Entrepreneurial judgment in the marketplace and the theory of profit and loss

Knight (Reference Knight2006: 272–282) developed a theory of profit and loss based on his view that the function of entrepreneurship consists of exercising judgment in the face of uncertainty. As Knight (Reference Knight2006: 271) notes, in the marketplace the entrepreneur bears this uncertainty and uses his subjective judgment in the allocation of scarce resources. The fact that entrepreneurs differ in their ability to exercise judgment helps explain how their decisions to allocate factors of production leads to the emergence of monetary profit and loss. This Knightian conception of entrepreneurship as the exercise of judgment within the marketplace has recently been rediscovered and developed, as is evidenced by a growing body of literature (Brown et al., Reference Brown, Packard and Bylund2018; Foss et al., Reference Foss, Klein and Bjornskov2019; Foss and Klein, Reference Foss and Klein2012, Reference Foss and Klein2015; Godley and Casson, Reference Godley and Casson2015; Hallberg, Reference Hallberg2015; Lounsbury et al., Reference Lounsbury, Gehman and Glynn2019; Mcmullen, Reference McMullen2015; Packard and Bylund, Reference Packard and Bylund2019).

The burden of Knightian uncertainty is not borne equally by all individuals in a market economy: it is a select group of individuals who exercise the function of entrepreneurship and the ability to form and exercise judgment is thus unevenly distributed. As Knight notes, there are two significant ways in which individuals differ in their ability to make decisions. First, they ‘differ in their capacity by perception and inference to form correct judgments as to the future course of events in the environment’ (Knight, Reference Knight2006: 240, emphasis in original); and second, they differ in their capacity ‘to judge means and discern and plan the steps and adjustments necessary to meet the anticipated future situation’ (Knight, Reference Knight2006: 241, emphasis in original). It follows that some individuals are better at dealing with Knightian uncertainty and can make less erroneous judgments when faced with it.

This uneven distribution in the ability to make correct judgments in the face of Knightian uncertainty implies that not everyone has to own a firm. Instead, these ‘differences in individuals in relation to uncertainty’ give rise to ‘a tendency to specialize the function of meeting it in the hands of certain individuals and classes’ (Knight, Reference Knight2006: 243–244). More specifically, they give rise to the ‘enterprise and the wage system of industry’ (Knight, Reference Knight2006: 271), where there is a specialization of functions within firms: ‘a special social class’, i.e. the entrepreneurs, ‘direct economic activity’ (Knight, Reference Knight2006: 271), own and control resources, and have the wherewithal to exercise their judgments, whereas ‘the great mass of the population’ (Knight, Reference Knight2006: 271) decide to simply work and earn wages, thereby opting out of the need to deal with Knightian uncertainty as far as the production of goods is concerned.

Situations involving Knightian uncertainty are unique and cannot be insured against. Instead, the relative accuracy of judgments made by entrepreneurs in these situations result in them either earning a profit or suffering a loss. Consider the case of entrepreneurs bidding to hire the services of a factor of production (Knight, Reference Knight2006: 271–281). Given differing expectations among multiple entrepreneurs, the factor price that emerges is a result of the forces of the competition. The monetary profit (or loss) than each entrepreneur earns reflects ‘the difference between the market price of the productive agencies he employs […] and the amount which he finally realizes from the disposition of the product which under his direction they turn out’ (Knight, Reference Knight2006: 277). Those entrepreneurs whose judgment turns out to be more accurate earn a greater monetary profit, or suffer a smaller monetary loss, whereas those who err to a greater degree are punished more severely.

The market process, error correction, and economic calculation

Knight's theory of profit and loss bears a striking resemblance to that advanced by Mises (Reference Mises1998: 286–291; Reference Mises2008), which is not surprising given that the Misesian conception of uncertainty and the function of entrepreneurship are similar to Knight's.Footnote ³ Mises (Reference Mises1998: 291) stresses that the difference between cost and revenue ultimately stems from the imperfect knowledge that an entrepreneur has of future market conditions. Thus, incomes earned by entrepreneurs reflect the quality of their anticipations and judgments: the ultimate source of an entrepreneur's profit ‘is his ability to anticipate better than other people the future demand of the consumers’ (Mises, Reference Mises1998: 288, emphasis added).

Mises (Reference Mises1998: 330–335) and Kirzner (Reference Kirzner1973, Reference Kirzner1997, Reference Kirzner2011) also take Knight's analysis further. They provide an analysis of a market process, or a process of error correction, that emerges from the erroneous judgments of entrepreneurs.Footnote ⁴ In the market, entrepreneurs are motivated to bear uncertainty and make judgments to improve their well-being: the lure of possible monetary profit impels them to look into the future and adjust their actions in line with their expectations (Kirzner, Reference Kirzner and Kirzner1982). Thus, they have an incentive to form the best possible judgments of the uncertain future (including underlying consumer preferences). The monetary profit and loss system rewards those entrepreneurs that are more successful in doing so, while penalizing those who are less capable of bearing uncertainty. It is this same lure of possible profit, Kirzner (Reference Kirzner and Kirzner1982: 148–151) argues, that also incentivizes entrepreneurs to recognize the errors that they have made, and to correct these errors by reformulating their judgments of the future.Footnote ⁵

Thus, it is monetary calculation enabled through the price system that allows for emerging factor prices to reflect the less than perfect judgments of competing entrepreneurs. Profits and losses earned in market exchange then allow entrepreneurs to use their judgment to make changes to their production decisions (e.g. either expanding production or reducing production to cut losses). Entrepreneurs can thus make use of money prices to engage in economic calculation (Hayek, Reference Hayek1945; Mises, Reference Mises1920): they can use money prices ex ante, while planning their actions, as well as ex post, in reviewing the outcome of their decisions. In this sense, markets inherently enable the coordination of production decisions and entrepreneurial judgments with consumer preferences. There is only one distinct class of entrepreneurs that undertakes judgment under Knightian uncertainty and only one class of wage earners/consumers whose preferences get satisfied. Furthermore, the interests of these two groups are naturally aligned with one another within the institutional setting of markets.

Who exercises judgment?

First, who exactly is it that exercises judgment in the political realm? In democratic politics, judgment is divided and distributed among multiple groups of actors including, but not limited to, politicians, legislators, unelected bureaucrats, administrators, and private-sector lobbyists. Klein et al. (Reference Klein, Mahoney, McGahan and Pitelis2010: 2) provide a definition of public entrepreneurship as ‘any action in pursuit of the public interest’. However, they acknowledge that this definition comes with its drawbacks. ‘A caveat in this endeavor’, they write, ‘is that public interests may not be well defined’. For starters, the ‘alignment of individual objectives into a public interest is a complex problem’. Citing works by Downs (Reference Downs1957) and Buchanan and Tullock (Reference Buchanan and Tullock1962), they acknowledge that divining the will of the public is a task that is far easier said than done. ‘Mechanisms such as majority voting, arbitration, and consensus-building are highly imperfect aggregators of individual interests’, they note. ‘In some situations’, as was most famously outlined by Arrow (Reference Arrow1951), ‘such aggregation may not even be possible’.

However, a broader notion of political entrepreneurship has been examined by numerous authors (Bylund and McCaffrey, Reference Bylund and McCaffrey2017; Holcombe, Reference Holcombe2018; McCaffrey and Salerno, Reference McCaffrey and Salerno2011; Wagner, Reference Wagner2016a, Reference Wagnerb). A common finding in this literature is that market and political entrepreneurship cannot be treated as separate and distinct phenomena. Private and political entrepreneurship are often mutually dependent and co-evolving (Ostrom, Reference Ostrom1990, Reference Ostrom2005). To pursue their objectives, private entrepreneurs must constantly work with politicians and regulators; politicians and bureaucrats must likewise work closely with private actors to achieve their ends (Holcombe, Reference Holcombe2018; Wagner, Reference Wagner2016a, Reference Wagnerb). This symbiotic relationship becomes increasingly evident over time as governments grow to play a more active role in the economy (Bylund and McCaffrey, Reference Bylund and McCaffrey2017). We proceed with this broader definition for the remainder of the paper.

What goals are political entrepreneurs trying to accomplish? Whose preferences get satisfied?

A second question that arises is: what goals do political entrepreneurs try to accomplish? Voters are often treated as the core group of ‘consumers’ whose preferences political action is aimed at satisfying. If we accept the broader definition of political entrepreneurship as encompassing a broader network of actors in both the public and private sphere, however, it follows that the goals of multiple groups or classes of judgers must be accounted for, and not just those of voters.

Three branches of the existing literature help to explain what motivates political entrepreneurs. First, the public choice literature emphasizes how political entrepreneurs are motivated by self-interest (rather than public interest) and a desire to capture rents, as when private firms lobby the government for special privileges (Krueger, Reference Krueger1974; Tullock, Reference Tullock1967). This rent-seeking behavior can also emanate from various other actors/judgers within government. Wagner (Reference Wagner1966) argues that the primary goal of regulators and bureaucrats is to satisfy the wishes of interest groups and thus expand or maximize their own budgets and authority. In this view, bureaucrats and public officials should not be treated as mere passive intermediaries of the public's interests; like private actors, they often act to advance their own self-interest.

The second branch that examines the goals of political entrepreneurs is the entrepreneurship literature, where the emphasis is on what political and market entrepreneurs share in common. Like market entrepreneurs, political entrepreneurs are primarily motivated by the desire for profit. The core difference is that rather than competing in market settings to earn monetary profits, they must compete in the political realm, often in the absence of explicit price signals. Klein et al. (Reference Klein, Mahoney, McGahan and Pitelis2010: 3–4) summarize the parallels between political and market entrepreneurs: like Knightian entrepreneurs, political entrepreneurs also exercise judgment under uncertainty to ‘invest resources, tangible and intangible (time, effort and reputation), in anticipation of uncertain future rewards’ (ibid.: 4). Like entrepreneurs in the marketplace, political entrepreneurs who exhibit superior judgment are rewarded, whereas those whose judgment is relatively inferior are penalized. In some cases, these rewards may come in the form of monetary profits (e.g. a solar company lobbying politicians to pass a tax rebate on solar panels to increase its sales). In other cases, like the entrepreneurship conducted by a politician or bureaucrat, the reward may come in non-monetary form such as higher re-election chances or increased budgetary autonomy. In either case, these rewards constitute what we might call a ‘political profit’ (Holcombe, Reference Holcombe2002).

The third branch comes from the literature on new institutional economics (NIE). Traditionally, NIE scholars have analyzed how market entrepreneurs respond to changes in a society's rules of the game. More recent work, however, has focused on the active role that political entrepreneurs play in devising and altering political institutions to advance their interests.Footnote ⁷ A key idea in this literature is that entrepreneurs often play an active role in altering institutions: as such, there is a bidirectional relationship between institutions and entrepreneurship (Elert and Henrekson, Reference Elert and Henrekson2016). Entrepreneurs don't merely abide by rules; they can also alter or evade these rules in actively pursuing their goals (Bylund and McCaffrey, Reference Bylund and McCaffrey2017; Coyne and Leeson, Reference Coyne and Leeson2004; Henrekson and Sanandaji, Reference Henrekson and Sanandaji2011). This is especially true when the rules of the game themselves are unclear or subject to change – that is, when entrepreneurs must cope with ‘institutional (or regime) uncertainty’ that is similar to the uncertainty discussed by Knight (Higgs, Reference Higgs1997). In these situations, entrepreneurs have an incentive to act not just within the rules but at the institutional level to alter rules in ways that might mitigate this uncertainty.Footnote ⁸

Whose preferences do political entrepreneurs aim to satisfy? Voters as ‘consumers’ represent the core group whose preferences politicians' actions are aimed at. But even if politicians do win elections, they cannot assume that voters are giving them a mandate to pursue all their campaign platforms.Footnote ⁹ Furthermore, political entrepreneurs do not have an inherent incentive to meet voter or ‘consumer’ preferences if political activity is tax-funded or relies on rent-seeking interest groups and campaign contributions. Hence, interest groups and other private-sector lobbyists are also a class of ‘consumers’ in democratic politics as far as politicians and legislators directly or indirectly seek to satisfy their preferences. In fact, interest groups oftentimes have an incentive to decrease access to accurate information available to voters, who are rationally ignorant (Boudreaux, Reference Boudreaux2014; Caplan, Reference Caplan2011; Downs, Reference Downs1957).Footnote ¹⁰

How do political entrepreneurs detect and correct errors?

Third, how are ‘errors’ identified and corrected in the realm of politics? The feedback signals that political entrepreneurs rely on are far weaker, and the selection mechanism for allocating resources toward more successful political entrepreneurs is ‘complex and poorly understood’ (Klein et al., Reference Klein, Mahoney, McGahan and Pitelis2010: 4). Political entrepreneurs are not subjected to the same discipline that is provided by market competition and are rarely able to refer to money prices or profits and losses to assess their performance.

McCaffrey and Salerno (Reference McCaffrey and Salerno2011: 554), however, argue that by shifting the economy's production patterns from what it would have been in an unhampered market, political entrepreneurs can capture ‘quasi-profits’. This mirrors Holcombe's (Reference Holcombe2002: 147) notion of ‘political profits’ that politicians can reap in the form of higher approval ratings and reelection odds or that bureaucrats can reap in the form of a promotion or securing more funding and power for their agency. Similarly, Wagner (Reference Wagner2016a, Reference Wagnerb: 535) notes that ‘to be successful, political enterprises must raise sufficient revenue to return profits to investors. Those profits are disguised through indirect transactions and ideological formulations but are profits all the same’. These political profits, although they are often psychic, and are not the monetary profits that market entrepreneurs use to engage in economic calculation, still play a vital role in guiding the actions of political entrepreneurs.

Moreover, there are two important structural mechanisms to constrain poor decision-making and check bad outcomes in the political realm: election cycles (typically every 4 years) and terms limits for executive and legislative administrators (Erler, Reference Erler2007; Reed et al., Reference Reed, Schansberg, Wilbanks and Zhu1998; Will, Reference Will1992). In terms of whether there exists a systematic tendency to correct errors over time, Boettke et al. (Reference Boettke, Tarko, Aligica, Boettke and Storr2016) build on Hayek (Reference Hayek1945) and argue that there are indeed parallels between the market process that informs the actions of private actors and the democratic process that informs public actors. In much the same way that the market process generates the very knowledge that is required to engage in rational economic calculation, the democratic process helps generate the knowledge necessary for solving collective action problems. This, they argue, helps explain why Western democracies have done better than non-democratic nations in getting rid of the most harmful economic policies (e.g. nationalization of industries, price controls, etc.).

However, although market and political entrepreneurship share some of these similarities, there are also many important differences between the two. Market entrepreneurs receive more constructive and immediate feedback than their political counterparts (Mises, Reference Mises1944).Footnote ¹¹ Price signals allow them to quickly adapt to constantly changing circumstances and to assess their performance in real time. They also help entrepreneurs identify errors and convey valuable information to guide them on the best ways to correct these errors moving forward. The feedback signals that political entrepreneurs rely on, in contrast, are far weaker than market price signals and often come with longer lags. Politicians, for instance, have to wait years for elections to take place to receive concrete feedback from voters. Furthermore, the inability to meaningfully aggregate consumer/voter preferences also reduces the coordinative capacity of democratic elections.

The selection mechanism for allocating resources toward more successful political entrepreneurs is also more difficult than it is in markets. Market entrepreneurs typically own and exercise full control over the resources they exercise control over and thus directly bear the burden of uncertainty in the form of profits and losses. Political entrepreneurs, in contrast, don't typically own or fully control their resources, nor do they directly bear the financial costs of their decisions because the resources they control are jointly- or publicly-owned, and because the very definition of what is ‘public’ often shifts over time. In short, political calculation is beset by more obstacles than market calculation, particularly in a world of Knightian uncertainty.

Again, none of this implies that political entrepreneurs receive no meaningful feedback signals. Political entrepreneurs do have access to a number of non-market feedback signals. For example, politicians can reference election results, and bureaucrats can refer to the size of their budgets. Our core argument is that non-market signals do not provide feedback that is as accurate and immediate as that provided by market price signals. In markets, price signals help one class of market entrepreneurs coordinate their actions with the interest of one class of consumers whose interests are naturally aligned with theirs. Such coordination in politics is more difficult because it involves several disparate classes of entrepreneurs (politicians, bureaucrats, interest groups, and legislators) and consumers (voters, lobbyists, etc.) whose interests are not naturally aligned.

Who undertakes judgment?

The role of the non-profit or charitable entrepreneur is distinguishable from that of the social entrepreneur (Frank, Reference Frank, Shockely, Frank and Stough2008). Social entrepreneurship is defined as market entrepreneurship with an additional social end in mind, such as a coffee shop that donates a percentage of its revenue to local foodbanks and commits to employing homeless people or those temporarily unemployed. It thus earns monetary revenue as well as aims at achieving a well-specified ‘social’ end while doing so. Thus, social enterprises and social entrepreneurs can and do calculate profit as well as strive for social goals simultaneously and hence do not belong in the non-calculative action category.

Boettke and Prychitko (Reference Boettke and Prychitko2004) further distinguish between nonprofit entrepreneurship and not-for-profit entrepreneurship. Hospitals and universities fall within the latter category in that they can and do calculate monetary revenue and accounting cost, yet any profits generated are not distributed among stakeholders but are channeled into the operating costs of the enterprise. In this sense, the goal of not-for-profits is not to maximize monetary profit (Ben-Ner, Reference Ben-Ner and Rose-Ackerman1986; Ben-Ner and Gui, Reference Ben-Ner, Gui, Anheier and Ben-Ner2003; Frank, Reference Frank, Shockely, Frank and Stough2008; Hansmann, Reference Hansmann1980, Reference Hansmann and Powell1987) as they are legally bound by the non-distribution constraint.

True nonprofit or charitable entrepreneurship, however, does belong in the realm of non-calculative action. Here, the explicit goal is the achievement of a certain social goal such as charity or direct transfers to the poor, disaster recovery with the aid of community members, voluntary housing associations, religious groups that seek to bring spiritual awareness, philanthropic endowments that seek to promote education or awareness about environmental issues, etc. Such nonprofit enterprises make up an important part of civil society and play an important role in developing as well as in developed countries (Acs and Desai, Reference Acs, Desai, Acs and Stough2008; Acs and Phillips, Reference Acs and Phillips2002; Harvey et al., Reference Harvey, Maclean, Gordon and Shaw2011). In this case, the nonprofit entrepreneur plays the crucial role of coordinating between two disparate groups: benefactors/donors and beneficiaries. In order to do this, the nonprofit entrepreneur may act alone or through the creation of a nonprofit organization. More recently, nonprofit entrepreneurship has been enabled through technology and peer-to-peer giving through online platforms in the absence of a nonprofit organization (Nair and Miller, Reference Nair and Miller2020).

The crucial difference between socially useful action carried out by the nonprofit entrepreneurs and entrepreneurs who exercise judgment in government is the role of voluntarily raised or private funding. Not only do nonprofit entrepreneurs bear uncertainty and carry out judgment with regard to the preferences and ends of beneficiaries, but they must also solicit and raise funding privately from donors/benefactors interested in investing in the social cause at hand.

Tullock (Reference Tullock1966) provides an economic analysis of the similarities between charities and bureaucracies. He models the typical donor as analogous to a self-interested voter in a democracy, who tends to be rationally ignorant, as discussed above. Donors are thus unlikely to have strong incentives to acquire accurate information from the charitable entrepreneur about the true state of the project or the true state of the intended beneficiaries. Given the behavioral assumption of self-interested donors, Tullock (Reference Tullock1966) finds that charities are likely to maximize expenditures on promotional materials, marketing and soliciting donations rather than maximizing expenditures on improving beneficiary outcomes.

Tullock (Reference Tullock1966) posits that either ‘bureaucratic charities’ become similar to government agencies whereby the goal is to maximize donations/budgets, or they can tend toward becoming ‘ideal charities’ whereby the goal is to maximize expenditure on beneficiaries. Tullock (Reference Tullock1966) concludes that significant donor involvement, feedback and monitoring of the nonprofit entrepreneur is essential to avoid the fate of the nonprofit enterprise becoming overly ‘bureaucratic’. Haeffele and Storr (Reference Haeffele and Storr2019) provide a similar assessment: the effectiveness of the nonprofit organization and the nonprofit entrepreneur, they argue, is explained by whether the organization resembles a public or a private enterprise.

Which goals matter? Which preferences get satisfied?

As discussed above, the charitable or nonprofit entrepreneur bears Knightian uncertainty in the non-calculative realm of socially beneficial action. Either acting on his own, as in the case of peer-to-peer crowdfunding through an online platform, or embedded within a nonprofit organization, the nonprofit entrepreneur must judge the need/demand for a specific social good as well as secure/raise funding in order to bring it about.

In markets, consumers are easily identified, and market entrepreneurs seek to discover and satisfy their preferences (Kirzner, Reference Kirzner1997). Analogously, beneficiaries or the intended recipients of charitable endeavors are, in a sense, the true consumers of the nonprofit enterprise, as the main actions of the enterprise are directly aimed at them. In this sense, charitable or nonprofit entrepreneurs must engage in discovery and learning of what the needs of their beneficiaries are as well as seek meaningful feedback in order to learn about their own impact (Frank, Reference Frank, Shockely, Frank and Stough2008).

However, donors are rightful consumers as well (Andreoni, Reference Andreoni1990; Andreoni and Payne, Reference Andreoni, Payne, Auerbach, Chetty, Feldstein and Saez2013; Hochman and Rodgers, Reference Hochman and Rodgers1969; Sugden, Reference Sugden1982, Reference Sugden1984; Warr, Reference Warr1982). Altruism on the part of a donor implies the existence of inter-dependent utility, in that the donor is made better off when the beneficiary is made better off. In this sense, donors are consumers of the utility gained from knowing that the beneficiary was made better off and are willing or more likely to donate to those charities that they believe will bring about such results (Hochman and Rodgers, Reference Hochman and Rodgers1969).Footnote ¹² Thus, the problem faced by the uncertainty-bearing nonprofit entrepreneur is made more complicated in that he must seek to satisfy the preferences of two distinct groups of individuals simultaneously: donors and beneficiaries.

However, the coordination of charitable activities with ‘consumer’ preferences is more likely than under democratic government, because there is only one class of entrepreneurs who must satisfy the ‘consumers’ (donors and beneficiaries), using privately raised funding. Furthermore, it follows that if donor and beneficiary interests are aligned with each other, in that donors are altruistic and genuinely care about beneficiary welfare, coordination of resources is more effectively achieved than when the two groups' interests are not aligned.Footnote ¹³

Error correction within nonprofits

Non-price learning and feedback mechanisms in the absence of monetary calculation become prominent within the context of charitable or nonprofit entrepreneurship and the existence of Knightian uncertainty (Boettke and Coyne, Reference Boettke, Coyne, Shockely, Frank and Stough2008; Boettke and Prychitko, Reference Boettke and Prychitko2004; Chamlee-Wright and Myers, Reference Chamlee-Wright and Myers2008). Perhaps the most significant error-correcting mechanism that exists in the nonprofit entrepreneurial realm is the voluntarily funded nature of project (Boettke and Coyne, Reference Boettke, Coyne, Shockely, Frank and Stough2008). Nonprofit entrepreneurs must be able to solicit and raise funding from voluntary sources and do not have the power to tax or direct access to tax revenue. In this sense, nonprofit entrepreneurs are more constrained than entrepreneurs in the government and closer to market entrepreneurs.

Short of losing funding, however, error correction or feedback must take place along non-monetary dimensions. Several such mechanisms are suggested in the literature on nonprofits. Boettke and Coyne (Reference Boettke, Coyne, Shockely, Frank and Stough2008) borrow from the literature on microfinance and suggest the use of reputational collateral as a useful device to evaluate nonprofit entrepreneurs. For the purpose of credibility, the entrepreneur should stake his own reputation on the charitable project that he chooses to invest in. Chamlee-Wright and Myers (Reference Chamlee-Wright and Myers2008) discuss the role of embeddedness in social networks as a useful enforcement mechanism for socially motivated endeavors. Evidence of this mechanism is found in real world social learning situations but also in online fundraising endeavors where research finds that online donors are much more likely to donate to a project where they already know and are familiar with the fundraiser in real life (‘relational altruism’), or are inspired by the fundraiser and identify with him rather than the project itself (‘the champion effect’) (Nair and Miller, Reference Nair and Miller2020).