The Impact of Entrepreneurship On Economic Growth: M.A. Carree, and A.R. Thurik
The Impact of Entrepreneurship On Economic Growth: M.A. Carree, and A.R. Thurik
The Impact of Entrepreneurship On Economic Growth: M.A. Carree, and A.R. Thurik
=
Hence, in Cournot equilibrium total output within market x equals
(3.3) .
1
x
x x
x
N
N a
Q
=
By inserting equation (3.3) into the profit function we derive that in equilibrium
(3.4) .
) 1 (
2
=
x
x
x x
x
k
N
a
N N
Q
There is an equilibrium across regions in case entrepreneurs in one region earn as much as
entrepreneurs in the other region. This implies that
(3.5) .
j
i
j
i
a
a
N
N
=
This equilibrium condition assures maximum total output for the two markets combined given
a certain fixed number of entrepreneurs, N. To derive this, note that
i j
N N N = and that, there-
fore the sum of outputs is
10
(3.6) . /
1 1
= +
i
i
j
i
i
i j i
N N
N N
a
N
N
a Q Q
Maximizing equation (3.6) with respect to
i
N gives us the exact same outcome as given in
equation (3.5). Now we come to the final issue of how many entrepreneurs there will be. Follow-
ing Carree and Thurik (1999b) we assume there exists a critical profit level
*
that entrepreneurs
seek to receive as compensation for their efforts. In case profit falls short of the critical level, en-
trepreneurs will exit until the profit level increases to the critical level. In case profits exceed the
critical level (new) entrepreneurs will enter until the profit level decreases to the critical level. An
important determinant of the critical profit level is the extent to which entrepreneurs want to be
compensated for the risk they face.
We give a numerical example to indicate the impact of a lack of either Kirznerian or Knightian
entrepreneurship. Assume that the two markets are identical in size, 50 = =
j i
a a , and that the
fixed costs parameter and critical profit level
*
both equal one. The variable costs parameter
is assumed to be 0.1. The total number of retailers in each of the two markets is then derived
from
* 2
/ =
x x
N a and is found to equal five after inserting the numerical values. The total
output of the two markets is derived from (3.3) to equal 800.
Now assume that instead of both markets having five firms that there is one market with six
and one market with four firms. Total output then equals 792 instead of the maximum output of
800. Hence, the consequence of at least one of the six retailers not being alert to the prevailing
disequilibrium entails a output loss of one percent. The lack of Kirznerian entrepreneurship that
would otherwise have alerted one retailer to change location (market) leads to lower output.
12
Now
assume instead that entrepreneurs want to have a (50%) higher compensation for the uncertainty
they are confronted with and that the critical profit level
*
equals 1.5 instead of 1. The number of
firms is each market then reduces to 4.47 and total output drops to 776. Hence, the consequence
of entrepreneurs being more averse to risk is a drop in total output. A decrease in the number of
individuals prepared to take risks in the marketplace (Knightian entrepreneurs) leads to an output
loss.
13
The next section will elaborate on this issue: choosing between entrepreneurship and em-
ployment.
4. The effects of the choice between entrepreneurship and employment
In this section we present a simple model of occupational choice in which the impact of entre-
preneurial activities is analyzed by considering the consequence of not allowing firms to enter (or
exit) or of not allowing firms to expand (or to limit) their activities. We distinguish between three
possible economic systems labeled market economy, semi-planned economy and planned
economy. Before presenting the details of the occupational choice model we will first discuss
important recent papers concerning the intertemporal relation between occupational choice and
economic development.
We will briefly discuss the contributions made in three articles: Banerjee and Newman (1993),
Iyigun and Owen (1999) and Lloyd-Ellis and Bernhardt (2000). The papers deal with the compli-
cated issue of the two-way interaction between occupational choice and economic development.
On the one hand, both the number of individuals choosing to become self-employed and their
entrepreneurial skills affect economic development. On the other hand, the process of develop-
12
Yu (1998) provides an interesting analysis of the importance of Kirznerian (adaptive) entrepreneurship in explaining
Hong Kongs economic development. He finds that the small Hong Kong firms are usually the first groups to get out of a
declining sector and move into new markets. He claims that the diversification of Hong Kongs economy into the service
sector can be explained consistently by the dynamic operations of adaptive entrepreneurship. (p.902-903).
13
Ilmakunnas and Kanniainen (2001) find empirical evidence for OECD countries to support the Knightian view that
economic risks shape equilibrium entrepreneurship in an occupational choice model. They find evidence of both na-
tional economic risk (changes in GDP) and social insurance for labor risks (unemployment compensation), assumed
not to be available to self-employed, to negatively impact the rate of self-employment.
11
ment affects the returns to occupations. It transforms the nature of risks and the possibilities for
innovation.
Banerjee and Newman (1993) develop a model in which the distribution of wealth plays a cen-
tral role. They assume that occupational decisions are dependent upon the distribution of wealth
because of capital market imperfections, due to which poor agents can only choose working for a
wage and wealthy agents become entrepreneurs. The initial distribution of wealth determines
whether in the long run an economy converges to a case of only self-employment in small-scale
production (stagnation) or to one where an active labor market and both large- and small-scale
production prevail (prosperity). Banerjee and Newman stress that the model implies that the ini-
tial existence of a population of dispossessed whose best choice is to work for a wage, is the con-
dition needed for an economy to achieve the stage of prosperous capitalism.
Whereas Banerjee and Newman focus on financial requirements as the defining characteristic
of entrepreneurship, Iyigun and Owen (1999) focus on the element of risk. Iyigun and Owen dis-
tinguish between two types of human capital: entrepreneurial and professional. Entrepreneurial
activities are assumed to be more risky than professional activities.
14
Entrepreneurs in the model
accumulate human capital through a work-experience intensive process, whereas professionals
human capital accumulation is education-intensive. The models predicts that, as technology im-
proves, individuals devote less time to the accumulation of human capital through work experi-
ence and more to the accumulation of human capital through professional training. The allocation
of an increasing share of time to formal education continues until a steady state is reached (see
Iyigun and Owen, p. 224). Hence, entrepreneurs would play a relatively more important role in
intermediate-income countries and professionals are relatively more abundant in rich countries.
However, both entrepreneurship and professional activities are important and those countries that
initially have too little of either entrepreneurial or professional human capital may end up in a de-
velopment trap. Iyigun and Owen point at former communist countries as an example of econo-
mies that have a highly educated labor force but that still not achieve the high-income steady
state due to a shortage of entrepreneurs (p.225).
Lloyd-Ellis and Bernhardt (2000) also derive how the scarcity or abundance of entrepreneurial
skills is the defining variable behind the equilibrium development process. In their model, indi-
viduals may choose between working as entrepreneurs, wage laborers in industry or in subsis-
tence agriculture. J ust like in the Banerjee and Newman model entrepreneurs are faced with a
limited capital market and (inherited) wealth is needed to permit entrepreneurial activity to ex-
pand. The economy in the model goes through four separate stages. An interesting outcome of
the model is that the average firm size rises quickly in the first stages of the development proc-
ess, but then falls in the later stages of the development process. The number of entrepreneurs
(outside agriculture) as a fraction of population may rise in each of the stages (Lloyd-Ellis and
Bernhardt, p.157).
We will present a simple new model of occupational choice in which the impact of entrepre-
neurial activities is analyzed by considering the consequence of not allowing firms to enter (or
exit) or of not allowing firms to expand (or to limit) their activities. We distinguish between three
possible economic systems. In the first system, labeled market economy, there is complete
freedom of entry and exit and of firms adjusting their inputs to maximize profits. In this system
there is complete entrepreneurial and managerial freedom. In the second system, labeled semi-
planned economy, there is no freedom of entry or exit. However, firms are free to adjust their
input quantities so as to achieve maximum profits. In such an economic system the large incum-
bent firms are considered as the engines of economic progress. Starting new enterprises is ham-
pered by regulations and by relatively low esteem of business ownership. The third economic
system, labeled planned economy, has also lost its managerial freedom of adjusting inputs to
14
The uncertainty in the return to entrepreneurial ventures is that with probability q an individual achieves an income of
t
, the endogenously determined technology level, times his entrepreneurial capital and with probability 1-q he re-
ceives no income. There is no uncertainty assumed in the return to education, being
t
times their professional capital
(see Iyigun and Owen, p.220).
12
maximize profits. Firms are assigned to produce output using a certain fixed amount of labor even
though it may lead some firms to be unprofitable.
Clearly, the three economic systems are extremes. However, comparing the economic per-
formance of such virtual systems may enhance our understanding of the total contribution of en-
trepreneurial activity on the long and short term on economic performance. In addition, the condi-
tions in the three systems may approximate actual conditions in existing economic systems. For
example, the market economy of the United States grants (potential) entrepreneurs considerable
freedom with little government intervention. In contrast, the economies of Continental Europe, like
France and Germany and the Scandinavian countries, have a much larger role for government. In
these countries government has actively intervened to support large enterprises in the recent
past. The Soviet type of economic systems is the prime example of the planned economy system.
The model described below is used to compare the relative performance of the three systems.
15
The non-mathematically interested reader may want to proceed with the last paragraph of this
section in which we discuss the main results.
Consider a population of N individuals that can choose between being an employee and being
a manager (business owner). Each person i is assigned a certain managerial ability
it
e in period t.
This ability can be used in combination with an input of
it
L employees earning an equal wage
t
w
to produce a total output of some (homogeneous) good
it it it
L e Q = with in between zero and
one. Assuming the price of the good to be unity total profit for manager i in period t will be
it t it it it
L w L e =
. From the first order condition ( 0 / =
it it
L ) we find the optimal levels of labor
input and profit:
(4.1) ( ) = 1
1
*
/ w e L
it it
and
(4.2) ( ) . / ) 1 ( 1
*
= w e e
it it it
From equation (4.2) it is clear that individuals with higher levels of managerial ability will have
higher profits ( 0 /
*
>
it it
e ). In case individuals are free to enter and/or exit we would see in-
cumbents exiting the market (and becoming employee) in case their optimal level of profits is less
than the wage level, while employees would start enterprises in case their optimal level of profit
would exceed their wage level. In conformity with Lucas (1978) an equilibrium is reached where
individuals become managers if and only if
(4.3) .
) 1 (
1
>
t
it
w
e
In each of the three economic systems it is assumed that the wage level is determined by the
equilibrium condition of demand and supply of labor to be identical. If we denote the number of
managers/entrepreneurs by
t
M and their set by
t
, then this condition reads
(4.4) . ) /(
1
1
1
*
= =
t
i
it t
i
it t
M N e w L M N
t t
From equations (4.3) and (4.4) the equilibrium structure given free entry and exit can be de-
termined. Given the distribution of the abilities
it
e the equilibrium occupational choice and (maxi-
mum) total output can be derived. In case of changes in the ability distribution the manner in
which equilibrium on the labor market is restored differs across the economic systems. In case of
the market economy system there will be entry of managers with increased ability and exit of
managers with decreased ability, changes in firm sizes and changes in the wage level. In case of
15
The model is only concerned with occupational choice, not with the (dis)incentives present in economic systems to
pursue product or process innovation.
13
the semi-planned economy system there will be changes in firm sizes of incumbents and
changes in the wage level. The one variable that restores equilibrium in the planned economy
system is the wage level because of the absence of managerial discretion to adapt labor demand.
It is obvious that due to larger degrees of freedom the total output after changes in the ability
distribution will be highest for the market economy and smallest for the planned economy. The
differences between the performances will be larger, the more the ability distribution changes
over time. Hence, in periods of important changes in technological regimes and on the longer
term the differences are likely to be largest. This finding is related to that presented by Eliasson
(1995) that lack of new entry of firms will adversely impact economic performance not so much on
the short term but in the long term.
5. Entrepreneurship in endogenous growth models
One of the reasons that entrepreneurship disappeared from economic theory is that it played
no role in the neoclassical growth model as developed by Solow (1970). An important characteris-
tic of this growth model is that technological improvements are exogenous and therefore inde-
pendent of economic incentives. Economic growth in the traditional growth models is achieved by
capital accumulation and exogenous technological progress, both of which leave little room for
any entrepreneurial role whatsoever (see also Baumol 1968). The more recently developed en-
dogenous growth models also support the idea that improvements in technology have been the
key force behind perpetually rising standards of living. However, this long-term growth process is
assumed in many endogenous growth models to be determined by purposive, profit-seeking in-
vestment in knowledge (Grossman and Helpman (1994, p. 24)). The act of seeking profits by
shifting resources to achieve improvements in technology can be seen as an entrepreneurial act
because the outcome of the investments is uncertain. However, it is not common for endogenous
growth models to explicitly address the issue of entrepreneurship as driving force of technological
and economic development. We will discuss three exceptions in this section. The first exception is
the Aghion and Howitts (1992) model of creative destruction (see also Aghion and Howitt, 1997;
Howitt and Aghion, 1998). The second exception is the endogenous market structure model by
Peretto (1998; 1999a; 1999b) and the third exception is the imitation model developed by Schmitz
(1989). Of these three exceptions the model by Aghion and Howitt has been the most influential
and we will discuss it in some detail.
Aghion and Howitt introduce the notion of Schumpeterian creative destruction into a growth
model by having firms investing resources in research to achieve a new product that renders the
previous product obsolete.
16
Capital is excluded from the basic model and growth results from
technological progress, being a result from competition among firms that generate innovations.
Firms are motivated by the prospect of (temporary) monopoly rents after a successful innovation
is patented. A next innovation will again destroy these rents as the existing good is being made
obsolete by the Schumpeterian entrepreneur. We will discuss a simple version of the basic model
as presented by Aghion and Howitt in their Section 2. The non-mathematically interested reader
may want to proceed below equation (5.8).
Assume that there are four different kinds of units: a final consumption good y, an intermedi-
ate good x, unskilled labor used to produce the final good and skilled labor that can be used to
produce the intermediate good or that can be used in research. The total amount of unskilled la-
bor is fixed at M. The total amount of skilled labor is fixed at N and the amount used to do re-
search is denoted by n, leaving N-n units for production of the intermediate good. The final good
is assumed to be produced using a Cobb-Douglas type of production function (with input factors
unskilled labor and intermediate goods) and, since M is fixed, it can be written as
(5.1) 1 0 < < =
t t t
x A y
16
It may be argued that Schumpeterian entrepreneurship cannot be modelled using the standard assumptions of the
neo-classical model like profit maximization. It is evident that the Aghion and Howitt models fail to do complete justice
to Schumpeters discussions of the motivations that underlie entrepreneurial behaviour. We are grateful to the referee
of this chapter for pointing this out.
14
where t is the index of period. The parameter
t
A denotes the productivity of the intermediate
input in period t. The intermediate good is produced using skilled labor, not used for research,
and linear technology:
(5.2) .
t t
n N x =
Innovations arrive in a random sequence, with the Poisson arrival rate of innovations in the
economy equal to
t
n (see also Howitt and Aghion, 1998, equation (6)). The arrival rate depends
only upon the current flow of input to research. Hence, there is no memory in the technology of
research. The index t of period increases by one each time a new innovation has arrived, hence it
is not a time index. The length of the time interval from t to t+1 is random and has an exponential
distribution with parameter
t
n . During this time interval prices and quantities are assumed to be
constant. Each innovation (the invention of a new intermediate good) makes the previous inter-
mediate good obsolete because it allows the production of the final good
t
y to become more effi-
cient. The increase in efficiency is determined by the factor :
(5.3) . 1
0
> =
t
t
A A
The model is a winner takes it all-model in the sense that a successful innovator is assumed
to obtain a patent used to monopolize the intermediate sector. The patent lifespan is assumed to
be infinite but the monopoly lasts only till the next innovation when the intermediate good is re-
placed by the next vintage. Each market is assumed to be perfectly competitive with the excep-
tion of the monopolized intermediate sector.
The successful innovator has a temporary monopoly and seeks to maximize its profit during
this interval. The final good sector will choose the amount of intermediate goods,
t
x , so as to
maximize
t t t
x p y with the price of the final good as the numrair and
t
p being the price
charged by the monopolist. The first order condition is
(5.4) .
1
=
t t t
x A p
The monopolist takes this condition into account and maximizes its own profit ( )
t t t t
x w x A
1
with
t
w being the wage level of skilled labor. The optimization gives as outcomes for profit, price
and output of the intermediate good:
(5.5) . and / ,
1
) 1 /( 1
2
= =
t
t
t t t t t t
A
w
x w p x w
We now turn to the amount of resources devoted to research,
t
n . Because of constant returns
to scale in the technology of research, the number of firms performing research is indeterminate.
The firm(s) that employ(s)
t
n units of skilled labor performing research activities to achieve mo-
nopoly in period t+1 will have an instantaneous probability
t
n of having a successful innovation
with instantaneous value
1 + t
V (which does not depend upon
t
n ). The expected flow of profits
equals
t t t t
n w V n
+1
which is maximized for 0
t
n . Because the research sector is perfectly
competitive
1 + t
V equals the wage level
t
w .
17
The value
1 + t
V is the expected present value of the flow of monopoly profits
1 + t
, or
(5.6) 0
1
1
1
>
+
=
+
+
+
r
n r
V
t
t
t
17
We do not discuss the possibility of the wage level being less than
1 + t
V .
15
with r being the constant rate of time preference. Equation (5.6) reveals the important charac-
teristic of the Aghion and Howitt model that current research negatively depends upon future re-
search: creative destruction discourages current research because the prospect of monopoly
rents is diminished.
The intertemporal relation between
t
n and
1 + t
n is determined by substituting equations (5.2),
(5.5) and (5.6) into the condition
1 +
=
t t
V w . This results in
(5.7) .
) (
1
1
1
1
1
1
+
+
+
+
=
t
t
t
t
n r
n N
n N
n N
We now concentrate upon the (unique) stationary equilibrium in which n n n
t t
1
= =
+
. From
equation (5.7) we then derive the stationary equilibrium value
(5.8) .
) / ) 1 ( 1 ( / ) 1 ( 1
/ ) 1 (
+
=
r
N n
Equation (5.8) shows a direct connection between research in stationary equilibrium n and
the degree of market power. The higher the value of the lower is the degree of market power.
Specifically, 1 is the Lerner index (price minus marginal costs divided by price). Hence, some
extent of market power to achieve rents is needed for Schumpeterian entrepreneurs to engage
into research. Aghion and Howitt (1992, p. 336) derive the average growth rate of real output to
be ) ln( n . The effect of market power attracting entrepreneurial energy shows the importance
of imperfect competition for the growth process.
Competition and growth are inversely related in this Schumpeterian model, something usually
not supported by empirical evidence (for instance, see Nickell, 1996). Aghion and Howitt (1997),
therefore, extend their model to show that a more competitive market structure may contribute to
economic growth. In Howitt and Aghion (1998), the authors add capital to their model of creative
destruction. They show that capital accumulation and innovation are complementary processes
and equal partners in the growth process. Aghion and Howitt have contributed to the endogenous
growth literature by connecting purposive, profit-seeking investment in knowledge to the persons
performing this task: entrepreneurs.
In a series of papers Peretto introduces a different kind of endogenous growth model where
an endogenous market structure is incorporated. His model has a key role for the number of
firms, again in the intermediate sector, determining the returns to investment and R&D. An impor-
tant difference between his model and the model by Aghion and Howitt is the assumption that
monopolistic firms in the intermediate sector set up in-house R&D facilities to produce a continu-
ous flow of cost-reducing innovations. This differs from the independent research firms in Aghion
and Howitt (1992). The relation between the number of firms and returns to investment and R&D
in the Peretto (1999b) model is determined by a trade-off between external and internal econo-
mies of scale. External economies of scale are a result of complementarities across firms be-
cause aggregate output is increasing in the number of intermediate goods.
18
A large number of
firms in the model therefore leads to high specialization, large investment and R&D programs,
and fast growth. On the other hand, the fragmentation of the market due to a large number of
firms leads to small investment and R&D programs, and slow growth. An increase in the number
of firms increases the market size through the specialization effect whereas each firms market
share is reduced through the fragmentation effect. As a consequence there is a hump-shaped
relation between the number of firms and economic growth.
18
Peretto uses a Dixit-Stiglitz type of production function, exhibiting economies of specialization, with the homogeneous
final good y determined by the N intermediate goods
i
x as:
) /(
N
/ ) (
i
di x y
1
0
1
=
.
16
In Peretto (1998) entrepreneurs play a more visible role. His model seeks to explain a shift in
the locus of innovation from R&D undertaken by inventor-entrepreneurs (competitive capitalism)
to R&D undertaken within established firms in close proximity to the production line (trustified
capitalism). In the model the economy converges to a stable industrial structure where entrepre-
neurial R&D and the formation of new firms peter out, while growth is driven by corporate R&D
undertaken by established oligopolists.
19
While it is true that from about 1870 till 1970 the corpo-
rate laboratories affiliated with large manufacturing firms have been increasingly responsible for
commercial R&D, the disappearance of entrepreneurial energy as important determinant of eco-
nomic growth is an unrealistic feature of the model. In Perettos setup entrepreneurs must de-
velop new differentiated products since entering an existing product line in Bertrand competition
with the incumbent is bound to lead to losses because of sunk entry costs. Entrants are net crea-
tors of knowledge, as they create a new product and the knowledge necessary to run manufac-
turing operations. (p. 58). Although in more developed stages the economy in Perettos model
experiences a transition from entrepreneurial to corporate R&D, entrepreneurship plays a vital
role in economic development: only when a critical number of firms have entered the market, es-
tablished firms begin investing in R&D. A key result of Perettos models is that there is an in-
verted-U relationship between the number of firms and steady-state growth. (Peretto, 1999a, p.
1762).
Schmitz (1989) was the first to present an endogenous growth model that relates entrepre-
neurial activity and economic growth. However, his entrepreneurs are more passive than in the
other models because their role is restricted to that of imitation. This may have contributed to the
Schmitz model being less influential than the Aghion and Howitt model. His model implies that the
equilibrium fraction of entrepreneurs in an economy is lower than the social optimal level, provid-
ing a rationale for policies stimulating entrepreneurial activity. We end this section stressing that
one may also set up endogenous growth models in which (a specific notion of) entrepreneurship
may not be beneficial to growth. Peng (2000) constructs such a model in which entrepreneurs do
not carry out research but choose between research projects. He finds a negative relationship
because of the rent-seeking element in the exercise of entrepreneurship.
20
6. Empirical evidence
There are various strands in the empirical literature showing the effect of entrepreneurship on
economic growth. We will concentrate on four strands of empirical research.
21
The first deals with
the question of the effect of turbulence on economic growth. Turbulence, viz., the sum of entry
and exit in industries or regions, can be interpreted as an indicator of entrepreneurial activity. The
second strand concentrates on the effect of (changes in) the size-distribution in regions on sub-
sequent economic growth. In case a region has a larger share of small firms when compared to
another region this could indicate a higher level of entrepreneurial activity. The third strand inves-
tigates the effect of the number of market participants in an industry on economic growth. An in-
crease in the number of competitors is usually related to more intensive entrepreneurial activity.
The fourth strand of empirical literature concentrates on the effect of the number of self-employed
(business owners) on subsequent growth. In developed economies the rate of self-employment
will be related to the extent of entrepreneurial activity. New firms usually start with a phase of self-
employment sensu stricto, viz., with no paid employees. A fifth and last source of evidence on the
relation between self-employment and progress is the economic history of the formerly central-
ized planned economies. A characteristic of these economies was the almost complete absence
of small firms (and private ownership of the means of production), and this extreme monopoliza-
19
This is an escalation effect: the fall in the number of firms is due to technological opportunities leading firms to invest
in R&D which is characterized by sunk costs that make entry and incumbency more costly and labor more scarce for
production.
20
The idea that entrepreneurial energy as such may not suffice for economic progress was also expressed by Baumol
(1990) stressing the importance of entrepreneurship being led into productive channels.
21
The Global Entrepreneurship Monitor (GEM) research program (Reynolds et al., 2001) is yet a different approach. It
seeks to assess the level of national entrepreneurial activity and to relate this to the rate of economic growth. Entrepre-
neurial activity is measured through questionnaires in 29 countries in 2001, 21 countries in 2000 and 10 countries in the
first year of assessment, 1999. The research program shows some preliminary evidence of the level of entrepreneurial
activity to be associated with economic growth.
17
tion constituted one of the major factors leading to the collapse of state socialism (Acs 1996). The
development of small enterprises is considered a vital part of the current transition process in
Eastern Europe. This last source of evidence will not be discussed in the present chapter.
22
The empirical evidence of the effect of turbulence on subsequent economic growth is mixed.
Caves (1998, p.1973) concludes that in the short run, turnover from entry and exit appears to
make only a very small contribution to an industrys productivity growth. However, he adds that in
the long run, the entry-exit turnover makes a more important contribution. Bosma and Nieuwen-
huijsen (2000) use data for 40 Dutch regions for the 1988-96 period and find that turbulence posi-
tively affects total factor productivity growth in the service sector but not so in manufacturing.
A different literature has focused on the impact of entrepreneurship on subsequent economic per-
formance. at the regional level. The unit of observation for these studies is at the spatial level,
either a city, region, or state. The most common and and most exclusive measure of performance
is growth, typically measured in terms of employment growth. These studies have tried to link
various measures of entrepreneurial activity, most typically startup rates, to economic growth.
Other measures sometimes used include the relative share of SMEs, and self-employment rates.
Reynolds (1999) finds some evidence for turbulence to be related to economic growth using
American regional data for the 1980-92 period. research in several ways. Acs and Armington
(2002) link a measure of entrepreneurship to growth at the regional level. Their paper makes
three important contributions. First, their approach is more comprehensive, including data for the
whole private sector economy, rather than selected industries. Second, their unit of analysis is
not just cities, but entire local economic areas (394 Labor Market Areas, covering the entire
United States), which generally include a metropolitan area and the surrounding rural area from
which it draws both employees and consumers. Third, they use a direct measure of entrepreneu-
rial activity, the new firm birth rate in each of these local economies. They test the hypothesis that
increased entrepreneurial activity leads to higher growth rates of local economies. They find that
the higher levels of entrepreneurial activity are strongly positively associated with higher growth
rates, even after controlling for establishment size, and agglomeration effects.
Audretsch and Fritsch (1996) analyzed a database identifying new business startups and exits
from the social insurance statistics in Germany to examine whether a greater degree of turbulen-
ce leads to greater economic growth, as suggested by Schumpeter in his 1911 treatisie. These
social insurance statistics are collected for individuals. Each record in the database identifies the
establishment at which an individual is employed. The startup of a new firm is recorded when a
new establishment identification appears in the database, which generally indicates the birth of a
new enterprise. While there is some evidence for the United States linking a greater degree of
turbulence at the regional level to higher rates of growth for regions (Reynolds, 1999), Audretsch
and Fritsch (1996) find that the opposite was true for Germany during the 1980s. In both the ma-
nufacturing and the service sectors, a high rate of turbulence in a region tends to lead to a lower
and not a higher rate of growth. They attribute this negative relationship to the fact that the under-
lying components the startup and death rates are both negatively related to subsequent eco-
nomic growth. Those areas with higher startup rates tend to experience lower growth rates in
subsequent years. Most strikingly, the same is also true for the death rates. The German regions
experiencing higher death rates also tend to experience lower growth rates in subsequent years.
Similar evidence for Germany is found by Fritsch (1997).
Audretsch and Fritsch (1996) conjectured that one possible explanation for the disparity in results
between the United States and Germany may lie in the role that innovative activity, and therefore
the ability of new firms to ultimately displace the incumbent enterprises, plays in new-firm star-
tups. It may be that innovative activity did not play the same role for the German Mittelstand as it
does for SMEs in the United States. To the degree that this was true, it may be hold that regional
growth emanates from SMEs only when they serve as agents of change through innovative activi-
ty.
22
Others examples of the role of entrepreneurship in economic history are given in Wennekers, Thurik and Uhlaner
(2002).
18
The empirical evidence suggested that the German model for growth provided a sharp contrast to
that for the United States. While Reynolds (1999) had found that the degree of entrepreneurship
was positively related to growth in the United States, a series of studies by Audretsch and Fritsch
(1996) and Fritsch (1997) could not identify such a relationship for Germany. However, the results
by Audretsch and Fritsch were based on data from the 1980s.
Divergent findings from the 1980s about the relationship between the degree of entrepreneurial
activity and economic growth in the United States and Germany posed something of a puzzle. On
the one hand, these different results suggested that the relationship between entrepreneurship
and growth was fraught with ambiguities. No confirmation could be found for a general pattern
across developed countries. On the other hand, it provided evidence for the existence of distinct
and different national systems. The empirical evidence clearly suggested that there was more
than one way to achieve growth, at least across different countries. Convergence in growth rates
seemed to be attainable by maintaining differences in underlying institutions and structures.
However, in a more recent study, Audretsch and Fritsch (2002) find that different results emerge
for the 1990s. Those regions with a higher startup rate exhibit higher growth rates. This would
suggest that, in fact, Germany is changing over time, where the engine of growth is shifting to-
wards entrerpeneurship as a source of growth.The results of their 2002 paper suggest a some-
what different interpretation. Based on the compelling empirical evidence that the source of
growth in Germany has shifted away from the established incumbent firms during the 1980s to
entrepreneurial firms in the 1990s, it would appear that a process of convergence is taking place
between Germany and the United States, where entrepreneurship provides the engine of growth
in both countries. Despite remaining institutional differences, the relationship between entrepre-
neurship and growth is apparently converging in both countries.
The positive relationship between entrepeneurship and growth at the regional level is not limited
to Germany in the 1990. For example, Foelster (2000) examines not just the employment impact
within new and small firms but on the overall link between increases in self-employment and total
employment in Sweden between 1976-1995. By using a Layard-Nickell framework, he provides a
link between micro behavior and macroeconomic performance, and shows that increases in self-
employment rates have had a positive impact on regional employment rates in Sweden.
Hart and Hanvey (1995) link measures of new and small firms to employment generation in the
late 1980s for three regions in the the United Kingdom. While they find that employment creation
came largely from SMEs, they also identify that most of the job losses also came from SMEs.
Callejon and Segarra (1999) use a data set of Spanish manufacturing industries between 1980-
1992 to link new-firm birth rates and death rates, which taken together constitute a measure of
turbulence, to total factor productivity growth in industries and regions. They adopt a model based
on a vintage capital framework in which new entrants embody the edge technologies available
and exiting businesses represent marginal obsolete plants. Using a Hall type of production functi-
on, which controls for imperfect competition and the extent of scale economies, they find that both
new-firm startup rates and exit rates contribute positively to the growth of total factor productivity
in regions as well as industries.
The empirical evidence of the effect of (changes in) the size distribution of firms on subse-
quent growth performance appears more clear-cut, at least for data of the late 1980s and early
1990s. Carree and Thurik (1998, 1999a) show that the share of small firms in manufacturing in-
dustries in European countries in 1990 has had a positive effect on the industry output growth in
the subsequent four years. Thurik (1996) reports that the excess growth of small firms
23
has had a
positive influence on percentage change in gross national product for a sample of 16 European
countries in the period 1988 through 1993. Robbins, Pantuosco, Parker and Fuller (2000) perform
an analysis of 48 U.S. states for the 1986-95 period and find that states with a higher proportion
of (very) small business employment experience higher level of productivity growth and Gross
State Product growth. Audretsch, Carree, van Stel and Thurik (2002) find evidence for 17 Euro-
pean countries that the consequences for economic growth of not shifting the industry structure
23
The excess growth of small firms in that study is defined as the percentage change in the value-of-shipments ac-
counted for by small firms minus that accounted for by large firms.
19
away from large business towards small business have been rather large. Likewise, Carree
(2002) shows evidence for the five largest economies (France, Germany, J apan, U.K. and U.S.)
that manufacturing industries that underwent only little downsizing in the 1977-90 period experi-
enced less subsequent growth when compared internationally.
Nickell (1996), Nickell, Nicolitsas and Dryden (1997) and Lever and Nieuwenhuijsen (1999)
present evidence that competition, as measured by increased number of competitors, has a posi-
tive effect on the rate of total factor productivity growth. This positive effect is in line with Geroskis
(1989) finding of overall productivity growth in 79 U.K. manufacturing industries to increase with
the lagged rate of gross entry of new firms. One reason for these findings is that an increased
number of market participants and increased entrepreneurial activity often go hand in hand. There
have been some studies on the impact of the number of market participants on regional economic
growth as well. Glaeser, Kallal, Scheinkman and Shleifer (1992) examine three determinants of
regional sectoral growth: specialization, diversity and competition. They find that local competi-
tion, measured as the relative number of businesses per worker, encourages employment growth
in industries. Fritsch (1997) and Audretsch and Fritsch (2002) relate start-up activity in German
regions to subsequent growth. They find that for Germany the impact of start-up activity on eco-
nomic growth was absent in the 1980s but became positive in the 1990s.
A fourth strand of literature has started to focus upon the effect of self-employment on growth.
Blanchflower (2000, p.497) finds no evidence for a panel of OECD countries of increases in the
self-employment rate to increase economic growth. However, he uses uncorrected OECD Labor
Force Statistics data suffering from lack in comparability across countries and, in a list of addi-
tional cases, lack in comparability over time due to changes in counting procedures. In a recent
paper Carree, van Stel, Thurik and Wennekers (2002) investigate whether countries that deviate
from the equilibrium business ownership rate for comparable levels of economic development
suffer in terms of economic growth.
24
In their view deviations between the actual and the equilib-
rium rate of business ownership will diminish the growth potential of an economy in the medium
term. A shortage of business owners is likely to diminish competition with detrimental effects for
static efficiency and competitiveness of the national economy. It will also diminish variety, learning
and selection and thereby harm dynamic efficiency (innovation). On the other hand, a glut of self-
employment will cause the average scale of operations to remain below optimum. It will result in
large numbers of marginal businesses, absorbing capital and human energy that could have been
allocated more productively elsewhere. They develop an error-correction model to determine the
equilibrium rate of business ownership as a function of GDP per capita.
25
Their estimated equi-
librium relationship, using corrected OECD Labor Force Statistics data, is presented in Figure 2
together with the actual (corrected) data of the G7-countries. The estimation results show that a
deviation of the actual number of business owners from the equilibrium rate has a significantly
negative impact on economic growth.
Figure 2 shows that most countries had too few self-employed relative to the equilibrium
value. An obvious exception is Italy. It indicates that the high level of self-employment in Italy is
not efficient: it has a relatively large negative impact on economic growth.
26
Countries with a low
business ownership rates compared to the equilibrium include the Scandinavian countries. These
economies are characterized by a large public sector, relatively low entry and exit rates and high
taxes. Eliasson (1995) and Braunerhjelm and Carlsson (1999) blame part of Swedens relatively
bad economic performance in the 1980s on limited private initiative and a lack of structural ad-
justment. Another country with a relatively low business ownership rate is Germany. Figure 2 also
shows that, at least until recently, Germany has failed to restructure where for example the United
Kingdom has. Klodt (1990) blames (West) German industrial policy for repressing structural
change in supporting large-scale industries with subsidies. An important reason for the lack of a
24
See also Audretsch, Carree and Thurik (2002).
25
Carree, van Stel, Thurik and Wennekers hypothesize an equilibrium relationship between the rate of business own-
ership and per capita income that is U-shaped, but in fact find it to be impossible to statistically discriminate U-shaped
equilibrium functions from L-shaped functions.
26
In Italy, research and development expenditures are by far the lowest among the largest OECD countries as a per-
centage of gross national product. This is in line with the idea that when there are too many business owners, the scale
advantages in research and development are not utilized. See Cohen and Klepper (1996).
20
vibrant sector of new firms and industries in Germany up till the mid 1990s has been the high bar-
riers to innovative activity (Audretsch 2000).
Figure 2 The actual and equilibrium rate of business ownership for G7-countries,
1972-1998
YCAP
Equilibrium
UK
FRA
GER
CAN
J AP
US
ITA
0.00
0.05
0.10
0.15
0.20
9,000 14,000 19,000 24,000
E
Note: E stand for the ratio of self-employed over labor force. YCAP stands for GDP per capita in US dollars (of 1990).
Source: Carree, van Stel, Thurik and Wennekers (2002).
It should be stressed that the number of self-employed is a possible yardstick of entrepreneurship
as statistical information is often available along the ownership dimension. However, this yard-
stick can be misleading. For instance, it is unknown whether the relatively high number of self-
employed in Italy as compared to Germany expresses a high level of Schumpeterian entrepre-
neurship or merely a time lag in economic development influencing the number of marginal estab-
lishments or merely differences in sectoral composition. In recent empirical studies other ap-
proximations are brought forward. Audretsch (1995) uses the employment share of surviving
young firms as a proxy for entrepreneurial activity in manufacturing industries. This variable may
well express the comparative entrepreneurial positions of these industries. Outside the manufac-
turing sector this variable may be biased due to the occurrence of franchising firms and marginal
or part-time start-ups. Moreover, the rate of intrapreneurship, both in new and incumbent firms, is
lacking.
7. Future analysis and policy issues
We expect a framework relating entrepreneurial activity to economic growth to hinge on at
least four elements. First, on the literature identifying the micro-economic foundations of growth
emphasizing the role of knowledge externalities in the growth process (Romer, 1986 and 1994).
Second, it should identify intermediate linkages like the ones mentioned in Figure 1. Third, it
should deal with dual causality in the relation between entrepreneurial activity and growth. And
finally, it should take into account the multidisciplinary character while linking together different
21
levels of analysis.
27
Before discussing some policy issues we will first present such a framework
derived from Wennekers and Thurik (1999).
A framework for future analysis
Figure 3 presents a framework inspired by the many insights reaped from the various strands
of the literature. Three levels of analysis be distinguished since linking entrepreneurship to eco-
nomic growth also means linking the individual level to the firm and the macro level.
Entrepreneurial action happens at the firm level. Entrepreneurs need a vehicle transforming
their personal qualities and ambitions into actions. Small firms where the entrepreneur has a con-
trolling stake provide such a vehicle. Larger firms often mimic smallness (using organizational
forms like business units, subsidiaries and joint ventures) to introduce corporate entrepreneurship
or intrapreneurship. The outcomes of these entrepreneurial manifestations at the firm level gen-
erally have to do with 'newness'. This can be newness through product, process and organiza-
tional innovation, entry of new markets and innovative business start-ups.
At the aggregate level of industries, regions and national economies the many individual en-
trepreneurial actions compose a mosaic of new experiments. In evolutionary terms this can be
termed variety. A process of competition between these various new ideas and initiatives takes
place continuously leading to the selection of the most viable firms and industries. Variety, com-
petition, selection and also imitation expand and transform the productive potential of a regional
or national economy (by replacement or displacement of obsolete firms, by higher productivity
and by expansion of new niches and industries).
In this process Schumpeterian entrepreneurs, intrapreneurs and managerial business owners
all play their part (see Table 1). Next to the linkages from the individual level to the aggregate
level, there are important feedback mechanisms. Competition and selection amidst variety un-
doubtedly enable individuals (and firms) to learn from both their own and others successes and
failures. These learning processes enable individuals to increase their skills and adapt their atti-
tudes. The outcome of these so-called spillovers will be new entrepreneurial actions, creating a
recurrent chain of linkages.
Figure 3 Framework for linking entrepreneurship to economic growth
level of
analysis
conditions for
entrepreneurship
firm
level
business culture
incentives
start-ups
entry into new markets
innovations
start-ups
entry into new markets
innovations
firm performance
self-realization
personal wealth
attitudes
skills
ACTIONS
attitudes
skills
ACTIONS
psychological
endowments
culture
institutions
individual
level
impact of
entrepreneurship
crucial elements of
entrepreneurship
macro
level
culture
institutions
variety
competition
selection
variety
competition
selection
competitiveness
economic growth
competitiveness
economic growth
Source: Wennekers and Thurik (1999)
Clearly, the outcome of these dynamic processes depends on a set of conditions like the ones
referred to in Figure 3. First, this refers to the national (or regional) cultural environment, and to
27
See Audretsch, Thurik, Verheul and Wennekers (2002) for such a framework concerning the determinants of entre-
preneurship.
22
the internal culture of corporations. The linkages between culture and entrepreneurship are by no
means simple and straightforward, and much is still unknown about these processes. The history
of the rise and fall of nations has shown that cultural vitality, thriving sciences and high tide in en-
trepreneurship often coincide (Wennekers and Thurik, 1999). Second, the institutional framework,
both on the national level and within firms, defines the incentives for individuals to turn their ambi-
tions into actions, and determines to what extent unnecessary barriers will hamper them. The
importance of institutions for the development of entrepreneurship is paramount and deserves
further study.
Some policy issues
One of the central goals of public policy common among all modern economies is the genera-
tion of growth and the creation of employment. Much of the policy debate to generate growth and
jobs has relied on a macro-economic framework and focused on the traditional macro-economic
policy instruments. The survey of the present chapter suggests that a different, less traditional
instrument for generating growth and employment plays an important role policies that generate
and promote entrepreneurship (OECD, 1998). Empirical evidence surveyed in this chapter sug-
gests that those countries that have experienced an increase in entrepreneurial activity have also
enjoyed higher rates of growth. However, the actual mechanisms, i.e., the intermediate linkages,
why entrepreneurship generates growth are less obvious. The present chapter relies on a rich
body of literature, both theoretical and empirical, analyzing the micro foundations of entrepre-
neurship. Entrepreneurship generates growth because it serves as a vehicle for innovation and
change, and therefore as a conduit for knowledge spillovers. Thus, in a regime of increased glob-
alization, where the comparative advantage of modern economies is shifting towards knowledge-
based economic activity, not only does entrepreneurship play a more important role, but also the
impact of that entrepreneurship is to generate growth. This has led You to argue that any policy
recommendation on economic development should be based on an analysis that incorporates
entrepreneurship, the engine of economic growth (You, 1998, p.906). Similarly, Holcombe claims
that the incorporation of entrepreneurship into the framework of economic growth not only fills in
the institutional details to help make the growth process more understandable, but also points
toward more promising economic policy recommendations for fostering economic growth (Hol-
combe, 1998, p.60).
As the comparative advantage in Western Europe and North America has become increas-
ingly based on new knowledge, public policy towards business has responded in two fundamental
ways. The first has been to shift the policy focus away from the traditional triad of policy instru-
ments essentially constraining the freedom of firms to contract regulation, competition policy or
antitrust, and public ownership of business. The policy approach of constraint was sensible as
long as the major issue was how to restrain footloose multinational corporations in possession of
considerable market power. Instead, a new policy approach is emerging which focuses on ena-
bling the creation and commercialization of knowledge (Audretsch and Thurik, 2001a). Examples
of such policies include encouraging R&D, venture capital and new-firm startups. The shift from
constraining to enabling policies goes together with the shift from the Schumpeter Mark II regime
to the Schumpeter Mark I regime. The second fundamental shift involves the locus of such ena-
bling policies, which are increasingly at the regional or even local level. The last decade has seen
the emergence of a broad spectrum of enabling policy initiatives that fall outside of the jurisdiction
of the traditional regulatory agencies. See for instance the issues of the European Observatory for
SMEs (EIM/ENSR, 1993 through 1997 and European Commission, 2000).
28
The current decade
will witness many more such enabling policies.
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