Performance and Dynamics of Micro and Small Firms in Developing Countries

Apl. Prof. Dr. Jann Lay
2015 - 2018

Prof. Dr. Stephan Klasen, University of Göttingen, Germany

Prof. Dr. Lukas Menkhoff, DIW Berlin, Germany

Centre for Basic Research (CBR), Uganda



Research Questions
The project empirically analyses the performance and dynamics of urban micro and small enterprises [MSEs] and studies specific risks and constraints that these enterprises face.

The project takes a vulnerability perspective on firm performance and focuses on the lack of productivity improvements and innovation in MSEs. Risks associated with innovation are likely to be a major constraint preventing MSEs from growing and improving productivity, thereby potentially causing income poverty traps for individuals, groups, and, eventually, entire economies., MSEs are the main source of employment in many developing countries, which underscores the importance of better understanding their performance. Against this backdrop, the project investigates the following questions:

  • How dynamic are MSEs over time, and which firm and owner characteristics determine firm dynamics? What is the role of behavioural factors, specifically risk aversion, time preferences, and overconfidence, in determining MSE growth?
  • How do MSEs innovate and adopt technologies and what are the implications for total factor productivity and investment decisions?
  • What is the role of savings for investment and entrepreneurial performance, and to what extent can individual feedback influence saving behaviour?

The first two sets of questions are analysed in the context of the project “Risk, Investment, and Poverty: Dynamics of Micro and Small Firms in Developing Countries”, in a collaborative effort with the University of Göttingen. The third set of questions is analysed in collaboration with the German Institute for Economic Research (DIW Berlin).

Contribution to International Research
Recent empirical work on MSEs has shown that marginal returns to capital stocks in MSEs can be high initially; yet, they also tend to decline rapidly with higher capital stocks. On the one hand, this might indicate capital scarcity driving high marginal returns initially. On the other, the stagnation of many MSEs may be caused by low productivity and the lack of innovation. There is, however, hardly any empirical literature that examines innovation and technology adoption in urban MSEs in low income countries and the project intends to fill this gap. One of the main reasons for the lack of innovation and, indeed, any major capital investment may be the risk associated with doing so. Risky endeavours like innovation or investment activities are likely to be influenced by behavioural determinants. Such determinants, for example risk and time preferences, have received quite some attention in the context of savings, but not much in the literature on innovation in MSEs.

Research Design and Methods
We study MSE behaviour using state-of-the-art micro-econometric methods. This includes in particular differences-in-differences and instrumental variable specifications, as common in the impact evaluation literature. The quantitative analyses are informed by own panel survey data from Uganda. The first wave sampled 450 MSEs and was implemented in 2012. Four consecutive survey rounds were implemented in 2013-2016. During the project, the survey will be extended to a total of seven annual waves with changing foci, but a consistent core questionnaire. While panel data on MSEs is very scarce, our data has another unique feature, as it combines firm surveys with lab-in-the-field experiments on risk and time preferences and overconfidence, as well as randomised experiments on cash transfers, financial literacy, and technology use.

Preliminary Results
This project builds upon the previous project on “Micro- and Small Enterprises in Developing Countries: Opportunities and Constraints”. Three main insights have emerged from our research to date: (1) The typical informal MSE should not be considered a subsistence enterprise. This is evident from the very high marginal returns to capital that can be earned in these enterprises. Rather, an important share of MSEs, even in poor economies, for example in the Sahel zone, can be considered "constrained gazelles". (2) High returns in microenterprises remain unexploited due to a number of economic, institutional, and social constraints. While credit constraints are found to be a key constraint for MSEs, specific sectors are heavily constrained by access to public utilities. In addition, forced solidarity, i.e. social constraints, can also partly explain the lack of investment in MSEs. (3) The role of behavioural constraints is not yet well understood. First results suggest that risk and risk aversion can be important obstacles to capital accumulation. (4) Overconfidence is a widespread phenomenon among MSE owners in Uganda. More than two-thirds of Ugandan firm owners have overly optimistic views about their own skills and abilities. Whether and how this behavioural bias influences economic decision making and performance will be analysed in the course of this project.