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Start-ups and Job Creation

Sunday, 17 June 2012 07:57

There was a lengthy and pointless debate that began in the early 90s over what sized businesses created the most jobs. The original story was that small businesses created the most jobs. This turned out not to be true on more careful investigation, since small businesses also lost the most jobs. There were various twists and turns in the academic literature before most economists came to the conclusion that businesses of all sizes on net create jobs at roughly the same rate.

While this debate kept many economists employed and no doubt helped to boost wages in the profession, it did little to advance our knowledge of the economy. Unfortunately economists learn little from such experiences.

We now have the sequel to this silliness with the claim that it is new businesses that create jobs. This claim emanates most prominently from the entrepreneurially oriented Kauffman Foundation. It was picked up in an Ezra Klein column yesterday. The argument coming from this direction is that all the job growth in the last three decades came from new businesses. Employment in firms that existed in 1980 has just stayed roughly even.

The reason this claim is silly is that the decision of a corporation to expand and open a new division depends to a large extent on the ease with which new businesses can form. If it is easy for start-ups to form, then existing businesses will be less likely to expand their operations by setting up a new division. If they want to get into a new area, then they will just buy a start-up that looks promising.

The logic here is simple. The vast majority of start-ups will fail. However if there are a large number, then certainly some will succeed. The ones that do can then be purchased by existing companies that want to expand. The new jobs can then be attributed to start-ups and not existing businesses, but this is entirely due to the fact that we make it easy for start-ups to form.

An example of this story is Google's acquisition of Youtube. The fact that there was a successful start-up that Google could buy made it easier to enter this market. But does anyone think that Google would not have moved itself in a similar direction had Youtube not existed?

The point is that even if we accept that all net new jobs came from start-ups it does not follow that we necessarily want to do more to encourage start-ups nor adopt any policies that have a negative impact on existing businesses to favor start-ups. The reason why the former is not true is that the vast majority of new businesses fail within a decade. It is reasonable to assume that the marginal start-up (the ones we encourage with our new more start-up friendly policies) will be less successful on average than the current group that did not need this extra boost from the government.

This means that we will possibly be encouraging millions more people to take their life's savings, work ridiculously long hours, usually dragging in other family members, in pursuing a venture that will fail. We will then see the person without a business, without savings and without a job and just a few years left to retirement. That doesn't sound like good policy, nor is it a good use of the economy's resources.

On other side, suppose we tilt the playing a field a bit to favor new businesses at the expense of existing businesses. Well, if we accept the Kauffman analysis, imagine that instead of holding their own existing businesses had lost 5 percent of their jobs over the last three decades. That would give us a really big hole. Would the additional tilt to new businesses fill this gap? We don't know -- at least the Kauffman data don't answer this question.

The long and short is that new businesses are wonderful, but policies that go overboard to push people to start new businesses are likely to ruin many lives and lead their promoters with lots of egg on their face.

Comments (9)Add Comment
written by RueTheDay, June 17, 2012 9:32
I think there are some solid arguments in favor of encouraging entrepreneurship and innovation by startups.

Before we even go there, however, we need to separate the signal from the noise. A significant percentage of small businesses and new businesses are not actually businesses. In many cases, they are simply new independent contractors, ofentimes working for the same large/old business doing the same thing they used to do as an employee of that busniess, sans benefits. Those examples need to be removed from the data before attempting to draw any meaningful conclusions.
written by JSeydl, June 17, 2012 9:37
I agree. The start-up space is such a winner-take-all market. People often forget that for every successful Mark Zuckerberg, there are millions of aspiring entrepreneurs who failed and have lost their entire savings. Also, luck has more to do with being successful in that space than anything else, as Robert Frank has written about numerous times.

The worst, in my opinion, is the whole Peter Thiel nonsense. Here's a guy who is a product of higher education -- undergrad and grad degrees from Stanford -- yet he's encouraging high school students to forgo college. If that's not hypocritical, then I don't know what is. And remember, Thiel takes an equity stake in every company that is formed through his foundation, so it's not like he cares about whether some companies fail -- i.e., whether some college dropouts ruin their lives by forgoing college to join his foundation -- because Thiel just needs a few to be successful in order to make money.
written by Jeff, June 17, 2012 9:51
I suspect this claim from Kauffman has a lot to do with trying to legitimize that steaming pile of cow dung known as the JOBS act, just another hallmark piece of legislation from this administration.
written by Jay, June 17, 2012 11:48
This is a good post. There are a lot of people that promote entrepreneurship to avoid discussing the anemic rates of hiring and failure to mobilize idle workers by increasing demand. It it a risky proposition to start a business with weak demand unless you gamble on serving only rich people and sell products or sevices with extremely high margins while not creating a fad that will disappear quickly.
written by Kat, June 17, 2012 2:54
More of this. Your voice is sorely needed on this subject.
written by pete, June 17, 2012 4:24
"An example of this story is Google's acquisition of Youtube."
And I guess the myriad of counter-examples are that nobody like NCR or IBM bought HP when it was starting out, or Google, or Apple, or Microsoft, or Amazon, or EBay, or the latest, Facebook...I guess the list is kind of infinite. Clearly large behemoths like IBM, SONY, ATT, etc. could not move fast enough. Why didn't they just buy the upstart startups which are now are tech backbone? And of course the other flip side is that plenty of mergers fail too, such as MYSPACE, or AOL. I.e, sometimes there is winners curse. This post is the least informed from Dr. Baker in quite a while.

Fortunately, the conclusion is accurate, and quite libertarian for a change...no subsidies. Entrepreneurs are irrational, and will chase their dreams, with a few wild successes making up for the many failures. Some even have famous failures before their success. No need to encourage them with bribes. There is some good theory out their on these sorts of games, with irrational overconfidence being the key to survival. Data is unfortunately scarce.

Finally, new businesses might be anybody that has to file Schedule C consulting income, such as many university professors who do consulting or grant work. No employees, no business so to speak, but filing the same form as a small preincorporated business. The IRS data base is not a good source for identifying entrepreneurs.
Job Churn
written by scott moore, June 18, 2012 1:01
Nailed it Dean. Yes it is all about job churn. I brought this point up to a buy local advocate (small business)- and I got that deer in the headlights look. They did not realize the hype surrounding small business employment never includes the jobs loss discussion!
written by r minty, June 18, 2012 9:14
Item - Large & small businesses create roughly the same number of jobs. What counts on this front is the SPEED with with they do so. A single large business may decide to hire 5,000 new employees, and will do so over the next year. 5,000 small businesses will hire 1 additional employee - next week.

Item - Large businesses provide little opportunity for new entrants to the job market and are willing to train people on the essentials of the work-world (be on time, dress appropriately, work hard, go get appropriate training, etc). It is small businesses do this type of grunt work

Item - It's not that people need to be pushed into entrepeneurship. Entrepeneurs are entrepeneurs. But the regulatory environment actually discourages start-ups. 1/3 of all occupations now require some sort of professional licensing. To what end? To keep people OUT of the designated market. Why should NYC taxicabs require a $1 million medallion to take passengers? Why do nail technicians need a years training (and a license) to paint fingernails? City licenses; State licenses; health certificates; City, County, and State, tax licenses; occupancy certificates .... all with substantial fees before a business can even think about making the first sale. This is absurd!

Item - Encouraging, or at least not DIScouraging, entreneurship, costs existing businesses nothing.

Item - The entrepeneurial learning curve is steep and most businesses WILL fail within the first five years. But most entrepeneurs are serial entrepeneurs, so if 75% of new businesses fail, and the self-starter learns from each failure, and tries 5 times, his odds of eventual success are near 100%.

Item - Business models/ideas like Youtube MAY eventually have been followed up on by Google, but WHEN? Mature businesses rarely branch out into unknown territory, except after years of determining that there is sufficient demand for an unknown product, with an unknown client base, etc. The entrepeneur will step out into an apparent void.

Item - New businesses often offer benefit to established businesses by offering better and/or lower cost goods and/or services. Competition is the name of the game.

Item - let us NEVER forget that every mature business began as a an entrepeneurial start-up. Today's American auto and airline companies began in barns. Microsoft and Apple began in garages. Wal-Marts was a single Five-and-Dime. McDonalds was a solo BBQ joint back in 1940. They all began somewhere, often as the vision of a single person
written by kharris, June 19, 2012 8:55
Item - for the most part, r minty's list of items don't really address the point Dean made.

Item - for the most part, r minty's list of items are not as much true as truthy. They seem to partake of the small business mythos, rather than to reflect reality.

I grew up in the household of a guy who built several businesses over the years and most of the adult social set we saw growing up were, at one time or another, owners of small businesses. My observation is that generalizations about entrepreneurs are fatuous. Some succeed early. Some fail every time. There is no "5 tries => 100% odds of success" formula. Lots of folks start businesses because they want additional income, while working at a large corporation - often buying franchises. There are lots of hobby businesses. Businesses are started as pure cash funnels to avoid taxes - not always successfully. Others are structured to fail after a wad of cash goes from one partner to another.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.