The need for innovation as a rationale for government involvement in entrepreneurship

Governments around the world seek to support entrepreneurship, yet the justification for such intervention varies. Some governments support entrepreneurship as a means to create jobs. Others support entrepreneurship as a means to create competition in markets, with attendant lower prices. In this paper, we offer a different justification for government support for entrepreneurship: to support and encourage innovation. Innovation does raise competition, lower prices, and create jobs, but more importantly through innovation entrepreneurship creates wealth for individuals and nations. We offer a model of government support for entrepreneurship to yield innovation that is grounded in theory yet rich in practical implications. Innovation is stimulated when the innovator receives the resulting payoff (termed residual claims in economic theory). In many instances, because small firms concentrate residual claims more effectively than large firms, entrepreneurial firms out-innovate established corporations. To accelerate this process, government should advance policies that facilitate new business formation and the concentration of residual claims. Such a prescription suggests two direct approaches: raising the returns to entrepreneurship and reducing the risk. Each has specific policy implications that are discussed at length. Finally we analyse aiding entrepreneurship without a commitment to innovation, and our analysis suggests that this approach is unlikely to be as successful as the focus on innovation.