Why is Entrepreneurship Important?

“[E]ntrepreneurs throughout modern economic history…have been disproportionately responsible for truly radical innovations – the airplane, the railroad, the automobile, electric service, the telegraph and telephone, the computer, air conditioning, and so on – that not only fundamentally transformed consumers’ lives, but also became platforms for many other industries that, in combination, have fundamentally changed entire economies.” ~ Robert Litan and Carl Schramm

The United States has an economic growth problem. From the 1960s through the 1990s, the U.S. economy grew at an inflation-adjusted average annual rate of 3.5 percent, while employment increased at an average annual rate of 2.3 percent. [1] Since then, gains in both measures have slowed substantially – averaging, respectively, 1.9 percent and 0.7 percent per year between 2000 and 2016.

Similarly, growth in labor productivity – an efficiency measure for the economy, also used as a rough proxy for innovative activity – has slowed to an average annual growth rate of 0.9 since 2010, compared with an average of 2.2 percent per year during the previous five decades (1960s-2000s). In other words, the pace at which the economy has been increasing output for a given level of inputs – the key to long-term economic growth and rising standards of living – has slowed significantly.

Clearly, something has broken down inside the economic engine, and we’ll need a swift reversal in those trends to ensure economic prosperity – and, importantly, broader participation in that prosperity – both now and in the future. A revival of American entrepreneurship is central to achieving those national objectives for several reasons:

  1. Entrepreneurship improves productivity – entrepreneurship injects the economy with a fresh batch of higher productivity firms, increases competition among existing businesses, and pushes out less-productive ones.
  2. Entrepreneurship spurs innovation – new firms are disproportionately responsible for commercializing new innovations, particularly radical innovations that spawn entirely new markets or substantially disrupt existing markets.
  3. Entrepreneurship creates jobs – new and young businesses, not small businesses, are the engine of net job creation in the economy.

Entrepreneurship Improves Productivity

Over most of economic history, it had been widely assumed that economic growth stems from enhancements to one or both of the two principal components of an economy – capital and labor. For an economy to grow, it was thought, either the labor market had to expand or capital intensity had to somehow increase.

But in 1957, American economist Robert Solow demonstrated that most of economic growth cannot be attributed to increases in capital and labor, but only to gains in productivity – more output per unit of input – driven by innovation. As businesses and workers become more efficient, costs fall, profits and incomes rise, demand expands, and economic growth and job creation accelerate.

Solow’s identification of innovation-driven productivity gains as the driver of economic growth has been echoed by economists ever since. Summarizing what is known about the drivers of sustained economic growth, Nobel Laureate Paul Krugman once observed:

“Productivity isn’t everything, but in the long run it’s almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.” [2]

If that’s true, then what drives productivity growth? Two broad areas have been established in the research literature. [3]

The first of these is “efficiency,” or the manner in which the factors of production are assembled. An efficient economy will generate a greater level of output for a given level of inputs (capital, labor, technology) compared with a less efficient economy. Productivity growth is fundamentally about achieving more with less.

A key aspect of this efficiency is “reallocative efficiency” – the ability for resources (capital and labor) to flow freely to where is most beneficial. In an economy where reallocative efficiency is high, more productive companies stay in business and grow, while less productive firms contract or possibly close doors. In sports, this is akin to making sure your best players are on the field and the second- and third-stringers ride the bench.

Indeed, the continual process of the birth, death, growth, and decay of businesses is a natural, healthy, and desirable feature of a modern economy – it keeps markets competitive, vibrant, and replenished with fresh energy and thinking.

The formation of new businesses – what we loosely refer to as “entrepreneurship” – is a particularly important component of this process of reallocative efficiency. Why? Because new businesses enter the market to challenge established firms, products, and method of production and distribution; they bring something new or improved and, in the process of doing so, their emergence promotes a more competitive environment.[4]

How important is reallocative efficiency? Well, despite being less exciting than the part of productivity driven by breakthrough technological innovations, reallocative efficiency is important enough to drive macroeconomic performance. In fact, a group of leading economists have identified the slowdown in reallocative efficiency in the American economy during the last two decades as the central culprit for the decline in productivity growth that has occurred over this period. [5]

And the decline in the firm start-up rate – our proxy for entrepreneurship – is the single biggest factor contributing to that decline.

Entrepreneurship Drives Innovation

The second and more significant force driving productivity growth is innovation – the advance of new technologies, the creation of something new or improved, or doing something in a superior way. Innovation enhances the productive capacity of an economy while holding inputs (capital and labor) constant. Growth in productivity raises the material well-being for a society, improves standards of living, and is the primary source of long-term economic prosperity.

If innovation drives productivity, what drives innovation? Put simply, new ideas and knowledge, or more precisely, commercially useful ideas and knowledge. [6]

In his seminal work on economic growth, Joseph Schumpeter wrote in 1942 about the “creative destruction” inherent in a capitalist economy – innovation is a constant, disruptive force, and a necessary one, for economic advance. Schumpeter also wrote about the central role of entrepreneurs in driving this change:

“… the function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply of materials or a new outlet for products, by reorganizing an industry and so on.” [7]

In other words, economies rely on constant improvement and fierce competition – they do not grow without innovation, especially transformative or “disruptive” innovation. And these types of innovations depend heavily on the contributions of entrepreneurs.

A large and growing body of evidence supports this understanding. Entrepreneurs play a disproportionate role in commercialization of new products, and essentially all of the most transformative innovations have been brought to the fore by entrepreneurs. [8] As economists Robert Litan and Carl Schramm have pointed out:

“… entrepreneurs throughout modern economic history, in this country and others, have been disproportionately responsible for truly radical innovations – the airplane, the railroad, the automobile, electric service, the telegraph and telephone, the computer, air conditioning, and so on – that not only fundamentally transformed consumers’ lives, but also became platforms for many other industries that, in combination, have fundamentally changed entire economies.” [9]

Entrepreneurship Creates Jobs

During the industrial era, economies of scale prevailed – bigger was better, and the largest businesses employed most people. That began to change with the decline of manufacturing and a shift towards knowledge-intensive activities – smaller, more nimble firms started factoring more prominently in the American economy during the 1970s. [10]

By the 1980s, the notion that small businesses were the engine of job creation had been set in stone – it was politically popular, consistent with the American cultural vision, and was empirically verifiable. The data, and narrative, were clear – small businesses accounted for the majority of employment and new job creation.

But a small group of economists began to challenge this thinking in the mid-1990s, and by the mid-2000s, aided by a breakthrough in data availability at the U.S. Census Bureau, turned this concept upside down. They found that it’s not small businesses that drive new job creation, but rather new and young businesses. [11] These researchers found that after adjusting for firm age, the “small business effect” of net job creation disappeared. In fact, outside of new and young firms, small businesses as a whole are net job destroyers – some create jobs, while others destroy them, but overall the second effect is larger.

Put differently, small businesses as a whole are disguised as net job creators simply because young businesses tend to be small. Untangling the size-age relationship has been a critical development for policy development – traditional small businesses have fundamentally different characteristics and objectives from growth-oriented companies in their formative years (i.e., “start-ups”).

Net Jobs

Read More

Innovation, Reallocation, and Growth,” Daron Acemoglu, Ufuk Akcigit, Nicholas Bloom, and William R. Kerr, National Bureau of Economic Research, 2013.

How Is Entrepreneurship Good for Economic Growth?” Zoltan Acs, Innovations, March 2006.

Entrepreneurship: A Survey of the Literature,” David Audretsch, European Commission, 2003.

Clusters of Entrepreneurship and Innovation,” Aaron Chatterji, Edward L. Glaeser, and William R. Kerr, National Bureau of Economic Research, 2003.

The Role of Entrepreneurship in U.S. Job Creation and Economic Dynamism,” Ryan A. Decker, John C. Haltiwanger, Ron S. Jarmin, and Javier Miranda, Journal of Economic Perspectives, 2014.

Who Creates Jobs? Small Versus Large Versus Young,” John C. Haltiwanger, Ron S. Jarmin, and Javier Miranda, Review of Economics and Statistics, 2013.