The Academic-Industry Research Network The Theory of Innovative Enterprise: A Foundation of Economic Analysis AIR Working Paper #13-0201 William LAZONICK Cambridge, Massachusetts February 1, 2013 (revised August 2015) 5/1/2013 © 2015 The Academic-Industry Research Network. All rights reserved. The Theory of Innovative Enterprise: Foundation of Economic Analysis* William Lazonick University of Massachusetts The Academic-Industry Research Network Revised August 2015 * This essay is a revised and elaborated version of an essay that appeared as “The Theory of Innovative Enterprise: Methodology, Ideology, and Institutions” in Jamee K. Moudud, Cyrus Bina, and Patrick L. Mason, eds., Alternative Theories of Competition: Challenges to the Orthodoxy, Routledge, 2013: 127-159. I am grateful to the editors of this volume for extensive comments on an earlier draft of this paper. Lazonick: The Theory of Innovative Enterprise 1. The Schumpeterian Challenge In The Theory of Economic Development, first published in 1911, Joseph Schumpeter, drawing inspiration from Karl Marx, argued that capitalism had to be conceptualized as an economic system in which technological change, or more broadly speaking innovation, constantly disrupted the general equilibrium of market exchange (see Lazonick 2011a). As Schumpeter (1950, 106) would put in his 1942 book, Capitalism, Social and Democracy: What we have got to accept is that [the large-scale enterprise] has come to be the most powerful engine of [economic] progress and in particular of the long-run expansion of total output not only in spite of, but to a considerable extent through, the strategy that looks so restrictive when viewed in the individual case and from the individual point in time. In this respect, perfect competition is not only impossible but inferior, and has no title to being set up as a model of ideal efficiency. Yet a century after the publication of The Theory of Economic Development and over seventy years since the appearance of Capitalism Socialism, and Democracy, the mainstream of the economics profession still ignores the role of the innovative enterprise in the operation of the economy, and sets up perfect competition as the model of ideal efficiency.1 To make the case, neoclassical economists have since the publication of Joan Robinson’s The Theory of Imperfect Competition (1933) put forth the monopoly model as the demonstration of the inefficiency that occurs when perfect competition does not hold. Under monopoly, according to the neoclassical model, product prices are higher and output lower than under the perfectly competitive ideal. For decades now, the neoclassical theory of monopoly has been touted as proof of perfect competition as, to use Schumpeter’s words, “a model of ideal efficiency” while apparently incorporating into neoclassical theory an obvious characteristic of twentieth- century capitalism: the existence of “big business” in the economy. Yet, as I will show in this essay, the neoclassical theory of monopoly commits a fundamental error of logic by positing that the monopolist optimizes subject to the same cost structure as perfectly competitive firms. In committing this logical error, neoclassical economists have ignored not only Schumpeter but also the empirical and theoretical observations of Alfred Marshall (1961), whose Principles of Economics focused on the growth of the firm relative to the growth of its industry (Lazonick 1991, ch. 5); the pioneering work of Edith Penrose (1959) on “the theory of the growth of the firm” (Lazonick 2002); and the historical synthesis of Alfred Chandler (1962; 1977; 1990; 2001 and 2005) on the growth of the industrial corporation and its implications for the operation and performance of the economy (Lazonick 2010b; Lazonick 2012a). Building on these intellectual contributions, the theory of innovative enterprise shows how by transforming its cost 1 Endogenous growth theory (for example, Grossman and Helpman 1994; Romer 1994; Aghion and Howitt 1998 and 2009) inserts the concept of “innovation” into macroeconomic models of the economy but lacks a theory of innovative enterprise, and perceives innovation as an element of “imperfect competition.” It will require a separate paper to critique this approach to innovation. For critical comments on endogenous growth theory’s adherence to the notion of “imperfect competition”, see Moudud 2010, ch. 3 and 2012. 1 Lazonick: The Theory of Innovative Enterprise structure a firm can grow large while, in sharp contrast to the monopoly model, enhancing the efficiency of the economy. Superior economic performance depends on innovative enterprise: the development and utilization of productive resources to generate higher quality, lower cost goods and services. Government policies to support the achievement of superior economic performance must be based on a theory of how an innovative enterprise evolves, operates and performs. In this paper I outline a theory of innovative enterprise in which social conditions summarized as strategic control, organizational integration, and financial commitment are central to the development and utilization of productive resources. The need for these social conditions derives from the uncertain, collective and cumulative character of the innovation process (Lazonick and O’Sullivan 1998; O’Sullivan 2000). From the perspective of innovative enterprise, I critique alternative theories of the firm and their general policy implications. The neoclassical theory of the market economy that has long underpinned government economic policy in the advanced economies lacks a theory of innovative enterprise. Instead it posits the “optimizing firm” as the relevant microeconomic unit of analysis, and calls for the breakup of large-scale business enterprises so that large numbers of small-scale optimizing firms can move economic activity closer to the purported “ideal” of “perfect” competition (see Lazonick 2011b). Under the sway of the theory of perfect competition, the theoretical case for government policy that can influence business behavior and performance has long focused on the monopoly model in which large-scale business enterprises prevent the achievement of superior economic performance by producing lower output at higher prices than would be the case under conditions of perfect competition. The basic empirical problem with the neoclassical monopoly model is the fact that in many industries that are central to the operation and performance of the economy, a small number of innovative firms can grow to be very large by generating more industry output at lower product prices than would have been the case if the industry had been populated by large numbers of near-identical competitors. This critique is not new. Economists such as Alfred Marshall, Joseph Schumpeter, and Edith Penrose understood the inferiority of so-called “perfect competition” as a benchmark of economic performance. Central to the growth and performance of advanced economies in the twentieth century was, as the business historian, Alfred Chandler, put it, “the visible hand” of managerial coordination. Within the economics profession, the most widely touted alternative to the neoclassical monopoly model as an explanation of departures from perfect competition has come from transaction-cost economics. Oliver Williamson (1985), the foremost proponent of transaction-cost theory, has argued that the existence in a “market economy” of “hierarchies” – i.e., distinctive business enterprises of the type that Chandler and others have documented – derives directly from asset specificities that are given to the firm and not subject to change (for an extended critique see Lazonick 1991, chs. 6 and 7). The intended implication is that public policy must live with these immutable “market imperfections” rather than invoke the neoclassical “monopoly model” as the rationale for the pursuit of the perfectly competitive ideal. 2 Lazonick: The Theory of Innovative Enterprise Through the elaboration of the theory of innovative enterprise, I show both the illogic of the neoclassical monopoly model as proof of the superiority of “perfect” competition and the irrelevance of the Williamsonian transaction-cost model for understanding the growth and performance of the firm. The neoclassical monopoly model is illogical because it assumes that the monopolist optimizes subject to the same cost structures as perfect competitors. The Williamsonian transaction-cost model is irrelevant because “asset specificity” is not given to the firm but is rather an outcome of its investment strategy. The challenge is to explain the conditions under which this investment strategy results in innovative outcomes: higher quality, lower cost products than had previously been available. In the conclusion of this paper, I draw out the methodological, ideological, and institutional implications of the theory of innovative enterprise. In the next section of this essay, I outline the theory of innovative enterprise, and show how it provides a framework for explaining the growth and performance of the firm. The theory of innovative enterprise demonstrates clearly why the neoclassical model of perfect competition is just the opposite of an ideal model of economic efficiency. From the perspective of the theory of the innovating firm that makes investments to transform technologies and access markets that can potentially give it a competitive advantage the neoclassical theory of the optimizing firm in perfect competition is a theory of the un- innovating