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9.4 Government Policies

Learning Objectives

  1. What government policies impact job creation and destruction?
  2. What are the effects of trade on job creation and destruction?

Governments are very interested in job creation. A political leader whose economy loses a large number of jobs without creating new ones is unlikely to be reelected. On a local level, state and local governments compete fiercely to have firms locate in their region by offering lucrative tax reductions. This is seen as a way to create jobs in the local economy. We now examine some of these policy interventions and trace out their implications, focusing on three policies: restrictions on closing plants, policies that promote small businesses, and trade policies.

Plant-Closing Restrictions

In the United States, if you want to close a factory, you do not have to have approval of the government, but an act of Congress—the Worker Adjustment and Retraining Notification ActUS Department of Labor, “Other Workplace Standards: Notices for Plant Closings and Mass Layoffs,” elaws Employment Law Guide, accessed March 14, 2011,—requires you to announce your intentions ahead of time. According to the US Department of Labor, “The Worker Adjustment and Retraining Notification Act (WARN) protects workers, their families, and communities by requiring employers to provide notification 60 calendar days in advance of plant closings and mass layoffs.”US Department of Labor, The Worker Adjustment and Retraining Notification Act (WARN), accessed January 22, 2011,

This law was passed in 1988 during a time of higher than average unemployment in the United States. Similar restrictions apply in some European countries, such as Spain and France. You cannot simply close an unproductive plant; employees must be given advance notice, and government approval may be required. Such restrictions on plant closings are intended to reduce job destruction. After all, if you make something more expensive to do, then less of it will be done. If it becomes more expensive to close plants, then fewer jobs will be destroyed by the exit of plants.

Economists point out, however, that the incentives of such policies are complicated and go beyond the effects on job destruction. To see why, think about our earlier discussion of entry and exit. When a firm decides to enter into an industry, it compares the profit flow from operating to the entry cost. When a firm thinks about the profits it will earn if it enters, it recognizes that if the demand for its product disappears, it can exit and thus avoid periods of negative profits. But if you take this option to exit a market away from a firm, then the value of entering an industry will decrease. Fewer firms will enter, and fewer jobs will be created. Thus laws that make it costly to close plants will also reduce job creation. The effect on net job creation is unclear.

Small Business Promotion

Started in the 1950s, the Small Business Administration (SBA; is a US government agency whose goal is to protect and promote small businesses. Small firms obtain preferential treatment in terms of taxes, regulation, and other policies. Part of the argument in favor of promoting and protecting small businesses is the view that job creation is centered on these firms. According to the SBA website, small businessesSee

  • represent 99.7 percent of all employer firms and
  • have generated 60–80 percent of net new jobs annually over the last decade.

So it appears that small businesses are critical to an economy.

We must remember that these are indeed small firms, however. Suppose there were 5 firms in an economy. Four of them have 2 workers, and the fifth has 92 workers. The typical firm then has 2 workers: 80 percent of the firms in this economy have 2 or fewer workers. From the perspective of workers, though, things are rather different. Ninety-two percent of the workers are employed by the single large firm. If you ask workers how many employees are in their firm, the typical worker will say 92. Most firms have few workers, but most workers are employed by the large firm.

This is not far from the reality of the US economy, where much economic activity (employment and output) is centered on relatively few firms. A recent study of about 5.4 million businesses found that 182,000 of them operate multiple units. Dividing 182,000 by 5.4 million, we learn that these larger firms are less than 4 percent of the total number of firms. But they account for about 61 percent of the revenue of the business sector of the economy. So most firms are relatively small, but those that are large are huge compared to the rest.Steven J. Davis et al., “Measuring the Dynamics of Young and Small Business: Integrating the Employer and Non-employer Universes” (NBER Working Paper 13226, 2007), accessed January 30, 2011,

Davis, Haltiwanger, and Schuh point out that “large firms and plants dominate the creation and destruction of jobs in the manufacturing sector.”See Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction (Boston, MA: MIT Press, 1998), chap. 7, sect. 4. Larger firms and plants both destroy and create more jobs. For example, at a job destruction rate of 10 percent a year, a small firm of 50 workers will destroy 5 jobs, while a large plant with 1,000 workers will destroy 100 jobs. So even if the job creation and destruction rates are higher for small firms, this does not necessarily mean that these small entities create and destroy more jobs than large firms do.

This is not to say that small firms are unimportant. Most of the large firms in the economy started small. Likewise, all the older, more successful firms were once young firms. So any impact the SBA has on either small or young firms will influence these firms as they age and grow. However, the rationale for the SBA is not completely clear. Normally, government interventions are based on the idea of either correcting some problem with the operation of free markets or redistributing resources. It is not clear whether the SBA fulfills either of these roles.

Trade Policy

Job creation and destruction are also affected by things that happen outside US borders. The removal of trade barriers allows countries to benefit more fully from the gains from trade. But in the process, some jobs are destroyed, while others are created.

Job destruction frequently takes center stage during debates on trade policy. In the early 1990s, for example, the United States was contemplating a reduction in trade barriers with its neighbors—Canada and Mexico—through negotiation of the North American Free Trade Agreement (NAFTA). Ross Perot, a third-party candidate for the US presidency in 1992 and 1996, was extremely critical of NAFTA. His focus was on job destruction, and he was famous for forecasting “a giant sucking sound” as employment opportunities moved from the United States to Mexico in response to NAFTA.

The loss of some jobs from a reduction in trade barriers is part of the adjustment one would expect. For countries to reap the gains from trade brought about by the removal of trade barriers, production patterns across countries must change. That process leads to job destruction and creation. Firms that used to produce certain goods in one country exit, as firms in other countries start to produce those goods instead. Workers at the exiting firms will certainly lose their jobs, but other jobs are created in the economy at the same time.

NAFTA was implemented in January 1994. More than 15 years later, it is still difficult to say exactly what the effects were and will be of NAFTA. Economics is not a laboratory science. It is not possible to subject the economies of Canada, Mexico, and the United States to this reduction in trade barriers, holding everything else the same. Instead, we have to look at data from before and after 1994 to try to infer the effects of NAFTA. But of course many other economic factors have also changed over this period. In parts of the United States where manufacturing jobs have been lost over the last 15 years, there is a tendency to hold NAFTA responsible. In fact, there is little evidence that NAFTA led to net job destruction.

What has happened over the last decade is that the US manufacturing sector has been exposed to increased competition from other countries, most notably China. It is this trade that has had a bigger impact on US manufacturing. At the same time, this has meant that NAFTA has been less of a success story for the Mexican economy than was predicted and hoped, as US consumers have purchased very cheap goods from China rather than Mexico.

Key Takeaways

  • In the United States, firms are able to close plants if they choose to do so. This is not the case in all countries.
  • The government promotes small businesses, viewing them as a source of job creation.
  • The reduction of trade barriers creates new jobs and destroys others.

Checking Your Understanding

  1. If plants, once opened, were never allowed to be closed, what would this do to the incentives of a firm to open a plant?
  2. In your college classes, what is the analogue of the statement that most firms have few workers, but most workers are employed by the large firm? Is it that most classes are small, but most students are in large classes?