Allocation of Alertness During Recession: The Baseline Model
My model is a metaphor that conveys the idea of entrepreneurs choosing the focus of their alertness. The expected relative profitability of the different opportunities is the criterion of such choice, and more profitable opportunities therefore tend to attract more alertness.
Entrepreneurial alertness in my model[2] is a factor of production whose production function has the standard property of diminishing marginal returns. I assume that there is a fixed amount of alertness and that this alertness can be allocated to two types of projects. One type predominantly pertains to new investment, for which I use the corresponding subscript of “NI.” The projects associated with subscript “Fix” pertain to rearranging the existing factors of production into more efficient allocations.
Figure 2.1 shows an initial equilibrium, in which the product of the price (P) of output and the marginal product of entrepreneurial alertness (MPE) is the same for the two types of projects. Note that the amount of entrepreneurial alertness is in this model given, which is why the horizontal axis is boxed in from both sides. The more to the right the equilibrium point (E) moves along the axis, the more alertness entrepreneurs direct toward new investment projects.
Now the recessionary shock hits the economy. To keep things simple, I assume that the profitability of the prospective new projects does not change. The rearranging of the existing factors of production will compete for entrepreneurs’ attention, and portions of the quasi-rents are in this competition offered to the entrepreneurs to incentivize them to use the existing factors of production instead of focusing on other projects. The higher profitability of rearranging does not mean there are new possibilities for using the existing factors, so the marginal product of the entrepreneurial input itself does not change. Instead, it is the price of the given marginal product that increases thanks to the higher fraction of the quasi-rent captured by the entrepreneurs. Figure 2.2 illustrates my reasoning and shows how the recessionar y shock and related need to reallocate existing factors of production also changes the allocation of entrepreneurial alertness. Of course, if less alertness goes toward new investment, the amount of new investment decreases, alertness being one of the inputs.
Fig. 2.2 The new equilibrium, E2, illustrates a change in the allocation of entrepreneurial alertness from new investment toward restructuring the existing factors of production (Source Author’s creation)