The Economics of Small Firms

In the Fall of 1988 an international conference was held at the Wissenschaftszentrum Berlin fur Sozialforschung (WZB). This was the first conference devoted entirely to the subject of Small Business Economics. The present volume which is an outgrowth of that conference contains revised versions of papers which were presented at that conference. Most of the papers in this book grew out of research projects examining the role of small firms in national economies. We include papers from six countries exploiting twelve rich databases.

The prolonged economic stagnation and widespread unemployment of the recent decade have stimulated an unexpected reappraisal of the place of the small manufacturing sector in advanced industrial societies; until recently, this sector was considered an impediment to modernization and development (Berger 1980a; 1981). Indeed, in the United States where the number of small firm establishments have recently swelled (Granovetter 1984), there are growing doubts about the capacity of large mass production organizations to satisfy the needs of an advanced society (Piore and Sabel 1984).

It might have been expected that clearly articulated theories of the relationship between firm size and performance would have been developed. Yet, despite the important role which individual firm performance plays in any economy, and despite the extensive empirical work undertaken in this matter, the relationship remains unsatisfactorily understood.

Several American studies have recently estimated models of employment growth from longitudinal data sets of business firms (Evans 1987, Leonard 1986, Hall 1987). By and large, these studies find that the growth rate of employment is inversely correlated with initial size (measured by employment) and with age — young firms tend to grow more rapidly than old ones. These studies have cast considerable doubt on Gibrat’s Law, or the assumption of independence between firm size and the rate of growth. However, departures from Gibrat’s Law are modest, especially among firms above minimum size. Recently a group of researchers has proceeded along similar lines of investigation using data from a panel of Italian manufacturing firms located in Northern Italy. The purpose of this paper is to compare our results with those obtained for the U.S. and to explore in more detail the soundness of this approach. Our results are similar to the abovementioned American studies. We find that departures from Gibrat’s Law are not large.

In recent years, one observes a renaissance of small business research efforts. The stimuli came from different directions. One strand of more policy oriented research concentrated on the impact of small businesses on the creation of new employment opportunities.¹ Another host of studies paid attention to the relationship of innovation productivity of small versus large business.² And industrial economics research examined the role of small businesses as actual and potential challengers of larger competitors in a given market.³ Whatever motive guided this research, it was emphasized that the cumulated knowledge about large business behavior is by far greater than about their small business counterparts.

About 4.2 million men and women operate businesses on a full-time basis. Comprising more than a tenth of all workers, they run most of our nation’s firms and employ about a tenth of all wage workers. The fraction of the labor force that is self-employed has increased since the mid-1970s after a long period of decline.¹ This paper examines the process of selection into self-employment over the life cycle and the determinants of self-employment earnings using data from the National Longitudinal Survey of Young Men (NLS) for 1966–1981 and the Current Population Surveys for 1968–1987.

There is a growing interest in dynamic modeling of capitalism as recent experience has demonstrated the importance of innovation in shaping the structure and growth rate of capitalist nations. Economists recognize that innovation by its nature describes a dynamic, evolutionary model of capitalism which is inadequately described by the equilibrium models which have dominated economic thought since the 19th century.

Competitive markets are driven by the decisions of business owners and consumers’ responses to those decisions. The efficiency outcomes of these decisions in response to known prices and technologies have been extensively examined. However, in a world in which future prices and technologies are unknown and are revealed incompletely in a time-dependent process through “market experimentation”, the role of the “firm” or the owner of the firm is supplanted by the role of the “entrepreneur”. Entrepreneurs are economic agents that must make resource allocation decisions in the context of risk, uncertainty and imperfect information, and market imperfections not faced by the business automatons of textbook markets (Herbert and Link, 1989).

Throughout the twentieth century there has been a general movement towards larger minimal optimum plant size. Sands (1961) found that average physical output per plant increased between 1904 and 1947 by about 3 percent per annum. Blair (1972) found the share of industry sales originating in the eight largest plants declined from 1947 to 1958 thereby concluding that this seeming reversal of past trends was attributable to fundamental changes in the direction of technological advances away from centralizing innovations and towards decentralizing technologies.¹ Shepherd (1982) found a substantial increase in the scope of competition within the four-digit Standard Industrial Classification (SIC) industries between 1958 and 1980 confirming the trend identified by Blair. Also, Carlsson (1989a) showed that both firm and plant size decreased between 1972 and 1982 in manufacturing as a whole and especially in metalworking industries in several industrial countries. He hypothesized that the emergence of new computer-based technology has improved the quality and productivity of small and medium scale production relative to standardized mass-production techniques which dominated previously. According to Piore and Sable (1984) the emergence of this new technology represents, in fact, an “industrial divide” where firms and society are confronted with a choice of technological modes.²

There is a wide literature on the role small and medium-sized firms (SMFs) play in technological development. Rothwell (1988) argues that SMFs are increasingly important in the process of technological innovation. Pavitt (1988) also argues that SMFs are significant contributors to innovation. He shows that although business-funded Research and Development (R&D) in most OECD countries is concentrated in a few large firms, SMFs are important innovators. In the U.K. Pavitt found that whereas firms with fewer than 1000 employees account for only 3% of business firms’ R&D expenditure, they are responsible for 30% or more of significant innovations. In certain sectors — machinery, instruments, and R&D laboratories — firms employing below 1000 account for more than 45% of all innovations in the sector. Furthermore, firms employing less than 500 have increased in innovation intensity (innovations/share of employment) between 1956 and 1983 (Pavitt, Robson and Townsend, 1987).

In 1975, the United States was the world’s largest producer of machine tools, the second largest exporter, and had the lowest degree of dependence on imports of all major machine tool producing countries. By 1987, the U.S. had slipped into fourth place as producer of machine tools (behind Japan, F.R.G., and the USSR), into sixth place in exports (behind Switzerland, G.D.R., and Italy), and relied on imports for more than half of its supply of machine tools.

There currently exists an unprecedented enthusiasm for small business in virtually every country in the world. This applies not only to the developed nations, the so-called market economies, but also within the socialist bloc (Sato 1989). Traditionally there exist two reasons why centrally planned economies usually prefer larger plants and firms to smaller ones: (1) the belief that economies of scale are found in larger firms, and (2) a small number of firms are more conducive to central planning, and party control. Monopoly power will not be questioned since the party itself constitutes a monopoly. These motives prevailed for many years leading to highly centralized economies in Eastern Europe.