What Do Small Businesses Do?

By Hurst, Erik; Pugsley, Benjamin Wild | Brookings Papers on Economic Activity, Fall 2011 | Go to article overview

What Do Small Businesses Do?


Hurst, Erik, Pugsley, Benjamin Wild, Brookings Papers on Economic Activity


ABSTRACT 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.

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Economists 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 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. (1) 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. …

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