Why Might We See Small Firms in Developing Countries?

Entrepreneurs and private firms play an integral role in the macroeconomic development of a country. Firm-size distributions typically differ markedly between developed and developing countries - with small and informal firms dominating the distributions in developing countries. There are many economic theories that try to explain this phenomenon; I am only going to focus on three in this post. The first theory suggests that small firms are disadvantaged in low-income countries, while the second suggests that large firms are disadvantaged. With a different focus, the last approach focuses on human capital differences between developed and developing countries and uses these to explain the firm-level differences.

The first explanation suggests that the institutional environment in developing countries disadvantages small firms and favours large firms. The most common version of this theory is based on the claim that small firms are credit constrained and large firms are not; small firms in developing countries would like to borrow a larger quantity of funds to expand their growth, but are unable to find a lender who is willing to lend to them. Household savings and loans from family often provide start-up capital, but micro-entrepreneurs typically experience shortages of capital within months of inception. This lack of finance also means that small firms are unlikely to be able to afford the cost of modern technologies, leading to the continued use of simple production technologies.

Furthermore, a non-financial constraint often cited is the poor state of infrastructure in developing countries. Roads, communication facilities and power access all tend to be relatively limited in developing countries and this affects the incentives of small firms. For example, irregular and expensive electricity disincentivises technological innovation and encourages the use of traditional, low-technology methods of production in small firms. Large firms are not impacted to the same extent by these constraints as they can often access credit to develop alternative solutions, such as installing energy generators. Overall, this theory suggests that institutional constraints in developing countries limit the growth and technological adoption of small firms, leading to a large number of small firms producing few goods with simple technologies.

The second theory contradicts the first and asserts that large firms are disfavoured in poor countries; consequently, small firms have no incentive to grow into larger firms. Whereas large firms have to comply with labour laws and regulations (such as age-restrictions and minimum wages), small firms can often evade these and procure labour at a lower rate than larger firms; for example, small firms can often attract very young, inexperienced and unskilled people through the apprenticeship system at low wages. Furthermore, small firms are frequently able to avoid other laws and regulations that large firms have to abide by; examples include providing retirement benefits, license fees, taxes and worker safety. Small firms are also often able to utilise family labour as a large part of their labour force; this allows them to overcome the principal-agent problem better and reduce supervision costs.

The third theory relies on structural differences in the labour force between rich and poor countries, specifically focusing on the skills distribution of the workforce. Lucas (1978) developed a model in which each individual has a unique “talent for managing” and chooses the size of their enterprise largely based on this ability. Workers with a better ability to manage firms will be able to employ more individuals without losing control over their workforce and will thus operate larger firms. In his model, Lucas (1978) considered managerial ability to be an endowment; however, it has been argued that this ability is a function of the level and quality of education. Due to poorly functioning education systems, developing countries often have low rates of secondary education and a scarcity of skilled technicians; this means that the distributions of managerial ability in these countries are likely to be further skewed to the right than those in developed countries. Consequently, many entrepreneurs in poor countries may wish to expand their firms but lack the knowledge and capabilities to run large organisations.

A related model, that also focuses on the effect of differing skills, is Michael Kremer’s O-ring model (1993). In this model, production processes require the completion of a series of tasks performed by different workers. A mistake in any one task reduces the product’s overall value, and mistakes in multiple tasks have multiplicative negative effects on the end value. This implies that, in poor countries with a large population of unskilled workers, firm owners are incentivised to keep their production processes simple and only hire a small number of workers to avoid large multiplicative effects of mistakes. Conversely, if there is an abundance of highly-skilled workers in the economy, who are less likely to make mistakes, firm owners can design complex production processes that hire a large number of workers; this is what we see in developed countries. Therefore, under this model, firm size and the complexity of production depend largely on the skill distribution in the country.

The three theories discussed above all give plausible explanations as to why we might expect to see firm distributions in developing countries being dominated by small firms using simple production technologies. However, to evaluate the extent to which the theories hold in different contexts, they should be applied to data. I will now discuss some of the applications of these theories that exist in literature.

A central prediction of the first theory is that the marginal returns to resources should be higher in small firms compared to large firms; if small firms are truly inhibited in their ability to obtain capital, they should have high marginal products for the capital that they do possess. Using a randomised experiment, De Mel, Woodruff and McKenzie (2008) tested this hypothesis on small firms in Sri-Lanka and found very high returns to capital – at least 60 percent increase in profits per year. Using agricultural data from southern Ghana, Urdy and Anagol (2006) also found high returns to capital in the informal sector; they estimated the real return to capital to be 60 percent. However, using firm data from Mexico, India and Indonesia, Hsieh and Olken (2014) find that the average product of capital is increasing with firm size; they argue that, if the average product of capital is proportional to the marginal product of capital (as it is in the Cobb-Douglas production function), this suggests that the marginal product of capital is lower in small firms relative to large firms.

To evaluate the second theory, Hsieh and Olken (2014) test whether the existence of a tax, or regulatory notch, that only affects firms above a certain size impacts the firm-size distribution. They argue that, if these regulations disincentivise small firms to expand, one might expect to find a bunching of firms just below the size determined by the regulation or tax, and a missing distribution of firms just above the threshold. In their paper, they examine the effect of three separate policies in Indonesia, Mexico and India and do not find any substantial discontinuities in firm size for any of the policies. Furthermore, with regards to the labour advantages, a national survey of informal enterprises in Burkina Faso found that apprentices constituted between 67-70 percent of all micro-enterprise employment; this suggests that small firms in the country may be reluctant to expand in the fear that they may lose their ability to hire cheap apprentices (Fidler and Webster, 1996).

Although managerial ability cannot be easily quantified, Gomes and Kuehn (2014) measure how differences in education endowments and public employment affect average firm size and productivity. Using data from Mexico and the United States of America, they find that education and public employment explains about 40-45% of the differences in average firm size, GDP per capita, and GDP per hour (a measure of productivity) between the two countries. Furthermore, Fidler and Webster (1996) identified that poorly developed business skills were a binding constraint to enterprise growth in West Africa - even more than lack of access to credit in many cases.

There are many different theoretical explanations that try to account for the differing firm characteristics seen in developed and developing countries. I have only focused on three in this post. It is important to note that these three theories do not necessarily operate in isolation; all three may apply and the extent to which each applies likely depends on the specific characteristics of a country and the individual firm.

*Disclaimer: This post is a reworked version of an essay that I submitted for my Master's programme at The University of Oxford.

References:

Banerjee, A. V. and Duflo, E. “Growth Theory Through the Lens of Development Economics”. Massachusetts Institute of Technology Department of Economics Working Paper Series: Working Paper 05-01.

De Mel, S., McKenzie, S. and Woodruff, M. (2008). “Returns to Capital in Microenterprises: Evidence from a Field Experiment”. Quarterly Journal of Economics, 123(4): 1329–72.

Fafchamps, M. (1994). “Industrial Structure and Microenterprises in Africa”. The Journal of Developing Areas 29(1):1-30.

Fidler, L. and Webster, R. P. (1996). “The Informal Sector and Microfinance Institutions in West Africa”. World Bank Regional and Sectoral Studies.

Gomes, P. and Kuehn, Z. (2014). “Human Capital and the Size Distribution of Firms”. Institute of Labor Economics Discussion Paper Series: Discussion Paper No. 8268.

Hsieh, C. and Olken, B. (2014). “The Missing “Missing” Middle”. Journal of Economic Perspectives 28(3):89-108.

Kremer, M. (1993). “The O-ring theory of economic development.” The Quarterly Journal of Economics 108(3): 551-575.

Kremer, M., Lee J., Robinson, J. Rostapshova, O. (2013). “Behavioral Biases and Firm Behavior: Evidence from Kenyan Retail Shops.” American Economic Review 103(3):362–68.

Krueger, A. O. (2013). “The Missing Middle.” Indian Council for Research On International Economic Relations, Working Paper Number 230.

Lucas, Jr., R. E. (1978): “On the Size Distribution of Business Firms”. Bell Journal 9:508-523.

Tybout, J. R. (2000). “Manufacturing Firms in Developing Countries: How Well Do They Do, And Why?”. Journal of Economic Literature 38(1): 11–44.

Udry C., and Anagol, S. (2006). “The Return to Capital in Ghana”. American Economic Review 96(2): 388–93.