Plate ii in print

The Entrepreneur

Knight; the firm as the bearer of uncertainty, the entrepreneur who guarantees the wage and claims the residual, and profit as the reward for shouldering the risk no one could price.

The promise is made before the sale; the remainder is known afterward.

— the argument of this plate, after Knight (1921) and Coase (1937)

The workshop pays its people before it knows what their work will fetch. Its orders may disappoint; the product may find a public that nobody expected. The wage is an obligation named in advance. The owner's remainder is whatever the undertaking leaves after its obligations have been met. Between those two ways of receiving an income lies the entrepreneur's wager. Someone commits resources to an opinion about the future and accepts a claim whose amount the future will decide. The arrangement can give the worker a steadier income and the enterprise a person responsible for choosing its course. It does not make the future certain, or promise that the remainder will be a reward.

Frank Knight distinguished a risk whose probabilities could be measured from an uncertainty for which no dependable distribution was available. A new undertaking may have precedents without having a known set of odds. Its founder still forms an estimate, compares alternatives, and offers prices; uncertainty does not make judgment impossible. It makes judgment something other than reading a settled actuarial table. Nor does knowing a probability by itself remove the cost of a loss: pooling depends on the exposures and the terms on which someone will carry them. Knight's entrepreneur undertakes the less mechanical business of deciding which productive commitments are worth making when the estimate itself can be wrong. The residual is where the difference between that estimate and the realized account appears.1

1. Frank H. Knight, Risk, Uncertainty, and Profit (1921), Part III, ch. VIII, opening distinction and qualifications; ch. IX, on enterprise and profit. A subjective estimate can guide conduct without becoming a known frequency.

Suppose the workshop promises 60 units in wages and buys 40 units of other inputs. Its receipts will be 140 in one possible outcome and 80 in another. The owner's cash remainder is therefore 40 or minus 20. In the second outcome, keeping those promises requires 20 from elsewhere; the existence of a deficit does not supply the funds to cover it. Now allow 15 for the owner's own labor and capital at the returns available to them elsewhere. Economic profit becomes 25 or minus 35. The cash left in the till and the gain above all opportunity costs answer different questions. Neither pair of numbers tells us the expected result without probabilities. Even an expectation calculated from a founder's beliefs would be an assessment made before the venture, not an income guaranteed by the venture.2

2. The figures are an illustrative one-period account, with no taxes, discounting, or additional financing charges. The 15-unit allowance is an opportunity cost, not another cash payment. Knight, ch. IX, distinguishes the entrepreneur's residual from the remuneration of resources he supplies himself.
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The person who shoulders that account need not possess every relevant skill. She may employ an engineer to judge a machine, a merchant to judge a market, and a manager to organize the working day. She must then judge the judgments she purchases. A successful decision can owe something to knowledge and something to a favorable event; the receipt does not separate them. A failed decision can have been reasonable on the information available. Profit consequently gives the enterprise a test it cannot safely disregard, without giving the historian a complete measure of foresight or the philosopher a complete measure of desert. A founder may contribute useful judgment and still lose money. Several founders may each expect to gain while their enterprises, taken together, fail to earn the return they anticipated.3

3. Knight, ch. IX, on judgment, confidence, luck, and the delegation of judgment, including his distinction between an individual's expected gain and realized profit. His argument allows entrepreneurial losses; uncertainty-bearing is not a theorem that every entrepreneur earns a positive premium.

There is also a difference between promising an income and making it secure. The worker's wage can be fixed while its payment remains exposed to the firm's ability to pay. A supplier can have an agreed invoice and still depend on the buyer's survival. The owner may put substantial resources behind the promises without putting unlimited resources behind them. If the enterprise exhausts what it can obtain, some of its uncertainty reaches the people whom the contract was intended to shelter. The distribution of that loss depends on the actual claims and their enforcement. The residual claimant is therefore a particular place in the arrangement, not necessarily its only bearer of danger. Knight himself ended the chapter on enterprise by allowing that guarantees are incomplete and uncertainty is shared.4

4. Knight, ch. IX, concluding discussion of divided entrepreneurial functions and incomplete guarantees. This plate makes no claim about a particular jurisdiction's insolvency priorities or about which assets a particular owner has pledged.

Coase pressed a further question. A purchaser can promise a contractor a fixed payment for a specified delivery without acquiring the right to direct the contractor's working day. Bearing the uncertainty of the eventual sale does not, by itself, explain why the purchaser must employ the producer. Knight illuminates the relation between judgment, commitments, and the remainder; an account of the firm's boundary must also explain the choice between buying a result and organizing its production. In our workshop, the same 60-unit payment could purchase an agreed output or a bounded power to assign work. The two bargains can place similar financial exposure on the purchaser while leaving different decisions inside her authority. Who carries the uncertain receipts and who directs the productive acts are related questions, but their answers must be worked out separately.5

5. R. H. Coase, “The Nature of the Firm”, Economica 4 (1937), §III, pp. 398–401. His criticism concerns the inference from uncertainty and guaranteed payment to managerial direction.

The entrepreneur thus gives the firm a center of commitment, but not an explanation sufficient for every feature of its constitution. The wage, the loan, the supplier's invoice, and the ownership claim distribute different parts of a future nobody fully commands. Their terms influence whose judgment can become action and whose resources make that action possible. The firm must arrange those commitments before it learns how well they fit the world. It must also live with what the commitments subsequently do to the parties who made them. A specialized machine can cease to have an alternative buyer; a learned skill can cease to have an alternative employer. The next plate follows this second difficulty: a venture may survive the uncertain future only to discover that its participants have become indispensable to one another.