Strategic and Natural Risk in Entrepreneurship: An Experimental Study

• Author: Dana Sisak,John Morgan,Martin Sefton,Henrik Orzen
• Date: 01 April 2016
• Published date: 01 April 2016
• DOI: http://doi.org/10.1111/jems.12140

Strategic and Natural Risk in Entrepreneurship:

An Experimental Study

JOHN MORGAN

Haas School of Business and Department of Economics

University of California, Berkeley

California, United States

morgan@haas.berkeley.edu

HENRIK ORZEN

Department of Economics

University of Mannheim

Mannheim, Germany

MARTIN SEFTON

School of Economics

The University of Nottingham

Nottingham, United Kingdom

DANA SISAK

Erasmus School of Economics & Tinbergen Institute

Erasmus University Rotterdam

The Netherlands

We report on the results of experiments where participants choose between entrepreneurship

and an outside option. Entrepreneurs enter a market and then make investment decisions to

capture value. Payoffs depend on both strategic risk (i.e., the investments of other entrepreneurs)

and natural risk (i.e., luck). Absent natural risk, participants endogenously sort themselves

into entrepreneurial and safe types, and returns from the two paths converge. Adding natural

risk fundamentally changes these conclusions: Here we observe excessive entry and excessive

investment so that entrepreneurs earn systematically less than the outside option. These payoff

differences persist even after many repetitions of the task. With a risky outside option, entry

further increases and about one-third of entrepreneurs adopt a passive strategy,investing little or

nothing. Finally, we examine an environment where an individual must become an entrepreneur

but chooses the stakes over which she will compete. Due to under-entry and under-investment in

the high stakes setting, the returns gap grows to over 15 percentage points. A two-factor model

incorporating loss aversion and love of winning can rationalize these returns patterns.

We thank Amy Nguyen-Chyung, participants at the 2009 Amsterdam Symposium on Behavioral and Ex-

perimental Economics, the 2009 winter meetings of the Economic Science Association, the 2010 Bay Area

Experimental Economics Conference, and the University of East Anglia for helpful comments and sugges-

tions. This paper substantially benefited from helpful referee comments. Weare indebted to Elke Renner for

kindly sharing her data on risk attitudes at the University of Nottingham. Financial support from the National

Science Foundation and the Swiss National Science Foundation is gratefully acknowledged. Sefton thanks the

ESRC (ES/K002201/1) for support.

The copyright line for this article was changed on July 13, 2016 after original online publication.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License,

which permits use, distribution and reproductionin any medium, provided the original work is properly cited

and is not used for commercial purposes.

C2015 The Authors. Journal of Economics & Management Strategy Published by Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 2, Summer 2016, 420–454

Risk in Entrepreneurship 421

1. Introduction

Many view entrepreneurship as a fundamental driver of economic growth. As a

result, countries routinely subsidize entrepreneurship, especially small-scale ventures.

An important determinant of entrepreneurial activity and performance are the risks

entrepreneurs face. Thus, much of the entrepreneurship literature seeks to identify

characteristics, such as risk preferences, as well as personality traits of would-be

entrepreneurs.1Wu and Knott (2006) point out that, although entrepreneurs are

conventionally risk-averse in responding to demand uncertainty, they are risk-seeking

(overconfident) about risks related to their own ability. In this paper, we distinguish

between two aspects of risk: Strategic risk is the risk associated with the fact that payoffs

are affected by the actions of other entrepreneurs and success or failure depends not

only on one’s own entrepreneurial decisions, but also on the entrepreneurial decisions

of others. It is more difficult to succeed, and entrepreneurial returns are likely to be

lower, in crowded markets where competitors invest heavily. Natural risk recognizes

that entrepreneurial decisions alone do not determine financial outcomes. Luck also

plays a crucial role. Certainly, any aspiring entrepreneur opening up a new restaurant

or coffee shop realizes the role that fads, fashions, and other vicissitudes of fortune

have on outcomes. We study the impact of these different types of risk on entry into

entrepreneurship and subsequent performance.

Controlling for differences in strategic versus natural risk as well as the levels and

riskiness of a would-be entrepreneur’s outside option is difficult using field data. Thus,

we use laboratory experiments to examine how these factors influence entrepreneurship.

This has the advantage that we can control for these aspects of the market precisely. It

also lets us compare rates of return between entrepreneurship and an outside option

including how these returns vary over time. Finally, we also examine the life-cycle of

entrepreneurship decisions, that is, how experience affects both entry and investment

in entrepreneurial activity.

As far as we are aware, our study is one of the first to investigate different types

of entrepreneurial risks using the methodology of laboratory experiments. We do this

by examining choices to enter a competitive environment, where we manipulate the

risks associated with entering or not.2Although we refer to entrants as “entrepreneurs”

throughout the paper, this is merely a metaphor for the situations that we sought to

approximate via experiments. We labeled choices neutrally when presenting them to

subjects, and we cannot know if a subject had in mind the role of entrepreneur. We

could equally well have labeled an entrant as a “contestant” because our entrepreneur-

ship game is mathematically equivalent to a Tullock contest. Previousexperiments have

examined isolated aspects of the entrepreneur’s choice. For example there is an extant

experimental literature on the decision to enter the market in the first place. In the stan-

dard entry experiment, individuals simultaneously decide whether or not to enter and

payoffs are determined according to a schedule such that entry payoffs are decreas-

ing in the number of entrants. Equilibrium, which is in mixed strategies, suggests that

1. See, for example, Parker (2009) who offers a survey as well as Caliendo and Kritikos (2012) for an

overview of recent developments in this literature.

2. Camerer and Lovallo (1999) also study entry into a tournament-like setting, but do not manipulate

risks. Several experiments have used a similar competitive environment to us (Tullockcontests, Tullock, 1980),

and manipulate the riskiness of the contest, but do not examine entry decisions (e.g., Chowdhury et al., 2014;

Masiliunas et al., 2012; Fallucchi et al., 2013; Shupp et al., 2013). Wesummarize these findings on p. 6. See also

Bohnet et al. (2008), as well as Eckel and Wilson (2004), for comparisons of strategic and natural risk in trust

settings.

422 Journal of Economics & Management Strategy

entry will occur up to the point where the expected profits of each entrant are equal

to the value of the outside option. The main finding in this literature is that theory

models of entry perform well in characterizing behavior. Indeed, Nobel Laureate Daniel

Kahneman famously quipped that theory worked like “magic” in predicting behavior

in these games.3Subsequent studies have found slight tendencies toward excess entry

when equilibrium predicts few entrants and under-entry when equilibrium predicts

many entrants (see Camerer, 2003, for a review). Even so, the fundamental prediction

of competitive equilibrium—payoff equalization of entrants relative to the second best

alternative—continues to acquit itself nicely.

The central contribution of our paper is to study entry decisions in contexts that

more closely mimic those faced by entrepreneurs. Specifically, we modify the standard

entry game as follows: Subjects make real-time entry decisions where they observe the

number of entrants currently in the market. In our view, this is a closer match to the

reality of entry than the usual model where entry decisions aremade simultaneously and

where the key difficulty is to overcome the coordination problem. Following the entry

decision, entrants participate in a Tullock (lottery) contest in which they simultaneously

make investments in their businesses. Larger relative investments produce a greater

expected share of the profits in the industry; however success is by no means guaranteed.

In some treatments, luck plays a key role—here a single winner is determined where

the probability of winning is proportional to the relative investments made. In contrast,

in our Shares treatment, the link between payoffs and investment is more direct. Each

entrant enjoys a fraction of industry profits in proportion to their investments.

We also vary the nature of the outside option. We conduct treatments where the

outside option is deterministic. But in practice the alternative to not entering a market

may be inherently risky. Indeed, often the second best use of an entrepreneur’s time and

talent is undertaking another, different startup. To capture these differences, we also re-

port the results of treatments wheret he payofffrom the outside option is stochastic (Coin

Flip treatment) and where the outside option represents an alternative entrepreneurial

opportunity with different stakes (Dual treatment).

Together, our treatments shed light on the role of strategic versus natural risk

on entry decisions and post-entry performance. They also allow for a more nuanced

view of the fundamental prediction of competitive equilibrium—the equalization of the

value of inside and outside options—when outside options have both environmental

and strategic risk as well. Our experiments are designed to come closer in bridging the

gap between the simple and elegant theory of equilibrium entry with the messy reality

of real world entry decisions.

We begin by reproducing the results from standard entry experiments (Baseline

treatment). Consistent with earlier studies, we observe payoff equalization between

entrepreneurship and the fixed outside option in a setting where “entrepreneurship”

merely amounts to entering a market and where each entrepreneur earns a fixed payoff

which is declining in the number of entrants. Moreover, specialization naturally arises:

some individuals repeatedly choose the entrepreneurship path whereas others follow a

different path and select the outside option.

Our main findings are:

In the Baseline experiment, entrepreneurs’ return on investment converges to

the outside option from below.This conclusion is unaltered with the addition

of strategic risk. When entrepreneurship involves natural risk as well, its return

3. Kahneman (1988).