Success from Satisficing and Imitation: Entrepreneurs’ Location Choice and Implication of Heuristics for Local Economic Development

0:00This paper is motivated by a broader question about the potential value to Austrian economics, to asking questions about the decision process that entrepreneurs use. On the one hand, von Mises and Rothbard set out to carefully delineate what it is they do from whatever it is that other stuff that psychologists and decision theorists do. There's certainly some clear statements against the idea of opening the black box of what goes on in the mind. But on the other hand, when we encounter Hayek's The Sensory Order and see his keen interest in psychology, in models of mind, and then one can't help but be interested in how Austrian market process relates to Hayekian and other Austrian ideas about the way the mind works.

1:01Kirzner and Schumpeter in places they seem to write dismissively about psychology and decision process and certainly the overriding focus in the entrepreneurial studies in the The Austrian literature focuses on action, judgment and the nice taxonomy that you presented for us. What I'm hoping to do is propose a research program and show you what I've been doing of talking to entrepreneurs and thinking about what this might portend in terms of potential for future Austrian research. I would submit that I'm certainly undertaking to analyze the action of entrepreneurs but but also to complement the study of action with a more detailed description of underlying decision process.

1:53So what are the questions? I wanted to know how entrepreneurs choose the locations that they do. And one thing that's different than in the discussion we just heard was that the tacit knowledge is quite public. When I choose a location, then it's quickly observed by competitors in the market. I want to know how long do they search? How many locations do entrepreneurs, good ones, consider before finalizing a decision? What constitutes a stopping rule? What are the metrics for evaluating what a good location is? Certainly we wouldn't from an Austrian perspective expect it to be one thing, although in the neoclassical literature we tend to to reduce this to moments of known probability distributions, expected payoffs.

2:41And then we want to know what are the criteria that entrepreneurs use to stop search and then finally make a decision how to bet their own personal capital in choosing a location.

2:57If you go to the Economics 101 textbook, The benefit-cost calculus presumes that the decision maker has a known menu of alternatives. So if I were buying a house for a budget of $200,000, then the idea here is that I would have an exhaustive list of all the affordable homes everywhere, all continents, and that presumably there could be some hedonic attributes of living in a faraway place that would outweigh or offset the costs of going there. So, the standard textbook model is that exhaustive search has to be undertaken, that each element in this choice set has to be scored numerically, usually by expected payoff, without saying exactly what payoff means.

3:46And then, by definition, we hear this also from Austrian economists, interestingly, that choice is definitionally the selection of the best feasible alternative, and I'm hoping I wanted to enlarge that discussion a little bit based on my collaborations with psychologists and biologists. Well, neoclassical economists realized that smart people sometimes stop searching before the entire menu of alternatives is completed. That gave rise to optimal search theory. Many of you probably know the secretary problem, which was an early example of statistics that led to the 1 over E rule. So, basically, if you've got a list of unknown job candidates in a known sequence, and the only goal is to maximize the probability that you'll choose the best one, then it can be proved, and mathematical economists like to prove this, that the optimal stopping rule is you look up about a third of them and then pick the next dominating alternative that comes down the pike, Most choice problems that entrepreneurs face, though, don't simply have to do with durations of search, they also have to do with paths of search.

5:01In the secretary's problems, it's assumed that there's an exogenously given list of alternatives and they come in a fixed order. So, the proponents of neoclassical search theory, in trying to get a more realistic model of the choice problem This is a problem that people under time and decision cost pressures make. They make even more heroic assumptions about the givens in terms of the data that are available to the presumed users of this kind of optimization theory. And you can even think about it, if I just have three alternatives, then there would be three possible durations of search. I could look up all three, I could look up two, I could look up one, but then there are multiple paths I can go.

5:48and when you get into the combinatorics of the search path space combined with the duration length then the choice problem just becomes mathematically more formidable and computer scientists refer to this kind of problem as NP-hard, it's not computable for as the length of and as the sizes of choice sets get bigger and nobody, no supercomputer could compute it and we don't expect people to actually do it so then neoclassicals put this forward as a good as-if story. Okay, here's the world I'm interested in, the one that all of our heroes in the Austrian canon talk about under various labels, profound uncertainty I'm talking about. We don't know all the possible outcomes and we certainly don't have a list of probabilities. One can draw on numerous sources, I just listed a few.

6:46My point of departure here is to get into the behavioral economist's idea about how to deal with this problem. So I was trained as a mathematical modeler and I began working on models of financial market equilibrium where people sometimes believe the wrong thing. And I was intrigued with interesting results that sometimes equilibrium requires everybody to believe something different and sometimes you can get Pareto dominating equilibria when everybody believes the wrong thing. And this calls into question some of the basic normative tenets about the whole rational explanations conversation in the neoclassical theory. Now, when I first went to UT Dallas 13 years ago, I ran into Peter Lewin, an Austrian economist who began mentoring me and finding a richer literature to probe my interest in uncertainty and subjective beliefs.

7:46And I was always intrigued with this kind of this tension between a professed lack of interest in the introspective mind, but also a recognition in this radical heterogeneity of goals, of information sets that seems to have so much potential for the descriptive richness of models of mind. So, I could talk about a gazillion behavioral economists that have, at various stages in the arc of behavioral economics, tried to flirt with various authors in the Austrian tradition and then quite a few well-known Austrian authors, Lachmann and Buchanan and Van Berg. You'll see talking about taking psychology seriously and being interested in the decision process of entrepreneurs.

8:38I'll leave it there and move on to what the behavioral economists have done. I think there's a huge arrogance and a methodological misguidedness in the so-called behavioral economics revolution. So this was the methodological fight. When I was a PhD student, I was interested in working with otherwise standard neoclassical models, but where the beliefs were wrong. And already that was considered exotic, weird, behavioral. Then in the last 15 years, we've had this self-described methodological opening up. Now we can dump everything into the utility function, exotic preference models, and the self-description of the people who are editing the top neoclassical, or formerly neoclassical journals, now profess a new kind of methodological openness.

9:33But my point would be that this is more or less a retrenchment of a very rigid, singular methodological norm based on the mathematics of constrained optimization. What's new is we have a few new inputs in the utility function, we have a few new decision parameters, asymmetric weighting of gains and losses, you well know the work of Danny Kahneman and this claim of widespread irrationality. My point of view is that by deviating from the axioms, the rationality axioms of the neoclassical model, this is sometimes required to be an adaptive, smart, intelligent agent acting purposefully the way that Austrian heroes have described.

10:21and I have tried to write about this expansion of what counts as a legitimate question in economics and a paradoxical hardening of its normative interpretation that really everybody should be maximizing something in a small world that's so simple that we can list all the alternatives, write down probability distributions, describe payoff functions. I don't believe those models Work, and many of the people contributing to this have a diverse range of perspectives about it, but what they typically come back to is after putting a bunch of exotic stuff in the utility function, they hold the neoclassical axioms as the right normative model for what we all should be aspiring to, that business schools should be teaching everybody to maximize their expected utility theory, and if you look at the thousands of papers that are written and non-Basian behavior and loss aversion, standard behavioral topics, you might get the feeling that there's well established that there are billions and trillions of dollars of losses out there to the economy simply because people aren't maximizing the right

11:30thing. You can look wide and far for that empirical evidence. There's actually almost no data at all linking pathological decision process to any kinds and the kinds of norms that an Austrian would care about, accumulated wealth, life span, happiness. I will leave it at that and hope we can continue discussion about that. So what I did is I started talking to entrepreneurs in Dallas. A few of them, 17 of them had very large projects, over a million of their personal capital invested and the rest, smaller projects, and what I was most interested in was eliciting a description about how the choice of location was made, the length of search, the number of items considered, and what kinds of criteria were used to stop the search and finally make the decision. Here is a typical account. The idea struck me as I was driving by that area that it could be developed into a Property of Note. I told my husband to drive by to get a feel for the area. We liked it. It felt right. Then I ran the numbers and it looked like we could get at least 20% any return on capital within two or three years. That was enough to make it worthwhile to go ahead.

12:54You'll notice there's nothing about equating marginal benefit with marginal cost or considering all the possible search lengths and finding the optimal duration or the optimal path of search. There's and, instead, a discussion of threshold conditions that have to be fulfilled in order for this decision to be okay. So this, to me, looks a lot like the satisfying behavior that Herb Simon described. And I think this raises some methodological problems in some parts of the Austrian literature. And I'm eager to have conversations about this. The satisfying implication of this tells me that if you live in an opportunity-rich world, there are many, many ways to be successful.

13:46There are many good enough paths. Therefore, the imperative should not be to maximize something written down in a small world, but to take this massively high-dimensional action space and simply find a good enough path. Here is the empirical distribution of the number of elements in the consideration set. The entrepreneur is considered very few locations and this is kind of what you'd expect if you are reading Schumpeter and talking about a man of action and intuition. Nine of the 49 looked at only one, did not even think about opportunity cost or next best.

14:36The modal number of items considered was three. That may be enough. I probed, so I was using this scripted interview with numerous follow-up questions, trying to get as rich an informational set as I could about the self-described decision process. And the kinds of things that you heard from these entrepreneurs, They were sophisticated quantitatively. This is not a function of being incapable to collect information or not being good at numbers. Quite to the contrary, we even talked to a couple consulting firms that do do a kind of exhaustive search using census data, going down to the block group level and linking those with real estate openings. So there are services out there. If you wanted to do an exhaustive search of a state or of a city, it certainly can be done.

15:27I didn't find anybody who was remotely interested in that, and then when I asked point blank, well, why didn't you search more, or did you think about searching more, then I would often get the response, oh, I know what you're thinking, you're thinking about the optimization model, you're thinking, many of them had studied economics, and they said, yeah, you're probably wondering why more wasn't better. And you have to understand in the kind of environment I live in, things are changing The Theory of Money and Credit

16:26I'm interpreting this as a purpose of openness to serendipity and evidence of the kind of alertness and intuition that one finds discussed in Austrian writings on entrepreneurial behavior. The purpose of openness to serendipity and evidence of the kind of alertness and intuition that one finds discussed in Austrian writings on entrepreneurial behavior. Although I'm quite aware there would be alternative interpretations and would welcome some conversation about that. Okay, the threshold conditions. Nobody said they were setting any two variables equal to each other. I need 20% return on investment, I need an occupancy rate over 80%, if I think I can get X return after Y years, where Y is one year, two years, maybe five years.

17:18This is the kind of conditional threshold that defines nearly everybody I talk to as stopping rule. Imitation. This is something I know that bothers a lot. Some writers in the Austrian traditions considered too automatic, too much of an automaton kind of algorithmic rule. It doesn't seem to draw on the intuition, great man, great woman leader that we write about. What I found though is that the smaller projects, once I asked about their self-described return, whether their returns exceeded expectation, met expectation, fell below expectation, many of the smaller projects did quite well imitating.

18:06And there was lots and lots of talk about the presence of Starbucks or a laundromat or a drugstore nearby. People choosing locations are very conscious of nearby business activity. So many people mentioned wanting Starbucks nearby so that their employees would have good coffee to drink that it makes you wonder why there's even positive rent. These guys should be paid to locate. If you're selling real estate or renting, It's questionable whether Starbucks is actually earning a fair return on its positive spillover effects. Okay, then I told you a little bit about this, and I will cut to the chase. There was one of the things that, as an Austrian, I have a PhD student that became head of local economic development initiatives in Dallas.

19:01The cities often want to do things like target tax incentives to motivate and incentivize firms to invest in particular sectors of the city. In Dallas, there are big islands that are devoid of any commerce or any visible commerce and of frustratingly small responsiveness to tax incentives. And then we also ask questions about this. Most of the people we talked to said they would never put it in their consideration set. You could give me rent for free for a year, I still wouldn't consider it. Which really raises questions about whether these small marginal incentives have any chance of getting a location that's not in the consideration set into the consideration set.

19:49Of course their thinking is that if you see a neighborhood that has no profit, that has no business activity, Then if everybody's profit maximizing and everybody does exhaustive search, then that means that those places have no opportunity. But then if you talk to the way entrepreneurs actually make their decisions, many of them wisely economizing on search costs and information and accumulating in well-known neighborhoods, then this does portend the possibility that there could be profitable opportunities in unexploited neighborhoods that go unexploited for a long time simply because of the decision process that the entrepreneurs are using. So, I will leave it there and hope we have a continued conversation about decision process in Austrian economics.

20:35Thanks. Thank you very much.