Business Psychology - Latest Findings

Article No. 114
Business Practice Findings, by James Larsen, Ph.D.

New Business Formation

Researcher identifies factors that spur the formation of specialized small companies.

Right now entrepreneurs are watching for signals that will tell them the time is right to start a new business. Have you ever wondered what those signals are?

Anand Swaminathan, from the University of Michigan, has investigated this topic, and he recently discovered a rich source of information to explore: a complete record of business foundings in the American wine industry.

The U.S. wine industry rose like a phoenix from an extinction imposed by Prohibition. By 1940 1,033 wineries were in operation. But a downward trend began with the war and continued for 27 years, even though sales increased steadily during the period. By 1967, only 330 wineries remained, but then the trend reversed and by 1990, over 1,300 wineries were in operation.

Professor Swaminathan compiled data from government reports and trade periodicals and he considered demographic information on population and income looking for factors that accelerated the establishment of small, specialized wineries that catered to local markets. In the industry, these are called farm wineries. He found 4 factors.

One factor was evolving customer preferences (market niches). Small businesses are well suited to exploit these opportunities. Interestingly, Swaminathan discovered a source of data that signals the emergence of a customer niche, an increase in imports. So this was one of the signals entrepreneurs in the wine industry noticed that spurred them to establish new firms.

A second factor involved the actions of large companies in the industry. Typically, as their market shares grew, they absorbed smaller firms. This led to a few large companies dominating the industry and competing vigorously for the center of the market. They streamlined production and distribution, standardized product features, and targeted their advertising at large, national market segments. They ignored the fringes of the market. Localized customers with special preferences offered an opportunity for entrepreneurs to establish firms to address their tastes. Swaminathan's analysis demonstrated an acceleration of winery foundings when these conditions existed. This is another factor entrepreneurs noticed.

A third factor can best be described as following the leader rather than the follower. It proved to be responsible for both accelerating business foundings and retarding them. When the number of wineries was low, in 1967, for example, the first new farm wineries attracted attention. They demonstrated a new way of entering the industry, a new form of business that others could copy. Swaminathan analyzed founding data state by state, and found each new farm winery accelerated the establishment of new farm wineries, like bees swarming to a rich source of nectar. But when the number of wineries was high, then establishing a new firm led to a decline in the founding rate, a slow down reflecting a saturation of the opportunity. Entrepreneurs noticed this factor too.

A fourth factor involved legislative and association support. In 1968 Pennsylvania pioneered legislation supporting farm wineries and new business foundings rose dramatically. Other states soon followed their lead. The federal government also granted an exemption of an excise tax increase for the first 100,000 gallons of a winery's production, which gave them a competitive advantage over large firms. So supportive legislation and association activities are also factors that led entrepreneurs to begin firms.

Finally, Swaminathan compared the factors and found "following the leader" to be by far the most influential, followed by reacting to large firms' neglect of market fringes as they competed for the center. Favorable legislation and association support followed next, and emerging customer niches followed close behind.

Entrepreneurs have an unsettling ability to change everything in an industry, revitalizing it whether established firms like it or not. Swaminathan believes his findings apply to many industries, and now, thanks to his work, we have a keener insight into factors that spur entrepreneurs to act.

Reference: Swaminathan, Anand (1995). The Proliferation of Specialist Organizations in the American Wine Industry, 1941-1990. Administrative Science Quarterly, 40 (December), 653-680.

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