No Free Lunch: Economics for A Fallen World

9 | P31W: Enter the Entrepreneur!

The Entrepreneur as Alert Arbitrageur

As a reminder, arbitrage is simply the act of buying a good in a cheap market and selling the same good in a dear (expensive) market. The markets may be separated by distance or time, and the good could be resource inputs that can be used more productively in alternative settings. Under the broad rubric of problem solver, yet broader than that of the entrepreneurial function of appraisal, is the alert arbitrageur. As the economist Israel Kirzner wrote, the most critical aspect of entrepreneurship is alertness: someone who is more attentive to opportunities. The nature of these heretofore unnoticed opportunities lies in the market underpricing resource inputs (e.g., labor), compared to the value of what that resource could earn if used in a different way (maybe producing a different product). The entrepreneurial function of appraisal, as discussed earlier, is embedded in the alert arbitrageur as the entrepreneur becomes alert to a potential opportunity. Appraisal will be a key function to confirm that the potential price discrepancy is real (in the mind of the entrepreneur) and therefore should be acted on.

Let’s use an obviously unrealistic example to illustrate the point. The alert arbitrageur might notice that Joe’s Bag of Donuts is hiring Ph.D. physicists to serve coffee, and is only paying them $7.50/hr. The alert arbitrageur would realize the physicists are undervalued in their current usage. He will hire them away from Joe’s Bag of Donuts to use them more productively according to their talents. While this is an extreme case, the idea happens all the time. An entrepreneur may have a great idea for a new product, and he will hire resources away from other uses for his venture. He may not be thinking about arbitrage (and he is almost certainly not thinking that way), but that is what he is doing. He sees a price differential between the value of their current output— as represented by the price of the inputs in their current use—and what he hopes to be able to produce, in terms of what it would cost him to hire the resource inputs away from their current use. Similarly, the P31W made linen clothes and sold them; she bought the field and planted the vineyard. Anyone else could have done this, but they didn’t. She was alert to the opportunity, and her gain was good.

This entrepreneurial alertness may come in many forms:

The key is an alertness to profit opportunities by changing production (either through resource inputs or product outputs) to satisfy future consumer demands. Alertness on the part of the entrepreneur is contrasted with ignorance on the part of others in the market. Just as the entrepreneur “sees” the unexploited profit opportunity, the rest do not. Further, they don’t realize they are even missing the opportunity; for them, there is no opportunity to be pursued. They don’t know what they don’t know. Thus the essence of alertness is “seeing the unseen and unknown.”

One can think about the effects of entrepreneurship via its effects on a nation’s production possibilities frontier (PPF).1 The alert arbitrageur is able to see opportunities to rearrange productive resource inputs in a more efficient manner. In Figure 9.1, this might take the US’s PPF from point A to point B. With the discovery of the profitable opportunity, we find that the prior dashed line PPF was actually an interior point, and it is possible to gain more total output with the same amount of resources. Notice that point A was previously on a PPF (the dashed line) that was possible—absent the entrepreneur’s alertness. This was a PPF that was thought to be an efficient use of resources, only the entrepreneurial alertness was able to “see” the potential increase to point B.

Entrepreneurial Alertness Expands PPF
Figure 9.1, Entrepreneurial Alertness Expands PPF. Going back to our Production Possibilities Curve from Chapter 2, we can imagine the U.S. is on a PPF interior point such as A above. Prior to an entrepreneur’s alert discovery of a profit opportunity, the market participants believe they are producing as efficiently as possible, and that the dashed line through A is the PPF. But the entrepreneur shows a recombination of assets could actually produce at B, on a much higher PPF. No new savings or investment is needed here to expand the PPF, just entrepreneurial alertness to use the existing assets more efficiently.

Thinking about the PPF may also help show the importance of entrepreneurship to economic growth. We typically think of economic growth as occurring when a nation saves more today to allow more consumption in the future. Investment is a way to push out the PPF over time. As we invest in more productive human (education) or physical (machinery) capital, we can produce more overall. Entrepreneurship is similarly seen as a way to increase future consumption; but to the extent that entrepreneurs are successful, it does not come at a cost of sacrificing current consumption! As seen earlier, existing resources simply needed reallocation—no new savings is necessarily required for entrepreneurship to succeed. The entrepreneur serves a valuable social purpose indeed!

To demonstrate this a little more formally, recall that in chapter 7 we introduced a simple production function with output (Q) as a function of labor (L) and capital (K), which assumed that there were fixed natural resources and entrepreneurship. Our model looked like this:

Q = f(L,K)

A slightly more robust production function could include natural resources (N) as well as human capital (H) within the production function. This function could be represented as:

Q = A f(L,K,H,N)

This function suggests output is related to the amount of labor, capital, human capital, and natural resources that are available in the production process. Human capital is simply the education and training that each individual worker possesses, and natural resources are the physical outputs of land (the land itself, trees, mineral rights, etc.). But what is this term “A?” “A” can be thought of as technological knowledge: the knowledge of the best ways to produce things—the knowledge of how to produce with an assembly line, or with lean manufacturing for example. In other words, “A” represents the best knowledge of how to make use of existing resources. So when Henry Ford initiated the assembly line on a massive scale, he didn’t make more labor, capital, human capital, or natural resources. But he did figure out a better way to use of the resources we already had.

This broadened concept of the production function, with its formula including technological knowledge, unlocks the secret of how the entrepreneur is able to shift the PPF outward without having to sacrifice consumption. This is because in a production function, entrepreneurship can be captured in the technological function “A,” which determines the best ways to use available resources. No reduction in consumption is required (as would be the case if additional savings were needed); we just need to work smarter and more alertly.

While one might think that entrepreneurial alertness is rather rare, in fact, it’s everywhere. I love watching those makeover TV shows that take the “diamond in the rough” and transform it into something spectacular. We have Overhauling for car makeovers, Extreme Makeover: Home Edition for houses, and What Not to Wear for people makeovers. And while these may not be for profit, there are many people that do the same thing for profit. Barrett-Jackson takes cars that were originally sitting heaps and auctions them off once people restore them, hoping for a profit. Photographers like Ansel Adams see something that you and I don’t, and are able to capture it and present it in a way that is amazingly beautiful. You and I could have taken the same picture…but we didn’t.

There are many examples of famous people who didn’t get discovered at the earliest opportunity. The Beatles were originally rejected by Decca Records rather than given a fat (expensive) contract. Decca Records obviously didn’t know what they didn’t know (in terms of the lost opportunity). Several record companies rejected popular contemporary country singer Taylor Swift before an “alert arbitrageur” at Big Machine Records eventually signed her. In perhaps one of the biggest surprises ever, and certainly one of the most heart-warming, Susan Boyle rocked the world with her unexpected voice on Britain’s Got Talent. This middle-aged, slightly overweight woman walked on to the stage and, overcoming all the prejudices of what an up-and-coming singer ought to look like, wowed us all with an amazing performance. Watch the video here:

She followed that up as the #1 artist in the US and the UK with The Gift. While Simon Cowell may give us the “yes” on her talent, there was someone that spotted her earlier in the audition process—someone who saw what everyone else could not. That is the alert arbitrageur.

One of the most famous entrepreneurs in the US is Bill Gates, one of the co-founders of Microsoft. Bill Gates is both widely admired and despised, with many of his critics suggesting he never really created anything, but rather leveraged others’ work and made a fortune off of it. The critic’s claim has some merit, as a review of Gate’s and Microsoft’s history shows (although clearly Microsoft did more than repackage others’ work). Nevertheless, the critics are missing the genius of Gates; he saw what others could not see. He was the alert arbitrageur that could recognize the differentials in how current software resources were being employed and how they could be employed. By purchasing those undervalued resources (fully valued in their current use, but undervalued in ways Gates thought they could be used), he was able to transform them into a product that more effectively met consumer demand. Sure, Windows was a copy of a Mac—and not very creative—but it nonetheless made Microsoft millions. As we’ll see later, Gates may not have been a creative destroyer, but he certainly was an alert arbitrageur.

Endnotes:

  1. P.J. Boettke and C.J. Coyne, Context Matters: Institutions and Entrepreneurship, Foundations and Trends in Entrepreneurship, vol 5, no 3, pp. 135-209, 2009.

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