The Economics of Small Business

The following sections are included:

• Contents
• About the Author

The purpose of this book is to introduce the economic research on enterprises of small and medium scale. This has been a topic of active economic research for about a generation. In earlier economics, there was little or no special study of small business, probably because economists thought of small business as the norm. Agricultural enterprises, which are typically small, were the special study of agricultural economics. Otherwise, it seemed that it was “big businesses” that needed specialized study—monopoly and oligopoly. Much was learned about these enterprises in the specialized studies of industrial organization and public utilities. These studies showed how the abstract idea of “the firm” in economic theory could give way to a more detailed, empirical understanding of business organizations. In the late 1980s, some economists began to study small business in a similar way. The journal Small Business Economics began to be published in 1988. In the quarter century that has followed, a great deal has been learned, some of it built on work that had already been done before 1988 and proved particularly valuable for the study of small- and medium-scale businesses, and much of it novel. The purpose of this book is to convey the results of this research in a form accessible to undergraduate students in economics and others with some preparation in economics. The focus will be on non-agricultural small and medium enterprises (SMEs)…

As we have seen, there are far more small businesses in the American economy than big businesses, although small businesses account for a less-than-proportional mass of production and employment; this is no less true in most countries. Indeed, the small business sector is itself very diverse. Small and medium enterprises as we have defined them include non-employer proprietorships and partnerships and employers of 1–500 employees. Certainly, an employer of four or five will operate quite differently than an employer of 45–50, which again will operate differently than an employer of 400 or 450. At the same time, the boundaries between the different size categories are blurry and arbitrary. An employer of 95 may be categorized as a small employer and an employer of 105 as a medium-size enterprise, but they are likely to be more similar in their operation. This is a problem not only for classification but also for statistics: how may we summarize the statistics of such a diverse population of business firms?

The purpose of this chapter is to review some ideas of microeconomics in the context of the economics of small business, for readers who have limited preparation in microeconomic theory. Readers who are confident of their knowledge of microeconomics might skip Sections 1 and 2 of this chapter without losing the thread. Among the most important concepts for this purpose are perfect competition, monopolistic competition and economies (and diseconomies) of the scale of the firm.

Entrepreneurship is one of the most popular topics in the business press and popular economics of the 21^st century and is often casually identified with small business. But there is less to this than meets the eye. Entrepreneurship and small business certainly are interrelated, and this chapter will discuss some of the interrelations. More importantly, there are a number of different definitions of entrepreneurship. The most popular definition — one associated with the ideas of Joseph Schumpeter — is the one that is least useful for the study of small business, however important it is for other purposes. For the American Internal Revenue Service, an entrepreneur is simply the person who receives the net proceeds of a business. This is a key point! The one thing all definitions agree on is that the entrepreneur is the recipient of the profits, if there are any. This chapter will review some of the definitions of the word “entrepreneur,” including Schumpeter’s, and will then consider some of the evidence on the relation of Schumpeter’s conception in particular to small business in the American economy.

Early research on small business was stimulated by a book by Birch (1979) that argued that small business expansion accounts for a disproportionate number of new jobs. Public policies in favor of small businesses are often justified on that basis. We will see, however, that the relation of small businesses and jobs is more complex than Birch supposed.

Not all small businesses are family businesses, and conversely. However, there is an overlap, and family ownership and management are especially common in the smallest size range. Accordingly, this chapter will review some research on family businesses, which, in practice, are mostly small and medium enterprises (SMEs). In particular, if a small business relies a great deal on family labor, in both managerial and other activities, will this be an advantage or a disadvantage relative to other businesses that do not rely on family labor? A case can be made for both possibilities. We will not be concerned with the succession from one family manager to another in this chapter; however, that will be discussed in a later chapter.

In this chapter, we focus on the life cycle of small businesses. A key question is: what is the role of experience and formal learning in the founding of small businesses? In particular, is the probability of a start-up, and the success of the start-up, influenced by earlier employment in larger businesses? What sort of businesses are most likely to “spawn” small-business start-ups…

Small businesses differ from bigger businesses in important ways. One of the “stylized facts” mentioned in Chapter 2 is that “efficient markets” hypothesis does not seem to apply to small businesses. On the other hand, it is often said that small businesses sometimes cannot get access to capital funds even though their business plans could be profitable. Some research on small business has observed that small closely-held businesses often have definite preferences as to how they might raise capital. This is called the “Pecking Order Hypothesis” (e.g. Koropp et al., 2012). The Pecking Order Hypothesis is that a closely held firm will predictably prefer internal finance to borrowing but prefer borrowing to share issues that would dilute the close control. Thus, where internal finance is insufficient, borrowing may play a strategic role, and limits to the firm’s access to loan capital may be a particular strategic handicap…

In a previous chapter, we discussed the founding of small businesses, but now we turn to a later stage in the life cycle. The typical small business relies on a single individual for the entrepreneurial input — management and initiative — or at most on a compact group. The entrepreneur will often be the proprietor or owner of a significant proportion of the firm. A key manager may also be an important owner. In a family business, the chief or key manager is likely to be a family member. What happens when the chief or a key manager does not continue — due to retirement, ill health or death? This is the succession problem, and it has two aspects. First, a retiring proprietor, or his heirs, will often want to take their capital out of the business: as a retirement fund, for example. This may create a problem in that the transition to new ownership will have to be financed. If small businesses have limited access to capital, this may present a particular obstacle. Second, it will be necessary to choose a new chief manager. If the business is a family business, the new chief may be chosen from among the departing chief’s relatives. Even if the business has not been run as a family business, the heirs of the proprietor will have a particular interest in the choice of the new chief manager. In fact, it is common the world around for the chief manager of a family-owned firm to be a member of the owner family. But why so? Wouldn’t the owners be better off to appoint the best manager available, regardless whether she is a family member or not? If not, why not? Those topics will be taken in reverse order.

A large number of small businesses benefit from long-term relationships with bigger businesses through contracts of franchising. In the United States, there are approximately one million business establishments involved in franchising. This chapter will consider some research on small businesses in franchising. A franchise is a long-term relation between two businesses that is aimed at their mutual benefit. To the extent that it is successful, the relationship will generate a surplus, which economists call a “quasi-rent” and others might designate as value creation. This poses at least two questions. First, how can the governance of the relation be arranged so as to yield the largest surplus? Second, how is the surplus divided between the participants? The answer to both questions, but especially the second, will depend on the bargaining power of the participants. These questions will be taken up in turn, but first we will expand on the definition of franchising.

In this chapter, we consider one of the oldest research topics in the economics of small business, and a very long-running controversy. The earliest research in this area was done by a French engineer, Robert Gibrat, and has to do with the general rule he proposed and which is known as “Gibrat’s law.” But this is not a purely intellectual exercise. To understand “Gibrat’s law,” and to determine whether it is a good approximation to the truth, we need to understand how small businesses grow, and that is a key issue for economic policy with respect to small business.

In some previous chapters, we have seen evidence that nonpecuniary motives are often important in the formation of small businesses. Some nonpecuniary motives that have been mentioned include a desire to be one’s own boss, to make one’s own schedule, to do work one enjoys, or to benefit family members. This chapter returns to the topic, with more detailed information from questionnaire studies on the importance and nature of nonpecuniary motives in small business, and a model of small business formation that is focused on nonpecuniary motives.

We have seen (in Chapter 1) that women, African-Americans and Hispanics in the United States are less likely to be business proprietors than to be employees. In the late 20^th and the early 21^st centuries, it has been a major policy goal in the United States and some other countries to increase the role of women and people of color in small business. This chapter will explore the status of women and people of color in small business, along with some of the policy responses and some attempt to understand the reasons for the difference in status between people of different kinds in a market economy…

Economics is a policy science. One of the best reasons to explore the economics of small business is to form a basis for the evaluation of policy. This chapter will focus mainly on the United States, and specifically on activities of and coordinated through the Small Business Administration (SBA), since most federal public policy for small business is administered through that agency, and many state, local, and nonprofit and voluntary activities in favor of small business are coordinated with the SBA. Some comparisons with other countries will be given.

The following section is included:

• Index