Economics of Small Business

1. Economics of Small Business Drexel University Spring Quarter 2014 Ninth Week

2. Happiness

3. Nonpecuniary Benefits • We have already seen the argument that small business proprietorship has “nonpecuniary benefits.” • That is, some people simply prefer to be independent businessmen or businesswomen. • Can we test that idea more directly?

4. Ask Them • In economics we have various indirect methods of testing and measuring the nonpecuniary benefits. • We might follow the example of psychology: ask them.

5. Satisfaction with life • For about 40 years, we have had a large number of questionnaire surveys that ask people to rate their satisfaction with life on a relative scale, such as “very unsatisfied, somewhat unsatisfied, somewhat satisfied, very satisfied.” • Economists have explored the relation of the answers to economic variables. • This is sometimes called “the economics of happiness.”

6. Economics of Happiness • While there is plenty of controversy on how to interpret the results, we know quite a lot. • The relation of money income to self-reported happiness is complicated. • Unemployed people are less happy than employed people, even if they have the same income. • Married people are happier than unmarried. • Married or unmarried, people are happier on the average if the get more sex.

7. Job Satisfaction • These questionnaire studies often also ask people to rate their satisfaction with their jobs or homes. • If small business proprietors really benefit from nonpecuniary advantages, we might expect them to report more job satisfaction or more satisfaction with life. • The study by Benz and Frey addresses this.

8. Procedural Utility • In place of “nonpecuniary benefits” they use the term “procedural utility.” • “Outcome utility” is the utility we get by spending the wages or profits. • “Procedural utility” is the utility we get from the way we earn the wages or profits – from the “procedures” we go through to earn the money.

9. Procedural Utility and Politics • Frey and another collaborator had previously showed that Swiss direct democracy let to higher reported satisfaction, which they give as another example of procedural utility.

10. European Data • They study European data from questionnaire panels carried out in Germany, Switzerland, and Britain. • They do find that self-employed people report greater job satisfaction that employees. • Relevantly for us, they also find that employees in smaller firms report greater job satisfaction!

11. Ceteris Paribus • In principle, this difference might be a result of some other differences – for example, self-employed businessmen might be happier because they make more money, or because they work different hours. • Benz and Frey adjust for this, of course, using the economist’s usual method: regression, using methods that correct for some known problems.

12. Correlation is not Causation • Nevertheless it could be that the correlation between self-employment and happiness is seen because happier people become self-employed. No, really! • The authors apply a method that (they say) tests for this.

13. Why Should we Care? • The authors argue that self-employment satisfies some “basic psychological needs” for self-determination and/or autonomy. • That’s not a new idea – John Stuart Mill subscribed to it, and so do I – but I’m not sure that it is uncontroversial in psychology, and I don’t regard it as certain.

14. Hypotheses • The basic assumption is that having one’s work directed in a hierarchy is unpleasant, and the bigger the hierarchy the more unpleasant. • This leads to two hypotheses: • “Self-employed people derive higher procedural utility from work than people employed in organizations. “ • People working in smaller firms enjoy higher procedural utility than people working in larger firms.

15. According to the Authors, • “Utility is increasingly seen as being directly measurable using self-reported satisfaction measures as a proxy.” • Anyway, that is their approach.

16. Sample Questions • “'How satisfied are you today with the following areas of your life: your job?” • Rated 0 to 10 • “All things considered, how satisfied or dissatisfied are you with your present job overall?” • Rated 1 to 7 • On a scale from 0 'not at all satisfied' to 10 'completely satisfied', can you indicate your degree of satisfaction with your job in general.

17. Overall Responses • According to their responses, most Germans, Swiss and British are quite satisfied with their jobs. • “Job satisfaction was highest in Switzerland in 1999, where the average worker stated a job satisfaction score of 8.10 (st. dev 1.72) on a scale of 0-10.”

18. Self-Employment as Independent Variable • “The dummy 'self-employed' takes on the value 1 when individuals state that they are self-employed in a given year, and 0 when people in the workforce are employed by an organization.” • “In West Germany an average 8.3% of the total workforce sampled in the GSOEP was self-employed in the years 1984-2000, and this ratio was relatively constant over the period …. In Britain an average 12.0% of the workforce was self-employed during the years 1991-99 …. In Switzerlandt he ratio amounted to 10.5% in 1999.”

20. Say What? • Let’s take this step by step. • The dependent variable is the job satisfaction rating, and a “logit regression” is a method that predicts the average response from a limited, ordered set of responses such as the ones we see here.

21. The Main Point • This tells us that self-employment increases average job satisfaction by 0.196 in Germany, 0.258 in Britain, and 0.418 in Switzerland, relative to employed workers, the reference group; and the probability that the correct number is zero is less than 1%.

22. Income • This tells us that an increase of 1 in the log of net income increases job satisfaction rating by an average of 0.374 in Germany, for example. This seems to vary among the three samples.

23. Hours • This tells us that long working hours reduce job satisfaction, but with a marginal effect that decreases slightly. • The other coefficients indicate the effects of several other reasonable variables.

24. Details • We will skip over some other details. • The authors do some double-checks with the data sets that allow them to analyze individual movements in and out of self-employment and on those in east Germany who became self-employed only after the political change there permitted them to. • They offer these as evidence that the causation runs from self-employment to happiness.

25. Firm Size 1 • The typical self-employed person works in a much smaller firm than the typical employed person. • If working in a small firm has nonpecuniary benefits, then it could be that part of this effect comes from the size of the firm and not the fact of ownership. • Accordingly, they run a new regression with dummy variables for the size classes.

26. Firm Size 2 • The results are consistent with their hypotheses. • Working in a firm bigger than the smallest size class is associated with lower ratings for job satisfaction. • The worst tends to be in the 100-1000 range. • Proprietors do report higher job satisfaction after allowing for enterprise size, but by a smaller and less significant margin than in the regressions that do not allow for firm size.

27. Small Firm Employees • This poses an interesting question that they do not consider. • We know that, on the average, small firm employees are paid less than employees of large firms. • We also know that they are different in other ways – still: • Could it be that large firm employees are paid more to compensate them for their lower job satisfaction?

28. “Procedural” Utility • The British survey asked some specific questions about the sources of the differences in well-being. • Two were satisfaction with “outcomes:” job security and work load. • Two were “procedural:” Use of initiative and the actual work itself. • When the latter two were included, there is no separate satisfaction with proprietorship. • Satisfaction with small firm employment is reduced, though not eliminated.

29. “Outcome” Utility • Inclusion of “job security” and “workload” has no such effect. • The coefficients for those variables are large, always “significant,” and stable. • Thus, they are important variables – • But they do not explain the satisfaction of proprietors, as the “procedural” variables do.

30. Interpretation • The evidence suggests, and the authors conclude, that • The satisfaction derived from small-business proprietorship is identical with the (procedural) utility of the use of the proprietor’s initiative and the work itself. • Some important part of the satisfaction derived from small-business employment is also from those sources. • Job security and workload, while important, do not contribute to these other satisfactions.

31. A Model • Recall, research by Hurst and Pugsley indicated that most small business founders do not intend their businesses to grow large. • Like Benz and Frey, they argue that nonpecuniary motives are central. • In later work, they propose a model of equilibrium in enterprise foundation and size. • It uses some quite advanced methods, but we will look at some aspects.

32. Individuals • Individuals may choose to found a business or get a job. • An individual’s utility is an increasing function of consumption, with diminishing marginal utility, plus a fixed increment (zero or positive) if the person founds a business. • Individuals differ in the self-employment increment and also in their household wealth. • Business ownership is a “normal good.”

33. Normal Good 1 • To say that business ownership is a normal good is to say that the “demand” to be an owner increases with increasing wealth. • This is a result of the diminishing marginal utility of consumption. • They write the utility function as U=logC+gE • C is consumption, E is 1 if the individual is a business owner and zero otherwise, and g varies from one person to another.

34. Normal Good 2 • Given utility function U=logC+gE • The marginal utility of consumption is 1/C • The marginal utility of owning a business is constant at g • The wealthier the person is, the greater the marginal utility of business ownership is relative to that of consumption. • Thus, the likelier the person is to form a business. • Given wealth, however, the bigger g is, also, the likelier the person is to form a business.

35. Industries 1 • They also assume that economies of scale differ from one sector of production (“industry”) to another. • Their approach is typical of 21st century research in economic theory. • They treat production as the production of intermediate goods, which are combined by a black-box market economy to produce a single aggregate consumption good.

36. Industries 2 • These assumptions enable them to take a more or less macroeconomic perspective and ignore consumers’ choices among different consumer goods (since there is only one.) • They use integral calculus to capture the assumption that developments in one industry have only negligible influences on developments in other industries. • These assumptions simplify the math!

37. Economies of Scale • Capital investment plays no part in the model. • Production can be carried out by “firms” (corporations) of “small businesses” (family businesses.) • For a corporation, output is Q=Ahq-b, where h is the firm’s labor force and the constants differ from industry to industry.

38. Economies of Scale Example This is a long run avarage cost curve. For this example, the optimum scale is 10 employees. The constants are A=100, q=0.9, and B=80.

39. “Small Business” • A corporation can hire as many employees as it chooses; so, in equilibrium, will operate at the optimum scale. • However, a “small business” cannot hire labor in this model, and the labor supplied by the family is another parameter, r, that varies from household to household. • Thus, most “small businesses” will operate at less than the optimal scale.

40. Equilibrium • In this model, in equilibrium, individuals sort themselves out so that the wealthier, and those whose taste for business ownership is greater, tend to form “small businesses” and these “small businesses” are more concentrated in industries with a smaller optimal scale. • The returns to each industry, “firm” and “small business” are the same, but for “firms” this is the sum of (lesser) profits and a component of utility.

41. Policy • In this model, a subsidy to small business is inefficient and favors the rich as against the poor!

42. Critique • There are two obvious weak points in this model: • Capital investment plays no role; • Small businesses cannot hire labor. • A more “realistic” – and only slightly more complex – model might assume instead that • Business foundation requires investment proportionate to total employment; • Hiring and scale for a small business are limited by the founder’s initial wealth.

43. Further Critique • Hurst and Pugsley say their model shows that capital asset constraints are not the only explanation of the distribution of firm size. • There is some truth in that – the assumption that business ownership is a normal good helps to explain it. • However, in a sense they have stacked the cards – in a model without capital assets, of course asset constraints can play no role.

44. Interim Conclusion • The Hurst and Pugsley model is an important advance in our understanding of small business, and should be the basis of further work. • However, their policy conclusions seem a bit slanted, and should be taken with caution – though their points must also be taken into account!

45. Overall Conclusion • It now seems clear that nonpecuniary benefits are important in the formation of small business, and contribute to the well-being of their employees. • These observations need to be incorporated in our understanding of market equilibrium, and some progress has been made in that direction.