If it is feasible, a company can try to avoid confrontation with competitors having high exit barriers and can thus sidestep involvement in bitter price cutting. Where does it stand against substitutes? Against the sources of entry barriers? I shall consider each strategic approach in turn. Strategy can be viewed as building defenses against the competitive forces or as finding positions in the industry where the forces are weakest.
If the company is a low-cost producer, it may choose to confront powerful buyers while it takes care to sell them only products not vulnerable to competition from substitutes. The success of Dr Pepper in the soft drink industry illustrates the coupling of realistic knowledge of corporate strengths with sound industry analysis to yield a superior strategy.
Dr Pepper chose a strategy of avoiding the largest-selling drink segment, maintaining a narrow flavor line, forgoing the development of a captive bottler network, and marketing heavily. The company positioned itself so as to be least vulnerable to its competitive forces while it exploited its small size. Dr Pepper coped with the power of these buyers through extraordinary service and other efforts to distinguish its treatment of them from that of Coke and Pepsi. Many small companies in the soft drink business offer cola drinks that thrust them into head-to-head competition against the majors.
Dr Pepper, however, maximized product differentiation by maintaining a narrow line of beverages built around an unusual flavor. Finally, Dr Pepper met Coke and Pepsi with an advertising onslaught emphasizing the alleged uniqueness of its single flavor. This campaign built strong brand identification and great customer loyalty.
Thus Dr Pepper confronted competition in marketing but avoided it in product line and in distribution. This artful positioning combined with good implementation has led to an enviable record in earnings and in the stock market.
When dealing with the forces that drive industry competition, a company can devise a strategy that takes the offensive. This posture is designed to do more than merely cope with the forces themselves; it is meant to alter their causes.
Innovations in marketing can raise brand identification or otherwise differentiate the product. Capital investments in large-scale facilities or vertical integration affect entry barriers. Industry evolution is important strategically because evolution, of course, brings with it changes in the sources of competition I have identified. In the familiar product life-cycle pattern, for example, growth rates change, product differentiation is said to decline as the business becomes more mature, and the companies tend to integrate vertically.
These trends are not so important in themselves; what is critical is whether they affect the sources of competition. Consider vertical integration. In the maturing minicomputer industry, extensive vertical integration, both in manufacturing and in software development, is taking place.
This very significant trend is greatly raising economies of scale as well as the amount of capital necessary to compete in the industry. This in turn is raising barriers to entry and may drive some smaller competitors out of the industry once growth levels off. Obviously, the trends carrying the highest priority from a strategic standpoint are those that affect the most important sources of competition in the industry and those that elevate new causes to the forefront. In contract aerosol packaging, for example, the trend toward less product differentiation is now dominant.
The framework for analyzing competition that I have described can also be used to predict the eventual profitability of an industry. In long-range planning the task is to examine each competitive force, forecast the magnitude of each underlying cause, and then construct a composite picture of the likely profit potential of the industry. The outcome of such an exercise may differ a great deal from the existing industry structure. Today, for example, the solar heating business is populated by dozens and perhaps hundreds of companies, none with a major market position.
Entry is easy, and competitors are battling to establish solar heating as a superior substitute for conventional methods.
These characteristics will in turn be influenced by such factors as the establishment of brand identities, significant economies of scale or experience curves in equipment manufacture wrought by technological change, the ultimate capital costs to compete, and the extent of overhead in production facilities.
The framework for analyzing industry competition has direct benefits in setting diversification strategy. Corporate managers have directed a great deal of attention to defining their businesses as a crucial step in strategy formulation.
Theodore Levitt, in his classic article in HBR, argued strongly for avoiding the myopia of narrow, product-oriented industry definition. One motive behind this debate is the desire to exploit new markets. Another, perhaps more important motive is the fear of overlooking latent sources of competition that someday may threaten the industry. Many managers concentrate so single-mindedly on their direct antagonists in the fight for market share that they fail to realize that they are also competing with their customers and their suppliers for bargaining power.
Meanwhile, they also neglect to keep a wary eye out for new entrants to the contest or fail to recognize the subtle threat of substitute products. The key to growth—even survival—is to stake out a position that is less vulnerable to attack from head-to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods. Establishing such a position can take many forms—solidifying relationships with favorable customers, differentiating the product either substantively or psychologically through marketing, integrating forward or backward, establishing technological leadership.
You have 1 free article s left this month. You are reading your last free article for this month. Subscribe for unlimited access. Create an account to read 2 more. Competitive strategy. How Competitive Forces Shape Strategy. Awareness of these forces can help a company stake out a position in its industry that is less vulnerable to attack by Michael E.
While space does not permit a complete treatment here, I want to mention a few other crucial elements in determining the appropriateness of a strategy built on the entry barrier provided by the experience curve: The height of the barrier depends on how important costs are to competition compared with other areas like marketing, selling, and innovation. The barrier can be nullified by product or process innovations leading to a substantially new technology and thereby creating an entirely new experience curve.
If more than one strong company is building its strategy on the experience curve, the consequences can be nearly fatal. By the time only one rival is left pursuing such a strategy, industry growth may have stopped and the prospects of reaping the spoils of victory long since evaporated. A version of this article appeared in the March issue of Harvard Business Review. Read more on Competitive strategy or related topic Strategy formulation. Michael E.
For most other commercial activity, however, competition on the merits is the presumed policy. As one American court observed: The Sherman Act, embodying as it does a preference for competition, has been since its enactment almost an economic constitution for our complex national economy. A fair approach in the accommodation between the seemingly disparate goals of regulation and competition should be to assume that competition, and thus antitrust law, does operate unless clearly displaced.
In condemning private and public anti-competitive restraints, competition officials and courts invariably prescribe competition as the cure. But that is a function of market conditions, not competition itself. Competition itself cannot cause market failures. Economist Irving Fisher over a century ago examined two assumptions of any laissez-faire doctrine: first, each individual is the best judge of what subserves his own interest, and the motive of self-interest leads him to secure the maximum of well-being for himself; and, secondly, since society is merely the sum of individuals, the effort of each to secure the maximum of well-being for himself has as its necessary effect to secure thereby also the maximum of well-being for society as a whole.
Competition policy typically assumes that market participants can best judge what subserves their interests. Suboptimal competition can arise when firms compete in fostering and exploiting demand-driven biases or imperfect willpower. To illustrate, suppose many consumers share certain biases and limited willpower. Competition benefits society when firms compete to help consumers obtain or find solutions for their bounded rationality and willpower.
Providing this information is another facet of competition—trust us, we will not exploit you. The credit card industry provides one example.
Some consumers do not understand the complex, opaque ways late fees and interest rates are calculated, and are overoptimistic on their ability and willpower to timely pay off the credit card purchases. For other credit card competitors, exploiting consumer biases makes more sense than incurring the costs to debias. Alternatively, the debiased consumers do not remain with the helpful credit card company.
Instead they switch to the remaining exploiting credit card firms, where they, along with the other sophisticated customers, benefit from the exploitation such as getting airline miles for their purchases, while not incurring any late fees.
This problem, of course, can arise under oligopolies or monopolies. But here entry and greater competition, as one recent survey found, can worsen, rather than improve, the situation: The most striking result of the literature so far is that increasing competition through fostering entry of more firms may not on its own always improve outcomes for consumers.
Indeed competition may not help when there are at least some consumers who do not search properly or have difficulties judging quality and prices … In the presence of such consumers it is no longer clear that firms necessarily have an incentive to compete by offering better deals. Rather, they can focus on exploiting biased consumers who are very likely to purchase from them regardless of price and quality.
These effects can be made worse through firms' deliberate attempts to make price comparisons and search harder through complex pricing, shrouding, etc and obscure product quality. The incentives to engage in such activities become more intense when there are more competitors. Second, after identifying these consumers, firms must be able to exploit them. But firms, like consumers, are also susceptible to biases and heuristics. In competitive settings—such as auctions and bidding wars—overconfidence and passion may trump reason, leading participants to overpay for the purchased assets.
If repeated biased decision-making is not punished, the problem is too little, rather than too much, competition. Given the cost of losing, it is also illogical to enter a bidding war. But if everyone believes this, no one bids—also illogical. If only one person bids, that person gets a bargain. Once multiple bidders emerge, the second highest bidder fears having to pay and escalates the commitment. Bazerman and Moore analogize their experiment to merger contests.
Competitors A and B, in their example, fear being competitively disadvantaged if the other acquires cheaply Company C, a key supplier or buyer. Firms A and B may rationally decide to enter the bidding contest. Both are better off if the other cannot acquire Company C, nonetheless neither can afford the other to acquire the firm. Here clear antitrust standards can benefit the competitors. If they both know they cannot acquire Company C under the antitrust laws, neither will bid. Antitrust, while not always preventing the competitive escalation paradigm, can prevent overbidding in highly concentrated industries where market forces cannot punish firms that overbid.
Suppose the first assumption Fisher identifies is satisfied—people aptly judge what serves their interest, which leads them to maximize their well-being. One avoids the problem of behavioral exploitation and perhaps the competitive escalation paradigm. Competition benefits society when individual and group interests and incentives are aligned or at least do not conflict.
Difficulties arise when individual interests and group interests diverge. One area of suboptimal competition is where advantages and disadvantages are relative.
Hockey players are another example. Hockey players prefer wearing helmets. But to secure a relative competitive advantage, one player chooses to play without a helmet. The other players follow. None now have a competitive advantage from playing helmetless. Collectively the hockey players are worse off. A recent example is Wall Street traders who inject testosterone to obtain a competitive advantage. They and society are collectively worse off.
Below are five additional scenarios where competition for a relative advantage can leave the competitors collectively and society worse off. Today corporations and trade groups spend billions of dollars lobbying the federal and state governments. Microsoft now spends millions of dollars annually on lobbying. The Supreme Court quickened the race to the bottom when it substantially weakened the limitations on corporate political spending, and thereby vastly increased the importance of pleasing large donors to win elections.
These corporations fear that officeholders will shake them down for supportive ads, that they will have to spend increasing sums on elections in an ever-escalating arms race with their competitors, and that public trust in business will be eroded.
A system that effectively forces corporations to use their shareholders' money both to maintain access to, and to avoid retribution from, elected officials may ultimately prove more harmful than beneficial to many corporations.
It can impose a kind of implicit tax. When auditor Ernst and Young recently surveyed nearly chief financial officers, its findings were disturbing: When presented with a list of possibly questionable actions that may help the business survive, 47 per cent of CFOs felt one or more could be justified in an economic downturn. Worryingly, 15 per cent of CFOs surveyed would be willing to make cash payments to win or retain business and 4 per cent view misstating a company's financial performance as justifiable to help a business survive.
While 46 per cent of total respondents agree that company management is likely to cut corners to meet targets, CFOs have an even more pessimistic view 52 per cent. Competition, economist Andrei Shleifer discusses, can pressure companies to engage in unethical or criminal behavior, if doing so yields the firm a relative competitive advantage. Other firms, given the cost disadvantage, face competitive pressure to follow; such competition collectively leaves the firms and society worse off.
But under a shared value worldview, these concepts are reinforcing. The conflict between collective and individual interests arose in the financial crisis. Banks, the OECD described, are prone to take substantial risks: First, the opacity and the long maturity of banks' assets make it easier to cover any misallocation of resources, at least in the short run.
Second, the wide dispersion of bank debt among small, uninformed and often fully insured investors prevents any effective discipline on banks from the side of depositors. Thus, because banks can behave less prudently without being easily detected or being forced to pay additional funding costs, they have stronger incentives to take risk than firms in other industries. Examples of fraud and excessive risk are numerous in the history of financial systems as the current crisis has also shown.
Even for rational-choice theorists like Richard Posner, the government must be a countervailing force to such self-interested rational private behavior by better regulating financial institutions. One may ask if competition is the problem, then is monopoly the cure.
The remedy is neither monopoly nor overregulation which besides impeding competition, stifles innovation and renders the financial system inefficient or unprofitable. The FTC in Ethyl described this divergence: An individual customer may rationally wish to have advance notice of price increases, uniform delivered pricing, or most favored nation clauses available in connection with the purchase of antiknock compounds.
However, individual purchasers are often unable to perceive or to measure the overall effect of all sellers pursuing the same practices with many buyers, and do not understand or appreciate the benefit of prohibiting the practices to improve the competitive environment …. In short, marketing practices that are preferred by both sellers and buyers may still have an anticompetitive effect.
What the appellate court failed to grasp is that MFNs—while individually rational—can be collectively irrational. If the buyers fiercely compete, MFNs seemingly provide a relative cost advantage.
Why should they uniquely incur the cost, when the benefits accrue to their rivals? Status competition epitomizes competition for relative position among consumers with interdependent preferences. Either people adapt to their fancier lifestyle, and envy those on the higher rung. Status competition not only taxes individuals but society overall. Status competition has confounded consumers and economists for centuries. John Maynard Keynes, for example, assumed that with greater productivity and higher living standards, people in developed economies would work only fifteen hours per week.
Keynes correctly predicted the rise in productivity and real living standards. This analysis would reveal that the failure to live it is due to a kind of unconscious cut-throat competition in fashionable society. Status competition is often, but not always, detrimental. On the bright side, people voluntarily compete and use Internet peer pressure to change their energy consumption, driving, and exercise habits.
One interesting empirical study sought to understand why academics cheated by inflating the number of times their papers were downloaded on the Social Science Research Network SSRN.
Why the deception? Status competition, the study found, was a key contributor. In all five scenarios, competitors seek a relative advantage that ultimately leaves them collectively and society worse off.
This suboptimal competition is not a new concept. Many, however, used a pejorative term, instead of competition, to describe it, such as: a collective action problem, Firms—independent of any competitive pressure—at times impose a negative externality to maximize profits.
For example, electric power utilities, whether or not a monopoly, will seek to maximize profits by polluting cheaply and having the community bear the environmental and health costs.
The utility monopoly, for example, may lobby to keep abay pesky environmentalists, but it would not expend resources on lobbying to secure a relative competitive advantage when its market power is otherwise secure.
The previous subsection identifies five scenarios where competition for a relative advantage leaves the competitors and society worse off. Underlying democracies is the belief that competition fosters the marketplace of ideas: truth prevails in the widest possible dissemination of information from diverse and antagonistic sources. For if the problem were attributable primarily to misaligned incentives, then the problem would arise in duopolies, and be unaffected by entry and increased competition.
Here, misaligned incentives play an important role, but so do increased entry and competition. This subsection discusses two industries, where, as recent economic studies found, greater competition yielded more unethical conduct among intermediaries.
But this problem can arise in other markets as well. Home appraisers, pressured by threats of losing business to competitors, inflate their valuations to the benefit of real estate brokers who gain higher commissions and lenders who make bigger loans and earn greater returns when selling them to investors.
Ratings agencies provide several complementary functions: i to measure the credit risk of an obligor and help to resolve the fundamental information asymmetry between issuers and investors, ii to provide a means of comparison of embedded credit risk across issuers, instruments, countries and over time; and iii to provide market participants with a common standard or language to use in referring to credit risk. Interestingly, unionization appears to mitigate the negative impact of concentration on wages.
The potential link between employer concentration and wages is still the subject of an active research discussion. As with diagnosing monopoly power, understanding the boundaries of the market is both crucial and difficult. Posted vacancies might not accurately capture the true range of job options for workers; in addition, many workers can move across industries.
Still, the observed associations between local concentration and wages—combined with the fact that concentration appears to be growing—suggest that the relationship between concentration and wages deserves more research and policy attention. Market concentration has long concerned policymakers, and the leading tool to address it has been antitrust regulation.
Antitrust policy has its origins in the Sherman Antitrust Act of and the Clayton Act of , but the details of regulatory policy have evolved over time. In the modern era, the Merger Guidelines of DOJ —and subsequent revisions—have directed enforcement of antitrust law Kwoka and White From its early stages, antitrust policy has focused on the potential for market power to harm consumers or other purchasers by raising prices. The law considers three primary ways in which this can occur.
First, individuals might attempt to fix prices in a market. Microsoft Corp. Third, firms might attempt to merge, thereby increasing their combined market power Baker The antitrust consumer welfare orientation directly informs how regulators assess proposed mergers. Regulators first attempt to define the relevant market by determining the set of products and places that are within its scope.
This is crucial to any review of a proposed merger: the more expansively lines are drawn, the less likely a merger will appear to impair competition Katz and Shelanski Next, regulators calculate the increase in market concentration, as captured by the HHI, that would result from the merger, as well as the post-merger HHI level.
By contrast, a proposal that would cause market HHI both to rise by points and then exceed 2, is presumptively anticompetitive and will often be challenged DOJ and FTC These thresholds are not part of an inflexible, uniformly applied formula, but they give a rough sense of how the DOJ and FTC are likely to begin their evaluation of merger proposals.
If regulators judge action to be needed, they will consider a few options. They might approve the merger with conditions e. Antitrust enforcement continues to evolve, and recent research implies four key lessons for antitrust policy that are not fully incorporated into existing practice:.
It is increasingly apparent that the market power of employers is an important policy concern, and policymakers might need to extend antitrust enforcement to encompass it Marinescu and Hovenkamp ; Naidu, Posner, and Weyl forthcoming; Krueger and Posner It is now necessary to refine the traditional antitrust framework when prices charged to consumers are zero, as is the case with many online businesses Newman The traditional antitrust emphasis on consumer prices might be insufficient when addressing online platforms that are characterized by strong returns to scale Khan Antitrust regulators increasingly must grapple with dynamic questions of competition and innovation Katz and Shelanski ; Shelanski For example, the FTC blocked a merger of heart device manufacturers in based on the argument that it would reduce innovative pressure Farrell, Pappalardo, and Shelanski Other nonmerger related policy shifts may be needed as well to bolster innovation in the face of rising concentration.
Common ownership of firms may diminish incentives for competition Azar, Schmalz, and Tecu forthcoming. In the extreme case, two firms with identical ownership would have no incentive to compete with each other; partially common ownership would diminish this incentive.
Regulators may need to consider or constrain either common ownership or the voting behavior of large families of funds. The DOJ also polices collusion, price-fixing, and other such anticompetitive behavior, typically in markets with a limited number of competitors where collusion is more feasible.
Total fines for criminal antitrust violations hit a new high in CEA , though whether that represents increased enforcement or increased anticompetitive behavior by firms cannot be established. Beyond merger control and criminal prosecutions, governments can take several sector-specific steps to enhance competition using other regulatory policies. For example, the U. Department of Transportation has authority over the allocation of airport capacity and can help ensure robust competition in certain capacity-constrained airports.
The Federal Communications Commission FCC ruled in favor of net neutrality, aiming to prevent broadband providers from using their market power to privilege certain content although these regulations were subsequently reversed; FCC Since , FCC rules have given consumers the rights to their cellphone numbers, facilitating portability across carriers and enhancing competition in wireless communications Kessing More recently, in the Obama administration issued an executive order instructing agencies to use their authorities to promote competition White House Broadly, merger enforcement and criminal antitrust sanctions will remain the core bulwark against declining competition.
For example, where market power exists, mandating greater interoperability across devices or platforms and limiting the ability of firms to force vertical integration can be important for competition. Antitrust regulators must take account of the many specific, idiosyncratic features of a merger proposal and the market it would impact.
However, there are regularities in antitrust enforcement. Mergers tend to be approved when a sizable number of significant competitors remain in a market, or, alternatively, when HHI is low and a merger would not increase it by much DOJ and FTC The stringency of antitrust enforcement can also change over time.
But it is difficult to infer changes in stringency from changes in regulatory outcomes. Ultimately, what matters for markets is how many and what kinds of mergers regulators allow to occur. Mergers that would leave only one or two remaining competitors are nearly always blocked, while mergers leaving three or four competitors are only sometimes challenged. In recent years antitrust regulators have not brought enforcement actions against proposed mergers that would leave five or more significant competitors.
Interestingly, this has not always been the case. Antitrust regulators have become much less likely to act against mergers that would leave five, six, or seven competitors, while becoming slightly more likely to block mergers that would leave only one to four competitors. A similar pattern is observed by post-merger HHI. Merger policy extends beyond merely blocking or permitting mergers. Of investigated mergers for which agency decisions and actions were disclosed, half were subject to divestiture or conduct requirements Kwoka, Greenfield, and Gu In other words, firms were permitted to merge on condition of abiding by restrictions that regulators deemed necessary to ensure robust competition.
At the same time that markets are becoming more concentrated, they are also becoming less dynamic: the number of business start-ups is falling, recently created firms generate fewer jobs than their predecessors, and a smaller fraction of individuals are becoming entrepreneurs. To understand how market competition is changing, it is necessary to examine the life cycle of businesses and how changes in it have affected wages and productivity.
In recent years it has become clear that young firms—and not necessarily small firms, as is commonly supposed—are the engine of employment and productivity growth in the United States Haltiwanger et al. As they introduce new technologies and business methods, new firms contribute substantially to productivity growth Acemoglu et al.
More broadly, the reallocation of workers from low- to high-productivity firms generates substantial improvement in productivity Decker et al. It is therefore discouraging to observe that young firms i.
In addition, the percent of start-ups has declined in all major sectors see fact 9. These developments might be of less concern if innovation and productivity growth were increasingly located in large, incumbent firms. While some large firms may be engaged in research and make greater strides in innovation, there has not been a noticeable recent increase in measured productivity growth on average at older firms Alon et al.
These trends are both a symptom and a cause of declining market competition. To the extent that rising market concentration is associated with increasing barriers to entry, concentration will both reduce the incentive to start new businesses and limit the potential of start-ups to expand into new markets Hathaway and Litan But fewer and smaller start-ups also mean less competition for incumbent firms.
In either case, diminished business dynamism imposes economic costs. This can have important effects on wage growth through a decline in job offers and job switching, as discussed in a Hamilton Project framing paper by Shambaugh, Nunn, and Liu With fewer firms bidding less aggressively for workers, the so-called job ladder functions less effectively Haltiwanger et al. Both wages and productivity suffer when workers move more slowly from low- to high-productivity firms.
This phenomenon is especially pronounced during recessions and their aftermath, when diminished labor demand leads to slower operation of the job ladder Barlevy ; Haltiwanger et al. Declining business dynamism makes it especially urgent to understand the role of start-ups in generating employment and economic activity. What do we know about the characteristics of successful start-ups and the conditions that allow them to prosper?
Any analysis of start-ups should start with an acknowledgment of their extreme variability. Entrepreneurs do not all aim at the same target: some start-ups are created by subsistence entrepreneurs who aim strictly to support themselves and their families, while others are created by transformational entrepreneurs who seek to build a large business. Moreover, there appear to be few transitions over time from the former to the latter categories Gompers, Lerner, and Scharfstein ; Schoar Start-ups vary tremendously in the outcomes they achieve.
A few start-ups—often referred to as gazelles—will experience high employment growth rates. Some firms will persist at a small size, while others will come in and out of existence over short periods Pugsley, Sedlacek, and Sterk Unsurprisingly, it is principally the gazelles that are the focus of economists interested in the labor market and economic growth. At different times and in different regions of the country, start-ups have had varying chances of successful growth; areas with high measured quality of entrepreneurship have tended to experience higher rates of economic growth Guzman and Stern While the Boston and Silicon Valley regions are host to particularly high-quality start-up activity, cities like Miami host start-ups that are less likely to grow quickly.
But the success of start-ups is not entirely a function of their own characteristics; market conditions affect their chances of success. One frequently cited variable is the availability of financing: small firms might have a harder time finding financing today than they did in the past.
Interestingly, these surveys suggest that small and large firms were affected in roughly equal measure Board of Governors of the Federal Reserve System Still, to the extent that consumer credit or home equity lines of credit are often financing sources for very early-stage start-ups, a reduction in the amount of home equity due to the crash in housing prices or a general tightening of consumer credit standards could have had a disproportionate impact on small firms.
Policy conditions also play an important role in start-up performance and chapter 4 will highlight some important considerations. Across sectors of the economy, business start-ups are less common than they were decades ago. Figure 9 shows start-up rates in , , and ; the continuous decline across those three years demonstrates that the disappearance of start-ups is an ongoing trend and not primarily a cyclical phenomenon.
Additionally, the consistent fall in start-up rates across industries is suggestive of a broad-based rather than sector-specific trend. The fall in start-up rates has had negative effects on productivity growth. Replacement of low-productivity firms with high-productivity young firms, and reallocation of workers to the highest-productivity firms, are both crucial mechanisms for raising economic output and living standards Alon et al.
The fall in start-ups after was particularly pronounced for high-tech firms within the industries shown in figure 9; the high-tech sector has historically been a strong source of job creation and productivity growth Decker et al. Though declining business dynamism is not entirely understood, several factors have been identified as likely contributors. One important possibility is that increased market concentration is making the environment for start-ups inhospitable.
Controlling for region-specific factors, Hathaway and Litan find that changes in the business consolidation rate the ratio of mean firm size to mean establishment size are negatively associated with changes in start-up rates at the metropolitan area level from —80 to — In addition to demographic trends, public policies ranging from non-compete contracts to land-use policies could have important roles Shambaugh, Nunn, and Liu As discussed in chapter 4 of this document, there are also concerns that increasing regulations may make it more difficult for new firms to start.
While the fall in the start-up rate is striking, it does not address some important questions about business dynamism. Is the decline part of a more general disappearance of small businesses? How is the decline in start-ups affecting the labor market? And what is happening to firms after they age out of the start-up category? Figures 10a and 10b use Census Bureau Business Dynamics Statistics — to show how the employment shares of firms have changed over time, dividing firms by age and by size.
In both relatively young firms age 0 to 10 and small firms with 49 or fewer employees accounted for roughly a third of total employment, but by this share had dropped to While young and small firms have both dwindled in labor market importance, the position of young firms has deteriorated more rapidly. Given their significance for productivity and wage growth, it is particularly important to examine the changing employment shares of young firms.
Within firms age 0 to 10, the decline was evenly distributed across all three age groups shown in figure 10a. Young firms employ a smaller share of the population both because there are fewer of them and because each employs fewer people on average than in the past. Decomposing the reduction in the employment share of firms age 0 to 5, we find that falling number of workers per firm accounted for about 40 percent of the decline, while the decreasing number of firms accounted for 60 percent.
Recent start-ups are producing strikingly fewer jobs than their predecessors, and this is particularly the case during their earliest years. Net job creation as a fraction of employment for one-year-old firms not shown hovered in the 1 to 2 percent range from the late s through —as the surviving start-ups added more employment than failing start-ups subtracted—but the rate fell gradually to less than —10 percent in , has not fully recovered since then, and still remains negative.
At the same time, the net job creation rate for two- to five-year-old firms was more consistently negative. Understanding business formation and the policy factors that support or undermine it is crucial to maintaining a dynamic, competitive economy. Drawing links between the two is usually not straightforward, but data are increasingly becoming available that support this research.
A new dataset from the Census Bureau—the Business Formation Statistics—reveals that the typical time between application and business formation has steadily increased in recent years. Figure 11a shows that the average number of months increased from 4. Interestingly, federal regulation does not appear to be limiting business dynamism Goldschlag and Tabarrok , although available data with which to explore this question are very limited. Figure 11b shows a related trend: the number of high-propensity business applications, defined as those applications that have characteristics associated with becoming an employing business, has declined from about , in to , in Though most of the decline occurred during the Great Recession, applications have not rebounded in subsequent years.
Reflecting a different focus on start-ups likely to have superior growth outcomes, Guzman and Stern find that the rate of high-impact start-ups was very high in the late s, followed by a lower but stable period in the s Guzman and Stern One relevant type of entry cost is financing, the availability of which varies in response to both economic and policy developments.
Interestingly, places with larger collapses in housing prices experienced larger reductions in high-propensity business applications, suggesting that home equity is an important source of capital that varies with the business cycle Bayard et al. These regions also typically had worse outcomes during the Great Recession, which likely depressed entrepreneurship directly, and not only indirectly through the balance sheets of potential entrepreneurs.
The factors that impede or promote business dynamism do not affect all businesses or entrepreneurs equally, and an exclusive focus on business-level data can obscure some of the ways that individual entrepreneurs are changing.
Accordingly, figure 12 examines trends in entrepreneurship—defined here as self-employment with at least 10 employees—by the educational attainment of entrepreneurs.
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