9 The role of innovation in the postentry performance of
9.2 Start-up of small firms and their subsequent early performance: a review of the literature
Entry has an important role in the model of perfect competition since an excess level of profitability induces entry into the industry; that is, if excess profits occur – caused by the opening of a market niche, a cost-saving innovation, or product differentiation – additional agents are attracted into the market. In this view, a queue of well-informed potential entrepreneurs is supposed to be waiting outside the market, and the expected level of profit is the ‘pull factor’ determining entry (Khemani and Shapiro, 1986; Acs and Audretsch, 1989a; Geroski, 1991; Geroski and Schwalbach, 1991).
In most of the conventional entry models, the maximization of expected profits is discounted by taking into account barriers to entry. In these models, entry is still driven by expected profits, but it is also hindered by factors such as initial sunk costs, minimum efficient size, industry-specific features such as innovation and advertising expenditure (Mansfield, 1962; Orr, 1974; Baldwin and Gorecki, 1987).
More recently, ‘strategic barriers to entry’ have attracted the attention of many scholars: in these models entry barriers play a preemptive role in a game between incumbents and potential entrants (Tirole, 1989, Ch. 8). The main shortcoming of this traditional approach to industrial organization is that by treating the industry market as the essential unit of observation, it is virtually impossible to take into account individual characteristics of the potential founder (push factors). In fact, while the diversification of an existing firm into a new market can be fully explained through the consideration of expected profits and (strategic) entry barriers, Innovation and firms’ postentry performance 117
the study of the foundation of a new small firm by a single entrepreneur requires a wider perspective. Indeed, if the unit of observation is the level of the market, this obscures the decision-making process at the level of the individual (Winter, 1991) and underestimates the factors shaping the entrepreneur’s motivation in starting a new business (McClelland, 1961).
As a complement to the simplified view of entry discussed so far, a different tradition can be singled out in the history of economic thought: Schumpeter (1911), Knight (1921) and Oxenfeldt (1943) drew attention to the subjective characteristics of the actual founder of a new firm. Their well-known definitions of entrepreneurship opened the way to a more general framework where pull fac- tors are studied together with some push factors concerning the environment and the particular situation of the potential founder (for a discussion of push factors contrasted with pull factors, see Kilby, 1971).
This literature is mainly empirical in nature and gives interesting insights into the actual process of entry. For instance, according to the results of the surveys carried out by Storey (1982) and Johnson (1986), the founder of a new firm is heavily influenced by his/her own background, with particular reference to his/her previous job experience (it has to be taken into account that the vast majority of new firms originate through spin-off from a mother company: 60% in Storey (1982) and 68% in Vivarelli (1991)). In other words, his/her entrepreneurial pro- ject is dependent on technical and managerial competence acquired in the previous job: technical savoir faire, organizational skills, knowledge of the market, and so on (Bates, 1990). Thus, spin-off results can be affected by the previous hierarchi- cal job position of an ex-employee (for instance, successful entrepreneurs are more likely to have been managers involved in supervisory functions). As regards the personal characteristics of the founder, family background is also singled out as a key factor by econometric estimates explaining new firm formation as an act of self-employment (De Wit and Van Winden, 1989; Evans and Leighton, 1989).
However, other empirical studies tend to play down the relative importance of this factor in shaping the start-up decision (Vivarelli, 1991).
An interesting way to model entry decision to encompass both pull and push factors is the so-called ‘income choice’ approach (Creedy and Johnson, 1983;
Storey and Jones, 1987; Blanchflower and Oswald, 1990; Evans and Leighton, 1990; Blanchflower and Meyer, 1994). In this theory, a potential founder com- pares his present income and prospects as an employee with the expected income from the independent activity; if this difference is more than a given threshold, whose level depends on the individual’s risk aversion and on particular psycho- logical aptitudes such as a strong desire to be independent, the new firm will be founded. While this approach encompasses the traditional view whereby entry is pulled by expected profits, it also explains some situations where the founding of the new firm is induced either by uncertainty about future career perspectives or by a strong psychological motivation to be independent (for an application of this model to the Italian case, see Foti and Vivarelli, 1994; for a general view of entry and survival processes in Italy, see Contini and Revelli, 1992; Santarelli and Sterlacchini, 1994). Obviously, this model is of particular interest in modelling 118 Alessandro Arrighetti and Marco Vivarelli
the spin-off of previously dependent workers who opt for self-employment (for theoretical models based on the income choice, see Lucas, 1978; Kihlstrom and Laffont, 1979; Blau, 1987; Holmes and Schmitz, 1990).
In addition, the income choice approach can be adapted to some situations where the decision to start a new firm is induced either by unemployment or by fear of becoming unemployed; that is, by a very low expected income from the present employment. Indeed, this kind of start-up has been called ‘escape from unemployment’ (Oxenfeldt, 1943, Ch. 10). Storey and Jones (1987) discovered a percentage of previously unemployed founders varying between 25% and 50%, whereas Highfield and Smiley (1987) found evidence for a counter-cyclical fea- ture of new firm formation (for critical reviews of the escape from unemployment hypothesis, see Hamilton, 1989; Storey, 1991).
The literature on the entry process has roots in the history of economic thought, but a new strand of literature on the postentry performance of firms has emerged in the last few years (see, for instance, Reid, 1991; Boeri and Cramer, 1992; Dunne and Hughes, 1994; Audretsch and Mahmood, 1995; Baldwin and Rafiquzzaman, 1995; Mata, Portugal and Guimaraes, 1995). These studies have drawn attention to issues of industry dynamics such as postentry patterns of survival, growth and early exit. In these analyses, cohorts of new firms are tracked over time and their postentry performance is theoretically modelled and empirically observed. Here it will be sufficient to focus attention on those studies that have attempted to relate postentry performance to some newly founded firms’ initial characteristics. For instance, Dixit (1989) and Hopenhayn (1992) both argue that postentry perfor- mance may be affected by the level of sunk costs in the industry: higher sunk costs should reduce the likelihood of early exit since precommitment can be seen as a signal of superior entrepreneurial capabilities. Other studies are more concerned with industrial rather than firm characteristics; for example, Audretsch (1995) focuses on the degree of scale economies in a given industry, arguing that new small firms not able to grow and to approach the industry’s minimum efficient scale will presumably be characterized either by bad postentry performance or by early exit (see also, Acs and Audretsch, 1989b).
On the whole, although these studies are very useful in representing the role of entry in determining evolutionary patterns at industry level (industry differentiation and innovation, Gibrat’s law, patterns of early exit and population renewal, and so on), they say little about the postentry performance of the single new-born firms.
In this paper, however, the focus of the analysis will be the microperformances of newly founded firms and how their performances can be linked to their initial characteristics.
Jovanovic’s studies (1982, 1994) are based on the hypothesis that the income decision resulting in a new entrepreneurial firm and subsequent postentry perfor- mance are formed under a ‘veil of ignorance’. In this paper the hypothesis is that the determinants of the starting of a new firm do not have a neutral influence on the postentry performance. In Jovanovic’s framework it is the postentry learning that matters. In our analysis, postentry performance is partially predetermined on the basis of the founder’s preentry features. For example (and taking into account Innovation and firms’ postentry performance 119
120 Alessandro Arrighetti and Marco Vivarelli
both conventional entry models and the income choice model), if the underlying motivation to start a new firm is explicitly linked to innovative projects, then a better postentry performance may be expected than if a new firm is started on the basis of a purely defensive motivation, such as the fear of becoming unemployed (for the role of innovation in making a new small firm successful, see Acs and Audretsch, 1990; Audretsch, 1991). Similarly, some deeply rooted psychological motivation, such as the strong desire to be independent, can hinder a rational and objective consideration of actual profit expectations for the new firm and jeopardize future chances of business success. Moreover, a spin-off originated by a managerial position may have better chances than a spin-off originated by a low-skilled worker.
More generally (and taking into account that our sample is made up of new-born firms originated through spin-off), it is important to see that an individual eco- nomic agent’s choice to start a new firm rather than remaining employed in an incumbent organization can be influenced by many different factors related to the founder’s previous job experience and learning within the mother company (Porter, 1980; Storper and Salais, 1997, p. 164 and ff.).