Entrepreneurship, Arbitrage, and Capital

18 August 2007 at 10:28 am 12 comments

| Peter Klein |

Over the years I’m increasingly convinced that Israel Kirzner’s metaphor of entrepreneurship as costless discovery — a form of arbitrage, exploiting differences between actual prices and their Walrasian equilibrium values — is a misleading way to think about entrepreneurship. Emphasizing knowledge, the awareness of facts that other market participants do not possess, the metaphor leads our attention away from action, the employment of scarce means to achieve economic ends. I’ve argued in a series of papers (1, 2, 3) that opportunity exploitation, not opportunity discovery, drives the market process.

A key problem for the Kirznerian metaphor is that entrepreneurship does, in practice, involve capital investment, despite Kirzner’s insistence that “pure entrepreneurship” does not require ownership of resources. (As Joe Salerno reminds us, favorable reviews of Kirzner’s Competition and Entrepreneurship by Austrians Murray Rothbard, Henry Hazlitt, and Percy Greaves all pointed to the separation of entrepreneurship and property ownership as the lone weakness in Kirzner’s otherwise excellent exposition.) But what about financial-market arbitrage, an example often cited in the Kirznerian literature? Isn’t arbitrage an example of costless discovery of pure profit? Doesn’t the arbitrageur operate without capital?

Actually, real-world arbitrage does not resemble Kirznerian alertness at all. Brad DeLong recently reminded me of Shleifer and Vishny’s important 1997 Journal of Finance paper on arbitrage. Write Shleifer and Vishny:

Theoretically speaking, . . . arbitrage requires no capital and entails no risk. When an arbitrageur buys a cheaper security and sells a more expensive one, his net future cash flows are zero for sure, and he gets his profits up front. . . . [But] the textbook description does not describe realistic arbitrage trades. . . .

Even the simplest realistic arbitrages are more complex than the textbook definition suggests. Consider the simple case of two Bund futures contracts to deliver DM250,000 in face value of German bonds at time T, one traded in London on LIFFE and the other in Frankfurt on DTB. Suppose for the moment, counter factually, that these contracts are exactly the same. Suppose finally that at some point in time t the first contract sells for DM240,000 and the second for DM245,000. An arbitrageur in this situation would sell a futures contract in Frankfurt and buy one in London, recognizing that at time T he is perfectly hedged. To do so, at time t, he would have to put up some good faith money, namely DM3,000 in London and DM3,500 in Frankfurt, leading to a net cash outflow of DM6,500. However, he does not get the DM5,000 difference in contract prices at the time he puts on the trade. Suppose that prices of the two contracts both converge to DM242,500 just after t, as the market returns to efficiency. In this case, the arbitrageur would immediately collect DM2,500 from each exchange, which would simultaneously charge the counter parties for their losses. The arbitrageur can then close out his position and get back his good faith money as well. In this near textbook case, the arbitrageur required only DM6,500 of capital and collected his profits at some point in time between t and T.

Even in this simplest example, the arbitrageur need not be so lucky. Suppose that soon after t, the price of the futures contract in Frankfurt rises to DM250,000, thus moving further away from the price in London, which stays at DM240,000. At this point, the Frankfurt exchange must charge the arbitrageur DM5,000 to pay to his counter party. Even if eventually the prices of the two contracts converge and the arbitrageur makes money, in the short run he loses money and needs more capital. The model of capital-free arbitrage simply does not apply. If the arbitrageur has deep enough pockets to always access this capital, he still makes money with probability one. But if he does not, he may run out of money and have to liquidate his position at a loss.

In reality, the situation is more complicated since the two Bund contracts have somewhat different trading hours, settlement dates, and delivery terms. It may easily happen that the arbitrageur has to find the money to buy bonds so that he can deliver them in Frankfurt at time T. Moreover, if prices are moving rapidly, the value of bonds he delivers and the value of bonds delivered to him may differ, exposing the arbitrageur to additional risks of losses. Even this simplest trade then becomes a case of what is known as risk arbitrage. In risk arbitrage, an arbitrageur does not make money with probability one, and may need substantial amounts of capital to both execute his trades and cover his losses. Most real world arbitrage trades in bond and equity markets are examples of risk arbitrage in this sense. Unlike in the textbook model, such arbitrage is risky and requires capital.

Shleifer and Vishny are primarily concerned with the agency relationship between arbitraguers — a “a relatively small number of highly specialized investors [who use] other people’s capital” — and the wealthy individuals, banks, endowments, and other investors who provide the necessary resources. My point here is simply that there is no such thing as costless discovery of profit opportunities, even in financial-market arbitrage. Profits are earned by those who put resources at risk — the basic idea of the Knightian “judgment” framework Nicolai and I have been developing. When we invoke the theoretical construct of the entrepreneur to explain the existence of profit (as distinguished from wages, rent, and interest), we must recognize that the entrepreneur is, in essence, a resource owner.

Entry filed under: - Klein -, Entrepreneurship, Theory of the Firm. Tags: .

Managing the Philanthropic Enterprise Two Entrepreneurship Papers

12 Comments Add your own

  • 1. Steve Phelan  |  18 August 2007 at 6:57 pm

    It seems to me that Kirzner was very keen to portray entrepreneurs as a non-standard resource. At the time, any theory that portrayed entrepreneurship as a resource could be subsumed into neoclassical equilibrium theory because arguably one could calculate an optimal investment in entrepreneurship to maximise welfare in the economy. By setting entrepreneurship outside the traditional factor framework, Kirzner was able to champion the market process/disequilibrium approach of Austrian economics. Any thoughts?

    Would it be fair to argue that neoclassical economics is open to more realistic models of the world and that the threat outlined above is receding?

  • 2. Steve Phelan  |  18 August 2007 at 6:58 pm

    Oh, I also have an empirical paper on entrepreneurial exploitation:


  • 3. Peter Klein  |  18 August 2007 at 9:21 pm

    Steve, thanks for the link to your paper.

    In linking entrepreneurship to resources I do not at all mean to suggest that entrepreneurship is itself a resource. Rather, entrepreneurship is the faculty of identifying, valuing, combining, and deploying resources. (In long-run general equilibrium with no uncertainty, but positive time preference — what Mises calls the “evenly rotating economy” — laborers would continue to earn wages, landowners would collect rents, and capitalists would receive interest, but there would be no entrepreneurial profit and loss, because all factor payments would equal their discounted marginal revenue products, leaving no residual for the entrepreneur. Hence entrepreneurship is not a factor like land, labor, and capital.)

    I agree with your characterization of Kirzner. But his discovery-process approach is not the only way to put entrepreneurship outside the usual optimization framework. Knight’s concept of judgment, which I prefer, does this too.

  • 4. Steve Phelan  |  19 August 2007 at 12:08 am

    Hi, Peter, I am also a big fan of Knight. Just thought I would try to defend why Kirzner might have been so focused on the knowledge side of things.

    I am not much of an economic historian, but if entrepreneurship is characterised as risk rather than ignorance would it not have been considered as a type of capital in neoclassical formulations?

  • 5. Sudha Shenoy  |  19 August 2007 at 1:57 am

    Is Kirzner trying to separate two _functions_ analytically? Mere resource ownership isn’t entrepreneurship. The latter function is to spot opportunities. To _exploit_ said opportunities, resources are needed. That’s why in practice only resource-owners can exercise entrepreneurship. But there are two distinct functions — analytically. — Practically, the two must go together.

    See Mises’ discussion of ‘ideal types’. Also his point that (eg) ‘workers’ exercise entrepreneurship when they move to an area in anticipation of higher wages.

  • 6. Bruce Koerber  |  19 August 2007 at 10:16 am

    Dear Peter,

    I have nothing but praise for your work and recognize that you are neatly bridging subjectivist economic science with the empirical attempts to describe economic action, but the essence of entrepreneurship is alertness.

    There are many examples of how alertness appears in the economy and studying them intricately can be instructive but never will such an exercise justify losing the underlying essence of what it is.

    Even though Kirzner was quite precise in his work and even empiricists can identify with his economic contribution he nevertheless was a subjectivist and his definition of pure entrepreneurship is one proof of that inclination. To try to say that his definition of pure entrepreneurship was a little off is mistaken for two reasons:
    1. It subtly attacks the subjectivist methodology.
    2. It fails to recognize that action is a continuum and not made up of distinct intervals or units. For detailed study it may be instructive to define intervals but that is not reality, only a model.

    With warm regards,
    Bruce Koerber

  • 7. Paolo MARITI  |  19 August 2007 at 11:41 am

    Sudha Shenoy :
    well taken points indeed! One couldy perhaps add that an entrepreneur needs not to own resources but the rights to use them.

  • 8. Peter Klein  |  19 August 2007 at 2:13 pm

    Steve, I don’t think entrepreneurship as uncertainty-bearing (note: not bearing insurable risk) can be classified as capital.

    Sudha, you are right, of course, Kirzner’s pure entrepreneur is meant as an ideal type. He doesn’t claim that real, flesh-and-blood entrepreneurs cannot own property. My point is that the analytical separation of alertness and ownership makes sense only in a model without uncertainty. (See Mises’s discussion of “the imaginary construction of functional distribution,” discussed in Joe’s paper cited above.) Given Knightian uncertainty, entrepreneurship and ownership cannot be separated, even analytically. In such a world, what does it mean to “spot opportunities”? There are no opportunities, only entrepreneurial judgments about actions that might or might not generate receipts in excess of their outlays (with appropriate discounting).

    Mises’s example of workers exercising entrepreneurship illustrates this perfectly. In a world of uncertainty all human action involves a measure of entrepreneurship, since we employ known means in pursuit of ends that may or may not be achieved. If I buy a new suit before a job interview I am acting entrepreneurially, making an investment I hope will pay off in higher wages. Workers, consumers, landlords, all exercise a measure of entrepreneurship. But the entrepreneurial function (judgmental decisions about deploying resources under uncertainty) can be separated, analytically, from the wage-earning or rent-earning or interest-earning functions.

    To make a long story short, I don’t see how invoking “alertness” or “discovery” helps us here. What phenomena does it explain that judgment cannot explain?

    Bruce, thanks for the kind words. You could have stopped there! :-) As for the rest, I’m not criticizing Kirzner’s subjectivism at all. Actually, one could argue that Kirzner’s concept isn’t subjectivist enough, because it treats profit opportunities as objective (albeit not universally perceived) phenomena. In the Knightian view profit opportunities don’t “exist” in any meaningful sense. Rather entrepreneurs take actions based on their perceptions of possible outcomes. What could be more subjectivist than that?

    As for your point #2 about discrete intervals, I don’t get what you mean.

    Paolo, as Nicolai and I have written in several papers, the “rights to use resources” cannot be separated from the ownership of resources if contracts are incomplete. Ownership implies residual rights of control, in Hart’s terminology — the right to make decisions about the employment of resources in situations not covered by contract. In Nicolai and Kirsten’s “assets and attributes” terminology, ownership gives the owner the rights to attributes of assets that are not known ex ante.

  • 9. Bruce Koerber  |  19 August 2007 at 9:22 pm

    Dear Peter,

    I am trying to digest your points and I seem perfectly satisfied with your explanation.

    Regards point #2, I was referring to the action of pure entrepreneurship which appears to have been further divided into two parts (intervals): opportunity discovery and then opportunity exploitation. They are a part of the same process and since one preceeds the other it can be viewed as a continuum. Since the discovery may or may not always be recognized (As I mentioned as a comment on the Mises Blog: ‘If my discovery is personal and ideal it is still mine and yet it may never appear as a transaction so it may never seem ‘exploited.’ But if action has taken place and my ‘property’ has expanded how can someone declare it insufficient to drive the market. It may be subtle but somewhere along the line the market will feel the effects!’)
    it cannot be discrete enough to identify and classify without losing the reality that the subjectivist methodology permits. As a consequence this step of separating the two parts of the same action process has the effect of separating the model from reality. Nevertheless this model may yield useful insight.

    My point is that pure entrepreneurship exists and that it is one of the ways, in the powerful and magnificent economy, that property rights are constantly revitalized, potentially rendering wealth into poverty and poverty into wealth and that it is available to every human being. It is as simple as moving from latent entrepreneurship to active entrepreneurship.

  • 10. Peter Klein  |  19 August 2007 at 11:37 pm

    Bruce, OK, now I see what you mean. I don’t disagree. As I mentioned in my reply to Sudha above regarding workers, judgmental decision making under uncertainty is entrepreneurial even if the means invested are purely personal and subjective (e.g., the opportunity cost of the actor’s time). Kirzner’s “pure entrepreneur” does not invest even that. He simply “discovers,” without any expenditure of resources at all, even his own time and effort! (If effort is involved then the actor is engaged in Stiglerian search, not discovery, according to Kirzner.)

    Empirically, of course, this kind of personal entrepreneurship, if we want to call it that, is not as important to the market economy as the entrepreneurship of the business investor, the firm founder, etc.

    In the entrepreneurship literature in management is is common to separate the entrepreneurial process into distinct stages, such as discovery and exploitation. In my framework, this separation is illegitimate, because discovery without exploitation isn’t entrepreneurship at all. As Rothbard (1985) put it, “Entrepreneurial ideas without money are mere parlor games untilthe money is obtained and committed to the projects.”

  • 11. Bruce Koerber  |  20 August 2007 at 9:29 pm

    Dear Peter,

    I trust that you know these intricacies since you study deeply the literature. You said, ‘Kirzner’s “pure entrepreneur” does not invest even that. He simply “discovers,” without any expenditure of resources at all, even his own time and effort! (If effort is involved then the actor is engaged in Stiglerian search, not discovery, according to Kirzner.)’

    When I read Kirzner as a non-specialist but as a subjectivist I do not see a problem with ‘discovery’ and I never assumed that the entrepreneur didn’t use his own time and effort since active entrepreneurship is technically an effort and it is a real world experience so it takes time.

    I acknowledge that your very fine scrutiny is meant for specialists like yourself. Such in-depth examination will lead to refinements possibly and maybe Kirzner was a specialist of that degree which makes him ‘guilty’ of an error.

    I am not doctrinaire with regards Kirzner or other great classical liberals but how accountable are our predecessors given the advantages we have (including their contributions).

    This is the reason I still accept that pure entrepreneurship represents ‘something from nothing.’ But I still find your refinement interesting.

  • 12. Asamoah Robert (Robbyking,k-Poly)  |  14 December 2010 at 2:56 pm

    In aligning his theory with the Austrian subjectivity approach,Kirzner identifies a key role for entrepreneurship as an equilibrating force within market economies,inwhich preferences and technologies are always changing somewhere in the system. Entrepreneus help to restore markets to equilibrium through the probess of price adjustment but Kirzner did not concerned with explaining the process of change and can therefore offer little account of why preferences and technologies change.

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