Why do Entrepreneurs exist?
In 1946, Masaru Ibuka left his position at a photochemical laboratory to start a radio repair shop in a bombed-out building in Tokyo. Soon after, he co-founded Tokyo Tsushin Kogyo with his friend Akio Morita and a total of eight employees involved in the business of magnetic recording tape. In 1952, the company obtained a license for transistors from Western Electric, foreseeing the potential of this unknown component. Several important developments followed, the company introduced Japan’s first transistor radio in 1955 and the world’s first transistor television in 1960. Tokyo Tsushin Kogyo officially changed its name to Sony Corporation in 1952.
Much research in the field of entrepreneurship is focussed on the ‘entrepreneur’. Why do certain individuals start firms when others, under similar conditions, do not? Focus is laid on identifying traits that differentiate entrepreneurs: the need for achievement, locus of control, risk-taking ability, etc. However, a concrete understanding of the phenomenon of ‘entrepreneurship’ has eluded management theory and practitioners alike.
My own personal experience was that for ten years we ran a research center in entrepreneurial bistory, for ten years we tried to define the entrepreneur. We never succeeded. Each of us had some notion of it — what he thought was, for his purposes, a useful definition. And I don’t think you’re going to get farther than that. — Arthur Cole, 1969
Joseph Schumpeter described the conduct of entrepreneurs as irrational to an economic man. He characterized an entrepreneur as the one who carries out new combinations in the circular flow of an economy, the putting into practice of new ideas. By ‘new combinations’ he meant new consumer goods, new methods of production, or new markets. Entrepreneurs he claimed aim to disturb existing equilibriums in the market and earn Schumpeterian rents while the market adjusts to a new equilibrium.
To understand this better, let’s explore the idea of economic rents:
In a perfectly competitive market, economic profits diminish over time and ultimately converge to zero. That is because the presence of economic profits (after accounting for opportunity costs) in any market will attract competitors. An increase in competition will lower prices and the market will settle at an equilibrium where market price equals average cost.
For the profits to maximize, the marginal cost of every producer should equal the market-determined price.
Economic profits can be visualized in the adjacent graph as the difference between market price and average cost curve. Under competitive equilibrium, marginal cost equals average cost, and economic profits for all competitors becomes zero.
However, we observe profitable businesses in the world outside. That implies, that markets are not perfectly competitive or in other words, markets are inefficient.
Inefficient markets enable incumbents to earn two major types of rents,
- Monopoly rents
- Ricardian rents
Monopoly rents accrue when the number of competitors is constrained. This prevents market prices to converge to the competitive equilibrium. Monopoly rents arise out of the industry characteristics. Barriers to entry, network effects, pricing power, vertically integrated incumbents, licensing, patents, etc. Incumbents encourage such inefficiencies for their benefit.
Ricardian rents accrue when competitors within an industry are characteristically different. This differentiation may arise out of a lower cost structure, by means of better technology, scale, organizational capability, information asymmetry, etc. Incumbents take advantage of such inefficiencies to drive out competition and then gradually increase prices to earn higher rents.
Ricardian rents also accrue by means of creating perceived differentiation. This creates an environment where customers are willing to pay more for products from certain businesses over others. This may arise out of a strong portfolio of brands, trade secrets, custom offerings, customer service, compliment products, inimitability, etc. In commoditized markets, such rents may also accrue by means of the quality of service and reliability of support.
Accumulation of huge profits through such rent-seeking behavior causes incumbents to become myopic to disruptions. They end up establishing power structures and processes which encourage the status quo for as long as possible. For example, carriage makers like The Studebaker Brothers resisted the advent of railroads. Railroad firms resisted the advent of automobiles. Conventional automobile firms resisted the advent of the electric powertrain. This blinds them to the potential of new innovations, rather they deliberately end up erecting barriers that poison their own culture.
Often, in big corporations, capital allocation decisions are made by considering the entire portfolio which becomes a piece of baggage that is too alluring in the short term to let go of. Large incumbents also end up establishing objective processes of valuing individual projects. This does a poor job of assessing the potential and risk of ‘new combinations’. By their very nature, innovations are difficult to identify only through formal techniques. A combination of intuition and procedure is needed.
This encourages irrational actors to emerge who have a distinct risk-return perception of the world. For them, monetary returns are not the first priority. The opportunity to bring about change is.
So why do entrepreneurs exist? First, there is the dream and the will to find a private kingdom, then there is the will to succeed for the sake, not for the fruits of success. Finally, there is the joy of creating, of simply exercising one’s energy and ingenuity.
Here’s to the crazy ones.
The round pegs in the square holes.
The ones who see things differently.
They’re not fond of rules.
And they have no respect for the status quo.
You can quote them, disagree with them, glorify or vilify them.
About the only thing you can’t do is ignore them.
Because they change things.
Jack Kerouac — Crazy Ones (Think Different Apple)