Theory connecting NFF and economic growth

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Theory connecting NFF and economic growth

The theoretical framework linking NFF to economic growth is provided by the new theories of industry evolution. The old (traditional) equilibrium based view of firm formation – the neoclas-sical school – suggest that NFF retards economic growth, while the new theories of industry evo-lution – the evolutionary school – suggest the exact opposite; that NFF drives economic growth. The empirical evidence seems to favor the new evolutionary school (Andersson 2006), but for clarity, both schools will be presented.

The neoclassical school

In neoclassical theory, new firm formation (NFF) is seen as the outcome of expected profits ad-justed for the costs of entry in a market. The entrepreneur is expected to start his company in that particular market where his profits are assumed to be maximized. In the neoclassical model the expected profits of the entrepreneur has been estimated by looking at earlier profits in this market, and the cost of entry has been estimated by looking at for example the intensity of capital and marketing and the minimum efficient scale of production. NFF under this theoretical framework is seen as the outcome of a process called error-correction process in which NFF affects the profits of the already existing firms. A result of this process is expected to be that high profits in a particular market is forced down until it reaches a long term equilibrium, dependent on the barriers to entry in that particular market. The number of firms on a market, given unified tech-nology and perfect competition, will therefore be a function of the barriers to entry or the sunk costs which cannot be transferred to other markets. (Andersson 2006)
This, equilibrium based view, actually suggest that entrepreneurship will retard economic growth, here “new knowledge plays no role; rather, static efficiency, determined largely by the ability to exhaust scale economies dictates growth” (Audretsch 2003 p10). Simply put, economic growth needs larger firms – not more of them. Large firms achieve economy of scale, while more new (small) firms (NFF) detract resources from these established firms.
The empirical support for this neoclassical model of firm formation is weak. Investigations based on this model has “not even nearly” been able to explain variations in NFF; “differences in prof-its and cost of entry between industries must be much greater than observed to be able to explain the variations in NFF.” Further, it does not sit very well with the observed differences in profits between different markets which are “surprisingly large and stable over time” or why “profits do not tend to even out between different firms in the same market over time.” The weak support for this traditionalist view may be related to difficulties in estimating future profits and cost of en-try. (Andersson 2006 p16

The evolutionary school

In this school of thinking; the dynamics of firms is seen as an outcome of a selection process which Schumpeter called “creative destruction”. Entrepreneurs (creative) enter the market with an innovation. The innovation may lie in the form of the production technology or in the product itself. In the process of creative destruction it is assumed that new entrepreneurs, with new (bet-ter) products, services or production methods (innovations) succeed in the market over and above established firms (using conventional technology) – leading to destruction of established firms.
For a new firm to be able to successfully establish itself on a competitive market it is necessary for it to have an innovation that is good enough; allowing it to increase productivity in the new firm more than the competing firms using conventional technology – or sell a product/service not provided elsewhere. Hence an important condition for making innovations successful is as-sumed to be the creation of temporary monopolies for innovations – making sure that the gains from innovations are reaped by the new firm, which is assumed to be in a more difficult situation due to its recent entry into the market. (Andersson 2006)
The ambition to gain monopoly profits drives entrepreneurs to invest in R&D, generating innovations and growth through a process of creative destruction. (Andersson 2006 p 19)
The new theories of industry evolution “…are dynamic in nature and emphasize the role that knowledge plays”. Because of particular problems related to knowledge7 – it is inherently uncer-tain, asymmetric and associated with high costs of transactions; different opinions are formed as to the true value of new ideas (innovations). “Economic agents therefore have an incentive to leave an incumbent firm and start a new firm [NFF] in an attempt to commercialize the perceived value of their knowledge.” (Audretsch 2003 p. 11)
Anderson (2006 p19) argues that evolutionary theory “…where NFF coincides with the introduction of new innovations…cannot be tested since innovations are assumed to appear randomly.” This is the problem with some economic theory – that it cannot be empirically (dis)proved. This doesn‟t keep this particular theory from being useful for our purposes though. Innovations or ideas may appear randomly – but that does not necessarily mean that NFF appears randomly. All new innovations (ideas) does not lead to NFF – there are barriers to overcome (also likely to influence the relative longevity of firms) – so, it would seem logical that where the barriers to NFF are less severe – NFF is relatively large. Audretsch talks about this using the term entrepreneurship capital. This term is defined simply as “the capacity of an economy to generate the start-up of new firms”, and; “The emergence of entrepreneurship policy to promote economic growth is interpreted as an at-tempt to create entrepreneurship capital” (Audretsch 2007 p65). So, one could say that this thesis will be about the determinants of “entrepreneurship capital” i.e. what influences the capacity of economies to generate the start-up of new firms

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The determinants of NFF: theoretical framework

To understand what determines NFF and how public policy can be adapted to promote NFF, a model developed by (Audretsch et al 2002), is useful8. It helps in two ways; 1) it demonstrates reasons why the degree of firm formation varies across countries, and 2) it identifies the different ways in which public policy can be implemented to increase NFF. This model makes a distinction between factors shaping the supply of NFF, and factors influencing the demand for NFF. The demand for NFF reflects the opportunities for NFF – recognizing that the opportunity of individu-als to start firms varies across countries. The supply of NFF, contrastingly, is shaped by characteris-tics of the population. (Audretsch 2003)
The framework is depicted in Figure 1 below. It visualizes how demand and supply factors (to be elaborated on below) help to shape the risk-reward profile of individuals contemplating starting a firm.
The framework emphasizes that while the decision to start a firm is embedded into a broad range of social, economic, political and cultural factors, ultimately it is individuals who make a choice whether or not to start a firm9. Given all of the factors from both the supply and demand sides,

  • It is important to separate knowledge from information. Knowledge is the ability to use (Karlsson & Nyström 2007, footnote p13)
  • Originally the model uses the problematic word “entrepreneurship” in its theoretical framework; this has been rephrased so that it is absolutely clear what we are talking about – NFF.
  • Technically, economic agents (individuals, firms, agencies, and organizations) start firms. (Karlsson & Nyström 2007) individuals weigh the perceived risks and rewards from starting a firm. As a result, they may choose to start a firm (entry) or not to, or even to terminate an existing firm of theirs (exit). (Au-dretsch 2003)

The risk-reward profile represents the process of weighing alternative types of employment. That is, the choice of the individual between wage-labor, unemployment, and starting a firm. This choice is influenced by the opportunities presented by the demand side and the resources and ab-ilities presented by the supply side. (Audretsch 2003)
If the actual degree of NFF deviates from its targeted degree (NFF*), government policies may be undertaken to alter the basic forces shaping firm formation activity. As visualized in Figure 1, such policies are implemented by changing the different components shaping either: the demand side, the supply side, or else the risk-reward profile directly. (Audretsch 2003)
Figure 1: Framework for the determinants of Entrepreneurship. Source: Audretsch et al. (2002)
G1: Demand factors; promotes NFF by altering the factors shaping opportunity for NFF. Such policies include: deregulation of entry into markets, the privatization of government services, access to government support programs, promoting firm linkages and clusters. (Audretsch 2003) Supply factors; promotes NFF by altering the factors shaping the supply side. Policies such as:
G2: Facilitating the participation and access of previously excluded minorities
G3: enhancing the skills and capabilities of individuals through education and training, or by pro-vision of micro-credit or other types of finance;
G4: improving views toward NFF, including promotional campaigns using the media and the educational system
G5: Policies changing the risk-reward profile directly, such as: taxes, subsidies, labor market rules and bankruptcy regulation. (Audretsch 2003

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Institutions and entrepreneurship

in·sti·tu·tion: A custom, practice, relationship, or behavioral pattern of importance in the life of a community or society.10
10The American Heritage® Dictionary of the English Language, Fourth Edition. Retrieved January 31, 2008, from Dictionary.com website: http://dictionary.reference.com/browse/institutions Boettke & Coyne (2004) identify the role of institutions as to: “remove uncertainty and facilitate social interaction” by making the actions of others predictable.
During the 1960‟s and 70‟s economists began to focus on the importance of institutions for economic growth. The standard (neo-classical) growth models suffered from an “inability to con-sider the rules of the game and the incentives that those rules provide”. Put simply “the neoclas-sical model failed to answer the pertinent questions why? and what? [see below]” (Ibid p 12)
Why is there capital accumulation through forgone consumption and investment or a lack thereof? Why are there new technological advances in some countries and not others? Why is existing technology used more efficiently in some places as compared to others? What causes laborers to invest in their own development and what causes employers to invest in their employees? … (Ibid)
These questions can only be answered by considering the role of institutions i.e. the rules of the game. William Baumol (1990), with his theory of „productive and unproductive entrepreneurship‟ made some very influential conjectures about the effect of institutions on entrepreneurship. Con-jectures that today appear accepted as virtual truisms in the literature, and have received consi-derable empirical support (see e.g. Sobel 2006). Baumol (1990 p 6) wrote that:
If entrepreneurs are defined, simply, to be persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige, then it is to be expected that not all of them will be overly concerned with whether an activity that achieves these goals adds much or little to the social product or, for that matter, even whether it is an actual impedi-ment to production…
Baumol (1990), like Ludwig von Mises and Israel Kirzner, saw entrepreneurship as an omnipre-sent feature of human nature, and therefore believed that what differs between economies, is not so much the underlying entrepreneurial spirit – but how that spirit is channeled through institu-tions or the rules of the game. (Sobel 2006, Boettke & Coyne 2004)
If entrepreneurship is the imaginative pursuit of position, with limited concern about the means used to achieve the purpose, then we can expect changes in the structure of rewards to modify the nature of the entrepreneur‟s activities, sometimes drastically. The rules of the game [institutions] can then be a critical influence helping to determine whether entrepre-neurship will be allocated predominantly to activities that are productive or unproductive and even destructive (Baumol 1990 p 14)
Entrepreneurial individuals (using Baumols definition) have a choice to devote their labor efforts toward either 1) private-sector wealth creation (productive entrepreneurship), or 2) toward secur-ing wealth redistribution (unproductive entrepreneurship) through political, economical,11 and legal processes (such as lobbying for privileges or rent seeking through litigiousness12). Unproductive entrepreneurship would also, of course, cover illegal activities such as drug dealing. This choice of the entrepreneur over where to direct his efforts, to productive or unproductive entrepreneur-ship is influenced by the corresponding rates of return to the two activities. Institutions , such as: secure property rights, a fair and balanced judicial system, contract enforcement, and effective limits on government‟s ability to transfer wealth through taxation and regulation, give lower returns to unproductive entrepreneurship, hence stimulate its productive counterpart. (Baumol 1990, Sobel 2006) NFF may be classified as a venue for “productive entrepreneurship”. Following the theoretical framework just described then, good institutions should increase the rate of firm formation. Pri-marily through changing the risk-reward profile of entrepreneurship described in Figure 1

1 Introduction 
1.1 Outline of the thesis
2 Theory connecting NFF and economic growth
2.1 The neoclassical school
2.2 The evolutionary school
3 The determinants of NFF: theoretical framework 
3.1 Institutions and entrepreneurship
4 Data: sources and variables 
4.1 Entrepreneurship between countries
5 Statistical Method
5.2 Expected results
6 Empirical results and analysis
6.1 General findings
6.2 Cost of enforcing contracts and the case of Sweden
7 Conclusions and suggestions to further studies
8 References
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