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.

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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.