The role of small and large businesses in economic development

The Role of Small and Large Businesses in Economic Development Increasingly, economic development experts are abandoning traditional approaches to economic development that rely on recruiting large enterprises with tax breaks, financial incentives, and other induce- ments. Instead, they are relying on building businesses from the groundup and supporting the growth of existing enterprises. This approach hastwo complementary features. The first is to develop and support entrepre-neurs and small businesses. The second is to expand and improveinfrastructure and to develop or recruit a highly skilled and educatedworkforce. Both efforts depend in large part on improving the quality oflife in the community and creating an attractive business climate. The reason for the shift in approaches is clear. Experience suggests that economic development strategies aimed at attracting large firms areunlikely to be successful—or successful only at great cost. Smokestackchasing can be especially costly if it generates competition for firmsamong jurisdictions. Further, because of the purported job creation roleand innovative prowess of entrepreneurs and small businesses, creatingan environment conducive to many small businesses may produce morejobs than trying to lure one or two large enterprises. The hope is not Kelly Edmiston is a senior economist in Community Affairs at the Federal Reserve
Bank of Kansas City. This article is on the bank’s website at www.KansasCityFed.org.
FEDERAL RESERVE BANK OF KANSAS CITY only that new businesses will create jobs in the local community, but,through innovation, some new businesses may grow into rapid-growth“gazelle” firms, which may spawn perhaps hundreds of jobs and becomeindustry leaders of tomorrow. This article evaluates this shift in economic development strategies.
The first section describes traditional economic development strategies.
The second section explores the role that small businesses play in creat-ing jobs. The third section compares job quality between small firmsand larger firms. The fourth section examines how important smallbusinesses are in the development of new products and new markets. The overarching question is whether promoting entrepreneurship and small businesses makes sense as an economic development strategy.
This article concludes that it probably does but with some caveats. Smallbusinesses are potent job creators, but so are large businesses. The attri-bution of the bulk of net job creation to small businesses arises largelyfrom relatively large job losses at large firms, not to especially robust jobcreation by small firms. More importantly, data show that, on average,large businesses offer better jobs than small businesses, in terms of bothcompensation and stability. Further, there is little convincing evidenceto suggest that small businesses have an edge over larger businesses ininnovation. More research is needed to properly evaluate the case for asmall business strategy, and, indeed, to determine whether or not publicengagement in economic development itself is a cost-effective andworthwhile pursuit.
ISSUES WITH TRADITIONAL ECONOMIC
DEVELOPMENT POLICIES
On the surface, one might think that a large firm would spur local economic growth by yielding significant gains in employment and per-sonal income. The direct effect—the jobs and income generated directlyby the firm—would certainly suggest this to be the case. In reality,however, it is often the effects on other firms in the area—the indirecteffects—that carry the greatest weight in the net economic impact.
Experience suggests that because of these typically large indirect effects ECONOMIC REVIEW • SECOND QUARTER 2007 and the costs of incentives and competition, economic developmentstrategies aimed at attracting large firms are unlikely to be successful orare likely to succeed only at great cost. A recent study of new-firm locations and expansions in Georgia suggests that, on net, the location of a new large (300+ employees) firmoften retards the growth of the existing enterprises or discourages theestablishment of enterprises that would otherwise have located there(Edmiston). Specifically, the location of a new plant with 1,000 workers,on average, adds a net of only 285 workers over a five-year period. Thatis, the average firm would add 1,000 workers in its own plant but wouldalso drive away 715 other jobs that would have been generated (orretained) if the new large firm had chosen not to locate there. Anotherrecent study suggests that the net employment impact of large-firm loca-tions may actually be closer to zero (Fox and Murray). Much has been made of the indirect effects, or spillovers, of new large firms. The positive spillovers include links with suppliers, increasedconsumer spending, the transfer of knowledge from one firm to another,and the sharing of pools of workers. But negative spillovers are impor-tant as well. They include constraints on the supply of labor and otherinputs, upward pressure on wages and rents, congestion of infrastruc-ture, and (if fiscal incentives are provided to the locating firm) budgetpressures from increased spending without commensurate increases inpublic revenues. Even perceptions of these negative effects can driveaway firms, whether or not they actually materialize. The evidence sug-gests that the negative effects dominate with many large-firm locations(Edmiston; Fox and Murray). Expansions of existing firms, however, tend to have multiplicative pos- itive employment impacts. On average, a plant expansion adding 1,000employees is expected to generate a net employment impact of 2,000. Thisresult supports the notion that internal business generation and growth haspotentially better prospects as a strategy than firm recruitment.
The costs per job of incentive packages are generally measured in terms of gross new jobs at the new firm. The dollars of incentives aredivided by the number of jobs. During the recruitment stage, these costsare often substantially underestimated. For example, the cost per job FEDERAL RESERVE BANK OF KANSAS CITY created for an enterprise creating 1,000 new jobs and offered $20million in incentives is $20,000. But if the net job impact is only 285,the true cost per job created soars to $70,175. In many cases, states or local communities could arguably receive greater returns by investing the same resources in creating a more con-ducive business environment for existing firms—both large and small.
Thus, recruiting large firms is often costly, in both direct expendituresand the lost opportunities for other forms of economic development. Recruitment of large firms is also costly because it may engender a competitive economic development landscape. For example, decisionsby local governments to use tax abatements to lure firms are highlydependent on the decisions of their neighbors (Edmiston and Turnbull).
The likelihood that a county uses tax abatements to lure firms increases41 percentage points if its neighbors use them. In other words, a countythat has a 20 percent probability of using tax abatements when none ofits neighbors use them would have a 61 percent probability when all ofits neighbors use them. The presence of a border with a neighboringstate may also encourage the use of tax abatements.
This type of competition can be very costly. Recruiting a firm will generate costs for infrastructure, such as roads, sewers, and public serv-ices. If a community gets into a bidding war with another community,fewer resources will be available for absorbing these costs, and neithercommunity gains an advantage by aggressive recruiting. If, for example,one community offers tax incentives to win the new firm, it will faceincreased costs but no property taxes to offset them. The recruitment offirms can therefore be a losing proposition for all involved.
Perhaps most important, from the perspective of society at large, aggressive courting of large firms can distort rational behavior, causing awaste of economic resources. For example, one region may offer a lowercost option for a newly locating enterprise because of a larger supply oflabor, cheaper costs of transport to market, or other natural advantages. Ifanother region is able to capture the firm away from its optimal locationby offering lucrative financial incentives, resources will be expended need-lessly. For example, shipping the final product over longer distances will bemore expensive. While welfare in the winning region may improve (butnot necessarily), welfare for the larger community encompassing theregion will suffer: Fewer resources would be available for production thanwould be the case if the firm chose its economically optimal location.
ECONOMIC REVIEW • SECOND QUARTER 2007 SMALL BUSINESSES AND JOB CREATION
An alternative to recruiting large firms with tax incentives and other inducements is to focus on the small business sector. Perhaps the great-est generator of interest in entrepreneurship and small business is thewidely held belief that small businesses in the United States create mostnew jobs. The evidence suggests that small businesses indeed create asubstantial majority of net new jobs in an average year. But the widelyreported figures on net job growth obscure the important dynamics ofjob creation and destruction. Nevertheless, small businesses remain asignificant source of new jobs in the United States. Data published by the U.S. Census Bureau clearly show that the bulk of net new jobs are generated by firms with less than 20 employees(Chart 1). Net new jobs are the total of new jobs created by firm startupsand expansions (gross job creation) minus the total number of jobsdestroyed by firm closures and contractions (gross job destruction).
From 1990 to 2003, small firms (less than 20 employees) accounted for79.5 percent of the net new jobs, despite employing less than 18.4percent of all jobs in 2003.1 Midsize firms (20 to 499 employees)accounted for 13.2 percent of the net new jobs, while large firms (500or more employees) accounted for 7.3 percent.2 At first glance, the net new job figures are difficult to reconcile with the fact that, over the same period, small firms’ share of total employ-ment actually fell. In 1990, small firms employed 20.2 percent of allworkers, while large firms employed 46.3 percent. In 2003, the numbersfor small firms dropped to 18.4 percent but climbed to 49.3 percent forlarge firms. The explanation lies in the migration of firms across size classes from year to year. In any given year, some small firms will grow beyond20 workers and join a larger size class. Such migration trims the share offirms in the smallest class size, in the same way that small business fail-ures trim the class size.3 Likewise, some large firms will contract, fallingbelow the 500-employee level and dropping into a smaller size class.
Also, new small businesses are born, increasing the share of jobs in the FEDERAL RESERVE BANK OF KANSAS CITY Chart 1NET JOB CREATION BY FIRM SIZE, 1990-2003 Source: U.S. Census Bureau Statistics of U.S. Business small-firm class. The data, thus, suggest that the effects of migration ofsmall firms into larger size classes and small business failures outweighthe effects of the migration of large firms into smaller size classes andsmall business startups. Migration also makes it difficult to attribute jobgrowth to firm size.4 While striking, the net job growth figures presented above can also be somewhat deceiving. Gross job flows are considerably larger than netjob flows. Roughly 23 million net new jobs were created from 1990 to2003, but these figures represent the difference between 239 milliongross new jobs created and 216 million gross jobs lost. Clearly, netemployment figures mask a great deal of volatility in the labor market. The relatively high share of net new jobs created by small businesses stems mainly from relatively large gross job losses among larger firms—not from massive job creation by small firms. From 1990 to 2003, smallfirms created almost 80 percent of net new jobs but less than 30 percentof gross jobs (Table 1).5 Small firms also accounted for about 24 percentof gross job losses. Large firms created almost 40 percent of gross newjobs but suffered 43.5 percent of gross job losses. ECONOMIC REVIEW • SECOND QUARTER 2007 Table 1JOB CREATION AND DESTRUCTION BY FIRM SIZECLASS, 1990-2001 Source: U.S. Census Bureau, Statistics of U.S. Businesses.
Most gross and net new jobs at small businesses stem from existing business expansions rather than from new business startups. Small busi-ness startups created about 36 percent of gross new jobs from 1990 to2004, an average of roughly 1.8 million jobs per year. At the same time,the death of small firms was responsible for an average loss of more than1.6 million gross jobs each year. Thus, the net job growth from smallbusiness startups in the 1990s and early 2000s (new jobs created minusjob losses) was relatively small, representing less than 13 percent of totalnet job growth among the smallest firms. In the United States, 75 percent of business establishments repre- sent the self-employed and, therefore, have no payroll at all. Some of theself-employed have other jobs as well, but for many, self-employment istheir primary source of income. Clearly, many entrepreneurs start theirbusinesses as self-employed people. They acquire new employees as theirbusinesses expand. Mainly because these establishments generate only about 3 percent of total receipts (sales) annually, data for the sector are generally less availablethan for the employer sector. But the Census Bureau annually collectslimited information from business tax returns filed with the InternalRevenue Service. In 2004, more than 19.5 million individuals were self-employed or operated businesses with no payroll. This number is roughly12 percent of the working population and about 26 percent higher than FEDERAL RESERVE BANK OF KANSAS CITY in 1997. The number also corresponds to a compound annual growth rateof about 3.4 percent over the period. By contrast, total private employ-ment over the same period increased 0.8 percent annually.6 III. JOB QUALITY AT SMALL BUSINESSES
Knowing that small businesses create a significant share of new jobs, it is natural to ask how these jobs compare to those at larger firms.
Simply put, large firms offer better jobs and higher wages than smallfirms. Benefits appear to be better at large firms as well, for everythingfrom health insurance and retirement to paid holidays and vacations.
Finally, job turnover, initiated by both employers and employees, islower at large firms. The lower rates of employee-initiated turnoversuggest that job satisfaction and mobility are relatively greater at largerfirms. Lower rates of employer-initiated separations suggest that jobs atlarger firms are more stable.
Large firms pay higher wages than small firms. In 2005, the average hourly wage in establishments with less than 100 workers was $15.69and increased consistently with establishment size. Wages increased to$27.05 (a 72 percent premium) for establishments with 2,500 or moreworkers (Chart 2). Smaller businesses are also much more likely toemploy low-wage workers. In 2004, establishments with less than 100workers paid nearly a fourth of their workers less than $8 per hour.
Establishments with 2,500 or more workers paid only 3 percent of theirworkers less than $8 per hour (Bureau of Labor Statistics 2004). Again,the percentage of workers earning low wages declines consistently asestablishment size increases. The gap does not appear to be narrowing,as research finds wage growth at large firms equals or exceeds that atsmall firms (Hu).7 There are several explanations for the general wage discrepancies across workers or classes of workers. Workers doing the same job mightbe willing to accept a lower wage for increased job stability, better fringebenefits, or other positive job attributes. In fact, research has found thatmany workers accept lower wages in exchange for health benefits ECONOMIC REVIEW • SECOND QUARTER 2007 Chart 2AVERAGE HOURLY WAGE, BY ESTABLISHMENT SIZE, 2005 Source: Bureau of Labor Statistics, U.S. Department of Labor (2007). National Compensa-tion Survey: Occupational Wages in the United States, June 2005 (Olson). But this is not a plausible explanation for the size-wage effectbecause large firms tend to offer more stable employment and betterbenefits than small firms. Large firms often have undesirable working conditions, such as weaker autonomy, stricter rules and regulations, less flexible scheduling,and a more impersonal working environment. But, to the extent thatempirical evidence can capture these differences, working conditionscannot explain the firm size-wage effect (Brown and Medoff ).
Demographics may offer a plausible explanation: Women and minorities typically earn less than their white male counterparts. Butevidence shows that, with the exception of Hispanics, women andminorities are generally more likely to work for larger firms. Blacksmake up about 10 percent of smaller firms (less than 500), compared to13 percent of larger firms (Headd).8 Similarly, women make up 45percent of smaller firms but 48 percent of larger firms. This patternholds for higher paying jobs as well. Professional women are dispropor-tionately employed by large establishments (Mitra). The same is true forminorities in science and engineering fields (National Science Founda-tion). Only Hispanics show a contrary trend, making up 12 percent ofsmaller firms but only 9 percent of larger firms. FEDERAL RESERVE BANK OF KANSAS CITY Another potential explanation for the size-wage effect is the differ- ence in average firm size across industries. If the industries that paybetter wages generally have larger firms, part of the size-wage effectwould arise from industry makeup. In reality, however, the size-wageeffect persists across industries (Table 2). There are a few minor excep-tions (shaded in the table), but, for the most part, the exceptions areindustries that offer relatively low pay overall.
Analysts have explored many other possibilities. But even after con- trolling for variables such as “collar color,” union status, plausibility of aunion threat, and industry makeup, researchers have been unable toexplain away the persistent firm size-wage effect (Brown and Medoff ).
The relationship persists even for piece-rate workers and for workersmoving across different-sized employers. In 1989, Brown and Medofffinally concluded: “Our bottom line is that the size-wage differentialappears to be both sizable and omnipresent; our analysis leaves usuncomfortably unable to explain it, or at least the part of it that is notexplained by observable indicators of labor quality.” Other theories to explain the size-wage effect have surfaced since the Brown and Medoff study, some of which have empirical support.
Among these are theories suggesting that larger employers may makegreater use of high-quality workers. This might occur, for example,because larger firms are more capital-intensive and require higher skilledemployees to operate the plant and equipment. Empirical data seem tobear this out, as 25.5 percent of workers at larger firms in 1998 had abachelor’s degree or higher, compared to 20.3 percent at smaller firms(Headd). Further, some argue that workers at large firms have a greaterincentive to gain additional education and new skills because of greateropportunities for upward mobility (Zabojnik and Bernhardt). Otherssuggest that because employee monitoring is more costly at larger firms,these firms pay higher wages to deter shirking on the job—but thisexplanation is not supported by the data (Oi and Idson). Another possi-bility is simply that the larger scale of larger firms in some industriesmeans lower costs (Pull; Idson and Oi). Or perhaps less stable employ-ees, who are likely to have lower wages, are attracted to small firms(Evans and Leighton; Mayo and Murray).
ECONOMIC REVIEW • SECOND QUARTER 2007 Table 2SALARY DATA BY INDUSTRY AND FIRM SIZE Industry
Ann. Salary
Ann. Salary
Ann. Salary
Ratio (%)
Small Firms ($)
Medium Firms ($) Large Firms ($)
Forestry, Fishing, Hunting, and Agriculture Support Professional, Scientific, and Technical Services Administrative and Support,Waste Management and Remediation Services Other Services (except Public Administration) Source: Author’s calculations using data from Statistics of U.S. Businesses, U.S. Census Bureau Note: NA indicates that data were not available.
FEDERAL RESERVE BANK OF KANSAS CITY Many explanations for the size-wage effect have been explored with little success. Lacking a satisfying explanation, however, workers stilltend to earn higher wages at large firms. Small business owners and their employees are much less likely to have employer-based health insurance policies or health insurance poli-cies of any kind. Survey data from the Census Bureau reveals that in2002 about 31 percent of workers at small businesses (25 or lessemployees) had employer-based health insurance policies in their ownname, compared to 69 percent at large businesses (1,000 or moreemployees) (Mills and Bhandari).9 Of the nearly 44 million uninsuredpeople in the United States in 2002, fully 60 percent were in familieswho owned or worked at small businesses.10 Among the self-employed,about 32 percent are uninsured, compared to 18 percent of all workers.11 Perhaps the best source of information on fringe benefits by employer size is the National Compensation Survey conducted by theBureau of Labor Statistics (2006). Workers at large firms are much morelikely to receive retirement benefits; life insurance; and health, dental,and vision insurance (Table 3). Eligibility for both short-term and long-term disability benefits are about twice as likely at large firms than atsmall firms. Aggravating the discrepancy in disability benefits is the factthat very small employers generally are not required to provide employ-ees with workers’ compensation insurance.12 The average number ofpaid holidays is almost 13 percent higher at large firms, and paid vaca-tion days are roughly 20 percent to 40 percent greater at large firms,depending on length of service. The difference in paid vacation daystends to increase in both absolute and relative terms with length ofservice. Eligibility for nonproduction bonuses (that is, bonuses notbased on sales or output) is comparable at large and small firms, butbenefits generally appear to be much more generous at larger firms.
Perhaps the best measure of job satisfaction is the propensity of employees to separate from their employers. Likewise, the likelihood ofbeing dismissed from a job is an important factor in determining the ECONOMIC REVIEW • SECOND QUARTER 2007 Table 3FRINGE BENEFITS AVAILABILITY BY FIRM SIZE, MARCH 2006 Fringe Benefit
100+ Employees
1-99 Employees
Source: U.S. Department of Labor, Bureau of Labor Statistics, National Compensation Survey:Employee Benefits in Private Industry in the United States, March 2006 quality of jobs. Turnover in general, that is, both employer-andemployee-initiated separations, is therefore indicative of lower qualityjobs—due to job instability in the former case and (relative) job dissatis-faction in the latter. Tabulations show a consistent downward trend in annual rates of permanent job separations as firm size increases (Anderson andMeyer). Permanent separation rates were close to 22 percent for firmswith less than 100 employees, 13 percent for firms with 500-1,999employees, and only 8 percent for firms with 2,000 or more employ-ees. Temporary separations, which are about 28 percent of allturnover, occurred at roughly equal rates at small and large firms. Theauthors back up their tabulations with more sophisticated statisticalanalyses that show a significant negative relationship between job dis-solution and firm size (Groothuis). While these separations includeboth employer- and employee-initiated separations, other research FEDERAL RESERVE BANK OF KANSAS CITY shows a significant negative relationship between firm size and proba-bility of layoff (Winter-Ember; Campbell). Similarly, quit rates declinewith firm size (Brown and Medoff ). A natural reason for lower quit rates at large firms is the higher average wage and better fringe benefits at large firms, which would beexpected to reduce employee decisions to separate. This is especially truefor pensions, which reward long tenure specifically. As shown in Table 3,retirement benefits are available to 78 percent of large-firm workers butonly 44 percent of small-firm workers. The presence of labor unions,which are much more common at large firms, may indirectly reduceturnover through the higher wages generally paid to unionized workers,but unions may also directly reduce turnover by giving dissatisfiedworkers a “voice” in their employment situation, offering an alternativeto leaving (Anderson and Meyer). Further, larger firms offer more on-the-job training and more advancement opportunities, which makes iteasier for them to maintain long employment relationships with theirworkers (Idson). Finally, some argue that the size-layoff relationship maybe a spurious relationship resulting from the tendency of smaller busi-nesses to attract less stable and capable workers, which also would workto explain part of the size-wage relationship (Winter-Ember).
A critical factor in greater labor turnover at smaller businesses is that the failure rate of small businesses is somewhat greater than that of largerbusinesses, which leads to higher rates of employer-initiated separations(Dunne and others; Idson). Failure rates of establishments drop markedlyas firm size increases to 100 employees, but then turn upward again suchthat firms with 500 or more employees have larger failure rates than firmswith 20-99 employees. Nevertheless, the failure rates for the smallestfirms (one to four employees) generally are about one and one-half timeshigher than those of the largest firms. More important for this analysis isthe loss of jobs from business failures. As seen in Chart 3, approximately12.6 percent of all workers in the smallest firms (one to four employees)lost their jobs from business failures in 2002-03, compared to 5.1 percentat the largest firms (500 or more employees).
ECONOMIC REVIEW • SECOND QUARTER 2007 Chart 3JOB LOSSES FROM BUSINESS FAILURES, 2002-2003 Source: Statistics of U.S. Businesses, U.S. Census Bureau IV. SMALL BUSINESS AND INNOVATION
Joseph Schumpeter, the renowned analyst and advocate of capital- ism, asserted that the hallmark of capitalism is innovation: “Thesweeping out of old products, old enterprises, and old organizationalforms by new ones.” He referred to this process as “creative destruc-tion.” In capitalism, therefore, the only survivors are those whoconstantly innovate and develop new products and processes to replacethe old ones. Small businesses are largely thought to be more innovative than larger firms for three reasons: a lack of entrenched bureaucracy, more competi-tive markets, and stronger incentives (such as personal rewards). Smallbusinesses are indeed crucial innovators in today’s economy and are thetechnological leaders of many industries. But the conventional wisdom—that small businesses are the cornerstone of innovative activity and thatlarge firms are too big and bureaucratic to make significant innovations—is false. Both small and large firms make significant innovations, and bothtypes of firms are critical to the success of today’s economy.
FEDERAL RESERVE BANK OF KANSAS CITY Schumpeter asserted that larger firms are better positioned to make innovations, especially if operating in a concentrated market (such as amonopoly or a market in which only a few firms dominate). Severalconcepts underlie his reasoning (Vossen; Symeonidis). Research and development (R&D) expenditures involve very large fixed (sunk) costs. R&D costs can be recovered only with a large salesvolume, so that the costs can be spread over a large number of items.
Further, larger firms generally have better access to external financing, andmonopolistic firms, which tend to be larger, have better access to internalfinancing because of their generally higher profitability. Larger firms alsohave a greater capacity to undertake several R&D projects at once and,hence, dilute the risk of any one project in a diversified portfolio. There are several other advantages to innovation at large firms beyond financing and managing R&D. Large firms tend to have estab-lished reputations and name recognition, which make it easier to enternew markets and/or established marketing channels. Thus, larger firmsare often better able to take advantage of innovations through produc-tion and sale. In addition, having a large number of colleagues, which ismore likely at a large firm, facilitates a division of labor and the solutionof problems (for example, by seeking the assistance of colleagues) andincreases the likelihood that “serendipitous discoveries [are] recognizedas important” (Vossen). Finally, many of the largest firms operate inindustries in which only a few firms operate or dominate the market.
For the most part, these firms do not compete with one another on thebasis of price, but rather on the basis of quality and product differentia-tion. Given this market structure, large firms may, therefore, havegreater incentive to innovate.
While large-firm strengths are mostly material in nature, small-firm strengths are mostly behavioral (Vossen). Perhaps the most criticalstrength is the lack of an entrenched bureaucracy that often characterizeslarger firms. An entrenched bureaucracy can lead to long chains ofcommand and subsequent communication inefficiency, inflexibility, andloss of managerial coordination. Further, small firms, to the extent thatthey operate in more competitive environments, may have a greaterincentive to innovate so as to stay ahead of rivals. Finally, because own-ership and management are more likely to be intertwined at smaller ECONOMIC REVIEW • SECOND QUARTER 2007 firms, the personal rewards of potential innovators are higher. As arelated factor, smaller firms may be better able to structure contracts toreward performance (Zenger).
Given the relative strengths of large and small firms, whether small businesses are more innovative is an empirical question. Numerousstudies have presented results on the relationship between firm size andR&D or innovative activity using a myriad of measures (Symeonidis).
Unfortunately, the results are mixed. The large majority of small firms (especially those with less than 100 employees) do not engage in formal R&D, and the degree to whichthey engage in informal R&D is difficult to gauge (Symeonidis). TotalR&D increases with firm size, but studies have offered differing viewson the intensity of R&D. Intensity is generally measured across firm sizeclasses as R&D expenditure per employee or relative to sales. The pre-ponderance of the evidence suggests two tendencies. First, R&Dintensity increases with firm size in some industries and decreases inothers, as do R&D outcomes, such as patents (Scherer; Acs andAudretsch; Pavitt and others). Thus, a general statement about the rela-tionship between R&D and firm size probably is not sensible. Second,to the extent that a generalization can be made, the relationship is likelya moderate U-shape, meaning that both smaller firms (above a thresholdsize) and very large firms engage in R&D more intensively thanmedium-sized firms (Gellam Research Associates; Bound and others;Pavitt and others).
More clear is that smaller businesses are more efficient at innova- tion, which means they produce more innovations for a given amountof R&D than do larger firms (Vossen). Thus, they often create moreinnovation value per given amount of R&D. Part of this may be duesimply to underestimation of R&D expenditure at smaller firms, butothers suggest that small firms are more effective in taking advantage ofknowledge spillovers from other firms (Acs and others).
Perhaps the industry with the greatest history of innovations by lone entrepreneurs and small businesses is the computer industry.13 The con-sensus first personal computer, the MITS’ Altair (1975), and the firstpersonal computer as we know them today, the Apple II, were devel-oped and marketed by what were, at the time, very small businesses.14The first software written specifically for the personal computer FEDERAL RESERVE BANK OF KANSAS CITY (BASIC) was developed and marketed by Paul Allen and Bill Gates aspart of a small business, Traf-O-Data, which would later evolve intoMicrosoft (1975). The PC era arguably would have been substantially delayed if not for entrepreneurs starting small businesses. The large computer compa-nies seemed to have little initial interest in personal computers.
Hewlett-Packard, for example, rejected as nonviable the first Apple com-puter when it was developed by employee Steve Wozniak in 1976. Itwas the rapid sales of the Apple II that spawned development of IBM’sPC, which was not introduced until 1981. Xerox rejected a proposal in1971 to design a “portable” computer and rejected multiple proposals in1976 to market its personal computer, Alto, which was designed in theearly 1970s for research use. Clearly, many of the great innovations in this industry were made by lone entrepreneurs and small businesses. Nevertheless, the innova-tions were made possible by years of R&D by large firms like AT&Tand IBM and their precursory innovations (like the transistor). Many ofthe enhancements in personal computing since then have come fromlarge firms as well, including the hard drive (IBM PC/XT), althoughenhancements in personal computing, software, and their marketingcontinue to be made by both small and large firms.
The message seems to be that both small firms and large firms make significant innovations that keep the economy moving and growing,although small firms may be more efficient at innovation. Small firmsare the great innovators in some industries, while large firms are thegreat innovators in others. Moreover, small and large businesses interactin innovative activity. The computer industry was largely developed bylarge firms (AT&T and IBM), small firms advanced computing throughthe development of personal computers (MITS and Apple), large firmsbrought the innovation to the public at large through mass marketing(the IBM PC), and both small and large firms continue to improvecomputing today with additional innovations and enhancements. Often entrepreneurs leave large enterprises to start small firms, either because innovation was hampered in their existing enterprise orbecause the entrepreneurs wanted to ensure the rewards for themselves.
And many small firms grow rapidly to become the largest of the largefirms. Further, innovative small businesses often benefit enormouslyfrom the basic R&D of large firms. ECONOMIC REVIEW • SECOND QUARTER 2007 CONCLUSION
This analysis evaluated the economic development role of small businesses vis-à-vis large businesses. It suggests that small businesses maynot be quite the fountainhead of job creation they are purported to be,especially when it comes to high-paying jobs that are stable and offergood benefits. Big-firm jobs are typically better jobs. Moreover, whilesmall businesses are important innovators in today’s economy, so arelarge businesses. There is no clear evidence that small businesses aremore effective innovators. Further, the innovations of both small busi-nesses and large businesses are inextricably linked. Still, small firmscreate the majority of net new jobs and are critical innovators, andefforts to encourage the formation and growth of small enterprises areprobably sensible in most cases.
While large firms offer better jobs on average and contribute signif- icantly to job creation and innovation, research and experience suggestthat attempts to recruit large enterprises to a specific community areunlikely to be successful (because of competition from competing com-munities). And they are not likely to be cost-effective even if they aresuccessful. More generally, an economic development strategy thatfocuses on a particular business or industry is very risky because sortingprospective winners and losers is difficult at best. Where do these facts leave economic development strategy? As noted earlier, net employment impacts from firm expansions tend to bemuch greater than those associated with new-firm locations. This sug-gests that concentrating on organic growth, or the growth of existing or“home-grown” businesses, is likely to be a much more successful strategythan the recruitment of new firms. Given the role of small businesses inemployment growth, supporting entrepreneurs and budding businessesis also likely to be an effective strategy. The hope is that some of thesesmall businesses can grow to become the large firms of tomorrow andoffer the kinds of benefits that typically come with employment in alarge firm. The key to a successful strategy is to get the policies right. Evidence increasingly suggests that the right approach is usually to focus on devel-oping an attractive and supportive environment that might enable anybusiness, whether small or large, to flourish, and to allow the market tosort out which businesses succeed. Many communities have had success FEDERAL RESERVE BANK OF KANSAS CITY in creating this environment. They have developed and fostered a high-quality workforce through great schools, community colleges, anduniversities. They have provided life-long learning opportunities; builtand maintained high-quality public infrastructure; created a businessclimate with reasonable levels of taxation and regulation; and, throughgood government and quality amenities, have created the kinds of com-munities where highly educated and skilled people want to live and work.
ECONOMIC REVIEW • SECOND QUARTER 2007 FIRM MIGRATION, CLASSIFICATION, AND GROWTH The migration of firms into and out of size categories also makes attributing job growth to size categories difficult (Okolie). The jobfigures presented in Chart 1 classify firms into size classes based on theirsize at the beginning of the period, which favors a finding of highergrowth among small firms, rather than at the end of the period. TableA1 decomposes job growth from the second quarter of 2000 into jobclasses using beginning size of firm, mean size of firm over the period,and end size of firm. If the beginning size of the firm is used to classifyfirms, small firms with less than 20 employees are responsible for 53.2percent of net job growth in the quarter, whereas if end-of-period size isused, small firms are responsible for only 16.2 percent of net job cre-ation in the quarter. Again, this pattern is consistent with significantmovement of small firms into larger class sizes.
SHARE OF NET JOB GROWTH BY FIRM SIZE, SECOND QUARTER 2000, BY SIZE CLASSIFICATION SCHEME FEDERAL RESERVE BANK OF KANSAS CITY 1The latest date for which data were available is 2003. All charts in this article use data through the latest year in which they were available.
2These numbers are somewhat obscured by large job losses in 2002 and 2003, especially at large firms. Through 2001, small firms created 69.1 percent ofnet new jobs, compared to 10.1 percent for midsized firms and 21.2 percent forlarge firms.
3For this reason, it would be misleading to measure net employment changes as total employment in a size class at the end of the year less total employment inthe size class at the beginning of the year. The numbers presented in this sectionwere generated by the U.S. Census Bureau from longitudinal data from individualfirms.
4The job figures presented in Chart 1 classify firms into size classes based on their size at the beginning of the period, which favors a finding of higher growthamong small firms, rather than at the end of the period (Appendix).
5Some research suggests that the size-job creation nexus operates in reverse for manufacturing plants: Small firms create most gross jobs and suffer the most grossjob losses, but larger firms contribute the most to net job creation (Davis and others).
6According to the Bureau of Labor Statistics, total private nonfarm employment increased from 104.6 million in 1997 to 110.7 million in 2004. Private employmentgrew at a much faster 2.2 percent annual rate in the prerecession period from 1997 to2000. Recessions often find individuals moving out of traditional employment andinto self-employment, which explains some of the discrepancy in growth rates.
7The firm size-wage effect persists across other countries as well. Similar results have been found, for example, in Canada (Morisette), Germany (Schmidtand Zimmermann), Austria (Winter-Ember), the United Kingdom (Belfield andWei), and Switzerland (Winter-Ember and Zweimüller), among others.
8Kraybill and others show that the large-firm wage premium is higher for 9Some workers may have been covered by another family member’s employer- 10U.S. Census Bureau, Current Population Survey, 2003 Annual Social and 11Some research suggests, however, that health-care utilization rates for the self-employed generally are the same as those for wage earners, despite their muchlower rate of health insurance coverage (Perry and Rosen). This suggests that self-employed people may have been finding other means for financing their medicalcare other than health insurance.
12See National Academy of Social Insurance, 2003. The maximum number of workers who can be employed without coverage varies from state to state but generally is in the range of three to five workers. Texas does not mandate workers’compensation coverage.
13The source for much of the historical information in this section is “Chronology of Personal Computers.” Accessed March 23, 2007, athttp://www.islandnet.com/~kpolsson/comphist/index.htm.
14The Altair was preceded by the Scelbi and the Mark-8, both in 1974.
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