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A Proposal Submitted for PhD Degree in Economics
under the Title of:
The Mediating Role of Institutional Factor on the
Relationship between Entrepreneurship and Economic
Growth
Prepared by:
Rafia Khalil
2017
1 Introduction
Entrepreneurship is a mean of change that can generate new environments that raise
additional opportunities for growth and development. Despite the fact that
entrepreneurship has been acknowledged by the majority of researchers to have a great
impact on our economic well-being, it will only be able to have an influence because of a
prevailing entrepreneurial environment. Therefore, the essence for the success or failure
of entrepreneurship in promoting economic growth relies on the presence of institutional
environment.
1.1 Research Background
Determining the wealth of nations, defining the factors that affect it, in addition to
identifying the elements that have an impact on it, was and still is an ongoing crucial
concern in the economy dating back to the first schools of economic thought. Thus, there
have been substantial progress in what is known as “the growth accounting” where the
growth rate of the economy’s total output was first explained by the classical factors of
production, capital and labor, to include human capital at a later stage, or other
determinants of investment such as entrepreneurship, in addition to explanatory causes of
what has been known as the Solow Residual such as social capital.
The complexity of the analysis of the endogeneity of several factors required a
framework that can reckon and estimate these latter.
In 1957, Robert Solow developed a growth model relying on a theoretical framework that
explained income deviations by capital stock differences, however, a great deal of the
deviation remained unexplained; this residual “Solow Residual” was generally
interpreted as exogenous technology. Despite the fact that the quantitative approach of
the Solow model was revolutionary, however, additional works was needed to
incorporate other factors into the basic model.
In the early 1960’s, several economists pursued unveiling additional factors starting with
Arrow and Uzawa who developed models of human capital accumulation and learning2
by-doing; and thus, since the 1970s the need to quantify human capital and to include it
as a factor of production have reinforced, however, it will be several decades before it is
reconciled as a real capital with no additional disputes about its effect on development.
After 1970’s, endogenous growth theories introduced technical progress into the human
capital methodologies which decreased the residual, and despite the fact that they were
more refined than Solow’s erogeneity, however, it could not been interpreted into
significantly improved empirical accuracy.
After the first oil crisis in 1973, western economies suffered from a period of stagflation
that persisted till the beginning of 1980’s. Stagflation and high unemployment rates
necessitated drastic resolutions in order to encourage economic growth. The quest for
such solutions resulted in shedding the light on the supply side economics and its related
factors. David Birch boosted the attention on a new theory about business formation due
to his research where he found that it is not the corporations that are the sources of the
employment but rather young and small firms. Consequently, a flow of researches
followed to reevaluate the role of small firms and namely entrepreneurship on economic
growth.
By the beginning of the 21st century, several researchers have included issues such as
institutions, governance, and corruption that were previously considered as elements for
sociology but turned into a concern for economists.
Daren Acemoglu conducted a study on the role of institutions in development, and
developed it further in 2001 with Johnson and Robinson where they found that income
levels variation between countries were due to differences in historical institutions;
nevertheless, institutional variations provided a partial answer since large regional
differences in income across the same country persisted despite considerably similar
institutions. Thus, additional factors should be determined in order to reveal the reasons
underlying such variations.
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There are several types of capital that might be considered as assets of different forms
delivering benefits and making productive process more efficient; thus, social capital
might be defined as accumulation of Corporate, psychological, cultural and institutional
assets. These latter will grow the extent of reciprocal positive behavior for the individuals
involved and for the society in general (Neira, et al., 2009.)
The initial economic theory of entrepreneurship has emanated from the fact that the
economy is endowed with several factors; hence, entrepreneurship is the main contributor
to the production process through a combination of productive factors (capital and labor),
consequently, the achievement of greater production and well-being are conditioned by
more entrepreneurial resource allocation.
Latest studies achieved in the domain pursue the identification of certain features and
characteristics of the contribution aspect of entrepreneurship in Economic Growth. In
2009, Koo and Kim argued that there are several interconnected policy issues that should
be studied in a broader policy framework such as entrepreneurship, human capital, social
capital, and industry structures.
It became widely acknowledged that entrepreneurship is a main factor for economic
development, as such; stimulating entrepreneurship activities is a main focus for policy
makers.
Despite that, there are many gaps in the researches undertaken in the subject that need to
be filled in order to develop a better understanding of the relationship between
entrepreneurship and economic growth.
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1.2 Research problem
Despite the emergence of the importance of entrepreneurship in fostering economic
growth, however, the theoretical and empirical studies for recognizing the role of
entrepreneurship are not yet conclusive. Certain studies found evidence pointing to totally
different directions about the effect of entrepreneurship on developing economies.
Therefore, there are other topics to be considered in determining the factors that affect
entrepreneurship and the way entrepreneurship stimulate economic growth.
Entrepreneurship is bound by the presence of an adequate environment that encourages
and controls the entrepreneurial activity; such environment is manifested by
interdependencies between level of economic development and institutions. The latter are
essential factors of economic behavior (North, 1990) and economic transactions in
general (Williamson, 1998).
Consequently, in investigating the relationship between entrepreneurship and economic
growth, institutions is a critical determinant that should be implemented in the study since
it will carry more insight about the reason why the influence of entrepreneurship on
economic growth might vary significantly across countries and regions.
In a perfect world, researchers should have fully recognized and defined the variables and
mechanisms determining the relationship between entrepreneurship, institutions and the
entrepreneurial outcome. Despite that progress has been made in this field; however there
remain several shortcomings on theoretical, methodological and empirical levels.
First, a basic problem arises from the choice of appropriate variables reflecting the
measures of the entrepreneurial activity and the outcome of such activity; second the
omitted variable bias, the literatures about entrepreneurship have not converged on
consent about the empirical specifications; thus, results have differed widely among
researches.
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1.3 Research Questions
The study contributes to the literature on the role entrepreneurship plays in economic
growth and addresses the following basic questions:
- What is the effect of entrepreneurship on economic growth in developed and
developing countries?
- What is the role of the aspects of governance and institutions measured by Global
Competitiveness Index (GCI), Ease of Doing Business, and Composite Governance
Index on the relationship between entrepreneurship on economic growth?
1.4 Research Importance
One of the most central objectives of modern economics is defining the factors that lead
to economic growth.
Traditional neoclassical theories concluded that the determinants of economic growth of
a nation are capital and labor in addition to the level of technology available in that
nation. The theory has developed over time with Robert Solow and at a later stage with
Endogenous Growth theories that identified the factors of economic growth as capital,
labor, the level of knowledge available in a given society, and the level of pro-market
government policies adopted by the government.
Since early 1990’s, the field entrepreneurship has emerged gaining increased attention
among researchers with substantial number of theoretical and empirical studies linking
entrepreneurship to economic growth. However, these studies were mostly limited to two
units of observations: the creation of the firms and the region, with little consensus
regarding the relationship between entrepreneurship and economic growth on country
level.
Several studies proved positive relationship between entrepreneurship and economic
growth (Vazquez, E., et al 2010; Salman, D.M. & Badr, K., 2011) whereas others found
that such relationship remains undetermined and related to other conditions prevailing in
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the country such as institutions (Audretsch and Fritsch, 2002); Urbano and Aparicio,
2015).
Results from these studies varied depending on the definition of entrepreneurship and
simultaneously the stages of development.
There persist difficulties in this regard related to absence of agreement on the definition
of entrepreneurship, the units of analysis to be studied and the preconditions for the
success of entrepreneurship.
Given the fact that further efforts should be achieved in this domain in order to
understand how entrepreneurship is defined and therefore how it will lead to economic
growth; this thesis will present recent hypothetical understandings from the intersection
of the studies on entrepreneurship and economic growth, also providing an empirical
model that highlights the role of institutional elements as a precondition involved in the
relation between entrepreneurship and economic growth.
1.5 Research Plan
The research will be divided into the following chapters:
Chapter one:
Introduction
Chapter Two:
Theoretical Background and Literature review
Chapter Three:
Research Methodology
Chapter Four:
Results
Chapter Five:
Conclusion and Implication
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2 Literature Review
In section 2.1, we will present the three main views of Entrepreneurship (Historical,
Psychologist and Sociologist, and Economical). Section 2.2 will summarize the literature
review on the relationship between entrepreneurship and economic growth while section
2.3 will expand such relationship by considering the role of institutional environment
particularly by summarizing previous empirical studies.
2.1 Literature review on Entrepreneurship
The literature review on entrepreneurship demonstrates that its definition widely varies
among researches and there is no consensus in this regard. These definitions can be
categorized in three main views: Historical, The Psychological and Sociological and
economical.
2.1.1 Historical views on entrepreneurship
In the middle ages, the word entrepreneur was utilized in order to designate both an actor
and an individual who directs large production projects where there is no risk to be taken;
thus, the individual in charge just manages the project with the resources provided,
generally by the government or the country. A typical example would be the cleric which
is the person responsible of prodigious architectural works such as castles, cathedrals,
monasteries, public buildings, etc.
During the 17th century, the concept of entrepreneurship has totally developed and the
linkage between entrepreneur and risk has emerged. An entrepreneur is defined as an
individual engaging in a predetermined contractual agreement with the government in
order to accomplish a service or to supply required products in return for a fixed price,
therefore, any resultant profits or losses were at the entrepreneur’s. One of the leading
entrepreneurs in that era was John Law who was permitted to found a royal bank; with
time, the bank has developed into an exclusive franchise and becoming a trade company
“the Mississipi Company”. Law’s work was studied by Cantillion, economist and author
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who established one of the oldest theories of entrepreneurship. He considered them as
risk takers since they buy at a specified guaranteed price but sell at an uncertain price.
In the 18th century, and with the rise of the industrialization, there was a distinction
between the person that has capital from that who is in need for it, thus, differentiating
between capital provider and entrepreneur.
In the late 19th century and 20th century, Entrepreneurs and managers were considered
similar from an economic perspective. Richard T. Ely and Ralph H. Hes (1937, p488 )
briefly stated:
“The entrepreneur organizes and operates an enterprise for personal gain. He
pays current prices for the materials consumed in the business, for the use of the
land, for the personal services he employs, and for the capital he requires. He
contributes his own initiative, skill, and ingenuity in planning, organizing, and
administering the enterprise. He also assumes the chance of loss and gain
consequent to unforeseen and uncontrollable circumstances. The net residue of the
annual receipts of the enterprise after all costs have been paid, he retains for
himself”.
This definition can be illustrated by Andrew Carnegie who created products by adapting
new technology in order to realize economic vitality.
In the middle of the 20th century, the concept of an entrepreneur as innovator was
founded by Shumpeter (1952, p72).
“The function of the entrepreneur is to reform or revolutionize the pattern of
production by exploiting an invention or, more generally, an untried technological
method of producing a new commodity or producing an old one in new way,
opening a new source of supply of materials or a new outlet for products, by
organizing a new industry”.
Thus, innovation and newness were in the core of the entrepreneurial activity and one of
its most difficult tasks (Robert D. Hisrich and Michael P. Peters, 2002).
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Today, entrepreneurship has gained great importance since its relationship with economic
growth has been recognized (Baumol 1968, Stevenson and Jarillo, 1990; Wennekers and
Thurik, 1999; Van Stel and Caree, 2004).
Entrepreneurship is not limited to a certain industry or nation, but it is rather present in
every individual depending on its own desire. It has its foundation in all societies and
economic environments; and though the term usually denotes an individual, however,
organizations might be categorized as entrepreneurial according to the way they conduct
business and aim for growth. Zimmer and Scarborough (2005) defined the entrepreneur
as the person who has the capacity to explore the environment, recognize opportunities
for expansion allocate the appropriate resources and undertakes measures to benefit from
those opportunities. They are risk takers that identify new products and services and have
a valuable contribution to their societies.
2.1.2 The Psychologist and Sociologist approaches of Entrepreneurship
Most of the literature on entrepreneurship can be distributed into two main approaches
concentrating on individuals and structure respectively (Martinelli 1994, Thoronton
1999).
The first aims to elucidate the pervasiveness of entrepreneurs based on their intrinsic
psychological characteristics while the second emphasizes on the role of social and
cultural structures to motivate entrepreneurs by providing and creating opportunities.
David McClelland presented in his book “The Achieving Society” a factual foundation
for assessing economic, historical and sociological theories explaining the rise and fall of
civilization; it is considered as a significant contribution to the study on Entrepreneurial
individuals where he discussed that certain civilizations have cultural attitudes that are
interpreted into main socialization practices promoting entrepreneurial individuals.
A
similar conclusion was found in 1977 by Kets de Vries who discussed that
entrepreneurial personality is an outcome of a certain agonizing upbringing.
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The emphasis on individual behaviors has been mainly associated to both neoclassical
assumptions regarding complete information and Schumpeter’s Entrepreneur. On the
other hand, the contemporary trend concerning heterogeneity is affected by economic
theories, mainly Austrian Economics. Other economic perceptions have emerged with
extensive studies to empirically test the entrepreneurial behavior.
As for the structural tradition, it aims to explain the effects of social, cultural, and
institutional factors on entrepreneurship.
While some economists have found that marginality boosts entrepreneurship, however,
the majority underlines that the cultural and institutional support permitting the access to
resources are the main drivers for promoting entrepreneurship (Martinelli 1994) though
some authors segregate them into regulatory, cognitive and normative factors (Busenitz,
Gomez and Spencer, 2000) in order to elucidate both groups of entrepreneurship in
different nations.
Such tradition believes that the environment modeling the economy disturbs the
dynamics of entrepreneurship in any given nation. This environment is shaped by the
interdependencies between institutions and economic growth, which affect other factors
such as governance, access to capital, and the behavior of entrepreneurs. In this context,
institutions are considered as crucial determinants of economic behavior and economic
transactions and thus, they can exercise direct and indirect influence on entrepreneurship.
Accordingly, when considering entrepreneurship in a certain country, the wider nexus
linking entrepreneurship, economic growth and institutions is a major area of
investigation since it will shed the light on identifying the reasons why entrepreneurship
influences can differ considerably across countries and regions.
Institutional theories have emerged in the past few years while concentrating on profound
and robust features of social structure (Scott, 2004). It deliberates the practices by which
structures comprising guidelines, procedures, and norms become recognized as
authoritative rules for organizational behavior. The principal belief of the theory is that
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individual and organizational actions are formed and modeled by institutions present in a
given country (Powell & DiMaggio, 1991).
In 1994, Gnyawali and Fogel listed five dimensions determining entrepreneurial activity:
a) government policies and procedures (Measures undertaken by the governments in
order to affect the mechanisms and rule of the market so that it functions proficiently); b)
social conditions (encouraging attitudes regarding entrepreneurship and public support)
and economic conditions (economic growth, proportion of small firms in the population
of firms, variety of economic activity, unemployment rate, etc.); c) entrepreneurial
knowledge and skills (high level of technical and business skills required to motivate
entrepreneurs to start new venture and encourage them to overcome any problem, which
can be attained by business management training); d) financial support for
entrepreneurship (financial assistance is needed to start a new business, accumulate
startup capital, or to grow and expand the business); and e) non-financial support (support
services is crucial for the success of entrepreneurship translated through assistance in
undertaking market studies, formulating business plans, accessing loans, and opening
social networks).
Shane and Venkataraman (2000) support the institutional approach. They have developed
a model constructed based on business opportunities, which considered the necessity to
integrate the economic and institutional characteristics of markets into the theoretical
framework.
Criticisms were addressed to both approaches since the latter have failed to explain
entrepreneurial activity on the micro level: the individual behavior is a single-cause logic
that does not take into account external factors and is not influenced by progressive
dynamics while the structure approach does not account for human agency (Thornton,
1999).
Thus, researchers today are more concerned with social, political, cultural
entrepreneurship with heterogeneity in terms of knowledge, preferences, capabilities,
performances, etc. as main hypothesis for theory-building (Davidsson, 2003).
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Entrepreneurial activity is stimulated by economic theory and therefore, studied from
several economic perceptions whether by identifying the phenomenon or conducting the
empirical research.
2.1.3 Economic Perspectives of Entrepreneurship
There are three main economic perspectives regarding the entrepreneurial behavior. The
first is the German Convention of Von Thünen, Schumpeter, and Baumol, the second the
Neoclassical Convention of Marshall, Knight and Shultz, and the third the Austrian
Convention of Menger, Von Mises, and Kirzner. Though they have several common
points regarding entrepreneurship, however, each convention deals with a different angle
of the function of the entrepreneur with different methods and emphasis.
Schumpeter is considered to be one of the most influential economists of
entrepreneurship. He considers the entrepreneur as someone who symbolizes innovation
in the community and differentiates himself by being creative player enjoying nonrational and unusual qualities. They use information that is available to everyone without
any unique access to discrete information. Schumpeter highlighted the non-utilitarian
qualities of the entrepreneurs by focusing on their psychological capabilities. The typical
Schumpeterian entrepreneur is an aristocratic character being amongst the innovative
elite in capitalist society that is driven by a vision of establishing a “private kingdom”, an
intrinsic desire to “succeed for the sake … of success itself”, who feels “the joy of
creating” and “delights in ventures” (Schumpeter 1961: 93-94). Schumpeter also
considers that innovation is not enough by itself since news ideas need to be implemented
and it takes a strong character having the power to get things done, thus, creative
destruction is the essence of capitalism.
The economy is stationary and repetitive, and the introduction of the entrepreneurs of
new inventions and innovations will surprise and shock the predominant equilibria
causing distortion of current economic goals and thus, altering the direction of the
economy.
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The neoclassical convention assumes rationality in individual’s behavior trying to
maximize their utility and leading markets to equilibrium. Therefore, some economists
debated that entrepreneurs do not have a real role in the neoclassical economics (Baumol
1968, Bianchi and Henrekson 2005) since they can only be efficient if the economic
system is at disequilibrium. The latter can occur as an outcome for exogenous dynamics
such as public R&D (Shultz, 1980), therefore, providing individuals with a framework
where they can maximize their utility; thus, entrepreneurs should have special capacity
and speed enabling them to provide a fast response to any disequilibrium since
information is equally available to everyone (Demsetz 1983) or them should be risk takers
(Kihlstrom and Laffont, 1979).
As for the Austrian convention, it emphasizes on the abilities of the entrepreneur to
identify and categorize profit opportunities that frequently follow an exogenous shock.
Austrian economists are rigid methodological individualists and subjectivists seeking to
elucidate the actions undertaken as directed by beliefs and desires.
2.2 Literature Review on the Relationship between Entrepreneurship and
Economic Growth
2.2.1. Threads of the Economic Literature
The relation between entrepreneurship and economic growth is rooted in three main
threads of the economic literature.
The first thread is related to the role that entrepreneurship plays in modern economy, and
is mainly led by Knight (1921), Schumpeter (1934), and Kirzner (1973). These
economists have different understandings regarding the role of the entrepreneur.
Knight emphasized on risk taking aspect where an entrepreneur should endure
uncertainty to realize profits, Schumpeter on innovation and creativity where he
considered the entrepreneur as being an individual taking an idea and turning it into an
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economic knowledge, and Kirzner concentrated on leading markets to equilibrium
through entrepreneurial activities where he considers the markets to be basically
disequilibrated; according to Kirzner, the entrepreneur is an individual who seeks profits
and exploits disequilibrated markets thus, benefiting from arbitrage opportunities that are
capable of restoring market opportunities.
In 1992, Acs introduces the influence of small firms in modern economies. He considers
small firms undertaking entrepreneurial activities to be key vehicles of entrepreneurship
and agents for change since they are a basis for innovation; thus, encouraging the
industry development and creating new job opportunities. However, the positive effect of
entrepreneurship and small firms on economic growth is intriguing and complex since
there are a number of factors causing such relationship and thus, several intermediate
variables are involved such as entry and exit of firms (i.e. competition), innovation, and
diversity of supply. Many theoretical frameworks were developed to apprehend the role
of these variables mainly that provided by Thurik et al. (2002).
The second thread is related to mathematical modelling of economic growth. Despite the
fact that neoclassical growth theories consider technology to be an exogenous factor, and
therefore entrepreneurship has no role in economic growth; however, recent endogenous
growth theories found that entrepreneurship has an important role in achieving economic
growth. For example, in 1992, Aghion and Howitt constructed a model of growth
revolving around Schumpeter’s ideas: long run growth is mainly engendered from
innovations, innovations stem from entrepreneurial investment, and creative destruction.
In their model, economic growth exclusively resulted from technological progress which
in turn emanates from competition between firms that engender innovations.
They
consider firms to be motivated and driven by potential monopoly rents once the
innovation is patented; however, these rents are wrecked by the subsequent innovation
As a result, competition engendering innovations is an endogenous variable determining
economic growth and technological progress.
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The third thread comprises empirical modelling and measurement of the relationship
between entrepreneurship and economic growth. The result of entrepreneurial activities,
in terms of economic performance, has spawned widespread empirical literature (Carree
and Thurik, 2003). Nevertheless, the latter has mostly been limited to two units of
observation, the firm and the region though studies on the firm level are the most
dominant. Surprisingly there are limited number of studies on the relationship between
entrepreneurship and economic growth on country level with controversial results.
2.2.2. Traditional theory vs. new Growth theory
The theoretical framework associating entrepreneurship and economic growth is drawn
by new growth theory and mainly theories of industrial evolution (Jovanovic, 1982;
Hopenhayn, 1992; Ericson and Pakes, 1995; and Klepper, 1996). These theories advocate
that entrepreneurship will encourage and produce economic growth, at the contrary of the
traditional theories that propose that entrepreneurship will delay economic growth. The
discrepancies between these two theories arise from the framework of the underlying
theory.
The traditional theory relies on the role of capital and labor in inducing economic
development without any acknowledgment of the role of new knowledge; thus, growth is
driven by a static efficiency that is mainly determined by its capacity to deplete scale
economies. The theory was first developed in 1956 by Robert Solow in his paper “A
contribution to the Theory of Economic Growth” where he discusses that economic
growth is a function of two inputs, capital and labor. He argues then that the nature of the
function relies on technology available in the country (i.e, the level of knowledge),
however, it was unaccounted for and perceived as exogenous.
At the contrary, new growth theories take into account the role of knowledge in economic
development. Since knowledge is intrinsically ambiguous and asymmetric by nature in
addition to being correlated to high costs of transaction, the expected value of new ideas
differs widely. Thus, economic agents have a reason to leave a company and found a new
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one in order to commercialize their knowledge. In other words, entrepreneurship is the
mean to implement ideas. The essential phenomenon of these new theories is the
emphasis on change.
Change can be translated through innovative activities, in this regard; entry, growth,
survival and other forms through which companies and even industries change over time
are directly related to innovation.
2.2.3. Entrepreneurship: New Entry, survival and Exit
The reason for new firms to enter an industry whether they are startups or existing firms
diversifying the business activity is mainly embedded in the traditional equilibrium based
view that assumes entry to be motivated by abnormal profits. As a result, the growing
supply resulting from firms entry will reduces prices and reinstates profits to their long
run equilibrium level. Therefore, the equilibrium view is a disciplinary mechanism for
firms. Alternative classifications of entry based on innovation and costs of firm growth
were introduced and assessed by new theories of industry evolution. A study conducted
in 1995 by Audretsch examines the variables affecting the rate of new firm startups. He
concluded that the latter are common in industries where small firms earn the greatest
share of the industry’s innovations. Thus, firms are created to capitalize on distinguished
knowledge created outside the industry’s leaders. New entrant firms face a greater degree
of uncertainty compared to incumbent ones, which is the basis of the theory of firm
selection and industry evolution suggested by Jovanovic (1982). He introduced a model
in which new firms - referred to as entrepreneurs- confront costs that are random and
differs widely across firms. The firm cannot determine its cost function and relative
efficiency prior to its entry but rather learns it from its post-entry performance.
Jovanovic considers that entrepreneurs are uncertain about their prospects for success.
They enter the industry based on certain expectations of post-entry performance,
however, their real ability to run the firm in terms of managerial know-how and viability
of the idea underlying the firm cannot be determined unless the firm is already
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established. As a result, many firms will expand the scale of the business if their ability
proved to surpass their expectations while others will exit the industry if their
performance was less adequate with the expectations. The Jovanovic’s model is a theory
of “noisy selection” where proficient entrepreneur will survive and develop while
incompetent firms will degenerate and exit the industry; the model is one of the most
influential models regarding the growth and survival of the firms, linking innovation,
entry, exit and the evolution of the industry.
2.2.4. Sources of Economic Growth
More recently, researchers and policy makers suggested other sources for economic
growth such as market friendly government policies. Hans Pitlik, in the paper “The Path
of Liberalization and Economic Growth” (2002), elucidates several empirical studies
proving the positive effect of pro-market government policies on economic growth of a
country.
Such policies raise the benefits individuals obtain in return of conducting activities that
favor economic growth. Such findings suggest that entrepreneurship is significantly
affected by market friendly government policies. It was highly sustained by other studies
conducted by Matthieu Chemin. In his article “The Impact of the Judiciary on
Entrepreneurship: Evaluation of Pakistan’s ‘Access to Justice Program” (2002), Chemin
found that the reform of the jurisdictional system in Pakistan led to a substantial upsurge
in the entrepreneurial activity which is also consistent with the previous finding that
certain government policies are positively correlated with the level of entrepreneurship
and this latter is affected by at least one of the traditional factors of economic growth.
Nevertheless, though entrepreneurship might be affected by certain traditional elements
of economic growth but it doesn’t revoke it as an isolated predictor of economic growth.
In the case where a factor affecting entrepreneurship is not considered amongst the
traditional factors of economic growth while entrepreneurship does affect economic
growth, then, entrepreneurship should be considered as additional independent factor of
economic growth. The intuition behind the conclusion is that if entrepreneurship is
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impacted by determinants other than the traditional ones of economic growth and in its
turn has an impact on economic growth, then it is basically acting as proxy for these
variables.
Accounting for entrepreneurship as a separate determinant of economic growth would
therefore guarantee that the impact of the other factors was at least partially being taken
into account. Many theories suggested that entrepreneurship is certainly affected by
several factors beyond traditional ones believed to affect economic growth. Such theories
are present in the notions of Joseph Schumpeter. In “The Theory of Economic
Development”, Schumpeter considered that entrepreneurship leads to economic growth in
a society by using the factors of production in innovative and effective combinations.
Consequently, he concluded that technological innovation is not only caused by
knowledge, but also through entrepreneurship. He claims that entrepreneurship is a
practice that is totally different from the rational economic behavior dominant in a
society and not a natural outcome of it. In fact, for individuals to act in an economically
rational way, they must have a certain level of knowledge that enables them to make
decisions. He also indicated that since individuals naturally count on past experiences to
develop their knowledge, all their economic behavior will be relying on past thoughts and
practices.
Thus, rational economic behavior cannot be considered as innovative according to
Schumpeter. Consequently, it cannot lead to the formation of completely new
arrangements of the means of production, the main element of entrepreneurship
(Schumpeter, pp. 79-81). Therefore, rational economic behavior would just allow people
to adjust to any modifications in these traditional issues in
whatsoever manner had
found to be most effective in the past.
Subsequently, entrepreneurship, necessitating innovation, cannot be considered as an
outcome of just the traditional elements of economic growth.
In this regard, a similar argument for dealing with entrepreneurship as an independent
element of economic growth is embedded in the study of Max Keilbach and David
Audretsch: “Entrepreneurship and Regional Growth: An Evolutionary Perspective” who
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examined the precise nature of the relationship between knowledge and economic
growth.
They reasoned that a differentiation should be done between the common forms of
publicly accessible knowledge and economic knowledge that can be identified as a
subdivision of common knowledge which industries have figured a system to use
commercially and beneficially.
Keilbach and Audretsch (2004) argued that accessible knowledge can be altered into
economic knowledge by entrepreneurs who basically examine the general knowledge till
they discover a part that they consider it can be exploited and thus, start a new business
relying on that part of knowledge. Such way of scrutinizing and inspecting the common
knowledge can be considered as the course of innovation. Such economic knowledge is
the driver for economic growth (Keilbach and Audretsch, pp. 606-607). The authors
concluded that knowledge solely cannot generate economic growth but rather
entrepreneurship that alters accessible knowledge into economic knowledge.
Such argument runs against the old theories considering entrepreneurship as a natural
outcome of high levels of labor, capital and knowledge. In fact, the findings of Keilbach
and Audretsch’s were supported by other studies conducted by C. Mirjam van Praag and
Peter H. Versloot (2007) who, in their article “What is the Value of Entrepreneurship? A
Review of Relevant Research” found that countries having high levels of
entrepreneurship enjoyed high levels of innovation and technological change. This is
consistent with the theory of Keilbach and Audretsch considering that entrepreneurship is
essential for converting common knowledge into economic knowledge and thus
innovation. And it is also analogous to another theory established in the work of Kirzner
“The Alert and Creative Entrepreneur: A Clarification”. In this article, Kirzner disputes
that the key reason driving entrepreneurship is the individuals observing and benefiting
from formerly unrecognized price discrepancies. An illustration of such idea might be
translated through individuals recognizing the fact that they may possibly utilize a present
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but little-known method needed for the production and sale of a certain good cheaply
than anyone else, or individual buying goods that can be sold later at a higher price. Such
recognition and exploitation of the price discrepancies is the main driver leading markets
to equilibrium.
Despite the fact that Kirzner’s idea contradicts with the ideas of
Schumpeter who considers entrepreneurship to unavoidably disturb market equilibrium;
However, both Kirzner and Schumpeter approve that entrepreneurship is not only
affected by the traditional factors of economic growth but there are other factors
involved.
Despite the fact that Keilbach, Audretsch, and Kirzner disagree about the precise nature
of the opportunities for profits facing prospective entrepreneurs, however, they agree that
entrepreneurship is initiated by the capacity of individuals to recognize these
opportunities and act on it with innovation. Based on the assumption that this finding is
correct, the level of entrepreneurship in a certain society is determined by the extent to
which individuals identify and exploit hidden opportunities in order to realize profits on
one hand and by the existence of the traditional factors of economic growth on the other
hand.
Robert Bednarzick (2000), in his article “The Role of Entrepreneurship in U.S. and
European Job Growth,” also argued that entrepreneurship is not only caused by the
traditional factors of economic growth. He presented seven main factors that affect
entrepreneurship in a certain society, of which six are already defined in the Global
Entrepreneurship Monitor study in 1999: The Entrepreneurial Opportunities, the
Entrepreneurial Capacity, the Infrastructure, the Demographics, the Level of Education,
the Culture, in addition to the seventh important cultural and structural feature identified
by Bednarzick which is the shift for capital control (i.e. if capital is controlled chiefly by
banks or public markets) (Bednarzick, pp. 14-15). Only the first three factors are
considerably influenced by traditional factors of economic growth in a certain nation. The
entrepreneurial opportunities would be considerably affected by the presence of pro-
21
market governmental policies. Likewise, the level of education would evidently be
associated with the level of knowledge in that nation, and the size of the labor force
would be influenced by the population demographics of that nation.
Other factors listed in Bednarzick’s article cannot be strongly correlated with the
traditional factors of economic growth. Entrepreneurial capacity would be normally
perceived as an exogenous variable with uncertain causes (Otani, p. 273). The
infrastructure would be mainly affected by government spending and not by marketfriendly government policies and regulations, and the degree to which a nation’s culture
fosters entrepreneurship is most probably affected by sociological factors. The shift for
capital control relies on the general economic structure of a given country.
This implies that, despite the fact that the traditional factors of economic growth will
impact entrepreneurship in a nation to a certain level, however, they do not have enough
influence to explain its rejection from the neoclassical model of economic growth.
R.G. Hubbard (2008) strongly supports this view in his article “Nondestructive Creation:
Entrepreneurship and Management Research in the Study of Growth”. He concluded that
the high economic growth witnessed in the US in the 90’s and early 2000’s is a direct
consequence of increased levels of entrepreneurs and managers at firms having the
flexibility to adapt to varying business conditions. He stresses on the fact that high level
of economic growth cannot only be caused by high levels of labor, capital and technology
existing in the U.S., indicating that several European and Asian countries had high level
of technology exceeding that of the U.S. throughout the same period and that productivity
in the U.S. remained high despite its decrease in the early 2000’s in several other
countries.
Based on the assumption that the level of technology in a certain nation relates to the
level of knowledge in that nation, Hubbard argument implies that at least three out of the
four traditional economic growth factors do not significantly influence entrepreneurship.
22
The analysis of Hubbard’s on the U.S. economic growth during this period strongly
recommends the inclusion of a measure of entrepreneurship as an independent factor of
economic growth.
2.3 Literature Review on the Relationship between Entrepreneurship and
Economic Growth: effect of Institutional environment
While the previous section of the literature review explored the relationship between
entrepreneurship and economic growth, however, not every practice of entrepreneurship
is growth engendering. Since entrepreneurs are driven by personal profit opportunities,
the institutions prevailing in a society significantly impact the magnitude to which
entrepreneurial actions produce innovation and prolific outcomes. Institutions defined as
the “rule of game” promote social, economic, and political interfaces and therefore, might
affect the drivers and outcomes for an entrepreneur to participate in growth generating
behavior. Since individuals react to incentives by assessing the costs and benefits of their
actions, therefore, they are to a great extent influenced by the institutions prevailing in
that society. A society where the individual is unable to benefit from his invention cannot
be a technological hub; in another society where the costs of starting a business are too
high, the individual is most likely to be dissuaded from establishing a new business and
turning into an actual entrepreneur. In other words, institutions might produce
encouragements for certain actions or might discourage individuals from undertaking
other actions; when the latter find profit opportunities resulting from engaging in
activities
like
innovation
and
arbitrage,
entrepreneurship
thrives.
Therefore,
entrepreneurial activity depends on institutions to encourage or hinder economic growth.
2.3.3 Impact of institutions on Economic Growth through Entrepreneurship
In 1990, Baumol unveiled the impact of institutions on economic growth in his article
“Entrepreneurship: productive, unproductive, and destructive”. His arguments were a
restoration of the idea of Adam Smith who considered that economic agents following
23
their own interest can engender value for the whole society if the underlying institutions
create reciprocally valuable exchange.
Baumol distinguished between three forms of entrepreneurs that encourages or hinders
economic growth: productive, unproductive, and destructive. Productive entrepreneurs
are the ones to introduce new goods, methods of production, new markets, and new
managerial strategies, etc. while unproductive entrepreneurs are usually associated with
rent seeking or even criminal activities, i.e. an entrepreneur who employs resources to
lobby policymakers for subventions and grants is considered unproductive and therefore
such actions diminishes long run economic growth. In 2010, Coyne, Dove, and Sobel
explained the way unproductive entrepreneurship produces unproductive niches for
profits and therefore alters the pattern of incentives in the society and creates
unproductive opportunities, social capital and networks and consequently crowds out
productive activities and hence economic growth.
As for destructive entrepreneurship, it is analogous to unproductive entrepreneurship but
it adds to it destruction of the available resources in the attempt of the entrepreneur to
grow his personal wealth.
Baumol emphasizes on the payoffs of productive, unproductive and destructive
entrepreneurship. If the institutional environment recompenses productive entrepreneurs,
then entrepreneurial players will be routed towards achieving the profits from innovation
and trade; however, if gains from rent seeking and other criminal activities are greater,
then the entrepreneurial players will react to those incentives consequently.
2.3.3 Institutional Structures
The essential institutional structure recognized in permitting productive entrepreneurship
to thrive is the institution of property rights. Weak protection of property rights reflects
the fact that the entrepreneurs won’t be capable to maintain enough of their gains or they
might consider that their capital investments will be detained or stolen, thus, it is less
lucrative to participate in business ventures (Boettke and Coyne, 2003; 2009). In 2013,
24
Acs, Carlsson, and Karlsson elucidate that securing property rights is crucial for
entrepreneurs since they need to depend on the protection of their outstanding claims for
the proceeds generated from the businesses they have established. After all, entrepreneurs
provide capital, take risk, and enter new markets; these actions necessitate long term trust
supported by stable property rights that are efficiently applied.
Another important structure is the tax. If it penalizes market success, entrepreneurs will
be induced to shift their resources from designing new products and developing new
markets towards more profitable projects and plans outside the market and therefore
entrepreneurship become unproductive and destructive and thus, disturbs economic
development and might even trigger economic decline.
Competition is considered as another institutional structure that might modify the
equilibrium of incentives between different forms of entrepreneurship and therefore can
accelerate or delay economic growth. In 1985, Kirzner explains that competition in the
market occurs given that there aren’t any arbitrary barriers to entry. Without the latter,
competition engenders entrepreneurs seeking the establishment of new products and
services and new technologies for production. In other words, barriers to entry can be
considered as barriers for undertaking entrepreneurial activity (Boettke and Coyne,
2009).
It is essential to highlight the role of institutions since entrepreneurship is to a great
extent abundant; it is present across societies, nations and over time, and entrepreneurs
will constantly engage their vision and creativeness in order to realize personal benefits
(Baumol, 2002; Koppl, 2007). Consequently, the variations of entrepreneurship in a
certain nation do not only rely on the differences in the characteristics of the
entrepreneurs but might be due to the variations of institutions that outline and restrain
the incentives to entrepreneurs.
25
2.3.3 Development of Empirical Studies
The pioneering studies conducted in 1994 by Audretsch and Acs, and Audretsch and
Fritsch, in order to test the relationship between economic growth and entrepreneurship
did not emphasize on specific institutions; however, consequent empirical studies
introducing institutions were conducted starting 2005 ( Kreft and Sobel, 2005; Ovaska
and Sobel, 2005; Bjørnskov and Foss, 2008).
Kreft and Sobel conducted the first study on how institutions and economic policy affect
entrepreneurship in the United States, followed by a similar model applied in the same
year by Ovaska and Sobel for transition countries. In 2008, Bjornskov and Foss examined
a larger sample of 27 countries, and McMullen, Bagby, and Palich conducted a study for
37 countries. For measuring the institutional aspect, the four studies relied on the concept
of economic freedom mainly the protection of property rights, regulations and tax
differences across countries.
Following studies examined more specific institutions and policies. In 2008, Nystrom
investigated the relationship between institution and entrepreneurship and concluded that
smaller government sector, better legal structure and property rights as well as less
regulations of credit, labor and business increase entrepreneurship. In 2010, Djankov et
al. investigated the effects of corporate tax rates on investment, FDI and Entrepreneurial
activity.
In 2009, Ardagna and Lusardi accounted for regulations as a way to affect
entrepreneurship; they concluded that strict regulations negatively affect the productivity
of entrepreneurship. In 2010, Djankov et al. studied the impact of corporate tax rates on
investment, FDI and entrepreneurship.
On the other hand several studies has also accounted for governance as a proxy for
institutions (Campos and Nugent, 1999).
26
Researchers applied various ways in order to measure entrepreneurship. First, there are
prerequisites of entrepreneurship defined in the institutional framework. These comprise
the ease and cost of doing business and the quality of the regulatory environment. Such
measures regard entrepreneurial activity as the same as the conditions that are considered
crucial for the entrepreneurial activity to thrive. Second, measures related to the output
indicators such as the number of new firms, the size of the firm, and the growth of the
new firms. Third, measures that can be developed and computed through surveys
investigating the attitude and social qualities that affect the residents’ opinions
concerning entrepreneurship.
However, there isn’t any common agreement among scholars and researchers about
which is the best measure to be adopted that best quantifies the entrepreneurial activity.
An ideal measure should comprise the three mentioned modules (framework, output, and
attitude).
In 2014, Gwartney, Lawson, and Hall, relied on an index that was published in Economic
Freedom of the World in order to measure institutions. This measure is composed of five
elements being a part of economic freedom: size of the government, legal system and
property rights, sound money, freedom to trade internationally and regulation. These
elements are considered crucial for entrepreneurial activity since they have great
influence on the incentives in a society.
The World Bank has also developed the Doing Business Index in 2014 as another
challenge to measure entrepreneurial activity by studying indicators of regulation.
The Doing Business index (World Bank Group, 2014) is another attempt to measure the
entrepreneurial environment by analyzing indicators of regulation. The two central
indicators are the complexity and cost of regulatory process and the strength of the legal
institutions. The first comprises the costs of starting a business, paying taxes, finalizing
27
construction permits, while the second comprises the execution of contract, labor market
regulation and protection of minority investors.
Klapper, Love, and Randall has adopted this index in their study and concluded that
improved regulatory environment is positively correlated with economic growth. In 2014,
Jovanovic studied the impact of business regulation (measured by the Doing business
indicators) on foreign direct investment in 28 European and Asian countries. He found
that reducing the cost of starting a business will positively affect FDI flows while more
strict regulations will have negative impact on FDI and therefore on economic growth.
In 2002, Scarpetta, Hemmings, Tressel, and Woo studied the relationship between
regulations and entrepreneurship. They found that the business entry rates will decrease
with more rigid administrative regulations and sector specific market regulations.
Similarly, in 2003, Desai, Gompers, and Lerner concluded that greater protection of
property rights and reduced government corruption will cause the growth of firm entry
rate, and decrease firm exit rates.
However, Ovaska and Sobel (2005) investigated the relationship between regulations and
entrepreneurship. They have relied on the EFW index for the regulation component, but
they did not find a strong relationship. Nevertheless Freytag and Thurik (2007) conducted
the same study using the same data with minor adjustments and found that regulations do
have an important impact on entrepreneurial activity.
Van Stel, Carree, and Thurik (2005) used the measures of entrepreneurship from the
Global
Entrepreneurship
Monitor
to
investigate
the
relationship
between
entrepreneurship and economic growth. They found a positive relationship for rich
countries only while in poor countries, entrepreneurship negatively affect economic
growth.
In conclusion, the empirical literature demonstrate that there is a relationship between
entrepreneurship and economic growth, however, and that such relationship may be
driven by
institutions and there are several variables used to measure both
28
entrepreneurship and institutions since there isn’t yet a sole universally established
indicator measuring institutions nor entrepreneurship.
29
3 Research Methodology
After two decades of theoretical and empirical contributions in developing models of
economic growth, many researchers and economists found conclusions consistent with
several expectations of the new growth theories.
The mainstream studies have inspected previous empirical studies and economic growth
theories to identify a set of variables as being related to growth.
The typical methodical framework is based on the following growth regression:
𝑌 = 𝐵𝑖 𝐼 + 𝐵𝑚 𝑀 + 𝐵2 𝑍 + 𝜇
Where:
Y: the average annual growth rate of GDP per capita
I: the set of variables or the so-called conditioning variables always included in the
regression
M: the variable of interest
Z: the subset of variables, selected from a pool of variables, which are expected or
recognized to be significant explanatory variables to growth.
The selection of Z-variables is built based on either past empirical studies or
economic theory.
µ: the random error term indicating the collective unobservable effect of any omitted
variables.
The empirical model in this thesis will be developed starting from this general equation.
The I variables are chosen based on the previous studies as summarized in Thirwall book
“Growth and Development” (p.118), where he concluded that four variables remain
robust irrespective of what other variables are added in the equation: the rate of savings
30
and investment to GDP, population growth, the initial level of per capita income, and
investment in human capital measured by the secondary school enrollment rate.
The variable of interest in this thesis is Entrepreneurship measured through Bentry which
is the business entry rate represented by the new limited liability corporations registered
in the calendar year per 1000 people aged 15-64. The choice of this variable as proxy for
entrepreneurship is in line with previous studies (Audretsch and Kielbach, 2004), and
several studies conducted by the World Bank.
As a first step, the regression will be estimated through a time-series-cross-section
analysis that will be conducted for 30 countries over the period 2009-2012 only with the I
variables and the variable of interest M (Entrepreneurship); Countries incorporated in the
study presents a representative and illustrative sample because of the wide variety of
countries included in this data set. Then the other variables Z will be added and tested.
The choice of the latter was also based on previous empirical studies. In 2002, Audstretch
et al. developed a model for German and Brazilian regions to test the effect of
entrepreneurship on economic growth where gross domestic product was hypothesized to
be a function of capital, labor, knowledge and entrepreneurship. An analogous model was
used by Wong et al. (2005) to examine the impact of entrepreneurship on economic
growth for 37 mixed countries participating in the GEM (Global Entrepreneurship
Monitor) 2002. Aloysius (2002) has also implemented a similar model for Cameroon. In
2010, Daniel Smith, investigated the effect of entrepreneurship on economic growth
using a cross-sectional data set for the year 2005 containing data for 77 different mixed
countries.
-
Labor:
labor force participation rate (% of total population aged 15-64)
which measures labor
-
Percapitacap:
gross capital formation (% of GDP) which measures capital. It is
formerly known as gross domestic investment. It consists of outlays
31
on additions to the fixed assets of the economy plus net changes in
the level of inventories
-
Rdspend:
research and development spending (% GDP) which measures
knowledge. These expenditures are current and capital expenditures
(both public and private) on creative work undertaken systematically
to increase.
All the data is collected from the World Bank’s online World Development Indicators
database.
In this thesis, a deep empirical strategy will be presented to test the effect of
entrepreneurship on economic growth by adopting two approaches taking in addition to
the direct effect, the indirect effect through institutions and governance.
First Approach:
Several researches argue that institutions define the environment in which the
entrepreneur functions and influence entrepreneurial activity (Acs, et al., 2008; Hwang
& Powell, 2005).
Past studies concentrated on reviewing the effect of institutions on entrepreneurial entry
in general (Arenius & Minniti, 2005; Wennekers, Uhlaner, & Thurik, 2002), while recent
studies assesses how specific types of institutions affect different forms of entrepreneurial
activity (Boettke & Coyne, 2009; Levie & Autio, 2011). The investigation of the impact
of institutional structures on growth-aspiration entrepreneurship is very recent (Bowen &
De Clercq, 2008; Estrin, et al., 2012; Stenholm, et al., 2013).
Entrepreneurship is not only shaped by institutions but entrepreneurs influence
institutions themselves. Such bilateral causal relationship should be tested in this thesis;
thus, an interaction variable representing the product of the two variables (Institutions
and Entrepreneurship) should be included in the main Equation, we will add the variable
(Ent- Inst) to the regression model. The result is:
32
𝑌 = 𝐵𝑖 𝐼 + 𝐵𝑚 𝑀 + 𝐵2 𝑍 + 𝐵3 𝐼𝑛𝑠𝑡 + 𝐵4 𝑀 ∗ 𝐼𝑛𝑠𝑡 + 𝜇
Where Inst measures Institutions
Second Approach:
Based on previous empirical studies and mainly Acs Et Al. (2005), and Nystrom (2008),
the following simultaneous equation model will be developed:
𝑌 = 𝐵𝑖 𝐼 + 𝐵𝑚 𝑀 + 𝐵2 𝑍 + 𝐵3 𝐼𝑛𝑠𝑡 + 𝜇
𝑀 = 𝛽0 + 𝐵1 𝑆𝑈𝑀𝐸𝐷𝑈 + 𝐵2 𝑃𝑂𝑃 + 𝐵3 𝑈𝑁𝐸𝑀𝑃 + 𝐵4 𝐺𝐷𝑃 + 𝐵5 𝐼𝑁𝑆𝑇 + 𝐵6 𝐼𝑁𝑇
+ 𝜀1
-
Sumedu:
sum of per student expenditures for primary, secondary and tertiary
education (percent of per capita GDP) which measures knowledge.
-
Pop:
Population growth (annual %)
-
Unemp:
unemployment which measures the macroeconomic conditions
-
GDP:
GDP per Capita which measures economic development
-
Inst:
which measures institutions
-
Int:
lending interest rate which measures a stable monetary environment
This model will be investigated through three main proxies for Institutions/governance:
I. GCI:
Global Competitiveness index; it integrates micro and macroeconomic aspects
of competitiveness made of 110 variables and organized into 12 pillars:
-
Institutions
-
appropriate infrastructure
a stable macroeconomic framework
good health and primary education
higher education and training
efficient goods markets
efficient labor markets
developed financial markets
the ability to harness the benefits of existing technologies
33
-
and its market size, both domestic and international
by producing new and different goods using the most sophisticated production
processes
innovation
According to Drzeniek-Hanouz , Head of Global Competitiveness and Risks, (2015),
institutions has the pivotal influence on all other pillars since the beginning of
measuring competitiveness in 1979.
Institutions in their turn are divided into sub categories:
1. Public institutions:
-
Property rights
Ethics and Corruption
Undue Influence
Government Efficiency
Security
2. Private institutions:
-
Corporate Ethics
-
Accountability
Thus, each category will be tested separately in order to capture the main variable
affecting entrepreneurship and indirectly economic growth.
II.
Ease of doing business: it is an estimate of the institutional regulations. The index
is based on 10 indices:
-
Starting a business: Procedures, time, cost and minimum capital to open a new
business
-
Dealing with construction permits: Procedures, time and cost to build a
warehouse
Getting electricity: procedures, time and cost required for a business to obtain a
permanent electricity connection for a newly constructed warehouse
Registering property: Procedures, time and cost to register commercial real estate
Getting credit: Strength of legal rights index, depth of credit information index
Protecting investors: Indices on the extent of disclosure, extent of director liability
and ease of shareholder suits
Paying taxes: Number of taxes paid, hours per year spent preparing tax returns
and total tax payable as share of gross profit
-
34
-
III.
Trading across borders: Number of documents, cost and time necessary to export
and import
Enforcing contracts: Procedures, time and cost to enforce a debt contract
Resolving insolvency
Composite governance index: it captures six main dimensions for governance that
will be tested separately
-
Voice & Accountability
Political Stability and Lack of Violence
Government Effectiveness
Regulatory Quality
Rule of Law
and Control of Corruption
35
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