Basis for GEI

It is widely accepted that entrepreneurs play a central role in economic growth. However, while everyone agrees on this broad notion, the details are much murkier. As a result, there is little real understanding of policies that actually support the creation of the kind of high-growth, high-impact firms that drive economic dynamism.

In policy discussions, the notions of high-growth entrepreneurship, new ventures and small business are often confused. A frequent misconception is to equate increasing the number of new businesses with the enhancement of entrepreneurship. This approach confuses outputs and the processes that drive those outputs. Large numbers of new businesses do not automatically translate into rapid growth.

In fact, job creation does not flow from the creation of numerous tiny businesses. The bulk of new jobs by entrepreneurs are instead the result of a small number of extraordinary high-growth entrepreneurial ventures, or “gazelles”. While there are many societal benefits to small and new firms, the real economic impact is generated by “gazelles”.

The Five Stages of Economic Growth

In his classic text, Rostow (1960) suggested that countries go through five stages of economic growth. Michael Porter (2002) has provided a modern rendition of Rostow’s typology by identifying three stages of development (as opposed to growth): a factor-driven stage, an efficiency-driven stage, and an innovation-driven stage, and he adds two transitions. While Rostow focused on the age of high mass consumption, Porter’s model encompasses recent developments in the economics of knowledge and innovation. Historically, an elite entrepreneurial class appears to have played a leading role in innovation and economic development.

The factor-driven stage is marked by high rates of agricultural self-employment. Countries in this stage compete through low-cost efficiencies in the production of commodities or low value-added products. Sole proprietorships—i.e., the self-employed—probably account for most small manufacturing firms and service firms. Almost all economies experience this stage of economic development. These countries neither create knowledge for innovation nor use knowledge for exporting.

To compete in the efficiency-driven stage, countries must have efficient productive practices in large markets, which allow companies to exploit economies of scale. Industries in this stage are manufacturers that provide basic services. The efficiency-driven stage is marked by decreasing rates of self-employment. When capital and labour are substitutes, an increase in the capital stock increases returns from working and lowers returns from managing.

The innovation-driven stage is marked by an increase in knowledge-intensive activities (Romer 1990). In the innovation-driven stage, knowledge provides key input. In this stage the focus shifts from firms to agents in possession of new knowledge (Acs et al 2009). The agent decides to start a new firm based on expected net returns from a new product. The innovation-driven stage is biased towards high value-added industries in which entrepreneurial activity is important.

According to Sala-I-Martin et al (2007), the first two stages of development are dominated by innovation. In fact, innovation accounts for only about 5 percent of economic activity in factor-driven economies and rises to 10 percent in the efficiency-driven stage.  However, in the innovation-driven stage when opportunities for productivity gains from factors and efficiency have been exhausted, innovation accounts for 30 percent of economic activity. Many of today’s developing countries are experiencing all three stages of development; this places additional pressure on policymakers, business leaders and social leaders making decisions in such dynamic socio-economic systems.

We see an S-shaped relationship between entrepreneurship and economic development because in the first transition stage entrepreneurship plays a role but it increases at a decreasing rate as the efficiency stage takes over. However, as a country moves from efficiency-driven stage to innovation-driven stage (the knowledge-driven stage), entrepreneurship plays a more important role, increasing at an increasing rate and latter at a decreasing rate.

Note that Figure 1 highlights the potential impact that entrepreneurship can generate in the economy. If we were to look at raw numbers of new businesses, the s-curve would be turned upside down, because low-income economies are characterised by large numbers of subsistence and self-employment businesses.