November 30, 2012 | Contribution by
MARY HALLWARD-DRIEMEIER Mary Hallward-Driemeier, Lead Economist, Office of the Chief Economist, World Bank Whereas much attention has been paid to small and medium enterprises in recent years, many new papers are now looking more closely at larger firm growth – and the productivity, wage, and employment benefits that can result. Indeed, this was one of the many topics at the recent LACEA-LAMES conference in Peru (Nov 1-3) and the IZA-World Bank Employment and Development Conference in India (Nov. 5-6), which brought together two of the largest gatherings of research economists working on development. The JKP was active in both conferences and will blog about some of the findings presented at these events (including interviews with some of the speakers). Today's blog highlights five working papers – all still works in progress - that look at questions of firm size and job creation. The papers argue from different perspectives that ignoring distortions that can keep firms from becoming large is costly. If the aim is to raise productivity and expand overall employment, the contribution of larger firms is critical.
Worker in factory, 2008. India. Photo: © Ray Witlin / World Bank
Bigger firms may offer bigger economic benefits We know that removing frictions to larger firm growth, particularly of productive ones, can significantly boost overall productivity and employment. After all, in most middle- and high-income countries, the majority of formal employment is in large firms. In addition, larger firms, on average, pay higher wages than smaller firms. This might be because larger firms may hire more skilled workers, use more sophisticated technology that raises productivity, or allow employees to gain more skills by working with a more diverse set of colleagues. How big is the employer size wage effect? Using matched employer-employee data for Brazil, Alessandro Casalecchi and Naercio Menezes-Filho examined the issue in Brazil. Unlike earlier studies they have an 8-year panel, enabling them to follow workers across multiple jobs. Not surprisingly, controlling for the three types of fixed effects (characteristics of the firms, workers, and the matching between them) soaks up most of the variation – but not all. Whereas in the raw data firms with 1,000 employees paid 65 percent more than firms with 5 or less employees, controlling for the fixed effects reduces the unexplained wage premium to 19 percent. If larger firms provide more and higher paying jobs, enabling firms to grow is all the more important. So which firms should we focus on? A paper by Hugo Hopehayn argues that the distortions that are likely to be disproportionately costly in terms of productivity and employment are those that keep more productive firms from growing. Rather than focus on distortions that simply move the entire size distribution down, he argues, focus on ones that skew the distribution such that firms with the greatest productivity potential are held back and are smaller than firms with lower productivity potential. Born large or born to grow The question of whether distortions affect the distribution of firms can also be looked at in terms of the growth dynamics of firms – and how they may vary for small and large firms. In my own work, I look at how large firms become large over time, whether they can start small and grow or do they need to begin as large firms. With more than 50 percent of all manufacturing workers in Chile employed in firms with 150 employees and more than 70 percent in Morocco, the dynamics of these large firms is a critical source of overall job creation. In both countries, the data show that for 10-year-old firms, 85 percent of them started as "large" – whether this is defined as more than 500 employees or even a lower cut-off of 150 or more employees. There is certainly more fluidity in size transitions lower down in the size distribution, but at the upper end, there does not appear to be nearly as much movement. That large firms can be born large could be understood as a lack of distortions, with firms able to access the needed capital and set up near their optimal scale. However, that relatively few firms expand significantly enough to join the group of large firms provides some concern about the reallocation process and the ability of more productive firms to grow. On-going work is examining how these processes of entry and firm growth by size vary with the degree of competition and between pre- and post- reform periods. Enabling "high end entrepreneurs" From the side of the entrepreneur, what helps predict who will be a "high end entrepreneur" - that is, those with greater potential to start a larger and more productive enterprise? Markus Poschke provides a theoretical model for choosing whether to be a worker or an entrepreneur (taking into account occupational choice, differences in workers' abilities, and an ex ante unknown productivity of start-up firms). He examines how institutions (particularly labor regulations, restrictions on entry, and taxes) not only affect the likely upside return to being an entrepreneur but also the relative costs of failure and thus the willingness to start a firm. His work helps explain why there can be relatively unproductive self-employed entrepreneurs earning less than wage workers, as well the trade-offs facing highly skilled potential entrepreneurs that affect the likelihood of larger enterprises being started. Proposed additional work includes calibrating the model to test how well it can predict the size distribution of firms in different countries. Julian Messina, Caglar Ozden, and Miguel Salcedo are also interested in understanding the potential for "high end entrepreneurs" empirically. They seek to tease out the differences between entrepreneurial characteristics and the business environment by comparing the size and productivity distributions of new firms in various Latin American countries with the firms begun by immigrants from these countries in the United States. The selection of who the migrants are is an issue the authors are working to address; patterns in age and education do vary both within and across countries of origin. What is striking is a repeated pattern of productivity where there are two peaks in the distribution: most firms are relatively low productivity, but there is a second, albeit smaller set of higher productivity firms that are established in most of the countries. Shedding light on how to expand the scope for these higher productivity enterprises could help policy makers in Latin America who are keen to (re)vitalize entrepreneurship in their own countries.