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Made to be Broken?

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Which makes the world go round, entrepreneurs or institutions?

Depending on whom you read, the emphasis differs.

Some scholars (Ludwig von Mises, Joseph Schumpeter, Israel Kirzner) highlight the entrepreneur’s role as an innovator, a change agent, a market driver, a forecaster of the future, a disruptor of the status quo, or an equilibrator.

Other scholars (Ronald Coase, Douglass North) stress the importance of society’s institutions, the “humanly devised constraints,” that structure the payoffs associated with alternative courses of actions.

In a famous 1990 paper, William Baumol famously asked: Why not both? 

For Baumol, the interaction of institutions and entrepreneurship permits explanation of both institutional change and subsequent economic outcomes.  

Consider that all societies contain profit-seekers (or “entrepreneurs”), but not all societies generate widespread wealth. 

Economically vibrant societies have institutions which channel entrepreneurial energy toward productive enterprise, while discouraging what Baumol called “unproductive” (transfers) or “destructive” (organized crime) entrepreneurship. In the end, the interaction of entrepreneurial effort and the institutional rules of the game give rise to either economic growth, stagnation, or decline.

It’s good as far as it goes. Rules matter. Yet, Baumol’s brilliant article assumes that the rules promulgated and enforced by governments are perfectly enforced and understood. While Baumol’s approach has proven indispensable for explaining cross-country variation in economic outcomes, his seemingly innocent “perfection” and “homogeneity” assumptions clash with popular conceptions of entrepreneurs.

Aren’t entrepreneurs rule-breaking rogues? Think Uber. Or consider the popular Silicon Valley advice that, when it comes to regulators, it’s better to ask forgiveness than permission. While a myopic focus on rule-breaking success stories might yield the conclusion that government regulations are “made to be broken,” the marketplace is also littered with the carcasses of ventures that succumbed to collisions with the law. Why do some rule-breakers transcend institutional constraints while others, like Icarus, come crashing back to earth?

In a recent paper published in the Journal of Business Venturing, David Lucas, Mark Packard, and I decided to relax Baumol’s perfection and homogeneity assumptions.

“Made to be Broken? A Theory of Regulatory Governance and Rule-Breaking Entrepreneurial Action,” seeks to explain why society’s rules of the game sometimes effectively constrain entrepreneurs, but in other instances allow for rule-breaking entrepreneurial action.

Our paper develops a theory of rule-breaking entrepreneurial action, or behavior aimed at launching new ventures in a manner inconsistent with law or other state-provided policies. Specifically, we examine which institutional conditions foster rule-breaking entrepreneurship and which constrain entrepreneurial action. Next, we illuminate the process by which some entrepreneurs identify and exploit such institutional conditions, whereas others do not.

Some ventures seek profits in outright defiance of the law. For such black-market rule-breaking entrepreneurship to occur, imperfect enforcement is a necessary institutional precondition. But weak enforcement is not a sufficient or comprehensive explanation. 

Who becomes a black-market entrepreneur? Successful black-market founders possess both knowledge about which rules are enforced in practice (as opposed to those simply listed on paper) and an attitude of “rule illegitimacy” such that they face no personal scruples about rule-breaking in the relevant context. Relational knowledge as to who will enforce rules and who is susceptible to bribery is also key.

A great example of black-market rule-breaking in action is the case of Zenefits, a business-to-business software platform that offers software-based HR solutions. So far, so good. 

Yet, beneath the legally licensed surface, Zenefits’ insurance brokers were flouting state insurance licensing laws. Zenefits’ initial, wild success was tightly linked to its ability to cut corners by deploying unlicensed employees. Imperfect enforcement provided the opening, but eventually the SEC stopped the unicorn startup in its tracks. Zenefits abandoned its original business model to focus exclusively on its HR software.

Gray-market rule-breaking is, well, grayer.

Rather than imperfect enforcement constituting the opening, gray-market entrepreneurial opportunities arise due to deviation from established rule interpretations. Such opportunities are not addressed by prior enforcement, nor are they outright forbidden by the de jure rules. In fact, such ventures might be intended to be legal, but uncertainty surrounds the application of the rules to certain or all aspects of these ventures.

Knowledge of the interrelationship between rules, as well as knowledge about ungoverned areas, is crucial for the would-be gray-market entrepreneur. Unsurprisingly, a prerequisite to gray-market entrepreneurship is heterogeneous interpretation of the rules: how they apply, what a loophole is, which actions the law proscribes, and the like. For instance, legal literacy can facilitate exploitation of the ambiguity that exists in every legal code.

Importantly, the response to gray-market rule-breaking is “socially constructed.” It’s not only regulators who (may) react to the new upstart; “legal intermediaries” also play a role. Such legal intermediaries are groups in the market who influence the interpretation of regulatory rules.

A few quick examples will make these abstract ideas concrete. Square, a financial startup founded in 2009, offers a technology which facilitates credit card payments via smartphone. Right away, commentators noted that this technology was “potentially subject to regulation.” But interpretations varied.

For one, the jurisdictional structure was unclear. Who had the right (duty?) to regulate Square? Years passed before Illinois regulators issued a cease-and-desist against Square. By then, it was too late. Square’s concentrated customer base constituted a strong legal intermediary which argued that regulatory intervention would hamper its business and economic growth. Illinois quietly dropped the cease-and-desist order in 2015. But not all gray-market entrepreneurs meet with Square’s success.

Aereo (2012-2014) was a startup that enabled buyers to stream broadcast TV without the consent of the networks. Subscribers would lease an antenna and a digital video recorder from Aereo’s warehouse, an arrangement which allowed around-the-clock access by way of streaming technology.

Meeting with initially positive reception, Aereo held that its approach was not proscribed by the 1992 Cable Television Consumer Protection and Competition Act. The company even secured significant financial backing. Success was short-lived, however. The networks appealed to the Supreme Court, and legal intermediaries in the form of the NFL and the MLB filed an amicus brief in support of the prosecution. The Supreme Court eventually ruled against Aereo, which declared bankruptcy soon thereafter.

The paragon cases of Square and Aereo illustrate something important about gray-market rule-breaking. In the language of economics, gray-market entrepreneurship is not an “equilibrium outcome.” It’s always en route to something else. Gray-market entrepreneurship exists in contested space. The interplay of consumers, regulators, the venture itself, and legal intermediaries ultimately determines how the situation resolves, either pushing the startup out of the market (Aereo) or accepting the venture’s questionable activity as legitimate (Square).

So, is it entrepreneurship or the institutional environment which, at the end of the day, drives economic outcomes? Baumol was right, it’s both. But the relationship between the two is far more complex than a casual reading of Baumol would suggest. After all, laws are like sausages. It’s better not to see them being made.

This may be a helpful quip for anyone seeking a cheerful, carefree existence. Unfortunately, it’s also been the dictum of those researching the interplay of institutions and entrepreneurship. 

While scholars have long argued that “institutions matter,” the devil is always in the (institutional) details. Understanding just how and when institutions matter requires an appreciation for imperfections in governance, the socially constructed nature of rules, and the unique knowledge and motivations of entrepreneurial actors. We hope our paper can contribute to a rich and important conversation exploring these timeless questions.

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