Risk Compensation Theory and Entrepreneurship
Risk Compensation Theory: Do Safety Nets Fuel Startups?
What is the Risk Compensation Theory of entrepreneurship? It stems from a counter-intuitive economic principle: When people feel safer, they take more risks.
This concept originated with Sam Peltzman’s (1975) pioneering study of automobile accidents. He argued that safety regulations (like seatbelts) didn't always reduce fatalities because drivers, feeling safer, compensated by driving more aggressively.
This phenomenon, now dubbed the ‘Peltzman Effect,’ extends to NASCAR racing, hockey visors, and bike helmets. But does it also explain why strong social safety nets might actually increase entrepreneurship?
The Safety Net Hypothesis
There is emerging evidence that social safety nets function like seatbelts for aspiring founders. By reducing the catastrophic risks associated with failure, they encourage individuals to leave stable employment and start ventures.
Evidence from the Field
Several studies support the idea that government support fuels private innovation:
- Food Stamps (Olds, 2016a): States that provided more food stamps saw higher LLC registrations among newly covered households. Individuals felt entrepreneurship was a viable option because their basic nutritional needs were covered.
- Public Healthcare (Olds, 2016b): When children received government health insurance, their parents were 12% more likely to start a business. Furthermore, the quality of these businesses improved, with a 36% increase in incorporated ventures.
- Unemployment Insurance (Hombert et al., 2014): A reform in France providing benefits to entrepreneurs for three years led to an immediate 25% increase in firm creation. These firms were also more productive than the older firms they replaced.
- Startup Subsidies (Caliendo & Künn, 2011): In Germany, 80% of unemployed individuals who received startup subsidies were found to be productive and happier five years later.
The "Lock-In" Effect
Conversely, the lack of a safety net creates "Employment Lock." Fairlie, Kapur, and Gates (2011) found that employer-sponsored medical insurance strengthens the ties of employees to their jobs, discouraging them from venturing out on their own.
The Future: Universal Basic Income (UBI)
This theory is highly relevant to the modern debate on Universal Basic Income (UBI). By extending a safety net beneath everyone, UBI might alleviate "desperation entrepreneurship" (starting a business because you have to), but simultaneously encourage "opportunity entrepreneurship" (starting a business because you can afford to take the risk).
As more nations experiment with UBI, we will likely gain the data needed to definitively test if guaranteed income creates a new generation of risk-takers.
Video: Elon Musk on Universal Basic Income
Related Theories
When the "cost of failure" is lowered, the "propensity for risk" increases. These frameworks explore how structural safety nets fuel entrepreneurial innovation:
1. Structural Safety
- Institutional Theory: How the "rules of the game" create the floor for risk-taking.
- Necessity vs. Opportunity: How safety nets move founders from survival to innovation.
- Real Options Theory: Viewing the safety net as a low-cost "exit option" for founders.
2. Psychological Impacts
- Self-Efficacy Theory: Reducing the physiological "fear of ruin" to boost belief.
- Resilience Theory: How structural safety supplements personal grit.
- Ambiguity Tolerance: Why those with safety nets drive faster through market uncertainty.
References
Caliendo, M., & Künn, S. (2011). Start-up subsidies for the unemployed: Long-term evidence and effect heterogeneity. Journal of Public Economics, 95(3-4), 311-331.
Fairlie, R. W., Kapur, K., & Gates, S. (2011). Is employer-based health insurance a barrier to entrepreneurship? Journal of Health Economics, 30(1), 146-162.
Hombert, J., Schoar, A., Sraer, D., & Thesmar, D. (2014). Can unemployment insurance spur entrepreneurial activity? (No. w20717). National Bureau of Economic Research.
Olds, G. (2016). Food Stamp Entrepreneurs. Harvard Business School Working Paper, No. 16-143.
Peltzman, S. (1975). The effects of automobile safety regulation. Journal of Political Economy, 83(4), 677-725.
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