Thursday, April 23, 2009

Entrepreneurship Amid Decline

With the economy in a severe economic downturn, there have been lots of comparisons to earlier recessions and depressions. Aside from the obvious macroeconomic comparisons, we frequently hear stories about firms that were formed during recessions (Genentech, Microsoft, Google, Southwest Airlines...). One report from Kauffman looks at how such firms do and whether it matters that they were started during weak economic times. Kauffman Senior Fellow Paul Kedrosky writes:
Across all years, the results show that it is slightly more likely a post-1975 IPO came from a non-recessionary period. That group’s productivity was eighty-three companies per year, while the recession subset’s productivity was seventy companies per year that went public. If, however, we remove the Great Depression and WWII, both of which introduce some unrepresentativeness, we end up with 138 companies/year from expansion periods, and 140 from recession periods. In other words, these data suggest that the likelihood of a company being part of the public IPO set post-1975 is unrelated to whether it came from a recessionary or non-recessionary period.
Another vein of this research looks at what impact economic downturns have on an individual's decision to start a business. Frank Knight set up the basic framework for thinking about the effects of recessions on entrepreneurship. According to Knight, individuals can be in one of three states of the world, either as an employee for a firm, self-employed, or unemployed. We can imagine a stable equilibrium and then introduce a shock - such a shock is certainly easy to imagine currently. This causes a change in the relative prices of each activity. As the number of unemployed workers increases, we want to know, at the margin, what effect this will have on entrepreneurship, as defined simply as self-employed.

There are two main hypotheses. First, increased unemployment may "push" people into starting their own business. Such "forced entrepreneurship" occurs because it becomes more difficult to find work during a downturn, for obvious reasons, and because there is a broader pool of unemployed talent that can be productively utilized. According to a survey from CareerBuilder: "A highly competitive job market is motivating some workers to be their own boss. One-in-four workers who have not found jobs are considering starting their own business" (for further discussion see this USA Today story.)

There is also a pull effect from a booming economy. The clearest and most recent example of this was the recent tech boom and bust. Plenty of bright young college students dropped out in the 90s to start their own firms. The decision was simple. With a booming economy their odds of cashing in were high and the downside was relatively low (going back to school.) A recent paper by Roy Thurik, Martin A. Carree, André van Stel, and David B. Audretsch examines these two competing theories:
This paper investigates the dynamic relationship between self-employment and unemployment rates. On the one hand, high unemployment rates may lead to start-up activity of self-employed individuals (the “refugee” effect). On the other hand, higher rates of self-employment may indicate increased entrepreneurial activity reducing unemployment in subsequent periods (the “entrepreneurial” effect). This paper introduces a new two-equation vector autoregression model capable of reconciling these ambiguities and estimates it for data from 23 OECD countries between 1974 and 2002. The empirical results confirm the existence of two distinct relationships between unemployment and self-employment: the “refugee” and “entrepreneurial” effects. We also find that the “entrepreneurial” effects are considerably stronger than the “refugee” effects.

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