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New Business, New Life; A Perspective on Business and Economics, with Ilustrations from Small Business Inception

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The theme of this paper is developed in three parts. The first is concerned with methodology. The case is argued for a 'grounded' approach to the analysis of business economics. The second is concerned with intellectual history. It argues that the great economists, such as Smith, used this method, and that the best business economists have followed this lead. The third is concerned with displaying how the method espoused and justified is applied to the theme of 'new business, new life'. It appeals to an empirical model of small firm survival, emphasising the complex of decisions undertaken by the entrepreneur.
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NEW BUSINESS, NEW LIFE:
A PERSPECTIVE ON BUSINESS AND ECONOMICS,
WITH ILLUSTRATIONS FROM SMALL BUSINESS INCEPTION
a
Professor Gavin C Reid, University of St Andrews
ABSTRACT
The theme of this paper is developed in three parts. The first is concerned with methodology. The case is
argued for a ‘grounded’ approach to the analysis of business economics. The second is concerned with
intellectual history. It argues that the great economists, such as Smith, used this method, and that the best
business economists have followed this lead. The third is concerned with displaying how the method espoused
and justified is applied to the theme of ‘new business, new life’. It appeals to an empirical model of small firm
survival, emphasising the complex of decisions undertaken by the entrepreneur.
I. INTRODUCTION
My theme is ‘New business, new life’ and its ultimate focus is on the role of new business in revitalising the
life of the system of enterprise. In developing this theme, my intention is to keep business and economics very
much in mind, in keeping with the mission of what is itself a new enterprise, the Business and Economics Society
International (B&ESI). In the North West of the UK a best friend is called a ‘Besi’ and I think the warm and
positive atmosphere of this meeting encourages me to treat the ‘BESI’ launched by Demetri and Helen Kantarelis
in 1996 as a best friend.
My paper proceeds as follows. First, I identify the position of the small business enterprise in the economy.
Mae West said ‘it’s not the man in my life I care about, it’s the life in my man’. Similarly, it is not just that we
care about the existence of small firms in the body of enterprise, but that we identify with the small firm the
capacity to invigorate and re-vitalise the body of enterprise. According to what Acs and Audretsch (1993) call
the ‘new learning’ of industrial organisation, small firms are distinguished by their flexibility. They can adapt
readily to exploit new market niches, and rapidly both embrace and develop new technologies. Second, I set the
scene in a methodological sense, advocating a closer relationship between business and economics. I trace the
roots of that relationship back to the beginnings of economics, and show that whilst frequently neglected, it
continues to flourish in the hands of the very best economists. Third, I advocate a particular methodology for the
pursuit of studies in business and economics. It involves a solid ‘grounding’ of the subject in business reality, in
order that the theoretical, quantitative and qualitative work of economists always enjoys a solid foundation in
actual business practice. Fourth, I appeal to a unique body of evidence and analysis on ‘New business, new life’,
which has two parts: a set of small business vignettes; and a set of econometric estimates. The former display
key features of new business inception; and the latter display determinants of the survival of this new business
life form in the early stage of its life cycle.
The justification for an interest in small business is not difficult. There is a generic size distribution of firms.
The precise measure of size used is not critical. It can, for example, be sales (perhaps the most common),
employment, assets, profit or market value. Whatever the measure of firm size, the size distribution is of the
Pareto form
1
, which indicates that the smaller is the firm size, the more frequent is the firm type. Thus the very
highest frequency of firm type is the sole proprietorship, and so-called micro-firms (employment size of ten or
less) are the typical or modal firm type. This generalisation is robust across all market or mixed market
economies. To illustrate with reference to the EU, across all member states, SMEs employ 70 million people,
which is 70 per cent of the working population. Micro-firms contribute one third of employment and one quarter
of total turnover.
II. BUSINESS AND ECONOMICS, AND BUSINESS ECONOMICS
The business form as an institution goes back thousands of years. The discipline of economics itself certainly
started hundreds, if not thousands of years ago.
2
However, ‘business economics’, that blend of the two, is a
relatively new subject, and essentially twentieth century in origins. To judge by recent texts and monographs on
the subject, like Townsend (1995), Nellis and Parker (1992) and Kay (1996), the subject matter of business
economics is the microeconomic analysis of real business practices, and its scope ranges from firms, markets and
industries to the aims of business and types of competition. To amplify, the analytical heart of business
economics includes resource allocation, opportunity cost, diminishing returns, marginal analysis, business
objectives, dynamics and externalities. A feature of the methodology it espouses is that it has a prescriptive
dimension. Thus it aims not just to analyse and predict, its positive dimensions, but to meet the needs of the
business manager in the daily process of decision making, Nellis and Parker (1992, p.2). Although the
perceptions which business managers have of economics may sometimes be negative, it can be argued, as Kay
(1996) does, that this is because they think economics is all about forecasting. As the forecasting capabilities of
economists are strictly limited, managers are not unduly impressed. However, the key problems of business
executives, like the internal organisation of the firm, relations between suppliers and customers, and strategic
interactions between small groups of firms, are at the core of modern economics. Thus the business of
economics should be the economics of business, and business can benefit from this orientation.
This argument for a closer relationship between business and economics is not new, though it can never be
rehearsed enough. It was certainly central to the methodological principles of the very greatest of economists.
To take three examples, drawn from each of the three centuries over which economics has been identifiable as a
coherent, independent discipline, namely the eighteenth, nineteenth and twentieth, I would refer to Adam Smith,
Alfred Marshall, and Ronald Coase, respectively. Smith developed the first complete account of the enterprise
economy and its properties; Marshall greatly refined it, creating new analytical tools which we still use today;
and Coase brought it to a new high point, introducing the all embracing notion of transactions costs. As shall
become apparent, all three were expert analysts of business, and they integrated this expertise into their
economics.
We identify the eighteenth century writings of Smith with the modern origins of the science of economics.
His analysis of the firm, its owner manager, and the beneficent consequences of their each seeking individual
competitive advantage (encapsulated in the phrase ‘the invisible hand’), is both analytical and descriptive. That
is, the ‘invisible hand’ is both a conceptual vehicle for showing how it is possible to achieve desirable, or even
ideal, outcomes; and also a practical description of the forces observable in the real world of competition
between enterprises. The example of the pin factory to illustrate the principle of the division of labour will be a
familiar one to anyone who has read even the first few pages of Smith’s great work The Wealth of Nations
(1776). Whilst this empiricism is commendable, it is known to be based on the work of the French
encyclopaedists. However, Smith was more than a passive consumer of others’ observations. He knew well the
leading merchants of his day, and lived in Glasgow when it was a thriving commercial city. Provost Andrew
Cochrane was a personal friend, and provided Smith with important statistical and institutional information for
use in The Wealth of Nations. Further, Smith was skilled at acquiring primary source data from custodians of
archives. An example of this, is his acquisition of extensive pricing data from Lord Hailes in 1769, about which
he commented acidly ‘all the estimated prices of grain….seem to have been extremely Loose and inaccurate’.
3
He is concerned that this lapse was made by the Lords of Council and Sessions ‘from whom the greatest accuracy
might have been expected’. The problem of data quality has ever been with us!
In the century to follow, Alfred Marshall was to develop the basic toolkit of what we call neoclassical
microeconomics. His devices of supply and demand analysis, elasticities, the profit maximising position of the
firm, industry equilibrium, increasing returns, and so on, are all essential components of the contemporary
business economist’s set of analytical tools. They were first expressed in the form in which we now use them by
Marshall, notably in his great microeconomics work Principles of Economics (1890). He was strongly aware of
business reality, and in 1875 made a long visit to the USA, which he used actively to explore business practice.
His visits into factories laid the basis for his paper on ‘Some features of American Industry’
4
. We know, for
example, that he visited Chickering’s piano factory, the world’s largest watch factory at Waltham, and also the
world’s largest organ factory (Mason and Hamblin).
5
Ten years later, when no longer a bachelor, but with his
wife on holiday with him, Marshall was continuing to directly observe business practice. Every August and
September he would undertake extensive tours of English factories and mines. As Whitaker (1975, Vol 2, p 55)
has put it, ‘his zeal for field work remained unimpaired’. He became so expert that he was able to forecast
accurately the prices and wages within a firm, without being given any hints, based on general knowledge of the
industry and his specific observation of the firm’s operations during a site visit.
In the twentieth century, arguably the most fundamental economic thinker has been Ronald Coase.
6
He is an
Englishman who has spent most of his academic career at the University of Chicago. He proudly proclaims never
to have taken an economics course! His seminal paper of 1937 on ‘The nature of the firm’ asked what
determined the boundary between the firm and the market. As markets are expensive to use, for example because
price dispersion must be checked, and contracts are costly to write and conclude, there is a motivation to use the
firm to allocate resources by fiat. The decision whether to use the market or the firm for allocation is therefore
one of relative transactional efficiency. This contractual view has been immensely influential, and has
revolutionised not only business economics, but also numerous other areas, including law & economics, and
business strategy. Viewed broadly, the firm is seen as a set of contracts. It provides a general framework for the
relative evaluation of market and non-market institutions.
It is noteworthy that Coase too grounded his theory in business practice. After completing his studies at the
LSE in 1931, Coase was awarded a Cassel travelling scholarship. This allowed him to visit the USA to examine
business practices. He threw himself into this energetically, much as Marshall had done. His particular interest
was in vertical integration, and he paid especial attention to practices in the automotive industry, including the
famous Fisher Body case.
7
Coase wondered why General Motors had acquired the firm Fisher Body, and had
been told it was because their body plants were located near General Motors assembly plants. The question he
was asking, in a fashion which was firmly grounded in business practice, may be posed as follows.
8
Suppose
there is a large business, Firm A, and a small business, Firm B, where the latter is an important supplier to the
former. Should a new vertically-integrated firm, Firm C be contemplated, which unifies A and B? Is the
vertically-integrated arrangement necessarily advantageous? Both the posing of this problem, and the variety of
solutions Coase proffered involve a combination of induction and deduction, of the form that effectively
illustrates the advantage of a well grounded approach to business economics. Our now well developed theory of
transactions costs would not have been possible without Coase’s youthful and pioneering investigations into
actual business conditions.
It has not been difficult to find the above examples of a grounded approach to economics, because the greatest
economists practised their trade in this way. I shall return to some more examples of this sort with a particular
emphasis on business and economics, and indeed business economics itself: but for the moment, I should like to
put into sharper focus what one means by saying an approach is ‘grounded’, and should like to show how this
approach is pursued ‘in the field’
9
III. THE BUSINESS ECONOMIST IN THE FIELD
My starting point will be the ‘space’ within which research activity is conducted. The universe of interest to
the investigator may be described as ‘the field’. To the business economist this field will usually be the industry.
Within this space are the objects of interest, which are generically described as ‘sites’. Such sites are typically
companies, so far as the business economist is concerned.
10
So much seems familiar. However, the sampling
procedures of the ‘grounded’ approach differ from that of the statistical approach. The samples that Smith,
Marshall and Coase used were not statistical samples. They were what field work specialists call ‘theoretical
samples’. Typically these are small samples, and therefore they are of limited use from the standpoint of classical
statistical inference. However, they are of great use from the standpoint of theory generation, hence the
nomenclature. Thus Smith’s data suggested a theory of equilibrium prices, Marshall’s data suggested a theory of
the representative firm, and Coase’s data suggested what determined the boundary between the firm and the
market. Whereas in statistical sampling, the purpose of cross-section analysis is to subject hypotheses to tests of
their veracity, in theoretical sampling, the purpose of cross-site analysis is to generate hypotheses. To illustrate
the former, one might test the hypothesis that price-cost margins and concentration are positively associated for a
cross-section of firms in oligopolistic industries (a type of market power hypothesis)
11
. To illustrate the latter,
cross-site analysis might suggest the hypothesis that, for dyads of venture capital investors and their investees, the
desired form of contracting involves a ‘trading’ of risk sharing and information handling capabilities.
12
The grounding of economics in business reality depends on field work methods of the sort that have been
illustrated above. If one were to list the full catalogue of such methods, it would probably embrace the following:
direct observation; participant observation; semi-structured interviews; unstructured interviews; and document
collection. In direct observation one might proceed as Marshall did, by looking at production techniques in
action in a horseshoe works
13
. When I started work on enterprise stimulating institutions, as reported in Reid &
Jacobsen (1987), my co-worker Lowell Jacobsen spent several weeks in a business incubating unit called an
Enterprise Trust, participating in the day to day tasks of that unit. This phase of the research strategy is
sometimes called unstructured field work, as it is exploratory, and ungoverned by any pre-conceived framework.
More formal methods of investigation involve so-called ‘instrumentation’. Three such instruments are the
unstructured, semi-structured and structured questionnaire. The latter two are often designed after preliminary,
unstructured field work has been accomplished. In my work, Reid (1993), on small business enterprise, I used
both semi-structured and structured interviews. The former investigated, by face to face interview, pricing,
competition, costs, finance etc. in a relatively formal way. This allowed little discretion to respondents, and
generally limited responses to real variables (like sales), categorical variables (like the order in which actions
were taken should demand for a product decline) and binary variables (like whether or not the entrepreneur
advertised his products). The latter investigated small business strategy, using a three part agenda on competitive
forces, competitive strategy and defensive strategy as adapted to Porter’s (1980, p.211) fragmented markets
case. The responses were qualitative, and textual data were recorded under coded agenda headings. For
example, comments on the bargaining leverage of customers were recorded under the secondary sub-heading of
customers, which itself fell under the primary heading of competitive forces. These textual data were themselves
the basis of cross-site analysis. Finally, document collection is facilitated by field work investigation. A cold
call to a business for data that may have some sensitivity is unlikely to be successful. After an interview and a
plant visit, it is much more likely that one will have access to high quality and revealing data. These may take the
form of price lists, product or service descriptors, technical specifications, financial accounting, cost accounting
or even management accounting data.
By these and other means, the raw data of business economics are garnered or constructed. These ‘other
means’ include secondary source data. These are a crucial source of knowledge about the economic universe, but
they have notable drawbacks. The most important is that the data were rarely gathered for economic purposes,
but instead for other reasons, like making returns to the Inland Revenue, or satisfying reporting conventions or
protocols. Other weaknesses include the proneness of secondary source data to unknown errors of reporting or
omission. It is for these sorts of reason that I have argued the case above for primary source data collection.
They force the investigator to get in direct contact with the object of analysis, be it the corner store or the
multinational. Many advantages flow from this. The quality of the data are then very much under control, as to
source, variation, completeness, representativeness, and so on. Further, these data can be collected in a way
which directly relates them to theoretical concepts. Thus there is no need to make unsatisfactory compromises
with proxy variables, if one has the data collection process under one’s control.
Although the databases constructed using either primary or secondary source data constitute the main modern
forms of evidence upon which analysis is conducted, the subject of business economics also benefits from a
pluralistic approach to data. For example, case study evidence, which may be a blend of primary and secondary
source, and indeed of quantitative and qualitative data, is heavily used in both business and industrial economics.
The case study approach both illustrates theory in action, and provides the basis for new hypotheses which are
well grounded in business reality. Recently, the National Bureau of Economic and Social Research (NBESR)
made much play of its desire to encourage direct contact with business managers, with a view to facilitating both
the case study and econometric analysis of business.
14
Finally, one must not ignore the value of personal and
business histories. Philip Andrews, who is considered in greater detail below, was a methodological pluralist
who embraced grounded studies of the industry and the firm, based on primary source data, and also personal and
business histories. His Life of Lord Nuffield and Capital Development in Steel, the latter a study of the United
Steel Companies Ltd, both with Elizabeth Brunner, provide excellent examples of these study forms in business
economics.
IV. THE BUSINESS ECONOMIST YESTERDAY AND TODAY
Having exemplified the forms of analysis used by those interested in the relationship between business and
economics, I turn now, taking the lead of the last sentence, to those who best exemplify good practitioners of
these forms of analysis. My choices are personal, but I believe display much of what may be regarded as of the
highest quality in business economics. By chance, two are Scotsmen and three are associated with the University
of Oxford. Covering the era from the thirties, through the forties, fifties, sixties and beyond, they are: Joel Dean,
Philip Andrews, George Richardson, and John Kay.
Joel Dean, an American of English descent, was born in 1906 in Vershire, Vermont.
15
He was educated at
Pomona College, Stanford and Harvard Business Schools, and the University of Chicago. He had a short spell at
IBM, but found its authoritarian structure unpalatable. He was too much of an individualist to accept this form of
organisation for long. He started his career at Indiana University, but is most associated with his tenure of posts
at the University of Chicago, where he was Director of the Institute of Statistics and Marketing from 1939 to
1945, and Columbia University, where he spent all his post-war years, as professor of business economics, in the
Graduate School of Business and the Graduate Faculties of Political Sciences. He founded a management
consulting firm in 1940, Joel Dean Associates, and it became both prominent and successful. This involvement
was the route by which he was able to ground his work so well in business reality. For example, his utility rate
consulting laid the basis of his pioneering work in the measurement of the cost of capital. Ford were a major
client, and other clients included Chrysler, IBM, General Electric and American Airlines.
Although very much driven by his consulting work, to the extent that Dean ran into conflict with several deans
over the time he spent off campus, he was stimulated by this work in the laboratory of the real business world to
write extensively.
16
He is widely regarded as the founder of managerial economics, and wrote over a hundred
scientific papers and many books. Of the latter, I would single out Statistical Determination of Costs (1936) and
Capital Budgeting (1951) as being particularly significant. In the former, which was based on his Chicago
doctoral dissertation, he used primary source data from a furniture factory for 47 two-week accounting periods
over 1932 to 1934. His pioneering work used multiple correlation techniques to examine the effects that order
size, quality, labour turnover, and product variety had on production cost. He concluded from this that it was a
reasonable approximation to regard the relationship between total cost and output as linear. Thus he estimated
marginal coast to be constant. He was subsequently to criticise the accounting profession for providing average
cost, rather than marginal cost, information to businessmen for pricing decisions. In his Capital Budgeting
(1951), Dean tried to correct what he considered to be the widespread and mistaken view that equity capital was
a free good or of low cost. He argued that equity capital had a high opportunity cost. It was he who is largely
responsible for the universal use today of discounted cash flow analysis in corporate capital management. Again
we find him grounding his work in the business reality opened up to him by his consulting client base, and he first
used discounted cash flow analysis privately for clients, before publishing Capital Budgeting.
Philip Andrews was an English economist who received less recognition than he deserved in his lifetime. His
Manufacturing Business (1949) is a classical work, rich in detail and argument, and he was particularly
associated with the work of a group of Oxford economists who advocated a grounded approach to the analysis of
business practices. The method favoured by this group is well illustrated by the paper on ‘Some economic
aspects of the building industry’ (1975), which investigated decision-making with respect to costing and
pricing.
17
The basis for this investigation was face to face meetings with businessmen, with each interview being
based on common instrumentation, a ten point interview agenda, Andrews & Brunner (1975, p. 164). The
approach was between the unstructured and semi-structured, and we are told (p.121) that ‘discussion ranged
freely’. Just seven businesses were studied, ‘chosen on the basis of a diversity of characteristics which were
thought relevant to the purposes of the inquiry’. It was made clear that the sample so obtained ‘was not intended
to be a representative cross-section of the industry’ but rather that representativeness ‘from the point of view of
theoretical work’ was sought. Here, it was made clear that businesses were not chosen at random, but ‘selected to
represent in diverse ways such elements as size, variety of financial and managerial control, and variety of work
and diversity of location.’ In other words, Andrews was proceeding very much along the lines of grounded
theory, as outlined above. It was made explicit that the methods used were those of the Oxford University
graduate seminars in the economics of industry, of which Andrews was chairman for many years.
Lee (1981) has given an extensive account of how that methodology emerged. He has traced the initial
involvement of Andrews to his time as a research student at Oxford in the 1930s, working on company accounts
under the supervision of Phelps Brown. One of the many fruits of the then Oxford Economists’ Research Group
(OERG), formed in 1935 to further methodology in the study of business behaviour, was the kinked demand
curve of oligopoly. This is a well-known construction to all students of business and economics. Of course, the
basic features of this grounded theory are that when excess capacity is extensive, price cuts tend to be followed,
but not price increases. The demand curve is then ‘kinked’ at a price which is insensitive both to demand and
cost shocks. However, in full capacity conditions, the theory predicts price flexibility, or even price volatility, as
the direction of the kink changes to a reflex from an obtuse angle between demand segments. The device was
developed simultaneously by Sweezy (1939), whilst working on his Harvard doctoral dissertation, and by Hall
and Hitch (1939) whilst working with the OERG at the same time as Andrews was active there.
18
Sweezy
certainly had informal contacts with the business community, and was an expert on the English coal industry, and
Hall & Hitch approached the subject from an even more coherent methodological standpoint, as they were
working extensively within the grounded theory framework. The theory that they developed has had a long life.
Recently, it has been given a game theoretic form, which is amenable to testing by econometric means, Bhaskar,
Machin and Reid (1991). The theory proves robust to contemporary conditions, and can be extended
successfully to the small firms context.
An Oxford economist who overlapped with Andrews was George Richardson. A Scot, he was born in 1924,
and educated at the universities of Aberdeen and Oxford.
19
His Information and Investment (1960) has become a
modern economic classic, and has recently been the object of festschrift treatment, Foss and Loasby (eds.)
(1998). Because of his strong mathematical background (he studied mathematics and physics at Aberdeen), his
mentor at Oxford was the theorist John Hicks.
20
As Earl (1998, p.16) observes, the irony of this is that
Richardson’s important work leads away from applications of mathematics in economics. Rather, its emphasis is
on the need to know and understand the institutional details of those methods that firms use to facilitate co-
ordination. However, Richardson was fortunate in having Hicks as a mentor, as there is evidence that Hicks
actively tried to get Andrews relieved of his Fellowship at Nuffield College. By contrast, Richardson was easily
established in Oxford with the benefit of Hicks’s patronage. Earl traces out the surprising way in which Andrews
and Richardson seemed to have had very little discussion together in Oxford. Yet Richardson was eventually to
adopt a research style which very much resembled that of Andrews.
Richardson, after the apparent neglect by the economics profession of his Information and Investment, turned
increasingly to applied work. After a chance meeting with the industrialist, Sebastian de Ferranti, at a college
dinner, at which the topic of restrictive trade practices for electrical equipment was raised, Richardson started his
applied work, to complement his theoretical work on co-ordination. This led to his accepting membership of the
Monopolies Commission, and through his work for them he established in his mind a large ‘knowledge base’ of
case evidence. Much of this was obtained by primary source data collection, upon which he could build
grounded ideas. This methodology is notably in his most cited article ‘The organisation of industry’ (1972). In
this article, as we all now know, Richardson (1972, p. 888) established the notion of ‘capabilities’ within an
organisation (like the firm), these being ‘appropriate knowledge, experience and skills’. This capabilities theory
of the firm is now very influential, especially in the business strategy literature (see my comments on Kay below),
but also more widely in the markets and hierarchies literature. As David Teece in Richardson (1990, p.x) put it:
Information and Investment anticipates what is now a very large literature on transaction costs and the
economics of internal organisation’
By the 1960s Richardson was chairing an OERG inquiry into ‘Business Policy in an Expanding Economy’
which led to an elegant piece of grounded theory entitled ‘The limits to a firm’s rate of growth’. Based on
interviews with sixteen businessmen over three years, he identified four potential constraints on growth, which
were physical, or financial, or related to investment opportunity or managerial capacity. His field work evidence
suggested that the main constraint was the availability of suitable management. It was on the basis of this that he
constructed his grounded theory. In it, he achieved significant advances upon the work of Marshall, in terms of
developing a theory of the growth-profitability trade off for the business enterprise.
21
The subsequent career of Richardson has been full of interest, in that he left academia to become Chief
Executive of Oxford University Press in 1972. This was a position of great power and responsibility, as OUP is
the largest educational publishing house in the world. After managing OUP for fifteen years, an experience that
seems to have benefited considerably from his having had an economics training, he became Warden of Keble
College, Oxford. He retired in 1994, but continues to have an active interest in economic research. In his recent
work, Richardson (1998, p. 53) appeals to his experience in OUP to develop a grounded theory which treats the
running of a business enterprise in terms of the management of a micro-economy.
My final example is of another Scotsman and Oxford economist, John Kay. Born in Edinburgh in 1948, and a
First Class Honours graduate of Edinburgh University, John Kay is a noted economic theorist, applied economist,
and business strategist. Like George Richardson, he became a Fellow of St John’s College, Oxford. He is a very
different kind of economist, but the theme of grounding theory in evidence, and of relating business practice to
economic analysis is similar. He has written many articles, and numerous books, including, most notably The
British Tax System (1975) (with M.A. King), which has gone through many editions, and Foundations of
Corporate Success (1993), a resource-based view of business strategy, which has become a world best seller.
In Foundations of Corporate Success, Kay (1993, p. 85) acknowledges the influence of Richardson’s (1972)
analysis of corporate capabilities and relational contracting. The career of John Kay also bears some similarity to
that of Joel Dean. Kay has managed to combine a top flight academic career with a heavy involvement in
consulting activity. Like Dean, he has been glad to ground his theory in business practice, and to use his theory
on new bodies of evidence. In his earliest work in industrial economics, culminating in Concentration in Modern
Industry (1977) (with L. Hannah), he established a reputation as a technically skilled analytical economist who
could also turn his hand effectively to applied issues. He has held senior posts in major institutions
22
, and was
the founding owner manager of London Economics, the leading independent UK general economic consultancy
firm. Whilst at one time seeming to be attached to economic agenda determined by Conservative policy in the
UK, especially industrial policy like deregulation and privatisation, it was actually London Economics who
constructed the innovative and successful economic strategy of New Labour. This brought the Labour Party to
power in the UK after a long absence from government, and heralded the new industrial analysis of the so called
‘stakeholder society’, a concept very much created by Kay and colleagues at London Economics.
What Dean, Andrews, Richardson and Kay all illustrate is the value of maintaining a close relationship
between economics and business. These benefits spill over from academia to practical and innovative business
advice, in the form of consulting services which enhance business performance. Furthermore, public policy
towards industry is also an important beneficiary from those forms of expert advice which are well grounded in
business reality. We have seen that the methods of Dean, Richardson, Andrews and Kay, while not always
practised by the journeyman economist, are very much in the tradition of the very greatest economists, including
Smith, Marshall and Coase. I should now like to turn to illustrations of the grounded approach in a small firms
context. My starting point is with a set of small business vignettes, which illustrate what one discovers when in
the field going on site visits.
V. THE GROUNDING OF SMALL BUSINESS ECONOMICS: CASES AND ECONOMETRICS
The above principles and methods can now be illustrated. I wish to do so both by description (formerly), and
by analysis (latterly). My aim is to characterise the individual small business enterprise in a way would be
impossible with just secondary source data. My starting point is a set of within-site analyses of Scottish small
businesses. They may be thought of as brief case studies, vignettes, or ‘profiles’ (my own term). They are taken
as the starting point because I want to provide a unique characterisation of each business, being it ever so brief.
In doing so, my intention is to convey what is so special about going into the field and learning by direct
observation and measurement.
In 1993 I created a set of Profiles in Small Business with two co-workers, Lowell Jacobsen and Margo
Anderson. My aim was to provide the first book length treatment of small business strategy. The data were
based on two phases of fieldwork within seventy-three small firms in Scotland in 1985 and 1988. The analysis
was a modification of Porter’s (1980) competitive strategy approach for the small business case. It emphasised
fragmented markets, bespoke supply and niche sales opportunities. These businesses were micro-firms, with an
average employment size of nine, and they were very young (on average 3½ years from inception). Their
average sales and assets were £85,000 and £76,000, respectively (at 1985 prices). The average number of
products (or services) supplied was fifty, these being put into six product groups. For the principal product
group, the average market share was 8%. The modal description of the degree of product differentiation of the
firm’s main good or service was that it was ‘similar to rivals’.
From that set of seventy-three firms, I have chosen three to provide a feel for the world of small business. For
analytical purposes the whole sample was grouped according to whether the main product markets was subject to
low, medium or high concentration. I have chosen one firm from each group. The firms were: a supplier of
industrial cleaning chemicals and equipment (A); a developer of computer software (B); and a supplier of
security printers blankets (C).
23
Their main features are given in Table 1. Firm A was in the most
Table 1. Three Small Business Profiles
A
Cleaning
B
Software
C
Blankets
Market Regional International International
Market Share <1% <1% 11-20%
Product Differentiation Little Little Marked
Entry/Exit Barriers Low Medium High
Growth Rate (assets) 230% 1,105% 11%
Age (months) 9 17 32
Gearing (years 1,2,3) 1.0, 0.5, 2.86 0, 0, 2.7 0.5, 0, 0
Employees 10 90 16
competitive market, but flourished well because it rapidly invaded a new niche. Firm B was in a less
competitive, but very dynamic, market, but enjoyed enormous success by using aggressive strategies and always
getting quickly to market. Firm C was in the least competitive market, and took advantage of high entry barriers
and strong protection of intellectual property. It exemplifies the principal that small firms can be big firms within
their market segment, even if it is international. All firms adapted cautious policies on gearing, with A and B
only contemplating higher gearing three years in, after establishing a firm toehold in their markets. Firm C aimed
to hold no debt.
On first crossing the threshold of A, I was delighted to confront one of my former students. The location
seemed improbable, a small factory unit near the sea shore in an economically depressed area. This was not the
smart modern office in the City of London, which is the stuff of students’ dreams. Nevertheless, one was glad to
see economics and accounting being put to good use, and the owner’s exercise of good business judgement in
detecting a niche opportunity. The firm had been set up to capture the opportunity offered by the privatisation of
hospital supplies. The products supplied were cleaning agents, detergents, liquid soaps etc. All were apparently
generic products, which could be differentiated in minor, but significant ways e.g. by colour, odour and
packaging. The firm had been set up under the Enterprise Allowance Scheme, which provides a subsidy to new
business start-ups. The benefits of this scheme were tangible. Within three years the firm employed ten people
in an economically depressed area, an inexperienced economics graduate had become an entrepreneur, and
hospital supplies had been stimulated to better quality and lower cost. Thus new life had been injected into the
local economy by new business.
B was one of the major success stories in the sample. When I first entered this business, it had fifteen
employees. It was set up in a run-down part of town by a group of young men. They had taken flight in
disillusionment from a major computer company, which ran what they perceived to be an oppressive regime.
They were liberated by their owner-manager status, and applied unbounded energy to build an innovative firm
with a highly skilled and creative work-force. When I visited their new and impressive premises three years on,
they were employing 90 people, and had just received the Prince Phillip Award for Enterprise. They talked the
argot of high technology business. Markets were ‘hunting grounds’, rivals were there to be ‘leapfrogged’, and
the overriding issue was being ‘first to market’. They too exemplified well the title of this keynote address, ‘new
business, new life’.
When I first visited C, I found myself in familiar circumstances. They were in a set of new factory units built
to establish a toehold for new enterprise in an economically declining area. A friend of mine had acquired
several of these units to develop garage services for the rapidly growing classic car market, especially MGs.
Nearby was the mysterious firm C producing strange products called ‘blankets’. Incongruous though these
surroundings were, C was a world leader in the provision of ‘blankets’ of high-quality synthetic rubber, which
were used for printing currency and travellers cheques. The original firm had existed for over one hundred years,
and C had been created by a management buy-out. Specialist technology and highly secret trade channels
enhanced C’s performance and survival prospects. Even in this traditional area of production, technical change
was rapid, and customer service needs were rapidly evolving. The management buy-out had been a phoenix
operation, creating new business by shedding many traditional product ranges, and re-focussing on high-value-
generating products.
The above vignettes or profiles give animation to the theme of ‘new business, new life’ and provide a bird’s
eye view of what fieldwork methods can accomplish. However, as ever, the more important and prosaic task of
analysis falls on the shoulders of the business economist. So I turn now to formal ways of handling these primary
source data. Whilst in my recent work, Reid (1998), I have tried to show what can be accomplished by the
almost exclusive use of qualitative methods, this time applied to the venture capital industry, the use of fieldwork
methods is no impediment to serious econometric work. Far from it, for one has the advantage of measuring
variables, and of considering forces of action, in ways which map closely into theoretical concepts. Let me
illustrate what I mean by another small firms example, which focuses on the ‘complex’ of actions taken by the
entrepreneur.
24
In the neoclassical microeconomics which we all teach, the entrepreneur of the competitive firm has a
particularly elementary decision to make. It is simply: how much do I produce? This is motivated by the desire
to maximise profit, and hiring in the factor market is thereafter automatically determined. Prices are given,
quality does not count, nobody says where the firm is located, whether it holds stocks, or what its financial
structure looks like. To those who work in the field, this extreme reductivism is more than unpalatable. In a
recent issue of Small Business Economics, Rispas (1998, p.113) posed the important question: what activities
does the entrepreneur perform? Clearly, it is much more than just setting output. The activities of an
entrepreneur involve a complex of actions concerning matters like location, product quality, business strategy,
financial structure and organisational structure. To put it slightly more formally, suppose the entrepreneurs
actions a
i
define a vector of actions
a
which are chosen from a wide action set
A
. Then revenues and costs
themselves depend upon these actions, and may be written R(
a
) and C(
a
). I will continue to adhere to a profit
maximising assumption, which is appropriate for small entrepreneurial firms, cf. Reid et al (1993, Ch.1). Then if
π denotes profit,
π
(
)
(
a
a
a
=
R
C(
is to be maximised over
a
A
, where concavity is assumed. This
defines a set of first-order conditions
R C( ) ( )a a 0
for all a
i
0. These have a familiar form. The most
obvious is setting the marginal cost of a positive output equal to its corresponding marginal revenue. Another is
setting the marginal value productivity of money capital equal to the capitalised value of the full marginal cost of
borrowing.
In considering the viability of a small entrepreneurial firm, when a set of actions
a
is chosen, a simple but
powerful constraint is:
π
( )
*
a0
. That is, in the long run, whatever set of actions
a
the entrepreneur may take,
no matter how complex their form, the business must not run at a loss. Thus the neoclassical view still has a
cutting edge, even when the complex of actions that an entrepreneur within a small firm can take, embracing
markets, costs, finance, strategy, human capital, organisation and technical change, is considered. For long-run
survival, we require simply
π
0
. To use this modelling perspective on fieldwork data, a sample of small firms
was tracked over a period of three years, and any withdrawal from a market was noted as a violation of the simple
condition
π
0
. In this way, mapping from (unobserved) profit to (observed) survival or non-survival, an
econometric model of the consequences of a complex of actions on survival probability was estimated, Reid
(1997).
Fieldwork data were available over the period 1994-1995 for the Scottish economy. The data were generated
by face-to-face interviews with entrepreneurs, creating a random sample of 150 new business starts, stratified by
region. The sampling frame was created from the client lists of Enterprise Trusts, a type of ‘business incubator’
unit. In terms of sample composition, two-thirds of firms were in services (SIC 50-99), and one third of firms
were in manufactures (SIC 01-49). The breakdown by business types was: sole trader (54%); partnership (19%);
private company (27%). This compares well with figures of 50%, 23%, 27%, respectively, for 21,000 new
Scottish firms started in 1995. In terms of sample attributes, over six hundred variables are available on each
firm, so the characterisation is very rich. Some of the salient features of these firms are as follows. Average
employment size was six-and-a-half, putting these businesses in the micro-firm class. About one third used a
bank loan to launch the business, and 90% used a business plan. Although highly qualified entrepreneurs were
uncommon, 75% had received some form of further education beyond high school. An average of 58 hours per
week was spent in running the business, with the maximum running to over 130 hours.
A variety of econometric estimates of the model were run, with the full model embracing around thirty
entrepreneurial actions. Sectoral effects were also considered, but found to be insignificant. However, here I
will confine attention to a parsimonious model, as represented in Table 2. This is a probit model, run using
Shazam software. The control variables are entrepreneurs’ actions, and the binary variable is survival/non-
survival. The survival probability was 79%, and the percentage of correct predictions was high, at 78%. The
adjusted R
2
was 0.250, which is satisfactory for cross-sector models, and on a likelihood ratio test the model is
significant at the 10% level (Chi-square equals 25.7). Single, double and triple asterisks denote significance at
the 5%, 2.5% and 1% levels, respectively. The probability weighted Hencher-Johnson elasticities provide a
useful measure of the leverage of entrepreneurs’ actions on survival probability. Overall, the statistical
performance of this model is satisfactory, and the economic interpretation, to which I now turn, is of considerable
interest.
Having launched a business partly on debt finance (Bankloan) is significantly negatively associated with
survival. The better quality business starts will tend to be entirely self-funded. At this stage, use of a loan
suggests adverse selection of business quality. Duration (Inbus), as expected, is significantly positively
associated with survival. This is suggested by the view that duration in business fosters entrepreneurial learning.
The ratio of part-time to full-time employment (Ptft) is insignificant, masking an important effect to be
considered below. All non-pecuniary motives for business involvement, to avoid unemployment (A), to be one’s
own boss (E), and to satisfy achievement needs (F), are strongly negatively associated with survival. In joint
work elsewhere, Reid and Smith (1996), it is shown that only pecuniary goals, like rate of return maximisation,
Table 2. Parsimonious Model
Variable Coefficient t-Ratio Weighted Elasticity
Bankloan -0.638 -2.168** -0.736.10
-1
Inbus 0.198.10
-1
1.868* 0.105
Ptft -0.353.10
-1
-0.186 -0.107.10
-1
InvolveA -1.184 -2.930*** -0.109
InvolveE -0.957 -2.365*** -0.682.10
-1
InvolveF -0.907 -2.372*** -0.886.10
-1
Smlprof 0.839 1.947* 0.221
Employ 0.200 1.938* 0.283
Ftime -0.235 -1.956* -0.175
Wages -0.102.10
-1
-1.907* -0.820.10
-1
Constant 0.635 1.144 0.192
foster performance and survival. If the entrepreneur is willing to sacrifice short-run for long-run profits
(Smlprof), a motive emphasised by Philip Andrews himself, this raises survival prospects.
Finally, I come to the main variables of interest, employment headcount (Employ), number of full time
workers (Ftime) and the wage bill (Wages). Headcount (Employ) is positively associated with survival. The
effect is significant and, perhaps even more important, the weighted elasticity is high (indeed, the highest), at
0.283. This is consistent with the widely held view that size is important for survival and performance, based on,
for example, long-purse arguments, or models of ruin. However, less obvious, but clearly significant and
quantitatively important, is that full-time employment (Ftime) should be negatively associated with survival.
Again, the elasticity (-0.175) is relatively large. Further, the proportional wage bill (Wages) is significantly
negatively related to survival. These last two observations are consistent with the finding on small business
strategy for the previous sample of firms, in Reid, Jacobsen and Anderson (1993, p.129), that tight control of the
wage bill is a major strategic goal in small firms.
An important feature of the grounded approach to small businesses adopted is that one can now tease out, in a
way which would be impossible with conventional secondary source data, the causes of the above findings. That
is, how can falling full-time employment yet a rising headcount improve survival prospects for the small firm.
The first point to note is that even these small firms have a hierarchical structure. They tend to be more peaked at
the top, and less flat at the bottom, than the classical pyramid form. It is known, Reid (1997)
25
, that hierarchies
are more incentivised for surviving firms, with pay at the top level being a multiple of four of that of the bottom
level for survivors, but only a multiple of two for non-survivors.
Fieldwork data for the sample under discussion can illuminate the nature of the micro-firm job hierarchy.
This extended example is based on Reid (1997)
26
. Suppose, to introduce an element of formalism, that w
i
= wage
rate at i’th hierarchical level, and that l
i
= headcount at i’th hierarchical level. Further, we write total headcount =
l
i
= L, and the wage bill = w
i
l
i
= W. Then the question to be addressed is: Can the headcount (L) rise and
wage bill (W) fall? The data I shall use to illuminate arise from enquiry into the hierarchical structure of my
sample of micro firms. These data indicate: (a) average headcounts from the top level of the firm down are 1.9,
1.8, 3.3 and 2.0; and (b) average wages from the top level down are 3.6, 2.1, 1.4, 1, where the wage rate at the
bottom of the hierarchy is normalised to unity for reason of confidentiality. These figures are not invented, but
grounded in observation. Based on the facts, consider an Initial Situation in which the average small firm had a
headcount of (1.9 + 1.8 + 3.3 + 2.0) = 9 persons; and wage bill of (1.9 × 3.6) + (1.8 × 2.1) + (3.3 × 1.4) + (2.0 ×
1.1) = 17.44 normalised units. Consider now a New Situation, in which the action the entrepreneur takes is to re-
structure the job hierarchy. The casualised part of the work force is at the bottom (level 4) of the hierarchy. To
promote survival, suppose that all junior employees (level 3) are casualised, as is one unfortunate senior
employee (level 2), and that labour effort is boosted by a further casual employee (level 4). Then average
headcount becomes (1.9 + 0.8 + 0.0 + 7.3) = 10.0, which is one person higher than in the Initial Situation.
Further, the new wage bill is (1.9 × 3.6) + (0.8 × 2.1) + (7.3 × 1.1) = 16.55, which is 1.11 normalised units more
than in the Initial Situation. Comparing the Initial Situation to the New Situation gives us the following answer
to the above question: Yes, casualisation can raise headcount yet lower wage bill, for plausible wage and job
structures.
Thus by a combination of fieldwork, grounded theory, the theory of markets and hierarchies, and a smidgen of
econometric methods, it has been possible to arrive at some interesting and insightful conclusions. They are also
novel, in that the issue of hierarchy in small firms has never been addressed, simply because investigators were
guilty of ignorance of their existence, let alone their nature.
CONCLUSION
If I were to summarise briefly this paper, I would say it makes a methodological point, supports it by
intellectual history, and then illustrates it by empirical example. The methodological point is that economists
would gain much from adopting a grounded theory approach that better relates economic analysis to business
practice. The intellectual history that supports this stance is that the greatest economists, like Smith, Marshall
and Coase, implicitly adopted this methodology, and in so doing achieved the biggest breakthroughs in the
subject. Further, major twentieth century luminaries in business and economics have not been reluctant to follow
their lead. The empirical example illustrates the nature of micro-firms, and then explored its structure in a novel
way. A model of survival is estimated in which the complex of actions taken by an entrepreneur determines the
probability of the firm surviving. It is shown how the hierarchy within the firm can itself be influenced by
entrepreneurial action. It illustrated with grounded data how casualising the work force can both raise the size of
the small firm in terms of headcount, and yet meet the common strategic goal of lowering the wage bill.
In writing this Keynote Address, particularly with a location like Italy in mind, I was reminded of the
wisecrack: What do you get if you cross an industrial economist with a Mafioso? The answer, of course, is an
offer you can’t understand! In drawing on methodology, intellectual history, economic theory and econometrics,
I was therefore acutely aware of the requirement to be accessible to all. I hope that largely I have succeeded in
that endeavour, and that this does encourage all present to further advance levels of rigour and understanding in
business and economics, as have many papers in this B&ESI conference. I express this hope that B&ESI, as a
new business start-up itself, will continue to innovate, flourish and grow. It has, after all, in your collective
wisdom, the ideal intellectual basis on which to do so.
a
Keynote address of the Business and Economics Society International Conference 1998, given on 20
th
July to
conference delegates at the Massimo d’Azeglio Hotel, Rome, at the Conference Lunch. I am grateful to Demetri
Kantarelis for useful comments on the form and content of this address, and to Penny Cullen and
Denise Jarret for further comments which have materially influenced the drafting of the written form of this
address. The author alone remains responsible for any errors of omission or commission that this paper may yet
contain.
ENDNOTES
1
Essentially a monotonically decreasing, convex function with an asymptote bounded away from the origin and
an asymptote to the horizontal axis.
2
Conventionally, modern economics is identified as starting with the work of Adam Smith (1776), though earlier
roots can be traced back to the writings of the ancients, as illustrated by works like Gray (1931, Ch1), and indeed
the paper by Petrochilos (1998) in this year’s conference.
3
See the letters 115 to 118 between Adam Smith and Lord Hailes in The Correspondence of Adam Smith,
Mossner and Ross (eds.) (1977, pp. 139-152). Lord Hailes provided detailed data on the prices of corn, cattle
etc. from the earliest accounts to the death of James V. The sources were the registers of accounts of bishoprics
and monasteries.
4
Paper read to the Cambridge Moral Science Club, November 17, 1875. See Whitaker (1975, Vol 2).
5
See Groenwegen (1995, Ch. 7)
6
Coase was awarded the Nobel Prize in Economics. In his Laureate address Coase (1992) complained about the
excessive use of what he called blackboard economics, this having the undesirable features that ‘the firm and the
market appear by name but lack substance…there is little doubt that a great deal more empirical work is needed’
7
See Coase (1988) for an account of his earliest ideas on the firm, and a description of his field work experience.
8
Coase did not only look at Fisher Body and GM. His many other site visits included Union Carbide, Sears
Roebuck, Montgomery Ward, the steel works at Gary, and the stockyards in Chicago. See Coase (1988).
9
The fundamental reference here is Glaser and Strauss ( ). For an exploration fo what they can contribute to
the perspective of industrial economists, see Reid (1987, Ch. ).
10
The terminology of field, site, and later terms like theoretical sampling and cross-site analysis, are standard in
the literature. See Burgess (1984) for the methodological background, and Miles and Huberman (1984) for
analytical methods.
11
See Reid (1987, ch 2) for illustrations of this sort of methodology.
12
See Reid (1998) for a fully developed treatment of this grounded hypothesis.
13
As Marshall put it: “The central operation was this: a bar of iron …was put red hot into a machine, and a sort
of hook caught it & pulled it back thus giving it the general outline of the shoe, then came two moulds down on it
which gave it the rims & holes for the nails etc. They could make 60 a minute running extra high speed”. This
account of Marshall’s direct observation is given by Whitaker (1975, vol 1, p. 54) under the general heading of
‘The Search for Economic Reality’.
14
See the special issue of the Journal of Industrial Economics (1998) on ‘Inside the Pin-Factory: Empirical
Studies Augmented by Manager Interviews’, edited by S. Borenstein and J. Farrell , Vol. 46 (2).
15
This, and further detail on Dean’s life and works, is drawn from Primeaux (1984).
16
Dean’s son said “I think my father considered American business his laboratory in which he could test his
microeconomic theories and constantly correct them so that they could be better predictive models”. See
Primeaux (1984, p.14)
17
See Andrews and Brunner (1975, ch. 5)
18
Further detail on all this is contained in my monograph on the kinked demand curve, Reid (1981).
19
Much of the biographical detail I include on Richardson is obtained from Earl (1998).
20
Later Sir John Hicks, and Nobel Laureate in Economics.
21
This is, of course, related to cognate work by Baumol (1962), Penrose (1959), and others.
22
Including: Director, Centre for Business Strategy, London Business School; Research Dean, London Business
School; Director, Institute of Fiscal Studies; and Director, Oxford.
23
These were Profiles E, I and B, respectively in Reid et al (1993) and have been re-lettered here for
convenience.
24
The more complete treatment of this is contained in CRIEFF Discussion Paper No.9721, see Reid (1997).
25
CRIEFF Discussion Paper No.9712.
26
CRIEFF Discussion Paper No.9721.
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