acs (2009) entrepreneurship in developing countries

8/7/2019 Acs (2009) Entrepreneurship in Developing Countries

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Foundations and Trends R inEntrepreneurshipVol. 6, No. 1 (2010) 168c 2010 Z. Acs and N. Virgill

DOI: 10.1561/0300000031

Entrepreneurship in Developing Countries

By Zoltan Acs and Nicola Virgill

Contents

1 Introduction 2

2 The Evolution of Development Policy 5

2.1 Colonial Origins of Development Policy 72.2 Import Substitution 92.3 Outward Orientation 14

3 Entrepreneurship and Development 20

3.1 Why is Entrepreneurship Important for Development? 203.2 The Entrepreneur in Economic Theory 223.3 What Does Entrepreneurship Look Like in Developing

Countries? 253.4 An Externalities-based Framework 27

4 New Policy for Entrepreneurshipin Developing Countries 47

4.1 Demonstration Externalities 474.2 Knowledge and Information Externalities 514.3 Network Externalities 53


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5 Conclusion 55

References 58


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Foundations and Trends R inEntrepreneurshipVol. 6, No. 1 (2010) 168c 2010 Z. Acs and N. Virgill

DOI: 10.1561/0300000031

Entrepreneurship in Developing Countries

Zoltan Acs 1 and Nicola Virgill 2

1 School of Public Policy, George Mason University, Fairfax, VA, [email protected]

2 School of Public Policy, George Mason University, Fairfax, VA, [email protected]

Abstract

This study offers that entrepreneurship is consistent with and even com-plementary to the older and more traditional development strategies.We survey the literature on entrepreneurship in developing countrieswhich, admittedly, is wide and covers a range of issues from cultureand values; institutional barriers such as nancial sector development,governance, and property rights; and to the adequacy of education andtechnical skills. A broad literature has also developed on foreign directinvestment and its positive and negative effects on technology transferand entrepreneurship. After the collapse of the Soviet Union, a numberof studies examined the development of small- and medium-sized enter-prises in transition economies. As these economies moved from central-ized economies to market economies, enterprise and entrepreneurshipbecame important. Yet, other studies examine the effects of infrastruc-tural development and the macroeconomy on entrepreneurship. With

such a wide scope of issues, a framework for synthesizing the literatureis needed. This study offers that the identication of the externalitieswhich affect entrepreneurship provides a useful framework to examinethe literature on entrepreneurship in developing countries.


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1Introduction

Between 1945 and 1980 nearly 100 colonies in Africa, Asia, and theCaribbean gained their independence and began the process of initi-ating a development strategy for their citizens. Sadly, many of thosecountries experienced neither signicant per capita growth nor eco-nomic development (Easterly, 2001, pp. 141143). Indeed, moderate

and extreme poverty remains a signicant concern for many developingcountries (Sachs, 2005, pp. 2223).

While developing countries have used a number of policies andstrategies in their development pursuits, two forms of industrial pol-icy were particularly prominent. The rst was import substitution a process of industrialization by producing previously imported goodsfor the countrys domestic market. However, by the 1980s, in the faceof economic crisis, many developing countries then turned to a secondstrategy export promotion. However, with the exception of somecountries in East Asia, neither industrial strategy has resulted in mean-ingful economic development. Both development approaches relied onstrong state intervention and persistent market distortions to sustaintheir viability thus often crowding out or thwarting altogether thetraditional and important role of the entrepreneur.

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3

Hence, after failed attempts at development through import substi-tution and infant industry protection programs and somewhat mixedresults from export promotion strategies, developing countries arebeginning to focus on their business environments and creating an eco-nomic space which is conducive to private enterprise both domestic(i.e., local entrepreneurs) and foreign (i.e., foreign direct investment).Indeed, the promotion of entrepreneurship and the promulgation of small- and medium-sized enterprise (SME) policy have become animportant development prescription in recent years (World Bank,2005). Entrepreneurship policy, then, joins a list which includes reformsto countries macroeconomic, exchange rate, trade and industrial poli-

cies, and improvements in governance (Hart, 2003).Both national governments and the major international organiza-

tions, as part of their poverty reduction, growth, and economic develop-ment programs, are beginning to focus on improving countries businessand investment environments for entrepreneurship. The World Bankand United Nations Industrial Development Organization (UNIDO),for example, have each established units to promote private sectordevelopment in developing countries and to provide technical assistancein the formulation of SME and entrepreneurship policy. In 2003, theWorld Bank began an initiative to measure and rank countries businesssectors and investment environments (World Bank, 2005). Additionally,a number of developing countries have recently drafted SME legisla-tion and launched programs to assist small businesses and domesticentrepreneurs.

While a focus on entrepreneurship for development may appear tobe a separate approach to development, this study offers that it is con-sistent with and even complementary to the older and more traditionaldevelopment strategies. We survey the literature on entrepreneurshipin developing countries which, admittedly, is wide and covers a range of issues from culture and values; institutional barriers such as nancialsector development, governance and property rights; to the adequacy of education and technical skills. A broad literature has also developed onforeign direct investment and its positive and negative effects on tech-nology transfer and entrepreneurship. After the collapse of the SovietUnion, a number of studies examined the development of small- and


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4 Introduction

medium-sized enterprises in transition economies. As these economiesmoved from centralized economies to market economies, enterpriseand entrepreneurship became important (Acs and Audretsch, 1993).Yet, other studies examine the effects of infrastructural developmentand the macroeconomy on entrepreneurship. With such a wide scopeof issues, a framework for synthesizing the literature is needed. Thisstudy offers that the identication of the externalities which affectentrepreneurship provides a useful framework to examine the literatureon entrepreneurship in developing countries (Audretsch et al., 2006).These externalities have resulted from and have become embedded incountries institutions and help to explain the level of entrepreneurship

in an economy.This survey proceeds as follows. First, we examine the evolution

of development policy beginning with the colonial period and theimmediate post-colonial era. In both of these periods there was stronggovernment intervention and a heavy emphasis on government plan-ning for development. An important cornerstone of the post-colonialperiod was the use of import substitution programs. Import substitu-tion was an attempt by developing countries to industrialize by pro-ducing goods which had been traditionally imported. Second, withthe failure of import substitution, many developing countries thenswitched to outward-oriented strategies, beginning with many of theAsian economies. Again, export promotion relied on strong governmentintervention.

Third, we set out a framework to explore the literature onentrepreneurship in developing countries based on the existence of net-work, knowledge and demonstration, and failure externalities. Each of these types of externalities is discussed in greater detail in the fol-lowing sections. Fourth, this review identies the core policy issuesto address these externalities. Internalizing these externalities, it isargued, by nding mechanisms to reward and encourage the rms andpeople which produce them, should increase the level of productiveentrepreneurship in developing countries.


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2The Evolution of Development Policy

The search for policies to bring about both growth and developmenthas been the focus of economic discovery since the very beginning of the science. While economic growth relates to the expansion of aneconomy based on its current structure, economic development impliesa process of structural transformations leading to an overall higher

growth trajectory (Brinkman, 1995, p. 1183). Lewis (1984, p. 3), in anessay outlining the importance of development economics, points to atleast 14 formal development models, including two-sector and unbal-anced growth, technology-based and surplus labor models which havebeen used since the 1950s to account for economic stagnation and theabysmal development trends of many less developed countries (LCDs).Harris and Todaro (1970, p. 126), in their two-sector model of economicgrowth, show that labor is induced to move from the rural (agriculture)sector to the urban (industrial) sector based on the higher expectedearnings in the modern sector. Wages in the modern sector are usuallyhigher, not necessarily only because of higher productivity (i.e., in theusual case where wage is equal to the marginal product of labor) butalso because of the imposition of social policies such as a minimum wage(Harris and Todaro, 1970, p. 129). While governments may attempt to

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6 The Evolution of Development Policy

control the growing unemployment problems in the cities caused by theexcessive migration by either increasing employment in the public sec-tor (Harris and Todaro, 1970, p. 132) or by imposing direct restrictionson the movement of labor to the urban sector (Harris and Todaro, 1970,p. 135), economic development through industrialization can only besustained by concurrent investments and productivity improvements inthe agricultural sector (Fei and Ranis, 1969, pp. 386400). Continuousinvestments in the agricultural sector during the development processare also important so as to achieve a more balanced development(Johnston and Mellor, 1961, pp. 566593).

Other studies have tried to distill patterns of economic growth. Ros-

tow, for example, outlined the stages of economic growth (Rostow,1959, pp. 45). In this model, nations, beginning from a traditionalsociety stage, pass through at least three additional stages of devel-opment: the pre take-off stage; the take-off stage; and then to matu-rity. The development process occurs as technology, transportation andtrade deepen and improve and as societies evolve to become more tol-erant of change (Rostow, 1959, pp. 45). These changes gave rise totensions which emerge because of the institutional and ideologicaladjustments which were necessary to facilitate economic development(Kuznets, 1973, pp. 247, 253). There are societal conicts as industri-alists and the skills they possess gain more inuence and importanceover the agricultural sector and as workers migrate from rural to urbanareas during the transition from the traditional to the mature economy(Kuznets, 1973, pp. 251254). In the take-off stage, the economy couldbe characterized as resilient such that,

. . . the corps of entrepreneurs and technicians must beenlarged, and the sources of capital must be institution-alized in such a ways as to permit the economy to sufferstructural shocks; to redispose its investment resources;and to resume growth (Rostow, 1959, p. 7).

Finally, in mature economies, there is a process of innovation and dis-placement ( a la Schumpeter) within the industrial sector leading to adynamic growth process (Rostow, 1959, p. 8).


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2.1 Colonial Origins of Development Policy 7

A nal set of studies have tried to determine the variables whichaffect the growth and development. Lewis (1965, pp. 116), for example,identied capital formation through national savings, foreign invest-ment, or foreign aid; policies which encourage entrepreneurship andskill development; the increase in international trade; and the intro-duction of market distortions through social policy as important factorswhich affect economic development. Indeed, these factors are consistentwith the set of policies which came to be known as the Washing-ton Consensus in the late 1980s. However, the Washington Consensusalso includes measures to address scal discipline and a range of lib-eralization measures for capital ows, trade policy, and interest rates

(Williamson, 2000, pp. 251264).

2.1 Colonial Origins of Development Policy

Notwithstanding the formal theories of development discussed earlierin this review, it is important to remember that a countrys develop-ment policy does not emerge in a vacuum and therefore a review of pre-independence development policy is essential. The colonial periodsin Africa, Latin America, the Caribbean, and Asia, generally estab-lished a centerperiphery economic system of state-led extraction andprimary production for export with little benets accruing to the col-onized populations (Prebisch, 1959, p. 251). Storr (2002) nds that,

That colonialism on net beneted the colonized is amyth. A myth that has roots in the same logic thatwas used to justify colonialism in the rst place andthat has legs only because of the existing poverty of information about the extent of development the rstcolonialist encountered. Colonialism, it should not beforgotten, was conquest economic, social, political,religious and cultural conquest that was attended

by the destruction of whole societies, the enslavement,dislocation and/or disenfranchisement of millions, thetheft of land and the pirating of resources (p. 11).


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International trade, based on extraction and forced production, wasone of the driving forces behind colonization (Resnick, 1975, p. 319).It is, therefore, not surprising that trade policy features prominentlyin any discussion of the colonial period. Another important aspect of the period was the development of large state bureaucracies to man-age colonial production and trade. Acemoglu et al. (2001, p. 1375) forexample, offer that, the Spanish crown. . . . set up a complex mercan-tilist system of monopolies and trade regulations to extract resourcesfrom the colonies. Similar controls were placed on African coloniesby the French, British, Belgian, and Dutch (Acemoglu et al., 2001,p. 1375). In the Belgian Congo, tax rates on Africans . . . approached

60 percent of their incomes during the 1920s and 1930s (Acemogluet al., 2001, p. 1375) in order to compel Africans to provide their laboron the colonial plantations. In South East Asia, the centralizationof taxation was an important focus of colonial policy to fund the largeinfrastructure projects which were needed to support the productionand export of agricultural goods (Booth, 2007); however, with this pol-icy also came a burgeoning of the public sector (Booth, 2007). In Kenya,because of a complex licensing system, African farmers were generallyprevented from competing with colonial coffee exporters (Fahnbulleh,2006, p. 35). Additionally, some colonial industrialists were granted theright to exist as monopolies further reducing competition in the localmarkets (Fahnbulleh, 2006, p. 34).

These colonial institutions were found to continue well after the endof the colonial period (Acemoglu et al., 2001, p. 1376). The longevity of colonial institutions could be related to the high nancial and oppor-tunity costs of changing them and whether there was a potential forthe large gains associated with these systems to be appropriated by thenew ruling elite (Acemoglu et al., 2001, p. 1376). Fahnbulleh (2006)concluded that,

The colonial economy not only created a weak socio-economic base from which post-independence statescould launch their development projects, but it alsosowed the roots of socio-economic problems that wouldprove decisive in shaping the patterns of developmentafter Independence (p. 35).


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2.2 Import Substitution 9

Colonial economic policies, therefore, set an important platform for theeconomic policies which followed in many developing countries.

2.2 Import Substitution

A primary goal of developing countries immediately after independencebecame industrialization as a means to economic development . Therst major attempt at industrialization in developing countries wasthrough import substitution programs producing goods that wereimported to the local market. Prebisch (1959), a key promoter of importsubstitution, found that industrialization is an inescapable part of the

process of change accompanying a gradual improvement in per capitaincome (p. 251). Prebisch sets out a two-country model consisting of an advanced country specializing in industrial goods and a peripherycountry producing primary goods. The economy of the periphery ischaracterized by surplus labor and disguised unemployment in thetraditional sector from which the modern, industrial sector can draw itslabor (Prebisch, 1959, p. 252). Finally, the income elasticity of demandfor imported industrial goods is higher in the periphery country thanin the advanced country (Prebisch, 1959, p. 253).

The periphery economy has a choice of how to industrialize byeither increasing its production for export or for domestic consump-

tion. Import substitution was thought to be the most efficient way fordeveloping countries to achieve industrialization and income growth(Prebisch, 1959, pp. 253254). Indeed, even if a developing countrychose to increase its exports and experienced an increase in income,because of its relatively high income elasticity demand for imports,there would be a large corresponding increase in import demand. There-fore, domestic production of the imported good (i.e., import substitu-tion) would still be required (Prebisch, 1959, p. 254). Among the policyrecommendations to maintain import substitution programs were hightariffs, export taxes, and production subsidies to domestic producers(Prebisch, 1959, pp. 256257). While countries could have chosento increase exports to produce the foreign currency to import theseindustrial goods, Singer (1999) opined that industrializing developingcountries would nd it initially easier to produce for an existing andknown domestic market than for an unknown global market. (p. 911).


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Bruton (1998, p. 904) offered that import substitution was a neces-sary strategy for developing countries because these economies neededto provide protection to their new infant industries. Even morerecently, it was also generally thought that developing countries neededto produce the goods that advanced countries produced in order toavoid the poverty trap of continuously producing low-value goodswith volatile prices (Bruton, 1998, p. 905; Hausmann et al., 2006). Toachieve industrialization through import substitution, countries used anumber of market-distorting tools such as overvalued exchange ratesand policies which raised the cost of imports (Bruton, 1998, p. 908).Summing up nicely the motivation for import substitution, Bruton

(1998) states that,

To industrialize, given the existence of already indus-trialized and highly productive economies (the North),the countries of the South must protect their economiesfrom imports from the North and concentrate onputting in place new activities that will produce anarray of manufactured products currently imported(p. 904).

An analysis of the experiences of countries which pursued importsubstitution strategies reveals the absence of a space for theentrepreneur. First, it is important to examine how the questions of what to produce and for whom were answered. In market economies,these decisions are left largely to enterprises and entrepreneurs who areguided by prices and prots. However, for countries pursuing importsubstitution, there was strong government intervention. In the 1960s,for example, when Zambia pursued its import substitution program,its newly created manufacturing sector focused production on lux-ury goods which had previously been imported for the countries elite(Seidman, 1974, p. 606). In a poorly planned joint venture between the

Zambian Government and the automaker Fiat, the contracted numberof automobiles to be produced annually was almost as great as thetotal number of vehicles in Zambia at the time (Seidman, 1974, p. 607).Production under import substitution was also heavily skewed by the


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demand prole of the wealthy in Latin America (Baer, 1972, p. 108).As Baumol et al. (2006) point out,

Governments that guide their economies and attempt topick winners (rms or industries) in the process oftenget it wrong . . . the rms in the industries chosen by gov-ernments practicing state guidance may prove unableto turn their state-advantage into commercial successbecause their activities are constrained by bureaucratswith little market experience (p. 24).

Second, the guiding forces for production were quite different. Whiledistortions are a by-product of errors in market economies and pro-vide opportunities for correction by entrepreneurs, import substitutionrequired long-lasting distortions. Tariffs and other types of governmentinterventions were used to ensure that production took place in import-competing industries while also protecting those domestic manufactur-ing rms (Prebisch, 1959, p. 256). However, these policies were oftenineffective, as the tariff structure distorted price signals and actuallyprovided incentives for rms to produce the high-priced consumptiongoods, rather than desired capital goods (Steel, 1972, pp. 220221).Steel (1972) adds that,

Distortions introduced or maintained by the structure of protection and other policies. . . make prices poor indi-cators of opportunity costs, and high effective protec-tion creates prot opportunities in nal-stage industriesregardless of their social productivity (pp. 220221).

Countries which used import substitution also had to maintain inatedexchange rates to ensure that domestic manufactures could afford theneeded capital inputs (Bruton, 1998, p. 908). Indeed, as countriesswitched to the importation of capital goods, import demand actu-

ally became more inelastic as the importation of capital goods wasno longer a choice, but a necessity (Prebisch, 1959, p. 268). Krueger(1980, p. 289) points out that import substitution policies also nega-tively affected the countrys exports, especially when they include[d]


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overvalued exchange rates and quantitative restrictions on imports further reducing foreign exchange earnings. Given these severe marketdistortions which existed under import substitution regimes, it wouldhave been difficult for the entrepreneur to discover or act on sociallyoptimal opportunities.

Finally, the enormous bureaucracy which had to be constructed tosupport import substitution lent itself to the perpetuation of perma-nent inefficiencies in industry and corruption in government bothimportant barriers to productive entrepreneurship. Government poli-cies which actively encouraged new entry often led to markets withmany small and inefficient rms (Baer, 1972, p. 103). Many of these

rms were operating with excess capacity, high labor costs relative toproductivity and foreign exchange shortages which impacted their abil-ity to obtain necessary inputs resulting in further slack (Bruton,1998). The complex import licensing systems also created cripplingmismatches between the time that capital investments were actuallyrequired and the times that import licences were obtained againresulting in underutilization (Bruton, 1998, p. 914). In the case of Ghana, companies often chose suppliers based on the ability of the for-eign company to offer exible nancing options rather than the mostefficient ones (Steel, 1972, p. 218). Additionally, because of the Ghana-ian governments outright or joint ownership of many of these rmsand the high unemployment rates in the countries, factories continuedto operate even when they were inefficient for political reason (Steel,1972, p. 228). Krueger (1998) points out that import substitution,

result[ed] in a dilemma: either the number of rms pro-ducing a given good must be very small, or the size of individual plants may well be below minimum efficientsize. If the number of rms is very small, the absenceof competition results in low-quality high-cost produc-tion...(p. 1515).

The complex bureaucracy also supported corruption. For example,the import licensing process facilitated dishonest business dealings aslicence allocation decisions came to be dominated more by corrup-tion and personal favour than by evaluation of economic viability.


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(Steel, 1972, p. 222) Indeed, the complex bureaucratic systems whichhad been created to support import substitution encouraged expe-diters whose incomes were derived from facilitating the process of approvals and paperwork. (Krueger, 1993, p. 353). Additionally, thesupplier credit approval process, opened new avenues for corruption(Steel, 1972, p. 218). Haggard et al. (1991) referring to a 1962 USGovernment Accounting Office report on South Korea, found that theimport licensing system used during the countrys import-substitutionprogram, led to collusion between supplier and importer, shipment of defective merchandise, kickbacks, and overpricing. (p. 854). Given theinefficiency of the import substitution strategy and the complexity of

the bureaucracy created by import substitution, this review offers thatentrepreneurs would be more likely to engage in rent-seeking, evasiveand unproductive entrepreneurial activities rather than in sociallyproductive entrepreneurship (Baumol, 1980).

Import substitution was not successful. Indeed, the expected pro-ductivity and technology improvements and the indigenous learningprocesses needed to sustain high incomes did not emerge (Bruton,1998, pp. 919920). Baldwin (1969, p. 298) points out that the infantindustry argument for protection often fails because even when a pro-tective duty has been provided, there is no guarantee that individualentrepreneurs will undertake greater investment in acquiring techno-logical knowledge. As such, rms often operated with excess capacity,offering too much variety (Steel, 1972, p. 108). Indeed, an unintendedconsequence of import substitution programs was the existence andpersistence of inefficient industries and market distortions (Baldwin,1969, p. 298; Steel 1972). Additionally, the large bureaucracies whichhad to be created to support the import substitution programs oftenlent themselves very easily to corruption.

This discussion of the colonial and immediate post-colonial experi-ence with import substitution shows that many developing countriesmarkets became severely distorted by industrial policies. Economieswere characterized by overvalued exchange rates, import and foreignexchange controls, and large inefficient monopolies. Business regula-tions associated with the import substitution programs were often com-plex and supported the growth of corruption. As economies performed


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worse, more distortions were created, leading to Kruegers (1993,p. 352) virtuous and vicious cycle. Given these government fail-ures it is easy to see why import substitution failed to achieve mean-ingful growth for the countries which used this strategy and createdan environment which was poorly suited to promoting productiveentrepreneurship.

2.3 Outward Orientation

With the failure of import substitution and the success of the newlyindustrializing Asian countries, the conventional wisdom changed tothe promotion of exports and an acceptance of international trade asa means of development (Krugman, 1995, p. 725). International tradeis generally viewed to have positive effects on economic performance.Helleiner (1973), for example, touted the benets of not just an exportorientation, but more specically, the export of manufactures in devel-oping countries as a means to growth. Data on Asian manufacturedexports show a signicant association between exports and economicgrowth (Balassa, 1971, 1988). Krueger (1998, p. 1514) acknowledgesthat trade liberalization is . . . associated with more rapid growth thanthe nal phases of IS [import substitution] which precede it. Sachset al. (2005, pp. 22, 36) nd a signicant and positive association

between growth and the degree of trade openness.1

However, Rajan(2002, p. 133) cautions that,

trade liberalization must be accompanied by a milieu of other policies to ensure that a country is successful inintegrating more intensively with the world in a mannerthat is favorable to growth and poverty reduction.

Like import substitution, the discovery of the export promotionstrategy appeared to have occurred accidentally. Haggard et al. (1991,p. 863), for example, point to the effects of the poor harvestscombined with the expectations of devaluation and rumors of a U.S.

1 The degree of trade openness is measured by an index of factors including tariff andnon-tariff barriers, a comparison of official and non-official exchange rates, the economicsystem, and government involvement in the export sector.


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2.3 Outward Orientation 15

cutoff which could have led to food and foreign exchange shortagesmay have been the genesis of South Koreas export promotion strategyin the early 1960s. By 1965, the export promotion strategy was formal-ized within South Koreas Ministry of Commerce and Industrys ExportPromotion Subcommittee (Haggard et al., 1991, p. 865). South Koreanexport promotion policies included the establishment of subsidies andaccess to cheap credit for exporters (Haggard et al., 1991, pp. 867-867)which were tied to export targets for rms in each sector (Haggardet al., 1991, p. 866). The South Korean government also concentratedon maintaining the quality of exports and on marketing efforts to UScompanies (Haggard et al., 1991, p. 866) Comparing the successful

Asian economies with agging Asian export promoters, Amsden (1991,p. 284) reveals that in the successful East Asian economies, subsidieswere linked to concrete performance standards with respect to out-put, exports, and eventually, R&D. Glick and Moreno (1997), in theirreview of government policies used by the Asian miracle countries, alsofound that,

Government support was by and large given to rmsaccording to their success in the market place, particu-larly world markets. Somehow East Asian policymakersavoided the temptation to direct most resources to sub-

sidize loss-making rms or to benet well-connectedrent-seekers (p. 23).

Krueger (1980, p. 288) points out that the experience has been thatgrowth performance has been more satisfactory under export promo-tion strategies. Indeed, because open economies are exposed to worldprices derived from global productivity differences, domestic resourcescan be more efficiently allocated compared to countries where distorteddomestic prices are the main guide for a countrys production mix(Krueger, 1980, p. 289).

There were, however, signicant barriers to developing countries

manufactured exports. These included high levels of protection withindeveloped economies (Helleiner, 1973, p. 35), the additional transporta-tion costs associated with producing offshore (Helleiner, 1973, p. 36),and the effects of political instability on production (Helleiner, 1973,


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p. 40). Additionally, technology, training and experience in marketingtheir products to the nal markets also constituted major internalbarriers to export production for many African countries (Kinunda-Rutashobya, 2003, pp. 226227). For these reasons, it was often offeredthat foreign rms would be better suited to produce export goodsin developing countries (Helleiner, 1973, p. 27). Foreign rms wouldwish to expand production into overseas markets to access new oppor-tunities (Penrose, 1956). Additionally, Penrose (1956) offered thatfrom the perspective of the host country, foreign direct investment wasmore advantageous compared to other forms of private investment owsbecause it came with the,

Resources and experience of the parent concern, includ-ing not only managerial and technical personnel butalso that indenable advantage in its internal opera-tions which an efficient going concern usual has over anew one (p. 225).

There are also political economy considerations associated withmoving production to developing, low-income countries. However,despite the potential for political protests within developed countriesas a result of the labor dislocations, it was anticipated that this phe-nomenon the vertical integration of production across countries would be a lasting phenomenon (Helleiner, 1973, pp. 3234).

Given the importance of the outward orientation strategy, an impor-tant question became How do exports affect growth? First, exportorientation is associated with growth through its impact on foreignexchange earnings. Export orientation also generated needed foreignexchange to fund capital investments, thereby eliminating the needfor excessive government intervention as required under import sub-stitution (Krueger, 1998, p. 1516). Indeed, Keesing (1967, p. 303) hadpreviously pointed out those inward-looking strategies permit[ed] ahigh degree of government intervention compared to outward-oriented

economies. Balassa (1971, p. 180) nds that export growth is associatedwith raising national income and greater foreign exchange earnings.Dollar offers that as export companies operate in foreign currencyearning sectors, they can more readily and effectively utilize foreign


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currency debt compared to those companies which produce for thedomestic sector (Audretsch et al., 2006, p. 523). Indeed, Sachs et al.(2005, p. 55) suggests that, [t]he outward orientation of the East Asianeconomies had saved them from the developing country debt crisis thatravaged Latin America.

Export orientation is also associated with structural changes withinan economy which can have positive effects on economic development(Krueger, 1998, p. 1515). Indeed, export promotion could become a cat-alyst for these structural changes (Krueger, 1980, p. 288). Additionally,export promotion strategies allow for economies of scale in industry asproduction is targeted to a much larger market compared to production

for only the domestic market (Balassa, 1971, p. 181). Outward-orientedtrade policies also allowed for the generation of scale economies, with-out the use of monopolies (Krueger, 1998, p. 1515). Even for smallcountries, Keesing (1967, p. 314) found that the severe handicapof smallness cannot be abolished; but it can be minimized under anoutward-looking strategy because of the economies of scale associatedwith exporting to a larger market. Balassa (1988), for example, pointsout that,

Exports make it possible for developing countries toovercome the limitations of their domestic markets in

exploiting economies of scale and ensuring full capacityutilization. (p. S280).

International trade can have a positive effect on economic growth,and therefore on poverty, because trade allows for a more efficient useof resources and exposes domestic producers to larger, more compet-itive markets which encourages productivity improvements (Sapsfordand Garikipati, 2006, p. 1577). Exporting can also generate importantproductivity spillovers (Weiss, 2005, p. 9). Aky uz and Gore (2001) con-clude that development requires the production of increasingly morecomplex exports and state that,

Rapid and sustained economic growth in the most suc-cessful developing countries have involved a process of late industrialization in which the production structure


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has shifted from the primary sector to manufactur-ing alongside a progressive move from less to moretechnology- and capital intensive activities both withinand across sectors, allowing countries to build compet-itiveness in a range of activities established in moreadvanced countries (pp. 266267).

Hausmann et al. (2006) construct an index of countries exports andrank them based on the income level of the countries which producethem. They nd that there are important similarities between the prod-ucts that wealthier countries export and those which poorer countries

export (Hausmann et al., 2006, p. 3). In their analysis, they nd thatcountries, which have shifted to the production of goods which areassociated with high productivity, also have experienced high levels of growth (Hausmann et al., 2006, pp. 9, 17). Although, they acknowledgethat the ability to switch to more productive goods is limited by humancapital factors (Hausmann et al., 2006, p. 14), they nd that,

. . . anything that pushes the economy to. . . specializein good(s) with higher productivity levels-sets forth adynamic (if temporary) process of economic growth asemulators are drawn in to produce the newly discoveredhigh-productivity good(s) (p. 9).

Indeed, they conclude that countries should attempt to correct the mar-ket failures which reduce the incentives for entrepreneurs to enter newmarkets and produce new products which are associated with higherproductivity (Hausmann et al., 2006, p. 17). The increase in productvarieties across Latin America has generally been benecial for reducingthe economic instability associated with excessive export specializa-tion. (de Pineres and Ferrantino, 1997, p. 476).

Outward strategies were also more likely to restore market effi-

ciencies. Export promotion was associated with less distortionary andbureaucratic policies compared to import substitution which could havea positive effect on growth (Krueger, 1980, p. 291; 1993, p. 352). Thisis consistent with the nding that GDP growth was signicantly and


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negatively associated with real exchange rate distortions a measureof inward-oriented policies (Dollar, 1992, p. 535).

Finally, production is also more likely to occur along a countryscomparative advantage under an outward-oriented strategy (Balassa,1988, p. S281; 1971, pp. 180181). As exporters compete against aninternational market, there is an incentive to improve productivity andtechnology compared to producers who compete in protected domesticmarkets (Balassa, 1971, pp. 181183). Asian export-oriented countries,for example, experienced increasing levels of total factor productivitywith increasing levels of exports (Balassa, 1988, p. S281). Productivitygrowth and government intervention were important for explaining the

regions miracle growth (Krueger, 1998, p. 1514). However, Rodriket al. (1995, p. 69) contend that there is virtually no evidence thatexports or outward orientation was associated with technological exter-nalities. While Rodrik et al. (1995) admit that there are correlationsbetween exports and technology spillovers, they argue that causationcannot be determined. Instead, another explanation may be that pro-ductive rms simply export more (Rodrik et al., 1995). Indeed, perhapsthe growth in the East Asian miracle countries was more related to anincrease in investments and capital accumulation which was facilitatedby export earnings (Rodrik et al., 1995, p. 97).

Lucas (1993, p. 270) explanation of the Asian miracle growth offerssome insights for this debate. For Lucas capital, specically, humancapital was the important factor in explaining growth differentials. Itwas recognized that human capital could be acquired in the course of producing goods and engaging in trade (Lucas, 1993, p. 270). However,it is not sufficient to simply increase the volume of exports. Instead,the increase in exports must also be accompanied by an increase in thevariety and complexity of goods produced (Lucas, 1993, p. 269) throughongoing innovation, or more likely, ongoing imitation (Grossman andHelpman, 1991a,b, p. 577).


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3Entrepreneurship and Development

Given the poor experience with import substitution and export pro-motion, countries have begun to examine the role of entrepreneurshipin development. With this shift in development policy came a greaterfocus on the role of the private sector as an important engine for eco-nomic growth and a de-emphasis on the role of government planning.

3.1 Why is Entrepreneurship Important for Development?Brinkman (1995, p. 1183) points out that economic developmentimplies a process of structural transformations leading to an over-all higher growth trajectory. For Leibenstein (1968),

Per capita income growth requires shifts from lessproductive to more productive techniques per worker,the creation or adoption of new commodities, newmaterials, new markets, new organizational forms, thecreation of new skill, and the accumulation of new

knowledge . . . the entrepreneur as gap ller and input-completer is probably the prime mover of the capacitycreation part of these elements in the growth process(p. 77).

20


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3.1 Why is Entrepreneurship Important for Development? 21

Again, economic development involves change and the entrepreneurbecomes the best agent for this change. Indeed, entrepreneurship mat-ters for developing countries because markets matter. Hayek recog-nized that knowledge was dispersed throughout society (Hayek, 1945,p. 520) with each person having a unique stock of information (Hayek,1945, p. 521). However, the market, through its frequent adjustmentsin response to the separate actions of different people and the con-ditions of supply of various factors of production, communicated newinformation through prices which enabled the efficient allocation of resources (Hayek, 1945, pp. 526530). With the collapse of centrallyplanned economies it has been seen that governments cannot allocate

resources efficiently and that markets are, indeed, necessary.The empirical evidence is also strong in support of a link

between entrepreneurship and economic growth. Studies have foundthat regional differences in economic growth which are correlated tolevels of entrepreneurship. The recognition of the importance of theentrepreneur and the necessity of the markets for the entrepreneur tooperate has led many countries to begin to work on perfecting theirmarkets by eliminating barriers to entrepreneurship and other mar-ket failures. However, policy makers must also take the additional stepto ensure that the positive externalities knowledge, network, anddemonstration and failure externalities can assist in the growthof entrepreneurship and economic development. As Leff concludes,entrepreneurship is essential for development because in developingcountries entrepreneurs ll in important gaps 1 left by incomplete andunderdeveloped markets (Leff, 1979, pp. 4647). He states,

Indeed a key function of entrepreneurship in developingeconomies is precisely to mobilize factors such as capi-tal and specialized labor which, being imperfectly mar-keted, might otherwise not be supplied or allocated tothe activities where there productivity is greatest (Leff,

1979, p. 48).

1 For a discussion of the gap-lling role of entrepreneurs see Leibenstein (1968).


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22 Entrepreneurship and Development

However, even when market imperfections are severe, entrepreneursstill exist. Indeed, entrepreneurs respond to these market imperfec-tions by using various gap-lling and, perhaps, second-best solutions.In extreme cases, where market and non-market failures are pervasive,entrepreneurs are pushed out of the formal sector into the informalsector. In less severe cases, large diversied indigenous business groupshave formed in many developing countries in response to market failures(Leff, 1978). The group . . . is thus an intrarm mechanism for dealingwith deciencies in the markets for primary factors, risk and interme-diate products in the developing countries (Leff, 1978, p. 667). Manyof these groups were found to combine both banking and industrial

operations (Leff, 1978, p. 664) and account for large portions of busi-ness activities in many developing countries (Leff, 1978, p. 665). Largegroups were formed in India to correct the information and capital mar-ket deciencies (Ghemawat and Khanna, 1998, p. 39). Importantly,these groups engage in entrepreneurial behavior (Leff, 1978, p. 669)while also provid[ing] the capital and the technical and managerialresources (Leff, 1978, p. 670). In this way, the group economizes theentrepreneurial efforts necessary in developing countries (Leff, 1978,pp. 669672). Nevertheless, these groups are not the optimal structurefor entrepreneurship in developing countries as they result in a spe-cial form of monopoly capitalism which can be disruptive to overalllong-term economic development (Leff, 1978, p. 673). It is therefore,still necessary to continue to perfect markets in developing countriesrather than only relying on second-best options.

3.2 The Entrepreneur in Economic Theory

The entrepreneur had been ignored in economic theory. Cole (1946,p. 3) offers that despite Jean-Baptiste Says analysis of the entrepreneurin the early 1800s, economists often overlooked the entrepreneur as asource of economic change and paid little attention to the essential

characteristics of their economic period the disruptive, innovat-ing energy which resulted from the activities of the entrepreneur(Cole, 1946, pp. 23). Schumpeter (1947, p. 149) also lamented that theentrepreneur was a sadly neglected actor in economic development


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3.2 The Entrepreneur in Economic Theory 23

theory despite his central role in market processes. Soltow (1968, p. 84)offers that although economic historians often told the tales of busi-nessmen and rms, they failed to examine the importance of his pres-ence. Kirzner (1997, p. 62) argues that neoclassical economics focus onperfect information, perfect competition (Kirzner, 1997, p. 64) and gen-eral equilibrium theories failed to explain how markets really worked(Kirzner, 1997, p. 61) and that entrepreneurial activity [had] no placeat all in neoclassical microeconomics (Kirzner, 1997, p. 67). Hayek(1945, p. 527) also criticized many of the assumptions of perfect infor-mation. While Hayek does not specically refer to the entrepreneur,his focus on the actions of individuals in the market is consistent with

entrepreneurship theory.Recognizing these deciencies in neoclassical economics, Austrian

economics, in particular, offered alternative views on the functioningof the market and the role of the entrepreneur in economic growth(Kirzner, 1997, p. 70). Kirzner (1997) states that,

From Mises the modern Austrians learned to see themarket as an entrepreneurially driven process. FromHayek they learned to appreciate the role of knowledgeand its enhancement through market interaction, for theequilibrative process (p. 67).

One of the earliest descriptions of the entrepreneur is by Jean-BaptisteSay. Says entrepreneur performed a specic role in the economy bycoordinating other factors of production (i.e., labor, capital, etc.) withhis knowledge in order to meet the demands of the nal consumers(Koolman, 1971, p. 272). Says entrepreneur assumed risks (Koolman,1971, p. 273) and employed judgment in his entrepreneurial activities(Koolman, 1971, p. 275). Finally, an important contribution of Saysentrepreneur to the concept of entrepreneurial prots which comprisedwages for the entrepreneurs labor, interest for the capital used, andpure prot above that normally provided in the market (Koolman,

1971, p. 278).While Says entrepreneur emerged earlier, Schumpeters entre-preneur is perhaps better known. The Schumpeterian entrepreneuris characterized by his creative and disruptive response to external


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shocks (Schumpeter, 1947, p. 150). Innovation, for Schumpeter (1947,p. 153), was central to entrepreneurial activity and included the dis-covery of new products, new processes and the discovery of new mar-kets in response to exogenous shocks of new information (Shane andEckhardt, 2005, p. 171). However, as the potential gains of these dis-coveries, [could not] be proved at the moment at which the action hasto be taken (Schumpeter, 1947, p. 157), the entrepreneur assumed therisks of his actions and received the surplus gains (Schumpeter, 1947,p. 155) or prots if he was correct. Schumpeter (2002, p. 97) also rec-ognized that development was a process of disturbance and changeinstigated by the entrepreneur.

Juxtaposed against the disruptive nature of the Schumpeterianentrepreneur was the Kirznerian entrepreneur (Kirzner, 1999). 2 Acentral feature of Kirzners (1997, p. 68) entrepreneur was the herestored a market to equilibrium. Kirzner (1997, p. 71) found thatmarkets were often in disequilibrium due to previous errors made byentrepreneurs and that this disequilibrium generated new prot oppor-tunities (Kirzner, 1997). However, alert, imaginative entrepreneurs,imbued with superior knowledge, were able to exploit these protopportunities by recognizing or discovering these errors and by tak-ing action to correct the market (Kirzner, 1997). The market wouldalso be brought into equilibrium by new entrants who would drive downentrepreneurial prots (Kirzner, 1997, p. 72).

How does the entrepreneur become alert to and discover protopportunities? First, Hayek (1945, p. 520) recognized that knowl-edge was dispersed throughout society, while also understanding theimportance of the uniqueness of each individuals stock of informa-tion (Hayek, 1945, p. 521). Additionally, the market, through its fre-quent adjustments in response to the separate actions of differentpeople (Hayek, 1945, p. 526) and the conditions of supply of var-ious factors of production, communicated new information throughprices (Hayek, 1945, pp. 526530). While Hayek (1945, p. 526) sug-gests that this new information would be communicated to everyone,

2 For a synthesis of Kirznerian and Schumpeterian entrepreneurs see Israel M. Kirzner,Creativity and/or Alertness: A Reconsideration of the Schumpeterian Entrepreneur,The Review of Austrian Economics V11, no. 1 (1999).


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3.3 What Does Entrepreneurship Look Like in Developing Countries? 25

and used correctly (Hayek, 1945, p. 527), the Kirznerian and Schum-peterian models demonstrate that mistakes and misallocations do occurand provide new opportunities for the entrepreneur. Therefore, it isonly the alert entrepreneur, drawing on his unique knowledge set, whois able to use this new information in innovative ways. Hayeks the-ory, therefore, emphasized a knowledge-opportunity matching process of entrepreneurial discovery. Knowledge accumulation, in a sense, expandsthe realm of surprises that an alert entrepreneur is able to spot andact upon. Knowledge accumulation is thus an important limiting factorfor entrepreneurship.

3.3 What Does Entrepreneurship Look Like in DevelopingCountries?

It is important to clarify what is meant by entrepreneurship in develop-ing countries. A number of terms are used interchangeably to describeentrepreneurial activities. For example, entrepreneurship and small-and medium-sized enterprises (SMEs) have been used synonymously.Discussions of entrepreneurial activities in developing countries havealso included the informal sector and petty capitalism (Smart andSmart, 2005). Many African manufacturing rms, for example, hadfewer than 150 employees (Fafchamps, 2001, p. 114) and thereforewould fall into the SME sector. Fafchamps (2001, p. 114) writes thatmarket intermediation in Africa is characterized by a plethora of smalltraders, seldom exceeding a handful of employees and family helpers.The World Bank, in its efforts to target entrepreneurship, has focusedon both the small business and the informal sectors. In 2003, the WorldBank released a new database on the SME sector and the accompany-ing study found that when both the SME and the informal sectors areconsidered, the joint contribution . . . to GDP remains approximatelyconstant across income groups at around 6570 percent. As incomeincreases however, there is a marked shift from the informal to the

SME sector (Ayyagari et al., 2003, p. 11). This nding indicated thatthe informal sector in developing countries is an important source of economic activity. Another concept is petty capitalists, or small busi-nesses which employ relatively few employees and rely heavily on their


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owners and the owners familys labor, include a wide spectrum of entrepreneurs from the numerous export enterprises of Hong Kong(see also Yu, 1998), the maquila workshops in Mexico which producegarments for export, the furniture manufacturers in Italy, to Taiwansintegrated circuit producers (Smart and Smart, 2005). In developedeconomies, however, scholars have argued for a distinct concept of entrepreneurship. Carland et al. (1984), for example, writing on theAmerican economy, make a strong distinction between the SME sectorand entrepreneurship. They nd that,

Although there is considerable overlap between smallbusiness and entrepreneurship, the concepts are not thesame. Entrepreneurial rms may begin at any size level,but key on growth every time. . . . The entrepreneur ischaracterized by preference for creating activity, mani-fested by some innovative combinations of resources forprot (Carland et al., 1984, p. 357).

However, while SMEs and entrepreneurship have different meanings,both are important in an economy (Thurik and Wennekers, 2004).Indeed, the small business sector may serve as a vehicle both forSchumpetarian entrepreneurs introducing new products . . . and for peo-ple who simply run and own a business for a living (Thurik and Wen-nekers, 2004, p. 140). Similar distinctions have been made betweensurvival or necessity entrepreneurs and opportunity entrepreneurs.

Do these distinctions matter for developing countries? As the majorshare of rms in developing countries is small, in terms of the numberof employees and assets; and many operating in the informal economyusing family labor, this reviews distinction of entrepreneurship can-not, therefore, be based on size. Any distinctions drawn in this reviewbetween entrepreneurship, the small business sector, petty capitalism,and the informal sector will be based on the Schumpeterian conceptof innovation new products, new markets, and new processes. How-

ever, as Schumpeter (1947, p. 151) pointed out, that the new thingneed not be spectacular or of historical importance. . . . To see the phe-nomenon even in the humblest levels of the business world is quiteessential though it may be difficult to nd the humble entrepreneurs


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3.4 An Externalities-based Framework 27

historically. Therefore, this study adopts the widest possible denitionof entrepreneurship.

3.4 An Externalities-based Framework

This review introduces an externalities-based framework to examinethe literature on entrepreneurship in developing countries because of the breadth and scope of the subject. What are the relevant external-ities in the case of entrepreneurship? Acs and Armington (2006) andAcs et al. (2004, 2005), writing on the Knowledge Spillover Theoryof Entrepreneurship in developed countries identify network, knowl-

edge, failure, and demonstration externalities as reasons for govern-ment intervention into entrepreneurship (Audretsch et al., 2006). First,they nd that dense networks of entrepreneurial rms are benecial toentrepreneurial activity (Audretsch et al., 2006). Hansen (1992) hadpreviously pointed out the importance of cooperative networks and howindustry clusters could be facilitated by a regions social capital. Acs(2002, p. 171) also offered that regional clusters and networks fosterfast learning and perpetuate spillovers.

Second, Audretsch et al. (2006, p. 174), nd that there is an inher-ent tendency to under-produce knowledge because it is a non-rival,partially excludable good (Acs, 2002, p. 9). Knowledge expansionresults in productivity improvements within the rm which createdit and other proximate rms and thus promotes economic growth (Acs,2002, p. 10). Indeed, the underproduction of knowledge and educa-tion can be particularly problematic in developing countries as alow level of human capital accumulation will slow down technologicalchange (Nijkamp and Poot, 1998, p. 21). Additionally, for developingeconomies, knowledge is important in the product and productiondiscovery process (Hausmann and Rodrik, 2003). Knowledge and infor-mation spillovers will be particularly helpful where there are high trans-actions costs to discovery or large information asymmetries.

Finally, Audretsch et al. (2006, p. 174) point to failure anddemonstration externalities. New rm creation, rms life cycles andeven rm failures are found to be benecial for other entrepreneurs(Audretsch et al., 2006). Entrepreneurs learn from examples around


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them. An important element, therefore, is market entry. In fact,for Kirzner, market entry was essential. Kirzner (1997) states,

To induce dynamic entrepreneurial competition werequire the fulllment of only one condition: guaran-teeing free entrepreneurial entry into any market whereprot opportunities may be perceived to exist (p. 74).

While the Knowledge Spillover Theory of Entrepreneurship (Acs, Z.J., et al., 2005) was intended for developed economies, the externalitiesidentied by Audretsch et al. (2006) are valid for developing countries.The major themes which appear in the literature on entrepreneurship

in developing countries relate to one or more of these failures. Each setof failures and the issues which contribute to them will be explored inthe next few sections. While not tested in this review, our hypothesisis that economies which are able to generate more of these positiveexternalities through its institutions and policies will produce greaterlevels of entrepreneurship.

The idea that examining market imperfections provides insights intounderstanding entrepreneurship is by no means a completely new one.However, it may have been overlooked. Leibenstein (1968), after all,pointed out that,

For policy purposes. . . development economists [should]focus their attention when concerned with speciccountries on studying the gaps, obstructions, andimpediments in the market network of the economy inquestion and on the gap-lling and input-completingcapacity and responsiveness to different motivationalstates of the potential entrepreneurs in the population(p. 83).

It is, therefore, important to study how markets function and how theyfail in order to discover how to expand entrepreneurial activities in an

economy.Buchanan and Faith (1981) had also examined the effects onentrepreneurship of different methods of internalizing negative exter-nalities. They examine Coases property rights theorem which requires


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an ex ante resolution (i.e., the assignment of property rights and thusa payment for potential damages before the transaction) comparedto a liability rule which results in an ex post payment in the eventof damages resulting from negative externalities from entrepreneurialactivity (Buchanan and Faith, 1981, p. 97). They conclude that therehas been a shift from using the law to recognize liabilities (an ex post solution) to a greater emphasis on ex ante internalization of exter-nalities through regulation (Buchanan and Faith, 1981, pp. 103104).This new approach can be seen in the increase in regulatory activitieswhich, in effect. . . becomes the institutional equivalent of a modiedproperty rule (Buchanan and Faith, 1981, p. 106). Furthermore, if

the public interest agent or the regulatory authority becomes politi-cized, entrepreneurship can be severely curtailed, even though marketand legal solutions to remedy the negative externalities are available(Buchanan and Faith, 1981, pp. 108111).

Hupp, in an examination of ways to internalize and encouragepositive land use spillovers, offers useful insight into the effects of positive externalities on entrepreneurial activities. While research hasgenerally usually focused on approaches to internalize negative exter-nalities and has neglected benecial externalities (Hupp, 1979, p. 457),in many instances assigning property rights or implementing the lia-bility rule is not effective in the case of many positive externalities(Hupp, 1979). Instead, she proposes the establishment of an admin-istrative agency that would reward the generators of positive exter-nalities. This approach should result in the socially optimal solutionbeing implemented (Hupp, 1979, p. 472). The argument presented byHupp would appear to work best where there is a public good and thuswould provide a way of encouraging the private provision of publicgoods and other goods with positive spillovers where user fees cannotbe assessed. Such an approach may be useful in fostering the positivespillovers which encourage entrepreneurial activity.

3.4.1 Demonstration and Failure Externalities

The relatively small number of examples of successful entrepreneurshiprenders demonstration and failure externalities extremely important


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in developing countries. King and Robson (1993, p. 449) describeda similar effect as learning by watching where new investmentprojects in one sector of the economy have a demonstration effect onthe efficiency of other sectors. An important aspect of their modelis that the spillovers are generated by the act of investment itself and do not depend on the actual outcome of the project (King andRobson, 1993). Therefore, each new investment yields productivityspillovers. However, the model assumes that the positive externalitiesto observing new projects (i.e., the increases in productivity) graduallydecline over time (King and Robson, 1993) and that the productivitygrowth rate (dened as the technological progress frontier) eventually

levels off (King and Robson, 1993, p. 451). In a similar way, there areimportant spillover effects from having examples of business formationand from entrepreneurs observing successful going concerns. Potentialentrepreneurs observe the strategies and business operations of existingentrepreneurs and gather information about potential markets, inputsuppliers, and production techniques. As such, market entry becomesincreasingly important for generating these externalities. Additionally,potential and existing entrepreneurs also learn from failing and failedbusinesses. They learn what not to do or what to do differently. Mar-kets must, therefore, be free from excessive interventions which do notallow rms to fail for these failure externalities to be effective.

We identify four core themes in the literature which affectdemonstration and failure externalities through their effects onentrepreneurial entry, business operations, and entrepreneurial exit: (1)culture, values and norms; (2) views on outsiders and inclusiveness,(3) the level of economic freedom, and (4) an economys fundamentalsincluding its macroeconomic stability, infrastructure, and the level of development of its nancial markets.

(a) Culture, Values, and Norms

Geertz (1973, p. 5) describes culture as the webs of signicance that

man has spun for himself. Culture, therefore, provides the frameworkwithin which individuals make sense of their lives and live in and adaptto their worlds. It is, consequently, not surprising that culture, values,and norms can have an effect on entrepreneurial entry and general


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business culture and thus on demonstration and failure externalities.Lavoie and Chamlee-Wright (2002, p. 17) offer that one cannot studyeconomic development without exploring culture. Indeed, a number of studies on entrepreneurship in developing countries have focused on theissue of culture as a source of entrepreneurial advantage or disadvantagein an economy.

An important question which has been explored in the literatureis whether there are similar traits which exist between entrepreneursacross all cultures. Is there an ideal entrepreneur type? Thomasand Mueller (2000, p. 291), for example, point out that, the termentrepreneur implies a conguration of psychological traits, attributes,

attitudes, and values of an individual motivated to initiate a businessventure. Thomas and Muellers (2000) study nds that personalitytraits considered relevant to entrepreneurship such as having a highenergy level, feeling personally in control of ones own destiny (internallocus of control) and having a high risk tolerance were signicantly neg-atively associated with entrepreneurs cultural distance from Americanculture. In their study, therefore, entrepreneurs from countries whichwere more culturally similar to the United States were more likely topossess these qualities. However, innovation, which is perhaps the primedriver of entrepreneurial activity, was found to be unrelated to having acultural similarity with the United States (Thomas and Mueller, 2000).

One ideal entrepreneur type portrayed in the literature is thatof an entrepreneur who possesses the Protestant Ethic. Writing onAfrican entrepreneurs, Elkan (1988a, p. 173) nds that among indige-nous Africans, there is one quality that most successful African busi-nessmen have in common. They share the local (and often Muslim)equivalent of the Protestant Ethic. In a study of The Bahamas, Storr(2006) identies a cultural trait termed the Junkanoo Ethnic whichembodies Webers spirit of capitalism as an explanation for theexistence of entrepreneurship in that country and also as a culturaltrait of successful Bahamian entrepreneurs. This ethic is importantfor the development of modern capitalism (Landes, 2000, p. 11).Thomas and Mueller (2000, p. 290) offer that the ideal prole of theentrepreneur continues to reect the characteristics of Protestanismand achievement. Hoselitz (1952, pp. 106108) also points to traits


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oriented toward productivity, working and creative integration andleadership and innovation. There, therefore, appears to be some evi-dence that some personality traits are common among entrepreneurs.

In addition to those studies focused on commonalities betweenentrepreneurs, other studies have discussed whether some culturaltraits will need to adjust as entrepreneurship becomes more preva-lent in developing countries. Zapalska and Edwards (2001, p. 286),for example, offer that culture is a dynamic factor in regionaldevelopment in the context of reforming the Chinese economy.They propose that while some aspects of Chinese culture are con-ducive to entrepreneurship (Zapalska and Edwards, 2001, p. 289),

other cultural traits are changing to adapt to a market economy(Zapalska and Edwards, 2001, p. 290). Dana (2000, p. 86) foundthat the combination of social structure and cultural values hasconstrained entrepreneurship in India. Specically, it was suggestedthat Indias caste system and the passive nature associated with someaspects of Indian culture may not be as well suited to the creativedestruction needed for entrepreneurship (Dana, 2000, pp. 8788).On some of the cultural barriers to entrepreneurship, the 2001 GlobalEntrepreneurship Monitor (GEM) report on India stated that,

Sociocultural rigidities persist. In addition, there areseveral inhibiting factors such as custom and tradition,low status given to businessmen, the high risks involvedin enterprise, absence of vertical mobility on the socialladder, market imperfections and arbitrary changes inthe laws of the land and their administration (Manimalaet al., 2002).

Cochran (1960, p. 517) performed a study in Latin America andconcluded that certain characteristics of Latin American culture havebeen relatively unfavorable to economic development and, therefore,to the success of entrepreneurship. It was observed that entranceinto the professions was more socially respected than becoming abusiness owner. In Botswana entrepreneurship was generally shunnedby younger Batswana in favor of government employment (Tesfay-ohannes, 2005, p. 6). While, the countrys educational system and


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socio-cultural factors were cited as explanations for these viewson entrepreneurship (Tesfayohannes, 2005), it is also important toquestion why public sector employment appears more attractive.Finally, the business culture which developed in the former SovietUnion under socialism was thought to stie independent innovativeculture (Aidis, 2005, p. 13).

However, it is not clear how binding culture is on entrepreneurshipand how much depends on reinforcing economic and social systems.First, entrepreneurs in India, China, and transition economies haveresponded quickly as liberalization occurred. Indeed, Chinese andIndian entrepreneurs are key participants in the world economy as

the globalization phenomenon opens up new opportunities (Friedman,2006). Additionally, Chinese and Indian immigrants, in particular, haveplayed an important role as entrepreneurs in entrepreneurial countriessuch as the United States (Saxenian, 1999, p. 22) and in developingcountries such as Mauritius and developing Asian countries. In a studyof Cuba, one of the last remaining centrally planned economies, itwas noted that, Cuban immigrants in Miami established a thrivingSpanish-speaking enclave economy that offers entrepreneurs substan-tial prots. (Evans, 1989, p. 950).

It would therefore appear that entrepreneurial opportunity allowsthose individuals who possess an entrepreneurial spirit to transcendany cultural boundaries. However, culture and opportunity appear tore-enforce each other. Acs et al. (2007, p. 124) sum up nicely that, astrong cultural context that supports entrepreneurial activity is onewhich will lead to more individuals perceiving entrepreneurial activityas a desirable economic choice. Indeed, Hoselitz (1952, p. 108) notedthat countries need to create a climate which allows entrepreneursto pursue opportunities, while also encouraging the personality traitswhich leads to entrepreneurial activities.

(b) Outsiders and Inclusiveness

A countrys acceptance and tolerance of outsiders and its levels of inclusiveness can impact entrepreneurial entry. Here, the concept of social capital an instantiated set of informal values or norms sharedamong members of a group that permits them to cooperate with oneanother (Fukuyama, 2000, p. 98) becomes important. The trust,


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engendered by social capital, enables members of a society to coordi-nate their activities with lower transactions costs (Fukuyama, 2000,p. 99). A societys level of inclusiveness determines how large its radiusof trust extends. Elkan (1988b, p. 177) nds, for example, that thereis a distrust of outsiders which has limited the growth of rmsin many African economies. More generally, in developing countriesentrepreneurs have often utilized their extended families as these kin-ship relations are the extent of the radii of trust in these societies(Leibenstein, 1968, p. 81). However, this close control of business oper-ations can negatively impact business success (Elkan, 1988b, p. 172),as outside managerial and technical talent is often excluded.

The high level of ethnic fragmentation in many developing countriesis also important for explaining entrepreneurship. For example, thatoutsiders such as ethnic minorities in developing economies oftenmove into entrepreneurial activities because they are excluded fromother types of employment (Leibenstein, 1968, p. 81). This exclu-sion, therefore, lowers the opportunity costs of entrepreneurship(Leibenstein, 1968). Elkan, for example, nds that ethnic Asian andLebanese minorities in African countries were prominent enterpriseowners (Elkan, 1988b, p. 185) and that their feelings of insecurity[as minorities] may have encouraged them to seek economic success asbusiness owners (Elkan, 1988b, p. 171). While some cultural groups doappear to be more entrepreneurial as immigrants than others, in a studyof Australia, it was argued that the size of the immigrant group in thehost country and the relative linguistic isolation of that group affectthe likelihood of members of a particular immigrant group engaging inentrepreneurial activities in addition to other factors such as educationand skills (Evans, 1989, p. 958). Similar conclusions have been made instudies of immigrants to the United States (Mora and D avila, 2005).While both of these studies relate to developed countries, the resultscould be useful for understanding the differences in entrepreneurshiplevels for some ethnic minorities in developing countries. Ethnic minori-ties which are relatively isolated from the indigenous population wouldbe more likely to engage in high rates of entrepreneurial activity.

On the other hand, however, while some groups are often pushedinto entrepreneurship, restrictions may be placed on ethnic minority


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and non-indigenous local entrepreneurs in many developing countrieswhen they are perceived as being too entrepreneurial (Leff, 1979, p. 51).A study of SMEs in the South Pacic found that there were gen-uine differences between indigenous and non-indigenous entrepreneursin the South Pacic Islands. More importantly, however, there was aperception among indigenous Pacic Islanders that non-indigenousentrepreneurs. . . [had] a depth of experience and resource to drawfrom which may have provided them with an advantage in theirentrepreneurial activities (Yusuf, 1995, pp. 7071). Indeed, it wasfound that government policies were biased against non-indigenousentrepreneurs to compensate for this advantage (Yusuf, 1995, p. 71).

The literature reveals that there is a pushpull effect toentrepreneurship in developing countries with deep ethnic fragmen-tation. On the one hand, ethnic minorities may be pushed intoentrepreneurship; while on the other hand barriers may constrain theiractivities. Where there are severe ethnic tensions, outsider groupsmay be excluded altogether such that the society loses the benets of their business demonstration externalities.

(c) Economic Freedom An Expansion of the Scopefor EntrepreneurshipEconomic freedom affects demonstration externalities by its effects on

both entrepreneurial entry and activity. von Mises (1949, ch. 6 xxix,p. 16) nds that economic freedom paved the way for the sub-stantial improvement in living standards in capitalist countries. Forentrepreneurial activity to occur, potential entrepreneurs must be ableto not just perceive an opportunity, but to also be able to legally acton it to become an acting man (von Mises, 1949, ch. 4 xiv, p. 72)Hoselitz (1952, p. 109) adds that a societys cultural norms shouldallow persons to be free to choose their occupations. Without this eco-nomic freedom, von Mises (1949, ch. 6 xxx, p. 3) points out that thenthe market, interpersonal exchange, private ownership of the meansof production, entrepreneurship, and private initiative, virtually disap-

pear altogether. Elkan (1988a) nds that,

Giving the private sector a greater role in developmenthas two facets: rst, a change in policy regime that


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removes restrictions on the private sector; second, thedivestiture of activities from the public sector priva-tization (p. 179).

Two strands of the literature are therefore explored. The rst dealswith excessive government involvement in the private sector and thesecond with the growing trend toward privatization.

First, some countries governments discouraged entrepreneurship,while in others government activity is so pervasive that it crowds outprivate entrepreneurship opportunities (Elkan, 1988a, p. 177). Wheregovernment activity is pervasive, a managerial type of business cul-ture is likely to prevail rather than one which supports innovativeentrepreneurship (Hoselitz, 1952, p. 100). In China, although therehas been some decentralization of economic activity, government offi-cials interfered in the affairs of enterprise managers (Zapalska andEdwards, 2001, p. 290). For example, Zapalska and Edwards (2001)nd that,

Mobility of entrepreneurs seeking new opportunities isobstructed. Entrepreneurs wanting to retain the adviceand expertise of foreign consultants are blocked by thefact that investment decisions are controlled outside theenterprise by higher authorities (p. 291).

They offer that until a market economy is fully implemented,entrepreneurship will not reach its full potential (Zapalska andEdwards, 2001). Chinas complex business environment may act as abarrier to private investment (Zapalska and Edwards, 2001). A sur-vey of 32 Nigerian SMEs respondents reported that there is frequentharassment by government officials who extort money from busi-nesses (Mambula, 2002, p. 59). An examination of post-colonialNigeria and Tanzania explored the role of socialist ideology and thestrong negative views toward capitalism in strangling private enter-

prise and entrepreneurship (Heilman and Lucas, 1997, p. 146). Dana(2000, pp. 8790) had similar ndings in a study of India and notesthat the post-independence strong state-led economy stied oppor-tunities for entrepreneurship. Indeed, the strong hold of government


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over all spheres of economic life led to vibrant informal sectors inmany African countries such that, the informal sector and small scaleincome generating projects became a form of resistance to the statecontrolled economy which forced the government to tolerate and even-tually encourage private sector activities (Heilman and Lucas, 1997,p. 159). A similar phenomenon was observed in former Soviet countrieswhere the informal economy ourished in spite of their being a formalnon-market economy (Aidis, 2005, p. 15). However, through the workof business associations such as chambers of commerce, a new paradigmis being built with a new relationship between the state and itscitizens. . . which encourages private sector activities and entrepreneur-

ship (Heilman and Lucas, 1997, p. 155).A second phenomenon which has led to new opportunities for

entrepreneurship in many developing and transition countries is thewave of privatizations generating new demonstration and failureexternalities. The creation of markets, through privatization, providesthe space for entrepreneurs to operate and to innovate, using pricesand other information as a guide. The transition economies provide aninteresting case for analyzing the importance of entrepreneurship. Likeother regions, entrepreneurship is associated with economic growth. Forexample, although Russia has generally performed poorly in terms of the policy environment for entrepreneurship, Berkowitz and DeJong(2005, p. 25) nd that regions with higher entrepreneurial activitywithin Russia also experienced stronger economic performance. Theyalso nd that,

The view that entrepreneurial activity is an impor-tant engine of growth emerges from the observationthat post-socialist economies that have experienced rel-atively robust patterns of entrepreneurial developmenthave tended to enjoy relatively high rates of economicgrowth (Berkowitz and DeJong, 2005, p. 26).

A review of the literature reveals that the key feature of the transitionwas the privatization of large government enterprises. Indeed, imme-diately after the collapse of the socialist system there were high ratesof new rm start-ups (McMillan and Woodruff, 2002, p. 154). While


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business formation proceeded at a rapid pace, the formal institutionswhich were needed to support increasing complex forms of enterpriseswere non-existent (McMillan and Woodruff, 2002, p. 155) and infor-mal institutions developed to compensate for the inadequacies of thesenew market economies (McMillan and Woodruff, 2002, pp. 159160).The creation of conditions which would assist in the development of entrepreneurship was not the focus of the reforming countries nor theinternational agencies initially (Arzeni, 1996, p. 52). However, this lackof formal institutions created high barriers to entrepreneurial activi-ties in the years following the transition which has slowed the growthof new businesses (Aidis, 2005, p. 2). McMillan and Woodruff (2002)

point out that,

Entrepreneurs require more from the state, in themedium and long-run, than the absence of interference.If rms are able to grow to yield economies of scale, theyneed laws of contract so they can take on anonymousdealings and nancial regulation so they can get bankloans and outside shareholding (p. 165).

Indeed, a major issue for transition economies is the lack of formalinstitutions related to property rights, supervision of market activities,

dispute resolution mechanisms, and improved nancial and account-ing systems (Reynolds, 1996, pp. 2930). Therefore, the transition toentrepreneurship in the formerly centrally planned economies of East-ern Europe is not complete. While private enterprises are now the norm,thus expanding the scope for entrepreneurial activity, the business andregulatory environment does not yet address the imperfections in theirnew markets related to high transactions costs, information asymme-tries and the missing markets for nancial services in many countries.

(d) The Fundamentals Financial Markets Developmentand Physical Infrastructure

Issues pertaining to a countrys macroeconomic stability, the stateof its nancial markets and its infrastructure are pervasive in theliterature on entrepreneurship in developing countries. A survey of Nigerian entrepreneurs, for example, nds that access to credit, poor


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transportation infrastructure and a lack of dependable utilities are aleading constraints to rm growth (Mambula, 2002, p. 59, Table 1). In astudy of rms in Romania, Earle et al. (2005, p. 62), nd that the avail-ability of loans is an important factor in promoting the growth of smallstart-up rms. Yusuf and Schindehutte (2000, p. 45) studied the effectsof macroeconomic performance on the types of entrepreneurial activity.They survey 160 entrepreneurs who had formed businesses during peri-ods of economic decline in Nigeria. This decline resulted from a numberof poor policies (Yusuf and Schindehutte, 2000, p. 43) such that despiteNigerias considerable oil income, the governments reinvestment activ-ities did not accelerate growth (Eifert et al., 2002, p. 21). However,

the authors point out that post-colonial Nigerian government, unlikemany other African countries, was not overly hostile to the privatesector and had developed a number of programs to support the devel-opment of indigenous SMEs (Yusuf and Schindehutte, 2000, p. 44).The study revealed that entrepreneurs started businesses for a numberof reasons during the period in review. However, extrinsic rewardsrelated to securing income were more important than purer Schum-peterian type entrepreneurial motivations (i.e., innovation) (Yusuf andSchindehutte, 2000, p. 49). It would therefore appear that in periods of economic hardship necessity entrepreneurship rather than opportunityentrepreneurship becomes more important (Yusuf and Schindehutte,2000).

The inadequacy, in terms of both quantity and quality, of infras-tructure in developing countries is another important factor whichlimits successful business entry and growth and thus demonstrationexternalities. Writing on the Chinese economy, Liao and Sohmen (2001)nd that,

Lack of infrastructure may limit areas of futureentrepreneurial growth. Technology is a relativelylabor-intensive and capital-unintensive industry. Like-wise, service industries typically require little initial

capital input. Yet other areas that will require priva-tization in the future may face obstacles due to thelack of an efficient credit system and lack of necessaryinfrastructure (pp. 3132).


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In addition to physical infrastructure inadequacies, entrepreneurs indeveloping countries such as Cyprus also face the inadequacies of policy infrastructure (Hadjimanolis, 1999, p. 562). The EconomicCommission for Africa (ECA) (2004), in their review of the effects of energy infrastructure on international trade, nd that the low pene-tration of electricity in Africa limits the ability of countries to trade.Indeed, the scarcity of good infrastructure directly increases the costsof doing business and reduces the reliability of production, therebyincreasing costs indirectly (Economic Commission for Africa, 2004).The ECA also nd that,

. . . small rms cannot afford to make costly investmentsto meet their power needs. Given that SMEs are greatlyaffected by unreliable power supp

acs (2009) entrepreneurship in developing countries

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