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A report on small firms prepared by the Office of Economic Research of the U.S. Small Business Administration's Office of Advocacy.
June, 1998
----------------
Dear Friend of Small Business,
Americans have strong feelings about individual and political
freedoms and are quick to defend them if they are threatened.
But what about economic freedom? Are there essential elements
worth defending? Those looking for an answer would do well to
observe the stream of visitors from countries struggling to get
their economic feet on the ground. What do they want to know about?
The remarkable phenomenon of small business-and why it thrives
in the United States.
Just released by the Office of Advocacy, The New American Evolution,
written by Advocacy's Chief Economic Advisor Zoltan Acs, in conjunction
with Chief Economist Fred A. Tarpley and Office of Economic Research
Director Bruce D. Phillips, assembles recent research and the
best thinking of top economists on that very topic. This white
paper is based on a 1997 Office of Advocacy conference titled
"Are Small Firms Important? Their Role and Impact."
The impressive performance of the U.S. economy over the last six
years contrasts with rather lackluster performance in both Europe
and Asia. During the Clinton Administration, while employment
has remained virtually unchanged in the European Union, it has
increased by at least 14 million in the United States. What accounts
for the disparity in performance between the United States and
its trading partners? Differences in competition, entrepreneurship
and new firm startups are a major factor.
Throughout most of this century, observers looked at what amounted
to a still photograph of the American economy, saw that bigness
had distinct advantages in producing products at lower cost, and
concluded that big business drove the economy. But the American
economy is not a still photograph-it's a dynamic organism that
changes while you're looking at it. Looked at from the perspective
of process, change, and evolution, small firms make at least two
indispensable contributions to the American economy:
In short, the crucial barometer of economic freedom and well-being
is the continued creation of new and small firms in all sectors
of the economy by all segments of society. And it's our job in
the U.S. Small Business Administration's Office of Advocacy to
measure the contributions of small firms and to ensure that small
business concerns get a fair hearing in government legislative
and regulatory processes.
We appreciate your support in those efforts, as well as your comments
and questions. Write the Office of Economic Research, Office of
Advocacy, U.S. Small Business Administration, 409 3rd
Street, S.W., Washington, D.C. 20416. Or look us up on the Internet
at http://www.sba.gov/ADVO/ or call at (202) 205-6530.
We will be happy to hear from you.
Jere W. Glover
Chief Counsel for Advocacy
----------------
Abstract
The purpose of this white paper is to document the role of small
and medium-sized enterprises in the new economy. Small firms make
two indispensable contributions to the American economy. First,
they are an integral part of the renewal process that pervades
and defines market economies. New and small firms play a crucial
role in experimentation and innovation that leads to technological
change and productivity growth. Second, small firms are the essential
mechanism by which millions enter the economic and social mainstream
of American society. Small business is the vehicle by which millions
access the American Dream by creating opportunities for women,
minorities and immigrants. In this evolutionary process, community
plays the crucial and indispensable role of providing the "social
glue" and networking that binds small firms together in both
high tech and "Main Street" activities. The crucial
barometer for economic and social well-being is the continued
high level of creation of new and small firms in all sectors
of the economy by all segments of society. It should be
the role of government policy to facilitate that process by eliminating
barriers to entry, lowering transaction costs, and minimizing
monopoly profits by large firms.
----------------
The Historical View
The New Evolution
Small Firms in Economic Theory
The Static View
Dynamic Theory
Community
Innovation, New Firm Start-ups, and Job Creation
Innovation
New Firm Start-ups
Job Creation
Entrepreneurship, Women, Minorities and Immigrants
Women Business Owners
Ethnic Entrepreneurship
Evolution, Community and the Global Economy
Summary and Policy Implications
----------------
A quiet evolution has revolutionized the American economy in its
transition from the industrial age to the information age. The
purpose of this white paper is to document the role of small and
medium-sized enterprises in the new American evolution by asking
a fundamental question, "Are small firms important?"1
The response to this question requires an understanding of change
in the economy as a dynamic process. Joseph A. Schumpeter observed
as much more than a half century ago in his classic work on capitalism,
and many economists are reconsidering his analysis in light of
recent experiences.2 To understand why small firms are important,
one needs to take an evolutionary view. A static view misses the
point completely by asking the wrong question or asking the question
wrongly. Viewed through an evolutionary lens, small firms make
two indispensable contributions to the American economy:
The crucial barometer for economic and social well-being is the
continued high level of creation of new and small firms in all
sectors of the economy by all segments of society. This examination
of small firms' role is divided into six segments: the performance
of the U.S. economy in the 1990s; historical background about
small firms; a theoretical framework for understanding the role
of small firms in the economy; the impact of small businesses
on innovation, new firm start-ups and job creation; how small
firms interact with the fabric of American society by creating
opportunities for women, minorities and immigrants; and how community
and the evolutionary process jointly connect us to the global
economy.3
At the time of the 1992 presidential election, one of the main
issues in the public debate was competitiveness. A common perception
was that U.S. industry was losing the global economic race. If
government didn't respond, living standards would suffer. In that
recession year, then Under Secretary of Commerce Jeffrey E. Garten
summed up the conventional economic thinking about the state of
affairs:4
Relative to Japan and Germany, our economic prospects are poor
and our political influence is waning. Their economic underpinnings-trends
in investment, productivity, market share in high technology,
education and training-are stronger. Their banks and industry
are in better shape; their social problems are far less severe
than ours5
By 1996 it had become apparent to experts and others that profound
change had occurred and the economic anxiety of four years earlier
was no longer to be found in the electorate. After a quarter century
of painful ups and downs, the U.S. economy was doing extraordinarily
well. According to Lawrence H. Summers, Deputy Treasury Secretary,
"The economy seems better balanced than at any time in my
professional lifetime"6
Unemployment in 1998 is just under 5 percent, the economy is
growing at 3 percent a year, inflation is at bay, manufacturing
productivity is rising by 4 percent a year, the dollar is strong,
and the Dow Jones Industrial Average is breaking records almost
as a matter of course. It seems clear that the U.S. economy
has restructured, moving from an industrial economy to an information
one, and has made the transition to the 21st century.
The impressive recent performance of the United States may be
contrasted with the rather lackluster performance in both Europe
and Japan, where GNP has grown at less than 1.5 percent per annum
in the last five years. In the European Union (EU) the unemployment
rate has remained stubbornly in double digits, and in Japan the
stock market has been stagnant since the early 1990s at half of
its previous level.
But a comparison of only the last few years may be heavily influenced
by cyclical elements that may distort more long-term developments.
It is instructive, therefore, to compare the macroeconomic experience
in Europe and the United States over the last few decades. In
the 1960-1984 period, GNP grew at almost identical rates in Europe
and the United States: by 3.3 percent annually in the European
Union and 3.1 percent in the United States. But beneath this superficial
similarity lie some fundamental differences. While total EU employment
was virtually unchanged, it increased by 33 million in the United
States. (Another 25 million jobs were added between 1983 and 1996.)
At the same time, the capital stock increased by 3.5 percent per
year in the European Community and by 2.4 percent in the United
States.7 As a result, labor productivity rose much more rapidly
in Europe than in the United States-but so did unemployment. The
unemployment rate hovered around 5 percent in the United States
from 1960 to 1975, while it stayed below 3 percent in the European
Community. By 1982 it rose rapidly on both sides of the Atlantic
to about 10 percent. The unemployment rate has remained around
10 percent in Europe while it has been cut in half, to less than
5 percent, in the United States.
What explains this divergent macroeconomic behavior? While a number
of factors can be cited, one is certainly differences in competition,
entrepreneurship and new firm start-ups. The U.S. economy has
had extremely strong performance by new firms. Between 1960 and
1983, the number of corporations and partnerships in the United
States more than doubled (from 2.0 million to 4.5 million) while
the number of companies in Europe stagnated.8 It declined in Sweden,
Denmark, the Netherlands, and Britain and increased only slightly
in West Germany, France, Switzerland, and Italy.9
Between 1990 and 1996, this trend has continued in the United
States. The number of corporations and partnerships increased
from 5.271 million in 1990 to 6.631 million in 1996. The number
of sole proprietorships also increased from 14.783 million to
16.664 million, or 3.1 percent annually. The difference in business
formation rates, in turn, reflects a number of other economic
factors, such as consistently higher return on investment in the
United States than in Europe, higher productivity, and lower unit
labor costs. Other institutional factors such as less rigid labor
and capital markets, freer competition, and lower industrial subsidies
also play a role. According to Gary S. Becker, the 1992 Nobel
laureate, "Europe's regulatory roadblocks and onerous taxation
keep the job growth enjoyed by the U.S. out of reach."10
How did the U. S. economy reinvent itself? It did so by
fostering and promoting entrepreneurial activity.11 There
are at least three entrepreneurial stories to the U.S. success.
First, large firms that existed in mature industries have adapted,
downsized, restructured, and reinvented themselves during the
1980s and 1990s and are now thriving. Large businesses have adopted
and learned from smaller firms as they have downsized. In a word,
they have become more entrepreneurial. As large firms have become
leaner, their sales and profits have increased sharply. For example,
General Electric cut its work force by 40 percent, from more than
400,000 20 years ago to fewer than 240,000 in 1996, while sales
increased fourfold, from less than $20 billion to nearly $80 billion
This was accomplished in many cases by returning to the firm's
"core competencies" and by contracting out functions
formerly done in-house to small firms.12
Second, while these large companies have been transforming themselves,
new and small start-up companies have been blossoming. Twenty
years ago, Nucor Steel was a small steel manufacturer with a few
hundred employees, which embraced a new technology called thin
slab casting, allowing it to thrive while other steel companies
were stumbling. In 1995, Nucor had 59,000 employees, sales of
$3.4 billion, and a net income of $274 million. In fact, according
to Lynch and Rothchild, 25 companies, some of which did not exist
in 1975, have created 1.4 million jobs.13
Third, thousands of smaller firms have been founded, many by women,
minorities, and immigrants. These new companies have come from
every sector of the economy and every part of the country. Together
these small firms also make a formidable contribution to the economy,
as many firms hire one or two employees. The cumulative effect
of this new firm formation was evident during the recovery from
the 1991 recession. Between March 1992 and March 1993 small firms
with fewer than five employees together created more than 1 million
net new jobs. The last two entrepreneurial success stories
overlap with the role of new and small firms in the economy. (Small
firms are defined as those with fewer than 500 employees).
With a few notable exceptions, for the better part of the history
of the profession, economists have not spent much time studying
small firms.14 However, this has begun to change in
the last 20 years. The twin oil shocks during the 1970s triggered
an unexpected reappraisal of the role and importance of small
and medium-sized enterprises, because it undermined the
mass production model. A surprising finding has been that small
firms and entrepreneurship play a much more important role in
economic growth than had been acknowledged previously.15
The Historical View
The view that the cornerstone of the modern economy is the large
firm dates back to the onset of the industrial revolution. The
concept of scale economies was proposed by Adam Smith with the
famous passage on the pin factory.16 The classical
economist's approach to industrial competition was dominated by
an environment where technology was constantly increasing the
minimum average plant size in a static context. Unfortunately,
it reached its zenith in the late 19th century with
the dominance of the trusts in steel, oil, and automobiles. The
subsequent passage of the Sherman Anti-Trust Act of 1890 was intended
to stem the growth of monopoly power.
In this view, which has prevailed for the better part of this
century, small firms were not seen to play an important role in
the economy, except as suppliers to large firms, and their role
was expected to diminish in the future.17 This has been the case
especially in the manufacturing sector where large and even giant
firms dominated Western economies throughout most of the 20th
century. The way to improve performance was to fully exploit economies
of scale. As E. F. Schumacher pointed out: "I was brought
up on the theory of 'economies of scale'..."18 In
country after country, official policies favored large units of
production and mechanisms of ownership. These goals were pursued
in free market and planned economies alike, as well as in developed
and developing countries. Thus, for the better part of two
centuries, there was a convergence of opinion on the relevance
of firm size and economies of scale, and its importance for economic
growth.19
Readers interested in documenting the role of small firms in
the 1970s found much talk but few facts. For years the small-firm
sector remained ignored and poorly understood, even though many
people worked for small firms. However, all that has begun to
change as powerful computers and large data sets have enabled
researchers to assemble a far better understanding of the economic
role of small firms.
In the first authoritative book on small businesses, Small
Business Economics, Brock and Evans examined the changes in
small businesses over time (Table 1).20 Between 1958
and 1980, the number of businesses in the U.S. economy increased
from 10.7 million to 16.8 million. But the relative economic importance
of small business in the overall economy declined over this period.
Between 1958 and 1977 the static share of employment accounted
for by firms with fewer than 500 employees decreased from 55.5
percent to 52.5 percent. Between 1958 and 1979 the share of business
receipts obtained by companies with less than $5 million in receipts
declined from 51.5 percent to 28.7 percent, in part because the
real value of the dollar declined. Between 1958 and 1977, the
share of value-added contributed by firms with 500 or fewer employees
decreased from 57 percent to 52 percent. The decline in the small
business share of value-added was because of a shift in the small
business share of value-added within industries. In other words,
firms were getting bigger, and therefore the share of small firms
was being reduced.21
However, by the early 1970s, cracks had begun to appear in the
structure of the manufacturing sector in some developed countries,
including some of the most important firms and industries. At
the same time, casual evidence began to suggest that small firms
in several countries were outperforming their larger counterparts.
In some industries the impact of technological change was to reduce
the minimum efficient scale of production. One example of this
was the U.S. steel industry, where new firms entered in the form
of "mini-mills" (for example, Nucor) and small firm
employment expanded, while the incumbent large companies shut
down plants and reduced employment in a number of countries. Other
examples are found in industries characterized by rapid product
innovation, such as electronics and software. This development,
following the twin oil shocks, triggered an unexpected reappraisal
of the role and importance of small manufacturing firms, resulting
in a divergence of opinion on the importance of firm size.22
Table 1. Changes in the Small Business Share of Employment, Sales,
and Gross Product Originating (Percent)
(1958-1977) | (1958-1979) | (1958-1977) | |
|---|---|---|---|
| Total Change | |||
| Change Due to Shifts in Industry Composition (2) | |||
| Change Due to Shifts in Small Business Share Within Industries (3) |
Note: Small businesses are those with fewer than 500 employees for the employment and value added measures and those with sales of under $5 million in 1958 dollars for the sales measure.
Source: Brock and Evans (1986), Economics of Small Firms,
Table 2.11, p.21.
The New Evolution
In fact, several lines of research have found that something happened
to the centuries-old trend toward larger business. Depending upon
the measure of business size examined, the trend decelerated,
ceased, or reversed itself sometime between the late 1960s and
late 1970s. Contrary to the conventional wisdom:
Between 1982 and 1992, the formerly declining small firm share
of value-added in the U.S. economy stabilized at 51 percent, peaking
at 52 percent between 1985 and 1987 (Table 2).30 This
result is quite remarkable in light of the mega-mergers and consolidation
in retail trade during the 1980s and the growth of giant global
business service firms during the 1990s. The significant expansion
of the service sector-and the role of growing small firms in it-helped
end the decline in the small firm share of value-added. If the
industrial makeup of the U.S. economy had remained constant at
its 1982 distribution, the small business share of value-added
would have declined from 51 percent in 1982 to 48 percent in 1992.
Small service firms-many of them new startups in new industries-contributed
to maintaining the aggregate small business output share during
the 1980s and early 1990s.
While the small business output share has declined in some sectors
during the past 10 years, declines have been counterbalanced by
gains in other sectors. In construction, for example, small business
value-added rose from 78 percent to 88 percent of the industry
total during the 1982-1992 period. The small firm share of value-added
in manufacturing and mining rose from 23 percent to 25 percent.
According to Piore and Sabel, the economic crisis of the 1970s
resulted from the inability of firms and policymakers to maintain
the conditions necessary to preserve mass production-that is,
the stability of markets.31 Their claim is that the deterioration
in economic performance in the 1980s resulted from the limits
of the model of industrial development found in mass production:
the use of special-purpose machines and of semi-skilled workers
to produce standardized products. In fact, if the Great Depression
represented a macroeconomic crisis, the economic problems of 1970-1990
were essentially microeconomic in that the focus was on the choice
of technologies and the organization of firms, industries, and
markets. The emerging conventional wisdom seems to suggest
that small firms and entrepreneurship are both necessary for macroeconomic
prosperity.32
Small Firms in Economic Theory
In thinking about the economic role of small firms, the obvious
starting point is the theory of the firm.33 The field of economics
that focuses the most on links between the organization of firms
in industries and economic performance has been industrial organization.
It is the task of industrial organization scholars to sort out
the perceived trade-off between economic efficiency on the one
hand, and political and economic decentralization on the other.
Two disparate views about the impact of small firms on economic
efficiency have emerged in the economic literature: first, static
theory suggests that large firms are efficient because it focuses
on the status quo: second, dynamic theory suggests that small
firms are efficient because it focuses on change.
Table 2. Small Business Share of Private Nonfarm Gross Product,
1982-1992
| 1982 | 1983 | 1984 | 1985 | 1986 | 1987 | 1988 | 1989 | 1990 | 1991 | 1992 | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Total Private | 51 | 51 | 51 | 52 | 52 | 52 | 51 | 51 | 51 | 51 | 51 |
| Mining & Manufacturing | 23 | 23 | 24 | 25 | 25 | 25 | 24 | 24 | 24 | 25 | 25 |
| Construction | 78 | 81 | 83 | 84 | 86 | 87 | 88 | 88 | 88 | 88 | 88 |
| Trans, Comm, & Pub Util | 22 | 21 | 22 | 23 | 23 | 23 | 23 | 23 | 24 | 24 | 24 |
| Trade | 70 | 69 | 68 | 67 | 66 | 65 | 64 | 64 | 63 | 61 | 62 |
| Fin, Ins, & Real Estate | 62 | 60 | 60 | 58 | 56 | 55 | 54 | 52 | 51 | 50 | 51 |
| Services | 81 | 81 | 80 | 79 | 78 | 77 | 76 | 76 | 75 | 74 | 74 |
Source: Joel Popkin and Company, "Small Business Share of
Private, Nonfarm Gross Product," prepared under contract
for the U.S. Small Business Administration, Office of Advocacy,
SBAHQ-95-C-0021, June 1997, Table 1, p.2.
The Static View
One of the most striking findings emerging in the static view
of industrial organization is that small firms generally operate
at a level of output that is too small to sufficiently exhaust
scale economies, even when the standard definition of a small
firm employing fewer than 500 employees is applied. The importance
of scale economies in the typical manufacturing industry relegated
most small firms to being classified as sub-optimal. Almost 79
percent of firms in 1995 had fewer than 10 employees (Figure 2).
Static theory argues for reducing the share of firms that are
sub-optimal to increase efficiency.
Static analysis takes a snapshot of the economy at two different
time periods and then compares different equilibrium points. Static
theory assumes prompt adjustment to changes in the economic environment.
It is not concerned with the time required for changes to take
place, or the organizational and managerial structure needed for
the change. Static theory is concerned with determining the direction
in which economic variables move in response to other variables
The two snapshots are compared and an assumption is made about
the role of small or large firms, monopoly profits, market structure
or efficiency.
Static theory favors large firms in the old raw-material-based
economy because of economies of scale. For example, in the electric
utility industry, if you doubled the size of a coal-fired utility
plant, the output of electricity doubled, while the cost of building
the plant went up only 70 percent. The building of larger and
larger plants contributed to cheaper electricity rates.
What are the economic welfare implications? In static theory, the existence of small sub-optimal firms represented a loss in economic efficiency. Seen through the static lens provided by traditional industrial organization and labor economics, the economic welfare implication of the recent shift in economic activity away from large firms and toward small enterprises is unequivocal: overall economic welfare is decreased because productivity and wages will be lower in small firms than large. As Weiss argued in terms of efficiency and Brown, Hamilton and Medoff in terms of employee compensation, the implication for public policy is to implement polices to shift economic activity away from small firms and toward large enterprises.34
Dynamic Theory
Why do firms exist? Ronald Coase was awarded a Nobel Prize for
explaining why a firm should exist.35 His answer? To
reduce transaction costs. But why should more than one firm exist
in an industry? One answer is provided by the traditional economics
literature focusing on industrial organization. An excess level
of profitability induces entry into the industry. This is why
the entry of new firms is interesting and important-because the
new firms provide an equilibrating function in the market, in
that the levels of price and profit are restored to the competitive
levels.
But why do firms start up in industries where the incumbent firms
are experiencing negative profits and a loss in market share to
foreign companies? Traditional static theory would support either
entry or exit, but not both at the same time. An alternative explanation
was needed.36 It was suggested that new firms entering the
industry were not simply to increase output by being smaller replicas
of large incumbent enterprises, but by serving as agents of change.
However, there is nothing unique about firms.37 The firm is in
no sense a natural unit of analysis. Only individuals can claim
that distinction. All of us are potential entrepreneurs. It seems
then that an economic theory of efficiency needs to build
up from men and women rather than from firms. When the focus is
shifted toward individuals and away from the firm as the relevant
unit of observation, the question becomes, "How can entrepreneurs
with a given endowment of new knowledge best appropriate the returns
from that knowledge?"
Each economic agent must choose how best to appropriate the value
of his or her endowment of economic knowledge by comparing the
wages he or she would earn in continued employment with an incumbent
enterprise to the expected net value of the profits accruing from
starting a new firm.
An additional layer of uncertainty pervades a new enterprise.
It is not known how competent the new firm really is, in terms
of management, organization, and work force. At least incumbent
enterprises know something about their underlying competencies
from past experiences. A new enterprise is burdened with uncertainty
as to whether it can produce and market the intended product as
well as sell it. The degree of uncertainty will typically exceed
that confronting incumbent enterprises.
Dynamic theory favors small firms because it shines the light
on change. In the "new information economy," continued
innovation and change is the rule. More than half of the sales
of high technology firms come from products less than 18 months
old. What emerges from the new evolutionary theories of new
and small firms is that markets are in motion, with many new
small firms entering an industry and many exiting. About 10-16
percent of firms are new each year and about 9-14 percent exit
each year.38
The prevalence of small enterprises in the firm size distribution
reflects the continuing entry of new firms into industries and
not necessarily the permanence of such small and sub-optimal enterprises
over the long run. Although the skewed distribution of firms (a
few large firms and many small firms) persists with remarkable
stability over long periods of time, a constant set of small and
sub-optimal scale firms is not responsible for this skewed distribution.
Instead, a changing set of new small firms provides an essential
source of new ideas and experimentation that otherwise would remain
untapped in the economy. A constant supply of new firms seems
to replace existing ones.
What are the welfare implications of dynamic theory? With dynamic
theory, the existence of small sub-optimal firms does not represent
a loss in economic efficiency. Seen through the dynamic lens of
evolutionary theory, the economic welfare implications of the
recent shift in economic activity away from large firms and toward
small enterprises is welfare-enhancing because new start-ups introduce
change into the economy. As Schumpeter argued in terms of economic
development, and Kirchhoff in terms of dynamics, the implication
for public policy is to implement policies that encourage the
entry of new firms, support their survival, and promote their
growth.39
Community
How can an unrelated collection of small businesses prosper in
the face of competition from large firms?40 There are
two mechanisms by which small firms can succeed. First, they can
become part of the value chain of an industry. For example, small
firms can write software for a larger project. Second, small firms
can become part of a larger social community like the "Third
Italy" or "Silicon Valley."
Community comes in many flavors-from the high tech communities
of Silicon Valley to the Cuban immigrant communities of Miami.
The essence of community is a shared set of values and customs
concerning behavior and family. Community and evolution play the
crucial and indispensable role of providing the social glue and
networking that binds small firms together in both high tech and
"Main Street" activities. In other words, small firms
are about becoming, not about being; about the prospects for the
future, not the inheritance of the past.
What holds a disparate collection of small firms together, then,
is social capital. Social capital is a powerful new force at work,
recently recognized by economists. Economists are assessing how
the social fabric affects individual choice and economic growth.
The essential qualities of social capital, as opposed to physical
or human capital, are that it reflects a community or group and
that it impinges on individuals regardless of their independent
choice. According to new research, what is important is the interplay
between social dynamics in the community and economic performance
over time. Strong community ties lead to strong commercial ties.41
Innovation, New Firm Start-ups, and Job Creation
What are the consequences of a dynamic economy? Underneath the
smooth surface of macroeconomic aggregates is a very active microeconomic
world. Massive reshuffling of factors of production is constantly
taking place. Market economies seem to handle this overwhelming
"churn" with remarkable success.42 Small
and new firms are an integral part of the renewal process that
pervades and defines market economies. New and small firms play
a crucial role in experimentation and innovation that leads to
technological change and employment growth. In short, small
firms are about change and competition because they change market
structure!
Innovation
Almeida and Kogut rely on the semiconductor industry to explore
the role of small firms and community in radical innovation.43
They support the view that small firms play a key role in
innovation and the evolution of markets, arguing that small firms'
importance lies not only in the productivity of their research
relative to large firms, but in the unique role they play in the
innovative process. Small firms play a critical role in technological
and economic development by exploring and innovating in new technological
fields.
Almeida and Kogut use patent data to identify the patterns of
innovation in large and small firms. Start-ups produce innovations
in less crowded technological fields, while larger firms appear
to succeed in more established fields. Discoveries for new small
firms usually come just a few years after their founding. Therefore,
small firms act as agents of change by providing an essential
source of new ideas that otherwise would remain untapped.
The innovativeness of small firms and their ability to explore
new technologies is, perhaps, surprising since often they are
resource-poor and have small research and development (R&D)
budgets and limited manpower. Small firms overcome their limited
resources by turning to community networks. They often rely on
regional knowledge networks for important inputs into the innovation
process. Through this process of accessing and sharing knowledge
with geographically proximate firms, small firms help the circulation
and building of regional networks.44
In the Almeida-Kogut study, both large and small firms cited local
patents significantly more than would be expected, indicating
localization effects. These effects were most significant for
the start-up sample; that is, start-up firms were much more closely
tied to other firms within the same regional network than were
larger firms.
New Firm Start-ups
The entry of new firms is impressive in most economies. Over a
five-year period, entry in manufacturing industries accounts for
almost half of the net new employment increase in both the United
States and Canada. However, while the size of the entry population
is impressive, the importance of entry is tied to its dynamic
impact on innovation. Entrants play a key role in the entrepreneurial
process that constantly offers consumers new goods and services.
Entrants are often seen as providing the dynamic new force that
leads to change in an industry. This process is costly. Many entrants
fail soon after they enter-but some become the next Microsoft.
Baldwin surveyed a large number of start-ups to better understand
the innovation process.45 He examined firms' innovative and technological
competencies and their human capital development. The survey focused
on new entrants that emerged from their early years and survived
to their teen years. The frame consisted of all entrants to the
commercial sector (both goods and services) in the period 1983-1986
that survived to 1993.
The results helped generalize the importance of innovation to
firms in all industries. Firms in the semiconductor and electronics
industries are clearly innovative, but other firms have also developed
the capacities needed for innovation in their particular industries.
Innovations thus enhance firm survival. These capabilities often
involve developing new technologies, nurturing worker skills,
or devising products that are highly novel. The range and diversity
of the innovative skills of new firms across all industries is
remarkable.
The importance of the relationship between innovation and firm
growth is also clear. The successful entrants that grow most are
those that develop some type of innovative activity, whether in
new products, technology, or human resources. The diffusion of
new technologies throughout the economy plays a crucial role in
keeping an economy vibrant and the small firm sector dynamic and
productive. For example, the diffusion of computers has reduced
costs in many small businesses.
Job Creation
What is the contribution of new establishments, start-ups and
small firms to job creation? The public discourse about the role
of employer size has focused primarily on the contribution of
small businesses to job creation. However, there is less agreement
about this aspect of the role of employer size than, for example,
the role of small firms in innovation, compensation or productivity.
The widely cited claim that small businesses are the primary creators
of jobs in the United States derives primarily from studies by
David Birch and the U.S. Small Business Administration using the
only data publicly available in the 1980s from Dun and Bradstreet.
What is the relationship between employer size and age?46 Strong
arguments can be made why employer age might be relevant. First,
and foremost, new and young businesses are inherently a part of
the ongoing process of renewal that pervades market economies,
as predicted by the dynamic model. The introduction of new ideas,
products, and techniques involves a process of trial and error
in which many new businesses fail, while others are dramatic successes.
Just a few years ago, computers did not talk to each other either
within or between offices.47
A new Longitudinal Establishment and Enterprise Microdata (LEEM)
file has been jointly constructed by the Office of Advocacy of
the U.S. Small Business Administration and the Bureau of the Census
of the U.S. Department of Commerce. This file has the advantages
of being longitudinal and covers all private sector establishments
with employment, even new firms in the 1-4 employee firm size
class. This file takes over where the Longitudinal Research Datafile
ends in the early 1990s, and covers the time period of 1990-1995.48
Indeed, for the whole economy, the smallest firm size is important.
Using a beginning year classification, the largest percentage
increase in employment was in the 1-4 firm-size class where employment
increased by 1,879,546 (36.8 percent) over five years between
1990 and1995 (Figure 3). This was even true in manufacturing,
where employment in the 1-4 employee firm-size class increased
by 107,722. Of the net new jobs created in the whole economy,
new establishments accounted for 69 percent of new jobs, compared
with 31 percent for existing establishments. New firm startups
(as distinguished from new establishments) that did not exist
before 1990 created 21.9 percent of all net new jobs between 1990
and 1995. Using the new Census data it seems that both size and
age are important determinants of employment growth.
The contribution of small firms to the economy may be summarized
in terms of efficiency and dynamics. The essence of the efficiency
argument is that there are certain things small firms do better
than large firms. Through the division of labor between small
and large firms, the efficiency of the economy is increased. This
is especially important in production and innovation.49
The argument with respect to dynamics is that small firms
are needed to provide the entrepreneurship and variety required
for macroeconomic growth and stability. In fact, the connection
between entrepreneurship and small business is interesting from
an economic growth perspective. While the static effects of the
division of labor between large and small firms may be tied to
the vast majority of small firms, the dynamic aspects are
tied to a subset of firms that are entrepreneurial.
Small firms provide the lion's share of entrepreneurship in the
economy, and a high rate of new firm entry is associated with
dynamics. This is because highly structured organizations
are inefficient when dealing with changes in the environment.
New small firms, therefore, are needed for the production of variety
in the economy and the elimination of stagnation.50
Entrepreneurship, Women, Minorities and Immigrants
While change is important for the economy-since it directly affects
productivity and growth-the broader social and political issues
are equally important. Small firms are the essential mechanism
by which millions enter the economic and social mainstream of
American society. Small business is the vehicle by which millions
access the American Dream by creating opportunities. The American
economy is a democratic system, as well as an economic system,
that invites change and participation. What is the entrepreneurial
role of women, minorities and immigrants in the economy?
Women Business Owners
Less than half a century ago, the entire work force in the United
States was composed of less than 26 percent women, who most often
were employed as secretaries, nurses or teachers.51 Regulatory
events, notably the passage of the Civil Rights Act in 1964, the
Equal Credit Opportunity Act in 1975, and the Affirmative Action
Act in 1978, helped to remove structural barriers women faced
in business ownership.
Parallel to regulatory changes, the role of women in society also
changed. The National Organization for Women (NOW) was founded
with the goal of bringing women into full participation in American
society. As more women successfully created, managed and grew
companies, greater recognition of their achievements was recorded
by the media and government. Women's business groups such as the
National Association of Women Business Owners (NAWBO), and the
National Foundation for Women Business Owners (NFWBO) were founded.
Why are women-owned businesses important? The role of women-owned
businesses has changed dramatically over the past decade.52
Since the 1970s, women's share of small business increased
from 5 percent to 38 percent.53 One reason the
U. S. economy has created so many new businesses in the past decades
is that many women have chosen self-employment over wage employment.
Despite this dramatic increase, there is very little research
on women-owned businesses. The extent to which they are different
or have different needs should be studied.
The role of women-owned businesses can be better understood by
taking a broader perspective about their role in society over
time, and examining the social context influencing women business
owners. Of particular importance is the role of community, and
paramount is the relationship between family and work. According
to many authors, one of the key variables that has facilitated
women starting businesses has been the change in technology. As
the economy continues to shift toward an information base, innovations
in telecommunications and computers have made it much easier to
start home-based businesses, about a quarter of which are operated
full-time. The socioeconomic context of many women-owned businesses
is different from that of many businesses owned by men, but technology
is creating greater diversity in the reasons for business startups,
as well as their costs.
Judged from a static, efficiency perspective, many small women-owned
business are sub-optimal. However, from an evolutionary and contextual
social perspective, many of these small businesses turn out to
be socially efficient. This is because being a woman entrepreneur
fulfills a large number of social and economic needs. For example,
raising children and self-employment seem to go together, and
home-based firms have the capacity for both.
Ethnic Entrepreneurship
From another perspective, what is the role of ethnic entrepreneurship
and its relationship to the concept of community? Like women-owned
businesses, minority- owned businesses increased significantly
between 1987 and 1992, from 8.8 percent to 12.5 percent of total
firms.54
A clear distinction is made here among immigrant-owned businesses,
minority-owned businesses, and ethnic entrepreneurship. Ethnic
entrepreneurship has a very special meaning in this context, being
defined as "a set of connections and regular patterns
of interaction among people sharing a common national background
or migration experiences."
The debate here is about the role of entrepreneurship in shaping
a community-a debate with a long history. Butler and Green present
three case studies describing three ethnic- or minority-owned
business communities.55 The case studies are drawn from different
historical periods to clearly illustrate the dynamics of community
entrepreneurship. Because community entrepreneurship has not always
been driven by ethnicity or immigration, they take a history from
the pages of black America also. For these groups, business enterprise
is a very important tool, contributing to the incorporation of
ethnic immigrants into American society.56
Two important lessons may be drawn from these case studies consistent
with the concept of small firms. First, just as there are two
views of efficiency in industrial organization, there are also
two views of efficiency in ethnic entrepreneurship. The static
view would suggest that most of these businesses are sub-optimal,
while a dynamic view suggests that these businesses are building
a community and developing networks, and therefore will grow and
prosper in the future. Ethnic entrepreneurs probably have
inside information about business opportunities and community
that they are able to exploit. This is especially true in the
Asian communities. While this information could be transmitted
outside the community, there could be disagreement about its value.
Second, just as community is important for small high technology
firms, it important for ethnic entrepreneurship. In other words,
small businesses-whether they are high tech or low tech-need a
community to survive and grow. Community provides the instrumental
networks, entrepreneurial apprenticeships, and sources of funds.
The crucial barometer for economic and social well-being is the
continued creation of new start-up firms and establishments by
all segments of society.
Evolution, Community and the Global Economy
The world economy at the end of the 20th century is characterized
by increasing cross-border awareness and interdependence among
nations. Both international trade and investment have increased
manifold. Total world trade increased from $629 billion (in 1995
dollars) in 1960 by eight times to $5 trillion by 1995, while
world output grew only by 3.6 times.57 Total world
foreign investment went up faster than either world trade or world
output.
Small firms make an important contribution to the U.S. role in
the international community. What are the linkages among evolution,
community and the global economy? What role do small and medium-sized
firms' innovations play in the globalization process?58
Why are small firms such radical innovators? Innovations arise
only when property rights are properly aligned. Property rights
may be less perfectly aligned in large firms than in small firms.
Innovators in small firms can hold clear property rights.
However, small firms perform only limited amounts of R&D.
Because small firms have fewer resources than large firms, they
rely more on community and localized knowledge networks for important
inputs into the innovation process. Comparing the innovative activity
of start-up firms and large firms reveals that small firms do
explore new technologies by innovating in less crowded areas and
are tied into regional knowledge networks to a greater extent
than large firms. In other words, community building is more important
for small firm innovations than for large firms.59
Smaller firms can conduct international expansion on their own,
or by collaborating with a multinational firm. The intermediated
form of international expansion has certain advantages. The small
firm benefits from having access to the multinational firm's global
market reach. From the large firm's perspective, the arrangement
enhances the value of its existing contributions to internationalization.60
The world is changing rapidly, and firm boundaries are blurred
by competitive network connections. Large firms can now be thought
of as coordinating transaction units rather than merely integrating
production units. In this way, regions and multinational global
networks are interconnected, with small firms playing an important
dynamic role as radical innovators.
Summary and Policy Implications
Are small firms important? Yes. The impressive performance of
the U. S. economy over the past six years can be contrasted with
the rather lackluster performance in both Europe and Japan. This
divergent macroeconomic performance can be explained in part by
differences in competition, entrepreneurship and new firm start-ups.
Small firms make two indispensable contributions to the American
economy.
First, they are an integral part of the renewal process that pervades
and defines market economies. New and small firms play a crucial
role in experimentation and innovation, which leads to technological
change and productivity growth. In short, small firms are about
change and competition because they change market structure! The
U. S. economy is a dynamic organization always in the process
of becoming, rather than an established one that has arrived.
Second, small firms are the essential mechanism by which millions
enter the economic and social mainstream of American society.
Small business is the vehicle by which millions access the American
Dream by creating opportunities for women, minorities and immigrants.
In this evolutionary process, community plays the crucial and
indispensable role of providing the social glue and networking
that binds small firms together in both high tech and "Main
Street" activities. The American economy is a democratic
system, as well as an economic system, that invites change and
participation.
A successful entrepreneurial environment features continual "creative
destruction," to use Joseph Schumpeter's apt term. New companies
prosper and help the economy, in part by destroying the markets
for semi-monopolistic industries. Nations that protect the markets
and incomes of existing larger companies prevent the creative
destruction so essential to progress. Therefore, the crucial barometer
for economic and social well-being is the continued high level
of creation of new and small firms in all sectors of the economy
by all segments of society. It should be the role of government
policy to facilitate that process by eliminating barriers to entry,
lowering transaction costs, and minimizing monopoly profits by
large firm.
----------------
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----------------
End Notes
1. This white paper is based in part on a conference sponsored by the Office of Advocacy of the U. S. Small Business Administration, "Are Small Firms Important? Their Role and Impact," The conference was held on May 9, 1997.
2. Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper and Row, 1942).
3.This white paper does not deal with the question of entrepreneurial finance. Financing is, however, according to many, a barrier to entry. For a discussion of the issues, see D. Blanchflower and A. Oswald, "What Makes a Young Entrepreneur," Journal of Labor Economics, 1998; J. Lerner, "The Government as Venture Capitalist," Working Paper #96-038, (Boston, Mass.: Harvard Business School, 1996); and John Freear, Jeffrey E. Sohl, and William E. Wetzel, Creating New Capital Markets for Emerging Ventures, prepared for the U.S. Small Business Administration, Office of Advocacy, under Contract No. SBAHQ-95-m-1062 (Springfield, VA: National Technical Information Service, 1996).
4. Jeffrrey E. Garten, A Cold Peace: America, Japan, Germany, and the Struggle for Supremacy (New York: Times Books, 1992).
5. See also Laura D"Andrea Tyson, Who's Bashing Whom? Trade Conflict in High Technology Industries (Washington, D.C.: Institute for International Economics, 1992) and Lester Thurow, Head to Head: The Coming Battle Among Japan, Europe, and America (New York: William Morrow and Company, 1992).
6. "U.S. Sails on Tranquil Economic Seas," The Washington Post, December 2, 1996, 1.
7. H.W. De Jong, "Free Versus Controlled Competition," in B. Carlsson (ed.), Industrial Dynamics: Technological, Organizational, and Structural Changes in Industries and Firms (Boston, Dordrecht and London: Kluwer Academic Publishers, 1989).
8. This trend may be changing. See "Startups to the Rescue," Business Week (March 23, 1998), 50.
9. DeJong, "Free Versus Controlled Competition."
10. Gary S. Becker, "Make the World Safe for Creative Destruction," Business Week (February 23, 1998), 20.
11. R. F. Hebert and Albert N. Link, "In Search of the Meaning of Entrepreneurship," Small Business Economics 1(1) (1989), 39-50.
12. B. Harrison, Lean and Mean (New York: Basic Books, 1994).
13. P. Lynch and John Rothchild, Learn to Earn (New York: Simon and Schuster, 1996).
14. A notable early exception was the work of J. Steindl in Small and Big Business (Oxford: Basil Blackwell, 1945).
15. For reviews of the literature, see Zoltan Acs, Small Firms and Economic Growth, vols. I amd II (Cheltenam: Edward Elgar, 1996); P.H. Admiraal, ed., Small Business in the Modern Economy (Oxford: Basil Blackwell, 1996); Organisation for Economic Cooperation and Development, SMEs: Employment, Innovation and Growth: (Paris: The Washington Workshop, 1996), and D.J. Storey, Understanding the Small Business Sector (London: Routledge, 1994).
16. Adam Smith, The Wealth of Nations (Oxford: Clarendon Press, 1776), 54.
17. John Kenneth Galbraith, American Capitalism: The Concept of Countervailing Power, revised edition (Boston, Mass.: Houghton Mifflin, 1956).
18. E.F. Schumacher, Small is Beautiful (New York: Harper and Row, 1973).
19. C. Pratten, The Competitiveness of Small Firms (Cambridge: Cambridge University Press, 1991).
20. Research and data for this project were provided by the U.S. Small Business Administration, Office of Advocacy.
21. Joel Popkin and Company, Small Business Gross Product Originating: 1958-1982, report no. PB88-240692, prepared under contract for the U.S. Small Business Administration, Office of Advocacy (Springfield, Va: National Technical Information Service, April 1988). Note that the small business share of value-added is the best measure of the relative importance of small business in the economy. Sales tend to understate the importance of small businesses, and employment tends to overstate the importance of small businesses because they are more labor-intensive than large businesses.
22. Zoltan J. Acs, The Changing Structure of the U.S. Economy (New York: Praeger, 1984). Many of the issues raised in that book were examined by David B. Audretsch and Zoltan J. Acs at the Wissenschaftszentrum (WZB) in Berlin in the late 1980s. These findings are to be found in the inaugural issue of Small Business Economics 1(1) (1989), and in Acs and Audretsch, proceedings from the first Global Workshop on Small Business Economics in Berlin, 1990. Subsequent issues of Small Business Economics 6 (2) (1994); 8(3) and 8(5) (1996) have reported more recent research findings from the second and third Global Workshops.
23. David Birch, "Who Creates Jobs?" The Public Interest 65 (1981), 8.
24. S. Davis, "The Distribution of Employees by Establishment Size: Patterns of Change and Co-Movement in the United States, 1962-1985," working paper, University of Chicago, 1990.
25. William A. Brock and David S. Evans, "Small Business Economics," Small Business Economics 1(1) (1989), 7-20.
26. G. Loveman and W. Sengenberger, "The Re-emergence of Small-Scale Production: An International Comparison," Small Business Economics 3(1) (1991), 1-39.
27. Zoltan J. Acs and David B. Audretsch, Small Firms and Entrepreneurship: An East-West Perspective (Cambridge: Cambridge University Press, 1993).
28. Bruce D. Phillips, "The Increasing Role of Small Firms in the High-Technology Sector: Evidence from the 1980s," Business Economics (January 1993), 40-47.
29. Zoltan J. Acs and David S. Evans, "The Determinants of Variation in Self-Employment Rates Across Countries and Over Time," University of Maryland working paper, 1995.
30. Joel Popkin and Company, Small Business Share of Private, Nonfarm Gross Domestic Product, report no. PB91-80723 prepared under contract for the U. S. Small Business Administration, Office of Advocacy (Springfield, Va.: National Technical Information Service, February 1997).
31. M.J. Piore and C. F. Sabel, "Possibilities for Prosperity: International Keynesianism and Flexible Specialization," The Second Industrial Divide (New York: Basic Books, 1984), 251-280.
32. OECD, SMEs: Employment, Innovation and Growth, The Washington Workshop, Paris, 1996.
33. For a review of the literature on small firms in economic theory see J. You, "Small Firms in Economic Theory," Cambridge Journal of Economics 19 (1995), 441-462.
34. Leonard W. Weiss, "The Structure-Performance Paradigm and Antitrust," University of Pennsylvania Law Review, 127 (April 1979), 1104-1140 and C.. Brown, et al., Employers: Large and Small (Cambridge: Harvard University Press, 1990).
35. Ronald Coase, "The Nature of the Firm," Economica 4 (1937), 386-405.
36. Zoltan J. Acs, The Changing Structure of the U.S. Economy (New York: Praeger, 1984).
37. David B. Audretsch, "Small Firms and Efficiency," conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
38. Statistics of U.S. Business (SUSB), U.S. Small Business Administration, Office of Advocacy from data provided by the U.S. Department of the Census, Bureau of the Census, Table 9S.
39. Joseph A. Schumpeter, The Theory of Economic Development (Cambridge: Harvard University Press, 1934) and Bruce Kirchhoff, Entrepreneurship and Dynamic Capitalism (London: Praeger, 1994). Perhaps the most important determinant of the survival and growth of new firms is the availability of human and financial capital. See R. C. Cressey, "Are Business Startups Debt-Rationed?" The Economic Journal 106 (1996), 1253-1270.
40. M. Lazerson, "Organizational Growth of Small Firms: an Outcome of Markets and Hierarchies?," American Sociological Review 53(3) (1988), 330-342.
41. "The Ties That Lead to Prosperity," Business Week (December 15, 1997), 153.
42. R.J. Caballero and L. Hammond, "On the Timing and Efficiency of Creative Destruction," Quarterly Journal of Economics 446 (3) (August 1996), 805-852 and Wilbur R. Maki and Paul D. Reynolds, Business Volatility and Economic Growth, report no. PB90-269226, prepared by Regional Economic Development Associates, Inc. under contract with the U. S. Small Business Administration, Office of Advocacy (Springfield, Va.: National Technical Information Service, 1990).
43. Paul Almeida and B. Kogut, "The Exploration of Technological Diversity and Geographic Localization in Innovation: Start-up Firms in the Semiconductor Industry," Small Business Economics 9 (1) (1997).
44. A. Saxenian, "The Origins and Dynamics of Production Networks in Silicon Valley," Research Policy 20 (1994), 423-37.
45. John R. Baldwin, "Innovation and Entry," conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
46. J. Haltiwanger and C. J. Krizan, "Small Business and Job Creation in the United States: The Role of New and Young Firms," conference paper prepared for the U. S. Small Business Administration, Office of Advocacy, 1997.
47. While the Longitudinal Research Datafile (LRD) may be inadequate for the purposes of characterizing the role of employer size in job creation for the U.S. economy, it can be used effectively to characterize the role of employer size for U.S. manufacturing, which is useful in its own right. In so doing, it serves as a testing ground for methodological and conceptual issues.
48. The LEEM is a joint project of the Office of Economic Research, Office of Advocacy, U.S. Small Business Administration, and the Center for Economic Studies, Bureau of the Census, U.S. Department of Commerce. For documentation of the LEEM file, see Zoltan J. Acs and Catherine Armington, "Longitudinal Establishment and Enterprise Microdata (LEEM) Documentation, Including Strengths and Weaknesses," working paper, U.S. Department of Commerce, Bureau of the Census, Center for Economic Studies, May 1998.
49. See C. Pratten, The Competitiveness of Small Firms (Cambridge: Cambridge University Press, 1991) and Zoltan J. Acs and David B. Audretsch, "Innovation in Large and Small Firms," The American Economic Review 78 (1988), 678-690.
50. Bo Carlsson, "Entrepreneurship, Industry Evolution and the Macroeconomy," conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
51. B. Bergman, The Economic Emergence of Women (New York: Basic Books, 1986).
52. Candida Brush and Robert D. Hisrich, "Women-Owned Businesses: Why Do They Matter?" conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
53. The State of Small Business: A Report of the President (Washington, D.C.: U.S. Government Printing Office, 1995). The figure drops to 25 percent for firms with employees.
54. The State of Small Business: A Report of the President (Washington, D.C.: U.S. Government Printing Office, 1996).
55. John S. Butler and Patricia Gene Green, "Don't Call Me Small: The Contribution of Ethnic Enterprises to the Economic and Social Well Being of America," conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
56. For another perspective see T. Bates, Race Self-Employment and Upward Mobility: An Elusive American Dream (Baltimore: The Johns Hopkins University Press, 1998).
57. The Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 1997), 243.
58. Zoltan J.Acs, Randall Morck, and Bernard Yeung, "Evolution, Community and the Global Economy," conference paper prepared for the U.S. Small Business Administration, Office of Advocacy, 1997.
59. Paul Almeida and B. Kogut, "The Exploration of Technological Diversity and Geographic Localization in Innovation: Start-up Firms in the Semiconductor Industry," Small Business Economics 9(1) (1997).
60. See Georgia S. Vozikis, A Strategic Disadvantage Profile
of the Stages of Development and the Stages of the Exporting Process:
The Experience of the Small Business Exporters in Georgia,
report no. PB82-185224, prepared under contract for the U.S. Small
Business Administration, Office of Advocacy (Springfield, Va.:
National Technical Information Service, 1979).
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