Entrepreneurship and Firm Boundaries: The Theory of a Firm
66 Pages Posted: 26 Nov 2008
Date Written: December 28, 2005
In this paper, we consider how a better understanding of entrepreneurial activities can help explain how firm and industry boundaries change over time; and how a more complete understanding of boundary setting can help us understand where entrepreneurial activities are directed. We argue that while entrepreneurs believe themselves to have superior ideas in one or multiple parts of the value chain, they often are short of cash - or of the ability to convince others to provide them cash / capital. On the basis of this observation we construct a simple model in which the entrepreneur has a value-adding set of ideas for "upstream" and "downstream" parts of a value chain, as well as for the ways to make these two parts of the value chain work together even better. Assuming that the entrepreneur's objective is to maximize her wealth , we observe that even in the presence of transactional risks or other factors that might make integration preferable to specialization, scope depends on factors that theory has not explored: in particular (a) how severe the entrepreneur's cash constraint is, and (b) how much value the entrepreneur's ideas add at each part of the value chain. Entrepreneurs will focus on the areas that provide the maximum profit yield per available cash - a criterion which implies that scope choices depend on cash availability and the depth of the demand for the new idea along the value chain. We also consider the implications of admitting that entrepreneurs make money not only from the operating profits of their firms, but also from sale of the assets the firm has accumulated. This can change the optimal choice of the firms' boundaries, as entrepreneurs must be sensitive to choosing the segment that will enable them to benefit not only in terms of profit, but also in terms of asset appreciation. In conclusion, we propose that rather than speaking generically about firm boundaries and the theory of "the" (representative) firm, we should instead focus on the considerations affecting the choice of boundaries for "a" firm - the choices made by an individual entrepreneur, taking into account all the conditions that face him. Scope, then, will depend on the entrepreneur's own theory of "how to make money".
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