across industries. They find that their measure of idiosyncratic risk is significantly positively associated with industry measures of product turnover, R&D, and investment-specific technological change.<sup>10</sup> Enterprises respond to these and other exogenous risks by undertaking accommodating endogenous risky investments through two types of investment decisions, **_reallocating resources and/or innovating_**<sup>11</sup> – in addition to mechanisms such as limiting the down-side risk of capital owners through limited liability, and limiting excessive fluctuations in employment and income of their workers through employment contracts. Reallocation and innovation, in turn, are typically facilitated by a more flexible and formal enterprise sector. Flexibility in the enterprise sector, namely a greater extent of “creative destruction” driven by both more reallocation and innovation (enterprise expansion, contraction, exit and re-entry with better ways of producing), is important for enterprise risk management as it facilitates experimentation and learning in response to shocks. Insufficient entrepreneurial experimentation and enterprise risk-taking is costly for the enterprise sector as a whole because it results in too little investment in knowledge and knowledge spillovers, and prevents the efficient reallocation of resources towards more productive activities and the introduction of better ways of producing in response to supply and demand shocks and changing trends over time. The main risk management problem facing informal enterprises, on the other hand, is that they typically have only limited access to financial markets, professional management, foreign partners, and other essential channels to access, adopt and better use global knowledge – which limits their ability to adjust to shocks and changing trends.<sup>12</sup> As enterprises are able to take advantage of 10 Their industry-level proxies for product turnover, R&D and investment-specific technological change (ISTC) are, respectively: the monthly item substitution rate as collected by the US Bureau of Labor Statistics from sales outlets on more than 300 consumer good categories; the industry’s average ratio of R&D expenditures to sales in COMPUSTAT; and a time series of quality improvements collected by Cummins and Violante (2002). On average, 1% increase higher product substitution rate implies 0.25% higher volatility of TFP growth, 1% increase in R&D intensity implies 30% volatility increase, and 1% increase in ISTC is associated with 0.93% volatility increase. 11 Enterprise resource reallocation involves expansion or contraction of factors of production while doing more or less of the same things, namely shifting resources across existing goods and services that the enterprise produces, including exiting some or all product lines. Enterprise innovation, on the other hand, is broadly defined as the commercialization through markets by entrepreneurs of improvements in technology, where technology captures transformations of inputs into outputs including improvements in products, processes, business processes/organization, and marketing – namely doing any productive activity in better ways by making progress over and above the duplication of physical capital and labor. In the context of development, innovations should be recognized as applying to a broader range of non-replicative entrepreneurial accomplishments than just new-to-theworld frontier products, and include value and productivity-enhancing activities that commercialize ideas that are new-to-the-firm – thereby including the adoption, adaptation to local context and use of technologies already used elsewhere but not yet used in the local economy (see Dutz et al. 2012a). Innovation can be measured as the withinfirm component of TFP growth (see Dutz 2013). In addition to being a source of endogenous risk, innovation helps firms manage exogenous shocks that require more adaptation than just reallocation of resources. There are of course important interactions between the two: ease of reallocation affects the expected profitability of innovation, while innovation typically requires complementary reallocation of resources.

12 The informal sector typically exhibits more flexible reallocation only when government policies overly constrain the formal sector’s flexibility. In Turkey, for instance, the share of informality increased in growing non-agricultural employment between 2004 and 2010 in the Anatolian East due to rigid and costly labor market rules facing formal enterprises, including a very expensive severance payment regime leading to one of OECD’s most rigid employment protection rules for permanent workers, and the most restrictive rules for temporary contracts among OECD countries (Gonenc et al. 2012). Taymaz (2009) suggests that the significant productivity gap between informal and formal firms, and wage gap between informal and formal workers, can be traced back to differences in professional and technical skills of owners and managers, with more educated entrepreneurs and workers moving to the formal sector. This process of self-selection contributes to widen the productivity gap between informal and formal enterprises.

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