The Economics of Small Firms

An Introduction

Peter Johnson

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9780415393386
• eBook ISBN: 9781136713866
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Student-friendly and international in scope and relevance, this book provides an accessible introduction to the economics of small business for those with little knowledge of economics.

Economics, alongside other disciplines and interacting with them, has some important insights to offer and it is in this context that The Economics of Small Firms examines the formation, survival, growth and financing of small businesses, spatial variations in business formation, the economic role of small businesses, and key policy issues.

This informative text is an essential purchase for anybody studying business and management who is eager for an easy-to-use and engaging overview of economics, entrepreneurship and small business.

1     Introduction

Policy interest in small firms

Since the early 1970s there has been a very substantial increase in policy interest in the economic role of the small firm. This growth in interest has been world wide. Governments in advanced economies have increasingly attributed key economic roles to such firms – employment generation, the development and introduction of new and improved products and processes, and the maintenance and enhancement of competitive forces. Entrepreneurial activity is seen as being channelled principally through new and small firms. The question of whether or not such views are justified is addressed at various points in this book.

The development of government policies towards small firms has reflected numerous factors including a more positive social culture and economic environment for entrepreneurship and self-employment, and changes in demand and technology. How far government policies have driven such developments, and how far they have simply reacted to them, is however a question that must remain open.

A further stimulus to policy interest in the economic role of small firms in recent decades was the collapse of Communism in Eastern Europe and the move by the countries involved towards more market-based economies. The consequent privatisation of state industries, and the search for employment opportunities for workers made redundant as a result, have focused attention on how best to encourage indigenous industry. The development of new, homegrown, small firms is one obvious route for developing such industry.

In developing economies, the activities of small firms have long received a good deal of attention, since such firms, typically consisting of a single individual or family, have traditionally been the dominant form of productive organisation. But the increased focus on small firms in developed economies has further stimulated this concern.

The growth in interest in small firms in the policy arena has been matched in the academic field. In the United Kingdom for example, there is now a multitude of courses, offered at all levels, on entrepreneurship and the management of new and small business. Numerous research centres devoted to the analysis of small firms and the problems and opportunities they face, have been set up. Many university chairs in the subject have been established. There are now several well-established journals in the small firms area.

Academic work on small firms

Academic work on small firms has been carried out in a variety of disciplines, notably business management, economics, geography and sociology. Research has benefited from the different perspectives that these disciplines have brought to the task. Economists were perhaps the slowest to get off the mark in making a contribution to the understanding of small business. The reasons for this tardiness are not difficult to find. Up to the late 1960s and early 1970s, a key preoccupation of industrial economists was the existence and benefits of economies of large scale, in both production and technology, and little attention was given to the benefits that small operations might bring.¹ Furthermore, microeconomic theory characterised the small firm operating in an atomistic market as essentially a passive responder to its economic environment. These firms were perceived as having no distinguishing features worthy of investigation: each firm is forced into a uniform mould by the rigours of competition; any firm not conforming to that mould is forced out of business. And there was little room for entrepreneurial drive and activity in a world where economic actors were assumed to have full information.

Fortunately, the interest of economists in small firms has increased very substantially in recent years, and there have been many important contributions to the literature. This increased interest was reflected in, and further stimulated by, the launch, in 1989, of Small Business Economics, the first journal specifically devoted to small firm economics. There is however still much to do, and the following chapters will highlight some of the main gaps that remain.

Plan and purpose of the book

The purpose of this book is to provide an introduction to the economics of small business that is accessible to those whose economics training is limited. The book covers both theoretical and empirical issues. In Chapter 2 the justification for examining small firms is explored. This chapter also considers some basic international data on the importance of small firms. As the notion of entrepreneurship is often closely linked to small firms, Chapter 3 explores the contributions made by economists to the understanding of the entrepreneurial function. It also examines the implications of these contributions for the analysis of small firms’ activity.

In Chapter 4 the focus is on the formation decision and the factors affecting it. Chapter 5 builds on this discussion with an examination of variations in formation rates across countries and regions. This chapter also draws on research into variations in these rates over time and across industries. It is of course one thing to form a business, and quite another to survive or to grow. Chapter 6 considers some of the factors that affect the survival rate and the growth of new businesses. It also looks at the determinants of small firm growth more generally. As part of this exercise, the various attempts that have been made to categorise entrepreneurs and owners are considered.

Chapter 7 examines some key aspects of the economic impact of new and small businesses. The contribution of these businesses to employment generation, their role in innovation, the ways in which they influence competition and their contribution to economic growth are considered.

Finance for small firms is already the subject of a substantial literature. It is therefore considered as a topic in its own right in Chapter 8. As financial support for small firms has been a key element in policy, this chapter forms a good basis for looking at the broader policy issues in Chapter 9. The book concludes, in Chapter 10, with some reflections on the implications of the economic analysis of small firms for their management.

Although there is a fairly strong bias towards UK material in this book, especially when it comes to some of the descriptive material, the underlying issues that are addressed have much wider application. Use has also been made, where appropriate, of European Union (EU) and US studies and data.

There are of course a number of excellent texts that deal with some of the ground covered here. David Storey’s (1994) text is outstanding in this field but is now looking a little dated. Several management texts on small business – a good example is Paul Burns’ (2007) comprehensive volume – inevitably draw on economic concepts and evidence. However, the primary focus of these books is elsewhere. There are also some important collections of readings and studies.²These constitute an invaluable source of reference but for most students, they offer too much detail and depth.

2 Why study small firms?

Introduction

Why study small firms? One obvious reason is that these firms account for nearly all firms in most advanced countries. For example, firms of fewer than ten employees (‘micro enterprises’ in the official EU jargon: see Table 2.2 on p. 9) represent about 92 per cent of all firms in the non- agricultural sectors of ‘Europe-19’ countries (Table 2.3 on p. 11).¹ This rises to 99 per cent if the upper limit for the number of employees is raised to forty-nine (micro plus ‘small’ enterprises). Thus if the focus of interest is on explaining firm behaviour, it makes sense to concentrate on these businesses. Firms at the lower end of the size distribution do of course account for a much smaller proportion of (say) total employment or sales, because of the presence of a few very large firms. Even when these yardsticks are used however, they remain significant: for example, Europe-19 micro enterprises have a share of about 39 per cent of total employment.

The actual number of micro and small enterprises is very substantial. The data in Table 2.3 suggest that there were over 19 million such businesses in the Europe-19 countries in 2003. Even this figure may be a significant underestimate.² The European Commission (2004: 33) estimated that the figure for the United States was in the order of 21 million.

In addition to numerical significance, a number of important economic functions have been attributed to the small firm. They are widely seen as important generators of jobs, and as significant conduits for innovation and productivity growth, topics that are considered in more detail in later chapters. Small firms, through their role as a competitive ‘fringe’, may also have a part to play in restricting the ability of dominant firms to exploit their existing market positions (see Chapter 7).

Furthermore, a few small firms may grow to a significant size, and eventually challenge the current generation of large firms. It is important to acknowledge however that this typically takes considerable time. For example, the Sainsbury Group, which in 2005 had a turnover of £16.4 billion, and employed around 153,000 people, has taken well over 130 years to reach its current position, starting out life as a single shop in Drury Lane, London at the end of the 1860s (Williams 1994). Some of today’s major businesses developed in a far shorter time – Microsoft for example was founded in 1975 and Body Shop in 1976 – but these are the exception. Whatever the time span involved, it still remains relatively rare for a small firm to develop into a major corporation. At the same time, it is salutary to remember that virtually all of today’s giants can be traced back to very small beginnings. This ‘seedbed’ role of the small firm sector is considered in Chapter 7.

Another reason for examining small firms is that they may have distinctive business characteristics in relation to management style, ownership patterns and product range, that make it logical for them to be studied as a separate group. Most small firms for example may be classified as family businesses; as Chapter 6 shows, such businesses face particular challenges.

Finally, small firms may raise distinctive policy issues. For example, it is frequently argued these firms experience various forms of disadvantage as a result of their size. Compliance with taxation requirements, safety and employment legislation are all instances where diseconomies of small size may be experienced as a result of the presence of significant ‘fixed’ costs. The policy issue here is whether firms that are disadvantaged in this way should receive assistance from the state to compensate. This proposition is considered further in Chapter 9. It is sufficient to note here that even if some of these arguments for intervention are valid, it does not automatically follow that efficient policies can be devised to offset the inherent disadvantage of being small.

A number of possible justifications for looking at small firms has been suggested above. It should however be stressed that much of the case for singling out small firms for separate study rests on their distinctiveness relative to firms of other sizes. For example, as far as the contribution of small firms to innovation is concerned, it is important, both for policy reasons and for an understanding of business behaviour, to show that this contribution differs in some way from that of large firms. Such comparisons can be made only if the whole size range is studied, and the effects of scale on business activities and characteristics are examined. This is not simply an academic point. It is often unclear from empirical research on small firms whether the reported results are distinctive to a particular size category. For example the Acs and Audretsch (1988) study – see pp. 93–4 – on firm size and innovation is based on a single break point of 500 employees, but it is unclear how the results might change if different size boundaries were used.

It should also be pointed out that some of the interest in small firms arises because the lower end of the size distribution is likely to include the most recently formed firms, some of which will rapidly grow out of their initial size band. Firm age and firm size are likely to have different impacts on the way in which firms behave and on their economic contribution. Disentangling the effects is however difficult.

Some definitional issues

Defining the boundaries of the firm

So far two important definitional questions over small firms have been conveniently sidestepped. The first of these questions is: what is a ‘firm’ (or ‘enterprise’ or ‘business’)? The second is: what is meant by ‘small’? The first opens up a range of issues relating to the nature of the firm, a topic on which there is a huge literature.³ This literature lies largely outside the remit of this book. The main focus here will simply be on legally independent trading organisations. Firms which in legal terms are subsidiaries of other businesses are not considered.

While the emphasis on legally independent traders is convenient in that it provides a useful practical test for delineating firm boundaries, it nevertheless throws up some potential difficulties. One of these is that ostensibly legally independent organisations may sometimes be heavily dependent on other similar organisations. For example, a self-employed tenant of a public house would, under the definition adopted here, be regarded as a firm, even though such an individual is wholly dependent on his or her landlord for supplies, and may have to conform to a wide var...

Table of contents

• Cover 
• Firms
• Title 
• Copyright
• Contents
• Illustrations
• Preface
• Acknowledgements
• Abbreviations
• 1 Introduction
• 2 Why study small firms?
• 3 The entrepreneurial function
• 4 Setting up in business
• 5 Variations in formation activity
• 6 Survival and growth
• 7 The economic role of small firms
• 8 Finance
• 9 Issues in policy
• 10 Some implications for small business management
• Notes
• References
• Index