Business start-ups, closures and economic churn A review of the literature

Final report Prepared for the Small Business Service
23rd August 2006
Catherine Robinson, Brigid O’Leary, Ana Rincon1 Consultants: Mary O’Mahony and Geoff Mason

URN 06/2112

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We would like to thank John Forth for helpful comments on earlier drafts. Our thanks also extend to our colleagues at the SBS, in particular, Daniel van der Schans and Jonathan Gershlick.

Table of Contents
Business start-ups, closures and economic churn ..........................................................i A review of the literature ...............................................................................................i Executive Summary .....................................................................................................iv Introduction....................................................................................................................1 2. The theoretical foundations........................................................................................4 3. The definition of economic churn............................................................................10 3.1 Unit for consideration – plant or firm?..........................................................10 3.2 Types of entry and exit ..................................................................................11 3.3 The importance of industry............................................................................13 3.4 The importance of time..................................................................................13 3.5 Conclusions....................................................................................................14 Measurement of entry, exit and churn..........................................................................15 4.1 Conclusions....................................................................................................18 5. Rates of churn...........................................................................................................20 5.1 Churn at the regional level.............................................................................23 5.2 Conclusions....................................................................................................24 6. The impact of churn on the economy.......................................................................25 6.1 Productivity....................................................................................................25 6.2 Empirical studies of the productivity impact of churn..................................27 6.3 Employment...................................................................................................32 6.4 Economic growth...........................................................................................34 .....................................................................................................................................35 7. The costs of churn....................................................................................................36 7.1 Conclusions....................................................................................................39 Alternative modes of entry and exit.............................................................................40 8.1 The entry decision..........................................................................................40 8.2 Entry by diversifying firms............................................................................42 8.3 Changes in ownership....................................................................................46 8.4 Modes of exit..................................................................................................50 8.5 Conclusions....................................................................................................50 9. Start-ups and closures: the UK experience...............................................................52 9.1 Competing theories of the firm......................................................................54 9.2 Business start-ups...........................................................................................55 9.2.1 The case for entrepreneurship.....................................................................58 9.2.2 Industry conditions......................................................................................63 9.2.3 Concentration..............................................................................................64 9.2.4 Barriers to entry ..........................................................................................65

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9.2.5 The regional dimension...............................................................................66 9.3 Technology and innovation............................................................................68 9.4 Survival versus exit........................................................................................72 9.4.1 The role of size in survival..........................................................................73 9.5 UK industrial start-up policy .........................................................................74 9.6 Conclusion......................................................................................................78 10. Analysing churn from the top-down......................................................................79 11. Proposals for future analysis..................................................................................81 11.1 Rates of churn..............................................................................................81 11.2 Churn and productivity................................................................................82 References....................................................................................................................84 Annex 1: Table of Evidence.........................................................................................97

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Executive Summary
Aims and objectives: 1. This review of the empirical and theoretical literature was commissioned by the Small Business Service (Department for Trade and Industry). Our brief was to consider existing research that has examined the causes and the impact of economic churn on productivity, employment and ultimately economic growth. As well as considering the effect of churn on markets, we were also asked to look at the determinants of business start-ups and closures at the firm level; an integral part of the churn process. Finally we were asked to identify existing gaps in the literature and put forward methodologies for addressing these. Structure of report: 2. Following our introduction, our review begins with an overview of the relevant theoretical arguments that offer insight into why churn takes place. There are two reasons why churn is thought to raise productivity. Firstly, through the competitive effect whereby entrants create an environment in which incumbent businesses must ‘raise their game’ in order to remain in the industry. The second positive impact on productivity is through the introduction of new technology. The most notable body of literature is that which relates to the Schumpeterian concept of ‘creative destruction’, by which new firms enter markets introducing new technologies and then displace older, less efficient firms. From the standard neoclassical theoretical position entry will take place when firms identify a profitable opportunity and firms continue to enter up to the point where the last entrant is breaking even. This standard theory does not take into account asymmetries in information, sunk costs, and other market imperfections. Instead, models of imperfect competition are likely to be more realistic and mirror behaviour in the ‘real world’. The importance of research in determining the level of creative destruction is highlighted by macro economic models which emphasise the importance of innovation. Macroeconomic conditions, such as the interest rate, are also found to be important in determining the level of churn. Industry models of entry and exit consider the relationship between product diversity and entry both from an economic and welfare perspective. Entry is likely to take place when firms feel they have an alternative or improved product to bring to the market. A number of these models highlight the importance of industry specific characteristics in determining turnover rates. At the firm level, models have been developed to analyse firm entry decisions and how they survive by learning. Again, these models emphasise the importance of industry specific factors such as market concentration. Our attention then turns more directly to the concept of economic churn and its definition. Chapter 3 highlights a number of aspects that need to be taken into consideration when measuring economic churn. These differences are not only semantic but have real bearing on any comparisons that are iv

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made. We consider explicitly the importance of being clear at which level churn is considered. It could be argued that economic churn relates primarily to the entry and exit of businesses but a large proportion of the reallocation of resources takes place at the plant level within multiplant organisations. Another important factor to be aware of is that entry is not simply start-up, nor is exit simply business failure and we return to alternative modes of entry and to a lesser extent exit in Chapter 8. Finally, we highlight the importance of industry level and the time horizon in defining economic churn. When churn is considered at a relatively aggregate level, less reallocation between industries is observable. This needs to be considered when making comparisons between similar studies. The time period of analysis is similarly important, with short run improvements to productivity being less noticeable than long run effects. The theoretical chapter highlighted the importance of macroeconomic conditions and thus comparisons over time periods where there are differences in the economic cycle are likely to result in misleading conclusions. 6. Chapter 4 considers the measurement of entry and exit. From our review of the literature we have found that there are a large number of ways in which churn can be measured. A ‘turn over’ measure comprising of aggregated start-up and closure rates generally captures the overall churn effect. We find that in young industries, measures of net entry may also provide a clear indication of the competitive effect of entry. In more mature industries, where exit is likely to form a substantial proportion of the churn, a composite measure of turbulence might be more relevant. Ultimately, the most appropriate measure will depend on the purpose of the study and the industry conditions that are being examined. Chapter 5 goes on to present empirical findings of churn rates from a number of international studies. Our primary focus is on a recent study that goes to great lengths to harmonise definitions and time periods across countries. From this study it can be seen that there are higher levels of churn in service sectors compared to manufacturing sectors. The UK appears to have a higher recorded rate of churn in comparison to other countries. In other studies we see that there is also significant variation in UK regional churn rates that reflects the industrial profile of each region. In Chapter 6 we consider the extent to which business churn leads to improvements in the economy through employment, productivity and economic growth. Overall, creative destruction is viewed positively since it reallocates resources from less to more efficient uses in the economy. Given this, we would expect to see a positive impact on productivity in industries where churn rates are relatively high. Empirical research on this shows that the time horizon for analysis is particularly pertinent for identifying the impacts from churn. Entry effects through start-ups are slow to generate higher levels of productivity but longer run panel studies have been more effective in finding positive productivity impacts. The relationship between churn and employment is also considered here. The entry of new plants is thought to be a major source of new employment opportunities and for this reason is often the focus of government policies to encourage start-ups, particularly in less

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successful regions. However, the literature emphasises that the short run productivity impact of entry is not likely to be substantial. 9. Through the churn process, firms and markets are thought to grow, resulting in increased employment, productivity and welfare. It could be argued that creative destruction represents only a component of overall churn and that not all churn is beneficial. There are situations in which the level of churn may be considered excessive, for instance when entry crowds out incumbent firms leading to inefficient payment of sunk costs and no corresponding improvements to market performance. Chapter 7 considers the costs associated with churn. The possibility that churn is not always positive and can result in the inefficient reallocation of resources might imply that an ‘optimal rate of churn’ exists. This is an under-researched area in the literature and this review has been unable to identify an optimal rate of churn. Chapter 8 returns to the issues of definition and measurement by outlining the differences between the various modes of entry and exit. All forms of entry face common factors that influence the decision to enter but the relative importance of these is likely to favour one or other mode of entry. This chapter specifically considers diversification and changes in ownership as an alternative means of reallocating resources. Firms that choose to diversify are at an advantage over start-up entrants since they are better equipped to choose their preferred size of entry to test market conditions before committing substantial resources to the market. Diversifying firms may also have a brand name to exploit and are able to utilise resources and expertise from the parent company. As a result, entrants through diversification are generally larger than start-up entrants, and are more likely to enter concentrated markets. Diversifying firms are more likely to alter incumbent firm behaviour than new start-ups and have a greater competitive influence on incumbent behaviour. Entry through changes in ownership such as mergers and takeovers are both a form of market entry and exit. There are three basic reasons why acquisitions take place. Firstly, there are the potential synergies from subsuming an existing firm and streamlining duplicated departments to increase efficiency. Secondly, ownership changes may occur for reasons not associated with profit but in the pursuit of managerial objectives, such as the growth of the firm or managerial prestige. Finally, it could be that firms make mistakes in identifying potential synergy gains arising from a take over or merger and they do not actually materialise. From an exiting perspective, two competing theories exist. Firms may be taken over because they are performing badly, and thus takeovers are a form of managerial discipline. An alternative view is that well performing firms are targets for acquisition as the acquiring firm wishes to access greater operational efficiency by purchasing it. Entry through mergers and takeovers are also likely to be on a larger scale than start-ups and, as a means of churn, are less disruptive to workers and supply chains than business closures. Chapter 9 is devoted to considering entry through new business startup and closures. These are the more prevalent modes of entry considered in this review, compared with diversification and changes in ownership. Our empirical focus is primarily on the UK, however we begin with some

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theoretical considerations about what constitutes a firm, drawing on the resource based model of the firm where the firm is viewed as a bundle of assets which are specific to that firm and not easily transferred through the market place. Our other key model is that of the evolutionary approach, which views the firm more as a means of facilitating technological change and market knowledge. Policy recommendations for the support of start-ups are likely to differ, depending on the model that dominates in the industry. 13. We consider business start-up rates and find that these vary considerably across the UK, and by region. Existing research focuses almost exclusively on the manufacturing sector and thus there are problems with drawing economy-wide conclusions on the basis of this evidence alone. A number of key factors emerge from our consideration of the literature. We find that it is widely recognised that entry rates are highly correlated with exit rates, which is partly due to survival rates of new entrants being relatively low. We also see that industry churn rates are broadly similar across countries, suggesting the importance of industry specific factors, in additional to institutional factors. This suggests that industry specific sunk costs act as a deterrent to entry, and consequently also act as a barrier to exit as well. Given the high correlation between entry and exit, we go on to consider the role of entrepreneurship in start-ups, looking at the empirical evidence to establish what factors contribute to a successful entrepreneur. We find that both environmental factors (such as the region – population levels, local government policy) and socio-economic factors (such as wealth, family background and education) have significant influences on whether individual choose to start-up their own business. The main motivation for starting ones own business is reported as being ‘to be ones own boss’. Implementing a new idea i.e. innovation, was a much less popular response. This suggests that a large number of entrants are not bringing an innovation to the market and may account for the high number of exits due to displacement of one another. The literature looks at industry conditions as a key determinant of startup. We find that the level of industry concentration and various barriers to entry are all thought to contribute significantly to determining the number of start-ups in an industry. The greater the level of observed profitability in an industry the more likely entry is to occur, subject to barriers to entry prevalent in the market. This suggests that the less concentrated the industry is, the higher the probability of entry occurring. Industry life cycle effects are also likely to influence the proportion of start-up entry. The importance of region is again emphasised and is particularly important with respect to the policy implications of churn. These are considered in greater detail in Section 9.5. In Section 9.3 we go onto to consider the literature that looks at the importance of innovation in business start-ups. The link between start-ups and innovation is discussed extensively in the small business literature, and we find that there is support for the ‘u’ shaped relationship between firm size and innovation, whereby firms that are small and large are the most likely to innovate. A recurring theme throughout the literature on churn is the high mortality rate of new entrants. In Section 9.4 we examine the relationship between survival and exit, looking particularly at the factors which are likely to vii

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assist plant survival. We see that size and age are found to be especially important in survival and consider the validity of Gibrat’s Law that asserts that growth is independent of size. We find that a large body of empirical literature has found that the likelihood of firm survival is not independent of firm size. 18. Chapter 9 considers the UK current enterprise policy. It has recently been argued that there is a lack of transparency in the objectives of small business policy. Our findings in relation to the costs of churn suggest that encouraging excessive entry is not likely to result in higher employment and growth, but is likely to raise the exit rate correspondingly. Assistance to small business perhaps needs to focus on a nurturing role, whereby government aims to create a conducive environment for all enterprises. However a potential problem with the increased use of relatively ‘soft’ intervention is that its impact is much more difficult to assess. Chapter 10 considers approaches for analysing the aggregate impact of churn. This chapter highlights a major gap in existing literature in that the vast majority of studies use a bottom-up approach with the use of micro data. One study that considers a top-down approach looks at the extent to which the gap between actual and optimal industry structure impacts on growth. The report concludes with a section that puts forward a number of suggestions for further work in this area. Most notably, the extension of the micro data based analysis of the service sector is essential to gain an insight into the impacts of entry and exit within this sector. In addition, this area of churn and productivity could be considered more thoroughly using a top-down approach with industry level datasets.

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Introduction
The continual entry and exit of plants and firms is crucial to the growth of an economy. This turbulent process is known as economic churn and is thought to impact on industry productivity through increased competition leading to greater cost efficiency. It can also facilitate creative destruction whereby more innovative firms enter the market, replacing existing incumbent firms using current technologies. The role of dynamic markets in reallocating resources through the entry and exit of firms has been explored extensively in the industrial organisation literature, and various aspects of entry and exit have been considered in the small business and the regional literature. This review draws on these areas in an attempt to explore the channels through which entry and exit takes place and the influence this dynamic process has on productivity at the industry and national level. As well as the positive effects associated with the replacement of exiting firms, it is recognised that there are costs associated with the reallocation of resources such as the destabilising effects caused by redundancy. There is a trade-off between the benefits churn brings and the costs associated with the reallocation process and this will be explored further within the review. The purpose in this literature review is to consider economic churn in detail. The review begins in chapter 2 with a discussion of the relevant theoretical models which have implications for the nature of entry and exit. On close inspection of the literature, we find that definitions are central to our understanding of what is meant by the phrases ‘churn’, ‘entry and exit’ and ‘creative destruction’. Particularly, a clear understanding of the definition of churn or entry and exit is essential for meaningful cross-country comparisons to be made. In chapter 3 we provide a detailed explanation of the terminology used in the literature.

Having considered the definitional issues, chapter 4 then considers measurement issues and the different approaches for calculating churn. In chapter 5, the review looks at the existing empirical evidence of churn from a large range of countries. In chapter 6 we are specifically concerned with presenting a complete picture of the role that economic churn plays in the economy by considering its impact on productivity, employment and ultimately GDP growth. Chapter 7 identifies that not all churn raises productivity and employment and, where churn is ‘noisy’, it may be an inefficient use of resources. We therefore consider the costs that arise from business churn. Our findings from the literature suggest that it has not been possible to robustly calculate an optimal level of churn, and that churn rates are largely determined by industry and market specific conditions. Chapter 8 considers diversification and changes in ownership as alternative means of transferring resources and as alternative modes of churn to start-up and closure. These may have a larger impact on the industry than just focusing on start-ups. In chapter 9 we consider the role of start-ups and closures in the UK and identify the obstacles that they face and the policy environment in which they operate. The importance of start-ups in the process of churn is not so evident in the short run since start-ups face high failure rates and represent a small proportion of total market share. However, the impact of start-ups should not be underestimated as they bring innovations to the market and in the longer run, expand their market share. Therefore, the time dimension is a very important factor to consider when assessing the impact of churn. In chapter 10, we highlight the scarcity of studies that take a top-down approach to the impact of churn instead of the current focus on micro data. The use of top down approach enables the use of richer sources of data than are available at the micro level and ensures a greater consistency across space and time. In the final chapter of the review we briefly consider the main gaps in the existing evidence and highlight areas for further research. In particular, we identify the poor coverage analysis relating to the service

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sectors of the UK to date and again highlight the importance of consistent definitions for cross country comparisons.

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2. The theoretical foundations
Much of the theoretical literature on entry and exit concentrates on the Schumpeterian idea of ‘creative destruction’ (Schumpeter 1943), by which many new firms enter the markets introducing new (improved) products and new technologies and processes that replace old ones, resulting in firm closures. Churn has therefore largely been positively viewed for its role as the driving force behind improvements in productivity. However, the effect of churn is also linked to the impact of competition on corporate performance, i.e the pressure churn creates acts as a form of market discipline, ensuring that the market operates efficiently. As such, there are two broad reasons for why the churn process can be viewed as beneficial including its effect on facilitating innovation and competition. Before we can fully explore the effects of churn we need to consider the determinants of entry. Standard neoclassical economic theory states that firms will enter a competitive industry in which positive profits act a signal for entry. The threat of competition drives firms in the industry to produce at the lowest point on their average cost curve, which then constrains long run profits to zero (Nicholson, 1989, p.576). This theory is based on the following assumptions: a) Rational preferences by individuals and firms b) Individuals choose to maximise utility (satisfaction) and firms maximise profits c) People act independently to one another and have all relevant information. In the real world, these assumptions are not always realistic. For example markets may be incomplete with missing or inaccurate information and/or there may be incentive problems. In addition, there may be increasing returns to scale, or natural monopoly conditions which favour one single firm to supply the market. In these circumstances, the assumption of a competitive

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equilibrium solution does not hold and perfect competition is unlikely to be reflective of the market structure. Given this, we have to consider theories that move beyond the simple perfectly competitive framework and consider firm behaviour under imperfect conditions. Within this review we consider entry and exit at three different levels:
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Macro economic level Industry level Firm level

2.1 Macro Economic Level Business churn can lead to improvements in the performance of the macro economy such as economic growth. In addition, the stability of the macro economy and the effect of interest rates on innovation may affect levels of churn. Taking a macroeconomic perspective, Aghion and Howitt (1992) and Romer (1990) develop models of creative destruction that consider technological progress directly affecting economic growth. Aghion and Howitt (1992) show that monopoly profits motivate businesses to innovate (and make improvements in product quality) but this causes obsolescence of existing goods. Churn in the sense of creative destruction is then related to the amount of Research and Development (R&D) that is undertaken. ‘Too much’ R&D can be a deterrent to new firm entry because monopoly profits are lost too quickly. This balance may be affected by government policy towards protecting intellectual property rights through patents, as these give firms a chance to earn profits from their innovations before the patent expires. Progress in research and development may be associated with higher demand for skilled labour and higher wages demanded by workers. This will reduce the profits derived from innovation and reduce the likelihood of businesses carrying out innovation. Where research projects are a choice between current costs and future benefits, the level of innovation will be sensitive to the interest rate (Romer 1990). Therefore, the macroeconomic 5

environment directly affects the propensity for businesses to innovate, and will also affect the level of churn observed. 2.2 Industry Level Consideration also needs to be given to business churn at the industry level. Churn is substantially determined by product life cycle factors. Mature, traditional manufacturing industries have seen substantial contraction and downsizing in recent years, at the same time as major growth in the service sector. Thus we can see the importance of taking an industry perspective in the analysis of churn and its impact. A model of the relationship between (monopolistic) competition and product diversity developed by Dixit and Stiglitz (1977) identifies the difference between market competitive solutions and socially optimum solutions. Innovation takes the form of diversifying products; firms create new ideas within an industry that reduce the profits of existing firms with old ideas (following Schumpeter, 1943). The model recognises that there is a trade-off between quantity and diversity, combining the benefits of scale economies (larger quantities of fewer goods) with the demand for variety of product which increases consumers’ welfare. The competitive solution will be based on the profit criterion while achieving the socially optimal requires maximizing consumer welfare. Asplunt and Nocke (2000) suggest that industry-specific characteristics (such as sunk costs and market size) offer causal explanations as to why some industries have higher firm turnover than others. Firm profits are dependent on market size, cost and their relative position in the industry distribution of costs. Entry decreases with the existence of sunk costs so that once a firm has entered a market it will choose to remain if the value of investing for another period is greater than zero. Sunk costs are costs that are irrecoverable after entry such as specialised assets that have no alternative economic use. An increase in market size results in higher sales and profits for firms, but when associated with a wide distribution of firms, the least

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efficient firms (or those with highest costs) will have lower price cost margins and will exit. The level of concentration in an industry is also thought to have significant bearing on entry and exit decisions. Amel and Liang (1992) suggest that market structure and concentration have an ambiguous effect on firm’s decision to enter. This is because concentration will have a positive effect on new entry if high market concentration results in high observable profits, making the market look relatively attractive. On the other hand, a negative effect may be seen so that market concentration is accompanied by collusive behaviour of the incumbents which restricts new entry. If firm entry is declining with market concentration, this may indicate the existence of implicit barriers to entry and anti competitive behaviour by the incumbent firms. When considering entry and exit at the industry level, the behaviour of existing firms in the market is crucial to the impact churn has on aggregate indicators such as employment and productivity growth. Incumbents are affected by new entry through an immediate effect on profits and also by long run adjustments in firm behaviour and strategy in response to the increased competition (Hines 1957). 2.3 Firm Level Turning to firm level models of entry and exit, Jovanovic (1982) made an early contribution to the literature on firm entry and learning processes through his passive or learning by doing model. Jovanovic puts forward a model of ‘noisy selection’ where firms enter with incomplete information about their efficiency and learn about their potential profitability from realised profits. Uncertainty is recognised as occurring at the individual level but not at the aggregate level. That is, all firms know output prices and the equilibrium product price but not their own productivity capabilities and cost functions. In this model, firms fail when they are not efficient enough to maintain positive profits. Within an industry, firms differ in size because some are more efficient than others. The Jovanovic model predicts that firm size and concentration are positively

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related to rates of return and that the correlation over time of rates of return is higher for larger firms and in concentrated industries. Developing from the Jovanovic model, Ericsson and Pakes (1995) put forward the active learning model, whereby the firm explores actively the economic environment and makes investment decisions to increase its capability to earn profits under competitive pressure from both within and outside an industry. A firm’s potential and actual profitability changes over time in response to unpredictable outcomes generated by the firm’s own investment and those of other firms in the market. Firms will grow if they are successful but will shrink and/or exit if unsuccessful. In these firm level models of learning (Jovanovic 1982; Ericsson and Pakes 1995), exit rates are related to the age of the firm. Young firms are less familiar with their attributes and capabilities, and so it is more likely that learning about the cost structure will induce exit. Hazard rates, which calculate the probability of exit, will be lower for older and larger firms (Hopenhayn 1992). These selection models predict that the size and the age of a plant will determine the failure and growth rate distribution. In these models, firms are assumed to be single plant establishments and the relationship between survival and size or age may be different for already established firms seeking to diversify. Firms can however benefit from experiences in other establishments or other lines of products, and do not have to rely completely on learning from the market (Disney, Haskel and Heden 2003b). 2.4 Conclusions In this chapter we have considered the theoretical underpinnings that offer explanations for entry and exit, where it is likely to take place, under what sort of conditions - at the firm, industry and macroeconomic level, and the effects that churn is likely to have on the market. We see that churn is thought to have two key impacts on the market that result in raising productivity growth – through the innovation and the competition effects. When we consider traditional economic theory, we 8

find that the perfectly competitive market offers us only a partial view of why entry takes place. In addition to being attracted to above normal profits, entry takes place to introduce new technology to a market and to satisfy a consumer’s need for diversity. Entry and exit rates are likely to be hindered by adverse macroeconomic conditions, such as high interest rates while high levels of concentration are thought to have an ambiguous effect on entry (and exit). At the firm level, we see the importance of the learning process and the level of uncertainty the firm faces as a key determinant of survival. The models described above tend to focus on the entry decisions rather than exit and as such, offer less of an explanation as to how firms exit, and also do not clearly distinguish between modes of entry or exit. Indeed it is implicitly assumed that all entry is start-up and all exits are business failures. These narrow interpretations of entry and exit contribute only a proportion of productive churn. In the following sections we explore the different definitions of churn and elaborate on key modes of entry and exit.

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3. The definition of economic churn
Understanding how churn has been defined and calculated is crucial to our ability to compare empirical findings. At its simplest, economic churn may be defined as the entry and exit of firms from a market. There are a number of aspects in relation to this definition that warrant further consideration and these are outlined below.
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Unit for consideration: Plant or firm? Different types of entry and exit Importance of industry Importance of time

3.1 Unit for consideration – plant or firm? Although the focus in the industrial economics literature is on the entry and exit of firms (or enterprises) in a market, some firms will be comprised of a number of plants2. The reallocation of resources through the opening and closure of plants within a multiplant firm is a significant component of churn (Harris and Robinson, 2001a) and there are instances where this unit may be the more appropriate for consideration, particularly if we are trying to identify sources of productivity growth. The reallocation of resources within multi-plant organisations is discussed further in the empirical section, but both firm and plant measures of entry and exit may be useful depending on the purpose of the study. In this review, the firm is the preferred unit of analysis rather than the plant, since this is of most interest to policy makers within the Department of Trade and Industry’s Small Business Service. However, the term firms may be used interchangeably with plant on occasion, particularly in reference to small firms. Where the distinction is important, it will be clearly made.

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In a large number of cases, firms are single plant enterprises and so the plant is equivalent to the firm.

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3.2 Types of entry and exit Another aspect surrounding the definition of churn relates to what is actually meant by entry and exit. Much of the theoretical literature starts with the underlying presumption that entry is start-up but the way in which entry takes place is largely determined by market conditions and is not limited solely to start-ups. Dunne, Roberts and Samuelson (1988), in their study for US manufacturing, identify three modes of entry: a) The creation of a new plant b) A change in product mix produced by an existing plant c) Buying a plant from an existing producer in the same industry. An additional distinction not made by Dunne et al (1988) is entry and exit by a firm from another industry (diversification). In his consideration of the definitional issues, Mueller (1991) distinguishes plant openings from firm openings and splits this former category into two: a) Entry by newly created firm b) Entry by existing firm that builds a new plant in the industry. Mueller (1991) further highlights the importance of distinguishing whether the entry in any of the above ways comes from a foreign-owned or from a domestic firm, a point also made by Baldwin and Gorecki (1987). We explore this in relation to ownership changes in section 8.3 but it can be seen there is a need to consider entry more broadly than start-ups. Exiting firms are generally less well explored in the empirical literature but the definition is still more complex than simply closures and the reallocation of resources. The definition of what constitutes an exit is also of crucial interest in the Schumpetarian model of creative destruction. As with entry, the mode of exit is not always as clear-cut as just focusing on bankruptcy, and may not necessarily be as disruptive. Baker and Kennedy (2002) consider the two main forms of exit as being takeover and financial distress (including bankruptcy). Their paper considers firms that de-listed from the New York and American Stock Exchanges over the period 1963-1995 and looks at market value of firms prior to exiting. They find that takeovers and financial distress are substitutes for resource reallocation, but evidence from the UK suggests

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that there are often other reasons for de-listing from stock markets or deregistering from VAT registers3. Storey (1994) shows that only 60 per cent of UK businesses are VAT registered in the early 1990s and thus studies that are based on VAT registers fail to account for 40 per cent of businesses which are exempt from VAT registration. He reports that only 58 per cent of firms that de-registered in 1987 actually went out of business, the remaining 42 per cent were either taken over, changed legal status or fell under the threshold for VAT registration. In this way it can be seen that not all exits are closures or bankruptcies. Over time, recorded exit and entry rates may change as a result in improvements in surveying techniques, thus it should be borne in mind that the correction of measurement errors may result in the exit or entry rates appearing to increase. In addition changes to the VAT threshold such those occurring in 1991 and 1993, may affect number of businesses recorded as registering and deregistrating for VAT. Changes to the tax regime may affect the incentive for businesses and self employed to incorporate as a firm. These changes are often administrative and lead to businesses and individuals reclassifying themselves rather than representing the creation of completely new businesses. In relation to the plant level, it should be remembered that the closure of plants within multiplant organisations might also feature in some of our measures of exits. Motivations for closures within multiplant organisations may be motivated by cost structures within a firm and the desire to merge some resources and not as the result of business failure. In summary, it can therefore be seen that the different types of entry and exit as mentioned above will take place under specific conditions for different reasons.

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Reason for VAT deregistration include the business decreasing in size to below the VAT threshold.

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3.3 The importance of industry The level and industrial classification at which industry dynamics effects are considered has implications for the observed level of churn. Entry and exit data measured at the aggregate level can be considered at a number of different levels. For instance, the industry sector can be measured at the 1digit SIC code e.g manufacturing or at a more disaggregated level such as 4digit SIC industry codes. There is evidence in the literature that shows the use of entry and exit rates at an aggregate level can be problematic. Baldwin and Gorecki (1989), and subsequent work by Baldwin (1995), examine the difference in entry and exit rates when measured at different industry levels. They identify the problem that a firm can enter one 4-digit industry without appearing to enter the manufacturing sector as whole because it had previously existed in another 4 digit SIC manufacturing industry. Confusions can arise when we consider the industry level at which churn is considered. We see that measurement from a higher aggregation is likely to hide reallocation. For example, a business producing glass bottles may choose to instead switch to producing plastic bottles. This would result in a reallocation of this production effort from one four-digit industry (e.g glass products) to another (e.g plastic productions). However, analysis at the one digit level (i.e. whole manufacturing) would not see the production effort shift. Thus, rates of churn measured at the more aggregate level are likely to be lower than the rate of churn at a more disaggregated level as firms enter and exit similar industries. In addition, there may be difficulties in classifying innovative new products.

3.4 The importance of time There are two ways in which time is relevant to economic churn. The first relates to the importance of the macro economy when looking at crosscountry comparisons of empirical findings, i.e. sensitivity of entry and exit to the business cycle. It is also important to recognise that when we are considering entry and exit, it is defined by some sort of reference period. This is relevant because the impact of entry and exit are likely to vary between the 13

long and the short run. This is particularly pertinent when considering the various modes of entry and exit since the employment and productivity impacts are likely to vary between the long and the short run. 3.5 Conclusions The definition of churn and, consequently, entry and exit is likely to vary across a number of factors, including industrial coverage (definition of coverage of industry), time reference period and specific mode of entry and exit. All of these factors need to be taken into account when making comparisons of empirical studies of churn.

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Measurement of entry, exit and churn
Having considered factors that relate to the definition of churn, our attention now turns to the ways in which entry and exit are measured. There are numerous ways to measure entry and exit, which largely depend on the data source used. There are also a number of measures of the combined effect, i.e. economic ‘churn’. Caution must be taken when comparing cross-country rates of entry and exit as the definitions and coverage of start-ups and closures differ, and may be the cause of any observed differential. It is possible that differences in churn rates across time and countries may be the result of measurement differences rather than real differences in the dynamic market. The question of how to define entry and exit and the focus of empirical research is largely determined by data availability contained in existing microeconomic datasets. Examples of datasets used for analysis include the LRD4 or the ARD/ABI5 and each dataset will have its own unique design; e.g. each plant/ firm has a unique identifier, the plants/firms are in the dataset year after year; any new plants/firms are thought to be entrants, and any missing plants/firms are assumed to be exitors. Studies based on VAT registers have minimum turnover threshold levels. Direct comparisons of empirical research are not always clear as the method of measuring churn used in the individual study will be an important factor for explaining the empirical results. Standard methods of measuring entry, exit and business turnover are defined in Ahn’s recent review of the empirical evidence for the OECD (2001). At its simplest, an entry rate is generally calculated as the number of industry entrants over a specific time period, divided by the total number of firms within the industry (the stock). Gross measures of entry and exit reflect how much entry or exit is taking place, which captures the level of turbulence in an
4 5

The US Longitudinal Respondents’ Database – a survey of manufacturing enterprises over time The UK Annual Respondents’ Database, subsequently the Annual Business Inquiry – a survey of manufacturing and subsequently service enterprises over time.

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industry. A net measure considers exits as negative entries, and captures the overall change in an industry over a specified period. This net measure reveals more about changes in competition than the gross measure. The turnover rate is the sum of the entry and exit rate in a given period and captures the overall churn effect. Determining which measure is the most appropriate to use depends on the purpose of the study. Geroski (1991) considers the rate of entry in UK manufacturing during the mid 1980s and suggests that the gross number of entrants overstates the actual importance of entry in the UK for 1983-1984. He argues that entry is likely to induce exit or, at the very least, the impact of a gross flow of entrants of any given size on market performance is greatly reduced when exit is high. Geroski (1991) goes on to point out that there is a positive correlation between entry and exit, which suggests that turnover rather than “net entry” may be a more useful measure of inter-industry variation in entry patterns. A further complication to the measurement issue is whether all entrants are valued equally or whether some sort of weighting system should be applied to entrants and exitors to take into account their relative size. An output variable, such as gross sales, may be used to weight entry or exit and is then termed the entry penetration rate. The entry penetration rate is generally much lower than the ‘gross’ entry rate, and is a way to measure the competitive challenge, since most of entry flows are composed of small firms seeking to occupy specialised market niches. Measures of market penetration are useful in measuring strength of competitive force associated with entry. Geroski (1991) focuses on entry, measured as the net market share penetration of new domestic firms in their year of entry. The rate of entry may be seen as an increase in the number of potential competitors and acts as a proxy for the competitive threat. A way of measuring the number of “effective competitors” is to count new firms that reach a given minimum size; another is to measure entry as a change in some numbers equivalent measure of concentration. 16

Baldwin and Gorecki (1991) study measurement problems of entry and exit for the Canadian manufacturing sector in the 1970s. They find that if year-to year data on entry and exit are examined and only a narrow definition of entry is used, the turnover process appears to be insignificant. They find that greenfield6 entrants at birth rarely account for more than 1 per cent of employment. They find that when “corporate organisation” (sale, acquisition) is added to greenfield entry and closed-down categories, the share of employment in entrants and exits doubles, although it can be seen that this still represents a small proportion of entry. Baldwin and Gorecki (1991) also find that industry specific effects largely determine the level of churn, as they compare US and Canadian industry entry and exit rates in manufacturing at the two-digit industry level. Factors that determine entry and exit rates across industry sectors include market demand conditions, barriers to entry (and exit), scale economies, and product life cycle stage. More recently, attention has turned to composite measures of entry and exit in order to net-out observed changes in the overall number of establishments. Audretsch and Fritsch (2002) introduce a volatility measure that combines the turbulence rate and the net entry rate by subtracting the latter from the former, effectively giving a net turbulence rate. This approach is adopted by van Stel (2005) to capture what he terms the ‘extent’ of business dynamics separately from the ‘composition’ of business dynamics, which he defines as net entry, in a regression model analysing employment growth in manufacturing in six OECD countries, 1994-2000. Exit rates are calculated in a similar fashion to entry, in that it is the number of firms exiting during a given time period, divided by the total number of firms in an industry (stock). As an alternative, an employment based exit rate can also be used, where the employment of exiting firms is divided by total industry employment. Exits can also be measured by the number of firms exiting or by their market shares, which reveals their competitive importance. A major
6

The term ‘Greenfield’ entry is often referred to in the foreign direct investment literature and means a brand new set up, as opposed to the acquisition of existing capital.

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problem with using a weighted measure of exits is highlighted by Baker and Kennedy (2002): the market value of exiting firms is likely to have been diminishing prior to exit and so may not be truly reflective of the resource capabilities that are leaving. In this regard, current market valuations may not be useful measures of productive capabilities of the resources of exiting firms. Another important measure is the growth rate of a continuing firm, which is based on a certain size variable such as employment, sales, or net assets. These types of measures allow the researcher to consider the probability of the firm surviving or dying but generally require more data than entry, exit and net effects. More sophisticated measures of industry dynamics involve tracing cohorts of firms through time in order to consider their hazard/survival rates. Survival is often reported instead of the exit rate and relates to the proportion of firms that are still in the industry x years on from entry. The survival rate is calculated as the share of surviving firms in a given year from a cohort, as a percentage of those surviving from the beginning of the year. Alternatively, others report the hazard rate which is the probability of exiting the industry. It measures the share of exiting firms in a given year from a cohort, as a percentage of the total number of survivors of the previous year. Both survival and hazard rates are exit measures and as such are only partial measures of churn, high levels of survival suggest low levels of churn, however in an expanding market, entry may be a significant component. Whilst survival rates identify the life span of new businesses, turnover rates are a more general measure of churn. Although they may be broadly correlated with one another, differences between the measures may exist when the decision to exit occurs at a certain point beyond which the survival rate covers.

4.1 Conclusions There are a number of ways in which entry and exit can be measured and the method chosen is dependent on data availability and the 18

purpose of the study. Jeong and Masson (1991) state that there is no single “correct” measure of entry, since “as a multifaceted phenomenon” each type of entry captures a different facet of entry, and this appears to be borne out by the numerous measurement options available. For instance, in young industries/economies a measure of net entrants can be a good measure of the effect of entry on competition. For more mature economies, some measure that weights the significance of entrants and exitors (e.g market shares) is likely to better capture the effects. Where issues relating to the competitive effect of entry and exit are important, a measure of market penetration is more enlightening, when the focus of the study relates to inter-industry dynamics an unweighted entry/exit rate may best explain behaviour.

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5.

Rates of churn7

The previous sections consider the importance of factors that relate to definition and the problems associated with measuring churn. With these caveats in mind this section goes on to consider recent empirical evidence of churn rates across countries and regions. Bartelsman et al (2005) make extensive efforts to harmonise entry and exit data across a wide number of countries. Table 5.1 illustrates their findings at the broad sector levels, although the paper provides details for two-digit industries. The data cover different periods, ranging from the early 1980s to 2001. The rates of churn in all industries appears to be around 20 per cent on average, slightly higher in services than in manufacturing industries, which may in part reflect the lower sunk costs that start-ups and exitors face in the service sector. Deviations from the cross-country average are in the form of ratios, so for example, the rate of firm turnover in the Canadian total economy is 1.05 times the average of 21.6 per cent. Table 5.1 reveals that higher than average levels of churn are generally associated with semi-industrial countries, with the exception of the UK. West German churn levels appear very low in comparison with other European countries, as do Argentina’s. Churn levels in Latvia are the furthest from the mean levels throughout. The findings provide some evidence to support the claim that economic stability is likely to lower churn, however the UK does appear to be an outlier8.

7

The table in the annex provides details of a number of empirical studies of churn, not only reporting rates of churn but highlighting the impact of churn, where available. 8 Micro data on the service sector for the UK has recently become more available, however the time series is limited, beginning only in 1997.

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Table 5.1: Gross firm turnover across countries and broad sectors as a ratio of the cross-country average Country Total Manufacturin Services Economy g Cross country average 21.6 19.0 22.7 Canada 1.05 0.91 1.04 Denmark 0.91 0.97 0.89 Finland 0.96 0.91 0.92 France 0.89 1.06 0.84 (West) Germany 0.76 0.61 Portugal 1.00 0.96 0.97 UK 1.24 USA 0.93 0.93 0.87 Industrial countries 0.90 0.89 0.89 Mexico 1.22 1.29 1.16 Slovenia 1.21 1.12 1.23 Hungary 1.21 1.17 1.23 Estonia 0.81 0.81 0.82 Brazil 1.31 Latvia 1.30 1.48 1.23 Romania 1.26 1.19 1.27 Argentina 0.75 0.78 0.75 Semi-industrial countries 1.16 1.18 1.14 Source: Adapted from Table 9, Bartelsman, Haltiwanger and Scarpetta (2005)

More detailed data in the paper (Bartelsman et al, 2005) shows that the sectors in UK manufacturing that have particularly high levels of churn are medical, optical and precision instruments, motor vehicles and food, drink and tobacco. The latter two sectors are traditional, declining manufacturing sectors which have arguably undergone restructuring in recent years, with high exit rates. The former is considered a high tech sector that may have been experiencing higher than average entry rates over the period. Bartelsman et al (2005) point out that industry effects largely hold across countries. That is, high churn sectors are consistent across countries, suggesting that the determinants of churn are similar, with factors such as technology and costs dominating over institutional differences. The Bartelsman et al (2005) study is the most comprehensive cross-country comparison of churn rates to date since it uses consistently constructed variable over a clearly defined time period. Where possible industry levels and churn definitions are harmonised to allow like with like comparisons to be 21

made. Given the complexity of such a data harmonisation process, due attention should be given to the possibility of measurement error and the potential for further refinements to be made. Other studies that focus on one or two countries over different time horizons, with different industry classifications and different definitions of churn make comparisons but they are considerably less meaningful (see Annex for further details of these studies). In summary we see considerable variability in the rates of churn across countries from a range of studies. Roberts and Tybout (1997) undertook a cross-country analysis of turnover rates for semi-industrial countries, including Chile, Columbia and Morocco. Although their findings may be less comparable to the UK, their analysis, which covered the 1980s, found an annual turnover rate in these countries of between 25 and 30 per cent in the manufacturing sector, which is consistent with the headline figures contained in Bartelsman et al (2005) study. Aw et al (1997) looked at entry and exit rates in Taiwan in three separate years, 1981, 1986 and 1991, tracing plants over time. They find that the exit rate over the 10-year period is 87 per cent. Haltiwanger (1997) considered the US between the 1977 and 1987 period and find that net entry accounts for 18 per cent of average industrial change over the period. For the UK the most notable study is that by Disney, Haskel and Heden (2003), which considered UK manufacturing establishments9 over the 1980-1992 period. They find that 65 per cent of new entrants have exited within 5 years, demonstrating the high correlation between entry and exit. Further evidence on churn rates is included in the Annex to this report. These studies give a number of important findings. Firstly there is high probability of new entrants exiting the market so that industry entry rates are often highly correlated with industry exit rates. The headline aggregate and broad industrial sectors figures of churn generally hide a great deal of variation that is prevalent at the more disaggregated industry level.

9

Measured at the reporting unit level of the ABI, that is, above the plant level, but below the firm level.

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5.1 Churn at the regional level We have seen that churn rates vary across industries and across countries, but within countries, churn is also likely to vary considerably. Evidence for the UK based on VAT registration data (SBS, 2006) is presented in Figure 5.1 below. London has the highest level of churn, at around 25.0 per cent. The South East, at 19.7%, is much closer to the UK average figure of 19.8%. The South West has a churn rate of 17.8%, which is the lowest churn rate of all the English regions. Wales has a churn rate of 17% and Northern Ireland’s churn rate is extremely low at just 14.7%. Regional variations may be attributed to differences in factor endowments (including available resources and enterprise culture), the availability of skilled labour, intensity of competition and a number of other location advantages. Thus it can be see that churn and regional performance are likely to be highly correlated with one another. In addition, regional churn rates may be influenced by the industrial structures located within that region. The regional dimension of start-ups is considered in greater detail in Section 9. Figure 5.1: Churn rate by region
United Kingdom Yorkshire and Humber East South West Northern Ireland North East East Midlands London Wales North West West Midlands South East Scotland

30% 25% Churn Rate 20% 15% 10% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: SBS analysis of VAT registration and deregistration data

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5.2 Conclusions In this section, we have considered rates of churn. We began by considering the most harmonised study available to provide crosscountry comparisons of the rates of churn in manufacturing and services. We find that at the industry level, rates of churn are persistent across countries, but also we find that at a more aggregated industrial level, there are variations across countries. This suggests that institutional factors affect aggregate measures of churn, but at the disaggregated level, there are similarities in the technological and cost structures across countries (Bartelsman et al, 2005). Similar differences exist at a regional level in the UK. Regional differences in churn are largely reflective of factor endowments and are highly correlated with the prosperity of a region, although consideration of the industrial composition and history may also be needed. Whilst ‘headline’ levels of churn are useful for comparisons of competitive and innovative environments, we are really concerned with the impact that churn has on the economy, through raising employment, firm and industry level productivity and ultimately raising economic growth.

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6. The impact of churn on the economy
Previous sections consider the process of churn, where and why it takes place, and its impact at the industry level, in terms of incumbent behaviour. Overall, entry and exit are viewed as positively contributing to improvements in resource allocation and use. The impact of churn will now be assessed through its effect on employment, firm and industry level productivity and economic growth.

6.1 Productivity The expectation is that churn will contribute positively to productivity. Much of the empirical focus on ‘churn’ has been on the Schumpeterian idea of creative destruction. However, it is clear from the theoretical literature that entry and exit (and hence churn) is considerably more than this. Empirical studies on the prevalence of churn suggest that a large proportion of churn is industry and market specific. The process of creative destruction has been at the centre of much of the existing empirical research at firm and establishment-level. The use of micro datasets over aggregate figures allows more sophisticated analysis and greater insight into the dynamic process than is possible with sectoral or macro data. Haltiwanger (1997) states:
“It is becoming increasingly apparent that changes in the key macro aggregates at cyclical and secular frequencies are best understood by tracking the evolution of the cross-sectional distribution of activity and changes at the micro level”.

The use of these types of data presents some advantages with respect to more aggregate comparisons in economic performance. Bartelsman et al (2005) highlight that “the firm dynamics approach has potentially a tighter theoretical link between specific institutional measures and relevant outcomes”.

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The growth in the use of micro panel datasets has enabled researchers to examine more accurately the birth and death of plants and the extent to which entry and exit of plants with different productivity levels contributes to industrylevel productivity growth and the connection to aggregate productivity growth (Bartelsman and Doms, 2000). Previous work by Harris and Robinson (2005) using longitudinal panel data for the UK considered manufacturing in the light of a specific government policy – the regional selective assistance (RSA) grant. Using a decomposition approach, they divided measures of productivity into various components that represented the impact of resource allocation across surviving plants as well the impact on productivity of the entry and exit of plants. Within the empirical literature that considers the impact of churn on productivity, two main approaches to entry and exit have been adopted; regression analysis and decomposition analysis. The former mostly involves hazard estimations and survival regressions but here we focus decomposition analysis as it offers greater insight into reallocation and productivity effects of churn. Decomposition analysis was developed by Baily et al (1994) and used in Foster, Haltiwanger and Krizan (1998)10. It decomposes measures of productivity into various components that represent the impact of resource allocation across surviving plants as well the impact on productivity of the entry and exit of plants. For the purpose of this review, we are really interested in the entry and exit effects. In their study of US manufacturing, Foster et al (1998) reach 4 major findings in relation to the link between churn and productivity growth: a) An ongoing pace of reallocation is considered a necessary element for the reallocation of resources to have an effect on aggregate productivity growth. b) The pace of this reallocation varies over time and across sectors c) Most of this reallocation reflects within rather than between sector reallocation.

10

Further discussion of this approach is available in Harris and Robinson (2001a).

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d) There are large and persistent differentials in the levels and the rates of growth of productivity across establishments within the same sector. Research by Haskel and Martin (2002) supports the Foster et al (1998) finding of a wide spread of firm productivity levels within industries and suggest that reducing the ‘spread’ of firms is an intuitively obvious way to raise productivity – i.e. if the least productive firms were made to exit. This is prompted by the empirical evidence of a ‘long tail’ in the distribution of productivity in UK manufacturing. They find that the labour productivity gap between the top and bottom decile is 5:1 and total factor productivity is 1.6:1 11. Further, they find that the overall productivity of manufacturing would rise by up to 10 per cent if the least productive firms performed at the median level.

6.2 Empirical studies of the productivity impact of churn Much of the empirical evidence reviewed in Section 3 relates to the motivation and consequences of the various modes of entry and exit. This section draws heavily on the table in the Annex, where the key empirical papers have been summarised. A number of review articles have concentrated on the role/impact of entry and exit in microeconomic analysis, and have tried to draw together the lessons learnt (see Caves, 1998; Tybout, 2000; Bartlesman and Doms, 2000; Haltiwanger, 2000 and Ahn, 2001). The findings of these key papers are summarised below. If we accept that churn in some way reflects both innovative and competitive pressures in a market, cross country comparisons of churn are a useful way of considering the relative levels of efficiency between nations. However, as we have already highlighted, the contribution of reallocation to productivity growth is also sensitive to measurement methodologies especially across countries. Bartelsman, Haltiwanger and Scarpetta (2005) argue that simple cross-country comparisons of the process of entry and exit may be
11

Note that the labour productivity measure suggests greater spread, but this in part captures different input ratios.

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misleading, since differences in market structures and institutions may indicate differences in the nature of the process of creative destruction, such as the composition of entering and exiting firms, rather than the absolute magnitude. For example, they consider a situation where high barriers to entry may not reduce the size of firm turnover but may affect the composition of entrants and exitors. When firms face higher entry costs, new firms may decide to enter on a smaller scale than they would otherwise to avoid specific regulations or enter at a larger scale in order to spread the large entry costs over a larger capital investment. Bartelsman, Haltiwanger and Scarpetta (2005) use harmonised data to show that while the ongoing process of restructuring and upgrading by incumbents is essential in raising aggregate productivity the net entry process also contributes positively to productivity growth. In their sample of more than 20 countries, they observe a stronger contribution of net entry to productivity growth in high-technology industries compared to those using low-technology, and the differences between these two groups varies significantly across countries. Thus, according to Bartelsman et al (2005) churn is more important for raising productivity in high technology industries. Evidence of the factors affecting the relationship between churn and productivity for the US is substantial. Baily, Hulten and Campbell (1992) discover that increasing (decreasing) output share in high productivity (low productivity) firms is directly related to productivity growth. However they find that entry and exit play a small role in industry growth when considered over a five-year period. Similarly, Haltiwanger (1997) finds that a shift in output towards plants that are also increasing their productivity is a major factor in accounting for the average industry productivity growth. Net entry is also found to play an important role. For the period 1977-1987, Haltiwanger (1997) reports that net entry accounts for about 10 percent of average industry change in productivity. These results are consistent with those in Olley and Pakes (1996). In their case study of the telecommunications equipment industry for the period 1974-1987, productivity increases followed after major

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restructuring of the industry. They attribute the gain to the reallocation of capital to more productive establishments. Foster, Haltiwanger and Krizan (1998) also consider the US manufacturing sector, 1977 to 1987, and find that reallocation from less productive exiting plants to more productive entering plants had a large impact on aggregate productivity growth. Although the existing empirical literature on the relationship between micro and aggregate productivity growth dynamics has so far exclusively focused on manufacturing industries, Foster et al (1998) are also able to present results for selected service industries and find that the contribution of net entry dominates. In a more recent study, Foster, Haltiwanger and Krizan (2002) show for the retail trade sector that net entry explains basically all labour productivity growth - without churning retail trade would not have exhibited productivity growth. Other studies for Chile, Colombia and Morocco (Liu 1993, and Roberts and Tybout 1997) find that entry, exit and market share reallocations among firms or plants within and industry contribute very little to productivity growth, generally because there are only small productivity differences between entering and exiting plants or these groups account for a small share of industry output. However, Aw, Chen and Roberts (1997) show evidence for the manufacturing sector in Taiwan that the churning of firms has been a significant source of productivity growth in Taiwan. For Korea, Hahn (2000) finds that plant entry and exit account for 45 per cent and 65 per cent respectively in manufacturing productivity growth. Martin and Jaumandreu (1999) provide an overview of entry and exit rates alongside productivity estimates (Total Factor Productivity). Whilst care should be taken in cross country comparisons, as highlighted in the previous sections, it can be seen that there is considerable variation, and whilst it appears that higher levels of TFP growth are associated with higher levels of churn, it is by no means clear that high levels of churn are necessarily likely to result in higher productivity growth (e.g Norway).

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Table 6.1: International comparisons of productivity and churn in manufacturing Entry rate Exit rate Churn (%)12 (%) (%) Belgium 3.4 5.8 6.3 12.1 Canada 0.4 4.0 4.8 8.8 France 1.9 5.0 3.9 8.9 Germany 1.3 3.8 4.6 8.4 Norway 1.0 8.2 8.7 16.9 UK 3.0 6.5 5.1 11.6 USA 1.3 7.7 7.0 14.7 Spain 2.7 7.3 9.7 17 Source: From Martin and Jaumandreu (1999), calculated using STAN (OECD) and Flows and Stocks of fixed capital (OECD). Country TFP (%) Evidence for the effect of churn on productivity improvements in the UK is relatively more sparse, but Disney Haskel and Heden (2003a) show for the period 1980-1992 that the contribution of entry and exit is 50 per cent of labour productivity and TFP growth in manufacturing. This arises because entrants are more productive than exiting firms. Much of this effect comes from multi-establishment firms closing down poorly performing plants and opening high-performing ones. They compare their findings to similar US studies for the period 1982-87, although they are cautious on drawing strong conclusions. They find that the impact of entry was almost the same but that the within establishment effect in the US was larger. In their analysis of UK manufacturing, Harris and Robinson (2001) show that entry and exit were important contributors to productivity in the UK between 1990 and1998 (mirroring US-based findings surveyed by Bartelsman and Doms, 2000). Using a decomposition approach, they find that entry accounts for 12 per cent of the increase in labour productivity over the 1990-1998 period in UK manufacturing and exits account for 4.5 per cent of labour productivity increase. Entry and exit together were responsible for over half of the 30 per cent increase in labour productivity over the 8-year period.

12

Churn rates compiled from aggregating entry and exits rates from the figures provided by Martin et

al

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Other country studies of interest include Griliches and Regev (1995), who show for a panel of Israeli industrial firms for the period 1979-1988 that most of the growth in aggregate productivity arose from productivity changes within firms rather than from entry, exit or differential growth. In a recent study for Canadian manufacturing sector during periods 1973-1979, 1979-1988 and 1988-97 Baldwin and Gu (2002) conclude that productivity growth within continuing plants is the predominant source of productivity growth. Plant turnover contributes between 15 and 25 per cent of labour productivity growth. Martin and Jaumandreu (2004) measure productivity growth using a growth accounting method and analyse its sources at the industry level for the Spanish manufacturing sector during the period 1979-1990 using a GMM regression approach. They find that the displacement of inefficient firms accounted for 80 per cent of productivity growth during the period. We can see from the findings of these studies that observed differences across countries reveal the importance of the temporal dimension when analysing the impact of reallocation on productivity. Our expectation that productivity and churn are positively related is dependent particularly on the time horizon. In the short run, turnover from entry and exit is thought to have a minimal impact on industry productivity growth. For this reason, a large number of cross sectional studies have found the impact to be small. In general, studies over a short horizon (e.g. Griliches and Regev 1995) tend to find a small contribution of net entry to aggregate productivity growth while studies over longer horizon find a larger role for net entry (e.g. Haltiwanger 1997, Aw, Chen and Roberts 1997). This has been attributed to the fact that exiting firms had below average productivity and entrants are likely to account for a small share of market activities (Caves 1998). In the longer run, firm turnover is thought to be very important for productivity gains and the new entrants that survive are thought to grow rapidly. It is important to note that the majority of studies mentioned focus on the manufacturing sector, which is experiencing a structural change in the UK. As such, these finding may be less relevant to the economy in general and caution is needed.

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6.3 Employment Volatility in the labour market is intrinsically linked with business startups and closures, together with multiplant firms opening and closing plants. This section reviews the literature that considers the relationship between economic churn and employment change. Measuring employment churn is complex because data for the numbers of jobs created and destroyed will include the employment of new entrants as well as increased employment from the growth of existing plants (Barnes and Haskel 2002). Where business churn is high this will be associated with higher earnings volatility and greater job uncertainty (Comin et al 2006). For example, lower company performance may lead to lower remuneration staff. Evidence shows that this may be consistent across occupations within a specific industry but there are larger variations in non-manufacturing firms. Data for the UK manufacturing sector finds that small establishments were responsible for 38 per cent of job destruction and over 50 per cent13 of job creation over the 1980s (Barnes and Haskel 2002). They also find that large establishments in UK manufacturing account for more of the total number of jobs destroyed but small establishments have (proportionately) higher job creation and destruction rates due to their higher entry and exit rates. It is important to note that job churn has costs. If we assume that all jobs are equally valuable, it could be argued that the net cost of job ‘churn’ is cost of re-creating a job in a different firm. However, as highlighted in section 2 of the review, markets may not function as efficiently as neoclassical economic theory suggests and this means that there are costs incurred while the market returns to equilibrium. Costs are incurred to individuals, businesses and the economy as a whole as agents take time to match workers to vacancies. There are also reasons to suggest that job destruction is selective, affecting the lower skilled more than higher skilled labour. This is in part related to new technology, which requires at least in the short run, higher skilled workers (O’Mahony et al, 2006). In addition, we need also to be aware that there are social costs to job churn. The cost of a destroyed job to an individual is
13

Exact figures depend on method of calculation

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positive, even if it is efficient at a firm or industry level (Caballero and Hammour 1998). The employment impact of new firms is not likely to be immediate. Storey (1994) states that firms reach peak employment 8 years after initial entry, but because of exits due to displacement and failure to establish, the maximum employment impact of a new cohort may vary. In contrast to the theory that the importance of entry grows over time, Fritsch et al (2004) state that
“the direct employment effect of new business formation is strongest in the year that follows the start-up. From the second year on this direct employment effect is abating. However, the direct employment effects of the annual cohorts accumulate over the years. In 2002… the employment share of businesses founded in the 18 preceding years account for about 25 per cent”.

The assumption of a strong relationship between new firm start-up and employment change underpins much government policy directed towards small business (van Stel and Storey 2004). New firms contribute a relatively small proportion to the stock of jobs and the scale of job creation in new firms varies considerably (van Stel and Storey 2004); Storey and Strange (1992; cited in van Stel and Storey, 2004) consider the employment contribution of new firms in the UK and find that only 2 per cent of new firms created 33 per cent of jobs in new firms. This might indicate the Government should target its business support on the 2% high quality start-ups, but this fails to take into account the indirect supply side effects that are prevalent, and may only become apparent in the long run. The employment gains from indirect supply side effects of new business formation are though to be much larger than the initial employment created in the newly founded business (Fritsch et al 2004). Supply side effects arise due to induced competitiveness arising from improvements in the structure of the industry. To summarise, churn contributes to volatility in the labour market. Although new business formation does lead to job creation, the contribution is relatively small due to many firms not growing or closing. Supply side effects may have a larger contribution to employment than initial business entry.

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6.4 Economic growth The evidence presented so far shows that economic churn may lead to improvements in productivity through reallocation of resources to more productive uses and also to increases in employment due to supply-side effects. It is therefore possible that churn, through these mechanisms, also contributes to economic growth and leads to economic prosperity. Chapter 10 gives further details on the use of top down approach approaches for assessing the impact of churn at the aggregate level. Although we are not aware of many studies that directly look at churn and economic growth, van Stel (2005) considers the impact of entrepreneurial activity and economic growth by combining sectoral data for industrial countries with micro data. Van Stel considers the extent to which the gap between actual and ‘optimal’ industry structure impacts on growth, where the optimal industry structure is defined in terms of the number of business owners or the small firm share in the value of shipments. His evidence suggests that those countries that have moved more rapidly towards a more decentralised industry structure have experienced higher growth. He concludes that there is a cost in terms of foregone economic growth of not adjusting industry structure towards the optimal structure and he also suggests that evolving economic conditions (e.g globalisation, deregulation and technological improvements) are conducive to less concentrated markets with greater opportunities for small enterprises.. Van Stel (2005) also considers whether total entrepreneurial activity (TEA) influences GDP growth. Making a comparison across counties and controlling for other factors. Van Stel shows that TEA has a positive impact on growth for relatively rich countries, although a negative effect for poorer ones. The latter may be due to insufficient presence of large firms important in the transforming developing to developed countries. He interprets the positive finding for industrial countries, after controlling for GCI (growth competitiveness index), as supporting the idea that entrepreneurial activity

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may be important in commercialising new technology and creating a healthy dynamic business environment. The impact of churn on economic growth has not been well researched in the literature. However, it follows that if churn has a positive impact on productivity, we would expect to see economic growth positively affected in the longer run. Total entrepreneurial activity has a positive impact on growth for wealthier countries but in the case of poorer nations, the link between entrepreneurial activity and growth is not positive.

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7. The costs of churn
Economic churn may be seen as indicative of a free and open market that is not hindered by barriers to entry or other distorting rigidities. Churning, however, can also be a turbulent process for firms and their employees. Reallocation of resources is not a smooth or immediate process as there are adjustment costs. Business closures are disruptive to supply chains, networks and the labour market. As well as representing the smoothly operating free market, economic churn may also be the result of distortions in the market, an outcome of business cycles and market failures. These are often put forward as a rationale for government intervention and grounds for industrial support that, in effect, often lowers the level of churn. It appears therefore that there is a need to consider the trade-off between the ‘bad’ socio-economic consequences of churn and the ‘good’ competitive effect. This section considers the theoretical evidence for there being an ‘optimal rate of churn’, defined broadly as the rate that maximises the gains of entry and exit, less the associated costs. The welfare considerations of entry and exit have not been extensively considered in the industrial economics literature. Caballero and Hammour (1998) consider this aspect of churn and focus on the costs associated with reallocating resources from one particular use to another. Where churn is an ongoing reallocation of resources there will be a ‘mal-adjustment cost’ when markets are not operating as efficiently as before. The welfare effect of churn to society is related to unemployment, productivity and set up costs. When churn is ‘efficient’, i.e. when it results in a better use of resources, the net effect is a productivity improvement, less the adjustment costs. The welfare of the economy is then decomposed into an unemployment cost and net productivity effect, where net productivity is defined as the costs and benefits from entry and exit. Destruction is estimated as the sum of three different exits:

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1. Passive destruction – units which fail for reasons beyond the control of the firm, e.g. limited access to capital markets 2. Privately efficient destruction (Schumpeterian) – units which fail because they hit a profitability constraint (i.e the means by which unproductive components of economy are removed through Plant closures, downsizing etc) 3. Privately inefficient destruction – failure due to financial constraints, either because of insufficient capitalisation or because they run out of internal funds to continue production. This may also be a result of market failures. Caballero and Hammour (1998) argue that if firms fail because of (imperfect) financial constraints (i.e. where liquidity is a problem), more efficient firms may be forced to leave the market but firms with better access to capital may be able to stay in the market even though they are less efficient. In this case, the churn of small businesses may not be productivity enhancing. This suggests that current government policy of identifying and targeting market failures affecting enterprise may help to maximise the benefits from any given level of churn. Care is needed when targeting SME policy to focus on the identified market failures and avoid supporting inefficient businesses that actually interferes with the beneficial churn process. Free entry is assumed to be desirable for social efficiency but, sunk costs can act as a form of deterrent, such that the number of firms under free entry may be either over or under the socially desirable level (Mankiw and Whinston 1986). In this case, finding an ‘optimal level’ of churn involves considering entry conditions and all the associated social costs that arise from the aggregation of individual businesses’ sunk costs. Free entry can be excessive (i.e. more than socially optimal), for example, in homogenous good markets with imperfect competition where firms do not act as price takers (i.e. there is a displacement effect with no additional gain in efficiency). In this case, there is an argument for entry restrictions. When product diversity is introduced, the effect of free entry is unclear and will depend on consumer preferences for variety and the share of market captured by new entrants. 37

In his industry study of movie theatres (a homogenous good), Davis (2002) finds that ‘business stealing’14 may account for 30-50 per cent of median revenues. While ‘excess’ entry is associated with some market expansion and consumer benefits, it is also an important factor in business bankruptcy. This highlights the trade off between business stealing and market expansion evident in economic churn, where regulating entry may be associated with an ‘optimal level’ of churn. Where fixed costs are high and the market size is fixed, payment of multiple fixed costs by all entrants until monopoly profits are dissipated into set-up costs results in a deadweight social loss (Mankiw and Whinston, 1986). This is demonstrated in an empirical study of radio broadcasting where, with large fixed costs and no marginal cost, free entry causes a welfare loss because of the benefit of additional choice to listeners is less than the total sunk costs paid (Berry and Waldfogel 1999). In both industry studies (Davis, 2001; Berry and Waldfogel, 1999), the optimal number of firms is estimated and then compared to the number in existence. Their suggested welfare effects highlight that where free entry leads to more firms than socially optimal, the resulting level of churn is inefficient, characterised by crowding out and inefficient payment of sunk costs without market improvements. The implications of this for government policy are significant. Santarelli and Vivarelli (2000) argue that subsidies designed to encourage entry bias market competition and are ultimately useless (because subsidised firms will leave when the subsidy stops) and temporarily harmful (where inefficient firms stay in the market and distort efficiency). This is confirmed by Harris and Robinson (2001) who considering plants assisted by the Regional Selective Assistance (RSA) programme. They find entry and exit of RSA supported plants played a significantly smaller role in improving productivity, with entry actually negatively contributing to labour productivity growth. These results suggest that RSA grants may have delayed the exit of less productive plants and, consequently, the reallocation of resources to new entrants. In other
14

Defined as when the equilibrium strategic response of existing firms to new entry results in their having a lower volume of sales (Mankiw and Whinston, 1986).

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circumstances, the case for government intervention is stronger. This is discussed in chapter 9. In his thesis, van Stel (2005) uses the volatility measure to test for evidence of an optimal rate of return, a point at which further churn has a negative impact on employment growth. However, he finds no evidence for an optimal churn rate on employment. 7.1 Conclusions This section has considered the costs associated with churn and identifies that there are situations in which the level of churn may be considered excessive. For example, when entry crowds out incumbent firms or with inefficient payment of sunk costs and no improvements in market performance. This is an under-researched area in the industrial economics literature, however it can be seen that the welfare effects of entry and exit are highly relevant, particularly in relation to appropriate government industrial policy.

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Alternative modes of entry and exit
So far in this review we have assumed the definition of entry and exit to be straightforward comprising of new business start-ups and closures. In Section 3 however, we established the complexities of definition and highlighted the importance of the mode of entry and exit for understanding the nature of churn. In this section of the review we elaborate on this point. It is first worth considering some of the fundamental factors facing (potential) entering or exiting firms. In so doing, the need to distinguish between the various ways of entering an industry becomes more apparent.

8.1 The entry decision In their review of the deterrents to competition, Caves and Porter (1977) list the factors influencing a firm’s decision to enter a market. These include: • • • • • • the profits earned by firms currently in the market structural barriers to entry the incumbents reaction to entry other members in the queue of potential entrants relevant resources in possession of the entrant sunk costs of gathering information and taking the decision.

The elements of the decision making process for entry are likely to impact differently for different modes of entry and their impact on market structure may be different. Gorecki (1975) finds that conventional structural entry barriers prevented new firms from entering UK manufacturing but not diversifying firms. One reason for this is that high levels of concentration in an industry are more likely to deter a new start-up than they are an existing firm in another market. It is likely that both fixed and sunk costs are more of a constraint for new entrants than for diversifying firms. This may be due to imperfections in capital markets, since a firm already established and intent

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on expanding its activities may be able to raise the capital required to establish a new plant at a lower cost than brand new entrants. Baldwin and Gorecki (1987) consider Canadian manufacturing (1970-1979) and also find that it is inaccurate to treat entry as only coming from newly established firms. They find that existing firms that enter via a merger or via new plant creation account for over half of entry when measured by the proportion of sales. Newly created plants tend to be small and plants acquired by diversified mergers are larger than average, thus the diversification and merger process is likely to place competitive pressure on the largest size classes in concentrated industries. In addition, whilst newly created plants might start at a smaller size than those created by established firms, they may experience higher growth if they survive (Geroski, 1995; Mata et al, 1995). The high correlation between entry and exit has been a recurring theme in this review. Siegfried and Evans (1994) show that entry of new business starts is related to the exit of firms that were new business starts in a previous time period, but is unrelated to the exit of firms that had originally entered through diversification. This suggests that new business starts may operate in different market segments than other firms in the industry. Small-scale entry is also likely if scale disadvantages for small firms disappear or decrease, or if small firms can implement an innovative strategy. An example of this would be where businesses are able to identify a niche market. The mode of entry and exit may also vary in importance by country. Schwalbach (1991) reports for German manufacturing industries between 1983 and 1985 and finds that entry and exit are more important in explaining the change in concentration than factors like mergers, internal expansion and firm displacement. On average he finds that the effect of entry and exit on concentration are limited. Baldwin and Gorecki (1991) analyse Canadian manufacturing at a detailed level (1970 to 1979) and focus on plant turnover (rather than firm turnover). They find that the process is dominated by firm entry (16.9 per cent) and exit (15.0 percent) rather than incumbent firm plant opening and closure (4.5 per cent and 5.0 per cent). In the short run they find 41

change associated with entry and exit is dominated by the expansion and contraction in the continuing sector. Whilst they find that in the long-run entry and exit both contribute positively to productivity growth, their results indicate that entrants have little effect on incumbents and basically replace other small firms that exit. Shepherd (1984) observed that large existing firms do not have to worry about entry, only about which of the large number of entrants will move out the fringe and challenge them and this seems to be borne out by Baldwin and Gorecki’s findings. Thus it can be seen that there is considerable empirical evidence within the churn literature to suggest that separate consideration of the modes of entry and exit are necessary if we are to understand how and why it takes place. The evidence suggests that the different sources of entry and exit have different determinants and impacts on the industry and economy as a whole. These differences also change over time so that the impact of new entry in the short run is unlikely to be as substantial as the impacts of diversification and changes in ownership. The following sections are devoted to exploring these differences, beginning with diversifying entrants, followed by changes in ownership. The subsequent chapter 9 goes on to consider business start-ups and closures in detail.

8.2 Entry by diversifying firms In their study of US manufacturing, Dunne, Roberts and Samuelson (1988) identify diversifying firms as those which produce in a different 4 digit manufacturing industry from the previous year. They also analyse their entry according to whether they entered through a new plant construction or by changing their product mix. Their empirical results show that most of the entering firms in an industry are newly created. However firms that enter through diversification are larger and represent almost half the market output, and thus they account for proportionately more of the market share of output by all ‘new entrants’. Further, diversifying firms with new plants account for a smaller number of exits and of market share but those that do exit are relatively larger than other types of exiting firms. Thus it can be seen that 42

diversifying entry is different to start-up entry and it is therefore pertinent to consider how and why existing firms decide to diversify and the reasons for their success, relative to new firms. Traditionally, all market entry decisions are modelled as being a function of firm and market attributes, as described above (Caves and Porter, 1977). Agarwal and Gort (1996) suggest that a combination of market attributes, such as growth in demand, barriers to entry, scale economies and probability of survival, should be considered in conjunction with stages of market evolution. This is because patterns of entry are not adequately explained in terms of U-shaped cost curves and responses to market growth. From this perspective, there may be several reasons why firms that diversify into a new market are at an advantage over entirely new entrants and why they may be better at exploiting existing resources or knowledge (Hines 1957). These include having better: • information about opportunities for profitable entry (as firms usually diversify into related industries, exploration of potential opportunities may be easier, and existing methods/procedures may be applied to new industry) • access to productive resources (firms may shift equipment/processes from one product to another more quickly than a new firm could establish them) and they are better positioned • ability to overcome immobilities and other frictions by relying on existing and known brands. Diversifying firms have the potential to enter markets at a smaller scale than new starts ups15. While entrants need to be competitive with industry incumbents, they will also want to enter at lowest scale possible to minimise investment and commitment (Hariharan and Brush 1999). Under uncertainty and where resources can easily be transferred between parent and diversified firms, diversifying firms may choose to enter a smaller scale than is competitively viable, i.e. below their Minimum Efficient Scale (MES), until uncertainty over their market performance is resolved. New entrants on the
15

This does not preclude the small scale entry of firms into niche markets; it will be dependent on market conditions.

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other hand have to enter at, or close to their MES in order to remain competitive (usually at the minimum point on their average total cost curve). Diversifying firms may instead use ‘factors’ already available to minimise fixed/sunk costs and operate at the point where average variable cost is at its lowest. This gives the new entrant through diversification an advantage, at least in the short run. Jovanovic and Gilbert (1993) suggest that the obvious reason for firms to diversify is to maximise efficiency – where managerial and R&D inputs can be better exploited among various activities. The choice to diversify is either resource based, to utilise excess capacity of assets such as R&D, managerial ability, customer relationships and brand reputation, or agency based, where diversification is related to the relationship between shareholders and managers and there is prestige associated with managing a larger firm or because it increases demand for managerial skills (Smith and Cooper, 1988, Gourlay and Seaton, 2004). Diversifying firms are likely to have better knowledge on minimising start-up costs and will recognise scope for shared activities (e.g. through R&D/advertising). Product life cycle effects are also likely to influence a firm’s decision to enter through diversification. Smith and Cooper (1988) consider diversifying firms which enter into a new market. Firms serving more mature markets achieve lower levels of performance than firms serving newer markets, but high performers tend to have access to a larger financial base and to have entered earlier. Smith and Cooper’s (1988) analysis suggests that firms will time their entry to exploit their relative strengths. Those with relevant technology experience entered the market earlier and shaped the development of the market, in contrast to firms with experience of large-scale production that entered later when consumer acceptance was clear. The impact of entry through diversification on existing firms is likely to be felt more keenly than entry through start-up. Existing firms may have a wide base of resources from which to diversify and may not be confounded by barriers to entry which deter new entrants. In addition, they may enter and exploit their 44

existing brand name enabling them to capture a larger market share than a new firm without an existing reputation. Large firms entering another market can displace business from incumbents but also widen the consumer base of a market by attracting new customers16. The importance of branding in diversified entry is an additional factor the entering firm may have which is not available to new start-up entrants. A brand name entering into a new market can have two effects on market shares of existing brands (Meisel 1981): • • An arithmetic effect – the amount by which the incumbents’ share changes upon the entry of a new brand. A behavioural effect – whereby a new brand entry initiates a non-price competitive mood in response to an entry disturbance. This ability to use branding in a new market has implications for start-up entry as it is likely to exacerbate existing barriers to entry. Empirical analysis of diversification as a means of entry is not extensive. Gourlay and Seaton (2004) provide a detailed look at diversification in the UK for a ten-year period and consider both the decision to diversify and the degree of diversification (i.e. number of different industries in which a firm may operate). Diversification is measured as operating in more than one three digit industry. They test whether firm size is a determinant of diversification, since large firms have access to more resources to pursue diversification strategies. They find this is true for most industries, with the notable exception of business services. However, other factors thought to be important, such as R&D activity and intensity, governance issues and labour productivity and wages, show no clear relationship across industries. Mata et al. (1995) analyse survival rates at the plant level in Portuguese manufacturing. They find that new plants from diversifying firms are larger than new plants (both single and multiplant) at entry but display lower survival and post-entry growth (showing very little change in their growth rate up to seven years after entry). However, this study also suggests that diversified
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I.e. we may see shifts in both the supply and the demand curves.

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firms’ current size has a significant and negative impact on plant age that is at odds with other empirical and theoretical studies. Thus it can be seen that entry through diversification is a significant component of entry. Firms that enter through this mode are more likely to survive since they have certain cost advantages which may aid entry and survival. In addition, firms that enter with an established reputation and brand are able to affect incumbents’ market shares and may potentially facilitate the expansion of the market.

8.3 Changes in ownership Takeovers, mergers or acquisitions17 are a form of reallocation of resources from the ownership of less to more efficient users, and in this respect the change in ownership may be seen to represent both an exit and an entry. However, there are competing theories of the motivation for takeovers and these have different implications for the impact that such changes in ownership are likely to have on productivity performance, in particular. Berkovitch and Narayanan (1993) condense the literature into three major motives: synergy, agency and hubris. The first of these relates to the economic gains from the merging of resources – the more efficient application of resources, economies of scale, etc. The agency motive relates to the growth maximising goal thought to be pursued by management to maximise their welfare (Baumol 1959; Firth 1980). Finally, hubris refers to the mistakes that management make in evaluating target firms, undertaking acquisitions that do not reap any synergy gains. This may relate to an unrealistic expectation of the cost of assimilation as well as incorrectly estimating the potential gains. The neoclassical approach assumes that takeovers and mergers are a form of natural selection (Meade 1968) whereby poorly managed and performing plants are taken over by more efficient firms. Much of this literature focuses
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These terms are used here interchangeably.

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on the role of the market for corporate control where, it is reasoned, the threat of takeover acts as a check on the managerial pursuit of maximising growth to the detriment of shareholder returns (Scherer, 1988). Attempts by managers to deviate too far from the objective of maximising stockholder returns are kept under control by the threat of takeover. This may be regarded as the ‘managerial discipline’ theory which predicts that plants will perform better following their acquisition. In an extension of this theory, Lichtenberg and Siegel (1987, 1990) focus on matches between enterprise unit and plant unit. The idea is similar to that in the theory of job search, as employees separate from their employers to find a better match. This also predicts that lower productivity plants are likely to be taken over. Jensen (1988) argues that takeovers occur in response to changes in technology and market conditions where major restructuring of corporate assets is required. Acquiring firms will benefit in the long run from economies of scale and other synergies (Jensen, 1988). An alternative explanation is provided by McGuckin and Nguyen (1995), who put forward an ‘operating efficiency’ explanation for acquisition whereby acquisitions are motivated by the need to acquire operating efficiency in a new industry or in a new country. This is fundamentally different from the managerial discipline hypothesis since it predicts that higher productivity plants are more likely targets than low productivity plants. Takeovers motivated by the managerial discipline motive are thought to benefit both the target and the instigating firm, in the form of more efficient applications of resources and the potential for savings through economies of scale. Merged firms are likely to require only one personnel department, R&D activities can be streamlined as they are combined, etc. Mergers that are motivated by the desire for market share should in theory increase monopoly power, to the detriment of society as a whole. Indeed, takeovers may also be wasteful if resources are devoted to preventing hostile bids. In addition there are costs associated with acquiring existing organisational structures and management practices (Penrose, 1959). These adjustment costs are thought to be short term but are likely to weaken the relationship between performance and acquisition that is predicted by the managerial discipline hypothesis. 47

These competing theories of the motivation for takeovers are of interest particularly in relation to entrants (and exitors) who have a choice of mode of entry or exit, since the theories differ in their predictions for performance post takeover. This has implications for policy recommendations. Caves (1998) argues that takeovers as a mode of entry and exit is not likely to alter industry behaviour. It is also worth noting that larger plants generally favour this mode of entry. Baldwin and Gorecki (1991) find that small firms tend to favour plant openings whereas large firms generally enter through (foreign) acquisitions. Characteristics of firms that favour this mode of entry are explored in more detail in the empirical literature considered below. The empirical evidence on the nature of takeovers and the consequences for acquired and acquiring firms is mixed. A strand of the literature focuses on the impact that takeovers has on stock market valuations for both the acquiring enterprise and the target. Another strand of the literature concentrates on the productivity impact of takeovers, using microeconomic panel data. Whilst we have considered the former in our reading, the latter is more pertinent to our analysis. Much of the existing evidence relates to the US. Ravenscraft and Scherer (1987) and Matsusaka (1993) both find that acquired firms were highly profitable before acquisition with little or no gain to the acquiring firm postacquisition. Ravenscraft and Scherer (1987) also find that there is no clear evidence of a productivity enhancing effect for the acquired plant. In contrast, Berkovitch and Narayanan (1993) look at the US between 1963 and 1988 using a financial approach (as opposed to a productivity approach) and conclude that on average, there are positive gains to the stock market valuation of the business in around three quarters of takeovers, which they take to mean that the synergy effect dominates. Additional explanations for the ambiguity of the findings include adjustment costs and also other objectives of takeovers than to improve the efficiency of the target firm. These other objectives might include the need to gain access 48

to a market, particularly in the case of Foreign Direct Investment (FDI), and the desire to acquire firm specific attributes such as technology. Harris and Robinson (2002) consider the motivations behind foreign acquisitions and the subsequent productivity performance post-acquisition. Their findings for the UK indicate that the most productive domestically owned plants were acquired by foreign owned businesses. Indeed, plants that were acquired by foreign firms compared to those that did not change ownership (i.e they continued to be domestically owned) were 41 per cent more productive. Their findings of ‘cherry-picking’ support the operational efficiency hypothesis. However, the findings vary by industry and the managerial discipline hypothesis seems to hold for some of the more traditional manufacturing sectors. Feliciano and Lipsey (2002) also look specifically at foreign entry through takeovers. They consider the US and state that foreign acquisitions are likely in industries that have low average annual growth rates in value added, higher capital to labour ratios, lower market concentration ratios and lower import tariff rates. A key policy motivation for the encouragement of FDI is the new technology that such firms are thought to bring to the domestic market via spillovers of technology and best-practice management and production processes. A recent paper by Jovanovic and Rousseau (2002) specifically compares the relationship between entry and exits and mergers and the introduction of general purpose technologies. They argue that mergers and takeovers are a means of speeding up technology transfer, and focus on the US economy during two periods of rapid technology diffusion: 1890-1930 and 1971-2001. They find that mergers do result in the reallocation of capital to more productive purposes and to more efficient management. They also acknowledge that adjustment costs, in terms of upgrading technologies have risen substantially over time, which they say reflects the rising importance of organisational capital and teamwork in the production process. It follows therefore that if these have become more important, the cost of destroying them through exit has also risen. In summary, changes in business ownership are part of the reallocation process of churn, as assets are reallocated from existing producers to other, 49

more efficient owners. There are competing reasons for acquisitions that lead to different predictions as to the relative productivity levels of the acquired plant and their subsequent performance, post acquisition. In addition, foreign firms are likely to acquire plants for different reasons to domestic firms. There are also likely to be industry differences dependent on product life cycle differences. As a means of churn, it is argued that this is less disruptive than the more traditional modes of entry and exit.

8.4 Modes of exit By their nature, the characteristics of exiting firms are more difficult to observe and characterise as they are no longer in existence. The biggest area of analysis relates to survivorship and the hazards of exit. Baker and Kennedy (2002) highlight two modes of exit – takeovers and financial distress. They provide some empirical evidence to support a theory that the two are substitutable mechanisms for reallocation of resources. Takeovers have been considered in the previous section, as a form of entry, but we did consider the evidence of which type of plant was most likely to be takeover. In contrast to the belief that the least efficient plants are acquired, in line with the managerial discipline argument, there was significant support for the idea that cherry picking took place in the case of acquisitions of UK firms by foreign firms (Harris and Robinson, 2002). Daly (1992) looked at business failure statistics and found that in the longer run, only liquidations followed the business cycle trends, other forms of exits followed very different patterns, not altogether consistent with macroeconomic conditions.

8.5 Conclusions This section has been devoted to considering the motivation for different modes of entry and exit. We highlight three modes of entry that are considered in the literature: diversification, changes of ownership and the traditional start-up entry. The first two of these three modes generally result in larger entrants than start-ups and these modes of entry have a higher probability of survival. Whilst exits form a much

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smaller part of the literature it is clear that the reallocation of resources need not always be the result of business failure. This is particularly pertinent when churn is considered at the plant level, as opposed to the firm level, since reallocation of resources within firms is considerably less transparent but is thought to be responsible for a substantial proportion of churn

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9. Start-ups and closures: the UK experience
This section begins with the theoretical underpinnings on why firms exist. This is covered extensively in Harris and Robinson (2001b) but here we highlight the two models of the firm; the resource based model and the evolutionary approach. Understanding the nature of the firm provides insights into why start-ups and closures take place, and also on how best government policy can affect numbers of start-ups and closures. We then go on to review the literature on the determinants of start-ups. Emphasis is naturally given to small start-ups and, consequently, the distinction between the environment facing small entering firms in contrast to that faced by the larger incumbent firms. Technology and innovation and their contributions to employment, firm survival and, ultimately, productivity growth are key areas to explore in both frameworks, as is the ability to identify ‘high quality’ start-ups. The previous section highlighted the importance of alternative modes of entry, other than start-ups. The aim in this section is to explore the motivation behind business start-ups and closures and their contribution to churn, with particular emphasis on the UK. The relationships between start-ups, closures and economic churn is also investigated at the regional level to identify the role that regional clusters can play in fostering an environment in which innovative firms can grow. Implicit in much of the discussion below is that start-ups comprise of small firms, but it is important to note that not all small firms are new to the industry. The relationship between growth and survival has been discussed but a large number of small firms continue to exist in the longer run without substantial growth. As early as the Bolton Report (1971), and more recently in the Small Business Council Annual Report, 2004, the role of small firms to the UK economy has been considered. Their contribution is recognised as filling niche markets and providing a mechanism for competition to flourish, but also by keeping open channels of entry for business with new ideas and products.

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A common theme in the start-up literature is that small firms have a very high mortality rate. Thus, we consider survival rates and the factors that influence survival. One of the main findings in the literature is that a key way to survive is to grow. Given this, time is devoted to considering the relationship between size and growth. The review then goes on to consider business closures. It should be pointed out that many of the conditions that determine entry and survival are also likely to impact on the decision to exit an industry. This section will however avoid as far as possible repetition of material presented elsewhere in this report. Following on from the review of the business start-ups, survival and closure literature, this chapter goes on to consider relevant UK industrial policy, its evolution over the past 20 years and its success in encouraging entry and facilitating exit, where appropriate. From a societal perspective, entry is essential for long-term economic growth. ‘New business creation is an integral component of an entrepreneurial and dynamic economy’ (Atherton, 2006). As such, firm start-ups are viewed as fundamental sources of new wealth and jobs, leading to an overall improvement in competitiveness. Conversely, business closures free up the resources necessary for reallocation, either elsewhere in the same industry, or elsewhere in the economy, and are an equally crucial part of the dynamic process of resource reallocation. Governments have long been concerned with the encouragement of conditions conducive to new business growth and development. However, Government policy on ‘assisting closure’ is less likely due to the political considerations making it less viable. There are indirect ways that government policy can assist the closure process to make it more straightforward and less traumatic. For example, changes to the bankruptcy laws were seen to have a significantly positive effect on start-ups as a consequence of the fact that many entrepreneurs try, try and try again (Storey, 1994). We also consider here some of the key recommendations that have been presented in the recent policy literature.

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In summary, the evidence suggests that influences on start-ups and closures can be divided into two sources: environmental and firm related factors. Environment is broadly defined here to reflect regional endowments in terms of resources, human capital levels and transport and communications, industrial structure and characteristics, and macroeconomic conditions. Firm related factors include entrepreneurial ability and innovation. A resource based theory of the firm emphasises the importance of the latter factors and sees scope for firm level support policies. A more evolutionary approach (Metcalfe and Georghiou, 1997) emphasises the environmental conditions and would thus advocate more general policy interventions that target improving the environment in which firms operate by fostering cooperation and the development of clusters, enhancing the skills base, improving access to finance and assisting small businesses in their acquisition of knowledge.

9.1 Competing theories of the firm There is a need to consider exactly what constitutes ‘a business’ or a firm in order to answer the question of what determines start-ups from the entrepreneurial perspective. Harris and Robinson (2001) consider the theory of the dynamic firm literature in relation to the determinants of impediments to business growth and development. They consider the Coasian rationale for internalising many of the production processes into a single ‘firm’ to lower transactions costs between different parts of the supply chain. In this review, they also highlight the important contribution of the theory of the resourcebased firm (Teece, 1986). This theory views the firm as a bundle of firmspecific assets, comprising management know-how, technology, processes and practices, etc. These assets are firm specific and do not readily transfer through the market, hence the role of the firm as the unit of organisation. It is useful to view the firm in this context since a firm’s ability to succeed is determined by its technological ability to profitably produce products for which there is a demand and where the technological ability is broadly defined to include managerial and organisational practices. In order to consider the determinants of business start-ups, we need to consider a potential entrant’s

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endowments, not only in terms of finance but more broadly defined to include technological know-how, skills and management ability. An alternative, evolutionary model of the firm is put forward by Metcalfe and Georghiou (1997) where the firm is identified as the key agent for technical change. Innovations arise from within the firm and are due to technological and market knowledge (both of which are cumulatively built up through the acquisition of sunk intellectual and institutional capital). This model identifies the role of the firm as being to draw together entrepreneurial conjectures about the market and technology. Thus the model predicts a heterogeneous industry with firm growth being largely stochastic, i.e. industries are diverse in terms of their make-up and firms within industries experience unpredictable and diverse growth patterns. Considering this model, Harris and Robinson (2001) argue if firm behaviour is too complex and idiosyncratic to influence, policy emphasis should be placed on creating the infrastructure in the form of networks and institutions. These two models differ primarily in their interpretation of the relationship between innovation and the firm. The resource-based model stresses the importance of firm specific assets, the evolutionary model emphasises the stochastic process of innovation within the firm in the context of the wider market. The policy implications from these two theories are different, since the former identifies the firm as being a target for policy, whereas the latter suggests that policy should target the environment and not the firm. With these differences in mind, this section now goes on to consider the importance of business start-ups.

9.2 Business start-ups Conceptually, new start-ups are the simplest component of entry and churn. As previously highlighted, business start-ups are thought to be the major source of new employment opportunities, innovation and competition. Entry encourages competition, weakens market power and is likely to result in product and process innovation (Love, 1996). Start-ups are typically small and 55

medium sized businesses and these have received continued attention because of their growth in numbers since the early 1980s in the UK. SMEs account for a substantial proportion of net employment growth in the UK (Keeble 1997), especially the service sector (Patten, 1997). However, in international comparisons, the share of employment in small firms (with less than 100 employees) has been lower in the UK and US than in Italy and Japan since the 1970s (Patten 1997). This suggests that market conditions in Italy and Japan may be more conducive to business start-ups than in the UK and US, or that there are fundamental differences in the nature of the startups across countries. These differences may relate to wider environmental conditions and the nature of entrepreneurship, for example. Start-up rates, like entry and exit rates, vary over time, country/region and industry; Storey has estimated that in 1990, 14 per cent of all businesses had registered as new in the previous 12 months; recent internal unpublished work by the Small Business Service in 2006 shows the evolution of start-up rates in the more recent period, by UK region which shows the average start-up rate of about 10 per cent18. The variability in birth rates is determined by macroeconomic conditions, industry conditions and location, and these are considered further below. Differences in birth rate across different studies may be due to differences in the way the data are collected and the definition of business start-up. Entry by newly created firms seems to be the most common form of entry in most industries in the UK. The annual entry rates in the UK for the period 1974-1979 varied from 2.5 per cent to 14.5 per cent in 87 three digit manufacturing, with average rates ranging from 1.5 per cent to 6.4 per cent (Geroski 1995). Disney et al (2003) find that for the period 19861991 the average rates range from 9.7 per cent of the sector man-made fibres to around 14 per cent for metals. Both macroeconomic and microeconomic factors are thought to affect the creation of new firms (Highfield and Smiley 1987) and the importance of newly created firms is evident for a wide range of countries. In the US, the averages of five year entry rates at the four digit industrial breakdown varied from 41.4
18

Both sources cite VAT records as their metric.

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per cent and 51.8 per cent between 1963 and 1982, with average penetration rates ranging from 13.9 per cent to 18.8 per cent (Dunne et al. 1988). Lay (2003) considers two effects of entry and exit on the market: a replacement effect, by which high industry failure encourages new entrants to replace failing firms and a displacement effect by which more efficient entrants displace less efficient ones. In an empirical study of the Taiwanese manufacturing sector for the period 1987-1998, Lay (2003) found an average entry rate across industry of 13.47 per cent and an average exit rate of 12.8 per cent and suggested there was evidence of a moderate displacement effect. This was partly due to government support schemes which encouraged entry but also increased industry failure rates. Where government support allowed potential entrants to establish their businesses and to distribute their products easily, it also allowed inefficient firms to survive longer than they would have otherwise, resulting in high failure rates later on. In their review paper, Bartelsman et al (2005) argue that the cross-country differences in firm size may be the result of specialization towards industries with small efficient scale, i.e. niche markets. Among industrial countries, the US has a very high proportion of industries with firm size above average both in manufacturing and services. Western European countries however tend to have smaller firms in most industries, with exceptions in heavy industries in Germany and Portugal, high-tech industries in Finland, some low-tech industries in UK or in basic services in France and Portugal. When the costs of entering a market are not recoverable firms will be discouraged from entering and existing firms may have a lower probability of failure because of the reduced competitive pressure. The effects of entry sunk costs and the interactions between firm entry and exit are analysed in a number of US based studies (Shapiro and Khemani 1987; Dunne and Roberts 1991). Kessides (1986) tests the influence of sunk costs on entry in US manufacturing for census years 1972 and 1982. He finds that sunk costs impose an asymmetry in the incremental cost and risk faced by an entrant and incumbent. Mata (1991) tests the impact of sunk costs on entry for the 57

Portuguese

manufacturing

sector

for

period

1979-1982.

He

finds,

paradoxically, that sunk costs seem to be important only for large entrants. Despite ease of entry, small-scale entrants generally have short life expectancy (Mueller 1991). In their review, Bartelsman et al (2005) found that about 20 to 40 per cent of entering firms fail within the first two years of life (for a sample of 20 countries). This suggests that even if entry in an industry occurs frequently, survival for small entrants can be particularly difficult. The fact that an industry experiences high rates of entry is not incompatible with the idea of barriers of entry, since they can act as obstacles preventing firms from surviving rather than from entering. A number of other empirical studies also reveal a high correlation between entry and exit across industries (Shapiro and Khemani 1987, Geroski 1995). In his review Ahn (2001) reports that in the US, 60 per cent of the entrants exited within five years and 80 per cent within ten years. In Portugal over 20 per cent of new plants exited during their first year and only 30 per cent of the population survived for seven years. In Canada, 40 per cent of the cohort entrants in 1971 were still alive in 1982. The variation in survival across countries may be due to institutional factors or the nature of the study. Further analysis into reasons for exiting might shed more light on this. Geroski (1991) argues that low survival rates may be the result of a learning and selection process or of the entrants’ over-optimistic predictions regarding post-entry returns. The empirical result that de novo entrants have higher failure rates supports this hypothesis. In the context of a neoclassical model, the probability of a firm’s survival for a given interval of time is dependant on certain market attributes but also on the individual firm.

9.2.1 The case for entrepreneurship If survival is in part determined by the internal competences of the firm then it is worth devoting some time to considering the role of entrepreneurship in driving start-ups. Indeed, the line between self-employment, entrepreneurship and business start-ups is blurred. Recent qualitative research presented by 58

Cosh (2006) reveals the motivations behind business start-ups. He found that 70 per cent of business owners gave the desire to run their own business as the predominant reason for self-employment. Other reasons given include unemployment (as the alternative, particularly prevalent in the management buy-out form of start-up; 21 per cent), the desire to implement a new idea (27 per cent) and wealth ambitions of the founder (27 per cent). The desire to implement a new idea was associated with new, fast growth, innovative firms (Cosh 2006). A small proportion of the total responses to the CBR survey cite a novel product or process as the key motivation for start-up (a technology/process firm-specific asset to exploit), which may be a contributory factor to the high failure rate of start-ups. The choice of whether to become self-employed is also determined by the macroeconomic environment. In periods of high unemployment, the opportunity cost to the individual is lower than in times of relatively high employment (recession push) (Storey, 1994). Conversely, there are other theories that suggest that business start-ups are driven by high aggregate demand since firms are attracted by market opportunities (demand pull). Both views undoubtedly have credence in different cases of start-ups over the business cycle. GEM also makes this distinction between necessity and opportunistic entrepreneurship. Overall though there are a number of ‘environmental factors’ that impact on the decision to become self employed/set up a new firm, and these are summarised by Storey (1994): • • • • • • • • population and characteristics unemployment wealth qualifications and occupations characteristics of the enterprises in the area housing local government industrial policy

These environmental factors can be grouped into location endowments (such as population density, clusters of similar industries and firms, local planning regulations, transport, communications and infrastructure, national industrial policy – often determined by geographic location) and individual endowments

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that are associated with the entrepreneur i.e. wealth, qualifications and experience. This grouping broadly corresponds to the policy choices facing governments wishing to assist start-ups. Dealing firstly with individual endowments, there is a whole body of literature within labour economics that focuses on the sociological determinants of entrepreneurs; for example, their age, their family background, their education levels, or their ethnicity. A recent review article by Georgellis, Sessions and Tsitsianis (2005) provides a detailed discussion of the empirical literature that considers factors that affect the decision to move into self-employment. They consider 6 factors in detail: financial capital, relative earnings before and after the move to self-employment, intergenerational issues, personal characteristics, labour market hardship and immigration. These are discussed in some detail below. We discuss elsewhere barriers to entry in the form of restricted access to capital, however, in their paper, (Georgellis et al 2005) highlight the fact that this can in many respects be associated with initial endowments of capital (in the form of gifts and inheritance, etc), as opposed to the venture capital market. Their survey of this literature highlights the importance of family wealth and studies indicate that this has a positive but non-linear impact on the probability of choosing to enter self-employment (Evans and Jovanovic, 1989; Hotz-Eaking, Joulfaian and Rosen, 1994, cited in Georgellis et al, 2005). The finding of non-linearity is appealing since it reflects the need for sufficient capital to make the venture viable but as the amount of wealth increases the effect of the preference for leisure offsets the desire to work. Another source of capital that has been found to be significantly positive on the choice to become self-employed is homeownership, since properties are often used as collateral for loans and homeowners may be able to release equity built up in their homes. Finally, the correlation between wealth and selfemployment may be the result of wealthy people being generally less risk averse and therefore more likely to undertake entrepreneurial activity (Blanchflower and Oswald, 1998).

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Another determinant of the propensity to become self-employed is social capital. This is largely determined by family background and it may be argued is fundamental to an entrepreneur’s ability to succeed. Georgellis et al (2005) stress the role played by the labour market status of parents in accounting for intergenerational transfers of human capital and entrepreneurial ability. They argue that the psychological barriers are less strong in people with selfemployed parents. Perhaps more the tangible family impact relates to where businesses are inherited. They go on to consider intergenerational links by gender and race and report that having a self employed father is more likely to result in self employment amongst ethnic minorities (from Fairlie 1999). Earnings both prior to and post self-employment have been another key area explored in the empirical literature. If wages are considered to be representative of the opportunity cost facing an individual considering leaving employment for self employment, this implies that higher wage earners are less likely to enter self employment. The role played by experience, education and tenure in determining the earnings of the self employed have been explored, however these have been found to be significantly less important factors in relation to self employed earnings compared with employees. Evans and Jovanovic (1989) find that self employed earnings and initial capital assets are positively correlated, which Georgellis et al (2005) suggests that ‘wealthier people start businesses with more efficient capital levels. These two findings taken together suggest that even if lower wage individuals enter self-employment, it is the wealthier that are more likely to survive. It has been argued that assessing the impact of any variable on self employed earnings is likely to be problematic because of the tendency to under-report. However, work by Parker (1999) weights earnings to adjust for underreporting and finds similar results with and without weights, suggesting that underreporting does not affect the underlying relationship in the earnings function. In terms of individual characteristics, Lucas (1978) argues that education enhances managerial skills and therefore increases the likelihood of survival. 61

Indirectly, human capital may enhance the entrepreneur’s ability to raise external finance, in which case more educated entrepreneurs may be more likely to survive than those less educated. This suggests that quality of entrepreneur and start up may also have an effect on survival and growth of the business, and may be an area that policy makers want to consider further. Another aspect to consider is the specificity of the human capital. The empirical results discussed in Georgellis et al (2005) suggest there is a positive correlation between education and self-employment but the correlation between education, earnings, wealth and occupation is likely to lead to bias in estimates of the individual effects. Age is negatively associated with the decision to enter self employment and older individuals appear to be less likely to take risks (Georgellis et al, 2005). However, while younger people on average are more inclined to enter self employment, the average age of the self employed is found to be higher than the employed workforce. This implies that survival is assisted by the experience that comes with age. Theoretical models of entry highlight that entrepreneurs do not know how suited they are to their pursuit until after entry, hence the high levels of exit associated with new start-ups. However, labour market experience is thought to be positively associated with start-ups. Job tenure, on the other hand, is negatively correlated with self-employment (Evans and Jovanovic, 1989). In addition to employment experience, Georgellis et al (2005) cite selfemployment experience as being particularly positively correlated with selfemployment. Understanding this tendency to ‘try and try again’ may be particularly pertinent for policy considerations, including issues surrounding the quality of the entrepreneur and start up.

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9.2.2 Industry conditions The most obvious determinant of entry is profitability in an industry. Entrepreneurs will be attracted to an industry if they perceive there to be profits to be captured, which are a function of existing producers not satisfying consumer demand either through not providing the right product/service or not producing enough of an existing product/service. This may be the result of the stage in the product life cycle; a young product/industry will attract entrants as the existing producers cannot satisfy demand, or it may be the result of innovation and/or the identification of a niche market. The role that innovation and technology plays (broadly defined) in generating entry is therefore crucial (Harris and Robinson 2001b). For example, if, as a result of innovative entry, we see an increase in the size of the market, this may also raise the profitability of incumbents and thus encourage entry further, leading to a fall in market concentration. A negative correlation between the size of the market and the concentration has been considered to hold across industries generally. However Sutton (1991) argues that this link is only valid for certain group of industries, specifically, it does not include those industries in which advertising and R&D outlays play a significant role. In this context, advertising and R&D can be both thought of as sunk costs incurred by the firms with a view to enhancing consumers’ willingness to pay for the firms’ products. Theoretically, there exists a lower bound to the equilibrium level of concentration in these industries, no matter how large the market becomes. The level of this lower bound depends on the degree of demand responsiveness to the firms’ increases in advertising and/or R&D. The higher the degree of responsiveness the higher will be this lower bound to concentration levels in the industry. structure. In other industries in which sunk costs are exogenous to the firms and firms offer a more homogeneous product, as the size of the market increases the number of firms entering the market increases and concentration declines Under these circumstances increases in market size cannot lead to a fragmented market

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indefinitely. Sutton analyses the way in which market size/market structure relationship will vary between industries in which sunk costs are exogenously given and those in which endogenous sunk costs play an important role. In order to do this he focuses in the food and drink sectors (two-digit SIC level), since this sector has one of the lowest levels of R&D intensity together with the highest levels of advertising intensity. This makes it possible to undertake analysis on the effects of advertising on the market structure treating advertising as an endogenous sunk cost, separate from R&D. The study covers the following countries: United States Japan, Germany, France, United Kingdom and Italy. He finds some evidence within advertising-intensive industries (frozen food, beer, pet food) that the minimal level of concentration is not zero and is independent of the market size. On the contrary in advertising non-intensive industries (salt, sugar, flour, canned vegetables, bread, processed meat) he finds evidence that the minimal level of concentration decreases to zero as the size of the market relative to the level of set up costs increases. Thus, a general conclusion to be drawn from Sutton (1991) is that industry conditions are a major determinant of entry and exit since they determine the nature of sunk costs such as R&D expenditure and/or advertising.

9.2.3 Concentration Traditionally, the more concentrated an industry, the less likely firms are to enter. This is particularly true in relation to start-up entry as the establishments are generally smaller. Geroski and Murfin (1991), in their analysis of entry into the UK car industry, highlight the fact that entry into a market need not necessarily be complete, but that entry through strategic niches might be a more appropriate way to enter particularly concentrated industries. In car manufacturing, the majority of entrants in the 1980s targeted the large and medium size car market and then after a lag of a year or so, entered the small car market (Geroski and Murfin, 1991). They also note that price competition in the car industry is very weak, emphasising the importance of post-entry advertising expenditure as a key determinant of entry. In this 64

example however, entry is most likely through an alternative mode to start-up such as merger or takeover.

9.2.4 Barriers to entry Start-ups can only take place once a potential entrepreneur feels that the entry costs can be overcome through the application of an adequate knowledge base and the necessary complementary assets (Harris and Li, 2005)19, thus the resource base of the firm is a key determinant of start-up. Barriers to entry (and exit)20 have already been considered but they are particularly relevant in the context of the start-up decision. Factors such as product differentiation, the existence of scale economies and access to inputs, in particular finance, are all seen as significant deterrents to entry. Storey (1994) highlights the problems that SMEs face in terms of credit rationing as a result of banks’ failure to lend. This is tied up with their inability to separate the low risk SMEs from the high risk ones, since size is an observable characteristic on which to base a lending decision. Also, SMEs may have insufficient collateral on which to secure any borrowed finances. However, reporting on the findings of a study undertaken by Cambridge researchers, Hoffman et al (1998) state that, despite being found to be a frequently cited barrier for SMEs, only a small number of firms seeking finance failed to find it. A report by Hutchinson and McKillop (1992, cited in Wren 1998) indicated that borrowing SMEs could expect a mark up of 3 per cent above national base rates, compared with 1 per cent for large firms. Whilst these results will be very sensitive to when in the business cycle the research was actually carried out, the clear implication is that small start-ups are likely to face different financial constraints to other forms of entrants. Sunk costs, i.e. costs that are not recoverable even on exit, are likely to be a significant barrier in relation to start-ups, especially small start-ups. This
19

Harris and Li (op cit) were specifically considering firm entry into a foreign market but their point still holds. 20 The symmetry hypothesis postulates that barriers to entry also deter firms from exit (Shapiro and Khemani, 1987).

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relates to their inability to cross subsidise and spread costs such as advertising and other expenditures across a number of activities (Hariharan and Brush, 1999). Where some sunk costs are recoverable, poorly performing firms may be more inclined to exit.

9.2.5 The regional dimension Co-operation between organisations within markets has long been identified as a key factor in economic success. Here we consider the current business environment in the UK, with international comparisons and in light of academic research on economic effects of networks and clusters. Keeble et al (1998) assert that the firms in the early stages of development benefit from location within a formal or informal networking environment. They argue that there are benefits both in international and local networking activities in research collaboration, labour recruitment, ownership and facilities location. Further, high levels of international networks tend to be correlated with above average levels of local networks. Different theories have been developed to explain the impact of different regional environments on small firm performance (Keeble et al, 1998). A first theory stresses that successful, innovative and growth-orientated small firms are concentrated in core regions with easy access to factors production, information networks and markets create and appropriate environment. The second theory asserts that in these peripheral regions there may also be successful and innovative small firms, where active entrepreneurial efforts are able to overcome resource deficiencies. There are indeed strong regional differences in enterprise rates across the UK (GEM 2003), as discussed in Section 5. London and the South East have the highest TEA (Total Entrepreneurial Activity) indices, and the North East, Northern Ireland and Yorkshire and Humberside have the lowest levels. The GEM (2004) identifies an increase in the numbers of technology start-ups and owner-managed businesses across all regions of UK since 2003. The Southwest region has seen the highest number of new technology start-ups at 66

29.9 per cent of all start-up activity; London experiences the second highest number with 24.6 per cent of all start-ups. The region with the smallest number of technology start-ups is the North East with only 4.2 per cent of all start-up activities. As highlighted earlier however, there are other means of measuring start-ups that might be more appropriate, such as the VAT register. The possible link between business start-up rates and wealth and job creation is particularly of interest. Policies that favour entrepreneurship assume that there is a causal link between entrepreneurship and higher economic growth and productivity. Van Stel and Storey (2004) analyse the extent to which a geographical area is ‘entrepreneurial’ and the extent to which it is ‘economic successful’. In theory, new firms may generate more jobs, constitute a competitive pressure on existing firms to perform better and provide a means to introduce new ideas an innovation. However these effects may not be clear due to the fact that new firms contribute only to a very small proportion of the jobs in the economy and innovation is not so frequent among new firms. Van Stel and Storey (2004) find that start-ups had a much greater impact on job creation in the 1990s than in the 1980s, even though raising the start-up rate was the key policy objective in the 1980s. In contrast, in the 1990s there was a shift towards policies to improve the quality of the SME sector as a whole. This research suggests that implementing policies to raise formation of new firms, particularly in ‘unenterprising or deprived’ areas may not be the best solution, although this seems to be one of the focuses of current UK policy. These policies generally lead to poorly suited individuals (with poor human capital) starting businesses that are very likely to fail. Recent data on business start-ups confirm that deprived areas tend to have lower start-up rates and higher failure rates (SBS, 2004). Johnson (2004) concludes that structural characteristics of a region may influence formation activity in that region. This is a reflection of many influences and it may be inappropriate to alter that structure simply to increase the formation rate. Keeble et al (1998) argue that even if the South East and especially London experienced higher growth than Scotland, Wales and Northern England 67

during the 1990s, northern regions cannot be considered completely as ‘hostile environments’ for successful SME growth. In fact, some peripheral firms show better innovation rates and technological intensity than some Southeast firms. Southeast SMEs present higher original product innovation rates but peripheral SMEs are better at continuing innovativeness. Although policies could make a difference and increase levels and success of newly formed firms, there is no ‘one-size-fits-all’ regional policy that can be applied across all regions and nations. In some regions such as the East Midlands and the North West there has been policy focused on the specific need of the labour market. As Regional Development Agencies acquire more autonomy they will be able to formulate policy on the basis of regional priority. (GEM 2004) 9.3 Technology and innovation Start-ups, and SMEs in particular, are thought to be important because of the role they play in bringing innovations to the market. A major determinant of successful entry is the ability to produce viable new products or processes, for which there is demand (presented in Table 2.1 as points 3 to 5). Innovation and technology are therefore at the heart of a viable entrant. Geroski (1991) distinguishes between innovative and imitative entry, with the imitative entry being more dependent on shifts in demand and/or cost functions to facilitate entry. He argues that imitative entry is more likely to face entry barriers than innovative entrants. This is consistent with the early empirical findings of Beesley and Hamilton (1984), who argue that the plants that survive are generally hard to classify into an existing industrial SIC which they attribute to the ‘newness’ of their emerging industry. There is general empirical support for a “u-shaped” relationship between firm size and innovation outputs, in which it is the smallest and the largest firms are the most likely to innovate. Hoffman et al (1998) reviewed the literature on the role of R&D, technology and innovation in small firm development. They identified the characteristics of SME innovators as being located in niche markets, largely product innovators and particularly innovators with collaborative linkages to private and public organisations such higher 68

education institutions. This type of research may help to identify the characteristics of ‘survivors’ for policy purposes (see the work by Atherton, 2006, reported in Section 9.5). The predicted relationship between innovation and competition is negative, since more competition reduces the monopoly profits that reward successful innovators (e.g Aghion and Howitt 1992). However, empirical research work has found a positive correlation between product market competition and innovative output. Geroski (1989) tests the effect of competition on productivity growth for a sample of 79 industries in the UK between 1976 and 1979. He finds that competition plays a significant role in stimulating productivity and industries that experience rapid changes in technologies are likely to be those in which incumbents are under pressure to perform well. He argues, “entry and the innovation process and undoubtedly intertwined and the effect of competition might best be measured as the joint effect of the two”. Similarly, Blundell, Griffith and Van Reenen (1999) show for a panel of British manufacturing firms between 1972 and 1982 that “less competitive” industries (those with lower import penetration and higher concentration levels) had fewer aggregate innovations. Recent research by Aghion et al (2005) attempts to reconcile the idea that competition can have potentially a positive and a negative effect on innovation. Their model predicts that relationship between product market competition and innovation is an inverted ‘u’ shape. For example, when competition is low, higher levels of competition may increase the incremental profit from innovating, but when the competition is higher more competition may reduce innovation as the follower’s reward to catching up with the technological leader may fall. Klepper (1996) puts forward an explanation for the interrelations between entry, exit, market structure and innovation within a product life cycle framework, which focuses on how technologically progressive industries evolve from birth to maturity. When industries are new, there is a lot of entry, firms offer many different versions of the industry’s product, the rate of product innovation is high, and market shares change rapidly. Subsequently market maturity causes entry to slow, with the number 69

of exits overtaking entry. This leads to a shakeout in the number of producers, with the rate of product innovation and the diversity of versions of the product declining. Firms change their behaviour to devote increased effort to improving their production processes and eventually the market shares of established firms stabilises. In a more recent paper Aghion et al (2006) go on to show that the threat of entry has a positive effect on the incentive for incumbents to innovate that leads to productivity growth in industries initially close to the technological frontier, but not in those industries that are initially further away from the frontier, i.e. the absolute maximum limit of production possibilities, given current technologies. The frontier represents the most efficient firms. The intuition behind this is that those closest to the frontier can escape threat from entry by innovating and those that are further behind frontier are less able to compete against an entrant. These results have interesting policy implications. Policies directed to decrease or remove entry barriers may not be sufficient to foster productivity growth of incumbents in all industries. It perhaps suggests policies to facilitate the reallocation of factors of production from less to more technologically developed industries that react more positively to entry threat. Some factors that affect innovation performance may be considered ‘internal’ to the firm (such as educational background and prior experience of the founder/managers, professional qualifications of the workforce and various kinds of technological capabilities such as formal/informal R&D or on the job training) or ‘external’ (networking capabilities, geographical advantages or institutional support). Romjin and Albaladejo (2000) show that firms can use large corporations or academic institutions as a breeding ground for innovation and benefit from the external support and the opportunity to carry out “substantial pre-competitive research completed before the decision to branch out on their own”. They also benefit from the training and internal learning opportunities that are available. Romjin and Albaladejo (2000) also find that high levels of science/engineering qualifications are positively associated with innovations. Similarly, Cosh et al (2005) find that in high-tech 70

industries, knowledge related factors play a crucial role on innovation performance, while in low/medium-tech industries managerial incentives and organisational flexibilities are more significant. Technological advancement requires technological capability (knowledge and skills required to choose, install and develop technologies) and innovation capability (ability to make modifications and improvements – contribute to dynamic competitive advantage) (Romjin and Albaladejo 2000). However, in understanding the performance of firms, it is important to consider the extent of innovation (how different the idea is to those already available/in practice), rather than just the innovation itself (Cosh et al 2005, Romjin and Albaladejo 2000). In general, managerial share-ownership, performance related pay,

organisational flexibility with a formal management structure are positively associated with innovative efficiency. Cosh et al (2005) find that small firms are likely to have informal management structures and that the impact of these characteristics on innovative efficiency is likely to be high. In small hightechnology firms innovative efficiency is significantly increased by more formality in management, research partnership and training. This provides support for policy to focus on increasing the quality of start-ups through ensuring entrepreneurs and starts ups have the necessary organisational systems in place. Finally we observe that market power also plays a significant role in innovation. Firms with high market share have the greatest incentive to preemptively innovate – and tend to benefit most from innovations (Blundell, Griffiths, van Reenen 1999). Small firms that can implement process innovation do benefit from higher survival likelihood. Overall, innovation increases survival probability by 11 per cent and this offsets the ‘liabilities of newness’ often experienced by new, small firms (Cefis and Marsili, 2005).

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9.4 Survival versus exit The recurring theme in the empirical evidence of churn is that small firms are both the most likely entrants and exitors. Empirical research by Harris and Hassaszadeh (2002) on UK manufacturing shows that the hazard of closure declines as plants get older, and usually bigger. Growth is often seen as the most effective form of survival (Harris and Robinson, 2001b). In this section, we also recognise the importance of industry life cycle effects and the need to consider how firm behaviour differs in different industries. Business closures are generally defined as bankruptcies, as discussed in previous sections, but may also be the result of transfers of ownership, or perhaps reclassification of business type. The focus in this section is closures, defined as liquidations and bankruptcies. Daly (1992) argues that bankruptcies are closest to the concept of entrepreneurial failure. The theoretical development of exit models is not as advanced as entry models. In part, this is attributed by Storey (1994) to the problems of modelling performance as a function of personal attributes, managerial abilities and styles. Existing theories assume that the decision to close is determined by the relative cost of closure compared to the cost of continuing (Reid, 1991 and Baden-Fuller, 1989; cited in Storey, 1994). Closure costs to take into consideration include the scrap value of the capital stock as well as the expected future value of anticipated profits (or losses), together with the costs associated with deferring the decision to a later time period. Storey (1994) provides a list of factors that influence the probability of business failure which broadly summarise the findings of the empirical literature. These are: • • • • • • • the size of the firm the age of the firm Ownership People/management Firm type Past performance Macroeconomic conditions

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• • •

Location Sector Businesses in receipt of state subsidies

It is recognised that these are not necessarily independent of one another, and again we see that they largely fall into factors that relate to the enterprise (size, age, management past performance), and factors that relate to the environment (macro conditions, location, sector, etc), most of which have been discussed in the case of start-ups. For example, smaller, older firms are more likely to close in a downturn in the business cycle, especially those in more mature industries or those in more remote locations. We also see that this list of factors is strikingly similar to those that determine entry. Thus many of these issues have been dealt with earlier in this review.

9.4.1 The role of size in survival A large body of empirical literature has found that the likelihood of firm survival is not independent of firm size. Gibrat’s Law asserts that firm growth should be independent of size and provides the foundation for research into the relationship between entry, growth and survival with respect to firm size. In models of profit maximising behaviour where growth represents adjustment towards a minimum efficient scale of production, it is predicted that there exists a negative relationship between the size of the firm and growth (Hughes 1997). Philips and Kirchhoff (1989) point to the key influence on survival of young firms being that of growth, with the rate of growth being secondary.21 Evans (1987a, 1987b) and Dunne et al (1988) find evidence that the larger is a firm (plant) the greater is the likelihood of its survival, but larger firms show lower growth rates. Therefore small firms seem to experience higher churn, but can have greater potential for growth. Cabral (1995) provides a theoretical explanation for this negative relationship based on the notion that capacity and technology choices involve some degree of sunk costs. Since small entrants are more likely to exit than are large entrants it is rational for small
21

Further empirical research into Gibrat’s Law is detailed in the Annex table at the end of this report.

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entrants to invest more gradually and thus experience higher expected growth rates, than larger entrants. There is a mass of research that suggests that entry of smaller sized firms have a lower likelihood of survival than larger counterparts (amongst others, Geroski (1995), Caves (1998)). However, Almus and Nerlinger (2000) provide empirical evidence that suggests that small firms have higher growth potential than large ones, although survival is still conditional on reaching the minimum efficient scale of production. Agarwal and Audretsch (2001) argue that small firms entering mature industries can fill strategic niches that reduce pressure to innovate and may counter the negative effect of entry size. Small firms tend to implement different strategies to larger firms in order to survive in a market and to compensate for other size-related disadvantages. Small firms can overcome scale disadvantages by identifying market niches in which it is profitable to operate, though a process of “flexible specialisation” (Carlsson 1989). Acs and Audretsch (1989) find for US firms for the period 1978-1980 that the entry patterns of small firms are different to the patterns of large firms. Past profit rates do not necessarily induce entry of the smallest enterprises, since these probably operate in market niches less likely to be subject to intense competition. Agarwal and Audretsch (2001) show that for US manufacturing, survival is higher for larger firms only in the early stages of the life cycle and in products with low technological intensity. The ability of small firms to identify strategic niches takes place more in the mature phases of the life cycle, and in high technology products. 9.5 UK industrial start-up policy The successful establishment of SMEs and their subsequent evolution and development has been a source of interest and concern for researchers, government and policy makers since SMEs are important to the economic growth of the economy (Robson and Bennett 2000). In a recent policy article, Atherton (2006) presents two dimensions to the success of start-ups. The first relates to the business proposition itself, the idea and its viability. The second facet relates to the management competencies of the entrepreneur/firm (table 74

9.1). Atherton (2006) proposes that start-ups are evaluated against these criteria in order to determine which start-ups are most likely to succeed, with a view to these then being selected to receive government support. This is contrary to the existing government policy of maximising the impact of its intervention by focusing on the marginal firm. Industrial support for start-ups is considered in greater detail below but this proposal by Atherton (2006) fits well within the theoretical construct of the resource-based firm. It also provides an overview of the conditions that need to be considered in relation to start-up that is consistent with the earlier findings of Storey (1994). The management capability considerations have largely been discussed in the section above and are summarised in the table below: Table 9.1: Determinants of start-up success Business proposition 1.Required resources secured 2. Strategy and planning of the venture in place 3. Viable underpinning proposition as basis of venture 4. Product/service/technology advantage secured 5. Positive financial outcomes apparent or demonstrable Management capability Entrepreneur/founder Management team Overall management capability Operational capability Overall entrepreneurial capabilities

6. Conducive market dynamics Source: constructed from Atherton, 2006 If we now consider the UK policy environment, the government’s action plan for small businesses is to make the UK “the best place in the world to start and grow a business”. This involves consideration of both firm characteristics and the economic environment into which they are ‘born’. Broadly, its objectives are broken down into 7 streams with accompanying policies or services. These are • • Knowledge and enterprise culture Dynamic start-up

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• • • • •

Improving management capabilities for business growth Financial constraints Encouraging enterprise in disadvantaged groups and areas Providing better access to government services Reducing the impact of regulation.

These policies address some of the ways discussed above in which new, small start-ups may be disadvantaged in entering a market with diversifying or larger firms. Atherton (2006) suggests that one challenge for policy is to identify future viability of small businesses by start up characteristics and to realise how intervention can enhance prospects and to reduce/minimise the policy and socio-economic costs of unsuccessful start-ups. Government policy currently leans towards multiple objectives where industrial policy for small business may cross with industrial policy for science and technology and regional development (Wren, 2001). It is also a means to further government social policy and is at risk of being overwhelmed by political motivation for ‘entrepreneurial culture’ with insufficient regard to the economic effects of churn. (Curran and Storey 2002). Santarelli and Vivarelli (2000) suggest that offering subsidies to new start-ups interferes with the ‘churn’ process because the subsidised firms will either survive anyway (in which case the subsidy is unnecessary) or will not reach a threshold level of efficiency, in which case they will die when the subsidy ceases. In this way, government intervention may be a costly and an ineffectual way to assist new businesses. The support for government intervention focuses on the aggregate effects of business creation, including contributing to employment and a more flexible and adaptable market economy (Atherton 2006). The Government suggests that there are market failures which demand intervention or correction. if we are to develop an economy that fosters small business (SBS report 2003). For example, inherent uncertainty over small business outcomes means that some businesses will not gain support where, if profitability were guaranteed in the long term, venture capitalists would consider business start-ups as a viable investment and compare the rate of return with other investments. Failure to secure private funds may also

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suggest asymmetric information on the part of banks, who do not fund firms, and firms, who do not recognise market opportunities (Wren 2001). However, even where there is a case for intervention, and even where the policies are clearly in place, it is not clear why there has not been more demonstrable impact and return on the public expenditure (Atherton 2006). Increases in birth rates can lead to additional job creation in short and medium term and thus, it may be tempting for government policy to directly target start-up as a means of creating additional employment with the long term hope of raising productivity. Fritsch et al (2004) suggest that empirical evidence from Britain shows that a definitive link between start-ups and employment creation cannot be made. Birth-rate policies which lead to individuals with limited human capital being encouraged to start in business are unlikely to develop into strong businesses with employees that grow and are also predominantly based in low value added sectors. When policy shifted from focusing on start-ups towards established firms, the job creation impact of new firms was positive and significant. However, the reverse was observed in Scotland so that new firm formation led to falling employment. Thus public policies to raise new firm formation, particularly in less enterprising areas, are likely to be unproductive at best and counter-productive at worst (van Stel and Storey 2004). It has been recently argued that there is a lack of transparency in the objectives of small business policy and how they are assessed (Storey 2002), compounded by methodological problems and lack of adequate data (Curran and Storey 2002). They further point out that assessment of policies is confounded by self-selection problems, where businesses choose whether or not to take advantage of available government assistance. Indeed, one of the problems to be addressed is the constant struggle against low take-up of most policies (Curran 2000) and this would reduce any observed impact business support programmes have on the industry or wider economy. An example of this could be R&D Tax credits.

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9.6 Conclusion The purpose in this section was to provide an overview of the literature in relation to the determinants of business start-ups and closures. Business start-ups are thought to be the major source of new innovation and possibly new employment opportunities although the evidence is mixed. Firstly we considered the competing theories of the firm, i.e. why are firms created? In the resource-based model, the firm is defined as a bundle of firm-specific attributes that are not easily transferred or acquired; this bundle includes knowledge as well as other, more tangible assets. An alternative, evolutionary model is also put forward, in which technology is seen as the key driver of new firms. Policy recommendations for the support of start-ups are likely to differ, depending on the model that operates in the industry under consideration. Business start-ups are driven by entrepreneurial ability and we find that socio economic characteristics of individuals are also seen as being important in determining whether or not individuals seek selfemployment. We find people who have been involved with selfemployment in the past are more likely to enter self-employment in the future.

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10.

Analysing churn from the top-down

So far, the evidence presented in this review is generally based on the analysis of micro firm level data. To the extent that any papers cover data at the aggregate level such as manufacturing or services, this tends to be aggregated up from the micro- (plant or firm) level data. However there are grounds for suggesting that a top down approach may be more appropriate if the objective is to consider the impact of churn on productivity or employment at the industry or total economy level, particularly when we have highlighted the importance of industry specific effects. Attention would be needed to ensure that any definitional issues surrounding the measurement of churn identified earlier in the review would need to be overcome to ensure that the results from a top down approach are robust. The impact of a variable such as entry and exit rates on aggregate activity requires information on both the magnitude of the impact on the sample of firms in the micro-datasets and the importance of this sample to total activity, hence a number of micro datasets also provide weights, for grossing-up the observations to make them representative of the population as a whole. In addition, when considering changes through time or international comparisons it is important to allow for changes or non-comparabilities in definitions employed. All time series and panel data are inevitably affected by definitional changes, as new industries emerge, for example, or thresholds change. These changes are also unlikely to be uniform across countries and these differences need to be taken into account. The current literature includes few examples of a top down approach. A recent exception is van Stel (2005) whose results we considered in chapter 5. He considers the impact of entrepreneurial activity and economic growth by combining sectoral data for industrial countries with micro data. In Chapter 4 of his thesis, van Stel considers the extent to which the gap between actual and optimal industry structure impacts on growth. He measures changes in

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industry structure by changes in the relative importance of small firms, employing data provided by the European Observatory on value of shipments by size class of firm. This is linked to aggregate data on GDP for manufacturing and services from OECD National Accounts. Van Stel estimates an equation that specifies that the change in GDP is related to the deviation between actual and optimal industry structure. The top down approach is appealing since it allows access to a richer source of data than might be available at the micro level while ensuring a greater degree of consistency across space and time. The next section outlines an approach that might be employed in the future linking macro and microdata.

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11.Proposals for future analysis
The report has so far considered in detail the role and scope of economic churn, both in terms of what it includes and the impact it has on employment and productivity growth. In essence we find that churn is not simply the opening and closing of plants and firms, but that there are a number of ways in which businesses may enter a market. In addition to new business start-ups, firms diversify and also acquire assets through mergers, takeovers and buyouts. Taken together with our consideration of the empirical literature, this highlights the importance of harmonised measures of business start-ups, closures and churn, in order that meaningful comparisons can be made. A key finding of our review is the importance of other sources of entry and exit, beyond start-up and business closure. Survival rates are low for new starts ups but are important, particularly from the perspective of bringing new ideas to the economy. Entry through diversification and changes in ownership is more likely to succeed and to have a greater impact on incumbent behaviour and industry performance as a whole.

11.1 Rates of churn In our review of the cross-country evidence we find that the most recent evidence suggests that the UK has a particularly high level of churn, compared with other OECD countries (table 1.1, Bartelsman et al 2005); however the UK data was restricted to manufacturing. Drawing conclusions for all firms from one particular sector, especially one that is experiencing a structural change, reduces the validity of existing studies. It appears that it would be timely to consider entry and exit more widely in the UK economy, given the increased availability of service sector micro data from ONS. Much of the existing empirical evidence concentrates on manufacturing, and given that this now accounts for less than 20 per cent of the UK economy, consideration elsewhere is imperative.

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Alternative data sources could include the CBI quarterly data that may provide useful insight into the determinants and rates of churn. This survey asks firms a host of questions about their costs, prices, output and investment, both forward looking and over the past four months. In addition, the survey asks general questions on the perception of uncertainty and business confidence. This survey is economy wide and is based on the Inter-department Business Register, as such, it is possible that the firms could be matched into other micro datasets that have perhaps more accurate records of births and deaths.

11.2 Churn and productivity It may be possible to combine micro and the more aggregated industry data to investigate the impact that churn has on productivity growth. As discussed in the previous section, aggregate business data series are often constructed by national statistical offices to ensure consistency over time. Industry data series that are consistently measured across countries include the OECD STAN data and the series underlying O’Mahony and van Ark (2003). In addition, current research is underway to further extend these productivity databases both in terms of industry coverage and time series (EUKLEMS) 22. This database will include more countries and more refined measures of outputs and inputs, although it not will be available until early in 2007. Microdata sets, although richer in detail, do not share the same degree of consistency and often involve relatively crude measures of output and inputs. Combining the richness of microdata sets with the consistency of aggregate data would seem like a way forward in measuring the impact of churn on aggregate economy output and productivity growth. This builds on the work by Bartelsman et al (2005). An example would be to derive data on entry and exit rates by industry from microdata and include as variables in a dynamic panel regression analysis. Since sectoral patterns of churn tend to hold over time, it is probably best to consider country panels for similar industries rather than combining all industries in the one panel. In addition aggregate analyses will only identify
22

See http://www.euklems.net for further information.

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the magnitude of the impact, not the channels through which the productivity gains (if any) emerge. For this, a two-stage process will be required, with the micro data used to model the way churn impacts on firm productivity and the industry data used to measure the aggregate impact.

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Annex 1: Table of Evidence
Study Evans (1987b) Country US Sample period 1976-1982 Data 100 four-digit manufacturing industries from SBSD (Small Business Database) Census of Manufactures Entry/exit They study survival, growth and variability of growth. Firm entry, growth and exit. Type of study Regression analysis Findings -Age is an important determinant of firm dynamics (firm failure, firm growth) -Firm growth decreases at a diminishing rate with firm size. (departure from Gibrat’s Law mainly for small firms) -New-firm new-plant entrants are 55.4 per cent of total entrants in each industry, diversifying-firm new plant entrants are 8.5 per cent, product-mix entrants are 36.1 per cent. -Importance of new entrants diminishes when examining market shares. -Similarity between entry and exit rates across sectors. -Failure rate and growth rate of nonfailing plants decline with age/ -Large plants have lower failure rates and lower growth rates if they survive than small plants. -Large multi-unit plants have lower failure rates and higher growth rates if successful than large single-unit plants. -Over 70 per cent of the turnover in employment opportunities occurs across plants within the same two-digit industry and geographic region. -Although structural reallocations of employment across industry or regions is rather small their importance as a source of turnover is larger in periods of

Dunne, Roberts and Samuelson (1988)

US

1963, 1967, 1972, 1977 and 1982 (census)

Regression analysis

Dunne, Roberts and Samuelson (1989a)

US

1963, 1967, 1972, 1977 and 1982 (census)

Manufacturing: Census of Manufactures

They examine post-entry employment growth and failure of 200,000 plants.

Regression analysis

Dunne, Roberts and Samuelson (1989b)

US

1963-1982

Census of Manufactures (CM)

It measures gross employment flows and turnover in labour demand

Regression analysis

97

Study

Country

Sample period

Data

Entry/exit

Type of study

Findings contraction. -Much of the employment turnover that occurs may be generated by plants that enter, live a relatively short life, and are replaced by new group of plants, many of which will exit quickly. -Barriers to entry are high in most industries in the UK, of similar magnitude for domestic and foreignbased entrants. -Neither type of entrant provides much challenge to incumbents. -Entry increases with profit level of incumbents, holding fixed expected losses that entrant would suffer. -Sunk costs are an important obstacle for contestability. -Belgian industries show high turnover . -Entry by new firms in Belgian industries is largely explained by Europe-wide growth and profitability prospects. -Exit across Belgian industries explained by deteriorating domestic profit performance with respect major trading partners. -Entry and exit occurred in 90 per cent of German manufacturing industries between 1983 and 1985. -Entrants and exitors were small but exiting firms were larger than entrants. -Entry and exit are more important in explaining concentration than mergers,

Geroski (1991)

UK

1983, 1984.

Sample of data on entry into 95 3-digit UK Minimum List Heading (MLH) industries.

Entry, exit

Regression analysis

Kessides (1991)

US

1977-1982

Cross-section sample of all 4-digit industries that experienced entry between 1977 and 1982. Cross-section time series sample of 109 Belgian industries

Entry

Regression analysis

Sleuwaegen and Dehandschutte r(1991)

Belgium

1980-84

Entry and exit

Regression analysis

Schwalbach (1991)

German

1983-1985

183 4-digit German manufacturing industries.

Entry and exit

Regression analysis

98

Study

Country

Sample period

Data

Entry/exit

Type of study

Findings internal expansion and firm displacement. -Profits and growth expectations attract entrants, but entry barriers limit mobility subsequent to entry. -Entry and exit play small role in industry growth over five year periods. -Increasing output share in highproductivity and decreasing output shares in low productivity very important for productivity growth. -An important part of and economy’s productivity growth accounted by means of resource allocation from less to more productive plants. - New plants are not more productive than old plants, but new plants face greater uncertainty in their evolution. -Larger plants appear to be more productive than small plants. -Competitive pressures force less efficient producers to fail more than others. -Gap in productivity between surviving and exiting plants and between exiting and entering has widened over time, whole the gap between surviving and entering has narrowed. Differences are subtle. -Plants that increased employment as well as productivity contribute as much to overall productivity growth in the

Baily, Hulten and Campbell (1992)

US

1963, 1967, 1972, 1977, 1982, 1987 (census), 19721988 (Annual Survey) From 1972 to 1986

23 manufacturing industries (SIC 4 digit)

Entry and exit

-Productivity growth decompositio n (TFP) -Regression analysis Productivity growth decompositio n Regression analysis

Bartelsman and Dhrymes (1994)

US

Census Longitudinal Research Data (LRD) for large firms in the two-digit industries: 35 (Machinery exc. Electrical), 36 (Electrical and electronic), 38 (Measuring instruments) Plant level panel data for Chilean manufacturing with at least 10 workers.

Continuing plants: They study the movement of plants within crosssectional distribution pf productivity as time progresses.

Liu (1993)

Chile

1979-1986

Entry and exit

Regression analysis

Baily, Bartelsman and Haltiwanger

US

1977 and 1987

Plant data from Longitudinal Research Database. (LRD)

Entry and exit

Productivity growth decompositio

99

Study (1994)

Country

Sample period

Data

Entry/exit n.

Type of study

Findings 1980s as the plants that increased productivity at the expenses of employment. -Most of variance in employment and productivity growth accounted for by idiosyncratic factors. -More than 20 per cent of plants died during their first year more than 50 per cent do not survive for 4 years and only 30 per cent of the initial population survive for 7 years -Plants started by newly created firms are smaller than those created by established firms and grow faster. -Size is an important determinant of the chances of survival, especially for new entrants compared to established firms. -New plants likely to live longer if they enter growing industries or with little entry activity. -Exit is not responsive to the cycle, which contradicts the view that recessions are times of ‘cleansing’. -Growth of survivors displays little cyclical sensitivity, but is more responsive to aggregate business fluctuations as cohort ages.

Mata, Portugal and Guimaraes (1995)

Portugal

1983-1992

Data from Quadros de Pessoal, of the Ministry of Employment (MESS).

They identify new plants created during the 1980s and followed performance

Duration models to estimate effect of plant size and market dynamics variable on the survival of new plants

Boeri and Bellmann (1995)

Western Germany

1978-1992

Employment Statistics register of Federal Office of Labour

They analyse relationship between growth and exit of entering cohorts and aggregate business fluctuations.

Griliches and Regev (1995)

Israel

1979-1988

Panel data on Israeli industry (mining and manufacturing) from CBS

Entry, exit

Logit equation in which set of regressors includes structural factors as well as cyclical indicators. Regression analysis

Most of growth in aggregate productivity comes from productivity changes within firms rather than from entry, exit or

100

Study

Country

Sample period

Data (Central Bureau of Statistics)

Entry/exit

Type of study

Findings differential growth. Firms which will exit in the future have lower productivity performance several years earlier. Overall there was little TFP growth in Israeli industry during 1979-1988. -Restructuring has been important in Canadian manufacturing sector: -Small and less productive plants have gained employment. -In semi-industrialised countries on average each year the turnover rate is between 25 and 30 per cent. -This turnover reflects resource movements within same industry. -Exit concentrated among smaller and younger plants. -Short-run productivity effects small as new firms only slightly more productive than the ones they replace. Long- term: more substantial productivity improvements. -Conclusion: Artificial obstacles to producer failure can be counterproductive particularly if kept over long periods of time. Productivity increases after major restructuring of telecommunications equipment industry over the last two decades occurred primarily as a result of a reallocation of capital towards more productive establishments.

Baldwin (1996)

Canada

1973-1990

Longitudinal data file of plants in the Canadian Census of Manufactures World bank: establishment-level panel data with at least 10 workers for all manufacturing.

Entry, exit continuing

Roberts and Tybout (1997)

Colombia Chile Morocco

1977-1991 1979-1986 1984-1990

Reallocation via entry, exit, expansion and contraction of incumbents.

Decompositio n of labour productivity and TFP growth. Productivity growth decompositio n

Olley and Pakes (1996)

US

1974-1987

Telecommunications equipment industry from Longitudinal Research Database (LRD)

Entry, exit and restructuring of incumbents.

Productivity decompositio n Regression analysis

101

Study Aw, Chen and Roberts (1997)

Country Taiwan

Sample period 1981, 1986, 1991

Data Firm level panel data Census of Manufactures

Entry/exit Entry and exit in general and specific to the export market.

Type of study Productivity growth decompositio n (TFP)

Findings -High entry and exit rates: Cohort of 1991 accounts for 66.6 per cent of firms, cohort of 1996 20 per cent in 1991, As for exitors, between 70 and 87 per cent of the 1981 producers are not present in 1991. -These firms account for significant shares of total output. -There are significant differences in TFP across firms. New firms have lower average productivity than incumbents, the more productive ones survive, exiting firms are less productive than survivors. -Firm entry and exit significant source of productivity growth. -Shift in output towards more productive plants major factor in industry change -Net entry plays a supporting role, for period 1977-1987 net entry represents 18 per cent average industry change. -Relative contribution of reallocation varies through time, 1977-1982 exhibit slow productivity growth and within-plant and between-plant components are negative. In 1982-87exhibit robust productivity growth, with large positive contributions from within and between components. -Reallocation from less productive to more productive establishments has large impact on aggregate productivity

Haltiwanger (1997)

US

1977, 1982, 1987

LRD Census of Manufactures (CM) at four-digit level.

Entry, exit, continuing firms

Productivity growth decompositio n (TFP)

Foster, Haltiwanger and Krizan

US

1977, 1982, 1987

Manufacturing and selected services: Census of Manufactures

Reallocation via Entry, exit an across continuing establishments.

-Productivity growth decompositio

102

Study (1998)

Country

Sample period

Data (CM) NBER Productivity Database Census of services

Entry/exit

Type of study n -Regression analysis.

Findings growth. -Large entry and exit in selected services (3-digit industry automotive repair shops) which dominates productivity growth in the industry. -Contribution of reallocation to aggregate productivity growth increases in horizon over which is measured, since a longer horizon yields greater differentials from learning and selection. -Contribution of reallocation varies over time and industries. -Entry and exit rates in Korean manufacturing are high. -Plant entry and exit account for 45 and 65 pre cent in manufacturing productivity growth -Plant turnover reflect differences in productivity, death are less productive than continuing plants, births less productive than continuing plants but also than deaths in first year observed. Productivity of switch-ins and switch-out higher than birth or deaths and comparable to continuing. -Post entry performance of births show presence market selection and learning process. -Role of resource reallocation in aggregate productivity growth is greater in cyclical downturns.

Hahn (2000)

Korea

1990-98

Plant level data manufacturing

Entry and exit

Productivity growth decompositio n (TFP)

103

Study Harris and Hassaszadeh (2002)

Country UK

Sample period 1974-1995

Data Manufacturing: ARD (Annual Respondents Database) Exits

Entry/exit

Type of study Regression analysis: Hazard model to estimate probability of plant closure.

Findings -Plants foreign owned less likely to exit. -Initial size positive impact on hazard of closure, although the relationship is negative for older plants. -Current size more important than initial size. -Only a negative relationship between sunk costs and hazard as plant ages. -Technical efficiency important factor in determining plant exits. -Taiwanese industries are characterized by less concentrated market structure, more producer turnover, smaller withinindustry productivity dispersion across producers, a smaller percentage of plants operating at low productivity levels, and smaller productivity differentials between surviving and failing producers. -Productivity growth within continuing plants is predominant source of productivity growth. -Plant turnover contributes 15-25 per cent of labour productivity over the periods 1973-1979, 1979-1988 and 1988-97. -A very large fraction if the contribution from plant turnover is due to foreign controlled or multi-plants firms -Entrants with high productivity and large size more likely to survive -Output and employment grow more

Aw, Chung and Roberts (2002)

Taiwan and South Korea

Korea: 1983, 1988 and 1993. Taiwan: 1981, 1986 and 1991.

Micro panel data in seven two-digit manufacturing industries

They examine the relationship between productivity, size and turnover.

Calculation of TFP index

Baldwin and Gu (2002)

Canada

1973-1979 1979-88 1988-97

Annual Survey of Manufactures (ASM) over the period 19731997.

They examine effect of plant turnover on labour productivity growth.

Labour productivity decompositio n at 4-digit level SIC80.

104

Study

Country

Sample period

Data

Entry/exit

Type of study

Findings quickly for surviving than for incumbent, and productivity growth of surviving is slower than that of incumbents. -Between 15-20 per cent of all firms are new each year. -Impact on employment is less, since entrants are on average smaller than average firm in industry. -Looking at entrants that survive 5 years, the surviving entry rates ranges from 5-6 per cent -Surviving entry rates for new firms that enter by building new plants is 2.5 per cent of the economy. -Continuous large scale reallocation of output and labour across establishments in narrow defined industries. -Much of reallocation accounted for by entry and exit but and important part is due to within firm reallocation. -Net entry explains all labour productivity growth in retail trade, without churning retail trade would not have exhibited productivity growth, in manufacturing accounts only for one third. -Exiting establishments less productive than incumbents and entering exhibit same productivity as incumbents. -External restructuring accounts for 50 per cent of establishment labour productivity growth and 80 per cent-90

Baldwin, Beckstead and Girard (2002)

Canada

1989-1997

Statistics Canada Business Register, Longitudinal Employment Analysis Program (LEAP)

Entry

Different measures of entry and their different impact.

Foster, Haltiwanger and Krizan (2002)

US

1987, 1992 and 1997.

Data from the Census of Retail Trade (CRT)

Entry and exit

Labour productivity decompositio n Regression analysis

Disney, Haskel and Heden (2003a)

UK

1980-1992

ARD Panel of establishments from Census of Production.

They analyse effect of ‘internal’ restructuring (new technology and

Productivity growth decompositio

105

Study

Country

Sample period

Data

Entry/exit organisational change among survivors) and ‘external’ restructuring (exit, entry and market share change).

Type of study n Regression analyses.

Findings per cent of establishment TFP growth. -Much of the external restructuring effect comes from multi-establishment firms closing down poorly-performing plants and opening high-performing ones -External competition is an important determinant of internal restructuring. -Entry and exit rates in the UK correlate across time and within industries -In any year, 3 in 10 establishments have just entered or will exit -Survivors are four times as large as establishments that enter or exit -65 per cent of entrants will have exited after five years. -Half of entry and exit employment is due to entry/exit from new establishments set up by existing -The decline with age of their hazards are less apparent for multi-plants than for single plants. -Virtually all the productivity growth in Colombia for the average 3-digit industry is accounted for by the improved allocation of activity across existing businesses. -This contribution rose further after market reforms -Next step in this research is to explore dynamic implications of the reforms in terms of their impact on the entry and exit dynamics of businesses in Colombia.

Disney, Haskel and Heden (2003b)

UK

1980-1992

ARD (Annual Census of Production Respondents Database)

Entry, exit and survival of establishments.

Regression analysis (estimation of augmented Cox proportional hazard)

Eslava, Haltiwanger, Kugler and Kugler (2004)

Colombia

1982-1998.

Colombian Annual Manufacturers Survey (AMS)

Studies reallocation across exiting businesses

Estimation of TFP at establishmen t level. And cross sectional decompositio n methodology TFP, as in Olley and Pakes

106

Study Martin and Jaumandreu (2004)

Country Spain

Sample period 1979-1990

Data 75 manufacturing industries from EI (Industrial Survey from National Statistics Institute)

Entry/exit Impact of entry and exit on productivity growth at industry level

Type of study (1996). Regression analysis

Findings -Estimations show an important impact on productivity growth of entry, exit and the competitive pressure derived from import penetrations. -The displacement of less efficient firms by new entrants account in total for 80 per cent of productivity growth. -Average size of incumbents firms varies across sectors and countries. -Firm turnover represent 10-20 per cent in industrial countries. -Entering and exiting firms are small and firm flows affect only 5-10 percent of total employment. -20-40 per cent of entering firms fail within 2 yrs of life. -Successful entrants expand rapidly -Creative destruction is important for promoting productivity growth

Bartelsman, Hlatiwanger and Scarpetta (2005)

Estonia, Hungary, Latvia, Romania, Slovenia, Argentina , Brazil, Chile, Colombia , Mexico, Venezuel a, Indonesi a, South Korea, Taiwan, Canada, Denmark , Germany , Finland, France, Italy, Netherla

Varies by country, the earliest year available is 1977 (Germany) and the latest 2002 (Latvia).

Harmonized micro datasets elaborated by World Bank and OECD from national sources (business registers, social security databases, corporate tax roles)

They examine connection between productivity growth and reallocation via entry, exit and reallocation among continuing businesses.

Productivity decompositio n considering ‘within effect’, ‘between effect, cross effect, entry effect, exit effect.

107

Study

Country nds, Portugal, UK, US. US

Sample period

Data

Entry/exit

Type of study

Findings

Evans (1987b)

1976-1982

100 four-digit manufacturing industries from SBSD (Small Business Database) Census of Manufactures

They study survival, growth and variability of growth. Firm entry, growth and exit.

Regression analysis

Dunne, Roberts and Samuelson (1988)

US

1963, 1967, 1972, 1977 and 1982 (census)

Regression analysis

Dunne, Roberts and Samuelson (1989a)

US

1963, 1967, 1972, 1977 and 1982 (census)

Manufacturing: Census of Manufactures

They examine post-entry employment growth and failure of 200,000 plants.

Regression analysis

Dunne, Roberts and Samuelson (1989b)

US

1963-1982

Census of Manufactures (CM)

It measures gross employment flows and turnover in labour demand

Regression analysis

-Age is an important determinant of firm dynamics (firm failure, firm growth) -Firm growth decreases at a diminishing rate with firm size. (departure from Gibrat’s Law mainly for small firms) -New-firm new-plant entrants are 55.4 per cent of total entrants in each industry, diversifying-firm new plant entrants are 8.5 per cent, product-mix entrants are 36.1 per cent. -Importance of new entrants diminishes when examining market shares. -Similarity between entry and exit rates across sectors. -Failure rate and growth rate of nonfailing plants decline with age/ -Large plants have lower failure rates and lower growth rates if they survive than small plants. -Large multi-unit plants have lower failure rates and higher growth rates if successful than large single-unit plants. -Over 70 per cent of the turnover in employment opportunities occurs across plants within the same two-digit industry and geographic region. -Although structural reallocations of employment across industry or regions is rather small their importance as a source of turnover is larger in periods of

108

Study

Country

Sample period

Data

Entry/exit

Type of study

Findings contraction. -Much of the employment turnover that occurs may be generated by plants that enter, live a relatively short life, and are replaced by new group of plants, many of which will exit quickly. -Barriers to entry are high in most industries in the UK, of similar magnitude for domestic and foreignbased entrants. -Neither type of entrant provides much challenge to incumbents. -Entry increases with profit level of incumbents, holding fixed expected losses that entrant would suffer. -Sunk costs are an important obstacle for contestability. -Belgian industries show high turnover . -Entry by new firms in Belgian industries is largely explained by Europe-wide growth and profitability prospects. -Exit across Belgian industries explained by deteriorating domestic profit performance with respect major trading partners. -Entry and exit occurred in 90 per cent of German manufacturing industries between 1983 and 1985. -Entrants and exitors were small but exiting firms were larger than entrants. -Entry and exit are more important in explaining concentration than mergers,

Geroski (1991)

UK

1983, 1984.

Sample of data on entry into 95 3-digit UK Minimum List Heading (MLH) industries.

Entry, exit

Regression analysis

Kessides (1991)

US

1977-1982

Cross-section sample of all 4-digit industries that experienced entry between 1977 and 1982. Cross-section time series sample of 109 Belgian industries

Entry

Regression analysis

Sleuwaegen and Dehandschutte r(1991)

Belgium

1980-84

Entry and exit

Regression analysis

Schwalbach (1991)

German

1983-1985

183 4-digit German manufacturing industries.

Entry and exit

Regression analysis

109

Study

Country

Sample period

Data

Entry/exit

Type of study

Findings internal expansion and firm displacement. -Profits and growth expectations attract entrants, but entry barriers limit mobility subsequent to entry. -Entry and exit play small role in industry growth over five year periods. -Increasing output share in highproductivity and decreasing output shares in low productivity very important for productivity growth. -An important part of and economy’s productivity growth accounted by means of resource allocation from less to more productive plants. - New plants are not more productive than old plants, but new plants face greater uncertainty in their evolution. -Larger plants appear to be more productive than small plants. -Competitive pressures force less efficient producers to fail more than others. -Gap in productivity between surviving and exiting plants and between exiting and entering has widened over time, whole the gap between surviving and entering has narrowed. Differences are subtle. -Plants that increased employment as well as productivity contribute as much to overall productivity growth in the

Baily, Hulten and Campbell (1992)

US

1963, 1967, 1972, 1977, 1982, 1987 (census), 19721988 (Annual Survey) From 1972 to 1986

23 manufacturing industries (SIC 4 digit)

Entry and exit

-Productivity growth decompositio n (TFP) -Regression analysis Productivity growth decompositio n Regression analysis

Bartelsman and Dhrymes (1994)

US

Census Longitudinal Research Data (LRD) for large firms in the two-digit industries: 35 (Machinery exc. Electrical), 36 (Electrical and electronic), 38 (Measuring instruments) Plant level panel data for Chilean manufacturing with at least 10 workers.

Continuing plants: They study the movement of plants within crosssectional distribution pf productivity as time progresses.

Liu (1993)

Chile

1979-1986

Entry and exit

Regression analysis

Baily, Bartelsman and Haltiwanger

US

1977 and 1987

Plant data from Longitudinal Research Database. (LRD)

Entry and exit

Productivity growth decompositio

110

Study (1994)

Country

Sample period

Data

Entry/exit n.

Type of study

Findings 1980s as the plants that increased productivity at the expenses of employment. -Most of variance in employment and productivity growth accounted for by idiosyncratic factors. -More than 20 per cent of plants died during their first year more than 50 per cent do not survive for 4 years and only 30 per cent of the initial population survive for 7 years -Plants started by newly created firms are smaller than those created by established firms and grow faster. -Size is an important determinant of the chances of survival, especially for new entrants compared to established firms. -New plants likely to live longer if they enter growing industries or with little entry activity. -Exit is not responsive to the cycle, which contradicts the view that recessions are times of ‘cleansing’. -Growth of survivors displays little cyclical sensitivity, but is more responsive to aggregate business fluctuations as cohort ages.

Mata, Portugal and Guimaraes (1995)

Portugal

1983-1992

Data from Quadros de Pessoal, of the Ministry of Employment (MESS).

They identify new plants created during the 1980s and followed performance

Duration models to estimate effect of plant size and market dynamics variable on the survival of new plants

Boeri and Bellmann (1995)

Western Germany

1978-1992

Employment Statistics register of Federal Office of Labour

They analyse relationship between growth and exit of entering cohorts and aggregate business fluctuations.

Griliches and Regev (1995)

Israel

1979-1988

Panel data on Israeli industry (mining and manufacturing) from CBS

Entry, exit

Logit equation in which set of regressors includes structural factors as well as cyclical indicators. Regression analysis

Most of growth in aggregate productivity comes from productivity changes within firms rather than from entry, exit or

111

Study

Country

Sample period

Data (Central Bureau of Statistics)

Entry/exit

Type of study

Findings differential growth. Firms which will exit in the future have lower productivity performance several years earlier. Overall there was little TFP growth in Israeli industry during 1979-1988. -Restructuring has been important in Canadian manufacturing sector: -Small and less productive plants have gained employment.

Baldwin (1996)

Canada

1973-1990

Longitudinal data file of plants in the Canadian Census of Manufactures

Entry, exit continuing

Decompositio n of labour productivity and TFP growth.

112

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