Are Entrepreneurs Irrational? (According to Standard Economic Theory)

Peter Turchin

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For me the greatest eye-opener in The Rainforest: The Secret to Building the Next Silicon Valley by Victor Hwang and Greg Horowitt was a realization that starting your own innovative company is a deeply irrational decision. Considering the amount of effort (and often your own money) that you are going to invest in it and the very low probability of success, it simply doesn’t make sense to start a company—as long as you measure success in dollars. As the authors write at one point, “the process of launching a startup company has many similarities to riding a roller-coaster. It is a highly irrational act.”

There is useful diagram on p. 224 of The Rainforest explaining the components that have to work in order for the venture to become success:

  • Technology works
  • Product works
  • Customers buy
  • Manufacturing works
  • Business model works
  • Enough capital
  • Team can handle this whole thing

There are seven components of success in this scheme, and all of them must work in order for “this whole thing” to succeed. Even if we assign an unrealistically high chance of success—50%—to each step, the probability of all of the seven tosses coming heads up is less than 1%. A more realistic chance of success for each step, like 20%, yields an overall probability of around 0.001 percent. If you want to become a billionaire, there are much more certain routes to wealth—for example, working up the corporate ladder in a well-established large company or running a hedge fund. Or, as Thomas Piketty suggests, inheriting the wealth.

And I am not even talking about the “psychic costs” involved in starting a successful business. It can take many years before you find out whether you succeed, and all that time one must live with the very real possibility of failure, that all that hard work will be, in the end, wasted. At least, if you fail at becoming a CEO of a huge corporation, you will be still very handsomely remunerated along the way and can look forward to a very comfortable nest egg when you retire. Another huge psychic cost is having to ask people for money, and then almost always being turned down. As Hwang and Horowitt write, “successful innovation requires self-sacrifice.”

We have the examples of success in front of our eyes, the Bill Gateses and Steve Jobses, but for each of them there are thousands of entrepreneurs who ruined their lives by trying to launch a firm. Even the brilliant Nikola Tesla died in poverty, weighed down by debt (at the end of his life, he lived in a series of New York hotels, leaving behind unpaid bills).

Curiously enough, I have a great personal understanding of the costs of entrepreneurship, because launching Seshat: Global History Databank was in all respects, except one, an identical experience to an investor launching a successful business. The one difference, of course, is that the success of Seshat is measured not in dollars, but in the number of publications in top journals, the number of citations by other researchers, the theories that we either confirm or reject, and our increased understanding of how human societies evolve and function.

So, what does actually motivate entrepreneurs? Some of them are in it just for the money, and most of those fail. Successful ones are typically motivated by extrarational reasons: “thrill of competition, human altruism, a thirst for adventure, a joy of discovery and creativity, a concern for future generations, and a desire for meaning in one’s life.”

Even more eye-opening was the new understanding of venture capitalists that I gained after reading The Rainforest. I used to refer to them as “vulture capitalists”, but I now understand that it was unfair, especially when talking about successful VCs. Because successful VCs, as The Rainforest explains, also cannot be motivated by greed alone. The problem is, again, the high probability of failure. It is simply not rational to invest in a startup at the very early stage. Usually VCs will know that the first hurdle (“technology works”) has been successfully passed. But the remaining six hurdles still need to be surmounted. One way of increasing the payoff in case the venture succeeds is to force the entrepreneur to yield a large percentage of equity in the company. But that’s self-defeating, because that destroys the motivation of the entrepreneur to work hard.

At a later stage, once most of the hurdles have been cleared, it makes perfect sense to invest in a startup, but how do they get to that stage? It takes either investors behaving extrarationally, being motivated by the same values cited above, or collective action channeled by governments—in fact, it takes all of that.

Most venture funds that help entrepreneurs during the early stages are funded by governments who hire VCs to run them, or by VCs who venture their own money in parallel with a government fund. I had some experience of this recently, when one of the Seshat directors, Kevin Feeney, launched a new company, Data Chemist (read about it in The Irish Times).

I end my review of Hwang and Horowitt’s book with this quote “Rainforests depend on people not behaving like rational actors.” It requires extrarational motivations of all the key players, including the inventors and investors, and also governments. I am not saying that all business is like this. From what I read in the press, the world of financial organizations, large corporations, and corporate law seems to be driven largely, or entirely by greed. Branko Milanovic is right in that. But not all business is like that. Innovation is really the key to why we live better than people did one hundred, or one thousand years ago. And that business requires extrarational motivations, self-sacrifice, and cooperation.

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William Berkson

I think you need to distinguish between “not purely monetary” and “irrational”. Living your life only to make more money is to me not very rational, and money and happiness are not identical, though related. There are many other factors involved, including having an interesting life, having loving relationships, and having a sense of satisfaction from having contributed. So entrepreneurs are to me often rational, but just not purely motivated by money.

Jakib

The point is if they are rational according the economic theory

William Berkson

Classical economic theory, yes. But if you use Herbert Simon’s notion of ‘satisficing’ instead—which is more realistic—then multiple goals are allowed, including desire to make a difference and for social approval, and ego. So it is a question of which model of rationality you use in economics.

Jakob

And yet these blog posts are about classic economic therory and how strictly following its assumptions about human nature might actually be negative for cooperation and innovation.

Something I fully agree with, trade existed long before economic theory

William Berkson

Yes, but the larger context is the questions of what actually supports successful groups. That’s why we should take into accounts insights such as those of Herbert Simon, and more recently Kahneman & Twersky.

Lorenzo from Oz

Frank Knight covered a lot of this in “Risk, Uncertainty, and Profit”, originally published in 1921.
https://www.amazon.com/Risk-Uncertainty-Profit-Frank-Knight/dp/1614276390

Herbert M Gintis

Simon Kuznetz showed fifty years ago that in most countries, starting a business, and even running a business, has costs that exceed profits. But this is not irrational because money is not the only reward. You should not call non-monetary rewards “irrational.” You know better than that, Peter.

Jakob

Did you read the posts? its about what economists assume as rational

Peter J Richerson

I have helped Christian Cordes and Georg Schwesinger with models of companies as loci of cooperation. This seems to be especially true of of startups. You can find the papers on my web site http://www.des.ucdavis.edu/faculty/richerson/richerson.htm. A couple most ambitious ones are:

A corporation’s culture as an impetus for spinoffs and a driving force of industry evolution. With Christian Cordes and Georg Schwesinger. Journal of Evolutionary Economics 24: 689-712. 2014.

How corporate cultures coevolve with the business environment: The case of firm growth crises and industry evolution. With Christian Cordes and Georg Schwesinger. Journal of Economic Behavior and Organization 76: 465-480. 2010.

steven t johnson

“One way of increasing the payoff in case the venture succeeds is to force the entrepreneur to yield a large percentage of equity in the company. But that’s self-defeating, because that destroys the motivation of the entrepreneur to work hard.”

Is there any serious reason to regard “hard work” as the cause of success? I’m inclined to think high payoffs, whether to innovators or to humdrum high executives in corporations and stock funds, are not at all aimed to inspiring hard work. But they are aimed at inspiring an unscrupulous determination to do what ever it takes. Investors are buying the loyalty of henchman who do the dirty work. In an industrial corporation, a disregard for the employees can be greatly useful. In a financial form, a disregard to social consequences of exchanging money for paper can be greatly useful. And in innovation, inspiring a relentless use of IP rights and less officially respectable methods to secure de facto monopoly can be greatly useful.

On a more fundamental level, how is a start-up essentially different from someone buying lottery tickets when the jackpot hits an amazingly high level? Most people don’t really sacrifice any significant amount in tickets. The ticket buyer who says, somebody has to win, doesn’t realistically estimate the odds. But neither does the start up founder. Is being an unrealistic estimator of odds really qualify as “irrational?”

“Innovation is really the key to why we live better than people did one hundred, or one thousand years ago. And that business requires extrarational motivations, self-sacrifice, and cooperation.”

I think this sharply overestimates the role of individuals in most innovations, most of which are the results of a developmental process rather resembling evolution. (Strictly speaking, artificial selection, not natural selection, unless you regard modern markets as nature.) The picture of innovation as the deeds of Great Men does help justify the great rewards to the Great Man taking the credit. No doubt it is useful for Gates and Jobs and Musk and Bezos et al. to claim to be the creators, rather than the businessmen who exploited it. But I’m strongly inclined to think these gentlemen, if they every actually invented or discovered anything at all, did less and less inventing and discover anything the more time they spent being successful entrepreneurs.

Scheming to improve your business model may not be so irrational, but is it really innovation? Indeed, the whole notion that entrepreneurial exploitation is the innovation seems to me to be doubtful. It is highly uncommon for the actual innovators to successfully become tycoons. I think that it is indeed true that the real source of innovation lies in the personal, nonmonetary motives of the actual inventors. But the Silicon Valleys the authors want are not necessarily the engines of creation they imagine. The hype says so. But is it true?

Peter van den Engel

The question is whether when 1 in a thousand is successfull, how many of the thousand contributed to the success of the 1, because they certainly must have tought him something, or it needed the chance of one in a thousand before the right answer could be found in principle.

It takes the whole to succeed. Not just one.
Edison tested a million solutions before he found the right one for the lightbulb/ but lucky for him they did not eat.

This is a different type of resilience, than to percieve without an income you won’t survive. That’s the inverted relation.
So, yes enterpreneurs are cooperative/ but not because of the system.

Did Tesla die poor because he did not do the invention, or because it was imperfect?
No, he gave up his patentrights in order to save the company he sold them to from bancrupcy, due to other factors.
So, in the end there was no cooperation at all.

Steve Jobs was fired by Apple because of bad results and difference of opinion. Cooperation is not a given.
When he returned the cooperation of the evolving environment fel into his lap, because mobile devices demanded the hardware/software combination he had always favored and the music industry was in shambles due to free sharing on the internet, so he offered them a new financial model with the device he had a monopoly on.
Finances was his final success/ not just creativity.
As well as only paying app designers outside Apple if they were successful in selling on phones and tablets. So there was no risk for him.
Is that cooperation? Or excluding risk, by shoving it to others.
There are different types of “cooperation”.

The type of singularities they create makes you wonder, if that is necessary or counterproductive.

The question is not if enterpreneurs are cooperative/ but if they could only be that due to an uncooperative system.
I don’t believe in that “magic”.
You dont’t need artificial bounderies, when reality already creates them for you.

Forecaster

My guess is that most people who undertake such ventures don’t think of themselves as just another firm playing the odds, instead they have a big idea which they think will catch on. It’s kind of like how, in a given area, the number of plots of land which contain buried treasure are extremely low compared to the total number, but if one has a reason for believing a specific plot contains such valuables, an argument can be made for being willing to purchase it at a considerably higher price than the land would normally fetch. So to evaluate how extrarational these actions are, one should evaluate them on an individual basis and see how reasonable it was to think their specific product would stand out. The same thing goes for investors.

I repeat what I said in my previous comment, if the argument is that these start-ups are the drivers of technological advancement, this should be demonstrated with data showing that they are overwhelmingly important compared to established companies and governments. There doesn’t strike me as being anything extrarational about why a government would be interested in engaging in this area either directly or indirectly so long as the inventions thereby produced allow it to enhance its power in some way.

Peter van den Engel

The original post was about capitalism in relation to rhe financial system, which would lead to greed according to economic theory.
Greed was (falsely) explained as unwanted competition.
Hence the attempt to prove competition does not really play a role, by comparing it solely to the latest technilogical revolution in silicon valley.

Because the original problem was already falsely explained (the monetary reward for succes remains greed, also in cooperation), silicon valley as an exception also does not prove general economic theory.

Athough technilogical evolution is efficient by itself/ its disruption also created monopolies which are in capitalist perspective unwanted and fi as uber or airbnb disrupt local economies, which is unwanted by their fiscal states. So, no in either respect both do not contribute to what state power would be interested in/ athough I would be the last to say their technologies are unuseful. I am the democracy/ not a fiscal state.

Forecaster

By “these start-ups” and “this area” I meant start-ups and technological advance in general, not just Silicon Valley. I agree that not every advance either in Silicon Valley or elsewhere is conducive to the government, which is why I attached the addendum “so long as the inventions thereby produced allow it to enhance its power in some way.”

Jakob

competition does play a role but according to multi level selection , its in group competition and group vs group competition . If in group competition is too great , group cohesion breaks down and another group with greater cohesion wins, also group vs group competition puts pressure on in group competition to limit it, social norms with limit in group competition are adopted or the group is destroyed by the more cohesive one .

As Dr. Peter Turchin explained so well in his book Ultrasociety

Competition always plays a role, but the key is the type of competition, cooperation exists because of group vs group competition .

There are numerous examples why this is right, for example a sports team would not exist if everyone would just look out for his own max advantage .

Peter van den Engel

Agree, that’s human behavioral logic. The overlapping (money) system though is parallel to an unpersonal energy system level.
Group needs are translated back to individual overproduction (efficiency), so the two create an interdependency which is not personal anymore.
So you can ask yourself on what level its function exists and whether the feed back is correct when it simulates energy for life/ while it only mitigated in the proces.
This creates the so called observed ‘greed’ in behavior, which is actually not social selection/ but system behavior.

It observes an unparallel in expected outcome, which it basicly is. It creates a psychology.
Group cooperation is not the same thing. Its kind of behavior creates a progressive potential/ and the overlapping (thermal) one is involved in a negative missing potential (entropy).

It can be understood in general by Quantum Mechanics Learning (QML), which depends on dominators with different meanings, creating a simulation.

In fact a sportsteam is nothing but a simulation. In fact it produces nothing. When you believe your personal destination depends on that group, it has created a funny kind of psychology. It suggests a group interdependency which in this case is irrelevant.
Although there are parallels to the general functioning. You can ask yourself if this is learning, mimicking/ or simply reproduction.

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