Introduction
Human attention has limits, and people, at least to some extent, choose what they pay attention to. I explore how limited, or scarce, attention might matter during recessions, when entrepreneurs suddenly face a cluster of opportunities resulting from previous misallocations of factors of production.
Entrepreneurs’ alertness is, at that point, suddenly divided between the profit opportunities from fixing the existing production processes and the opportunities for brand-new investment projects. As a result, entrepreneurs decide to postpone or discard some of the possible new projects. This discussion of the limits of entrepreneurial alertness is useful for two reasons. First, it provides an additional—and to my knowledge novel—framework to understand the procyclical character of aggregate investment that, for example, Stock and Watson (1998, 13) document. Of course, the framework is a complement to rather than a substitute for the existing theories that account for that procyclical character because the procyclicality is a generally accepted stylized fact. In one way or another, business cycle models therefore incorporate this fact as,S. Bilo (B)
Arlington, VA, USA
© The Author(s) 2021 13
A. John and D. W. Thomas (eds.), Entrepreneurship and the Market
Process, Mercatus Studies in Political and Social Economy, https://doi.org/10.1007/978-3-030-42408-4_2
for example, Plosser (1989) exemplifies for real business cycle theory and Lucas (1977) for new classical theory.
Second, it leads to an analytic framework that captures the allocation of entrepreneurship during recessions. I later enhance the baseline framework with an extension that includes unproductive entrepreneurship, such as rent-seeking associated with fiscal expansion, as such entrepreneurship can aggravate recessions.
My discussion of the allocation of entrepreneurship during a recession lies at the intersection of three sets of literature.
First, it builds on the stylized fact that recessions tend to reveal clusters of errors, as suggested by Hayek in his Copenhagen lecture ([1939] 1975, 141), meaning that recessions are associated with a large number of entrepreneurs realizing that their projects are unprofitable. This fact can be observed indirectly—for example, through increases in the number of bankruptcies during recessions, as documented by Altman (1983) and Platt and Platt (1994), through procyclical employment and countercyclical unemployment (Stock and Watson 1998, 15), or through higher dispersion of total-factor-productivity growth rates across industries (Eisfeldt and Rampini 2006). I link the first two observations with what seems to be a reasonable assumption: that companies usually do not plan to go out of business and people usually do not plan to become unemployed. The dispersion of total-factor-productivity growth is also consistent with the existence of suddenly revealed mistakes that slow output growth in certain industries.The higher incidence of recognized errors during the recession matters because it implies that the existing allocations of factors of production— both capital and labor—might be inefficient, requiring their repurposing, which is costly and requires imagination. In other words, investments are to some extent irreversible because of the specificity and heterogeneity of factors of production, which connects my discussion with a second stream of literature. Some of the works on the irreversibility of investment under uncertainty—including Bernanke (1983), Majd and Pindyck (1987), and Pindyck (1993)—emphasize the irreversibility of deployed factors of production from an ex ante perspective (that is, before investment). My discussion instead focuses on what to do with already-existing capital goods ex post, as emphasized by the Austrians, including Hayek ([1935] 1967), Mises ([1949] 1966, 503-514), Lachmann ([1956] 1978), and Garrison (2001). The ex post emphasis is the appropriate one in the context of recessions: during recessions entrepreneurs face the problem of the misallocation of existing irreversible investment.
Witnessing a large number of specific factors of production employed in unprofitable production processes, they have to decide which ones to repurpose and which ones to discard. The rearranging of such factors is not a trivial problem; it resembles that of a five-thousand-piece jigsaw puzzle that was designed to portray the painting of Mona Lisa and has to be reassembled into a picture of Mickey Mouse after some kids lost or disfigured many of the pieces. Such reassembly is costly, and for the same reason is that of factors of production. While reassembling the factors of production represents new possible profit opportunities, it also imposes a demand on the limited attention, or alertness, of entrepreneurs. Their attention is more diverted than it otherwise would be and thereby must be spread more thinly across other competing demands.My discussion on how these limits on entrepreneurs’ alertness play out during the recession builds on a third stream of literature: the works of Kirzner, Baumol, and Gifford, where Kirzner ([1973] 1978) represents the methodological base for thinking about entrepreneurship, Gifford (1992) highlights the importance of limited attention of entrepreneurs, and Baumol (1990) illustrates how changing incentives change entrepreneurial outcomes. Kirzner’s ([1973] 1978) key insight is that entrepreneurial alertness, which can be described as “knowing where to look for knowledge” (68), is an essential part of the market process. Markets cannot work unless people are alert to and perceive profit opportunities. This means, Kirzner [1973] 1978, 225-231) argues, that even the absence of transactions costs, which include information costs, is not enough for markets to equilibrate. Entrepreneurs, according to Kirzner, also have to perceive the importance of available information regarding potential profit opportunities.
I continue with what hopefully is a reasonable assumption: that Kirznerian alertness has limits and that if entrepreneurs ponder a certain set of information, they are not able to do so with some other information set.
This follows along the lines of Gifford (1992), who recognizes the limited attention of entrepreneurs, although, unlike Gifford, I do not distinguish between the attention entrepreneurs give to “current operations” and that given to “prospective projects,” because such a distinction does not fully capture the decisions entrepreneurs have to make about misallocated factors of production during recessions. Under the assumption of alertness with limits, I turn to Baumol’s (1968, 1990) general idea that different structures of incentives determine the “allocation of entrepreneurial inputs” (1990, 897), understanding the term “input” as Kirzner's “alertness.”Using this connection of Baumol's, Gifford's, and Kirzner's ideas, I apply Baumol's conceptual description to a framework with microfoundations. However, unlike Baumol (1990), I do not consider the allocation of entrepreneurship in the context of long-run economic growth, but, instead, in the context of a recession, when it turns out that many factors of production, both capital and labor, cannot remain employed as initially intended. Entrepreneurs' production costs (in the case of capital) and costs of acquiring human capital, hiring, and training (in the case of labor) are already sunk and do not matter when considering factor reallocation. Remaining quasi-rents associated with the factors then represent potential new profit opportunities, thereby incentivizing the entrepreneurs to turn their alertness from investing in brand-new production processes toward salvaging existing factors of production. The necessary assumption is that the existing factors of production are substitutes for rather than complements to new investments. Accordingly, the resulting decrease in new investment is in line with the stylized fact of procyclical investment.
As I suggested before, this model of allocation between the two types of entrepreneurial activities—new investment and fixing the old allocations of capital and labor—can also be extended to include the reallocation of entrepreneurial alertness into unproductive and destructive activities, as Baumol (1990) explores in the context of economic growth. This extension makes it possible to analyze the consequences of a possible fiscal-stimulus response to a recession, where new, unproductive rentseeking opportunities associated with the stimulus divert entrepreneurial alertness from productive activities, including new investment. Such diversion then makes aggregate investment even more procyclical. This extension relates to Takii (2008), who also discusses the interrelationship of entrepreneurship and fiscal policy, although in a different context, in which fiscal expansion tends to crowd out private consumption. As government then plays a larger role in the market and it is, by assumption, less capable of identifying changes in the tastes of consumers than entrepreneurial firms, overall output decreases.