THE EFFECT OF FIRM

FORMATION AND GROWTH

ON JOB CREATION
IN THE UNITED STATES
BRUCE A. KIRCHHOFF
Babson College

BRUCE D. PHILLIPS
U.S. Small Business Administration

This paper demonstrates the importance of new$rm formation to economic

EXECUTIVE growth. It begins by providing data that describe the United States as
SUMMARY having had greater employment growth than most developed nations of
the world over the last 25 years, and focuses upon why job growth in the
United States has exceeded that of other nations.
Job Creation by Firm Size. We$rst examine the data on the relative
contribution of small and large firms to U.S. job growth. By summarizing research that is uniformly
expressed in two-year periods and defines smalljrms as those with less than 100 employees, conclusive
evidence emerges that small firms are the major sources of net new creation.
Firm EntrylExit Rates and Economic Growth. Further understanding of smalljirm job creation
is obtained when we examine firm entry and exit data. Here we find that firm entry rates vary
considerably from period to period (range: 10.4%-12.5%), whereas exit rates remain relatively stable
from period to period (range: 9.6%-10.4%). Thus, variation in entrepreneurial activity-theformation
of newjrms-is the major cause of net increases in the number offirms. In both the United States
and the United Kingdom, netJirm increases are positively related to overall economic activity.
Firm EntrylExiC and Job Creation. Further exploration of this correlation can be conducted
by examining job creation and loss dejned by source: entries, expansions, exits, and contractions.
The data for 1976 through 1984 shown here demonstrate that new entries account for 74.0% of the
50.8 million new jobs created. Expansions of existing firms accounted for 26.0%. Small firms (less
than 500 employees) produced 54.6% of the entry jobs and 56.8% of the expansion jobs.
On the other hand, job losses totaled 33.8 million, 79.0% due to exits and 21 .O% to contractions.
Small firms account for 53.6% of the jobs lost from exits and 47.8% of those lost from contractions.
Overall, small firms account for 60.5% of the 17.0 million net new jobs.
Given the data that show correlation between netjrm formation rates and economic growth, the

Address correspondence to: Bruce A. Kirchhoff, Ph.D., Center for Entrepreneurial Studies, Babson College,
Babson Park, MA 02157.

Journal of Business Venturing 3, 261-272

0 1988 Elsevier Science Publishing Co., Inc. 655 Avenue of the Americas, New York, NY 10010

261
262 B.A. KIRCHHOFF AND B.D. PHILLIPS

finding that entry rates vary more than exit rates, and thefinding that new entries create most of the new
jobs, it can be concluded thatfirm formation-especially small firm formation-is a significant factor in
economic growth. Increases in smallJirmformation rates have a significant effect on net job creation.
Schumpeter’s Model and Observed Market Turbulance. AnotherJinding from this data on job
creation by entry, expansion, exit, and contraction is the large amount of job creation and destruction
activity taking place. For the period studied, three jobs were created and two jobs destroyed for each
net new job created. This describes a turbulent job market with many workers moving from job to
job. The labor markets are much less stable that normally envisioned.
This observed phenomenon fits well with Schumpeter’s theory of capitalism; he proposes that
capitalistic growth occurs because entrepreneurs use innovations to form new firms which enter existing
markets. When successful, these growing new firms destroy existing market structures, causing decline
of established firms while creating increased demand and producing overall economic growth. If
Schumpeter is correct, one would expect to find high rates of firm formation and failure, and large
numbers ofjobs created by new firms, while many jobs are lost by exits and contractions of established
firms.The findings reported here show this.
Government Policy Affects on EntrylExit. Our results also show that formation of small, new
firms is a necessary requirement for economic growth. Historically, however, Government policy has
not considered small firm entry as a central issue. Thus, government policies can and have had a
negative effect on entry rates and therefore upon economic growth rates.
Furthermore, high rates of new$rmformation cause a great deal of turbulence in labor markets,
with three jobs created and two lost for every one net new job. Such labor turbulence may be seen
by policy makers as undesirable as it entails considerable worker movement from job to job. As such,
policy makers have recently proposed policies to protect workers from job loss due to contractions
and exits. However, such protection policies, as demonstrated in recent European experience, will
also construct barriers to entrepreneurial entry. The result may be a decline in small firm entry and
a decline in economic growth.
Instead of protecting specific jobs, appropriate policies are those that facilitate movement of
workers from job to job. Adequate unemployment compensation for short term unemployment, fully
vested and portable pension plans, and retraining programs are examples of policies that allow the
labor market to remain Jexible while reducing the negative effect on those who lose jobs.

INTRODUCTION
The United States displayed an outstanding ability to create new jobs during the 1970s and
early 198Os, especially when compared to western Europe. Civilian employment increased
33.5% in the United States from 1970 to 1984, whereas it increased only 2.4% in France
and 6.9% in Italy, and declined 8.2% in Great Britain and 5.8% in West Germany (Doyle
and Hartle 1985).
Entrepreneurship has been given a leading role among the many explanations cited
for the United States’ outstanding job creation performance. The popular media have focused
considerable attention on entrepreneurship: best selling books have been published, and
magazines and journals as well as newspaper sections or columns have been formed solely
to focus on entrepreneurship. However, most of the evidence offered in these sources to
support the “entrepreneurship belief’ is anecdotal, not rigorously empirical. In fact, in 1985,
after reviewing the existing empirical research, the Organization for Economic Cooperation
and Development concluded: “The job-creation potential of small firms is an issue that has
received considerable attention in recent years. Unfortunately, the evidence on this topic . is
somewhat contradictory and difficult to interpret,” (Organization for Economic Cooperation
and Development 1985).
This paper bridges some of the theoretical and empirical gaps in the analysis of
 EFFECT OF FIRM FORMATION ON JOB CREATION 263

TABLE 1 Percentage Total and Manufacturing Job Growth: United States and Selected Other
Industrialized Nations, 1960-1982

Change in number of jobs

Nation 1960-1980 1970-1980 1980-1982

Total employment
United States 19.5% 24.9% 0.3%
Japan 14.8% 8.7% 1.8%
France 9.4% 3.9% -0.9%
Germany 1.6% - 1.4% -2.4%
Great Britain 2.7% 1.3% -6.3%
Italy -4.9% 7.0% 0.0%
Netherlands 12.4% 1.9% -3.1%
Sweden 7.1% 9.8% -0.3%

Manufacturing employment
United States 20.1% 5.8% -7.5%
Japan 45.8% -0.9% 0.8%
France 7.8% -3.8% NA”
Germany 9.8% -9.5% NA”
Great Britain -4.6% - 18.1% - 16.0%
Italy 10.0% 3.6% -3.8%
Netherlands 4.0% - 19.7% NA
Sweden -5.0% - 37.0% -7.7%

Source: Bureau of Labor Statistics, Statistical Supplement to International Comparison of unemployment bulletin, September,
1983. As cited in U.S. Congress, Joint Economic Committee, “Industrial Policy Movement in the United States: Is It the Answer?“,
98th Congress, 2nd Session, 1984. S. Prt. 98-196, p. 31.
“NA, not available.

entrepreneurship’s contribution to job growth. First, we compare employment growth in the

United States and other western nations to demonstrate that job growth in the United States
is an economy-wide phenomenon, not merely a phenomenon of a particular sector or industry.
Second, the job generation research in the United States is reviewed to confirm that small
businesses have been the source of most job generation. Third, we combine the concept of
job generation with firm entry and exit to show that the dynamics of the United States
economy comply with Schumpeter’s descriptive theory of capitalism. Finally, the effect of
government policy on new firm formation is explored.

UNITED STATES EMPLOYMENT GROWTH

Table 1 shows employment changes in eight major western nations for 1960-1980, 1970-
1980, and 1980-1982. First, note that from 1960 through 1980, the United States had the
highest growth in total civilian employment, even exceeding Japan’s growth. In fact, of the
eight nations, only three-the United States, Japan, and the Netherlands-had employment
growth in excess of 10%.
Given the unprecedented scale of 1960s economic expansion in the U.S. and the
equally renowned lackluster “stagflation” of the 1970s one might assume that most of the
U.S. employment growth occurred in the 1960s. The 1970 through 1980 changes, however,
shown in column two of Table 1, reveal that the United States had the highest percentage
change in employment during the decade of the 1970s. Even Japan lags far behind the
United States in employment changes. Only the United States exceeds 10% growth.
264 B.A. KIRCHHOFF AND B.D. PHILLIPS

The recession of the early 1980s substantially dampened the United States employment
growth rate, as noted in the third column of Table 1. However, the worldwide recession
also dampened the growth of the other seven nations. In fact, the United States had the
second highest percentage growth among the eight nations. Only the United States and Japan
show positive change. All others show zero or negative changes in civilian employment.
The United States has obviously fared quite well in employment growth compared to
these seven nations. In addition, this growth, especially in the 197Os, occurred in the face
of significant increases in the U.S. trade deficit. Thus, even though the United States was
buying more goods and services from these seven nations, the net effect of such trade is
not evident in its relative increases in employment growth within its domestic economy.

Services or Manufacturing
The popular view is that most, perhaps all, new jobs in the U.S. have been created in
services rather than in manufacturing. According to analysis of the U.S. Small Business
Administration’s (SBA) data base, 48.3% of the 17 million new jobs created between 1976
and 1984 were in services. Contrary to popular belief, however, U.S. manufacturing em-
ployment has also increased, far more than most realize. Again using SBA’s data base,
6.4% of the new jobs from 1976 through 1984 were created in manufacturing.
The lower half of Table 1 shows these changes in manufacturing employment in the
United States compared to other nations from 1960 to 1982. Note that from 1960 to 1980,
the United States showed the second greatest increase in manufacturing jobs among the eight
nations, exceeded only by Japan. Japan is the clear leader in manufacturing employment
growth during these 20 years but no country is even close to the U.S.’ second position.
Furthermore, all of Japan’s growth in manufacturing employment is attributable to the
decade of the 1960s. From 1970 to 1980 (column two in Table 1) Japan experienced a
decline in manufacturing employment. Only the United States and Italy experienced growth
in manufacturing employment during the decade of the 1970s. The other six nations ex-
perienced declines.
The recession of 1980 to 1982 caused a decline in manufacturing employment in the
United States despite some offsetting growth among small firms. But similar, or even more
severe losses were experienced by three of the four other nations reporting. Only Japan
weathered the recession with a slight growth in manufacturing employment. Thus, although
much of U.S. employment growth has been in services, especially during the 1980 to 1982
recession, the United States had exceptional growth in manufacturing employment during
the 1970s compared to the other economically developed nations.
Outstanding growth in overall employment bolstered by exceptional growth in man-
ufacturing employment demonstrated by these data suggests that the U.S. economy has
characteristics that other nations would like to define and emulate. The characteristic sug-
gested by recent research reported in the popular media is that the United States has an
“entrepreneurial” economy. However, the popular media tend to rely upon anecdotal infor-
mation, and when the OECD reviewed the more rigorous research, it remained skeptical of
entrepreneurship’s role (OECD 1985).

FIRM SIZE AND EMPLOYMENT GROWTH

Employment growth in any economy can occur in two ways: existing firms can grow and
add employees, or new firms can form and grow, thereby initially acquiring and then adding
 EFFECT OF FIRM FORMATION ON JOB CREATION 265

employees. Let us first examine the growth of overall employment as a net indicator of these
two phenomena and then isolate the formation and growth phenomenon for separate analysis.

Growth in Employment by Firm Size

Since Birch (1979) first published his innovative microanalysis of job growth, a thury of
other studies replicating his methodology have appeared. Those available to the OECD in
1985 are neatly summarized in OECD Employment Outlook (1985). ’ It is this summary that
led to OECD’s confusion and doubt about the meaning of these studies, confusion resulting
from the lack of uniformity in definitions of size, base year, and length of time period
analyzed. In the United States OECD notes four studies showing that firms with less than
100 employees accounted for between 26% and 39% of jobs created. Birch’s original study
reports 82% of new jobs were created by firms with less than 100 employees.
Recent work by the SBA, however, expands upon Birch’s findings to create a uniform
set of definitions for firm size, base year, and time period. First, all firms are defined by
size of enterprise. An enterprise contains all establishments (individual places of work) under
the same ownership or control such as separate factories, subsidiaries, or multiple offices.
This is an important distinction since many large firms (enterprises) own, operate, and
control multiple places of work; the employment growth of a small manufacturing plant
(establishment) owned by a large firm would not be considered small firm growth within
the enterprise definition.
Furthermore, the definition of small has been set at 100 employees or less. SBA prefers
a definition of 500 or less employees, but Birch’s results are most consistently comparable
with SBA’s results if the 100 employee definition is used.
Second, the base year is uniformly taken every two years, and the time period is two
years corresponding to the updating cycle of firms by Dun and Bradstreet. Thus, there is
uniformity among time periods. This is important since firms move into larger size classes
as they grow, and the longer the time period, the greater the percentage of job growth that
may be attributed to smaller firms. For example, if one defined all firms as small or large
on a base year of 1950 and analyzed their job growth until 1980, the growth of many of
our giant corporations would be included in the small firm category. Xerox, Polaroid, Control
Data, Digital Equipment, and many others were small or started small after 1950. Such a
base year and time period would create unrealistic distortion of the intent of the analysis of
the small category.
A summary of the job generation research is shown in Table 2. Note that the first base
year (1969) and time period (3 years) are not uniform. This is because Birch’s data file
begins with 1969, not 1970 as would be desirable. However, in spite of this minor distortion,
the table clearly shows that small enterprises contribute a major share of total net new jobs
in the U.S. economy.
The results in Table 2 show that small firms make their greatest percentage contribution
during recessionary periods. Note that economic recessions occurred in 1969-70, 1973-75,
and 1980-82. The percentage of jobs created in 1969-72, 1974-76, and 1980-82 are among
the highest in the table, 82%, 66%, and lOO%, respectively. This suggests that small firms
experience disproportionately larger employment increases during recessions than farge firms.

‘A more recent summary reaches the same conclusion. In addition, many job creation studies in Europe
are conducted for manufacturing only. See Storey, D.J. and Johnson, S.G. 1987. Job Crearion in Small and
Medium Sired Enrerprises, Volume I-Main Report, Brussels: Commission of the European Communities.
266 B.A. KIRCHHOFF AND B.D. PHILLIPS

TABLE 2 Job Generation in the U.S. by Firms With Fewer

Than 100 Employees

Jobs generated by
Period of firms with fewer
observation than 100 employees (%)

1969-1972” 82
1972-1974” 53
1974-1976” 65
1976-197fib 56
1978-1980’ 38
1980-1982b 100
1982-19846 66

“Data from: Birch, David L. and MacCracken, Susan. January 1981. Corporate
~volutioo: A Micro-based Analysis. A report prepared for the U. S. Small Business
Administration by the MIT Program on Neighborhood and Regional Change under
SBA award no. 1451. Some of the establishments added to the files from 1969 to
1976 represent new listings rather than the creation of the new jobs.
bU.S. Small Business Administration, Office of Advocacy, Small Business Data
Base. The Small Business Data Base measures changes from the first quarter of one
period to the fiat quarter of the next period of observation.

It is more likely, however, that small firms show less job loss during recessions than large
firms. Thus, the net job gain of large firms is less during recessions because of their greater
losses. As evidence to support this conclusion, note that in 1980-82 all of the net new jobs
were created by small firms. Large firms actually experienced a negative net change in
number of jobs. Therefore, the substantial percentage con~bution of small businesses (100%)
is due more to a major decline in net job creation by large firms rather than to a major
increase in job creation by small firms.
Small firms’ contribution to employment varies by stage of the business cycle. Im-
mediately after recessions, 1976-78 and 1982-84, small firms still contributed a major share
of net new jobs. However, late in an exp~siona~ period, 1978-80, small firms cont~buted
a much smaller percentage of new jobs. Apparently, the high growth of small firms occurs
during the early stages of recovery, whereas large firms do not experience significant growth
until later in an expansion period. This evidence derives from only two recession-expansion
cycles so these conclusions remain tentative.
Not only has the United States thus experienced an outstanding growth in employment
compared to other developed nations, but most of this growth has occurred through the
activities of small firms. This evidence of small firms at the core of economic growth is
clearly conclusive for the United States.

Firm Formation and Growth

As noted earlier, employment growth can occur because of growth in existing firms or
because of new firm formation. Although the difference may seem unimportant to many
who are concerned solely with overall growth, investigation into the formation phenomenon
has revealed that it is a significant component of and determinant of economic growth rates.
Let us begin by examining the components of net new firm formation, i.e., the growth
in total number of firms. The process of net new firm fo~ation consists of new firm fo~ation
minus firm discontinuances; discontinuances can be firm terminations for a variety of reasons,
 EFFECT OF FIRM FORMATION ON JOB CREATION 267

TABLE 3 United States and United Kingdom-Firm Entry and Exit Rates, Annual Percent
Change from Firm Population at Start of Year

Net GNP or
change GDP growth
Entry (o/o) Exit (o/o) (8) (%I

United States
1976-78 11.7 -9.6 2.1 5.2
1978-80 10.4 - 10.4 0.0 1.2
1980-82 10.4 - 10.2 0.2 0.2
1982-84 12.5 -9.7 2.8 5.2
Average 11.3 - 10.0 1.3 2.9

United Kingdom
1979-80 12.1 - 10.9 1.2 -2.2
1980-81” 11.3 -9.4 1.9 - 1.1
1981-82” 12.0 -9.8 2.2 1.9
1982-83 12.0 - 8.6 3.4 3.4
Average 11.9 -9.7 2.2 0.5

Source: Armington, Catherine. March, 1986. Entry and Exit of firms: An International Comparison. An unpublished paper prepared
for the U. K. conference on Job Formation and Economic Growth, London. England, p. 16.
“Exits in these years were adjusted by shifting 0.5 percentage points, a 7000 closures, from 1982 to 1981 to correct for the
estimated effect on deregistration counts of a 1981 civil service strike.

bankruptcy being only one. Firms also voluntarily terminate. To sterilize the terminology
to avoid debates on why or how firms discontinue, we chose the terms “entry” and “exit.”
The data source for the following U.S. statistics is the Small Business Data Base of
the Office of Advocacy within the Small Business Administration. This data base provides
longitudinal data on individual firms (enterprises) from 1976 through 1984. This allows us
to trace each firm from entry through expansion and possible exit. In addition, since the
raw data for this data base come from Dun and Bradstreet Inc., the firms in the data base
are real operating businesses, not tax shelters (The State of Small Business 1984).
The results of analysis shown in Table 3 are taken from Catherine Armington’s in-
novative work with SBA’s data base on firm entry and exit. The table compares rates in the
United States and the United Kingdom. The table shows that overall, the United States has
entry rates higher than exit rates in three of the four time periods studied. Only 1978-80
shows a zero net change. The fourth column in Table 3 shows the growth in gross national
product (GNP) in each of these time periods. Note the striking relationship between GNP
growth and net change in firm formations. In years of greatest GNP growth, the net new
formations are also greatest; net new firm formation is correlated with GNP growth (Ar-
mington 1986).
Armington notes that entry rates range from low period to high period by 1.3% to
2.1%. Exit rates, however, vary less than 1% from period to period. Exit rates are more
stable from period to period than entry rates. Changes in “net change” percentages are largely
due to variations in entry rates rather than exit rates (Armington 1986). Later, we will show
additional data (Table 4) that new firm formation is the major contributor to job growth, so
that this correlation may indicate causal relationship, i.e., new firm formation may be a
significant cause of GNP growth.
Table 3 also shows entry/exit rates and economic growth for the United Kingdom.
Here again, net change in entry/exits is related positively to Gross Domestic Product (GDP),
268 B.A. KIRCHHOFF AND B.D. PHILLIPS

TABLE 4 Components of Net Changes in Number of Jobs From 1976 Through 1984 Classified
by Firm Size and Establishment Dynamics”

Total
Changes in establishment employment changes
Firm
size Entries Exits Expansions Contractions
(number
of Cum Cum Cum Cum Cum
employees) Number (%) Number (%) Number (%) Number (%) Number (%)

<20 9285 24.1 -6741 25.3 3339 25.3 - 930 13.1 4953 29.1
20-99 6163 41.1 -4116 40.7 2384 43.4 - 1340 32. I 309 1 47.3
100499 5056 54.6 - 3455 53.6 1767 56.8 - 1120 47.9 2248 60.5
>500 17074 100.0 - 12366 100.0 5700 100.0 - 3692 100.0 6716 100.0
Total 37578 - 26678 13190 - 7082 17008
Row % 220.9% - 156.9% 77.6% -41.6% 100.0%

Source: U.S. Small business Administration. Office of Advocacy, Small Business Data Base, USEEM file, unpublished data,
1987.
“Data are expressed in thousands. Detail may not add to totals due to rounding.

where GDP is GNP less imports and exports. Armington notes that in those years where
net changes are greatest, GDP is also greatest (Armington 1986). Notice that the magnitude
of the exit rates is about the same for both nations, but in the United Kingdom, the entry
rates in 1979-80 and 1981-82 are greater and therefore the net changes are also greater.
Nevertheless, the overall net changes in GDP are lower than those for U.S. GNP, suggesting
that the entry/exit phenomenon of the two countries differs in its contribution to overall
economic activity. Perhaps the United Kingdom has not yet built as large a base of entre-
preneurial activity or as efficient a mechanism to channel resources into newer entrepreneurial
opportunities. It is also possible that the large firm employment base is deteriorating more
rapidly in the United Kingdom than in the United States.
These results suggest that the lower rates of growth in employment may be related to
the differences in entry/exit rates; however, the data are inadequate to test this hypothesis.
Armington concludes that microdata should be developed in more nations so that the role
of entry and exit in determining economic growth can be determined (Armington 1986).

Firm Dynamics and Job Changes

The effect of entry and exit upon the creation of jobs can be extracted from SBA’s data by
examining the number of job changes resulting from the dynamics of entries, exits, con-
tractions, and expansions. The information for 1976-1984 is shown in Table 4.
Confirmation of Armington’s findings is shown by noting that 37,578,000, or 74%,
of all new jobs created were new establishment formations (entries column total) and 13,190,000,
or 26%, of new jobs were created by expansion of existing establishments. Clearly, new
establishment formation is the greatest source of new jobs.
Furthermore, within the new establishment formation total, 41.1% of these are new
establishments formed by firms with less than 100 employees; 54.6% are new establishments
formed by firms with less than 500 employees. Smaller firms dominate job creation resulting
from new establishment formation.
Within the establishment expansion category, firms with less than 100 employees
 EFFECT OF FIRM FORMATION ON JOB CREATION 269

contribute 43.4% of the new jobs, whereas firms with less than 500 employees contribute
56.8%. Smaller firms create most of the jobs deriving from establishment expansions.
Note that small firms’ percentage of net jobs created is greater than the percentage of
new jobs created by either entry or expansion. The reason lies in the jobs lost due to
contraction. Establishments owned by large firms account for a disproportionately large
percentage of the jobs lost by contraction.
At first glance, the last row of Table 4 seems to misrepresent the data because the
percentages exceed 100. What this row reveals, however, is the extent to which the dynamics
of entry, exit, expansion, and contraction contribute to the overall “flow” of jobs. The flow
is the total number of job changes, the sum of the gains and the losses. Table 4 shows that
there were 33,759,OOO jobs lost by the combination of exits and contractions, and 50,768,OOO
jobs created by entries and expansions for the net increase of 17,009,OOO. Thus, in total,
84,527,OOO job changes were necessary to create a net gain of 17,009,OOO. In other words,
for every net job gained, three new jobs were created and two were lost.
As noted earlier, entries created 74.0% of all new jobs while expansions created 26.0%.
The greater role of entries in job creation suggests that economic recessions have a different
dynamic than the popular view that focuses upon firm “failures.” Since the vast majority of
new jobs are created by firm entries, Armington’s finding that economic growth declines
when firm entry rates decline suggests that entry rates may be a causal variable in economic
cycles. Hypotheses about the dynamics of economic cycles should test entry rates as a causal
variable rather than treating failure rates as a resultant variable.
As the total flows of jobs are much larger than expected, and entries ate so important
to job creation, examination of the causes of new firm entry takes on a more important role
in understanding capitalist economies. European researchers acknowledge that the signifi-
cance of new firm entry increases the longer the elapsed time. Yet they do not stress the
role of such entries as suggested above. One possible reason is that new firm formations do
not generate a majority of new jobs in European manufacturing (expansions are more im-
portant) and the European economies are more tied to manufacturing than the United States.
In a recent study for the Common Market countries, Storey and Johnson (1987) list the rise
of the service sector as one reason for the increased interest in firm formation and small
firm job creation. Still, Storey and Johnson’s discussion of the formation process is blandly
descriptive and far short of an endorsement of the formation process as a correlate with
growth.

SCHUMPETER’S MODEL OF GROWTH THROUGH ENTRY

The above observations fit well with Schumpeter’s model of capitalistic economies. He
proposed that competition in capitalistic economies was not characterized by marketplace
give and take as described by classical economics, but instead consisted of entrepreneurs
using innovations to enter established markets. Such entry entails risk of failure; however,
when entrepreneurs succeed, the existing market structures/relationships among established
firms in the industry are destroyed. This he called “creative destruction.” The net result of
such entry and expansion dynamics would be the contraction and failure of some of the new
and old firms. Overall, economic growth would emerge as demand and supply are increased.
He hypothesized that when entrepreneurial entry declined, so would growth (Schumpeter
1942). The flows of job changes among entries, exits, expansions, and contractions shown
in Table 4 would not surprise Schumpeter.
Furthermore, Schumpeter believed that new firm entries occur in the early recovery
270 B.A. KIRCHHOFF AND B.D. PHILLIPS

phase of the business cycle and even hypothesized that entries were a major cause of economic
expansions. Thus, Armington’s findings combined with Table 4 give support to this hy-
pothesis as well.

Contemporary Innovation
Schumpeter perceived technological innovation as the principle mechanism of entrepreneurial
entry. Most anecdotal evidence in the popular press also stresses technological innovation
as the primary mechanism. Yet, some have cast doubt on the entire entrepreneurial thesis
because the rates of technological change, although high, cannot explain the phenomenal
growth in number of new firms arising in the last 15 years. However, the nature of innovation
may have changed just as our economy has shifted from products to services.
Bishop’s research (Bishop 1987) provides an interesting example of analysis that
focuses on “new” innovations as entry mechanisms. Bishop analyzed the differences in U.S.
and European job growth for the last 25 years and developed a model of entrepreneurial
innovation that is market, not technology, based. He examines the supply side and the
demand side of the labor markets. He concludes that the relatively free U.S. labor markets
responded to high unemployment with a reduction in the real wages paid to workers. Because
government pursued an expansionary course, the excess supply in the markets was absorbed
by small firms that had the flexibility to take advantage of the decline in real wages.
Meanwhile, large firms were often inflexible in setting wages due to established policies or
union influences. He attributes the substantial growth in small firm employment (as we
reported in Table 2) to small firm entry and growth based upon their ability to use the
reduction in real wages and the abundance of skilled labor available as large firms laid off
more employees when faced with declining demand.2
In Europe, he notes, governments intervened in the labor markets to prevent high
unemployment and thwarted the decline in real wages. This government intervention was
reinforced by the increasing strength and militancy of European labor unions. The net result
is a much lower growth in employment among European nations (Bishop 1987). Also, as
Armington’s preliminary data for four European nations suggest, it may have resulted in
much lower rates of firm entry and exit.
Bishop’s model fits well with Schumpeter’s description of innovative entrepreneurial
entry. In the United States, many entrepreneurs found entry innovations in simply supplying
similar products/services as large firms but with a labor force hired at substantially lower
wages. The entrepreneurial entry of new, low fare airlines shortly after airline deregulation
is an obvious example of new firm formation using this entry innovation. Viewed as a
Schumpeterian creative destruction process, these new low cost airlines entered an established
industry and created new competition that drove down prices, expanded services, and even-
tually destroyed several established firms while greatly expanding the demand for and supply
of airline travel.

SUMMARY AND CONCLUSIONS

We began by describing how the United States has had greater employment growth than most
developed nations of the world and how this growth has been broadly based including manu-

*Bishop’s analysis, however, fails to adjust for the large increase in voluntary part time employment during
the 1970s which contributed to the lowering of real wages.
 EFFECT OF FIRM FORMATION ON JOB CREATION 271

facturing. Next, we examined the data on the relative contribution of small and large firms to
the U.S. job growth. Here we find conclusive evidence that small firms are the major source of
net new job creation with strongest performance in periods of economic recession.
Further understanding of small firm job creation is obtained when we examine firm
entry and exit data. Here we find that variations in firm entry rates are the major dete~inant
of net new firm formations, as the exit rates are relatively stable from period to period.
Entrepreneurial activity, the formation of new firms, is the major cause of net increases in
the number of firms. Furthermore, evidence from the United States and the United Kingdom
suggests that net firm formation activity is positively correlated to overall economic activity.
Next we examine the role of entry, expansion, exit, and contraction upon job creation.
This finding, combined with the positive correlation of firm entry rates and economic growth,
suggests that new business formation is a significant determinant of economic growth as
hypothesized by Schumpeter. As further evidence of a Schumpeter-like economy, we find
that the magnitudes of entry, exit, expansion, and contraction are far greater than the net
changes in jobs imply. Three jobs are created and two lost for each net new job formed.
Creation of new jobs alongside the des~ction of existing jobs fits Schumpeter’s model well.
The causal relationship between net new firm entry rates and growth in gross national
product is hard to prove. Yet the correlational information is persuasive. In Europe, the
correlational evidence is taken as sufficiently adequate that promotion of new firm entry has
become ingrained in public policies (although not embraced by researchers as noted earlier).
In both the United Kingdom and Ireland, for example, an “enterprise allowance scheme”
provides unemployed persons a lump sum of money equivalent to a year’s unemployment
compensation payments if they start a business. A similar scheme operates in France. In
West Germany, the Netherlands, and Belgium, government provides deferrable loans for
those wishing to start a business. Repayment begins when profits are generated (Storey and
Johnson 1987). While U.S. government policy does not include such inducements, several
state governments have equity and debt investment organizations for new business starts.
Government policies can and have affected the creative destruction process. Bishop’s
research concludes that government policies of controlling labor markets decreased economic
flexibility in Europe. This prevented small firms from taking advantage of the decline in
real wages. In the United States, open labor markets led to more jobs and far greater economic
growth than experienced in Europe.
Furthermore, capitalistic economic phenomena as theorized by Schumpeter may not
be the only mechanism operating in the United States. It may be that deregulation activities
during the Carter and Reagan administrations created the entry opportunities. For example,
no amount of cheap labor would allow entry of a new airline while regulatory agencies
maintained a barrier of laws, regulations, and codes. Government policy can and does make
a difference, not only labor policy as described by Bishop but also regulatory policies.
Since entries create well over half of the new jobs and economic growth is related to
the rise and fall of entry rates, we conclude that entrepreneurial entry is a necessary re-
quirement for economic growth. In addition, since entrepreneurial entry is affected by
government policies, we conclude that consideration should be given to entry (or barriers
to entry) during economic policy making.
Histo~cally, however, government policy has not considered small firm entry an issue
during policy formation. Labor policy addresses labor issues without examining entry issues
as part of the formation process. Admittedly, including entry issues in labor policy is especially
hard to do because a Schumpeter-like creative destruction dynamic is characterized by a great
deal of turbulence in labor markets (three jobs created and two lost for everyone net new job).
272 B.A. KIRCHHOFF AND B.D. PHILLIPS

This turbulence entails considerable worker movement from job to job, and such labor move-
ment may involve uprooting of families from one geographic area to another. Turbulence may
be seen by policy makers as socially undesirable. For example, policies have recently been
proposed to protect workers from job loss due to contractions and exits. But such policies, as
demonstrated in recent European experience, will also construct barriers to entrepreneurial en-
try. The result may be a decline in small firm entry and a decline in economic growth.
Instead of protecting specific jobs, appropriate policies are those that facilitate movement
and reduce the suffering of workers when they involuntarily move from job to job. Adequate
unemployment compensation for short term unemployment, fully vested and portable pension
plans, and retraining programs are examples of policies that allow the labor market to remain
mobile while reducing the negative effect on those who involuntarily lose jobs.
Regulatory policy typically addresses consumer interests without recognizing that reg-
ulations create barriers to entry of new firms. For example, there is a clamor in Congress
to re-regulate the airlines since problems have emerged with delays in schedules and near-
miss accidents. Yet a form of regulation now exists in many busy aides-allocation of
take-off and landing rights (slots). Interestingly, the demise of the Civil Aeronautics Board
left the Federal Aviation Administration (FAA) in regulatory control because the FAA
operates the constraining resource, the air traffic control system. Thus, implicit regulation
still exists. Expansion of the number of lauding and takeoff slots in the air traffic control
system in the near future is unlikely as the adminis~ation has not budgeted funding for
significant expansion. Yet, no new airline can enter the system without take-off and landing
rights. Whether the conditions are right now for a new entry is arguable but conditions will
be right sometime in the future. Will FAA’s implicit regulation or even re-regulation, prohibit
entry in the future? Will the concept of barriers to entry even be considered as policy
alternatives are developed?
If the U.S. economy is going to continue to expand, government policy must address
the question of new firm entry as a major policy issue. Historically. our government has
developed interesting and useful macroeconomic policy prescriptions, but for the future the
essence of growth lies in new firm fo~ation~ntrepreneurship.

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