The Entrepreneurial Economy II: Risk, Uncertainty, and Innovative Entrepreneurship

Massimiliano Amarante Universite de Montreal y Onur Ozgur Universite de Montreal z Edmund S. Phelps Columbia University x November 1, 2011 Abstract This is the second of a series of papers in which we address the questions How do capitalist systems generate their dynamism and Why a capitalist economy is inherently di erent from a centrally planned one. We believe that, in order to study these issues, we must thoroughly reconsider the role played by entrepreneurs and

nanciers in actual economies. Although it is widely accepted that entrepreneurs are at the wheel of the free-market capitalist innovation machine, mainstream microeconomic theory is mostly silent about them (Baumol, 2002). We provide here a novel theoretical model of an economy with innovative entrepreneurship in the spirit of Knight (1921). Innovating entrepreneurs need

nancing. Ordinary consumers are incapable of assessing their likelihood of success. Financiers, though, take chances in those projects systematically, hence channel resources from the part of the economy where the only concern is risk and risky assets are priced on the asset markets, into the part where the concern is uncertainty and agreements take the form of bilateral contracts between entrepreneurs and

nanciers. Equilibria with e

cient bilateral contracts Pareto dominate those without and in turn We would like to thank Max Stinchcombe for very useful conversations. Part of this research was done while Ozgur was visiting the Economics Department at the Universite Laval. He would like to thank Yann Bramoulle and Bernard Fortin for organizing the visit. He is grateful for

nancial support to \La Chaire du Canada en Economie des Politiques Sociales et des Ressources Humaines" at Universite Laval, CIREQ, CIRPEE, IFM2, and FQRSC. y Department of Economics and CIREQ; e-mail: massimiliano.amarante@umontreal.ca z Department of Economics, CIREQ, and CIRANO; e-mail: onur.ozgur@umontreal.ca x Department of Economics and The Center on Capitalism and Society; email: esp2@columbia.edu 12 Amarante, Ozgur, Phelps are dominated by the social planner's allocation. A central authority's (CA) planned allocations will not agree with those of the market if either (i) the degree of ambiguity of CA is too high, or (ii) there is fundamental disagreement among entrepreneurs and

nanciers regarding the joint likelihood of competing innovations. Under mild regularity conditions, it is welfare improving to tax capital to subsidize

nanciers. Finally, equilibria in capitalist economies under uncertainty are characterized by their dynamism, generating higher levels of entrepreneurial activity relative to centrally planned economies. Journal of Economic Literature Classi

cation Numbers: C62, D51, D53, D81, P1, P51. Keywords: Ambiguity, capitalist systems,

nancial contracts, entrepreneur, innovation, Knightian uncertainty.Innovative Entrepreneurship 3 1 Introduction An economy's economic system and the choice of the economic institutions that constitute it is critical to the major economic policy issues of the past two decades: the \transition" in the eastern European countries, which raised the question of whether it was Anglo-Saxon capitalism or Continental corporatism to which they ought to \transit"; the ongoing and worsening slowdown in western continental Europe, where disagreement has broken out over whether the causes lie largely in the over-grown welfare state or instead in the lingering corporatism of many of its economic institutions and public-policy mentality; and the accounting and corporate scandals in the U.S., which raise questions of how e ective and reliable are America's corporate institutions in driving entrepreneurs to innovate and how much further damage to entrepreneurship might result from some of the corporate reforms enacted in the name of improving things. To help with these issues economists must study the mechanisms of entrepreneurship and innovation in capitalist economies: the role of entrepreneurs in seeing commercial possibilities for developing and adopting products that exploit new technologies; the role of entrepreneurs in conceiving and developing new products and methods; the role of

nanciers in identifying entrepreneurs to back and to advise; and the incentives and disincentives for entrepreneurship inside established corporations. This means studying both the entrepreneur as a micro actor and the entrepreneurial economy as an interactive system. We start from the view that capitalism as an economic system/organization of economic institutions is relatively well suited to engender economic dynamism that is, a ow of innovative ideas from the economy's entrepreneurs that are ample and well-conceived, that are well-chosen for testing and development by the economy's

nanciers, well-developed and well-launched by its managers, and well-received by prospective users. Succinctly put, capitalism is viewed as a means to an entrepreneurial economy that is, one producing new models, which lead to novel commercial ideas and to diverse and competing beliefs (see for e.g. Baumol, Litan, and Schramm, 2007). One question to be investigated asks how the relatively capitalist systems function, how they work, to generate their dynamism. From observation and intuition we can see that a predominantly capitalist economy has mechanisms and institutions that appear to support and foster a supply of innovative ideas from entrepreneurs; it also has

nancial institutions that appear to aid in the4 Amarante, Ozgur, and Phelps selection of entrepreneurial projects to be developed and tried out on the market in the matching of entrepreneur to

nancier; it also has institutions possibly facilitating the adoption (di usion) of newly marketed products/techniques; even institutions a ecting the rate at which

nal users (consumers etc) try the new things. But this is not satisfactory. There are gaps in our knowledge here. One is theoretical. The analytical apparatus of supply curves for

rms and demand curves for consumers (or other

rms), the central authority calculating the market-clearing prices, is not helpful in explaining the operation of the capitalist systems|not at their core, at any rate. The investment banks and other suppliers of

nance may have supply curves but the entrepreneurs want as much

nancing as they can get. And each entrepreneurial project is a di erent good, so we need as many prices as there are projects

nanced. Which entrepreneur gets what? And which project is the marginal one, with the rest going begging? Fortunately, the fact that each entrepreneur's idea is idiosyncratic, thus unique, does not by itself preclude a manageable and attractive model of equilibrium, provided we are willing to accept the supposition of a rather simple setting. Irving Fisher and the late James Tobin imagined a setting in which a large number of entrepreneurs, each with a project, and a large number of

nanciers, each with a pile of liquid capital, get into the same place to settle the value to be put on each project. They showed that, theoretically, the capital market would

rst

nance the project(s) with the highest perceived value per dollar of investment cost, then the next-highest, and so forth until there were no more projects with hopes of a positive rent with a perceived value-to-cost ratio (Tobins Q ratio) greater than one. Such a Fisher-Tobin equilibrium may exist even if the pro

tability of each project o ered is a matter of uncertainty the radical kind of uncertainty that Frank Knight (Knight, 1921) pointed to, in which no one knows or can know the probabilities of the various imaginable outcomes or even knows all of the possibilities there may be. Unfortunately, there is a complication that, it appears, may (but in many actual cases might actually not) get in the way of that simple equilibrium story: it could thus get in the way of a manageable and attractive model of the operation of capital markets|even a simple market where all the entrepreneurs

nanciers actually meet and interview. The source of the trouble lies in the point that, generally speaking, each entrepreneur's idea presents some ambiguity|the

nanciersInnovative Entrepreneurship 5 can see only dimly what each idea is, what it involves, and even more dimly what its merits are. Hence, although each

nancier may fall under a group of like-minded

nanciers each of whom views the entrepreneurs' proposals the same way, such a group might rank the projects di erently from the way the

nanciers in one or more other groups do. Not all scholars saw entrepreneurs' ideas that way. In the view of the early 20th century German school, when a navigator or scientist has made a discovery, some entrepreneurs (it does not matter which ones act and which do not) at once deduce the commercial applications, which are bankable propositions. In Schumpeter (1911), little is changed except that it is the entrepreneur who makes the discovery. But it is like

nding a $5 bill in the woods: the banker immediately knows its value. The breakthrough was M. Polanyis tacit knowledge (\We can know more than we can tell."), followed by Hubert Dreyfus, later Gary Klein. Like

ghter pilots, entrepreneurs cannot explain their own decisions and thinking; the

nanciers can understand even less. A usable model of the intersection of the entrepreneurs' projects and the

nanciers' capital necessitates seeing whether disagreements in

nanciers' rankings could be a barrier to a coherent story and, if it's yes, seeing whether there is an attractive and useful fallback position|some disagreement but not any arbitrarily disagreement. Although a workable model of equilibrium in this rather abstract market for entrepreneurs' ideas may be possible where the analysis might start with a relatively general model in which no structure is imposed on the rankings, if the rankings are su

ciently di erent, there would be no stability in the results|no equilibrium can be said to exist. (For example, the values placed on the projects may depend on the order in which they are auctioned.) In the current paper, to get around this di

culty, we build a model of a more structured sort in which each

nancier prefers to back the idea of an entrepreneur whose \thinking", or model, seems to be like his|thinking with regard to which industry is the best bet, swinging for the fences or not, etc. The insight here, which originates with Hayek and M. Polanyi, is that everyone in a capitalist system carries around a sort of personal model of the economy|at any rate, some piece of it. Thus the \capital market" is a sort of matching process that matches a

nancier to an entrepreneur whom the former sees as having a model compatible with his own model. In short, capitalism is portrayed as producing a profusion of ideas representable as competing models of the economy (or a piece of6 Amarante, Ozgur, and Phelps it). Capitalism is more than the goods, which is why it's hard and avoided. We are convinced this is worth doing: Entrepreneurship, innovation and capitalism will make it into economics classrooms only with the arrival of abstract, formal representations. 1 When those arrive, capitalism|and its entrepreneurs etc. will get a huge boost. And in policy deliberations, consequences of a policy move that would otherwise be unanticipated will be more likely to be caught beforehand. Finally, in Baumol's own words, we see this paper as our contribution to the attempt of bringing back the Prince of Denmark (read innovative entrepreneurship) into the discussion of Hamlet (read micro growth theory) (see Baumol, 1968, p.66). 1.1 Related Literature The existing body of work on entrepreneurship in economics is mainly concerned with the nature and the function of entrepreneurs in the economy. The term \entrepreneur" is known to have been introduced by Cantillon (1775) who thought of entrepreneurs as speculators, risk takers, arbitrageurs, and not as innovators. Although much later, Kirzner's (see Kirzner, 1979, 1985) entrepreneur shares the same characteristics with Cantillon's: Succesful entrepreneurs are people who are more alert, who notice, and bene

t from opportunities that are in principle available to everyone (Parker, 2009). In contrast, Say's entrepreneur is an innovator. He is not shy to argue that te absence of entrepreneurs in the economy can undercut prosperity and development (Say, 1828). Baumol tells us that up until Schumpeter's breakthrough, economists, such as J. S. Mill, Alfred Marshall, and Frank Knight touched upon the theory of entrepreneurship. However, their main concern was management's role in directing going concerns rather than in establishing new

rms for innovation (Baumol, 2010). Finally, Schumpeter (Schumpeter, 1911) brings a fresh voice to the entrepreneur. He regards entrepreneurial activities as the primary cause of business cycles, by making discontinuous changes, altering the ongoing paradigm and driving economic development (Schumpeter, 1939). 1 Baumol's early writings point to the fact that the theoretical

rm in economics is entrepreneurless (see Baumol, 1968). More recent writings of Baumol (see Baumol, 2010) argue that although there is an invaluable body of empirical work being accumulated on the subject of innovative entrepreneurship, formal theory is still virtually nonexistent; one cannot even

nd the word `entrepreneur' in most successful economic textbooks.Innovative Entrepreneurship 7 Most celebrated modern theories of entrepreneurship stands on the premise that entrepreneurship is the outcome of an occupational choice process, in which the outside option is usually taken as paid employment. Lucas (1978) uses heterogeneous ability to explain varying observed entrepreneurial occupational choices, in a model where individuals knew their abilities. Jovanovic (1982) relaxes this latter assumption in a dynamic model where entrepreneurs learn about their abilities over the long run and this dynamic learning process induces an equilibrium entry, growth, and exit behavior across cohorts of individuals. Kihlstrom and La ont (1979) use heterogeneous aversion to risk to generate the heterogeneous selection into occupational choices. Entrepreneurs also take the center stage in macroeconomic theoretical models, (i) as generator, accumulator of wealth that promotes growth and further entrepreneurship, e.g., Evans and Jovanovic (1989), Banerjee and Newman (1993), Aghion and Bolton (1997), Acemoglu et al. (2006), Berger and Udell (1992), and Newman (2007), (ii) as entities adapting their actions to advances in technology, exogenous (Calvo and Wellisz, 1980) or endogenous (Aghion and Howitt, 1992, 1997), and (iii) as promoters and exploiters of knowledge spillovers in the new endogenous growth theory, e.g., Romer (1986) and Schmeidler (1989). A current debate in the literature is whether patents and temporary monopoly pro

ts are necessary to give entrepreneurs the incentive to undertake innovation activities. A literature on `patent races' argue that

rms compete against each other for the right to monopoly pro

ts, while rendering previous products obsolete as observed by Schumpter. In Aghion and Howitt (1992), for example, imperfect competition is needed for entrepreneurs to be willing to conduct research. Lucas (1978) and Romer (1986) suggest that either a complicated set of taxes and subsidies or allowing monopoly power and relative pro

ts is necessary to let innovators internalize the unpriced \spillovers" they generate with their innovative ideas, so that they are fully rewarded for their incremental contribution to aggregate productivity. Boldrin and Levine respond to that claim by arguing that monopoly is neither needed for, nor a necessary consequence of innovation. In particular, intellectual property is not necessary for, and may hurt more than help, innovation and growth (see e.g. Boldrin and Levine (2004a,b, 2005a, 2008, 2009)). We depart from the existing literature in the way \uncertainty" is modelled. In the existing theory, following the Bayesian tradition, uncertainty is modelled as Risk. It is an old idea, dating8 Amarante, Ozgur, and Phelps back to at least Knight (1921), that some|and, perhaps, the most relevant|economic decisions are made in circumstances where the information available is too coarse to make full sense of the surrounding environment, where things look too fuzzy for having a probability distribution over a set of relevant contingencies. In such situations, Risk Theory is simply of no use. This distinction between Risk and Ambiguity was fully appreciated by Knight (1921), who attempted to build a theory of entrepreneurship and pro

t based on it. We adhere to this view. In fact, our main claim is that, granted the presence of Ambiguity, the main di erences between a decentralized economy and a centrally planned one could be explained by the di erent ways each type of economy deals with Ambiguity. The study and the usage of uncertainty and probabilistic methods go a long way in economics (see Lippmann and McCall, 1981). When it comes to distinguishing between risk and uncertainty, Knight (1921) receives the credit. The modern de

nition of risk is any situation where the likelihoods of possible events are precisely measured by a unique objective probability. Uncertainty or ambiguity as suggested by Ellsberg (1961) refers to situations where events likelihoods are unknown. In the classical Arrow-Debreu model, at an economys equilibrium there is nothing uncontroversial about the way one deals with uncertainty. Decision theorists have developed several models to deal with this problem, all of which stipulate that the behavior of agents facing Knightian uncertainty is described not by a single probability but rather by a set of those (Amarante (2009), Bewley (2002), Schmeidler (1989), Gilboa and Schmeidler (1989), Ghirardato et al. (2004), and Klibano et al. (2005). An important special case of variational preferences is the so-called multiplier model of Hansen and Sargent (2007). See also Hansen and Sargent (1999, 2001). Though originally not motivated by the Ellsberg paradox and ambiguity, the \model uncertainty" literature due to Hansen and Sargent falls within the scope of the literature on decision making under ambiguity. As argued by Ghirardato (2010), both decision models they employ are special cases of models in the ambiguity literature: the \multiplier model" is a special case of variational preferences (Maccheroni et al., 2006), and the \constraint model" is a special case of Maxmin Expected Utility by Gilboa and Schmeidler (1989) For good surveys of this fast-growing literature see Mukerji (1997), Marinacci and Montrucchio (2004), Mukerji and Tallon (2004), Ghirardato (2010), and Gilboa and Marinacci (2010). For a few (by no means anInnovative Entrepreneurship 9 exhaustive list) applications of this framework to general equilibrium, asset pricing, and contracts see Dow and Werlang (1992), Mukerji (1998), Mukerji and Tallon (2001), Epstein and Wang (1994), Epstein and Schneider (2008), Easley and O'Hara (2009) and Rigotti and Shannon (2005), There is one paper that comes closest to the current one regarding the question it asks and the formalism it uses: Rigotti, Ryan, and Vaithianathan (2011) (RRV henceforth). RRV studies the occupation choice of a continuum of agents between an old safe technology and a new technology whose return is uncertain. In equilibrium, the fractions of agents who are most ambiguity tolerant select into the new technology, get matched up with another agent to form a

rm. Moreover, within a new

rm, the more tolerant one assumes the residual ambiguity while providing the less ambiguity one with a

xed wage contract. RRV terms the former the \entrepreneur" and the latter the \worker" type. There are many important distinctions between RRV and the current model. First of all, our main objective is to understand what it is that makes free-market capitalist economies better habitats to engender economic dynamism, relative to other economic systems. To that e ect, in contrast to RRV, heterogeneity, plurality of innovations (read as many new technologies, innovations as the number of entrepreneurs) is crucial for us. RRV does not study

nancing of innovations. We do because we believe that a crucial di erence between centrally planned and capitalist systems might reside in the latter's ability to deal with Knightian uncertainty when it comes to channelling credit toward ambiguous innovations. We also focus, as in RRV, on ex-ante e

cient contracts between matches of entrepreneurs and

nanciers. However, we show that the general equilibrium is necessarily ine

cient when there are multiplicity of innovations being

nanced. Finally, in contrast to RRV, we study the question of whether it is Pareto improving to subsidize innovation and to create a

nancier class to boost the dynamism in the economy. The answer turns out to be true under mild regularity conditions. Overall, the current paper is the

rst model of its kind that studies both the entrepreneur and the

nanicer as micro actors and the entrepreneurial economy as an interactive system. The remainder of the paper is organized as follows. Section 2 introduces the general class of economies we are interested in along with the fundamental roles played by entrepreneurs and

nanciers as micro actors. Section 3 presents an economy with entrepreneurial innovation and provides the main10 Amarante, Ozgur, and Phelps results of the paper for that economy, mainly, equilibrium existence, characterization of bilateral contracts between entrepreneurs and

nanciers, (in)e

ciency of equilibria and welfare comparisons across economic systems. Section 4 contains the arguments regarding the feasibility of welfare improving subsidies and a general conjecturere. Finally, Section 5 discusses possible future research and concludes. 2 The Environment 2.1 Entrepreneurs and Financiers as Micro Actors This section introduces formally the main ingredients of the class of economies we study. There are two dates, denoted by t = 0; 1. There is a single all-purpose good that can be used for consumption or that can be invested in productive technologies and which serves as a numeraire. The economy is populated by individuals who can each be of three possible types: ordinary consumers, innovative entrepreneurs, or

nanciers. Let C, E, and F be the sets of each type of individuals respectively; let I := C [ E [ F be the set of all agents. There is no uncertainty at date 0. We distinguish between two sorts of uncertainty at date 1, namely, risk, and ambiguity (Knightian uncertainty). Let p := f1; : : : ; Sg denote the

nite set of publicly known states of the world. All agents agree on the likelihood of these publicly observed states, and hence hold the same belief, represented by the probability distribution p on

p. The second sort of uncertainty, namely ambiguity, is created by entrepreneurs' innovations, whose discussion we postpone until when we describe what we mean by innovation below. Agents have streams of endowments of the consumption good, denoted by wc; we, and wf , for consumers, entrepreneurs, and

nanciers respectively, contingent on the realizations of the publicly known states in p. More precisely, for i 2 I, let wi :=

wi;0;(wi;1(s)) s2

2R S+1 + . We assume for simplicity that agents invest at date 0 before the resolution of uncertainty and consume at date 1 ex-post. In order to consume in the next period, agents need to invest in one of the following set of possibilities: Asset market: There exists a complete set of Arrow securities for contingent consumption at date 1. At date 0, agents can trade in these securities that pay contingent on the publicly