Category: Microeconomics

Supports:  Econ & Micro: Chapter 11, Technology, Production, and Costs (Section 11.6); Chapter 13, Monopolistic Competition; Chapter 14, Oligopoly (Section 14.1); Essentials: Chapter 9, Technology, Production, and Costs; Chapter 11, Monopolistic Competition and Oligopoly

Can Mom and Pop Businesses Survive the Coronavirus Pandemic?

By early April 2020, because of the coronavirus pandemic, all 50 state governments had issued declarations of emergency and had closed schools and some or all businesses considered to be non-essential.  A survey by Alexander Bartik of the University of Illinois and colleagues indicated that about 43 percent of small businesses in the Unites States had closed, causing most of their revenue to disappear.  As a result, those businesses had laid off about 40 percent of their employees.

In March 2020, Congress and President Donald Trump enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The act included the Paycheck Protection Program (PPP), which provided loans to businesses with 500 or fewer employees to pay for up to eight weeks of payroll expenses and certain other costs. The government would forgive the loans if business owners used 75 percent of the funds for payroll expenses.

            The PPP was administered by the federal Small Business Administration with the loans being made primarily by local banks. Many small businesses have trouble borrowing from banks, particularly if they lack collateral, such as owning the building they operate in, or if they don’t have a long-term relationship with a bank by having borrowed from them in the past or having maintained a business checking account with them. In a survey by the Federal Reserve conducted in 2019, before the coronavirus pandemic, 64 percent of small businesses had faced financial challenges, such as paying operating expenses or purchasing inventories, during the previous year.  Of those firms, 69 percent had relied on the owner’s personal funds to meet the financial challenge. 

            In mid-April 2020, it was unclear whether Congress might change the PPP to make it easier for small businesses to borrow through credit unions and other lenders that are not commercial banks. News reports indicated that a significant number of small businesses had exhausted the funds their owners had available and intended to permanently close.  It’s not unusual for a small firm to fail. In a typical year, even when the economy is expanding, hundreds of thousands of businesses fail (and a similar number open).  But some economists and policymakers were concerned that the effects of the pandemic might lead to a permanent reduction in the number of small firms, particularly so-called “Mom and Pop businesses”—sole proprietorships that employ fewer than 20 workers.  (We discuss the differences between sole proprietorships and other ways of organizing a business in Chapter 8, Section 8.1)

The pandemic posed particular challenges for these businesses.  Many small retailers, such as clothing stores, shoe stores, card shops, and toy stores, had already been hurt before the pandemic as consumers shopped at online sites such as Amazon. This trend increased during the pandemic. In addition, as many consumers shifted from eating in restaurants to buying groceries from supermarkets or online, the future of some small restaurants seemed in doubt.

Even as states and cities began to allow nonessential businesses to reopen, many consumers were reluctant to return to eating in restaurants, staying in hotels, and shopping in brick-and-mortar stores in the absence of a vaccine against the coronavirus.  The shift to online buying was evident during March and April 2020 when, as many small businesses were laying off workers, Amazon was hiring an additional 175,000 workers and Walmart was hiring an additional 150,000.  Some public health authorities and epidemiologists were suggesting that businesses take certain steps to reassure consumers, although doing so would raise the businesses’ costs of operating. For instance, Scott Gottlieb, former Food and Drug Administration commissioner, suggested that “businesses … should look at trying to bring testing on-site at the place of employment” to reassure customers that the businesses’ workers did not have the virus. He also suggested that restaurants print their menus on paper that could be thrown away after each use and commit to more frequent disinfecting. Clearly, the revenue earned by larger businesses would be better able to cover these costs while still at least breaking even.

            If the world is entering a new period with more frequent epidemics of viruses to which most people lack immunity, small businesses will be at a further disadvantage. Although Congress and the president responded to the coronavirus with the PPP program, whether they would have funds to do so during future epidemics remained unclear. As a result, it may be of increased importance that firms have the resources to finance periods of closure without having to rely on government payments, loans from banks for which they may lack the necessary collateral, or running balances on high-interest rate credit cards. The survey by Alexander Bartik and colleagues referred to earlier indicated that the average small business has $10,000 in monthly costs and less than that amount readily available to use to pay those costs.  In other words, many small businesses are dependent on paying their current costs from their current revenues.

            Most small business owners are resourceful enough to respond to changing conditions, but the challenges posed by the coronavirus seemed likely to reshape the structure of some industries, including restaurants, small retail stores, gyms, non-chain hotels, and small medical and dental practices. When discussing the role that barriers to entry play in determining the level of competition and the size of firms in an industry, we emphasized the role played by physical economies of scale. For instance, we noted that:

A music streaming firm has the following high fixed costs:  very large server capacity, large research and development costs for its app, and the cost of the complex accounting necessary to keep track of the payments to the musicians and other copyright holders whose songs are being streamed.  A large streaming firm such as Spotify has much lower average costs than would a small music streaming firm, partly because a large firm can spread its fixed costs over a much larger quantity of subscriptions sold.

We also noted that economies of scale of this type did not exist in the restaurant industry. Prior to the pandemic, it was reasonable to argue that large restaurants were typically unable to serve meals at a lower average cost than smaller restaurants and that even if smaller restaurants faced higher average costs, by differentiating the meals they served, smaller restaurants could still attract customers despite charging a higher price than larger restaurants. But if small restaurants lack the ability to finance periods of closure during epidemics and have trouble breaking even due to the higher costs of printing paper menus, testing their employees onsite, and more frequent cleaning, they may struggle to survive. Larger restaurants can spread these costs over a larger number of meals, reducing the average cost of one meal compared with smaller restaurants. As more consumers avoid restaurants and eat more frequently at home, smaller restaurants may be pushed further up their average cost curves by being able to sell only a smaller quantity of meals.

The following figure illustrates how the pandemic may affect the costs of a typical restaurant.  The long-run average cost curve LRAC_BP shows the situation before the pandemic. The higher costs necessary to operate after the pandemic, including printing paper menus and more frequent cleaning, shifts up the long-run average cost curve to LRAC_AP.  Before the pandemic, the average total cost curve for the small restaurant is  and for the large restaurant is .  Notice that even though the large restaurant serves Q₂ meals per week and the small restaurant serves Q₁ meals per week, they both have the same average total cost per meal, ATC₁.

Also notice that before the pandemic, serving Q₁ meals per week was the minimum efficient scale for a restaurant.  Minimum efficient scale is the level of output at which all economies of scale are exhausted.  The pandemic increases the costs of the small restaurant from  to is , and the costs of the large restaurant from to .  Minimum efficient scale increases to Q₃, which is more meals per week than a small restaurant can sell. As a result, the average total cost of small restaurant increases to ATC₃. A larger restaurant is still selling a quantity of meals that is beyond minimum efficient scale, so its average cost only rises to ATC₂.  With higher average costs, smaller restaurants are less able to successfully compete with larger restaurants.  

Small firms in other industries are likely to face similar challenges. The result could be a contraction in the number of firms in some industries.  For instance, we may see franchised firms replacing Mom and Pop businesses—more Domino’s and Pizza Hut outlets and fewer independent pizza restaurants.  Although it’s too early to tell the full effects of the coronavirus pandemic on U.S. businesses, the effects are likely to be far-reaching.

Question: 

Sendhil Mullainathann of the University of Chicago wrote an opinion column in the New York Times describing the situation facing the owner of a small restaurant:

She has little money in cash reserve; operating margins are thin … and her savings had already been spent on expanding the cramped kitchen. What was a thriving enterprise before the pandemic will emerge—if it emerges at all—as a hobbled business, which may well fail shortly thereafter.

A) What does Mullainathan mean by the restaurant’s “operating margins are thin”? Why would we expect the operating margins of a small restaurant to be thin?

B) If this restaurant was a “thriving enterprise” before the pandemic, why might it be likely to fail after the pandemic?

For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.