How the heterogeneity of capital and risk affect business organisation

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Capital and risk have a different orientation in Austrian Economics .The two are better understood when we consider the role of the entrepreneur in the business process. Austrian Economists believe that the entrepreneur must own capital assets to be able to initiate investment decisions and also the idea of how to put to use a particular asset rests in his mind .It follows from this that capital assets may not be in only one form and may be put to varied uses. This is a central theme upon which this essay is built. It follows from arguments by Menger (1871) on the order of capital goods and capital as time dimensioned and heterogeneous assets (Kirzner, 1966, 1973, 1997) The essay shows how all these contributions from the above mentioned Austrian Economist and others explain how the diversity ( heterogeneity) of capital and risk affect business organization. The idea of heterogeneous capital rides on the back of the Austrian idea of entrepreneurship

Capital and Risk Defined

Neo-classical economists consider capital to be a distinct and separately identifiable factor of production which role in the production function is to provide the wherewithal to combine the other factors of production. The commonest form is money capital .In the traditional theory of the firm, technology which is considered a factor of production is deemed to be constant and cannot be increased or changed within the short term. According to that theory technology is therefore not considered as part of the capital contribution to the firm.

Risk in business refers to a condition or business activity in which there is a chance or probability that the eventual outcome may be different from the planned scenario. The business man or entrepreneur or decision maker may not know the eventual outcome with certainty but may have possible scenarios from which to expect the eventual outcome. It is therefore safe to assume that any individual in this position with the same detail of information knowledge can arrive at the same prediction. Austrian Economics school of thought views risk from a different perspective. Von Mises in his book Human Action asserts that economic action is a human act and therefore an individual act which future is indeterminable from the start of the act. He further asserts that "probabilities can only be defined ex post as learned through experience and cannot exist priori. Mises distinguishes between case probability and class probability and he defines "……case probability or uncertainty as a case in which probabilities in the frequentist sense do not exist" [1] 

It is the view of the Austrian writers that business risk faced by the entrepreneur belongs to this case probability and therefore indeterminate when he needs to take decisions to deploy capital. Capital and risk are so related because risk affects return on capital.

The view of the Austrian school of Economics on capital is a heterogeneous bundle of goods which are different in terms of value and in terms of timing in the resource deployment process.

The Austrians are of the view that capital assets are not the same in terms of their contribution to the production process, that they can be deployed at different stages of the production process and that their definition should not be determined based on their physical properties but rather how useful they are to the production process and at what time that they are required to be used.

Menger (1871) argues that value of all goods is determined by their ability to satisfy consumer wants. He identifies lower order goods and higher order goods. Menger showed that the value of the higher-order goods is given ("imputed") by the value of the lower-order goods they produce. Moreover, because certain capital goods are themselves produced by other, higher-order capital goods, it follows that capital goods are not identical, at least by the time they are employed in the production process" [2] 

Kirzner's work on capital reveals one feature of the entrepreneurial process as a grey area because business ventures are subjective plans conceived by the entrepreneur and continually modified by him according to the profit potential that they hold "Capital goods should thus

be characterized, not by their physical properties, but by their place in the structure of production

as conceived by entrepreneurs [3] ,

The importance of capital in the production process is influenced by how well capital goods are actively traded either in an organized market or exchange. The value placed on each capital asset is a subjective expression by a particular entrepreneur without any basis for determining or validating such value. The price quoted for the capital goods is determined by how much future profit or cash flow the entrepreneur intends to make out of the capital good.

.( P 5 of DRUID Working Paper No 02-01 Heterogeneous Capital, Entrepreneurship, and Economic Organization Kirsen Foss, Nicolai Foss, Peter G. Klein & Sandra K. Klein20. December 2001)

This definition of capital accepted by the Austrians imply that it is the entrepreneur who knows to which use he can put any capital assets and by extension its value. It is also correct to infer that the value of capital will change in the course of the production process. The role of the entrepreneur in understanding the definition of capital and its contribution to the capital theory is very paramount

Capital as heterogeneous

Now we infer from our introduction that capital is so defined in terms of its value and time of use in the production process. Capital is considered as heterogeneous by virtue of the fact that it has several attributes and that these attributes are varied and cannot be determined completely at any time. The attributes depend on the use which also varies with time. Peter Klein in his book (The Capitalist and the entrepreneur-page 111) defines capital attributes as "characteristics, functions, or possible uses of assets as perceived by the entrepreneur" [4] . These attributes are not known to the entrepreneur and that some of them may also be too expensive to attempt to measure. Attributes also vary over time. Therefore the holder of a capital asset at any point in time is the best placed person to know its value.

Entrepreneurs must own these assets to be able to use them in the view of the Austrians. These entrepreneurs lack a perfect knowledge of the attributes of capital therefore the argument holds that entrepreneurs trade in the physical assets and not the attributes. One must own an asset to be able to enjoy the future cash flow from its use. This conclusion is compatible with modern day business definition of an asset where the owner is so defined because s/he has the right to future cash flows from the use of that asset .It can be concluded that because all the attributes of a capital asset cannot be known at a go, the entrepreneur may need to undertake a trial and error session with different combinations of the capital and other factors in order to explore all other available attributes in the asset.

Capital heterogeneity and business organization

Capital heterogeneity affects the costs of doing business i.e., transaction cost. Central to the capital theory of the Austrian school is the role of the entrepreneur in taking initial decisions on capital deployment. If capital goods were similar in terms of their attributes all the entrepreneur does is to choose from a set of similar goods. The most relevant decision under such a scenario will be to choose either to deplore more capital relative to labour (capital intensive) or more labour relative to capital (labour-intensive) after all it is irrelevant which capital good is deployed since they have same characteristics. The only cost we could envisage in this case will be contractual manpower costs that are cost incurred to negotiate and draft various contracts.

There will be no need to monitor the capital assets because they are homogeneous

Because capital is heterogeneous, there is the need to monitor it at various stages of the production process because whoever possesses it at any point in time discovers the attributes and its value. Therefore costs will need to be incurred initially to ascertain some determinable attributes which will inform the initial investment decision. This could be in the form of consultancy fees paid to subject experts and technicians for evaluations on business ideas and the like .Because the use to which the entrepreneur intends to put the capital assets depends on what he has conceived, he must be able to articulate this so well to the management of the enterprise so that they can all be on the same page with where the business is going. This is not so easily attainable because of the conflicts of interest between principal (owners) and agents (managers) and this is where substantial transaction costs are incurred in business. The costs of internal and external auditors and various structures in corporate governance that seek to ensure that the entrepreneur's investment is put to use in the very way it was intended is part of the transaction costs incurred as a result of the fact that the capital in the hands of the managers has heterogeneous attributes and that the managers have the power to alter the entrepreneur's intention of use if not checked.

We can also illustrate the transaction cost problem when we consider specific investments. Suppose an oil rig manufacturer has a contract to manufacture a specific rig for a customer .The investment is specific to the use of the buyer and the supplier may not have any use of the item (value) in the event that the buyer doesn't take the supply. So it is the case that if the price is not agreed at the start, the supplier could lose out in profits because of the nature and technicality of the item. Though it is not the usual practice to determine the price of the item before production, in the unlikely event that the buyer decides he has no need of the item (rig) any more or probably has a lower use for it either because his business circumstances have changed the supplier will be in a big mess. The rig will not have any value to him at that point. Substantial transaction costs are incurred to prevent these mal adaptation cost in business relationships including contingency clauses and so forth.

Another way capital heterogeneity affects business organization is how it affects the limits of business firms. It helps to explain the rationale behind business combinations such as mergers and acquisitions.

Because all the attributes of the assets are not known at the time of purchase, the entrepreneur will have to experiment with combinations of the capital assets to be able to derive or discover further attributes. Acquisitions arise out of a valuation discrepancy from the perspective of the acquirer and the acquiree. The acquirer values the acquiring business higher than the acquiree business because in the view of the acquirer, the business asset is worth more and further attributes are yet to be discovered. It is true that merged entities do end up performing better than the sum of the two previously single entities due to the power of synergy and the elimination of costs through the use of common departments and shared services

Capital heterogeneity thus has two important implications for economic organization. First of all, because it is difficult, or perhaps even impossible, to identify all relevant attributes of an asset before deployment, it is the title and concomitant benefits that are assigned to assets, not their attributes. Ownership of an asset gives the owner the rights to exploit attributes unknown at the time of purchase or transfer of title. Because firms are defined in terms of asset ownership, this entrepreneurial perspective helps explain the boundaries of the firm.


Second, because it is difficult to measure attributes/properties/characteristics of assets entrepreneurs must often risk by experimenting with different combinations of capital goods to find out which combination produces the optimal returns. This explains why firm boundaries are constantly shifting over time. Some acquisitions are for this purpose and nothing else


The discussion above has established a basis for conclusion as follows

That capital is a heterogeneous asset. It is so defined by its attributes which are valued by reference to their place in the production process and therefore depend on the time period within the production process that the entrepreneur has need for it. Its value is a time-dimensioned factor. Because of its heterogeneous nature it is expensive to monitor and gives rise to transaction cost. That its heterogeneous nature calls for some level of experimentation which impacts on the limits of the firm