Economics of Small Business

1. Economics of Small Business Drexel University Spring Quarter 2014 Seventh Week

2. 1. Capital Market Constraintsa. Review: The Indifference curve approach to saving theoryi. Review of Indifference Curves

3. Preference • Recall, indifference curves are a way of expressing preference rankings. • (They can also be derived from a utility function.) • So we begin with the concept of preference. • Preferences rank different lists or vectors of quantities of goods, some as more desirable than others. • Here is an example based on wings and fries.

4. Wings and Fries • John Doe’s preferences rank alternative menus that John Doe could choose: no wings, one wing, two wings, and no fries, fifteen pieces of fries, …

5. About Preferences • This ranking illustrates some ideas from the preference approach. • First, preference is an order-ranking, not a number. • Second, preferences are applied to combinations of the two goods. • Third, given the amount of one good, more of the other good is preferred to less. • When two alternatives are ranked the same, we say that the two alternatives are "indifferent choices" or "indifferent alternatives."

6. Indifference Curves • We can express this preference ranking more completely as a map of indifference curves. • Along each curve, all the combinations are equally ranked – ties.

7. Budget Line 1 • We must also take into account the fact that John Doe’s choice is limited by his budget and by the prices of wings and fries. • We illustrate this with the budget line.

8. Budget Line 2 • John can afford to buy any combination of wings and fries on the budget line. • He can also afford to buy any combination in the gray area under the budget line, with money left over. • The budget line, with the gray area underneath it, are a visualization of John's "opportunity set"

9. Putting them Together • Where the budget line just touches indifference curve 2, John Doe chooses the alternative he most prefers along all of those available to him. • Thus he will choose one wing and 15 fries.

10. Conclusions 1 • Here are some key conclusions from this analysis: • Since the budget line and the indifference curve are just touching at 15 fries and 1 wing, they have the same slope, as we can see. • The slope of the indifference curve is the marginal rate of substitution, which tells us how many fries the person is willing to give up to get one more wing.

11. Conclusions 2 • Further, • The slope of the budget line is the relative price, pwings/pfries, which tells us how many fries the consumer has to give up to get one more wing. • We can express the rule for optimal spending in this way: MRS= pwings/pfries (the relative price of wings and fries.) • But our objective is to apply this to saving and investment – allocation over time.

12. 1. Capital Market Constraintsb. Review: The Indifference curve approach to saving theoryii. Allocation over time

13. Borrowing • Common experience tells us that small businesses often rely a great deal on borrowing, probably to a greater extent than larger businesses. • This discussion will introduce a model of borrowing for a personal business (or for some other purposes) at the level of intermediate microeconomics. • For this example, the individual will be trading off two goods: consumption in the current period and income in the next period.

14. Endowment • Suppose the person has a certain amount of financial assets in the first period. • Call this amount M. • Call income in the next period Y. • Call consumption in the first period C.

15. Trade-offs • There are at least two ways the person can trade off a reduction of his or her consumption in the first year to increase his or her income in the second year. • Save and make investments in financial instruments • Save and invest in the proprietor’s own business.

16. Financial Investment 1 • Suppose the rate of return on financial assets is r. • Then every dollar set aside as financial assets in the current period will yield 1+r dollars of assets to use for consumption or other purposes in period 2. • We can represent that aspect of the person's choice by the budget line shown in Figure 1.

17. Financial Investment 2 In the figure, M and C are represented on the horizontal axis and Y is on the vertical axis. The amount saved is M-C, so the budget line intercepts the horizontal axis at M and has a slope of negative 1+r showing that each dollar life consumption given up increases next year's income by 1+r.

18. Financial Investment 3 The preferences between consumption this year and income next year are shown by the curves labeled I, II, III in Figure 1. We see that, as in many other applications of this approach, the saver chooses the point where an indifference curve just touches the budget line, in order to reach his or her most preferred trade-off.

19. Investment in the Business 1 • By using his or her financial assets to maintain and increase the capital stock of his or her own business, he or she may earn a better rate of return than he or she could obtain in the financial markets. • However, this is likely to be subject to some decreasing returns. • We have a pretty standard way of representing this in economics: a production function.

20. Investment in the Business 2 • Figure 2 shows a production function in diagram form. • the horizontal axis represents the capital stock of the business, • the vertical axis represents the next period income

21. Opportunity Set • In Figure 3, the production function is turned around backward, intercepting the horizontal axis at consumption of M (reflecting zero investment in the business) and with income in the next period increasing step by step (with diminishing returns) as the businessperson shifts funds from first period consumption to investment. • This shows his opportunities for consumption in this period and income in the next.

22. Preferences • The individual’s preferences between consumption this period and income next period can be expressed as indifference curves.

23. Still too Simple • Assuming that he or she will neither borrow nor lend or invest in financial assets – for some reason he or she is isolated from financial markets – the most preferred rate of investment is the one where an indifference curve is just tangent to the possibility frontier. • But the businessperson may also have some opportunity to participate in financial markets.

24. Both Options • The businessperson has M in assets to invest in his or her business, save, and/or finance his or her own consumption.

25. Borrowing • By investing in his or her own business he or she moves up the production possibility frontier to the point where the slope of the production possibility frontier is just 1+r, that is, where the marginal productivity of investment in his or her business is the same as the market rate of return. • This is investment of M-Q. • our businessperson can now participate in capital markets, either saving for a market rate of 1+r, or borrowing at that rate.

26. Liquidity Constraint 1 • But what if the businessperson cannot borrow? • This is called “liquidity constraint.” • If the businessperson cannot borrow, we see both a reduction of investment in the business and a reduction in the businessperson’s consumption.

27. Liquidity Constraint 2 • Notice that investment at Q – where the marginal rate of return in the business is equal to the market rate of return – puts this businessperson on a lower indifference curve. • Conversely, liquidity constraint can result in an inefficient allocation of capital, at least in the sense that Mpcapitat ≠1+r.

28. Collateral • Why would a business be unable to borrow? • The idea of a “market rate of interest” is a bit of an abstraction. • In general, in order to borrow the borrower will have to put up some collateral. • If the borrower cannot put up satisfactory collateral, the banker may require much higher interest rates or may “ration capital,” refusing to lend at all beyond some modest limit.

29. Lack of Collateral • A successful small business is likely to have a substantial value on the market that could be offered as collateral. However • this value is likely to be very illiquid, and for that reason a bank may be reluctant to accept it as collateral, and • the businessperson may reasonably be unwilling to take the risk of losing the business entirely by putting it up as collateral.

30. Human Capital • This will be especially likely if a large proportion of the business’ capital is specific human capital such as “good will” or the result of learning-by-doing. • We call it “liquidity constraint” because the assets are illiquid, and this constrains the business from borrowing.

31. No Need to Borrow • Here is an example of a very successful business that has no need to borrow. • N-Q of the business’ revenue is saved and invested in financial assets.

32. A Very Productive Small Business • Notice that the production possibility frontier is very steep – the marginal productivity of capital in the business is large. • The businessperson’s most preferred option is to invest only in the business – not in financial or other liquid assets.

33. Corner Solution • In this case, the marginal productivity of business capital is greater than the market rate and the marginal rate of substitution is in between. • In mathematical economics this is called a corner solution.

34. Continued Li quidity Constraint • Since the businessperson does not invest in liquid assets, she or he will continue to be liquidity constrained for the foreseeable future. • Remember, this is the optimal solution for the businessperson.

35. Policy Conclusion? • There is reason to think that liquidity constraint is common among small businesses, and that efficiency would be improved if small businesses as a category had more access to capital markets. • This is debateable – my tentative opinion is that it is correct – but it is the rationale for some policies of the Small Business Administration.

36. 2. Franchising

37. Franchising • “Franchising is a system of marketing that enables firms to increase their turnover without increasing their assets. • “Franchising involves two parties, the franchiser and the franchisee. • “The franchiser owns a trademark or brand, which he (or she) agrees to allow the franchisee to use for a fee (often an original purchase price plus a percentage of sales).”

38. Ongoing • “The franchiser provides the franchisee with assistance (financial, choice of site, and so on) in setting up their operation, and then maintains continuing control over various aspects of the franchisee’s business; for example, via the supply of products, discussion of their marketing plans and/or centralised staff training.”

39. Advantages • “The franchisee buys into a proven business plan and considerable expertise. Other advantages to the franchisee include cost savings from the bulk buying capacity of a large operation, and the marketing benefits of central advertising and promotion of the business.”

40. Dangers • “Some franchisers have antagonised their franchisees by selling new franchises for sites close to existing operations.” • The franchiser might fail to maintain the brand or even go into bankruptcy. • Franchises may have a limited term and not be renewed, or even taken over by some opportunistic employees (in a case known to me.)

41. Economies of Scale • I suggest that franchising can be a way of adapting to economies of scale. • Many businesses will require two or more business processes to be carried out in parallel. • Service provision versus national promotion, e.g. • Franchising provides a way to have them carried out by different organizations at different scales.

42. Bargaining • A franchise is a cooperative arrangement between (usually) a small and large business. • A successful cooperative arrangement generates a surplus over what the participants could realize separately. • This raises the question: how will the surplus be distributed among the parties? • This is a matter of bargaining.

43. Reading • The reading “Investments to create bargaining power” starts from that fact. • It argues that some common characteristics of franchising systems reflect the attempts of the franchisors to enhance their bargaining power. • It relies on the economics of organization approach, also known as the transaction cost approach.

44. Transaction Cost Approach • Recall, this approach assumes that contracts are often incomplete (because it would be very costly to make them complete. • Therefore • Opportunistic behavior may occur. • Conflicts over the details of the contract may occur. • A conflict may be resolved by renewed bargaining over the specific issue. • If not, a lawsuit may occur.

45. Opportunisms • Opportunism may occur on either side. • The franchisor may • Reduce promotion and/or quality • Sell competing nearby franchises • Profit from tied sales of franchise-branded merchandise. • The franchisee may • Reduce quality and rely on customers who are motivated by the reputation of the national brand.

46. Bargaining Power • Bargaining power comes from • Alternatives to the proposed or existing partnership, with the threat to dissolve it • Other threats that do not dissolve the partnership but may reduce the payoffs to the other party. • If the bargaining is successful, the threats do not take place and so are not ordinarily observed. • For a franchise contract, dissolution by one party may require a lawsuit.

47. How To Increase Bargaining Power • According to the reading, the franchisor may increase her bargaining power by two strategies: • “Tapered integration,” that is, owning some outlets. • Choosing franchisees without experience in the industry and training them. • “Tapered integration” means the firm is partly, but not fully, vertically integrated. • Both of these could contribute to the surplus as well as shifting bargaining power.

48. Tapered Integration • Tapered integration increases the options available to the franchisor and so increases franchisor bargaining power. • It would also contribute to the franchisor’s experience at the retail level, enabling the franchisor to improve its service to the franchisees. • (The reading does not point out that possibility.)

49. Training • If the franchisor chooses franchisees without experience in the field, and training them, the franchisees have fewer alternatives, and thus less bargaining power. • But training, which is the quantity used to represent this policy, will enhance franchisee productivity as well. • (Again, the reading does not use that idea.)

50. How Many Lawsuits? • The reading assumes that greater franchisor bargaining power will result in fewer lawsuits, probably because it seems that most lawsuits are filed by franchisors as a way of cancelling the franchise. • I believe that the increased surplus that would result from the productivity effects of tapered integration and training would also lead to fewer lawsuits.