Chapter Listing | Return to 1997 Topical Index


For most of the twentieth century, economics has begun with the assumption that firms are the economy's basic units of production-i.e., an irreducible primitive in the economic process-just as households are its basic units of consumption. Even today's standard textbooks on economics begin the same way. Starting in the 70's, however, economists increasingly began to acknowledge that firms are composite entities-a nexus of contracts between individual agents (Alchian & Demsetz, 1972; Jensen & Meckling 1976) whose self-interests might lead to conflicting purposes, and hence challenge received economic theories of maximization, equilibria, etc.

Acknowledgment of the composite nature of the firm has led to important insights about the boundaries of the firm, its interactions with the environment, and the role of knowledge in dealing with dynamic changes in the environment. Central to understanding the boundaries between firms and markets is Coase's seminal idea of the "price discovery process" (Coase 1937; 1960): this is the idea that the economy cannot operate merely as a set of bilateral market interactions between factors of production because the interacting parties would have to re-negotiate contracts and set new terms of exchange every time there is a change in market conditions or new knowledge (technology) becomes available. This idea was later expanded to explain why a firm is organized as a partitioned hierarchy consisting of a framework of ongoing relations between an accepted authority-who, as new contingencies arise, re-assigns tasks between employees, and resources between tasks-and the employees who are the factors of production (Cheung, 1983; Demsetz, 1983; Williamson, 1985).

The recognition that prices have to be discovered and that there are costs attached to the discovery process raises the issues of discovery of new supply and new demand and the dependencies between the two. For, if the economy consisted only of a relatively fixed set of products, then the problem of price discovery would be reduced to a triviality. All future demand would depend primarily on past demand with minor adjustments needed for changes in population; competition would be limited to direct substitutes; and profits would depend largely on simple cost minimization.

It is the continual development of new supply (i.e., new products, technologies, etc.) that makes the price discovery process complex, costly, and interesting. Competition then, as Schumpeter puts it, becomes a process of creative destruction through innovation (Schumpeter, 1934). The question of the discovery of new supply has been further advanced elegantly by Hayek (Hayek, 1978). His striking insight is in that competition is a discovery process that leads to an increase in the dimensionality of the commodity space. This is in stark contrast to the view of classical economics that competition merely allocates demand between a fixed set of products, mostly direct substitutes at that.

All the same, this leaves unanswered the question: Does the development of a new product automatically lead to its production and supply? Or are there unexplained lags between supply and demand? Furthermore, could it be that both demand and supply exist, but no firm arises to actually carry out the production to fulfill the demand? Several examples come to mind. Xerox had long had the technology to produce a user-friendly personal computer-but the Macintosh was created by Apple much later, after Jobbs and Wozniak had visited Xerox. A more recent example is the commercialization of the internet. This required the development of a browser such as the one developed by Netscape-several years after the development of the internet. But in transforming the idea into Netscape, not only new technology had to be developed, but also new ways of marketing and financing had to be discovered. Subtler examples of unexplained lags between supply and demand exist; and they compellingly demonstrate the need for an explicit mechanism to overcome such lags. One such example, U-Haul, is discussed in detail in Section 6 of this paper.

Examples such as these and the conspicuous lack of discussions in the literature about dependencies between demand and supply bring us to a very important question: If competition is the discovery procedure for new supply, what is the economic mechanism for the discovery of new demand?

This paper proposes an answer to that question through an entity called the pre-firm. The pre-firm transforms an idea into a firm. Every inventor or entrepreneur who failed at building a company to commercialize his/her invention or idea has gone through the pre-firm process. Every firm that exists today, or has ever existed in the past, has successfully completed the pre-firm process. Every pre-firm, whether it results in the creation of a firm or not, provides the economy with an opportunity to learn what works and does not work-the pre-firm is the mechanism through which the economy discovers/creates future demand. Yet economics is eerily silent on the subject of the pre-firm.

One could argue that as conscientious economists, it is incumbent upon us to recognize that an economics that begins with firms, excluding pre-firms from the economic process, might make a good story, but it is bad science. An analogy from biological evolution serves to illustrate this point. Stephen Gould, the noted evolution theorist uses Kipling's "Just so stories" (Kipling, 1995) to bring into focus a subtle but insidious problem: a historical bias towards stories of successful adaptation. Such a bias leads evolutionary biologists to ignore "the nonadaptive consequences of inherited structure in systems of change that affects all parts in integrated and unanticipated ways" (Gould, 1980). Economics too proceeds with "Just so stories" explaining a wide range of economic phenomena such as firm diversity, organizational capabilities, feasible contracts and optimal resource allocations, without taking into account the constraints and consequences chosen and inherited through decisions made in the pre-firm. Pre-firm activity has always been a substantial portion of economic activity in toto and in recent decades it has been increasing at an increasing rate (Timmons, 1994). Yet, by completely ignoring the pre-firm, economics creates the illusion that firms spring into existence full grown from the womb, as it were.

But firms do not come into existence automatically to fulfill pre-existing demand-if they did, all pre-firms would become firms. If we are to meaningfully discuss the kinds of issues presented above, we need to make a further conceptual leap in our understanding of the nature of the firm: viz., firms are not only composite entities, they are also artificial entities in the sense that they have to be created.

Given that firms are artificial entities, the role of the entrepreneurial process becomes vital in explaining how firms come to be. In fact, it is the thesis of this paper that the central question for research in entrepreneurship should be: How do firms come to be? Furthermore, the paper presents a model of the entrepreneurial process in which the entrepreneur as the primary decision maker is inextricably intertwined with the answer to that question.

Top of page | Chapter Listing | Return to 1997 Topical Index

1997 Babson College All Rights Reserved
Last Updated 03/01/98