Small and Medium Enterprises: past and current relevance for the UK economy

Introduction

Small and medium enterprises (SMEs)[1] have been a very important economic agent for the UK economy on the last fifty years, even though its development level and importance has not been homogeneous during all of this time. Since this fact was widely recognized by the Bolton Report on 1971, began a new positively increasing trend for SMEs in the UK economy. Before the Bolton Report, the SMEs had been suffering a continuously decreasing, so, a shift on share of SMEs occurred on the earlier seventies. Why did this shift happen and what kind of implications had for the UK economy?

This work intends to describe how the development through the time has been for the SMEs and how its influence has changed. In short, the question for being answered is why the SMEs has become and remained as a relevant business sector for the UK economy. This work faces this question from three paths of response: a) for analyzing the role of market structure, b) explanations based on efficiency approaches and, finally, c) the role of innovation as a competitive advantage. Previously to face these approaches, a brief historical framework is done.

The facts: a brief historical framework

The path of SMEs in the UK economy has not been easy. During the three decades following the Second War World (1945-1970) was widely believed that large firms enjoyed higher economies of scale, stimulated more innovation and increased competitiveness in world markets. As a consequence, the UK government policy was designed to stimulate growth of large firms (Acs and Audretsch, 1990; Griffiths et. al. 2004). In spite to have suffered a long period of diminishing share, the SMEs remained alive and then a renewed interest over them occurred on earlier seventies. This new interest was generated because the policy maker realized that large firms often grew through mergers, not from internal growth. In addition, small firms demonstrated to be more innovative than thought and very important creators of employment (Griffiths et.al. 2004; Johnson, 2008). According to Storey (1994) the revival of SMEs can be explained by many factors, being the most important the re-assertion of an enterprise culture, increase in outsourcing, subcontracting and vertical disintegration of enterprises and, finally, privatization.

Figure 1

Evolution of percentage of share for business size (measured in number of business, employment and turnover).

The whole of the UK economy, period 1979 – 2009.

Therefore, the role and state of SMEs has been continuously increasing from earlier seventies (Storey, 1994). Considering the three ways for measuring the share, its influence is significant in the UK economy. As it can be seen in the figure 1, number of businesses (99.9% of UK business), employment level (59% of the total private sector workforce) and turnover (49%) show a strong influence into the UK economy on 2009.

In terms of the number of business, nonetheless the stock of enterprises is very stable (it has remained over 95% from 1976), there is a massive amount of churn through the time. According to Storey (1994) is quite difficult to precisely estimate the number of small and medium business because high annually rates of creation and destruction of companies on this sector, with no mentioning the high number of created businesses that have not been still registered.

In terms of employment level, the relevance of SMEs for the UK economy has been central. As we can see in figure 1, from 1979 the micro, small and medium firms together have accounted more than half of employment and this trend has been constant through the rime. Unfortunately there is not available data for the whole of UK economy in the previous periods, but if we look the employment level in the manufacturing sector from 1920 to 2000 (figure 2), we can see that such a trend has not been homogeneous because before 1971 the SMEs share in employment level was continuously decreasing.

Figure 2

Employment share of enterprises with less than 200 employees in UK manufacturing sector.

Source: Storey (1994), p. 26.

Nonetheless all of above, we need to be careful in order to analyze the employment impact of SMEs. As we can see in table 1, the large amount of business without employees, it means, business attended for the owner, has kept extremely high on the last fifteen years in the UK. This trend reflects the importance that self-employed workers sector has had for the UK economy (Storey, 1994) and its impact should not be uncared by the policy makers because is determinant in the labor market performance, doing it more instable (Doi et.al. 1998).

The share in all of three measures, nonetheless, has not been homogeneous through the time nor across the several industries. As we can see in figure 2, there are economic sectors which the SMEs´ influence is more important than others, such as Agriculture-Forestry-Fishing and construction sectors. In terms of the number of business, this input has not been included in figure 3 because in all of sectors the share overtakes a 96% per cent.

Table 1

Evolution of number of business and percentage share by number of employees.

The whole of the UK economy, period a974 – 2009.

Source: BIS, Department for Business, Innovation and Skills, web site of Economics and Statistics.

In terms of the employment share, the importance of SMEs has kept constantly high during the last fifteen years, particularly in agriculture and construction sectors (98% and 85% of share in 2009). This trend is the same in the case of turnover, although the sector of health and social work has overtaken to construction in the second place during the last ten years (it should be highlighted the increase of SMEs´ turnover share starting on 2004 in health and social work sector). In both employment and turnover share a decisive role of small and medium firms is seen in the case of personal services of assistance and advisory. Finally, if we analyze the particular case of manufacturing, is remarkable that despite the constant increase shown in employment share from earliest seventies, this sector is not the most important in terms of SMEs impact. Finally, we should acknowledge and discussing the reasons why there is not a significant presence of SMEs in energy and mining sectors.

Figure 3

Evolution of SMEs share across several industries (share measured in employment and turnover)

The whole of the UK economy, period 1994 – 2009.

Source: BIS, Department for Business, Innovation and Skills, web site of Economics and Statistics.

Nonetheless such a SMEs influence for the UK economy, is not easy for any SME being created and remaining alive longer on the time. Particularly small firms, problems related to higher power of large firms (including delayed payments from them to small companies), difficulties for getting finance and poorer professional management knowledge or skills in comparison to larger firms (Griffiths et.al. 2004; Keeble, 1995) are continuously faced. Nonetheless all of this problems, the share of SMEs shows an increasing trend and they have not been overtaken by the large firms at all.

Why do the SMEs exist and why they have remained relevant for the UK economy?

Acs and Audretsch (1990) developed a model which three main variables will determine the share for a specific economic sector: structural variables, efficiency level and innovative performance. Whereas the structural variables imply to analyze the external forces determining the business environment for the SMEs (which would be damaged by the national policies supporting large firms), the last two variables are regarding internal characteristics. According to the explanation given by Acs and Audretsch (1988, 1990), the structural variables played against of SMEs during the three decades following the Second War World because the government effort for rise the large companies. However, the SMEs, particularly small enterprises, can overtake, and in fact they have overtaken, the structural entry barriers (large firms with increasing levels of capital intensity and higher economies of scale) through higher internal efficiency and, specially, higher innovation in both product creation and productive processes. This model is very consistent with the main theoretical explanations about why the SMEs exist at all.

3.1 The role of market structure

The market structure can become an important determinant of the SMEs performance such as Acs and Audretsch (1990) suppose. Di Tomasso et.al. (2000) also recognize this importance and trying to set which market structures are more useful for small and medium enterprises´ survival and growth. According to them, the general assumption about market structures is related to SMEs just can exist in markets with imperfect competition because they can face as flexibly as larger firms the consumers´ taste differentials, in spite of cost differentials and their lower economies of scale. In other words, it would be quite difficult to find SMEs because they could not to do too much against, for instance, the oligopolistic markets where the larger firms do not compete through the prices, being tightly interdependent each other. In imperfect markets, the "size distribution is derived from conditions of imperfect competition in which all participants in the economic system must act" (Di Tomasso et.al. 2000, p. 10).

Nonetheless, the assumption shown above has been questioned by some researchers, for instance, Reid (1995). For analyzing the outcomes obtained in his studies, carried out on small firms from Scotland during the eighties, Reid derived the "heterogeneous oligopolistic" model which state the possibility, under specific conditions, for getting small firms in significant interdependence but with a marked degree of differentiation. They were in both balanced (similar size rivals) and unbalanced (e.g. large dominant firm(s) and a fringe of smaller similar size firms. However, even though the Reid´s studies could imply the presence of small and medium business as being oligopolies, which may arise when markets are very segmented and when there are only a few rivals in a segmented section, it is not still clear how long time the SMEs can survive in such a market structures. For other kinds of market structures, such as monopolies, a similar discussion has not been arisen because there is a strong consensus about the unlikely existence of SMEs in these markets.

The key thing about market structures is how companies can success into a specific market. On this sense, the structure-conduct-performance paradigm (SCP) can help us to explain the SMEs performance in several market structures operating in the UK economy. According to the model, is said that the structure influences conduct, which means the kind of concentration of market (structure) determines if the behavior of the firms will become competitive or collusive, for instance, if the concentration of market is lower, the behavior of the firms should be more competitive (McWilliams et.al. 1993). Such is the case of perfect competition In the following assumption is said that conduct influences performance, for instance, if we have more competitive behavior, we should get less market power and greater social efficiency. By the other hand, the collusion leads to higher market power and less social efficiency. Such is the case in the oligopolies and monopolies, where the competition does not exist at all. All of above mean that as number of firms increase, the market concentration falls and the market power per each company in the market declines. The prices get closer to marginal cost which is more social efficiency (McWilliams et.al. 1993). If we assume as true this model, we should say that for the UK economy just the structures encouraging a higher competition, in imperfect conditions such has been said by Di Tomasso et.al. (2000), have let the birth and growth of small and medium companies. As an example, that could be the reason because the presence of SMEs in energy or mining sectors has been historically lower.

3.2 Explanations based on efficiency approaches.

If we took the Acs and Audretsch (1990) ideas as being true, we would expect of efficiency approaches to explain the significant role that SMEs have had on last thirty years. This idea is shared by Di Tomasso et.al. (2000) who aim that "observation of the competitive dynamics of the real world seems to suggest that the relationships between these two variables (firms size and efficiency) are far more complex than what economic theory has so far realized" (p.17). On this path, two are the most important theoretical streams: the technical efficiency and institutional efficiency theories. Both of them are related to efficiency on managing cost. However, the first one is concerned to economies of scale, highlighting that higher levels are more feasible in large firms because they have a better ratio between average cost and output in the long run [2]Nonetheless, higher economies of scale are also feasible for SMEs such as Oughton et.al. (1997) demonstrated. According to them, even though economies of scale depending on cost managing (such as internal economies, pecuniary external economies, technological or exogenous external economies) are difficult to get for SMEs, a special kind of economy of scale have been achieved by SMEs through collective external economies when firms cooperated over input activities such as, research and technological development (RTD), training, finance, marketing, export promotion and other business services, via the pooling of fixed costs.

In the side of institutional efficiency theory, Di Tomasso et.al. (2000) aims that there are transaction costs which operate in contrary to the incentives to the dispersion of productive activity into a plurality of enterprises. The key thing, then, is identifying the mechanism to minimize the transaction cost´ effects. However, is supposed that larger firms have better expectations to lower such costs in comparison to small and medium firms. For the UK economy, a lower level of transaction costs has been observed in the last two decades in comparison to other developed countries (Keeble, 1995). Even though there is not an enough amount of evidence on this sense, we can suppose that the lower transactions costs in some UK economy sectors, such as agriculture and construction, have let a high share of SMEs.

Nonetheless, the efficiency should not be understood just like a matter of cost managing. In several researches has been demonstrated that efficiency can be found even in domestic markets where economies of scale are unobtainable (Doi et.al. 1998). Two concepts are very important on this path: productivity and business flexibility. About productivity, there is evidence showing an increase in the labor productivity during the last two decades in the small and medium firms, especially in the manufacturing sector (Mahmood, 2008).

According to Doi et.al. (1998) the flexibility means to adapt the productive processes to new customers´ exigencies which are a remarkable characteristic of SMEs. In the earlier nineties, when the fragmentation and specialization of domestic markets (particularly manufacturing), did unobtainable the economies of scale and obligated to large firms to leave theses markets because a higher foreign competitiveness, then a fertile breeding was provided to flexible and specialized small firms to operate within. If we combine this effect with an increasing demand for heterogeneous products then it was perfectly rational to expect to observe an increase in the population of small firms (Doi et.al. 1998). Storey (1994) also highlights this capability for saying that there is a higher likelihood of the evolution and change in the smaller firms.

3.3 The role of innovation as a competitive advantage.

When Storey (1994) identifies the three main reasons in order to explain why SMEs are different of large companies, he makes a fearless statement for saying that even though the SMEs do not invest too much money in research and development activities, "small firms are more likely to introduce fundamentally new innovations than larger firms" (p. 12). However, such as Hughes (2001) highlights, a decisive government policy is needed in order to transform innovation into profits. He aims that even though there is evidence about a positive relationship between innovation and employment or turnover growth, which is easy to confirm for looking figures 1 and 2, the relationship between innovation and profitability is weak or absent. A second obstacle in order to transform innovation in profits is related to the fact that "small firms in the UK are relatively more constrained by management skills than they are by financial market failures. It follows that an important emphasis in policy should be placed on building management competence in UK small firms" (Hughes, 2001, p. 157).

Conclusions

Nowadays nobody can deny the importance of SMEs for the UK economy, especially in terms of the employment share in the last thirty years. However, in spite of recent government efforts for raising the small and medium companies sector, still is quite difficult for them to overtake the remaining obstacles such as difficulties for getting credits and abusive behaviors from large firms in terms of delayed payments.

In spite of these difficulties, it has been seen that is feasible to support the Acs and Audretsch (1990) model in terms of SMEs´ capability for overtaking the negative structural conditions through higher efficiency and innovation. Both of them have let to SMEs keep alive and growing in the last forty years into the UK economy. Indeed, is necessary to conclude that efficiency should not be understood just in terms of economies of scale and cost managing (in both the SMEs show a hardly comparable performance with larger firms), but also should be understood in terms of flexibility skills and higher productivity. This work has shown the high relevance of the efficiency in the SMEs´ survival. In the same way, it has been demonstrated that the innovative performance is a very important skill in order to guarantee the growth for small and medium companies.

Bibliography

Acs, Z. and Audretsch, D. 1988, "Innovation in Large and Small Firms: An Empirical Analysis", The American Economic Review, Vol. 78 (4), pp: 678-690.

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Autor:

Rodrigo Valdivia Lefort

PAPER DUE FOR COURSE OF ECONOMICS OF SME"s

MASTER OF SCIENCES IN BUSINESS ECONOMICS

KINGSTON UNIVERSITY OF LONDON

MAY 2011

[1] On this work, small and medium enterprises are identified according to UE definition (Griffiths et.al. 2004): Micro Max. n° of employees 009 / Max annual turnover € 02 m / Max annual balance sheet € 02 m Small Max. n° of employees 049 / Max annual turnover € 07 m / Max annual balance sheet € 05 m Medium Max. n° of employees 249 / Max annual turnover € 40 m / Max annual balance sheet € 27 m

[2] There are three main reason because in the long run an icrease in the output level yields higher economies of scale. Firstly, the fixed cost become better distributed. Secondly, a deeper specialization is gotten and, finally, firms take advantage of a better productivity of machinery and other technical assets.