What is Entrepreneurial Judgment?

Nicolai Foss and Peter Klein give a full overview of judgment in chapter 4 of their book Organizing Entrepreneurial Judgment. Foss and Klein present an overview of the economic literature which treats entrepreneurship as judgment and proceed to flesh out the attributes of judgment. They conclude the chapter by suggesting that investments should be the unit of analysis for those studying entrepreneurship.

History of Economic Thought on Entrepreneurial Judgment

Foss and Klein (FK) take note of several economists who have contributed to the literature on judgment. Frank Knight and Ludwig von Mises are the two economists most emphasized by FK. Knight distinguished between risk and uncertainty. He believed risk applied to cases he termed “apriori probability” (such as the probability of getting heads when flipping a coin) and “statistical probability” (such as the probability of your house burning down which an insurance company takes into account). To Knight, uncertainty applied to cases of “estimated probability”, situations where there is “no valid basis of any kind of classifying instances.” To deal well with uncertainty, one must be able to articulate and communicate estimates about the future. However, there is no sound way to calculate an accurate probability estimate.

Mises distinguished between what he termed “class probability” and “case probability”. Class probability applies when a certain event qualifies as a unique element of a homogeneous class, the properties of which are known. FK point out that the probability of your house burning down falls under class probability. The homogeneous class is house fires. Insurance companies can make accurate estimates of the probability of your house burning down by using data on other elements in the class (e.g. the number of past house fires in your neighborhood.) Case probability applies to cases in which each event is unique and no general class probabilities can be defined. Mises argued that purposeful human behavior (or action) in general cannot be part of a homogeneous class, and therefore action must be considered under case probability. In a world characterized by unique individuals and an uncertain future, human action cannot be treated as belonging to a homogeneous class. Each action must be considered itself.

FK also mention economists George Shackle and Ludwig Lachmann in their discussion. Shackle ascertained that human imagination and innovation make for an open ended economy which leaves people ignorant of the future. He saw the nature and identity of some future states as unknown and unknowable. He also recognized that the economy is given to radical change when imagination and innovation upset the existing allocation of resources. Lachmann emphasized a growth of knowledge in his writing. He asserted that future knowledge must be unpredictable; if it weren’t it would be present knowledge. The thought put forth by all these economists implies that the entrepreneur must use his subjective judgment to interpret economic data and anticipate future market conditions.

Examining Judgment

With the aid of the existing economics and entrepreneurship research literature, Foss and Klein put forth their best explanation of judgment. They claim that judgment is “the crucial entrepreneurial element of making uncertain decisions regarding uses of current or new resources to satisfy future preferences.” They break judgment down into some key elements. Skills and experience is one of these elements. Imaginative skills, derivation of decision rules, analytical skills and searching skills are all parts of entrepreneurial judgment. They also support the notion of effectuation. This puts forth that entrepreneurs take an incremental and flexible approach to their goals using their experience. Their plans and goals are adjusted as they continue to gain new knowledge of how available resources can be used.

Creativity is another element of judgment and deals with exploring, defining and redefining a problem which the entrepreneur can then solve with what he produces. A third element noted by FK is uncertainty preferences. Uncertainty preferences does not imply that entrepreneurs are simply less risk averse than the average person, but rather means, more accurately, that entrepreneurs are particularly confident when they confront ambiguous decisions. They demonstrate that they believe their judgment to be good judgment which can successfully navigate through an uncertain situation.

How should Judgment be Classified?

Foss and Klein claim that judgment is not only decision making under conditions of uncertainty, but can be more fully understood as decision-making about resources which the entrepreneur owns and controls. Entrepreneurship is not another factor of production like wage labor and capital goods. It is something which should be conceived differently. You cannot simply add or subtract a unit of entrepreneurial service in production. Rather, entrepreneurship itself is embodied in the firm. It is an attribute of the firm itself. This is because individuals acting on behalf of the firm employ judgment in their decision making. FK argue that although entrepreneurship has been treated by some as a measurable factor of production, such as when it is defined as an occupational category like “small business owner” or “self-employed”, this is not a conception which encapsulates entrepreneurship. They argue it is best to treat it as a functional category of judgment, regarding it as more than a factor of production.

Investment as the Unit of Analysis in Entrepreneurship Research

Foss and Klein conclude their chapter by suggesting that investment should be treated as the unit of analysis in entrepreneurship research. They define investment as “the assembly of resources in the present in anticipation of (uncertain) receipts in the future.” Investment of resources is made into various projects. A project is conceived as a stock of resources committed to particular activities for a specified period of time. Resources are allocated to maximize the rate of return for the total amount of projects undertaken. Thus, entrepreneurs do not focus on merely maximizing the rate of return on any one project they carry out. Rather, they set out to maximize their profit across projects, ensuring that their resources are allocated in the most efficient way possible. In studying entrepreneurship, scholars should focus on the how, what, when and why of investments.

Chapter 5 will explain the nature of capital goods as a means to which entrepreneurs apply their judgment.

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  1. Summary of Organizing Entrepreneurial Judgment, chapters 4-7 « entrepreneurship@McQuinn - October 7, 2012

    […] post; John Dellape’s summary of chapter 4 — probably the heart of the book — is here, and his summary of chapters 5-7 is here. Enjoy, and thanks John! Share this:Like this:LikeBe the […]

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