My Contributions to Entrepreneurship Theory
[Editor's Note: This essay is forthcoming in The Routledge Companion to the Makers of Modern Entrepreneurship (Routledge, 2017), edited by David B. Audretsch and Erik E. Lehmann.]
I briefly summarize my contributions to entrepreneurship theory, focusing on the links between contemporary entrepreneurship research, the “Austrian” understanding of markets and prices, and the economic theory of the firm. I articulate the “judgment-based approach” to entrepreneurial action and argue that entrepreneurship can and should be more tightly integrated into theories of production and exchange, firm strategy and organization, and public policy and administration. I also distinguish the judgment-based approach from the opportunity-discovery perspective associated with Israel Kirzner.
My background is unusual for an entrepreneurship scholar. I began my career as an industrial organization economist with little knowledge of the modern entrepreneurship literature (and little experience with entrepreneurship practice). I was trained at Berkeley in the late 1980s and early 1990s by Oliver Williamson, focusing on corporate governance and organizational economics. I was particularly interested in how large firms manage information flows and provide incentives, especially in rapidly changing environments. My dissertation dealt with conglomerate diversification in the 1960s and 1970s from the perspective of transaction cost economics. I was interested in theories of firm behavior and focused on empirical work on firm boundaries and organization. I maintained a general interest in various topics in applied microeconomics, economic growth, and business-cycle theory, and did as much popular writing and speaking on economics and economic policy as the tenure clock would allow.
However, I had reservations about “mainstream” neoclassical economics. As an undergraduate economics major I was attracted to Austrian school writers such as Ludwig von Mises, F. A. Hayek, Henry Hazlitt, and Murray Rothbard and eagerly read as many of their books and articles as I could find (with limited understanding). During my graduate studies I was a research fellow of the Mises Institute and developed a personal relationship with Rothbard, the great libertarian polymath and the most dazzling intellectual I have ever known. I also read a lot of Hayek, working at Stanford as a research assistant for W. W. Bartley, III, founding editor of The Collected Works of F. A. Hayek. Bartley was also working on of intellectual biographies of Hayek and Karl Popper, his own mentor.1At seminars and conferences I met leading contemporary practitioners of the Austrian school including Israel Kirzner, Mario Rizzo, Joseph Salerno, Roger Garrison, Gerald O’Driscoll, and Hans-Hermann Hoppe, and I became immersed in the Austrian literature, as well as the neoclassical economics and transaction cost economics that were central to my Ph.D. program. My interests were idiosyncratic, to say the least.
I read Kirzner’s Competition and Entrepreneurship (1973) as an undergraduate student and studied his works more closely while pursuing my PhD. 2 Like most of Kirzner’s contemporaries, I viewed the book as a contribution to microeconomics, not entrepreneurship (Klein and Bylund, 2014: 261). I shared Kirzner’s conception of the entrepreneur as an abstract force, not an actual person or group of people acting in real time. As Kirzner (2009: 145–146) later put it, “my own work has nothing to say about the secrets of successful entrepreneurship. My work has explored not the nature of the talents needed for entrepreneurial success, not any guidelines to be followed by would-be successful entrepreneurs, but, instead, the nature of the market process set in motion by the entrepreneurial decisions.” For Kirzner, the entrepreneur plays a largely instrumental role—entrepreneurship is that which recognizes and exploits profit opportunities existing in a world of disequilibrium, full stop. I too viewed the entrepreneur as the central actor in a market system, the agency responsible for moving resources from lower- to higher-valued uses, but had little interest in flesh-and-blood entrepreneurs. 3
Austrian Economics, Entrepreneurship, and the Theory of the Firm
As I have noted elsewhere (Klein, 2008a, 2008b), the Austrian economists, going back to Carl Menger, have differed from their neoclassical economist colleagues in giving the entrepreneur this central position in the analysis of the market. While entrepreneurship played a prominent role in economic theory from the time it emerged as a systematic discipline (Cantillon, 1755), by around World War II the entrepreneur had mostly dropped out of economics journal articles and textbooks. As the language of economics became more formal and stylized, and economists were drawn to highly abstract concepts of markets and competition such as the model of perfectly competitive general equilibrium, it was simply too difficult to incorporate a creative, dynamic, coordinating or disruptive actor into the analysis. Microeconomics became the description of various equilibrium states (existence, stability, welfare properties), and there was nothing for an entrepreneur to do. For the Austrians, by contrast, the entrepreneur as a speculator, coordinator, allocator, and innovator was always what Mises (1949: 326) called the “driving force of the market.”
Note that the term “entrepreneur” to most Austrian economists does not mean self-employed person, small-business owner, or technological innovator (though all these persons can act entrepreneurially). Rather, entrepreneurship is a generalized function associated with resource allocation and value creation. For Kirzner, building on Friedrich Wieser and Hayek, that function is alertness to profit opportunities that result from prices that are not at their equilibrium values (Foss and Klein, 2010b). For Mises, Rothbard, and others such as Salerno (1993, 2008) and me (Klein, 2008b; Foss and Klein, 2012), that function involves acting under conditions of Knightian uncertainty. 4In either case, entrepreneurship is not uniquely associated with a particular job category (self-employment), firm type (small firm, young firm, high-growth firm), or strategy (R&D-intensive firm) (see Klein, 2008: 176–178).
I began thinking more carefully about the entrepreneurial function while writing two papers applying Austrian economics to the theory of the firm (Klein, 1996, 1999). The second paper included a section on “Financiers as Entrepreneurs” (Klein, 1999: 36-38) in which I discussed David Scharfstein’s (1988) argument that unregulated financial markets will not produce enough disciplinary takeovers, because shareholders in an underperforming target firm will refuse to tender their shares to a raider or acquiring firm for less than their share of the post-takeover value of the firm, leaving no profit for the acquirer. This kind of argument, I realized, assumes that all market participants have the same beliefs about future share prices and are equally willing to bear the uncertainties associated with the restructuring process. In contrast, I saw post-takeover profits (and losses) as returns to exercising the entrepreneurial function. The analysis of firm governance could not, then, be understood without seeing financial-market participants as entrepreneurs who seek to exploit gaps in the market (à la Kirzner) or specialize in bearing fundamental uncertainties (à la Knight and Mises). 5
Describing business restructurings as entrepreneurial actions led me to think more systematically about entrepreneurship and to read more widely in the contemporary entrepreneurship literature. I discovered that Kirzner’s concept of alertness provides the theoretical foundation for the opportunity-discovery perspective (Shane and Venkataraman, 2000; Shane, 2003), while Knight’s and Schumpeter’s ideas play smaller roles. I quickly came to the belief that the entrepreneurship literature had not read Kirzner carefully enough, and that many theoretical and applied studies (e.g., surveys asking entrepreneurs or prospective entrepreneurs to list the number of opportunities discovered, evaluated, and exploited) were inappropriately reifying the metaphor of “opportunity” used by Kirzner to explain market coordination.6
The Judgment-based View
Around that time Nicolai Foss and I were invited to contribute to a Festschrift in honor of Kirzner. We assumed that most of the participants would write about entrepreneurial discovery and we wanted to do something different. My wife, also a trained economist, reminded me that Kirzner wrote an interesting and underappreciated book on capital theory (Kirzner, 1966). There Kirzner argued, building on earlier work by Ludwig Lachmann (1956), that the nature and value of an asset or resource is determined not by its objective properties (size, weight, location, construction, technical capabilities), but by its imagined place in the subjective production plans of a forward-thinking entrepreneur. Kirzner’s capital theory seemed to provide a useful means of integrating the theory of the entrepreneur and the economic theory of the firm, two bodies of literature that had developed largely in isolation, despite much overlap in approach and subject matter. Developing and extending Kirzner’s capital theory led to the Festschrift chapter (Foss et al., 2002) and two follow-up papers (Foss et al., 2007; Foss, Foss, and Klein, 2007) and, a few years later, to Foss’s and my 2012 book Organizing Entrepreneurial Judgment: A New Approach to the Firm.
I usually describe my approach here as the “judgment-based view” of entrepreneurship (see Foss and Klein, 2015, for a summary and reflections). The term judgment comes from Knight, who described judgment as decision-making under uncertainty that cannot be modeled or parameterized as a set of formal decision rules. Judgment is midway between the “rational decision-making” of neoclassical economics models and blind luck or random guessing. We sometimes call it intuition, gut feeling, or understanding. 7In a world of Knightian uncertainty, and heterogeneous capital resources with attributes that are subjectively perceived and unknowable ex ante, some agency must bear the responsibility of owning, controlling, deploying, and redeploying these resources in the service of consumer wants. That, in my formulation, is the role of the entrepreneur. The entrepreneur’s job is to combine and recombine heterogeneous capital resources in pursuit of profit (and the avoidance of loss). When the entrepreneur is successful in acquiring resources at prices below their realized marginal revenue products—i.e., when the entrepreneur exercises good judgment—she earns an economic profit. When her judgments are poor, she earns an economic loss. Competition among entrepreneurs (and those who provide financial capital to entrepreneurs) tends to steer ownership and control of productive resources toward those entrepreneurs with better judgment.
In this model, a firm is an entrepreneur plus the alienable assets she owns and controls. The multi-person firm includes multiple owners and/or employees who may exercise “derived judgment” on the part of the entrepreneur-owner or owners, who exercise judgment in selecting, monitoring, and delegating decision authority to these employees. Organizational characteristics (size, vertical boundaries, diversification, ownership structure, internal organization, etc.) evolve over time as entrepreneurs experiment with different combinations of heterogeneous assets and different strategies and business models. As Lachmann (1956: 16) put it, “We are living in a world of unexpected change; hence capital combinations . . . will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur.”
The judgment-based approach plays a distinct role in the current conversation and controversy about the nature of entrepreneurship research (Short, Ketchen, Shook, & Ireland, 2010; Dimov, 2011). The once-dominant opportunity-discovery perspective has come under fire from a variety of perspectives. Alvarez and Barney (2007) kicked off a lively debate by challenging the ontological status of entrepreneurial opportunities, arguing that opportunities are best understood as created, subjectively, rather than existing outside of entrepreneurial action. The judgment-based view goes a step further, arguing that the construct of opportunity itself is unnecessary at best, misleading at worst. 8Entrepreneurial action is seen as beginning with the entrepreneur’s interpretation of current (objective) conditions, his beliefs about possible future states of the world (e.g., a profitable product or venture), and his expectations and confidence in his the ability to bring about that possible future. The entrepreneur then acts (or doesn’t act), with success or failure determined ex post, largely by objective factors.
In this formulation, there is simply no need for the opportunity construct. The discovery view mistakenly implies that opportunities exist independent of human belief and action. The creation view rightly emphasizes human belief and action, but mistakenly implies that profit opportunities, once the entrepreneur has conceived or established them, somehow come into being. I definitely see entrepreneurship is a creative process but say that what entrepreneurs create (or attempt to create) are not opportunities, but new firms, new products, or new markets. When they are successful, their efforts may be recast after the fact in opportunity language. But little or no additional insight is produced by doing so (Foss and Klein, 2016). Moreover, it is extremely awkward to describe entrepreneurial failure—financial loss, bankruptcy, or other forms of unintentional exit—in opportunity language. (Kirzner refers to losses as resulting from “mistaken opportunities,” but wouldn’t it be clearer to refer to them as the results of mistaken actions?)
I see much of my recent work as an attempt to convince entrepreneurship scholars to make action, not opportunities, the unit of analysis for entrepreneurship research, teaching, and outreach. An action-theoretic perspective helps us (and our students and consulting clients) to remember that action always takes place under conditions of uncertainty (even for mundane activities in established industries!). The language of opportunity may also encourage overconfidence, by mistakenly conveying the idea that the results of entrepreneurial action exist ex ante, before profits and losses are realized, either because these results were there waiting to be discovered, or because the entrepreneur created them through an act of will.
These efforts are bearing some fruit as a judgment-based perspective on entrepreneurship is beginning to emerge (Hülsmann, 1997, 2000; McMullen and Shepherd, 2006; McCaffrey and Salerno, 2011; Huang, 2012; Halberg, 2015; McCaffrey, 2014, 2015; McMullen, 2015), though its basic claims are often misunderstood (Klein, 2013; Foss and Klein, 2016). Much of this work has been conceptual and theoretical, though we are beginning to see applied work in entrepreneurial cognition, venture formation, and public policy. My hope is that the judgment-based perspective will continue to grow and join the opportunity-discovery, opportunity-creation, and effectuation/bricolage approaches as a recognized alternative (though not necessarily mutually exclusive) framework for understanding entrepreneurial action and its role in the economy and in society.
Reflections on Kirzner
Besides seeking to address the entrepreneurship research and teaching communities, I have also continued to engage the contemporary Austrian economics literature. While I continue to have the greatest respect for Israel Kirzner as a scholar and teacher, I am increasingly convinced that his highly influential work on market competition as a process of entrepreneurial discovery (Kirzner, 1997a)—often characterized as “the” Austrian approach to entrepreneurship—has led Austrian microeconomics down the wrong path. It is essentially Walrasian price theory with a twist. Walrasian general equilibrium is seen as the end state toward which the market process is tending, though not quite reaching. Kirzner’s entrepreneur is simply an addition to neoclassical market theory, a disembodied agency making sure that disequilibrium arbitrage opportunities are ephemeral by acting upon them quickly, if not quite immediately. Kirzner’s entrepreneur owns no capital but pursues “pure entrepreneurial profit” by exploiting these arbitrage opportunities, which can be siezed at zero risk, moving the economy closer to its hypothetical equilibrium state (Klein, 2008a; Foss and Klein 2010a).
Along with Salerno (1993, 2008), I have tried to rehabilitate an alternative Austrian theory of the market and the entrepreneur, one based on Cantillon, Menger, Mises, and Rothbard. This conception of the market focuses on day-to-day, real-world market-clearing prices, not hypothetical equilibrium prices, and views the entrepreneur as a capital-owner who invests resources under conditions of uncertainty in pursuit of economic gain. The “market process,” in this understanding, is not the continual pressure toward equilibrium in particular markets but the continual competition among capitalists and entrepreneurs for ownership and control of productive resources that can be used to generate profits. Successful flesh-and-blood entrepreneurs may be particularly alert to changes in market conditions, just as they may be particularly charismatic, creative, and inspirational, but this is not a theoretically necessary component of entrepreneurial action. It is the investment of resources under uncertainty, not alertness to some potential future, that distinguishes the entrepreneurial function from other roles in an economic system (see Klein, 2008a, for a detailed discussion).
This revisionist Austrian perspective has put me at odds with some contemporary Austrian economists, and generated some confusion in interactions with entrepreneurship and management scholars with only a passing interest in internecine Austrian controversies. But it shows that there is remarkable diversity within the modern Austrian tradition, as there was in the days of Carl Menger—signs of a healthy and growing movement.
I continue to explore a variety of topics in entrepreneurship theory, the applications of entrepreneurship and innovation, public policy, and related topics in strategy, organization, and governance. I am particularly interested in the effects of public policy on entrepreneurial judgment and in the ways that entrepreneurial judgment, alertness, and innovation can be applied to non-market actors, including universities and government officials (Klein et al. 2010, 2013; Kolympiris and Klein, 2016). My sense is that we tend to apply entrepreneurial metaphors too loosely, referring to creative and innovative persons as “entrepreneurs” without fully considering the differences in institutional context (for example, government bureaucrats are investing other people’s resources under conditions of uncertainty, not their own resources). But we can gain some insight on the behavior of non-market actors, and the emergence and growth of public organizations, by thinking about entrepreneurial processes of resource assembly and recombination.
Underlying these various projects is my continued belief that entrepreneurship is not a separate field of economics or management—the study of self-employment or new-venture formation—but should be integrated more tightly into theories of the firm and market, theories of firm strategy and organization, and theories of public policy and administration.9The entrepreneur is at the very heart of a market system, the person who creates and operates firms, who allocates capital across activities, who formulates and executes strategies, who designs and governs organizations. It is my hope that scholars in a variety of academic disciplines will put the entrepreneur back in his proper place.
Alvarez, Sharon A., and Jay B. Barney. 2007. “Discovery and Creation: Alternative Theories of Entrepre-neurial Action.” Strategic Entrepreneurship Journal 1(1–2): 11–26.
Baker, Ted, and R. E. Nelson. 2005 “Creating Something from Nothing: Resource Construction through Entrepreneurial Bricolage.” Administrative Science Quarterly 50: 329-366.
Cantillon, Richard. 1755. Essai sur la nature du commerce en général. Henry Higgs, ed. (London: Macmillan, 1931).
Dimov, Dimo. 2011. “Grappling with the Unbearable Elusiveness of Entrepreneurial Opportunities.” Entrepreneurship Theory and Practice 35: 57–81.
Foss, Kirsten, Nicolai J. Foss, and Peter G. Klein. 2007. “Original and Derived Judgment: An Entrepreneurial Theory of Economic Organization,” Organization Studies 28(12): 1893–1912.
Foss, Kirsten, Nicolai J. Foss, Peter G. Klein, and Sandra K. Klein. 2002. “Heterogeneous Capital, Entrepreneurship, and Economic Organization,” Journal des Economistes et des Etudes Humaines 12(1): 79–96.
Foss, Kirsten, Nicolai J. Foss, Peter G. Klein, and Sandra K. Klein. 2007. “The Entrepreneurial Organization of Heterogeneous Capital,” Journal of Management Studies 44(7): 1165–1186.
Foss, Nicolai J., and Peter G. Klein. 2010a. “Alertness, Action, and the Antecedents of Entrepreneurship,” Journal of Private Enterprise 25(2): 145–164.
Foss, Nicolai J., and Peter G. Klein. 2010b. “Entrepreneurial Alertness and Opportunity Discovery: Origins, Attributes, Critique,” in Hans Landström and Franz Lohrke, eds., The Historical Foundations of Entrepreneurship Research (Cheltenham, U.K.: Edward Elgar, pp. 91–120).
Foss, Nicolai J., and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment: A New Approach to the Firm (Cambridge: Cambridge University Press).
Foss, Nicolai J., and Peter G. Klein. 2015. “The Judgment-Based Approach to Entrepreneurship: Accomplishments, Challenges, New Directions,” Journal of Institutional Economics 11(3): 585–599.
Nicolai J. Foss and Peter G. Klein. 2016. “Entrepreneurial Discovery or Creation? In Search of the Middle Ground,” Academy of Management Review, forthcoming.
Halberg, Niklas L. 2015. “Uncertainty, Judgment, and the Theory of the Firm,” Journal of Institutional Economics 11(3): 623-650.
Hayek, F. A. 1992. The Fortunes of Liberalism: Essays on Austrian Economics and the Ideal of Freedom, ed. Peter G. Klein. vol. 4 of The Collected Works of F. A. Hayek (Chicago: University of Chicago Press and London: Routledge).
Huang, Laura. 2012. A Theory of Investor Gut Feel: A Test of the Impact of Gut Feel on Entre-preneurial Investment Decisions. Ph.D. dissertation, University of California, Irvine.
Hülsmann, Jörg Guido. 1997. “Knowledge, Judgment, and the Use of Property,” Review of Austrian Economics 10(1).
Hülsmann, Jörg Guido. 2000. “A Realist Approach to Equilibrium Analysis.” Quarterly Journal of Austrian economics 3(4): 3–51.
Kirzner, Israel M. 1966. An Essay on Capital (New York: Augustus M. Kelley).
Kirzner, Israel M. 1973. Competition and Entrepreneurship (Chicago: University of Chicago Press).
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Kirzner, Israel M. 1997b. “The Kirznerian Way: An Interview with Israel M. Kirzner,” Austrian Economics Newsletter 17(1).
Kirzner, Israel M. 2009. “The Alert and Creative Entrepreneur: A Clarification,” Small Business Economics 32: 145–152.
Klein, Peter G. 1996. “Economic Calculation and the Limits of Organization,” Review of Austrian Economics 9(2): 51–77.
Klein, Peter G. 1999. “Entrepreneurship and Corporate Governance,” Quarterly Journal of Austrian Economics 2(2): 19–42. Reprinted in David B. Audretsch and Erik E. Lehmann, eds., Corporate Governance in Small and Medium Sized Firms (Cheltenham, UK: Edward Elgar, 2011).
Klein, Peter G. 2008a. “The Mundane Economics of the Austrian School,” Quarterly Journal of Austrian Economics 11(3–4: 165–187.
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Klein, Peter G. 2009. “Risk, Uncertainty, and Economic Organization,” in Jörg Guido Hülsmann and Stephan Kinsella, eds., Property, Freedom, and Society: Essays in Honor of Hans-Hermann Hoppe (Auburn, Ala.: Mises Institute), pp. 325–337.
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Klein, Peter G., Joseph T. Mahoney, Anita M. McGahan, and Christos N. Pitelis. 2013. “Capabilities and Strategic Entrepreneurship in Public Organizations,” Strategic Entrepreneurship Journal 7(1): 70–91.
Kolympiris, Christos, and Peter G. Klein. 2016. “Universities as Innovators: The Effect of Academic Innovators on Patent Quality,” working paper, University of Bath and Baylor University.
Lachmann, Ludwig M. 1956. Capital and Its Structure (Kansas City: Sheed Andrews and McMeel, 1978).
McCaffrey, Matthew. 2014. “On the Theory of Entrepreneurial Incentives and Alertness,” Entrepreneurship Theory and Practice 38(4): 891–911.
McCaffrey, Matthew. 2015. “Economic Policy and Entrepreneurship: Alertness or Judgment? In Per L. Bylund and David Howden, eds., The Next Generation of Austrian Economists: Essays in Honor of Joseph T. Salerno (Auburn, Ala.: Mises Institute).
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Sarasvathy, Saras D., and Nicholas Dew. 2013. “Without Judgment: An Empirically-based Entrepreneurial Theory of the Firm.” Review of Austrian Economics 26(3): 277-296.
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Short, Jeremy C., David J. Ketchen, Christopher L. Shook, and R. Duane Ireland. 2010. “The Concept of ‘Opportunity’ in Entrepreneurship Research: Past Accomplishments and Future Challenges.” Journal of Management 36(1): 40–65.
- 1. Bartley died in 1990 before the Hayek or Popper biographies were complete. Before his death he and I were planning to coedit a volume in the Hayek Collected Works, and I assumed responsibility for the volume, which appeared in 1992 as The Fortunes of Liberalism: Essays in Austrian Economics and the Ideal of Freedom (Hayek, 1992). My first academic publication was an edited book!
- 2. I applied to NYU’s PhD program with thoughts of studying under Kirzner before eventually choosing Berkeley. A long telephone interview with Kirzner was a highlight of my pre-doctoral studies, as was an even longer and livelier telephone conversation with Murray Rothbard as part of my application for a Mises Institute fellowship. Sadly, I never met Hayek, who was alive until 1992 but in poor health during the time I was working on his papers.
- 3. The same could be said about Schumpeter (1911) and Knight (1921). For Schumpeter, entrepreneurship is that which moves an economy from one equilibrium to another; for Knight, entrepreneurship is that which bears uncertainty.
- 4. Mises refers not to Knightian uncertainty, but to his brother Richard von Mises’s construct of “case probability,” which functions in this context much like Knightian uncertainty (see Klein, 2009).
- 5. I also noted (Klein, 1999: 38): “This account, however, could use further elaboration. For example, how is the bearing of uncertainty distributed among participants in various forms of restructuring? How do regulatory barriers hamper the [entrepreneur’s] ability to exercise the entrepreneurial function in this context?”
- 6. As Kirzner noted in a 1997 interview: “I do not mean to convey the idea that the future is a rolled-up tapestry, and we need only to be patient as the picture progressively unrolls itself before our eyes. In fact, the future may be a void. There may be nothing around the corner or in the tapestry. The future has to be created. Philosophically, all this may be so. But it doesn’t matter for the sake of the metaphor I have chosen. . . . Ex post we have to recognize that when an innovator has discovered something new, that something was metaphorically waiting to be discovered. But from an everyday point-of-view, when a new gadget is invented, we all say, gee, I can see we needed that. It was just waiting to be discovered” (Kirzner, 1997b).
- 7. The German word Verstehen works better than its English equivalent in convening a sense of deep, and possibly intuitive or tacit, knowledge or understanding.
- 8. In this sense, the judgment-based view is closer to the effectuation and bricolage approaches (Sarasvathy, 2008; Baker and Nelson, 2005) in viewing entrepreneurial action, not opportunity, as the unit of analysis—even though effectuation theorists have not always seen this connection (Sarasvathy and Dew, 2013)!
- 9. This is not to say that entrepreneurship studies should not be contained within separate university departments, published in specialized entrepreneurship journals, and so on. I refer here to the intellectual concept of a distinct field, not the institutional concept.