Review of Industrial Organization 11: 173-182,1996. @ 1996 Kiuwer Academic Publishers. Printed in the Netherlands.

173

Small Firm Births and Macroeconomic Fluctuations *

JO?& MATA Banco de Portugal, Universidade Nova de Lisboa, Lisbon, Portugal

Abstract. Using different definitions of what constitutes a small firm, this paper analyses the effect of business conditions on the start-up of small firms. It is found that small firm births exhibit a pro-cyclical hehaviour, irrespective of the threshold used to define a small firm. The smallest new firms, however, seem to be less responsive to the opportunity cost of capital. Finally, no relationship was found between entry of small firms and industry growth and profiability.

Key words: Author Please Supply

JEL Codes: L 11, L60

I. Introduction

New firms have been subject to the attention of two different branches of the economics profession, labour and industrial economics. Most of the interest devoted by labour economists to the creation of new firms stems from their interest in the analysis of transition between wage employment or unemployment and self- employment. Labour economists have been typically concerned with the study of the individual characteristics that lead people into these different states, paying little attention to the particular conditions of the sectors in which these new business are created while, on the contrary, industrial economists seem to have been devoting much of their effort to the analysis of the industry specific conditions that attract new firms into activity and to those that hinder new firm competition, paying relatively less attention to the entrepreneurs’ characteristics.’

Despite their different roots, a common concern that seems to be slowly emerg- ing from these two research traditions is an interest on the effect of overall business conditions on the start-up of new firms. The reason for such increasing interest largely lies in the two somewhat contradictory hypotheses that have been made with respect to this topic. The first hypothesis posits that firm entry ought to be par- ticularly important when macroeconomic conditions are most favourable because,

* This paper was written while I was visiting the London Business School. Its hospitality and financial support from the EU Human Capital and Mobility Program are gratefully acknowledged. Address for conespondence: Banco de Portugal, Av. Almirante Reis, 7 1, 1150 LISBOA, Portugal, Fax: +351-l-813 22 21

’ See Geroski (199 1) for a survey.

174 JO.36 MATA

in such conditions, profit opportunities are widely available and new firm survival is easier. The alternative hypothesis contends that an increasing number of firms would be created when the opportunity costs of being an entrepreneur are lower, i.e., in periods of high unemployment. The empirical evidence on this discussion is, however, still rather sparse and inconclusive.2

Although most new firms are small, it is not true that all new firms are small and it is certainly not true that they are all of the same size. Despite the increased interest in the economics of small business and the widespread recognition that small firms are not only reduced versions of their larger counterparts (see Brock and Evans 1989), very little attention has been paid in this debate to the size of new firms. However, different determinants of entry according to firm size were already identified at the cross-sectional level by Acs and Audretsch (1989) and Mata (199 l), using cross sections of American and Portuguese manufacturing, respectively.

In this study, I have extended the analysis to encompass the time series dimen- sion. Studies on self-employment (e.g. Evans and Leighton 1989 and Meager 1992) have found that the likelihood that an individual becomes self-employed is greater for the unemployed. This suggests that the creation of small entrepreneurial firms may respond to business conditions in a different manner from the start-up of larg- er corporations, in particular that they are less likely to respond pro-cyclically to business conditions. To investigate this issue, I have employed different definitions of small firms and analysed whether or not small scale entry is determined by the same forces that determine the creation of their larger counterparts.

The plan is the following. In Section II, I briefly describe the data source used to obtain our measures of firm creation. In Section III, an overview of small firm creation in Portuguese manufacturing during the eighties is given. Section IV presents the empirical model and the estimation results. Finally, Section V summarizes the main results.

II. Data

Data on new firms employed in this work are the author’s computations based on unpublished data obtained from an inquiry conducted by the Portuguese Ministry of Employment.3 This survey has several distinctive characteristics that make it a very good source for the study of market dynamics. The first is its comprehensive- ness, since it includes virtually all firms with paid employees in the economy. In manufacturing, this means that it includes nearly all firms with 5 or more employ- ees. Even though this survey investigates only l/4 of the total number of firms employing less than 5 people that were considered by the Census of Manufactur- ing, it reports more firms in all the other employment classes and records a greater employment figure than the Census itself. Hence, except for very small firms, it

’ This debate is surveyed in Storey (1991). ’ This source is described in some detail in Mata (1992).

SMALL FIRM BIRTHS AND MACROECONOMIC FLUCTUATIONS 175

can be seen as a highly reliable source. The second is that, unlike the Census, the survey is conducted on a yearly basis, which allows for the analysis of the effect of macroeconomic fluctuations. A third advantage of this survey is that it allows unequivocal identification of firms over time. Firms are identified by unique num- bers that are given in sequence when firms first report to the survey. Before a new identifying number is given to a particular firm, the Ministry staff makes sure that the firm was not included in their files in previous years. This check can be quite accurate, since firms include in their statements the numbers given by the Firms Register, when they are set up as an autonomous legal entity.

Due to data availability constraints, we had to restrict our attention to firms in manufacturing. With respect to this sector, however, we were able to work with raw files containing information on each one of the firms in operation in each year from 1982 to 1990. Given the identifying scheme described above, we were able to identify entrants in one particular year by finding, in the file relative to this year, all those firms whose identifying number is greater than the highest number in the file relative to the previous year. This assures that firms classified as entrants have not been previously included in the files. We present data from 1983 to 1990. Although data is available since 198 1, we did not measure entry in 1982 because in 198 1 data is not very reliable and, given the way we measured entry, availability of reliable data for the year before the one we are interested in is crucial for the accuracy of the measurement.

The sample used in this study consists of 70 industries from Portuguese manu- facturing, which meet the requirements of data availability. “Miscellaneous” indus- tries, industries in which the public sector has a predominant position, and those judged to have essentially local markets were excluded. Finally, as our source can only be considered highly reliable for firms employing 5 or more people, only firms above this threshold were considered in this study.

Hi. Small Firm Creation and the Business Cycle

The extent of new firm creation in the economy can be measured in many different ways. Here, we describe the extent of this phenomenon in Portuguese manufactur- ing, using two of the more commonly employed measures. The first measure, the entry rate, is obtained by dividing the number of new firms by the total number of firms in activity. The second measure, the entrants’ employment share, which we will call the entry share, is obtained by dividing the employment in new firms by the total employment in the industry. These two measures (expressed as per- centages) were computed for different size classes, as reported in Table I. The entry rate and share differ in the weight they give to the different firms, the former weighting small firms in a heavier way that the second. However, they are positive- ly and significantly correlated, both for each size class, as well as for the overall sample.4

’ The correlation coefficients between the two measures are always above 0.6.

176 JO& MATA

TABLE I. Firm creation by firm size class (average during the period 1983-1990) Total 5-9 10-19 2OA9 50-99 100-199 2OOA99

Entry Rate (%) 10.5 4.7 3.1 2.0 0.5 0.1 0.1 Entry Share(%) 4.1 0.6 0.8 1.1 0.6 0.4 0.4

6-

-1 -

-2 -I

1962 1963 1964 1965 1966 1967 1966 1969

Year

Fig. 1. GDP growth.

The typical new firm is quite a small unit. Forty five percent of the total number of new firms in our sample employ less than ten persons and firms with less than fifty make up more than ninety percent of the total population of business starts. Judging from the employment share attained by entrants, the figures are rather less extreme, but nonetheless quite impressive. Firms with less than fifty people are still responsible for more than sixty percent of the total number of jobs created by new firms, while the corresponding figure is around fifteen for firms with less than ten people.

Looking now at the time-series dimension, the aggregate figures for small firm creation in Figures 2 to 5 reveal an apparently pro-cyclical response to overall business conditions. In Figure 1, GDP real growth rates are presented for reference. These figures are lagged one year, since we are assuming that small firm creation entry between t and t+l may be induced by GDP growth in the previous year, i.e. between f - 1 and i. They show the 1984 recession, when GDP experienced negative growth rates, followed by a period of prosperity starting in 1986 and continuing afterwards with GDP persistently growing above the 3% threshold. The creation of small fmns seems to accompany this tendency. At least for firms employing less than one hundred people, there is a clear adherence to this general pattern in the entry figures. For the larger size classes the tendency is much less neat, perhaps because firm starts do not follow the same tendency or perhaps because the data for these classes are produced from a much lower number of units.

SMALL FIRM BIRTHS AND MACROECONOMIC FLUCTUATIONS 177

1.0 -

1963 1964 1965 1966 1967 1966 1969 1990

Year . . . . . . S-9 people -.-. 10-i 9 people 20-49 people -

Fig. 2. Entry rates by size classes.

0.6 - k..

0.5 - .---.. .-. . . . .I... . . . . . . . . . . ~ .*.eee...... 4.. . .

. . . . .:. k, '... T L

0.4 - . . . . . . .:. .:. . . . . . . . . . . .

al x. . . . .

g 0.3 - *... .,...... . . . . . . . ./

0-l

1963 1964 1965 1966 1967 1966 1969 1990 Year

...... 50-99 people -.-. 100-l 99 people - 200-499 people

Fig. 3. Entry rates by size classes.

1.6

1.4 -

'... . . . . . . . . . . . . . . . . . . . . . . . . . .

0.2 -

0-l 1983 1904 1965 1986 1967 1966 19s9 1990

Year . . . . . . 5-9 people -.-. 1 O-l 9 people - 20-49 people

Fig. 4, Entry shares by size classes.

178 JOSE MATA

-.-.-. -.-.s.-

0.2 -

0.1

01 0-l

1963 1963 1964 1964 1965 1965 1966 1966 1967 1967 1966 1966 1909 1909 199c 199c Year Year

...... SO-99 --SO-99 people people -.-. -.-. 100-199 100-199 people people - 200-499 - 200-499 people people

Fig. 5. Entry shares by size classes.

IV. The Determinants of Small Firm Creation

To fully appraise the effect of macroeconomic conditions on entry, one needs an empirical model that also takes into account the industry specific conditions that determine firm creation. Given the availability of a panel of 70 industries observed over a period of eight years, our models will take advantage of these two dimensions by using pooled data.

In the time-series dimension, the estimated models include GDP growth and the average real interest rate charged by the banking system for operations of less than one year. At the beginning of the period under analysis, interest rates in Portugal were administratively established by the monetary authority and these controls were only gradually removed during the decade. In particular during the early eighties, when inflation reached its peak, rates were set at levels lower than inflation. The banking practice at that time was to charge the payment of interest at the moment the loan was given, thereby charging a higher equivalent rate. Although we have no data on how this procedure varied over time, the difference between the two rates is particularly important when nominal rates are higher, as in the early eighties. Therefore, we assumed that the practice persisted through the period and used the equivalent rates. The sources for these variables are the Bank of Portugal for the interest rate and the Institute of Statistics for GDP growth. Data is referred to the first quarter, since this is the period of reference of our entry data. Unemployment could not be incIuded due to colinearity with GDP growth, but qualitatively simiIar results to those reported, are obtained when unemployment growth is used instead of GDP growth.

In the cross-sectional dimension, two types of factors are usually considered in empirical models of entry. The first includes the entry inducing factors, like pre- entry industry profits and growth. Profitability is measured by the pre-entry industry price-cost margin and industry growth is the growth rate of industry production. The

SMALL FIRM BIRTHS AND MACROECONOMIC FLUCTUATIONS 179

source for both measures is the National Institute of Statistics, Since the data refers to calendar years and our entry data refers to the periods between two consecutive months of March, the rule we adopted was to consider that entry between March of year i and March of year t + 1 is explained by the price-cost margin during year i - 1 and the industry growth between year t - 2 and i - 1. The second group comprises the entry deterring factors, or entry barriers. Measuring entry barriers has. proven to be one of the most challenging tasks in empirical industrial organization, the problems associated with this endeavour being clearly identified by Geroski, Gilbert and Jacquemin (199 1). However, entry barriers belong to that category of industry structural conditions that arc not likely to change much over time (at least within the time span we are considering here). Rather than trying to measure the extent of entry barriers, the approach we take here is to acknowledge the difficulties involved in this measurement and to avoid them by including a set of industry fixed effects in the regression.

Because the entry share and the entry rates are bounded between zero and one their values can be interpreted as probabilities.5 If these variables are employed as dependent variables and OLS is used as estimation method, the predicted values resulting from the estimated coefficients can lie outside the [O, 1] interval, which is incompatible with the probabilistic interpretation. The logistic transformation, which is normally used to handle this problem, has two important disadvantages in our context. The first is that the logits are not defined for the extreme values, although the addition (or subtraction) of small values to these extreme cases allows one to include them in the regression.6 The second problem, which is more impor- tant in our case, is that, because the original variables are concentrated in very small values, the logit model predicts levels of entry which are much lower than those actually observed.

Because of these two problems, our most preferred results are those obtained by OLS using the original variables as the dependent variables.7 However, logit regressions were also run without qualitative changes in the results, thus confirming their robustness.* The models were estimated for different definitions of small firms, ranging from those firms employing fewer than ten people to those employing fewer than five hundred. Results are displayed in Table II and III.

The results show a remarkable lack of influence of industry specific business conditions together with quite a robust effect of macroeconomic conditions, in particular of GDP growth. Industry profits and growth were never found to be statistically related to the start-up of small firms, irrespective of the measure and

’ The entry share can be interpreted as the probability that a firm in activity in one particular year has started its activity in this particular year in a given size class. Similarly, the entry share may be viewed as a measure of the probability that a worker employed in a specific industry in one particular year is employed by a new firm of a given size class.

’ See Greene (I 993) and also Maddala (I 983). ’ We will not try to interpret the results in the probabilistic context. ’ Different correcting schemes were employed to deal with industries with no entry, without

qualitative changes in results.

180

TABLE II. Regression results: The determinants of new firm entry rates

JO.56 MATA

(1) w (3) (4) (51 03 (fewer than) (fewer than) (fewer than) (fewer than) (fewer than) (fewer than) (10 people) (20 people) (50 people) (100 people) (200 people) (500 people)

Profit 3.38 (1.03)

Growth 0.25 (0.66)

GDP 0.09 Growth (1.57) Interest 0.01

(0.26) R2 0.30 R2 0.19

3.34 3.31 2.08 3.85 3.37 (0.87) (0.70) (0.39) (0.68) (0.59) 0.69 0.25 0.13 0.09 0.001 (1.31) (0.50) (0.22) (0.13) (0.01) 0.16 0.21 0.26 0.26 0.26 (2.36) (2.54) (3.05) (2.87) (2.88)

-0.03 -0.09 -0.14 -0.16 -0.18 (-0.87) (-2.21) (-2.96) (-2.97) (-3.25)

0.39 0.38 0.34 0.32 0.32 0.29 0.29 0.24 0.22 0.21

Absolute values of robust t-statistics in parenthesis.

TABLE III. Regression results: The determinants of the employment share of new firms

(fewer than) (fewer than) (fewer than) (fewer than) (fewer than) (fewer than) (10 people) (20 people) (50 people) (100 people) (200 people) (500 people)

Profit -0.09 -0.11 -1.10 -4.49 -1.70 -2.91 (-0.12) (-0.11) (-0.52) (-1.56) (0.41) (-0.69)

Growth -0.02 0.19 0.01 -0.05 0.07 0.21 (-0.18) (0.79) (0.25) (-0.15) (0.11) (0.34)

GDP 0.03 0.05 0.01 0.14 0.15 0.19 Growth (2.91) (2.42) (2.92) (3.66) (2.25) (2.75) Interest -0.00 -0.001 -0.02 -0.06 -0.07 -0.11

(-0.01) (-0.82) (-1.47) (-2.50) (-2.21) (-2.87) R2 0.44 0.48 0.48 0.40 0.36 0.33 R2 0.36 0.40 0.40 0.31 0.26 0.23

Absolute values of robust t-statistics in parenthesis.

the particular definition of small firm employed. It has been argued that past profits are not a good proxy to the profits expected by firms when they make their entry decision. The argument is that, on the one hand, entrepreneurs would not expect the state of nature to be the same over time and, on the other hand, they would not hold the naive expectation that their entry exerts no effect on market profitability. Because of this, profit expectations ought to be specifically modelled; forecasts obtained from an autoregressive model of profits (Highfield and Smiley 1987) and a rational expectations proxy (Geroski 199la) have been suggested to be better proxies to measure the industry profit potential as perceived

SMALL PIRM BlRTl-lS AND MACROECONOMIC PLUCTUATlONS 181

by entrants. Both alternatives were experimented but without much success, as none of these expected profits was ever significant.9 With respect to industry growth, the estimations were also performed using alternative measures of industry growth, namely employment and value added growth in the industry, but results remained qualitatively unchanged. lo

GDP growth, on the contrary, is positively associated with small firm starts, irrespective of the measure employed or the definition chosen, and this seems to be the most stable result of this research. This does not support the hypothesis that most new firms would be created by unemployed people, as a last resort to get a job. However, a word of caution seems important here. Since our new firms employ at least five people, and this is not exactly the type of firms that most unemployed would create, our result does not really contradict the findings of the literature that has asserted that unemployment leads to self-employment.

The results for the interest rate are much less stable. Indeed, when narrower definitions of small firms were used, we were not able to uncover any statistically significant relationship between new firm starts and the interest rate. Only when our definition of small firm is broadened to include firms with fewer than 100 employees are we able to reject the null hypothesis. These results are in line with the claim that small firms raise their funds mostly through informal capital markets rather than through the banking system (Gaston 1989, Walker 1989), thus being less affected by the interest rate charged by banks. Another explanation (equally compatible with our results) would suggest that, because smaller firms are typically less capital intensive, they ought to be less sensitive to variations in the cost of capital.

V. Conclusion

This paper analysed the effect of business conditions on the start-up of small firms. Several findings are reported. The first is that new firm entry displays a pro-cyclical behaviour. Small firms are created mostly when aggregate demand is growing fast and this result is robust to the particular definition of small firm employed. Our results thus support the pull rather that the push hypothesis of the debate on the effect of macroeconomic conditions on firm creation. These results are consistent with the findings of Audretsch (1995) for the United States.

’ The lack of significant relationship between profit expectations and entry is less surprising if we consider the available evidence that a large proportion of entrants exits during the first year of life (see, for example Dunne, Roberts and Samuelson 1989 and Mata and Portugal 1994), which necessarily means that entrants’ expectations are not completely fulfilled. This casts some doubts on the assumption that entrants are able to properly forecast profits and, in particular, on the validity of using rational expectations. In fact, as we are dealing with small firms, the hypothesis that firms expect their entry to go unnoticed does not seem to be unreasonable.

lo On investigating the robustness of results, several alternative specifications were tried, including and excluding the different measures of industry growth and profitability. Not only were these variables never significant, but also the results for the other variables did not show remarkable changes.

182 JO& MATA

However, we did not find evidence of any effect of the industry specific business conditions in attracting small new firms into activity. Past profits and past industry growth were found to be uncorrelated with any of our measures of small firm births.

With respect to the effect of the interest rate, our results are different. Small new firms were found to differ from the typical new firm with respect to the way they respond to the interest rate. As opposed to the average firm, we did not find evidence that entry by very small firms responds to the interest rate.

Finally, although our results suggest that the pro-cyclical effect on firm starts does not depend on the size of the new firms under scrutiny, it remains true that all firms analysed are firms employing paid employees. Lack of data prevented us from comparing the determinants of the start-ups of these firms with those of people going into self-employment, but such a comparison remains a must for future research.

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