Evidence on Creative Destruction: Small Business Creation and Unemployment

Abstract

This paper provides novel empirical evidence supporting Schumpeter's Theory of Creative Destruction. Earlier research has established the role of technological shocks, cycles and disruptive innovation in facilitating individual firm survival and destruction but few studies have isolated causal mechanisms of such economic renewal. The first contribution of this paper is to demonstrate one such mechanism that drives the process of creative destruction. I illustrate that a negative economic shock, characterized by an increase in state-year level of unemployment creates a sharp wage drop for high-ability Black individuals relative to Whites, and changes the payoff from employment relative to entrepreneurship. This creates an incentive for the high-ability Blacks to become entrepreneurs. Thus the destruction from economic downturns is accompanied by a simultaneous process of creation through the establishment of small ventures by Black individuals with high human capital. The second contribution of this paper is to present evidence on the quality of ventures created. I show that these ventures do not opportunistically disappear as soon as the downturn is over, but prove to be of average quality and are economically meaningful assets.