"Institutions and Risk Cognition of Entrepreneurs in Newly Emerging Sectors"

Yoshitaka Okada

Technological1 advancements, innovation2 and the creative destruction of industries (Schumpeter, 1983 translation) are considered to be indispensable for the development of an economy. The main innovations, to Schumpeter, stem from R&D in large-sized firms carried out by managers in high-risk projects. In contrast, Knight (1965), focusing on uncertainty as being at the forefront of technological innovation, argues for the importance of entrepreneurs, who obtain direct financing for newly emerging small-sized firms (hereafter venture firms) and recognize incentives from facing uncertain and high risk situations (Brouwer, 2002). Although these classical arguments suggest the importance of having both large-sized and venture firms, Pisano (2006), agreeing with Knight (1965), argues that large-sized firms find it rather difficult to quickly and flexibly equip themselves with forefront technological and innovative capability, especially referring to the biotechnology area. Thus, venture firms are more suitable for innovations using forefront technologies. Hence, this research focuses on venture firms as actors for innovations using forefront technologies.

Firms engaging in technological development and innovation unavoidably face uncertainty and risks. For small and vulnerable venture firms, to minimize threats and damages from uncertainty and risks and to sustain firm operation are vital concerns, especially for those in newly emerging sectors where risks and uncertainty are higher than well-established sectors. As Knight (1965) emphasizes, essential is support for entrepreneurs through institutional arrangements, defined as mechanisms coordinating diverse actors (Hollingsworth, 2000), in which different interacting partners provide different supports and opportunities for advantages. Institutional arrangements, hence, help entrepreneurs not only to minimize potential damages from and reduce their perception of uncertainty and risks, but also to feel psychologically encouraged to venture into new activities.

Institutions, understood as rules of the game in society (North, 1990:3), however, often restrict the way a nation develops institutional arrangements. But such restriction may also stimulate entrepreneurs to develop substitutes for inadequate institutional arrangements. The government, as a highly influential actor, may politically introduce sector-specific arrangements, even if they are incongruent with existing institutional environments, to mobilize necessary resources and generate a ground for institutional changes, adaptation, and hybridization (Casper, 2000; Casper and Kettler, 2001). Newly-devised institutional arrangements may play a vital role in reducing the sense of risks and uncertainty for entrepreneurs. But clearly government policy relates to only a segment of functional areas, while entrepreneurs face a wide range of risks and uncertainty. They may find long-existing actors in well-established sectors helpful in partially reducing risks, while they may develop new types of networks for sharing risks and uncertainty. Who develops effective networks in which functional areas and why? And how do these actors in effective networks relate to each other? As a way to cope with institutional restrictions, what types of roles do some actors play as substitutes for inadequate institutional arrangements? This research tries to find answers to these questions by conducting a comparative analysis of two nonliberal economies, Germany and Japan.

Germany and Japan share some similar institutional characteristics, such as long-term employment, emphasis on skill accumulation, labor-management harmony, technology supporting systems, etc. (Streeck and Yamamura, 2001: Soskice, 1997; Casper and Vitols, 1997). Even so, the institutional arrangements in newly emerging sectors may be quite different, partly due to differences in institutional restrictions, long-existing institutional arrangements, government policies, and the effectiveness of newly-devised institutional arrangements. For example, Germany developed very strong public venture capital in 1996 (Casper and Kettler, 2001), while the Japanese Government continues its traditional path of financing R&D, leaving the function of capital provision mostly to the private sector. How do such differences influence the subjective risk perception of entrepreneurs and their adaptive behavior. Given different characteristics of institutional restrictions, what are differences in substituting mechanisms for entrepreneurs to reduce risks and uncertainty? Are there any difference in their ways of making use of long-existing actors in well-established sectors and developing new-types of networks? What are differences in relationships between policy implementation and the development of interacting networks? These are the questions asked in this research, exploring relations among institutions, institutional arrangements and the risk cognition of entrepreneurs in newly emerging sectors. Here, newly emerging sectors mean industries where venture firms are becoming increasingly active with innovative technologies, products and services, such as biotech, nanotech and semiconductor industries.

Knight differentiates risks from uncertainty. Risk exists when decision-makers can assign probabilities of events with known chances, while uncertainty exists when decision-makers cannot assign probabilities due to the lack of known chances, but can provide subjective estimation (Runde, 1998: 540). Whether uncertainty and risk can be measured has often been debated among scholars (Langlois and Cosgel, 1993; Savage, 1954). This author, following an argument by Epstein and Wang (1994) that intertemporal subjective preference exists in any time-specific situation, understands uncertainty and risks as the continuum of the subjective risk perception of decision makers, the degree to which entrepreneurs feel uncertainty.

The subjective risk perception of entrepreneurs differs in the functional areas of finance, technology, intellectual property, marketing, and human resources. The stage of venture firm development from an early stage to an advanced one (Kazanjian, 1998) also differentiates the level of subjective risk perception, as well as the types of risks. And given differences in institutional environments, German and Japanese entrepreneurs are expected to show different levels of subjective risk perception in different functional areas and development stages.

Proposition 1a: Entrepreneurs in venture firms show different levels of subjective risk perception in different functional areas as venture firms advance from an early stage to an advanced one

Proposition 1b: Germany and Japanese entrepreneurs show different levels of subjective risk perception in different functional areas as venture firms advance from an early stage to an advanced one.

Knight argues for direct financing arrangements (financial markets) to support venture firms and for providing incentives to entrepreneurs. Needs for institutional arrangements extend to technological issues, intellectual property protections, access to markets and/or human resources. A set of institutional arrangements reduces subjective risk perception, so that entrepreneurs become risk-taking and adventurous not only for monetary gains based on risk-return calculations (Knight, 1965; Weber, 1997), but also for satisfying their own spirit of games (Browuer, 2002). Institutional arrangements provide mechanisms to minimize damages from uncertainty and risks, clearly influence the way a venture firm chooses their interacting partners, and reduce the level of subjective risk perception. Institutional arrangements matter very much in stimulating innovative activities in newly emerging sectors.

Hence, scholars (Powell et al., 1996; Powell et al., 2005) studying bio ventures find networks, as a part of institutional arrangements, important for nurturing their dynamics. Networks also provide psychologically enabling environments for risk-taking behavior. But the types of interacting partners used by venture firms to minimize risks and uncertainty may differ by type of industry, by functional areas and by the stage of firm growth (Kazanjian, 1998). Besides, given different institutional environments, German and Japanese entrepreneurs may also show different use of interacting partners.

Proposition 2a: The use and type of institutional arrangements differ by type of industry and the stage of development, and these arrangements function to reduce subjective risk perception of entrepreneurs.

Proposition 2b: The use and type of institutional arrangements differ between German and Japanese entrepreneurs, due to different institutional environments.

Institutions, being path-dependent, can be highly restrictive. They may retard the speed of developing newly-devised institutional arrangements, incapable of providing sufficient support to minimize entrepreneurs' sense of risks and uncertainty (e.g. Japanese venture-capital firms behave differently from those in the U.S., playing a less vital role to reduce financial risks). Hence, firms that show an unfavorable perception of newly-devised institutional arrangements may alternatively make use of existing and traditional actors for minimizing risks and uncertainty, generating diverse paths for risk-taking activities. In this situation, other types of well-established institutional arrangements may function to cover the vulnerability of newly-devised institutional arrangements. In a sense, adaptiveness for venture firms can be found in two fronts of (1) developing alternative relations with long-existing actors, less involving newly-introduced actors, and (2) fully making use of newly-introduced actors. Given established mechanisms of the former, venture firms may find rather smoother and easier development by collaborating with existing firms that provide necessary resources for reducing risks and uncertainty in each stage of development. In contrast, venture firms making use of newly-devised institutional arrangements may enjoy risk reduction in highly specific areas in specific stages of firm growth, while they may face difficulty in transforming from one stage to another due to the different nature of risks and uncertainty in different stages. Hence, diverse adaptive responses provide diverse paths for venture development, possibly resulting in variety of capitalism (Hall and Soskice, 2001; Streeck and Yamamura, 2001). This may also mean that the adaptive behaviors of venture firms are different between Germany and Japan.

Proposition 3a: Risk-taking firms sometimes involve newly-devised institutional arrangements, while they sometimes, having unfavorable perceptions of those institutional arrangements, make use of existing and traditional actors for minimizing risks and uncertainty, suggesting diverse paths for venture growth.

Proposition 3b: Given institutional differences, Germany and Japan show different ways of using institutional arrangements, developing diverse paths for venture growth.

Although this research involves multi-level elements of (1) national-level institutions and institutional arrangements, (2) organizational-level characteristics and (3) individual-level risk cognition, the unit of analysis is the individual entrepreneur. Data would be collected by interviewing an entrepreneur in each firm with a questionnaire about the history of their companies, retrospective impressions of risks and uncertainty, their actions to minimize risks and uncertainty, and their assessment of the ability of long-existing and newly-devised institutional arrangements to be helpful to them. Yoshitaka Okada developed an open-end questionnaire, conducted interviews with 107 bio and nano firms (including established ones) in Japan, and will conduct additional interviews with forty bio and nano firms (venture only) in Germany. Professor Rolf D. Schlunze, a German-native professor specializing in business at Ritsumeikan University will join this project and improve the framework of analysis in a way more suitable to German industries and business. He will come to Sophia for a few days, and we engage in intensive discussions to improve the framework of analysis. In my return from Germany, he will jointly analyze data obtained in Germany. His participation to this project is essential to make right interpretations of data analyses and conduct solid and sound research. This collaborative effort will provide a good ground for both qualitative and quantitative comparative research, especially between two nonliberal economies.

If the above propositions are found valid, findings will indicate that relations between institutions and the behavior of venture firms are strongly influenced by entrepreneurs' cognition of risks and uncertainty. Stimulating technological innovation which leads to economic development is neither a matter of risk-taking behavior, nor the provision of new institutions for encouraging entrepreneurship and the birth of venture firms. But it is a matter of relations between risk cognition of entrepreneurs and institutions. One important element of developing proper venture environments, however, is variation and novelty in institutional arrangements, focused on venture firms' relations with diverse actors to minimize damages from uncertainty and risks and reduce the risk perception for entrepreneurs. If this comparative research can find diversity in existing and new institutional arrangements and substituting mechanisms, then the variety of capitalism argument can be proven. And risk cognition and entrepreneurs' attempt to minimize damages caused by risks and uncertainty can be understood as another important factor for determining institutional diversity.

1. In this research, technology is understood as a kind of knowledge that allows the adaptation of means for production goods. It is the collection of theoretical and practical knowledge, know-how, skills and artifacts that individuals and organizations use to develop, produce, and deliver their products and services (Burgelman and Rosenbloom, 1997: 273). It involves not only innovation, but also diffusion and utilization of technological information (Carlsson, 1994). Socio-economic conditions greatly influence whether technology is effectively and efficiently innovated, involving the process of conceptualization, development, and production (Mole and Elliott, 1987:15).

2. Technological innovation is understood as making an idea technically and commercially viable, involving a process of conducting basic and applied research and implementing incremental improvements leading to a product (West, 1992).