report on the role of small business in a particular industry.

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Economics of Small Business

Third Week

Entrepreneurship

For this period we will explore the relation of small business and entrepreneurship.
That will depend on your definition of entrepreneurship!
There are several, and the most familiar is not the most appropriate for our purposes.
For the IRS, an entrepreneur is simply the person who received the net proceeds of a business.

History of an Idea

We can trace the concept of the entrepreneur at least to J. S. Mill, and according to some accounts, to J. B. Say and the Physiocrats.
By Mill’s time, there was a clear distinction in practice between the capitalists who would finance a business and the active owner who manages the business.
Mill described that person as the “undertaker.”
“Entrepreneur” is French for “undertaker.”

I. Menger

Founder of The Austrian School

For our purposes, the clearest early definition of the role of the entrepreneur comes from the founder of the Austrian school of thought, Carl Menger.
It helps to know a little about his theory of production.

Austrian Production Theory

Menger distinguishes first-order goods, which directly satisfy human needs, from second and other higher-order goods, which satisfy human wants only indirectly.
Machines, raw material, and labor are instances of higher-order goods.
Higher-order goods complement one another in production.

The Entrepreneur in Menger

“The process of transforming goods of higher order into goods of lower or first order, provided it is economic in other respects, must also always be planned and conducted, with some economic purpose in view, by an economizing individual.”
This individual is the entrepreneur.

From Menger’s Book 1

“Entrepreneurial activity must definitely be counted as a category of labor services. It is an economic good as a rule, and as such has value to economizing men.”
“Labor services in this category have two peculiarities: (a) they are by nature not commodities (not intended for exchange) and for this reason have no prices; (b) they have command of the services of capital as a necessary prerequisite since they cannot otherwise be performed.”

From Menger’s Book 2

“ Entrepreneurial activity includes: (a) obtaining information about the economic situation; (b) economic calculation—all the various computations that must be made if a production process is to be efficient (provided that it is economic in other respects); (c) the act of will by which goods of higher order (or goods in general—under conditions of developed commerce, where any economic good can be exchanged for any other) are assigned to a particular production process; and finally (d) supervision of the execution of the production plan so that it may be carried through as economically as possible.”

Entrepreneurship and Management

Entrepreneurship, in Menger’s sense, can be distinguished from management.
Items a), b), and d) are “management.”
But item c), “the act of will” is something more.
We could call it initiative.
We could then say that entrepreneurial activity comprises both management and initiative.

From Menger’s Book 3

“In small firms, these entrepreneurial activities usually occupy but an inconsiderable part of the time of the entrepreneur. In large firms, however, not only the entrepreneur himself, but often several helpers, are fully occupied with these activities.”
“… in the case of small manufactures, entrepreneurial activity is usually performed by the same economizing individual whose technical labor services also constitute one of the factors in the production process.”

“In small firms ….”

These last two points will be important for us.
In firms of the smallest size – microenterprises and non-employers – the person who carries on “entrepreneurial activities” will do so only on a part-time basis.
In MSEs, “entrepreneurial activity” is more likely to be a full-time role.
Statistics show that the proportion of employment of “management” and “administrative support” is relatively high in MSEs.

Management Education

Entrepreneur-managers of smaller firms, like their employees, probably have less education on the average.
We now have evidence (more than just common sense!) that professional-level management training can increase productivity.
This may be an important source of economies of scale.

II. Schumpeter

Innovation

The most common interpretation of entrepreneurship is due to Schumpeter.
Schumpeter writes, “One necessary distinction is that between enterprise and management: evidently it is one thing to set up a concern embodying a new idea and another thing to head the administration of a going concern, however much the two may shade off into each other.”

Creativity

But Schumpeter is pulling a fast one, here. His definition really joins two things that are quite separable – as he himself acknowledges – entrepreneurship and creativity.
Schumpeter was trained in the Austrian School of Thought, and was influenced by Menger.
In his first work, The Theory of Economic Development, Schumpeter is quite Austrian, describing innovations as “new combinations” of higher-order goods.

Initiative

If, as I previously suggested, entrepreneurship (in Menger’s sense) combines management and initiative, Schumpeter wants to add a third element: creativity.
For this class, I will use Menger’s definition.
For Schumpeter’s concept I will use the term “creative entrepreneurship.”

Further Distinctions

“Again, it is essential to note that the entrepreneurial function, though facilitated by the ownership of means, is not identical with that of the capitalist.”
“In the third place, it is particularly important to distinguish the entrepreneur from the ‘inventor.’”

Creativity 1

That said, creativity is indeed quite important as a basis of human progress, and what Schumpeter has to say about this will be important for us.
“Creative response has at least three essential characteristics. First, from the standpoint of the observer who is in full possession of all relevant facts, it can always be understood ex post; but it can practically never be understood ex ante.”

Creativity 2

“Secondly, creative response shapes the whole course of subsequent events and their ‘long-run’ outcome.”
“Creative response changes social and economic situations for good, or, to put it differently, it creates situations from which there is no bridge to those situations that might have emerged in its absence.”

Creativity 3

In other words, the creative response creates not only the innovation, but the standard by which it is judged adequate.
‘Thirdly, creative response … has obviously something … to do … with individual decisions, actions, and patterns of behavior.’

Historic or Relative

“It should be observed at once that the ‘new thing’ need not be spectacular or of historic importance. It need not be Bessemer steel or the explosion motor. It can be the Deerfoot sausage. To see the phenomenon even in the humblest levels of the business world is quite essential though it may be difficult to find the humble entrepreneurs historically.”

Deerfoot Sausages

Deerfoot was a very popular and expensive brand of sausages in the US in the 19th and early 20th century, known for high quality and healthy production – a problem with sausages at the time.
Not so humble – this was a pretty major step forward in branding and marketing consumer goods!

Small Business

Since creative entrepreneurship is indeed of critical importance for economic development, we will want to explore its relationship to small business.
Hurst and Pugsley, who are among the leading researchers on small business in the past decade, argue that small businesses are typically quite different from Schumpeter’s creative entrepreneurs.

Importance

“In 2007 roughly 6 million firms had paid employees; the 90 percent of these firms that had fewer than 20 employees accounted for about 20 percent of aggregate paid employment and about 15 percent of sales receipts and payroll.”

Industry

B&P examine “4-digit” industries – a more detailed classification than we have seen before.
They measure “concentration” as the proportion of small businesses that are in each classification.
“The first 20 industries accounted for just about half of all firms with fewer than 20 employees in that year.

Small Business Industries 1

“ … most small businesses are either restaurants (full service, limited service, or bars), skilled professionals (physicians, dentists, lawyers, accountants, architects, consultants), skilled craftspersons (general contractors, plumbers, electricians, masons, painters, roofers), professional service providers (clergy, insurance agents, real estate agents), general service providers (auto repair, building services such as landscaping, barbers and beauticians), or small retailers (grocery stores, gas stations, clothing stores).”

Small Business Industries 2

“ Any theory focusing on the distribution of firm size thus needs to account for several facts: that most small businesses are concentrated in a small set of industries, that the fraction of total employment in small businesses within these small business–intensive industries is higher than in other industries, but that even these small business–intensive industries contain many large firms.”

Interim Summary

“To summarize, most small businesses operate in a limited set of narrowly defined industries in which a larger share of economic activity takes place in small firms than is true of other industries.”
The point being (I interpret) that these are industries with little or no economies of scale.

Growth

Among small businesses, growth depends very much on the age of the firm.
“… even well into their life cycle, the overwhelming majority of firms remain small.”
“Only 14 percent of [surveyed] small businesses added an employee between 2002 and 2003, and only 21 percent did so between 2000 and 2003. Thus, by this measure, roughly 80 percent of surviving small firms did not grow at all even over a relatively long period.”