Freeman

ARTICLE

Small Business and Entrepreneurship

SEPTEMBER 01, 1982 by E.C. PASOUR

Business news in the United States focuses on economic activities of giant corporations. In recent years, for example, politicians and newspaper editors have castigated the “obscene profits” of “Big Oil.” A large increase in profits by Exxon, IBM, and other large corporations frequently evokes calls for divestiture. The conventional wisdom is that the American economic system is dominated by large corporations because big business firms are so productive that small firms cannot compete. In this view, ever vigilant government regulation of these large firms is required to prevent exploitation of workers and consumers.

In addition to the concerns about “big business,” there is a growing feeling that the entrepreneurial spirit has lost its vitality in the “new industrial state.” The rate of increase in labor productivity has been decreasing over time, and United States business firms have become less competitive with foreign manufacturers in the production of a wide range of products including automobiles, watches, steel, and television sets. Current economic problems including financial difficulties on the part of Chrysler, International Harvester and other large companies, the slowdown in labor productivity, and a rising level of unemployment have evoked calls for the U.S. Government to underwrite a “reindustrialization” policy. More central economic planning is held to be necessary to revitalize American industry and provide jobs both for the unemployed and for new entrants into the labor force.

The purpose of this paper is to show that the preceding scenario is not an accurate description of the business environment in the United States or in other countries where entrepreneurial incentives are not stifled by inflation, taxes, economic regulations, and other factors contributing to an unfavorable business climate. Small business, already the most important source of innovative activity and new job opportunities in the United States, can play an even more important role with an easing of the restrictions on entrepreneurial incentives. A market economy is a dynamic discovery process generated by the competitive entrepreneurial scramble for profits.

Entrepreneurship and the Market Process

In a free enterprise economic system, expected prices and profits provide incentives for entrepreneurial activity. If market participants had perfect information, all market activity would be perfectly coordinated and there would be no profit opportunities nor role for profit-seeking entrepreneurs. In a dynamic economy, however, market conditions are constantly changing due to the invention and introduction of new products, changes in production technology, changes in consumer preferences, and so on. Consequently, there are always profit opportunities available for alert individuals with innovative ideas.

Entrepreneurship may be aptly defined as an alertness to profit opportunities which have not been grasped and acted upon by others. It should be stressed that the potential for (and expectation of) profits in the competitive market process creates powerful incentives for profit seeking individuals to discover and make use of information before it is widely known by other people.

In a fundamental sense, entrepreneurship is the key to market creativity. Business firms are induced by the profit motive to search for a unique profitable niche. This search for profit may take a number of quite different forms. An enterprising firm, for example, may invent and produce a new product. Henry Ford, the founder of the Ford automobile company, provides a classic example of successful entrepreneurship based on this approach. However, the creation and development of a new product does not ensure financial success for the inventor. Of the thousands of inventions each year in the United States, only a handful prove to be an economic success. In order for a new product to be profitable, the producer must be able to sell the product and at a price high enough to cover the .production costs (including a return to management).

Another possible road to profits is to advertise or market a product in a way that differentiates the product in the eyes of the consumer. McDonald’s, for example, reaped substantial profits as a pioneer in the production and selling of “fast food” hamburgers. This profitable business organization soon spawned a host of close competitors. Regardless of the road to success, the effect of profits on competition is predictable.

Profits invite competition and ensure that rival firms will compete to erode the profit advantages of the innovating firms. The result is that profits, whether due to the nature of the product, the conditions under which the product is sold, or to other special advantages, are invariably short lived unless the profitable firm can obtain the aid of government to restrict or exclude competition. In all countries in the developed world, there is a long history of the use of tariffs, patents, franchises, and other government enforced restrictions on competition. The conclusion is that monopoly advantages which persist over time are invariably due to governmental restrictions on entry by potential competitors.

Entrepreneurship and Job Creation

The preceding discussion emphasizes that entrepreneurship is not a sure and certain road to profits. In a dynamic economy where economic conditions are constantly changing, entrepreneurship is, by its very nature, a high risk activity. Economic growth in a rapidly changing economy depends upon a large group of individuals who are willing to engage in risk- taking activity. It is estimated that more than two-thirds of all new business ventures in the United States collapse within five years. Despite the high failure rate of new firms, it is small firms rather than large corporations which are primarily responsible for economic growth and technological innovation. Small firms appear to be both more flexible and more inventive.

New developments seldom emerge from the leading companies in an industry, and even if a breakthrough is made by a large well-established firm, the new item is often launched by smaller firms. The result is that the more dynamic the local economy (e.g., Houston, Texas), the greater the risk-taking and the greater the proportion of firms that fail. A recent study of job creation in the United States by a group of researchers at the M.I.T. Program on Neighborhood and Regional Change found that the most successful business areas of the country were those having the highest rate of innovation and business failure—not the lowest.

The implications of these findings for job creation are startling. Large firms in the United States are not the major source of new job opportunities. The study alluded to above found that two-thirds of the net new jobs in the United States from 19691976 were created by small firms having fewer than 20 employees. A closely related finding revealed that 80 per cent of net new jobs were created by businesses no more than 4 years old. The fact that most new jobs are created by small business should not be surprising since, as suggested above, small firms have the capacity to start up and expand rapidly.

Shifting Job Requirements

There also has been a shift in the kinds of these new job opportunities. New jobs are predominantly associated with the production of services as opposed to jobs in the traditional “goods” industries—manufacturing, agriculture, construction, and mining. This shift in production from goods to services implies a shift from “brawn to brain” and an increasing dependence on education and training rather than physical capital.

Other countries are experiencing shifts in the nature of job requirements similar to those observed in the United States. Accompanying the shift toward the service sector has been a shift in the method of financing. As Nobel Laureate Milton Friedman points out, risky ventures have almost invariably been financed by small groups of individuals risking their own funds or funds of their relatives and friends. This method of financing contributes toward the increased flexibility and adaptability of small business.

The preceding discussion should not be taken to suggest that large corporations are not important in the U.S. economy. Large firms play a vital role, both as a source of jobs and in consolidating the advances pioneered by small firms. There appears, however, to be little basis for the widespread feeling that large firms have increased their competitive advantage over time due to technological developments. George Gilder in his recent best seller, Wealth and Poverty, finds that aside from communication satellites, there is no evidence that recent changes in technology have worked to the advantage of large firms. It is the small firms that are best able and most likely to respond to rapidly changing economic conditions.

Implications for Economic Planning

In view of the crucial place of small firms in job creation, what are the implications for the role of government in fostering economic growth? The political muscle of large firms makes it more difficult for market signals to operate. Chrysler and other large corporations in financial difficulty generate attention by the news media and bring calls for government aid. The number of jobs at stake in such cases means that the fate of these firms is likely to hinge on political considerations rather than on basic economic conditions. Propping up large scale noncompetitive firms through governmental assistance is to subsidize incompetence. A small business employing relatively small numbers of workers is more likely to have the opportunity to succeed or fail on the basis of economic factors rather than political expediency.

Since most new jobs are created by small firms, it might appear that government should intervene directly. A policy of direct government intervention to assist small firms, however, is difficult to formulate—even in theory. The success of any particular firm hinges not only on what that firm does but also on what its current and future competitors do. Thus, success hinges on technological developments as well as on business conditions.

There is no way to predict technology or future knowledge of any kind since, if this were possible, future knowledge would become present knowledge. Since the risk of failure is very high for small firms, in a policy of direct government intervention a decision would first have to be made as to which firms to assist. However, there is no accurate way to predict firm success, and government assistance of large numbers of unprofitable firms would be both politically unfeasible and economically unwise. Thus, direct government intervention becomes less and less feasible in an economy where small service-oriented firms are increasingly important in providing job opportunities.

In view of these problems associated with direct intervention, a more feasible alternative is for government to stress the creation of a favorable business climate—to adopt policies which are consistent with risk-taking and entrepreneurial activity. In this business climate approach, the role of government is largely passive and necessarily limited. Consequently, the suggested approach involves a definite change in government policies.

There is a consensus that high interest rates, high marginal tax rates, and government regulations have actively discouraged risk-taking and innovative activity in the United States. During the past decade, savings by individuals and business firms have been discouraged because gains were taxed at high marginal rates even though such gains were, in many cases, not real but due solely to inflation.

High Interest Rates Hamper Entrepreneurial Activity

Entrepreneurial activity in the United States in recent years also has been hampered by high and rapidly changing interest rates. It is always difficult for business firms to make decisions based on anticipated future conditions. The difficulty and the cost of mistaken forecasts increase when interest rates are high. There is a direct link between inflation and interest rates.

Nominal or money interest rates consist of two parts. The first part, a real interest component, is based on time preference—the extent to which people place a higher value on consumption in the near future relative to the more distant future. Although there is no way to measure the real interest rate, economists have generally assumed this rate to be around 3 percent.

The money rate of interest equals the real rate of interest plus a second part, the anticipated rate of inflation. This inflation component has been the dominant factor in the money rate of interest in recent years, and reduced inflation is a necessary condition for a reduction in interest rates. Thus, governmental monetary and fiscal policies to control inflation along with a reduction of taxes and regulations are important in establishing the economic climate necessary for increased saving, investment, and capital formation.

What are the implications of the preceding analysis for central economic planning? It is sometimes maintained that while a limited role for the state was feasible in sparsely-settled nineteenth-century America, it is inevitable that government must play a larger role in economic planning in an increasingly urbanized and industrial society. However, as shown below, information problems intensify as the complexity of society increases which makes reliance on market prices more necessary and government planning less feasible.

Price Signals

Market prices are the signals which direct economic activities for consumers and producers in a market economy. When the price of oranges increases relative to other fruits, for example, consumers reduce their consumption of oranges. When the price of small cars rises relative to that of large cars, auto producers shift more resources into small car production. It is through this market process that relative prices induce individual decision-makers to respond to changes in economic conditions regardless of firm size.

The market integrates and mobilizes information automatically without any person having to gather information together in one place. The housewife in New York City, for example, may know nothing about a poor coffee crop in South America, but she adjusts her actions to it when the price of coffee rises. At the same time, price and profit signals provide incentives for the discovery of new facts which improves the adaptation of market participants to ever changing circumstances. Thus, market prices convey an immense amount of information to market participants which makes possible the utilization of more data than is possible through any other known means of coordinating economic activity.

The factors which cause prices to change and thereby guide the behavior of decision-makers in a market economy are influences which would need to be taken into account in any conceivable system of coordinating economic activity. Moreover, no other way has been discovered for coordinating and transmitting information in the organization of production to accommodate consumer’s wants which even approaches the efficiency of the market process. Thus, there is inevitably a loss of information when price signals are suppressed or overridden by minimum wages, rent controls, price ceilings, or other forms of wage and price controls.

Prices are important information signals in any market economy and information becomes more important as society becomes more complex. Consequently, the importance of market prices in coordinating economic activity increases with the complexity of society. The result is that central economic planning is more difficult and less feasible in a modern industrial economy characterized by rapidly changing economic conditions.

Conclusions and Implications

A generation ago, a famous economist, Joseph Schumpeter, predicted the withering away of the entrepreneur. In a view later adopted by many economic analysts, Schumpeter considered entrepreneurship to be crucial only in the early stages of capitalist development. In the “mature” phase of capitalism, economic activity was to be dominated by a combination of large corporation and government bodies leaving no scope for individual entrepreneurship. Today, many people still feel that the small inventors and fabled entrepreneurs of early capitalism are a dying breed having no role to play in the “new industrial state.”

The actual situation concerning entrepreneurship and small business bears little resemblance to the scenario just depicted. Although large corporations dominate the business news, small business provides the dominant source of new job opportunities in the United States. Small firms, by their very nature, are more flexible and better able to adapt to ever-changing but unpredictable economic conditions. Under these conditions, pleas for a “reindustrialization” policy guided and aided by government are fundamentally misplaced. Rather, emphasis should be placed on improving the investment climate as a means of fostering entrepreneurship and small business activity.

Inflation, high taxes, and widespread government regulations inhibit entrepreneurial activity for firms of all sizes. Entrepreneurship is especially difficult under inflationary conditions both because the uncertainty created by inflation makes planning more difficult and because inflation causes income to be overstated for tax purposes. Consequently, the government can contribute importantly toward a favorable business climate through non-inflationary monetary and fiscal policies.

Small business now plays a crucial role in the rapidly changing modern industrial society. If, as seems to be the case, there is a further shift away from the production of autos, steel and other products in which the United States once had a comparative advantage, the solution lies not in trade barriers and protection or other attempts to insulate these industries from market forces but in developing those products in which the United States is competitive.

The United States, for example, is the leader in producing “thought-ware” (software as compared with hardware) upon which so much of new technology is based. New technologies such as the laser and microbiology are on the horizon. However, the precise direction of these developments is unknown and anyone who predicts the technological future is sure to soon appear foolish. Consequently, the importance of entrepreneurial activity in ferreting out profit opportunities will continue. Moreover, regardless of which products prove to be most profitable for U.S. business, there is little question that small business with its inherent advantages of flexibility and adaptability will be at the cutting edge of these new developments. []


References

Birch, David L. “Who Creates Jobs?” The Public Interest 65 (1981): 3-14.

Friedman, Milton. Market Mechanisms and Central Economic Planning. Washington: American Enterprise Institute, 1981.

Gilder, George. Wealth and Poverty. New York: Basic Books, Inc., 1981.

Kirzner, Israel M. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973.

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September 1982

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