Enterpreneurship is the answer to Unmployement

The relationship between unemployment and entrepreneurship has been shrouded with ambiguity. On the one hand, the simple theory of income choice, which has been the basis for numerous studies focusing on the decision confronted by individuals to start a firm and become an entrepreneur (Blau, 1987; Evans and Leighton, 1990; Evans and Jovanovic, 1989; and Blanchflower and Meyer, 1994) suggests that increased unemployment will lead to an increase in startup activity on the grounds that the opportunity cost of not starting a firm has decreased. On the other hand, the unemployed tend to possess lower endowments of human capital and entrepreneurial talent required to start and sustain a new firm (Lucas, 1978; Jovanovic, 1982), suggesting that high unemployment is associated with a low degree of entrepreneurial activities. A low rate of entrepreneurship may also be a consequence of the low economic growth levels, which also reflect higher levels of unemployment (Audretsch, 1995). Entrepreneurial opportunities are not just the result of the push effect of (the threat of) unemployment but also of the pull effect of produced by a thriving economy as well as by entrepreneurial activities in the past.[1] In addition to unemployment leading to more or less entrepreneurial activity, the reverse has also been claimed to hold. One the one hand, new-firm startups hire employees, resulting in subsequent decreases in unemployment (Picot et al., 1998 and Pfeiffer and Reize, 2000a). On the other hand, the low rates of survival combined with the limited growth of the majority of small firms imply that the employment contribution of startups is limited at best, which would argue against entrepreneurial activities reducing unemployment. As Geroski (1995) has documented, the penetration rate, or employment share, of new startups is remarkably low.

The ambiguities found in the empirical evidence reflect these two conflicting forces. Some studies have found that unemployment is associated with greater entrepreneurial activities, but others have come to the opposite conclusion, that entrepreneurship and unemployment are inversely related. For example, Evans and Leighton (1990) found that unemployment is positively associated with a greater propensity to start a new firm, but Garofoli (1994) and Audretsch and Fritsch (1994) found that unemployment is negatively related to new-firm startups, and Carree (2001) found that no statistically significant relationship exists. Audretsch and Thurik (2000) show that an increase in the number of business owners reduces the level of unemployment. They identify a “Schumpeter” effect in terms of the positive impact on employment resulting from the entry of new firms. In reviewing the empirical evidence relating unemployment rates to new-firm startup activity, Storey (1991)concludes that,

“The broad consensus is that time series analyses point to unemployment being, ceteris paribus, positively associated with indices of new-firm formation, whereas cross sectional, or pooled cross sectional studies appear to indicate the reverse. Attempts to reconcile these differences have not been wholly successful.”

Thus, while there are not just theoretical reasons, but also empirical support as well, that while unemployment leads to increased entrepreneurial activity, entrepreneurship leads to reduced unemployment. Unraveling the relationship between entrepreneurship and unemployment is crucial, because policy is frequently on assumptions that do not reflect this ambiguity. For example, in advocating a greater role for public policy to promote entrepreneurship in Europe, the President of the European Commission, Romano Prodi (2002), recently asserted that “increases in entrepreneurial activity tend to result in higher subsequent growth rates and a reduction of unemployment.”

Unemployment is linked to entrepreneurship dates back at least to Oxenfeldt (1943), who pointed out that individuals confronted with unemployment and low prospects for wage employment turn to self-employment as a viable alternative. This was an extension of Knight’s view that individuals make a decision among three states – unemployment, self-employment and employment. The actual decision is shaped by the relative prices of these three activities but there was a clear prediction that entrepreneurship would be positively related to unemployment.

However, as Storey (1991) documents, the empirical evidence linking unemployment to entrepreneurship is fraught with ambiguities. While some studies find that greater unemployment serves as a catalyst for startup activity (Reynolds, Miller and Makai, 1995; Reynolds, Storey and Westhead, 1994; Hamilton, 1989; Highfield and Smiley, 1987, and Yamawaki, 1990; Evans and Leighton, 1989 and 1990), still others have found that unemployment reduces the amount of entrepreneurial activity (Audretsch and Fritsch, 1994; Audretsch, 1995).

On the other hand, why should an increased amount of entrepreneurial activity impact unemployment? One approach to address this question can be inferred from the literature on Gibrat’s Law. Gibrat’s Law asserts that firm growth is independent of size. Sutton (1997, p. 43) interprets “Gibrat’s Legacy”, as “The probability that the next opportunity taken up by any particular active firm is proportional to the current size of the firm.” An important implication of Gibrat’s Law is that shifting employment from large to small enterprises should have no impact on total employment, since the expected growth rates of both types of firms are identical. Thus, a restructuring of the economy away from large enterprises and towards small ones should have no impact on the unemployment rate.

However, there is strong and systematic empirical evidence suggesting that, in fact, Gibrat’s Law does not hold across a broad spectrum of firm sizes. Two comprehensive and exhaustive compilations (Sutton, 1997; and Caves, 1998) of studies relating firm size to growth have produced what Geroski (1995) terms as a stylized fact that smaller firms have higher growth rates than their larger counterparts. Beginning with the pioneering studies by Evans (1987a and 1987b) and Hall (1987), along with Dunne, Roberts, and Samuelson (1988 and 1989), a central finding of this literature is that firm growth is negatively related to firm size and age. These findings have been confirmed in virtually every subsequent study undertaken, despite differences in country, time period, industry, and methodology used.

Thus, if the growth rates of smaller firms systematically exceed those of their larger counterparts, restructuring economic activity away from large firms and towards new and small firms should not result in a neutral impact on employment. Rather, the higher growth rates of small firms should result in lower unemployment rates.