micro and small enterprises: unexplored … amap mses unexpect… · the development of the micro...

MICRO AND SMALL ENTERPRISES: UNEXPLORED PATHWAYS TO GROWTH microREPORT #63

JUNE 2006

This publication was produced for review by the United States Agency for International Development. It was prepared by the IRIS Center, at the University of Maryland.

MICRO AND SMALL ENTERPRISES: UNEXPLORED PATHWAYS TO GROWTH microREPORT #63

DISCLAIMER

The author’s views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government.

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The IRIS Center, University Research Corporation International

SUBMITTED TO

Scott Kleinberg, CTO (USAID/EGAT/MD)

CONTRACT NUMBER

GEG-1-00-02-00029-00 Task Order #5

ACKNOWLEDGMENTS

This paper was written by Dr. Meghana Ayyagari, Assistant Professor of the School of Business, George Washington University and Dr. Vojislav Maksimovic, Professor of the School of Business at the University of Maryland College Park. IRIS expresses its appreciation to the authors for the innovative research and analysis they undertook to produce this paper.

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IRIS Center University of Maryland Department of Economics 2105 Morrill Hall College Park, MD 20742 USA

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ABSTRACT

This paper argues that Micro and Small Enterprises (MSEs) play a complex and integrated role within the development process. This point is often overlooked in the current literature, which suggests MSEs’ main contributions relate to employment generation only. The paper suggests that MSEs perform unique roles that can also include issues of competition, human capital development, and the creation of a financial system. This paper identifies three key pathways to growth for MSEs: innovation and entrepreneurship, economic dynamism, and linkages with large firms.

KEY WORDS

Micro and small enterprise; employment generation; innovation; entrepreneurship; economic dynamism; growth

CONTENTS

INTRODUCTION................................................................ 5

1. Literature Review .......................................................................... 7

2. Theory of the Firm and Small Enterprises ................................ 10

3. Pathways to Growth: How Small Firms Benefit the Economy ........................................................................................... 12

4. Elaboration of key themes .......................................................... 14

5. Review of types of research that may be useful ........................ 17

Conclusion ........................................................................................ 20

TABLES & FIGURES ......................................................... 22

APPENDIX A...................................................................... 26

REFERENCES ..................................................................... 28

INTRODUCTION Over the last decade, the international community has channeled a large and growing amount of aid into subsidizing micro and small enterprises (MSEs) under the premise that MSEs play a critical role in addressing both poverty reduction and economic growth goals. MSE proponents argue that healthy economies require a balanced distribution of firms of varying sizes playing complementary roles and a large MSE sector is important for job creation and poverty alleviation. In contrast, recent academic literature has questioned the emphasis on micro and small firms vis-à-vis large firms (Biggs, 2002) and has challenged the pro-MSE approach by arguing that there is no causal link between MSEs and GDP per capita growth (Beck, Demirgüç-Kunt and Levine, 2005). These two perspectives have widely differing policy prescriptions with respect to donor programs targeted towards the MSE sector.

The purpose of this paper is to reframe the debate about MSEs and growth by analyzing the different avenues through which MSEs may contribute to economic growth and poverty reduction in developing countries and to survey the empirical evidence in support of (or against) the proposed avenues. Specifically we ask the following questions:

1. What are the different pathways to growth for micro and small enterprises?

2. What is the impact of institutions and the business environment on the different pathways to growth for micro and small enterprises?

3. What are the implications of the different ways in which micro enterprises contribute to growth, for both the necessity of intervention and the metric for measuring the success of intervention programs?

To address these questions we review the recent literature in industrial organization and corporate finance. Based on this literature we distinguish three pathways to growth by which MSEs can significantly impact economic growth.

The paper argues that micro and small enterprises play a complex and integrated role in development that is missed by the narrow conceptualization of the role of MSEs in the current literature as contributing mainly to employment generation. MSEs play a unique role that goes beyond employment generation, related to issues of competition, human capital development, and creation of a financial system. In particular, the paper identifies three key pathways to growth for MSEs: innovation and entrepreneurship, economic dynamism, and linkages with large firms. These key pathways hold the most potential for further research and aid focus.

First, small firms, especially young ones make vital contributions to innovation and entrepreneurship in an economy. A huge body of evidence shows that small firms are more advantaged than large firms in leading innovation since they face lesser bureaucratic constraints and are willing to invest in narrow detailed inventions that may be too modest for giant corporations. Further, recent survey evidence from Russia suggests that the most important determinant of entrepreneurship is family ties and social networks, the kind that is fostered by micro enterprises.

Second, micro and small enterprises add dynamism and flexibility to the economy by way of new firm formation, contribution to competitive forces resulting in higher efficiency and by faster and less expensive adjustments to economic shocks. While entrepreneurship was once just thought of as a by-product of the

MICRO AND SMALL ENTERPRISES: UNEXPLORED PATHWAYS TO GROWTH 5

development process, recent literature in industrial organization has positioned entrepreneurship and the creation of new firms as key engines of economic growth.

Third, MSEs contribute to economic and social change via their linkages with large firms. By forming alliances, clusters and networks, small firms are able to compete, grow and cooperate with large firms thus enabling the firms to link up with larger producers and break into national and global markets. There is further evidence of this linkage in the use of trade credit where large firms in an industry provide capital to new, smaller firms who may be suppliers of materials, components or services or may be just new firms that are offering innovative products.

Empirical evidence suggests that the extent to which MSEs can fully realize their potential along the different pathways is crucially dependent on the general business environment in which they operate and in particular, on the financing they receive. There is a significant body of literature pointing to market failures constraining the development of the micro and small enterprise sector in low-income and transition countries. Asymmetric information, one of the main causes of market failure investigated in the economics literature, creates adverse selection and moral hazard problems causing lenders to ration certain borrowers. Empirical evidence indicates that it is the information sensitive micro and small enterprises that are most hurt by credit rationing, leading even high quality MSEs to under invest. Hence, despite the existence of development banks, venture capital, secondary capital markets and an active financial sector in low income and transition countries, there may be a need for intervention programs and aid providers, focused on improving access to finance for micro and small enterprises.

The paper also discusses how MSEs are affected by the regulatory costs associated with doing business in different countries. For instance, specific regulations related to starting a business, closing a business, registering property, labor regulations, contract enforcement and investor protection could either enhance or constrain productivity and growth of micro and small enterprises. In some instances, the costs of formalization itself may be too high, providing disincentives for micro and small enterprises to grow and expand into medium enterprises. In the presence of poor institutions and regulations, it may become necessary for aid agencies to even the playing field for MSEs.

The extensive literature on MSEs and growth is reviewed in the next section. This paper makes two main contributions to the existing literature: First, although several of these papers investigate different channels through which MSEs impact development, they generally focus on a narrow subset of the different pathways to growth faced by MSEs. Our paper identifies an exhaustive set of the different pathways and provides supporting anecdotal and empirical evidence, or the lack there of, in each case. The paper draws from a wealth of empirical research in other fields of study like finance, economics and industrial organization and elaborates on implications for the MSE-growth debate.

In particular, the paper shows that there is need for more research on how effective each of these pathways to growth are and the main constraints facing MSEs along these pathways to growth. While the recent study by Beck, Demirgüç-Kunt, and Levine (2005) examining the causal linkages between small and medium enterprises’ contribution to employment and overall economic growth is provocative research, we still do not know much about MSEs’ pathways to growth.

Secondly, the paper places emphasis on three key pathways to growth that exhibit the most potential for reform priorities – innovation, dynamism and small-large firm linkages. The breadth of the many pathways presented in section 3 of the paper, while important in their own right, may have limited policy prescriptions.


Even if MSE performance is likely to benefit from improvements in the enabling environment along each of the pathways, addressing all of them at once would be challenging for any government or aid agency. The paper argues that intervention along the primary pathways identified is bound to have the biggest impact on growth and development.

The remainder of the paper is organized as follows: Section 1 discusses the current literature and our analysis of the missing pieces in the MSE-growth debate. Section 2 presents a theory of the firm exploring advantages of small and large firms. Section 3 details the different ways in which MSEs can benefit the economy with a detailed discussion of the three key pathways in section 4- entrepreneurship, new firm creation and business dynamics and MSE-large firm linkages. Section 5 points to possible future research in this area and section 6 concludes the discussion.

1. LITERATURE REVIEW This section reviews the theories and existing microeconomic evidence on whether the micro and small enterprise sector contributes to economic growth and poverty alleviation.

Most proponents of MSE development argue that these enterprises play a crucial role in driving economic growth in both developing and developed countries through their job creation potential. Most new jobs in the economy are created in the MSE sector with many of these jobs being taken by poor, semi-skilled or unskilled workers. Hence, MSE development has been a critical component of poverty reduction strategies. Other theories allude to MSEs being more productive than large firms and their role as the seedbed of innovation, entrepreneurship and dynamism in an economy. However for each of the theories in support of MSEs, there are also several papers taking the opposing viewpoint. See Hallberg (2001) and Biggs (2002) for an extensive review of the literature in support of and against subsidizing small and medium enterprises. Appendix A of this paper summarizes some of this evidence.

This debate is further complicated by the lack of sufficient and consistent data at both the country level and firm level to do a detailed analysis of the impact evaluation of MSEs. Most existing studies are single country-focused or cover mainly developed countries, thus limiting the conclusions that can be drawn from these studies, to low-income and transition economies. Further, different countries adopt different criteria - such as employment, sales or investment - for defining micro and small enterprises. In addition, even the definition of an MSE on the basis of a specific criterion, is not uniform across countries.

Despite these data challenges, Beck, Demirgüç-Kunt, and Levine (2005) is one of the first papers that makes a serious attempt to investigate the importance of the small and medium enterprise (SME) sector for GDP per capita growth and poverty reduction. The paper uses a new cross-country database from Ayyagari, Beck, and Demirgüç-Kunt (2004) that presents comparable information on the contribution of the SME sector to total employment in manufacturing and GDP across different countries. Beck, Demirgüç-Kunt, and Levine (2005) conclude that while there is a strong correlation between growth and the proportion of small and medium firms, there is no causal link between SME intensity and GDP per capita growth.

The finding that there is a correlation, but no causal link rests on the finding that the coefficient of the size of the SME variable in the cross-country regression of GDP growth on the size of the SME sector loses significance when instrumental variables are used to correct for potential simultaneity. The validity of that result rests heavily on the maintained hypotheses that the instrumental variables used perform adequately. However, the choice of instrumental variables in general and their validity in a particular application is a matter of ongoing research in econometrics and is open to differing interpretations.


The absence of a causal link in Beck, Demirgüç-Kunt, and Levine (2005) could also be due to the different data limitations in their paper that also affects the existing literature on SMEs. First, the data set uses a firm size of 250 workers as the cut-off for an SME (micro enterprises are not a part of this dataset) and considers only the formal labor force in the manufacturing sector. In many low income and transition economies, the cut-off of 250 workers may be too large to effectively capture the impact of micro and small enterprises, most of which operate in the non-manufacturing and informal sectors. Most studies, including the paper by Beck, Demirgüç-Kunt, and Levine (2005) do not count agriculture and farm based enterprises as part of the MSE/SME sector even though in most developing countries, farms, which are family owned are counted as micro enterprises. Related to this is the issue of land rights, tenure rights and property rights in general, which is not touched upon by existing literature. Further, most data on MSEs is biased because of its similar treatment of independent small firms and small firms that are part of huge conglomerates.

More fundamentally, the research methodology adopted by Beck, Demirgüç-Kunt, and Levine (2005) and others takes a static, “snapshot’ approach relating the size of the SME sector to economic performance. However, the size distribution of firms in an economy evolves over time and is determined by various factors such as market structure, economic development, transaction costs and economies of scale. Every economy is therefore characterized by an equilibrium distribution of firm sizes rather than an ideal distribution, and hence we would argue that it is not evident that the size of the SME sector is the correct measure to capture the contribution of small and medium enterprises. To take an extreme example, if one was to gauge the importance of SMEs in the high-technology sector in the US using a static approach, one would conclude that large firms like Microsoft and Apple are the principal wealth creators while start-ups are a net drain on resources. However, this static approach neglects the fact that the present success of Microsoft and Apple is based on their initial success as SMEs. To estimate this effect one would have to relate economic growth to the dynamism and characteristics of the SME sector, rather than its size as is done in current research.

It is also possible that the SME sector has a non-linear relation depending on the level of economic development but there are no such interactions of the SME sector with economic development in the Beck, Demirgüç-Kunt, and Levine (2005) study to capture any existing non-linearities. Further, although the dataset used in the study is over a period of ten years from 1990 to 2000, very few countries have contiguous time series observations and hence the study does not examine firm dynamics by way of firm entry and exit which could influence the net job creation by the MSE sector in any given year.

An even bigger issue rests with the way the question is posed - suppose some small firms are extremely efficient and grow to become medium and large sized firms, then by definition, the efficient small firms stop being small and therefore don’t get counted in a static analysis. Hence it is not apparent from the aggregate measures of size of the SME sector used in the study whether a large SME sector reflects (i) a dynamic economy with the entry of many new enterprises over and above the exits and growth of successful SMEs into larger enterprises or (ii) a stagnant economy with stifling regulations that prevent entry and exit, and provides incentives for firms to stay small.

Finally, from a policy perspective, the relation between size and macro performance (GDP per capita growth) is a relation between two endogenous variables and does not per se have implications for how we should affect interventions. The absence of a relation in past natural data does not logically imply that an intervention does not work. To use an analogy from medicine, the absence of a documented relation between eating penicillin bacteria and getting well in patients prior to 1940 does not mean that antibiotics don’t work.


Several of the issues discussed above can be demonstrated using available US data. Table I shows the percentage of employees in US industries employed by firms of different sizes for the year 2002, derived using data from the Small Business Administration (SBA). In the manufacturing sector, only nine percent of the total numbers of workers are employed by firms with twenty employees or fewer. The percentage of total industry shipments by such firms is likely to be even lower.1 As a result, it is highly unlikely that moderate differences in the growth rates of very small and larger firms are going to show up strongly in manufacturing data. Overall the data suggests the manufacturing sector is unlikely to yield interesting cross-sectional results linking growth to output where as a static cross-sectional approach applied to agriculture or the service sector might yield more interesting results.

The importance of viewing industry growth dynamically is illustrated by Klepper and Grady (1990), again using US data. They argue that new industries typically go through three stages: an initial growth stage (Stage 1), a shakeout during which only the strongest firms survive (Stage 2) and a stable period (Stage 3). Their study of industry dynamism has implications for how one can think about the contribution of the MSE sector.

Adapting their classification for our purposes, it is likely that small firms will play a significant role in industry growth in Stage 1. However, for most of that period the industry is likely to be relatively small. Thus, it is unlikely that the role of small firms would be captured by the growth rate of GDP per capita. Many of the small firms exit in Stage 2. The industry is most likely to make a significant contribution to GDP per capita in Stage 3, when it is bigger and when most of the producers are large. However, the competition between small producers that occurs earlier is important for economic efficiency because it allows the selection of the strongest producers. A static cross-sectional approach will miss this important contribution of the MSE sector.

The magnitude of the sorting in manufacturing is illustrated in Table 2 from Klepper and Grady (1990). On average, 50% of the producers exit in a shakeout, even in the US, a large market. Since the economic significance of encouraging entry of small firms in manufacturing industries is likely to differ across stages of the industry life-cycle, it is hard to draw any conclusions from studies that do not control for industry stage.

Further evidence comes from historical data on the evolution of significant US industries, such as automobile manufacturing, the tire industry and the manufacture of radios. Although we now associate these industries with large multi-national corporations, in the early years of the 20th century they were populated by many small producers. The overwhelming majority of the small firms failed or sold out to more successful rivals. Klepper (2004) and Barnstorm and Klepper (2005) have gathered data on the small producers in these industries and have studied the characteristics of the survivors. They conclude that the resources available to the producers at the time of start-up significantly determined their failure rate over time, in some cases years after the start-up. Specifically, they find that larger start-ups and start-ups by entrepreneurs who had already held senior positions in established firms in their industries had a much greater probability of long-term survival. Thus, for example, using historical county level records on locations of start-ups in the nascent early 20th century US tire industry, Barnstorm and Klepper argue that the quality and experience of

1 Using Census data, Maksimovic and Phillips (2001, 2002) provide evidence that larger plants are more productive than smaller plants in US manufacturing.


the initial management team overwhelms any locational advantages or economies of the entrants, such as being located near potential purchasers.

At face value, these historical studies suggest that only a limited sub-set of small firms can be expected to survive in the long term and generate significant growth for their economies. There may be considerable value to mechanisms that identify such firms early and we may already have them in place. We believe that a more nuanced conclusion might be that even the firms that subsequently fail contribute to the creation of human capital and supplier/customer relationships that can afterwards be profitably redeployed to surviving firms or elsewhere in the economy. The value of such redeployed assets is yet to be quantified.

2. THEORY OF THE FIRM AND SMALL ENTERPRISES According to the Coasian view of the firm, the firm is an alternative to the market which coordinates activities that would be too costly to coordinate by relying on market transactions within a single organization. Therefore, the optimal size of the firm is determined by the nature and magnitude of transaction costs in the markets in which it operates. Recent industrial organization literature has shown that the size of an individual firm is an endogenous choice given the business environment, market structure, economies of scale, demand and competition, and knowledge of the entrepreneur. Thus, rather than an ideal or optimal size distribution of firms, there is an “equilibrium” size structure in each industry and economy, and the factors that condition it can be influenced by policy. Given this, economic theory suggests that there are two main rationales in the literature for why micro and small enterprises need to be supported: market imperfections and institutional failures.

First, the most widely cited market imperfection is capital market failure2 where the formal financial sector discriminates against MSEs compared to large firms. The underlying sources of market failure are moral hazard and adverse selection problems stemming from information asymmetry. Micro and small enterprises have a higher exit rate compared to large firms and hence face credit rationing in both developed (Fazzari, Hubbard and Peterson 1988), and developing countries (Tybout 1984 for Latin America; Biggs et al. 1996 for Africa, World Bank 1993 for Asia). MSEs are the first to be denied access to the market because of information and enforcement problems. Even the MSEs that have access to loans are charged a very high interest rate, compounding the adverse selection problem since only high risk entrepreneurs are willing to take on high cost debt. In other cases, lack of financing may just be the result of a non-existent market.

Further, markets do not function in vacuum. They are strongly influenced by legal, political, economic and socio-cultural institutions in the country. In the absence of good institutions, the transaction costs associated with market exchanges increases dramatically. Empirical evidence indicates that it is the micro and small enterprises that are disproportionately disadvantaged by the failure of institutions to enforce property rights and business contracts.

While the MSE literature has focused on the presence of market imperfections, few studies bring to bear the implications of studies in the industrial organization and institutions literature for MSEs. First it has been

2 Other types of market failures include labor market distortions and market failures in training, education and health. In each of these instances, MSE entrepreneurs are disadvantaged vis-à-vis large firms.


shown that large firms are better able to cope with market imperfections and institutional failures. While large firms are able to devise their own private institutions to an extent, such as business group structures, MSEs are not able to do the same because of the economies of scale involved in building private institutions. There is also ample evidence that large corporations operate an internal capital market, redistributing capital between their divisions [e.g., Lamont (1997) and Shin and Stulz (1998)]. Thus, large firms are able to internalize many of the capital allocation functions carried out by financial intermediaries and financial markets unlike micro and small enterprises. The presence of business groups and conglomerates and pyramidal ownership structures, which Almeida and Wolfenzon (2005) argue are attractive when external financing is costly, further makes it harder for MSEs to raise finance and thus inhibits their growth.

In a recent study using firm-level data, Beck, Demirgüç-Kunt, and Maksimovic (2005a) investigate to what extent small firms face greater obstacles than large firms. This study is particularly pertinent because it is based on the World Business Environment Survey (WBES), a major cross-sectional firm level survey conducted in developed and developing countries in 1999 and led by the World Bank.3 The survey asks very detailed questions that permit analysis beyond earlier papers that derive estimates of financing constraints using firms’ financial statements. The firms that were surveyed reported how their growth was constrained by specific features of the financial and legal systems in their countries and the corruption they faced. Thus, it is possible to distinguish (a) the magnitude of different types of constraints faced by firms in different financial and legal systems, and (b) whether these constraints in fact do affect firm growth. Unlike many previous studies that have mainly looked at large, listed firms, approximately eighty percent of the surveyed firms in this survey are SMEs.

Beck, Demirgüç-Kunt and Maksimovic (2005a) find unambiguously that small and medium firms not only face greater financial, legal and corruption obstacles compared to large firms, but also stand to benefit the most from improvements in financial development and a reduction in corruption. This finding has potentially important implications for the analysis of the role of MSEs in developing economies. If larger firms are less affected by imperfections in the business environment, then they may have a comparative advantage in delivering growth in poor environments. However, the evidence on this point is not clear-cut. In a cross-country study of very large firms, Beck, Demirgüç-Kunt, and Maksimovic (2005b) find no evidence of association between poor business environments and the size of the largest firms in a country. Such an association would be expected if the largest firms had a comparative advantage.4

More broadly, given that our focus is on developing countries, one can ask to what extent the problem of supporting growth can be cast as one of improving financing opportunities to firms in developing countries. Recent literature points to a number of factors as obstacles to growth. Inefficient functioning of financial markets, inadequate security and enforcement of property rights, poor provision of infrastructure, inefficient regulation and taxation, and broader governance features such as corruption and macroeconomic stability are all discussed. However, there is little evidence on their relative importance. Ayyagari, Demirgüç-Kunt, and Maksimovic (2005) use WBES data to evaluate the relative importance of a broad range of potential imperfections in the business environment on firm growth. They correlate firms’ growth rates with their reports of the institutional and infrastructure obstacles they face in the operation of their businesses. Since

3 The referenced study used data from over 4,000 firms in 54 countries. 4 It is also possible that such a comparative advantage does exist, but that firms in poor business environments are unable to realize their optimal size.


firms in poor institutional environments face more obstacles of all kinds, the challenge in this type of research is to statistically disentangle the effect of each obstacle. Moreover, some obstacles might affect firm growth only indirectly through their influence on other obstacles faced by firms. Thus, this type of research calls for a great deal of robustness testing of conclusions.

Ayyagari, Demirgüç-Kunt, and Maksimovic (2005) find that although firms report many obstacles to growth, not all the obstacles are equally constraining. They find that obstacles related to Finance, Crime and Political Instability directly affect the growth rate of firms. Robustness tests further show that the Finance result is the most robust of the three. These results have important policy implications for the priority of aid to firms. The results suggest that maintaining political stability, keeping crime under control, and finding mechanisms to relax financing constraints are likely to be the most effective routes to promote firm growth, and in particular MSE growth.

The empirical evidence surveyed above on market frictions and institutional failures again suggest that the size of the MSE sector is not an accurate depiction of the importance of the MSE sector to growth and development highlighting the need for an alternative framework to think about the contribution of MSEs.

3. PATHWAYS TO GROWTH: HOW SMALL FIRMS BENEFIT THE ECONOMY In this section, we briefly outline the different ways in which small firms can contribute to the overall economy. While previous literature has focused predominantly on the job creation aspect of MSEs, there are several unexplored pathways to growth that could be just as equally important, if not more important, than looking at direct contributions of the SME sector to macroeconomic growth.

We classify the different pathways to growth into primary and secondary pathways. The primary pathways to growth are the avenues through which micro and small enterprises have the most direct and biggest impact on growth. These include the role of the MSE sector in promoting entrepreneurship, dynamism and creation of linkages with large firms, and are discussed in detail in Section 4. The secondary pathways are the indirect channels through which MSEs may contribute to overall economic growth and may be broadly categorized into human capital improvement, financing, rural development, and contributions to other industry sectors. This section is meant to lay out the different pathways to growth for MSEs and is not meant to be a literature survey of the evidence for or against each of the pathways. Figure 1 presents the different pathways to growth in schematic form. The primary pathways to growth include:

Innovation and Entrepreneurship. Micro and small enterprises are considered to be the engines of innovation and entrepreneurship in many countries. It is argued that MSEs often follow niche strategies and use their flexibility to experiment with high product quality and greater responsiveness to customer needs, and are thus instrumental in bringing innovations to the marketplace. Recent work by Djankov et al (2005) also shows that in countries like Russia and China, most entrepreneurs come from family owned micro and small enterprises that rely on experience and family ties to become successful.

Dynamism. It is now widely accepted that most new plants and firms begin on a small scale (Acs and Audretsch, 1991). Therefore, MSEs play a vital role in new firm creation and overall firm dynamism. The rate of formation of new firms varies according to industry life cycles even in countries with good institutions and so does the role of MSEs in an economy. Further, MSEs are crucial for studying the evolution of industries since many industries see an early build-up in the number of enterprises followed by a shake-out.


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Linkages with Large Firms. A huge determinant of the entrepreneurial development and overall economic success of a region is the effectiveness with which MSEs can interface with large firms or with other small firms. These linkages compensate for the shortcomings and constraints facing micro and small enterprises and are essential for the progression of MSEs into medium and large companies. With increased globalization and the changing role of the private sector in economic and industrial development, the formation of TNC-MSE linkages and the insertion of MSEs into global value chains are essential for the development of the MSE sector and the economy as a whole.

The primary pathways to growth mentioned above are elaborated in detail in the following section. While these are the most direct and key pathways along which MSE influence can be seen, MSEs could also influence growth and development through several other channels. Below, we briefly review the secondary pathways to growth:

Human Capital. MSEs contribute to the development of human capital in several different ways: (i) Employment generation: MSEs employ a significant share of the active workforce in OECD countries. In addition, small firms are believed to create jobs at a faster rate and are considered to be more labor intensive and thus better suited to economies characterized by abundant unskilled labor and shortage of capital. (ii) Poverty Alleviation: MSE development is often seen as a critical component of pro-poor growth strategies. MSEs generate many of the new jobs that are suitable for semi-skilled and unskilled workers and hence can be taken up by the poor. Further, MSEs help restructure weak uncompetitive sectors, thereby absorbing labor that would otherwise drop into the ranks of the poor. In addition, if SME promotion increases growth, faster growth itself promotes poverty reduction since growth has been shown to be good for the poor (Dollar and Kraay, 2002). (iii) Train ng and Experience: MSEs employ a large section of the unskilled labor force and provide them with formal training thus increasing the overall quality and skill level of the labor pool in the country. The experience gained with the MSE, benefits the employees even after they leave the micro-enterprises to accept employment in larger enterprises, by way of increased salaries. (iv) Soc al Benefits: MSE employment could also have significant positive indirect effects on human capital. It seems plausible that households running MSEs have a higher propensity to send their kids to school, to provide better nutrition and to pay for medical services. More broadly, employment of women in MSEs can have a significant impact on overall household welfare. The development microeconomics literature has argued that a much larger fraction of an extra dollar earned by a mother goes to improving children’s heath and education than that of an extra dollar earned by the father. (v) Rise of the Middle Class: MSEs may be an indispensable base for the creation of a middle class and all the economic benefits this generates.

Financing. Micro and small enterprises play key roles in access to finance issues both at the micro level and macro level: (i) Internal Financing: MSEs are a source of cash for investment to individuals who would not have access to the formal financial system. The presence of capital market imperfections in most developing financial systems emphasizes the importance of internal finance thus allowing MSEs to play an important role in improving access to finance for small entrepreneurs. This was seen in the example of the success of the East Asian tigers financed largely by Chinese businessmen. In particular, Chinese businessmen in Hong Kong and Singapore, with ample capital but very restricted building space and labor supplies, wanting to hedge their bets and diversify, went to Thailand and Indonesia to invest in productive facilities thus contributing to the economic success of these regions. (ii) Role in Promoting the Creation of a Financial System: More broadly, at the macro level, MSEs serve as an important source of capital creation, asset accumulation, and domestic investment. Consistent with the historical process of structural transformation, off-farm MSEs are also an important means by which surplus agricultural labor is absorbed in an expanding economy.


Rural or Regional Development. MSEs provide services outside of regional or district capitals, to areas that are marginally less profitable for larger merchants and hence tend to be ignored. The MSEs help integrate a significant percentage of developing country societies into the national economy than would otherwise be the case. This is particularly the case with regards to internal and cross-border trade. Small-scale traders are the vital links in matching supply and demand in developing countries. In the process, they help expand the market, reduce prices for rural households (creating a direct income benefit), and reduce transaction costs.

Contributions to Other Industry Sectors. MSEs are vital contributors to the growth and development of non-manufacturing sectors: (i) Indispensable for Service Sector: The service sector is widely recognized for its decentralized and individualized nature – e.g. hair cuts, shoe repair, housing repairs. This seems to be particularly the case in developing economies where the contributions of mechanics, carpenters, tailors, family-run pharmacies provide crucial linchpins for the sustenance of most other economic activities. Most of this sector is serviced entirely by micro and small enterprises. (ii) Marketing of Agricultural Commodities: Many developing country economies have traditionally been hamstrung by (state-controlled) commodity marketing boards. The typical regulation has been that farmers are required to sell their produce to these boards with the idea that through economies of scale, the marketing board can fetch a higher price on the international market. Farmers are usually offered marginal prices for their produce (payments for which are often late or non-existent). This mediocre incentive suppresses production. However, when the commodity marketing sector is competitive, small-scale entrepreneurs play an invaluable role as middle-men between producers and the final markets. Farmers have a choice on who they can sell their goods to, placing them in a stronger negotiating position regarding prices. The incentives to produce high-quality crops are sharpened considerably, creating more income, revenue and assets in the economy.

4. ELABORATION OF KEY THEMES In this section we elaborate on the primary pathways to growth identified in the previous section.

4.1. INNOVATION AND ENTREPRENEURSHIP Entrepreneurship plays a vital role in successful economies. According to the Schumpeterian approach to growth (Aghion and Howitt, 1997), entrepreneurs are the primary engine of innovation and growth. Related to this view is a growing literature that emphasizes the development of a vibrant micro, small and medium enterprise sector in the process of economic development. Hence it is important to understand how MSEs contribute to entrepreneurship, innovation and growth and the factors that make entrepreneurs.

Acs and Audretsch (1990) show that while SMEs account for a very small fraction of total business R&D in the OECD countries, they contribute greatly to the innovation system by introducing new products and adapting existing products to the needs of customers. They also show that small firms account for a disproportionate share of new products innovation given their low R&D expenditures. Link and Rees (1990) and Acs, Audretsch and Feldman (1992, 1994) attribute the high innovation rates of SMEs relative to their R& D expenditures to their ability to better exploit research at universities and large corporations while large firms are themselves bogged down by bureaucratic procedures that inhibit both innovative activity and the rate at which new innovations reach the market.

In an ongoing entrepreneurship project by Djankov et al. (2004) involving five large developing countries - Brazil, Russia, India, Nigeria and China - researchers are attempting to study why entrepreneurship thrives in certain societies and not in others and the determinants of entrepreneurship. Preliminary evidence from


Russia suggests that in addition to individual characteristics, social networks, especially having entrepreneurs in the family and among one’s friends, are significant determinants of which individuals are likely to be entrepreneurs. This also has significant implications for MSEs as these long term relationships with social networks emphasize the importance of “social collateral” in access to finance issues, which help fill in the gap left by formal financial institutions. However, more research is needed to sort out whether these networks merely alleviate credit constraints or whether there are certain special characteristics associated with these networks of entrepreneurs.

4.2. DYNAMISM Recent industrial organization literature has established the importance of micro and small enterprises in promoting dynamism in the overall economy. The contribution of the MSE sectors can be linked to both the dynamics of firm growth as well as systematic patterns of entry and exit in an economy. We examine both these contributions in detail below.

Much of the literature on growth dynamics has centered on whether firm growth is independent of firm size (Gibrat’s law). This is equivalent to assuming that firm size distributions are approximately lognormal (Sutton, 1997). Recent empirical studies, including Evans (1987), Hall (1987), and Davis, Haltiwanger, and Schuh (1996), have shown that growth rates and size are inversely related. These works have inspired a number of theorists to develop depictions of the evolution of industry dynamics. In models such as Lucas (1978), Jovanovic (1982), Jovanovic and MacDonald (1994), and Ericson and Pakes (1995), the basic empirical patterns are explained through such factors as gradual learning by entrepreneurs/firms about their own ability and the nature of technological innovation in emerging industries. More recently, capital constraints have been offered as an explanation for the pattern in the size distribution of firms and the relationship between size and growth (Cooley and Quadrini, 2001).

Using a sample of Portuguese manufacturing firms, Cabral and Mata (2003) show that as capital constraints worsen, firm size distributions will become more skewed. The intuition behind their result is that small firms with good investment opportunities may be periodically unable to raise the resources to exploit those opportunities. In that case, they will under-invest and grow more slowly than larger firms with internal cash flow to fund their projects. They argue that the distribution of firm size will be more highly skewed for younger firms because they are more likely to be capital rationed.

A second theme of dynamism research focuses on the dynamics of firm entry and exit. In a series of papers, Dunne, Roberts, and Samuelson (1988, 1989) document the rapid pace of entry during the early phases of a particular industry and that these rapid entry rates are also associated with rapid exit rates. Another set of studies has focused on individuals’ transitions into self-employment [e.g., Evans and Leighton (1989), Holtz-Eakin, Joulfaian, and Rosen (1994a, 1994b)], showing that the availability of personal capital is positively related to an individual’s choice to become an entrepreneur. The authors interpret these results as implying that credit constraints are a critical factor in both the founding and survival of new firms. A third area of the entry and exit literature, most closely associated with Steven Klepper [e.g., Klepper and Grady (1990), Klepper and Simons (2000)], has examined the empirical regularities associated with the changes in the number of firms active in an industry over time. Over time the number of firms increases, reaches a peak, and then declines as the industry consolidates.

Country-level entry and exit rates may also vary considerably, but much of this variation could be due to the cross sectional composition of industries active in those markets. In more recent work, Desai, Gompers and


Lerner (2005) show that entrepreneurial activity across Europe is a function of political, legal, and regulatory variables that have previously been shown to impact capital market development. Greater fairness and greater protection of property rights are especially conducive to smaller firm sizes, increased entry rates and reduced exit rates.

4.3. LINKAGES WITH LARGE FIRMS In this section, we elaborate on the linkages of micro and small enterprises with large firms. We focus on two specific linkages: MSEs in the global value chain and Trade credit relationships between large firms and small firms.

The value chain describes the full range of activities which are required to bring a product or service from conception, through the different phases of production, delivery to final consumers, and final disposal after use. The linkages between MSEs and large firms can be classified into three different types: (a) Alliances which involves subcontracting and licensing agreements where the large firm (parent) depends on the MSEs (ancillaries) for timely delivery of high-quality inputs and the MSEs in turn depend on regular sub-contracting from the large firm for their sustenance; (b) Clustering where groups of firms in a specific sector and located in a specific geographic location actively collaborate in areas of infrastructure provision, access to financing and division of labor and are thus able to integrate with larger enterprises; and (c) Networks which describes a collection of firms working in cooperation and sharing risks and costs and access to markets. These are more horizontal linkages where no firm is a dominant firm. Figure 2 depicts the different types of linkages.

With increasing competition pressures from globalization, linkages with large firms are crucial for both MSEs and large firms to remain competitive on the world markets. There are several examples of these linkages having contributed to the economic success of a particular region. Porter’s (1990) article on the competitive advantage of nations discusses the importance of related and supporting industries and gives the example of the Italian ceramic tile industry where clusters of Italian producers in the Emilia-Ramagna region of Italy were instrumental in dominating world production and exports in ceramic tiles. More recently, the success of India and China in the technology sectors has been attributed to the establishment of Software Technology Parks in India and the Science and Technology Industrial Parks in China, whose objective has been to foster the linkages between new and old, and large and small enterprises in the science and technology sectors. In many African countries, creation of export processing zones (EPZs) has helped export oriented micro and small enterprises realize their full potential through industry clusters. For example, the benefits of clustering and vertical integration in the textile industry in Mauritius in the government established EPZ has resulted in large productivity gains and remarkable growth in the production of manufactured goods.

An important component of the large-small firm linkages is the increased access to financing. The trade credit literature has established the differences in patterns of financing between large and small firms. While large firms rely mostly on bank debt, smaller firms use more of short-term financing predominantly in the form of trade credit.

Frank and Maksimovic (1998) and Demirgüç-Kunt and Maksimovic (2002) identify an advantage of bundling the provision of credit with the sale of goods. When a small firm faces adverse selection risk in the market for capital, it is more efficient for the large firm to obtain external financing from financial institutions and advance trade credit to the small firm. Thus, large firms are found to play the role of financial intermediaries


by easing financing constraints faced by smaller firms. They also find that the provision of trade credit is complementary to the development of financial intermediaries.

4.4. KEY THEMES: WHAT THE EVIDENCE SHOWS The key approaches supported by the papers are grounded in substantial well regarded academic research in the industrial organization and corporate finance literatures. The evidence strongly suggests that the effects discussed are of substantial importance and could have a material effect on the development of micro enterprises. However, because the studies on which the evidence is based were not specifically intended to analyze the links between the MSE sector and development, we do not have data that would provide evidence on their magnitude.

5. REVIEW OF TYPES OF RESEARCH THAT MAY BE USEFUL While there has been an extensive body of literature theorizing on the importance of micro and small enterprises, there have been relatively few rigorous empirical studies that have contributed to our understanding of MSE contributions. In this section, we review two research programs that would directly address the issues identified in this review - identifying situations in which MSEs can significantly affect industry growth and identifying the characteristics of individual MSEs that predict future growth. We also have suggestions for the types of research that may be useful in shedding more light on the different pathways to growth identified in sections 3 and 4.

5.1. PROVIDING EVIDENCE ON SPECIFIC QUESTIONS RAISED BY THIS REVIEW

5.1.1. MSES AND THEIR INDUSTRY FROM A DYNAMIC PERSPECTIVE: FINDING THE OPPORTUNITIES While we have identified the importance of analyzing the role of small firms in a dynamic context, the industries and countries in which these considerations are of greatest relevance have not yet been identified. We need to know answers to questions such as:5

• In which industries are small firms niche players and in which industries do they play a dynamic role such that a significant proportion of them grow sufficiently big to make an important contribution to the growth of the industry?

• Can we determine the most important institutional characteristics that facilitate the growth of dynamic industries?

• Can we identify a set of countries/industries in which MSEs are expected to be a significant contribution to growth?

5.1.2. THE ENTREPRENEUR/OWNER: WHAT IS REQUIRED AND WHAT CAUSES ROADBLOCKS? On a micro-level, it is important to identify the characteristics of MSEs, and in particular of the MSE owners/entrepreneurs, who have succeeded in growing their businesses: Does success depend principally on

5 These themes are developed more fully in the “Proposal for a Paper Investigating Industry Growth and Dynamism.”


personal attributes and contacts, family connections, prior experience in the industry, or prior experience in large businesses or MSEs? How does the importance of each attribute depend on country-level institutional characteristics and on the industry involved?

More broadly, while a proportion of MSEs are growth-oriented and may have a reasonable chance of contributing significantly to industry growth, other MSEs may be characterized as being in a survivalist mode. Such firms may provide employment for their principals, who may have few alternatives, but are unlikely to play a significant role in wealth creation. In order to evaluate the potential of MSEs to affect growth in the long run it is necessary to distinguish the survivalist MSEs from the growth-oriented MSEs and to consider them separately, both in research and for policy purposes.

One approach to these questions would be to identify and survey former MSEs that have been successful in terms of growth.6 The entrepreneurs can be asked about the factors that affected the success of their startup and their experiences as MSEs. In addition, they can be asked to identify two control groups. First, MSEs that were in the past comparable to theirs but that have been less successful. Second, a group of their contemporaries (say a sample of their friends from their teenage years), who did not become entrepreneurs. The results from the three samples: successful MSEs, failed MSEs and non-entrepreneurs can then be compared and contrasted. Attempts would be made to contact and survey members of the control groups. The experiences of the three groups could then be correlated with country-level institutional characteristics and historical data on the characteristics of the industry involved.

This kind of research would be similar in spirit to the descriptions of Russian entrepreneurs by Djankov et al. (2005), but also go beyond it in several respects. First, it is necessary to focus on the factors that predict whether an individual will be successful as an entrepreneur, not only on factors which cause him or her to become an entrepreneur. Second, the level of resources and the personal characteristics required to run a growth-oriented MSE may differ greatly across industries. Thus, instead of focusing only on the characteristics of entrepreneurs and the resources they had access to when their businesses were founded, the research should examine to what extent these resources and characteristics are important for industries at different stages of their life-cycle and for industries characterized by different “optimal firm sizes.” Third, judging the effectiveness of growth-oriented MSE strategies requires that current and historical data about the subjects be collected.

The findings would provide input for 1) Evaluating whether there is a need for intervention with MSEs and 2) Providing an evidence-based methodology for meeting any identified needs.

5.2. A BROADER RESEARCH AGENDA Our knowledge of MSEs would benefit greatly from the following types of studies:

Sub-national Studies. There has been very little work at the regional or sub-national level investigating how MSEs have contributed to the economic success of a particular region. While there are several specific case studies of regions that have benefited from micro and small enterprises such as the Brazilian Shoe Cluster of Sinos Valley, the Knitwear Cluster of Tiruppur India, there has been no study that has looked at several

6 Successful former MSEs should be easier to locate than failed MSEs. The choice of industries/countries to sample would be informed by the results of the prior industry-level study described above.


different regional clusters, either in a single country or across countries, and attempted to identify the economic and social contribution of MSEs.

Ex-post Analyses of Interventions. Several international entities such as USAID, DAI and SEAF and many other microfinance institutions have established aid programs targeted towards micro and small enterprises in several countries. However there is little time-series data on the social and economic structure of the regions, before and after aid intervention in these project sites. Ex-post analysis of intervention and comparison with a control sample where there was no intervention is absolutely necessary to understand the effectiveness of the assistance rendered to the MSE sector. Examples of such studies include the difference-in-difference method used to study the impact of the Southwest China Poverty reduction Project by Chen and Ravallion (2003).

Experiments. One of the biggest challenges associated with impact evaluation using control groups is the danger of selection bias associated with the participation of MSEs in a particular aid program. There is no way to isolate the MSEs that are participants in the aid programs from unobservable characteristics such as pre-existing conditions or innate ability of these particular entrepreneurs. Hence it is essential that we have data from randomized experiments so that the randomized nature of the selection of control and treatment groups controls for any selection bias. Most of the existing studies using randomized experiments deal with microfinance, such as the study on deposit collectors by Karlan, Ashraf and Yin (2005) and on consumer credit by Bertrand et al. (2005). Proper evaluation of the donor programs through randomized experiments is crucial to making progress on the question of whether or not micro and small enterprises need to be subsidized.

Industry Case Studies. Section 5 of this paper elaborated on the changing role of micro and small enterprises with industry life cycles. However, most of the historical examples of the role of MSEs in industry evolution are from developed countries such as the US and Canada. It is important to understand to what extent the micro and small enterprise sector has played a role in the development of certain industries in the developing countries. The transition economies which are still undergoing a process of transition and structural transformation would be interesting sites to conduct such analyses in. In addition to the historical case studies, we need studies aimed at capturing the industry dynamics over time, even if data is available only over the past ten years.

Dynamic Simulations. The historical and dynamic industry case studies could be supplemented with calibrated dynamic simulations that would demonstrate how dynamic effects might propagate through time. Such studies would present a model for understanding how a particular industry or economy would evolve through time and would be particularly useful in countries where time series data is hard to come by.

Regional Level Analysis Using Input-Output Matrices. Existing MSE research fails to take into account all the factors in an economy and the importance of industries in the regional economy. A more rigorous technique suited to regional analysis is input-output analysis developed by Wassily Leontief. The Input-Output (I-O) models track intermediate purchases (industry to industry) and final purchases (industry to households and industry to government) as well as intermediate and final sales. These models allow one to examine inter-industry linkages and the total multiplier effects including employment, earnings and output. Coupled with the firm size distribution in different industries in a country, input-output tables could be the key to understanding the full role of micro and small enterprises in different sectors of the economy.

One of the big constraints facing the research ideas discussed above is the absence of good quality data across countries. The data on micro and small enterprises across countries is very noisy and suffers from a lack of


comparability and consistency across countries and within the same country. Until such time that government statistical agencies keep detailed records of the MSE sector in keeping with international standards and aid agencies undertake serious ex-post impact evaluation, randomized surveys might be the answer to investigating each of the issues described above.

CONCLUSION Many in the international aid community have argued that MSEs play a critical role in addressing both poverty reduction and economic growth goals. Such an argument often leads to a policy of providing aid to MSEs. In contrast, recent academic literature has strongly challenged the view that aid programs should treat MSEs differently (Biggs, 2002), arguing that there is no causal link between MSEs and GDP per capita growth (Beck, Demirgüç-Kunt, and Levine, 2005) or even industry growth. These two perspectives have very differing policy prescriptions for donor programs targeted towards the MSE sector.

The purpose of this paper is to review the economic literature on the subject and to suggest how to frame the debate about the relation between MSEs and growth. To this end we analyze the different avenues through which MSEs may contribute to economic growth and poverty reduction in developing countries and to survey the empirical evidence in support of (or against) the proposed avenues.

On the basis of the review of the evidence, this paper argues that existing academic literature takes a very static perspective on MSEs. The paper identifies three key pathways to growth for MSEs: Innovation and Entrepreneurship, Economic Dynamism, and Linkages with Large Firms.

First, small firms, especially young ones make vital contributions to innovation and entrepreneurship in an economy. A huge body of evidence shows that small firms are more advantaged than large firms in leading innovation since they face lesser bureaucratic constraints and are willing to invest in narrow detailed inventions that may be too modest for giant corporations. Further, recent survey evidence from Russia suggests that the most important determinant of entrepreneurship is family ties and social networks, the kind that is fostered by micro enterprises.

Second, MSEs add dynamism and flexibility to the economy by way of new firm formation, contribution to competitive forces resulting in higher efficiency and by faster and less expensive adjustments to economic shocks. Recent literature in industrial organization argues that entrepreneurship and the creation of new firms as key engines of economic growth.

Finally, MSEs and large firms often perform complementary roles within a value chain. As suppliers they cooperate with large firms thus enabling the firms to link up with larger producers and break into national and global markets. Moreover, evidence from several US studies suggests that in several critical industries, small start-up firms are more successful in the long run if they are started by, or have in important positions, personnel with experience in senior positions in successful large firms in the same or related industries.

Empirical evidence suggests that the extent to which MSEs can fully realize their potential along the different pathways is crucially dependent on the general business environment and in particular, the financing they receive. There is a significant body of literature pointing to market failures constraining the development of the micro and small enterprise sector in low-income and transition countries. Asymmetric information, one of the main causes of market failure, creates adverse selection and moral hazard problems causing lenders to ration certain borrowers. Typically, it is the information sensitive micro and small enterprises that are most hurt by credit rationing, leading even high quality MSEs to under invest. Hence, despite an active financial


sector and the existence of development banks, venture capital and secondary capital markets in low income and transition countries, there is a need for intervention programs and aid providers focused on improving access to finance for micro and small enterprises.


TABLES & FIGURES This table shows employment shares by firm size across different industries in the United States in the year 2002. Employment shares are expressed in percentages of total number of employees. The data is obtained from the Small Business Administration’s Small Firm Database.

TABLE 1: EMPLOYMENT SHARES BY FIRM SIZE IN THE UNITED STATES

Employment

Employment size

Industry <20 <500 500+

Major industries

Total 18 50 50

Agriculture, forestry, fishing, & hunting 48

Mining 14 44 56

Utilities 4 17 83

Construction 38 85 15

Manufacturing 9 42 58

Wholesale trade 22 63 37

Retail Trade 19 43 57

Transportation & Warehousing 14 42 58

Information 7 26 74

Finance & insurance 11 31 69

Real estate & rental & leasing 35 69 31

Professional, scientific, & technical services 30 64 36

Management of companies & enterprises 1 13 87

Administrative & support & waste management & remediation services 11 40 60

Educational services 8 47 53

Health care & social assistance 16 48 52

Arts, entertainment, & recreation 18 66 34

Accommodation & foodservices 18 61 39

Other services (except public administration) 47 86 14

Source: Own analysis of the SBA Database


MICRO AND SMALL ENTERPRISES: UNEXPLORED PATHWAYS TO GR

The table compares the number of firms in an industry during its initial growth phase (Stage 1) with the number of firms that exit during the subsequent shakeout period (Stage 2).

Table 2: Distribution of Firms across Industry Life Cycles (Klepper and Grady, 1990)

Product Name Peak Number of Firms Net Decrease in Number of Firms in Stage 2

Crystals, Piezo 45 17

DDT 38 33

Electric Blankets 17 11

Electric Shavers 32 18

Engines, Jet-Propelled 29 9

Fluorescent Lamps 34 14

Freezers, Home and Farm 61 38

Machinery, Adding and Calculating 55 28

Motors, Outboard 21 8

Penicillin 30 24

Photocopy Machines 43 23

Polariscopes 16 6

Radio Transmitters 76 55

Records, Phonograph 49 30

Saccharin 39 28

Shampoo 114 5

Streptomycin 13 11

Tanks, Cryogenic 84 29

Tires, Automobile 275 211

Tubes, Cathode Ray 39 11

Windshield Wipers 51 30

Zippers 49 9

OWTH 23

FIGURE 1: PATHWAYS TO GROWTH FOR MICRO AND SMALL ENTERPRISES

Micro and Small Enterprises

SecondaryPrimary

Human Capital Financing Rural Development

Other Industry Sectors

Linkages with Large firmsDynamism Entrepreneurship

Micro and Small Enterprises

Primary Secondary

Economic Growth

Human Capital Rural Other Industry Entrepreneurship Dynamism Financing Development Sectors

Economic Growth


FIGURE 2: MSE-LARGE FIRM LINKAGES ALONG THE VALUE CHAIN

A. Vertical Linkages A. Vertical Linkages B. ClustersB. Clusters C. Horizontal networksC. Horizontal networks

Large Firm (parent)

MSE (ancillary)

Large Firm (parent)

MSE1 MSE2

MSE5MSE4

MSE3

MSE6

MSEn…………

Large Firm (parent) Large Firm (parent)

MSE1

MSE1

MSE1

MSE1

MSE1

Large FirmMSE (ancillary)MSE1 MSE2

MSE5MSE4

MSE3

MSE6

MSEn…………

MSE1

MSE1MSE1

MSE1MSE1

Large Firm


APPENDIX A

REVIEW OF EVIDENCE FOR AND AGAINST THE CONTRIBUTIONS OF THE MICRO, SMALL AND MEDIUM ENTERPRISE SECTOR SMEs are Important Sources Of

Not Quite So

A. Job Creation and Overall Economic Activity

• SMEs boost both employment numbers and the quality of employment. In fact, in the 1970s, 8 out of 10 new jobs in the US were in SMEs (Birch (1987).

• Problems with Birch's Study: Many new jobs created in Birch's study are also destroyed by high failure rates (Dunne, Roberts, and Samuelson (1989). Birch's study was a regression-to-the-mean effect (Leonard (1986).

• No systematic relation between net job creation and firm size [Brown, Hamilton, and Medoff (1990), Davis, Haltiwanger and Schuh (1996)].

• Large firms were main source of employment in manufacturing sector in Africa (Biggs and Shah (1988).

• Regarding quality of jobs, large firms offer more stable employment, higher wages and more non-wage benefits than small firms (Brown, Medoff and Hamilton, 1990; Rosenzweig, 1988).

• Cross country studies show that SMEs do not have a causal impact on GDP/capita growth (Beck, Demirgüç-Kunt, and Levine (2005).

• SMEs are more labor intensive for a given scale of production and hence employ a large share of the labor force in developing countries.

• Firm size is not a reliable predictor of labor intensity [Snodgrass and Biggs (1996), Little, Mazumdar and Page (1987)].

B. Poverty Alleviation and Social Considerations

• SMEs contribute to more equal distribution of income and wealth.

• No evidence that SMEs alleviate poverty or decrease income inequality (Beck, Demiruc-Kunt and Levine (2005).


H 27 MICRO AND SMALL ENTERPRISES: UNEXPLORED PATHWAYS TO GROWT

• SMEs are an instrument of regional development especially in low income countries where micro and small enterprises are the domain of certain ethnic groups and minorities.

C. Innovation

• Smaller firms are more innovative in high technology industries in advanced economies (Acs and Audretsch, 1987).

• Though large firms invest more in R&D, SMEs are better able to generate innovations than large firms since they are unconstrained by bureaucracy [Acs, Audretsch, and Feldman (1992, 1994), Link and Rees (1990)].

• SMEs are important sources of competitive advantage in world export exports (Porter 1990) and are the competitive core of industry clusters (Muizer and Hospers, 1998).

• In developing countries, progress is driven not by innovation but by technology transfer from abroad [Rosenberg (1976, 1986), Baumol (1993)] and it is the larger firms that benefit from these technology transfers [Biggs, Shah and Srivastave (1996), Rodrigius-Clare (1996), Pack (1992), Pack and Westphal (1986)].

• Large firms have more resources to adopt and implement innovations (Acs, Morck and Young, 1999.

• SMEs have a low propensity to export in developing countries [Bigsten et al. (1998), Biggs et al. (1995), Regnier (1993), Cortes, Berry and Ishaq (1987)] and play only an indirect role in export markets if at all (Nooteboom, 1993).

D. New Firm Formation and Dynamism in the Economy

• Most new firms enter at a small scale (Acs and Audretsch, 1991). • SMEs add dynamism and flexibility to business activity and improve

economic performance [Carlson (1996), Acs and Audretsch (1993), Invernizzi and Revelli (1993), Nguyen and Reznek 91992)].

• Magnitude of entry, net of failures and exits is small [Acs, Carlsson and Thurik (1996), Behrman and Deolalikar (1989) and its effect on employment is actually just modest, in the range of 5-10% in the US and UK (Auddretsch (1995), Johnson (1986)].

• New firm formation is influenced by economic conditions and many micro enterprises are created as a measure of last resort by workers who are pushed into self-employment during economic downturns [Liedholm and Mead (1987) and De Soto (1987)]. Such enterprises have very low survival rates and rarely grow big enough to significantly impact the economy accounting largely for Africa's missing middle (Biggs, Ramachandran and Shah (1999), Sleuwaegen and Gooedhuys (2002)].

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