In the previous chapter we argued that, to assist people in thinking through complex decision problems, a quantitative framework is needed to encourage consistency, the essence of rationality. Decision theory provides such a framework, and in this chapter we give an account of this theory. We start, in Section 3.1, with value function theory, which is concerned with conflicting objectives. In Section 3.2 we discuss uncertainty, and how the calculus of probability may be used to describe it. Section 3.3 contains a description of utility theory, which is concerned with decision-making in the face of uncertainty, and in Section 3.4 we show how uncertainty and conflicting objectives may be handled at the same time. Finally, in Section 3.5, we discuss other approaches to creating a calculus for decision-making.

CONFLICTING OBJECTIVES

We all make decisions all the time. What clothes shall I wear this morning? What shall I have for lunch? Shall I watch television or read a book? Most of us have no difficulty in deciding matters like these, but on occasion we find ourselves spending a lot of mental effort in making up our minds. Choosing a career and then a particular job, or where to live, often falls into this category.

This is a book about decision-making – about how people do make decisions, and about how they may improve their decision-making. To say this makes some assumptions, and, before we go on to show the reader how decision-making will be tackled in this book, as we will do in the rest of this introductory chapter, we will examine these assumptions.

First, can decision-making be studied? One of the authors, when discussing his research work with a senior (and traditionally minded) colleague, was asked what subject he studied. On replying that he studied decision-making, the response was “Is that a subject?” Many readers will not need our prompting to answer that question affirmatively, but it is as well to spell out the nature of our study. It is principally concerned with the determinants of decision – that is to say, what it is that makes us take one course of action rather than another. In some cultural and intellectual traditions there is an easy answer to this question. Extreme forms of Calvinism, for example, itself a particularly severe kind of Protestantism, deny that free will exists; nobody may make decisions, therefore, since everything is fore-ordained by God. Then, as Howard (1980) points out, in an excellent article on the philosophy of analyzing decisions, many Eastern philosophies will not see the study of decision-making as a fruitful endeavor, since in these philosophies one accepts the unfolding of life as it presents itself.

Introduction

This book has three main divisions. The first introduces the major themes, the second studies the conditions under which an efficient equilibrium exists, and the third examines the consequences of rivalry.

The basic tenet is that an efficient equilibrium requires an appropriate combination of both cooperation and rivalry. Under the cost conditions typical of many industries in a modern free-enterprise economy, it is not possible to have efficient results unless there are areas of cooperation among firms and among customers as well as rivalry. This was not fully understood in the last half of the nineteenth century in the United States and is still hotly debated. The purpose of Chapter 2 is to place the debate in its historical setting by discussing the events preceding and following the passage of two major legislative acts, the Interstate Commerce Commission Act of 1887 and the Sherman Antitrust Act of 1890. The proposition that an equilibrium may not exist unless firms are allowed to cooperate in some areas would probably not have been accepted by the supporters of antitrust legislation and railroad regulation even if they had been aware of it. Many proponents of this legislation considered competition as good under all circumstances and did not recognize the complications arising from the new technology: capital intensive methods of manufacturing, mass production and the use of interchangeable parts, improvements in communication and transportation, and so on.

This book looks at the behavior of enterprises, the organization of markets, the structure of industries (particularly scientific ones) by putting the entrepreneurs' and the decision makers' perceptions at center stage. This departure point provides a unifying viewpoint, leads to a close relationship between facts and interpretation, and enables insights for formulation of policies promoting innovations.

The book does not deal with “markets,” “capital,” or “technology,” but looks at the human being and the society in which he lives in order to understand the decisions to compete or not to compete, to bet on new ventures or not, to reorganize the firm or not, and so forth. This departure point stands in sharp contrast with the usual ones treated in the field of “industrial organization,” where firms are frequently treated as a simple-minded “brain,” a decision-making unit that has not much to do but adjust output and prices of one or two products to very simple imagined changes.

So the questions raised will be: What do “firms” do and for what end? How do they compete? Do they always have the motivation to compete? What role exactly do entrepreneurs and managers play? How can they increase productivity and profits?

From words to facts. In previous studies a wide range of evidence on entrepreneurship has been examined: from data on minorities who have been discriminated against, to data on the emergence of the entrepreneurial trait within some well-defined historical circumstances (the Industrial Revolution), to a detailed examination of the relationship between patents (taken as a crude proxy for “novel ideas”) and changes in people's position in the distribution of wealth. The picture that emerged from all the verifications are similar: Within groups that suddenly fell behind, or following periods of deepening depressions, the entrepreneurial trait surfaced (although not always directed toward business, but sometimes toward criminal activities too – as indeed one should expect).

The facts presented in this and in some of the following chapters complement the pictures provided in Brenner (1983, 1985) and also regroup additional, scattered, at times forgotten evidence on entrepreneurship gathered by researchers in numerous disciplines. Before discussing them let's reemphasize some crucial points in the model presented in the previous chapter in order to justify the search for the type of evidence presented next.

First, the model suggests that not “the poor” but those who perceive themselves threatened and falling behind in wealth and status will tend to bet on novel ideas. This implication of the model immediately suggests that one must look at the problem in a historical perspective – both the history of the individual and that of the society within which his expectations were shaped matter.

Introduction

In a contest to name the words most often used by economists, supply, demand, market, and competition would be among the leading contenders. These words represent complex and subtle concepts. I choose them intentionally because they are all intertwined. The relations among them would interest few outside the circle of professional economists were it not that beginning in 1890 with the passage of the Sherman act, the policy of the United States seems to have embarked on a course never before seen among nations. This course was to preserve competition. It developed in a series of additional laws, prosecutions, court decisions, opinions of the attorney general, orders of the Federal Trade Commission, and so on. It has become a potent source of regulation over every part of the economy with many practical consequences. Yet the protection and promotion of competition is not always the motive or the effect of all this activity. Things are not what they seem on the surface. It may be that the results of antitrust policy are explained better by the forces affecting Congress than by economic analysis confined to facts and theoretical reasoning. An example may help clarify my point. Hardly any economist favors tariffs or import quotas. Yet the United States has many of these. Similarly, it is the exception not the rule when Congress makes antitrust legislation on the basis of high principles of welfare economics. The influence of constituents is more important.

Introduction

A self-enforcing agreement between two parties remains in force only as long as each one believes himself to be better off by continuing the agreement than he would be by ending it. It is left to the judgment of the parties themselves to decide whether or not there has been a violation. If one party violates the terms, then the other party has as his only recourse termination of the agreement after he discovers the violation. No third party intervenes to determine whether a violation has taken place or to estimate the damages that may be attributed to such a violation. No third party decides whether a violation has been “will-ful” or “accidental.” A party to a self-enforcing agreement calculates whether the gain from violating the agreement is greater or less than the loss of future net benefits from detection of the violation and the consequent termination of the agreement by the other party.

SOME EMPIRICAL RESULTS

Introduction

Innovation is the term coined and disseminated by Schumpeter to describe the application by entrepreneurs of that new knowledge that raises real per capita income. This happens in two ways. First, firms introduce new products or improve existing ones. These directly benefit their customers. Second, firms learn how to lower their costs of making and distributing existing products. The economy benefits from these changes as well. However, this distinction, better or new products and better or new ways of making them, is more useful as a theoretical device than as an exact description of reality. The fuzzy boundary is illustrated by the use of new products in order to lower production costs.

Actual innovations fall between two extremes. At one extreme, the knowledge of the innovator is secret. No one can learn what he knows or imitate what he does without his consent. It is prohibitively costly for anyone to obtain or copy the new knowledge of the innovator. At the other extreme, anyone who desires can obtain at little or no expense the newly found knowledge of the innovator. The first extreme implies the innovation is a private good and the second that it is a public good. It is hardly novel to remark that valuable new knowledge, costly to discover but costless to copy, poses a free-rider problem.

“If you move from third to second in your area, John [Gutfreund, chairman of Salomon Brothers, Inc.] says you're getting there. If you move from second to first, John says you're vulnerable.” … “But that ethos has its drawbacks: Big risks can mean big losses, and Salomon's approach has created a high-pressure environment that alienates some employees” (McMurray 1984). Frito-Lay, a Pepsi Co., Inc., subsidiary that takes in $2 billion on snack food a year, keeps its lead by coming up with new products. What is inspiring the workers to become innovative and look for the perfect snack? George Reynolds, the potato-chip marketing director, puts it bluntly: “I don't want it on my tombstone that I created the first big potato chip since Ruffles. But I do want to get promoted to president.”

These opinions exactly reflect the meaning of competition that emerges from the views presented in Chapter 1: Some entrepreneurs' and managers' conscious driving against both other business firms and against people who work beside them by innovations. Recall, every business was viewed as being organized for exploiting some ideas.

Innovations and entrepreneurship have been some of the main subjects examined in the previous chapters, and, as pointed out in this concluding one, their promotion must be the focus of policies whose goal is to restore the wealth of nations.

One should not be surprised to learn that such policies, today called “industrial strategies” or “industrial policies,” have always been nationalistic in character and were advocated by some social scientists and politicians when their nation started falling behind. The sudden relative prosperity of others (achieved through innovations) was perceived as a threat by those outdone. And with good reasons: Those who lost ground by being undersold could choose between lowering aspirations (and thus reducing wages and standards of living) or maintain aspirations and then make greater efforts, become more productive and innovative.