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An information based model of industrial exit
175
Economics Letters 33 (1990) 175-178 North-Holland
AN INFORMATION
BASED MODEL
OF INDUSTRIAL
EXIT
John HUDSON University of Bath, Bath, BA2 7AY UK Received 20 September 1989 Accepted 23 October 1989
This paper develops an information based approach to firm closures. It is argued that non-bankrupt exit firms will be older than firms forced out by creditors. Support for this and other hypotheses comes from U.K. survey data.
1. Introduction Several recent papers, in particular those by Jovanovic (1982) and Frank (1988) have developed theories of the firm based upon entrepreneurial learning. In Frank’s paper, unlike Jovanovic’s, entrants are characterised by differing beliefs concerning their own productivity. All entrepreneurs with beliefs above a certain level would enter an industry, with only the last entrant being marginal. In this paper I seek to extend this approach to examine the three different cases of firm closure: (i) forced exit when a bankrupt firm is forced into closure by its creditors, (ii) ‘voluntary’ exit where the owners of a bankrupt firm go into bankruptcy without being forced, and (iii) true voluntary exit where a firm closes down for reasons other than bankruptcy.
2. Theory Let us begin by defining the average self-estimates of entrepreneurial productivity by m” for the third type of exit and mf for the first two types, both of which involve insolvency. These change over time as entrepreneurs gain more evidence concerning their own ability. The true productivity levels of the two groups of entrepreneurs, which are assumed to be fixed over time, are CY”and af, respectively. Let (Y* be the critical level of productivity which is sufficient to keep the entrepreneur in the industry, that is, if in any period beliefs about productivity fall below (Y* the entrepreneur will quit the industry. This critical value will be determined by what the entrepreneur can expect to get in paid employment. Now, Frank’s equation (1988) relating the dynamic adjustment of beliefs over time was
where L represents the effort the entrepreneur puts into the firm, which varies over time, R is the firm’s revenue and h is the precision of the entrepreneur’s estimate of his own productivity level. We 0165-1765/90/$3.50
0 1990 - Elsevier Science Publishers B.V. (North-Holland)
J. Hudson / Information
176
shall assume
L, to be constant
based model of industrial exit
and, after rearranging,
m,,,
can then be expressed
as:
T-l m,+,
=7rTm r+1-T+
c
r’(l
-m>a,
(2)
i=O
where 77 =
l/(1
+ P),
(3)
and T represents the age of the firm at time t + 1, thus m,+, _T represents the entrepreneur’s initial beliefs at the time the firm was set up concerning his own productivity level. From this it is clear that the lower the actual level of productivity the greater will be the rate of decline of perceived productivity, presuming, of course, that actual productivity and effort are independently distributed across entrepreneurs. This situation is illustrated in fig. 1 which shows the rate of decline of perceptions of productivity for two entrepreneurs who start with the same initial perceptions in period 0, (Y’ is the level of productivity below which the entrepreneur will eventually fail with bad debts. The remaining parameters have already been defined. Looking first at curve AB, which relates to the entrepreneur with actual productivity below that necessary to stay out of bankruptcy. The latest date at which the firm will go bankrupt will be t,, when the entrepreneur will voluntarily close, unless he has not already been pushed into closure by creditors before that date. Firms which close ‘voluntarily’ at time t, may be either bankrupt or not depending upon whether the firm’s initial assets are sufficient to cover the losses the firm must inevitably have made up to this point. Curve AC relates to entrepreneurs with sufficient ability to keep them out of bankruptcy even in the long-run, but not with sufficient ability to keep them in the industry once their true level of
and believed productivity of the entrepreneur
nctual
af..................................:............:.......................................B I I 1 I I
5 Fig. 1. Entrepreneurs’
perceptions
of own productivity.
t2
Age of firm
J. Hudson / Information
based model of industrial exit
117
productivity has been perceived. We can see that their beliefs about productivity will decline more slowly than entrepreneurs with less ability, and that they will voluntarily close at time f2 when those beliefs have finally reached the critical point LX*. From this we can see that the earliest date at which firms will voluntarily leave an industry is t,, whilst many will leave considerably later at t,. Secondly, bankrupt firms will be at the most t, periods, and many will be younger. Thus we get the following conclusions: (i) Bankrupt firms will tend to be younger than firms who leave for reasons other than bankruptcy. (ii) Firms which are obviously forced out of the industry by creditors will leave before t, periods, as at that date they would leave voluntarily. Thus they will tend to be younger than bankrupt firms who agree voluntarily to close.
3. Empirical confirmation These conclusions receive empirical support from U.K. data. This comes from a sample of 1830 firms liquidated in the U.K. between the years 1978 and 1981, further details of which can be found in Hudson (1987). There are three categories of liquidation, two of which involve insolvency. Compulsory liquidations stem from winding up orders following petitions to the Court from creditors. Creditors’ voluntary liquidations occur when the company and its creditors come to terms without recourse to court proceedings. In the final class of liquidations, members’ voluntary liquidations, the company winds up for reasons other than insolvency. The data consisted of 595 firms in creditors’ voluntary liquidation, 596 firms in compulsory liquidation and 639 firms in members’ voluntary liquidation. In terms of the theoretical, analysis compulsory liquidations correspond to bankrupt firms forced out of the industry by creditors. Creditors’ voluntary liquidations correspond to bankrupt firms who leave voluntarily without being forced, and members’ voluntary liquidations correspond to non-bankrupt firms who exit voluntarily. Translated into these three types of liquidation in the U.K., the above theoretical analysis therefore implies that firms in compulsory liquidation should on average be younger than those in creditors’ voluntary liquidation, who in turn should on average be younger than those in members’ voluntary liquidation. The results tend to support this. Thus, 61 percent of compulsory liquidations were under seven years old compared with 54 percent of firms going into creditors’ voluntary liquidation. These are significantly different at the one percent level of significance, which provides support for the first of the theoretical implications set out above. Still stronger support is provided for the second implication, with just 11 percent of members’ voluntary firms being under seven years old on exit. In addition, the data provides support for an initial period of low risk of exit following the birth of a firm, with just four per cent of members’ voluntary liquidations being under three years old. This suggests that it takes considerably longer for over-optimistic expectations to be brought down in line with reality than is necessary to force the really incompetent firms out of business through failure.
4. Final thoughts Finally, it is also worth noting that the entrepreneur of a firm forced into bankruptcy will still believe his ability to lie above (Y*, and thus we would expect to see him re-entering the industry in the future. For other entrepreneurs their beliefs as to their own ability will be marginally less than (Y* and thus we would not expect them to re-enter the industry provided OL*does not change over time. This was the conclusion Frank (1988) reached. However, if (Y* was to fall at some point in the future
178
J. Huakon / Information based model of industrial exit
then we might expect such entrepreneurs to re-enter the industry. This might happen if there is a general improvement in long-run profitability which affects all classes of firms in the industry, or alternatively if the rewards from being an employee were to fall.
References Frank, F.Z., 1988, An intertemporal model of voluntary exit, Quarterly Journal of Economics 103, 333-344. Hudson, J., 1987, The age, regional and industrial structure of company liquidations, Journal of Business Accounting 14, 199-213. Jovanovic, B., 1982, Selection and the evolution of industry, Econometrica 50, 649-670.
Finance
&
Economics Letters 33 (1990) 175-178 North-Holland
AN INFORMATION
BASED MODEL
OF INDUSTRIAL
EXIT
John HUDSON University of Bath, Bath, BA2 7AY UK Received 20 September 1989 Accepted 23 October 1989
This paper develops an information based approach to firm closures. It is argued that non-bankrupt exit firms will be older than firms forced out by creditors. Support for this and other hypotheses comes from U.K. survey data.
1. Introduction Several recent papers, in particular those by Jovanovic (1982) and Frank (1988) have developed theories of the firm based upon entrepreneurial learning. In Frank’s paper, unlike Jovanovic’s, entrants are characterised by differing beliefs concerning their own productivity. All entrepreneurs with beliefs above a certain level would enter an industry, with only the last entrant being marginal. In this paper I seek to extend this approach to examine the three different cases of firm closure: (i) forced exit when a bankrupt firm is forced into closure by its creditors, (ii) ‘voluntary’ exit where the owners of a bankrupt firm go into bankruptcy without being forced, and (iii) true voluntary exit where a firm closes down for reasons other than bankruptcy.
2. Theory Let us begin by defining the average self-estimates of entrepreneurial productivity by m” for the third type of exit and mf for the first two types, both of which involve insolvency. These change over time as entrepreneurs gain more evidence concerning their own ability. The true productivity levels of the two groups of entrepreneurs, which are assumed to be fixed over time, are CY”and af, respectively. Let (Y* be the critical level of productivity which is sufficient to keep the entrepreneur in the industry, that is, if in any period beliefs about productivity fall below (Y* the entrepreneur will quit the industry. This critical value will be determined by what the entrepreneur can expect to get in paid employment. Now, Frank’s equation (1988) relating the dynamic adjustment of beliefs over time was
where L represents the effort the entrepreneur puts into the firm, which varies over time, R is the firm’s revenue and h is the precision of the entrepreneur’s estimate of his own productivity level. We 0165-1765/90/$3.50
0 1990 - Elsevier Science Publishers B.V. (North-Holland)
J. Hudson / Information
176
shall assume
L, to be constant
based model of industrial exit
and, after rearranging,
m,,,
can then be expressed
as:
T-l m,+,
=7rTm r+1-T+
c
r’(l
-m>a,
(2)
i=O
where 77 =
l/(1
+ P),
(3)
and T represents the age of the firm at time t + 1, thus m,+, _T represents the entrepreneur’s initial beliefs at the time the firm was set up concerning his own productivity level. From this it is clear that the lower the actual level of productivity the greater will be the rate of decline of perceived productivity, presuming, of course, that actual productivity and effort are independently distributed across entrepreneurs. This situation is illustrated in fig. 1 which shows the rate of decline of perceptions of productivity for two entrepreneurs who start with the same initial perceptions in period 0, (Y’ is the level of productivity below which the entrepreneur will eventually fail with bad debts. The remaining parameters have already been defined. Looking first at curve AB, which relates to the entrepreneur with actual productivity below that necessary to stay out of bankruptcy. The latest date at which the firm will go bankrupt will be t,, when the entrepreneur will voluntarily close, unless he has not already been pushed into closure by creditors before that date. Firms which close ‘voluntarily’ at time t, may be either bankrupt or not depending upon whether the firm’s initial assets are sufficient to cover the losses the firm must inevitably have made up to this point. Curve AC relates to entrepreneurs with sufficient ability to keep them out of bankruptcy even in the long-run, but not with sufficient ability to keep them in the industry once their true level of
and believed productivity of the entrepreneur
nctual
af..................................:............:.......................................B I I 1 I I
5 Fig. 1. Entrepreneurs’
perceptions
of own productivity.
t2
Age of firm
J. Hudson / Information
based model of industrial exit
117
productivity has been perceived. We can see that their beliefs about productivity will decline more slowly than entrepreneurs with less ability, and that they will voluntarily close at time f2 when those beliefs have finally reached the critical point LX*. From this we can see that the earliest date at which firms will voluntarily leave an industry is t,, whilst many will leave considerably later at t,. Secondly, bankrupt firms will be at the most t, periods, and many will be younger. Thus we get the following conclusions: (i) Bankrupt firms will tend to be younger than firms who leave for reasons other than bankruptcy. (ii) Firms which are obviously forced out of the industry by creditors will leave before t, periods, as at that date they would leave voluntarily. Thus they will tend to be younger than bankrupt firms who agree voluntarily to close.
3. Empirical confirmation These conclusions receive empirical support from U.K. data. This comes from a sample of 1830 firms liquidated in the U.K. between the years 1978 and 1981, further details of which can be found in Hudson (1987). There are three categories of liquidation, two of which involve insolvency. Compulsory liquidations stem from winding up orders following petitions to the Court from creditors. Creditors’ voluntary liquidations occur when the company and its creditors come to terms without recourse to court proceedings. In the final class of liquidations, members’ voluntary liquidations, the company winds up for reasons other than insolvency. The data consisted of 595 firms in creditors’ voluntary liquidation, 596 firms in compulsory liquidation and 639 firms in members’ voluntary liquidation. In terms of the theoretical, analysis compulsory liquidations correspond to bankrupt firms forced out of the industry by creditors. Creditors’ voluntary liquidations correspond to bankrupt firms who leave voluntarily without being forced, and members’ voluntary liquidations correspond to non-bankrupt firms who exit voluntarily. Translated into these three types of liquidation in the U.K., the above theoretical analysis therefore implies that firms in compulsory liquidation should on average be younger than those in creditors’ voluntary liquidation, who in turn should on average be younger than those in members’ voluntary liquidation. The results tend to support this. Thus, 61 percent of compulsory liquidations were under seven years old compared with 54 percent of firms going into creditors’ voluntary liquidation. These are significantly different at the one percent level of significance, which provides support for the first of the theoretical implications set out above. Still stronger support is provided for the second implication, with just 11 percent of members’ voluntary firms being under seven years old on exit. In addition, the data provides support for an initial period of low risk of exit following the birth of a firm, with just four per cent of members’ voluntary liquidations being under three years old. This suggests that it takes considerably longer for over-optimistic expectations to be brought down in line with reality than is necessary to force the really incompetent firms out of business through failure.
4. Final thoughts Finally, it is also worth noting that the entrepreneur of a firm forced into bankruptcy will still believe his ability to lie above (Y*, and thus we would expect to see him re-entering the industry in the future. For other entrepreneurs their beliefs as to their own ability will be marginally less than (Y* and thus we would not expect them to re-enter the industry provided OL*does not change over time. This was the conclusion Frank (1988) reached. However, if (Y* was to fall at some point in the future
178
J. Huakon / Information based model of industrial exit
then we might expect such entrepreneurs to re-enter the industry. This might happen if there is a general improvement in long-run profitability which affects all classes of firms in the industry, or alternatively if the rewards from being an employee were to fall.
References Frank, F.Z., 1988, An intertemporal model of voluntary exit, Quarterly Journal of Economics 103, 333-344. Hudson, J., 1987, The age, regional and industrial structure of company liquidations, Journal of Business Accounting 14, 199-213. Jovanovic, B., 1982, Selection and the evolution of industry, Econometrica 50, 649-670.
Finance
&