What are Capital Goods?

In chapter 5 of Organizing Entrepreneurial Judgment, Nicolai Foss and Peter Klein articulate the real nature of capital goods. They explain how the treatment of capital goods has varied among different schools of economic thought as well as the implications for the firm and the entrepreneur resulting from differing conceptions of capital goods. Foss and Klein argue that the Austrian School of economics offers the most realistic conception of heterogeneous capital and thus lays the best framework for developing a connection between a sound theory of entrepreneurship and a sound theory of the firm.

Capital Goods according to Modern Mainstream Economics

Foss and Klein (FK) argue that modern economics unfortunately does not give much attention to capital goods. Therefore a satisfactory conception of capital goods is not found in the majority of the economics literature. FK note that predominate treatment of production is the “production function view” which stems from the neoclassical school of economics. In this view, capital goods are a “homogeneous blob” or what is sometimes given the nickname “shmoo”. This shmoo can be defined as an infinitely elastic, fully moldable factor that can be substituted costlessly from one production process to another.

Neoclassical economics treats the firm as a “black box” which transforms inputs of homogenous capital (shmoo) into output (finished goods) which are sold on the market. The production function view (PFV) does not take the organization of the firm into account and assumes that the knowledge necessary for production is obvious and can be easily transferred. The PFV leaves one with a simple, unrealistic portrayal of the production process which brings goods to the market.

Foss and Klein mention some key implications which the PFV has on the firm and the entrepreneur. Since the organization of production is inconsequential in the PFV, a theory of the firm (the entity which organizes production) is inconsequential according to this view. For the same reason entrepreneurs (ultimate decision makers composing the firm) are not of any real importance in the PFV. The PFV takes a very non-complex view of the world and thus oversimplifies economic reality and completely diminishes the role of the firm and the entrepreneur.

Capital Goods as Heterogeneous Goods

When capital goods are viewed as heterogeneous instead of homogenous, we are left with entirely different implications for the firm and the entrepreneur. Capital heterogeneity means that different capital goods have varying physical features, uses and attributes. This is directly opposed to the view of homogenous capital. Foss and Klein note that many working towards a theory of the firm have already accepted the heterogeneous nature of capital in their writing. For instance, transaction cost economics and property right theory conceive assets as having specific uses and recognize that, in an uncertain world, the firm must adapt and change how they use assets over time.

FK note that management scholars view firms as bundles of heterogeneous resources and believe the interaction among resources is what give certain firms competitive advantages over other firms. Likewise, the “old” property rights theory advanced by Ronald Coase and Yoram Barzel recognize that assets have various attributes (characteristics, functions, or possible uses of assets, as perceived by an entrepreneur).

Foss and Klein note that the above views of capital heterogeneity can be best unified by the capital theory established by the Austrian School of Economics. Austrian capital theory recognizes that there is a complex structure of production. The structure of production consists of countless stages within a very complex hierarchy. Demonstrating this with a house as a final consumer good can aid in understanding this. A finished, fully constructed house would be a consumer good, a good of the lowest order in the capital theory. Numerous goods such as wooden beams, drywall, heavy machinery, shingles, windows, etc… must be used in constructing the house. These are goods of a higher order. The goods necessary to produce the wooden beams, drywall, etc… are of an even higher order, and so on and so forth.

Austrian capital theory recognizes that different capital goods cannot be easily substituted for each other. A window cannot simply be used to do the same thing as a wooden beam. Substitution between capital goods is limited. This theory also asserts the reality that production takes time. Factors of production are committed in the present for the production of consumer goods which will not be sold until a time in the future.

Austrian economist Izrael Kirzner claims that capital goods are heterogeneous because they play particular roles within an entrepreneur’s production plan, thus establishing a link between entrepreneurship and capital goods. A given capital good has various attributes which may vary over time as circumstances change. Entrepreneurs do not have omniscient knowledge and therefore do not know all relevant attributes of their assets at any point in time. Thus they must make the best decisions they can (with limited information) with how they use and combine their assets. Entrepreneurs have the potential to create and discover previously unknown attributes of capital goods as time goes on. They also have incentive to own capital goods to acquire legal rights to the income generated by an asset as well as the attributes they create and discover.

Entrepreneurial Judgment in a Complex Capital Structure

Foss and Klein tie in the theory of complex systems, most attributed to Herbert Simon and Stuart Kauffman, to complement the Austrian economist’s view of the capital structure. The theory of complex systems asserts that in the real world, we have systems composed of subsystems. There are different ways in which subsystems interact in a system. The capital structure can be thought of as a non-decomposable system in which the interactions among subsystems are essential. Suffice it to say, FK argue that when the capital structure is viewed this way, we can establish a metaphor for the capital structure as a “landscape” of combinations among capital goods.

This conception of a complex capital structure has multiple implications for the entrepreneur. For one, entrepreneurs will search the “landscape” in pursuit of the best, most profitable combinations of capital assets. This is not just simply a process of trial and error. The entrepreneur uses his judgment to decide which goods are relevant to his production and how to combine the goods. The entrepreneur’s experience influences his interpretation of the “facts” and thus helps guide him in his search. FK note that experiential knowledge can underlie innovative activity in established, mature firms and give them sustained competitive advantage, further challenging the notion that only new or small firms are entrepreneurial. Lastly the entrepreneur will experiment with the assets he has. He may do this in various ways such as mergers and acquisitions with other firms or trying out new combinations of his assets within his own firm.

Foss and Klein make a convincing argument in this chapter for a conception of heterogeneous capital goods scholars studying entrepreneurship and the firm. In their view, the Austrian School’s view of capital is most consistent with capital heterogeneity, most descriptive of the real world, and thus superior to alternative conceptions of capital held by mainstream economists. FK view capital heterogeneity as a crucial link in connecting a theory of the entrepreneur with a theory of the firm. Having laid the groundwork for a sound capital theory, Foss and Klein explore entrepreneurship and the firm in their next chapter.

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