Is Judgment Measurable?

20 August 2006 at 2:11 pm 6 comments

| Lasse Lien |

The hosts of this blog have offered an intriguing perspective on entrepreneurship, in which the entrepreneur is seen as an individual possessing judgment. Judgment is in short the ability to spot opportunities for profit under Knightian uncertainty (as opposed situations involving mere risk). Because there are prohibitive transaction costs associated with exploiting judgement via market contracting, the entrepreneur is left with little choice but to start his or her own firm to exploit this competence/skill/resource. This seems quite plausible, and I nodded enthusiastically as I read the paper. However, one problem kept — and keeps — bothering me (as a lowly empiricist); the problem of how to establish the existence of judgment empirically.

Consider the following rival theory. Entrepreneurs are distinguished by their lack of judgment (see Busenitz and Barney (1997) for circumstantial evidence). These are people who do not realize that the expected private gains from becoming an entrepreneur are grossly negative. Lack of judgment is of course also associated with transaction costs, and forces the entrepreneur to assemble a firm to capitalize on his or her (most likely) misguided ideas. If the supply of such individuals is sufficiently large, some of them will be lucky and draw the winning ticket, some perhaps even several times in a row. For society the total returns to entrepreneurship may still be positive, if the lucky ones create enough value to compensate for the many unlucky ones. So I guess my question is how we could devise a test that would allow us to distinguish between these two theories. Or more generally, how do we separate judgment from dumb luck? Note here that the decision criteria used by the entrepreneur must probably be unobservable, if not, we are most likely to be analyzing decision making under risk, which is not judgment.

Any ideas, anyone?

Entry filed under: - Lien -, Entrepreneurship.

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6 Comments Add your own

  • 1. AJE  |  20 August 2006 at 5:37 pm

    Isn’t “alertness” (=costless discovery) just a theory of luck?

  • 2. Peter Klein  |  20 August 2006 at 6:12 pm

    Lasse, this is an excellent question. Demsetz makes the same point about alertness. (AJE, in the paper described by Lasse we try to distinguish judgment from alertness, though there are obvious parallels.)

    One response to this point is simply to concede it, in the following sense. Many of the “judgment theorists” we follow — certainly Cantillon and Mises, and to an extent Knight — weren’t really concerned with the ontological and epistemological basis of judgment. Rather, their objective was to characterize the return to the entrepreneurial function — in particular, to decompose business income into two constituent elements, interest and profit. Interest is a reward for forgoing present consumption, is determined by the relative time preferences of borrowers and lenders, and would exist even in a world of certainty. Profit, by contrast, is a reward for correctly anticipating the uncertain future (e.g., purchasing factors of production at prices below the eventual selling price of the product), and exists only in a world of “true” uncertainty. In such a world, given that production takes time, entrepreneurs will earn either profits or losses based on the differences between factor prices paid and product prices received. Whether these residuals are “really” due to insight or to dumb luck doesn’t really matter, if the goal is simply to distinguish profit from interest.

    If profits and losses are random, then there is little more to say. If, on the other hand, particular individuals are more adept than others, over time, at anticipating future market conditions, then we can draw conclusions about the coordinating properties of the market. Mises maintained that entrepreneurship was more than luck, and that competition among entrepreneurs tended to drive the unsuccessful ones out of the market, thus leading to a particular kind of market coordination.

    As to Lasse’s question, under Mises’s concept of entrepreneurship it may indeed be impossible, empirically, to distinguish judgment from luck. (A very famous economist — a believer in the Strong Efficient Markets Hypothesis — once insisted to me that Warren Buffett is simply very lucky, that Buffet has gotten lucky many, many times in a row, but that he has no superior investment ability at all.) On the other hand, it’s worth noting that an a priori belief in some kind of entrepreneurial ability beyond pure chance is compatible with a wide range of ontological and epistemological beliefs.

  • 3. The Filter^  |  20 August 2006 at 6:20 pm

    MEASUREMENT!!!!!…

    Lasse Lien asks whether judgement is measureable:how do we separate judgement from dumb luck?My comment (trying to prompt Fred Sautet into sharing his thoughts) was:Isn’t “alertness” (=costless discovery) just a theory of luck?Of course I don’t …

  • 4. Lasse  |  22 August 2006 at 7:44 am

    Great reply Peter.
    So I guess that even if we could rule out luck, we could never positively identify the entrepreneurial ability as judgement? So the existence and importance of judgement must remain an article of faith, or?

  • 5. Peter Klein  |  22 August 2006 at 10:45 am

    Well, I wouldn’t go that far. I’m only saying that it may be impossible to distinguish judgment and luck empirically, simply by observing profits and losses. We could still distinguish them via other means, such as a priori theorizing, behavioral analysis, cognitive psychology, etc.

  • 6. Lasse  |  23 August 2006 at 3:44 pm

    OK Peter, but still, I cannot but keep wondering how we should isolate judgement by any of these methods since we do not know much about what judgement is, except for the outcome we think it produces. But, this may just prove I’m lacking it sorely :-)

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