Wednesday, September 27, 2006

Business Failures are Good for the Economy

The market imposes strict, severe and fierce discipline, through the profit and loss system, especially by imposing harsh penalities for firms that operate inefficiently. More than 80 percent of new firms in the United States end up failing and about 10 percent of all American companies fold each year. But do these business failures provide real economic benefits and enhance social welfare? Yes, business failures are good for the economy, according to a study by University of Michigan professor Hart Posen.

His study found that the more firms that enter a market, the greater the likelihood that poorly performing established companies will disappear, suggesting that failure is merely a byproduct of a phenomenon (excess entry) that yields superior firms.

In addition, competition from a glut of new companies—even those that eventually fail—leads to innovation and efficiency gains among incumbent firms, they say.

This happens for two reasons. First, excess entry, which leads to decreases in price margins, spurs incumbent firms to innovate and reduce costs over the long term. Second, knowledge produced by failed firms, while wasted on themselves, may be absorbed by survivor firms through a spillover effect.

Competition breeds competence. The market rules.


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