Baumol's Institutional Theory of Entrepreneurship
Baumol’s Theory: Productive, Unproductive, and Destructive Entrepreneurship
Why do some societies innovate while others stagnate? William J. Baumol (1990) argued that the answer isn't a lack of entrepreneurs. In fact, he assumed that every society is endowed with a roughly equal share of enterprising individuals.
The difference lies in how those entrepreneurs use their energy. Depending on the "Rules of the Game" (institutions), entrepreneurs will allocate their talent in one of three ways.
The Three Types of Entrepreneurship
Baumol moved beyond the idea that all entrepreneurship is "good." He categorized it by its economic impact:
- Productive: Innovation that creates new wealth (e.g., Steve Jobs creating the iPhone). This "grows the pie."
- Unproductive: Activities that merely redistribute wealth, often called Rent-Seeking (e.g., a corporate lobbyist securing a tax loop-hole, or frivolous lawsuits). This "slices the pie differently" but adds no value.
- Destructive: Activities that destroy wealth (e.g., the Mafia, drug cartels, or warlords). This "shrinks the pie."
The "Rules of the Game"
Baumol argued that the notion of a "spirit of entrepreneurship" (culture) is largely useless for policymakers because it is nearly impossible to measure or change.
Instead, policymakers should focus on the Rules of the Game: the formal and informal institutions that shape incentives. These include:
- Tax laws and regulations.
- The legal system (contract enforcement).
- Social norms and prestige.
If the tax code rewards lobbying more than inventing, entrepreneurs will flock to lobbying. If the legal system rewards theft (warlordism) more than trade, entrepreneurs will become warlords.
Historical Examples of Misaligned Incentives
Baumol used fascinating historical narratives to prove that entrepreneurs are chameleons—they adapt to whatever pays the most status and money.
1. Feudal Europe (Destructive)
In the Middle Ages, the "entrepreneurial" path for an ambitious young man was war. Princes would assemble armies to sack nearby fiefdoms. This required risk-taking and organization (entrepreneurial traits), but it resulted in death and destruction rather than economic growth.
2. Ancient China (Unproductive)
In Imperial China, the path to wealth was the Imperial Examination. Ambitious individuals spent decades mastering calligraphy and Confucian texts to enter the bureaucracy. While intellectually rigorous, it diverted the nation's best minds away from commerce and technology.
3. Ancient Rome (The Slavery Pathway)
Perhaps the most shocking example is how ambition manifested in Rome. The pathway to wealth often involved calculating slavery:
"A clever (and handsome) member of the lower orders might deliberately arrange to be sold into slavery to a wealthy and powerful master. Then, with luck, skill, and drive, he would grow close to his owner... The master then gained cachet, after a suitable period, by granting freedom to the slave, setting him up with a fortune of his own."
Policy Implications
The lesson for modern governments is clear: Don't try to teach "drive"; fix the incentives.
Policymakers must actively shape institutions to reduce the payoff for rent-seeking (e.g., closing tax loopholes) and increase the payoff for innovation (e.g., R&D subsidies). It is a process of constant experimentation to ensure the "Rules of the Game" channel human ambition toward productive ends.
Video: Baumol on Innovation
References
Baumol, W. J. (1990). Entrepreneurship: Productive, unproductive, and destructive. Journal of Political Economy, 98(5), 893-921.
Baumol, W. J. (1996). Entrepreneurship: Productive, unproductive, and destructive. Journal of Business Venturing, 11(1), 3-22.
