Entrepreneurship in Developing Countries

III.4.1 Demonstration and Failure Externalities 

 

The relatively small number of examples of successful entrepreneurship renders 

demonstration and failure externalities extremely important in developing countries.  King 

and Robson described a similar effect as “learning by watching” where “new investment 

projects in one sector of the economy have a demonstration effect on the efficiency of 

other sectors.” ([83], p.449)  An important aspect of their model is that the spillovers are 

 

Jena Economic Research Papers 2009 - 023

---

generated by the act of investment itself and do not depend on the actual outcome of the 

project ([83]).  Therefore, each new investment yields productivity spillovers.  However, 

the model assumes that the positive externalities to observing new projects (i.e. the 

increases in productivity) gradually decline over time ([83]) and that the productivity 

growth rate (defined as the technological progress frontier) eventually levels off ([83], 

p451).  In a similar way, there are important spillover effects from having examples of 

business formation and from entrepreneurs observing successful going concerns.  Potential 

entrepreneurs observe the strategies and business operations of existing entrepreneurs and 

gather information about potential markets, input suppliers and production techniques.  As 

such, market entry becomes increasingly important for generating these externalities.  

Additionally, potential and existing entrepreneurs also learn from failing and failed 

businesses.  They learn what not to do or what to do differently.  Markets must, therefore, 

be free from excessive interventions which do not allow firms to fail for these failure 

externalities to be effective. 

 

We identify four core themes in the literature which affect demonstration and 

failure externalities through their effects on entrepreneurial entry, business operations and 

entrepreneurial exit:  (1) culture, values and norms; (2) views on outsiders and 

inclusiveness, (3) the level of economic freedom and (4) an economy’s fundamentals 

including its macroeconomic stability, infrastructure and the level of development of its 

financial markets. 

 

 

Jena Economic Research Papers 2009 - 023

---