How does economics connect to entrepreneurship?

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Discussions of Why Economics Matters to Entrepreneurs

Entrepreneurship is seeing some great popularity at universities these days. The concept of entrepreneurship has been in our modern society for thousands of years and in the history of economic study.

But we somehow delegate the subject and learning of economics to the academics and policy makers. Almost never are the two subjects connected, and yet they are.

“It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.”
Economist Murray Rothbard

Understanding The Term: Entrepreneurship

Carl Voigt, dean of the Marshall School of Business at the University of Southern California, explains, “We sort of defined entrepreneurialism too narrowly as someone who wants to start their own business. But entrepreneurialism can also mean finding new business opportunities and expansion at existing companies.”

Starting with practically nothing, an entrepreneur is one who organizes a new venture, manages it, and assumes the associated risk. The term entrepreneur is broadly defined to include business owners, innovators, and executives in need of capital to start a new project, introducing a new product, or expanding a promising line of business.

We include technology transfer experts, technologists at leading universities, and consultants and advisors assisting in all aspects of venturing. An entrepreneur’s principal objectives are profit and growth, and they will employ formal strategic management practices to achieve them.

Origins of Capitalism

To better understand entrepreneurship, it is useful to look back to the early development of capitalism. Capitalism depends on harnessing private motives to produce the goods and services that the public wants as efficiently as possible. Historian Charles Van Doren leads us to the early roots of “primitive capitalism” in his book A History of Knowledge: Past, Present, and Future. He provides insight to the ancient Egyptians, economic life before the peasant, the introduction of the merchant, the king, the rise of the labor markets.

“Entrepreneurs . . . bring the new technologies and the new concepts into active commercial use. They are the change agents of capitalism.”
Economist Lester Thurow

Defined today, capitalism is a political, social, and economic system. It is characterized by the private ownership of property—not only of land and buildings but of patents, know-how, and processes that are used by entrepreneurs to create profits for themselves. Capitalism sharply contrasts with other economic systems, like feudalism and socialism. In capitalism, entrepreneurs are responsible for such economic decisions as what to produce, how much to produce, and what method of production to adopt.

The French Connection

The concept of entrepreneur is borrowed from the French words entreprendre, “one who undertakes”—that is, a “manager.” In fact, the word entrepreneur was shaped probably from celui qui entreprend, which is loosely translated as “those who get things done.” In the early eighteenth century, a group of thinkers called the Physiocrats surfaced in France around a school of new economic theory. They were the first proponents of laissez-faire and opposed all government intervention in industry, especially taxation. Their doctrine was that the economic affairs of society are best guided by the decisions of individuals.

One of the most famous among them was Richard Cantillon. In a paper he worked on between 1730 and 1734 and that was later published in 1775 as Essai sur la Nature du Commerce en General, he introduced the concept of entrepreneur. He developed these early theories of the entrepreneur after observing the merchants, farmers, and craftsmen of his time. Jean-Baptiste Say, a French businessman turned economist, followed Cantillon with his Trait d’economie politique in 1803. His work commented on the theory of markets and how the entrepreneur is involved in this transaction of goods for money.

Adam Smith’s Invisible Hand and Pin Production

The economic system based on the capitalism concept was completed by the Scottish economist Adam Smith. Leveraging the work performed earlier by the Physiocrats, and in particular Francois Quesnay, Smith completed his famous book, The Wealth of Nations, in 1776 at the beginning of the Industrial Revolution in Britain. Some believe that his main contribution to economics is centered on free enterprise. Introducing the concepts of liberal capitalism and entrepreneurial capitalism, Smith is “known as an architect of our present system of society.”

Smith concentrated on the growing manufacturing and trade industries. In particular he studied the division of labor in the manufacturing of pins, which was beginning to incorporate new machines. His central argument in The Wealth of Nations is based on the concept of what he called the “invisible hand.” He believed that human self-interest is the basic psychological driver behind economics, and that a natural order in the universe makes all individual, self-interested endeavors add up to the social good. He also studied the competitiveness of nations and multinational trade. His major theoretical achievement was to take the first steps toward a theory of the optimal efficient allocation of resources under conditions of free competition.

Austrian School Of Economic Thought

Ludwig von Mises was the acknowledged leader of the Austrian School of economic thought, a prodigious originator in economic theory, and a prolific author. Mises’s writings and lectures encompassed economic theory, history, epistemology, government, and political philosophy. His contributions to economic theory include important clarifications on the quantity theory of money, the theory of the trade cycle, the integration of monetary theory with economic theory in general, and a demonstration that socialism must fail because it cannot solve the problem of economic calculation. Austrian School made a unique contribution to the Family Tree of Economics: the entrepreneur’s role society as the driving force of the market.

“The issue is always the same: the government or the market. There is no third solution.”
Economist Ludwig von Mises

Through their research in the fields of economics, history, philosophy, and political theory, Mises’s students F.A. Hayek, Henry Hazlitt, Murray Rothbard, and others carried the Austrian school into the late twentieth century. Austrian economics is a method of economic analysis, and is non-ideological. Nonetheless, the Austrian school has long been associated with libertarian and classical-liberal thought; promoting private property and freedom, while opposing war and aggression of all kinds.

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F.A. Hayek’s Road to Serfdom

A classic work in political philosophy, intellectual and cultural history, and economics, The Road to Serfdom has inspired and infuriated politicians, scholars, and general readers for half a century. Originally published in England in the spring of 1944, when Eleanor Roosevelt supported the efforts of Stalin and Albert Einstein supported the socialist program, The Road to Serfdom was seen as heretical for its passionate warning against the dangers of state control over the means of production. For F. A. Hayek, the collectivist idea of empowering government with increasing economic control would inevitably lead not to a utopia but to the horrors of Nazi Germany and fascist Italy.

Václav Klaus, former finance minister, prime minister, and president of Czechoslovakia and the Czech Republic, highlights not only Hayek’s role in the fall of communism in Czechoslovakia in 1989, but also his relevance to modern Europe: “Europe needs Hayek,” argues Klaus, “and his merciless analysis of the over regulated, controlled, centrally administered European economic system and of the slippery road to serfdom that we have already embarked on.”

Joseph A. Schumpeter and His “Creative Destruction”

Joseph Alois Schumpeter, an Austrian-American economist, was one of the first to study entrepreneurs and the impact of entrepreneurial capitalism on society. As he wrote in The Theory of Economic Development, he believed that innovation and creativeness distinguished entrepreneurs from other businesspeople.

He observed that innovation and entrepreneurship are closely interwoven. He argued that the entrepreneur was at the very center of all business activity. He observed that entrepreneurs create “clusters of innovations” that are the causes of business cycles because their actions create disruptive dislocations and arrive in huge waves. In fact, Schumpeter believed that entrepreneurs deserve the credit for the industrial revolution.

Schumpeter introduced the phrase “creative destruction,” stating that the entrepreneur does not just invent things, but also exploits in novel ways what has already been invented.

He identified five types of entrepreneurial activity:

  • new product innovation or the introduction of a new service
  • new process innovation or new methods of production
  • market innovation or the opening of new markets, input or resources innovation
  • organizational innovation, which is the complete restructuring of an entire industry or the breaking up of a monopoly

Milton Friedman Defending Free Markets

Nobel Prize-winning economist Milton Friedman, an outspoken advocate of free markets and free choice, adviser to presidents and best-selling author. Often described as one of the most influential economists of the last century, Friedman led the Chicago School of monetary economics, which stresses the importance of the money supply in determining inflation and business cycles.

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Milton Friedman began his teaching career at the University of Chicago isolated intellectually. He defended the ideas that competitive markets work efficiently to allocate resources and that central banks are responsible for inflation. By the 1980’s, these ideas had become commonplace.

Friedman was one of the great intellectuals of the 20th century because of his major influence on how a broad public understood the Depression, the Fed’s stop-go monetary policy of the 1970’s, flexible exchange rates, and the ability of market forces to advance individual welfare.

His book “Free To Choose” published in 1980 became an international bestseller. The theme was a discussion on the extent to which personal freedom has been eroded by government regulations and agencies while personal prosperity has been undermined by government spending and economic controls.

Entrepreneurs + Risk Capital + Low Taxes = Economic Growth

For nearly every entrepreneur, access to private equity capital, or risk capital, is a key ingredient to successful business growth. For a business to grow it needs to be nurtured in an environment that supports entrepreneurial capitalism.

“Capital is like oil; it’s stored energy. It’s the fruits of someone else’s labor ready to be put into play in businesses.”
– Alfred R. Berkeley III, NASDAQ

Frank Knight, a professor of economics at Chicago in 1928, wrote in Uncertainty and Profits, “The only risk which leads to a profit is a unique uncertainty. Profits arise out of the inherent, absolute unpredictability of things.” For nearly every entrepreneur, access to private equity capital, or risk capital, is a key ingredient to successful business growth. In the broadest understanding of the stratification of capital, risk capital is money for investment in innovative enterprises or research in which both the risk of loss and the potential for profit may be considerable.

We use the terms risk capital and private equity to refer to the universe of that asset class—which includes angel investments, venture capital, leveraged buyout, and mezzanine financing—that make direct capital investments in high-growth potential ventures. The one element that binds this diverse group of investors is that they receive some type of equity or stock vehicle when they put money into a venture.

Definition of entrepreneurial capitalism: private capital, investing in private start-ups, with potential for a viable harvest

Entrepreneurship, combined with support from venture capital, is a major force driving economic growth in the United States. Thomas McConnell of New Enterprise Associates said, “Venture capital investment is a national phenomenon that helps set the U.S. economy apart from others in the world.” Venture capital financed groundbreaking research and untold improvements in infrastructure and technology. The average venture-backed company employs nearly 100 workers within five years and creates almost twice as many jobs as their nonventure-backed competitors.

Venture capital, risk capital, was perfected in the Reagan era with the help from Jack Kemp. Things changed with President Ronald Reagan’s election in 1980, when the business environment shifted from President Carter’s “Days of Malaise” as the Republicans produced political leaders committed to entrepreneurial capitalism. Their thrust took shape under “supply-side economics,” which was first envisioned by economic adviser Dr. Arthur Laffer. His winning thesis was simply this: Lower the marginal tax rates. He believed that individuals should keep more of their hard-earned money, which would encourage them to make more.

“Does government create jobs, or do entrepreneurs? Does government spending spur growth, or do lower taxes, less regulation, and spending limits? Can government direct investment better than the private sector? The answers to these questions provide the keys to designing a strategy for long-term growth in America.”
Jack Kemp

In August 1981, less than seven months after being sworn in, President Reagan signed the Kemp-Roth bill into law. It was the cornerstone of what would become the most successful economic policy for new business venturing in U.S. history. The bill’s treatment of capital gains, a lowering of the top capital gains tax rate from 28 percent to 20 percent, made high risk investments even more attractive, causing a twofold increase in commitments to venture capital funds in 1981.

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Entrepreneurs then launched a boom that would last, except for a brief eight months following the Gulf War in 1991, until the end of the twentieth century. It was the longest period of economic expansion in the nation’s history. Between 1983 and 2003, the Dow Jones Industrial average provided an annual return of 11 percent. For comparison, between 1965 and 1983 its annual return was 1 percent.

According to the U.S. Department of Labor Non-Farm Employment Data, the American economy generated over 27 million new jobs between 1980 and 1995. Over 24 million of these new jobs were created by small- and medium-size entrepreneurs operating high-growth ventures. As Dr. Laffer predicted, even Washington, D.C., prospered well, with the U.S. Treasury revenues increasing 28 percent to more than $1 trillion in 1990.

At the closing of the last century, MIT economist Lester Thurow had this to say: “In what will come to be seen as the third industrial revolution, new technological opportunities are creating fortunes faster than ever before. The United States has created more billionaires in the past fifteen years than in its previous history—even correcting for inflation and changes in average per capita gross domestic product.”

Jack Kemp Champion of Entrepreneurial Capitalism

When Ronald Reagan took the oath of office on January 20, 1981, the country was experiencing some of bleakest economic times since the Depression. The American dream had been restored with the help from Jack Kemp.

“Other than President Ronald Reagan himself, few people in the political world have had more influence on the last quarter century of wealth creation and rising levels of entrepreneurial business expansion than Jack F. Kemp.”
Steve Forbes

The quarterback-turned-politician died of cancer at age 73 in 2009, was remembered for his commitment to free-market principles that transformed the world in the 1980’s. Kemp was an early influence, along with economist Arthur Laffer and President Ronald Reagan, in getting the Republican Party to embrace the philosophy of tax cuts. Republican Sen. Robert Dole’s selection of Kemp as his running mate in the 1996 presidential election reaffirmed Kemp’s imprint on GOP economic policy.

Jack Kemp in His Own Words

“It was this economy, triggered by President Reagan’s supply-side revolution of tax cuts in 1981 that generated 21.5 million new jobs, more than four million new businesses, relatively low inflation and higher standards of living for most people. This economy has created more jobs in the past decade than all of Europe, Canada and Japan combined. And according to the U.S. Treasury, federal income taxes paid by the top 1% of taxpayers has surged by more than 80% to $92 billion in 1987 from $51 billion in 1981.”

“In my opinion, people of all colors and income levels don’t hate the rich. They want to get rich. They’re more interested in generating wealth than they are in redistributing wealth. They want to own property, educate their children and build a nest egg that can be passed on to their heirs. Unfortunately, some aren’t able to access the same ladder of opportunity that is so readily available to the majority. . . .”

“By giving people access to capital and allowing them to take ownership of assets, entrepreneurship will be encouraged and the cycle of poverty can begin to be broken. All persons should have the opportunity to go as high as their merit and determination can carry them.”

“My favorite quote is from Abraham Lincoln, who said, ‘I don’t believe in a law to prevent a man from getting rich; it would do more harm than good. So while we do not propose any war upon capital, we do wish to allow the humblest man an equal chance to get rich with everybody else.’ Lincoln’s definition of entrepreneurial capitalism is the best I have ever heard.”

Rising Tide Lifts all Boats

Around the world economic policy advisors are working to find solutions to the chronic unemployment and stifling lack of economic growth. For creating the environment for entrepreneurial capitalism to flourish they should look at success of the 1980’s that was first framed by President John F. Kennedy and put into practice by President Ronald Reagan.

President Reagan’s Radio Address to the Nation on Martin Luther King, Jr., and Black Americans on January 18, 1986. “Now, none of this happened by accident. The economy is expanding because from the beginning we made it clear that one of the prime motivating intentions of this administration was to get the economy going again. And it was clear the way to do that was cut tax rates, stop penalizing initiative, and sit back and watch the fireworks. All of us have benefited. The poverty statistics show John Kennedy was right when he said, following his own tax cuts, a rising tide lifts all boats.”

SOURCES: Roadmap To Entrepreneurial Success, Mises.org, Amazon.com
PHOTO: , Reagan Library, Old Library in University of Salamanca, Antoine Taveneaux WikiPedia, Hoover Institution
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