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Why Institutions are Essential to Entrepreneurship

Article at a glance

• The gradual emergence of economic institutionsencouragedimpersonal,long-distancetradetoflourish.

• Entrepreneurship will flourish only in economieswhereinstitutionsreducetransactioncosts,protectproperty and individuals from private theft andstate confiscation, and encourage innovation andrisktaking.

• Without strong institutions, markets andentrepreneurship will not flourish and long-rungrowthwillsuffer.

February 28, 2013

Mary M. ShirleyPresident

Ronald Coase Institute

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Introduction

An economy that is performing well at oneparticular point in time may be outperformedin the long-run by an apparent laggard, if thatlagging economy proves better able to takeadvantageofchangingcircumstances(Schumpeter,1942). What determines which economy lags orprospers? The answer, according to Schumpeter,is entrepreneurship: the constant creation of newgoods,newmarkets,newmethodsofproduction,andnewwaysoforganizing.Andwhatdetermineswhether entrepreneurship flourishes?The answer,I submit, is institutions, institutions that nourishratherthanstifleinnovationandchange,aswecanseeinthehistoryofthemodernmarketeconomy.

TodaywetakeitforgrantedthatindevelopedcountriesliketheUnitedStateswecanusuallybuyacarfromadealer,anapplefromthesupermarket,goods over the Internet, or investments in thestockmarketwithoutourmoneybeingstolen.Butwhenwemakethese impersonalexchangeswearerelyingonahostofinstitutionsofrelativelyrecentvintage to protect our interests. For centuriesmost exchanges were eyeball to eyeball, or elserestricted just to people you knew or someonethatyour family, church,neighborhood,guild,orcommercialnetworkknew.Tradingwithstrangerswasrisky,becausestrangerscouldnotbetrustedandthere were no low-cost ways to enforce bargains.Trading over distances and time was even riskierbecause of the ever-present threats of theft andviolence – consider the medieval etchings of themerchantandhisgoodssurroundedbyhisprivatearmy or flotilla.Costly risks limitedmarkets andstifled entrepreneurship.Although thebazaar stillexistsandnetworksarestillimportant,thegradualemergence of institutions that reduce transactioncosts and protect property rights encouragedimpersonal,long-distancetradetoflourish.

Functions of Institutions

What institutions allowed the global marketto develop? Some institutions were developedand enforced by traders themselves, including

commercialnorms,writtencodesofconduct,andother rulesdesigned to fostergoodbehavior;billsof lading, contracts, andotherways todocumentdeals; and business associations, trade fairs, andsimilar ways to share information on reputationand certify standards. Business organizationsbegan to have lives, legal status, and reputationsthat extended beyond those of the individualownersoremployees,furtherreducingtherisksofexchange.Theseinstitutionsandorganizationsnotonly protected property, they reduced transactioncosts.Transaction costs are the costs of finding abuyerorseller,gettingandprovidinginformation,strikingabargain,monitoringtheterms,enforcingthe bargain, and punishing those who cheat.Without institutions to control transaction costsdevelopment would be stunted, since when “thecosts of making an exchange are greater thanthe gains which that exchange would bring, thatexchange would not take place.” (Coase, 1992,p.197).

But businesses alone could only do so much.Marketsbasedon impersonal exchange flourishedonly when institutions began to be enforcedby a third party wielding power – the state.Thestate put teeth into themerchants’ rules of goodbehavior and then went further, enacting lawsthat governed commercial behavior, adjudicatingcontracts, containing civil strife and theft, andprotecting property rights and individual rights.The state, with its monopoly over the means ofviolence and treaties with other states, expandedthesafeenvironmentforproductionandtrade.

State enforcement was crucial to theexpansion of impersonal exchange, but it alsocreated a conundrum. A state strong enough toprotect property, trade, and individuals was alsopowerfulenoughtoexploit them.Moreover, stateactors were interested individuals, motivated toenhance their own and their cronies’ wealth atthe expense of others.How could state actors beencouraged to control their own grasping hands?How could investors know whether to trust thestate’scommitments?

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Again the answer was institutions, specificallyinstitutions to constrain the state’s ability toconfiscate property or returns (Shirley, 2008).These institutions include elections and otherpeacefulmeansofchanginggovernment,rightsoffreeassemblyandprotest,normsofcivicbehavior,rules of transparency and disclosure, individualand corporate rights to sue the state and to becompensated for seizures, an independent legalsystem, and independent mass media. They alsoincluded federalism, which protects rights whendifferent jurisdictions compete with one anotherfor investment and residents by offering a betterbusiness environment and decentralization, orwhendifferentbranchesand levelsofgovernmentactaschecksonarbitraryorcapriciousbehaviorbyotherbranchesorlevels.

Open Access Societies

These constraining institutions – elections,civicrights, legalpowers,andfederalism–canbefoundinsomeforminalmosteverycountryintheworld today. You might then ask why businessesandmarketsinsomeofthosecountriesarestillsoweak?The answer is that inmostpoor countries,these constraining institutions exist in formonly.Business,politics, and societyaredominatedbyafewpowerfuleliteswhousethepowerofthestateto favor their narrow interests and either overtlyexclude the majority of citizens from access tosourcesofpowerandwealthormakeittoocostlyfor them to try to get access (North,Wallis, andWeingast,2009).Constraintsonthestatefunctioneffectivelyinpracticeonlyinthefewmostdevelopedcountries,whichNorth,Wallis,andWeingastcall“openaccesssocieties.”Asthenameimplies,openaccess societies allow relatively free entry intopolitics,religion,education,andbusiness.Citizenswho are not powerful or rich can create differentkinds of organizations, from political parties tocorporations to social clubs, at relatively lowtransaction costs. Non-elite property is protectedbythestate inthesamewaythateliteproperty isprotected.Citizensofopenaccesssocietieshavethe

meansandmotivationtoprotecttheirinstitutionsfrom being captured by elites because they haveaccesstoeducation,media,thefranchise,andothertoolsofcivicengagementandvoice.

Openaccesssocietiesarenotthenorm,however.The vastmajority of people live in limited accesssocieties, where only elite groups have the powerand the means to create new businesses or otherorganizations, only elites benefit from the rule oflaw,andonlybusinesseswith ties to thepowerfulprosper. Entrepreneurs who try to challenge thestatus quo are co-opted, squelched, or thwartedby the costs of competing with privileged elite-dominated business. This is not to imply thatthere are no threats to entrepreneurship in openaccess economies. Unbridled monopoly power,costly and bureaucratic procedures for registeringnewbusinesses,excessiveprotectionofintellectualproperty, and other restrictions on entry cancripple entrepreneurship anywhere. Open accesseconomies have more self-correcting mechanismsthat allow two guys in a garage to start a hugelysuccessfulbusinessandallowthemarkettopunishthebusinesswhenitlosesitscreativeedge.

The China Puzzle

This history of the development of themodern market economy and open accesssocietiesarguesthatwithoutstronginstitutionstoreduce transaction costs, protect individuals andproperty, and allow entry by non-elites, marketsand entrepreneurship will not flourish and long-rungrowthwill suffer.Yet someobservers lookat

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What determines whether entrepreneurship flourishes? Institutions that nourish rather than stifle innovation and change.

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China and conclude the opposite: institutionssuch as property rights, constraints on thestate, and rule of law in general must notmatter to business development because Chinahas managed spectacular growth without thosevery institutions. But that conclusionmisreadsChina’s recent history. Under Mao, the statearrested and executed private entrepreneurs.After 1978, the safety of proprietors (if not ofproperty)wascomparativelysecure;thisinturnaccelerated business development even thoughconstitutional protection of private propertyrightswasonlyenactedin2004(Huang2012).Another key ingredient in China’s economicgrowthwasmarketcompetition.Thetransferofcontrolrightstoprivateactors,eventhoughtheserightswerenottradable,stimulatedproductivityand growth because these private actors weresubjecttothedisciplineofthemarket(CoaseandWang, 2012). Moreover, China did have someof the institutionsnecessary forentrepreneurialdevelopment but in different guises.Accordingto Xu (2011), subnational governments playeda significant role in law-making and lawenforcement. Competition among these localauthorities, who were promoted and rewardedbasedoneconomicgrowth,encouragedthemtoprotect private entrepreneurs during the earlyyearsof reformas longas the entrepreneurwassuccessfulinthecompetitivemarket.

Finally,weshouldnotforgetthatChinastartedfrom a very low base and therefore part of itsaccelerated growth has been “catching up”. ZhuestimatesthatChina’stotalfactorproductivityrosefrom 3 percent of U.S. total factor productivityin 1978 to 13 percent in 2007 (JEP p.121), adramaticgainbutstillalongwayfrompar.Manyobservers question whether China can continueto catch up with open access societies without amore independent judiciary, greater governmentaccountability, and an open market for ideas.Without institutional constraints on the state’sgraspinghands,businessdevelopmentwillbegintoflag;someseesignsofthisalready.Intheabsenceof institutional protections, investors in Chinaincreasingly rely on ties to state-owned firms or

powerfulleadersintheCommunistParty,shownbytheriseoftheso-calledprincelingsintodominantbusinesspositions.

I have argued that entrepreneurship willflourish only in economies where institutionsreduce transaction costs, protect propertyand individuals from private theft and stateconfiscation, and encourage innovation and risktaking. Economies without these institutionsmaytemporarilysurgeahead,but,asSchumpeterpredicts,willeventuallyflag.Entrepreneurshipisnot a luxury good, but a fundamental driver oflong-runeconomicperformance.

References

Coase,Ronald.1992.“TheEconomicStructureof Production.” American Economic Review.82(September),713-19.

Coase, Ronald and Ning Wang 2012. How China Became Capitalist. New York: PalgraveMacmillian.

Huang,Yasheng.2012.“HowDidChinaTakeOff?” Journal of Economic Perspectives. Vol 26(4)Fall,147-167.

North,DouglassC., JohnJ.Wallis, andBarryR. Weingast. 2009. Violence and Social Order: A Conceptual Framework for Interpreting Recorded Human History. NewYork:CambridgeUniversityPress.

Shirley, Mary M. 2008. Institutions and Development. Cheltenham, UK and Brookfield,VT,US:EdwardElgar.

Schumpeter, Joseph A. 1942. Capitalism, Socialism and Democracy. New York: Harper andBrothers.

Xu, Chenggang. 2011. “The FundamentalInstitutionsofChina’sReformsandDevelopment.”Journal of Economic Literature. Vol XLIX(4)December,1076-1151.

Zhu,Xiaodong.2012.“UnderstandingChina’s

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Center for International Private EnterpriseWhy Institutions are Essential to Entrepreneurship

Growth: Past, Present, and Future.” Journal of Economic Perspectives.Vol26(4)Fall,103-124.

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Mary Shirley is a founder and the President of the Ronald Coase Institute. She has a PhD in economics and has worked for over 30 years in development, including over 20 years as a research manager in the World Bank. She is the author of numerous scholarly articles and books on institutional issues in economic development, including Institutions andDevelopment (republished in paperback in 2009) and co-editor of the HandbookforNewInstitutionalEconomics (republished in paperback, 2008). She has published in, among others, JournalofBankingand Finance, Journal ofComparative Economics, Journal of Institutional Economics, Journal ofLaw, Economics and Organization, World BankEconomicReview, WorldBankResearchObserver, and World Development. She is a founder, board member, and past President of the International Society for New Institutional Economics (ISNIE). She is co-editor of New Institutional Economics, an e-journal of SSRN. Her research interests include institutions and development, foreign aid, regulation, water system reform, and privatization.

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