If small firms cannot grow in isolation, how extended should be its social network?

Can a small firm plot its own growth in isolation, relying solely on its efficiency and technology? Competition rewards the least cost producer, increasing its market share and profits, but when a small firm neglects the benefits of peer group social interactions, both within and across the industry, it could be working to its peril.

Gibrat’s law might state that firm size growth is a random process, yet the jury is out and other considerations could supplant chance in creating a path for the growth of small firms.

These considerations deal with both the characteristics of the firm and that of its environment.

• Firms compare themselves to their peers.

All businesses live within a community defined by location, industry or some other characteristic and tend to behave like their peers. It would be rational for a business to copy the size, investment strategies and marketing techniques of its peers. In the same way, in comparing itself to its peers, a firm could exhibit behavior that varies with the group because it has a better knowledge of the industry. In a theory of yardstick competition, Andrei Shleifer proposes that firms are price regulated based on the costs of identical firms. Therefore, each firm chooses a socially efficient level of cost reduction.

• The presence of a social multiplier effect.

The actions of a price leading firm can influence others in price setting. An incentive to raise the employment level of some firms will produce a positive impact on employment level of other firms in the same peer group. Then, strategic complementarity could be said to exist and can influence the growth of any firm, particularly the small ones, in imperfectly competitive markets.

• Economic geography.

Economic geography is the study of the location, distribution and spatial organization of economic activities across the world. Concentration of firms in the same region with many producers and potential customers will be more likely to encounter high growth than firms located elsewhere. In so doing, these firms realize scale economies while minimizing transport costs. In an analysis of 70 Swedish regions, it was found that there are strong reasons to believe that regions are most likely to branch into industries that are technologically related to the preexisting industries in the region. Unrelated industries had a higher probability to exit the region. Two economists have posited in a 1999 paper that in formulating policy directed towards innovation and technological change, concentration of firms representing diverse economic activities will tend to yield greater output, rather than concentration of firms from a particular industry, or specialization.

In contrast, in a recent study based on manufacturing firms in a developing economy, Tunisia, the author, Amara Mohammed, concludes that Gibrat’s law does not hold; that is, small firms do not grow faster than larger firms because they are small. On the other hand, young firms were found to grow faster than older ones and for that growth to be sustained, they need a more closed network.

This blog piece was inspired by the paper published by Amara Mohammed in the Economics Bulletin, Volume 34, Issue 1, titled: Gibrat’s Law and peer group effect: the case of Tunisian small manufacturing companies.