Business failures are good for the economy

September 6, 2006

ANN ARBOR—Most new businesses ultimately fail” and that’s good, says a professor at the University of Michigan’s Ross School of Business.

More than 80 percent of new firms in the United States end up failing and about 10 percent of all American companies fold each year. But these failures provide real economic benefits and enhance social welfare, says Hart Posen, assistant professor of strategy.

“Our question is whether the efforts of these failed entrepreneurs are in vain,” Posen said. “Do their efforts merely represent private losses or are there public gains to offset these losses?”

Posen and colleague Anne Marie Knott of Washington University in St. Louis studied the economic impact of failed firms in the commercial banking industry in all 50 states and the District of Columbia from 1984 to 1997. They chose banking because it is highly fragmented, has a significant ” knowledge” component and is marked by substantial failure.

They found that the more firms that enter a market, the greater the likelihood that poorly performing established companies will disappear, suggesting that failure is merely a byproduct of a phenomenon (excess entry) that yields superior firms.

In addition, competition from a glut of new companies” even those that eventually fail” leads to innovation and efficiency gains among incumbent firms, they say.

This happens for two reasons. First, excess entry, which leads to decreases in price margins, spurs incumbent firms to innovate and reduce costs over the long term. Second, knowledge produced by failed firms, while wasted on themselves, may be absorbed by survivor firms through a spillover effect.

“These spillovers take on many forms” advertising expenditures that expand demand for the product class, improvements in the technology supplied to the industry and training of employees,” Posen said. “While these spillovers occur even in the absence of failure, the excess entry may create a larger base of output over which the cumulative learning occurs.”

Posen and Knott say although policies to subsidize and encourage new firms may be good for the economy, an important consideration is whether the economic and social benefits gained from the excess of new businesses exceed the private losses incurred by firms that fail.

The answer, they say, is yes.

Among the nearly 800 new commercial banking firms that entered and subsequently failed during the study’s 13-year observation period, average profits totaled more than $15 million per company. Among the more than 600 existing firms that merged during this time, average profits exceeded $19 million per company. Only the 150 existing firms that failed during the observation period exhibited net losses, averaging $1.3 million per company.

Moreover, each failed firm generated cost-reduction among surviving firms, averaging 1.3 percent per year. This translates into total annual cost-reduction among survivors of more than $7 million for each firm that enters and subsequently fails.

“On average, failed entrants in commercial banking incur no private losses. In fact, they actually exhibit net profits,” Posen said. “The private gains plus the positive effect on survivor costs indicate that firms that fail may enhance social welfare.”


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