What Do Small Businesses Do

We show that most small business owners are very different from the entrepreneurs that economic models and policymakers often have in mind. Using new data that sample entrepreneurs just before they start their businesses, we show that few small businesses intend to bring a new idea to market or to enter an unserved market. Instead, most intend to provide an existing service to an existing market. Further, we find that most small businesses have little desire to grow big or to innovate in any observable way. We show that such behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftspeople, lawyers, real estate agents, health care providers, small shopkeepers, and restaurateurs. Lastly, we show that nonpecuniary benefits (being one’s own boss, having flexibility of hours, and the like) play a first-order role in the business formation decision. Our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. We conclude by discussing the potential policy implications of our findings. e and policymakers alike have long been interested in the effects of various economic policies on business ownership. In fact, the U.S. Small Business Administration is a federal agency whose main purpose, according to its mission statement, is to help Americans “start, build, and grow businesses.” Researchers and policymakers often either explicitly or implicitly equate small business owners with entrepreneurs. Although this association could be tautological, we show in this paper that the typical small business owner is very different from the entrepreneur that economic models and policymakers have in mind. For example, economic theory usually considers entrepreneurs as individuals who innovate and render aging technologies obsolete (Schumpeter 1942), take economic 74 Brookings Papers on Economic Activity, Fall 2011 risks (Knight 1921, Kihlstrom and Laffont 1979, and Kanbur 1979), or are jacks-of-all-trades in the sense of having a broad skill set (Lazear 2005). Policymakers often consider entrepreneurs to be job creators or the engines of economic growth. In this paper we shed light on what the vast majority of small businesses actually do and, further, what they report ex ante wanting to do. Section I highlights the industrial breakdown of small businesses within the United States. By “small businesses” we primarily mean firms with between 1 and 19 employees; firms in this size range employ roughly 20 percent of the private sector workforce. However, we also define alternative classifications, such as firms with between 1 and 100 employees. We show that over two-thirds of all small businesses by our primary definition are confined to just 40 narrow industries, most of which provide a relatively standardized good or service to an existing customer base. These industries primarily include skilled craftspeople (such as plumbers, electricians, contractors, and painters), skilled professionals (such as lawyers, accountants, and architects), insurance and real estate agents, physicians, dentists, mechanics, beauticians, restaurateurs, and small shopkeepers (for example, gas station and grocery store owners). We also show that although firms within these industries are heterogeneous in size, these industries account for a disproportionate share of all small businesses. This composition of small businesses foreshadows our empirical results. In section II we study job creation and innovation at small firms, both established and new. First, using a variety of data sets, we show that most surviving small businesses do not grow by any significant margin. Rather, most start small and stay small throughout their entire life cycle. Also, most surviving small firms do not innovate along any observable margin. Very few report spending resources on research and development, getting a patent, or even obtaining copyright or trademark protection for something related to the business, including the company’s name. Furthermore, we show that between one-third and half of all new businesses report providing an existing good or service to an existing market. This is not surprising when one thinks of the most common types of small business. A new plumber or a new lawyer who opens up a practice often does so in an area where plumbers and lawyers already operate. 1. Haltiwanger, Jarmin, and Miranda (2010) show that, when one controls for firm age, there is no systematic relationship between firm size and growth. They conclude that those small firms that tend to grow fast (relative to large firms) are newly established firms. We discuss in later sections how our results add to these findings. In particular, we show that most surviving new firms also do not grow in any meaningful way. erik hurst and benjamin wild pugsley 75 Most existing research attributes differences across firms with respect to ex post performance to either differences in financing constraints (for example, Evans and Jovanovic 1989, Clementi and Hopenhayn 2006), differences in ex post productivity draws across firms (for example, Simon and Bonini 1958, Jovanovic 1982, Pakes and Ericson 1989, Hopenhayn 1992), or differences in the owners’ entrepreneurial ability (for example, Lucas 1978). In section III we use new data on the expectations of nascent small business owners to show that these stories are incomplete. When asked at the time of their business formation, most business owners report having no desire to grow big and no desire to innovate along observable dimensions. In other words, when starting their business, the typical plumber or lawyer expects the business to remain small well into the foreseeable future and does not expect to innovate by developing a new product or service or even to enter new markets with an existing product or service. If most small businesses do not want to grow and do not want to innovate, why do they start? We address this question in section IV. The same new data set that we used to explore the expectations of nascent business owners also specifically asks about motives. Over 50 percent of these new business owners cite nonpecuniary benefits—for example, “wanting flexibility over schedule” or “to be one’s own boss”—as a primary reason for starting the business. By comparison, only 34 percent report that they are starting the business to generate income, and only 41 percent indicate that they are starting a business because they want to create a new product or because they have a good business idea. (Respondents could give up to two answers.) Exploiting the panel nature of the data, we show that those small businesses that started for other than innovative reasons were less likely to grow in the ensuing years, less likely to report wanting to grow, less likely to innovate, and less likely to report wanting to innovate. Collectively, these results suggest that the first-order reasons why most small businesses form are not the innovation or growth motives embedded in most theories of entrepreneurship. Rather, the nonpecuniary benefits of small business ownership may be an important driver of why firms start and remain small. Additionally, some industries (such as insurance agencies) may have a natural scale of production at the establishment level that is quite low. In section V we discuss how our results challenge much of the existing work on entrepreneurship and small-firm dynamics. We highlight how our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. In section VI we discuss the policy implications of our results. Section VII concludes. 76 Brookings Papers on Economic Activity, Fall 2011 More research into the diversity of motives and expectations among small businesses has been done in developing economies than in developed economies. Recent work by Rafael La Porta and Andrei Shleifer (2008) and a review of the literature by Abhijit Banerjee and Esther Duflo (2011) show that most small businesses in developing economies do not grow or innovate in any observable way. We discuss in section V how the qualitatively similar outcomes we observe in the United States are driven by different forces than in developing economies. Overall, our results reveal substantial skewness among small businesses within the United States, in terms of both actual and expected growth and innovative behavior. Although growth and innovation are the usual cornerstones of entrepreneurial models and the usual justifications for policy interventions to support small business, most small businesses do not want to grow or innovate. Our results suggest that it is often inappropriate for researchers to use the universe of small business (or self-employment) data to test standard theories of entrepreneurship. More specialized data sets, such as those that track small businesses seeking venture capital funding, may be more suitable for this task, because these firms have been shown to be more likely to actually grow or to innovate than other small businesses. For their part, policymakers who want to promote growth and innovation may want to consider more targeted policies than those that address the universe of small businesses. I. Industrial Composition of Small Businesses This section intends to show that most small businesses are concentrated in a small number of narrowly defined industries (industries at the four-digit level of the North American Industry Classification System, or NAICS) that mostly provide standard services to local customers. This context is important when interpreting our findings that the majority of small businesses do not intend to grow or innovate in any substantive way. 2. Two notable exceptions include Bhidé (2000) and Ardagna and Lusardi (2008). Bhidé (20