The Entrepreneurial Justice of the Market Process

  • A Liberty Classic Book Review of Discovery, Capitalism, and Distributive Justice, by Israel M. Kirzner.

Can the distribution of income generated by the market process be regarded as just? The answer to that question depends on the extent to which economic theory accounts for the role of the entrepreneur in the market process. Israel Kirzner is best known for his explication of the entrepreneur’s role in generating social coordination in the market process. Entrepreneurship, according to Kirzner, is the propensity to discover previously unnoticed profit opportunities in an open-ended world of uncertainty. In this respect, entrepreneurship is not only an analytic tool for understanding the role of entrepreneurship in the production of material wealth, but also the defining element of action inherent to all human beings. The importance of his work is not only reflected in its policy implications, but perhaps more importantly, in its moral implications regarding the institutional basis of a market economy: the right to private property and the distributive justice of income that flows from it.

The answer to the question motivating this essay is powerfully recounted in Kirzner’s masterful work, Discovery, Capitalism, and Distributive Justice. Written on the heels of the collapse of socialism in Eastern and Central Europe, Kirzner’s message was (and continues to be) particularly relevant in defending the economic and the moral superiority of the market process against the alleged superiority of socialism. However much socialism in Eastern and Central Europe may have proved to be economically unjust in terms of its moral aspirations, “the defense of capitalism against the charge of injustice does not by itself invest the system with overall moral worthiness.” Precisely “because capitalism is seen by millions as being built on injustice as one of its essential and defining characteristics”, this requires a positive analysis of the market process in order to assess its normative implications for distributive justice and the moral desert of pure entrepreneurial profits (Kirzner 1989 [2016]: 5).

To appreciate the profoundness of Kirzner’s book, one must first place in context the incomplete story of the market process left behind by classical and early neoclassical economists. The genius of classical political economists, going back to Adam Smith, was to reconcile how individuals can pursue their separate, though conflicting interests, in a manner that is peaceful, productive, and therefore cooperative, but without command. This “invisible hand” of the market process is predicated on the institutional prerequisite of private property and freedom of contract under the rule of law, creating the basis for productive specialization and exchange. From such exchange, market prices emerge, guiding consumers and producers in their decision-making, creating the coordinative tendency in the market process, and explaining how “Paris gets fed,” in the words of Frédéric Bastiat, without the mayor of the city commanding the production and distribution of food by central direction.

However much classical political economists and early neoclassical economists took the welfare of the poorest and least advantaged in society as the normative basis by which to assess to economic and moral superiority of an economic system, it provided no explicit account of how the market process generates a just distribution of income, as acknowledged by other economists, including George Stigler (1957) and James Buchanan (1991). From Kirzner’s standpoint, the market process, as understood by classical political economists, was not so much flawed, as it was simply incomplete in its explication of entrepreneurship and the role that pure entrepreneurial profits play in driving the market as a competitive process of discovery. Kirzner elaborates as follows:

  • The volume of pure profit won by entrepreneurs surely refers to only a small fraction of capitalist “profits” in the broad sense of the word used by the classical economists (and especially by Marx). It is no accident, it could be conjectured, that pure profit did not loom more importantly in the classic discussions of capitalist justice; the phenomenon was simply not important enough (emphasis in original; 1989 [2016], p. 109).

With this broader intellectual background in mind, Kirzner’s fundamental disagreement, and the more immediate intellectual context to which his argument is directed, is the manner in which economists have attempted to complete what was left behind by classical economists in explaining the distributive justice of the market process. Therefore, Kirzner’s disagreement with the literature on distributive justice under capitalism is not normative in nature, but how both critiques and defenses of distributive justice under capitalism have been entirely misdirected and therefore misperceived the fundamental issue. This is primarily due to the failure of mainstream economic theory to fully absorb the conceptualization of the market as an entrepreneurial process of learning and discovery, which has undermined its ability to adequately account for the moral implications of the distribution of income that is discovered as a result of pursuing pure entrepreneurial profit. Thus, Kirzner realizes that “quarrels over the morality of markets merely reflect different views concerning economic reality” (1989 [2016], p. 7).

By failing to account for the economic and moral relevance of discovering pure entrepreneurial profit, economists have only been able to demonstrate, in the best-case scenario, that the distribution of income through the market mechanism is not unjust, meaning it will be unable to justify the discovery of entrepreneurial profits and the pattern of income distribution that emerges from such discovery. At worst, profits earned by capitalists are categorized as “unearned rents” extracted by exploitation. Thus, any account of the morality of the market process, and the distributive justice emergent from entrepreneurial discovery, must first begin with the notion that the distribution of income is a nexus of entrepreneurial acts, the outcome of which is a by-product of realizing pure entrepreneurial profits. It is not only the final product that is created through entrepreneurial discovery, but also the economic value of those inputs that are part of the production process are created as well.

In order to explicate the normative implications that follow from his account of the entrepreneurial market process, Kirzner draws a distinction between production understood as a conversion of resources through the transformation of inputs into a final output, and production understood as the ex nihilo creation of both inputs and final outputs through entrepreneurial discovery. Clarifying this conceptual distinction explains why, according to Kirzner, economic theory has been unable to grapple adequately with questions of distributive justice.

Production understood in terms of transformation follows from an equilibrium paradigm in economic theory. According to this paradigm, prices of resources reflect their full opportunity cost of production, from which their marginal contribution to final output is already known and given since such knowledge is reflected in market prices. Therefore, the value of final output is directly reducible and inherent to its inputs, such that payment to each factor of production is distributed by virtue of possessing ownership over resources, such as land, labor, and capital. The distribution of income can be said to be “baked into” the ingredients that constitute their share in the size of the pie, and income earned by each factor of production is justified according to its marginal contribution to output. However, because entrepreneurial profits (or losses) do not exist, the role of the entrepreneur in organizing production, by definition, is squeezed out of the analysis. “So long as results can be attributed to inputs,” Kirzner argues, “the idea of discovery can be dispensed with. But pure profit, by its very definition, is not attributable to inputs” (1989 [2016], p. 49). The implication that follows from such positive theorizing is that differences in wealth must be attributed to the “luck” of being in the right place and at the right time or “unearned” windfalls by possessing superior resources. In both respects, the production of output, and the distribution of income that flows automatically from its inputs, are wholly determined by external circumstances not attributable to entrepreneurial discovery (Kirzner 1989 [2016], p. 94). The moral implication that follows from this view of production is elaborated by Kirzner as follows:

  • Here we have the ethical problem posed by the phenomenon of pure profit. It corresponds to nothing additional produced. The difference between the low price at which the speculator bought up grain, and its subsequent price, has been caused by no productive activity, by no services rendered by resources. A view on the ethical justification for incomes that insists on finding a productive counterpart to that income, must find pure speculative profit to be without justification (Kirzner 1989 [2009], pp. 50-51).

“… any ethical assessment regarding the distribution of wealth under the market process that is not constructed explicitly under the premise that wealth is created by discovery will have incomplete accounts of distributive justice.”

To the extent that any account of distributive justice under a market economy has taken equilibrium as its analytic point of departure, then distributive justice is seen merely as an allocation problem of distributing a given pie of wealth, rather than income distribution defined in the process of entrepreneurial discovery. Such a premise misleadingly implies that the conceptualization of distributive justice held to be appropriate for a centrally planned economy could be just as applicable to a market economy, as if prices are a set of marching orders that convey all prior knowledge and “assign” each factor’s marginal contribution to output (Kirzner 1989 [2016], p. 94). However, neither equilibrium prices nor central planners “assign” income to factors of production according to marginal productivity. Rather, the prices paid to factors of production, their marginal contributions to output, and the corresponding incomes paid to such factors, must be discovered through rivalrous competition between entrepreneurs in the market process bidding for such factors of production. However, Kirzner’s point is not to directly adjudicate any ethical disagreement regarding income redistribution. Rather, he simply highlights how assumptions built into economic theory, however implicit or explicit they may be, affect the moral implications of assessing the distributive justice of the market process. Thus, any ethical assessment regarding the distribution of wealth under the market process that is not constructed explicitly under the premise that wealth is created by discovery will have incomplete accounts of distributive justice.

To be clear, Kirzner’s point is neither to suggest that economic theory has failed to account for how redistribution of wealth affects the incentives of producing output, nor to claim it has failed to account for production as a creative activity. Rather, Kirzner’s subtle, but crucially important claim is that “the creative aspect is to be found only in the discovery element” that results from entrepreneurship, and therefore, “not over whether production is or is not creative, but over how one should perceive the creative aspect of production” (emphasis added; 1989 [2016], p. 47). None of this implies that Kirzner would deny the role of luck or good fortune in explaining the distribution of income. Rather, such external circumstances, however fortunate and available they may be, do not automatically guarantee that such circumstances will be perceived and realized by a particular individual at that time and place. As Kirzner states:

  • Luck and good fortune play an important role in the presence of these opportunities-waiting-to be noticed. Someone may be described as luckier than others because happens to be surrounded more thickly with such favorable opportunities than others are. But the perception of these opportunities depends on the alertness of the potential observer (emphasis in original; 1989 [2016], p. 34).

This brings us to an alternative understanding of production unique to Kirzner, which regards production as an ex nihilo creation resulting from entrepreneurial discovery. “There is nothing automatic or predetermined about the productive efforts put forth in the market economy” (Kirzner 1989 [2016], p. 16). Rather, each and every transaction in the market process expresses an entrepreneurial element of discovery, implying that all income earned in the market process is discovered income. This is because there is a distinction between production in a physical sense and production in an economic sense of creating awareness that such a productive opportunity exists in the first place, whether that includes discovering original or nature-given resources, which are physically available for production (including raw materials), or recombining already produced resources to create an output that would not have existed without entrepreneurial discovery.

The implications of regarding production as a process of ex nihilo creation are twofold. First, it does not require prior ownership of resources. Indeed, any productive activity requires that an entrepreneur must purchase and own resources to implement his or her vision. That being said, only “discovery made this purchase possible” (emphasis added; Kirzner 1989 [2016], p. 81). Thus, the “additional value now seen by all to have resided in the resource was in fact found by the innovative entrepreneur” (emphasis in original; Kirzner 1989 [2016], p. 105). Secondly, it provides scope for an important ethical principle, which Kirzner refers to as “finders-keepers,” upon which the pattern of income distribution that emerges from the market process will be justified.

According to Kirzner, the “finders-keepers rule asserts that an unowned object becomes the justly owned private property of the person who, discovering its availability and potential value, takes possession of it” (1989 [2016], p. 96). Such an ethical principle complements and reinforces other theories of distributive justice based on private property, whether that be a Lockean labor-mixing theory of distributive justice (Locke 1690 [1980], or a Nozickian entitlement theory of distributive justice (Nozick 1974). From Kirzner’s standpoint, whether distributive justice is based on a theory of labor mixing with unowned resources, or an entitlement theory of income based on exchange between consenting adults with just holdings of property rights, it must be preceded by an account of how such resources are discovered in the first place. Moreover, the finders-keepers principle also clarifies how Marxist accusations of capitalist injustice have been entirely misdirected, since “the ‘profits’ of capitalists which Marxist criticism, for example, saw as exploited away from labor, were not pure profits at all, of course, but a conglomerate of analytically disparate income categories” (Kirzner 1989 [2016], p. 109), the value of which must be discovered through rivalrous competition between entrepreneurs actively bidding for land, labor and capital in the first place.

Stack of cargo containers at the docks

The discovery of containerization by Malcom McLean best illustrates this understanding of production in terms of discovery and its ethical implications. Though McLean is credited as the “father” of container shipping, his entrepreneurial move was not to “invent” something new. Containers, ships, trucks, trains, ports, and cranes, all of which are necessary inputs for transporting goods internationally, had already existed for decades prior to containerization. Moreover, as a North Carolina truck driver by trade, McLean’s discovery was not predicated on having any prior ownership of resources required for implementing his vision of containerization. Rather, he first perceived a method of reorganizing and linking intermodal transport by land and sea in a way that no one else had realized before, and thereafter acquired resources to implement his vision. Like any great innovation, container shipping was so obvious after the fact it is incredible that it had not been implemented earlier. With a stroke of entrepreneurial alertness, McLean was able to perceive a way to profit from reducing transportation costs by utilizing cranes that transported containers directly onto a truck trailer or a railcar, eliminating the process of loading and unloading by hand until such goods arrived at their final destination.

However much McLean was entitled to the entrepreneurial profits from his discovery by virtue of having justly acquired ownership of the inputs required for containerization, Kirzner’s point, consistent with the finders-keepers principle, is that McLean’s entitlement to any income assignment, particularly entrepreneurial profit, is a consequence that follows ex post from the ex nihilo creation of both the inputs and outputs through entrepreneurial discovery. However, if the inputs and outputs required for production are created by entrepreneurial discovery, why is the entrepreneur not entitled to the whole of his or her product, including payments to land, labor, and capital? Does this imply that Kirzner’s argument is irrelevant to, as he puts it, “the problem of disentangling the separate contributions made by the various components” jointly in production? (Kirzner 1989 [2016], p. 132). Quite the opposite. Consistent with Kirzner’s theoretical framework, it is because other entrepreneurs are bidding for these same factors of production in alternative productive uses that the tendency for owners of land, labor, and capital to be compensated according to their marginal contribution to production becomes discovered.

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The implications of Kirzner’s argument in Discovery, Capitalism, and Distributive Justice are as relevant as ever, not only for their positive implications in economic theory, but also their normative implications for public policy. “The more affluent the market economy becomes,” Kirzner states, “the greater the variety of its productive offerings, the richer the arrays of possible employments that might be found for given resource services, the greater the significance of discovery insights—and the greater the relevance of a finders-keepers rule, were such a rule to be accepted” (Kirzner 1989 [2016], p. 123). Moreover, because the justification for income redistribution is based upon the way in which economists conceptualize how income is generated and distributed through the market process, answers to questions of distributive justice will depend on the extent to which economic theory has provided sufficient scope to explain how pure entrepreneurial profits are realized in the first place.