Entrepreneurship and Economic Growth

By Urmi Uppal

Edited by Nidhi Singh, Junior Editor, The Indian Economist

Theoretical Background

Meaning of entrepreneurship

Throughout intellectual history, the entrepreneur has worn many faces and fulfilled many roles.

I focus on three entrepreneurial roles, emphasized by Schumpeter, Kirzner and Knight, respectively.

A first is the role of innovator. Schumpeter was the economist who has most prominently drawn attention to the ‘innovating entrepreneur’. He or she carries out ‘new combinations we call enterprise; the individuals whose function it is to carry them out we call entrepreneurs.

A second is the role of perceiving profit opportunities. We label this role as Kirznerian (or neo-Austrian) entrepreneurship. A third is the role of assuming the risk associated with uncertainty. We label this role as Knightian entrepreneurship. When an individual introduces a new product or starts a new firm, this can be interpreted as an entrepreneurial act in terms of each of the three types of entrepreneurship.

The individual is an innovator, he (assumes that he) has perceived a hitherto unnoticed profit opportunity and he takes the risk that the product or venture may turn out to be a failure.

Based on their study of the history of economic thought about entrepreneurship, Hébert and Link (1989) propose the following ‘synthetic’ definition of who an entrepreneur is and what he does: ‘the entrepreneur is someone who specializes in taking responsibility for and making judgemental decisions that affect the location, form, and the use of goods, resources, or institutions’.

Entrepreneurship and economic growth

When searching for links between entrepreneurship and growth, the above definition does not suffice. The dynamics of perceiving and creating new economic opportunities and the competitive dimensions of entrepreneurship need more attention. The key contribution of entrepreneurship to economic growth might be singled out as being ‘newness’. This includes the start-up of new firms but also the transformation of ‘inventions and ideas into economically viable entities, whether or not, in the course of doing so they create or operate a firm’ (Baumol 1993)

Different types of entrepreneurship: different impacts on economic performance

The simplified version of the Carrying Capacity model by Carree and Thurik gives the broad results of the economic impact of (the lack) of Kirznerian (neo-Austrian) and Knightian entrepreneurship.

The results of the model are as follows:

• The lack of Kirznerian entrepreneurship that would otherwise have alerted one retailer to make better business decisions leads to lower output.
• A decrease in the number of individuals prepared to take risks in the marketplace (Knightian entrepreneurs) leads to an output loss.

The effects of the choice between entrepreneurship and employment

The contributions made in three articles are significant: Banerjee and Newman (1993), Iyigun and Owen (1999) and Lloyd-Ellis and Bernhardt (2000). The papers deal with the complicated issue of the two-way interaction between occupational choice and economic development.

On the one hand, both the number of individuals choosing to become self-employed and their entrepreneurial skills affect economic development. On the other hand, the process of development affects the returns to occupations. It transforms the nature of risks and the possibilities for innovation. 

Banerjee and Newman (1993) develop a model in which the distribution of wealth plays a central role. They assume that occupational decisions are dependent upon the distribution of wealth because of capital market imperfections, due to which poor agents can only choose working for a wage and wealthy agents become entrepreneurs. The initial distribution of wealth determines whether in the long run an economy converges to a case of only self-employment in small-scale production (‘stagnation’) or to one where an active labor market and both large- and small-scale production prevail (‘prosperity’).

Banerjee and Newman stress that the model implies that the initial existence of a population of dispossessed whose best choice is to work for a wage, is the condition needed for an economy to achieve the stage of prosperous capitalism.

Whereas Banerjee and Newman focus on financial requirements as the defining characteristic of entrepreneurship, Iyigun and Owen (1999) focus on the element of risk. Iyigun and Owen distinguish between two types of human capital: entrepreneurial and professional. Entrepreneurial activities are assumed to be more risky than professional activities. Entrepreneurs in the model accumulate human capital through a work-experience intensive process, whereas professionals’ human capital accumulation is education-intensive. The models predicts that, as technology improves, individuals devote less time to the accumulation of human capital through work experience and more to the accumulation of human capital through professional training. The allocation of an increasing share of time to formal education continues until a steady state is reached. Hence, entrepreneurs would play a relatively more important role in intermediate-income countries and professionals are relatively more abundant in rich countries.

However, both entrepreneurship and professional activities are important and those countries that initially have too little of either entrepreneurial or professional human capital may end up in a development trap. Iyigun and Owen point at former communist countries as an example of economies that have a highly educated labor force but that still not achieve the high-income steady state due to a shortage of entrepreneurs.

Lloyd-Ellis and Bernhardt (2000) also derive how the scarcity or abundance of entrepreneurial skills is the defining variable behind the equilibrium development process. In their model, individuals may choose between working as entrepreneurs, wage laborers in industry or in subsistence agriculture. Just like in the Banerjee and Newman model entrepreneurs are faced with a limited capital market and (inherited) wealth is needed to permit entrepreneurial activity to expand. The economy in the model goes through four separate stages. An interesting outcome of the model is that the average firm size rises quickly in the first stages of the development process, but then falls in the later stages of the development process. The number of entrepreneurs (outside agriculture) as a fraction of population may rise in each of the stages.

Carree and Thurik, however, present a simple new model of occupational choice in which the impact of entrepreneurial activities is analyzed by considering the consequence of not allowing firms to enter (or exit) or of not allowing firms to expand (or to limit) their activities. They distinguish between three possible economic ‘systems’. In the first system, labelled ‘market economy’, there is complete freedom of entry and exit and of firms adjusting their inputs to maximize profits. In this system there is complete entrepreneurial and managerial freedom. In the second system, labelled ‘semi-planned economy’, there is no freedom of entry or exit. However, firms are free to adjust their input quantities so as to achieve maximum profits. In such an economic system the large incumbent firms are considered as the engines of economic progress. Starting new enterprises is hampered by regulations and by relatively low esteem of business ownership. The third economic system, labelled ‘planned economy’, has also lost its managerial freedom of adjusting inputs to maximize profits. Firms are assigned to produce output using a certain fixed amount of labor even though it may lead some firms to be unprofitable.

Clearly, the three economic ‘systems’ are extremes. However, comparing the economic performance of such virtual systems may enhance our understanding of the total contribution of entrepreneurial activity on the long and short term on economic performance. In addition, the conditions in the three systems may approximate actual conditions in existing economic systems. For example, the market economy of the United States grants (potential) entrepreneurs considerable freedom with little government intervention. In contrast, the economies of Continental Europe, like France and Germany and the Scandinavian countries, have a much larger role for government. In these countries government has actively intervened to support large enterprises in the recent past. The Soviet type of economic systems is the prime example of the planned economy system.

Given the distribution of the abilities,the equilibrium occupational choice and (maximum) total output can be derived. In case of changes in the ability distribution the manner in which equilibrium on the labor market is restored differs across the economic systems. In case of the ‘market economy’ system there will be entry of managers with increased ability and exit of managers with decreased ability, changes in firm sizes and changes in the wage level. In case of the ‘semi-planned economy’ system there will be changes in firm sizes of incumbents and changes in the wage level. The one variable that restores equilibrium in the ‘planned economy’ system is the wage level because of the absence of managerial discretion to adapt labor demand.

It is obvious that due to larger ‘degrees of freedom’ the total output after changes in the ability distribution will be highest for the ‘market economy’ and smallest for the ‘planned economy’. The differences between the performances will be larger, the more the ability distribution changes over time. Hence, in periods of important changes in technological regimes and on the longer term the differences are likely to be largest. This finding is related to that presented by Eliasson (1995) that lack of new entry of firms will adversely impact economic performance not so much on the short term but in the long term.

Entrepreneurship in endogenous growth model 

One of the reasons that entrepreneurship disappeared from economic theory is that it played no role in the neoclassical growth model as developed by Solow (1970). An important characteristic of this growth model is that technological improvements are exogenous and therefore independent of economic incentives. Economic growth in the traditional growth models is achieved by capital accumulation and exogenous technological progress, both of which leave little room for any entrepreneurial role whatsoever. The more recently developed endogenous growth models also support the idea that improvements in technology have been the key force behind perpetually rising standards of living. However, this long-term growth process is assumed in many endogenous growth models to be determined by purposive, profit-seeking investment in knowledge (Grossman and Helpman). The act of seeking profits by shifting resources to achieve improvements in technology can be seen as an entrepreneurial act because the outcome of the investments is uncertain. However, it is not common for endogenous growth models to explicitly address the issue of entrepreneurship as driving force of technological and economic development.

I will discuss three exceptions in this section. The first exception is the Aghion and Howitt’s (1992) model of creative destruction. The second exception is the endogenous market structure model by Peretto (1998; 1999a; 1999b) and the third exception is the imitation model developed by Schmitz (1989). Of these three exceptions the model by Aghion and Howitt has been the most influential.

Aghion and Howitt introduce the notion of Schumpeterian ‘creative destruction’ into a growth model by having firms investing resources in research to achieve a new product that renders the previous product obsolete. Capital is excluded from the basic model and growth results from technological progress, being a result from competition among firms that generate innovations.

Firms are motivated by the prospect of (temporary) monopoly rents after a successful innovation is patented. A next innovation will again destroy these rents as the existing good is being made obsolete by the Schumpeterian entrepreneur.

This model shows a direct connection between research in stationary equilibrium and the degree of market power. Some extent of market power to achieve rents is needed for Schumpeterian entrepreneurs to engage into research. The effect of market power attracting entrepreneurial energy shows the importance of imperfect competition for the growth process.

Competition and growth are inversely related in this Schumpeterian model, something usually not supported by empirical evidence. Aghion and Howitt (1997), therefore, extend their model to show that a more competitive market structure may contribute to economic growth. In Howitt and Aghion (1998), the authors add capital to their model of creative destruction. They show that capital accumulation and innovation are complementary processes and equal partners in the growth process. Aghion and Howitt have contributed to the endogenous growth literature by connecting purposive, profit-seeking investment in knowledge to the persons performing this task: entrepreneurs.

In a series of papers Peretto introduces a different kind of endogenous growth model where an endogenous market structure is incorporated. His model has a key role for the number of firms, again in the intermediate sector, determining the returns to investment and R&D. An important difference between his model and the model by Aghion and Howitt is the assumption that monopolistic firms in the intermediate sector set up in-house R&D facilities to produce a continuous flow of cost-reducing innovations. This differs from the independent research firms in Aghion and Howitt (1992). The relation between the number of firms and returns to investment and R&D in the Peretto (1999b) model is determined by a trade-off between external and internal economies of scale. External economies of scale are a result of complementarities across firms because aggregate output is increasing in the number of intermediate goods.A large number of firms in the model therefore leads to high specialization, large investment and R&D programs, and fast growth. On the other hand, the fragmentation of the market due to a large number of firms leads to small investment and R&D programs, and slow growth. An increase in the number of firms increases the market size through the specialization effect whereas each firm’s market share is reduced through the fragmentation effect. As a consequence there is a hump-shaped relation between the number of firms and economic growth.

In Peretto (1998) entrepreneurs play a more visible role. His model seeks to explain a shift in the locus of innovation from R&D undertaken by inventor-entrepreneurs (‘competitive capitalism’) to R&D undertaken within established firms in close proximity to the production line (‘trustified capitalism’). In the model the economy converges to a stable industrial structure where entrepreneurial R&D and the formation of new firms peter out, while growth is driven by corporate R&D undertaken by established oligopolists.While it is true that from about 1870 till 1970 the corporate laboratories affiliated with large manufacturing firms have been increasingly responsible for commercial R&D, the disappearance of entrepreneurial energy as important determinant of economic growth is an unrealistic feature of the model. In Peretto’s setup entrepreneurs must develop new differentiated products since entering an existing product line in Bertrand competition with the incumbent is bound to lead to losses because of sunk entry costs. Entrants are net creators of knowledge, as “they create a new product and the knowledge necessary to run manufacturing operations.” Although in more developed stages the economy in Peretto’s model experiences a transition from entrepreneurial to corporate R&D, entrepreneurship plays a vital role in economic development: only when a critical number of firms have entered the market, established firms begin investing in R&D. A key result of Peretto’s models is that “there is an inverted-U relationship between the number of firms and steady-state growth.”

 Schmitz (1989) was the first to present an endogenous growth model that relates entrepreneurial activity and economic growth. However, his entrepreneurs are more ‘passive’ than in the other models because their role is restricted to that of ‘imitation’. This may have contributed to the Schmitz model being less influential than the Aghion and Howitt model. His model implies that the equilibrium fraction of entrepreneurs in an economy is lower than the social optimal level, providing a rationale for policies stimulating entrepreneurial activity.

Empirical Evidence of the hypothesized relationships       

Studying the impact of entrepreneurship on the Total GDP of the Economy

It is hypothesized that an increase in entrepreneurial activity (as measured by the number of new businesses registered) will have a positive impact on the Total GDP.

Model 1: OLS, using observations 1-252 (n = 118)

Missing or incomplete observations dropped: 134

Dependent variable: l_Total_GDP

Observations:

The regression[1] performed above provides strong evidence for the hypothesis. As the number of new businesses registered increases by 100%, the Total GDP increases by 273%. The coefficient of the explanatory variable is significant and the Adjusted R-squared of the model is 0.976 which is very high, indicating that the model has a very good fit.

I further divided the data set into developed and developing countries[2] in order to investigate whether entrepreneurship has a more significant role to play in developing countries versus developed countries.

The following is the regression performed for Developed Countries:

Model 3: OLS, using observations 1-75 (n = 39)

Missing or incomplete observations dropped: 36

Dependent variable: l_Total_GDP

The following is the regression performed for Developing Countries:

Model 1: OLS, using observations 1-140 (n = 73) (developing countries)

Missing or incomplete observations dropped: 67

Dependent variable: l_Total_GDP

 Observations:

It can be seen that both the coefficient have the same sign and are significant and the fit of the model (Adjusted R squared) is quite high, but the coefficient of the explanatory variable for the developing countries regression is greater than that for the developed countries regression. This may indicate that a %age increase in the number of businesses in developing countries leads to a larger %age increase in total GDP in developing countries than in developed countries (276% versus 269% for a 100% increase) 

What determines entrepreneurship?

Theoretically, factors such as access to capital, corruption/bribery, level of development of the economy and other institutional factors should affect the level of entrepreneurship in the economy. I have used the following variables in the regression:

1. Log of the number of new businesses started: as a dependent variable measuring the level of entrepreneurial activity
2. Informal payments made to officials (% of firms): as an independent variable to measure corruption or bribery
3. Log of total GDP: as an independent variable as a measure of the level of development of the economy
4. Domestic credit to the Pvt sector (% of GDP): as an independent variable as a measure of access to capital
5. Ease of doing business Rank (by World Bank): as a measure of the institutional and non institutional factors that affect how easy or difficult it is to start a business in an economy. A higher number indicates a more difficult set up.

Model 16: OLS, using observations 1-252 (n = 39)

Missing or incomplete observations dropped: 213

Dependent variable: l_No_of_new_bus

Observations:

The model above has a strong fit (Adjusted R squared of 0.98) and all the coefficients are significant. They can be interpreted as follows:

• As Total GDP increases by 100%, the number of new businesses increases by 49%
• If the percentage of firms who pay informal payments to officials increases by 1%, the number of businesses registered decreases by 5%
• If the ease of doing businesses rank increases by 1 (indicating a relative worsening of factors affecting the entrepreneurship setup) the number of new businesses registered decreases by nearly 2%
• A 1 unit increase in the domestic credit to private sector as a %age of GDP leads to a 3% decrease in the number of new businesses started. This may be because as credit expands, there is greater investment into expanding existing businesses as opposed to starting new ones.

Does entrepreneurship impact inequality?

I have again divided the data set into Developed and Developing Countries and attempted to study the impact of entrepreneurship on Inequality, as measured by the Gini Coefficient. A value of 100 in the Gini Coefficient means perfect inequality, a value of 0 means perfect equality.

The following is the regression for developing countries:

Model 5: OLS, using observations 1-140 (n = 22)

Missing or incomplete observations dropped: 118

Dependent variable: Gini_Index

 The following is the regression for developed countries:

Model 1: OLS, using observations 1-75 (n = 26)

Missing or incomplete observations dropped: 49

Dependent variable: Gini_Index

Observations:

The regression indicates that whether the country is developed or developing, an increase in entrepreneurial activity results in increased inequality. The coefficients are significant and the fit of the model is strong. For a 100% increase in the Number of new businesses, the Gini Coefficient increases by 3.6 (for developed countries) and 4.36 (for developing countries). This indicates that that for a given %age increase in the number of new businesses registered, inequality increases by more in developing countries than in developed countries.

Further, I regressed the log of number of new businesses started on the Gini Coefficient to study the reverse causation. The results were as follows:

Model 1: OLS, using observations 1-252 (n = 29)

Missing or incomplete observations dropped: 223

Dependent variable: l_No_of_new_bus

 Observations:

The regression indicates that inequality leads to a rise in entrepreneurship as well. For a unit increase in the Gini Coefficient (increase in inequality), the number of new businesses increased by 21%.

Note: All regression results presented above are free from multicollinearity and heteroscedasticity.

 Conclusions:

It can be concluded that empirical evidence exists pertaining to theory. The positive relationship and reverse causation between entrepreneurship and economic growth/ level of economic development has been established. It can also be established that economic inequality increases entrepreneurship and the reverse causation is true as well. Further, we have seen the differences that exist in these relationships between developing and developed countries.

References:

• World Bank
• Impact of Entrepreneurship on Economic Growth, Carree and Thurik

Appendix:

The appendix is the data set obtained from world bank used in the regression.

[1] The software used for regression is Gretl.

[2] The division between developed and developing countries has been done according to the status awarded by World bank. “High Income” Countries are Developed Economies whereas all other are developing.

The author just completed her graduation studies in Economics at St. Stephen’s College, Delhi University, and is set to join a reputed international consultancy firm. She is also the co-founder of the NGO Care for Bharat. You can contact her at urmiuppal@gmail.com

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