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Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Jun 13, 2023

Surge in New Business Formation Brings Migration of Opportunity

Among the startling changes observed during and since the COVID-19 pandemic is the sharp rise in new business formation since 2020, reversing a 20-year trend. Research from John Haltiwanger, Dudley and Louisa Dillard Professor of Economics at the University of Maryland and 2023 Kenan Institute Distinguished Fellow, demonstrates that applications for new businesses surged from mid-2020 onward and remain well above pre-pandemic levels. While it is too early to tell what is driving this trend, Haltiwanger’s early read points to a combination of opportunities created by remote work, emerging technologies such as artificial intelligence, changing lifestyles, and the resultant geographic shifts in where people are working. Following his talk at the Kenan Institute on April 27 (a recording of which can be viewed here), we sat down with Haltiwanger to discuss the implications of his findings.

You mention that the period from 2000 to 2020 was notable for a sustained decline in new business formation – and that a number of factors have been proposed to explain this decline. Is there a particular narrative or explanation that you think is most plausible to explain the decline during the first two decades of the 21st century?

John Haltiwanger: The main thing we were observing during those years was the high growth of what were pre-2000 the new tech companies – what we now consider the tech giants – such as Google, Amazon, Apple, Meta (Facebook), etc. Network externalities – the ability of a firm to capture customers because other people are using the same platform – and increasing globalization facilitated this period of high growth. This led to increased concentration of economic activity in the tech sector in these tech giants.

These changes yielded a significant change in the approach of new entrepreneurs. As the tech giants grew, we saw the goals of startup founders change; many of them were explicitly aiming to be acquired by one of the tech giants rather than become one. The acquiring firm could then choose to utilize the technology they acquired, or else simply sit on it and prevent it from reaching the market (otherwise known as a “killer acquisition”).

If we go back to the 1970s, this approach contrasts heavily with the way in which, for example, Microsoft acted when it was a new firm. In 1980, IBM struck a deal with Microsoft in which Microsoft would create the operating system for IBM mainframe computers. But IBM didn’t recognize the importance of software, and it allowed Microsoft to retain ownership of the operating system – which allowed Microsoft to keep growing. (To some extent, this dynamic has now come full circle with the deal between Microsoft and OpenAI. OpenAI is benefiting from its partnership with Microsoft, but it wasn’t bought and gets to keep its intellectual property.)

Some of this is also part of the natural cycle of firms, particularly in a sector like the tech sector. New technology arrives and certain entities are able to take advantage of it, which then propels them to the top of the market. But, as many of them get so big, they get more cautious about protecting their position. They’re also less flexible, so at a certain point, newer entrants become more able to utilize the latest technological advancements and become top players themselves.

As remote work has risen, we’ve seen increased migration to midsize and smaller cities. How much does the growth of these new markets fuel new business formation?

Haltiwanger: That’s an interesting point, and it’s complicated. In recent decades, we’ve seen a notable migratory inflow to the southern United States – and, while new business formation has grown overall since 2020, it’s particularly skyrocketed in the South. I think it’s certainly possible that the expansion of these markets has been an impetus for some of the new businesses we’re seeing, although the extent of that effect remains to be seen.

More broadly, I think we are currently in a period of restructuring across multiple dimensions (spatial, industry, regional). On a local spatial level, the pandemic has either brought about or sharply accelerated what we call the “doughnut effect.” Demand and economic activity are moving away from the downtown areas of major cities and toward less densely populated areas. This is to the benefit of the areas around or near urban downtowns, and to the detriment of the downtown areas themselves. And, on an industry level, we’re seeing both rapid technological change (such as the rise of AI) and the ability to work remotely on platforms like Zoom, Skype and Microsoft Teams.

Of these shifts, the one we understand the least is the regional shift. While population has been shifting to the South, there has been an extraordinary increase in business formation in the post-2020 period that is unlikely to be accounted for by population shifts alone. We’ll need some time and distance to properly understand what we’re observing.

And the other question that comes up is around remote work: How many workers are living in one city and working for an employer located elsewhere? This makes disentangling the variables and figuring out how much geography plays a role very difficult.

What’s the impact for consumers of a spike in new business formation? In theory, it could be a net positive (in that more options are available on the market) or a negative (these new businesses aren’t known entities, and it could subsequently be more difficult for consumers to discern the quality of a new firm).

Haltiwanger: Overall, I think it’s a positive. There is certainly some disruption that results from the arrival of new entrants into the market, but what we’ve seen is that consumers are quite capable of learning about the options available to them on the market and then spreading that information. This is probably easier for certain industries than others; for example, restaurant reviews are a very easy way for customers to determine the quality of a dining establishment.

As an additional point, I think the informational problem cuts both ways. The main challenge for new businesses is to build up a new customer base and convince buyers to use their product or service. Reputation and word of mouth take time to build up in many industries – especially business-to-business industries. Given the information-heavy environment in which we currently live, it can be increasingly difficult for a new business’s message to cut through the noise.

I also find it curious that the role of regulation hasn’t come up yet. How much does the regulatory environment play into the likelihood of new firm formation and the level of entrepreneurship?

Haltiwanger: To be sure, part of the rise of the South over the last half-century was in response to the high level of regulation in the Northeast and Midwest. However, there’s little evidence that the slowed rate of startups we saw from 2000 to 2020 was due to prohibitive levels of regulation. That could be a measurement problem, but this has been studied quite extensively. I would say the regulatory environment plays a role, but there’s something much deeper going on here that accounts for the decline and subsequent rise in new businesses.

What we have certainly seen is a surge in uncertainty about the regulatory and business environment on both a national and state level. The high levels of political gridlock and polarization we’re experiencing in the last several years have increased uncertainty for businesses – and yet we have still observed this rise in new business formation. Put another way, it’s very unclear what the future will look like, yet people are still interested in creating new market opportunities.

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