Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Role of Small and Large Businesses in Economic Development

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Role of Small and Large Businesses in Economic Development

Article excerpt

Increasingly, economic development experts are abandoning traditional approaches to economic development that rely on recruiting large enterprises with tax breaks, financial incentives, and other inducements. Instead, they are relying on building businesses from the ground up and supporting the growth of existing enterprises. This approach has two complementary features. The first is to develop and support entrepreneurs and small businesses. The second is to expand and improve infrastructure and to develop or recruit a highly skilled and educated workforce. Both efforts depend in large part on improving the quality of life in the community and creating an attractive business climate.

The reason for the shift in approaches is clear. Experience suggests that economic development strategies aimed at attracting large firms are unlikely to be successful-or successful only at great cost. Smokestack chasing can be especially costly if it generates competition for firms among jurisdictions. Further, because of the purported job creation role and innovative prowess of entrepreneurs and small businesses, creating an environment conducive to many small businesses may produce more jobs than trying to lure one or two large enterprises. The hope is not only that new businesses will create jobs in the local community, but, through innovation, some new businesses may grow into rapid-growth "gazelle" firms, which may spawn perhaps hundreds of jobs and become industry leaders of tomorrow.

This article evaluates this shift in economic development strategies. The first section describes traditional economic development strategies. The second section explores the role that small businesses play in creating jobs. The third section compares job quality between small firms and larger firms. The fourth section examines how important small businesses are in the development of new products and new markets.

The overarching question is whether promoting entrepreneurship and small businesses makes sense as an economic development strategy. This article concludes that it probably does but with some caveats. Small businesses are potent job creators, but so are large businesses. The attribution of the bulk of net job creation to small businesses arises largely from relatively large job losses at large firms, not to especially robust job creation by small firms. More importandy, data show that, on average, large businesses offer better jobs than small businesses, in terms of both compensation and stability. Further, there is little convincing evidence to suggest that small businesses have an edge over larger businesses in innovation. More research is needed to properly evaluate the case for a small business strategy, and, indeed, to determine whether or not public engagement in economic development itself is a cost-effective and worthwhile pursuit.

I. ISSUES WITH TRADITIONAL ECONOMIC DEVELOPMENT POLICIES

On the surface, one might think that a large firm would spur local economic growth by yielding significant gains in employment and personal income. The direct effect-the jobs and income generated direcdy by the firm-would certainly suggest this to be the case. In reality, however, it is often the effects on other firms in the area-die indirect effects-that carry the greatest weight in the net economic impact. Experience suggests that because of these typically large indirect effects and the costs of incentives and competition, economic development strategies aimed at attracting large firms are unlikely to be successful or are likely to succeed only at great cost.

A recent study of new-firm locations and expansions in Georgia suggests that, on net, the location of a new large (300+ employees) firm often retards the growth of the existing enterprises or discourages the establishment of enterprises that would otherwise have located there (Edmiston). Specifically, the location of a new plant with 1,000 workers, on average, adds a net of only 285 workers over a five-year period. …

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