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Press Release

    Small Business in America

    04/02/2002

    The American preoccupation with small businesses is rooted in the raw entrepreneurial spirit and freedom associated with working for one’s self. This is true for the owners of small businesses and farms, as well as the employees of upstarts looking to capitalize on their firm’s potential for growth. Too often, government intervention that seeks to help these constituencies threatens the same values that give “small business” its romantic character.

    Being small in a world of behemoths requires hard work, self-reliance, and deferral of gratification. When bigger competitors regard each of your sales as lost revenue, it can be an uphill struggle to just survive. For small farms, competition from vertically integrated agribusiness leads to razor-thin profit margins, or no profits at all. Similarly, upstart Internet firms and software developers have found that competition against the giants of these industries can be exasperating. Superstores like Wal-Mart and Target are despised by sizeable segments of the population, and family restaurants have been displaced by scores of restaurants chains that dominate the suburban dining scene.

    It is not surprising that the most reviled industries in contemporary America are those that seem to be hopelessly dominated by unresponsive, stodgy giants. Some Democrats and demagogues of the left have tried to channel this disaffection into malice. Airlines, energy conglomerates, and local telephone companies all suffer from public relations problems that – at least in part – arise from the cartelized appearance of their respective industries. And the biggest cartel of them all – OPEC – has become a pejorative.

    Antitrust
    Since the late 19th century, and even earlier in some instances, Congress and state governments have taken steps to regulate large businesses to the ostensible benefit of smaller competitors. The Sherman Antitrust Act of 1890 was supported by a coalition of American progressives and small businesses who marshaled public opinion against the consolidation of the steel and oil industries. Subsequent antitrust legislation in 1914 and 1936 went beyond Sherman’s prohibition on attempted monopolization and price-fixing to establish comprehensive regulations on virtually all business practices and partnerships. Larger businesses lost the freedom to set prices for goods, determine the quantity of goods to be produced, induce preferred behavior from customers through better contractual terms.

    But as most observers would agree, antitrust regulation has done little to stop the trend towards largess. Some, such as the antitrust cheerleaders at the Antitrust Institute, believe this is because the antitrust laws have not been enforced vigorously enough. Perhaps, but there is little doubt that augmented antitrust intervention would have profoundly negative consequences for consumers. Given the antitrust laws’ broad mandate, enforcement without regard for efficiency and the interests of consumers would ground all commerce to a halt.

    But worse than just ineffectual, antitrust law is directly responsible for concentration in many industries, particularly telecommunications. As Milton L. Mueller, Jr. describes in Universal Service (1997), competition thrived in the late 19th century when the Bell telephone company refused to interconnect with rivals. As a result, independent phone companies flourished in areas where the Bells had not wired for service. By refusing to interconnect, the Bells gave independents – small businesses –“exclusive access to every exchange built independent of the Bell system.”

    Two waves of antitrust crushed this competition. The first was scrutiny of Bell’s exclusionary conduct. Without interconnection, consumers were only able to connect to fellow customers of the same company. This limited the usefulness of non-Bell companies: The “network effects” or “network externalities” of the Bell system made a Bell telephone connection more valuable than a rival connection because it allowed you to communicate with a far greater universe. As a result, the specter of antitrust scrutiny led the Bell company to allow competitors to connect to its system in 1901.

    The “network externality” advantage disappeared, but so too did competition. Interconnection allowed the Bells to kill its only viable threat: a rival nationwide infrastructure. Once the Bells interconnected, they were able to gain access to consumers in remote areas and eliminate what Mueller calls the “independent orbit.” Interconnection created a single phone system, which was dominated and eventually wholly owned by the Bell company.

    Independents realized this would be the outcome and attempted to collaborate, but antitrust law intervened again in United States Tel. Co. v. Central Union Tel. Co to forbid exactly this type of behavior. Antitrust threw small businesses to the wolves by outlawing partnerships that were their last chance for survival as “contracts in restraint of trade.”

    Today, the same advantages provided by “network externalities” are used to support the imposition of draconian regulations on Microsoft. In this case, the rivals expected to benefit are not only small businesses, but also the hundred billion dollar software and computer giants that egged on the Justice Department to sue in the first place. If antitrust activism succeeds in this instance, the result for consumers and competition would be just as disastrous.

    Regulation
    Antitrust offers an easy answer, but its application thwarts competition more often than it liberates it. Instead of seeking to restructure markets politically, policymakers concerned with consolidation should address the economic factors that caused the consolidation. Often those problems related to significant upfront costs, a positive relationship between factory size and productivity, and few variable costs.

    But in markets where products are differentiated, these factors can be overcome. Small businesses succeed in many markets by providing a qualitatively better product. Italian designers enjoy higher margins on fashions because of the perception that their wares are of higher quality. This is also true of German and Italian automobile manufacturers.

    Because of health and safety regulations, similarly situated businesses in other industries are unable to overcome such disadvantages. For instance, in agribusiness, United States Department of Agriculture (USDA) regulations on slaughter and processing add administrative costs to the production process that cannot be recovered in the market. Larger competitors are able to absorb the regulatory costs by spreading them over more units of output.

    Both small farmers and small processors are handicapped by regulations that do little to improve the final quality of the product, mislead consumers, and add compliance costs that disproportionately affect the same small businesses that depend on higher quality products for their success. As a result, the number of independent farmers and processors is rapidly trending towards zero.

    In markets where consumers do not routinely differentiate between different providers, the adverse affects of regulation are even more profound. Environmental regulations prevent entry in the market for gasoline refinement, artificially raise the production costs on some fuels relative to others, and exacerbate the economies of scale disadvantage smaller competitors already experience by artificially raising production costs.

    While pollution is an externality that cannot be ignored, its threat to the public is difficult to assess. Very often regulations are designed to benefit favored constituencies at the expense of rival technologies, energy sources, and smaller competitors and do little to address the risks posed by pollution.

    The Future of Small Business
    Small businesses continue to employ 50 percent of the nation’s private workforce and have had their very own government agency, the Small Business Administration (SBA), for nearly 50 years. While the SBA’s $700 million budget, counseling services, and liberal financing packages are intended to reduce the burden of the aforementioned regulations on small businesses, they have the perverse effect of rewarding politically favored loan recipients – and loan agencies – at the expense of other businesses and lenders. The terms of these loans, and the price paid by lenders to become an SBA favored client – which allows them to foist their risk onto taxpayers through government guaranteed loans – are themselves subject to political wrangling that can be more easily influenced by large established players than small upstart businesses.

    Whenever the government intervenes in economic activity, it supplants private decisions with those made by the state. By influencing these collective decisions, large, established businesses can limit, or altogether eliminate, competition. If the business is a publicly traded corporation, favorable terms from regulators could guarantee revenues and attenuate shareholder risk.

    The Internet provides the perfect platform for small businesses to flourish, but as Dr.Wayne Brough depicts in his commentary, the Internet commerce market is bogged down with its own set of regulatory obstacles for small businesses. Here too, private interests have been able to secure revenue by influencing political decisions. E-commerce will never realize its potential as envisioned in 1999 as long as government regulations prevent small businesses from exploiting the Internet’s drastically reduced information costs. The technology of the Internet allows small businesses to serve consumer demand for their products and services anywhere in the world. The problem is that the law needs has yet to catch up to technology.

    Last year Congress repealed the Death tax, which is the leading cause of dissolution for small businesses and farms. Unfortunately, the tax will only be repealed for a year, at which time it reverts to its 2001 level: 55 percent of every estate in excess of $1 million. Needless to say, by imposing a draconian tax on equity not faced by public corporations and limited liability partnerships, the death tax limits competition from small businesses.

    Americans love small business because they love freedom and ingenuity. Whether working your own land, or setting you own stock options, there is something romantic about upstart businesses and farms. When government intervention threatens hard work and self-reliance, it threatens small business in America, because these are the values that allow small businesses to thrive. Regulatory strategies aimed at helping small business have hurt it, while regulations to enhance product quality have threatened the viability of small businesses and farms responsible for the highest quality products in their respective markets.

    The best agenda for small business is one that limits government involvement in the economy, protects property rights, and limits taxation.