Small Business and Entrepreneurship; E. C. Pastour, Jr.

In addition to the concerns about ~~big business," there is a growing feeling that the entrepreneurial spirit has lost its vitality in the ~~new Dr. Pasour is Professor of Economics at North Caro lina State University at Raleigh. 520 industrial state." The rate of in crease in labor productivity has been decreasing over time, and Uni ted States business firms have become less competitive with foreign manu facturers in the production of a wide range of products including auto mobiles, watches, steel, and televi sion sets. Current economic prob lems including financial difficulties on the part of Chrysler, Interna tional 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 en trants into the labor force.

The purpose of this paper is to show that the preceding scenario is not an SMALL BUSINESS AND ENTREPRENEURSHIP 521 accurate description of the business environment in the United States or in other countries where entrepre neurial incentives are not stifled by inflation, taxes, economic regula tions, and other factors contributing to an unfavorable business climate. Small business, already the most important source of innovative ac tivity and new job opportunities in the United States, can play an even more important role with an easing of the restrictions on entrepreneu rial incentives. A market economy is a dynamic discovery process gen erated by the competitive entrepre neurial scramble for profits. Entrepreneurship and the Market Process In a free enterprise economic sys tem, expected prices and profits pro vide incentives for entrepreneurial activity. If market participants had perfect information, all market ac tivity would be perfectly coordi nated and there would be no profit opportunities nor role for profit seeking entrepreneurs. In a dy namic economy, however, market conditions are constantly changing due to the invention and introduc tion of new products, changes in pro duction technology, changes in con sumer preferences, and so on.

Consequently, there are always profit opportunities available for alert in dividuals with innovative ideas. Entrepreneurship may be aptly defined as an alertness to profit op portuni ties whi:ch have not been grasped and acted upon by others. It should be stressed that the potential for (and expectation of) profits in the competitive marj{.et process creates powerful incentives for profit seek ing individuals t~ discover and make use ofinformatio,n before it is widely known by other people. In a fundamental sense, entrepre neurship is the key to market cre ativity. Busines$ 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, rna)" invent and produce a new product. Henry Ford, the founder of the Ford automobile com pany, provides cl. classic example of successful entrepreneurship based on this approach. However, the crea tion and development of a new prod uct 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 pro ducer must be able to sell the prod uct and at a price high enough to cover the ·production costs (includ ing a return to management).

Another possible road to profits is to advertise or market a product in a way that differentiates the prod uct in the eyes of the consumer. McDonald's, for example, reaped 522 THE FREEMAN September substantial profits as a pioneer in the production and selling of ~~fast food" hamburgers. This profitable busi ness 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 en sure 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 gov ernmental restrictions on entry by potential competitors.

Entrepreneurshipand Job Creation The preceding discussion empha sizes 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 na ture, a high risk activity. Economic growth in a rapidly changing econ omy depends upon a large group of individuals who are willing to en gage in risk-taking activity. It is es timated 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 innova tion. 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 break through is made by a large well-es tablished firm, the new item is often launched by smaller firms. The re sult 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 ofjob creation in the United States by a group of re searchers at the M.LT. Program on Neighborhood and Regional Change found that the most successful busi ness areas of the country were those having the highest rate of innova tion and business fail ure-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 oppor tunities. The study alluded to above found that two-thirds of the net new jobs in the United States from 1969 1976 were created by small firms 1982 SMALL BUSINESS AND ENTREPRENEURSHIP 523 having fewer than 20 employees. A closely related finding revealed that 80 per cent of net new jobs were cre ated 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 associ ated with the production of services as opposed to jobs in the traditional "goods" industries-manufactur ing, 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 train ing rather than physical capital.

Other countries are experiencing shifts in the nature of job require ments similar to those observed in the United States. Accompanying the shift toward the service sector has been a shift in the method of financ ing. As Nobel Laureate Milton Friedman points out, risky ventures have almost invariably been fi nanced by small groups of individu als risking their own funds or funds of their relatives and friends. This method of financing contributes to ward the increased flexibility and adaptability of small business. The preceding discussion should not be taken to, suggest that large corporations are hot important in the U.S. economy. Large firms playa vi tal role, both as ia source of jobs and in consolidating the advances pi 0neered by small firms. There ap pears, however, 'to be little basis for the widespread feeling that large firms have increased their competi tive advantag~ 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 thait are best able and most likely toirespond to rapidly changing economic conditions.

Implications for Economic Planning In view of the crucial place of small firms in job cr~ation, what are the implications fot the role of govern ment in fostering economic growth? The political muscle of large firms makes it more idifficult for market signals to opera~e. Chrysler and other large corporations in financial diffi culty generate attention by the news media and bring calls for govern ment aid. The number ofjobs at stake in such cases means that the fate of these firms is qkely to hinge on po litical considerations rather than on basic economic conditions. Propping 524 THE FREEMAN September 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 fac tors rather than political expe diency.

Since most new jobs are created by small firms, it might appear that government should intervene di rectly. 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 technologi cal developments as well as on busi ness conditions. There is no way to predict tech nology or future knowledge of any kind since, if this were possible, fu ture know ledge would become present knowledge. Since the risk of failure is very high for small firms, in a policy of direct government in tervention a decision would first have to be made as to which firms to as sist. However, there is no accurate way to predict firm success, and gov ernment assistance of large num bers of unprofitable firms would be both politically unfeasible and eco nomically unwise. Thus, direct gov ernment intervention becomes less and less feasible in an economy where small service-oriented firms are increasingly important in pro viding job opportunities.

In view of these problems associ ated with direct intervention, a more feasible alternative is for govern ment to stress the creation of a fa vorable business climate-to adopt policies which are consistent with risk -taking and entrepreneurial ac tivity. In this business climate ap proach, the role of government is largely passive and necessarily lim ited. Consequently, the suggested approach involves a definite change in government policies. There is a consensus that high in terest rates, high marginal tax rates, and government regulations have actively discouraged risk-taking and innovative activity in the United States. During the past decade, sav ings by individuals and business firms have been discouraged be cause gains were taxed at high mar ginal 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 rap idly changing interest rates. It is al ways difficult for business firms to make decisions based on anticipated future conditions. The difficulty and the cost of mistaken forecasts in1982 SMALL BUSINESS AND ENTREPRENEURSHIP 525 crease when interest rates are high.

There is a direct link between infla tion 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 con sumption in the near future relative to the more distant future. Although there is no way to measure the real interest rate, economists have gen erally assumed this rate to be around 3 percent. The money rate of interest equals the real rate of interest plus a sec ond part, the anticipated rate of in flation. This inflation component has been the dominant factor in the money rate of interest in recent years, and reduced inflation is a nec essary condition for a reduction in interest rates. Thus, governmental monetary and fiscal policies to con trol inflation along with a reduction of taxes and regulations are impor tant in establishing the economic climate necessary for increased sav ing, investment, and capital forma tion.

What are the implications of the preceding analysis for central eco nomic planning? It is sometimes maintained that while a limited role for the state was feasible in sparsely settled nineteenth-century Amer ica, it is inevitable that government must playa larger role in economic planning in an increasingly urbanized and industrial society. How ever, as shown below, information problems intensify as the complex ity of society incteases which makes reliance on market prices more nec essary and govemment planning less feasible. Price Signals Market prices are the signals which direct economic activities for consumers and producers in a mar ket economy. When the price of or anges increases relative to other fruits, for exaIIllple, consumers re duce 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 p~ocess that relative prices induce individual decision makers to respohd to changes in eco nomic conditioIlS regardless of firm size.

The market integrates and mobi lizes information automatically without any peI1sonhaving to gather information together in one place. The housewife ip New York City, for example, may Wnow nothing about a poor coffee crow in South America, but she adjusts p.er actions to it when the price of coffee rises. At the same time, price an~ profit signals pro vide incentives! for the discovery of new facts whicll improves the adap tation of mark~t participants to ever changing circumstances. Thus, mar526 THE FREEMAN September ket 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 ac tivity. The factors which cause prices to change and thereby guide the be havior of decision-makers in a mar ket economy are influences which would need to be taken into account in any conceivable system of coordi nating economic activity. Moreover, no other way has been discovered for coordinating and transmitting in formation in the organization of pro duction 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 mini mum 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 impor tant as society becomes more com plex. Consequently, the importance of market prices in coordinating eco nomic 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 charac terized by rapidly changing eco nomic conditions. Conclusions and Implications A generation ago, a famous econ omist, Joseph Schumpeter, pre dicted the withering away of the en trepreneur. In a view later adopted by many economic analysts, Schum peter considered entrepreneurship to be crucial only in the early stages of capitalist development. In the "ma ture" phase of capitalism, economic activity was to be dominated by a combination of large corporation and government bodies leaving no scope for individual entrepreneurship. To day, many people still feel that the small inventors and fabled entre preneurs of early capitalism are a dying breed having no role to play in the "new industrial state."

The actual situation concerning entrepreneurship and small busi ness bears little resemblance to the scenario just depicted. Although large corporations dominate the business news, small business pro vides 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 unpre dictable economic conditions. Under these conditions, pleas for a "rein dustrialization" policy guided and aided by government are fundamen tally misplaced. Rather, emphasis should be placed on improving the investment climate ·as a means of fostering entrepreneurship and small business activity.

1982 SMALL BUSINESS AND ENTREPRENEURSllIP 527 Inflation, high taxes, and wide spread government regulations in hibit entrepreneurial activity for firms of all sizes. Entrepreneurship is especially difficult under infla tionary conditions both because the uncertainty created by inflation makes planning· more difficult and because inflation causes income to be overstated for tax purposes. Con sequently, the government can con tribute importantly toward a favor able business climate through non inflationary monetary and fiscal policies. Small business now plays a cru cial role in the rapidly changing modern industrial society. If, as seems to be the case, there is a fur ther shift away froJll the production of autos, steel and other products in which the United States once had a comparative advantage, the solu tion lies not in trade barriers .and protection or other attempts to in sulate these industries from market forces but in developing those prod ucts in which the United States is competitive.

The United States, for example,is the leader in producing "thoughtware" (software i as compared with hardware) upon! which so much of new technology is based. New tech nologies such a~ the laser and mi crobiology are o~ the horizon. How ever, the precis~ direction of these developments iSiunknown and any one who predic~s the technological future is sure to ~oon appear foolish. Consequently, tij.e importance of en trepreneurial act~vity in ferreting out profit opportun.ties will continue. Moreover, regar~lless of which prod ucts prove to be, most profitable for U.S. business, there is little ques tion that small business with its in herent advantages of flexibility and adaptability will be at the cutting edge of these new developments. @ -REFERENCESBirch, David L. "Wh<:> Creates Jobs?" The Pub lic Interest 65 (198~): 3-14. Friedman, Milton. Market Mechanisms and Central Economic Planning. Washington: American EnterPI1se Institute, 1981.

Gilder, George. Weal~h and Poverty. New York: Basic Books, Inc., ~981. Kirzner, Israel M. Competition and Entrepre neurship. ChicagQ: University of Chicago Press, 1973. Competition Equals Freedom IDEAS ON COMPETITION is nothing but freedom looked at up~ide down. In a market ~ where buyers are free to shop around, sellers m~st outdo each other to UIU get and keep customers. Through competition jthere is produced the LIBERTY maximum of goods and services that the public wants most. HART BUOK, "Freedom to Shop Around"