The Need for Large Firms in Developing Countries

The Need for Large Firms in Developing Countries

Timothy Taylor 28/10/2020 4
The Need for Large Firms in Developing Countries

The US economy had about 6 million firms in 2017 (the most recent data).

About 20,000 of those firms employed more than 500 people, and those 20,000 firms (about one-third of 1 percent of the total) accounted for 53% of all US employment by firms. Another 90,000 firms employed between 100 and 499 workers, and those 90,000 firms (about 1.5% of the total) accounted for another 14% of all US employment by firms. The job totals here don't take into account employment by the public sector and by nonprofits. But the point I'm making is that an important social function of firms is to coordinate production in a way that provides a bridge between workers and suppliers on one hand and the desires of customers on the other hand. In high-income economies, large firms coordinating the efforts of hundreds of workers play a major role in this activity. 

But many lower-income countries have only very small numbers of larger firms, which is one of the factor hindering their development. A group of World Bank researchers--Andrea Ciani, Marie Caitriona Hyland, Nona Karalashvili, Jennifer L. Keller, Alexandros Ragoussis, and Trang Thu Tran--address this topic in "Making It Big: Why Developing Countries Need More Large Firms" (September 2020). 

The available evidence on firm size, employment, and productivity in low- and middle-income countries is sometimes sketchy, so the report pulls together data, studies, and comparisons from a range of sources. The evidence strongly suggests benefits from large firms:

This report shows that large firms are different than other firms in low- and middle-income countries. They are significantly more likely to innovate, export, and offer training and are more likely to adopt international standards of quality. Their particularities are closely associated with productivity advantages—that is, their ability to lower the costs of production through economies of scale and scope but also to invest in quality and reach demand. Across low- and middle-income countries with available business census data, nearly 6 out of 10 large enterprises are also the most productive in their country and sector.

These distinct features of large firms translate into improved outcomes not only for their owners but also for their workers and for smaller enterprises in their value chains. Workers in large firms report, on average, 22 percent higher hourly wages in household and labor surveys from 32 low- and middle-income countries—a premium that rises considerably in lower-income contexts. That is partly because large firms attract better workers. But this is not the only reason: accounting for worker characteristics and nonpecuniary benefits, the large-firm wage premium remains close to 15 percent. Besides higher wages—which are strongly associated with higher productivity—large firms more frequently offer formal jobs, secure jobs, and nonpecuniary benefits such as health insurance that are fundamental for welfare in low- and middle-income countries. 

Using various measures, the authors argue that there is a pattern of a "truncated top" in the distribution of firm sizes in low- and middle-income countries. 

Smaller and lower-income markets tend to host smaller firms. But even in relative terms, there are too few larger firms in these countries relative to the size of the economy and the number of smaller firms—there is a “missing top.” In 2016, for example, for every 100 medium-size firms, more than 20 large firms were operating in the nonagricultural sector in the United States, as opposed to less than 9 in Indonesia—a lower-middle-income country with roughly the same population. A closer study of the firm-size distribution in country pairs suggests that what is missing are the larger of large firms—that is, those with 300+ employees—as well as the more productive and outward-oriented firms. ... The evidence suggests that larger firms employing more than 300 workers are systematically underrepresented in the lower-income countries under observation. In Ethiopia, for example, large firms have a 7-percentage-point lower share of employment than what is predicted by the optimal distribution, while in Indonesia, the gap is 4.6 percentage points, corresponding to a rough estimate of 230,000 missing jobs in manufacturing. 

Why are there fewer large firms than expected, and how might low- and middle-income countries generate more large firms? As the report points out, there are basically four ways in which a large firm forms: "foreign firms creating new affiliates, other large firms spinning off new ventures, governments, and entrepreneurs."

Given that the lack of large firms is the problem in the first place, spin-offs from existing large firms is not likely to address the problem. Having governments of low- and middle-income countries start large firms hasn't usually worked well. 

To fill the “missing top,” governments have often resorted to the creation of state-owned enterprises (SOEs). These firms rarely deliver the benefits one might expect from their scale. First, it has proven difficult to establish governance sufficiently independent of the state to operate in a commercial manner. SOEs often pursue a mix of social and commercial objectives, which are used to justify regulatory protection from competition. It is also difficult for governments to manage the conflict of interest that arises between exposing SOEs to competition, on the one hand, and the risk of job losses and changes in product offerings that come with this exposure, on the other. As a result, SOEs in lower-income economies rarely emulate the productivity and dynamism of privately owned firms: they are three times less likely to be the most productive firm in their country and sector.

The remaining options are to have foreign firms start a larger company, or to have domestic entrepreneurs build one. But many low-income countries have set up rules and regulations that make it hard for larger firms to operate. For example, there are often a set of taxes, regulations, and rules about employment and wages that only apply to firms larger than certain employment size--often set around 100 workers or in countries even less. Foreign firms are often blocked. There are often a variety of rules aimed at protecting small incumbent firms from competition, making it hard for larger firms to get a foothold. My own sense is that governments in low- and middle-income countries often tend to view large firms as an alternative power structure and (not without reason) as a threat to their own political power. For a detailed explanation of how this dynamic plays out in Mexico, a useful starting point is my post on "Mexico Misallocated" (January 24, 2019).

To put it another way, larger firms have some natural advantages in productivity, at least in certain contexts, but in many low- and middle-income countries, the sum total of government actions counterbalances and offsets that advantage. Thus, the World Bank researcher suggest that policies to encourage larger firms (and remember, we're only talking here about firms with 100 or few hundred employees, not giant global multinationals) mostly involve existing governments getting out of the way: 

In low-income countries, governments can achieve that objective with simple policy reorientations, such as breaking oligopolies, removing unnecessary restrictions to international trade and investment, and putting in place strong competition frameworks to prevent the abuse of market power. Opening markets to competition benefits entrants of all sizes. In practice, however, regulation is often designed for the benefit of large incumbents using statutory monopolies and oligopolies, preferential access to natural resources and government contracts, or barriers to foreign competitors that rarely enter at small scale in new markets. The entry of more large firms to compete with incumbents would aim to disperse power by any one firm. There is a long way to go in this regard: regulatory protection of incumbents in lower-middle-income countries is more than 60 percent greater, on average, than the level observed in high-income countries.

Beyond the entry point, operational costs associated with a range of government policies can greatly influence investors’ decisions to establish new, large firms. Large firms in low- and middle-income countries are significantly more likely than small firms to report customs operations, the court system, workforce skills, transportation, and telecommunications infrastructure as constraining their operations. Bread-and-butter reforms that aim to improve market regulation, trade processes, and tax regimes and to protect intellectual property rights stand to make a difference in that respect, even when these long-term reforms do not have large-firm creation as the objective.

The need for expanding employment into jobs with decent pay is a huge topic for many low- and middle-income countries of the world--from India and south Asia to sub-Saharan Africa, from China to the countries of the Middle East. That policy goal is not likely to be achievable without a surge in large firms in these countries. 

A version of this article first appeared on Conversable Economist

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  • James Sparrow

    Developing countries fail to create large firms because they can't expand regionally and internationally.

  • Dawn Hewitt

    China is creating large firms that will rule the world !!

  • James Sparrow

    Interesting piece

  • Gary Hawkings

    Infrastructure in many developing countries tends to be inadequate

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

   

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