Wednesday, November 2, 2011

Do small firms underpin economic vibrancy and create major share of jobs?

One of the recurrent themes in the debate about the problems facing the US economy has been the relative weakness of small enterprises who are traditionally believed to have provided the labor market firepower in the aftermath of recessions and also underpin economic vibrancy of any economy. However, this conventional wisdom has been questioned by Jared Bernstein and Tyler Cowen in different contexts.

Tyler Cowen points to an interesting possible structural cause for the economic weakness in Italy and some of the peripheral economies - the over-sized role of smaller firms in their economies. Referring to Italy's vibrant clusters of family-owned niche businesses, he writes,

"With the advent of modern communications and information technologies, arguably the return to 'small family firms' has fallen. The return to 'largish projects consummated over large distances' has gone up. For Europe, the big winners here are the Nordic countries, which have worked very effectively with information technology and which do not rely so much on family ties to get efficient, non-corrupt management. The losers are Italy and Greece and Portugal too... Portugal is cursed by being stuck with all these small firms, inefficiently small for legal and regulatory reasons. These countries seem to be locked out from some of the major sources of contemporary economic growth."

He also points to Serguey Braguinsky, Lee Branstetter, and Andre Regateiro, who studied the transformation of Portugal's firms and found,

"For decades, the entire Portuguese firm size distribution has been shifting to the left... Portugal's shrinking firms are linked to the country's anemic growth and low productivity. We show that the shift in the Portuguese firm size distribution is not reflected in other advanced industrial economies for which we have been able to obtain comparable data."

Matt Yglesias has an excellent graphic that clearly refutes the small-firms-cause-economic vibrancy thesis.

I cannot but not agree with his broad assessment of firm growth in any economy. He writes,

"The way a healthy economy works is that you start with a bunch of firms and then it turns out that some of those firms are better-managed than others. The well-managed firms expand while the poorly-managed firms go out of businesses. At the end of the day, then, you wind up with the majority of workers working for relatively well-managed firms. Because the firms are well-managed, the workers are more productive and earn the well-known-in-the-literature large firm wage premium. Alternatively, you can have an economy like Italy’s with lots of barriers to competition so that poorly managed firms stay in business with low productivity."

Jared Bernstein writes about the role of small businesses in the US economy,

"It’s not small businesses that matter, but new businesses, which by definition create new jobs. Real job creation, though, doesn’t kick in until those small businesses survive and grow into larger operations."

Bernstein's assessment and the findings from the study of Portuguese economy has important lessons for India, where small businesses and policies favoring them are seen as holy cows. Braguinsky et al write about the distortionary role played by Portugal's uniquely strong protections for regular workers,

"Drawing upon an emerging literature that that attributes much of the productivity gap between advanced nations and developing nations to the misallocation of resources across firms in developing countries, we develop a theoretical model that shows how Portugal's labor market institutions could prevent more productive firms from reaching their optimal size, thereby constraining GDP per capita."

Their assessment of the Portuguese economy would also apply to India which too has similar tight labor market restrictions aimed at protecting smaller enterprises,

"Portugal's policy commitment to employment protections for regular workers in the formal sector is extreme, even by Western European standards. We present a model in which high levels of employment protection e ectively operate as a tax on wages, and can produce a shift in the rm size distribution, relative to the distortion-free benchmark, that reflects, in some ways, what we have seen in Portugal. An immediate implication of our model is that the same policy regime that shrinks firms also lowers aggregate productivity. Even a uniform tax tends to hit the most productive enterprises disproportionately hard, causing a degradation of the allocation of resources across enterprises. More resources are tied up in smaller, less protective enterprises and fewer resources are allocated to the most productive firms, relative to what we would see in a distortion-free economy."

In simple terms, the major share of job creation happens when small industries which started recently consolidate and start their expansionary phase. Public policy should accordingly facilitate this expansion. Unfortunately, both public policy and pervailing socio-economic institutions and conditions, both hinder such expansion.

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