Wednesday, 13 October 2010

Do economic freedom and entrepreneurship impact total factor productivity?

An interesting question, with an on the face of it strange answer, asked by Christian Bjørnskov and Nicolai J. Foss in a new working paper Do Economic Freedom and Entrepreneurship Impact Total Factor Productivity? The abstract reads:
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.
The strange bit is that they find that increasing the active involvement of the government in the economy as well as the tax burden actually increases the impact of entrepreneurship on TFP. Their explanation of this somewhat surprising, to say the least, 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. So entrepreneurs succeed despite the government rather than because of it.

(HT: Markets and Organization)

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