- What are the economic, institutional and social constraints that businesses face, especially in the informal sector, in developing countries?
- How important are these different constraints and how can they be overcome?
- What is the role of capital market constraints and risk? Are there important entry barriers?
- Does forced solidarity hamper entrepreneurial activity?
Contribution to International Research
In the past two decades, research on the informal sector has emphasized the heterogeneity of this part of the economy, e.g. in terms of entry costs, firm size, access to credit, forward- and backward linkages as well as human and physical capital endowments. Yet, not much research has investigated the causes of this heterogeneity and the implied inefficiencies. This is true in particular for Sub-Saharan Africa, where informality dominates urban labour markets. Understanding these causes and the implied inefficiencies is however necessary to design policy interventions that are able to remove the most binding constraints for informal entrepreneurs.
Research Design and Methods
Based on a concept of informality adapted to the African context and a comprehensive theoretical framework, the project analysed the quantitative importance of economic, institutional and social constraints to informal enterprises.
We examined the nature and the relative importance of these constraints, their interaction and the channels through which they impact on enterprise performance using quantitative microeconomic methods. The empirical basis of this research programme is a unique micro data set on informality (1-2-3 surveys) covering seven West-African countries and Madagascar. The data sets are representative for the entire urban non-farm informal sector. We furthermore have similar data for Peru and Vietnam which allows undertaking – where useful – inter-regional comparisons.
Decades of research on urban informal entrepreneurs in developing countries have at least provided us with one rather consistent observation: Next to a rather small group of successful entrepreneurs, we find a much larger group of entrepreneurs that struggle to survive. A major result of our research is that, next to these well-known top-performers and survivalists, an important third segment of entrepreneurs exists. These entrepreneurs that Grimm, Knorringa and Lay (2012) call “constrained gazelles” have very low capital stocks, but high returns to capital. They share many characteristics with top-performers, they even show similar managerial abilities in running their firm, but they operate with substantially lower capital stocks. Their stock of capital is almost as low as that of most survivalists. However, they are much more productive and can thus earn much higher returns than survivalists. These findings suggest that many entrepreneurs in the lower tier are more entrepreneurial and have better growth prospects than previously assumed.
These findings – albeit more nuanced than previous results – support the view of informal activities as being very heterogeneous, and so do other studies of the project. Grimm, Krüger and Lay (2011) show that notable entry barriers into some informal activities exist, in particular when current costs are taken into account. However, there is also a segment with very low entry costs. This study also identifies very heterogeneous patterns of capital returns in informal micro and small enterprises (MSEs). In particular, we find very high returns at low levels of capital, close to zero returns at medium levels of capital and relatively high returns at higher levels of capital. MSEs with initially low capital stocks may hence be severely capital constrained. Interestingly, we find very similar patterns in marginal returns to capital in a study on Peru (Göbel, Grimm, Lay, 2012).
Yet, re-investment rates have also been found to be low in small-scale activities despite high marginal returns. We show that risk plays a key role in explaining this observation (Grimm, Lange, Lay, 2012; Grimm, Göbel, Lay, 2012). Moreover, we evoke social constraints as possible explanations for this puzzle (Grimm, Gubert et al., 2011; Grimm, Hartwig, Lay, 2013). Sharing obligations or ‘forced redistribution’ may prevent entrepreneurs from saving and investing. The results by Grimm, Gubert et al. (2011) are consistent with the hypothesis that redistributive pressure tied to the village of origin leads to adverse incentive effects and that these effects seem to get diluted with distance. Finally, the empirical results by Grimm, Hartwig, and Lay (2013) from Burkina Faso support the idea that there are two behavioural among entrepreneurs: complying with sharing norms and staying small or stepping out of the solidarity network, investing and becoming big.
Our results suggest that policies towards the informal sector should also target entrepreneurs with very low levels of capital that have often mistakenly been considered subsistence-oriented entrepreneurs. In particular credit constraints and risk leave the potential of many small-scale entrepreneurs unexploited, thus providing a rationale for policy interventions addressing these causes, such as micro-credit programs and, at least, the protection against basic household-related risks through the provision of health and life-insurances. Our findings may also be taken as an argument for providing households with savings devices. Households would be better off if they were able to invest in the enterprises of others. Additionally, the important role of risk obviously hints at a reliable and stable business environment as being conducive to capital accumulation.
Considering social constraints, we furthermore conclude that policies intended to support MSEs in a context of strong sharing norms like in many parts of Sub-Saharan Africa should consider to provide insurance services not only to the entrepreneur to facilitate stepping out of traditional kinship network, but also to those that economically rely on them to reduce the pressure for redistribution. More broadly, the introduction of public health insurance may indirectly also enhance investment in MSEs as it will crowd out inter-household remittances and hence allow entrepreneurs to save and to invest. Such policies should be the more effective the more such networks are motivated by insurance and not by pure egalitarian norms.