8. Entrepreneurial motives

People become self-employed for a variety of motives, such as the following:

-          refuge from unemployment into self-employment due to economic crisis or discrimination in
       labour markets
-          independence and ‘doing one’s own thing’ as an aim in itself
-          desire to combine the personal with work
-          maintenance of small scale, escape from pressures for growth
-          unwillingness or inability to function under a hierarchy
-          ambition to pursue ideas that are not accepted in established firms
-          motivation to serve society according to one’s own convictions
-          thirst for profit, power or growth
-          answer to a ‘wake-up call’ from some personal crisis (illness, accident, divorce, bereavement)
-          an opportunity that happens to come along, in an inheritance, succession of a relative in a family
       firm, an offer of a partner to join, a facility that happens to become available.

 Different people become independents for different reasons, with different attitudes and ways of doing things. They can afford this to the extent that they or friends or family provide their own, private capital. This variety stands in contrast with larger firms, especially firms quoted on a stock exchange, who have to satisfy more uniform demands and expectations from capital markets.

The variety of motives and ways of doing things further increases the transaction costs that small firms impose on others. It also complicates government policy for small firms. While due to the idiosyncrasy of small firms a differentiated, custom-made approach, with tailored regulations and schemes is in order, precisely due to the small scale of the firms that is uneconomic.

Note that only some of the motives for self-employment are related to innovation. Some may well yield a highly traditional or even conservative venture. In fact, the great majority of self-employed (say 80 %) are hardly innovative. Novelty often goes no further than a new location for a traditional activity. 

Often, the only source of income is profit from the firm. As a result, motivation is strong. In bad times, independent entrepreneurs are more willing to absorb a cut in income than employees would be. Next to this advantage there is also a possible disadvantage here. For lack of a spread of risk (as is offered in capital markets) the entrepreneur may be more conservative, less willing to stake his source of income in risky projects. In fact, as already indicated, the majority of small business is traditional and wary of change.

The combination of private and commercial interests can yield problems. The bonds and emotions of family or partnership may yield a lock-in into relationships that are (no longer) viable, and in an excess of trust and informality, with too few explicit agreements, and an obstacle in expressing criticism. Such lack of openness can in fact lead to a breakdown of trust in the failure to achieve expectations that were left unclear and in misunderstandings that were left undiscussed.

Often, an entrepreneur is either technically or commercially oriented and inspired, and seldom both at the same time, while both orientations are needed for success. Hence one often sees teams of technical and commercial partners. A third and neglected dimension here is organizational ability, in particular the ability to collaborate with other firms.

By leaving innovation to entrepreneurs risk is privatized, left to entrepreneurs who undertake risk willingly. The alternative is to let government innovate, by which risk is socialized and imposed on a society that is largely risk-averse. That would not come off the ground.

 

 

7. Transaction costs

Transaction costs are costs of relations in general and markets in particular. They affect decisions to do things inside or outside the organization, and they affect the position of small relative to large firms. They are important for economics in general, but in innovation there are special features.

Between organizations there are transaction costs in different stages of  a relation: costs of contact and contract prior to a transaction and costs of control afterwards, in the execution of agreements.

Costs of contact are costs of searching for customers or suppliers and of judging their quality and reliability. Costs of contract are costs of coming to an agreement, whether formal, in a contract, or informal. Costs of control are costs of monitoring compliance, renegotiation, haggling, intermediation, and possibly litigation.

Costs of evaluation of quality vary between the following categories of products:

-          search goods: quality can be judged prior to use. Examples are cars, houses, appliances, etc.
-          experience goods: quality is judged during use. Examples are restaurants, performances,
       holidays, etc.
-          credence goods: even after use quality still cannot be judged. Examples are consultants, doctors,
       garages, etc. If one had the knowlwdge and skill to judge their work one would not have needed
       them in the first place.

Often there is a mix. Education is primarily a credence good: one can judge quality only later, in the practice of what is learned. However it is also an experience good in the skill and enthusisiasm of a teacher and conditions of class. Attempts are made to reduce transaction costs by turning it into a search good, by means of scores of graduation success and teacher evaluation. There is a danger here of reducing evaluation to what is readily measurable, even if the most important dimensions are difficult to measure.

In innovation transaction costs are particularly high due to the uncertainties of innovation. It is difficult to judge the quality and reliability of a product or a firm that is still under development, to specify contractual conditions under uncertain prospects, and to judge performance for which there are not yet any standards or benchmarks.  

An important point in the present context of comparing large and small firms is that there are economies of scale in transaction costs, both for a small firm and for others dealing with small firms. To judge a small firm and make agreements there are set-up costs (or threshold costs, see the preceding item in this blog on economies of scale) of a visit, acquaintance, evaluation and contracting that are relatively expensive when small volumes of business are involved. Furthermore, in small business much information is tacit, buried in the mind of the entrpreneur and not available in accessible documents, which are often available in larger firms. This is related to the condition that in small firms there is direct, visual control by the entrepreneur, so that costs of setting up and operating formal control systems may be saved. However, to judge the firm one needs to somehow pry the informal, tacit information from the entrepreneur, which is costly and imperpect.

For judging others, a small firm lacks the knowledge and expertise (technical, commercial and legal) for finding and judging opportunities and setting up agreements and monitoring. For this, it must employ third parties, who in their turn need to be judged, contracted and evaluated, which yields second order transaction costs.

6. Economies of scale

 Economies of scale are important in economics in general and in innovation in particular, in view of the role of small firms in entrepreneurship.

There are three types of effects of size or quantity on efficiency (low cost): economies of scale, scope and experience.

Economies of scale are efficiencies due to ‘more of the same’: the quantity of production per unit of time.  There are several forms of it. One is engineering economies, or ‘pots and pans effect’, due to the fact that the content of a spherical container for production (a reactor in oil and chemical industries, a building, a bulbous vehicle), which determines production capacity, is proportional to the cube of the radius of the sphere r (r³), while costs are a function of the surface (material costs, weight and transport costs, loss of heat or cold by radiation, ….), which is proportional to the square of the radius (r²). As a result, the costs per unit production are proportional to the inverse of the radius (1/r).

A second economy of scale lies in specialization (as identified already by Adam Smith, with his example of the pin factory): with a larger volume it pays to break down a production process into steps of specialized activity (for labour or machinery) that can be performed more efficiently than when they need to be combined in one unit with more general capabilities. A qualification here is that more integrated work can offer advantages of intrinsic motivation of labour that can have a positive effect on efficiency, and programmable machinery yields more flexibility.

A third economy of scale lies in the efficient utilization of some capacity that is available only in ‘chunks’: units of production with a minimum size. This can be a machine or a worker. We find the latter, for example, in a shop where a minimum of one attendant is needed during opening time, regardless of the number and flow of customers. This is a threshold cost. As the volume of production increases, the utilization of threshold capacity increases. At some point additional capacity will be needed (or else customers will have to wait too long to get service, and queues will lengthen), but then labour can be employed part-time, only to cover peaks in demand. This economy of scale has been the cause of a steady decline of the number of small shops. We find the effect at any service point for customers (in retailing, recreation, health care, municipal services, fire brigade, etc.)

Economy of scope is efficiency due to the combination of different products using the same resources. The classic example is that of an orchard in which trees must be at sufficient distance for air and light, and space between them is utilized for grazing cattle. Another classic example is the salesman of coal in winter who sells ice-cream in summer. Another is the combination, in freighting, of different products in one ride. Sometimes different products complement each other technically, sometimes in combination they yield a portfolio of choice for customers, and sometimes they pool and thereby spread risks. A qualification here is that diversification into a variety of products may also lead to a loss of efficiency due to a loss of focus on so-called core competencies, diluting resources. An alternative is to reap the advantages of scope in collaboration between different firms with different focus.

Economy of experience is efficiency due to an accumulation of production volume in time, creating efficiency of learning by doing, in which expertise is honed, processes are streamlined and redundant cost elements are eliminated. This yields what is called a learning curve. A qualification here is that routinization in cumulative experience may also yield lock-in, with blindness to new opportunities or needs and an inability to change. For change one has to step onto the beginning of a new learning curve, at a high level of initial cost.  

 

5. Entrepreneurship

With this item I start a series on entrepreneurship.

Entrepreneurship is essential for innovation, but what does it entail? In time, in the literature there have been various notions of it, as follows:

- risk taking
- configuring resources
- creative destruction
- novel combinations
- creating or entering new markets
- management
- inspiring people

Currently, the emphasis lies on the dimensions of innovation: risk taking, novel combinations, and new markets. The rest is seen as less a matter of entrepreneurship and more a matter of management.

A debate that goes back to Schumpeter concerns the questions whether small or large firms and perfect or imperfect competition most produce innovation. Schumpeter proposed that in early capitalism it was the small, independent outsider who produced innovation, while in later capitalism it was more the large firms that could sustain the specialized, knowledge intensive labour needed for high tech innovation, with large laboratories and deep pockets for the long slog of development.

Concerning competition an argument was that while it gives an incentive for innovation, long, costly and risky processes of development require a buffer of profit that can only arise under limited competition. Empirical research indeed indicates a curvilinear relationship: some competition has a positive but much competition a negative effect.

Concerning the issue of large versus small firms, the strength of large firms lies in resources of specialized knowledge, deep pockets, spread of risks across products and/or markets, market access and power, a longer-term perspective, and strategic action.

Weaknesses lie in conservatism, for several reasons. One is that decisions have to pass multiple levels, which slows down decision-making and increases the chance that innovative ideas will be voted down. Another is that with established products, and investments sunk in corresponding technologies and markets, large, established firms have an interest in halting or postponing innovations that cannibalise existing products and destroy existing competencies and investments. Also, because of their size and corresponding power of employment, economic leverage and lobbying in networks of supervisory boards and politicians, they can exert political power to achieve their ends. They have an interest and the capability to establish a focus of policy on incremental rather than radical innovation, to protect their investments, while they legitimise their actions by contributing to incremental innovation.

Paradoxically, small, independent outsiders are efficient in the innovation system because of their weakness in survival under failure. Failures are efficiently weeded out, while in large firms and government they may be propped up with subsidization from successful projects or from taxes, to protect the reputation of decision makers. Also, to the extent that they are not yet involved in existing markets, outsiders have no vested interests to protect, and decision-making is often up to the entrepreneur by him/herself.

To a large extent, the advantages of smaller firms are behavioural: in flexibility, fast decisions, motivation and willingness to sustain setbacks. I conclude that for radical innovation, the strength lies mostly in the smaller firm. I will dedicate a separate item to a further analysis of the strengths and weaknesses of small firms.

However, in view of the opposite strong and weak points of small and large firms, it is best to focus on their complementarity, seeking combinations that benefit the economy. Also, by decentralization into more autonomous units large firms can try to approach the advantages of small firms, and by collaborating in alliances and networks small firms can achieve some of the benefits of large size. The relative strengths of large and small firms also depend on the extent of economies of scale. I will dedicate the next item to that.