Companies and Productivity: Why Small Is Not Always Beautiful

The small business entrepreneur has replaced the yeoman farmer as the beau ideal of political economics.

Intrepid, independent, risk-embracing but prudent, successful. This class of manager is touted as the exemplar of all that is worthy about business. But beneath the hype, the data suggest a far more nuanced picture. Small businesses create many jobs - but they destroy as many - or more. They tend not to be as productive as larger businesses. And some stay small for their entire existence, adding no jobs whatsoever.

In the US, according to the most recent Census data, the firms that employ any staff beyond the owner account for about 28% of the total. Of those, approximately 70% employ only one to four people. In other words, for all the rhetoric about the essential role of small business, when it comes to the crucial factors driving the economy - productivity, growth and employment - medium to large businesses provide most of the momentum.

This is not to say that tiny businesses are not important. They contribute significantly as the data show. But when it comes to designing public policies that will provide for the greater good, a less emotionally wrought and more balanced approach may offer a more optimal set of solutions. JL

The Economist reports:

PEOPLE find it hard to like businesses once they grow beyond a certain size. Banks that were “too big to fail” sparked a global economic crisis and burned bundles of taxpayers’ cash. Big retailers such as Walmart and Tesco squeeze suppliers and crush small rivals. Some big British firms minimise their tax bills so aggressively that they provoke outrage. Films nearly always depict big business as malign. Tex Richman, the oil baron in the latest Muppets movie, is so bad he reads The Economist. Small wonder that whenever politicians want to laud business they praise cuddly small firms, not giants.

It is shrewd politics to champion the little guy. But the popular fetish for small business is at odds with economic reality. Big firms are generally more productive, offer higher wages and pay more taxes than small ones. Economies dominated by small firms are often sluggish.
Consider the southern periphery of the euro area. Countries such as Greece, Italy and Portugal have lots of small firms which, thanks to cumbersome regulations, have failed lamentably to grow (see article). 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.

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.

Big firms have their flaws, of course. They can be slow to respond to customers’ needs, changing tastes or disruptive technology. If they grew big thanks to state backing, they are often bureaucratic and inefficient. To idolise big firms would be as unwise as to idolise small ones.

It’s what you do with it that counts

Rather than focusing on size, policymakers should look at growth. One of the reasons why everyone loves small firms is that they create more jobs than big ones. But many small businesses stay small indefinitely. The link between small firms and jobs growth relies entirely on new start-ups, which are usually small, and which by definition create new jobs (as they did not previously exist). A recent study of American businesses found that the link between company size and jobs growth disappears once the age of firms is controlled for.

Rather than spooning out subsidies and regulatory favours to small firms, governments should concentrate on removing barriers to expansion. In parts of Europe, for example, small firms are exempted from the most burdensome social regulations. This gives them an incentive to stay small. Far better to repeal burdensome rules for all firms. The same goes for differential tax rates, such as Britain’s, and the separate bureaucracy America maintains to deal with small businesses. In a healthy economy, entrepreneurs with ideas can easily start companies, the best of which grow fast and the worst of which are quickly swept aside. Size doesn’t matter. Growth does.