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The Wrong Question
 

Column debating whether small or large companies are the greater source of job creation and technical innovation.
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Policymakers and researchers continue to debate whether small or large companies are the greater source of job creation and technical innovation. If they are really interested in the critical role small companies play in our economy, that debate is irrelevant

Government policymakers and traffic planners have a lot in common. While it is possible to make informed guesses about the frequency, location, and character of traffic accidents, what actually happens is often unpredictable and difficult to explain. Policymakers, too, can make informed guesses about how small businesses will react to one program or another. Yet, in the end, it is often impossible to predict what the outcomes will be or to explain how they occurred. That's evident if you look at some of the issues that form the core of debates about the role of small business in America.

Take, for example, the 1994 book by Carnegie-Mellon professor Bennett Harrison, Lean and Mean: The Changing Landscape of Corporate Power in the Age of Flexibility. Harrison devotes better than 10% of his book, 37 of 324 pages, to two policy-driven concerns: Do small companies create the most jobs? And what is the role of small companies in technological innovation?

Those are indeed very current policy questions because politicians want to know how to create jobs and whether they should rely on small companies or large ones to drive commercial innovation. Harrison concludes that small companies are not unusually bountiful sources of new jobs, nor are they driving new technology. His conclusions, carefully reasoned and bolstered by the best available evidence, are not necessarily wrong. But they are beside the point. Jobs and innovation may seem to be the critical intersection, but the "accident" happens further down the road.

The critical role small businesses play has more to do with pioneering markets and providing products and services that large companies will not provide than with providing jobs or fostering pure technological innovation.

Consider the evolution of the video-rental business in the United States. During the 1980s there was a simultaneous, interdependent boom in VCR sales and video rentals. When the video-rental market emerged, in the early '80s, it was a classic mom-and-pop entrepreneurial opportunity: the market was growing rapidly and was geographically fragmented, the cost of entry was low, and very little special expertise was required to open or run a video-rental business. Equally important, there were no dominant competitors and no proven economies of scale. As the industry rapidly matured, regional chains grew -- either by filling an unoccupied niche or by cannibalizing single-location enterprises -- followed shortly by national chains, at least one of which is now investing heavily in becoming a player in information-highway development and home-entertainment services.

Look at the video-rental-business story in the context of the typical small-business policy debates about job generation and technical innovation. In the larger picture, those debates are not relevant. The importance of early mom-and-pop video-rental activity is not that it generated jobs, though it did that and also let some people accumulate equity before the big players came along. The importance is that the early video-rental entrepreneurs pioneered a market that large companies could not have, and in doing so they bore a risk that large companies would not. Also, the incredibly rapid growth of video-rental stores certainly helped feed the boom in VCR sales and thereby was one of the forces that drove VCR prices down.

Nobody would claim that video rental is a technically innovative business, but it would be hard to imagine the current wealth of technical entrepreneurial opportunities in multimedia products and entertainment services if there wasn't already a potential customer base of people accustomed to renting or buying videotapes. Without that business there would be no data on which to base projections of demand for services such as video-on-demand. There would also be, arguably, a considerably smaller cadre of large companies and entrepreneurs interested in digitized home-entertainment products. In other words, the "accident" happened elsewhere.

In addition to pioneering important markets, small companies play a critical role in providing product diversity and technological innovation in small market segments. That's especially clear in the medical-devices industry. At present there are roughly 1,700 different types of medical devices, which are developed and manufactured by more than 10,000 companies operating in the United States. The overall U.S. market for medical devices and dental equipment is estimated at around $40 billion. That aggregate figure conceals a very fragmented market. The markets for individual devices are often small, ranging from tens of millions to hundreds of millions of dollars.

Changes in the health-care industry and in Food and Drug Administration regulation of devices are driving rapid changes in the industry, but historically, certain types of medical-device innovation have been driven by hobby-shop styles of invention. In particular, many devices used in limited quantities have been developed and tested by "accidental entrepreneurs," surgeons or other physicians who see a need or an opportunity as a result of their clinical work and who work alone or with an engineer to create a new device or a device paired with a procedure. That is not an unusual phenomenon in fragmented industries, since large companies rarely have the ability or the patience to develop innovations for small markets -- the risk is too high and the return too low. In the medical-devices industry the large number of innovative technical specialists, a historical (if now changed) lack of barriers to testing and bringing products to market, and the availability of venture capital to support the development of small companies all spawned an incredibly innovative industry.

The substantial benefits of small-business risk taking -- the rapid exploration of market possibilities, the development and refinement of new products and services, certain types of technical innovation, and product diversity -- accrue to individual consumers, to other companies, and to the national economy. Those benefits are different in every industry segment and are created by small companies operating in the context of a complex economy populated by businesses of all sizes. Though the process of making political decisions may force an artificial separation of small companies and large companies, we shouldn't be fooled. You might as well ask which is more important to a forest, saplings or mature trees, as ask whether small companies generate more jobs and technical innovation than large companies do.

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Henry Kressel is a managing director of Warburg Pincus Ventures, in New York City. Bruce Guile is the director of the Program Office of the National Academy of Engineering (NAE), in Washington, D.C. Kressel chairs a committee of the NAE, which is studying the ways in which small companies participate in technological innovation and contribute to the development of industries.

Last updated: Mar 1, 1995




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