Economics of Small Business

1. Economics of Small Business Drexel University Spring Quarter 2014 First Week

2. 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.

3. 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.

4. 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.

5. 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.

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

7. 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.

8. Updating 2 – 2011 Data

9. Updating 3 – 2011 Data

10. Distribution of Firm Size, 2007

11. The same, on a log scale

12. 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.

13. Of Course, Big Firms Earn More Money

14. And More per Employee, Mostly This is very approximate!

15. 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?

16. 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?

17. 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?

18. 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.

19. 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.

20. 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?

21. 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?

22. 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?

23. 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?

24. 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?

25. 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?

26. 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. businessesare nonemployer businesses

27. 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)

28. Non-Employer Firms 3 • Around 80% of nonemployer businesses for 2011 (or 18 million businesses) reported less than $50,000 in receipts

29. 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!

30. 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.

31. 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.

32. Small-Business Employees

33. 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.

34. Employees • With that caveat, we can say that the employees of smaller businesses are • More likely to be part-time • Slightly less likely to be female or African-American • A little more likely to be Hispanic • More likely to be under 25 or over 55 (especially for VSEs) • Less likely to have attended college except: • More likely to have a doctorate

35. Gender and Identity

36. Age

37. Education

38. More Differences • Employees of smaller businesses are • A little more likely to receive income transfers, either public or private • Differently distributed with respect to occupation (it’s complicated) • In the case of VSEs, more likely to be in farming, fishing, construction and services and less likely to be in manufacturing. • In the case of MSEs, more likely to be in manufacturing.

39. Occupation

40. Industry

41. 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.

42. Barriers • Gender Segregation • Lack of Business and Managerial Skills • Lack of Access to Capital • Lack of Access to Government Contracts • Family Responsibilities.** ** While the first four could apply to disadvantaged minorities, the last presumably does not.

43. 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.

44. 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:

45. Tentative Model • There are a limited number of opportunities of various kinds for business operation and experience. • Some are more profitable or useful than others, and this is just given. • There is a queue for each of these opportunities. • White males of the right sort can move to the head of the queue. • 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.

46. 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.

47. 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.

48. An Imaginary Universe 1 • Let us imagine a universe in which • “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. • Thus, they believe, businesses headed by blue-eyed people are significantly more likely to fail than other businesses. • Suppose, nevertheless, that a blue-eyed person proposes to start a business with a business plan that would, in itself, be promising.

49. An Imaginary Universe 2 • 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 the loan. • 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. • As a result, the new business fails – providing more evidence in support of “what everyone believes.”

50. An Imaginary Universe 3 • Most blue-eyed people, anticipating all this, rationally choose to become goatherds. • 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. • These fields, being crowded with competitors who have few options, are not very profitable. • That is, we observe eye-color segregation.