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Thursday, 18 September 2008

In praise of larger and larger firms...

A new paper by La Porta and Shleifer sheds new light on the relationship between informality and economic development. It touches on many issues we have discussed here and reaches some very profound conclusions. Among them being that there appears little support for the romantic view of informal firms as drivers of economic growth or that increased “enforcement” leads to significant benefits to society. Rather the paper concludes that the best hope for economic development lies in the creation of large registered firms, run by ducated managers and utilizing modern practices, including modern technology, marketing, and finance. Key conclusions below:

Our most basic finding is that high productivity comes from formal firms, and in particular large formal firms. Productivity jumps sharply if we compare small formal firms to informal firms, and rises rapidly with the size of formal firms. To the extent that productivity growth is central to economic development, the formation and growth of formal firms is necessary for economic growth (see also Lewis 2004, Banerjee and Duflo 2005).

Formal firms appear to be very different animals than informal firms, which accounts
for their sharply superior productivity. Perhaps most importantly, they are run by much better educated managers. As a consequence, besides being larger, they tend to use more capital, have different customers, market their products, and use external finance to a greater extent than do the informal firms. There is no evidence that informal firms become formal as they grow. Rather, virtually none of the formal firms have ever been informal. It strains imagination, given the available evidence, that informal firms would sharply increase their productivity if only they registered.

Informal firms nonetheless play a crucial role in developing economies. They represent perhaps 30 or 40 percent of all activity. They provide livelihood to billions of poor people. Because these firms are so inefficient, taxing them or forcing them to comply with government regulations would likely put most of them out of business, with dire consequences for their employees and proprietors. If anything, strategies that keep these firms afloat and allow them to become more productive, such as microfinance, are probably desirable from the viewpoint of poverty alleviation. But these are not growth strategies in that turning unofficial firms into official ones is unlikely to generate substantial improvements in productivity.

Growth strategies, then, need to focus on formal firms, especially the larger ones. Surely reducing the costs of formality, such as the registration costs, are a good idea, but these seem to be a small part of the story. Likewise, some of the almost‐standard proposals for development, such as improving land rights, the legal environment, and even the human capital of the employees appear to be relatively minor factors, from the viewpoint of official entrepreneurs. The main obstacles to the operations of formal firms, according to our data, are four: 1) human capital of entrepreneurs, 2) taxation, 3) electricity, and 4) finance.

To us, the most striking finding is the sharply higher education of managers of official than unofficial firms, with no corresponding difference in the human capital of the employees. This might suggest that educational policies, particularly those emphasizing secondary education, might be conducive to the formation of entrepreneurial talent that can run formal firms. We do not mean to suggest that formal education is either a necessary or sufficient condition for entrepreneurial skills. But the data seem to be quite clear that some kinds of management (for example marketing or finance) require education. One can also think of other sources of human capital, such as immigration, as supplying the required entrepreneurial talent.

There is growing evidence that corporate income taxation deters investment and formal entrepreneurship. Using a new data set of corporate income taxes in a large number of countries, Djankov et al. (2008) find strong evidence that those taxes reduce investment, foreign direct investment, and entrepreneurial activity. Our evidence similarly shows that official firms perceive taxation as the top obstacle to doing business. To the extent that formation and growth of official firms are the principal engines of development, this perception must be taken seriously. Needless to say, one needs to also think about alternative sources of public finance, as well as the size of government, in the developing countries to figure out whether corporate income tax cuts are warranted. But the evidence points to a potentially serious problem.

The evidence suggests that official firms (just like the unofficial ones) perceive lack of access to finance to be a serious obstacle to doing business. Recent research has pointed to a broad range of legal and regulatory reforms that can underpin the development of financial markets, reforms that broadly seek to improve the legal rights of creditors and (in the case of very large firms) shareholders (see La Porta et al. 2008 for a survey). We should note, however, that although the evidence that connects good laws and regulation to financial development is quite compelling, the evidence that connects financial development to economic growth is not as strong. Having said this, unlike with tax cuts, there seem to be no compelling counterarguments to improving laws and institutions that underpin financial markets.

Finally, the evidence indicates that electricity supply, including disruptions, presents a problem for the unofficial as well as the smaller official firms. This compares to an interesting lack of concern with other limitations of infrastructure, such as transport, phone, or mail. Most large firms have their own generators, although smaller official firms, and the unofficial ones, do not and hence are more vulnerable.

The overall picture of economic development that emerges from this analysis is in some ways very similar to the traditional pre‐growth‐theory development economics, although it is related to the modern reformulations of economic growth through the lens of development economics (Banerjee and Dulfo 2005). The recipe for productivity growth is the formation of official firms, the larger and the more productive, the better. Such formation must perhaps be promoted through tax, human capital, infrastructure, and capital markets policies, very much along the lines of traditional dual economy theories. From the perspective of economic growth, we should not expect much from the unofficial economy, and its millions of entrepreneurs, except to hope that it disappears over time. This “Walmart” theory of economic development receives quite a bit of support from firm level data.


  1. The recipe for productivity growth is the formation of official firms, the larger and the more productive, the better.

    Formation from where, from what?

    Without hundreds of thousands of SMEs, where are these 'larger companies' going to come from? Are they going to be attracted wholesale from abroad? We all know how destabilising and reducing of sovereignty it is to have the majority of the economy run by foreign companies.

    We use three sets of surveys of both official and unofficial firms conducted recently by the World Bank. The first set of surveys, known as Enterprise Surveys, covers small, medium, and large registered firms in nearly 100 countries. We use these surveys largely for comparison. The second set of surveys, known as Informal Surveys, cover primarily unregistered, but also some registered, small firms in about a dozen countries. The third set of surveys, known as Micro
    Surveys, covers primarily registered, but also some unregistered, small firms in about a dozen mostly different countries. These surveys enable us to make comparative statements about size, inputs, management characteristics, and – in a rough way – productivity of both official and unofficial firms.

    So this doesn't involve a specific analysis of the informal economy in Zambia itself, let alone compare the Zambian informal sector with Zambia's official companies, or the presence of foreign corporations and their impact on Zambian indigenous business. Or why these productive foreign corporations need all these special benefits, which are not extended the 'informal sector', or any Zambian owned businesses - free trade zones, government loans, etc.

    We note from the start that the data we use have many problems, not the least because we focus on firms that are by definition avoiding government notice. One of our interests in this project is to understand how data collection can be improved. Nonetheless, our findings tend to favor the dual view over the romantic and the parasite views.

    I would much rather see people who are specialists in SME's giving their opinion about their role in the economy.

    The unofficial firms tend to be small and unproductive – compared even to the small but registered firms (which themselves are much less productive than larger registered firms). The unofficial firms use lower quality inputs and have less access to public goods and finance. Extremely few of the registered firms have ever operated as unregistered, again suggesting, as argued by Rauch (1991), that the two groups are very separate animals.

    At no time do they define what 'larger' or 'small' mean. Are they all SME's? Are they comparing micro-businesses to corporations? What does 'more productive' mean?

    And since when is 'productivity' the only measure of the value of the company? Retailers like Wal-Mart or others have very low profit margins - is that what they mean with 'less productive'?

    Their whole argument rests on two measures of productivity. So how do they measure productivity?

    We have two crude measures of productivity: (1) sales per employee; and (2) (gross) value added per employee, where (gross) value added is defined as sales net of expenditure on raw materials and energy.4

    So definition 1, sales per employee, would mean that if there are more sales and fewer employees, productivity is higher.

    How about another measure. What is the overall economic benefit of SMEs in providing: employment and on the job training to school leavers; the dissemination of business skills to more entrepreneurs; redistributing wealth across the population; providing experienced staff to larger enterprises; being suppliers to larger companies?

    I think this is more theory by economists on what businesses are good or bad.

    Let's hear from actual people with actual SME experience to see what they need.

    My point is that 'productivity' (either as measured as sales per employee or value added per employee) is not the final measure of economic and social benefit. As long as they make more money than they spend, they're ok with me. As an investor, fine, but for overall economic benefit, no.

    There is very little support for the romantic view, and indeed the differences in productivity between the formal and informal firms are so big that it is very hard to believe that the registration of unregistered firms will lead to large productivity gains.

    That would be, for instance, because simply registering firms is not enough. They need infrastructure, trained employees, marketing and all the other things that all companies need to do business.

    I would conclude with this point - in most industrialized countries, by far most people who are employed, are employed by SMEs - not corporations or government - fact, not theory. All these companies are registered, have access to educated employees because of universal education, etc. People who work for these companies are not poor, because of the legal minimum wage and because they have gained skills through education - they contribute more to their company, and as a result they earn more too.

    Investors and the economy do not have the same goals. Investors are basically looking for healthy companies that will do (much) better in the future. They're looking for companies with little debt, no competitors, and expanding market share.

    From the economy's point of view, it is more important that goods and services are created at competitive prices, that there is high employment and that people have so much income that they can buy all the goods and services they want.

  2. In the US, 50.7% of all employees are employed by companies with 499 employees or fewer: Table 2.a

    In Scotland, 97.9% of people are employed in businesses of between 0-49 employees. (See Table 1)

    Canada is more like the US, but still:

    (employees - number of businesses)

    0 to 19 - 2,950.4
    20 to 99 - 2,706.5
    100 to 499 - 2,157.1
    500 and over - 5,940.1

    Total: - 13,754.1

    Year: 2003

    So in canada too, most people (58.6%) are employed in companies with fewer than 500 employees.

    The average company in Canada employs 28 employees in 2005.


    The economic and social importance of the Small and medium enterprise (SME) sector is well recognized in academic literature.[1] It is also recognised that these actors in the economy are underserved, largely in terms of finance.[2] This has led to significant debate on methods to serve this sector. Small and medium enterprises or SMEs are companies whose headcount or turnover falls below certain limits. ...

    SME definitions - in the US, Medium Sized Enterprises are defined as (100 upto) 500 employees.


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