Enterprise and Small Business Principles

The role of firm size

At the heart of the conventional wisdom has been the belief that large enterprises able to exploit at least some market power are the engine of technological change. This view dates back at least to Schumpeter, who in Capitalism, Socialism and Democracy (1942, p. 101) argued that: ‘The monopolist firm will generate a larger supply of inno­vations because there are advantages which, though not strictly unattainable on the competitive level of enterprise, are as a matter of fact secured only on the monopoly level.’ The Schumpeterian thesis, then, is that large enterprises are uniquely endowed to exploit innovative opportunities. That is, market dominance is a prerequisite to undertaking the risks and uncertainties associated with innovation. It is the possibility of acquiring quasi-rents that serves as the catalyst for large-firm innovation.

Five factors favoring the innovative advantage of large enterprises have been iden­tified in the literature. First is the argument that innovative activity requires a high fixed cost. Second, only firms that are large enough to attain at least temporary market power will choose innovation as a means for maximisation. This is because the ability of firms to appropriate the economic returns accruing from R&D and other knowledge - generating investments is directly related to the extent of that enterprise’s market power. Third, R&D is a risky investment; small firms engaging in R&D make themselves vulnerable by investing a large proportion of their resources in a single project. How­ever, their larger counterparts can reduce the risk accompanying innovation through diversification into simultaneous research projects. The larger firm is also more likely to find an economic application of the uncertain outcomes resulting from innovative activity. Fourth, scale economies in production may also provide scope economies for R&D. Economies of scale in promotion and in distribution facilitate the penetration of new products, thus enabling larger firms to enjoy a greater profit potential from innovation. Finally, an innovation yielding cost reductions of a given percentage results in higher profit margins for larger firms than for smaller firms.

A number of explanations have emerged why smaller enterprises may, in fact, tend to have an innovative advantage, at least in certain industries. The factors yielding small firms with the innovative advantage generally emanate from the difference in manage­ment structures between large and small firms. For example, the bureaucratic organisa­tion of large firms is not conducive to undertaking risky R&D. The decision to innovate must survive layers of bureaucratic resistance, where an inertia regarding risk results in a bias against undertaking new projects. However, in the small firm the decision to innovate is made by relatively few people. Second, innovative activity may flourish most in environments free of bureaucratic constraints (Link and Bozeman, 1991). That is, a number of small-firm ventures have benefited from the exodus of researchers who felt thwarted by the managerial restraints in a larger firm. Finally, it has been argued that while the larger firms reward the best researchers by promoting them out of research to management positions, the smaller firms place innovative activity at the centre of their competitive strategy.

Scherer (1988, pp. 4-5) has summarised the advantages small firms may have in innovative activity: ‘Smaller enterprises make their impressive contributions to innova­tion because of several advantages they possess compared to large-size corporations. One important strength is that they are less bureaucratic, without layers of “abominable no-men” who block daring ventures in a more highly structured organisation. Second, and something that is often overlooked, many advances in technology accumulate upon a myriad of detailed inventions involving individual components, materials, and fabrica­tion techniques. The sales possibilities for making such narrow, detailed advances are often too modest to interest giant corporations. An individual entrepreneur’s juices will flow over a new product or process with sales prospects in the millions of dollars per year, whereas few large corporations can work up much excitement over such small fish, nor can they accommodate small ventures easily into their organizational struc­tures. Third, it is easier to sustain a fever pitch of excitement in small organizations, where the links between challenges, staff, and potential rewards are tight. “All-nighters” through which tough technical problems are solved expeditiously are common.’

Two other ways that small enterprises can compensate for their lack of R&D is through spill-overs and spin-offs. Typically an employee from an established large cor­poration, often a scientist or engineer working in a research laboratory, will have an idea for an invention and ultimately for an innovation. Accompanying this potential innovation is an expected net return from the new product. The inventor would expect to be compensated for their potential innovation accordingly. If the company has a dif­ferent, presumably lower, valuation of the potential innovation, it may decide either not to pursue its development, or that it merits a lower level of compensation than that expected by the employee.

In either case, the employee will weigh the alternative of starting their own firm. If the gap in the expected return accruing from the potential innovation between the inventor and the corporate decision maker is sufficiently large, and if the cost of start­ing a new firm is sufficiently low, the employee may decide to leave the large corporation and establish a new enterprise. Since the knowledge was generated in the established corporation, the new start-up is considered to be a spin-off from the existing firm. Such start-ups typically do not have direct access to a large R&D laboratory. Rather, these small firms succeed in exploiting the knowledge and experience accrued from the R&D laboratories with their previous employers.

The research laboratories of universities provide a source of innovation-generating knowledge that is available to private enterprises for commercial exploitation. Jaffe (1989) found that the knowledge created in university laboratories ‘spills over’ to con­tribute to the generation of commercial innovations by private enterprises. Feldman (1994) found persuasive evidence that spill-overs from university research contribute more to the innovative activity of small firms than to the innovative activity of large corporations. Large firms are more active in university-based research. However, small and medium-sized enterprises apparently are better able to exploit their university - based associations and generate innovations. Link and Rees (1990) conclude that, contrary to the conventional wisdom, diseconomies of scale in producing innovations exist in large firms. They attribute these diseconomies of scale to the ‘inherent bureau - cratisation process which inhibits both innovative activity and the speed with which new inventions move through the corporate system towards the market’ (Link and Rees, 1990, p. 25).

Thus, just as there are persuasive theories defending the original Schumpeterian hypothesis that large corporations are a prerequisite for technological change, there are also substantial theories predicting that small enterprises should have the innovative advantage, at least in certain industries. As described above, the empirical evidence based on the input measure of technological change, R&D, tilts decidedly in favour of the Schumpeterian hypothesis. However, as also described above, the empirical results are somewhat more ambiguous for the measure of intermediate output - the number of patented inventions. It was not until direct measures of innovative output became available that the full picture of the process of technological change could be obtained.

Using this new measure of innovative output from the US Small Business Adminis­tration’s Innovation Data Base, Acs and Audretsch (1990) show that, in fact, the most innovative US firms are large corporations. Further, the most innovative American cor­porations also tended to have large R&D laboratories and be R&D intensive. At first glance, these findings based on direct measures of innovative activity seem to con­firm the conventional wisdom. However, in the most innovative four-digit standard industrial classification (SIC) industries, large firms, defined as enterprises with at least 500 employees, contributed more innovations in some instances, while in other indus­tries small firms produced more innovations. For example, in computers and process control instruments small firms contributed the bulk of the innovations. By contrast in the pharmaceutical preparation and aircraft industries the large firms were much more innovative.

Probably their best measure of innovative activity is the total innovation rate, which is defined as the total number of innovations per one thousand employees in each industry. The large-firm innovation rate is defined as the number of innovations made by firms with at least 500 employees, divided by the number of employees (thousands) in large firms. The small-firm innovation rate is analogously defined as the number of innovations contributed by firms with fewer than 500 employees, divided by the num­ber of employees (thousands) in small firms.

The innovation rates, or the number of innovations per thousand employees, have the advantage in that they measure large - and small-firm innovative activity relative to the presence of large and small firms in any given industry. That is, in making a direct comparison between large - and small-firm innovative activity, the absolute number of innovations contributed by large firms and small enterprises is somewhat misleading, since these measures are not standardised by the relative presence of large and small firms in each industry. When a direct comparison is made between the innovative activity of large and small firms, the innovation rates are presumably a more reliable measure of innovative intensity because they are weighted by the relative presence of small and large enterprises in any given industry. Thus, while large firms in manufac­turing introduced 2,445 innovations in 1982, and small firms contributed slightly fewer, 1,954, small-firm employment was only half as great as large-firm employment, yielding an average small-firm innovation rate in manufacturing of 0.309, compared with a large-firm innovation rate of 0.202.

The most important and careful study to date documenting the role of German SMEs (enterprises with fewer than 500 employees) in innovative activity was under­taken by a team of researchers at the Zentrum fur Europaeische Wirtschaftsforschung (ZEW) led by Harhoff and Licht (1996). Harhoff and Licht show that the likelihood of a firm not innovating decreases with firm size. For example, 52% of firms with fewer than 50 employees were not innovative. By contrast, only 15% of the firms with at least 1,000 employees were not innovative. More striking is that the smallest firms that do innovate have a greater propensity to be innovative without undertaking for­mal research and development. While only 3% of the largest corporations in Germany are innovative without undertaking formal R&D, one-quarter of the innovative firms with fewer than 50 employees are innovative without formal R&D.

Systematic empirical evidence also suggests that too long a high gestation period required to innovate was a very important barrier to innovative activity. Other major barriers to innovative activity include legal restrictions and restrictive government policies, an excessive time required to obtain government approval for a new product, a shortage of finance capital, a lack of competent employees, and too high a risk.

Thus, there is considerable evidence suggesting that, in contrast to the findings for R&D inputs and patented inventions, small enterprises apparently play an important generating innovative activity, at least in certain industries. By relating the innovative output of each firm to its size, it is also possible to shed new light on the Schumpeterian hypothesis. In their 1991 study, Acs and Audretsch find that there is no evidence that increasing returns to R&D expenditures exist in producing innovative output. In fact, with just several exceptions, diminishing returns to R&D are the rule. This study made it possible to resolve the apparent paradox in the literature that R&D inputs increase at more than a proportional rate along with firm size, while the generation of patented inventions does not. That is, while larger firms are observed to undertake a greater effort towards R&D, each additional dollar of R&D is found to yield less in terms of innovative output.

The contribution of small firms to technical change is uneven across technologies. Table 5.1 examines the presence of small firms in each technology using two measures. First, the table reports the small firm share of patents in each technology area, and the total number of patents. The second measure, the share of firms that are small by technology area, is more complicated because each firm had to be classified into a tech­nology area based on where most of its patents are found. Firms with presence in two areas were counted into both technology areas. Therefore, the sum of the number of firms across technology areas exceeds the number of firms in the study.

Overall, one-third of the top 1,000 most patenting US firms are small, and small firms have a 6% share of patenting. In biotechnology however, small firms produce one-quarter of the patents and account for 71% of the patenting firms. They are also over represented in the other health-related areas - pharmaceuticals, medical equip­ment and medical electronics. Patenting in chemicals and agriculture is related to the health areas and so the pattern is similar though weaker there.

The unclassified patents are another area of small firm strength. Unclassified patents encompass, among other things, patents on gaming - golf, snowboarding, toys, casino gaming, etc. - and 21% of them belong to small firms. In information technology (IT) the pattern is different. In health-related technologies small firms produce a higher

share of patents, and account for a higher share of firms whose patents focus on health technologies. Small firms account for one-third of patent share, which is in line with their presence overall. However, in information technologies - areas such as semicon­ductors and office equipment - the small firm share of patents is lower than 6%, but the share of firms that are small is higher than one-third. In other IT areas, telecom­munications and computers, the share of patents is low while the share of firms is about one-third. This suggests that although small firms are relatively more active in these areas, large firms have a higher propensity to patent than in other areas and so overshadow the small firm effort when simple patent counts are examined.

Areas where small firms are weakest include: oil and gas, aerospace, motor vehicles and industrial machinery. In all these areas, small firms have less than half the share of patenting we would expect given their overall presence in the study, and small firms account for less than one-third of firms. Health and information technologies were the fastest growing areas of patenting for US innovators over the past decade (Hicks et al., 2001). The strength of small firm innovators in these burgeoning areas of technology is not an accident. The small firms no doubt made innovation in these technologies more dynamic, and small firms were no doubt attracted into these areas because they offered great technical opportunity. The greater small firm presence in these newer industries is in line with previous research that has established that small firms play an important role in innovation early in the evolution of industries (Audretsch, 1995; Freeman and Soete, 1997).