Institutions, Incentives and Entrepreneurship

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Aidis & Estrin (2013) Institutions, Incentives and Entrepreneurship
Institutions, Incentives and Entrepreneurship
Ruta Aidis
George Mason University
raidis@gmu.edu
and
Saul Estrin
London School of Economics
s.estrin@lse.ac.uk
To be published as: Aidis, R. and Estrin, S. (2013) ‘Institutions, Incentives and
Entrepreneurship’ Chapter 3 in Z. Acs, L. Szerb and E. Autio, The Global Entrepreneurship and
Development Index 2013, Edward Elgar, pp. 18 – 26.
Introduction
The importance of entrepreneurship for economic growth and development is well understood.
However, when most people think about entrepreneurship, they tend to conceptualize it as an
innate skill or talent. Hence the debates on nurture versus nature which lie behind the policy
question of “educating” people to become entrepreneurs. However, this debate misses an
important point, as it ignores the regulating influence of national context and institutions in
shaping entrepreneurial activity
1
. When myopically focusing on the supply of entrepreneurs,
policymakers ignore that, most often, the real bottleneck is not supply, but rather, the quality of
entrepreneurial efforts that we observe in any given economy. This is why institutions and
incentives are important: they regulate how entrepreneurial effort is channelled into productive
use. As famously argued by William Baumol what tends to vary across economic contexts is not
the quantity of entrepreneurial effort, but rather, its quality. A country’s institutionsl create the
structure of incentives which determines whether a given individual will allocate his or her effort
into entrepreneurship or a salaried occupation, and also, the type of entrepreneurship chosen –
productive, unproductive, or even, destructive.
Depending on institutions and incentive, entrepreneurial effort may go into productive or
unproductive uses, and it may not materialize in new entrepreneurial ventures at all. Thus, the
prevalence as well as the forms of entrepreneurship that we observe in different countries will be
affected by institutional structures, the level of development, as well as country-specific cultural
and policy factors. In the following, we illustrate how the GEDI methodology allows us to
compare levels and quality of entrepreneurial activity across countries while taking institutional
differences into account. We explore some of the ways that entrepreneurial activity may be

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influenced by institutions in different national contexts, and also, consider how these differences
are addressed within the GEDI methodology.
The pioneering work of Douglass North and William Baumol provide the foundation this
chapter. According to North, entrepreneurs are the main agents of change. New business
organizations set up by entrepreneurs will adapt their activities and strategies molded to fit the
opportunities and limitations provided through the formal and informal institutional framework.
Many of the incentives underlying value-adding behavior depend on the quality of institutions.
North distinguished between formal institutions, namely the laws and rules that define the
economic incentives guiding individual and organisational choices, and informal institutions, that
is the social arrangements and norms that influence how formal institutions operate in practice.
His argument extends to entrepreneurial organizations, which adapt their strategies to fit the
opportunities and limitations defined by their institutional contexts. Thus, a functional business
environment provides positive incentives for entrepreneurs while a weak one is likely to be
deleterious
2
. Though ideally, formal rules are designed to facilitate exchange reducing
transaction costs, they are also likely to affect individuals or groups in different ways, as we will
illustrate below.
.
Formal and informal institutions and economic development
For many analysts of developed economies, the existence of an elaborate framework of
constraints, created and enforced by institutions, is simply taken for granted and not specifically
addressed. Thus, it is possible largely to 'ignore' the impact of institutions in advanced market
economies where for the most part, market institutions are present and functioning. However,
there is a growing recognition of the importance of the institutional environment for not only
entrepreneurship but for fostering national economic growth and stability. The work of Douglass
North has been illuminating in its identification of different institutional influences on economic
development. Institutions are defined as any form of constraint that human beings devise to
shape human interaction. As noted above, North makes a clear distinction between formal and
informal institutions. Put simply, formal institutions are the visible 'rules of the game' such as
constitutional law, which can be altered quickly to adapt to changing economic circumstances.
Moreover, formal rules are generally enforced by governments. In contrast, informal institutions
are the invisible 'rules of the game' made up of norms, values, acceptable behaviors and codes of
conduct. Informal rules tend not to be legally enforced. Change to informal rules occurs more
indirectly and usually as a result of accidents, learning, natural selection and most of all, the
passage of time
3
. Informal rules most often evolve to complement formal rules. North has also
identified the often conflictual role between formal and informal institutions in both the
historical perspective and in transition economies. Within North's framework, organizations such
as firms – existing or potential ones- will adapt their activities and strategies due to the

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opportunities and limitations in the formal and informal institutions. Institutional development
can be intentionally affected by organizational players such as entrepreneurs
4
.
Interestingly, institutions can be maintained for long periods of time, even if they are inefficient
5
There are several reasons for inefficient institutional outcomes. First of all, even when they clash
with new formal rules, informal rules have tenacious survival ability because they have become
part of habitual behavior (i.e. culture) and informal institutions provide a sense of stability.
Second, informal institutions may change more slowly due to the influence of path dependence.
Though the past cannot be used to neatly predict the future, pre-existing incentive structures in
the environment can illuminate the direction to which institutions affect further economic
development. This occurs because institutional change is usually incremental and is seldom
discontinuous
6
. As a result, unproductive paths may persist and in that sense, history matters.
Thirdly, lock-in can occur as a result of a symbiotic relationship between existing institutions
and organizations that have evolved as a consequence of the incentive structure provided to those
institutions. Even when the formal rules change, organizations which benefitted from the
outdated informal rules and which would lose their benefits if they adopted new informal
practices complementary to formal rule changes will continue to participate in detrimental
informal rule practices in order to retain their position of power. Fourthly, when formal and
informal institutions clash as in the case where formal rules are changed but informal rules have
not changed, noncompliant behaviors proliferate and can result in the formation of underground
economies
7
.
As North notes: ...the performance of an economy is an admixture of the formal rules, the
informal norms, and their enforcement characteristics. Changing merely the formal rules will
produce the desired results only when the informal norms are complementary to the rule change,
and enforcement is either perfect or at least consistent with the expectations of those altering the
rules
8
.
North's emphasis on the influence of formal and informal rules and institutions on economic
outcomes is relevant for emerging economies and especially in situations where formal
institutions are weak.
If the institutional framework rewards piracy then piratical organizations will come into
existence; and if the institutional framework rewards productive activities than organizations
and firms will come into existence to engage in productive activities
9
.
A considerable literature argues that weak institutions, notably the quality of the commercial
code, the strength of legal enforcement, administrative barriers, extra-legal payments and lack of
market-supporting institutions, represent a significant barrier to entrepreneurship
10
. In a study
comparing new firms in Poland, Slovakia, Romania, Russia and Ukraine, Johnson et al. (2000)

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establish that insecure property rights, in addition to weaknesses of macroeconomic stability and
adequate financing, inhibit the development of the private sector
11
.
Incentives, institutions and entrepreneurship
As Baumol noted in his seminal work, entrepreneurship development is a continuous process.
The types of entrepreneurs that will be 'activated' (actually start their businesses) is largely
affected by the existing incentive structure that results from the combination of formal and
informal institutions discussed above, such as rules, norms, rules and beliefs present in a given
environment
12
. He distinguishes between productive entrepreneurship, which creates economic
wealth through innovation and filling gaps in the market; non-productive entrepreneurship,
where entrepreneurial talent is dissipated seeking rents from government agencies, for example
privileged monopoly positions or individual tax and regulatory exempts; and destructive
entrepreneurship, such as criminal activity – drug production and distribution, or prostitution.
Different institutional arrangements, both formal and informal, change the balance of incentives
for individuals to choose between these alternative outlets for entrepreneurial talents, and thereby
influence the pattern of economic growth. Incentives that support productive entrepreneurship
results in entrepreneurship that contributes positively to economic growth whereas unproductive
and destructive entrepreneurship have a neutral or negative effect on economic growth.
For Baumol, an entrepreneur is an individual who engages in innovative activity who can be but
is not necessarily a business owner. For example, Baumol observes that wars in the early Middle
Ages in Western Europe could be viewed as unproductive entrepreneurship i.e. expressions of
'violent' yet innovative economic activity primarily engaged in rent-seeking activity. The result
of these activities led to the net reduction in social income and wealth but enriched the
'entrepreneurs'
13
. An example of productive entrepreneurship could be a Dutch merchant in 7th
century Europe. The incentives and subsequent choice to engage in productive or unproductive
entrepreneurial activities seem to depend on the socio-economic context.
In the current context, an innovative productive entrepreneur could be found starting a high-tech
venture in Silicon Valley. An innovative but unproductive entrepreneur could be a governmental
official drafting yet another bureaucratic procedure intended to increase his personal wealth
within an authoritarian regime.
Therefore, the dynamics of the entrepreneurial process can be vastly different, depending on the
incentive structure within a particular economy. As institutions become stronger, in the sense of
supporting market based economic activity, increasingly more entrepreneurship activity is
shifted toward productive entrepreneurship, thus strengthening economic growth and
development. In consequence, it is important to understand not only the individual
characteristics of the entrepreneur but also the context in which they operate: the incentives,
institutions as well as the stage of economic development. The interdependence between

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incentives and institutions also affects other characteristics such as quality of governance, access
to capital and other resources and what entrepreneurs perceive. Institutions are critical
determinants of economic behavior and economic transactions in general, and they can have both
direct and indirect effects on supply and demand of entrepreneurs.
In sum if the benefits of engaging in illegal entrepreneurial activity outweigh their costs,
entrepreneurs tend to be more inclined to engage in destructive entrepreneurship i.e.
entrepreneurship that is detrimental for economic development. Conversely if the incentives are
for ‘productive’ entrepreneurship (contributing positively to growth) then this form will
predominate. In each case entrepreneurs will weigh the incentives present in the environment
both in the form of regulations (formal rules according to North) as well as in terms of the
prevailing cultural values and norms (informal rules according to North). This does not mean
that the same individual will engage in productive, unproductive or destructive entrepreneurship
depending on the incentive structure; rather, different individuals will embark on entrepreneurial
activities under different incentive structures.
Textbox 1: Informal institutions and unproductive entrepreneurship
Baumol described a variety of historical examples in which innovation was not used for
productive entrepreneurial ends
14
. His case of medieval China seems the most similar to modern
day Russia; it did not present suitable incentives for productive entrepreneurship to develop and
as a consequence, unproductive forms of entrepreneurship flourished. One reason for this was
the absence of property rights; the Chinese monarch claimed possession of all property in his
territories. The enforcement of property rights has also been a major barrier for business
development in Russia, with violations common and the business community often opting for
informal resolution of conflicts rather than using formal institutions
15
. Baumol also highlights
the role of corruption as a way of life for civil servants in medieval China, since their official
salaries were too low to provide an adequate livelihood. Similarly, the pervasiveness of
corruption in Russia is attributed to the low wages paid to most civil servants. In terms of
informal institutions; Russians have become accustomed to a corrupt and a malfunctioning legal
environment
16
. This is characterized by corrupt behavior occurring in a disorganized way that
leads to the personal enrichment of government officials to the detriment of the rule of law and
private business development.
Medieval China was characterized by a negative view towards enterprise. As Baumol writes,
private enterprise was ‘not only frowned on, but may have been subjected to impediments
deliberately imposed by the officials’
17
. Similarly, in Russia, comparable sentiments exist
inherited from the Soviet period when entrepreneurs were equated to ‘speculators’ and deemed
criminals for making a profit. The Soviet state was built on an ideology that stifled independent
innovative culture and allowed for a punishment-oriented ‘inspection culture’ to develop
18
. The
economy had been run bureaucratically and the concentration of reward on plan attainment
suppressed the appetite for risk taking and instead bred habits of obedience and ‘playing it safe’.

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Baumol might argue that neither country therefore fulfills the preconditions for the existence of a
‘workable free-market economy’. However, China has apparently been able to harness strong
economic growth through productive entrepreneurial activity even within its inadequate
institutional environment
19
. In contrast, Russia has not been able to develop high levels of
productive entrepreneurship with the formal institutional environment being identified as the
main barrier to entrepreneurship development within its new institutional environment
20
The key institutions for entrepreneurship: property rights and the size of the state
Property rights systems form the backbone of the modern set of institutions that characterize the
market economy
21
. In essence, ‘legal property rights’ support the broader development of
economic property rights that are defined as “individual ability, in expected terms, to consume
the good (or the services of the asset) directly or to consume it indirectly through exchange”
22
.
These features of the constitution are especially important for entrepreneurs because they need to
rely on the security of their residual claims for the returns from the organizations that they have
created. Moreover, entrepreneurs must raise capital, bear risks and enter new markets. Such
activities require “transactional trust” over a long time horizon, and this is strengthened by
property rights that are stable and effectively enforced. Accordingly, in recent institutional
research, the focus has shifted from the assignment of rights and certification to the institutional
environmental conditions that make execution of these rights, especially exchange and other
legal contracts based on the property rights, effective. One important issue relates to the
accessibility of these rights to the population as a whole because the property rights system may
work well for the economic elite and remain deficient for the others
23
. This may in turn have
critical implications for the extent and performance of the entrepreneurial sector
24
. The formal
property rights system can also create a basis for financial contracts and a virtuous circle of
entrepreneurship, creation of assets and finance. Thus, property rights and finance form the two
key, mutually reinforcing blocks of the effective market economy system supporting
entrepreneurial entry.
Turning to the size of the government, when this is considered from a theoretical perspective,
one could argue that a larger government may be associated with better conditions for
entrepreneurship. More extensive government spending may create a basis for stronger
institutions, funding law and order enforcement systems that protect contracts and supporting
infrastructure that may enhance entrepreneurship. Conversely, lower government spending might
weaken the business environment.
However, this is not the only possible relationship between entrepreneurship and the size of the
state. Entrepreneurship may instead be associated with a smaller size of the state because of
various forms of crowding out. As the government becomes more active, it needs to absorb a
greater proportion of the resources of the economy and must compete for inputs with the private
sector. It therefore bids up the supply prices for key resources needed by entrepreneurs, notably

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finance and human capital, and these higher costs may be felt more keenly by entrepreneurs than
by existing firms because the former lack networks, contacts and experience. Greater
government activism also requires higher state revenues, and is associated with a more extensive
welfare system. These are likely significantly to influence both the opportunity cost and the net
financial return to entrepreneurship. The higher cost of capital resulting from financial crowding
out will also affect entrepreneurs while higher marginal rates of taxes will weaken the incentives
for entrepreneurship by reducing the expected gains. At the same time, higher levels of welfare
support provide alternative sources of income and, by increasing the alternative wage, may
therefore reduce the net expected return. And last but not least, “countries with generous social
security and welfare schemes do not emphasize the responsibility of the individual for their own
survival, which may hamper ambitions to strive for innovation and growth
25
.”
These two key dimensions of institutions have been explored by Aidis et al (2012). Their
approach allows us to categorize countries according to the quality of the property rights
institutions and the size of the state, using the GEDI index as an indication of entrepreneurial
activity. Of course, the quality of property rights institutions and the size of the state are not
necessarily distinct; the state has to be a certain scale to support institutions. One can distinguish
two potential models of institutions supporting high levels of entrepreneurial activity. The first is
a “Scandinavian” approach, in which a large and active state provides the necessary structural
foundations for a thriving entrepreneurial economy. We see examples of such an outcome in
Sweden (ranked 2nd); Denmark (ranked 3rd); and Finland (ranked 16th). But there is a second
model of success for key institutions and entrepreneurship, based on strong market supporting
property rights but otherwise a rather limited state sector. Examples include on the one hand the
United States (ranked 1st) and Singapore (ranked 13th), where the property rights system is strong
but the disincentive effects of a large state sector are kept relatively modest by, for example, the
standards of European Union countries. Economies with large state sectors can perform well
despite the disincentive effects if property rights are strong; for example Netherlands (ranked 6th)
or France (ranked 11th). However, weak protection of property rights will restrict people from
undertaking productive entrepreneurship, and countries in this situation should probably try to
limit government spending which tends to be misallocated. If we consider the GEDI study,
examples include Uganda (ranked 107th) and Guatemala (ranked 101th) who both exhibit high
levels of governmental spending, weak institutions and low levels of productive entrepreneurship
development.
Textbox 2: Networks as informal institutions
Informal institutions based on networks can positively affect entrepreneurial development. In the
absence of strong market supporting formal institutions, informal structures such as networks can
become significance, assisting entrepreneurs to mobilize resources and to cope with the
constraints of highly bureaucratic structures and officials. Networks have been found to be
important for access to resources (such as information, finance and labor) but also to greatly
enhance the entrepreneur’s opportunity recognition capabilities
26
. Social networks have also

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been identified as an antecedent for entrepreneurial alertness which constitutes a necessary
condition for opportunity recognition
27
. Some scholars have argued that a cohesive or densely
embedded network provides a competitive advantage for entrepreneurs
28
but others have
proposed that sparsely connected networks full of ‘structural holes’ provide a competitive
advantage
29
. In weak institutional environments, networks between enterprises and officials are
paramount for business survival and growth. New businesses without such connections are in
most cases destined to fail.
Institutions and the GEDI Index
The GEDI index represents the first attempt to measure productive entrepreneurship at the
national level, embedded in a specific institutional context. As such, the rankings generated by
the index go beyond those of traditional indicators of start-up, such as the Total Entrepreneurial
Activity (TEA) index produced by the Global Entrepreneurship Monitor, integrating measures of
national entrepreneurial activity with country-specific measures of the quality of institutions.
The GEDI framework is based on the idea entrepreneurship represents the dynamic reaction of
three factors, each representing an integration of individual behavioral variables and institutions.
These are entrepreneurial attitudes; entrepreneurial activity; and entrepreneurial aspirations
respectively. For each, the particular talents of individuals for entrepreneurship are weighted by
the national institutional context in which the entrepreneurial activity takes place. Thus for
example, entrepreneurial activity is measured by various indicators of startup activity, derived
from the GEM database. However, in the GEDI index, these are weighted by indicators of the
quality of institutions, notably indicators of institutional quality from internationally recognized
organizations such as the World Economic Forum and the Heritage Foundation. Thus the index
builds on the insights from Baumol that the effects of entrepreneurial effort on economic growth
will depend upon the national institutional context in which those efforts are placed.
Specifically, in the GEDI index, institutional influences are divided into the three sub-indices:
Entrepreneurial Attitudes, Actions and Aspirations. Institutional measures for Entrepreneurial
Attitudes include market size, level of education, the general business riskiness of a country, the
population’s use of the Internet, and cultural support for entrepreneurship as a good career
choice. The institutional variables included in the Entrepreneurial Action sub-index measure the
business regulatory environment, technology adsorption capacity, the extent of existing human
resources improvements through staff training, and the dominance of powerful business groups
in the domestic market. Finally, the Entrepreneurial Aspirations sub-index includes institutional
variables that measure R&D potential, the sophistication of the business and of innovation, the
level of globalization, and the availability of venture capital. One of the main criteria for
constructing the GEDI Index is selecting the key institutional (and individual variables) that
affect entrepreneurial performance. Even though 'property rights' and 'rule of law' are seen as key
factors affecting entrepreneurial development and performance, they tend to cover a wide range
of issues and no internationally acceptable measure currently exists that includes GEDI's
participating countries. Instead, the GEDI Index captures aspects of property rights through its

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variable ‘Freedom’, which represents the overall regulatory burden for starting, operating and
closing a business. In general, the institutional variables included in GEDI tend to be highly
correlated with one another.
Entrepreneurial activity will also be closely associated with the level of economic development,
measured for example by GDP/capita. Moreover, this is highly correlated with the quality of
institutions, which makes it hard to distinguish empirically between the impact of development
and of institutional quality on entrepreneurial activity. However, by integrating the measures of
entrepreneurial activity with those of institutional quality, the GEDI index is able to produce a
more credible interpretation of the way entrepreneurship is affected by development level.
This is illustrated in Figure 1, which shows that institutional development is rapid, whereas
individual features change more slowly. Thus we see that while the average values of the
institutional and individual variables are about the same, 0.49 and 0.44, respectively, their rates
of change are very different. This supports the general wisdom that institutions can be changed
relatively easily but people take a longer time to adjust to or to exploit the opportunities
presented by economic progress. The explanatory power of the connection between institutional
features and per capita GDP is high (R2 =0.80); it is much lower between individual variables
and per capita GDP (R2 =0.10). This also implies greater variation in individual entrepreneurial
characteristics.
At lower levels of economic development, individual entrepreneurial capabilities are stronger
than country-level institutional characteristics. However, institutions improve more rapidly than
individual characteristics. As countries move into the efficiency-driven stage of development, the
level of institutions reaches that of individual values, as the two curves cross. As institutions
become more highly developed in richer countries, the difference between institutional and
individual variables increases. The advantages of well-functioning institutions cannot be
exploited if individual capabilities are lagging, which is the challenge most developed countries
face. The implication is that less developed factor-driven economies should focus on improving
their institutions, efficiency-driven countries should balance improving institutions with
improving individual entrepreneurial development while the most developed countries should
focus on maintaining a high level of institutional quality and improving individual
entrepreneurial development.

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Aidis & Estrin (2013) Institutions, Incentives and Entrepreneurship
Figure 1: The average values of institutional and individual variables in terms of per capita
GDP
30
Key: Total number of countries =118
Conclusion
In this chapter, we have argued that the level and form of entrepreneurial activity, and therefore
its impact on economic growth, will be greatly affected by the national economic context,
notably the quality of institutions. We have summarized the rapidly growing literature on this
topic, which has begun to identify the key institutions influencing the incentives for individuals
to become entrepreneurs, as well as the complex inter-relationship between different forms of
institutions, and between institutions and the level of development.
We have noted that the GEDI index represents the first attempt systematically to address this
complex issue. It does so in a very original way, by seeking to integrate measures of
entrepreneurial activity in three broad areas with a large variety of indicators of institutional
quality which will moderate or enhance the impact of entrepreneurship on economic growth and
development.
Increasingly, national governments are interested in increasing economic growth and overall
welfare through enhanced entrepreneurial performance. As pointed out in this chapter, a
country's level of economic development is strongly related to their institutional environment.

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The GEDI index is an invaluable tool for providing an overview at the country level for the
specific constellation of institutional strengths and weaknesses.
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Notes
1
see Batjargal (2003), Hwang and Powell (2005), Boettke and Coyne (2009).
2
Baumol (1993).
3
North (1990:88).
4
North (2005).
5
DiMaggio and Powell (1983), North (1990).
6
North (1990:10).
7
Feige (1997:22).
8
North (1997:16).
9
North (1994: 361).
10
see McMillan and Woodruff (1999, 2002), Djankov et al (2004).
11
Johnson et al. (2000).
12
Baumol (1990).
13
Baumol (1990).
14
Baumol (1993).
15
Puffer and McCarthy (2001).
16
There is some tradition of this: Even during the Soviet period, the prevailing mentality was one of how to get
around the laws or enforce them for personal gain rather than a respect and understanding of the law as something
that protects the rights of its citizens and (private) businesses. As Gelman notes: ‘In the late Soviet period, informal
ties penetrated all levels of government and served as a survival kit in the everyday life of Soviet citizens, Such ties

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defended ordinary people from the arbitrary state, but they also contributed to a vicious circle of cynicism,
clientelism and corruption.’(2004:4).
17
Baumol (1993).
18
Puffer and McCarthy further note that in Russia the environment has been traditionally hostile towards
entrepreneurship even in the tsarist era, when modest entrepreneurial activity was conducted primarily by minority
ethnic groups (2001:29).
19
Hsu (2005).
20
Aidis, et al. (2008).
21
See North and Thomas (1973) and Williamson (1987).
22
Barzel (1997:3).
23
This is especially the case for 'extractive elites' see Acemoglu and Robinson (2012)
24
De Soto (2001).
25
Hessels et al. (2008: 328).
26
Hills et al (1997).
27
Ardichvili et al (2003).
28
Coleman (1988, 1990), Walker et al (1997), Ahuja (2000).
29
Burt (1992).
30
The GEDI scores for the United Arab Emirates were outliers and removed from this figure.