Ch. 4, Entrepreneurship and Integration

In the previous chapter, we discussed the ramifications of changes to and within a specialised production process. The division of labour onto separated operations, tasks and stages that constitute a production process entails serial interdependence between the tasks as well as between the labour workers who carry out those tasks. As the market allocates resources and productive endeavours vertically throughout processes, as well as horizontally between them, the problem emerges as a ‘specialisation deadlock’ because the decentralised market is not equipped to deal with or able to support radical, spasmodic change. This is not a matter of market frictions such as transaction costs, which apply to the process of resource allocation within and between existent production processes, but about incompleteness. Incompleteness entails productive action that effectively takes place outside the limit of the present market, whether or not it is within the production profitability frontier. The novelty or originality of such actions place them outside the limit of the market; frictions, in contrast, affect exchange taking place within the extent of the market.

It is important to note that incompleteness arises only where concerted and coordinated actions are required but not realised. The specialisation deadlock, while it implies limits to the workings of the market process throughout, is primarily a problem where comparatively intensive coordination is required in a highly decentralised setting. This is the reason we assumed a highly specialised but thoroughly decentralised – even atomistic – market-based production process above. Yet the existence of this specialised, decentralised production process should appear to be impossible, since the process of establishing it is itself subject to the ‘deadlock’. Consequently, the actors must have already overcome the problem somehow. This should also be the case with the advanced specialised market we all partake in and can observe around us in modern society.

We have noted that the ‘deadlock’ is more persistent in a highly specialised market, especially if it is highly decentralised, but it should be prevalent also in a relatively unspecialised market. The latter holds true if the market’s production includes and relies on advanced capital. Consider the self-sufficient life of Robinson Crusoe, who must take any and all productive action himself. While he will learn from experience and may figure out better methods for producing the necessary foodstuffs, shelter and clothing and therefore can increase his standard of living somewhat, it is not until he meets Friday that he may engage in specialisation through the division of labour. This presents no great problem, however, since Robinson and Friday can agree to simply divide tasks between themselves and thereby focus their efforts on certain chores and then share the fruits of their labour. For instance, Robinson may focus on producing clothing and build and maintain his and Friday’s shelter(s). Because this means Friday won’t have to do these same tasks, he is able to spend his days securing their sustenance. Both of them can increase their productivity by focusing on fewer tasks and saving on transitioning between them, as Adam Smith teaches. And through David Ricardo’s law of comparative advantage we can see that this simple focusing on particular tasks, when Robinson and Friday do what they are relatively better at (they naturally have no reason to do otherwise), will increase their total output.

But such specialisation through a division of labour between separate productive chores will not give rise to the specialisation deadlock, just like a traditionally wedlocked couple are not deadlocked only because the husband focuses on labouring to earn an income while the housewife cares for their home and children. Similarly, the owner of a farm with employees can without much problem assign his labourers different tasks and responsibilities rather than employ each of them to carry out all tasks in parallel.

These examples have in common that they rely on a simple division of labour onto already specific, separate tasks or processes. There is no economic or coordination problem involved with having labourer A focus on working the field to yield crops while B focuses on caring for the farm animals and C repairs the buildings on the farm. These are already ‘naturally’ separate chores that any individual and self-sufficient farmer would carry out separately but as part of the total work necessary to run the farm. Ploughing, sowing and harvesting the fields are activities that do not interfere with or depend on other farm activities such as milking cows, feeding goats, or fixing the roof of the farm house. Coordination problems emerge only when we introduce specialisation through the division of labour into a ‘naturally’ separate task where there is no market for the individual specialised subtasks or their required capital. Indeed, the problem arises because non-marketable action is taken as though it was within the realm of the existent market – when a productive innovation that is effectively outside the limit of the market is introduced to production carried out within this limit. In other words, the specialisation deadlock occurs where action is taken that expands the market. Some level of originality is thus required.

As is commonly the case in a modern market, the division of labour refers to splitting up a task into a number of processes and sub-processes with each part being carried out separately. Specialisation is not in itself problematic unless this type of division of labour is implied. One might also argue, without much error, that this kind of specialisation, to be effective, needs specific supportive capital to be feasible. Advanced production necessitates the development of capital, and it is reasonable to assume that split tasks, the ‘creation’ of several more narrowly defined and thus more specific tasks to replace a previous one, require new capital. Rothbard expresses this when stating that capital is ‘a way station along the road to the enjoyment of consumers’ goods’ and that it functions ‘to advance men in time toward their objective in producing consumers’ goods’.[i] Capital is itself the outcome of a production process that mixes the original factors land, labour and time intended to bring the state of the market closer to the satisfaction of specific wants. Capital is therefore specific in a sense that labour never is, since it is developed for a single or a limited number of purposes.[ii]

For the example of Robinson and Friday, therefore, the division of their labour onto the tasks necessary for their survival can be taken quite far as a number of separate tasks are needed to secure their survival. But it is bounded by the lack of density in their two-man economy, which constitutes a very narrow limit to their production endeavour. Even if they are joined by two more people, say a Saturday and a Sunday, they would have a no need for task-splitting and they would not automatically constitute a market. Rather, the group could work together in the same way a family would, and perhaps share the yield of their labours brotherly as in an idealised socialist society. In this situation, Smith’s observation that the division of labour is limited both by the group’s accumulated stock and the number of labourers available seems to hold because these individuals’ first priority must be survival.[iii] As they are already a group, their everyday and constant struggle amounts to dealing with all but the first of the Hobbesian description of life in the state of nature as ‘solitary, poor, nasty, brutish and short’. Unless they, despite being in this precarious situation, can accumulate a stock of goods or, obversely, have labour hours to spare, they cannot afford to develop capital. The situation seems to validate the Smithian paradox.

Smith’s argument does not hold, however, if our group is joined by more shipwrecked people or other natives like Friday, Saturday and Sunday. With a comparatively large population, and thereby greater density, the division of labour can be taken much further through engaging in intensive specialization. Simply due to the increase in manpower, distinct lines of production will emerge as separate specialisations for labourers: fishermen, hunters, farmers, tailors, and so on. This division increases overall output, but also brings about decentralisation of the coordination of production for the satisfaction of wants and needs through exchange – and therefore the inception of a simple market. This type of specialisation through the division of labour does not depend on a stock of goods overall in the little society, but decentralises the decision-making and thus management of production in separate processes. With decentralised management, and with it private ownership or at least de facto control of the means of production, the incentives to invest in the development of capital for greater yield are strengthened and so a rationale for saving and investment is manifested. It also becomes easier to identify opportunities for productive innovation. It is with this limited type of entrepreneurship, in the sense of individual uncertainty-bearing and innovation for increased yield and therefore better opportunities for barter, that advanced specialisation through capital development and task-splitting can begin.

If the population is large enough, and the market therefore is of sufficient density, labourers will find reason to split production processes vertically within their specialisations, which necessitates cooperation and coordination among those specialised toward the same trade. This specialisation process is distinct from the division of chores that previously took place only horizontally. As processes are split vertically they produce the type of serial interdependence we discussed above, which is of an entirely different kind and requires advanced coordination or standardised intermediate goods. Standardisation here relates to the interfaces between interdependent production tasks, and the specifications of intermediate deliverables. We will return to this issue later, as it facilitates but is also the product of market trade, especially in advanced economies. At this point, as our island-based production lacks a developed exchange market, and standardisation hence is not yet a major issue, we will focus on the immediately relevant issue of coordination as production processes continue to be split vertically and therefore become more roundabout. As the island’s labourers are specialised toward specific production processes horizontally, or even specific tasks within processes (vertically), but there are no directly competing production processes, there is consequently no market-based allocation of resources between them. This type of simplistic production economy without redundancy and competition should be rather inefficient and lacking of investments in capital. There is therefore no basis for strict interdependencies, and so a ‘specialisation deadlock’ could not occur. In this situation of primitive production, structuring the islanders’ productive activities in ways akin to a socialist planned economy may be feasible or even desirable in the short term. However, centralising decision-making and resource allocation at this point also retards the economy’s development toward more intensive specialisation through the division of labour and could for this reason stifle productive progress. Centralised decision-making, as Hayek[iv] noted, is unable to take advantage of specific local and dispersed knowledge, and also reduces or fully abrogates incentives for innovation and experimenting in productive processes. It therefore deters economic progress.

Specialisation in an underdeveloped economy, first horizontally and then vertically, tends to be proportional to the increase in its productive density and, therefore, to total supply of labour. As production processes are streamlined, specialised and separated along with the intensification of this division of labour, the economy’s productivity increases progressively with its density. Even without innovation and capital investments, while increases in density and specialisation would tend to be approximately commensurate, the result of specialisation is overall increased productivity and therefore increasing output quantities. This suggests a solution to Smith’s paradox.

On the more densely populated island, multiple labourers specialise to each production process and this redundancy in labour factors facilitates vertical division of the process into its specific tasks and operations. This division is simple enough for specialised labourers seeking to maximise their production at minimum expense. Any production process consists of at least a few identifiable separate operations specific to the process, and simple division of labour between these known operations and the advantages of doing so are easily conceivable. It is indeed a fact, as Mises notes, that ‘work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth’.[v] As far as is supported by and thus compatible with the overall production process, or can be agreed on by all involved, experimentation and minor improvements to the process will be carried out. However, specialisation through the vertical division of labour causes serial interdependence that could result in incompleteness should either labourer fall short in his productive efforts. As a rudimentary economy cannot sustain idle redundancy in its production processes, this is a real problem that our islanders face and that ultimately limits the feasibility of specialisation.

The division of labour within each production process will eventually come to a point where operations are so specialised that all of them can no longer be effectively performed by everybody involved in the process. In the least, as they specialise and improve on and develop their respective skills, the labourers are no longer fully substitutable but become experts. Just like the horizontal division of labour allowed the islanders to specialise in separate trades (fishing, hunting, etc.) and thereby develop specific skills, the vertical division of labour produces specialists with unique productive abilities. The labour factors are thus heterogenised through the development of their respective expertise. This type of division of labour is, writes Mises,

a factor bringing about differentiation. It assigns to the various geographic areas specific functions in the complex of the processes of production. It makes some areas urban, others rural; it locates the various branches of manufacturing, mining, and agriculture in different places. Still more important, however, is the fact that it intensifies the innate inequality of men. Exercise and practice of specific tasks adjust individuals better to the requirements of their performance; men develop some of their inborn faculties and stunt the development of others. Vocational types emerge, people become specialists.[vi]

This development is augmented with advanced specialisation through the ‘splitting’ of tasks within the production apparatus of a market.

Advanced Task-Splitting

The very limited economy we have so far analysed in this chapter included no productive redundancy and each production process was in this sense a monopoly. As the population grows, the new labour factors would likely be assigned their specialisation in this little and undeveloped economy based on the population’s most urgent needs. While there are productivity gains from populating a specific production process with labourers to specialise to its separate operations, there are very limited returns to over-populating a process. For hunting, for instance, different strategies may be used depending on the number of hunters available: from the lone hunter setting traps or waiting in hiding for his prey, to the hunting team with specific roles or positions relative their preferred game. But at some point the production process suffers from being overcrowded; the diminishing returns to the number of labour factors included in the process incentivises workers to adopt other lines of production or establish parallel production structures. For instance, the hunting team may split into two and concentrate on different areas, different types of game or different hunting methods. We have still to see, however, how labourers in a production process adopt task-splitting rather than the comparatively simple division of labour onto already separate operations.

Intuitively, the first ‘splitting’ of a task includes the production of capital. While a hunter at the beginning may simply rely on his ability to kill game with his hands or throw rocks to assist in the hunt, he will eventually benefit from producing more elaborate capital such as a bow and arrows, a net, or elaborate traps. Some of the simple capital can be produced by the single hunter since it requires little specific skill and since the production and consequent usage of this capital increases productivity sufficiently to constitute an immediate gain. For instance, the act of sharpening a pointless stick to produce an effective spear will take time from hunting but could make the hunt so much more productive that the time and effort needed for the combined activities sharpening and hunting fall short of what is needed when hunting with a blunt spear. If it usually takes the hunter ten hours to find and kill a certain type of game when using rocks and sticks, and if spending two hours to find the perfect stick and sharpen it to produce a spear shortens the time necessary to find and kill similar game by at least two hours, then there is no problem as long as the hunter realises this or is willing to chance it. The act of hunting may be delayed and the time available for it shortened, but this has no real effect on the production process as it is shortened by no less than it takes to produce the better tools and the expected outcome is the same. To the extent that time and effort invested in production of capital does not affect the general flow of goods, production of simple tools used in rudimentary production processes generally constitutes no economic problem.

If we let the same production process become more densely populated, it would allow for labour to specialise in the two separate tasks of simple tool-making and hunting with the produced tools, respectively. While this situation is different in the sense that hunting now consists of a more roundabout production process including the production of capital, it is not essentially different from specialising in separate operations in the process. The problem arises with innovation of advanced capital and a revolutionising restructuring of the production process that most likely requires investment of present resources for potential future gain.

Fast forward to when there are sufficient islanders to populate a particular production process so that at least one individual specialises to carry out each necessary operation. At this point, even though there are no competing production structures and thus no independent redundancy in production, we may see innovation of sufficient originality to cause a limited problem akin to the specialisation deadlock. The consequences are however of limited effect as there is no redundancy in production, and therefore no cross-process standardisation through factor markets. But they are still of economic significance and this limited case provides insights that are applicable also on the more advanced market situation.

Consider a generic production process consisting of three successive operations or production stages, o1-3, including production of capital needed to assist labourers in carrying out production. These three stages are carried out by four labourers, l1-4, with the more labour intensive stage o2 being carried out by two labourers. As per our assumption, the middle production stage requires approximately twice the labour power to produce as much output as the other stages, and this is the reason it is carried out by two labourers working side by side. Thus, these workers, l2 and l3, perform the same operation o2. Also assume that this situation is the result of the process described above, which means it has undergone a vertical division of labour to such degree that the separate operations have become distinct specialisations. Whatever naturally occurring inputs used in this process must undergo each of the three productive operations in the specified order to produce the expected outcome, which means the process is serially interdependent such that the output of operation o1 is the input for o2, and the output of o2 is the input of o3. Only the outcome of the full process is in itself a product and therefore the output of o1 and o2 are not serviceable for consumption. In other words, if operation o3 is not performed the process is incomplete as the intermediate good, the output of o2, remains unusable (or usable only at very high cost) unless it first undergoes o3. The four labour factors l1-4 are therefore ultimately dependent on each other, since if either of them fails or neglects to perform his stage, all work done to that point is without value. The value realised through production requires the full process to be carried out from beginning to end.

Imagine that, after another hard day’s work, l2 and l3 walk together back to their shelter as usual and discuss the day’s arduous experience. But today l3 says that he has been thinking about how to improve the production process, and presents to l2 an idea for how to make their performed stage more productive. His idea includes a new structure with two separate operations previously neither seen nor imagined. In essence, he suggests that there may be much to gain to carry out these two operations, which we will refer to as o21 and o22, in place of the presently performed o2. After l3 explains more specifically what this innovation entails and how he expects it can be implemented, l2 is thrilled by the idea. If it goes well, l3 anticipates, it would lessen their burden and increase production or, alternatively, free up time for other activities. The innovation, in short, introduces the sub process o21o22 to replace the operation o2, which produces a new process that is comparatively more roundabout: o1o21o22o3 instead of o1o2o3. As the innovation has not been tried, they will need to invest time and labour to implement it and test if it will function as expected.

Whether or not specific capital investment is necessary, l2 and l3 will need to invest their precious labour time and effort into this experiment. To the degree this affects their performance of o2, it will bring about a loss to all those involved in as well as dependent on the production process. Whatever is produced by l1 during this time will be incomplete, and at the same time there will be no inputs produced to use by l4 in performing o3 and he is therefore kept idle. This can amount to a significant loss of output, which a relatively undeveloped, rudimentary production economy may not be able to afford. It should be clear, however, that in the face of incompleteness and therefore loss, innovation affects all of those involved in production (and those dependent on its outcome) and in this sense becomes a collective effort. Indeed, the cost of failure is immense and is borne by everyone, and for this reason l2 and l3 have little incentive to experiment with the production process. Only if they can reliably predict that their efforts have minimal effect on the existent production process or that the innovation comes with great benefit and has a great chance of success would they be inclined to go through with it. Even so, they may face resistance by the other workers unless they are able to convince them that the effort does not jeopardize production. Rudimentary societies that rely for their survival on limitedly specialised production should thus tend to be highly sceptical toward innovative entrepreneurship since the cost of implementation is comparatively very high. They may even develop institutional means, whether formal or informal, to effectively resist such change.

What matters for our analysis here, however, is not the specific social structure of this type of basic society, but the fact that innovation to an existent and vertically specialised production process can upset the whole process due to its serial interdependence. Production is therefore exceedingly vulnerable to unpredictable, uncontrolled changes to the inclusive stages as well as the process as a whole and any disturbances can have disastrous consequences. This vulnerability can only be mitigated in a decentralised productive system that includes productive redundancy, which a rudimentary society cannot initially afford but that market coordination depends on. While redundancy, as we saw in chapter 3, lessens the cost of change by reducing direct dependence and thereby limiting the impact of incompleteness, it in no way abrogates the problem.

Advanced Task-Splitting with Redundant Production

We saw in the previous example that the innovation introduced by l2 and l3 affects the whole production process because it is serially interdependent: the third and final stage depends on the input produced by the second and middle stage, which in turn depends on the input produced by the first stage. As failure of any of the stages means the whole process fails, those specialised to the individual stages all ultimately bear the uncertainty of innovation. This is a theoretically important limiting aspect of specialised production, but is not necessarily of prohibitive magnitude under rudimentary production. In the used example, it may not be an insurmountable obstacle for the four islanders. Indeed, they are already both collectively and individually incentivised to ensure the production process is complete. In the simplest case, the problem may be limited to the ability of l2 and l3 to communicate the potential gains to l1 and l4, and their ability to come to an agreement with respect to the chance of success, the strategy for implementation and the costs involved.

As we saw in the previous chapter, however, the strict interdependence in a solitary production process under the vertical division of labour can be partly alleviated through redundancy. The effect of failure in one stage is of much lesser impact if production takes place in two or more production processes with their respective stages performed in parallel. Part of the reason for this is that competing, redundant processes constitute standardisation of stages. There is therefore redundancy not in production of a specific good, but also in production of the intermediate goods in each of the stages. For this reason, production as a whole will not fail with one of the operations but can continue; the interdependence is weakened. This is especially true because stage output standardisation is effectuated through exchange in markets and consequently the ongoing bidding for resources throughout production processes. In other words, if the second stage of process four fails, the previous stage of process four can sell its output and the subsequent stage of this process can equally procure inputs in the open market. The existence of both market and standardisation within or between each of the stages were assumed in the discussion on pin production in chapter 3.

As the density of the economy and the availability of labour factors increase, redundancy can emerge. Indeed, it was the increase in density that made the initial horizontal division of labour possible, the further increase that facilitated the vertical division of labour, and it is this development that provides the required resources for establishing parallel production processes of similar function. We already noted this above, but as labour becomes available it is likely to be put to use in production to increase the society’s overall standard of living. As production processes have been established relying on operations-based specialisation through the vertical division of labour, adding labourers to individual stages increases the potential output of these stages due to the effectuated redundancy.

We immediately recognise two outcomes of unevenly populated production stages. First, the burden of production decreases as this stage has access to more productive resources and therefore can produce greater quantities. If the number of islanders specialised to performing the first stage in the three-stage process above is doubled, the production potential is also approximately doubled. Yet as the second stage cannot produce more than was previously the case, the effect of this increased production capacity in the first stage is to release labour. Those carrying out this particular operation can therefore find time for other chores and efforts that can contribute to further increase the islanders’ standard of living. Alternatively, it affords them the opportunity for leisure.

Second, as these labour factors are freed from the burden of producing, they are also freed from some of the cost of interdependence. Say l5, newly arrived to our island society, joins l1 to produce o1, and that his doing so approximately doubles the production capacity of this stage whereas the production capacity of o2 and o3 remain unchanged. While l2 and l3 in stage two and l4 in the third stage continue to work long hours, the redundancy in stage one causes some of the productive factors to be idle since the other stages simply cannot handle more input. These slack resources can be used to produce savings that can support productive investments. In contrast to the example of innovation above, the addition of l5 means the first stage can in one day produce sufficient inputs to be used for two full days in the second stage. So l1 and l5 can take every other day off – or produce today and use tomorrow to implement and try out a productive innovation. This innovation could potentially save even more resources, and thereby allow for investments in the other two stages and possibly increase overall production. Do not forget, however, that the resources used in the initial investment for increased productivity may be misplaced or the implementation poorly executed such that the resources are lost. But as the example does not at this point include credit and borrowing, which means production always must precede consumption and saving, the impact of such entrepreneurial failures is limited to affect only the first stage. As the inputs needed for the second stage (the savings) are produced in the previous time period, innovation failure does not affect the totality of the production process.

Similarly, in a situation with redundant production throughout the process organised in parallel processes without a single point of failure, any effect on a single operation is primarily limited to that operation. This holds true for any direct effects on the operation such as failure, since failure of one operation does not automatically cause the whole process to fail. But the indirect consequence of any change will affect the whole process as well as parallel processes, and cause ripple effects throughout the economy. We saw this in the previous chapter as resources were reallocated across processes as well as between stages, as a response to more productive uses being revealed.

Advanced Task-Splitting in a Market

Let us revisit the example used throughout this chapter, but instead of the previously discussed productive innovations the little island society experiences a large increase in population. More people need to be fed, but there are also more hands to exploit in production. It just so happens that the inflow of people are sufficient to triply populate the already fully vertically specialised production processes. The previously discussed production process o1o2o3 can therefore triple its output and the processes are split into three separate production processes, each of them structured like the original and with four labour workers performing the three stages. The new workers contribute new perspectives and have ideas for how to improve the process further, but the resultant three parallel processes are nevertheless similar to the original process and as the labourers learn from each other the processes become close to carbon copies of each other. They are fully substitutable as processes as well as in the separate operations carried out.[vii]

These processes are subject to the dynamics discussed in the previous chapter. As there is redundancy, the cost of direct productive interdependency is averted somewhat and can also be dealt with to some extent through cross-process adjustments and pooling of resources. What remains of the interdependence constraint is in the form of standardised deliverables: the intermediate goods changing hands between stages is sufficiently similar to be considered substitutes. The production process is standardised and modular in the sense that it can be reorganised through any combination of stages from the three separate processes. A process consisting of the first stage from the first process, the second stage from the second process, and the third stage from the third process functions as well as any other combination as long as each stage is carried out in order. What holds a process together is the serial interdependence between stages, but as the stages are redundantly performed there is no dependence on a particular labourer with this specialisation. The deliverables are standardised and can be used interchangeably. In other words, the output of the first stage in the second process can be used by the second stage in either process.

While this situation is more similar to the modern market than a single unique production process, its modular productive redundancy also provides means to introduce productive innovations into the existing processes as long as it shares interfaces with existing stages. This means that the second stage, in its present shape, can be fully replaced by a new operation or set of operations as long as it (1) uses the same inputs and (2) produces the same output. How production within a stage is carried out, the technologies or methods or even materials used, is from the point of view of the production process as a whole irrelevant. What matters is that the production stages are carried out in the correct order and that their interfaces match, no matter how a production stage accomplishes the standardised outputs using the standardised inputs.

This facilitates innovation since the effect can be internalised within a specific stage and therefore will not affect other stages. In fact, the production process remains complete and can continue to produce ‘like before’ despite any and all of its parts having been replaced.

If we again consider the example above, in which l2 and l3 in stage two decide to try implementing a new way of carrying out o2, it becomes obvious that their doing so has only marginal effect on the overall production process. Even if they need to take full days off in order to attempt to realise the perceived improvement, doing so will not cause the whole production process and therefore the supply of the end product to come to a halt. Instead, as production is carried out through redundant production processes the limited production market will be able to reallocate intermediate goods to maximise production. In this limited example the reallocation efforts rely on the communication and trust of the involved labour factors, but in an advanced money economy this adjustment process may take place through the price mechanism in the form of Kirznerian arbitrage.[viii]

What is of import here is not the adjustments taking place in the remaining and standardised production process, but what the innovative efforts of l2 and l3 imply from the point of view of the productive system. Implementing the innovation is practicable only because it completely replaces the existing stage of production o2 and therefore does not suffer from incompleteness. This means that the innovative production sub process o21o22 also is internally strictly interdependent by in effect establishing a ‘bilateral monopoly’: the extent of the market for the producer of o21 consists solely of the single producer of o22, who in turn is fully dependent on the output of o21 to commence production of o22. The effect of implementing this innovative production sub process, which implies an outright splitting of a task and therefore intensified division of labour, is that l2 and l3 become mutually specialised.[ix]

A limited and very specific case of this is discussed by Oliver E. Williamson in terms of costs of misalignment due to opportunistic behaviour following relationship-specific investments.[x] To Williamson, the risk of incurring such costs is a powerful driver for integrating existing transactions within organisational hierarchies, which makes possible the use of selective intervention. The general problem, however, is another. Regardless of whether l2 and l3 trust or mistrust each other, the risk of opportunistic behaviour (as Williamson focuses on) is miniscule. The reason for this is that opportunistic behaviour by either or both parties causes incompleteness, and therefore is prohibitively costly for their mutual specialisation. It is indeed true that l3, specialised to carrying out the downstream sub task o22, can ‘hold up’ the producer of o21 l2 by refusing to use or purchase his output. But it is difficult to think of specific cases where this would be a real concern for l2 and l3 unless we assume self-destructive behaviour. The problem identified by Williamson is applicable only in very specific cases: where there already exists a market for the given transaction and where it requires an investment specific to the relationship such that it makes one party dependent on the other but not vice versa. The former is necessary because without an existing market for the intermediate products produced in the individual stages carried out as part of the transaction, both parties would suffer incompleteness and therefore loss in the case of hold-up. The latter is necessary to make opportunism a real and credible threat, as without specific investments creating a bilateral monopoly the threat of holdup is inconsequential. For both to hold, we must assume that the productive transaction itself and the transactional relationship are on different analytical levels and therefore distinct. Alternatively, we can assume that the transaction as carried out by the parties as facilitated the specific investment is not sufficiently innovative to constitute a real and significant productive gain, but that it is sufficiently different from the market to make resorting back to previous market positions costly to the point of deterrence. The case considered here is much more general in the sense that we consider the implementation of a productive innovation into an existent market situation. There is a market of sorts for each of the stages of production in the established production process, but not for the individual tasks carried out in the innovative sub process. So neither of the parties l2 or l3 has an incentive to act opportunistically with regard to the other party or the sub process itself, since it entails incompleteness and therefore failure. The sub process o21o22 is an all-or-nothing solution as it is a unique alternative to existing and workable production stages, and it is therefore either successful in its entirety or it fails. Whether it is successful, which is recognized by earning a profit in an advanced money economy or by measurably lower resource usage or higher output in our rudimentary production economy example, requires completing the whole sub process and supplying subsequent production stages with inputs. Opportunism is not a factor.

As is indicated by the completeness criterion for estimating the relative success of the productive innovation, the implementation of the sub process takes place outside the limits of the market. The labourers l2 or l3 are fully and mutually dependent on each other because there is neither market supply for the individual sub tasks carried out in the new sub process nor market demand for the outputs. There are no fall-back options, and this is what produces the bilateral monopoly and gives rise to the completeness criterion. In the simplest case as considered here, where one task is split in two, each new task is compatible with the market at one end while dependent on the other new task at the other. There is ample market supply of compatible inputs for o21 and ample market demand for o22’s outputs, but there is no external market at all for their intermediate product, that is, o21’s output and o22’s input. Each of the two parties is completely dependent on the other party doing his part. They are therefore at each other’s mercy and equally dependent on each other’s success, so their incentives are aligned rather than opposed. This effectively creates an ‘island’ outside the realm of the market that does things differently, and it entails a form of necessary integration of productive tasks that would be of no value within the extent of the market. Whereas the tasks may be observable as separate, everything else about them is integrated: the result is joint and inseparable; the operations are interdependent; and any failure or shortcoming is suffered by and threatens the whole enterprise.

It is true that the operations share interfaces with the existing market structure and the new sub process therefore is compatible with established market production. But the innovated process itself is ultimately insulated from market influence and is structured in ways not possible in the market. Those carrying out the tasks in this sub process are for this reason blind with respect to improvements of specific tasks as there is no feedback mechanism available other than for the complete process. For production processes established within the extent of the market, each production stage has a market and is therefore appraised separately. This promotes discovery of opportunities for improvement through competition and eliminates comparatively inefficient or ineffective production tasks and structures. These forces are not available for tasks carried out within the new production sub process. This means that the implementation of innovative production necessitates the uncertainty-bearing for the complete process rather than individual parts, which is akin to Robinson Crusoe’s primitive production discussed at the beginning of this chapter.


As we have seen, the newly implemented production process is, for all practical purposes, placed squarely outside the extent of the market. This follows directly from the nature of innovating, which suggests novelty and an action that, at least to some not insignificant extent, breaks new ground where the market is inapplicable and impossible. If this were not the case, the innovation would not be novel. We have also connected this novelty to the market’s production and capital structures, showing that an innovation is by definition distinct from production within the limits of the market and therefore of a different kind.

The previous discussion also suggested that changes to a production structure that are innovative to the point of being disruptive, and therefore of greater impact than simple arbitrage, fall outside established market production. The market adjusts well to both endogenous and exogenous changes by reallocating resources, but is impotent with regard to creation of novelty. The reason for this is that the market requires substitutability: uniqueness cannot be traded, and therefore cannot be allocated toward uses of different value, if productive stages are uniquely interdependent, as in the case of mutual specialisation. In the case of the novel sub production process o21o22 there is compatibility with the outside market, but no basis for interaction with that market for the internally coordinated operations. The sub process is therefore practically encapsulated and protected, as it were, from market influence. But this also means that the process cannot benefit from these market forces, and that it consequently is subject to a severe calculation problem: whereas the return to the full sub process is realized through profits, the contribution of each individual part cannot be observed, identified or calculated. The result is that the process overall cannot be properly improved because the economic efficiency of its parts are unknown and unknowable. The uncertainty of the enterprise is for this reason irreducible and borne centrally.

The lacking interconnectedness between the novel production structure and market effectively separates it from the market and makes it a separate phenomenon. It is unaffected and therefore unaided by market competition in its parts simply because they are unique and for this reason nonsubstitutable. But this does not imply that it is completely free from market conditions. The market has through competition established a minimum required efficiency in resource use and allocation, under which no alternatives are viable. This applies to the innovation as well as to actors producing competitively within the extent of the market, and therefore we would expect to see such innovations only where they outperform the regular market. In this sense, productive innovation may serve as a productive catalyst that functions to establish new technology or organization of productive efforts. Innovation constitutes a challenge to the present market order by offering an alternative that is, to the extent it is successful and therefore makes lasting rather than transient impression, that can revolutionise production. Productive innovation is the task of the entrepreneur, whose function is limited by the market’s existing production structure yet reforms and improves upon it. Joseph A. Schumpeter summarises: ‘the function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way’.[xi]

The entrepreneurial function is disequilibrating in the sense that implemented innovation constitutes a challenge to the status quo and threatens to outdo the market. It is a disruptive force that breaks with the accepted order and defies assumed truths and convention. The entrepreneur leaps into the productive unknown where technological and economic knowledge are unknowable and will become accessible only through the implementation process. By deliberately acting outside the realm of the market, the outcome is open-ended and at best imaginable. The uncertainty of the entrepreneurial enterprise is for these reasons irreducible and incalculable, and must be borne in its entirety until the implementation is complete.

The entrepreneurial implementation process is a very different undertaking than partaking in or organising production processes coordinated through market prices. It is by recognising the conditions for and characteristics of this extra-market development that we can best understand the business firm, which can be defined as the productive endeavour undertaken in an extra-market setting. The firm can most easily be characterised as an ‘island’ of integrated productivity that implements and utilises intensive specialisation of a kind and degree that is different from and aims to outperform the present market order. It is a market phenomenon that serves the entrepreneur in his attempt to establish a new type of production process.

Note that this view of the firm is neither subject to the ‘legal fiction’ nor of formal character. We see the firm simply as an economic phenomenon that arises around entrepreneurial pursuits placed firmly outside the realm of, but that ultimately become part of and transform, the market. It has a pure economic function that appears to be of transient nature but is frequently occurring (see chapter 6 below). As a generalised function, it is unrelated to any formal identification of firm entities and therefore unaffected by legal concerns. The firm is simply what emerges when more specialised production processes are implemented through entrepreneurial action. It is an economic phenomenon that serves to overcome the inertia of the interrelated market order, and that constitutes a productive challenge by introducing change and in the end disrupt the status quo. This is necessary for the progression of the market process not only for technological reasons and due to specialisation deadlocks in physical capital, but for social reasons as well. For as Schumpeter points out, ‘the environment resists in many ways that vary, according to social conditions, from simple refusal either to finance or to buy a new thing, to physical attack on the man who tries to produce it. To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and that define the entrepreneurial type as well as the entrepreneurial function.’[xii]

[i] M. N. Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition (1962) (Auburn, AL: Ludwig von Mises Institute, 2004):52

[ii] With regard to labour, the stronger claim that it ‘is almost always nonspecific’ can be made; ‘very rare indeed is the person who could conceivably perform only one type of task.’ Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition:523. Mises similarly states that ‘human labor is both suitable and indispensable for the performance of all thinkable processes and modes of production’ and that it ‘is the most scarce of all primary means of production because it is in this restricted sense nonspecific and because every variety of production requires the expenditure of labor’ L. v. Mises, Human Action: A Treatise on Economics. The Scholar’s Edition (1949) (Auburn, AL: Ludwig von Mises Institute, 1998), pp. 133, 135.

[iii] Quoted in chapter 2, note 20 above. See A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (Chicago, IL: University of Chicago Press, 1976), pp. 291-292.

[iv] See e.g. F. A. v. Hayek, ‘The Use of Knowledge in Society’, American Economic Review, 35:4 (1945), pp. 519-530, F. A. v. Hayek, ‘Economics and Knowledge’, Economica, 4:13 (1937), pp. 33-54.

[v] Mises, Human Action: A Treatise on Economics. The Scholar’s Edition:144

[vi] Mises, Human Action: A Treatise on Economics. The Scholar’s Edition:163-164

[vii] It may be the case that, as an immediate result, there is some trade or ‘sharing’ of outputs between the processes. All labour workers are not identical and therefore have different skill and productive capabilities, so some intermediate goods are shifted between the separate processes to alleviate these differences and create a smooth flow of goods so that the utilisation of labour power is maximise. But with experience the labour factors develop similar skillsets and find a work pace that facilitates high overall production volumes sustainable in the long term. We therefore treat them as almost perfectly substitutable.

[viii] I. M. Kirzner, Competition and Entrepreneurship (Chicago, IL: University of Chicago Press, 1973).

[ix] I discuss this elsewhere, see e.g. P. L. Bylund, ‘Explaining Firm Emergence: Specialization, Transaction Costs, and the Integration Process’, Managerial and Decision Economics, (forthcoming), pp. .

[x] See e.g. O. E. Williamson, ‘The Logic of Economic Organization’, Journal of Law, Economics, & Organization, 4:1 (1988), pp. 65-93, O. E. Williamson, ‘Comparative economic organization: The analysis of discrete structural alternatives’, Administrative Science Quarterly, 36:2 (1991), pp. 269-296.

[xi] J. A. Schumpeter, Socialism, Capitalism and Democracy (New York, NY: Harper and Bros., 1942), p. 132.

[xii] Schumpeter, Socialism, Capitalism and Democracy, p. 132.