Is small business a Good Thing?

Small business is, apparently, the Backbone of Britain. And the Backbone of Europe. And the Backbone of America. And the Backbone of Australia. If I could speak another language, I could probably find lots of other places that small business is the backbone of.

We like small businesses. They are much less stuffy than the boring old corporates. They are swift and nimble, unlike the lumbering bureaucracies which take ages to make simple decisions. Small businesses are efficient and decisive because they can’t afford to carry fat. Who’d want to ‘work for the man’ in a big dinosaur company when they could be working for a swashbuckling dynamic micro business?

The reality is a bit more complex, though. Small and medium-sized firms, defined by the EU as those with fewer than 250 employees, are actually not that efficient at all. They tend to have lower levels of productivity than larger firms. As the Economist explains:

Big firms can reap economies of scale. A big factory uses far less cash and labour to make each car or steel pipe than a small workshop. Big supermarkets such as the villainous Walmart offer a wider range of high-quality goods at lower prices than any corner store. Size allows specialisation, which fosters innovation. An engineer at Google or Toyota can focus all his energy on a specific problem; he will not be asked to fix the boss’s laptop as well. Manufacturers in Europe with 250 or more workers are 30-40% more productive than “micro” firms with fewer than ten employees. It is telling that micro enterprises are common in Greece, but rare in Germany.

According to the European Commission, small firms invest less per employee too.

So if a country has a lot of small firms, it is likely to have lower overall investment in technology, infrastructure and human capital than one with more big firms.

It is true that, between them, small businesses create more jobs than large ones but research in Europe and in the USA suggests that it is a subset of young, growing firms that create most of these jobs. This EIM study found:

Young enterprises are less likely to survive than older enterprises, but the surviving young enterprises tend to have higher employment growth rates. This is consistent with earlier findings: that so-called “fast growing firms” are usually rather young enterprises. The combined effect of these two opposite developments is positive: within the population of SMEs, the newly born SMEs accounted for the largest net employment growth during 2005-2008. Table 1 presents an overview.

In other words, a few small firms create jobs in the process of becoming larger firms. The rest, by and large, don’t.

It is no surprise, therefore, that economies with a higher proportion of small firms tend to be poorer. Last week, both the Economist and the Wall Street Journal cited the lack of large firms as one of the factors holding back southern European economies, with Greece having the most stunted firms in the EU.

The Economist said:

Firms with at least 250 workers account for less than half the share of manufacturing jobs in these countries than they do in Germany, the euro zone’s strongest economy. A shortfall of big firms is linked to the sluggish productivity and loss of competitiveness that is the deeper cause of the euro-zone crisis. For all the boosterism around small business, it is economies with lots of biggish companies that have been able to sustain the highest living standards.

The WSJ agrees:

But the platitudes surrounding SMEs deserve some closer scrutiny. Workers in smaller firms tend to be less productive; and sure enough, countries where employment is dominated by SMEs tend to have weaker economies, with significantly lower rates of worker productivity.

A higher percentage of workers are employed by SMEs in Greece and Portugal – 87% (in 2006) and 79% (in 2008), respectively – than in almost any other EU country, according to a study by Eurofound.

It is a similar pattern to the relationship between self-employment and low per capita income that I posted about a couple of weeks ago. In short, the greater the proportion of a country’s workforce is employed by small businesses, the more likely it is to have a weak economy and low per capita GDP. This CEPR report notes:

By every measure of small-business employment, the United States has among the world’s smallest small-business sectors (as a proportion of total national employment).

Rich countries just don’t have lots of small businesses.

In his book, 23 things they don’t tell you about capitalism, Professor Ha-Joon Chang explains:

What makes the poor countries poor is not the lack of raw individual entrepreneurial energy, which they in fact have in abundance. The point is that what really makes rich countries rich is the ability to channel the individual entrepreneurial energy into collective entrepreneurship.

If effective entrepreneurship ever was a purely individual thing, it has stopped being so at least for the last century. The collective ability to build and manage effective organisations and institutions is now far more important than the drives or even the talents of a nation’s individual members in determining its prosperity.

So it is the capacity of countries to concentrate and organise money people and things on a massive scale that makes them rich. The fact that, in the UK, we live in a country where a relatively large proportion of us work in large boring organisations is one of the reasons why we are more comfortable and prosperous than most. It’s not very zeitgeisty to say so, but perhaps ‘working for the man’ isn’t such a bad thing after all.