Many of the established and successful companies that we know have amazing stories in their origins. In the beginning, Sony, who started by repairing war-damaged radios after World War II, decided to produce an electric rice cooker. Why? Because originally clients would pay radio repairs with rice, in addition to the normal service fee. The experiment was a failure, but this didn’t prevent the company from becoming the successful multinational that we all know.
The purpose of this article is to explain how entrepreneurs like Sony’s founder make decisions, in particular when facing uncertainty, according to Professor Sara Sarasvathy’s theory of Effectuation (2001), as explained in her book “Effectuation: Elements of Entrepreneurial Expertise”.
Entrepreneurship is vital for economic growth
In economics, the factors of production are what is necessary for the production of goods or services to make a profit. Classical economists divided them into three categories: land, labor and capital. Accordingly, a product or service should cost no more and no less than the prices paid for the three factors. Therefore, in an open, efficient market where supply and demand are in sync with each other, “profit” should equal zero.
In 1921, the economist Frank Knight challenged the classical theory and argued that human capital (which includes entrepreneurship) should be considered a fourth factor of production. Entrepreneurs should be considered necessary for economic development because demand and supply cannot always be known before new products or services are produced and sold. Nonetheless, there is no assurance that they will indeed be bought at a price above the cost of production. Knight argued that entrepreneurs would earn profits as a return for putting up with uncertainty, that he defines as an event whose probability cannot be known (as opposed to “risk”, which refers to a situation in which the probability of an outcome can be determined).
Dealing with uncertainty
In a nutshell, entrepreneurs are essential to economic development because:
- They organize and put to use capital, labor and technology
- They explore new ideas
- They take risks
- But most of all, they put up with uncertainty
Knight identified three kinds of uncertainties:
1) The first is the known uncertainty, which is what we normally call risk. When tossing a coin, for instance, we don’t know the result in advance, but we can predict it will be 50% head or 50% tail.
2) The second is the unknown uncertainty. This scenario occurs when possible outcomes are known, but corresponding probabilities cannot be uniquely assessed. It is possible to predict an outcome by calculating the odds within a certain time based on the history of the outcome.
3) The third kind of uncertainty is the unknown unknown (unknowable). This happens when possible outcomes are unknown. Therefore, it is not possible to predict the outcomes.
Science has provided tools such as statistics and finance theories to deal with the first two types of uncertainty. However, these tools don’t get results when facing the unknown unknown.
How do entrepreneurs think?
Entrepreneurs constantly make decisions and take action. How do they do that? To answer these questions, Dr Saras Sarasvathy, conducted a study on 27 expert entrepreneurs, founders of companies from $200M to $6.5B. She provided them with a 17-page problem set, with typical decisions of a startup, and listened to them think aloud continuously. As a result, she was able to find out not only what they decided, but also how they did it. This is how she developed the widely acclaimed framework known as “Effectuation”, which she defined as “the logic of thinking used by expert entrepreneurs to build successful ventures”. Effectuation is a process theory that explains the process that entrepreneurs use to create new ventures.
When looking at ways to create value for a business, entrepreneurs have the choice between ways of thinking: causal (or predictive) thinking and effectual thinking (or effectuation). Both approaches are valid, as they solve different problems.
- Causal thinking means setting a goal and then acquire the resources needed to achieve it. Causal thinkers believe that “If I can predict the future, I can control it.”
- Effectuation unsettles traditional business planning and teaches another way of thinking. According to this theory, it’s impossible to predict the future. Effectual thinkers believe that “If I can control the future, I don’t need to predict it.”
Instead of predicting the future, effectuation teaches to build sufficient conditions for success, given whatever conditions you already have. It’s the act of bringing things to action – making things happen.
How can you control a future that you cannot predict?
The majority of us rely on the importance of investing in predictions, thinking that the more we can predict the future, the more we can control it. Expert entrepreneurs flip this concept: they have learned the hard way that the most interesting ventures are built in a space in which the future is not only unknown, but unknowable. Those entrepreneurs prefer to shape the future, rather than predict it. How? The research revealed that they use the following five principles:
1) Start with your means. Don’t wait for the perfect opportunity. Start taking action based on what you have readily available: Who you are, what you know, and who you know.
2) Set affordable losses. Limit risk by spending only what you can afford to lose at each step.
3) Leverage contingencies. Embrace bad news and surprises that arise from uncertain situations, and try to use them to create new markets.
4) Form partnerships. Collaborate with people and organizations willing to make a real commitment to jointly creating the future— product, firm, market—with you. These are your self-selected stakeholders. Don’t worry so much about competitive analysis and strategic planning.
5) Control the controllable. By focusing on activities within their control, expert entrepreneurs know their actions will result in the desired outcomes. Believe that the future is neither found nor predicted, but rather made.
Entrepreneurs are necessary for economic development because they think effectually. They don’t waste their energies in predictions, because they believe human action can control the future. Instead, they understand and work with the people who are engaged in the decisions and undertake actions that bring it into existence.
If you are interested in learning more about the effectual theory, I highly recommend the book “Effectuation: Elements of Entrepreneurial Expertise”, a practical guide to building an entrepreneurial venture, driving growth and shaping the yet-to-be-made future.
To quote the philosopher Nelson Godmann “All possible worlds lie within the actual one”.