The environment advantage
Research Paper Title:
“Calling Baumol: What telephones can tell us about the allocation of entrepreneurial talent in the face of radical institutional changes”
Authors:
Background:
In his seminal contribution, Baumol (1990) proposes that the direction of entrepreneurial effort towards its productive (e.g., start-up activity) or unproductive (e.g., rent-seeking) use in a society depends on institutions or the “rules of the game”. The authors of this study investigate how entrepreneurial individuals behave when institutions change radically, thereby formulating and empirically testing an important micro-foundation of Baumol's theory namely that certain individuals change the direction of entrepreneurial efforts when institutions change. More generally, the study sheds light on how individuals allocate their entrepreneurial effort in times of major historical shocks, focusing on the case of German reunification.
Highlights:
The authors analyze start-up activity during drastic institutional change.
The authors find loyal supporters of a communist regime becoming firm founders after the regime's collapse.
This paradox can be understood through the lens of Baumol's and Kirzner's theories.
Methodology:
Sample Description: East German sample of the German Socio-Economic Panel Study (SOEP)
Sample Size: Who decides to start a venture after a radical institutional change, such as the one witnessed by East Germans after the fall of the Berlin Wall? This study shows that people who demonstrated commitment to one of the most anti-entrepreneurial institutional regimes in history “communism” were more likely to start a firm after the transition to a market economy. The authors offer an explanation for this puzzling phenomenon by looking at it through the lens of Baumol's (1990) and Kirzner's (1973, 2009) theories. To this end, regime commitment does not have to be regarded as an affirmation of communist ideology, but as alertness to rent-seeking opportunities in an entrepreneurship-hostile context where material rewards can be obtained through demonstrating regime commitment. Entrepreneurial individuals promptly reallocate their entrepreneurial effort toward startup activity when institutions change and become entrepreneurship-friendly. This almost immediate re-allocation of entrepreneurial efforts indicates that alertness to arbitrage opportunities emerging in a market economy does not necessarily require experience in a market economy context.
Analytical Approach: OLS, logit regressions
Hypothesis:
The original Baumol's (1990) proposition is framed at the macro-level:
Entrepreneurial behavior changes direction from one economy to another in a manner that corresponds to the variations in the rules of the game (p. 899).
The authors of this study extend Baumol's views and formulate and test empirically a proposition that can be considered as a micro-foundation of Baumol's theory: “A person's entrepreneurial behavior changes direction in a manner that corresponds to the variations in the rules of the game".
Results:
People who were actively committed to the regime as evidenced by material rewards obtained in the GDR were more likely to (successfully) start a business after the fall of the Berlin Wall.
They earned higher incomes as entrepreneurs, and their start-ups survived longer, which largely rules out necessity-based explanations for their start-up motive.
It is observed that people with an entrepreneurship-prone personality profile and those who put a strong emphasis on entrepreneurial values, such as autonomy, were more likely to have obtained material rewards in communism that indicate a strong commitment to the system.
The results are robust when controlling for specific types of human capital, wealth holdings, and occupations including leading positions in management and the party apparatus.
Conclusion:
This study is a novel contribution to entrepreneurship literature. By following Baumol's original framework, it explores its micro-foundations and shows that when institutional incentives for start-up activity are weak, individual entrepreneurial efforts are directed towards rent-seeking. Thus, the findings support Baumol's idea that the institutional framework conditions determine the type of entrepreneurial activity to which entrepreneurially talented people devote their efforts. So far, this claim found support mainly in aggregated macro-level data. Another important insight is that entrepreneurs are flexible and agile economic agents who are alert to arbitrage opportunities and able to promptly adapt themselves to even radical changes in their environment, such as the shock transition from a socialist command economy to a market economy. Alertness to opportunities in a market economy context could hardly be learned in an anti-entrepreneurial context. Hence, an immediate re-allocation of entrepreneurial efforts indicates that alertness to arbitrage opportunities emerging in a market economy does not necessarily require experience in a market economy context.