The Entrepreneurship Myth

The Entrepreneurship Myth an interview with Scott Shane about his book The Illusions of Entrepreneurship.

Some things that aren't surprising.

Describe the typical startup that you found.
The median startup is a business that's capitalized with about $25,000. The financing of that business comes from the entrepreneur's savings. The business is a retail or personal service business, a hair salon or a clothing store, that kind of thing. The founder doesn't have expectations of a very high growth business, in fact [the entrepreneur is] probably thinking a goal of $100,000 a year of revenue is a good goal.

And it's most likely to be organized as a sole proprietorship and to have no employees besides the owner—is that correct?

That's right. And in fact we're getting close to half, very close to the median would even be home-based.
Why do you think the myth of entrepreneurship, the image that you're debunking, is so popular?
Part of it is we have a belief that entrepreneurship is good because it's associated with things that we like to believe about Americans: being independent, doing your own thing, going your own way. The other part of it is that paradoxically, there is one really, really good thing about entrepreneurship that people don't talk about, which is dominant and we have lots of evidence to support: People who run their own businesses have greater job satisfaction than people who don't. I think part of it is that we're trying to make sense of this paradox—that we really like it, but financially it isn't so great. So we create a myth that says because we like it and it makes us happy, it must also make financial sense, because otherwise there's a kind of conflict we can't resolve.

Some things that are surprising are the conclusion the author makes. Rather inappropriately from my perspective. I think the government's track record of picking winners and losers is pretty poor. The best strategy is always one that lowers costs for everyone, rather than favoring one group over another.

You write that "encouraging startups is lousy public policy," based on the data you've examined. What would you propose as policy alternatives?
The part that's lousy public policy is the idea that entrepreneurs, regardless of what kind, are good, and if we just have more of them, it's better. But what's a good public policy is if we picked certain kinds of startups, and we emphasized the increase in those. But the way the policies are set up, they don't encourage the specific high-potential startups. Most of the policies are: More entrepreneurs—just let's get volume. It's a very volume-oriented strategy. That's bad public policy.
You collect a lot of data in your book and come to some counterintuitive conclusions about entrepreneurship. What would you say is the biggest illusion?
I think the biggest myth entrepreneurs have is that the growth and performance of their startups depends more on their entrepreneurial talent than on the businesses they choose. I hate to deflate egos, but on the other hand I want people to have a realistic understanding of things. The industry a person picks to start a business has a huge effect on the odds that it will grow. If you go back 20 years or so, about 4% of all the startups in the computer and office equipment industry made the Inc. 500, 0.005% of startups in the hotel and motel industries made that list, and 0.007% of startups in eating and drinking establishments. So that means the odds that you make the Inc. 500 are 840 times higher if you start a computer company than if you start a hotel or motel.

Wealth Effect

I seldom agree with Dean Baker, but here he has a good point.

This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape. Even the soundest bank does not make loans to borrowers who it does not think can pay the loans back (except during times of irrational exuberance).

Visualizing the Election

CNN and other news outlets would have you believe this is still a divided country with red states and blue states.

But a better visualization would shade the areas based not upon who won the state, but by the degree to which they won the state. And the states themselves shouldn't be represented as a function of their geographic size, but rather the size of their population. Here we have just such a picture, and its clear, we are all purple now. More can be found here.

Kondratieff Cycles?

A regular attendee emails:

Just curious… Do you think that the current economic state is merely a “normal” manifestation of the Kondratieff wave? I was first exposed to the theory in 1989 in a marketing seminar as the economy was ramping up toward the unforeseen, at that time, DOT BOMB in 2001. Just thought it might be something interesting to weave into your next presentation. Any thoughts?

My Response:

I am familiar with Kondratieff waves, but I must say I’m pretty skeptical. That our economy - and capitalism in general - is prone to cycles is pretty clear. That those cycles have a regular periodicity is not so clear. In order for me to find any plausibility in theories which claim to have identified some regularity in the cycle it would have to have good predictive power, with fairly sharp predictions. The Kondratieff cycle hypothesis does haven’t very sharp predictions. What you really have is an ex-post justification for the data that we see, and even those that ascribe to the theory, don’t really agree on their identification of the phases of the cycle, making it a less plausible idea. At the end of the day cycles are a function of the collective, yet often idiosyncratic behavior of individuals. I have a hard time believing there is any mechanism that causes these things to occur with predictable regularity. I think you’ll find that this idea appeals to the econo-physicists much more than to any social scientist-economist.

Tax Math

Higher taxes are most likely in our future, regardless of who we elect:

Douglas Holtz-Eakin, a former Director of the Congressional Budget Office and current chief McCain economic advisor, is an honest man--which means he's something of a liability on the Straight Talk Express. A few months ago, he admitted to my colleague, Michael Scherer, that Barack Obama's economic plan would reduce taxes for most people. And now, in a forthcoming book by Fortune columnist Matt Miller, he makes it clear that the next President is going to have to raise taxes.

"If you do nothing on the spending side, you're going to have to raise taxes whether you're a Republican, a Democrat or a Martian," he tells Miller...and then he immediately makes it clear that the "spending side" part of the argument is nothing more than a political fig-leaf.

And the futures market is also betting on rising taxes according to Mankiw.

The top income tax rate is now 35 percent. According to the betting at Intrade, the probability that the top income tax rate in 2011 will exceed 38 percent is 0.87. Call this P(tax hike).

Barack Obama has made such a tax hike part of his campaign promises, and there is no reason to think the Congress won't deliver for him. So let's assume Obama is certain to get the tax hike if he wins. That is, P(tax hike / Obama) = 1.0. (If this assumption is wrong, and this conditional probability is less than one, then my conclusion below would be even stronger.)

According to Intrade, the probability of Obama being the next president is 0.53. Call this P(Obama). And P(McCain) = 0.47.

Now we can calculate the probability of a tax hike conditional on McCain winning. It comes from the formula

P(tax hike)
= P(tax hike/Obama) P(Obama) + P(tax hike/McCain) P(McCain),

and plugging in the above numbers. It tells us that

P(tax hike / McCain) = 0.74.

Foreclosure Filing Rate and The Unemployment Rate

The graph below shows the county's unemployment rate, and the foreclosure filing rate, with the size of the bubbles proportional to the population of the county. A larger version can be found here.

Property Taxes

We recently finished the semi-annual consumer sentiment survey for the 7 Rivers Region. The upcoming September meeting concerns the Wisconsin Way initiative. In preparation we asked our participants some of the questions that have been asked around the state. In particular we asked:

When you think about the property taxes you or your landlord pay on the home in which you live and the services you receive for those taxes would you say property taxes in Wisconsin (or your state of residence) are much too high, somewhat too high, about right, somewhat too low or much too low?

I've joined the following answers and created a word cloud.
a. Much too high
b. Somewhat too high
c. About right
d. Somewhat too low
e. Much too low
f. Other

The fact that you can not find Much Too Low or Somewhat Too Low in the graphic is not a mistake.

Hollywood Subsidies

La Crosse was initially in the running to become one of the locations for the new Johnny Depp "Public Enemies" movie. Wisconsin was chosen for several reasons, one of which was probably the newly passed tax considerations. Maybe we should look at the evidence and research done by other states. This headline says it all:

Rich stars pocket subsidies, state says
The analysis by the Department of Revenue this week estimated that at least half the film-industry payroll spending will go to out-of-town residents, mainly actors, directors, and producers commanding salaries of more than $1 million each. The Revenue Department assumes they will spend only a fraction of their paychecks in Massachusetts, limiting the benefits to the local economy.

The Revenue Department noted its analysis is consistent with a 2005 report on Louisiana's film tax subsidies, which estimated 60 percent of spending eligible for tax credits would go out-of-state. And when The Providence Journal reviewed records for a Wesley Snipes film subsidized by Rhode Island, it found just $1.9 million of the $11 million in production expenses went to local residents and vendors - less than the $2.65 million in tax credits issued to support the 2006 movie, "Hard Luck."

But in this week's report, the Revenue Department found the subsidies probably wouldn't generate enough money in income taxes and other revenue to offset the cost of the incentives, forcing the state to cut other government spending. Assuming $100 million a year in incentive spending, the state said it would only be able to recoup $18 million to $23 million in other tax revenue.

Mayo

The Economist has a good article on the impact of large hospitals on their surroundings. In particular they discuss the impact of Mayo. This is a mixed blessing.

The good:

The size of the health giants ensures that their reach extends far beyond the examination room. Each, for example, has made its city something of a destination for “health tourists” (people who come for operations or check-ups) and conferees. Rochester received 2.5m visitors in 2007; about 70% of these came to visit Mayo. At the last count, Rochester had the same number of hotel rooms as nearby Minneapolis, which is about four times as large.

The not so good:

For all this activity, community relations remain a work in progress. Mayo has dominated Rochester for so long, donating to a host of local programmes, that the mayor—himself a former Mayo employee—calls the clinic “a gorilla, but...a very nice gorilla”. The Cleveland Clinic's relationship with its city is more complex. Cleveland is much larger than Rochester and much more racially diverse; the city has an industrial hangover and the attendant headaches of poverty and urban decay. The clinic itself sits in a poor neighbourhood where few employees live, preferring to drive in from the suburbs.

Liability and Entrepreneurs

Marginalrevolution has a post on firm size and liability.

I would like to tile my front porch steps and have been shopping. Lowe's and Home Depot have plenty of tile but although they advertise installation they won't install it outdoors. The salespeople, however, will surreptitiously recommend small family contractors. Call Jose, they tell me handing me a number. Why won't the big firms install outdoor tile?

As best as I can figure the answer is liability. A few slips, falls and an enterprising lawyer or two and Lowe's could be out millions of dollars. The revenues aren't worth the risk so small firms step into the breach. The key, of course, is that the small firms won't be sued because they are judgment proof.

Roberta Romano was here yesterday and offered another example. The big auditing firms won't do SOX audits for small firms because the revenues are low relative to the risks. The smaller firms must turn to judgment proof auditors of less reliable reputation.

In one sense, this is a good workaround for a liability system that seeks out deep pockets. Consumers are better off than they would be if neither Lowe's nor the judgment proof firms offered services and they are also better off than if Lowe's was required to offer services, because the price at which Lowe's would do so voluntarily would be prohibitive (consumers would be forced to buy insurance they didn't want at the price).

But more deeply the resulting system is inefficient. Consumers don't get the insurance that the liability law is supposed to provide and they must turn to lower quality, higher cost service providers even when they would prefer larger firms with solid reputations.

So small entrepreneurs appear to be in some part an answer to our often litigious society.

How To Make An Entrepreneur

Two different views on how entrepreneurs are made.

Tyler Cowen:

A Brazilian entrepreneur, that is. First and foremost, entrepreneurship is predicted by family characteristics, most of all having other entrepreneurs in the family and coming from a large family. What predicts finding a successful entrepreneur?: "the individual's smartness and higher education in the family." Entrepreneurs are not more self-confident than non-entrepreneurs and overconfidence is a big danger. Social networks predict who becomes an entrepreneur but not who becomes a successful entrepreneur. Entrepreneurs in Brazil exhibit more trust but this result does not seem to generalize across countries.

Here is the paper, from the World Bank. I thank Russ Roberts for the pointer.

Chris Dillow:

In other words, what makes an entrepreneur is access to capital - the sort of access that comes from having a wealthy background. This is consistent with two other papers. David Blanchflower suggests here that lack of access to credit explains African-Americans low rate of entrepreneurship, whilst he and Andrew Oswald say here (pdf) that:
.....
Now, why do I stress this whilst Tyler picks out "family characteristics"? The difference between us, I suspect, reflects a widespread difference between supporters and critics of capitalism. Whereas supporters of capitalism look for personality-based explanations of differences in people's behaviour, critics look instead for more impersonal, structural factors - though of course these influence (determine?) personality.

And funnily enough, we can both easily find what we're looking for.

Wisconsin Entrepreneurs

Wisconsin Entrepreneurs:

Roughly half the people in Wisconsin are thinking about starting a business or have started a business, according to a new study of the state’s entrepreneurial climate. The study, “A Medium for Growth: The State of Entrepreneurship in Wisconsin,” (Download the complete report - 5 meg PDF) reported the strikingly high figures after surveying 1,144 randomly selected households across the state last year.

Distance and the City

Via the Economist Blog, channeling Ed Glaeser and Gaicomo Ponzetto.

The past forty years have seen a remarkable range of urban successes and failures, especially among America’s older cities. Some places, like Cleveland and Detroit, seem caught in perpetual decline. Other areas, like San Francisco and New York, had remarkable success as they became centers of idea-based industries.

In this paper, we suggested that these urban successes and urban failures might reflect the same underlying technological change: a vast improvement in communication technology. As communication technology improved, it enabled manufacturing firms to leave cities, causing the urban distress of Detroit or Manhattan in 1975. However, declining communication costs also increased the returns to new innovations, and since cities specialize in idea-production, this helped invigorate some cities.

The model suggests that future improvements in information technology will continue to strengthen cities that are centers of innovation, but continue to hurt cities that remain oriented towards manufacturing. Certainly, there is every reason to think that the free flow of people and capital across space will only continue to increase the returns to new ideas.

The important question for the future of cities is whether urban areas will continue to have a comparative advantage in producing ideas. The great challenge to urban areas therefore comes from the possibility that innovation will also leave dense agglomerations. While this is possible, there is a remarkable continuing tendency of innovative people to locate near other innovative people. Silicon Valley, for example, is built at lower densities than New York, because it is built for drivers not pedestrians, but it is certainly a dense agglomeration. As long as improvements in information technology continue to increase the returns to having new ideas, then the edge that proximity gives to innovation seems likely to keep such agglomerations strong.

Rather ironic isn't it? Improved communication technologies leads some people to locate CLOSER to each other. They do - if I understand the argument - precisely because they are better rewarded for their ideas since improved communication technologies increases the size of the audience for those ideas. Yet those same ideas are easier to generate when physical proximity is close.

I don't believe this bodes well for our region. As a professor of mine used to say: La Crosse is centrally isolated. It will be hard for knowledge workers in our region to avoid the pull of the magnets of Chicago and the Twin Cities.

Start Ups

The Governor of Wisconsin is encouraging Entrepreneurs. Here are the details:

The mission of the Governor’s Business Plan Contest is to encourage entrepreneurs in the creation, start-up and early-growth stages of high-tech businesses in Wisconsin. Participants have the chance to win seed capital, valuable services that will help them launch their businesses and a Grand Prize worth $50,000. Since its inception in 2004, more than 1,000 entries have been received and nearly $650,000 in cash and in-kind prizes has been awarded. In 2007, 12 finalists won cash prizes.

Produced by the Wisconsin Technology Council and a growing list of partners, the Governor's Business Plan Contest engages contestants in a six-month process that includes mentoring and comments from judges on selected plans. It will also lead to valuable public and media exposure for the best business plans submitted by contestants and spur economic growth in Wisconsin. In addition, past finalists have raised a reported $11 million in private equity, such as angel and venture capital.

The statewide contest is an opportunity to compete for cash and in-kind prizes, but it's also a chance to get constructive feedback on your business plan and to help move it from a virtual business to a reality. In 2008, contestants will once again have the opportunity to win upwards of $200,000 in cash and services!

More Foreclosures

Here is a post with an excellent graphic on the national distribution of foreclosures as a percentage of housing units.

Not least, the crisis is harming the neighbors of people in foreclosure, even those who aren’t having trouble making loan payments. According to one academic study, every foreclosure reduces the value of all other houses within an eighth of a mile by about 1 percent, as the sight of vacant property scares off potential buyers. Combine that with a market already in decline, and neighborhoods that begin to have troubles can go off the cliff.