Institutional Environment and Entrepreneurship

Several scholars have argued that the rate of new venture formation and growth is directly influenced by the institutional environment, both formal and informal, in which the venture is operating.[1]  New ventures, being both new and small, must struggle to gain legitimacy and survive in their external environment and one way to do that is to conform to the norms and practices that have been prescribed and sanctioned by the institutional environment.  In many ways, the institutional environment limits the range of strategic options that are available to new ventures in a society[2] and thus plays an important role in both the creation and destruction of entrepreneurial activities in that society.[3]  It is, therefore, not surprising that one area of comparative research with respect to international entrepreneurship is comparing the institutional environment of different societies as to their favorability for entrepreneurship.  The need for this type of research is particularly compelling for emerging economies as they struggle to identify and implement policies that can promote economic development including policies to encourage entrepreneurs to form new ventures that hopefully create new jobs and contribute to an increase in overall economic welfare.[4]  In fact, several researchers have asserted that the rate and trajectory of entrepreneurial activities in emerging countries is significantly influenced by the institutional environment in those countries.[5]

While North defined the “institutional framework” of a society as “the fundamental political, social and legal ground rules, which establish the basis for production and distribution”[6], Scott laid the foundation for meaningful comparison by suggesting that the formal and informal institutions that influence business can be categorized as follows: regulatory institutions, which include the formal system of laws and regulations which have been adopted and enforced in a given community, society or country; normative institutions, which include the commercial standards and conventions that have been established and recognized through professional and trade associations in a given community, society or country; and cognitive institutions, which encompass the culture-specific beliefs regarding socially appropriate behavior which are acquired by persons as they undergo the socialization process in the community, society or country.[7]  These categories served as the basis for the creation of a survey instrument by Busenitz et al. that has often been used as a means for measuring a country’s institutional profile.[8]  The survey items for the various categories, sometimes referred to as “dimensions”, included the following:

• Regulatory: The level of government assistance and special support to individuals looking to start their own business; the degree to which the government sets aside contracts for new and small businesses; the level of government sponsorship of organizations that assist in the development of new businesses; and the degree to which the government assist entrepreneurs who have failed in earlier business to start new businesses.
• Cognitive: The knowledge and skills possess by people in the country pertaining to establishing and operating a new business as indicated by the degree to which individuals know how to legally protect a new business; the degree to which entrepreneurs know how to cope with high levels of risk and manage those risks; and the availability of information regarding markets for products and services to be offered by new businesses.
• Normative: The degree to which entrepreneurship is an admired career path within the society; the degree to which innovative and creative thinking is valued and viewed as a route to success within the society; and the degree to which entrepreneurs are admired in the society.[9]

Eunni used the survey instrument to study and compare the institutional environment for entrepreneurship in two emerging economies: Mexico and Brazil.[10]  Eunni first concluded that the Busenitz et al. survey methodology, which was originally designed for industrialized economies, would also be valid for emerging economies in Latin America.  Eunni went on to observe that the results of the surveys in the two countries included evidence of significant differences between them with respect to both the regulatory and cognitive dimensions, with Mexico performing much better on both of those dimensions than Brazil.  When discussing the regulatory dimension, Eunni noted the importance of measuring the time and difficulty associated with starting a business, employing workers and registering property.  With regard to the cognitive dimension, relevant factors might include religious beliefs and the influence of parents and other family members.  Mexico also scored higher than Brazil with respect to its overall institutional profile; however, it was quite telling to see that while there were differences between the two countries neither of them were especially favorable to new venture creation.[11]  Eunni recommended that the number of countries sampled be increased in the future to test and validate the survey instrument and cautioned that, of course, institutional environments can be expected to evolve as time goes by and that it is therefore necessary to conduct follow up surveys as policy initiatives are implemented.

The Global Entrepreneurship Monitor (“GEM”) is a partnership between the London Business School and Babson College that administers a comprehensive research program to produce annual assessments of national levels of entrepreneurial activity.  The project was first launched in 1999, when it covered just ten countries, and has since grown to cover as many as 85 countries in subsequent years and is recognized as the largest ongoing study of entrepreneurial dynamics in the world.  The main objectives of the GEM program are measurement of differences in the level of entrepreneurial activity between countries, uncovering the factors that lead to appropriate levels of entrepreneurship and making suggestions for policies that may lead to enhancement of national levels of entrepreneurial activity.[12]

The GEM is based on a conceptual model of the institutional environment and its effect on entrepreneurship.  The model recognizes the importance of the social, cultural and political context in which entrepreneurial activities occur and assumes that these contextual factors influence three sets of conditions: basic requirements, which include institutions, infrastructure, macroeconomic stability, health and primary education; “efficiency enhancers”, which include higher education, goods and labor market efficiency, financial market sophistication, technological readiness and market size; and the following “entrepreneurial framework conditions” (“EFCs”), which represent elements of the institutional environment for entrepreneurship in a particular country:

• Finance:  The availability of financial resources—equity and debt—for small and medium enterprises (“SMEs”) (including grants and subsidies);
• Government policies:The extent to which taxes or regulations are either size-neutral or encourage SMEs;
• Government programs: The presence and quality of direct programs to assist new and growing firms at all levels of government (national, regional, municipal);
• Entrepreneurial education and training:  The extent to which training in creating or managing SMEs is incorporated within the education and training system at all levels (primary, secondary and post-school);
• R&D transfer: The extent to which national research and development will lead to new commercial opportunities and is available to SMEs;
• Commercial and professional infrastructure: The presence of property rights and commercial, accounting, and other legal services and institutions that support or promote SMEs;
• Entry regulation: Contains two components including “Market Dynamics”, which is the level of change in markets from year to year, and “Market Openness”, which is the extent to which new firms are free to enter existing markets;
• Physical infrastructure and services:  Ease of access to physical resources—communication, utilities, transportation, land or space—at a price that does not discriminate against SMEs; and
• Cultural and social norms: The extent to which social and cultural norms encourage or allow actions leading to new business methods or activities that can potentially increase personal wealth and income.

The study of the relationship of the institutional environment, regardless of how it is defined and measured, and entrepreneurship is part of the larger field of “new institutional economics” (“NIE”), which was pioneered by scholars, such as Coase, North and Williamson[13], who were interested in making sure that there was a recognition that “institutions matter” and that the structure and performance of institutions has a substantial influence on economic behavior.  Work in NIE has included property rights analysis, transaction cost economics, public choice theory and comparative economic systems.[14]  While there appears to be growing acceptance that institutions must be considered when developing and testing economic theories, particularly with respect to growth and development, the processes remain fairly new[15] and it has been observed that “the causality of the various links and channels of influence between the institutional set-up and development outcome is still not well or fully understood”.[16]  It has also been acknowledged that the effectiveness of formal institutions and institutional change depends on other factors.  For example, Milo noted that “[f]ormal rules must be securely nested in hospitable informal norms for them to function well, since it is the latter that legitimizes the former”.[17]  In addition, several scholars have cautioned that economic institutions must have the support of the appropriate political institutions in order to be effective.[18]  In fact, enlightened political leadership can make even ineffective economic institutions workable and Milo advised that “[t]here are times when it is preferable to work within the context of imperfect existing institutions, rather than use up political capital on long-term institutional reforms”.[19]

While much time, effort and capital has been invested in institutional reform in both developed and developing countries the results have not always been what had been expected.[20]  It seems clear that creating institutions is not sufficient and that growth and economic development only follows when the institutions are “efficient” and “encourage individuals to engage in productive activities by providing appropriate incentives and establish a stable structure of human interactions, which reduce uncertainty”.  Scholars have identified and defined two types of “efficiency” with respect to institutions.  The first is “substantive efficiency”, which includes rules that promote allocative efficiency, and the second is “procedural efficiency”, which include rules designed to either reduce the cost or increase the accuracy of participating in and using the system of rules that form the institutions.[21]  Milo has suggested that to achieve the institutional efficiency necessary for achieving development countries must have institutions “that promote exchange by lowering transaction costs and promoting trust . . . and [institutions] that induce the state to protect rather than expropriate private property”.[22]  Institutions that are likely to have the desired effect of improving the efficiency and integrity of economic transactions include “contracts and contract enforcement mechanisms, commercial norms and rules, and habits and beliefs favoring shared values and the accumulation of human capital” and institutions that can be expected to contribute to the creation and protection of private property rights include “[c]onstitutions, electoral rules, laws governing speech and education, and legal and civic norms”.[23]

This post is part of the Sustainable Entrepreneurship Project’s extensive materials on  Entrepreneurship.

[1] R. Eunni, “Institutional Environments for Entrepreneurship in Emerging Economies: Brazil vs. Mexico”, World Journal of Management, 2(1) (March 2010), 1-18 (citing H. Hwang and W. Powell, “Institutions and Entrepreneurship” in Z. Acs and D. Audretsch (Eds.), Handbook of entrepreneurship research. (Norwell, MA: Kluwer, 2005), 179-210; D. Gnyawali and D. Fogel, “Environments for entrepreneurship development: Key dimensions and research implications”, Entrepreneurship Theory and Practice, 18(4) (1994), 43-62; and H. Aldrich, “Using an ecological perspective to study organizational founding rates”, Entrepreneurship Theory and Practice, 14(3) (1990), 7-24).

[2] D. Ahlstrom and G. Bruton, “An institutional perspective on the role of culture in shaping strategic actions by technology-focused entrepreneurial firms in China”, Entrepreneurship Theory and Practice, 26(4) (2002), 53-70; and W. Roy, Socializing capital: The rise of the large industrial corporation in America (Princeton, NJ: Princeton University Press, 1997).

[3] H. Aldrich and G. Wiedenmayer, “From traits to rates: An ecological perspective on organizational foundings” in J. Katz and A. and Brockhaus (Eds.), Advances in Entrepreneurship, Firm Emergence, and Growth (Greenwich, CT: JAI Press, 1993), 145-195.

[4] A. Wennekers and A. Thurik, “Linking entrepreneurship and economic growth”, Small Business Economics, 13(1) (1999), 27-55; and W. Baumol, The Free Market Innovation Machine: Analyzing the Growth Miracle of Capitalism (Princeton, NJ: Princeton University Press, 2002) (both observing that new venture creation leads to the creation of new jobs and economic welfare).

[5] M. Peng and P. Heath, “The growth of the firm in planned economies in transformation: Institutions, organizations and strategic choice”, Academy of Management Review, 21 (1996), 492-528; D. Ahlstrom and G. Bruton, “An institutional perspective on the role of culture in shaping strategic actions by technology-focused entrepreneurial firms in China”, Entrepreneurship Theory and Practice, 26(4) (2002), 53-70; D. Smallbone and F. Welter, “The distinctiveness of entrepreneurship in transition economies”, Small Business Economics, 16 (2001), 249-262; and D. Smallbone and F. Welter, “Conceptualizing entrepreneurship in a transition context”, International Journal of Entrepreneurship and Small Business, 3(2) (2006), 190-206.

[6] D. North, Institutions, institutional change, and economic performance (New York: Norton, 1990).  In a later work, North commented that institutions “form the incentive structure of a society, and the political and economic institutions, in consequence, are the underlying determinants of economic performance” and then defined institutions as “the humanly devised constraints that structure human interaction . . . [t]hey are made up of formal constraints (such as rules, laws, constitutions), informal constraints (such as norms of behavior, conventions, self-imposed codes of conduct), and their enforcement characteristics”. D. North, Economic Performance through Time, American Economic Review, 84(3) (1994), 359–68, 360.

[7]  W. Scott, Institutions and organizations (Thousand Oaks, CA: Sage, 1995).  Scott’s classification model has been adopted by a number of other researchers.  See, e.g., D. Ahlstrom and G. Bruton, “An institutional perspective on the role of culture in shaping strategic actions by technology-focused entrepreneurial firms in China”, Entrepreneurship Theory and Practice, 26(4) (2002), 53-70; T. Kostova, “Country institutional profiles: Concept and measurement”, Academy of Management Best Paper Proceedings, 1997, 180-189; A. Parkhe, “Institutional environments, institutional change and international alliances”, Journal of International Management, 9 (2003), 305-316; and G. Bruton, V. Fried and S. Manigart, “Institutional influences on the worldwide expansion of venture capital”, Entrepreneurship Theory and Practice, 29 (2005), 737-760.

[8] L. Busenitz, C. Gomez and J. Spencer, “Country institutional profiles: Unlocking entrepreneurial phenomena”, Academy of Management Journal, 43 (2000), 994-1003.

[9] It should be noted, however, that when discussing the normative dimension a comparison of the institutional environment for entrepreneurship in Mexico and Brazil, Eunni included the role of industry and trade associations, formalization of recordkeeping and accounting requirements, the sophistication of local banking and insurance industries, support for new business incubation and the availability of funding for the promotion of innovation.  R. Eunni, “Institutional Environments for Entrepreneurship in Emerging Economies: Brazil vs. Mexico”, World Journal of Management, 2(1) (March 2010), 1-18.

[10] Id. (citing H. Hwang and W. Powell, “Institutions and Entrepreneurship” in Z. Acs and D. Audretsch (Eds.), Handbook of entrepreneurship research. (Norwell, MA: Kluwer, 2005), 179-210; D. Gnyawali and D. Fogel, “Environments for entrepreneurship development: Key dimensions and research implications”, Entrepreneurship Theory and Practice, 18(4) (1994), 43-62; and H. Aldrich, “Using an ecological perspective to study organizational founding rates”, Entrepreneurship Theory and Practice, 14(3) (1990), 7-24).

[11] Eunni reported that for both countries the means of their scores were below “4” on the 7-point Likert scale and observed that the findings were consistent with how the countries fared in other studies such as the World Economic Forum’s Global Competitiveness Report (in 2008 Mexico ranked 60^th and Brazil 64^th among 134 surveyed countries on indicators of economic competitiveness) and the World Bank’s “Ease of Doing Business” rankings (in 2008 Mexico ranked 56^th and Brazil ranked 125^th among 181 surveyed countries).  Id.

[12]  For further discussion of the GEM, see “Research in Entrepreneurship” in “Entrepreneurship: A Library of Resources for Sustainable Entrepreneurs” prepared and distributed by the Sustainable Entrepreneurship Project (www.seproject.org)..

[13] See, e.g., R. Coase, The Nature of the Firm, Economica, 4(4) (1937), 386–405; O. Williamson, The Institutions of Governance, American Economic Review, 88(2) (1998), 75-79; D. North, Economic Performance through Time, American Economic Review, 84(3) (1994), 359–68.

[14] M. Milo, Integrated Financial Supervision: An Institutional Perspective for the Philippines (Tokyo: Asian Development Bank Institute, ADBI Discussion Paper 81, 2007), 18.

[15] J. Aron, “Growth and Institutions: A Review of the Evidence”, The World Rank Research Observer, 15(1) (2000), 99–135.

[16] M. Milo, Integrated Financial Supervision: An Institutional Perspective for the Philippines (Tokyo: Asian Development Bank Institute, ADBI Discussion Paper 81, 2007), 19 (citing J. Jütting, Institutions and Development: A Critical Review (Paris: OECD Development Centre, Work Paper No. 210, 2003).

[17] Id.

[18] See, e.g., K. Chu, “Collective Values, Behavioural Norms and Rules: Building Institutions for Economic Growth and Poverty Reduction” in R. van der Hoeven and A. Shorrocks (Eds.), Perspectives on Growth and Poverty (Tokyo:  United  Nations University Press, 2003); F. Fukuyama, “Development  and  the  Limits  of  Institutional  Design”, Paper presented   at  the  Seventh  Annual  Global  Development  Network  Conference, St. Petersburg, 19–21 January 2006; and D. North, Economic Performance through Time, American Economic Review, 84(3) (1994), 359–68.

[19] M. Milo, Integrated Financial Supervision: An Institutional Perspective for the Philippines (Tokyo: Asian Development Bank Institute, ADBI Discussion Paper 81, 2007), 19.

[20] For discussion of the role of institutions in establishing a platform for entrepreneurship that can lead to economic growth and development, see “Entrepreneurship in Developing Countries” prepared and distributed by the Sustainable Entrepreneurship Project (www.seproject.org)..

[21] M. Milo, Integrated Financial Supervision: An Institutional Perspective for the Philippines (Tokyo: Asian Development Bank Institute, ADBI Discussion Paper 81, 2007), 19 (citing R. Posner, “Creating a Legal Framework for Economic Development”, The World Bank Research Observer, The World Bank, Washington DC, 1998.).

[22] Id.

[23] Id. at 20 (citing M. Shirley, “Institutions and Development” in C. Menard and M. Shirley, Handbook of New Institutional Economics (Dordrecht, Netherlands: Kluwer Academic Publishers, 2005)).