Entrepreneurship and Economic Development
Entrepreneurship and Economic Development
Abstract and Keywords
This chapter provides an overview of thinking on the intersection of development and entrepreneurship. Given the relative neglect of entrepreneurship by development scholars, it deals with: (i) recent theoretical insights from the intersection of entrepreneurship and development studies; (ii) the empirical evidence on the relationship between entrepreneurship and development; and (iii) fresh insights for entrepreneurship policy for development that have emerged from recent advances in this area, including female entrepreneurship in developing countries.
Adam Smith, founding father of modern economics, “detested business men” (Lewis 1988: 35). Development scholars and development economists in particular have, if not detested business men or entrepreneurs, (benignly) neglected them. Following Leff (1979: 51), many development scholars took the position that “entrepreneurship is no longer a problem” or a “relevant constraint on the pace of development” in developing countries. Entrepreneurship scholars, on the other hand, have been more concerned with the who, why, and how of entrepreneurship rather than with the impact of entrepreneurship on development or developing countries (Shane 1997; Bruton, Ahlstrom, and Obloj 2008), a state of affairs described as a “scholarly disconnect” (Audretsch, Grilo, and Thurik 2007).
Why does this matter? First, it is widely believed that entrepreneurship is beneficial for economic growth and development. Second, entrepreneurship has been remarkably resurgent over the past three decades in countries that have achieved substantial poverty reduction, such as China. Third, donors and international development agencies have turned to entrepreneurship to improve the effectiveness and sustainability of aid.
However, the theoretical and empirical cases for understanding the role of entrepreneurship are not yet solid. Evidence on whether entrepreneurship matters for economic growth is not straightforward; how entrepreneurship has been promoted and how it contributed to development in countries like China and the East Asian Tigers is still a matter of contention; and whether and why private-sector development initiatives may be effective is not well understood.
Closer scrutiny of the relationship between entrepreneurship and economic development is therefore needed. In order to stimulate the development–entrepreneurship discourse, it may be necessary first to attempt to formalize or reconcile the role of entrepreneurship in the “grand ideas” of development economics, and to consider how this resonates with available evidence and what it means for policy.
(p.312) There are at least three “grand ideas” in development economics. The first is that development requires a structural transformation of what, how, and where production and consumption take place: from low value-added, low productivity, and rural-based activities to higher value-added, more productive activities in services and manufacturing located in cities. The second idea is that development is a multidimensional concept that requires more than just the eradication of income poverty. The third is that market failures are prevalent and that the state has an important coordinating and regulatory role to play in development.
All of these grand ideas are currently at the forefront of thought in development, and much of what development scholars are occupying themselves with, either directly or indirectly, falls within the scope of these ideas.
This chapter provides an overview of thinking on the intersection of development and entrepreneurship. It addresses the theoretical insights from the intersection of entrepreneurship and development studies, the empirical evidence on the relationship between entrepreneurship and development, and the fresh insights on entrepreneurship policy for development that have emerged from recent advances in this area.
Concept, Definitions, Evolution, and Relevance for Development
The evolution in scholarly views of entrepreneurship is reflected in the categories of behavioral, occupational, and synthesis definitions.
Schumpeter (1950, 1961) famously defined the entrepreneur as the coordinator of production and agent of change (“creative destruction”). As such, the “Schumpeterian” entrepreneur is above all an innovator. Scholars who share this view do not consider entrepreneurship to be very important in the earlier stages of economic development; they see the contribution of entrepreneurship as much more important in later stages of development, where economic growth is driven by knowledge and competition. In earlier stages of development, entrepreneurship plays a much less pronounced role because growth is largely driven by factor accumulation (Ács and Naudé 2012).
Other behavioral definitions allow for a more substantial role for entrepreneurship in developing countries. Kirzner (1973) views the entrepreneur as someone who facilitates adjustment to change by spotting opportunities for profitable arbitrage (and “disequilibrium” situations in the market). This view has resonated among scholars who emphasize the opportunity-grabbing-for-profit nature of entrepreneurship (Shane and Venkataraman 2000), particularly in developing countries where market disequilibria may be common.
Behavioral definitions also stress the risk-taking dimension of entrepreneurship. Kanbur (1979: 773) described the entrepreneur as one who “manages the production function” by paying workers wages (which are more certain than profits) and shouldering the risks and uncertainties of production. Such definitions are seen as very relevant for developing country contexts characterized by high risk and uncertainty. The predominance of small firms in developing countries—most entrepreneurship studies in developing countries are concerned (p.313) with small and medium enterprises (SMEs)—has been postulated to be a symptom of economy-wide uncertainty, where the probability of success is small (Wiggins 1995).
Policy implications follow from these views—for instance, that government policy for promoting entrepreneurship should reduce uncertainty and transaction costs. Policy, however, is only a proximate cause for risk and uncertainty, and in recent years development scholars have recognized “institutions” (the “rules of the game”) as the ultimate determinant of development. Institutions affect not only the supply but, perhaps even more important, the allocation of entrepreneurship. According to Baumol (1990: 895), entrepreneurial ability can be allocated towards productive, unproductive, or even destructive activities. He defines entrepreneurs as “persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige.” Underdevelopment is due not to an insufficient supply of entrepreneurs, but to institutional weaknesses that result in a “lack of profit opportunities tied to activities that yield economic growth” (Coyne and Leeson 2004: 236).
In economic theory, entrepreneurship has been modeled as an occupational choice between self-employment and wage-employment (see Lucas 1978; Evans and Jovanovic 1989; Murphy, Shleifer, and Vishny 1991). Hence someone will become an entrepreneur if profits and the non-pecuniary benefits from self-employment exceed wage income plus additional wage-employment benefits. Entrepreneurship is thus often synonymous with self-employment. Because self-employment is often not by choice but by necessity, a distinction is often made between necessity and opportunity entrepreneurs, as, for instance, in the Global Entrepreneurship Monitor (GEM) (see Reynolds et al. 2005).
A synthesis definition combines behavioral and occupational views, and relates entrepreneurship to the three big ideas in development economics, as discussed in the introduction. As such, this definition to an extent reflects some of the evolution in the scholarly thinking about entrepreneurship, understood as the resource, process, and state of being through and in which individuals utilize positive opportunities in the market by creating and growing new business firms.
As a resource, entrepreneurship has the instrumental value that it is accorded in economics; as a process it accords to the attention given in management studies on the start-up, growth, and exit of firms; and as a state of being it recognizes that entrepreneurship is not limited to being instrumental, but is often valued in and of itself (as will be explained in greater detail below).
This definition emphasizes the process value of entrepreneurship and describes entrepreneurial opportunities in a broader sense than is usual in the literature. For instance, Shane and Venkataraman (2000) define an “opportunity” as when goods can be sold at a profit. From a development perspective this is inadequate, because it implies that utility from entrepreneurship depends only on monetary gains. “Opportunities” should include situations when persons can create new firms that will further the kind of lives they desire.
The use of the adjective “positive” in relation to opportunities reflects a subjective assessment that, while entrepreneurial ability may be allocated to destructive activities (as in Baumol 1990), it should not be defined as entrepreneurship if it detracts from either individual or societal welfare.
Whereas initially, scholars viewed entrepreneurship as being restricted to innovation and business creation, the view has expanded towards one where entrepreneurship is seen more appropriately as a social phenomenon that reflects the broader institutional characteristics of a society. Entrepreneurship is concerned not only with business success, as measured by (p.314) profits, but also with subjective welfare and non-economic well-being. Entrepreneurship is a catalyst for structural change and institutional evolution.
The following sub-sections consider the contribution that entrepreneurship can make to illuminating the three “big ideas” in development economics.
Structural Economic Transformation and Entrepreneurship
One of the seminal contributions to development economics has been dual economy models, inspired by Lewis (1954), utilized to explain the structural transformation of underdeveloped economies. The Lewis-model distinction between a traditional and modern sector can be expanded with the micro-foundations of optimizing households, firms, and labor market matching. One can also distinguish between mature and start-up entrepreneurs, between large firms and small firms, and between necessity- and opportunity-driven entrepreneurship. In this model the transformation from a low-income, traditional economy to a modern economy involves significant changes to production methods, a process of change where entrepreneurs play essential roles, including providing innovative intermediate inputs, permitting specialization, and raising productivity and employment.
This model builds on earlier work of Murphy, Shleifer, and Vishny (1991); Peretto (1999); Rada (2007). In Rada (2007), entrepreneurs “trigger” an investment in the modern sector once they have perceived profitable opportunities and facilitated the re-allocation of production factors from the traditional to the modern sector. Peretto (1999) provided a modified endogenous growth model that implied that long-run structural transformation depends on the degree to which an economy can make a transition from a growth path driven by capital accumulation (the “Solow economy”) to a growth path driven by knowledge accumulation (the “innovation-driven economy”).
In structural change, entrepreneurial ability has been accorded centerstage. Murphy, Shleifer, and Vishny (1991) provided a model that described firm size and the growth of the economy as a function of entrepreneurial ability. Nelson and Pack (1999) assign a key role to the “effectiveness of entrepreneurial ability,” which they see as a vital determinant of the rate of assimilation of technology (1999: 420)—as in Michelacci (2003), where entrepreneurial ability is vital for research and development (R&D). In Nelson and Pack (1999), a “rapid” expansion of skilled labor can be absorbed only if entrepreneurial ability is high, and without entrepreneurial ability the returns to physical and human capital are low.
The process of structural change as facilitated by high-ability entrepreneurs leads firms to adopt more complex production methods and produce more complex and specialized intermediate inputs. As a result, the technological intensity of a country's economic structure increases (Ciccone and Matsuyama 1996). These structural changes have interesting implications for the development of entrepreneurship itself, so that entrepreneurship may itself be endogenous in the development process.
Ciccone and Matsuyama (1996) explain this in a model where they make a distinction between consumer goods and intermediate goods. If a particular economy produces a limited range of intermediate goods, they show that the final (consumer) goods sector will use “primitive” production methods and will have little demand for sophisticated, new inputs. This will lead to lower incentives for potential entrepreneurs to start up new firms. The economy can get stuck in such an underdevelopment trap, with primitive production in its (small) (p.315) modern sector. They also point out that in such an “underdevelopment trap” there might be a case for assistance to new start-ups, since these can provide both pecuniary and technological externalities. If they start producing new intermediate goods, these will induce end producers to demand more, in turn improving the incentives for other entrepreneurs to start up firms in response to greater demand and the example provided by the application of new technology. In this model, start-ups face positive costs that include R&D activities in bringing a new good to the market.
That entrepreneurs create a positive externality by bringing new goods to the market, and in the process showcase new technology, has been extended by Hausmann and Rodrik (2003), who point out that entrepreneurs provide not only these technological externalities (by bringing new goods to market), but pecuniary externalities (by providing information on the profitability of new activities). Entrepreneurs fulfill a “cost-discovery” function in making sunk costs in a new activity that ex ante may or may not be profitable, but that will provide information ex post on such profitability to other entrepreneurs—information often lacking in developing countries.
Finally, an aspect of duality that is particularly pertinent to the debate on entrepreneurship in development is that between the formal and informal sector (Maloney 2004). De Paula and Scheinkman (2007) find that informal firms are often a form of “evasive” entrepreneurship in order to evade taxes or regulations, or to engage in illegal trade. They also find that they are less efficient, less able to obtain finance, and more likely to be dominated by entrepreneurs of low ability. Thus the informal sector is much like the traditional or subsistence sector in typical dual economy models, and growth may be enhanced by encouraging entrepreneurs of high ability to “migrate” to the formal sector.
Multi-dimensional Development and Entrepreneurship
The entrepreneurship literature generally takes a restricted view of development. Most empirical studies on the relationship between entrepreneurship and development have similarly been limited to GDP, productivity, and employment growth as proxies for development—and not multidimensional development (van Praag and Versloot 2007; Ács, Desai, and Hessels 2008). Yet entrepreneurship can also contribute to multidimensional well-being by demonstrating what people can achieve through their capabilities. This notion of human development—or human flourishing—has been pioneered by Sen (2000), Nussbaum (2000), and others.
This capabilities approach can inform both theoretical thinking on and measurement of entrepreneurship. It views entrepreneurship as a human functioning1 that can be valued as an end in itself, not just as a means to other ends. It can enrich human capabilities if people's complementary capabilities are expanded so that they can choose not to be entrepreneurs. An important implication is that the demand for entrepreneurs is not a derived demand as in the instrumentalist view (as in, e.g., Casson et al. 2006). Individual level data from the Global Entrepreneurship Monitor (GEM) show evidence of an inverse U-shape relationship between entrepreneurship and national happiness. Opportunity-motivated entrepreneurship may contribute to a nation's happiness, but only up to a point. Not everybody should become an entrepreneur, and the happiness of a nation cannot be indefinitely increased by increasing the number of entrepreneurs.
(p.316) Although the literature on whether entrepreneurship matters for multidimensional development is scant, there has been more research on the subjective well-being (or job satisfaction) of entrepreneurs (mostly measured as the self-employed). The evidence so far suggests that entrepreneurs experience higher levels of job satisfaction than employees (Benz and Frey 2004; Blanchflower 2004; Andersson 2008). They have also been found to be healthier and less prone to negative feelings and depression, and to experience flow and “procedural utility” (Block and Koellinger 2009).
Market Failures, the State, and Entrepreneurship
The third “grand idea” in development economics concerns market and state failures. In the aftermath of the Second World War, when development economics was founded, the belief was that market failures were important to understand underdevelopment. During the 1980s, the government was seen as similarly subject to failure, under a set of principles for market-oriented reform described as the “Washington Consensus.” The implicit assumption was that the supply of entrepreneurship would be forthcoming once the constraints imposed by state interference were loosened. After the global financial crises of 2008 and 2009, in which market liberalization and “Washington Consensus”-type policies were found to be complicit, the regulatory role of the state has been revived.
One role of the state that has received more attention is in industrial policy (Szirmai, Naudé, and Alcorta 2013; see also Di Miao, this volume). Here, old models of import-protection and state-owned enterprises have given way to policies that rely more on the private sector and entrepreneurship, but with government still playing an important role to address market failures in the entrepreneurial start-up and growth process. For example, some have argued that entrepreneurial entry may be sub-optimal due to the externalities that may justify “self-discovery” through supporting innovation by SMEs and new firm start-ups—for example, by reducing regulations and requirements or providing subsidized credit (Hausmann and Rodrik 2003).
In contrast, others have argued for taxing (regulating) entrepreneurship because it may cast negative externalities. De Meza and Webb (1987) make the case that credit market imperfections may lead to “overinvestment” when banks cannot accurately judge entrepreneurial ability. Because banks cannot observe any entrepreneur's ability ex ante, interest rates on start-up capital will reflect average entrepreneurial ability. If the proportion of entrepreneurs of low ability increases, it will result in higher borrowing costs, which impose a negative externality on entrepreneurs of high ability, who will consequently borrow and invest less. The entry of entrepreneurs with low ability might also hinder development because such entrepreneurs may have less productive workers, who will earn reduced wages as a result, and in turn reduce the opportunity costs of self-employment, thereby causing the entry of even more low-ability entrepreneurs (Ghatak, Morelli, and Sjöström 2007: 2).
There is thus a clear case for the state to play a role in addressing the market failures that plague entrepreneurial start-up and innovation activities (Ács and Naudé 2012). More research is needed to clarify this role, given the fact that many countries simultaneously exhibit different stages in different sectors.
The how of state support for entrepreneurship is also essential. For instance, private-sector development policies have tended to shy away from targeting entrepreneurs in specific (p.317) sectors or industries for fear of distorting markets, and for fear of government failure—especially fearing the potential for such selective support to encourage rent-seeking and corruption. The design of entrepreneurship policies is therefore a delicate art, and one that needs rigorous evidence.
Three important databases describe the entrepreneurial activity of countries: the International Labour Organization (ILO) measures self-employment, the Global Entrepreneurship Monitor (GEM) measures start-up rates of new firms, and the World Bank measures the registration of new firms. It is worth noting that these databases are concerned with formal as opposed to informal firms (for a comparison of these databases, see Desai 2010).
Studies using these databases have uncovered two sets of results. First, there is a lack of clear empirical evidence of whether entrepreneurship drives economic growth, productivity, or employment. Studies find a mixed bag of results. Second, there seems to be a U-shaped relationship between entrepreneurship and a country's level of economic development, as measured by GDP per capita.
The U-shaped relationship implies a higher rate of entrepreneurial activity in low-income countries than in middle-income countries (Wennekers et al. 2005). This result may reflect that entrepreneurs in developing countries are less innovative and tend to be proportionately more “necessity”-motivated (Ács, Desai, and Hessels 2008; Gollin 2008). Higher levels of GDP may therefore be associated with more “innovative” forms of entrepreneurship. Another implication is that causality may run not only from entrepreneurship to development, but also from development to entrepreneurship.
In conclusion, macro-level empirical work has been concerned with how entrepreneurship influences economic measures of development, such as GDP, productivity, and employment. Very few studies have considered non-monetary or subjective measures.
Most micro-level studies focus on the why and how of entrepreneurship, not its impact on development. Nevertheless, studies on productivity, innovativeness, growth, and female entrepreneurs provide insights on whether and how entrepreneurship matters for development. One lesson is that innovative entrepreneurship matters most for development.
Van Praag and Versloot (2007) consider the literature on the impact of entrepreneurship on employment, innovation, and productivity growth. They find that although the quality and efficiency of their innovation is higher, entrepreneurs do not spend more on R&D than their counterparts, and their contribution to productivity growth is low. The majority of entrepreneurs would earn higher incomes as wage employees, and while entrepreneurs create more jobs than non-entrepreneurs, the quality of the jobs they create is lower. Hence not all entrepreneurs drive development, and not all entrepreneurs are innovative (Stam and Wennberg 2009).
As these findings refer to the impact of the average entrepreneur, they perhaps suggest that focusing on the average entrepreneur may not be the best policy stance. It may be better (p.318) to focus on the small subset of innovative entrepreneurs who do make a difference. Studies find that innovative firms, particularly in high-tech sectors, have on average higher levels of productivity, tend to enjoy higher employment growth, and cause positive spillovers for other firms (Stam and Wennberg 2009). A study of manufacturing firms in Brazil, with the focus on a panel, found that firms who engaged in technological innovation experienced higher growth in employment, net revenue, labor productivity, and market share (Kannebley et al. 2010).
Female entrepreneurs in developing countries have attracted greater attention in recent years, given the key role of women in development and the still widespread discrimination they face. Evidence to date suggests that there are several reasons for the observed differences in entrepreneurial behavior between women and men. For instance, women entrepreneurs’ businesses tend to be smaller and to provide less employment growth than those owned by men. Women's businesses also tend to be less profitable than, and generate lower sales turnover than, those owned by men, even in same industry comparisons (Minniti and Naudé 2010).
These differences in entrepreneurial propensity and performance between men and women reflect disadvantages and discrimination in education and the labor market. It has been argued that labor market discrimination against women leads to a self-selection of the most highly talented women into labor markets. As a result, less talented women will opt for self-employment, a characteristic reflected in their enterprises’ lower survival and growth rates. Furthermore, many women may not have sufficient confidence in their ability to start a firm (Langowitz and Minniti 2007). Yueh (2009) discusses the case of women entrepreneurs in China and supports the idea that lack of self-confidence is a significant constraint hindering women's entrepreneurial entry in developing countries.
As a result they also lack access to credit and face higher start-up costs. Horrell and Krishnan (2007) report that female-headed households often lack assets or incomes, and that this constrains their ability to diversify their economic activities. In this regard a large number of studies have found that access to micro-credit has improved women's decision-making autonomy, and general household welfare and consumption.
In conclusion, although much has been learned about the obstacles faced by female entrepreneurs, much less is known about how the level of aggregate activity influences women's decisions about entrepreneurship, and even less about how the latter contribute to development. The lack of a systematic approach and data have prevented, so far, the formulation of a comprehensive and robust theory of female entrepreneurship and development. A solid understanding of how the distinctive characteristics of female entrepreneurship are accounted by existing models of growth would be very desirable for both science and policy.
Enhancing the Developmental Impact
Given the “grand ideas” in development economics, the main policy considerations for enhancing the developmental impact of entrepreneurship are to improve the quality and allocation of entrepreneurial ability, and reduce the need for necessity entrepreneurship. Both considerations require better quality and quantity of research and data generation.
(p.319) Improving the quality of entrepreneurial ability means not only improving the skills and education of entrepreneurs—their “human capital”—but focusing on the innovative abilities of entrepreneurs. Indeed, the discussion in this chapter implies that it is innovative entrepreneurship that is most desirable for growth. Innovation policy ought therefore to be a central focus of entrepreneurship promotion in developing countries, as it is in advanced economies. Entrepreneurs in developing countries often have a much greater propensity for innovation than is recognized in the literature or by policy-makers.
Stimulation of innovation has not been paramount in most development agencies or donors’ private-sector development programs, nor in national entrepreneurship support programs. The only innovation-relevant aspects of such support programs have been their concern to improve the general business environment, a prerequisite for innovation, and to argue for patent protection—and to a lesser extent basic research. Such policies tend to be more concerned with improving static and allocative efficiency than dynamic efficiency, which is more important for job creation and growth.
Taking aim at improving dynamic market efficiency through raising innovation, and aiming to limit necessity entrepreneurship, may have implications for policy that run counter to many current policies. For instance, many aim to improve static and allocation efficiencies in markets through increasing competition. However, this misses the fact that with underdeveloped financial markets in developing countries, raising competition may not improve dynamic efficiency. In the absence of financial markets, firms can only finance innovation through profits; if too much competition erodes their profits, it will also erode their innovative activities. Reducing the need for necessity entrepreneurship may also imply policies to encourage job creation and provide social security, policies not popularly associated with an entrepreneurial economy.
Promoting innovative entrepreneurship in developing countries runs into further difficulties in that there is a broad lack of sufficient impact evaluations2 with which to judge what works and what does not. Lopez-Acevedo and Tinajero (2010: 2) mention that most existing evaluations typically do not consider biases due to unobserved firm heterogeneity or self-selection. Evaluations of entrepreneurship policy tend to be qualitative rather than quantitative, and cannot keep track of continual changes in programs over time. Many “impact” studies also do not attempt to attribute impacts or outcomes to interventions, while a lack of reliable SME data makes evaluation and cross-country comparisons of programs difficult.
There is thus a need for much more rigorous empirical evidence as to what works and why, with respect to entrepreneurship policies. In the near future, most poor people will reside in so-called fragile states where an understandable lack of rigorous micro-level studies of firms and entrepreneurs limits the contribution of aid and other policies towards private sector development in conflict or post-conflict countries (Brück, Naudé, and Verwimp 2011).
One should be cautious of an undue reliance on randomized field experiments as the sole approach to inform appropriate policy formulation for entrepreneurship development (see also Deaton 2009). What is needed is interdisciplinary approaches combining insights from randomized field experiments with anthropological fieldwork, and with the political economy of development. Such approaches offer promise for further evolution of the scientific field demarcated by the intersection of development economics and entrepreneurship.
Reconsidering entrepreneurship's role in development leads to three novel realizations. First, it provides fresh perspectives on three of the “grand ideas” in development economics; second, entrepreneurship influences development outcomes positively as well as negatively; and third, entrepreneurship is in turn significantly determined by the dynamics of development.
Entrepreneurship is therefore a valid and important subject of study for development scholars, and development is a worthwhile subject of study for entrepreneurship and management scholars. The growing availability of more and better data from emerging and developing economies, the increasing adoption of rigorous evaluation methods in policy assessments, and the likelihood and desirability of closer collaboration across disciplines are all boding well for the intersection of development and entrepreneurship.
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(1.) The term functionings is central in the capabilities approach, and refers to valuable activities and states that make up people's well-being (Alkire 2005: 1) and includes “working, resting, being literate, being healthy, being part of a community, being respected” (Robeyns 2003: 6).