Chapter 2 The economics of entrepreneurship and public policy
The economics of entrepreneurship
Different theories to explain the growth in number and importance of small firms.
- Marxist theory: capitalism will degenerate into economies dominated by a small number of
large firms and society will polarize between those that own them and those that work in them.
Small firms are dependent upon larger firms for their custom and well-being; they absorb risk
and push down pay and conditions for workers because they are rarely unionized.
- Fritz Schumacher: the growth of small firms is part of a social trend towards a more
democratic and responsive society.
This leads to free-market economics. Increasing numbers of small firms were the natural result of
increased competition and a drive to prevent private and public monopoly.
But what does economic theory have to say about the creation of small firms?
- Traditional industrial economists: growth of new firms in terms of industry profitability, growth,
barriers to entry and concentration. More concerned with ‘entry’ to an industry, rather than
whether this is by a new or an existing firm. Entry to an industry is high when expected profits
and growth are high.
- Labour market economist: more interested in what influences individuals to become potential
entrants to an industry be becoming self-employed.
Entrepreneurship and economic growth
Invention, innovation and creativity
At the macro level, entrepreneurship and innovation are seen to encourage economic growth. At the
micro level, innovation is the prime tool entrepreneurs use to create or exploit opportunity.
What is the difference between innovation and invention? And how are they lined to creativity?
- Parkhurst: Creativity can be directed towards many other ends; however, it underpins
innovation.
- Amabile et al: Creativity is the seed of innovation that is important throughout the innovation
process.
- McLean: Innovation is an engine without any fuel. And creativity is needed throughout the
process of innovation.
- Mintzberg: Innovation is the means to doing things really differently.
- Kanter: Innovation is the generation, acceptance and implementation of new ideas, processes,
products and services… which involves creative use as well as original intervention.
- Meller: either creativity + application or invention + application.
The difference between invention and innovation is not just a question of scale, but also successful
implementation. Innovation can therefore take three forms:
- Product innovation – improvements in the design and functional qualities of the product or
service
- Process innovation – improvements in how the product is produces, assemble or delivered, so
that is better or cheaper.
- Marketing innovation – improvements in the marketing of the product or servise or changes in
the business model that might open up new markets.
There is an idea that the impact of innovation on competitive advantage might be measured on two
dimensions: frequency of innovation and scale or degree of innovation. Toghether these measure the
innovative intensity of the firm. Frequent smallscale innovations may be just as financially lucrative as
the occasional big-bang breakthrough. These frequent small-scale innovations are less risky.
Competitive advantage is therefore increased by pushing out the envelope and truly innovative firms
will tend to cluster along this envelope.
There is an idea that the impact of innovation on competitive advantage might be measured on two
dimensions: frequency of innovation and scale or degree of innovation. Toghether these measure the
innovative intensity of the firm. Frequent smallscale innovations may be just as financially lucrative as
the occasional big-bang breakthrough. These frequent small-scale innovations are less risky.
Competitive advantage is therefore increased by pushing out the envelope and truly innovative firms
will tend to cluster along this envelope.
What is also true, however, is the vital role played by the entrepreneur in matching the innovation to a
market need – existing or in the future.
The link between innovation and business growth
,Young, high-growth firms are few in number but have a disproportionate importance to national
economies. Middle-sized firms generally have a disproportionate impact on national economies.
Finding evidence of a direct relationship between business growth and innovation is problematic. The
rate of innovation seems to vary between firms of different size, across industries and sectors
depending on industry age and stability and even location.
The link between innovation and firm size
Advantages larger firms relative to smaller firms. Larger firms:
- Are more likely to be innovative
- Are more likely to conduct internal research and development and contracted out R&D
(resource and development).
- Are more likely to introduce product, process or managerial innovations.
- Seem to outperform small firms where resources are important, because of capital intensity or
because of scale of spending on R&D, advertising etc. They have better access to both
internal and external finance than smaller companies.
- Have greater access to resources.
Advantages smaller firms relative to larger firms. Smaller firms:
- Can introduce products or services that are clearly differentiated from those of the competition
to the point where one might question whether there is any direct competition.
- Are most likely to provide something marginally different from the competition in terms of the
product or service and thus find a gap in the market.
- Are far more likely to innovate in terms of marketing and customer service. They frequently
find new routes to market first.
- Are often innovative in their approach to key account management and customer
relationships. They find ways of networking with customers and suppliers so as to cut costs
and lead times.
- Conduct R&D more efficiently
- Introduce new products to the marketplace faster than big companies.
- Have behavioural advantages
- Have a closeness to the market
- Have a greater willingness to take risks
- Have an ability to act quickly.
It is in sectors or industries where these characteristics are important that small firms are more
important in terms of innovation.
There was no evidence that either large firms or industries with high concentration were associated
with high levels of innovation. Even if there was an association, this did not imply a causal relationship.
The influence of industry structure
In the less concentrated industries there was more likely to be radical or disruptive innovation – step
changes in products, processes or the framing of markets. And in the less concentrated industries
smaller firms tend to be the dominant innovators.
Larger firms have the advantage when it comes to incremental innovation. They have the product
experience, established marketing channels and resource capabilities.
Competitive advantage must be built from scratch and that is where the entrepreneurial DNA becomes
important. The main reason why existing, larger firms miss out on disruptive innovation is because
they develop a dominant logic which dictates how the world is viewed.
The influence of industry age and stability
Innovative behaviour is not entirely related to firm size. It varies across industry sectors, depending on:
- Innovation costs
SMEs (Small and Medium-sized Enterprises) are less important where there are high
resource costs. They are more active when resource costs are low, although they use
these resources more efficiently than larger firms.
- Size of markets
, SMEs thrive in industries where economies of scale are less important to customers
than other factors such as marketing, service quality or variety, where low-cost
innovation might be possible.
- Industry concentration, age and stability
SMEs are less important in stable, mature, high-concentration industries where the
innovation focus has switched to efficiency and cost-reduction. They have a significant
role to play by introducing disruptive innovation and creating new industries.
Advantages of large firms are generally the disadvantages of small firms, and vice versa.
Collaboration or partnering between the two sizes business can create powerful synergistic
relationships.
Innovation, location and network effects
Social enterprise and social innovation
Social enterprises are often seen as ways of encouraging ‘social innovation’. Just like commercial
SMEs, social enterprises need to create added value by doing things differently or more effectively so
that it can be applied additionally to the objectives of the social enterprise. And one of the
characteristics of successful social enterprises is their ability to network and mobilize a wide range of
supporting resources, often at a low cost. These are then brought together to enable the launch of the
new social initiative.
Public policy towards SMEs
Government economic policy in most countries tries to encourage the start-up, survival and growth of
SMEs. They do this because of start-ups’ ability to generate jobs and the ability of entrepreneurs to
increase innovation and improve productivity and growth. It might also have something to do with
owner-managers being a powerful political constituency. These policies generally fall into six
categories:
- The regulatory framework
These include all forms of taxation and social security, health and safety regulations,
product and labour market regulation and bankruptcy regulation, as well as
administrative burdens associated with market entry or growth.
- Entrepreneurial capabilities
These include business education and skills training, entrepreneurial training, advice
and mentoring and the general entrepreneurial infrastructure.
- Enterprise culture
These include a wide range of influences on attitudes towards entrepreneurship and
risk-taking. policy initiatives might be targeted at the young or the general public.
- Access to finance
These include grants, access to debt finance, including issues of collateral, credit
unions and micro-finance and equity finance, as well as stock markets.
- R&D and technology
These include R&D investment incentives, university/industry interaction, technology
diffusion, technology cooperation between firms, broadband access and patent
systems.
- Market conditions
These include competition policy and anti-trust laws including issues about access to
domestic and foreign markets, as well as the degree of public sector involvement and
government procurement policies.
In times when unemployment is high, encouraging start-ups is often seen as a way of reducing the
jobless. Those starting these firms are ‘pushed’, sometime reluctantly, into self-employment as a way
of earning a living. Using the framework above, governments may wish to influence this by improving
entrepreneurial capabilities and access to finance. They may be offered grants, soft-loans and training
and advice as inducements. However, the salary-substitute wage these businesses generate will often
still be below the salary it substitutes and self-employment is inherently risky, because many firms
don’t survive long and few grow to any size. In times of growth, when unemployment is low, public
policy might shift towards raising productivity and innovation. Using the framework above, the focus
