Do Economic Freedom and Entrepreneurship Impact Total Factor Productivity?

12 October 2010 at 2:50 pm Nicolai Foss 3 comments

| Nicolai Foss |

Cross-country studies of the antecedents and consequences of entrepreneurship have become something of a cottage industry. My contribution to the industry is an earlier paper with Christian Bjørnskov, as well as rather recent one, also written with Christian, “Do Economic Freedom and Entrepreneurship Impact Total Factor Productivity?” (and we have a third paper in the works with a certain Klein).

In the former paper we analyzed institutions and economic policies as determinants of entrepreneurship, paying particular attention to “freedom variables,” like sound money and a stable legal framework. In the latter paper, we focus on where the action is in the growth process, namely Total Factor Productivity, and proffer Austro-institutional arguments why entrepreneurship and the institutions associated with a free society may be expected to positively impact TFP.

While we find that entrepreneurship strongly and significantly impacts TFP, our results only partially support the intuition that institutions of liberty as well as liberal economic policies promote growth in productivity. In fact, we find no significant effects of sound money and legal quality on TFP in the medium run. When some of the freedom variables are interacted with the entrepreneurship variable, we in fact find that entrepreneurial activity is more effective in raising levels of TFP in environments dominated or strongly influenced by government activity, either through production in government-owned enterprises and investments or in its financing activities. Thus, increasing the active involvement of the government in the economy as well as the tax burden actually increases the impact of entrepreneurship on TFP. Our explanation of this somewhat surprising finding is that a reduced supply of entrepreneurship increases the marginal productivity of entrepreneurship; thus, the best ideas do survive even in the relatively hostile welfare state environment.Here is the abstract:

The economics of growth has shown that countries not only grow by deploying higher levels of inputs to production, but also by better allocating whatever resources are at their disposal and by introducing productivity-enhancing innovations. We proffer arguments as to why and how entrepreneurship as well institutions of liberty (i.e., economic freedom, including the rule of law, easy regulations, low taxes and limited government interference in the economy) positively impact total factor productivity (TFP): These institutions allow entrepreneurial experimentation with the combination of factors to take place at low transaction costs. We test these ideas on a unique panel data set derived from Compendia, World Bank data and the Fraser Institute’s economic freedom data. We find that while entrepreneurship positively impacts TFP, the marginal contribution of entrepreneurship to TFP is strongest in economies with substantial government activity.

Entry filed under: - Foss -, Austrian Economics, Entrepreneurship, New Institutional Economics, Papers.

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3 Comments Add your own

1. Rafe | 12 October 2010 at 4:04 pm

This looks like a great application of institutional analysis using maths in the form of regression models: the question is, how many units of maths do you need to do this kind of work? Quite likely none, so what about the idea of an economics course that has minimal maths so students (a) learn the economic way of thinking and (b) can step straight into interdisciplinary work? And pick up more maths units later if they find they are moving into a field where that will help.
2. Keith | 13 October 2010 at 1:48 pm

“Our explanation of this somewhat surprising finding is that a reduced supply of entrepreneurship increases the marginal productivity of entrepreneurship; thus, the best ideas do survive even in the relatively hostile welfare state environment.”

That was actually the first explanation that came to me when I read the previous statement. Very neat.