an earlier essay[1], we treated entrepreneurship and economic process at length. The present paper complements it by adding a treatment of the firm. Despite the incessant transformations of the economic background, which produce parallel changes in the organization of the firm, some basic features preserve substantial stability. Unfortunately, their meaning is obscured by various misunderstandings; some clarification is accordingly required.
A main feature of modern economies is the central and growing role that creativity and innovation play in the context of the process of dynamic competition. They generate uncertainty that makes entrepreneurship, decentralization and market institutions indispensable, being bureaucratic decision making no congenial to uncertainty. Therefore, the treatment of creativity, innovation and entrepreneurship requires a parallel and accurate treatment of uncertainty and a tight theoretical interaction amongst them.
At present, economics is afflicted by a sharp division between a line that presumes perfect knowledge, also including known probability distributions, and another emphasizing true or radical uncertainty, i. e. incomplete knowledge and the connected notion of bounded rationality. Unfortunately, the second and more realistic line unanimously supposes, as far as I know, that radical uncertainty is unmeasurable by definition. We shall see, both from a theoretical and empirical perspective, that this assumption is wrong, that it deviates attention from the level of uncertainty and its variation and that this condemns in a state of theoretical vagueness some important variables, such as entrepreneurship and innovation as well as decisional criteria. Besides, it prevents a coherent formalization of the dynamic competition process, which is indispensable to encapsulate the theory of the firm in general economics.
It will also be shown the way of measuring the degree of radical uncertainty and discussed the importance of such measure for the explanation of innovation, investment, the formation and use of (hence the tension in) entrepreneurial capability. Moreover, it will be pointed out that the refusal of optimization because it would require the irrealistic hypothesis of perfect knowledge is due to the wrong assumption of non measurableness of radical uncertainty; in the presence of that measure, it is perfectly possible to arrange optimization with radical uncertainty and hence to use the approach in decision-making.
The paper is organized as follows:
Section 1 expounds some very general consideration on organization, capabilities and uncertainty. Section 2 briefly discusses a number of significant aspects of the present debate on the firm. Section 3 is specifically dedicated to the controversy on optimization, relevant for its links with the notions of entrepreneurship and uncertainty. Section 4 presents some developments that give a special importance to uncertainty, entrepreneurial capabilities, innovation, the role of the firm and its decision-making. Section 5 sets out a formalization of the entire theory, and Section 6 presents some estimations of the model.
- Organization, capabilities and uncertainty
The question of the firm is part of the more general topic of organizational and institutional forms and may opportunely be hinged on such a general framework.
Man needs organizational forms, as a consequence of his skill limitations that make necessary co-operation and hence its organization. Social systems cannot limit themselves to the establishment of some general rules aimed at allowing common life, trusting for the remainder on individual action. Some more specifical and involving organizational problems must also be faced; otherwise not even the accomplishment of general regulations will be warranted.
Human societies have known, in the course of history, two main types of organizations that profoundly differ each other for both contents and implications:
a)Closed organizational forms, the nature of which is conservative and bureaucratic; they dominated in tribal societies based on relatives and strongly characterized the administrative structures of ancient great empires. These organizational forms are suitable to face repetitive processes and to operate in the presence of perfect knowledge. Accordingly, they thwart innovation and uncertainty that disconcert them and paralyse their ability to take decisions. In parallel lines, they tend to preserve and perfect the repetitivity of processes, which is congenial to them.
b)Open organizational forms, driven by entrepreneurial behavior. They characterize the social systems inclined to innovate and distinguished by high uncertainty. This kind of organization requires and feeds on some decisional skills that are the opposite of those sub a and are characterized by versatility, ability to meet unknown and to engender new situations, in sum, to meet and feed uncertainty.
Open organizational forms remained marginal for a long historical time. In the beginning, they came forth in the presence of natural contexts that promoted uncertainty or very aleatory activities (e.g. commercial relations) and/or as part of civilizations that stimulated critical behavior, adventure and evolutionary process. This kind of organization emphasizes, beside the limitation of skills, a more troubling kind of limitation concerning knowledge.
Open and entrepreneurial organization has vigorously spread in Western world; the economy has represented the most fertile soil of its development. The firm is a main entrepreneurial organization (sub b) devoted to produce goods or services. Therefore, the problem of its nature and existence is part of the wider field of dynamic and entrepreneurial organizational forms and the growing need of these caused by the acceleration of evolutionary process. In some sense, the firm has accentuated the peculiar traits of open organizations, first of all, the pattern of capabilities requested by true uncertainty. Therefore, in the study of the firm, the insistence on administrative organization may cause some serious misunderstandings, since it is mainly typical of non entrepreneurial forms (sub a) that often show a very sophisticated and well specified administrative organization. It is important to not forget that the firm derives its very nature of entrepreneurial agent from uncertainty. For one side, it causes uncertainty through innovation in a more direct and insistent way than other open organizational forms; for the other side, it is obliged to meet uncertainty caused by other innovators or exogenous accidents. Profit, the main target of the firm, is the result of uncertainty, i.e. the limitations of knowledge and the connected differentials in capabilities; as a matter of fact, only limited and hence differentiated skills can evolve and produce gains. In the absence of exogenous shocks or innovation, the opportunities for profit would disappear.
If considered in the perspective of general economics, the firm is the engine of the dynamic competition process, which characterizes the functioning of modern economies. For that process is the result of the entrepreneurial activity of search and discovery of profit opportunities based both on innovation and arbitrage over time and space, with the aim to extract gain from the disequilibria and darkness characterizing evolutionary processes. Therefore, dynamic competition seems to be the most appropriate tool for inserting the theory of the firm in general economics.
So, the skills, knowledge, innovation and, more in general, the role of the firm must be considered in relation to uncertainty since in the absence of this one there would be no need of entrepreneurial decisions and organization. But the simple reference to uncertainty is not enough. It is necessary to measure and verify its level that, as we shall see, assumes a central role for the formation and use of capabilities and hence for determining the tension in that use, as well as for explaining innovation, investment and, last but not least, representing dynamic competition, indispensable to conjugate the theory of the firm to general economics.
- Some significant aspects of the debate on the firm
Uncertainty is a dominating trait of the human societies where the economy holds a central position and hence strongly pushes growth and development. Notwithstanding, uncertainty has been turned round by mainstream economics through the hypothesis of perfect knowledge and competition that brings out play entrepreneurial skills. Upon this hypothesis (that includes the case of known probability distribution, i. e. probabilistic certainty)) has grown a theoretical system extremely coherent in the appearance but in effect undermined by a fundamental inconsistency: it is qualified for bureaucratic-conservative organizations typical of repetitive societies or, more in general, of societies that have less to do with uncertainty; nevertheless, it pretends to explain the behavior of open entrepreneurial economies.
The perception of the fundamental role that play uncertainty and the limitation of knowledge has progressively entered economics. A number of theoretical approaches have grown on this perception and may be unified under the denomination of “heterodox economics”.
In a seminal contribution of many years ago, E. Penrose reacted to the hypothesis of perfect knowledge, which erases entrepreneurial capabilities, through a “Theory of the growth of the firm” that is founded upon the availability and evolution of its managerial capabilities and knowledge and the ability to diversify production. She says: «Thus the availability of ‘inherited managers’ with such experience limits the amount of expansion that can be planned and undertaken in any period of time… Once a substantial increment of growth is completed, however, the managerial services devoted to it become available for further expansions»[2] A shortcoming of this development is the omission that such availability depends on the level of uncertainty, which markedly influences both the formation of entrepreneurship and the quantity of entrepreneurial knowledge used in ordinary activities and to manage the achieved expansion.
Penrose attributes great importance to versatility, which avoid that “the market for those products will restrict the firms opportunities of expansion”, and adds: «a versatile type of executive service is needed if expansion requires major efforts on the part of the firm to develop new markets or entail branching out into new lines of production»[3]. The author insists in depicting the firm as an administrative and planning organization. She does not consider that this kind of organization is mainly typical of bureaucratic-conservative forms sub a. The lack of caution in this matter is an effect of the minor role she attributes to uncertainty. This one is considered as: «the entrepreneur’s confidence in his estimates of expectations», i.e. as a subjective and not an objective fact that influences the firm’s behavior. She adds: «Risk, on the other hand, refers to the possible outcomes of action, specifically to the loss that may be incurred if a given action is taken».[4] These peculiar notions of risk and uncertainty are useful to Penrose’s analytical purposes, but they are deceitful if considered in a more general sense. She is concerned about the role of information in reducing subjective uncertainty and in the resources necessary to get information, and concludes that risk and uncertainty are final limiting factors only if managerial services are fully used. Again, she forgets to consider that the use and the need of managerial services depend on the level of uncertainty. This level is never considered; uncertainty is simply treated as a subjective entity, rather than an objective one influencing both demand and supply of entrepreneurship. A main shortcoming of Penrose’s analysis seems to be the marginality of the role she attributes to uncertainty. This marginalisation of uncertainty persists in all the theories of the firm that attribute a central role to capabilities; the reason of that is the usual way to intend uncertainty makes difficult to treat capabilities. In order to clarify this aspect, some considerations on the way economics consider uncertainty is required.
As is well known, a pioneeristic treatment of uncertainty was provided by F. H. Knight. But his analysis is afflicted by two main errors:
First, the idea that uncertainty only implies some deviation from the results of Neoclassical economics of perfect knowledge, but without substantial prejudice for its teaching.
Second, the idea that uncertainty is unmeasurable.
Heterodox economics that, polemically with mainstream economics of perfect knowledge, underlines the importance of uncertainty, plainly overcomes the first Knight’s error. But it completely shares the second one. In addition, its right perception of the qualitative jump with respect to Neoclassical economics that the introduction of true uncertainty in the analysis implies, has strongly accentuated the consequences of the second Knight’s mistake.
Neoaustrian economics gives a clear expression of some misunderstandings caused by this equivocation. Its sharp criticism against Neoclassical economics is hinged on uncertainty. But the assumption of unmeasurableness and impalpability of uncertainty has imprinted on Neoaustrian students an extreme hostility towards organization, leading them to erase the problem of the firm from the agenda of their work. More precisely, the emphasis on unknown and unintentional events has pushed their analysis, mainly in Hayek’s version, toward a prejudicial preference for spontaneous order over organization and command considered as arbitrary interferences obstructing the tendency of social events toward self adjustment. According to this school of thought, general rules, mainly market laws, are enough to allow the harmonization of spontaneous actions and unintentional events. But the emphasis on individual initiative ignores the simple fact that the limitation of skills requires organization.
Another main obstacle to a neo-Austrian theory of the firm is that this school sees entrepreneurial capability as an evanescent, non-measurable entity and, as such, not liable to rational evaluation and impossible to specify. But skills do exist, and the firm has the duty of evaluating its capabilities with a reliable degree of approximation so as to use them properly. Neo-Austrians’ work on market process, uncertainty, search and discovery can make an important contribution to the theory of the firm. Unfortunately, their prejudice against organization has deprived the analysis of the firm by these neo-Austrians deepenings.
J. A. Schumpeter made an opposite error: his attention for entrepreneurial capabilities disregarded uncertainty, notwithstanding this one springs out copiously from his “creative destruction”. This omission, that confirms the difficulty to conjugate capabilities to the usual way to consider uncertainty, induced him to emphasize, in “Capitalism, socialism and democracy”, the role of managerial services and in the absolute error to predict the end of capitalism as a consequence of bureaucratization. It is illuminating on the importance of a proper consideration of uncertainty the fact that the Schumpeterian theoretical effort, full of lightings and contradictions, gives space, in the end, to bureaucratic aspect (sub a) at the expense of the entrepreneurial one (sub b). As a consequence, the building of a general theory of the firm has also been deprived by the support of the branch of dynamic competition process represented by creative destruction, in addition to neo-Austrian (the other branch) refusal of the question of the firm.
The effects of these misunderstandings have partially affected evolutionary economics, that has accomplished an interesting analysis on the microfoundations of innovation along Schumpeterian lines. Nelson and Winter’s explanatory models of technical change, search and selection within the firm have represented an interesting starting point. But an important aspect differentiates this school of thought from Schumpeter: the remark it attributes to uncertainty, mainly under the notion of bounded rationality that, as we shall see, is an ambiguous way to call up incomplete knowledge. In a theoretical context marked by the notion of bounded rationality clearly appears the difficulty to treat entrepreneurial capabilities, being uncertainty considered as an unmeasurable, subjective, impalpable entity. In point of fact, evolutionary economics has performed some interesting researches on capabilities that stress the power of learning and tacit knowledge for explaining the behavior, internal organization, boundaries and results of the firm. But significantly, it insists in the identification of capabilities through the notion of decisional routine, as a partial remedy to the analytical vacuity deriving from the idea of unmeasurableness and impalpability of uncertainty. This insistence is coherent with the importance that Schumpeter attributed to managerial bureaucracy and with Penrose’s insistence on capabilities independently on uncertainty. In fact, decisional routines are concerned with the bureaucratic-conservative aspect of organizations. They refer to repetition and hence not to entrepreneurial decision-making since this requires versatility and some skills able to face uncertainty.
It must be underlined that a fundamental ambivalence characterizes evolutionary social thought, which is well reflected by evolutionary economics: for one side, this school is inclined to disregard the problem of the firm as a consequence of its tendency to exaggerate the limits in human knowledge and hence to distrust of organization at the advantage of spontaneous behavior; but, for the other side, a branch of evolutionary social thought is greatly attracted by the evolution of institutions, not only in the sense of Menger’s theory of the emergence of money as a result of unintentional events. In economics, this attraction is mainly concerned with the firm and the connected analysis was initially fertilized by Coase’s seminal article on “The Nature of the Firm”. He wrote «The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism… It is true that contracts are not eliminated when there is a firm but they are greatly reduced»[5]. Here the firm appears to be an organization that substitutes command for the price and market mechanism in the allocation of resources. This Coasian perspective has promoted useful investigations on the firm. Precisely, it has stimulated two lines of research directed towards explaining the nature and the role of the firm as an organization, now unified as the “contractual perspective”. One is derived from O. Williamson, who has developed Coase’s intuition on transaction costs and hence emphasized the distinction between “markets and hierarchies”; the other is Alchian and Demsetz’s approach on the “nexus of contracts”.