Entrepreneurship Theories

The External Enabler Framework (Davidsson, Recker & von Briel, 2020) is a conceptual toolbox developed for analyzing the strategic and fortuitous influence of changes to the business environment in entrepreneurial pursuits. External Enabler (EE) refers to significant changes to the business environment, such as new technologies, regulatory changes, macroeconomic shifts, demographic and sociocultural trends, changes to the natural environment, and the like. The basic assumption of the EE body of work is that every such change will benefit some entrepreneurial initiatives even if it disadvantages other economic activities. EE analysis focuses on those enabled; other frameworks are needed for analyzing negative consequences of change. Moving Beyond "Objective Opportunity" The EE concept was introduced as a more workable alternative to “objective opportunity” for realizing the idea of entrepreneurship as a nexus of enterprising agents and favorable ...

Informal Entrepreneurship: When Business is "Illegal" but Legitimate Informal entrepreneurship refers to economic activity that occurs outside of the formal economy. It is characterized by the absence of legal and regulatory frameworks. From street vendors to unlicensed home-based artisans, these businesses operate in the "shadows" of the law. While often dismissed as "underground" activity, the informal sector is a massive engine of livelihood for millions. To understand it, we must first distinguish it from the formal sector. The Formal vs. Informal Divide The Formal Economy is recognized and regulated by government institutions. Participants pay taxes, adhere to labor laws, and obtain necessary permits. This creates a level playing field and offers protections (like bankruptcy laws or police protection). The Informal Economy lacks these protections. While this allows entrepreneurs to bypass significant administrative burdens and costs, it al...

Information Asymmetry in Entrepreneurship: Definition & Risks Information asymmetry refers to a condition where two parties in a market or organizational relationship have access to different levels of information about an exchange. It acts as the alternative to the classical economic assumption of "perfect information." In the real world, one side usually knows more than the other, leading to power imbalances and market inefficiencies. 1. Regulatory Context: The "Insider" Problem Information asymmetries are the primary reason laws exist to forbid insider trading . Company insiders (CEOs, executives) possess a "high-definition" picture of the company's financial health, while the public sees a "low-resolution" version. As Aboody and Lev (2000) note, this gives insiders an unfair advantage when buying or selling stock. To counter this, executives have fiduciary responsibilities requiring them to be truthf...

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 ...

Hoselitz’s Theory: The Entrepreneur as the "Marginal Man" Why does entrepreneurship so often emerge from socially marginalized groups? Burt F. Hoselitz , a professor of economics at the University of Chicago, argued that the drive to create new ventures is often a reaction to being on the outside looking in. Hoselitz’s work (1963) suggests that marginalization is a feature, not a bug, of the entrepreneurial class. This concept shares DNA with the Withdrawal of Status Respect Theory and the Misfit Theory .   The Concept of the "Marginal Man" Hoselitz uses the specific term “Marginal Men” to describe the ideal entrepreneurial candidate. According to the theory, these individuals sit at the intersection of two distinct conditions: They belong to a socially marginalized population in their current society. They originate from a "developed" cultural base (or possess high cultural capital). Because these individuals are excluded from...

Prospect Theory: Why Founders Fear Loss More Than They Value Gain Why do some entrepreneurs take reckless risks while others play it too safe? The answer often lies in Prospect Theory . Developed by Nobel Prize-winning psychologists Daniel Kahneman and Amos Tversky in the 1970s, this behavioral economic theory changed how we understand decision-making. Its most famous hypothesis is Loss Aversion : the psychological pain of losing is about twice as powerful as the pleasure of gaining. The Two "Frames" of Risk The theory posits that humans are not rational calculators. Instead, our risk tolerance changes entirely based on whether we feel like we are currently "winning" or "losing." The Gain Domain (Winning): When individuals think they are ahead, they become Risk-Averse . They want to protect what they have won. The Loss Domain (Losing): When individuals think they are behind, they become Risk-Seeking . They are inclined to take bigger...

Cantillon’s Theory: The Origin of the Word "Entrepreneur" Who invented the word "entrepreneur"? It wasn't Steve Jobs, and it wasn't even Adam Smith. The term was traced back to Richard Cantillon , an Irish banker with French roots writing in the early 1700s. His work, Essai sur la Nature du Commerce en Général , laid the foundation for modern economics and gave us the first technical definition of the entrepreneur.   The Core Definition: Fixed vs. Uncertain Income Cantillon’s theory is built on a simple distinction between two types of economic actors: Hired People (Employees): Individuals with fixed incomes (wages). They know exactly how much they will earn. Entrepreneurs: Individuals with non-fixed incomes. They pay known costs now to produce goods that they hope to sell later at an unknown price. The Entrepreneur as Risk Bearer For Cantillon, the defining characteristic of an entrepreneur is not innovation (as Schumpeter woul...

Necessity vs. Opportunity Entrepreneurship: Push or Pull? Not all startups are created equal. While popular media celebrates the visionary founder who leaves a cushiony job to change the world, the reality of global entrepreneurship is far more diverse. Scholars (Harding et al., 2002) divide entrepreneurs into two distinct categories based on motivation: Necessity and Opportunity . This is often referred to as the "Push vs. Pull" theory. The Two Types of Motivation Basically, if you have one of these two motives, you are statistically more likely to become an entrepreneur. However, the economic impact of your venture will differ significantly depending on which one drives you. 1. Necessity Entrepreneurship ( The "Push") These individuals start businesses because they have no other choice. They cannot find a decent job, or they have been fired. They are "pushed" into self-employment to survive. Goal: Income replacement and survival. ...

Cluster Theory: Why Startups Flock Together Why do technology firms congregate in Silicon Valley? Why are movie studios in Hollywood and finance firms on Wall Street? For decades, researchers have debated the Cluster Theory of Entrepreneurship . The central question is: Do clusters form because of entrepreneurship, or do clusters create entrepreneurs? What is a Business Cluster? A cluster refers to a geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. According to Delgado, Porter, and Stern (2010) , these clusters are not just random collections of companies; they are engines of economic efficiency. [Image of Porter's diamond model] The "Spinout" Mechanism How do clusters actually grow? The primary mechanism is the Employee Spinout . Spinouts occur when employees leave an existing firm to start a complementary or competing independent venture. Berchicci, King, and Tucci (2011) found that ...

What is the Radical Subjectivist Theory of Entrepreneurship? German Economist Ludwig M. Lachmann proposed the Radical Subjectivist Theory as an alternative to existing Austrian School frameworks, such as: Kirzner's Alertness Theory Knight's Uncertainty-Bearing Theory Schumpeter's Creative Destruction Core Concepts of the Theory According to Lachmann, entrepreneurs develop plans based entirely on their subjective knowledge and expectations . Because the future is unknown, these expectations are formed by the entrepreneur's creative imagination, which envisions multiple competing futures. Key elements of Lachmann's view include: Capital Regrouping: Capital is not static. It is continually recombining. As investments are made sub-optimally, errors occur, leading to new stocks of capital that must be redeployed toward new purposes. Continuous Revision: Entrepreneurs continually revise their plans as they encounter ...

Israel Kirzner is a British-American economist and emeritus professor at New York University. He is a leading figure in the Austrian School of Economics . Below, we review Kirzner's "Alertness Theory" of entrepreneurship, which argues that entrepreneurs balance supply and demand by detecting market imperfections and exploiting them. The Cause: Market Imperfections Kirzner argues that opportunities exist because markets are not perfect. These imperfections are primarily caused by two factors: Information Asymmetry: Cases where different stakeholders have varying information about a business venture. If one stakeholder uses an information advantage to profit from another, it is considered opportunistic bargaining. Bounded Rationality: The idea that humans are not perfectly rational. While Neo-classical economics models the assumptions of "perfect" economic man, Kirzner acknowledges that real humans have limits on their knowledge and processing power...

X-Efficiency Theory: Why Incumbents Waste Resources and Startups Win Why do big, established companies waste so much money? And why does this waste create the perfect opening for entrepreneurs? American economist Harvey Leibenstein (1966) developed X-Efficiency Theory to answer these questions. While traditional economics assumes companies always maximize profits, Leibenstein argued that, in reality, most firms operate far below their potential due to "X-Inefficiency." The Problem: X-Inefficiency X-Inefficiency occurs when a firm fails to utilize its resources efficiently. This "gap" between actual performance and maximum potential emerges due to: Inertia: "We've always done it this way." Organizational Bloat: Excessive middle management. Lack of Motivation: Employees (and managers) who are not incentivized to work hard. Lack of Competitive Pressure: Monopolies get lazy. [Image of allocative efficiency vs x-effi...

What is the jack of all trades theory of entrepreneurship? The jack of all trades theory of entrepreneurship was proposed by Stanford University economist Edward P. Lazear in a working paper that was eventually published in The American Economic Review in 2004, entitle Balanced Skills and Entrepreneurship . The theory seeks to explain and predict who becomes and entrepreneur, and which entrepreneurs will be successful. According to Lazear, individuals that become entrepreneurs may have more balance in their investment strategy (on average) as compared with individuals that specialize employee roles. Jack of all trades, master of none, still better than a master of one? Lazear's core idea is that entrepreneurs need to be good at many different things, that is, they are generalists rather than specialists. For instance, when first starting out, a restaurant entrepreneur needs to select vendors for inputs such as food, furniture, equipment, and construction. He or she may als...

What is the resource scarcity theory of entrepreneurship? New ventures need to grow at a fast pace to keep up with incumbent firms. Oxenfeld and Kelly (1969) propose resource scarcity theory to explain which some new ventures choose franchising instead of chaining as a means of growth. A core assumption of the theory is that new ventures are founded below minimum efficient scale , such that there is a negative relationship between growth rate and failure of new ventures (Audretsch, 1995). Franchising  is  a quick way to expand a new venture with little upfront capital because the franchisees provide their own capital for their franchises. Since new ventures are often not able to access mainstream financial markets (e.g., for loans, bonds, and equity), franchising is an important alternative. Startups may also be less able to retain earnings to expand, given their commitments to initial investors who may want a quick return (Combs and Ketchen, 1999). Shane (1996) argues th...

Knowledge Spillover Theory: Why Smart Employees Leave Big Companies Big companies spend billions on R&D, yet startups often commercialize the most disruptive innovations. Why? Knowledge Spillover Theory (Acs et al., 2009) argues that productive innovation doesn't just come from R&D spending; it comes from the leakage of ideas. Knowledge is inherently "leaky," moving through networks and via stakeholder mobility. The Knowledge Filter The core of the theory is the concept of the Knowledge Filter . Incumbent firms create massive amounts of new knowledge. However, they are often inefficient at exploiting it. They filter out ideas that don't fit their current strategy or profit models. This unused knowledge "spills over" into the economy. [Image of knowledge spillover theory diagram] Why Incumbents Waste Knowledge Why would a company invent something and then not use it? Agarwal et al. (2010) identify several reasons why incumbents le...

Transaction Cost Theory: The "Make or Buy" Decision Why do companies exist? If markets are so efficient, why don't we just contract every single task to a freelancer? In the 1930s, Ronald Coase asked this exact question. His answer was Transaction Cost Theory (TCT) . It suggests that companies (Hierarchies) exist because sometimes the cost of using the open market is simply too high. The Three Hidden Costs of Exchange According to Coase (1937) and Nobel Laureate Oliver Williamson (1975) , every time an economic exchange happens outside of a firm, it incurs three specific costs: Search and Information Costs: The effort required to find the right supplier and determine if their price is fair. Bargaining Costs: The time and money spent negotiating contracts. This often involves lawyers, delays, and complex agreements. Policing (Enforcement) Costs: The effort required to ensure the other party actually does what they promised (monitoring quality, ...

Human capital theory was developed by Dr. Gary Becker, an American economist at the University of Chicago, and others. According to Becker (1994), human capital is a different kind of capital from physical and financial resources. Education, technology, etiquette training, and health expenditures are capital too because they improve well-being, health, earnings, and appreciation. Expenditures on education, training, and healthcare are investments in human capital. Definition of Human Capital Human capital refers to an individual or group’s stock of knowledge, routines, personality characteristics, and social habits. It even includes creativity that can be usefully applied to an economic purpose, and thus is considered to be a type of wealth. Countries, organizations, and groups with greater human capital are expected to be better able to accomplish goals to bring about economic improvement. Positive Associations Several studies have found a positive association between hu...

Agency Theory: The Battle Between Owners and Managers Why do investors insist on vesting schedules? Why do Boards of Directors exist? The answer lies in Agency Theory . Developed in the 1970s and 80s by economists like Michael C. Jensen at Harvard Business School, this theory provides the framework for understanding the often contentious relationship between those who own a company and those who run it. The Core Players: Principals vs. Agents Agency theory distinguishes between two parties with distinct roles: The Principal (The Owner): The party that delegates responsibility (e.g., the Investor or Shareholder). The Agent (The Doer): The party that performs actions on behalf of the principal (e.g., the Founder or CEO). [Image of principal agent theory diagram] The theory’s underlying assumption is cynical but realistic: Humans are self-interested. Therefore, the interests of the Principal and the Agent will inevitably diverge. If left unchecked, the Age...

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 dif...

Knight’s Uncertainty-Bearing Theory: Risk vs. True Uncertainty In the Roaring 20s, the world was changing fast. New technologies were booming, and the media idealized business tycoons as daring heroes. Amidst this backdrop of laissez-faire capitalism, **Frank Hyneman Knight**, an economist at the University of Chicago, developed a theory to explain exactly what these entrepreneurs were doing to deserve their wealth. His answer? They were bearing Uncertainty . The "Knightian" Distinction: Risk vs. Uncertainty Knight’s most enduring contribution (1921) is the distinction between two types of unknowns. While often used interchangeably in conversation, in economics, they are opposites: Risk (Insurable): Situations where the outcome is unknown, but the probability distribution is known. Example: Rolling dice or actuarial tables for life insurance. You can model this mathematically and hedge against it. Uncertainty (Uninsurable): Situations where th...