This is the second post in the live-blogging Economics as Religion series. The first post was published on Monday, March 11.

“To the extent that any system of economic ideas offers an alternative vision of the ‘ultimate values,’ or ‘ultimate reality,’ that actually shapes the workings of history, economics is offering yet another grand prophecy in the biblical tradition.”

Karl Marx is well-known as an outspoken opponent of religious belief. Calling religion the “opiate” of the masses, he was convinced that religion suppressed the proletariat’s desire to improve their economic condition in favor of a more heavenly focus. But Marxist philosophy illustrates perfectly the power of underlying religious influences on economic thinking.

According to Nelson, Marx’s ideas are founded upon a biblical eschatology.

“Humankind has fallen into evil ways, corrupted by the workings of the forces of the class struggle. The resulting “alienation” for Marx has virtually the same meaning for the human situation as “original sin” in the biblical message…The prospect for escape from this terrible condition, however, is close at hand. God (now replaced in Marx by the economic laws of history) has promised to deliver the world from sin (alienation). There will be a fierce struggle and a great cataclysm (a final war in history between the capitalist and the working classes), followed by the arrival of the kingdom of God on earth (the triumph of the proletariat and the arrival of pure communism).

Marx, then, should be understood as considering himself a messiah. Though his value system is not made explicit and is decidedly anti-Christian, his philosophy is nothing if not religious. He offers a vision of “ultimate reality” that is to be brought about by economic forces alone.

His faith in economic forces is made manifest in his attributing the religious, social and cultural features of society to economic causes. Capitalists, Marx argues, manipulate social institutions in order to serve their ends, regardless of the stated ends of these institutions’ originators. The laws of economics have literally assumed the role of God, who orders and designs the universe and transcends human action.

Though Marxism itself did not find staying power across Western universities, its use of economics as a means to explain almost all social phenomena became a common feature of new economic theories — “economic gospels.” While Nelson does not explore the relation of this type of thinking to the advent of Darwinism (and, on that note, similar tendencies in other disciplines like psychology, sociology and history), the influence of natural selection and evolutionary biology likely had much to do with the advent of Marxist-like theories about economic history as tending toward one particular utopic end state.

“In the economic gospels, the existence of evil behavior in the world has reflected the severity of the competition for physical survival of the past.”

Instead of viewing economic prosperity as the result of sound moral foundations, the economic gospel views material deprivation as the cause of bad morals. Jean-Jacques Rousseau, according to one authority, believed “it was property alone which induced crime and wars,” corrupting the happy state of nature by conflicts over material possession. In like manner, Friedrich Engels writes that the new rate of industrial production in the communist utopia will satisfy all demand, thereby rendering conflicts over material possessions a thing of the past.

While the economic gospel might have begun with Marx, it was most prominently displayed in the work of John Maynard Keynes. In his essay “Economic Possibilities for Our Grandchildren,” Keynes writes that capitalism is a “disgusting” system that separates human beings from their inner, better selves. But an era of abundance is coming whereby these problems will be eradicated and cut-throat capitalism will become unnecessary, giving way instead to an era of abundance and peace. All that is needed is faith and trust in economists’ incremental adjustments to the current economic system.

While presented as economic theory, Keynes’ ideas were nothing short of a new secular theology. Its followers were fueled by the passionate fervor characteristic of religious belief. As Joseph Schumpeter writes,

“A Keynesian school formed itself, not a school in that loose sense in which some historians of economics speak of a French, German, Italian school, but a genuine one which is a sociological entity, namely, a group that professes allegiance to One Master and One Doctrine, and has its inner circle, its propagandists, its watchwords, its esoteric and its popular doctrine.”

Keynes’ doctrines also had a special advantage over the likes of Marxism, in that his was carefully woven into the fabric of popular opinion. By recommending incremental change funneled through the medium of democratic government, Keynes avoided the cultish aura of Marx, and his theories soon become instantiated as quasi-law among economists and politicians alike. Fortunately for him, few saw his ideas for what they really were: tenets of a new, secular, economic faith.

Thanks for reading. Tenets of Economic Faith is a post from Hans Economics

Over the next few weeks, I will be live-blogging Robert H. Nelson’s Economics as Religion. Though the book is somewhat dated (published 2001), its discussion is still relevant. This is the first post in this series. Hope you enjoy!

Introduction: The Market Paradox

The role of self-interest in economic growth is a paradox.

Of course, no serious economist doubts the role of self-interest in facilitating economic growth. This idea began with Adam Smith and has since become an indisputable pillar of modern economic thought. But this doesn’t mean that the blessings of the invisible hand go without saying. In fact, defining the role of self-interest in economics is complex and represents a challenge to economists who seek to describe and prescribe the causes of economic prosperity.

“Society as a whole benefits from a well-functioning market, but many individuals could in fact themselves gain significantly from corrupt and other self-interested actions.”

While self-interest is undisputed as the motive for production and exchange, it is known to be the reason for theft, dishonesty, and countless other unethical (and economically-detrimental) behaviors. Africa, for example, is full of human beings pursuing their own self-interest. Yet corruption is rampant across the continent because no clear distinction exists between “legitimate” and “illegitimate” self-interested behavior. “The boundaries of community,” Nelson writes, “seldom extend much beyond the clan and the tribe, an arena much smaller than that required for the realization of the full benefits of competitive markets.”

Thus, Nelson explains, the pouring of financial aid into countries like Zambia has done little in the way of facilitating sustainable economic growth. While Zambia was for decades been one of the largest recipients of foreign aid in Africa, its GDP was actually less in the 1990s than it was in 1964.

Such phenomena has all but destroyed the once-common notion that a shortage of financial capital was the cause of economic underdevelopment. In its place, a focus on social factors and the role of social pressures in restricting illegitimate self-interested behavior has become of prime concern to those economists who seek to understand and aid in economic development.

One logical conclusion to such an idea is that wealthy countries must have more of these social pressures than poorer, underdeveloped countries. However, literature on this topic is sparse. Whereas economists around the world dedicate their energies to studying third-world economies, few have written at any length about the social values that have allowed for the sort of prosperity that exists in the modern-day United States.

“Culturally…a key requirement for a market system will be a set of values in society that offer vigorous encouragement to self-interest in the market and yet maintain powerful normative inhibitions on the expression of self-interest in many other less socially acceptable areas.”

As Nelson admits, describing such a culture is difficult in the ordinary language of the social sciences, not in the least because of the obvious allusion to religious belief. While the practical consequences of religious belief can be (and is often) integrated into economic analysis in the form of “preferences,” the sources of religious belief are all but unknown in traditional economic literature. Yet hardly anyone denies the special dependence of economic systems on underlying religious belief that provide a normative foundation for market activity.

Theologians, then, and not economists, may be the most important members of society when it comes to promoting economic growth. Their religious prescriptions often have much greater influence on the actions of the general public than cold, calculating economists, and–as argued above–religious belief is the most important cause of economic growth. But instead of simply handing the keys to priests and ministers, economists of the twentieth century assumed the role of priest themselves.

“Economists played their most important role in American society in the twentieth century as theologians and preachers of a religion.”

This religion, Nelson argues, has as its central tenet a limitation on self-interested behavior to (generally) those actions that are considered “legitimate” from a property-rights perspective. Economists justify this limitation by upholding the market economy as a religious end–its existence paving the road to economic progress, which will ultimately create “heaven on earth.” Indeed, many twentieth-century economists viewed economic progress as the means to create utopia. Describing their sentiments, Nelson writes, “If the love of money is…the root of all evil, the end of scarcity and the arrival of an era of full material abundance can mean the end of evil in the world.”

The implications of such ideas will be explored in later chapters. However, one obvious consequence is the justification of self-interested behavior in a market setting. Unlike Marxism and other “economic religions,” the religion of economic progress has facilitated economic growth by asserting that self-interest is, indeed, the fount of progress when manifested in the form of voluntary production, consumption and exchange.

Finally, one other immediate consequence of such a belief has to do with economic professionalism. If progress is a religious end that no rational human beings should act to thwart, then economist’s role in society is unlike any that of any other professional. This, too, will be explored in later chapters.

Thanks for reading. Economics as Religion: The Paradox of Self-Interest is a post from Hans Economics

This piece was originally published by the Ludwig von Mises Institute on February 11, 2013.

Employment law is a mainstay of state economic policy. Few question its efficacy as a means to correct “market failures”—like unlivable wages for meaningful work—that would leave society in shambles. In fact, no serious debate exists among American policymakers about the benefits of such laws. Their utility is simply assumed.

But laws that restrict or stipulate the terms of voluntary employment contracts stifle economic progress and make life harder for everyone—even those for whom the laws were designed to aid.

Minimum wage is the most basic example of such a law. By outlawing employment below a certain wage-rate, the state ensures that no one works for less than what its officials consider a “living wage.” The first federal minimum wage legislation was the Fair Labor Standards Act.[1] Since its passage in 1938, the bill has been amended many times—usually to adjust the minimum wage to account for inflation. Today, the federal minimum wage is $7.25 per hour.

In the act, Congress determines that “the existence … of labor conditions detrimental to the maintenance of the minimum standard of living necessary for health, efficiency, and general well-being of workers” causes inequity, burdens commerce and “the free flow of goods in commerce,” and leads to labor disputes that further hamper free commerce.[2] Minimum wage is their solution to this problem.

Read the rest at Mises.org.

Thanks for reading. Waging War on Work is a post from Hans Economics

Mia over at PragmaticMom.com has posted a great analysis of basic monetary economics over at her blog. I encourage you all to read it. Here’s an excerpt:

This is the key question of why the United States (and therefore Rosie) can’t just print endless amounts of money. This questions shifts from a question of Government in terms of who OWNS the money to one of economics. The question now for PickyKidPix is WHAT HAPPENS IF THE U.S. PRINTS ENDLESS AMOUNTS OF MONEY (thereby now allowing my friend Rosie and anyone else who works to make the money to take a pile of bills for herself).

The simple explanation is that prices rise when the government prints more money. For someone studying economics, here’s the reason along with graphs.

It’s great to see this type of analysis being done in the blogosphere. If there is any area in which Americans’ understanding is deficient, it is basic economics, and Mia’s post is a very sound way to begin to understand this issue.

But there is one thing I would add to this analysis in order to make sure that readers know the full effects of monetary inflation. That is, the first receivers of new money do not experience the same devaluation as everyone else. They experience real benefits at the expense of the last receivers.

Here’s an example:

Imagine there is $1 billion in circulation. The government decides, for whatever reason, that this number should increase by $1 million. So they print some money and send it into circulation. But this money has to start somewhere…not everyone’s bank account can simply increase by the proportionate amount (in fact, that would ruin the whole point of printing money as a form of economic stimulus). So what usually happens is new money is sent first to big investment banks on Wall Street, as they are the most capable of sending this money into circulation (they have billions of dollars and millions of customers).

When these banks receive the new money, stores and retailers around the country have not had the opportunity to increase their prices. The money has not been circulated yet, and though they might read in the newspaper that the money supply is going to increase, they cannot raise prices until their customers’ bank accounts experience the effects of the inflation.

The result: These banks are able to purchase, borrow and lend based on pre-inflation prices. This means they are given an unfair advantage and can increase profits only because of the new money–not because of any new ideas or hard work on their parts.

So while inflation might seem harmless (in the end, everyone’s prices simply increase), it actually benefits the big banks at the expense of the little guys. Among those most harmed by inflation are those on fixed incomes like the elderly and very-poor. For them, price hikes are not accompanied by wage-increases. They simply must learn to live with less.

I know what you’re thinking…this is starting sounding like an Occupy Wall Street rant against big banks. But believe me, I am anything but an OWSer. The simple fact is: Big banks do benefit from inflation at the expense of average Joe because new money has to start circulating somewhere, and it almost always starts in the hands of big banks.

Thanks for reading. The Dark Side of Monetary Inflation is a post from Hans Economics

This article was originally published at Values and Capitalism.

In recent years, the purported effect of oil speculators in raising the price of oil has sparked much debate and concern. Pundits of various political bents have sought an explanation for the rising price of oil among the activity of speculators, and legislation has recently been considered by Congress that would limit the profit margins of oil speculators with the goal of suppressing costs.

Summarizing perhaps the most prevalent belief about the role of speculators in altering the price of oil, President Obama argued this spring that the American people “can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit.”

Additionally, initiatives like Stop Oil Speculation Now (now part of the National Airline Policy Campaign) have gained considerable support from industries that rely heavily on oil for operations, such as transportation and energy companies. These industries allege that financial speculators drive up the price of oil by buying and selling it with no intention of using it, and that such speculation must end if their corporations are to function efficiently—or “based on supply and demand fundamentals instead of profiteering strategies.”

But these critics of speculators grossly misunderstand the role of speculators in the modern economy, and if their attempts to limit speculators’ activity succeed, the economy will suffer.

To understand why, it is critically important to understand what a speculator does…

To read the rest of this article at ValuesandCapitalism.com, click here.

Thanks for reading. In Praise of Speculators is a post from Hans Economics

Recently, a government corporation established as “Federal Prison Industries, Inc” (more commonly known as UNICOR), has gained attention in the public eye. Although UNICOR has been in existence since 1934, I first learned of its existence just last week while watching The Colbert Report. On October 7th, the Huffington Post ran this article criticizing UNICOR for undercutting small business in America.

What is UNICOR?

UNICOR is an American federal government run corporation operating under the mandate “to provide employment and training for inmates in the Federal Prison System while remaining self-sufficient through the sale of its products and services.” UNICOR employs inmates at wage rates far below the minimum wage from 23 cents per hour to no more than $1.15 per hour. The corporation provides products and services in various industries such as clothing & textiles, electronics and furniture. There are currently 14,200 inmates employed with UNICOR, 8% of the prison population eligible to carry out the work. All of this information can be found at www.unicor.gov.

The Economics of UNICOR

As UNICOR has gained visibility it has outraged some because it undercuts other businesses who compete for the work given to UNICOR by getting away with paying such incredibly low wages. When viewed in full light of economic analysis, the trouble with UNICOR runs much deeper than what has been expressed. The following is a list of points I feel all US taxpayers ought to be aware of in putting together the serious violation of economic freedom embodied in UNICOR.

1. US Incarceration costs

The US imprisons approximately 2.4 million people. CBS news reports that while the US has 5% of the world’s population, it has 25% of the world’s prisoners. They also report that taxpayers spend $63.4 billion a year to imprison people. That works out to an average of $31,307 per year for one inmate. While imprisoning dangerous criminals is typically viewed as a legitimate use of taxpayer money, the extraordinary rate in America still ought to raise alarm. Is there a legitimate reason why our incarceration costs are so astronomical? There is a real problem here which at this point is impossible
to ignore. In fact, CBS reports that prison funding has become a national issue that has Democrats and Republicans both working to cut costs and imprison rates.

2. US minimum wage laws

Nearly any economist you ask, regardless of his school of thought, will tell you that minimum wage laws increase unemployment. But most people are not economists. Most people believe that if a politician dictates to business the minimum amount they are allowed to pay for labor, the common laborer will benefit. The reality is that businesses will not employ as many people if they must pay higher wages than they would otherwise. For an explanation of why, see my friend Caleb Fuller’s article “Minimum Wage Distorts Reality”. Nonetheless, America has a minimum wage of $7.25 per hour. In establishing this, the federal government effectively increases the amount of unemployed Americans.

3. UNICOR is employing prisoners at wages below the minimum wage

While the federal minimum wage is $7.25 per hour, UNICOR does not employ prisoners for any more than $1.15 per hour. By employing prisoners who cannot work on the market, UNICOR is able to get cheap labor unavailable to any privately run American business. Thus the government-run UNICOR does not pay anywhere near the amount of labor costs as a private company legally must. With lower production costs, UNICOR can charge its customers prices far below those of competing private businesses. Hence UNICOR is able to undercut their competitors and decrease the amount of
employment available to law abiding citizens in the private sector.

4. The biggest customer of UNICOR is the federal government

To me, this is the most disturbing and unjust aspect of UNICOR. 84% of UNICOR’s revenue comes from purchases made by the federal government through departments of defense, homeland security, justice and others. The department of defense alone supplies 47% of UNICOR’s revenue. The Economist reports that the US pays $700 billion for military spending. This represents 4.8% of GDP, a higher percentage than any other nation in the world. This money is taken from law abiding taxpayers. Some of this money is used to purchase UNICOR products and therefore pay UNICOR’s laborers — US prisoners.

Connecting the Dots

UNICOR is a prime example of unjust and convoluted government intervention into the economy. First, the absurd magnitude of US spending on its prison system, especially when compared to other nations, leads one to believe that there are serious issues with the fairness of the US prison system. The federal government not only takes an immense amount of money from citizens to fund its prisons, but it runs a corporation which causes more unemployment among free citizens who need jobs the most by employing prisoners at wages far below the minimum wage. Departments of the federal government, especially defense, benefit the most from this as UNICOR’s biggest customer.

In essence, taxpayers are forced to pay way too much for our prison system and military. At the same time, taxpaying businesses are forced to pay minimum wages which decreases the amount of people they can employ and increases their cost of production. Instead of fully allowing private companies to supply products to the military, through UNICOR the government decreases the amount of contracts given to private business and instead employs prisoners to do the job.

I am interested to see how much more information comes out about UNICOR in the coming weeks. One does not have to look too far to see that there is something seriously unjust about its existence. If nothing else, it highlights how vast, convoluted and damaging our federal government’s intervention has become.

Thanks for reading. UNICOR undercuts economic fairness is a post from Hans Economics

The way “the economy” is discussed in our modern day has led to widespread misunderstanding about what “the economy” actually is. In the following, I will briefly share what it is, what it is not, and where the conversation about the economy has gone awry.

What it is:

The term “the economy” is used to describe the innumerable exchanges between people. The large majority of those exchanges take place between business organizations each composed of individuals who have chosen to come together in producing and exchanging goods and services. There are certainly a substantial number of businesses in any given city. The US Census Bureau estimates that as of 2007 there were a total of 24,600 business firms in the city of Pittsburgh alone (the city in which I reside and am very proud of). When aggregated to the state level of Pennsylvania, the number grows to a staggering 981,000 firms. Within a single firm, there are many decisions made by individuals at every level in the hierarchy. The firm itself is a complex nexus in which innumerable decisions are made by employees that influence the business itself, the business’s customers and the suppliers of the business. There are approximately 1 million businesses in Pennsylvania alone. The complexity involved in the interrelation of businesses on a city, state and national level is increasingly immense.

What it is not:

“The economy” is not and should not be considered some abstract entity constrained to a few aggregate statistics such as GDP and employment rates. Understanding this is absolutely essential for any sort of meaningful discussion about the economy. Our public discourse about the economy is terribly oversimplified and thus misleading. Cable news programs time and time again discuss the economy without any recognition of its complexity. These programs almost always assume that decisions can be quickly made by a group of people (most often government politicians) that will produce desirable employment rates and prices. Yet in reality those rates and prices are the result of the innumerable decisions made within and between individuals. The economy is not something that can be simply “fixed”. Beyond that, who is anyone to easily ascertain whether the economy is “broken” or not?

To be clear, it is certainly possible for one to learn about the economy and intelligently describe its condition on a national level. There would be little reason to be an economist if not. It is impossible, however, to give any intelligent analysis of the economy without first appreciating it for the complex nexus of human exchange that it is. That is something all economists, regardless of their ideological differences, should agree on.

My hope is that the next time you hear someone talk about “the economy” (which most likely will be in the next few minutes considering an election is a month away), you will have a greater appreciation for what that term means. Ask the person you are in conversation with, “what is the economy?”. We must begin to think more deeply about the subject. What better way to start than by defining our terms? I don’t foresee cable news doing these things anytime soon. That does not have to dictate your conversations. I hope it will not.

Thanks for reading. What is the Economy? is a post from Hans Economics

Yes, the title is intentionally provocative. Last night I decided I would read President Obama’s nomination acceptance speech from the DNC. Truth be told, when taken out of context, the President said some things that resonate with the Austrian School of economics. The President rightly evaluated that there is no easy, quick and painless way for the U.S. to escape the economic quagmire its stuck in. While his diagnosis was partly correct, his prescribed treatment of government activism will only make the problem worse.

The President spoke truth when he admitted, “I won’t pretend the path I’m offering is quick or easy… the truth is, it will take more than a few years for us to solve challenges that have built up over decades.” This is exactly right and worth stressing. In a world that’s become increasingly dominated by unfounded reactionary indignation, it should be emphasized that there are no easy, quick solutions to our economic issues. There’s no one person to blame for how we’ve gotten to the place we are in. It is wildly naïve to think that simply replacing elected officials will lead to improved standards of living. Elected officials no doubt have influence over a nation’s economy. Yet we have reached a point where no elected official can prevent reduced standards of living nor should we want him to.

Let me explain further. There are natural laws that apply to our economy. Politicians, republicans and democrats alike, often disrupt the natural functioning of the economy. This brings consequences in the form of lower standards of living. More government intervention can temporarily prevent standards of living from dropping, but not indefinitely. Additional intervention brings short term relief while amplifying the negative consequences that will eventually come to pass. The intervention leads to swings in economic prosperity, oftentimes called “booms” and “busts”, which do not naturally arise in the absence of intervention. We now face a “bust” in economic activity. There is no way to avoid the bust. Features of the bust include unemployment, bankruptcies, deflation and a general reduction in standards of living.

Fortunately, this is not the end of the story. There is a calm after the storm of economic hardship that comes with the bust. Sound economic analysis reveals that when the bust is allowed to occur, after a time, resources are reallocated more efficiently than they were before. This leads to less unemployment and sounder businesses than we had even before the bust. Our standards of living will be the best they have been in years. But the bust must be allowed to occur to reach new heights of prosperity.

Getting back to the President’s remarks, he immediately followed his correct assessment of the inevitable difficulty ahead by stating, “It’ll require common effort, shared responsibility, and the kind of bold, persistent experimentation that Franklin Roosevelt pursued during the only crisis worse than this one.” In reality, he is advocating to amplify the problems we face. To read up on how FDR made the Great Depression worse, I refer you to Hans Sennholz article here. The measures advocated by the President will further hamper the functioning of our economy. He cannot usurp the natural laws which govern economic activity.

In summary, though I disagree with the President’s prescription for our problems, I agree wholeheartedly with his admission that there is no easy, quick solution to what we confront. I urge any Romney supporters out there to receive this. I’ve heard many a Romney fan (if anyone is actually enthusiastic enough about him to qualify as a “fan”) say essentially, “once we get Obama out of there, things will be back on track.” Regardless of who takes office come November, it is beyond the power of any human or group of humans to “fix the economy”. If you anticipate Romney doing so, prepare to be let down whether he gets elected or not. No one can “fix” the economy. What Romney could do is adopt policies which let economic laws govern economic activity and allow the bust to naturally occur rather than amplify it by intervention. This will lead to improved standards of living for the future, but most likely not until his term in office is expired.

Obama or Romney, the near future will be characterized by economic hardship. The road ahead is difficult and it will take time to correct the issues that have resulted from government intervention no matter which route is taken. Either we can compound the issues with more intervention or allow the market correction to take its course and solve them. I’m not confident that either men have the will to choose market correction over intervention in the face of a public which will undoubtedly crucify their president for not “fixing the economy” in a timely manner. Regardless of your political affiliation, my hope is that you consider the economic reality we face, seriously reflect on the possibility that there are laws of cause and effect which are at work, and set your hopes and expectations accordingly.

Thanks for reading. President Obama Sounds like an Austrian Economist is a post from Hans Economics

The last subject covered by Nicolai Foss and Peter Klein in Organizing Entrepreneurial Judgment is the internal organization of the firm. Foss and Klein argue that the organization of the firm is critical to how entrepreneurial judgment will be manifested at different levels of the firm. Ownership rights are foundational for this organization to occur.

Original and Derived Judgment

Foss and Klein distinguish between original entrepreneurial judgment and derived entrepreneurial judgment within the firm. Original judgment is the judgment which belongs to the owner of the firm. The owner exercises original judgment in forming and executing a business plan. They have decisive control over the structure and goals of the firm. As a firm grows larger, the entrepreneur with original judgment will lack the information to make all firm decisions. At this point, the owner-entrepreneur delegates decision making to other employees within the firm. Foss and Klein call these employees with delegated powers “proxy-entrepreneurs”. They are given the right to exercise derived entrepreneurial judgment over certain decisions. In other words, Foss and Klein argue that the owner-entrepreneur makes “specifying decisions”; defined as a “set of formal and implicit contracts by which the entrepreneur delegates judgment to subordinates in the multi-person organization”.

Foss and Klein assert the truth, which has been underemphasized in the literature, that not all entrepreneurship is beneficial. Some entrepreneurial decisions are productive while others are destructive to the firm. Productive entrepreneurship results from employees using their discretion to create or discover new attributes of firm assets which add value to the firm. Destructive entrepreneurship occurs when employees use their discretion in efforts which reduce firm value.

Those with original judgment have the task of managing derived entrepreneurship. To expand derived entrepreneurial judgment to employees, the owner-entrepreneur will reduce constraints on employees. He then must manage the trade-offs between the productive entrepreneurship and destructive entrepreneurship of his employees. Foss and Klein state some ways this occurs within businesses. Owners can give employees bonuses for value adding outcomes in reward for productive entrepreneurship. They can also give employees direct equity stakes or stock options to incentivize adding value to the firm. To constrain employees judgment, the owner-entrepreneur can do such things as set the “proxy-entrepreneur’s” budget, determine which activities he’s allowed to engage in, assign which people he is allowed to work with, and determine how he’s allowed to use equipment.

Ownership and Internal Organization

Foss and Klein explain that ownership rights are central to the internal organization of the firm. Ownership rights allow the owner-entrepreneur to make contracts with his employees and define how entrepreneurial judgment will be exercised throughout the firm. By loosening contractual constraints on how employees can use firm assets, the owner-entrepreneur expands the scope of entrepreneurship for lower level employees. By tightening the constraints, he decreases the amount of entrepreneurial judgment his employees are allowed to exercise over firm assets.

To manage derived judgment efficiently, ownership needs to clarify two things up front. They must commit to rewarding employees for suggesting projects which the firm adopts. This gives employees incentive to seek out new and improved ways to use firm assets. If the firm does not commit to rewarding employees for finding better uses of assets, the employees will be less likely to take the time and energy to search for these uses as it will be too costly for them. Secondly, ownership must communicate what types of projects it will adopt. This gives employees incentive to focus on searching for projects that ownership wants to pursue and thus makes the searching process more efficient.

Dispersed Knowledge, Authority and Firm Organization

The last section of chapter 8 accounts for dispersed knowledge, most famously articulated by economist F.A. Hayek, and its implications for the firm. Foss and Klein define dispersed knowledge as “knowledge that is not possessed by any single mind and which may be private, fleeting, tacit and subjectively held and is necessary for the effective allocation of resources.” Thus in a firm, management does not have all the knowledge to make the best allocation of resources. Critical knowledge is dispersed throughout the organization to lower level employees.

Foss and Klein argue that management deals with this reality by giving employees discretion. In large organizations, owners will typically set a structure for distributing discretion. Mid managers are delegated decision rights by owner-entrepreneurs. These mid managers then delegate decision rights to employees under them, and so and so forth. Thus the firm is decentralized through this delegation of decision rights.

While management employs mechanisms to decentralize the firm in light of dispersed knowledge, authority is still retained by the owners for final decision making. Foss and Klein argue that a level of centralized authority is still necessary and beneficial even in light of dispersed knowledge. They argue it is better for employees to be constrained and guided to some degree rather than left to act solely according to their own judgment. FK point out a couple reasons why. One is that a need for urgent coordination often arises. Authority, or the right to direct factors of production, must be exercised quickly in such urgent situations. Owners often have decisive knowledge in such cases. They can make a decision based on their information without involving other pieces of information. Therefore a hierarchy of authority is very beneficial when someone needs to make quick decisions with firm assets. The property rights held by the owner-entrepreneurs secure their right to make these final decisions.

Conclusion

To summarize Foss and Klein’s chapter 8 conclusion, tying together entrepreneurship and the firm allows for a dynamic and realistic understanding of how the internal organization of the firm is established and the effects it has on performance. The internal organization determines how derived entrepreneurial judgment will be exercised by employees as circumstances change. The owner-entrepreneur exercises original judgment in determining the amount of discretion his employees will have. Thus, entrepreneurship is exercised in some way at every level of the firm. The owners should not be mistaken as passive bystanders to the actions of the firm, for they are the ones who ultimately establish and adjust over time the structure for how entrepreneurship is to be exercised by firm employees.

Thanks for reading. Organizing the Firm is a post from Hans Economics

In the final chapters of Organizing Entrepreneurial Judgment, Nicolai Foss and Peter Klein set out to theoretically account for the existence, boundaries and internal organization of the firm. They continue to focus on the central role of the entrepreneur in explaining the firm. Chapter seven is the point at which Foss and Klein really begin to connect and forge the theory of the firm with the theory of entrepreneurship.

The Emergence of the Firm

In explaining the existence of the firm, Foss and Klein focus on the prominent roles played by transaction costs, heterogeneity of assets, and experimentation. Foss and Klein argue, while drawing support from other scholars, that it is particularly difficult for entrepreneurs to communicate their judgment and therefore the value of their service to other market participants. They write, “Firms may emerge because those whose services are most difficult to measure become entrepreneurs, employing and supervising others, and committing their own capital to the venture.” The extraordinarily high transaction costs make it necessary for an entrepreneur to be part of a firm to exercise his judgment. Here, Foss and Klein establish that the firm as a minimum consists of the entrepreneur and the assets he owns.

Within the firm, as has been touched on already, heterogeneous assets are combined in the production process. Foss and Klein argue that experimentation with these assets is a central function of the firm. They define “experiments” to mean a range of things including assembly lines, implementing organizational architecture, inventing new products, etc… The entrepreneur arranges these experiments according to his judgment. The various attributes of assets are created and discovered through this entrepreneurial experimentation within the firm.

Through this process of experimentation, the firm alleviates coordination problems that arise in an economy. Foss and Klein state that coordination problems, “arise when those who deliver parts or carry out activities are not aware of the need for mutual adjustment, or do not have the incentive to make their activities mesh with those of others.” If all individuals are completely self-directed in exchange, these coordination problems would be more severe. When individuals come together and work in a firm, combining their knowledge and abilities to combine assets owned by the firm, these problems are alleviated.

The authors argue that submission to the authority of the entrepreneur by the employees of the firm may be the least costly way of organizing experiments with assets. By authority, FK mean “the entrepreneur has the right to redefine and reallocate decision rights among team members and to sanction team members who do not use their decision rights efficiently.”

The Boundaries of the Firm

Foss and Klein argue that an understanding of ownership rights is essential to understanding the boundaries of the firm. Here, Foss and Klein cite the literature coming from new property rights theory which argues that ownership rights over assets strengthen a person’s bargaining position when making contracts. Such ownership rights will also heavily influence one’s decision to either invest or not invest in developing a business idea.

Foss and Klein define ownership in terms of “having the residual control rights over a resource, especially the right to exclude others from a resource.” In essence, ownership rights are necessary for an entrepreneur to reap the rewards from his judgment and carrying out his ideas. For the entrepreneur to secure the proceeds from his venture, he must acquire the ownership rights of the resources he will use in his production venture. The boundaries of the firm are determined by the amount of resources the entrepreneur owns. An increase in resources leads to an expansion of firm boundaries while a decrease in resources leads to a contraction of boundaries.

Foss and Klein also make mention of and support the work done by Giovanni Gavetti and Daniel Levinthal on cognitive representations held by entrepreneurs. In summary, Gavetti and Levinthal emphasize that different individuals have different ideas of how to best combine assets to bring the best products to the market place. They call these ideas and speculations about production in the mind of entrepreneurs “mental models”. Foss and Klein argue that accounting for the heterogeneity of these mental models gives a solid framework for understanding firm boundaries. These mental models change over time causing firm boundaries to change as well. This helps avoid the misleading conclusions often drawn by those analyzing the economy from an equilibrium standpoint.

In equilibrium, any reversals in firm behavior represent errors and market inefficiencies. But reality is not equilibrium. Reality is that we live in a changing, dynamic world. What FK call a “process oriented perspective” is more fitting to analyze the world we live in. Foss and Klein write that from this perspective, “A divestiture of previously acquired assets may mean simply that profit-seeking entrepreneurs have updated their forecasts of future conditions or otherwise learned from experience. They are adjusting the structure of heterogeneous capital assets specific to their firms.”

Foss and Klein close their chapter by drawing upon economists Ludwig von Mises and Murray Rothbard to explain the limits of firm boundaries. In short, Foss and Klein conclude from the literature that no firm can become so large that it is both the unique producer and user of an intermediate product. Firms would be unable to calculate profit and loss within different divisions of the firm and therefore unable to efficiently allocate resources between these divisions. This is because there would be no market for the “intermediate product” in question to determine its price.

Mises convincingly argues that private ownership of factors of production is necessary to have markets for asset prices. If no exchange exists for a given asset (if it is entirely produced and used by one firm) then it cannot have a meaningful price. If it does not have a meaningful price, then there is no way to determine if the cost of producing the good is profitable or not. This is the basis for Mises argument that a socialist economy could not survive. In a purely socialist economy, all resources would be under the ownership of a single entity. There would be no private ownership of assets, therefore no exchange and thus no meaningful asset prices.

Conclusion

To conclude the blog on chapter 7, I will simply cite the summary of the chapter given by Foss and Klein. They write:

“Firms exist as manifestations of entrepreneurial judgment-to realize their visions, entrepreneurs must take possession of resources, and, in a world of heterogeneous assets and knightian uncertainty, they are continually combining and recombining these resources. Doing so as a network of independent contractors, each possessing residual income and control rights over his own resources, would be prohibitively costly. Hence it makes sense for entrepreneurs to own complementary resources.”

Thanks for reading. Entrepreneurship and the Nature and Boundaries of the Firm is a post from Hans Economics