Institutional Entrepreneurship

Citation

Rosolino Antonio Candela (2015), "Institutional Entrepreneurship", Journal of Entrepreneurship and Public Policy, Vol. 4 No. 1, pp. 136-140. https://doi.org/10.1108/JEPP-06-2013-0024

Institutional Entrepreneurship puts forth a collection of seminal articles that have revived and contributed to the relevance of institutions and entrepreneurship in economics and sociology. The increasing mathematical formalism characteristic of neoclassical economics since the mid-twentieth century has until recently marginalized the role of institutions and entrepreneurship. Magnus Henrekson and Tino Sanandaji (2012) have skillfully selected a body of work illustrating how institutions, or “the rules of the game,” provide the context in which economic outcomes take place and the role in which entrepreneurs, alert to exploit profit opportunities, catalyze such economic outcomes. The dynamic interaction between entrepreneurs and institutions not only affects how entrepreneurship is allocated, but also how entrepreneurs shape institutional incentives to their own benefit. Moreover, research in institutional entrepreneurship has implications for economic policy, such as stimulating economic growth and curbing rent-seeking, not by legislative discretion, but by discovering the constitutional rules that incentivize such policies.

Henderson and Sanandaji have structured the book to emphasize the dynamic interplay between institutions and entrepreneurs. Part I sets the tone of the book with two seminal papers by Baumol (1990) and Murphy et al. (1991), both of which had heavily influenced the resurgence of research on the relationship between institutions and entrepreneurship. The title of Baumol’s article, “Entrepreneurship: productive, unproductive, and destructive” exemplifies the different manifestations of entrepreneurship and the institutional conditions, both formal and informal, that incentivize different types of entrepreneurial activity. Baumol asserts “that it is the set of rules and not the supply of entrepreneurs or the nature of their objectives that undergoes significant changes from one period to another and helps to dictate the ultimate effect on the economy via the allocation of the entrepreneurial resources” (p. 4). That is, how entrepreneurs, defined “simply to be persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige,” exercise their talents in an economy depends largely on the institutional reward structure and the relative payoffs to different entrepreneurial activities (p. 7).

Murphy, Schleifer, and Vishny also build on the allocation of entrepreneurial talent, but focus on other constraints that affect relative payoffs. These include the extent of the market for different talents as well as “compensation contracts,” which determine how much of the returns to a particular entrepreneurial talent is internalized. On these two points, they argue:

Being a superstar in a large market pays more than being a superstar in a small market […] The more of the rents on her talent a superstar can keep, the more likely she is to join a sector (p. 33).

Therefore, whether entrepreneurs engage in productive entrepreneurship, such as creating new goods and services that benefits society as a whole, or pursue unproductive or destructive entrepreneurship, such as rent-seeking at the expense of the society, depends on formal institutions provided by government as well as informal institutions and cultural norms that filter, encourage, and reward entrepreneurial activity.

Part II takes up the theme of “productive abiding entrepreneurship,” demonstrating how both formal and informal institutions affect productive economic outcomes. Lerner and Schoar (2005) show the relationship between formal institutions and entrepreneurial financing. They assert that private equity investments in countries characterized by well-defined property rights, effective contractual enforcement, and common law tradition are more likely to employ convertible preferred stock rather than common stock or debt. Moreover, in civil law countries with weak contractual enforcement, entrepreneurs, and private equity groups are more reliant on firm ownership, where control and cash flow rights are bundled together. Moreover, other institutional constraints, such as labor rigidities and high-income taxation, stifle the emergence of entrepreneurship in the form of nascent, high-growth firms, as in the case of Sweden (Davidson and Henrekson, 2002). Informal institutions, such as trust, also affect entrepreneurship as well. Guiso et al. (2006) find that “trustworthy individuals have a comparative advantage in becoming entrepreneurs” (p. 99).

Part III focusses on “unproductive abiding entrepreneurship” and the role in which certain institutions erect barriers to growth, driving entrepreneurship toward zero or negative sum profit opportunities. An institutional environment that is interventionist and lacking well-enforced property rights undermines private investment and risk-taking by entrepreneurs into enterprises that create value. Instead, successful entrepreneurs within such a context are encouraged to discover profit opportunities that capture political influence and privileged access to the factors of production, as demonstrated by the Russian “oligarchs” after the collapse of Soviet communism. In such an environment, entrepreneurs must also engage in forging informal institutions, since “those without access to existing business networks are more vulnerable to opportunistic behavior by extortion-seeking officials”(p. 228).

It is precisely because of their capacity to form their own informal institutions and networks that entrepreneurs are not always bound by the given “rules of the game.” In Part IV, Boettke and Leeson (2009) argue “where governments cannot or do not protect citizens against private predation, ‘institutional entrepreneurs’ devise private mechanisms of property protection, providing the security required for productive entrepreneurship to grow” (p. 249). Institutional entrepreneurship on the “protective tier” generates positive externalities that allow for other “productive tier” entrepreneurs to generate innovation and wealth. Moreover, such entrepreneurs “must possess skills beyond those of a traditional entrepreneur, such as dealing with government officials and public opinion” (p. 244).

Entrepreneurship is limited not only to markets, but also extends into politics. Analogous to entrepreneurs in the marketplace, political entrepreneurs are also alert to discover profit opportunities. However, in the political realm, political profits may be earned productively or through predation. Moreover, democratic institutions skew the reward structure toward the latter:

The incentive structure in politics leads political entrepreneurs toward actions that benefit some at the expense of others rather than toward actions that benefit everyone, and leads entrepreneurs toward an inefficient allocation of resources rather than toward efficient allocation (p. 302).

Whereas voluntary market exchanges lead to Pareto optimal equilibria, predatory political exchanges always exist in a democratic system, wherein political profits are generated through pork barrel spending and redistribution to special interest groups. In Part V, Glaeser and Schleifer (2005) illustrate this inefficient tendency in politics as the “Curley Effect,” in which elected officials maintain power by pursuing redistributive policies. This effect not only impoverishes society as a whole, but also expands the electoral base of their constituency by displacing their political opponents through migration.

Political entrepreneurship may also yield unintended consequences on informal institutions, as highlighted in Parts VI and VII. Corruption and predation by political entrepreneurs erodes the reliability of the formal institutional framework, resulting in the formation of what Rodrik calls “second-best” institutions to successfully evade governmental inefficiencies (p. 355). These second-best institutions provide informal rules of governance, the manifestation of which leads either to productive or unproductive entrepreneurial outcomes. Although traditionally thought to be detrimental to economic development, Méon and Weill (2010) argue that bribing corrupt bureaucrats proves to be an “efficient grease,” or a second-best institutional alternative for productive entrepreneurs in order for economic development to gain traction, especially where formal institutions are very defective. Particularly in countries where institutional quality has been low, such as in sub-Saharan Africa, Boettke (2007) has observed that entrepreneurs “can also provide the required protective infrastructure for exchange relations when public sector governance is failing” (p. 361).

However, entrepreneurial outcomes may also prove unproductive under the shadow of the state. Without an effective framework of property rights and the rule of law, it is no surprise that entrepreneurial activity flows into black markets. In countries as different as Japan and Italy, organized crime emerged as “the dark side of private ordering-an entrepreneurial response to inefficiencies in the property rights and enforcement framework supplied by the state” (p. 369). Moreover, Torrini (2005) observes a positive relationship between self-employment and tax increases in countries where entrepreneurs find higher profit opportunities in tax evasion. That is, where tax laws are not properly enforced, tax increases inefficiently shift entrepreneurial activity into enterprises that afford “opportunities to hide income from tax authorities” (p. 667).

While many of the works presented in this book, and indeed in modern economic analysis, take a Schumpeterian approach to entrepreneurship as innovation, what marks the crucial link between institutions and entrepreneurship is the role of uncertainty in human action, without which neither would be necessary (North, 1990; Kirzner, 1973, 1985, 1997). In Part VIII, DiMaggio (1988) argues that what is “central to institutional theory is the assumption that humans have a preference for certainty and predictability” (p. 482). This does not underplay the “creative destructive” process in institutional formation. Rather, precisely because political and economic actors, both motivated by self-interest, cannot always anticipate the effects of their own entrepreneurial activity, changing the rules of the game should be viewed as an adaptive process, continuously discovering and amending the incentive structure that leads to various entrepreneurial outcomes, both politically and economically.

Furthermore, the political economy of entrepreneurship not only examines how institutional incentives determine which entrepreneurial activities are “profitable,” but also how entrepreneurs discover opportunities to shape the institutions to their own benefit. As an example, Henderson and Sanandaji note in their introduction that “a tax hike may not only deter productive entrepreneurs, but also encourage unproductive entrepreneurship” (p. xxiv), such as lobbying for tax loopholes, rent-seeking, and other entrepreneurial feedback loops that lead to incremental changes in the institutional framework.

Research in the political economy of institutions and entrepreneurship has grown significantly in the past 20 years, due in so small part to the seminal articles of Baumol (1990) and Murphy et al. (1991). Understanding the interplay between institutions and entrepreneurship will illuminate to future researchers and policy makers that discovering rules that incentivize productive entrepreneurial activity are more effective than simply legislating away unproductive entrepreneurial activities, such as organized crime and rent-seeking. Henderson and Sanandaji have successfully emphasized this theme throughout their book, not to have the final word on a self-contained collection of study, but to provide an important reference of works on a burgeoning subject for scholars to explore and incorporate into their own future research.

About the reviewer

Rosolino Antonio Candela is a PhD Mercatus Fellow at the George Mason University, where he is also a Humane Studies Fellow. Rosolino earned his BA summa cum laude from the St. John’s University, where he studied history and philosophy, and his MA in Economics and International Political Economy and Development (IPED) from the Fordham University. Prior to joining the PhD Economics Program at the George Mason University, Rosolino attended Suffolk University, where he was a Charles G. Koch PhD Fellow and a JIN Fellow. At Suffolk, he also worked at the Beacon Hill Institute, where he was also a Koch Summer Fellow. His research interests are in Austrian economics, constitutional economics, and the economics of organized crime. Rosolino Antonio Candela can be contacted at: candela@fordham.edu