[Cross-posted at Organizations and Markets]
Over the years I’m increasingly convinced that Israel Kirzner’s metaphor of entrepreneurship as costless discovery — a form of arbitrage, exploiting differences between actual prices and their Walrasian equilibrium values — is a misleading way to think about entrepreneurship. Emphasizing knowledge, the awareness of facts that other market participants do not possess, the metaphor leads our attention away from action, the employment of scarce means to achieve economic ends. I’ve argued in a series of papers (1, 2, 3) that opportunity exploitation, not opportunity discovery, drives the market process.
A key problem for the Kirznerian metaphor is that entrepreneurship does, in practice, involve capital investment, despite Kirzner’s insistence that “pure entrepreneurship” does not require ownership of resources. (As Joe Salerno reminds us, favorable reviews of Kirzner’s Competition and Entrepreneurship by Austrians Murray Rothbard, Henry Hazlitt, and Percy Greaves all pointed to the separation of entrepreneurship and property ownership as the lone weakness in Kirzner’s otherwise excellent exposition.) But what about financial-market arbitrage, an example often cited in the Kirznerian literature? Isn’t arbitrage an example of costless discovery of pure profit? Doesn’t the arbitrageur operate without capital?
Actually, real-world arbitrage does not resemble Kirznerian alertness at all. Brad DeLong recently reminded me of Shleifer and Vishny’s important 1997 Journal of Finance paper on arbitrage. Write Shleifer and Vishny:
Theoretically speaking, . . . arbitrage requires no capital and entails no risk. When an arbitrageur buys a cheaper security and sells a more expensive one, his net future cash flows are zero for sure, and he gets his profits up front. . . . [But] the textbook description does not describe realistic arbitrage trades. . . .
Even the simplest realistic arbitrages are more complex than the textbook definition suggests. Consider the simple case of two Bund futures contracts to deliver DM250,000 in face value of German bonds at time T, one traded in London on LIFFE and the other in Frankfurt on DTB. Suppose for the moment, counter factually, that these contracts are exactly the same. Suppose finally that at some point in time t the first contract sells for DM240,000 and the second for DM245,000. An arbitrageur in this situation would sell a futures contract in Frankfurt and buy one in London, recognizing that at time T he is perfectly hedged. To do so, at time t, he would have to put up some good faith money, namely DM3,000 in London and DM3,500 in Frankfurt, leading to a net cash outflow of DM6,500. However, he does not get the DM5,000 difference in contract prices at the time he puts on the trade. Suppose that prices of the two contracts both converge to DM242,500 just after t, as the market returns to efficiency. In this case, the arbitrageur would immediately collect DM2,500 from each exchange, which would simultaneously charge the counter parties for their losses. The arbitrageur can then close out his position and get back his good faith money as well. In this near textbook case, the arbitrageur required only DM6,500 of capital and collected his profits at some point in time between t and T.
Even in this simplest example, the arbitrageur need not be so lucky. Suppose that soon after t, the price of the futures contract in Frankfurt rises to DM250,000, thus moving further away from the price in London, which stays at DM240,000. At this point, the Frankfurt exchange must charge the arbitrageur DM5,000 to pay to his counter party. Even if eventually the prices of the two contracts converge and the arbitrageur makes money, in the short run he loses money and needs more capital. The model of capital-free arbitrage simply does not apply. If the arbitrageur has deep enough pockets to always access this capital, he still makes money with probability one. But if he does not, he may run out of money and have to liquidate his position at a loss.
In reality, the situation is more complicated since the two Bund contracts have somewhat different trading hours, settlement dates, and delivery terms. It may easily happen that the arbitrageur has to find the money to buy bonds so that he can deliver them in Frankfurt at time T. Moreover, if prices are moving rapidly, the value of bonds he delivers and the value of bonds delivered to him may differ, exposing the arbitrageur to additional risks of losses. Even this simplest trade then becomes a case of what is known as risk arbitrage. In risk arbitrage, an arbitrageur does not make money with probability one, and may need substantial amounts of capital to both execute his trades and cover his losses. Most real world arbitrage trades in bond and equity markets are examples of risk arbitrage in this sense. Unlike in the textbook model, such arbitrage is risky and requires capital.
Shleifer and Vishny are primarily concerned with the agency relationship between arbitraguers — a “a relatively small number of highly specialized investors [who use] other people’s capital” — and the wealthy individuals, banks, endowments, and other investors who provide the necessary resources. My point here is simply that there is no such thing as costless discovery of profit opportunities, even in financial-market arbitrage. Profits are earned by those who put resources at risk — the basic idea of the Knightian “judgment” framework Nicolai and I have been developing. When we invoke the theoretical construct of the entrepreneur to explain the existence of profit (as distinguished from wages, rent, and interest), we must recognize that the entrepreneur is, in essence, a resource owner.
{ 10 comments }
I am unaware of any way to arbitrage in the financial markets without using the services of an agent (broker), and they require that you have an account with funds on deposit to use as margin money and pay their fees.
Actually this is a variant of what I learned which is “It takes money to make money.”
I was always struck by the fact that Kirzner’s theory ignored the transaction costs of arbitrage. For example, even beyond monetary P & L there is the opportunity cost of your time looking for opportunities.
Professor Harper at NYU just kind of assumed away transaction costs and focused on the pure-entrepreneur when he taught one of my MA classes. I think he said something about Kirzner does not argue that the capitalist does not exist or that someone can only be a capitalist or an entrepreneur. Someone can wear both hats in Kirzner’s framework.
Over the years I’m increasingly convinced that Israel Kirzner’s metaphor of entrepreneurship as costless discovery — a form of arbitrage, exploiting differences between actual prices and their Walrasian equilibrium values — is a misleading way to think about entrepreneurship. Emphasizing knowledge, the awareness of facts that other market participants do not possess, the metaphor leads our attention away from action, the employment of scarce means to achieve economic ends. I’ve argued in a series of papers (1, 2, 3) that opportunity exploitation, not opportunity discovery, drives the market process.
I do agree with the above, but can I assume that in this paragraph you are saying that entrepreneurship does not require arbitrage?
I agree that the primary focus of the entrepreneur must be action, but this may lead to financial profit or loss even though the entrepreneur may receive psychic profits (Mises) in both instances. Can we not attribute a spirit of entrepreneurship to Mises when he choose to print and study economics when he might have been more secure, sure, and successful choosing another profession? Wasn’t he seeking psychic profits while facing the uncertainty of acheiving financial profits?
It seems to me that the entrepreneur is motivated more by psychic profits while the financial profits are a function of the consumer allocating resources to the most desirable and beneficial of the actions taken by various entrepreneurs.
Dick F., yes, of course, entrepreneurial action in the broad sense seeks to gain psychic profit (and to avoid pyschic loss). However, an entrepreneur who consistently earns financial losses cannot continue being an entrepreneur for long. As Mises emphasized there is an important market selection process for entrepreneurs, and this process selects entrepreneurs on their ability to earn monetary, and not just psychic, profits.
On your first question, I don’t like the arbitrage metaphor because arbtrage implies the exploitation of differences in _known_ prices. It ignores uncertainty, which for Cantillon, Knight, Mises, and others is the source of entrepreneurial profit. I prefer to think in terms of investment, paying today’s (known) prices, in anticipation of rewards that occur in the future, at prices that are not known with certainty. Entrepreneurship is the bearing of this uncertainty.
Dear Peter Klein,
I recognize the degree of specialization that you are speaking about and the practical requirements for ‘opportunity exploitation.’ It makes perfect sense that a transaction represents human action and this more closely resembles ‘opportunity exploitation’ than it resembles ‘opportunity discovery.’
At the same time opportunity discovery preceeds opportunity exploitation and yet it may be viewed as all a part of the same process.
Pure entrepreneurship seems to refer to the beginning of the process and therefore it is actually the discovery of something from nothing. Since humans are inherently entrepreneurial, that is they are inherently seekers, necessarily they are either in a state of latent entrepreneurship or active entrepreneurship.
Those who are in an active state are the ones who are exercising that human potential. It has all the characteristics of human action when we allow ‘human action’ to encompass the possibilities of both those that are material and ideal. In other words, active entrepreneurship is a manifestation of human action; and the discovery of something from nothing fits that criteria. Extending that action to exploitation is a continuation of human action but it is not its first appearance.
The significance of this recognition of pure entrepreneurship as universally available to all humans confirms: that the concept of property rights (a new property right comes into existence when there is the discovery of something from nothing) is the foundation of human civilization and is the source of prosperity and is accessible to everyone.
If my discovery is personal and ideal it is still mine and yet it may never appear as a transaction so it may never seem ‘exploited.’ But if action has taken place and my ‘property’ has expanded how can someone declare it insufficient to drive the market. It may be subtle but somewhere along the line the market will feel the effects!
Peter,
Thanks for the response. I do agree with you on the issue of arbitrage.
On the entrepreneur we also essentially agree but I do believe that there are some entrepreneurs who become the employees of other successful entrepreneurs to gain resources to pursue their own entrepreneurial dream even if that dream is realized at a financial loss.
Usually it is the more tenacious entrepreneur who is successful rather than the more intelligent. Often the intelligent entrepreneur has a sense of entitlement where the tenacious entrepreneur simple takes action.
Some have no entrepreneurial dream and for others the lack of fianacial profit overwhelms any psychic profits and they settle to be employees.
I also like the idea that Bruce brings in of the requirement for action.
Bruce, I am not sure I agree with you concerning the “discovery of something from nothing” idea. Some entrepreneurs simply find a better way to organize an existing idea without creating something from nothing. Now if you include this reorganization in your “something from nothing” concept then perhaps we agree.
I responded to Bruce on the issue of what might be called “personal entrepreneurship” at the other thread:
http://organizationsandmarkets.com/2007/08/18/entrepreneurship-arbitrage-and-capital/#comment-46862
Dick, on entrepreneurs who become employees of other entrepreneurs, we do not really disagree. Foss and I call the former “proxy entrepreneurs” who exercise a kind of secondary, or “derived” judgment on the part of their employers. See this paper:
http://web.missouri.edu/~kleinp/papers/05-076179-Foss.pdf
Dear Dick,
The entrepreneurship that I am addressing is the transition between latency and active. All humans have the capacity to be alert. Most of the time that capacity is latent.
When waken from latency, or even, the cause of wakening is what is perceived as a ‘discovery.’ The discovery may be material or ideal but nevertheless it becomes ‘property’ even if the ‘new knowledge’ is the type of property.
Peter,
Thanks for the link to the paper. I have a lot of reading to do but I will get to this as soon as I can.
Bruce,
Now I understand better, thanks. I have a little problem with calling intangibles property but I think I understand your reasoning.
Comments on this entry are closed.