The Accumulation of Firms and the Predominance of New and Young Companies

This is a sequel to last week's post about moving from Paul's drunkard's walk to the accumulation of firms over time. Basically, the message of those two posts is that the internal dynamics of the American economy--lots of new companies founded each year, the exit of firms at all ages, the persistent predominance of young firms as the economy moves through time--make it highly probable that job creation will come from new and young companies rather than older, more established companies. (In these data that we're using, a firm is no longer classified as "young" once it reaches age 6, so the term "older," perhaps imprecisely, includes firms ages 6 and up.) Thus, when we say that new and young firms account for most net job creation in the U.S. economy, we are partly describing the reality of these firm dynamics.

This doesn't diminish the importance of these companies or the jobs they create. After all, the reality of these dynamics is premised on four things: a more or less steady inflow of startups; more or less consistent survival rates from year to year; comparable gross job creation and gross job destruction in older companies; and a higher number of jobs created at young firms (4 versus 1). These are not functions of what might be perceived as mathematical inevitability--they are the reasons behind the mathematical probabilities we are describing. If the level of firm formation were more volatile, if older companies created more jobs than they destroyed, if young firms were somehow suppressed in their hiring (through, perhaps, bailouts of larger, older companies; just speculating here)--if these variables changed, the dynamics of firm age through time, and subsequent job creation, would be different.

But, in recent history, these variables have all held and together they have created a picture that does, in fact, resemble something like mathematical inevitability, but which is probably more accurately described as a likelihood, or something of higher probability. In any given year over the past three decades, young firms (startups [age 0] and firms ages 1-5) have constituted the largest demographic of firms in the United States. Starting an economy at t=0, going out 25 years, the influx of new firms and the survival rates of firms over time generate this outcome. And, we might expect (provided the other variables are true) that the largest demographic sector will create the largest number of new jobs. This says nothing, of course, of innovation or productivity, subjects for another day.

Here, I want to supplement last week's post, which used average figures calculated from the Business Dynamics Statistics data, with the actual numbers from that dataset, which covers 1977-2005. That is, did reality conform to the stylized numbers we used last week? (The charts will not follow precisely the same format because last week's charts extrapolated out beyond 5 years on an annual basis, while the actual data aggregates firms into 5-year age categories after the fifth year: 6-10, 11-15, and so on.) We'll start, first, with the U.S. economy starting de novo in 1977, with only firms that came into existence that year. How, over the next 28 years, did the composition of firms by age change?

Here, startups (age 0, new firms founded each year) are broken out separately while all other firms are combined into 5-year categories. The data generally track the accumulation pattern revealed in last week's post: in any given year, young firms (ages 1-5) will quite naturally comprise the largest sector in terms of firm demographics. Note how few firms in 2005 are included in the 26-28 age category--these firms were founded in 1977-1979. By 2005, 19% of the firms founded in these three years remained. That may be more than expected, but using the survival line for firms founded for 1977 we can trace a slowly declining line of survival out two decades. If we imagine that the line continues on that downward slope for the next two decades, it appears as if very few firms in the economy survive more than four decades. Either those firms we all delight in describing as "dinosaurs" should properly be seen as remarkable achievements, or firm failure (over time) is a much more dominant force in the economy than we perhaps imagined. Probably both, and I'm probably simplifying here.

The advantage of using the real data from BDS is that we can include the "left censored" firms in our calculations, those companies founded prior to 1977 but for which we don't have age information. In 1977, then, these firms could be anywhere from age 1 to age 100. But we can track their survival after 1977 against all firms founded after that year. How long do these companies persist?

I included a brief explanation within the chart itself, but you can clearly see how these pre-1977 firms gradually decline in number over time, while new and young firms in any given year gradually get bigger in comparison. By 1988 (the circle), the pre-1977 firm group has shrunk such that it is now smaller each subsequent year compared to cohorts of new and young companies. By 2005, these firms still number 1.5 million, accounting for about one-fifth of all firms in the economy. This is a lot, but is an aggregate of every year before 1977, so there are probably a good number from the 1970s, a proportionately smaller number from the 1960s, and so on. 

Now, we can include these pre-1977 firms in our overall chart of firm demographics over time and compare firms of all ages:

This is actually an incredibly interesting chart, as the text insert fleshes out, but I'll repeat it here so you don't have to open the image itself. It shows two different ways in which firm composition changes and in which new and young firms consistently account for the bulk of firms in the economy. In 1977, the t=0 moment here, the economy is composed  of a class of startups (age 0) and all other firms existing that were founded before 1977. As the economy moves through time, you see four things happen. First, age 0 firms and age 1-5 firms account for a steady slice. Second, the overall number of firms accumulates. Third, the pre-1977 firms gradually decline in number. Fourth, post-1977 firms that age through time also diminish in terms of their numbers as fewer survive in subsequent years. So new and young firms dominate the economy (numerically) by two mechanisms: gradual disappearance of older firms and gradual disappearance of firms as they age. Same thing, different pathways (on this time scale).

Finally, we'll move to the percentage shares of each firm demographic (excluding pre-1977 firms here):

Once we get to a point where we have firms older than age 6 (and remember, the pre-1977 firms account for the missing shares here) in 1983, new and young companies account for between 30 and 40 percent of all firms in the economy. This percentage naturally falls over time, albeit slowly, as the overall number of firms grows, but this demographic of firms nonetheless comprises the largest demographic slice--a plurality, if you will--in each year, and this would persist over time.

So what, if anything, does this all mean? It means that new and young companies account for most new jobs in the economy in part because they are the largest demographic category of companies. It also means that job creation may actually be a secondary story here because this reality is a reflection of underlying dynamics that have been remarkably persistent over the past three decades. The United States has enjoyed a more or less steady level (and rate) of firm formation and survival rates for those firms have also been rather steady. Older companies, moreover, experience roughly equal levels of gross job creation and destruction, meaning their net job creation approaches zero.

It is entirely possible that these are transitory phenomena. As far as I can tell from the desultory data and research on firm formation prior to the 1970s, entrepreneurship (and subsequent survival rates) across the entire twentieth century have been remarkably consistent (I mention this, with an accompanying citation, in a forthcoming paper, so I'm not simply making this up). According to some Census data, for example, the number of new business created each year doubled from the 1940s to the 1990s--yet the country's population also doubled so the per capita rate of firm formation remained steady. Over the past thirty years, moreover, entrepreneurship rates have been remarkably steady, not declining as some have alleged. 

Yet we surely can't assume that the dynamics beneath such factors are immutable. The preponderance of research concerning firm demographics in many European countries, for example, holds that firm exit is a much smaller factor and that, consequently, unproductive firms simply continue to exist and new firms are dissuaded from entering. Large companies enjoy favorable policy and so the above charts might look quite different for other countries and clearly indicate that the dynamics can change. Even if part of what the above charts do is describe a mathematical reality, it could be considered progress if policymakers in Washington and elsewhere spoke in terms of this reality rather than giving undue attention to the largest companies in the economy (which, incidentally, often seek regulation as a means of protection from competition from startups). What this all means is that startups and young companies are no less important than we thought before--they are a robust and enduring dimension of the U.S. economy. It would be foolish, however, to assume that this is somehow a natural or permanent state of affairs--policy could easily be made to alter these dynamics for the worse.

Comments

[juicy couture]

it seems so difficult to understand!

[jimmy choo]

but i will try my best!

[Doc Merlin]

Yes firm failure is so very important. Something that current politicians do not understand. The economy is a darwinian affair, and without failure the entire system stagnates and falls apart.

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