Saturday, March 10, 2012

Small is not beautiful - at least for firms...

"Why small firms are less wonderful than you think" is the title of an article in a recent edition of The Economist. Although this is something of a straw-man (who says they're wonderful?), it makes the point that countries with greater bureaucratic burdens on firms, through strict labour laws and the like, tend to have smaller firm size. The implication is that having lots of small firms is not a sign of flourishing innovation and entrepreneurship (even if you need to be entrepreneurial to get around the bureaucracy), but more a sign of constraints to firm growth. Small, young firms may have the potential to hit success and grow, raising productivity, and expanding employment, but if they do not, and hang around as inefficient small firms, then the economy also stagnates.

Although the Economist article refers to developed economies, the point is closely related to a point made elsewhere (it is, for example, Ha-Joon Chang's Thing 15): basically that poor countries do not need more entrepreneurs, but less!

Developing country economies are of course full of one-man companies, traders, stall-owners, small-holders etc, and people eking out livings where you might least expect (like queue-waiting for a fee).
Of course there is always a discussion about whether they are in this job out of necessity or desire, with a related discussion on informality, but nonetheless these entrepreneurial people are often considered by donors to represent the kind of spirit that is required for greater economic development - promoting entrepreneurship as a pathway out of poverty through access to micro-credit, business training and all that. The thinking goes that if only these people could get some assistance they would be able to expand, create jobs, raise their own income, and contribute to more inclusive sustainable economic growth.

While the logic is appealing, as Chang points out, in developed economies very few of us are actually entrepreneurs and  willing to take the risk of setting up a business (least of all us economists!). Most of us are instead employees, working within institutions that provide all sorts of framework conditions that make us much more productive than we otherwise would be. Take any multi-millionaire businessman from the North and drop him in the middle of Africa - do you really think that person is going to emerge with another million? It seems highly unlikely without relying to some degree on external institutions.

So what is missing in developing countries is not more entrepreneurs, but greater organisational frameworks, both in the form of institutional rules, and corporate structures. The impact of weak institutions of rule of law etc is broadly recognised in developing countries. But on the corporate side, if the blend of rules and weak institutions leads to discrimination against large firms, then clearly there is a disencentive to becoming a larger firm and therefore achieving the economies of scale and organisational structures to raise productivity and employment.

While the Economist article mentions employment laws for the cases of Greece and Portugal, tax policy may also be an important culprit in many developing countries - small companies stay below the radar to escape tax inspector attention, while larger firms are easy targets (while very large firms are likely to be large enough to negotiate specific tax incentives).

But that may not be the only factor. John Sutton raises the point that the skills required to run a successful large firm are quite different to those you need to work by yourself or with a single employee (discussed in an earlier posts here). He refers to his finding that most medium sized firms in Ethiopia and Tanzania emerge from other medium sized firms, not from successful small firms that grow.  They are the ones capable of negotiating the market conditions, testing markets, and building on existing experience from operating in that market.

Together, these insights simply further confirm that we need to "improve the business environment". But is this really the answer? Although it would theoretically remove the disencentive to larger firm size, and although removing red-tape is apparently relatively easy, given that countries such as Rwanda appear to have managed successfully with a bit of concentration, there is another aspect to take into account.

In another very interesting paper, Pritchett and Hallward-Driemeier compare Doing Business data with reported data from enterprises on certain business procedures, such as the time taken to get a construction permit. They find enormous differences in the average "de facto" conditions  compared to the "de jure" estimate from Doing Business estimates. While that in itself is indicative that firms do find a way around regulations, they also find enormous dispersion in the "de fact" conditions. That is, some firms manage to get things done very quickly, while others take a lot longer, presumably depending on their networks, ability to bribe and other hard-to-observe factors.

So actually, the "de jure" investment climate that we focus on for improving the business environment is actually not that experienced by ALL firms. Therefore, those who have gained the management skills and market share within the existing environment may not be particularly keen on making life easier for new entrants. And if certain politicians happen to be businessmen themselves, like some presidents, then the scope for change is further reduced.

So where does this leave us for trying to promote firm growth and productivity. Well,  Pritchett highlights that it means that the outcome of de-jure reforms is actually quite unpredictable, depending very much on who and what kinds of companies are anyway subject to these. But further, it may explain why it appears to be so hard to bring about these kinds of business reforms in some countries.

In some ways that leaves us with trying to work on those reforms that receive least resistance from the political and business elites - indeed, Sutton's proposal is to work on "doable" reforms, if you can recognise them (Pritchett may be able to help there also - see last post here). But maybe it just takes us back to trying to head in the long-term for stronger institutions.  That may take a while...

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