Entrepreneurship and Economic Freedom: An Analysis of Empirical Studies

Entrepreneurship is one of the main engines of the economy. Entrepreneurs invest, create jobs, and help increase the standard of living of all. This Research Paper looks at the empirical connection between entrepreneurship and economic freedom. If there is a positive correlation between these two variables, then public policies aiming to support business creation must take this fact into account.

Media release: Economic freedom promotes entrepreneurship more than government programs do
 

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Entrepreneurship and Economic Freedom: An Analysis of Empirical Studies

Highlights

Entrepreneurship is one of the main engines of the economy. Entrepreneurs invest, create jobs, and help increase the standard of living of all. This Research Paper looks at the empirical connection between entrepreneurship and economic freedom. If there is a positive correlation between these two variables, then public policies aiming to support business creation must take this fact into account.

Chapter 1 – Defining and Measuring Entrepreneurship

• Entrepreneurs are essential to economic activity. They are the ones who identify new ways of solving the economic problem (what to produce, for whom to produce, how to produce).
• According to one of the main theories of entrepreneurship, entrepreneurs are a source of economic change, and this change leads to instability. By innovating, entrepreneurs turn the established order on its head, and other companies have to adapt.
• A second theory is that of “alertness,” which is the dominant approach today in management sciences and, to a lesser extent, in economics. Entrepreneur-ship is an attitude of vigilance in the face of unrealized profit opportunities.
• According to a third theory, the skill of entrepreneurs resides in having good judgment in order to make decisions despite the uncertainty that every business or economic project must face.
• Certain institutions direct entrepreneurship toward productive activities, but if entrepreneurs are guided by bad institutions, they can become agents of stagnation and economic decline instead of being agents of growth and progress.
• Neither productive nor unproductive entrepreneurs are guided solely by institutions; they can also try to avoid institutional constraints, or even try to alter institutions.
• The fact that entrepreneurship is a more abstract concept than simply being the head of a company, and that there are several notions and types of entrepreneurship, does not mean that it is impossible to measure. It just means that it sometimes needs to be observed using indirect data.

Chapter 2 – Defining and Measuring Economic Freedom

• Economic freedom, like entrepreneurship, is a relatively abstract concept that cannot be measured directly. Instead, one must try to measure its constituent elements, namely institutions.
• The Economic Freedom of the World report divides economic freedom into five components: the size of government, the legal system and property rights, the quality of the monetary system, the freedom to trade internationally, and regulation.
• The first component, the size of government, aims to evaluate the extent to which it is the political process rather than the market that determines the allocation of resources and the production of goods and services.
• The second component, the legal system and private property rights, aims to evaluate the protection of persons and their rightfully acquired property, a central element of economic freedom and a civil society.
• The third component measures whether money and the monetary system are sound. In particular, inflation reduces economic freedom since it makes long-term economic calculation more difficult.
• The fourth component, the freedom to trade internationally, measures tariffs, quotas, hidden administrative restrictions, exchange rate controls, and limits to the movement of capital.
• The fifth component measures the regulation of credit, labour, and business, which prevents companies and individuals from making choices they would have otherwise made.
• A ranking closely related to the Economic Freedom of the World report is the Economic Freedom of North America report, which ranks states and provinces. Alberta stands out clearly as the province with the most economic freedom in Canada, and Quebec is at the bottom of the pack with a score that is far below all the other provinces.
• An additional level of detail is now available in the United States thanks to An Economic Freedom Index for U.S. Metropolitan Areas.

Chapter 3 – Does Economic Freedom Explain Variations in Levels of Entrepreneurship?

• The connection between economic freedom and business creation, at the international level, is quite obvious. A simple glance at the raw data confirms the close relationship that exists between these two variables.
• Three main studies look into this connection at the country level, confirming the positive effect of various components of economic freedom on entrepreneurship. Differences in the sources and methodologies used explain why the three studies do not arrive at exactly the same conclusions.
• Other studies look at differences between American states and confirm the positive effect of economic freedom on entrepreneurship at this level.
• One study at the metropolitan level in the United States finds that when economic freedom increases in one metropolitan area, more businesses are created there and also in neighbouring areas.
• While no econometric studies appear to have been carried out to verify if economic freedom can explain differences in the number of businesses created in the different Canadian provinces, an analysis of the raw data does reveal a clear trend line showing that more economic freedom is associated with a higher rate of business creation.
• As for the quality of entrepreneurship, three studies confirm that economic liberty can reorient entrepreneurship from unproductive activities toward productive ones. When there is more economic freedom, entrepreneurs start more companies in the business and trade sectors, and fewer in sectors directly related to the search for political privileges.

Introduction

Entrepreneurship is one of the main engines of the economy. It is the job of entrepreneurs to ensure that supply meets demand, but also to make innovations available to consumers. In so doing, they invest, create jobs, and help increase the standard of living of all.

Conscious of the importance of promoting entrepreneurship in order to stimulate economic activity, many governments have put in place assistance programs of various sorts. Among these are found, for example, entrepreneurship training and education programs, financial support for business incubators, and subsidies and loan guarantees for young entrepreneurs. It is not clear, however, that these government interventions have any notable influence on the level of entrepreneurship within a society. Some merely displace entrepreneurs, who start other kinds of businesses in order to be eligible for these programs.(1)

In contrast, the various factors that make up economic liberty play a much more important role. The size of government, the tax burden, property rights, the monetary system, openness to international trade, as well as economic regulation all have an effect on business creation. These factors correspond to what economics refers to as institutions, which is to say, the rules of the economic game.

This Research Paper looks at the empirical connection between entrepreneurship and economic freedom. The first chapter defines entrepreneurship and analyzes certain indicators used to measure this phenomenon. The second chapter defines economic freedom and introduces certain indices that measure economic freedom in the world and in North America. Finally, the last chapter provides an overview of the studies that establish the connection between economic freedom and entrepreneurship.

This Research Paper was prepared by Mathieu Bédard, Economist at the MEI.

Read the Research Paper (in PDF format only)

Note

1. Wenli Li, “Entrepreneurship and Government Subsidies: A General Equilibrium Analysis,” Journal of Economic Dynamics & Control, Vol. 26, No. 11, September 2002, pp. 1815-1844. This author even finds that the total level of entrepreneurial activity is reduced by loan assistance programs. Moreover, entrepreneurial activity attracts venture capital, but the inverse is not true, according to Steven F. Kreft and Russell S. Sobel, “Public Policy, Entrepreneurship, and Economic Freedom,” Cato Journal, Vol. 25, No. 3, Fall 2005, pp. 595-616. Another study notes that the effect of tax measures to encourage entrepreneurship in the United States has been negligible: Donald Bruce and Mohammed Mohsin, “Tax Policy and Entrepreneurship: New Time Series Evidence,” Small Business Economics, Vol. 26, No. 5, June 2006, pp. 409-425.