Entrepreneurship and development economics: convergence for better policy

What is the role of entrepreneurship in development? This question has been very topical in recent years as governments embrace the promotion of entrepreneurship and small businesses with ever greater enthusiasm. Yet much of this enthusiasm is still based on a thin scientific basis. The good news is that the scholarly fields of entrepreneurship economics and development economics have recently started to intersect, which bodes well for improving the foundation of entrepreneurship policies. This column outlines how the two fields are converging and how this may lead to better policies.

It is widely held that entrepreneurship is vital for development and that small firms are vehicles for such entrepreneurship in both advanced economies and developing countries. Scholars and policy-makers often consider small and medium-sized enterprises (SMEs) to be essential for job creation and new firm start-ups for innovation and growth. People talk about the need for an entrepreneurial revolution, and policies to promote entrepreneurship and SMEs are very popular.

But the scientific basis for such policies is limited. Policy-makers also fail to take account of the fact that the vast bulk of entrepreneurs are neither innovative nor significant job creators.

Furthermore, entrepreneurship policies suffer from serious weaknesses. For example, they mostly help those who already want to become entrepreneurs; they tend to result in one-person companies that do not grow, and they waste scarce financial resources by giving it to people who lack entrepreneurial talent. Such policies persist, partly because the positive impact of entrepreneurs is overestimated, and their detrimental effect underestimated.

These two biases may stem from the fact that there is no unified scientific approach to the role that entrepreneurship plays in development. The scholarly fields of entrepreneurship economics and development economics have been elaborated in isolation, and they have only recently started to intersect. This intersection is still fragmented and ad hoc, and it is not based on a unified theoretical approach.

Better policy-making for economic development will benefit from further scholarly work that extends and deepens the intersection of the fields of entrepreneurship and development economics. In a recent article, we identify five areas where these fields are converging. These are in terms of:

  • Externalities.
  • The phase of development.
  • Entrepreneurial ability.
  • Institutions.
  • Non-monetary incentives.

In the remainder of this column, we briefly discuss these and note the implications for policy.

Externalities

Externalities are unintended consequences or actions not captured in the market price of the product or service provided. While entrepreneurs can usually appropriate specific technological knowledge when developing new products or services (for example, using patents), general technological know-how that is produced as a by-product of the innovation process cannot be appropriated and may ‘spill over’ to others.

Such ‘knowledge spillovers’ characterized the growth take-off in the West after the First Industrial Revolution. Before the take-off (indeed, for most of history, known as the Malthusian era), per capita income levels hovered around subsistence levels. The growth take-off was triggered by a shift in technologies towards capital and knowledge.

Entrepreneurship drove this shift towards new technologies through the generation and use of externalities. For example, urbanization and population growth resulted in communities large enough to allow specialization. Specialization, in turn, facilitated learning and innovation. It also required trade, which, in turn, boosted all kinds of changes, creating a virtuous cycle of development.

In both trade and innovation, entrepreneurs, who created markets and matched people’s needs, were necessary, generating and benefiting from knowledge spillovers. In sum, the extent to which entrepreneurs drive development depends on how much externalities they create and use.

Phase of development

There is agreement within both development economics and entrepreneurship economics that entrepreneurs have different roles and effects across different stages of development. After the First Industrial Revolution started in Western Europe, other regions, such as Asia, began to catch-up. Their industrialization was in large part driven by entrepreneurs who identified, copied, and adapted existing technologies.

Catch-up requires a lot of effort and capability-building by poorer countries, such as that undertaken by entrepreneurs who obtain licenses to use foreign technology or who just copy, reverse engineer, or even steal new technologies without bearing all the sunk costs and risks of investments in new knowledge incurred by firms in advanced economies. One of the benefits of copying is that these entrepreneurs can focus on delivering incremental improvements to foreign designs, rather than the risky development of products and technologies new to the world.

Once rapid growth is underway, there is a gradual shift in the most prosperous countries to innovation at the frontiers of knowledge (as we see today in China, for example). This implies that there are varieties of entrepreneurship and that entrepreneurship should not be equated only with high growth, high-tech innovative (Schumpeterian) entrepreneurship. In many countries, the imitating, copying entrepreneur is a vital source of progress.

Entrepreneurial ability

The concept of entrepreneurial ability is another area in which research on development economics and entrepreneurship economics are converging. A challenge that many countries face is to make the transition towards an innovation-driven economy and avoid the so-called ‘middle-income trap’. Three interrelated sources that are important for such a transition are: allocation of talent, accumulation of human capital, and technological progress.

These three factors reflect or constitute entrepreneurial ability. Moreover, entrepreneurial ability is central to whether positive externalities occur or not. For example, highly talented entrepreneurs are required to bring innovation to the market that will create knowledge to underpin further innovations. An example is the iPad, which created opportunities for business by making possible the development of various apps.

Institutions

In entrepreneurship economics, there is a convergence with development economics thinking about the importance of institutions. Whether entrepreneurs with ability will have the incentives to commercialize ideas may depend on how entrepreneurial ability is allocated, a process in which institutions play a central role. The growth take-off in the West was accompanied by facilitating institutions—both formal (such as property rights) and informal (social networks) that encouraged and rewarded risk-taking by entrepreneurs.

The recognition by entrepreneurship scholars that governments are essential for generating positive externalities is similar to that by early development economists, who emphasized the need for a ‘big push’, as well as with the work of more recent development economists on the need for good institutions.

Non-monetary incentives

Just as in development economics, there has been a recognition in entrepreneurship research that development is about more than monetary wealth and that subjective wellbeing matters as well. Entrepreneurship scholars now recognize that entrepreneurship is not always motivated by dreams of wealth. They also recognize that the subjective wellbeing experienced by entrepreneurs from being independent, and from creating and running their own business, has intrinsic and procedural utility. In other words, being an entrepreneur has utility independent of the financial performance of the firm.

This implies that scholars and policy-makers should not be too obsessed with equating entrepreneurship with only high-tech or high-growth activities. They should also focus on concerns about threats to the life satisfaction of entrepreneurs, such as high levels of stress, low levels of work-life balance, and the dangers of burn-out and depression.

Conclusions

Entrepreneurship economics and development economics have been converging in at least five areas. The benefits, at least from a policy perspective, are that we are progressively coming to understand more about:

  • How to tailor entrepreneurship policies according to a country’s level of development.
  • How to offer more useful guidance on building and teaching entrepreneurial qualities.
  • Regulation of markets and oversight of governments, which are becoming more sensitive to incentive design and ‘nudges’.
  • Entrepreneurship support programs, which increasingly include initiatives to help entrepreneurs cope with the stresses and conflicts inherent in risk-taking.

Further convergence between development economists and entrepreneurship scholars will no doubt continue. It will result in an overall better environment for new start-ups, in more effective allocation of scarce public funding, and in better support of the kind of entrepreneurship that generates positive externalities.

 

Authors:

Jolanda Hessels is associate professor at the department of Applied Economics at Erasmus University Rotterdam. She is also affiliated with the Erasmus Happiness Economics Research Organization (EHERO).

Wim Naudé is Professor at Maastricht University and Maastricht School of Management, and Professorial Fellow at UNU-MERIT in the Netherlands. He is also Visiting Professor of Technology, Entrepreneurship and Development at RWTH Aachen University in Germany, and Research Fellow at the IZA Institute of Labor Economics in Bonn, Germany.