Enterprise and Small Business Principles

The knowledge production function reconsidered

The model of the knowledge production function becomes even less compelling in view of the evidence documented earlier that entrepreneurial small firms are the engine of innovative activity in some industries, which raises the question: Where do new and small firms get the innovation producing inputs, that is the knowledge?

The appropriability problem, or the ability to capture the revenues accruing from investments in new knowledge, confronting the individual may converge with that con­fronting the firm. Economic agents can and do work for firms, and even if they do not an incumbent firm can potentially employ them. In fact, in a model of perfect informa­tion with no agency costs, any positive economies of scale or scope will ensure that the appropriability problems of the firm and individual converge. If an agent has an idea for doing something different from what is currently being practised by the incumbent enterprises - both in terms of a new product or process and in terms of organisation - the idea, which can be termed as an innovation, will be presented to the incumbent enterprise. Because of the assumption of perfect knowledge, both the firm and the agent would agree upon the expected value of the innovation. But to the degree that any economies of scale or scope exist, the expected value of implementing the innova­tion within the incumbent enterprise will exceed that of taking the innovation outside the incumbent firm to start a new enterprise. Thus, the incumbent firm and the inventor of the idea would be expected to reach a bargain splitting the value added to the firm contributed by the innovation. The payment to the inventor - either in terms of a higher wage or some other means of remuneration - would be bounded between the expected value of the innovation if it was implemented by the incumbent enterprise on the upper end, and by the return that the agent could expect to earn if he used it to launch a new enterprise on the lower end.

A different model refocuses the unit of observation away from firms deciding whether to increase their output from a level of zero to some positive amount in a new indus­try, to individual agents in possession of new knowledge that, due to uncertainty, may or may not have some positive economic value. It is the uncertainty inherent in new economic knowledge, combined with asymmetries between the agent possessing that knowledge and the decision-making vertical hierarchy of the incumbent organisation with respect to its expected value, that potentially leads to a gap between the valuations of that knowledge.

Divergences in the expected value regarding new knowledge will, under certain con­ditions, lead an agent to exercise what Hirschman (1970) has termed as exit rather than voice, and depart from an incumbent enterprise to launch a new firm. But who is right, the departing agents or those agents remaining in the organisational decision­making hierarchy who, by assigning the new idea a relatively low value, have effec­tively driven the agent with the potential innovation away? Ex post the answer may not be too difficult. But given the uncertainty inherent in new knowledge, the answer is anything but trivial a priori.

This initial condition of not just uncertainty but greater degree of uncertainty vis - a-vis incumbent enterprises in the industry is captured in the theory of firm selection and industry evolution proposed by Jovanovic (1982). The theory of firm selection is particularly appealing in view of the rather startling size of most new firms. For example, the mean size of more than 11,000 new-firm start-ups in the manufacturing sector in the US was found to be fewer than eight workers per firm. While the minimum efficient scale (MES) varies substantially across industries, and even to some degree across various product classes within any given industry, the observed size of most new firms is sufficiently small to ensure that the bulk of new firms will be operating at a suboptimal scale of output. Why would an entrepreneur start a new firm that would immediately be confronted by scale disadvantages?

An implication of the theory of firm selection is that new firms may begin at a small, even suboptimal, scale of output, and then if merited by subsequent performance expand. Those new firms that are successful will grow, whereas those that are not suc­cessful will remain small and may ultimately be forced to exit from the industry if they are operating at a suboptimal scale of output.

An important finding of Audretsch (1995) is that although entry may still occur in industries characterised by a high degree of scale economies, the likelihood of survival is considerably less. People will start new firms in an attempt to appropriate the expected value of their new ideas, or potential innovations, particularly under the entrepreneurial regime. As entrepreneurs gain experience in the market they learn in at least two ways. First, they discover whether they possess the right stuff, in terms of producing goods and offering services for which sufficient demand exists, as well as whether they can produce that good more efficiently than their rivals. Second, they learn whether they can adapt to market conditions as well as to strategies engaged in by rival firms. In terms of the first type of learning, entrepreneurs who discover that they have a viable firm will tend to expand and ultimately survive. But what about those entrepreneurs who discover that they are either not efficient or not offering a product for which there is a viable demand? The answer is that it depends on the extent of scale economies as well as on conditions of demand. The consequences of not being able to grow will depend, to a large degree, on the extent of scale economies. Thus, in markets with only negligible scale economies, firms have a considerably greater likelihood of survival. However, where scale economies play an important role the consequences of not grow­ing are substantially more severe, as evidenced by a lower likelihood of survival.

What emerges from the new evolutionary theories and empirical evidence on the role of small firms is that markets are in motion, with a lot of new firms entering the industry and a lot of firms exiting out of the industry. The evolutionary view of the process of industry evolution is that new firms typically start at a very small scale of output. They are motivated by the desire to appropriate the expected value of new eco­nomic knowledge. But, depending upon the extent of scale economies in the industry, the firm may not be able to remain viable indefinitely at its start-up size. Rather, if scale economies are anything other than negligible, the new firm is likely to have to grow to survive. The temporary survival of new firms is presumably supported through the deployment of a strategy of compensating factor differentials that enables the firm to discover whether or not it has a viable product.

The empirical evidence supports such an evolutionary view of the role of new firms in manufacturing, because the post-entry growth of firms that survive tends to be spurred by the extent to which there is a gap between the MES level of output and the size of the firm. However, the likelihood of any particular new firm surviving tends to decrease as this gap increases. Such new suboptimal scale firms are apparently engaged in the selection process. Only those firms offering a viable product that can be pro­duced efficiently will grow and ultimately approach or attain the MES level of output. The remainder will stagnate and depending upon the severity of the other selection mechanism - the extent of scale economies - may ultimately be forced to exit out of the industry. Thus, the persistence of an asymmetric firm-size distribution biased towards small-scale enterprise reflects the continuing process of the entry of new firms into industries and not necessarily the permanence of such small and sub-optimal enter­prises over the long run. Although the skewed size distribution of firms persists with remarkable stability over long periods of time, a constant set of small and suboptimal scale firms does not appear to be responsible for this skewed distribution. Rather, by serving as agents of change, entrepreneurial firms provide an essential source of new ideas and experimentation that otherwise would remain untapped in the economy.