The Culture Of Entrepreneurship Promises An Exciting Breakout From Government, Corporatism And Dependency.

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The science of economics has a big problem with vocabulary. It attempts to capture complex concepts in single words and phrases, which only serve to confuse and befuddle and cause arguments. To take a current example, the word “socialism”, for an economist, means state ownership of the means of production (which, in itself, is a good example of clunkiness in economic terminology). But when the country and its journalists and its bloggers argue about socialism and who is or is not a socialist, they’re not arguing about who owns the means of production. They’re arguing about forcible redistribution of people’s income by government, and about the top-down imposition of all-encompassing resource allocation schemes like Green New Deal and Government Health Care. They’re arguing about the role and scope of government and what it means to be free. “Ownership of the means of production” doesn’t help us understand the issues to any great extent.

The opposite of socialism is entrepreneurship. This is another word that comes from economics, and is even harder to define than socialism. The definition of entrepreneurship at the Library Of Economics And Liberty (econlib.org) is 2000 words long. Within those 2000 words, there are references to the many disagreements between economists as to what entrepreneurship really means.

Let’s propose that, instead of defining entrepreneurship, we examine it as a complex and multi-faceted system of individual and social human behavior, and identify its consequences.

Entrepreneurship is the system for the generation of betterment for all in a society characterized wholly or partially by both collaboration and private property.

Entrepreneurship is action. Entrepreneurial individuals, teams or groups are alert to situations where their fellow citizens are dissatisfied with current conditions – when they feel things could be better. Entrepreneurs see this as an economic opportunity: if they take action to devise a new, different and better offering than is currently available, people might buy it to improve their condition, delivering a profit to the entrepreneur. Entrepreneurs do take that action – that’s what separates them from others. There’s a risk in acting. It takes time to design and produce the new offering; the finished product or service may not be as good as the entrepreneur imagined in the design phase; the selling price may not be right; the consumer may have changed preferences over time and no longer wants this new solution, instead preferring someone else’s offering. But whatever the outcome for the individual entrepreneur, the system is a win-win. The consumer ultimately has the choice of the various new offerings, and at least one entrepreneur is rewarded, and society is better off. The entrepreneurs who were not chosen by the consumer in this case will redirect their efforts in another direction until they find the right exchange in which they can reap the reward of the marketplace.

The nature of the entrepreneurial system is that both consumers and producers experience reward when one responds to the other in a way that aligns what the consumer wants with what the entrepreneur can provide. It’s a collaborative win-win, and society (i.e. all the producers and consumers rolled up) progresses and improves. Consumers are more satisfied. Entrepreneurs are more fulfilled. GDP per capita rises. The world gets better.

The system works for everyone.

The econlib.org encyclopedia entry on entrepreneurship informs us that widely cited studies conclude that between one third and one-half of the differences in economic growth rates across countries, states and localities can be explained by differing rates of entrepreneurial activity. Economic growth is the economists’ way of saying “things get better for everybody”.

That’s because the goal of entrepreneurs is to help customers towards better lives, in which they experience feelings of greater satisfaction. When they succeed, the entrepreneurs get paid, i.e. achieve the monetary reward of profit. And they, too, also feel greater satisfaction: a sense of achievement and the expanded horizons that come with success. Entrepreneurs’ personal pursuit of higher aspirations results in consumers’ attainment of higher levels of satisfaction and happiness. Everybody wins.

Entrepreneurship blossoms in a culture that supports it and admires it.

Entrepreneurship requires an institutional and cultural framework in which it can blossom. Primarily, it thrives in political and economic systems that protect and secure private property rights. The entrepreneur must have control over private property in order to transform it into new offerings and solutions for consumers to choose and enjoy. In this case, private property includes their own personal effort and ideas, physical resources and capital, and money to invest.

More broadly, entrepreneurship thrives in a framework of economic freedom: low taxes, minimal regulation constraining entrepreneurial imagination, and an unbiased and rapidly-functioning judicial system to resolve any contract disputes that arise. Empirically, the level of entrepreneurial activity in a country correlates closely with the Economic Freedom Index, a measure of the existence of premarket institutions.

There’s also an important element of how we think about feel about and talk about entrepreneurs and business’s role in our culture. If the culture tags the successful entrepreneur as an exploiter rather than a hero, and emphasizes the inequity of outcomes – some succeed, some don’t – rather than the achievement of those who establish and grow successful firms, then society will turn against those who bring betterment. We must, as Professor Deirdre McCloskey insists, assign dignity to our entrepreneurs.

The main barriers to entrepreneurial productivity are governments and corporatism.

Government action – regulations, subsidies, tariffs, taxes, manipulation of labor markets and financial markets, and so much more – impedes entrepreneurship. Governments limit the scope of entrepreneurial imagination and freedom, by restricting what is possible. They divert the productive efforts of entrepreneurs through taxation, which is the confiscation of the fruits of productivity so that they can be put to unproductive uses. They restrict productivity via regulatory constraints, such as the limitations on the location of new production facilities (think solar energy farms) and the distribution of produced goods (think interstate electricity distribution). Government, by its very nature, is anti-entrepreneurial.

As government gets bigger and more interventionist, it brings into existence new barriers to entrepreneurship. Entrepreneurial action can take place at any organizational scale – single employee companies, small businesses and venture-funded startups, and within medium and large-sized businesses. But, as Michael Munger explains, government distorts the incentives for entrepreneurship by creating conditions in which a dollar invested in lobbying can provide a greater return than a dollar invested in R&D and innovation. If a large corporation can secure the passage of a bill or a regulation or a tax or a tariff that is favorable to its business and unfavorable to competitors, domestic or foreign, it will be tempted to make that investment. R&D is starved, innovation is slowed or stopped, and incumbent corporations are insulated from the creative destruction that entrepreneurs generate and which raises consumer satisfaction through innovative improvement.

If we can restrict government and reduce its level of regulatory and fiscal activity, we will enjoy a double boost in economic productivity because the temptation for corporations to spend money cozying up to regulators and legislators will be reduced, if not removed, and the level of investment in entrepreneurial innovation will be increased.

Entrepreneurship is the antidote to the culture of dependency.

At the level of individual behavior and attitude, the culture of entrepreneurship can be energizing, motivating and fulfilling in ways that the current culture industry of state schools, leftist media and welfare state socialism can never emulate. The entire cultural edifice of government and its associated institutions is dependency. This culture insists that individuals can not be successful without state assistance, welfare, subsidies, and regulatory control. Since our children are continuously and exclusively indoctrinated in this dependency framework from the earliest age in state schools, it is not surprising that most of them never get to experience the joys and rewards of entrepreneurial striving. They feel that they must depend on others, especially the welfare bureaucrats, to achieve whatever goals they are capable of conceiving. As a result, self-reliance, imagination, resourcefulness and entrepreneurial energy are under-developed attributes among our young population. The long-term drift towards suffocating hopelessness and helplessness sometimes feels irreversible.

Yet the spirit of entrepreneurship has not been fully extinguished. We still have some entrepreneurial heroes, despite the cultural repudiation of “millionaires and billionaires”. We still have some supportive branches of our institutional framework, including local small business groups, entrepreneurial business school courses, private online education, incubators, venture capital, private loan platforms, and exchange platforms like Upwork and Angie’s List. Perhaps someday, we’ll be able to extend that list to include pro-entrepreneurship public policy.

Until that day, let’s celebrate every entrepreneur who breaks out from statism, corporatism and dependency.

Ideas Are Not Scarce. Excellent Implementation And Great Execution Are Scarce.

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We gathered together another insightful tweet stream from the entrepreneur’s highest rated economist, Dr. Per Bylund.

The problem of #entrepreneurship is not to come up with a unique idea or product, but to do it well–which means to supply a good or service that is well in line with what consumers value. It is as much about figuring out something new as it is to implement the idea well.

It’s a problem that people believe that the idea is what makes the entrepreneur, whereas the truth is that it is a lot of hard work. Very often the first mover has no advantage, while the second mover learns from the failures of the first mover. Which disproves the idea that profit is about the idea. It is not. Profit is about satisfying consumers’ wants, whether with a new type of good or just a better iteration of an already existing one.

Which means the uncertainty that entrepreneurs face is not about simply being able to “milk” the idea, but about running the business. Consequently, it’s not about only supply or demand, but about positioning what one offers with respect to both. This is why patents, copyrights, and other monopoly privileges are so dangerous: they provide the first mover with all benefits, whether or not they were deserved (meaning whether or not consumers value the offering).

Consider, for instance, if there were no iPads because the Apple Newton received monopoly rights on the modern tablet device market; if there were no iPhones because Windows Mobile received monopoly rights; if there was no VHS, DVD or Blu-ray because betacord received monopoly rights; etc.

First mover, or even the more efficient technology, may not be highest value. Consumers decide, and that’s the point. Entrepreneurs create value for consumers, and if consumers don’t like it entrepreneurs make no money but lose their investment. Then what do patents, copyrights, and other privileges do but cement and prolong the errors of the first mover–which means consumers *could have* received more value, but will not because legal privilege props up the *idea* at the expense of the *value* that’s not created. The loss is not only this difference, but under-utilized resources that could have created more value elsewhere as well as the innovations and elaborations of the new idea that could have satisfied consumers better.

And we’re missing out on the innovations following the first, but inefficient, attempt at a new good. This real loss is enormous. And, to put it bluntly, there really is no reason to reward the first-entrepreneur if s/he does not provide real value to consumers. Doing so is at the expense of society overall.

Definition of Entrepreneurship From Library Of Economics And Liberty

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An entrepreneur is someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit. An entrepreneur who takes the resources necessary to produce a pair of jeans that can be sold for thirty dollars and instead turns them into a denim backpack that sells for fifty dollars will earn a profit by increasing the value those resources create. This comparison is possible because in competitive resource markets, an entrepreneur’s costs of production are determined by the prices required to bid the necessary resources away from alternative uses. Those prices will be equal to the value that the resources could create in their next-best alternate uses. Because the price of purchasing resources measures this opportunity cost— the value of the forgone alternatives—the profit entrepreneurs make reflects the amount by which they have increased the value generated by the resources under their control.

Entrepreneurs who make a loss, however, have reduced the value created by the resources under their control; that is, those resources could have produced more value elsewhere. Losses mean that an entrepreneur has essentially turned a fifty-dollar denim backpack into a thirty-dollar pair of jeans. This error in judgment is part of the entrepreneurial learning, or discovery, process vital to the efficient operation of markets. The profit-and-loss system of capitalism helps to quickly sort through the many new resource combinations entrepreneurs discover. A vibrant, growing economy depends on the efficiency of the process by which new ideas are quickly discovered, acted on, and labeled as successes or failures. Just as important as identifying successes is making sure that failures are quickly extinguished, freeing poorly used resources to go elsewhere. This is the positive side of business failure.

Successful entrepreneurs expand the size of the economic pie for everyone. Bill Gates, who as an undergraduate at Harvard developed BASIC for the first microcomputer, went on to help found Microsoft in 1975. During the 1980s, IBM contracted with Gates to provide the operating system for its computers, a system now known as MS-DOS. Gates procured the software from another firm, essentially turning the thirty-dollar pair of jeans into a multibillion-dollar product. Microsoft’s Office and Windows operating software now run on about 90 percent of the world’s computers. By making software that increases human productivity, Gates expanded our ability to generate output (and income), resulting in a higher standard of living for all.

Sam Walton, the founder of Wal-Mart, was another entrepreneur who touched millions of lives in a positive way. His innovations in distribution warehouse centers and inventory control allowed Wal-Mart to grow, in less than thirty years, from a single store in Arkansas to the nation’s largest retail chain. Shoppers benefit from the low prices and convenient locations that Walton’s Wal-Marts provide. Along with other entrepreneurs such as Ted Turner (CNN), Henry Ford (Ford automobiles), Ray Kroc (McDonald’s franchising), and Fred Smith (FedEx), Walton significantly improved the everyday life of billions of people all over the world.

The word “entrepreneur” originates from a thirteenth-century French verb, entreprendre, meaning “to do something” or “to undertake.” By the sixteenth century, the noun form, entrepreneur, was being used to refer to someone who undertakes a business venture. The first academic use of the word by an economist was likely in 1730 by Richard Cantillon, who identified the willingness to bear the personal financial risk of a business venture as the defining characteristic of an entrepreneur. In the early 1800s, economists Jean-Baptiste Say and John Stuart Mill further popularized the academic usage of the word “entrepreneur.” Say stressed the role of the entrepreneur in creating value by moving resources out of less productive areas and into more productive ones. Mill used the term “entrepreneur” in his popular 1848 book, Principles of Political Economy, to refer to a person who assumes both the risk and the management of a business. In this manner, Mill provided a clearer distinction than Cantillon between an entrepreneur and other business owners (such as shareholders of a corporation) who assume financial risk but do not actively participate in the day-to-day operations or management of the firm.

Two notable twentieth-century economists, Joseph Schumpeter and Israel Kirzner, further refined the academic understanding of entrepreneurship. Schumpeter stressed the role of the entrepreneur as an innovator who implements change in an economy by introducing new goods or new methods of production. In the Schumpeterian view, the entrepreneur is a disruptive force in an economy. Schumpeter emphasized the beneficial process of creative destruction, in which the introduction of new products results in the obsolescence or failure of others. The introduction of the compact disc and the corresponding disappearance of the vinyl record is just one of many examples of creative destruction: cars, electricity, aircraft, and personal computers are others. In contrast to Schumpeter’s view, Kirzner focused on entrepreneurship as a process of discovery. Kirzner’s entrepreneur is a person who discovers previously unnoticed profit opportunities. The entrepreneur’s discovery initiates a process in which these newly discovered profit opportunities are then acted on in the marketplace until market competition eliminates the profit opportunity. Unlike Schumpeter’s disruptive force, Kirzner’s entrepreneur is an equilibrating force. An example of such an entrepreneur would be someone in a college town who discovers that a recent increase in college enrollment has created a profit opportunity in renovating houses and turning them into rental apartments. Economists in the modern austrian school of economics have further refined and developed the ideas of Schumpeter and Kirzner.

During the 1980s and 1990s, state and local governments across the United States abandoned their previous focus on attracting large manufacturing firms as the centerpiece of economic development policy and instead shifted their focus to promoting entrepreneurship. This same period witnessed a dramatic increase in empirical research on entrepreneurship. Some of these studies explore the effect of demographic and socioeconomic factors on the likelihood of a person choosing to become an entrepreneur. Others explore the impact of taxes on entrepreneurial activity. This literature is still hampered by the lack of a clear measure of entrepreneurial activity at the U.S. state level. Scholars generally measure entrepreneurship by using numbers of self-employed people; the deficiency in such a measure is that some people become self-employed partly to avoid, or even evade, income and payroll taxes. Some studies find, for example, that higher income tax rates are associated with higher rates of self-employment. This counterintuitive result is likely explained by the higher tax rates encouraging more tax evasion through individuals filing taxes as self-employed. Economists have also found that higher taxes on inheritance are associated with a lower likelihood of individuals becoming entrepreneurs.

Some empirical studies have attempted to determine the contribution of entrepreneurial activity to overall economic growth. The majority of the widely cited studies use international data, taking advantage of the index of entrepreneurial activity for each country published annually in the Global Entrepreneurship Monitor.These studies conclude that between one-third and one-half of the differences in economic growth rates across countries can be explained by differing rates of entrepreneurial activity. Similar strong results have been found at the state and local levels.

Infusions of venture capital funding, economists find, do not necessarily foster entrepreneurship. Capital is more mobile than labor, and funding naturally flows to those areas where creative and potentially profitable ideas are being generated. This means that promoting individual entrepreneurs is more important for economic development policy than is attracting venture capital at the initial stages. While funding can increase the odds of new business survival, it does not create new ideas. Funding follows ideas, not vice versa.

One of the largest remaining disagreements in the applied academic literature concerns what constitutes entrepreneurship. Should a small-town housewife who opens her own day-care business be counted the same as someone like Bill Gates or Sam Walton? If not, how are these different activities classified, and where do we draw the line? This uncertainty has led to the terms “lifestyle” entrepreneur and “gazelle” (or “high growth”) entrepreneur. Lifestyle entrepreneurs open their own businesses primarily for the nonmonetary benefits associated with being their own bosses and setting their own schedules. Gazelle entrepreneurs often move from one start-up business to another, with a well-defined growth plan and exit strategy. While this distinction seems conceptually obvious, empirically separating these two groups is difficult when we cannot observe individual motives. This becomes an even greater problem as researchers try to answer questions such as whether the policies that promote urban entrepreneurship can also work in rural areas. Researchers on rural entrepreneurship have recently shown that the Internet can make it easier for rural entrepreneurs to reach a larger market. Because, as Adam Smith pointed out, specialization is limited by the extent of the market, rural entrepreneurs can specialize more successfully when they can sell to a large number of online customers.

What is government’s role in promoting or stifling entrepreneurship? Because the early research on entrepreneurship was done mainly by noneconomists (mostly actual entrepreneurs and management faculty at business schools), the prevailing belief was that new government programs were the best way to promote entrepreneurship. Among the most popular proposals were government-managed loan funds, government subsidies, government-funded business development centers, and entrepreneurial curriculum in public schools. These programs, however, have generally failed. Government-funded and -managed loan funds, such as are found in Maine, Minnesota, and Iowa, have suffered from the same poor incentives and political pressures that plague so many other government agencies.

My own recent research, along with that of other economists, has found that the public policy that best fosters entrepreneurship is economic freedom. Our research focuses on the public choice reasons why these government programs are likely to fail, and on how improved “rules of the game” (lower and less complex taxes and regulations, more secure property rights, an unbiased judicial system, etc.) promote entrepreneurial activity. Steven Kreft and Russell Sobel (2003) showed entrepreneurial activity to be highly correlated with the “Economic Freedom Index,” a measure of the existence of such promarket institutions. This relationship between freedom and entrepreneurship also holds using more widely accepted indexes of entrepreneurial activity (from the Global Entrepreneurship Monitor) and economic freedom (from Gwartney and Lawson’s Economic Freedom of the World) that are available selectively at the international level. This relationship holds whether the countries studied are economies moving out of socialism or economies of OECD countries. Figure 1 shows the strength of this relationship among OECD countries.

The dashed line in the figure shows the positive relationship between economic freedom and entrepreneurial activity. When other demographic and socioeconomic factors are controlled for, the relationship is even stronger. This finding is consistent with the strong positive correlation between economic freedom and the growth of per capita income that other researchers have found. One reason economic freedom produces economic growth is that economic freedom fosters entrepreneurial activity.

Figure 1 Economic Freedom and Entrepreneurship in OECD Countries, 2002

ZOOM

 

Economists William Baumol and Peter Boettke popularized the idea that capitalism is significantly more productive than alternative forms of economic organization because, under capitalism, entrepreneurial effort is channeled into activities that produce wealth rather than into activities that forcibly take other people’s wealth. Entrepreneurs, note Baumol and Boettke, are present in all societies. In government-controlled societies, entrepreneurial people go into government or lobby government, and much of the government action that results—tariffs, subsidies, and regulations, for example—destroys wealth. In economies with limited governments and rule of law, entrepreneurs produce wealth. Baumol’s and Boettke’s idea is consistent with the data and research linking economic freedom, which is a measure of the presence of good institutions, to both entrepreneurship and economic growth. The recent academic research on entrepreneurship shows that, to promote entrepreneurship, government policy should focus on reforming basic institutions to create an environment in which creative individuals can flourish. That environment is one of well-defined and enforced property rights, low taxes and regulations, sound legal and monetary systems, proper contract enforcement, and limited government intervention.

https://www.econlib.org/library/Enc/Entrepreneurship.html

About the Author

Russell S. Sobel is a professor of economics and James Clark Coffman Distinguished Chair in Entrepreneurial Studies at West Virginia University, and he was founding director of the Entrepreneurship Center there.

23. Per Bylund on Entrepreneurial Strategy

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Business strategy in books and business schools has tended to towards metaphors of sports or war. There are playing fields or battlefields, and the strategy question is “Where to play, and how to win?” In other words, it’s a competitive strategy, where one firm wins and others lose, within some pre-set boundaries of industry structure. This is hardly useful for the start-up or SME entrepreneur, or indeed for any executive in any company who is dedicated to delivering customer value.

Austrian entrepreneurship, built on foundations from Austrian Economics, focuses on the strategic question of how to facilitate customer value. That requires a 100% focus on the customer — not competitors or industry structures. Per Bylund explains how adherence to this one core principle drives a very different approach to business strategy.

Show Notes

Strategy in business schools is about how to gain a competitive advantage. Austrian entrepreneurs think differently — they are constantly probing their own customer understanding rather than thinking about competition. An entrepreneur’s time is his or her most valuable resource, and they don’t waste it thinking about other entrepreneurs. Competition is usually understood as a firm’s relative position in a well-defined industry. It’s an idea from the economics of the early 20th century, when economists were thinking about market structures like oligopolies producing near-identical goods and services, and how firms performed within these structures. 21st century entrepreneurs don’t think that way.

Entrepreneurs pursue uniqueness: to become the customer’s choice by delivering the greatest value. Entrepreneurs spend their strategy time focused externally on customers and target customers. They are the ones who create value, in the form of an experience of satisfaction or pleasure. The entrepreneur’s task is to facilitate that value experience by offering a product or service that will be perceived as valuable. If the customer is dissatisfied with the status quo, then the entrepreneur’s strategy is to bring to market a solution that eliminates that felt dissatisfaction.

Deep understanding and deep empathy are the entrepreneur’s strategy tools. How can entrepreneurs facilitate value, if customers are the only ones who can create it? The answer lies in deep understanding of customers at the emotional level — how they feel. There is no shortage of data to help shed light: just initiate a conversation with them and they’ll talk about their dissatisfactions and hopes and concerns. They won’t design new products and services for you — that’s the entrepreneur’s job. But the application of deep empathy — truly understanding how the customer feels by seeing things from their perspective rather than yours — will take you to the level of understanding that’s required. If you are really, really good at this — in fact, if you can make it a unique capability — then you’ll realize success. Empathy is the best strategy.

Austrian entrepreneurs are rivals with each other for the customer’s dollar. Entrepreneurs’ continuous striving for uniqueness enables more and more satisfying and valuable customer experiences. All entrepreneurs are rivals — to do a better job of facilitating value for customers. If the customer buys a new digital printer rather than a new dress, the printer maker and the dressmaker are rivals. The dressmaker is stimulated to raise their game in value facilitation so that, next time, the customer buys the dress instead of, say, a bathroom rug.

There are some tools for customer understanding. The best one is conversation. We discussed various research techniques and tools such as the Voice Of The Customer, a method of data and information collection across all kinds of knowledge categories, capable of analysis and potentially leading to insightful interpretation. Dr. Bylund thought these tools worthwhile, but with the risk of being too formalistic. The Austrian route to deep understanding is one-on-one conversation: talking with customers about their feelings and their lives and their preferences, and perhaps getting them to discuss a prototype or rough description of a product or service. Numerical surveys and quantitative analysis are less useful.

Voice of the Customer Tool

There are also tools for internal allocation of resources to support uniqueness of products and services. We discussed the VRIN principle: reviewing the resources and capabilities of the entrepreneurial firm to ensure they are:

V – Value-creating: how much does a resource or capability or software feature or service element directly contribute to facilitating a valuable experience for the customer.

R – Rare: to achieve your uniqueness in delivering value, look for resources and capabilities that are unique, or at least rare. These could be particularly skillful individuals on the team or processes and recipes developed over time that are uniquely refined and uniquely aligned with the value preferences of your target customers.

I – Inimitable: if your capability can be imitated with a similar (but perhaps not identical) feature that delivers the same level of customer value, then your uniqueness is temporary.

N – Non-substitutable: if you are able to preserve uniqueness, but customers find they can substitute an alternative about which they feel just as good, then you are marketplace position in not sustainable. Customers can sometimes find value not only in direct substitutes but also indirect substitutes — like choosing a glass of wine over a glass of beer. Your unique beer recipe isn’t non-substitutable.

The VRIN formula is a useful lens to look at your internal capabilities. But Dr. Bylund stressed again and again that the strategy answer can not be found inside the company. Entrepreneurs must only think about the customer, and how to facilitate the greatest possible value for them. It’s the only way to build and sustain a business. Always reinvent and innovate. Always look for some new value that you can deliver. Keep talking to the customer, keep tapping into the infinite resource that their dissatisfactions represent — just ask them, they’ll tell you.

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22. Steven Phelan on Managing Expectations

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Entrepreneurs operate in the future. They imagine a future where lives are improved because dissatisfactions are removed and there’s greater well-being to enjoy. Everyone can embrace that future. So what could go wrong?

Well, your customer may expect more than they feel they actually get, so they stop being a customer. Investors and bankers may expect you to get to your next milestone faster, putting you in a race to recover their confidence. Suppliers may expect a better relationship than they actually experience, and they become more difficult to deal with. And heck, you didn’t expect all this angst, so you are dealing with your own disappointments.

What’s the commonality here? Mis-managed expectations. Steve Phelan reckons you might spend half your time as an entrepreneur on the task of expectations management. If you can do it well, it’s a resource for you. Follow these management steps.

To comment, ask questions or interact in any way, join us at mises.business/group, our LinkedIn Group Page.

Show Notes

Definition: Expectations management is actively and purposefully changing someone’s opinion about the value of a resource or asset. 

For example, many start-up or growing businesses suffer from a perception liability of newness or smallness. Target customers or potential investors or even potential employees might have a negative expectation about the company’s future prospects, which might present a barrier to securing capital or resources. You need to overcome the risk premium of smallness/newness in their eyes. You do so through expectations management.

Expectations Management Infographic

At the outset, when you are identifying your entrepreneurial opportunity and polishing your idea for a new business, a new project, or a new expansion phase, the expectations that most require management are your own. Get help. 

Entrepreneurs are confident, action-oriented people. Confidence is good – but research indicates that entrepreneurs are often over-confident about their plans. Steve Phelan calls this the Identification Phase, the point at which the entrepreneur forms the belief that arranging a new set of resources to serve customers in new and better way will achieve a profit.

While start-up entrepreneurs tend to over-confidence, those in business over 5 years tend to demonstrate tighter control over their expectations about what’s possible. So experience can be a good expectations management tool. But, if you don’t have the experience, try to gather more perspective from people who have. Assemble an extended team, even if it’s only by e-mail or Slack. Ask them to share their experience to substitute for your own experience gaps.

When you’re assembling resources, your goal is to give the right impression of a solid plan, trustworthy management, and a well-paced path to profits.  

Your target audience may be investors, whether friends and family or venture capital, or credit providers, like banks. In addition to the quality of your plan, your ability to manage expectations is also influenced by soft skills such as presentation style, and environmental variables such as how you dress. As always, the entrepreneur’s go-to tool is empathy. Take the time to learn about your audience’s history and preferences and form a clear idea about their goals and motivations. VC’s are portfolio managers – show them you fit. Bankers want zero defaults – assure them you can easily clear that bar.

If you are managing potential employees’ expectations, try to be sure you know how they form them. Are they thinking about future equity and getting rich? Or is security a higher preference for them? What about commuting versus working from home? What improvement over their current job are they are expecting? In order to manage expectations, you need to know and understand what the target audience expects.

In your growth phase, expectations management shifts to customers. They form their expectations entirely subjectively, and your task is to align with them emotionally. 

Austrian economists understand that it is customers who create value – it’s a consequence of their satisfaction, which only they can determine. In fact, they form satisfaction expectations in advance, based on your value proposition. If their experience is less than their expectation, they’ll be disappointed, even if your product or service performed well. Therefore, expectations management with customers is a matter of alignment.

If you operate a B2B business, the alignment vector is always trust. Customers are taking a risk when they embrace a new supplier or a new idea or a new product. Trust helps them embrace that risk. What is the signal of trust that will make the difference? Can it be influenced by guarantees or warranties? How can you demonstrate that the service level you promise will be the service level you deliver? And take the time required to identify the customer’s transaction cost (the cost of taking on a new supplier) and opportunity cost (what’s the alternative to your service). Be sure to address those two costs directly.

At some point, you will prefer to release assets. This is the time to manage expectations upwards. 

The exit stage may apply to selected assets – for example, you may want to reshuffle your capital structure by selling some and buying others – or you may be exiting a business by selling it. Steve Phelan had two pieces of advice for the exit stage. One was directed at the entrepreneur’s own expectations – to think about exit at the purchase stage (“making money on the buy”) so that there’s an advance plan for a realistic exit price. The second was to let multiple bidders be the influencers of each other’s expectations. Otherwise, you’ll need a strong case to manage expectations to be higher than the market average. For a hard asset, you may have to demonstrate how your ownership was a positive contributor to value – e.g. a superior maintenance regimen. For a financial asset, you may have to demonstrate the opposite – that new ownership can get a higher return. For example, entrepreneurs selling a business to a strategic buyer must create the expectations that the greater resources of the new owner can accelerate growth, reduce costs or increase profitability.

Do’s and don’ts. 

Manage expectations every day. Where are they set in the minds of others? Do they need adjusting?

Don’t create negative expectations (e.g. by failing to meet deadlines or over-promising). Don’t ignore inputs or advice. Don’t set expectations that can’t possibly be attained.

Your brand is not just your promise. It’s keeping your promise.

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21. Peter Klein on Transaction Costs

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Are you transaction cost-savvy? Peter Klein explains why it’s important.

We emphasize profitable value creation as the role of the entrepreneur. Managing costs can contribute to profitability – but there are some costs that are not easy to calculate and not even that easy to identify in some cases. They are not captured by traditional cost accounting. Economists call them transaction costs. They are the costs of acquiring, assembling, monitoring and managing and, in some cases, discarding or re-purposing the resources and assets your firm utilizes to produce output. They are not production costs per se; they are not value creation costs. They’re administrative and managerial costs.

Peter Klein explains:

Show Notes

Think of any transaction, like buying a cup of coffee at a Starbucks store. Now think of all the economic costs of that transaction above and beyond the actual dollars you hand over to the barista.

There’s the cost of traveling to the store, in both time and money (gasoline if you drive) and wear and tear on your vehicle. There is time spent on studying the menu, explaining your choice and waiting for delivery – and time is the entrepreneur’s most precious scarce resource.

Now apply that same thinking to the acquisition of any resource you want to bring into the firm to support your business model. There are many transaction costs in addition to the purchase price.

There is the time taken to research features and attributes, and comparative pricing. There may be negotiation or haggling with the vendor. There may be legal costs in a contracting process. There may be integration costs to fit the new resource into your production chain. If you’re buying from a wholesaler, there are issues of timely delivery and accurate order fulfillment you must monitor and manage. If the new resource is an employee you are hiring, there are advertising, interviewing and negotiation costs, as well as the benefits package that accompanies the salary agreement. All of these transaction costs, across the entirety of your business, add up to an amount that is pretty significant.

And, once you own the resource, transaction costs don’t disappear. They transform into monitoring and management costs.

Peter used the example of Walmart’s trucking fleet. Walmart owns many trucks and the drivers are employees. There are extensive monitoring costs associated with the ownership of these resources and the employment of the drivers and mechanics and service technicians. This group of costs can be characterized as the cost of confidence that you are getting the performance that you want out of the resource you own. In the case of Walmart’s truck fleet, these costs include monitoring the vehicles themselves (location, speed, downtime, tons hauled, gasoline used, etc), the drivers’ productivity, the maintenance burden, delivery accuracy and many more metrics. Walmart employs people and uses technology assets to implement all this monitoring, and those monitoring resources are not really creating value; they’re supervisory overhead.

Another kind of transaction cost arises when you decide you want to recombine, reshuffle or discard assets, or to use them in a new way.

In the entrepreneur’s uncertain business environment, it’s never certain that the asset you have acquired or the people you have hired are always going to be perfectly tuned to your business model. Circumstances change, and you want to make adjustments. Is the asset adjustable? Does the employee have exactly the skills you want for a new process or method? Will you be able to reprogram the asset or redirect the employee to a new job function? In many cases, you might have need of the legal system for a revised contract (legal costs are transaction costs), or there may be regulations preventing you from closing a plant or laying off workers. Any time you are constrained from making the adjustments you want at the speed you prefer, you are facing transaction costs. Could you have anticipated the situation when you first contracted for the resource or first hired the worker? Probably not – but trying to do so would be a transaction cost in itself!

Often, the issues raised by the problems of transaction costs are characterized as “make versus buy” decisions. Or rent versus own. Or in-house versus outsource.

It seems that there is a tendency today towards organizational models that are asset-lite, with a lot of the control that the firm seeks to exert over resources being exercised through renting or outsourcing, or by utilizing independent contractors rather than directly hiring employees. (Actually, Peter disputes this, suggesting that many such business models get a lot of publicity but there is no general tendency across multiple business sectors.) Does a virtual organization chart or a network model compared to a hierarchical model always have lower transaction costs?

Not necessarily. Compare Amazon, which mostly utilizes FedEx and UPS and USPS to make deliveries. Amazon still has many of the monitoring costs that Walmart has – it’s just that they are monitoring an outside vendor. Yes, FedEx and UPS bring their own tracking systems and technologies, but Amazon can’t afford to let its vendors go un-monitored.

In fact, in-house transaction costs are declining at the same speed as outsourced transaction costs.

With the advent of software HR and CRM systems and other kinds of monitoring and management technologies, internal transaction costs are not as burdensome as they were in the past. It would be unwise to make the automatic assumption that in-house transaction costs are always higher than outsourced costs.

Transaction Costs Types

Actionable Insight

So what’s the answer for entrepreneurs? There’s no simple formula, just the admonition to be transaction cost savvy. In every situation where there are alternative scenarios, the savvy entrepreneur thinks through the transaction costs of each one, and makes a best estimate of the economic costs. He or she thinks about the present costs, the future ongoing monitoring costs, and the potential costs when there is a future adjustment to be made.

Always relate this economic calculation of transaction cost alternatives to the creation of customer value. What is the best alternative transactional mode or organizational mode to deliver value to the customer, today, tomorrow and a year from now? What is the cost of the resource control you need in order to deliver value, especially if customer preferences change and you want to change with them?

Download our transaction cost checklist to help you become transaction cost savvy.

Buy Peter Klein’s book Organizing Entrepreneurial Judgement on Amazon.

Here are extra links to information that Peter Klein mentioned in the podcast:

An article Peter wrote to commemorate Oliver Williamson’s Nobel Prize – he is the originator of “transaction cost economics,” which is closely related to today’s discussion topics, though not directly dealing with entrepreneurship.

A longer, more academic survey on transaction costs – may be a useful reference.

Also, listeners may enjoy the comments on this blog post.

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