UE 3: Dispersed knowledge and an entrepreneurial theory of the firm

Question 1

What is the transaction cost theory, and what are issues with its explanation of organization?

Answer 1

The TCT states that a firm is created when costs (transaction, agency, supervision, monitoring…) are lower within a firm than on the market.

An issue with this is that it explains it solely as a mode of economic organization, not of particular firms or markets, and further does not cover the individual’s role.

Question 2

What is the the theory of firm creation as presented by Der et al (2004), and how is it unique?

Answer 2

Dispersion of knowledge in society creates uncertainty. Individuals discover opportunities, but sometimes cannot sell them on the market.

Unique in that:

• Opportunity is the first step in the genesis of a firm
• Individual centric
• Addresses the question of why particular firms exist

Question 3

What are the two types of knowledge in Hayek (1945)?

Answer 3

1. Scientific knowledge - stable and best known by respective experts
2. Dispersed knowledge - importance can only be judged by the individual possessing it

Different people know different things

Question 4

Explain the Akerlofian information asymmetry as presented by Aklerlof in 1970, what does it lead to, and how can it be obtained if unknown?

Answer 4

• Dispersed knowledge across people and places leads to asymmetries of knowledge at the same time
• Knowledge asymmetries lead to uncertainty, called cross-sectional uncertainty
• Information, unknown by an agent of the system, is available through some kind of transaction

Question 5

Explain longitudinal or Knightian uncertainty as presented by Knight (1921).

Answer 5

• Dispersed knowledge of particular times
• No agent of the system has the relevant information to predict the future
• Knowledge is unknown, but further unknowable

Question 6

Explain the two types of knowledge with regards to a problems that arise from Knightian uncertainty.

Answer 6

Structural knowledge: the degree how well the structure of a problem is known. Can all possible outcomes be classified?

Parametric knowledge: the degree how well the values of the parameters are known.

Question 7

What can be predicted about novelty in an Knightian uncertainty framework, and what arises from the dispersion of knowledge it produces?

Answer 7

The content, the timing of the arrival, as well as the effect of the novelty cannot be predicted.

The general dispersion of knowledge matters in the creation of new knowledge. It can result by combining incomplete or even contradictory knowledge by one or several agents.

Question 8

Explain heterogeneous expectations.

Answer 8

• A result of uncertainty
• Under cross-sectional uncertainty different people know different things
• If additionally Knightian uncertainty involved, then different people have even different expectation about future outcomes

Question 9

What are the four observations about dispersed knowledge and heterogeneous expectations - including their distribution, perception of costs, and volatility?

Answer 9

1. Expectations are subjective, they cannot be observed directly by others.
2. Even if knowledge about the outside world is not distributed unequally, differences between people like skills, aspiration, or psychological traits could lead to different expectations.
3. Future costs are often subjectively perceived by individuals.
4. Expectations are volatile.

Question 10

Define the individual opportunity nexus.

Answer 10

Particular individuals discover,
create, and exploit particular opportunities.

This should thus be accounted for in the theory of the firm.

Question 11

How do entrepreneurs manage to create new economic goods in the presence/absence of the respective market?

Answer 11

Because of absence of a market uncertainty about the final value of the goods prevails.

Question 12

How does an entrepreneur’s creative process change in service markets, and how would firms arise?

Answer 12

There is no market for the entrepreneur’s service if the related opportunity is judged under uncertainty because there is no intersubjective agreement about its value (Knight, 1921).

Under Knightian uncertainty residual contracts give the contract holder (here the entrepreneur) residual rights. A specific contract cannot cover all unknowable situation.

Firms arise from the absence of a market, where the entrepreneur organizes uncertainty, heterogeneous expectations, and their opportunity nexus into a contract.

Question 13

How does an entrepreneur’s creative process change in product markets with regard to novelty and the uncertainty of its value?

Answer 13

• Entrepreneur proposes to bring new products to the market.
• Degree of novelty of an opportunity positively related to the uncertainty about its value
• Uncertainty about the value positively related to the likelihood of failure in the market

Question 14

How does an entrepreneur’s creative process change in factor markets?

Answer 14

• Presence of a factor market does not mean the entrepreneur has the ability to purchase factors/resources at this market.
• This markets can be inefficient.
• The entrepreneur has then to resort to non-market sources.
• With limited resources and his/her abilities the entrepreneur manages to keep the price of the factors lower than in the factor market itself.

Question 15

What are the four possible outcomes of intersubjective agreement when an individual within a firm sees the value of an opportunity?

Answer 15

1. High intersubjective agreement about the value both within and outside the firm.
2. Intersubjective agreement only within the firm.
3. Intersubjective agreement only outside the firm.
4. No intersubjective agreement at all.

Question 16

What are the results of opportunities being discovered in firms when high intersubjective agreement about the value is both within and outside the firm?

Answer 16

− The opportunity is overall accepted as valuable and can be exploited within the firm or in the market.
− A formation of a new firm is not necessary.

Question 17

What are the results of opportunities being discovered in firms when intersubjective agreement is only within the firm?

Answer 17

− Typical case: The firm has the specific knowledge which is necessary to recognize the value of the opportunity.
− The exploitation of the opportunity is within the firm.

Question 18

What are the results of opportunities being discovered in firms when intersubjective agreement is only outside the firm?

Answer 18

− Typical case: The cost for the firm of implementing the opportunity are too high.
− Can lead to the individual’s exit who identified the opportunity.
− He/she exploit it by founding a new firm.

Question 19

What are the results of opportunities being discovered in firms when no intersubjective agreement is present at all?

Answer 19

− Case of true Knightian Uncertainty.
− Individual leaves the firm for exploiting the opportunity.
− Unable to access factor markets because of high uncertainty associated with the opportunity
− Resorting to non-market sources