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Learning Objectives

- Profit Theory - Innovation Theory - Efficiency Theory

- Assignments & Case Studies

Profit theory
Risk and Uncertainty-bearing theory of profit by Knight: What is Risk and Uncertainty? Entrepreneurs have to undertake the work of production under conditions of uncertainty. They have to make estimates of the future conditions regarding demand for the product and other factors in advance and these affect their future price and costs. In view of their estimates and anticipations, they make contracts with the suppliers of factors of production in advance at fixed rates of remuneration and own these contracts are, no, doubt, based on anticipations about the future conditions. Between the time of contracts and the time of the sale proceeds many changes may take place which may upsets anticipations for better or for worse. Knight distinguishes between risk and uncertainty. According to him, risks inherent in any business are of two kinds: 1) Insurable 2) Non-Insurable

Insurable risks are those risks which can be calculated statistically and thus insured with an insurance company. These in turn are of two types: a) Risk of loss of assets, resulting from natural factors like fire, flood,etc) Risk of theft, robbery etc. By paying insurance premium these risks can be taken care of by the entrepreneur. Non insurable risks: There are certain risks which have to be borne by the entrepreneur himself as these cannot be insured against risks.


These non-Insurable risks are: 1) Competition Risks: These are the risks arising from the policy changes of the rivals, which include things like changes in price, product line ,advertisement expenditure, etc. For i.e. change in prices of coke pet bottle made Pepsi also to change their prices. 2)Risks of market condition: Whole or major part of the business sector in an economy may enter a phase of recession or a boom, thus effecting the firm adversely or favorably. Like India business sector was hit by recession in 2008-09.
3) Risks of technological changes: This is also called risk of obsolescence which grows with advancement of an economy. These risks arise from the possibility of newly installed machinery becoming obsolete with the discovery of new and more economical processes of production. 4) Risks of public policy: Government policy regarding business undergoes a change over time, some of which cannot be predicted precisely. These policies changes may relate to price control, foreign trade policy, corporate taxation, etc. These non-insurable risks are called uncertainties by knight. According to him ,the term risk should be applied only to insurable risks.


Acc to Knight, the most significant function of an entrepreneur is to bear risk and uncertainty which is rewarded by Profit. He says that different rates of profit earned by different firms in the same industry reflect the differences in their capabilities of bearing risk and uncertainty. Weaknesses of Knight Theory: Actually uncertainty-bearing is not the only determinant of profit. Ability of the businessmen to mould demand in the market in favor of his commodity, innovative ability etcare also equally important for the emergence of profit.

Topics for Group Discussion

1) 2) 3) 4) Challenges faced by Women Entrepreneurs Challenges faced by Rural Entrepreneurs Challenges faced by entrepreneurs working from home Is organizing adequate Capital a bigger challenge or Idea for a successful set-up more challenging for any entrepreneur? 5) Will Rural or Urban Entrepreneurship be more beneficial for any nation? 6) Most important tool required for entrepreneurial success.

Innovation theory

Austrian economist Joseph Schumpeter, a pioneer when we talk about innovation management. Around the 1930s Schumpeter started studying how the capitalist system was affected by market innovations. In his book Capitalism, Socialism and Democracy he described a process where the opening up of new markets, foreign or domestic, and the organizational development illustrate the same process of industrial mutation, that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. He called this process creative destruction. After analyzing the capitalist model Schumpeter tried to understand what companies would be in a better position to innovate. He developed a theory where a companys ability to innovate was mainly connected to its size. Initially he defended that small companies should be in a better position due to their flexibility while large companies might get trapped in bureaucratic structures. Some years later, however, he changed his view, stating that larger corporations with some degree of monopolistic power could have an advantage to develop innovations. Compared to smaller firms such large corporations have better resources and more market power. Unfortunately the innovation theory was only a marginal part of Schumpeters work, it was derived from his analysis of the different economic and social systems. The theory therefore has no empirical foundation at all, there is no strong evidence to support a relationship between the size of a company and its ability to innovate.

One important insight arising from Schumpeter ideas, though, is that innovation can be seen as creative destruction waves that restructure the whole market in favor of those who grasp discontinuities faster. In his own words the problem that is usually visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroy them

Monopoly and X-Efficiency

The concept of X-Efficiency rejects the technical efficiency notion of profit maximizing and cost minimizing. Liebenstein (1966) argued that individual workers are free to choose their level and interpret their own jobs . The equilibrium position for a firm price is when every individual maximizes utility. In this essay, Justin Morton relates the theory of X-Efficiency to the monopolistic market structure. INTRODUCTION Adam Smith refers to monopoly as a "...great enemy to good management", and to competition as the medium for "...new divisions of labour, and new improvements of art, which never otherwise would have been thought of" Hayek claims that "It is only through the process of competition that the facts will be discovered." Cournot, after whom Cournot competition is named, finds that "the result of competition is to lower the price." If increasing social welfare or well-being is an objective, then we should have some notion of which market structure is the most desirable. With this we can design competition policy and competition law so as to maximize the economic cake. Hence in this essay, lets examine the market structure of monopoly and its associated costs, concentrating on the theory of X-Efficiency.

Competition Theory

Any study of monopoly would be vacuous without firstly outlining the underlying (neo-classical) theory of competition. It starts by assuming perfect competition in the goods market. This involves infinite buyers and infinite sellers, each with perfect information regarding costs, profits and demand, freedom of entry and exit into/from the marketplace, all selling an homogeneous good. The factor market is also perfectly competitive, which means the marginal productivities of both capital and labour are known, and all factor contracts are complete. In both spheres agents are profit and utility maximisers subject to constraints (budget, leisure, ability cost and technology). Given that these conditions are fulfilled in all markets consumer welfare is maximised (or more technically the economy is in a pareto equilibrium). Economic resources are allocated in the precise way consumers wish, wishes being reflected by the price system. As well as allocative efficiency, perfect competition leads to productive efficiency (minimum average cost production, in other words), since above minimum average cost selling would mean zero sales.

If the market structure has only one seller, rather than an infinite amount, and a barrier to entry (or exit) which guarantees only one market player, there is allocative inefficiency. Due to extra market power, the monopolist restricts quantity, sells at a higher price and earns supernormal profits.. One possible explanation is that monopolies waste resources by rent seeking. A second explanation is what is termed X-inefficiency.

The Concept of X-Efficiency

Leibenstein introduced this theory of inefficiency generated from non-competition. Since it was not allocative and he was unable to characterise it as motivational or technical, he named it Xefficiency. As a concept it may be summarised as follows: "for a variety of reasons people and

organizations normally work neither as hard or as effectively as they could. In situations where competitive pressure is light, many people will trade the disutility of greater effort, or search for the utility of feeling less pressure and of better interpersonal relations.

Scenario 1: Differing Costs of Monopoly and Perfect Competition Essentially, since extra costs do not mean immediate bankruptcy for a monopolist, they will be slack in cost control and in the amount of effort put in by management and workers. This concept of X-efficiency leads to the existence of different cost structures associated with different market structures, higher costs being associated with non-competition. It seems intuitively quite attractive. However, Leibenstein's related theory of X-(in)efficiency, by which he explains the higher cost phenomenon is more controversial.

The Theory

Leibenstein enters what is termed micro-micro theory; which is "the interactive, but

somewhat constrained, economically bargained decision among 'atomistic' individuals within the firm.

In examining the molecular make-up of the firm, which is treated as a maximising "blackbox" in neo-classical theory, he finds that the internal agents are non-maximisers. Invoking the Yerkes-Dodson Law, at low pressure levels, individuals will not put much effort into carefully calculating decisions, but as pressure builds they move toward more maximising behaviour. He identifies an inert area, probably due to the incomplete nature of labour contracts. Although payment is specified, effort generally is not. Variation in effort is due to the discretion which employees have in choosing effort levels and discretion which top management have with regard to working conditions. Clearly a Prisoner's Dilemma type outcome could exist with effort and wages both at a minimum. However Leibenstein rules this out due to conventions, which ensure equilibrium within the inert area surrounding the point c.

Scenario 2: Leibenstien's Theory of X-Efficiency

As pressure mounts, the circle reduces in size and wages reflect effort more and more accurately; with perfect information and honesty, the equilibrium is on the 45 line, where wages reflect effort.

Criticisms of the Theory

The theories of monopoly and X-efficiency are not without criticism. Some authors argue that a monopoly may generate higher social welfare than perfect competition. With the opportunity of profits, monopolists will innovate and invent since the extra guaranteed rent will not be competed away. These supernormal profits can be invested in new product development and new technological advances, which are not necessary in the perfectly competitive world of horizontal demand curves. Perhaps, safety and general working conditions may not be adhered to in the cut-throat perfectly competitive world. This is not, however the predominant thinking. Certain critics also question the existence of X-efficiency. Since all economic agents are rational, any slack is a rational leisure-income trade-off. Higher costs, therefore, are not a symptom of inefficiencies, but the effect of fully rational workers' preferences for leisure. According to Stigler (1976) "increased output due to (say) increased effort is not an increase in 'efficiency', but a change in output." Another criticism of X-efficiency theory comes in the empirical evidence of motivational slack in competitive industries. Leibenstein himself refers to an example of two petroleum plants in Egypt only half a mile apart. One transpired to have been X-inefficient for years, after a management change increased output substantially without changing inputs.

Why did this persist for so long in a competitive environment? It may be that the internal pressure is a greater influence than the external pressure. Internal pressure has been described as "inner prodding, be it religious, moral, or cultural" which motivates the individual to cost minimise for his employer. Leibenstein (1966) refers to a domino type effect - if a top manager is X- inefficient for whatever reason, this lack of motivation will in turn affect all those below him. Hence it is possible to explain X-Inefficiency in the competitive market place via focusing on internal pressure. General existence is not the key criticism, however. The main issue is that X-efficiency theory is not compatible with neo-classical microeconomic theory. Leibenstein's rejection of the black box firm would be an interesting advancement in non-competitive markets, if it were to agree theoretically with the general thinking. However, Leibenstein's idea of non-maximisers conflicts with the whole basis of economics as we know it. It is not logical or perhaps not possible to have an economic system based on non-maximising individuals.


In summary we have looked at the theories of monopoly and of X-efficiency. We raised some of the critical issues regarding the existence of X-efficiency and some of the theoretical objections to Leibenstein's explanations of the concept. Finally, we examined some of the empirical work done in the area. The million dollar question is whether there exists a gain other than Harberger's triangle in moving from monopoly to competition. The theory of X-efficiency provides us with an intuitive concept within the neo-classical world of maximisers predating Vickers and strengthened by positive empirical evidence. This should be sufficient to guide us in the area of competition policy and law

How Economic Growth Begins: A Theory of Social Change

Everett E. Hagen
Traditional agricultural societies have begun to rapidly progress technologically, which in turn impacts both economic growth and social change. In order for countries, including those with low incomes, to experience economic growth, two factors must exist: Extensive levels of creativity, including the identification of and implementation of problemsolving skills, Viewpoints which promote creative approaches towards production technology. The characteristics of a traditional agricultural society are discussed, including the typical hierarchical, authoritarian social structure and the impact of family status upon an individual's perceived social status. Additionally, an individual's personality may also impact their role and status within a society, as well as their impact upon a society's economic growth. Utilizing a Freudian, psychoanalytic approach, personality development of the individual is analyzed at length by studying the function of parental influence, as well as environmental factors, upon child personality development. Several examples of social change among historically authoritarian societies are presented. As an explanation for social change within these traditional societies, the study theorizes that alienated, creative individuals often seek to break away from traditional social patterns after being marginalized by society for being different. As a result, they pursue projects which will utilize their creative talents, while also allotting them the power and retribution they seek against their elitist society. (AKP)

Thematic Apperception Test (TAT) and McClelland's Achievement Motivation Theory

Criticizing economics as being an overly simplistic, and rationalistic discipline, David McClelland points out that it does not really account for how humans actually behave. For example, Elton Mayo and his work at the Hawthorne Western Electric plant in the 1920s and 30s recognized the non-economic motivations of workers. In the Hawthorne Studies... the importance of the peer group was recognized in determining employee motivation. Motivation research has long considered human motives and needs. However, isolating people's motivational needs can be a difficult process because most people are not explicitly aware of what their motives are. In attempting to understand employee motivation, Abraham Maslow proposed a hierarchy of needs. David McClelland furthered this idea in his learned needs theory. McClelland's experimental work identified sets of motivators present to varying degrees in different people. He proposed that these needs were socially acquired or learned. That is, the extent to which these motivators are present varies from person to person, and depends on the individual and his or her background.

McClelland's experiment -- the Thematic Apperception Test (TAT) -- consisted of showing individuals a series of pictures and asking them to give brief descriptions of what was happening in the pictures. The responses were analyzed in terms of the presence or absence of certain themes. The themes McClelland and his associates were looking for revolved around the following motivators: achievement, affiliation and power. According to David McClelland, regardless of culture or gender, people are driven by three motives: achievement, affiliation, and influence. Since McClelland's first experiments, over 1,000 studies relevant to achievement motivation have been conducted. These studies strongly support the theory.

Achievement (nAch).The need for achievement is characterized by the wish to take responsibility for finding solutions to problems, master complex tasks, set goals, get feedback on level of success..Affiliation (nAff).The need for affiliation is characterized by a desire to belong, an enjoyment of teamwork, a concern about interpersonal relationships, and a need reduce uncertainty..Power (nP).The need for power is characterized by a drive to control and influence others, a need to win arguments, a need to persuade and prevail..According to McClelland, the presence of these motives or drives in an individual indicates a predisposition to behave in certain ways. Therefore, from a manager's perspective, recognizing which need is dominant in any particular individual affects the way in which that person can be motivated.

UNDERSTANDING MOTIVES -- So, what does all this mean?.High achievement motivation. People driven by the achievement motive like to test themselves against their environment and attain standards of excellence. In areas of management where high levels of delegation may be required, high achievement motivated individuals may be unable to give up their personal involvement with the task.

Specifically, achievement motivation is defined as a non-conscious concern for achieving excellence through individual efforts. Such individuals set challenging goals for themselves, assume personal responsibility for goal accomplishment, are highly persistent in the pursuit of these goals, take calculated risks to achieve the goals, and actively collect and use information for purposes of feedback. High achievement motivated managers are also strongly inclined to be personally involved in performing their organizational tasks. However, they may also be reluctant to delegate authority and responsibility. Thus, high achievement motivation may be expected to result in poor performance of high- level executives in large organizations. High achievement motivation is predicted to contribute to effective entrepreneurship and effective leadership of small task-oriented groups.

Achievement motivation is positively related to the leadership of small task-oriented groups and small entrepreneurial firms and negatively related to the effectiveness of high- level managers in complex organizations or in political situations. .High power motivation People motivated by power are concerned about their impact on other people--convincing someone of their point of view or empowering others around them, and finding ways to connect with and influence powerful people. Power motivation is assumed to be predictive of leader effectiveness. ...the power motive is necessary for leaders to be effective because it induces them to engage in social influence behavior Power motivation is defined as the concern for acquiring status and having an impact on others. McClelland used power motivation as a measure of social influence behaviors. Clearly, since most management activities require the use of social influence behaviors and since power motivation measures an individual's desire to influence, the power motive is important for leadership effectiveness. David McClelland proposed the Leader Motive Profile Theory (LMP theory) in which he argued that a high power motivation, greater than the affiliation motive, is predictive of leader effectiveness.

Need for Achievement and Entrepreneurship.Originally, the need for achievement was the greatest concern for McClelland. He was particularly interested in this need and associated behaviors because most organizations want their employees to achieve. The 'need achievement' refers to an unconscious disposition to energize and drive. High nAch individuals are constantly 'competing with standards of excellence'. Further, they are attracted to tasks of moderate difficulty. McClelland further described the profile of an entrepreneur as someone high in nAch (Achievement) and low in nP (Power), while good managers have high nPower and low nAch. Over four decades of research into the characteristics of entrepreneurs has established that the essential need for achievement for entrepreneurship is learned at an early age. Persons with a high 'need achievement' have a general predisposition towards entrepreneurial activity. Summary. Adults are assumed to possess all three motivations to one degree or another, however, one of the motives is usually dominant. Managers need to identify what motivates others and to create appropriately motivating conditions for them. People with achievement motives are motivated by standards of excellence, delineated roles and responsibilities and concrete, timely feedback. Those with affiliation motives are motivated when they can accomplish things with people they know and trust. And the power motive is activated when people are allowed to have an impact, impress those in power, or beat competitors.