The Impact of Trust on Intra-Industry Resource Allocation and Aggregate Variables

Abstract

This paper explores the relationship between firm expansion and job creation, focusing on how it contributes to overall income growth. It highlights the crucial factor of profitability in entrepreneurial decision to expand their firms. Various influences on this decision are discussed, with emphasizing trust. The paper argues that the dynamism of small firms plays a role in shaping the endogenous distribution of firm sizes. Trust is identified as a significant determinant of this dynamism. Employing a monopoly-competition model, the paper demonstrates that higher-ability entrepreneurs tend to select firm expansion. The model predicts a distinct pattern in the distribution of firm sizes, characterized by a cut-off point where entrepreneurs are classified. When the trust level is higher, entrepreneurs have greater incentives to expand their firms, resulting in a larger population of large firms and increased aggregate income. The paper concludes with a policy implication, suggesting that governments should strive to create a higher level of trust conducive to firm expansion if their objective is to boost aggregate income. Overall, this paper contributes to the existing literature on entrepreneurship and firm-size distribution.

KEYWORDS:

• Entrepreneurs
• firm-size distribution
• managerial compensation
• monopolistic competition
• trust

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Based on Schoar's (2010) research, entrepreneurship can be categorized into two types: subsistence entrepreneurship and transformational entrepreneurship. Schoar emphasizes that entrepreneurs exhibit distinct characteristics depending on the type of entrepreneurship they engage in. This paper distinguishes small firms as examples of subsistence entrepreneurship, while large firms exemplify transformational entrepreneurship.

2 In particular, Melitz (2003) demonstrated that the presence of fixed cost leads to firm selection in the context of trade liberalization.

3 According to Syverson's (2011) survey, there are multiple important drivers of firm productivity differences. To gauge the significance of the correlation between management practices and productivity, Bloom et al. (2019) revealed that management practices account for 44.1% of the 90–10 productivity spread. This paper highlights the pivotal role of management practices as the primary source of firm productivity.

4 The study revealed that Indian textile companies displayed a tendency to have subpar management practices due to their preference for family-run operations and lack of delegation. These companies faced challenges primarily because of information barriers and the high cost associated with management consulting, estimated to be around USD 250,000. To address this, a few firms were chosen at random and provided with complimentary consulting services. As a result, these firms experienced improvements in their use of technology and decision-making decentralization. Consequently, their average productivity saw an approximate 10% increase following the treatment. The study identified the cost overhead as a key factor contributing to the reluctance in adopting effective management practices.

5 In a similar vein, the model shares similarities with the work of Monte (2011). In Monte's model, managers exhibit heterogeneity in their contributions to firm productivity, whereas workers are deemed irrelevant in terms of impacting firm productivity.

6 Lentz and Laband (1990) put forth a speculation suggesting that entrepreneurship-specific human capital may be inherited from parents to their children. Their research revealed that approximately 50% of the business owners included in their sample had at least one parent who was self-employed. Furthermore, Campbell and De Nardi (2009) discovered that 50% of male nascent entrepreneurs and 55% of female nascent entrepreneurs had parents who owned at least one business. This indicates that female nascent entrepreneurs are more likely to originate from families with a background in business ownership.

7 In the model developed by Hurst and Pugsley (2011), entrepreneurs exhibit heterogeneity in their preference for running businesses. Some entrepreneurs have a preference for operating small firms due to non-monetary benefits they derive from such ventures.

8 Previous studies offered varied explanations for the question at hand. Lucas (1978) explores the occupational choices of individuals with different abilities, where higher-ability individuals opt to become entrepreneurs only if the business's profitability surpasses the wage they would earn as workers. In Kihlstrom and Laffont (1979), it is less risk-averse individuals who choose entrepreneurship as their path. Poschke (2013, 2018) highlights that both the highest-ability and lowest-ability individuals are inclined towards entrepreneurship, as lower-ability entrepreneurs tend to take up abandoned projects. Poschke (2018) found empirical evidence supporting a U-shaped relationship between entrepreneurship and ability.

9 In their study, Ardagna and Lusardi (2010) made a clear distinction between two types of entrepreneurs: business-opportunity entrepreneurs and remedial entrepreneurs. Similarly, Cooper et al. (1989) referred to entrepreneurs in large firms as large-firm entrepreneurs. Mondragon-Velez and Pena-Parga (2010), as well as de Mel et al. (2010), used terms like business-owner entrepreneurs and self-employment entrepreneurs to describe different entrepreneurial categories. For the purpose of this paper, the terms ‘large(small)-venture entrepreneur’ and ‘large(small)-firm entrepreneur’ will be used interchangeably.

10 The authors substantiated these distinctions by analyzing data from the Global Entrepreneurship Monitor, a comprehensive survey conducted across 37 countries to gauge the state of entrepreneurship.

11 In the realm of wage inequality, Egger and Kreickmeier (2009) provided insights by employing the concept of fair-wage preference. They elucidated how higher productivity firms tend to compensate workers more, attributing wage disparities to differences in firm productivity. In line with these studies, the present model also adopts the assumption of fair-wage preference.

12 It can be assumed that $f_1$ is set at a minimal level to ensure that all entrepreneurs can enter the sector if they desire.

13 Similar to Kabul's model, the production function follows the form $F(\psi ,l)=\psi$, with $0<\mu <1$.

14 Hess (2012) pointed out that the skills of employees do not grow when the firm is expanded. After studying 54 companies in 23 states, he pointed to hiring errors as one likely outcome of firm expansion. In his study, some firms needed two to five attempts before finding the ‘right people’. In some cases, it generated the issues of loyalty and morale. That is, firm expansion needs ‘right people’ for the organizational change.

15 The use of group incentives has empirical evidence, with nearly half of the US workforce being employed under such schemes.

16 The derivation is in appendix.

17 The derivation is in appendix.

18 Previous research by Bartelsman et al. (2013) demonstrated significant differences in the covariance between firm size and productivity across countries. For instance, the covariance between firm size and productivity is high and positive in the United States, while it is comparatively lower in Western Europe and even lower in Eastern Europe. Interestingly, the covariance has been steadily increasing in Eastern Europe over the past few decades.

19 The derivation is in appendix.