Why Do Small Businesses Fail An Economic Perspective - Essay Example

Why do Small Businesses fail? An Economic Perspective “Why do Small Businesses fail? An Economic Perspective” The economic strength of any country is defined by the amount of productivity and efficiency practiced by the different stake holders of the system. These range from individual workers, corporations, small business owners to government regulators. From these Small Businesses are considered to be the most important economical contributors with respect to their social impact, and employment and innovation opportunities. In the US especially the perception of the small business owner is tied inexplicably to the ideals of hard work leading to success and the importance of the individual. Before verifying any such claims or talking in-depth about the problems and opportunities present for this sector, one must first define ‘Small Business’. While researchers provide their own specific parameters and variables for defining the term “There is no inherent definition of a "small" business.” (Priest 2003). For the US market, any business having 500 or less employees is considered a small business, with a significant amount of these having less than 20 workers. But the advantages associated with small businesses in general like more flexibility, an innovative environment, enhancing of entrepreneurial skills etc cannot be fully realized even in the relatively smaller size of 500 workers. For the purpose of this paper, the following description coined by the Wiltshire Committee (Australia) will be considered the standard for a small business “A business in which one or two persons are required to make all the critical management decisions: finance, accounting, personnel, purchasing, processing or servicing, marketing, selling, without the aid of internal specialists and with specific knowledge in only one or two functional areas” (1971). The decision about the ideal firm size in the economy is usually determined by the relationship between managerial efficiencies (costs) and market transaction costs- if a small person team can perform efficiently in a small market while keeping their transaction costs low the small business model will be suitable to them. From an academic point of view claims about the social and economic importance have to be empirically proved before any further discussion can be built upon them. At this time, there are no clear normative grounds which substantiate the claims about the significant contribution of Small businesses to overall revenue and employment generation (Priest, 2003); at the most the contributions are equal to that provided by large conglomerates and corporations. However, the rate of failure of small businesses is still a cause of concern for academics and professionals alike because there are some specific proven benefits associated with small businesses with cannot be provided by large firms working on economies of scale and mass production. These pertain to particularized customer demands in small demand markets; a small size market with demands for personalization can only be met by smaller businesses and the society benefits from the increased welfare provided by choice. Failure of the Small business is an accepted phenomenon in the market. In a study done by Inc. magazine and the National Business Incubator Association (NBIA) Statistics it was shown that 80% of new businesses fail within their first year. According to the Small Business Association In 2002, an estimated 550,100 new businesses were established in the U.S., while an estimated 584,000 closed their doors for good bringing the growth rate of small businesses to negative. From those that survive the first year, 8 out of 10 new businesses fail within the first three years. (Mason, 2012). This trend is not associated with US alone; studies in diverse nations like South Africa, Australia, UK, South East Asia have shown the same. The reasons behind these failures can be broadly categorized into External and Internal factors. External factors are those which can only be combated at an economic and systematic level while the internal ones are specific to each business and have to be dealt with at a firm level e.g training, education, capital investment etc. To understand the reasons behind the failures, first the types of failure have to be understood. The failure of the businesses can categorize into four types as well: bankruptcy, discontinuance of owner ship, Discontinuance of business and Failed to make a go at it (Everett & Watson, 1998). Discontinuance of ownership may indicate a change in the nature of business and management despite financial success, in this regard this will not be considered a business failure but a failure of purpose. The other types can adequately explained in term of macro and micro economic factors. Basic advice for small business owners usually pertains to internal factors. These take into account the skill of the people involved, management of the business, clarity of business objective etc. In economic terms this actually refers to the use and management of economic resources available to business owners. The four resources to be exploited are land, labor, Capital, Entrepreneurial Activity (McConnell et al, 2009). Any small business which is started without the adequate knowledge about the effective and efficient use of these resources will face great difficulty in achieving profitability. From Human Resource activities to machinery operations, the management will have a significant impact on whether the business will survive or fail. Similarly, under capitalization is often a major problem for these businesses; they fail to grasp the requirement of their business and without the capital requirements cannot expand or compete competitively (Schaefer, 2011).One example is of a Pure competitive market where there are many small scale suppliers and uniform goods. Any firm which cannot keep its average variable cost lower than the price of the good (through labor or capital utilization) will have to face the shut down case, i.e Discontinuance of business or Failed to make a go at it. Coming to the External problems, these are Macroeconomic factors at the National level e.g interest, inflation, government policies which impact whole industries not just single firms. Unfortunately, effect of changes in these factors, such as in a recession, is often more drastic for small businesses as they do not have the same financial options available to them as to bigger firms. Research done by Everett & Watson in 1998 show a direct correlation between rise in interest rates and rise in the rate of bankruptcy for small businesses. These businesses depend on banks and other financial institutes for their borrowing needs. The small size makes raising internal capital difficult and issuance of stocks or bonds is not feasible either. If the owners cannot afford to borrow to meet their transactional needs the only option might to close down the business for good. The evidence of this was highlighted in the financial crises of 2008. “Caught between contracting markets, late payments, increasing overheads and a sharp decline in access to finance, many viable small businesses have failed.” (FSB, 2010). As banks became ever more cautious of lending money, the small businesses were the once worst hit. In the same research, one more variable considered was the rates of employment in an economy. Increasing employment is usually an indicator that an economy is growing or moving out of a recession but interestingly the relationship between failure of small businesses and rise in employment is positive! “It appears that the probability of failure increases with increases in the lagged employment rate. This suggests that many marginal small business operators may have decided to move out of business and into employment when the opportunity to do so improved.” (Everett & Watson, 1998). The attitude indicates that despite the assertions that small businesses are more attractive to the general population, people actually prefer the general safety of regular employment and innovative measures are only taken up when other options are not viable. In such cases the failure of the business was a well thought out plan, leading to a discontinuance of owner ship. When applying this result to emerging economies, one can infer that the rate of failure of small businesses in such nations may be more impacted by increase in provision of employment opportunities. A steady income would be more attractive and risk free for a poor population. This seems contradictory to the prevailing notion that small businesses contribute most in terms of employment opportunities but the economic reasons behind this idea are valid. People will always make the more rational choice with regards to their resources and the returns associated with it. A steady job in a large corporation may bring higher risk free returns for their time and effort as opposed to working in or owing a small business. Finally there are the Government policies which affect the small businesses. Because of their perceived importance, special political support programs often exist for these businesses including small business finance, simplified securities registration, special forms of tax treatment, and debt relief make sense. The problem is that while these allow the businesses a relief in the initial period, unspecialized regulations for the whole industry serve as a deterrent for the smaller businesses. Their strength is in the niche market and these blanket regulation do not take into consideration their needs and abilities to perform. (Priest, 2003). To counter the negative effects of the regulations, often businesses would be tempted to take advantage of Unnatural incentives e.g a tax return for firms with less than 20 workers by restricting themselves to certain parameters. In such scenarios the business cannot grow competitively as the environment requires but is dictated in its operations to by government regulations. In the long run such a strategy would definitely lead to business failure. Talking about small businesses and their operations, the type of failure and reasons for failure are both important. Internal weaknesses can be worked on by individual firms but the systematic external factors have to be regulated by government bodies. In determining the real cause of failure it is important to look at all the variables and then decide that whether the failure was an unfortunate incident which could have been controlled or if it was simply the right time for the business to dissolve. References FSB, (2010). What Impact has the Financial Crisis had on Small Businesses in the UK? Federation of Small Business. Retrieved from: http://www.fsb.org.uk/policy/images/impact%20of%20the%20financial%20crisis%20on%20small%20businesses.pdf Wiltshire Committee, (1971), Report of the Committee on Small Business, Chairman: Wiltshire. F. M. Canberra: The Government Printer of Australia. Schaefer, P. (2011). The Seven Pitfalls of Business Failures and How to Avoid Them. Attard Communications, Inc. Retrieved from: http://www.businessknowhow.com/startup/business-failure.htm Everett , J and Watson, J. (1998). Small Business Failure and External Risk Factors. Small Business Economics. Vol. 11, No. 4 (Dec., 1998), pp. 371-390. Retrieved from: http://link.springer.com/article/10.1023%2FA%3A1008065527282?LI=true#page-1 Priest, G. L. (2003). Small Business, Economic Growth, and the Huffman Conjecture. Faculty Scholarship Series. Paper 637. Retrieved from: http://digitalcommons.law.yale.edu/fss_papers/637 Business Hub, (2012). Small business Failure rate, what’s the reason? The Start up. Retrieved from: http://www.startupbusinesshub.com/small-business-failure-rates/ Mason, M.K. (2012). Research on Small Businesses. Retrieved from: http://www.moyak.com/papers/small-business-statistics.html Mason, M.K. (2012). What Causes Small Businesses to Fail? Retrieved from: http://www.moyak.com/papers/small-business-failure.html McConnell, C.R., Brue, S.L. and Flynn. S.M. (2009). Economics: Principles, Problems and Policies. McGraw-Hill/Irwin, 18th Ed. Read More