Why Institutions are Essential to Entrepreneurship

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An economy that is performing well at one particular point in time may be outperformed in the long-run by an apparent laggard, if that lagging economy proves better able to take advantage of changing circumstances 1. What determines which economy lags or prospers? The answer, according to Schumpeter, is entrepreneurship: the constant creation of new goods, new markets, new methods of production, and new ways of organizing. And what determines whether entrepreneurship flourishes? The answer, I submit, is institutions: institutions that nourish rather than stifle innovation and change, as we can see in the history of the modern market economy.

Today we take it for granted that in developed countries like the United States we can usually buy a car from a dealer, an apple from the supermarket, goods over the Internet, or investments in the stock market without our money being stolen. But when we make these impersonal exchanges we are relying on a host of institutions of relatively recent vintage to protect our interests. For centuries most exchanges were eyeball to eyeball, or else restricted just to people you knew or someone that your family, church, neighborhood, guild, or commercial network knew. Trading with strangers was risky, because strangers could not be trusted and there were no low-cost ways to enforce bargains. Trading over distances and time was even riskier because of the ever-present threats of theft and violence — consider the medieval etchings of the merchant and his goods surrounded by his private army or flotilla. Costly risks limited markets and stifled entrepreneurship. Although the bazaar still exists and networks are still important, the gradual emergence of institutions that reduce transaction costs and protect property rights encouraged impersonal, long-distance trade to flourish.

Functions of institutions

What institutions allowed the global market to develop? Some institutions were developed and enforced by traders themselves, including commercial norms, written codes of conduct, and other rules designed to foster good behavior; bills of lading, contracts, and other ways to document deals; and business associations, trade fairs, and similar ways to share information on reputation and certify standards. Business organizations began to have lives, legal status, and reputations that extended beyond those of the individual owners or employees, further reducing the risks of exchange. These institutions and organizations not only protected property, they reduced transaction costs. Transaction costs are the costs of finding a buyer or seller, getting and providing information, striking a bargain, monitoring the terms, enforcing the bargain, and punishing those who cheat. Without institutions to control transaction costs development would be stunted, since when “the costs of making an exchange are greater than the gains which that exchange would bring, that exchange would not take place.” 2.

But businesses alone could only do so much. Markets based on impersonal exchange flourished only when institutions began to be enforced by a third party wielding power: the state. The state put teeth into the merchants’ rules of good behavior and then went further, enacting laws that governed commercial behavior, adjudicating contracts, containing civil strife and theft, and protecting property rights and individual rights. The state, with its monopoly over the means of violence and treaties with other states, expanded the safe environment for production and trade.

State enforcement was crucial to the expansion of impersonal exchange, but it also created a conundrum. A state strong enough to protect property, trade, and individuals was also powerful enough to exploit them. Moreover, state actors were interested individuals, motivated to enhance their own and their cronies’ wealth at the expense of others. How could state actors be encouraged to control their own grasping hands? How could investors know whether to trust the state’s commitments?

Again the answer was institutions, specifically institutions to constrain the state’s ability to confiscate property or returns 3. These institutions include elections and other peaceful means of changing government, rights of free assembly and protest, norms of civic behavior, rules of transparency and disclosure, individual and corporate rights to sue the state and to be compensated for seizures, an independent legal system, and independent mass media. They also included federalism, which protects rights when different jurisdictions compete with one another for investment and residents by offering a better business environmentand decentralization, when different branches and levels of government act as checks on arbitrary or capricious behavior by other branches or levels.

 

Open access of societies

These constraining institutions — elections, civic rights, legal powers, and federalism -- can be found in some form in almost every country in the world today. You might then ask why businesses and markets in some of those countries are still so weak? The answer is that in most poor countries, these constraining institutions exist in form only. Business, politics, and society are dominated by a few powerful elites who use the power of the state to favor their narrow interests and either overtly exclude the majority of citizens from access to sources of power and wealth or make it too costly for them to try to get access 4. Constraints on the state function effectively in practice only in the few most developed countries, which North, Wallis, and Weingast call “open access societies.” As the name implies, open access societies allow relatively free entry into politics, religion, education, and business. Citizens who are not powerful or rich can create different kinds of organizations, from political parties to corporations to social clubs, at relatively low transaction costs. Non-elite property is protected by the state in the same way that elite property is protected. Citizens of open access societies have the means and motivation to protect their institutions from being captured by elites because they have access to education, media, the franchise, and other tools of civic engagement and voice.

Open access societies are not the norm, however. The vast majority of people live in limited access societies, where only elite groups have the power and the means to create new businesses or other organizations, only elites benefit from the rule of law, and only businesses with ties to the powerful prosper. Entrepreneurs who try to challenge the status quo are co-opted, squelched, or thwarted by the costs of competing with privileged elitedominated business. This is not to imply that there are no threats to entrepreneurship in open access economies. Unbridled monopoly power, costly and bureaucratic procedures for registering new businesses, excessive protection of intellectual property, and other restrictions on entry can cripple entrepreneurship anywhere. Open access economies have more self-correcting mechanisms that allow two guys in a garage to start a hugely successful business and allow the market to punish the business when it loses its creative edge.

The China puzzle

This history of the development of the modern market economy and open access societies argues that without strong institutions to reduce transaction costs, protect individuals and property, and allow entry by non-elites, markets and entrepreneurship will not flourish and long-run growth will suffer. Yet some observers look at China and conclude the opposite: institutions such as property rights, constraints on the state, and rule of law in general must not matter to business development because China has managed spectacular growth without those very institutions. But that conclusion misreads China’s recent history. Under Mao, the state arrested and executed private entrepreneurs. After 1978, the safety of proprietors (if not of property) was comparatively secure; this in turn accelerated business development even though constitutional protection of private property rights was only enacted in 2004 5. Another key ingredient in China’s economic growth was market competition. The transfer of control rights to private actors, even though these rights were not tradable, stimulated productivity and growth because these private actors were subject to the discipline of the market 6. Moreover, China did have some of the institutions necessary for entrepreneurial development but in different guises. According to Xu, subnational governments played a significant role in law-making and law enforcement 7. Competition among these local authorities, who were promoted and rewarded based on economic growth, encouraged them to protect private entrepreneurs during the early years of reform as long as the entrepreneur was successful in the competitive market.

Finally, we should not forget that China started from a very low base and therefore part of its accelerated growth has been “catching up.” Zhu estimates that China’s total factor productivity rose from 3 percent of U.S. total factor productivity in 1978 to 13 percent in 2007 8, a dramatic gain but still a long way from par. Many observers question whether China can continue to catch up with open access societies without a more independent judiciary, greater government accountability, and an open market for ideas. Without institutional constraints on the state’s grasping hands, business development will begin to flag; some see signs of this already. In the absence of institutional protections, investors in China increasingly rely on ties to state-owned firms or powerful leaders in the Communist Party, shown by the rise of the so-called princelings into dominant business positions.

I have argued that entrepreneurship will flourish only in economies where institutions reduce transaction costs, protect property and individuals from private theft and state confiscation, and encourage innovation and risk taking. Economies without these institutions may temporarily surge ahead, but, as Schumpeter predicts, will eventually flag. Entrepreneurship is not a luxury good, but a fundamental driver of long-run economic performance.

Mary Shirley is President of the Ronald Coase Institute.

Endnotes

1 Joseph A. Schumpeter, “Capitalism, Socialism and Democracy”, Harper and Brothers, 1942.

2Ronald Coase, "The Economic Structure of Production", American Economic Review, 1992.

3Mary Shirley, "Institutions and Development", Edward Elgar, 2008.

4Douglas C. North, John J. Wallis, and Barry R. Weingast, "Violence and Social Order: A Conceptual Framework for Interpreting Recorded Human History", Cambridge University Press, 2009.

5Yasheng Huang, "How Did China Take Off?", Journal of Economic Perspectives, 2012.

6Ronald Coase and Ning Wang, "How China Became Capitalist", Palgrave Macmillian, 2012.

7Chenggang Xu, "The Fundamental Institutions of China's Reforms and Development", Journal of Economic Literature, 2011.

8Xiadong Zhu, "Understanding China's Growth: Past, Present, and Future", Journal of Economic Perspectives, 2012.

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