Enterprise and Small Business Principles

The geographic context

How can small firms’ innovative activity be explained? While many explanations have been offered for the innovative prowess of small firms, one that is consistent with both entrepreneurship and fundamental US American values is the role of property rights. Their relatively more generous property rights may explain small firms’ greater innova­tive capacity. People must be able to keep a portion of the fruits of their labour or they will not innovate. An innovator in a large company often has very limited property rights protection: the new product generally belongs to the firm, not the employee who invented it. Creative employees have less incentive to work hard for the company. The less-than-perfect incentive structure in many large corporations can allow bureaucratic inertia to drive corporate decisions. Managers’ and employees’ interests lie in protect­ing their claims on the firm’s cash flow. Small firms are better able to protect their property rights, which means that there is more incentive to work hard.

There are many incentives to work in addition to property rights. Corporate culture also affects motivation and incentives for hard work. For example, employees of Sun Microsystems (a large firm) have a commitment to succeed that is enhanced by the large number of people sharing it; that may be inspirational to the point of making people want to work harder. A small firm may not provide the commonly shared cul­ture of a large organisation and may therefore require more self-motivation to get new ideas out. New technology-based firms (NTBFs) gain their comparative innovative advantage by exploring new technological spaces that may have been overlooked by larger firms. In many industries small firms receive funding for such efforts. Regional networking facilitates this process and permits small firms to obtain and use know­ledge more efficiently in order to make radical innovations. Because their research is closely tied to that of other institutions and firms, it diffuses quickly.

Knowledge is localised for both start-ups and other firms, but start-ups are more closely tied into regional networks because they depend on networks for critical know­ledge inputs. If knowledge flows are localised, then firms located in distant regions are excluded from knowledge networks. Where this occurs, large firms must get knowledge inputs internally. Both small and large firms play important roles in innovative activity. Small firms tend to have the innovative advantage in industries with high technological opportunity and where large firms dominate. This suggests a division of labour between large and small firms. Small firms are superior in commercialising new knowledge; large firms are superior in their ability to appropriate returns from these innovations, either by buying property rights or acquiring the small firms. Thus, the greatest synergy might be achieved through continual mergers of new small firms with innovative products into large firms with international market access. For example, highly innovative small pharmaceutical companies are continuously absorbed into larger multinational firms as the industry is forced to become more efficient.

The evidence revealing small enterprises to be the engine of innovative activity in certain industries, despite an obvious lack of formal R&D activities, raises the ques­tion about the source of knowledge inputs for small enterprises. The answer emerging from a series of studies is from other, third-party, firms or research institutions, such as universities. Economic knowledge may spill over from the firm or research institu­tion creating it for application by other firms.

That knowledge spills over is rarely disputed. However, the geographic range of such knowledge spill-overs is greatly contested. In disputing the importance of knowledge externalities in explaining the geographic concentration of economic activity, Krugman (1991) and others do not question the existence or importance of such knowledge spill-overs. In fact, they argue that such knowledge externalities are so important and forceful that there is no compelling reason for a geographic boundary to limit the spatial extent of the spill-over. According to this line of thinking, the concern is not that knowledge does not spill over but that it should stop spilling over just because it hits a geographic border, such as a city limit, state line or national boundary.

A recent body of empirical evidence clearly suggests that R&D and other sources of knowledge not only generate externalities, but that such knowledge spill-overs tend to be geographically bounded within the region where the new economic knowledge was created. That is, new economic knowledge may spill over but the geographic extent of such knowledge spill-overs is limited (Jaffe, 1989). Krugman (1991, p. 53) has argued that economists should abandon any attempts at measuring knowledge spill-overs because ‘knowledge flows are invisible, they leave no paper trail by which they may be measured and tracked.’ But ‘knowledge flows do sometimes leave a paper trail’ - in particular in the form of patented inventions and new product introductions.