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Article written in 1985 for an economics journal but not published

ONE ENTREPRENEUR'S THEORY OF ENTREPRENEURSHIP



John J. Ray

University of New South Wales, Australia

Abstract

The theory is put forward that prospective profits must seem very large before an entrepreneurial activity is undertaken. This is reconciled with the fact that the average return from entrepreneurial activity is not characteristically very large and may even be negative.

If an entrepreneur had $100 to invest and the only investment available to him would increase his $100 by only one dollar, would he make the investment? With many qualifications, classical economic theory would answer "Yes". I am going to propose that real-life investment decisions are much more "lumpy" than this and that many everyday investment decisions taken by our businessmen require a return of more like $200 for every $100 before the money will in fact be put up.

No great theoretical innovations are required to support this proposal. I am thinking of mechanisms that are in general fairly well-known. The contribution I hope to make lies then in pointing out how big an effect certain influences can have.

The best-known reason why investors will need more than a 1% return to induce investment is, of course, the risk factor. Certainty is not a property of any living system and the range of possible outcomes facing an entrepreneur may quite commonly lie anywhere between bankruptcy and great wealth. One presumes that it is precisely this range of possible outcomes that deters the vast majority of the population from ever undertaking anything entrepreneurial. In fact, to be a non-entrepreneur is in a probabalistic sense far more wise. When we note that the vast majority of new businesses do not succeed in the short to medium term, we have to conclude, as Gilder (1980) does, that the entrepreneur is a double-dyed optimist of an exceptionally admirable kind. The point I wish to make, then, is that not only does risk add to the "profit" required of an undertaking but the unquantifiability of that risk to the investor makes the "profit" required exceptionally large. An investor who believed that his risk was a precisely quantified 10% might simply be prepared to add that 10% to the return required before he would make an investment, but an investor faced with an unknown degree of risk will surely require a very much larger inducement than 10% if he/she is to accept the risk at all.

Since I actually sympathize with the stress on quantification that seems to characterize modern economics, let me mitigate the harshness of what I have just said by saying that I do not believe that degree of risk is generally totally unknown as far as the individual entrepreneur is concerned. What I am proposing is that a range of possibilities is accepted but that the range concerned is often very wide. I am also proposing, in fact, that the "worst case" of the range of possibilities (complete loss of capital or even bankruptcy) is one that figures very largely in entrepreneur calculations. Given the actual rate of business failure, it would be strange if it did not. Where the entrepreneur differs from the common herd, then, is in his ability or readiness to accept this "worst case" outcome as a price he might have to pay for seeking wealth. For most people, no prospect of gain would be great enough to justify such a risk.

I am not, of course, saying that all entrepreneurs are insane optimists. Very often the entrepreneur will have a combination of optimism and special knowledge or ability. What may seem a great risk to most people may to one person with special knowledge or skills seem relatively unrisky and quite manageable. In his unique position, then, such a person may need only a little optimism in order to undertake what others less favoured would consider frightening. Let me give a fairly pedestrian example of this sort of thing from my own experience as an entrepreneur.

I am in the business of making money by a method which almost every Australian seems to have heard of at some time. It is often summarized as "Buying a house and letting the tenants pay it off for you". Needless to say, this is easier said than done and almost everyone who has contemplated it soon sees sufficient pitfalls to scare him/her off ever attempting it. Nonetheless it can be done and the profits can in the end be such as to make working for a salary seem ridiculous.

The main risk that people rightly see is that mortgage repayments are enormous and any failure by tenants to pay their rent could soon lead to insolvency. The required procedures for evicting tenants are often cumbersome and slow and there is no doubt that a bad tenant often gets away with a great deal indeed. I myself however feel that this is quite a manageable problem because I have good interpersonal and negotiating skills so that conflicts and other problems are headed off before they arise. I can, therefore, almost always ensure a reasonable standard of tenant behaviour. For me, then, the chance of major loss of revenue is remote and I can reasonably treat it as such. For other, less confident, people, by contrast, the risk would be ever-present and hence not to be undertaken. In other words, although the risk in being a landlord is generally great, I do not perceive it as being great for me. It needs therefore only a little optimism for me to decide to undertake the investment concerned. My profits are then a reward for special ability rather than a reward for willingness to take risk.

Even in this case, however, the need for enormous incentive is present before such special ability is exercised. As the phenomenon of I.Q. testing bears witness, mental abilities in humans tend to be fairly highly correlated. A person who is good at one problem-solving task tends to be good at many other problem-solving tasks. A person with good mental abilities, therefore, will generally have open to him/her many paths to the good life. He/she should be able to do well for himself/herself without undertaking the risks and hard work required of the entrepreneur. He/she was probably doing pretty well anyway even before the possibility of entrepreneurship arose. Given the law of diminishing returns, then, a really big reward will be required to give him/her only a small gain in satisfaction. In my case, for instance, I had a tenured and well-paid academic teaching job before I ever became an investor. With prestige, job-satisfaction, security, high income and extensive leisure what did I need a million dollars for? Had it not also been the case that (probably like most entrepreneurs) I like a challenge, even the prospect of becoming rich might not have tempted me to exercise my special abilities in an investment field. As it is, I devote far more time to writing large numbers of academic journal articles (something that earns me no money) than I do to managing my business interests.

In summary, then, both the prospect and the reality of very large percentage profits on my investments have succeeded in luring me into exercising my special abilities as an investor in only the most part-time way. I am sure I am far from being alone in this. In the customary language of economists, really large rewards may be needed to give an able person a small improvement in subjective "utility".

One may ask how the above theory squares with the apparent attention people give to matters of half a percent when they are investing in things like bank accounts and bonds. Does not my theory require that interest rates of something like 50% would be needed to coax out any saving? Not at all. Investments of this sort are not entrepreneurial and are made in circumstances much more like that of a simplified model in classical economics. There is, in other words, no appreciable risk and no personal effort or ability is required. There are some areas where a simple classical model approximates reality but my point is that entrepreneurship is generally far from being one of them.

Are there any macroeconomic implications of my account of entrepreneurship? There surely must be. Command economies excepted, the interest of any developing nation today is surely to maximize entrepreneurship among its people. I think in fact that my theory makes sense of a type of confusion that often seems to plague defences of free-market economies. Because actual examples are so much more persuasive than abstract theories, defenders of the market economy tend to point to certain nations which they believe represent a success-story for free markets. They point to places like Hong Kong, Switzerland, Taiwan, South Korea, Japan, Singapore, the United States etc. The odd thing about this list is that many on it have a system that departs a long way from free-market capitalism. Some are or have been highly authoritarian states with pervasive central planning (e.g. Japan, Taiwan and Singapore). Such states certainly are among the world's economic success stories of recent times but free-market capitalism is scarcely what they have in common. What they do have in common, however, is sufficient freedom to offer the prospect of relatively huge profit to entrepreneurial individuals. Contrary to the extrapolations of some observers of change in the Communist world, then, it is not freedom in general that is the prerequisite for high economic growth -- just freedom of one kind: The freedom to make proportionately huge profits. Insofar as reformist leaders of the once-Communist world try to curb such "excesses", therefore, they will be attacking the one thing they most need.

This is not to say that the entrepreneurs of any country will in general make huge profits. It is all too easy to think of examples of even brilliant business entrepreneurs ultimately experiencing bankruptcy or near-bankruptcy so huge profits are hardly likely overall. What is needed is simply that the opportunity be there.

How then do we explain why it is that the return on capital made by the average industrial company is so low? Why is it in fact commonly lower than what many small savers get from their bank accounts? Does this not suggest that even quite small returns will lure people into business? To answer this we need to distinguish between what is needed to get a business started and what is needed to cause it to continue once it has started.

A large component of the risk in starting up a business is unforseen, unforeseeable or underestimated costs. And the potential entrepreneur generally knows this. He knows that all he can do is guess as far as many of his costs are concerned. How can I as a landlord guess what it will cost me to repair damage done by tenants? Therefore, it is only the prospect of big profits that will induce me to bear such risks. What commonly ends up happening, however, is that the costs are in fact much greater than the level estimated. Staff and labour costs in particular tend to mount up from all sides. The result is that most new enterprises founder, often very rapidly, and those that survive show profits that are very much less than what was originally envisaged. The big profits expected then, are generally an illusion of overoptimism and poor knowledge of what the enterprise will entail. But this of course in no way detracts from the fact that the prospective entrepreneur must have grounds to believe that big profits are in the offing. Of those firms that do survive, of course, it is usually in the entrepreneur's interest to keep going. He often thinks that a breakthrough is just around the corner, he may be able to find nothing else he would rather do for a living or it may genuinely be the case that the business is worth more as a whole (by way of, for instance, "goodwill") than it would be if broken up and its assets sold off.

The rarest case is the one where the business does turn in profits of something like the magnitude expected. Since I am lucky enough to have business interests that approximate this, I tend to believe that such cases are not mere luck but are the cases where special knowledge, skills or abilities are present. One well-known example of this might be Henry Ford -- whose ideas concerning the organization of a workforce were indeed very special for the time. In such cases what commonly happens is that the huge profits achieved are ploughed back into the business as capital for expansion. The business grows, becomes bureaucratized, loses its initial advantage as competitors copy its methods and ends up again as a very ordinary enterprise with very ordinary profits. Even so, of course, the generation and deployment of capital entailed in this process is very beneficial to the national economy concerned. The enterprise becomes part of the social fabric of at least its employees and there is thus created a vested interest in keeping it going long after its initial dynamism and profitability are lost.

In general, then, it should be clear that enterprise is a delicate plant that should generally by most logic not exist at all. Governments that make life difficult for entrepreneurs may therefore succeed in stifling new enterprise entirely. If one has to add the vagaries of government to the vagaries of the market in one's calculations, the sum of even foreseeable risk may exceed what even the most chronic optimist will be prepared to bear. If governments want the benefit that entrepreneurial activity confers, therefore, they need to be perceived as being "pro-business" or at least not "anti-business". This, I think, is all that such countries as Switzerland, Hong Kong, Taiwan, Japan, South Korea, Singapore and the United States have in common. They provide a climate (including real concessions) wherein business optimism can reach ever new heights.


REFERENCE

Gilder, G. (1980) In defence of capitalists. Commentary 70(6), 42-45.




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