Entrepreneurship and its effect on economic growth in the transitional
economies: an institutional perspective
An empirical country-level study on the determinants of economic growth
ABSTRACT:
Entrepreneurial activity is theorized as being a main driver for stimulating economic growth. However, evidence within the literature is mixed, primarily since entrepreneurship is a variable that
is difficult to conceptualize. With the help of the GEM (Global Entrepreneurship Monitor) a major step has been taken in order to capture attitudes on entrepreneurship. This paper investigates whether entrepreneurial activity significantly affects GDP growth for 16 countries of the transitional
economies while taking the institutional environment into account. Transitional economies form an interesting outlet for research since the tradition of entrepreneurship is relatively young in those
countries, and empirical studies are scarce. Significant results for entrepreneurship negatively affecting economic growth are found. However, this study confirms Van Stel et al.,(2005)’s main
takeaways how the positive effects of entrepreneurship depend on the level of economic development. Entrepreneurship still deserves to be stimulated by policymakers, particularly because
of its externalities.
Key words: entrepreneurial activity, economic growth, GEM, economic institutions, political institutions
Joost van Leer s2056275
University of Groningen Faculty of Economics and Business
Msc Business Administration: Small Business and Entrepreneurship Supervisor: H.Zhou
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1. Introduction
The concept of entrepreneurship has always played an important role in economic growth globally. Within most countries in the world the view is that entrepreneurship always had a prominent role in furthering economic development. However, within the economic growth literature
entrepreneurship is surrounded by plenty of ambiguity (Naudé, 2010). This seems surprising, since in theory entrepreneurial activity should stimulate innovation, competition and efficiency of
production. Entrepreneurs may introduce new products or production processes, or may play a vital part in the early evolution of new industries (Van Stel et al.,2005). Examples of influential
entrepreneurs include Thomas Edison, Henry Ford, Bill Gates and many others. However, entrepreneurship was completely forbidden until 1990 in a group classified by the IMF as the transitional economies. In these economies, growth has traditionally been very sluggish and lagging behind the economies where entrepreneurship has been allowed for ages. An attempt will be made in this paper to researchif the lack of entrepreneurial activity and subsequent lagging economic growth are related. First, a definition of the transitional economies will be provided.
Transitional economies are those economies making a transition from a centrally planned economy to a market economy (EBRD, 1998). In 2000, the International Monetary Fund classified the transitional economies as follows: Transitional economies in Europe and the former Soviet Union (Central and Eastern Europe: Albania, Bulgaria, Bosnia-Herzegovina, Croatia, Czech Republic, FYR Macedonia, Hungary, Poland , Romania, Slovakia, Slovenia; Baltics: Estonia, Latvia, Lithuania; Commonwealth of the Independent States: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, Uzbekistan (Manev & Manolova, 2010).
The emergence of entrepreneurship within these economies represents chances for researchers. This thesis aims to make a contribution to the existing literature on entrepreneurship and growth in transitional economies in the following way. First of all, knowledge on entrepreneurship can be improved by better understanding the role of the different institutional and cultural contexts within these countries (Manev & Manolova, 2010). Secondly, it provides an opportunity to test
entrepreneurial theories for growth which were originally developed in the West in a different institutional and cultural environment, therefore providing researchers with helpful insights. Lastly, it has been hypothesized that the success or failure of a transitional economy depends on the
performance of its entrepreneurs (Johnson et al.,2000). Additionally, studies within the literature that focus on the relationship between entrepreneurial activity and growth are mostly performed in developed economies. The transitional economies are underrepresented and this study attempts to add that to the literature.
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for entrepreneurship and economic growth (Welter, 2012). If institutional trust is low, contracts cannot be enforced, business partners cannot be trusted, and the business infrastructure is lacking or not present at all, entrepreneurship is severely discouraged. Yet entrepreneurship has been a
significant factor and driver for overall economic development.
In fact, entrepreneurship played a significant role in increasing welfare within the transitional economies. The most important effect has been job creation. During the dismantling and
privatization of large state-owned enterprises many jobs were shed. The new firms had a primary role in providing the unemployed with new jobs. New firms do not show a distinct difference in job creation compared to privatized established firms however. Data by Johnson et al.,(2000) don’t show different growth rates of start-ups compared to privatized firms in Russia and Ukraine. New firms do have additional indirect benefits. Smaller and newer firms are more dynamic compared to their counterparts and in essence change and learn rapidly. They have their effect on the whole business environment due to their learning by doing.
Haltiwanger and Vodopivec (2000) divide net chance in employment by examining the creation of new jobs by firms that are expanding and additionally the destruction of jobs by firms that are contracting. They find that state-owned firms exhibit high percentages of job destruction, but no high amounts of job creation. New firms exhibit even higher percentages of job destruction, but also show a high amount of job creation. Here it shows that new firms play a substantial role in the learning process, which is very important in transition economies because of the related uncertainty and lack of information and entrepreneurial traditions. Lastly, new firms create an indirect welfare effect in the form of their spurring of competition. Due to competition, state-owned and privatized firms were far more likely to restructure. (Carlin et al., 2001; Djankov & Murrell 2002). This implies that new entrants stimulate incumbent firms to restructure and enhance their efficiency. Within the literature, an empirical study on the determinants of economic growth in the countries aforementioned while incorporating an institutional perspective has not been performed by my knowledge. That is the gap this study attempts to fill. The goal of this study is to refine current understanding of the effects of entrepreneurial activity on economic growth, within a sample of countries with unusual factor conditions.
This study has significant policy implications. Not only will it attempt to answer the question if entrepreneurship actually contributes to economic growth using a relatively new indicator on entrepreneurial activity by the Global Entrepreneurship Monitor but it will additionally examine the effects of the institutional environment. For policymakers this study addresses if entrepreneurship should be worthy of stimulating via policy. Additionally, it attempts to capture which types of institutions affect entrepreneurship, and in which institutional environments entrepreneurship has the strongest effects on economic growth. This has further implications for policymakers, since it provides an idea which institutional environments to improve in order to further economic growth and development. Although this paper theorizes the effects of entrepreneurial activity and economic growth, entrepreneurship has further welfare effects not captured only by economic growth.
While the academic literature has paid a substantial amount of attention to entrepreneurship in transitional economies its role on economic growth stays doubtful. Literature focuses on how the institutional environment has changed and how this has affected entrepreneurship (Smallbone & Welter, 2012; Ahlstrom & Bruton 2010; Estrin & Mickiewicz, 2010; Puffer & McCarthy, 2011) or how entrepreneurship has been such an important factor in economic growth within these
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development, but they have always been performed in developed countries (Nystrom, 2008; Klapper et al, 2007, Reynolds et al,2005). Empirical studies on country level for the transitional economies while taking note of the complex institutional environment have not been undertaken. For the transitional economies, these institutions are very interesting and dynamic, since they have had to be established from scratch, in countries which lacked many of these ''rules of the game'' (North, 1990), courtesy of their turbulent history under communist rule.
2. Research question
The aim of this research is to find out how entrepreneurship influences economic development within the transitional economies, and how differing institutional environments moderate economic growth. As mentioned in the introduction countless studies have been undertaken on how
entrepreneurship influences economic development. However, results have been mixed and not very robust. Many (macro-level) empirical studies are lacking due to weak methodologies and inadequate data. It has been difficult to find a single fitting definition for entrepreneurship. Studies have focused on using self-employment as an indicator to measure entrepreneurship, but this has not led to satisfactory and robust results. GDP growth is easy to find and to use as an indicator for economic development, but the same has not been so easy for the abstract term of
''entrepreneurship''. One source that captures entrepreneurship that has become more popular recently is the GEM(Global Entrepreneurship Monitor). This project represents an entrepreneurial index to measure entrepreneurial activity, compiled yearly. A prominent and relatively recent indicator of entrepreneurship is the measure of Total Entrepreneurial Activity(TEA), which is based on a survey of 3000 adultsregarding their attitudes and views on entrepreneurship. Nystrom(2008) provides a summary of 38 empirical studies during 1996–2006 on the relationship between
entrepreneurship and economic performance. Most of these empirical studies focus on developed economies. Only three studies focus on developing economies (Naude, 2010) and lack the influence of institutions. Institutions are still largely considered to be a black box (Naude, 2010).
Additionally, the co-evolution of institutions and how this relates to the incentives for
entrepreneurial behavior and the stage of development of a country is also largely under researched (Fogel et al., 2005). Therefore, this paper comes to the following research question
Does entrepreneurship positively influence economic growth in the transitional
economies, and how does this effect differ given different institutional
environments
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3. Literature review
Characteristics of entrepreneurship in transitional economies
In this section a general overview of entrepreneurship in the transitional economies will be provided based on a literature review relevant to the research question. This section will proceed with a short theoretical background on entrepreneurship in general, and how theoretically entrepreneurship can stimulate economic growth. It is followed by a general analysis of entrepreneurship in transitional economies.
General overview of entrepreneurship
According to Carree & Thurik(2003) entrepreneurship is a concept that has multiple dimensions, is ill-defined and this makes measuring its impact on economic performance a challenge.
Entrepreneurship can be related to innovation, new entry and venture creation, or creating
competition. Entrepreneurs have had several roles in history as important role models and figures. The most important and well-known actor that saw the entrepreneur as a critical factor in economic development was Joseph Schumpeter. Schumpeter (1942) remarks that the process of creative destruction that causes shocks to the economic environment is an important factor in advancing performance. The entrepreneur as an innovator contributes to these shocks. With help of these shocks, they disturb the current economic equilibrium and give place and opportunities to extract economic rents. From this, it follows that entrepreneurship should contribute to economic growth. In this paper the following definition of entrepreneurship will be used: ‘’Entrepreneurship is the manifest ability and willingness of individuals, on their own, in teams, within and outside existing organizations to perceive and create new economic opportunities (new products, new production methods, new organizational schemes and new product-market combinations), and to introduce their ideas in the market, in the face of uncertainty and other obstacles, by making decisions on location, form and the use of resources and institutions’’ (Wennekers and Thurik, 1999). This definition of entrepreneurship is fitting since it accurately captures entrepreneurship from multiple angles.
The research of entrepreneurship tries to examine how opportunities are created, identified, and ultimately exploited. That specific topic of entrepreneurship generated substantial attention within the literature. It became so integral that Shane and Venkatamaran (2000) included it within their definition on entrepreneurship research: ‘’Entrepreneurship research is the scholarly examination of how, by whom, and with what effects opportunities to create future goods and services are
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Entrepreneurship and economic growth
However, how does entrepreneurship actually contribute to economic growth? Entrepreneurship is said to be at the ‘’heart of national advantage’’(Porter,1990). Entrepreneurs set up businesses, which provide jobs, and also create competition which increases efficiency. They also might spur performance through technological innovation and an accompanying increase in Total Factor Productivity(TFP).
Audretsch(2006) explicitly discusses the link between economic growth, knowledge and
entrepreneurship. When knowledge acquired a more significant role as a determinant in economic growth, so did the small firm and entrepreneurial activity. Subsequently, due to the emergence of globalization the importance of large-scale production decreased significantly in high-wage countries, where knowledge and innovation gained in importance. Entrepreneurship can increase knowledge primarily due to knowledge spillovers. Smaller firms do not possess the budget for R&D to invest significantly, yet they perform relatively better than larger firms with respect to
innovational activities. This can be explained by the presence of knowledge spillovers due to research institutions and universities located within spatial proximity of the firm. Smaller firms make better use of knowledge spillovers due to the appropriability of new knowledge. Smaller firms are better suited to adapt new technology and knowledge made externally because of their relative flexibility compared to larger firms. Additionally, since small firms are more constraint by their size to perform substantial investments, it must engage in different strategies to innovate. This means smaller firms are more suitable to resort to networks, linkages, and other succinct types of spillovers.
Aidis(2003) sees entrepreneurship as a crucial mechanism of economic development, both at the micro as well as the macro level. On the macro-level it can be a driver of structural change as well as a major factor in job creation. When looked at from a micro-economic point of view
entrepreneurship gives birth to new firms and the subsequent growth of these new firms. Acs et al (2013) attempts to answer the question how entrepreneurship is good for economic growth. In this article, a distinction is made between the different types of entrepreneurship: self-employment, necessity entrepreneurship and opportunity entrepreneurship. Self-employment has no effect on economic development, on the contrary, lower levels of self-employment are associated with a higher level of economic development. The paper finds the ratio of opportunity-to-necessity one of the key factors in examining the relationship between entrepreneurship and economic development. When more of the population gets involved in opportunity entrepreneurship instead of necessity entrepreneurship, economic development will increase. The findings of Acs et al(2013) are confirmed in a study performed by Blanchflower (2000). Blanchflower(2000) studies the relationship between self-employment and economic growth for 23 OECD countries during 30 years and finds a negative relationship, even though entrepreneurship is theorized to enhance economic growth. Yet, this study was critiqued for using unharmonized data.
Within the literature, several studies have been performed with respect to the effects of
entrepreneurship on economic growth. Carree & Thurik (1998) report that the excess growth of small firms 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 et al., (2000) perform an
analysis of 48 U.S. states for the 1986-95 period. States with higher percentages of small business employment exhibit higher levels of productivity growth a higher Gross State Product(GSP).
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growth, which in this study is proxied by job creation. Firm formation is associated with creative destruction. However, creative destruction does not by itself appear to be a cause of economic growth.
Entrepreneurship in transitional economies
Entrepreneurship has been one of the main drivers for economic development within transitional economies. Not only because of the creation of wealth (Baron, 1998), but also because of the deeper development of personal and societal wealth. Theoretically, entrepreneurship enhances rivalry and stimulates innovations, this furthermore coincides with the decreased importance in employment share of larger firms (Thurik and Carree, 2003). New ventures started by entrepreneurs who helped absorb the job losses due to privatization of state-owned enterprises, which were inefficient and inflexible. Moreover, the creation of private enterprises on a massive scale has greatly accelerated the establishment of market driven governance mechanisms and therefore, the transition process from centrally-planned to market-based economic systems (Manev & Manolova.,2009). In this way, entrepreneurship can be seen both as a driver of improving governance as well as a product of the improved governance. Additionally, new entrepreneurial ventures offset job losses from the state-owned sector as well as spurring innovation
Especially the offset of job losses were important in the transitional economies. Old firms had to shed a considerable amount of jobs within the transition process, and new firms were responsible to absorb all these job losses. Transition economies have been the fastest growing firms compared to newly privatized firms according to data. In Poland and Russia new manufacturing firms grew faster, invested more, and generated faster employment growth (McMillan & Woodruff, 2003). In other transition economies, similar results are found. In Romania, 86 percent of start-up
manufacturing firms created jobs between 1994 and 1996, while only 13 percent of privatized firms did so. In Slovakia, 79 percent of startup firms grew against 52 percent of state firms that were privatized (Johnson et al., 2000). Apart from the offset of job losses, there are multiple benefits associated with new and entrepreneurial firms. Small firms are more dynamic compared to their counterparts. They exhibit patterns of learning by doing and provide substantial opportunities for other firms how to do business.. Lastly, overall economic performance is also related to new firm entry. Berkowitz & DeJong (2002) compare economic growth rates in different regions of Russia. They find that regions that exhibit patterns of higher rates of entry have higher economic
performance.
While new entrepreneurial firms have several benefits and played a substantial role in the transition process, the environment has not always been supportive. Entrepreneurship has been hampered by several barriers in transitional economies. An example is the atmosphere that remained even after transition into a market economy. Within the communist/socialist society entrepreneurship was forbidden and general looked down upon. Entrepreneurship as an individualistic expression did not conform to the collectivist norms held high in these countries. Another important barrier that
hampered entrepreneurship has been the lack of access to finance. Especially in the beginning of the transition banking systems supplying finance to SMEs were not present in any of the transitional countries. How lack of financing affects entrepreneurship is country-specific. In specific countries that feature more micro-firms finance is often not needed or can be acquired via informal
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Empirical studies on entrepreneurship and economic growth in transitional economies are almost entirely lacking. Difficulties conceptualizing entrepreneurship and low presence of data on
entrepreneurship have been the main culprits. The transitional economies have acquired substantial attention within the academic literature however, these mostly do not focus on the link between entrepreneurship and growth, but look at cultural and institutional contexts to explain performance. Ahlstrom and Bruton (2010) perform a longitudinal study of high technology entrepreneurial ventures in Russia based on institutional theory on how they handle rapid institutional shifts. Key takeaway of the paper is that entrepreneurial firms in transitional economies compared to mature economies need to adapt quicker, not only because of higher economic growth but also because of the enactment of commercial regulations that might be new to a transitional economy such as Russia.
Aidis (2005) offers an overview of the key issues surrounding entrepreneurship development in the transitional economies. The paper focuses on the economic and political choices that countries made that influenced their path of transition and their relative success compared to their counterparts. Even though countries had the same starting point, development turned out
comparably different, with countries such as Poland and Hungary far outperforming countries such as Croatia and Moldova. Furthermore, the paper stresses the importance of SMEs since they provide economic benefits even beyond their contribution to GDP as it gives a choice of employment to the population.
In a study by Earle and Sakova (2000) it is found that business owners which operated a business in the years prior to the transition had a higher chance of owning a successful business in 1993. In slight contrast, Aidis and van Praag (2004) perform a study where illegal entrepreneurship of business owners in Lithuania before the transition is associated with the size of their business after the transition. No significant results on turnover, size, or intention to growth is found; however, higher levels of motivation to further business development are found.
Characteristics of institutions in transitional economies
Previously, an overview has been provided how entrepreneurship can contribute to economic growth and what the state is of entrepreneurship in transitional economies. However, a key factor has been omitted. This concerns the role of institutions. This section will first analyze how a robust institutional environment is important for development and economic performance. This is followed by an overview of the distinct nature of institutions in transitional economies.
Institutions and institutional theory
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An instrument to explain how individuals behave and why specific countries are considered more entrepreneurial than others is institutional theory. Institutional theory concerns the importance of economic forces and technical imperatives that shape the social and organizational systems, but also seeks to examine the behaviors and preferences of organizations and other actors within the
economic system (Ahlstrom & Bruton, 2003). Institutional theory typically assumes that institutions are relatively stable over time and can be difficult to change. Institutional theory provides a useful theoretical foundation to the entrepreneurship literature since institutions are a prime instrument in reducing risk and uncertainty within the society. Reducing risk and uncertainty can be a tool to spur entrepreneurial activity within the society. An individual's capability to undertake action and to embrace risk is a key component of entrepreneurship, but so is the interplay between the individual and the opportunity itself. The opportunity is shaped and can be constrained by the institutional environment. If entrepreneurial activity is deemed in a community or culture to be constructive and positive, the intentions to get involved in entrepreneurship are more likely to occur. In addition to increasing the demand and supply of entrepreneurial activity, legitimacy also increases the
availability of resources which will support new firm formation and growth (Stenholm et al.,2013). The development of entrepreneurship as well as its extent is reflected by the institutional
environment and its enforcement mechanisms (Oliver, 1991). The institutional factors impacting entrepreneurial efforts include the direct action of governments in constructing and maintaining an environment supportive of entrepreneurship as well as societal norms toward entrepreneurship (Bruton et al.,2010) The main takeaway from institutional theory with respect to entrepreneurial activity is that in economies with higher institutional quality reduced risk and uncertainty can spur entrepreneurial activity.
Institutions are very important for the entrepreneurial environment. Entrepreneurs can both be enabled and constrained by institutions since the institutions define and limit the space for entrepreneurial opportunities and also affect new venture creation and opportunity exploitation (Bruton & Ahlstrom, 2003). Entrepreneurs are constrained if there is a lack of formalized
institutions, but also when institutions are too strict and suffocating. Baumol (1993) emphasizes the critical role of institutions in directing entrepreneurship, either to productive or to non-productive or even destructive activity. If entrepreneurs need to comply with too many rules or need to spend too much time and money in order to actually start a business, business ownership is discouraged. The institutional environment concerns both formal institutions as well as informal institutions. The government is the biggest actor in establishing formal institutions. Governments can ensure markets function efficiently by removing conditions that create entry barriers, market imperfections, and unnecessarily stifling regulation. A hostile external environment has a detrimental effect on entrepreneurship since it may impede the level of capital investment, place fiscal and regulatory burdens and can have a hampering effect on the entrepreneurial spirit within society (Bruton & Ahlstrom, 2003). When these institutions are lacking in certain environments, there can be a need for alternate governance or contractual arrangements. These can fill in the institutional voids caused by the lacking formalized institutions of the government (Khanna & Palepu, 1997).
One of the most important set of formal institutions to create a favorable entrepreneurial
environment is the presence of property rights. Without a well-established set of property rights, it weakens the propensity for aspiring entrepreneurs since they cannot gain trust in their transactions. Lacking institutions impede the flow of information, raise information costs, and can limit
entrepreneurial activity. Besides the negative direct effect, there is also a negative indirect effect present, namely the resulting hampering capital market (Fogel et al.,2005). Investors are not
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will put a dampen on the entrepreneurial aspirations of many.
Institutions in transitional economies
The institutional environment in transitional economies is drastically different from the
environment in the developed economies. Transitional economies were characterized by having a comprehensive use of central economic planning as well as a sense of bureaucratic control (Peng & Heath, 1996). Firms were mostly state-owned enterprises and never needed to be competitive or efficient. Transitional economies have experienced a drastic change in their institutional
environment from the 1990s. These economies had to move from a socialist planned economy to a market economy, and this has created a distinct yet diverse business environment (Bevan & Estrin., 2004). The institutions of these economies had to be started from scratch, which included private ownership, system of private property, capital markets and an appropriate legal and institutional infrastructure. All of these institutions are incredibly important in establishing a stimulating environment for entrepreneurs. If legal institutions are lacking such as the rule of law and property rights, how can entrepreneurs trust that they will be paid for their products and services? If the financial infrastructure is lacking how do entrepreneurs in transitional economies acquire loans and pursue growth strategies? If political institutions are lacking, and entrepreneurs are confronted with a government that is not supportive but only limiting and working against the entrepreneurs, how can entrepreneurs trust the government at all?
All of the factors of the institutional environment have their influence on the behavior of
entrepreneurs and impact the decision-making process in being entrepreneurial. Subsequently the institutional environment is a critical success factor for entrepreneurs as well. Although not all the circumstances in these countries are the same, they all share the fact that they do have experience under the Soviet-type central planning and as followers of the communist regime (Peng & Heath, 2001). Additionally, within their transitions entrepreneurs have faced similar problems, concerning weakened bureaucratic controls as well as corruption.
Corruption is (still) a serious problem in transitional economies and contributes to the harmful environment for entrepreneurs. Kaufmann and Siegelbaum(1997) define corruption as to be the abuse of official power for private gain. This concerns two dimensions. The first dimension is the misappropriation of wealth for the benefit of a government official and the second dimension is the extraction of rents such as bribes, kickbacks for private entities. The corruption rates within most post-Soviet countries are among the highest in the world, and there is no end in sight(Transparency International, 2008). The Central Eastern European economies also show higher rates of corruption than in most Western countries. Despite the fact that advanced western economies have become more corrupt over the years, a considerable gap in corruption levels still exist between East and West (Bjornskov & Paldam, 2004).
Corruption is detrimental for entrepreneurial behavior in multiple ways. Corruption may prevent businesses from growing too explosively, since otherwise business owners might face expropriation risk from corrupt government officials (Estrin et al., 2007). Not only does it discourage the growing of businesses, but it also has a discouraging effect on potential entrepreneurs to start a business, since they also might be risking expropriation of profits. A weak formal institutional environment therefore increases the dependency on more informal institutions, such as trust in business
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4.Hypotheses
The analysis in this paper is primarily based on Van Stel et al.,(2005). Van Stel et al.,(2005) test whether total entrepreneurial activity has a positive effect on economic development by analyzing a sample of 36 countries of which 5 countries are transition economies. They use the Total
Entrepreneurial Activity(TEA) indicator of the Global Entrepreneurship Monitor(GEM) as well as the Growth Competitiveness Index(GCI) which is used to compensate for weaker institutions in less developed countries. The GCI captures the quality of public institutions and the macroeconomic environment. They find that the TEA has a positive effect for countries which have a GDP per capita higher than $20.000. Therefore, increased entrepreneurial activity has a positive effect on economic growth but only in developed countries. For the developing economies the effect is significantly negative. However, they prove that this effect can primarily be contributed to the developing countries and not the transitional economies. Even after correcting for the GCI the effect of entrepreneurial activity is still significant. This can imply that entrepreneurial activity is healthy for the business population, in the microeconomic sense that this flushes out the least efficient firms within the spectrum. Additionally, new firms are also very important in introducing new
technological innovations compared to the incumbent firms and new firms are also more a vehicle where the degree of work-effort is higher since the entrepreneurial reward depends on their personal efforts (Van Stel et al., 2005). The results from this paper imply that entrepreneurial activity matters since they acquire significant results. Even though entrepreneurial activity has a negative effect on economic growth in this case it does not imply entrepreneurial activity should not be stimulated. Several factors can be identified that can hamper how developing countries can profit from
entrepreneurial activity. Based on the results of these study, the studies in the literature review and the theoretical rationale, the first hypothesis is formulated as follows.
H1: Countries that have a higher rate of entrepreneurship will show a higher rate of economic growth
Acemoglu et al., (2005) divided institutions into political institutions and economical institutions. Economic institutions matter for economic growth because they shape the incentives of key economic actors in society, in particular, they influence investments in physical and human capital and technology, and the organization of production. Property rights need to be enforced for all members of society so that individuals have incentives to invest, be innovators and are overall actors in economic activity (Acemoglu et al.,(2005). Economic institutions are also important since they can help allocate factors of production to their most efficient uses. Acemoglu et al.,(2005 consider institutions as endogenous structures. The rationale is that they are determined by collective choices of the society, and are shaped by economic consequences. Political institutions also constrain and incentivize the key actors in society, although this time it concerns the political sphere. Examples of political institutions include the choice of government, the extent of constraints on politicians and basically concern the distribution of political power. Political institutions
primarily matter for investors and shape entrepreneurial incentives. Although geographical and social factors also matter, the main factors that make a difference between countries in economic performance are the differences in economic factors which in turn shape the differences in growth and prosperity. Countries with higher institutional quality have more innovation, attract more foreign direct investment because of reduced risk of expropriation, and give better opportunities for entrepreneurs.
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appropriating the gains on their investments. When institutions are poor, investors might pass on these opportunities. He finds that ‘’good institutions’’ have a positive effect on investments, entrepreneurship, and results in an increase in Total Factor Productivity(TFP).
Based on these studies and the theoretical rationale, the following hypotheses are established .
H2a: Higher political institutional quality strengthens the relationship between entrepreneurial activity and economic growth
H2b: Higher legal institutional quality strengthens the relationship between entrepreneurial activity and economic growth
H2c: Higher economic institutional quality strengthens the relationship between entrepreneurial activity and economic growth
The hypotheses are summarized in a straightforward conceptual model. Entrepreneurship has a positive effect on economic growth. The institutional environment has a moderating effect on this relationship.
Figure 1: Conceptual model linking entrepreneurship to economic growth
5. Research Methodology
In this section, the method of data collection is discussed and the model of research is presented.
5.1 Data source and sample
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All of the data used is freely accessible on the internet at the sources previously referred to. The research performed in this thesis can easily be replicated with the use of statistical software. This should ensure the reliability and validity of the research performed.
Total Entrepreneurial Activity
Data on the independent variable TEA is taken from the years 2001-2010 from the GEM Adult population survey.
GDP growth
The dependent variable that will be used is GDP growth. GDP growth will be taken from the database of the World Bank for the years 2001-2010.
GDP per capita
GDP per capita will be used as a control variable. The data for GDP per capita is taken from the database of the World Bank for the years 2001-2010.
Legal institutions
The institutional quality dataset by Kuncic(2014) attempts to capture the legal environment by using several proxies of legal institutional quality. These proxies include how well property rights are protected, the amount of judicial independence as well as the quality of law and order . The score for legal institutional quality is compiled by averaging 12 indicators such as the Index of Economic Freedom, Freedom of the Press, Freedom of Law, and several others. The sources of these proxies are The Heritage Foundation, Freedom House, and the ICRG(International Country Risk Guide).
Political institutions
The political environment is captured by using several proxies that measure the political
environment within the country. Examples of these proxies are: several variables concerning the amount of corruption, freedom of the press, the amount of democratic accountability and a measure of internal conflict. The score for political institutional quality is compiled by averaging 13
indicators such as the Political Terror Scale, Corruption Perceptions Index, Control of Corruption, Democratic Accountability and several others. The sources of these data are Freedom House, Transparency International, ICRG, and Polity IV.
Economical institutions
Economical institutions are captured by several variables to measure the economic environment within the country. Examples of these proxies are: The index of economic freedom, several indices on credit, labor, and business regulations, an index on foreign ownership and capital controls, and the whole investment profile of the country. The score for economic institutional quality is
compiled by averaging 8 indicators such as Business Freedom, subsections of the index of
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5.2 Variables
The dependent variable in this paper is GDP growth. Since this paper attempts to investigate the relationship with economic growth, GDP growth is chosen as a straightforward proxy.
The Global Entrepreneurship Monitor (GEM) is designed to measure the individual capabilities, motivations, and attitudes about entrepreneurship (Szerb & Trumbull, 2015). TEA(Total
Entrepreneurial Activity) is chosen as a main independent variable. Total Entrepreneurial
Activity(TEA) is defined as that percentage of the adult population that is either actively involved in starting a new venture or is the owner or manager of a business that is less than 42 months old (Reynolds et al.,2002). TEA is taken as a proxy for entrepreneurship since it measures the
perceptions of entrepreneurship within society. This measurement is consistent with the expanded definition of entrepreneurs to include ‘‘true’’ Schumpeterian entrepreneurs as well as managerial business owners. The TEA has remained quite consistent over time and therefore it can be seen as a structural characteristic of an economy capturing entrepreneurial activity. This makes it suitable for the model in this paper since the goal is to examine the determinants of economic growth (Van Stel et al.,2005).
As a measure for the institutional environment the institutional quality dataset by Kuncic (2014) is used. Finding a measure for institutions within the literature is complicated since there are no proxies that capture the full institutional environment available. Kuncic (2014) bases the
formalization of institutions on Joskow(2004), who classifies institutions as being legal, political, social, or economical. Kuncic (2014) compiles more than 30 institutional indicators of formal institutions into three homogeneous groups of formal institutions: legal, political, and economic which capture for the most part the formal institutional environment within the country. The
concept of social institutions is dropped, because it is complicated to conceptualize and there is also a lack of internationally comparable indicators present. Legal institutions are the most omnipresent institutions which can range from state devised legal institutions as well as private legal institutions such as contracts. In every single interaction, some kind of legislature is present. Legal institutions are the most formal institutions. Legal institutions are especially important in issues such as property rights, origins of legal systems and their effects, and the enforcement of legal institutions (Kuncic, 2014). Political institutions can be defined as anything that concerns polity, such as the voters, political parties, the electoral rules, and the limits of power of political parties and the state. Finally, the economic institutions primarily concern well-functioning of markets. Primarily this concerns the amount of economic freedom, freedom of corruption, and the access and regulation of labor and credit markets.
This dataset is made freely available and includes the bulk of the countries of the world.
Additionally, it makes use of several indicators within legal institutions, political institutions, and economic institutions. Therefore I believe it captures the institutional environment accurately. An overview of how the institutional indicators are compiled can be found in the Appendix. This data set spans from 1990-2010 and covers up to 197 countries, and also includes a high percentage of the transitional economies. Countries are clustered into 5 groups, where 1 spans all the countries with the lowest institutional quality and 5 includes the countries with the highest institutional quality. Additionally, Kuncic (2014) uses relative factor scores and absolute averages for each institutional component and ranks these as well, in order to create World Institutional Quality Rankings(WIQR), both for countries that have full observations as well as countries with missing observations. In this paper, the absolute institutional quality measures are used. The reason to prefer this measure over the relative institutional quality is that the absolute institutional quality measures covers
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relative institutional quality indicators if too much data of the institutional proxies are missing. Since a structural problem of the transitional economies is data availability, this is not surprising. With respect to the construction of these variables, it is as follows. All proxies for each of the institutional quality dimensions are compiled, averaged, and scaled to represent values between 0 and 1, where 0 implies a very weak institutional environment, and 1 a very strong institutional environment.
As a control variable, GDP per capita is used. The reason to use GDP per capita in order to control is based on the neoclassical growth model by Solow of convergence. Theoretically, poor countries grow much more than more developed countries and should be able to catch up to the developed economies on the longer term. Therefore, the growth rate of GDP should be inversely related to the starting level of GDP per capita. By including GDP per capita it’s possible to control for the higher growth rates of the poorer countries within the sample. GDP per capita is measured in terms of purchasing power parity in US dollars.
5.3 Method
In this section the method of analysis will be presented. The regression that will be used will be a panel regression that spans the years 2001-2010. It is a panel data set since it involves different periods of time as well as different countries. I hypothesize that GDP growth is affected by the level of entrepreneurial activity but that this effect is moderated by the institutional environment.
The regression equation is therefore as follows
ΔGDPgrowth = β1TEAit + β2LEGALINSTit + β3ECONOMICINSTit + β4POLITICALINSTit + β5GDPPC + β6TEA ∗ LEGALINSTit + β7TEA ∗ ECONOMICINSTit + β8TEA ∗ POLITICALINSTit + D1year + D2CountryID + Uit
Where β1 represents Total Entrepreneurial Activity, β2,β3, β4 represent the institutional
variables, β5 represents the control variable GDP per Capita, β6, β7, β8, are interaction variables
that model the relationship between TEA and the three proxies for the institutional environment.
The D1 variable is a time variable for all years except 2001, to ignore the dummy variable trap. D2 is the Panel ID variable that accounts for country effects and Uit is the error term. The hypotheses are then that the coefficients for TEA, and the interaction effects are positive.
6. Empirical results
This section will give an overview of the empirical results of the paper. First the descriptive
statistics will be presented and analyzed, followed by the regression and the regression diagnostics.
6.1 Descriptives
The descriptive statistics of the key variables are presented in the table below. There are rather considerable differences in the level of TEA among the sampled countries. There is no clear distinguishable difference in TEA when comparing either the Central and Eastern European economies to the post-Soviet economies or the Baltic states. For example Kazakhstan has shown a considerably high TEA of 13.7%, where Czech Republic has topped at a rate of 7.8%. Therefore no conclusions can be drawn which group of countries are more or less entrepreneurial. As is usual for developing economies there are huge volatile swings in economic growth. Part of the huge
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these heavily rely on capital from foreign inflows and banks. Growth figures are generally the lowest in 2009 and 2010 and highest around 2005 and 2006. With respect to the institutional indicators the results are straight-forward. In general there are no considerable increases and they remain quite stable over time. The countries with the highest figures of institutional quality are the Central and Eastern European countries such as Hungary, Poland, and the Czech Republic. The lowest figures of all institutional quality indicators are the Commonwealth of post-Soviet countries such as Russia and Kazakhstan. With respect to GDP per capita, there are considerable
discrepancies between the country with the lowest GDP per capita and the highest. The country with the highest GDP has around 40 times the amount of the country with the lowest GDP per capita. Once again, the countries with the lowest level of GDP per capita are the post-Soviet countries, and the Central and Eastern European economies show the highest levels of GDP per capita. It is also worth noting that the growth of these countries has been rapid from 2001 to 2010, slowing down in final years once again because of the impending financial crisis.
Table 1: Descriptive statistics
6.2 Regression results
In the table below the regression results are presented. The regression uses the data for 16 countries that remained after dropping the countries with no or insufficient data. A problem with performing research on transitional economies is that data is often lacking because of data collection issues. In this case, 8 countries were dropped after a lack of observations, primarily the ex-Soviet states. In order to conserve observations data tweaking was used if for example, 2006 and 2008 had data, but 2007 did not. In that case, 2007 was calculated as being an average of 2006 and 2008. A random effects regression was ran. A Hausman test was used in order to decide between a fixed effects model or a random effects model. The Hausman test came out insignificant, so a random effects model was chosen. The Hausman test can be found in the Appendix. Additionally, as a robustness check a fixed-effects regression was ran. No significant discrepancies were found. Lastly, a check for multicollinearity is performed. An average VIF of 5 is found, which is far below the boundary of 10 when multicollinearity can form a problem. The first hypothesis is rejected. A significant result is found for the main independent variable of entrepreneurship at the 1 percent significance level. However, the coefficient is slightly negative, contrary to expectations. This result is contrary
(1 (2) (3) (4) (5)
VARIABLES N mean sd min max
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to the expectation that entrepreneurial activity has a positive effect on economic growth. Support is found for hypothesis 2a. Significant positive results at the 1 percent level are found for the variable that interacts entrepreneurial activity with the political institutional environment. In countries with better political institutions the effect of entrepreneurial activity on negative economic growth is stronger. Hypothesis 2b and 2c are rejected. There is no evidence found that a better economical or legal institutional environment strengthens the effects of entrepreneurial activity on economic growth. Additionally, significant results are found for the institutional indicators of the political and economic environment. The political institutional indicator is significant and positive at the 5 percent level, and the economic institutional indicator shows significance at the 10 percent level and is strongly positive. Although this is beyond the scope of this study it confirms the overall findings within the literature that institutions matter for economic growth.
Table 2: Random-effects regressions
(1) (2) (3)
VARIABLES Only CV No interaction Interaction
centered_tea -0.519*** (0.159) centered_legal -11.53 (7.672) centered_political 26.85** (11.65) centered_economic 12.16* (6.266) interactionTEAeconomic -0.433 (1.300) interactionTEAlegal -1.311 (1.182) interactionTEApolitical 4.470*** (1.686) GDPPC -0.000164 0.000127 0.000216 (0.000241) (0.000205) (0.000177) legal_abs -14.83** (7.329) political_abs 27.24** (13.13) economic_abs 13.13** (6.558) TEA -0.378** (0.183) Constant 4.307*** -2.902 10.59*** (0.833) (4.556) (2.213) Observations 160 160 160 Number of CountryID 16 16 16
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Year RE YES YES YES
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
7. Discussion
Research on entrepreneurship and its relationship with economic growth has always been complex. The biggest challenge that needed to be overcome was the measurement of the abstract variable ‘’entrepreneurship’’. With the Global Entrepreneurship Monitor project an important step has been taken in order to conceptualize entrepreneurship. In this paper this database has been used in order to find out if the use of this variable accurately can capture the impact of entrepreneurial activity on national economic growth. The first hypothesis investigated if a higher degree of entrepreneurial activity in fact leads to enhanced economic performance and a faster rate of economic growth. This hypothesis was rejected, instead a negative coefficient was found. These implies that
entrepreneurial activity has a slightly negative effect on economic growth. The three following hypotheses measured if the three dimensions of the institutional environment have a moderating effect on the relationship between entrepreneurial activity and economic growth. H2a was the only hypothesis accepted. Only the political environment moderates the relationship between economic growth and entrepreneurial activity. The sign was strongly positive, in this case this applies that the negative relationship between entrepreneurial activity and economic growth is stronger in
environments characterized by a stronger political institutional environment.
This study attempted to replicate the Van Stel et al., (2005) study but over a longer time period as well as having a different sample of countries. They found that entrepreneurship matters, but it depends on the level of development of the country. Entrepreneurship was shown to have a negative effect in developing countries, no effect in the sample of 5 transitional economies used, and positive effects in countries with a GDP per capita over $20.000. In the sample of transitional economies that they use primarily countries from Central and Eastern Europe are involved, which show higher levels of GDP per capita while this analysis includes countries with extremely low levels of GDP per capita such as Macedonia, Georgia and Kazakhstan.
This study is in line with the results of Van Stel et al., (2005). No countries with the exception of Slovenia and Czech Republic in the sample used even reach the threshold of a GDP per capita over $20.000. It is therefore not very surprising that negative results are found for entrepreneurial activity. Additionally, the sample used includes the years of the global financial crisis that erupted in 2008 and affected economic growth figures for years to come. The results found might be affected by this largely exogenous shock as well. With respect to the institutional environment it shows that entrepreneurial activity affects growth differently depending on the environment. Economic growth is more negative in countries sporting higher political institutional quality. The probable rationale for this result is that countries with higher political institutional quality are generally higher up in the development stage, and as theorized in the research methodology, more developed economies generally grow less than developing economies because of the catch-up effect. Furthermore it confirms what’s within the literature that institutions matter for economic growth.
This study finds slightly negative results for entrepreneurial activity and economic growth, and even stronger negative effects in countries with strong political institutions. However, does this mean that policymakers should stop encouraging and promoting entrepreneurship? The answer to this
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transitional economies where entrepreneurial traditions do not have a long history it might take time for the positive effects to take place. There might still be core rigidities and path dependencies in place that obstruct entrepreneurial success. This makes it difficult to look at a one-to-one correlation of entrepreneurship and economic growth on a short-term basis. Therefore it will probably take longer in these countries for the potential benefits of entrepreneurship to trickle through. The tradition of entrepreneurship within these economies is still very young and in most cases only emerged after the fall of the Soviet-Union. Many of these economies did not or only scarcely have role models such as Bill Gates, Steve Jobs, or Henry Ford that had a motivating and inspiring effect on the entrepreneurial ambitions of many. Without an entrepreneurial atmosphere and inspiring role models the effects of entrepreneurial activity actively supporting economic growth might hampered or not fully realizing its potential.
Another potential problem impeding entrepreneurship and its potential success is the bureaucracy and corruption which still run rampant in these countries. Evidence comes from the Corruption Perceptions Index 2014 published by Transparency International. The best ranked country is Estonia at rank 26. Most of the countries studied in this paper do not make the top 50 least corrupt countries, but especially the post-Soviet states show up in the bottom half of the ranking. As earlier proclaimed in the literature review, corruption still is very prominently embedded within the economy and continues to hamper entrepreneurial activity by reducing incentives.
8. Conclusion
The link between entrepreneurial activity and economic growth has always been ambiguous within the literature. Entrepreneurs create jobs, perform innovations, generate competition and can increase total factor productivity(TFP). Still, the empirical relationship has never been clear cut.
Additionally, this paper attempted to deepen comprehension on how institutional environments matter for entrepreneurial activity and subsequent economic growth. Within the transitional
economies these institutions are especially interesting since they needed to be founded from scratch. Systems that are especially important for entrepreneurial activity such as the protection of property rights, enforcement of legal contracts, and a system that distributes financial capital are were poorly developed or even absent in the socialist times. Institutions are incredibly important in shaping entrepreneurial activity. Entrepreneurial activity can either be constrained or stimulated by a well-developed institutional environment. A poor system for the protection of property rights will discourage entrepreneurs from starting up a business since their ideas lack the protection. The same goes for a weak legal system. If entrepreneurs cannot trust the legal system to enforce the rules, it will have a hampering effect on entrepreneurial activity. This study attempted to incorporate the institutional environment in order to assess the effects of entrepreneurial activity on economic growth in 16 transitional economies.
The answer to the research question is that entrepreneurship does not have a positive effect on economic growth in the transitional economies. A better political institutional environment
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capita lower than $20.000. The effect of entrepreneurial activity on economic growth also depends on the nature of the institutional environment. Negative economic growth is stronger in countries with stronger political economic institutions. This can primarily be attributed to the fact that countries that have better political institutions are more developed, and therefore grow less, courtesy of the neoclassical growth model by Solow. Hypothesis 2a therefore can be accepted, while hypothesis 2b and 2c are rejected. Lastly, strong and significant effects are found that
economic and political institutions stimulate economic growth. This confirms consensus within the literature that institutions matter.
The implications are as follows. Even though entrepreneurial activity seems to have a negative effect on economic growth, it does not automatically mean that policymakers should stop pursuing and stimulating people to be entrepreneurial. The transitional economies do not have a long history of entrepreneurship and policymakers might not be affluent and knowledgeable about knowing which policies to pursue to stimulate entrepreneurship. The policy implications are then that these countries should focus on improving their institutions, eliminating corruption and bureaucracy and administrative difficulties in establishing businesses. This bolsters economic growth, creates a more favorable environment for potential investors, and fosters a better atmosphere for entrepreneurs. Perhaps policymakers could take lessons from other countries transitioning from an essentially entrepreneurless society to a flourishing breeding ground for entrepreneurs such as China or Eastern Germany.
8.1 Limitations
This paper has several limitations. The first limitation is the fact that data was not available for all transitional economies. Around a third of the countries was dropped since the GEM did not have data available for all countries. Countries such as Bulgaria, Moldova, and Ukraine lacked
observations. Additionally, only three countries from the Commonwealth of Independent States found their place in the sample used. This makes this study more relevant for the countries in Central and Eastern Europe than that it provides a true analysis about the transitional economies as a whole. A methodological issue within the paper is that in some cases data for specific years was lacking. In order not to drop too many observations data tweaking was used. If only data was available from 2004, 2001 through 2003 took the values of 2004. This is on the basis that the values for TEA are a structural characteristic of the economy, and that they are hardly affected by change. Another limitation of the paper is a problem of reverse causality concerning the relationship
between institutions and economic growth. As Acemoglu & Johnson (2003) proclaim, institutions are deemed to be endogenous. It is not exactly clear from the model if a higher quality of
institutions stimulate economic growth, or if increased economic growth leads to improved
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