Company Formation Effect

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New firm formation - bad for the economy?

Research by the Max Plank Institute and Warwick Business School (Pamela Mueller, André van Stel and David J. Storey) into the effects of new firm formation in the UK developed previous studies undertaken in Germany with findings and data for the UK. The research showed that the overall impact on employment in England as a whole is strongly positive, but that the effect in “low entrepreneurial areas” is negative - new firm formation in these areas actually reduces employment.

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-0.3

-0.6

-0.9

-1.2

Lag (year)

Low entrepreneurial regions

Other regions

Initial employment effect

When a new company is formed, employment as a whole increases - the founder is employed. In strong economic areas the initial impact is lower than in weaker areas - companies are more often founded by people already in employment. In weaker economies there are more cases of “forced entrepreneurs” - who are unemployed and start a business as a means of employment.

Displacement effect

When a new business enters the market, it will have an impact on its competitors. If the new company competes locally, mainly by under-cutting local competitors on price, then it will have the effect of putting other companies out of business, and its own business model may not be sustainable in the long-run. So companies fail, with a resulting loss of employment and a lasting reduction in the overall attractiveness of the local market conditions (prices are reduced). Low entrepreneurial areas show a greater level of new companies operating locally and competing on price.

Competitive effect

As businesses succeed over time, they have a positive impact - both directly through their own employment, and through their impact on local competitors. The necessity to improve price competitiveness allows the new business, and others in their local market to be more competitive against businesses outside of their local economy.

Implications

The conclusion of this research could be that encouraging people into enterprise following the failure of traditional large employers is actually detrimental to the overall local economy.

It is true that many “forced entrepreneurs” do not stay in business long - often less than 2 years. This could be seen as a failure. But the other view is that they are using enterprise as a short term measure until they can find “a proper job”. This surely has to be preferable to unemployment.

And the side effect of their short experiment in entrepreneurism - increasing their own skills and improving the competitiveness of their local economy!