Economics of Small Business

First Week

Why Study Small Business? 1

• There are many more small than big businesses.• About 99 ¾ % of businesses are “small.”• According to one source, in 1986 small businesses

employed half of the work force and produced about 1/3 of GDP.

• Government policies often give small businesses special consideration.

Why Study Small Business? 2

• There is reason to believe that small businesses often face different conditions than larger businesses.– Small businesses are more likely to be located

in rural areas.– Small businesses tend to be in different

industries than large businesses: industries in which increasing returns to scale are less important.

What is a Small Business? 1

• In particular, how small? • The US Small Business Administration addresses

businesses with 500 or fewer employees. • At the other extreme, about ¾ of businesses have

no paid employees. – They employ the proprietor (maybe part-time) and, in

some cases, unpaid family labor.

What is a Small Business? 2

• In the US and some other countries, firms with fewer than 50 employees are excluded from certain regulations as “small businesses.”

• We should probably say “Small and Medium Enterprises” (SMEs) for 500 or fewer.

Categories

• Here, for the purposes of this course, are some subcategories that are likely to function very differently.

Updating 1

• According to the Census Bureau, in the United States in 2007,

– 21,700,000 firms had no employees

– 6,000,000 firms had employees

– That is, still ¾ of firms have no employees

• Less than 100,000 firms had 500 or more employees.

• SMEs employed almost exactly ½ of employees.

• These numbers dropped a bit in 2008 with the recession.

Updating 2 – 2011 Data

category number of firms

VSE 4,593,473

SE 391,299

MSE 193,184

other 9,792

Updating 3 – 2011 Data

category

proportion of employment in

firms of less than 2500 employees

VSE 25.83%SE 16.70%MSE 37.37%other 20.10%

Distribution of Firm Size, 2007

Logarithmic Plot of Distribution of Firm Size, 2007

Skewed

• What we see, especially in the first diagram, is that the distribution of firm sizes is extremely skewed.

• A skewed distribution is one in which more observations are on one side of the average than the other.

• Many distributions of economic data are skewed. • This means averages are not always meaningful.

Of Course, Big Firms Earn More Money

And More per Employee, Mostly

This is very approximate!

Agenda

• Here are some issues about small businesses that we need to explore:– Do economies of scale handicap small businesses?– Are growth and failure related to firm size?– What is the role of family management?– Are small firms especially job creators? Innovators?– Do small firms lack access to capital markets?– Are SMEs more profitable?– What are appropriate government policies for small and

medium business?

Scale

• Do bigger businesses have a technological advantage over smaller businesses?

• To say that another way, are there economies of scale for most businesses?

• If so, how do small businesses survive?

• Can scale economies be captured by franchising, cooperation, or B2B contacts?

Dynamics

• How does firm size affect the tendency of the firm to grow?

• How does firm size affect the probability of failure?

• Does the age of the firm modify the answers to these questions?

Family 1

• Many SMEs are family owned and managed. What are the implications of this?

• There are at least two possibilities:– Family management and work is an asset, as family

members have strong incentives to make an extra effort.

– Family managers are amateurs, and a shift to professional managers would increase productivity.

– This latter idea is probably more applicable to medium-size enterprises (MSEs), as professional management would not be feasible in the smallest categories.

Family 2

• Family management poses another issue. What happens when Pop-pop, who has managed the business since he founded it, wants to retire?– What if the kids don’t want to take over?– What if both of them want to be the next boss?

• This is called the succession problem.

Employment

• Are small firms job creators?

• Do smaller firms pay less for similar work? Why?

• Are small-firm jobs less stable? Why?

• Are small-firm employees more likely to be part-time? Why?

• Does this vary from very small to medium enterprises?

Women and Minorities

• What is the role of women and of historically disadvantaged minorities in small businesses?

• What public policies support these roles?

• How are these policies justified?

Innovation

• Are small firms more likely to innovate?

• Does this vary from very small to medium enterprises?

• Does the age of the firm affect this?

Start-Ups

• Most successful SMEs are not start-ups, but most start-ups are SMEs, at least at first.

• Are start-ups more likely than other firms to innovate?

• Are start-ups net job creators?

• Do former employees of successful small businesses have more success in start-ups?

Finance

• Are small businesses more likely to have difficulty raising capital? Why?

• Do small businesses earn a higher rate of profit? Why?

• Do market efficiency conditions fail for small firms?

Policy

• Are special government policies in favor of small business justified?– As a means of encouraging increased

employment? – To improve their access to capital markets?

• Should regulations provide special exemptions for small business?

Non-Employer Firms 1

• Many of our statistics refer only to employer firms, since they are classed by number of employees.

• Here are some updated data on non-employer firms from Forbes Magazine:– There were 22.5 million nonemployer firms in 2011

(up almost 2% from the year before)

– Approximately 75% of all U.S. businesses are nonemployer businesses

Non-Employer Firms 2

– To be classified as a “nonemployer” business you must have annual business receipts of $1,000 or more and be subject to federal income taxes. (Less than that and you are not considered to have a business.)

– 19.4 million nonemployer businesses are sole proprietorships, 1.6 million are partnerships and 1.4 million are corporations

– Total revenues from nonemployers was $989.6 billion in 2011 (up 4.1% from 2010)

Non-Employer Firms 3

– Around 80% of nonemployer businesses for 2011 (or 18 million businesses) reported less than $50,000 in receipts

What This Course is Not About 1

• There is no doubt that Microsoft, Apple, Google and Amazon have disrupted and transformed the American economy.

• It is probably true that they started as small businesses in somebody’s garage.

• But exceptional success is just that – exceptional!

What This Course is Not About 2

• They are 4 of the about 28 million firms in our economy -- 0.0000143%

• That’s “statistically insignificant!” • Of course they are very significant in other ways –

but that is not what this course is about. • In short, this course is not about entrepreneurship,

innovation, disruption, nor startups, except insofar as the economics research literature on small business addresses them.

Research Literature

• In economics, the research literature focuses on the 98+% of small businesses, and relies on statistical significance as our guide.

• On the other hand, these statistically significant categories of firms provide payrolls and profits to about 75 million Americans, and similar numbers in other countries.

• That’s pretty significant in any sense.

Small-Business Employees

Firms and Establishments

• In studying small business, it is important to distinguish between the firm and the establishment.

• Some firms have multiple locations – establishments – so the establishment may be small even if the firm itself is medium or large.

• Franchises generate a different problem. Most employees in McD’s restaurants are employed by the franchisee, not by McD corporation.

Employees

• With that caveat, we can say that the employees of smaller businesses are 1. More likely to be part-time

2. Slightly less likely to be female or African-American

3. A little more likely to be Hispanic

4. More likely to be under 25 or over 55 (especially for VSEs)

5. Less likely to have attended college except:

6. More likely to have a doctorate

Gender and Identity

Age

Education

More Differences

• Employees of smaller businesses are 7. A little more likely to receive income transfers, either

public or private

8. Differently distributed with respect to occupation (it’s complicated)

9. In the case of VSEs, more likely to be in farming, fishing, construction and services and less likely to be in manufacturing.

10. In the case of MSEs, more likely to be in manufacturing.

Occupation

Industry

Women and Minorities

• Public policy toward small business includes policies intended to encourage small businesses owned and operated by women and historically disadvantaged minorities.

• A 1991 study elaborates barriers that are seen as limiting female participation in small business.

• In part these could also be seen as limiting participation by African-Americans, Native Americans, and some other minority groups.

Barriers

1. Gender Segregation

2. Lack of Business and Managerial Skills

3. Lack of Access to Capital

4. Lack of Access to Government Contracts

5. Family Responsibilities.**

** While the first four could apply to disadvantaged minorities, the last presumably does not.

Connections

• Notice some connections – gender segregation and family responsibilities close many opportunities to gain managerial expertise that would be available to (at least some) men.

• Moreover, a rational woman might choose not to seek managerial expertise, not anticipating many opportunities to put it to work.

Is There a Model Here?

• Clearly the issues here go beyond what we usually think of as economics.

• Reading between the lines, the model seems to be something like this:

Tentative Model

1. There are a limited number of opportunities of various kinds for business operation and experience.

2. Some are more profitable or useful than others, and this is just given.

3. There is a queue for each of these opportunities.

4. White males of the right sort can move to the head of the queue.

5. Thus, only the less profitable and useful ones are available to women and non-preferred males, unless government action moves them to the head of the queue.

Critique

• Most economists will not like that model much!

• For example, if some opportunities are less profitable, economists would suspect that this is because of the pressure of competition – that these opportunities are crowded because many people have chosen to pursue them. Supply and demand, in other words.

• And choices tell us something about preferences!

• It is not clear that government policies to promote more female and minority small businesses could improve on a market equilibrium.

A Third Model – Nash Equilibrium

• A market equilibrium is unique (according to standard theory) and, in ideal conditions, efficient.

• Externalities and asymmetrical information can result in inefficient market equilibria, but the tentative model says nothing about those things.

• However, a market equilibrium is a kind of Nash equilibrium.

• In general, Nash equilibria may not be unique.

An Imaginary Universe 1

• Let us imagine a universe in which1. “Everybody knows” (that is, most people believe) that

blue-eyed people are ineffective at business management and better adapted to other occupations, such as goatherding.

2. Thus, they believe, businesses headed by blue-eyed people are significantly more likely to fail than other businesses.

3. Suppose, nevertheless, that a blue-eyed person proposes to start a business with a business plan that would, in itself, be promising.

An Imaginary Universe 2

4. The aspiring businessperson goes to a bank to ask for a loan. Knowing that businesses headed by blue-eyed people are more likely to fail, so that the bank would lose money, the banker (even if blue-eyed) rationally refuses to make the loan.

5. Established business people who might form B2B relationships with the new business rationally choose not to, since they may face losses if the new business fails – which, they believe, it is likely to do.

6. As a result, the new business fails – providing more evidence in support of “what everyone believes.”

An Imaginary Universe 3

7. Most blue-eyed people, anticipating all this, rationally choose to become goatherds.

8. The few exceptions who do establish successful businesses are in goat-connected fields, like shearing or spinning goat wool, where their experience gives them some advantage.

9. These fields, being crowded with competitors who have few options, are not very profitable.

10. That is, we observe eye-color segregation.

Nash Equilibrium

• Notice that everybody (except the one blue-eyed person who applied for the business loan) is rationally choosing the “best response” to the rational decisions of others.

• This is a Nash equilibrium. • One might also say that the belief that blue-eyed

people are not suited for business is a “self-confirming prediction.”

• But there may be other Nash equilibria.

An Alternative Universe 1

• Now, think of a less imaginary universe in which1. “Everybody knows” (that is, most people believe) that

blue-eyed and brown-eyed people are, on the average, equally effective business managers.

2. Thus, they believe, businesses headed by blue-eyed people are no more likely to fail than other businesses.

3. Then the banker has no reason to refuse a loan for a good business plan.

4. B2B links can be formed just as usefully for a blue-eyed as for a brown-eyed person.

An Alternative Universe 2

5. Blue-eyed businesses fail at about the same rate as other businesses, which provides evidence that the belief in equal business aptitude regardless of eye color is correct.

6. There is no eye-color segregation and rational blue-eyed people choose to start businesses about as often as anybody else.

7. Since the resource of blue-eyed talent does not go to waste (as in the imaginary universe) everybody is better off than they would be in the imaginary universe.

A Superior Nash Equilibrium

• Since, again, everybody has chosen their “best response” to the rational decisions of others, this is another Nash equilibrium.

• It is a better Nash equilibrium.

• In technical terms, it is “payoff dominant” or “Pareto preferable.”

(There are many small-scale examples in game theory that are like this. In the large scale of the real world, the second Nash equilibrium may be only approximately Pareto-Preferable.)

Transition

• How, then, can we make the transition from the inferior to the superior Nash equilibrium?

• Maybe moving some members of non-preferred groups to the head of the queue will help.

• Anyway, it might provide us with evidence that “what everybody knows” …“ain’t necessarily so.”

• If you have a better idea, let’s hear it!

Progress

• There does seem to have been progress on this score.– According to a bank report, “The rate of growth in the

number of women-owned enterprises over the past 16 years remains higher than the national average. Between 1997 and 2013, the number of women-owned firms is growing at 1 ½ times the national average.”

– Comprising just 17% of women-owned firms 16 years ago, firms owned by women of color now account for one in three women-owned firms in the U.S.

Nevertheless

• “Despite the fact that the number of women-owned firms … now accounts for 29% of all enterprises, women-owned firms only employ 6% of the country’s workforce and contribute just under 4% of business revenues—roughly the same share they contributed in1997.”

• Evidence of continuing gender segregation?

Takeaways 1

• SMEs are very numerous and their production and employment are significant, but they differ widely within the group. Contrast, for example– MSE’s, with 50 to 500 employees

– Non-employer firms

• These firms differ from “big business” in a number of ways that we will explore, and face some barriers big businesses usually do not.

Takeaways 2

• Their employees often come from the tails of the distribution – young and old, but less middle-aged, for example.

• Women and members of disadvantaged minorities face many of the same barriers as other small business operators, but generally in a more extreme form.