Ch. 2, Extent of the Market Process

To provide a satisfactory argument that explains why there are business firms in the market, it is not sufficient to assume a viable and unchanging equilibrium state. Doing so can at best produce a simple and under contextualized static rationale for organizing, either as a reason for establishing firms in an otherwise firmless market state or for why firms have value in a market already populated with firms. Yet an equilibrium explanation consisting of an independent rationale is likely to be both arbitrary and irrelevant. The reason for this is that a rationale without indicated implications for individual economic actions and value for the market structure in the aggregate may be inapplicable and extraneous, and therefore spurious. For this reason, an argument for why there are firms must also at least indicate a reasonable explanation for the progression from non-firm to firm; that is, it must suggest a process or method that describes how firms come to be and, by extension, why they prevail (if they do) or dwindle. Without addressing the ‘how’, the economic rationale explains little if anything.

It follows that, at a minimum, an explanation of why there are firms must include two states: the market state prior to the existence of the firm, and that subsequent to its founding. Without both states, we cannot explain how firms are formed and therefore cannot produce a sufficient rationale or argument for why and how there are (or would be) firms. But this also suggests that the argument must fill the void between the two states and so must take account of the step by step process of organizing, without which a market fails to move from the previous state to the latter state. The task is therefore to produce an image of what this process looks like, which can only be done by first drafting the before state, postulate the after – and tracing the economic actions that constitute and bring about the aggregate transformation of the market from the one to the other. The states must be consistent, rely on similar assumptions, be subject to the same argumentation, and be realistic in order to be persuasive and relevant. These requirements do not pose a big problem, however, since the transformation follows from the original state, and the end state follows from the transformation. What matters, therefore, is that the starting point presents a theoretically rigorous structure based on realistic assumptions.

Yet by assuming two states, whether or not they are considered stable equilibria, with an in-between process of change, suggests that the object of our study by definition must be the market process. This can be conceived of as a process from an otherwise stable original state. But assuming the original state is unchanging or equilibrated makes little sense, and should add little if any value, since the very purpose and intent of the analysis is to introduce a process of change that brings about a new state. We cannot reasonably assume that the creation of organizations in the market are caused by forces exogenous to the market, and therefore our model must allow for and indeed support the endogenously initiated and produced emergence of firms; it follows that the firm should be a solution to some problem experienced in the market place and therefore that it should have a specific economic function.

It is furthermore important to recognize that the change process is, as previously indicated, constituted by actions taken by individual economic actors (presumably for their own benefit), and therefore it would be absurd to consider the original state a static equilibrium. It should be neither stable nor unchanging, since the very purpose of the exercise is to trace the effects of actions taken. There should be very little rationale for actors to bring about change from within a state of equilibrium; the concept indicates stasis, and the bringing about of change should therefore necessitate the addition of an exogenous force that would severely undermine the analysis.

It is also not clear that the new state, following the creation of firms, can in fact be considered a state at all, since it is by definition the effect of the change process that is the object of our study – with actions at different levels of maturity – and therefore should likely be in a flux. Whether or not the market post firm creation could be thought of as eventually settling or stabilising around a certain number of firms, a certain market-equilibrating standard firm size or with a particular market structure (which, with some imagination, the Marxian analysis of capitalism may entail), this ‘final state’ is beyond the scope of this discussion. We are interested in the economic forces that bring about and therefore cause integration in business firms, and therefore the function of the firm; it matters not if the firm creation process will eventually result in a particular pattern. In fact, if the firm can be thought of as fulfilling a specific economic function, then it is not unreasonable to assume that this function – especially in its specific implementation in a particular firm – may be temporary rather than perennial. Yet this is a discussion for later chapters.

The only reasonable starting point, we must conclude, is to assume a market in some form of disequilibrium state and, in this sense, a market that is continuously changing but includes no formal organization. This does not presuppose that this original market model is the ultimate starting point for economic activity per se. On the contrary, in order to explain the function of economic organization in the market place, the starting point must rather be an advanced, specialised exchange economy. Assuming a rather contemporary market state sans business firms offers the advantage of intensifying the comparative problem that the firm supposedly solves and thereby simplifying the identification of its function. However, we must keep in mind that the firm’s function could be core to the development of specialised production and therefore make sure to allow for this possibility in the model. For this reason, the model of the market prior to the creation of firms must be ‘thick’ rather than ‘thin’ in the sense that it is based in yet also an elaboration of existing theoretical and empirical evidence. This means the model should be realistic so that it resembles, at least in terms of function and procedure, the real market and is characterized by intensive division of labour and therefore specialisation. Thereby, the starting point is a ‘real’ market in terms of its core characteristics and processes, only without formal organizations. This is also the starting point in Ronald Coase’s ground-breaking essay on the firm,[i] though Coase did not elaborate on the specifics of the market structure. Where he referred to economic theory, presumably to the model of perfect competition, we shall here provide a fuller picture by drafting the particular characteristics of the firmless market.

Heterogeneity of the Capital Stock

The existence of market is preconditioned by the existence of specialisation through an intensive division of labour.[ii] As production processes under self-sufficiency are divided into specific and separable tasks carried out by independent labour workers, the previously atomistic social landscape evolves into a modern market society or what Mises referred to as one characterised by ‘social cooperation’.[iii] This social cooperation is due to the serial interdependence of labour workers carrying out individual stages of a particular production process. The product of one worker’s labour is used as the input of another’s, but while the flow of intermediate products through production processes tends to be unilinear, the workers throughout the process are mutually dependent. Any labour worker who produces an intermediate stage is dependent both on the producer of the previous stage for supplying their input, on any producer of necessary tools to assist in production, and on the producer of the subsequent stage for demanding and procuring their output. Without either, the labourer is unable to carry out its task and must find another means to earn a living as this specific market position fails the market test.

As a production process is divided into minute tasks of very limited scope, each part of the process is simplified to such a degree that work previously carried out by a skilful labourer can be automated and therefore replaced by machinery. It is the highly intensive division of labour and thus the splitting up of a production process into very limited and simplified tasks that facilitates the development and use of capital. As Mises identified:

The division of labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of the division of labor, its most beneficial achievement, not its motive and fountain spring.[iv]

Considering this explanation, it is difficult to imagine a specialised market that does not also include a large body of specific capital goods that support its intricate production processes. This automated production apparatus, generally referred to as simply ‘capital’, is what facilitates the increased productivity of labour that entails economic growth beyond its initial division into separate tasks. The generation of productive capital, developed specifically to relieve labour workers of the already separate and thereby simple and oftentimes repetitive tasks of production, constitutes ‘a “division of capital”, a specialization of individual capital items, which enables us to resist the law of diminishing returns’.[v] This division, however, builds on and develops the already existent division of labour, and we can think of the two ‘divisions’ as facilitating each other’s further intensifying and thereby overall continuous productivity improvements in the market.

Our model of the specialised exchange market captures this mutual facilitation by assuming a particular intensiveness of the division of labour throughout the market’s production apparatus along with the corresponding division of capital. We hence assume that production processes have already been disintegrated into specific productive tasks carried out by differently specialised experts using tools and machinery developed to be suitable in assisting in carrying out these tasks. There is so a market for both specific labour factors and capital, which are both readily available and so procurable in the open market at market prices.[vi]

It should be noted that this existent market is functional only to the extent that there are multiple possible uses for resources. Should this not be the case, by which we mean that assets are purely or perfectly specific, then the market is severely limited in its fundamental allocative function since any particular asset will have only one specific use or usage.[vii] Where this is the case, the specificity of the resource itself completely undermines the allocative function of the market. Perfect specificity implies there can be only perfect substitutes, which is the case where there is a supply in excess of one of any particular resource, since any deviation suggests a different use specificity. This means the use of a resource is either discovered or not, and therefore the market value of any resource is easily recognizable. Under such circumstances, where pure specificity is the prevailing condition of capital, the market is needed neither for allocating resources nor estimating their value. In this sense, complete and rational planning may not lead to calculative chaos,[viii] since the physical contribution to production of a specific consumption good can be perfectly imputed from the value imbued by consumers. The conclusion, that for the market to properly carry out its allocative function, whether or not at a cost, it is necessary that resources are less than perfectly specific, is therefore not simply an empirical observation – it is a necessary precondition for market. Perfect specificity is impossible since we consider the use specificity of capital, not the physical composition of a capital good. The limitation to a resource’s usability is therefore the imagination of those willing to put it to use, and it is inconceivable to even imagine a resource that has only a single use. It thus follows that even seemingly specific capital goods, whether or not they are developed for carrying out a single and highly specific task, in general have multiple specificities,[ix] which means that they can be used in several different ways and for different purposes.

Different resources can (and due to the fact that their particular uses are imagined by individual actors, they probably will) have different degrees of specificity, meaning they can be put to different numbers of uses. A simple tool like a wooden cane is sufficiently unspecific to be usable as a measuring rod and a walking stick as well as for fencing, fishing, pointing, poking, drawing in the sand, and so on. A surgical instrument may have a much more limited number of possible uses. But it is not the level of sophistication and detail in how a particular resource is produced or designed that determines its possible uses. This becomes obvious if we instead of specificities in resource use describe resources in terms of their attributes.[x] Any physical object has several attributes, of which only some are of economic significance. The collection of usable or useful physical attributes in a particular resource determines how it can be used and at the same time defines it to buyers and sellers in the market. But these attributes are not what ultimately makes the resource valuable. Rather, the attributes – to the degree they are discovered or known – determine the possible uses or functions of the resource, which are subjectively perceived and therefore existent in the eyes (or, rather, the mind) of the beholder.[xi] These different possible uses makes the resource serviceable toward a number of different ends as well as combinable with other resources, and are what characterises productive capital from an economic point of view.[xii] As Lachmann puts it:

Beer barrels and blast furnaces, harbour installations and hotel-room furniture are capital not by virtue of their physical properties but by virtue of their economic functions. Something is capital because the market, the consensus of entrepreneurial minds, regards it as capable of yielding an income.[xiii]

Since uses are perceived by actors in the market, who are different in many ways (that is, with differing experiences, knowledge, imagination, judgment, and so on) and have different ends in mind, it follows that all uses may not yet be known and hence some of them are yet to be discovered. But this also means that different resources as well as their distinct uses should be combinable; in fact, most resources available in the market are composites that were themselves created by combining other, possibly less advanced, resources. For instance, a wooden beer barrel, to use Lachmann’s example above, can be produced by combining other capital goods (wood staves, iron hoops and barrel lids) using expert labour assisted by other capital goods (tools such as a mallet, handsaw, and sandpaper and so on). Each of these capital goods, components used in production, are themselves resources with sets of uses that exceed that of barrel-making. Ultimately, all resources in the market are products of mixing untouched nature (or what economists call ‘land’) with some amount of labour. We can therefore think of capital as the ‘produced’ means of production.[xiv]

As resources can be combined in structures to produce new and – if successful – more productive capital, a market’s productive apparatus can be thought of as a capital structure that is in turn decomposable to capital structures produced with specific purposes in mind. Not only do the combination of capital resources bring about structures that support highly specific production processes (both in terms of function and aim), but this process also changes the landscape for economic action. Some combinations are irreducibly combined such that the implementation of the structure changes their physical composition and therefore their use – perhaps to such extent that they can never again be returned to their previous state. Part of this reason is due to the non-permanent nature of capital goods, which – even if they are relatively durable – as they are used begin to diminish in terms of serviceableness and ultimately may lose it altogether. More importantly, perhaps, is that the act of combining – the implementation of the combination – causes or necessitates changes to the physical composition of the individual components that are only reversible at high cost or completely irreversible. It may not be possible to again put wooden staves to their previously available alternative uses when they have already been combined into beer barrels (for example, if they have been cut, soaked in beer, etc.).

Also, even disregarding changes to the physical composition of goods due to combining, the creation of new capital to support specific production changes goods prices throughout the market. The new capital structure, when aimed at replacing less effective capital, changes both the perceived productive value of its substitutes and the quantity supplied of the structure’s output; it may also change requirements for labour factors operating it as well as maintenance and upkeep. Such innovations therefore always to some extent skew and otherwise affect the fabric of the market structure, which changes prices as well as resource allocation throughout. This change should be expected, since the creation of capital effectively heterogenises the capital stock in the market. In a market for wood staves and iron hoops, the innovation of the beer barrel both adds to the uses for wood staves and iron hoops and creates sub categories of different usability (perhaps only certain sizes can be usefully employed in barrel-making). This development also supports production of goods previously unseen, which can be produced using beer barrels or the combination of beer barrels and the previously existent wood staves or iron hoops. This new market situation, which includes wood staves, iron hoops and beer barrels (and, possibly, intermediate products used in the process), offers more types of resources for sale through the creation of the new, specific resource (the beer barrel). It has also established a new productive relationship between certain types of wood staves and iron hoops: they are now, from the point of view of beer barrel production, complements.

We need not delve further into capital theory, even though it is a fascinating and highly important (but underdeveloped) topic.[xv] It is sufficient for our purposes to emphasize that the productive structure in a market is interdependent through its division of labour and therefore also its division of capital, as the latter is ultimately produced to assist and facilitate the former, and therefore reactive to change. The market’s production capital consists of heterogeneous capital resources that have been and probably can still be combined in order to bring about specific capital structures aimed at particular production processes and tasks. As noted above, the purpose and use of capital is to assist labour in production of goods valued by consumers; capital is the means by which the productivity of labour is improved. The specific characteristics of a capital structure determines what can be produced and how, and facilitates further development as well as limits existing choices. As capital is traded in the market, whose function is to allocate resources toward their most productive uses, even seemingly minor changes to the composition of capital goods affect the capital stock[xvi] via entrepreneurs and capitalists bidding for resources they consider suitable to their productive ends and, consequently, support their aim for profits.

The effect of the beer barrel above is that the market now has information of more uses for wood staves and iron hoops in production, which affect previously existing production structures. The availability of these specific resources diminishes as their overall demand increases with the discovered uses, which brings about a reallocation of capital from the less productive structures to those that are more efficient from the consumers’ point of view. While there may not, at least in our limited illustration, be any immediately available substitutes for the only just invented beer barrel, the increased relative demand for wood staves and iron hoops causes their respective prices, as well as the prices of substitutes, to go up. For this reason, production processes throughout the market are eventually affected by this change, though at differing degrees.

This market-based interdependence between production structures within the capital stock suggests a curious problem that is the topic of the following chapter. But in order to elaborate on this problem and attempt a solution we must first delineate the nature of and process through which production structures throughout the market are affected by a change to the composition of the capital stock. This is necessary since the discussion so far seems to imply that any extension of the divisions of labour and capital constitute an improvement in overall wealth production through increased productivity throughout. While this is true, at least in general terms, the structure of the market – while it is a result of specialisation of both labour and capital – itself impedes and ultimately resists implementation of further divisions.

The Structure and Extent of the Market

Adam Smith notably opens The Wealth of Nations[xvii] with a discussion on the productive powers of the division of labour. The splitting of a production process into parts, and the specialisation of labour to these separate, more narrowly defined tasks, he writes, ‘occasions … a proportional increase of the productive powers of labour’.[xviii] With the development of capital to replace or assist labour in production processes, the productivity of the latter can be further increased so as to even ‘resist the law of diminishing returns’.[xix] Yet the market structure poses a constraint on this development and therefore a limitation to what efficiency in production is practically and economically feasible. Smith formulated this constraint thusly:

As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.[xx]

While Smith ultimately appears to place the cart before the horse in theorising on the intensification of the division of labour,[xxi] the limitation of productive specialising by the extent of the market is nevertheless real. Productivity increases with specialisation, but the increased heterogeneity in the employments of labour and development of capital requires improved coordination as the individual factors of production become more limitedly compatible. This suggests the benefits of specialisation are neither automatic nor unlimited. Indeed, the intensity and feasibility of the divisions of labour and capital appear limited by the extent of the market available to each labourer.

Emile Durkheim elaborates on Smith’s observation and stipulates that this market access limitation lies primarily in the perceived density between factors. The availability of potential trading partners both constitutes the opportunity and limits a labourer’s ‘power of exchanging’: the ‘power’ consists of the total availability of suppliers of inputs and purchasers of produced output, the preconditions for both production and market exchange through production processes. Density is then defined as the ability ‘to act and react upon one another … and the active commerce resulting from it’,[xxii] by which should be understood that the market place under the division of labour constitutes an intricate web of mutually beneficial exchange relationships – or, in the words of Mises, the ‘social cooperation’ that emerges under the division of labour. The market’s density fluctuates throughout an economy, which suggests there should be a higher specialisation intensity in e.g. cities than in rural areas that potentially also explains the emergence of empirically established phenomena such as innovation clusters.

High levels of density implies a situation of increased substitutability since in general the ‘distance’ to (and consequently the cost to discover) equivalent or alternative capital resources is shorter (lower). In other words, in densely populated market situations (where density refers to the relative availability of compatible exchange partners) any market actor is in a position where he or she can choose from several or many suppliers of inputs and simultaneously has access to a sufficiently sized market for the sale of any produced outputs. This state of affairs greatly increases the ability to make economically beneficial choices based on the better (more data points as well as providers of) information through market prices, but it also entails more intense competition as any labourer’s position in the production structure is fully substitutable through readily available competing suppliers of the specific task or service. This should result in a market that is highly dependent on and realized through simple exchange and it is therefore reasonable to think that the velocity of exchange, the number of exchange transactions in any time period, in a dense market greatly exceeds that of sparsely populated markets. It is, in other words, more fiercely competitive but also prospectively enables greater overall responsiveness to exogenous changes such as in consumer tastes or preferences.

But while the dense market should therefore more smoothly carry out its allocative function and therefore establish more efficient production structures sooner (at lower cost),[xxiii] dense markets are also – due to the competitive discovery process[xxiv] – extensively standardised. Indeed, as competitive pressure increases there is less opportunity (and may even be unfeasible) to deviate from the market’s standard division of labour. The costs of incompatibility with competitively priced inputs as well as the markets for standard outputs may be prohibitively high.[xxv] Such deviation from the market standard, which can be a result of individual and uncoordinated specialisation, is simply not economically feasible where the lack of density is too persistent. Even minor deviations can have a severe impact on the individual labourer, since limited substitutability may entail or give rise to incompatibility for cost reasons. Greater deviations may cause outright incompatibility and therefore exclusion from the market.

Whereas the lack of density in this sense establishes the limits of the market, the primary effect of density is – as Smith notes – to enableand make possible a division of labour. Without sufficient density, labour and capital cannot develop or adopt highly specific uses and therefore there can be no division of a production process into narrowly defined (and highly interdependent) tasks and functions. This is problematic since the very division of labour, which creates heterogeneity to the degree of uniqueness through intensive specialisation, requires an already established density for exchange of the specialised outcome. This appears to turn the logic on its head, and suggests a paradox where the act itself undoes the conditions necessary for its viability.

This can be illustrated by the pin factory example in Adam Smith’s The Wealth of Nations. The high degree of resource complementarity within the pin factory is due to the resources already being ‘jointly employed’ as ‘means to the same end’.[xxvi] But such highly complementary structures, with relatively low (if any, at the outset) substitutability, are feasible only where sufficient resource availability and density is already provided and therefore existent. In fact, the lauded and awesome productivity observed within the pin factory is possible only because the factory satisfies and controls the availability of inputs and outputs for each separate and highly specialised task.[xxvii]

While a telling illustration, the generality of which we will have occasion to analyse further below, specialisation does not, of course, only exist within the ‘manufactory’. Indeed, Smith’s example would make little sense were it not for specialisation already being implemented in the market within which the pin factory is placed. Pin-making is itself a specialisation, so the pin factory only appears to further intensify the division of labour by splitting the market standard task of pin-making into several distinct specialisations. This difference is at this point of little concern to us, since our original model of the market does not include business firms such as pin factories and the issue therefore falls outside the scope of the discussion at present. But it is important to note that specialisation, whether or not there are business firms, can potentially exist at different intensities throughout the market – both between disparate industries and between implementations of similar production processes. The development and thus adoption of more intensive divisions of labour appears to be an ongoing process in the market with or without business firms since individual actors are incentivised to further specialise due to the promise of increased earnings made possible by improved productivity.

We should keep in mind, however, that specialisation is dependent on a previously existent level of perceived market density. This dependence ultimately limits the possibilities of utilising the productive power of specialisation, and poses an interesting contradiction since the adoption of more intensive specialisation is dependent on having already realised the fruits of specialising (both the development of necessary capital and the generation of market density to support further ‘splitting’ of tasks). We shall now expound on the dynamics of the market under specialisation, which will reveal how the divisions of labour and capital are mutually constituting and necessary for the adoption of more highly specialised production structures. Even though the market is characterised as a dynamic entrepreneurial process, it will become clear how the market’s density constitutes a real limitation to its further development.

The Entrepreneurial Correction Process

The starting point for this discussion is an advanced exchange market that suffers from imperfect allocation of resources. Accordingly, the market’s production apparatus is divided into numerous specialised production processes that utilise specific capital to support labour in carrying out productive tasks. However, the market is imperfect in the sense that it is not in a stable efficient equilibrium state; it is in disequilibrium. We can think of this assumed market state as that of a previously equilibrated developed market that has not yet fully adapted to the effects of change caused by some disruptive force (exogenous or endogenous).[xxviii] In other words, some number of exchange transactions remain to re-establish a fully coordinated equilibrium. The remaining imperfections in this market state have the form of underutilised labour or capital in existing production processes, opportunities for reorganising existing or establishing new production processes, introducing new capital or products, and so on. We further assume that some equilibration has already taken place so that the market is not completely uncoordinated but includes some properly coordinated elements. In other words, what remains is for profit incentives to play out through free market exchange so that the market can again assume an efficient equilibrium state.

Assuming there are no changes to the market data, neither exogenous nor endogenous, except for progress made toward equilibrium by adjustments in resource allocation, the market as a whole is involved in the temporary activity of reallocating scarce resources to their better or best possible ends. As market data do not change, there is no economic problem other than finding maximising uses of specific resources. Subject to reoccurring exogenous changes, this market may only temporarily find its equilibrium allocation, which may soon be upset by a subsequent change. This type of ‘adaptation’ of the market’s production structure to the changing tastes of consumers (an exogenous factor) presents the simple problem that Israel M. Kirzner refers to as ‘Robbinsian maximising’,[xxix] in which given resources are put to such uses that maximises the outcome from a given set of ends. While this ‘problem’ may be an interesting mathematical exercise, Kirzner correctly notes that ‘[a] multitude of economizing individuals each choosing with respect to given ends cannot … generate a market process’.[xxx] Indeed, a market consisting of given sets of means and ends from which actors simply choose, whether or not the market is affected by exogenous changes, poses no real economic problem. Where both means and ends are known, which means all market data are readily available for the actor, all actions are necessarily maximising. We cannot expect actors to make errors against better knowledge, since doing so will most severely hurt themselves in the competitive market place. We also cannot expect to find an economic reason for establishing formal organisations, since there is neither uncertainty nor open-endedness. The market under ‘Robbinsian maximising’ is in this sense perfectly competitive and therefore in effect devoid of competition.[xxxi] The reaction to exogenous changes is simply a reshuffling and simple reconfiguration of production processes, and the market should therefore quickly re-establish an appropriate equilibrium. Needless to say, this type of market bears little resemblance with the real market’s immense coordination problem, unavailable or tacit knowledge, uncertainty and open-endedness.

If we introduce variation in the means and ends available, it follows that market actors are no longer simply maximising the outcome of choices among a set of alternatives. This suggests the market suffers from and in effect becomes a knowledge problem, since actors are no longer able to figure out or calculate what the best means toward specific ends are. If consumer preferences are assumed non-static, which is a relevant as well as empirically necessary assumption, they also cannot know what possible ends will maximise their economic situation. In effect, they should at the time of choosing be at least partly ignorant of what ends will be economically feasible, since much of the market data that ex post maximising depends on are not yet in existence. Action takes time, and production under specialisation is quite time consuming (imagine setting up a new automobile manufacturing plant, which can take several years). The problem becomes acting based on access to data that is solely available ex ante and therefore may only be limitedly relevant to the market situation at the time the action is completed. In other words, the market is inherently uncertain.

It should be no surprise, then, that many actions taken in the market will result in errors, at least when considered retrospectively when the relevant data have become known, and that these errors themselves constitute opportunities for profit.[xxxii] These emergent errors, whether they are greater or smaller in magnitude than those occurring in the market state prior to the actions taken, present profit opportunities for entrepreneurs willing to invest in adaptation of established production processes. These further adaptations, which take place in a market setting brought about by previous entrepreneurial action, will be profitable only to the extent they constitute improvements to the existing capital structure from the point of view of satisfying future consumer preferences. Kirzner suggests a similar entrepreneurship-on-entrepreneurship market dynamic when he states that the ‘pattern of decisions in any market period differs from the pattern in the preceding period as market participants become aware of new opportunities. As they exploit these opportunities, their competition pushes prices in directions which gradually squeeze out opportunities for further profit-making’.[xxxiii]

However, this ‘squeezing out’ of profit opportunities by successful entrepreneurship seems to be unsupported under the stated assumptions. For Kirzner’s above quoted statement to be true, it is necessary to hold consumer preferences constant. Because if consumer preferences are unchanging, entrepreneurship amounts to a collective trial and error process. Entrepreneurs can make improvements to the capital structure established by previous (imperfect) entrepreneurship, and opportunities for profit tend to be ‘squeezed out’ as more successful entrepreneurship is added and thereby takes the market process closer to maximised consumer satisfaction.

Under constant consumer preferences, the market process in the aggregate will be equilibrating even if entrepreneurial activity is guided by profits but specific entrepreneurial decisions made at random. The reason for this is that relatively more accurate entrepreneurial actions will generate greater profits and therefore attract more entrepreneurs, and vice versa. Entrepreneurship here boils down to simple ‘arbitrage’ that, over time and even without qualities such as foresight or ‘alertness’ will tend to eventually ‘squeeze out’ opportunities for further improvements.[xxxiv], [xxxv]

It is very different under changing consumer preferences, where entrepreneurs are necessarily always aiming for a moving target. What worked yesterday may be an error today, and therefore needs adaptation. On the other hand, what did not work yesterday, may work today. Arbitrage activities that take time (that is, all actions, and especially those that for their success rely on first instituting some change to the capital structure) is estimated using two bases, of which only one is known ex ante. An entrepreneur at time t will make a decision for entrepreneurial action based on knowledge of the existing capital structure c(t) and the existing consumer preferences p(t). This knowledge may indicate a means-ends mismatch to the extent p(t) are not fully satisfied by c(t), which constitutes an opportunity for improvement. However, the preferred entrepreneurial action cannot be finished until time t+1, at which time the capital structure has changed to c(t+1) as a consequence of entrepreneurial actions, and consumer preferences have changed to p(t+1). As we are not yet at time t+1, the nature of the market at this future point in time is unknown.[xxxvi] While the entrepreneur does not have the full capital structure at his disposal, at least part of it can be acquired at present market prices and adapted toward satisfying an anticipated end at t+1. Yet this end, as Frank H. Knight recognized, is at best ‘an estimate of an estimate’[xxxvii] where the entrepreneur not only ‘forms the best estimate he can of the outcome of his actions, but he is likely also to estimate the probability that his estimate is correct’.[xxxviii] The outcome of the entrepreneurial actions, of course, is c(t+1) – a combination of his own actions including adaptations to the share of the capital structure that he controls and the actions of other entrepreneurs. Profitability is achieved where the part of the capital structure controlled by the individual entrepreneur, c’(t+1) ⊂ c(t+1)), corresponds to some subset of consumer preferences at that time p’(t+1). Of course, the individual entrepreneur’s achieved profit is also a function of the degree to which other entrepreneurs are equally successful, that is the correspondence between c(t+1) and p(t+1). The realisable value of the imagined opportunity is therefore an added uncertainty to the entrepreneur’s imagined opportunity: an estimate of an estimate of an estimate?

The process of changing the capital structure from c(t) to c(t+1) can be thought of as capital ‘regrouping’ for the sake of better serving consumers’ needs on a macro scale.[xxxix] It consists of entrepreneurs aiming their acquired capital toward maximising its estimated value in production by satisfying consumer wants. While such decentralised decision-making is bound to generate numerous errors, and therefore entrepreneurial losses, it is not a random but guided process. Capital is always configured to produce goods and services that entrepreneurs imagine will be serviceable to consumers. This ‘imagination’ is based on the entrepreneur’s personal experiences as well as his developed understanding of consumers and what they need, want or cherish. The latter is ultimately an expression of the entrepreneur’s own life experience and a function of his understanding and comprehension of humanity and human life, likely based on revealed preference through previous market actions, verbally expressed preference or discontentment and conjecture. The entrepreneur’s inability to think outside of his humanness results in a path-dependency in market production that limits the scope and frequency of errors.

Over time, failing entrepreneurs in the market amass losses that make continued market action impossible and they are as a result replaced by those who have exercised better entrepreneurial judgment. The market will for this reason in the long run tend toward increased wants satisfaction even though the market may not at all times be fully equilibrating. The development of productive capital, which is non-permanent but durable, increases the overall productivity of the market for some time. This lasting increase in productivity, a sort of inertia of capital’s structure, retains a level of productivity even in the face of clusters of entrepreneurial error. It also makes the economy vulnerable to radical, exogenous change that fundamentally alters market institutions and thereby changes the ‘rules of the game’.[xl]

More importantly, this indicates a limitation to the unfolding of the market process where the inertia of created capital structures cannot easily or costlessly be changed. Furthermore, the regrouping and reconfiguration of capital, part of which may include the creation of new capital, pushes the boundary for the path-dependent evolution of the capital structure. Capital is ultimately heterogenised through the creation of novel combinations, which initially places the new capital good outside the boundary of the market. The market for a newly created capital good is initially non-existent as it is not a known substitute for any already used capital good, and its creator therefore risks losing its full value as its second best use may be of very little market value. The problem is similar to the relationship-specific investments that engender asset specificity in Oliver Williamson’s transaction cost analysis of integration,[xli] but of a more general nature. While a created capital good’s specificity to a particular transactional relationship may aggravate the economic problem where actors are expected to act opportunistically, this is not necessary to make the situation problematic. Indeed, both Adam Smith and Durkheim would agree with our view that a new capital good without obvious substitutes would fall outside the extent of the market since it has no viable alternative market uses and is, therefore, neither demanded nor supplied and consequently lacks a price in the market.

This limitation translates to a more general as well as fundamental market problem since the development of capital is a necessary precondition for and dependent on the further division of labour. While we can think of innovative entrepreneurs willing to assume the risk of creating new capital beyond the extent of the market, a division of labour and therefore the development of more productive production processes requires the availability of labourers willing to specialise to production tasks that are also beyond the market boundary. Furthermore, such specialised tasks would be fully dependent on the creation of specific capital as well as other labourers willing to simultaneously assume a similarly vulnerable position.


[i]R. H. Coase, ‘The Nature of the Firm’, Economica, 4:16 (1937), pp. 386-405

[ii]A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776).

[iii]L. v. Mises, Human Action: A Treatise on Economics (New Haven, CN: Yale University Press, 1949).

[iv]Mises, Human Action: A Treatise on Economics, p. 164.

[v]L. M. Lachmann, Capital and Its Structure (1956) (Kansas City, MO: Sheed Andrews and McMeel, 1978), p. 79.

[vi] These prices are ultimately determined by entrepreneurs and capitalists, who, in accordance with their judgment of what type of production will generate future profits, bid for particular resources that they intend for specific uses in imagined or already realized production structures and processes. The derived valuation of these resources, on which their bidding is based, is in turn based on their appraisement of the value of final goods for the consumer. This type of dynamic market price determination through ‘imputation’ is discussed in, e.g., L. v. Mises, ‘Economic Calculation In The Socialist Commonwealth’, in Hayek (ed) Economic Calculation In The Socialist Commonwealth (London: George Routledge & Sons, 1935), pp. 87-13, L. v. Mises, ‘Profit and Loss’, in Profit and Loss (Indianapolis, IN: Liberty Fund, 2008), pp. 143-172.

[vii] For a discussion on production in a world with only specific factors, see M. N. Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition (1962) (Auburn, AL: Ludwig von Mises Institute, 2004), pp. 329-333.

[viii] For a discussion on calculative chaos due to rationally planning, see L. v. Mises, Planned Chaos (Irvington-on-Hudson, NY: Foundation for Economic Education, 1947). See also Mises, ‘Economic Calculation In The Socialist Commonwealth, L. v. Mises, Socialism: An Economic and Sociological Analysis (1936) (New Haven, CT: Yale University Press, 1951).

[ix]Lachmann, Capital and Its Structur, L. M. Lachmann, ‘Complementarity and Substitution in the Theory of Capital’, Economica, 14 (1947), pp. 108-119.

[x]Y. Barzel, Economic Analysis of Property Rights (Cambridge: Cambridge University Press, 1997).

[xi]K. Foss, N. J. Foss, P. G. Klein and S. K. Klein, ‘The entrepreneurial organization of heterogeneous capital’, Journal of Management Studies, 44:7 (2007), pp. 1165-1186.

[xii]K. Foss, N. J. Foss, P. G. Klein and S. K. Klein, ‘Heterogeneous Capital, Entrepreneurship, and Economic Organization’, Journal des Economistes et des Etudes Humaines, 12:1 (2002), pp. 79-96, pp. 81-83.

[xiii]Lachmann, Capital and Its Structure, p. xv.

[xiv] Hayek’s description of capital as ‘non-permanent’ rather than ‘produced’ is technically more accurate, since the problem of capital is not simply its production but its maintenance and upkeep in order to permanently increase the production of valuable output (and hence income). See further, F. A. v. Hayek, The Pure Theory of Capital (London: Routledge and Kegan Paul, 1941).

[xv] For important contributions to capital theory, see E. v. Böhm-Bawerk, Positive Theory of Capital (1889) (South Holland, IL: Libertarian Press, 1959, Hayek, The Pure Theory of Capita, I. M. Kirzner, An essay on capital (New York: Augustus M Kelley Pubishers, 1966, Lachmann, Capital and Its Structur, P. Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World (Auburn, AL: Ludwig von Mises Institute, 2011, M. Skousen, The Structure of Production (New York: New York University Press, 1990, R. v. Strigl, Capital & Production (1934) (Auburn, AL: Ludwig von Mises Institute, 2000)

[xvi] The capital stock of a market or society is sometimes referred to as its ‘subsistence fund’. See Hayek, The Pure Theory of Capital, chapter VII.

[xvii]Smith, An Inquiry into the Nature and Causes of the Wealth of Nations.

[xviii]A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (Chicago, IL: University of Chicago Press, 1976), p. 9.

[xix]Lachmann, Capital and Its Structure, p. 79.

[xx]Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 21.

[xxi] This is easily seen when considering Smith’s discussion on the spontaneous and unintended process of intensifying the division of labour, which is the result of individual decisions incentivised by man’s ‘propensity to truck, barter, and exchange’:

The division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another. (Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 17)

But in order to act on their propensity and so engage in specialisation, there must already exist a market of sufficient size to support their specialised employment. Such a market can scarcely exist until other labourers have already engaged in similar specialisation and thereby created demand for the specialised output. It must be concluded that specialisation in a single task ultimately relieves other labourers of the necessity to carry out this task and therefore facilitates their specialisation – not the other way around. This should be especially obvious within integrated and highly specialised production processes within ‘manufactures’ such as a pin factory, Smith’s well-known illustration the productive power of the division of labour. We will return to the process of specialisation below, as it is core to our understanding of the function of the firm.

[xxii]E. Durkheim, The Division of Labor in Society (1892) (New York: The Free Press, 1933), p. 257.

[xxiii] A different though compatible explanation based on the costs of using the price mechanism under lacking density can be found in Coase’s original discussion on the effect of transaction costs on market structure. For a discussion on the implications of Coase’s observation, see P. L. Bylund, ‘Explaining Firm Emergence: Specialization, Transaction Costs, and the Integration Process’, Managerial and Decision Economics, (forthcoming), pp. . For Coase’s original discussion, see Coase, ‘The Nature of the Firm’.

[xxiv]F. A. v. Hayek, ‘Competition as a Discovery Process’, New Studies in Philosophy, Politics, Economics, and the History of Ideas, (1978), pp. 179-190.

[xxv]Bylund, ‘Explaining Firm Emergence: Specialization, Transaction Costs, and the Integration Process’.

[xxvi]L. M. Lachmann, ‘Complementarity and Substitution in the Theory of Capital’, in Complementarity and Substitution in the Theory of Capital 1977), on pp. 201-202.

[xxvii] Smith observes that within the pin factory a company of ten workers, each specialised to performing ‘two or three distinct operations’, can ‘make among them upwards of forty-eight thousand pins in a day’ whereas ‘separately and independently’ they ‘certainly could not each of them have made twenty, perhaps not one pin in a day’. See Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 9.

[xxviii]What forced the market out of equilibrium (and whether this actually happened) is of no relevance here, since the disequilibrium state is our starting point for theorising on how and why business firms emerge.

[xxix]I. M. Kirzner, Competition and Entrepreneurship (Chicago, IL: University of Chicago Press, 1973), especially pp. 32-33.

[xxx]Kirzner, Competition and Entrepreneurship, p. 33.

[xxxi]F. A. v. Hayek, ‘The meaning of competition’, in Hayek (ed) The meaning of competition (Chicago: University of Chicago Press, 1948), pp. 92-106.

[xxxii]I. M. Kirzner, ‘Economics and Error’, in Spadaro (ed) Economics and Error (Kansas City MO: Sheed Andrews and McMeel, 1978), pp. 57-76.

[xxxiii]Kirzner, Competition and Entrepreneurship, p. 15.

[xxxiv] Frédéric Sautet elaborates on Kirzner’s entrepreneurship, and introduces two dimensions of arbitrage: spatial and temporal. The latter refers to entrepreneurial ‘discovery in time’ and adds to Kirzner’s alertness metaphor the ability to ‘imagine the future’. Writes Sautet, ‘the entrepreneur does not deal only with knowledge that is scattered in the economy but also with knowledge that is utterly unknown to anyone in the market. This knowledge exists (and may take the form of a property of matter, for instance) but is not present in the economic system’. F. E. Sautet, An entrepreneurial theory of the firm (Routledge, 2000), pp. 61-63.

[xxxv] For a relevant critique of Kirzner’s view of entrepreneurship, see e.g. N. J. Foss and P. G. Klein, ‘Alertness, Action, and the Antecedents of Entrepreneurship’, Journal of Private Enterprise, 25:2 (2010), pp. 145-164.

[xxxvi] We should perhaps note that not even t+1 is known; it is the point in time at which the entrepreneur anticipates to have finished the action.

[xxxvii]F. H. Knight, Risk, Uncertainty and Profit (1921) (Chicago, IL: University of Chicago Press, 1985), p. 227.

[xxxviii]Knight, Risk, Uncertainty and Profit, p. 226.

[xxxix]Lachmann, Capital and Its Structure, pp. 35-52, Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World, p. 134.

[xl]D. C. North, Institutions, Institutional Change and Economic Performance (Cambridge: Cambridge University Press, 1990), O. E. Williamson, ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38:3 (2000), pp. 595-613.

[xli] See e.g. O. E. Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985).