Why don’t African firms create more jobs?

Leonardo Iacovone, Vijaya Ramachandran, 7 February 2014

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There is an urgent need for job creation in Africa. Many economies on the continent suffer high rates of under-employment and/or low-productivity employment. In addition, because of demographic factors, many countries anticipate that large numbers of youth will enter the workforce in the near future. This may be beneficial to economic growth but also a potential threat to social stability.

Productive firms create jobs as they invest and grow. But market imperfections and weak business environments that lower the productivity of firms and prevent resources from being allocated toward better-performing firms may reduce the potential for job creation. Various existing models suggest that firms 'learn' about their productivity over time – hence efficient firms invest and expand while less productive ones stay small, shrink or exit the marketplace (Jovanovic 1982, Hopenhayn 1992). However, this process may not be happening naturally and recent research suggests that distortions in the business environment matter. Hsieh and Klenow (2012) show that firm growth patterns vastly diverge across countries because of distortions that impede the allocation of resources toward firms with higher productivity and growth potential.1

What pattern of firm dynamics characterises African economies?

Our new paper (Iacovone et al. 2014) examines growth patterns of African firms in comparison with firms located elsewhere in the world, using data from the World Bank's Enterprise Surveys.2 These surveys cover 41,005 firms from 119 developing economies, of which 41 are in Sub-Saharan Africa.

The pattern of firm growth is different in Africa. Firms in Africa remain smaller than firms in other regions, for almost every age quintile. Figure 1 describes the median value of firm size, by age quintile, for each of the four regions in our dataset.

Figure 1. Median firm size, by age quintile

Africa has an overabundance of relatively small firms, and relatively few large firms--Figure 2 graphs the kernel density estimation of the size distribution of all firms in the sample, grouped by region.3

Figure 2. Employment distribution of firms in the sample

This is not just due to the fact that firms in Africa are younger (and therefore smaller). Rather it seems more related to the existence of distortions that lead to misallocation of resources. This is consistent with the fact that we do not necessarily observe a positive relationship between size and productivity in Africa. Figure 3a shows the distribution of firms by size quartile in the food-processing sector in Nigeria. We see there are small firms in Nigeria that are quite productive as well as relatively large firms that are somewhat unproductive.

Figure 3a. Productivity of firms by size quartile in the food processing sector in Nigeria

In contrast, there is a positive relationship between size and productivity in Brazil (Figure 3b)—more productive firms are able to grow and are consequently larger. In sum, not only is the median size of firms smaller in Africa, but the distribution of firms is also different between Africa and other parts of the world.

Figure 3b. Productivity of firms by size quartile in the food processing sector in Brazil

What could be stunting firm growth in Africa?

Our initial hypothesis is that there may be constraints that prevent small (highly productive) firms from growing and existing (inefficient) incumbent firms from contracting/exiting in Africa as compared to elsewhere. To better explain our reasoning, Figure 4a describes firm growth in an “ideal” business environment. In this scenario, high-productivity firms are able to grow and thrive (because they are able to access credit, have good property rights and/or a steady supply of electricity, etc.) while low-productivity firms stay small and even exit early.

Figure 4a. Firm growth in an “ideal” business environment

Figure 4b shows what happens in a “distorted” business environment. In this scenario, high-productivity firms are not able to grow and are closer in size to low-productivity firms. Distortions such as the lack of enforcement of property rights and an overall low-quality business environment may also mean that low-productivity firms are able to survive longer, although they are not able to grow or compete with firms in better business environments.4

Figure 4b. Firm growth in an “distorted” business environment

Guided by this hypothesis, we estimate a model to evaluate the impact on firm size of several measures of the business environment, while also controlling for several key firm characteristics. First, we confirm that there appears to be an “Africa size gap”—African firms are about 20% smaller than their counterparts in other locations. In addition, we find that the business environment matters--measures such as power outages (as a proxy for infrastructure quality), access to finance, and the supply of unskilled labour are significant in determining firm size. Finally, and perhaps surprisingly, even after controlling for business environment, firm, and market characteristics, the dummy variable measuring whether a firm is located in an African country remains negative and significant at the 1% level of confidence. Our results indicate that about 60% of the variation in the size of African firms remains unexplained, even after controlling for firm characteristics and variables that capture the business environment.

Why are African firms not growing?

Small firms may want to stay below the government’s radar in Africa. Data from the Enterprise Surveys show that the burden of dealing with government increases substantially with size; this may act as a brake on firm growth.

The overall price level in Africa could also be a factor in determining the size of firms (Gelb et al. 2013). Relative to low-income comparators like Bangladesh, Vietnam and also India, African countries are considerably more costly. In absolute terms, and excluding South Africa as a middle-income country, the average purchasing power parity for a sample of African countries is about 20% higher than the average for the four poorest comparators (Bangladesh, Indonesia, Philippines and Vietnam). Africa’s higher costs may result in a lower level of competitiveness and consequently, in a distribution of firms that is different (smaller) than distributions in other countries. African firms may also face a steeper labour cost curve; as firms become larger and more productive, their labour costs increase more in other regions of the world.

At a more “micro” level, issues related to trust between managers and workers, as firms transition away from family-only employees, may play a role in limiting firm size. Bloom et al. (2012) find that managers at headquarters place greater trust in managers of subsidiary firms in “high trust” countries, this in turn increases productivity by affecting the organisation of firms and allowing more efficient firms to grow. Atkin et al. (2011) find that a lack of trust of outsiders (and the difficulty of punishing them for shirking) means that firms are limited to employing family members. Finally, the pressure to share profits among family members may also limit the growth of African firms. These are themes that need to be explored further to understand the slower growth of African firms.

References

Atkin, David, Amit M Khandelwal, and Jonathan Vogel (2011), Institutions, Family Firms and the Lack of Manufacturing Employment: Evidence from Ethiopia, October, PPT.

Freund, Caroline L and Pierola, Martha Denisse (2012), Export Superstars. World Bank Policy Research Working Paper No. 6222, October.

Gelb, Alan, Christian Meyer and Vijaya Ramachandran (2013), “Does Poor Mean Cheap? Africa’s Industrial Labor Costs in Comparative Perspective,” CGD Working Paper #325. Center for Global Development, May.

Hopenhayn, Hugo A, (1992), Entry, Exit, and Firm Dynamics in Long Run Equilibrium, Econometrica, Econometric Society, vol. 60(5), pages 1127-50, September.

Hsieh, Chang-Tai, and Peter J Klenow (2012), "The life cycle of plants in India and Mexico", No. w18133. National Bureau of Economic Research.

Iacovone, Leonardo, Vijaya Ramachandran and Martin Schmidt (2014), “Stunted Growth: Why Don’t African Firms Create More Jobs?”, Center for Global Development Working Paper #353, February.

Jovanovic, Boyan. "Selection and the Evolution of Industry." Econometrica: Journal of the Econometric Society (1982): 649-670.

Moulton, Brent R (1990), "An illustration of a pitfall in estimating the effects of aggregate variables on micro units." The Review of Economics and Statistics: 334-338.


1 In the US the average 40 year-old plant employs almost eight times as many workers as a typical plant five years or younger, in contrast, Indian plants grow very little in terms of employment or output while Mexico is in the middle--the average 40 year-old Mexican plant employs twice as many workers as an average new plant.

2 The Enterprise Surveys collect qualitative information on a country's perceived business environment as well as quantitative firm performance measures, predominantly in the formal service and manufacturing sectors of the economy. The dataset integrates all surveys that have been conducted after 2006, which use a common global methodology. The Enterprise Surveys consist of data from face-to-face interviews with owners or managers of formal firms in the following sectors--manufacturing, construction, retail, wholesale, hospitality and other services. The data are representative at the size, sector and location levels.

3 The size distribution of firms in Africa peaks at about seven employees per firm. There is a higher share of African firms at low levels of employment than in other regions, while the density of larger firms is lower in Africa than elsewhere. This pattern may have implications for African firms’ ability to export—Freund and Pierola show that firms which are export superstars tend to start out large and reach the top 1 percent after only three years of exporting (Freund and Pierola, 2012).

4 These results are robust to a number of robustness checks, including the addition of many other potential explanatory variables. With the exception of the coefficient of variation for terms of trade, the addition of these variables does little to change the sign and size of the Africa dummy.

Topics: Development, Labour markets
Tags: Africa, firms, jobs

Senior Economist in the Innovation, Technology and Entrepreneurship Global Practice, Financial and Private Sector Development Network, World Bank
Senior Fellow, Center for Global Development