Are we entering the Second Age of Small?

Over the last couple of years, there has been a heated debate as to whether it is a ‘good thing’ to be self-employed. You wouldn’t think so after reading news headlines such as ‘Young jobless fuel growth in UK start-ups’, and ‘Self-employment hits 20 year-high as people try to avoid unemployment’. But the results of several recent studies are unequivocal: the vast majority of the self-employed prefer to work for themselves. 

This much is now accepted by those on both the right and left. Yet just when you think we've arrived at some consensus, another debate (perhaps even more contentious) is eager to take its place. This is the question of whether the growth in self-employment is desirable for the UK economy as a whole, not just for the individuals involved. Striking out alone may make people happier, but does this come at the expense of strong productivity, vibrant innovation and a healthy tax base?

The answer from several leading economists is a resounding ‘yes’. Speaking at our Self-employment Summit earlier this month, Will Hutton described the growth in self-employment as “part of a picture of capitalism that is seriously dysfunctional”, while Vicky Pryce expressed concern that this phenomenon would “put us on a lower productivity path” for the foreseeable future (have a look at the spotlight video below).

These views are echoed in a number of academic papers, including a particularly gloomy one by Paul Nightingale and Alex Coad (hat tip to Steven Toft for drawing my attention to this). Responding to the supposed fetish that policymakers have with small businesses, the authors write:

'It certainly is the case that a small number of start-ups have a positive impact on the economy, but most of the time, for most of the firms, and for most of the performance metrics, the economic impact of entrepreneurial firms is poor.

The firms are marginal because they lack the ambition or capability to grow or innovate, have high death rates, and are poorly captured in statistics or academic studies. They are undersized because they lack the minimum efficient scale needed to perform on par with incumbents in their sectors and industries. As a result, they are poor performance: they have low productivity and low levels of innovation, and generate churn rather than economic growth.'

Are Nightingale and Coad right to be so sceptical? The first point to note is that the research on the economic impact of small firms is thin on the ground and suffers from several methodological issues. There is only so much we can extrapolate from a study of small manufacturing Italian firms, or an analysis of microbusinesses in the Canadian retail sector.

To complicate matters further, the self-employed community is highly heterogeneous. Is it really appropriate to include the large number of small businesses run by part-timers in our analysis? Or the 400,000 self-employed people who are over 65? Many of these are likely to run hobby businesses, and will therefore skew any analysis. 

But let’s put these issues to one side and focus on what we know. A cursory look through the literature and available data on small businesses indicates that they do indeed fare worse on several economic indicators. Take the example of innovation. The latest results from the UK Innovation Survey (formerly known as the Community Innovation Survey) reveal that small businesses are less likely to invest in R&D, to acquire external R&D and to spend money on training for innovative activities. Unsurprisingly, this in turn feeds into relatively low levels of product and process innovations.

Yet look beyond the topline figures and a more nuanced picture becomes apparent. In their excellent meta-review of the literature, the Dutch academics van Praag and Versloot find that, while there is conclusive evidence that small businesses produce fewer patents and radical innovations than large firms, there is some evidence to suggest they create more innovations per employee. In other words, they may be more ‘innovation intensive’. The authors conclude that:

‘Entrepreneurs and their counterparts contribute equally importantly to the innovativeness of societies. However, they serve different goals in terms of quality, quantity and efficiency, as well as in terms of producing (and adopting) more radical (and higher cost) innovations.'

We also need to take a dynamic perspective here. Many of the papers that economists refer to were published way back in the late 1990s and early 2000s. Yet since then, the increasing sophistication of the internet and other related technologies have radically changed the business landscape by bringing down barriers to entry and reducing the minimum efficient scale necessary to operate. Nowhere is this more apparent than in the tech sector, where small groups of developers have shown it is possible to outgun the innovation departments of the largest global behemoths.

Alongside changing technologies, the other major structural shift is changing markets. The UK economy continues to shift from manufacturing towards services, where small businesses are more able to thrive. Moreover, the service industry itself is morphing in response to changing consumer tastes and demographic pressures such as an ageing society. Some of the fastest growing sectors are those that rely on relationships, care and a ‘personal touch’ - all things that small businesses are arguably better able to offer. Think of the personal tutor, caregiver, trainer, and so on.

Indeed, our recent analysis found that microbusinesses* account for 41 percent of employment in the 20 fastest growing industries, as measured across 2010-2014. This is despite only making up 34 percent of overall employment. Microbusinesses are home to 75 percent of workers in personal service activities, 45 percent in computer programming and consultancy, 57 per cent in education, and 40 percent in human health activities. The implication is that microbusinesses may be the ideal economic unit for the future, driving growth rather than hampering it.

Of course, this is not an entirely new economic scenario. The pre-industrial revolution was characterised by cottage industries where many people made handmade goods and worked in small teams. This all changed with the introduction of mass production and managerial science. But perhaps, at least in certain sectors, we’re now going full circle – a second age of small, if you like.

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*Businesses with 0-9 employees. Sorry - a departure from 'small business', I know. Few studies refer exclusively to 'microbusinesses', and even the UK Innovation Survey excludes them from their available datasets. This is one of the methodological issues mentioned above.