Category Archives: Entrepreneurship

“Firm Dynamics, Persistent Effects of Entry Conditions, and Business Cycles,” S. Moreira (2016)

Business cycle fluctuations have long run effects on a number of economic variables. For instance, if you enter the labor force during a recession, your wages are harmed for many years afterward. Many other economic parameters revert to trend, leaving a past recession just a blip on the horizon. Sara Moreira, a job candidate from the University of Chicago, investigates in her job market paper whether entrepreneurship changes induced by recessions persist in the long run.

New firm formation is procyclical: entrepreneurship fell roughly 20 percent during the recent recession. Looking back at the universe of private firms since the late 1970s, Moreira shows that this procyclicality is common, and that the firms that do form during recessions tend to be smaller than those which form during booms. Incredibly, this size gap persists for at least a decade after the firms are founded! At first glance, this is crazy: if my firm is founded during the 2001 recession, surely any effects from my founding days should have worn off after a decade of introducing new products, hiring new staff, finding new funding sources, etc. And yet Moreira finds this effect no matter how you slice the data, using overall recessions, industry-specific shocks, shocks based on tradable versus nontradable commodities, and so on, and it remains even when accounting for the autocorrelation of the business cycle. The effect is not small: the average firm born during a year with above trend growth is roughly 2 percent larger 10 years later than the average firm born during below trend growth years.

This gap is double surprising if you think about how firms are founded. Imagine we are in middle of a recession, and I am thinking of forming a new construction company. Bank loans are probably tough to get, I am unlikely to be flush with cash to start a new spinoff, I may worry about running out of liquidity before demand picks up, and so on. Because of these negative effects, you might reasonably believe that only very high quality ideas will lead to new firms during recessions, and hence the average firms born during recessions will be the very high quality, fast growing, firms of the future, whereas the average firms born during booms will be dry cleaners and sole proprietorships and local restaurants. And indeed this is the case! Moreira finds that firms born during recessions have high productivity, are more likely to be in high innovation sectors, and and less likely to be (low-productivity) sole proprietorships. We have a real mystery, then: how can firms born during a recession both be high quality and find it tough to grow?

Moreira considers two stories. It may be that adjustment costs matter, and firms born small because the environment is recessionary find it too costly to ramp up in size when the economy improves. Moreira finds no support for this idea: capital-intensive industries show the same patterns as industries using little capital.

Alternatively, customers need to be acquired, and this acquisition process may generate persistence in firm size. Naturally, firms start small because it takes time to teach people about products and for demand to grow: a restaurant chain does not introduce 1000 restaurants in one go. If you start really small because of difficulty in getting funded, low demand, or any other reason, then in year 2 you have fewer existing customers and less knowledge about what consumers want. This causes you to grow slower in year 2, and hence in year 3, you remain smaller than firms that initially were large, and the effect persists every year thereafter. Moreira finds support for this effect: among other checks, industries whose products are more differentiated are the ones most likely to see persistence of size differences.

Taking this intuition to a Hopenhayn-style calibrated model, the data tells us the following. First, it is not guaranteed that recessions lead to smaller firms initially, since the selection of only high productivity ideas into entrepreneurship during recessions, and the problem of low demand, operate in opposite directions, but empirically the latter seems to dominate. Second, if the productivity distribution of new firms were identical during booms and recessions, the initial size difference between firms born during booms and recessions would be double what we actually observe, so the selection story does in fact moderate the effect of the business cycle on new firm size. Third, the average size gap does not close even though the effect of the initial demand shock, hence fewer customers in the first couple years and slower growth thereafter, begins to fade as many years go by. The reason is that idiosyncratic productivity is mean reverting, so the average (relatively low quality at birth) firm born during booms that doesn’t go out of business becomes more like an average overall firm, and the average (relatively high productivity at birth) firm born during recessions sees its relative productivity get worse. Therefore, the advantage recession-born firms get from being born with high quality firms fades, countering the fading harm of the size of these firms from the persistent demand channel. Fourth, the fact that high productivity firms born during recessions grow slowly due to the historic persistence of customer acquisition means that temporary recessions will still affect the job market many years later: the Great Recession, in Moreira’s calibration, will a decade later still be chewing up 600,000 jobs that firms from the 2008-2009 cohort would have employed. Really enjoyed this paper: it’s a great combination of forensic digging through the data, as well as theoretically well-founded rationalization of the patterns observed.

January 2016 working paper. Moreira also has interesting slides showing how to link the skilled wage premium to underlying industry-level elasticities in skilled and unskilled labor. She notes that as services become more important, where labor substitutability is more difficult, the effect of technological change on the wage premium will become more severe.

“Entrepreneurship: Productive, Unproductive and Destructive,” W. Baumol (1990)

William Baumol, who strikes me as one of the leading contenders for a Nobel in the near future, has written a surprising amount of interesting economic history. Many economic historians see innovation – the expansion of ideas and the diffusion of products containing those ideas, generally driven by entrepreneurs – as critical for growth. But we find it very difficult to see any reason why the “spirit of innovation” or the net amount of cleverness in society is varying over time. Indeed, great inventions, as undeveloped ideas, occur almost everywhere at almost all times. The steam engine of Heron of Alexandria, which was used for parlor tricks like opening temple doors and little else, is surely the most famous example of a great idea, undeveloped.

Why, then, do entrepreneurs develop ideas and cause products to diffuse widely at some times in history and not at others? Schumpeter gave five roles for an entrepreneur: introducing new products, new production methods, new markets, new supply sources or new firm and industry organizations. All of these are productive forms of entrepreneurship. Baumol points out that clever folks can also spend their time innovating new war implements, or new methods of rent seeking, or new methods of advancing in government. If incentives are such that those activities are where the very clever are able to prosper, both financially and socially, then it should be no surprise that “entrepreneurship” in this broad sense is unproductive or, worse, destructive.

History offers a great deal of support here. Despite quite a bit of productive entrepreneurship in the Middle East before the rise of Athens and Rome, the Greeks and Romans, especially the latter, are well-known for their lack of widespread diffusion of new productive innovations. Beyond the steam engine, the Romans also knew of the water wheel yet used it very little. There are countless other examples. Why? Let’s turn to Cicero: “Of all the sources of wealth, farming is the best, the most able, the most profitable, the most noble.” Earning a governorship and stripping assets was also seen as noble. What we now call productive work? Not so much. Even the freed slaves who worked as merchants had the goal of, after acquiring enough money, retiring to “domum pulchram, multum serit, multum fenerat”: a fine house, land under cultivation and short-term loans for voyages.

Baumol goes on to discuss China, where passing the imperial exam and moving into government was the easiest way to wealth, and the early middle ages of Europe, where seizing assets from neighboring towns was more profitable than expanding trade. The historical content of Baumol’s essay was greatly expanded in a book he edited alongside Joel Mokyr and David Landes called The Invention of Enterprise, which discusses the relative return to productive entrepreneurship versus other forms of entrepreneurship from Babylon up to post-war Japan.

The relative incentives for different types of “clever work” are relevant today as well. Consider Luigi Zingales’ new lecture, Does Finance Benefit Society? I can’t imagine anyone would consider Zingales hostile to the financial sector, but he nonetheless discusses in exhaustive detail the ways in which incentives push some workers in that sector toward rent-seeking and fraud rather than innovation which helps the consumer.

Final JPE copy (RePEc IDEAS). Murphy, Schleifer and Vishny have a paper, also from the JPE in 1990, on the topic of how clever people in many countries are incentivized toward rent-seeking; their work is more theoretical and empirical than historical. If you are interested in innovation and entrepreneurship, I uploaded the reading list for my PhD course on the topic here.

“What Do Small Businesses Do?,” E. Hurst & B. Pugsley (2011)

There are a huge number of policies devoted toward increasing the number of small businesses. The assumption, it seems, is that small businesses are generating more spillovers than large businesses, in terms of innovation, increases in the labor match rate, or indirect welfare benefits from creative destruction. Indeed, politicians like to think of these “Joe the Plumber” types as heroic job creators, although I’m not sure what that could possibly mean since the long run level of unemployment is constant and unrelated the amount of entrepreneurial churn in whatever economic model or empirical data you wish to investigate.

These policies beg the question: are new firms actually quick-growing, innovative concerns, or are they mainly small restaurants, doctor’s offices and convenience stores? The question is important since it is tough to see why the tax code should privilege, say, an independent convenience store over a new corporate-run branch – if anything, the independent is less innovative and less likely to grow in the future. Erik Hurst and Ben Pugsley do a nice job of generating stylized facts on these issues using a handful of recent surveys of firm outcomes and the stated goals of the owners of new firms.

The evidence is pretty overwhelming that most new firms are not the heroic, job-creating innovator. Among firms with less than 20 employees, most are concentrated in a very small number of industries like construction, retail, restaurants, etc, and this concentration is much more evident than among larger firms. Most small firms never hire more than a couple employees, and this is true even among firms that survive five or ten years. Among new firms, only 2.7% file for a patent within four years, and only 6-8% develop any proprietary product or technique at all.

It is not only in outcomes, but in expectations as well where it seems small businesses are not rapidly-growing innovative firms. At their origin, 75% of small business owners report no desire to grow their business, nonpecuniary reasons (such as “to be my own boss”) are the most common reason given to start a business, and only 10% plan to develop any new product or process. That is, most small businesses are like the corner doctor’s office or small plumbing shop. Starting a business for nonpecuniary reasons is also correlated with not wanting to grow, not wanting to innovate, and not actually doing so. They are small and non-innovative because they don’t want to be big, not because they fail at trying to become big. It’s also worth mentioning that hardly any small business owners in the U.S. sample report starting a business because they couldn’t find a job; the opposite is true in developing countries.

These facts make it really hard to justify a lot of policy. For instance, consider subsidies that only accrue to businesses below a certain size. This essentially raises the de facto marginal tax rate on growing firms (since the subsidy disappears once the firm grows above a certain size), even though rapidly growing small businesses are exactly the type we presumably are trying to subsidize. If liquidity constraints or other factors limiting firm entry were important, then the subsidies might still be justified, but it seems from Hurst and Pagsley’s survey that all these policies will do is increase entry among business owners who want to be their own boss and who never plan to hire or innovate in any economically important way. A lot more work here, especially on the structural/theoretical side, is needed to develop better entrepreneurial policies (I have a few thoughts myself, so watch this space).

Final Working Paper (RePEc IDEAS) which was eventually published in the Brookings series. Also see Haltiwanger et al’s paper showing that it’s not small firms but young firms which are engines of growth. I posted on a similar topic a few weeks ago, which may be of interest.

“Organizing Venture Capital: The Rise and Demise of American Research and Development Corporation, 1946-1973,” D. Hsu & M. Kenney (2005)

Venture capital financing of innovative firms feels like a new phenomenon, and is clearly of great importance to high tech companies as well as cities that hope to attract these companies. The basic principle involves relatively small numbers of wealthy individuals providing long-term financing to a group of managers who seek out early-stage, unprofitable firms, make an investment (generally equity), and occasionally help actively manage the company.

There are many other ways firms can fund themselves: issuance of equity, investment from friends or family, investment from an existing firm in a spinoff, investment from the saved funds of an individual, or debt loans from a bank, among others. Two questions, then, are immediate: why does anyone fund with VC in the first place, and how did this institutional form come about? VC is strange at first glance: in a stage in which entrepreneur effort is particularly important, why would I write a financing contract which takes away some of the upside of working hard on the part of the entrepreneur by diluting her ownership share? Two things are worth noting. VC rather than debt finance is particularly common when returns are highly skewed – a bank loan can only be repaid with interest, hence will have trouble capturing that upside. Second, early-stage equity finance and active managerial assistance appear to come bundled, hence some finance folks have argued that the moral hazard problem lies both with the entrepreneur, who must be incentivized to work hard, and with the VC firm and their employees, who need the same incentive.

Let’s set aside the question of entrepreneurial finance, and look into history. Though something like venture capital appeared to be important in the Second Industrial Revolution (see, e.g., Lamoreaux et al (2006) on that hub of high-tech, Cleveland!), and it may have existed in a proto-form as early as the 1700s with the English country banks (though I am not totally convinced of that equivalence), the earliest modern VC firm was Boston’s American Research and Development Corporation. The decline of textiles hit New England hard in the 1920s and 1930s. A group of prominent blue bloods, including the President of MIT and the future founder of INSEAD, had discussed the social need for an organization that would fund firms which could potentially lead to new industries, and they believed that despite this social goal, the organization ought be a profit-making concern if it were to be successful in the long run.

After a few false starts, the ARD formed in 1946, a time of widespread belief in the power of R&D following World War II and Vannevar Bush’s famous “Science: the Endless Frontier”. ARD was organized as a closed-end investment trust, which permitted institutional investors to contribute. Investments tended to be solicited, were very likely to be made to New England firms, and were, especially in the first few years, concentrated in R&D intensive companies; local, solicited, R&D heavy investment is even today the most common type of VC. Management was often active, and there are reports of entire management teams being replaced by ARD if they felt the firm was not growing quickly enough.

So why have you never of ARD, then? Two reasons: returns, and organizational structure. ARD’s returns over the 50s and 60s were barely higher, even before fees, than the S&P 500 as a whole. And this overstates things: an investment in Digital Equipment, the pioneering minicomputer company, was responsible for the vast majority of profits. No surprise, then, that even early VCs had highly skewed returns. More problematic was competition. A 1958 law permitted Small Business Investment Corporations (SBICs) to make VC-style investments at favorable tax rates, and the organizational form of limited partnership VC was less constrained by the SEC than a closed-end investment fund. In particular, the partnerships “2 and 20” structure meant that top investment managers could earn much more money at that type of firm than at ARD. One investment manager at ARD put a huge amount of effort into developing a company called Optical Scanning, whose IPO made the founder $10 million. The ARD employee, partially because of SEC regulations, earned a $2000 bonus. By 1973, ARD had been absorbed into another company, and was for all practical purposes defunct.

It’s particularly interesting, though, that the Boston Brahmins were right: VC has been critical in two straight resurgences in the New England economy, the minicomputer cluster of the 1960s, and the more recent Route 128 biotech cluster, both of which were the world’s largest. New England, despite the collapse of textiles, has not gone the way of the rust belt – were it a country, it would be wealthier per capita than all but a couple of microstates. And yet, ARD as a profitmaking enterprise went kaput rather quickly. Yet more evidence of the danger of being a market leader – not only can other firms avoid your mistakes, but they can also take advantage of more advantageous organizational forms and laws that are permitted or created in response to your early success!

Final published version, in Industrial and Corporate Change 2005 (RePEc IDEAS).

“Seeking the Roots of Entrepreneurship: Insights from Behavioral Economics,” T. Astebro, H. Herz, R. Nanda & R. Weber (2014)

Entrepreneurship is a strange thing. Entrepreneurs work longer hours, make less money in expectation, and have higher variance earnings than those working for firms; if anyone knows of solid evidence to the contrary, I would love to see the reference. The social value of entrepreneurship through greater product market competition, new goods, etc., is very high, so as a society the strange choice of entrepreneurs may be a net benefit. We even encourage it here at UT! Given these facts, why does anyone start a company anyway?

Astebro and coauthors, as part of a new JEP symposium on entrepreneurship, look at evidence from behavioral economics. The evidence isn’t totally conclusive, but it appears entrepreneurs are not any more risk-loving or ambiguity-loving than the average person. Though they are overoptimistic, you still see entrepreneurs in high-risk, low-performance firms even ten years after they are founded, at which point surely any overoptimism must have long since been beaten out of them.

It is, however, true that entrepreneurship is much more common among the well-off. If risk aversion can’t explain things, then perhaps entrepreneurship is in some sense consumption: the founders value independence and control. Experimental evidence provides fairly strong evidence for this hypothesis. For many entrepreneurs, it is more about not having a boss than about the small chance of becoming very rich.

This leads to a couple questions: why so many immigrant entrepreneurs, and what are we make of the declining rate of firm formation in the US? Pardon me if I speculate a bit here. The immigrant story may just be selection; almost by definition, those who move across borders, especially those who move for graduate school, tend to be quite independent! The declining rate of firm formation may be tied with inequality changes; to the extent that entrepreneurship involves consumption of a luxury good (control over one’s working life) in addition to standard risk-adjusted cost-benefit analysis, then changes in the income distribution will change that consumption pattern. More work is needed on these questions.

Summer 2014 JEP (RePEc IDEAS). As always, a big thumbs up to the JEP for being free to read! It is also worth checking out the companion articles by Bill Kerr and coauthors on experimentation, with some amazing stats using internal VC project evaluation data for which ex-ante projections were basically identical for ex-post failures and ex-post huge successes, and one by Haltiwanger and coauthors documenting the important role played by startups in job creation, the collapse in startup formation and job churn which began well before 2008, and the utter mystery about what is causing this collapse (which we can see across regions and across industries).

%d bloggers like this: