PRINCETON – When researchers at the McKinsey Global Institute (MGI) recently dug into the details of Mexico’s lagging economic performance, they made a remarkable discovery: an unexpectedly large gap in productivity growth between large and small firms. From 1999 to 2009, labor productivity had risen by a respectable 5.8% per year in large firms with 500 or more employees. In small firms with ten or fewer employees, by contrast, labor productivity growth had declined at an annual rate of 6.5%.
Moreover, the share of employment in these small firms, already at a high level, had increased from 39% to 42% over this period. In view of the huge gulf separating what the authors called the “two Mexicos,” it is no wonder that the economy performed so poorly overall. As rapidly as the large, modern firms improved, through investments in technology and skills, the economy was dragged down by its unproductive small firms.
This may seem like an anomaly, but it is in fact an increasingly common occurrence. Look around the developing world, and you will see a bewildering fissure opening up between economies’ leading and lagging sectors.
What is new is not that some firms and industries are substantially closer to the global productivity frontier than others. Productive heterogeneity – or what development economists used to call economic dualism – has always been a central feature of low-income societies. What is new – and distressing – is that developing economies’ low-productivity segments are not shrinking; on the contrary, in many cases, they are expanding.
Typically, economic development occurs as workers and farmers move from traditional, low-productivity sectors (such as agriculture and petty services) to modern factory work and services. As this takes place, two things happen. First, the economy’s overall productivity increases, because more of its labor force becomes employed in modern sectors. Second, the productivity gap between the traditional and modern parts of the economy shrinks, and dualism gradually diminishes. Agricultural productivity increases during this process, owing to better farming techniques and a decline in the number of farmers working the land.
This was the classic pattern of postwar development in the European periphery – countries like Spain and Portugal. It was also the mechanism that generated the Asian growth “miracles” in South Korea, Taiwan, and eventually China (the most phenomenal example of all).
One thing that all of these high-growth episodes had in common was rapid industrialization. Expansion of modern manufacturing drove growth even in countries that relied mostly on the domestic market, as Brazil, Mexico, and Turkey did until the 1980’s. It was structural change that mattered, not international trade per se.
Today, the picture is very different. Even in countries that are doing well, industrialization is running out of steam much faster than it did in previous episodes of catch-up growth – a phenomenon that I have called premature deindustrialization. Though young people are still flocking to the cities from the countryside, they end up not in factories but mostly in informal, low-productivity services.
Indeed, structural change has become increasingly perverse: from manufacturing to services (prematurely), tradable to non-tradable activities, organized sectors to informality, modern to traditional firms, and medium-size and large firms to small firms. Quantitative studies show that such patterns of structural change are exerting a substantial drag on economic growth in Latin America, Africa, and in many Asian countries.
There are two ways to close the gap between leading and lagging parts of the economy. One is to enable small and microenterprises to grow, enter the formal economy, and become more productive, all of which requires removing many barriers. The informal and traditional parts of the economy are typically not well served by government services and infrastructure, for example, and they are cut off from global markets, have little access to finance, and are filled by workers and managers with low skills and education.
Even though many governments exert considerable effort to empower their small enterprises, successful cases are rare. Support for small enterprises often serves social-policy goals – sustaining the incomes of the economy’s poorest and most excluded workers – instead of stimulating output and productivity growth.
The second strategy is to enlarge opportunities for modern, well-established firms so that they can expand and employ the workers that would otherwise end up in less productive parts of the economy. This may well be the more effective path.
Studies show that few successful businesses begin as small, informal firms; they are started, instead, at a fairly large scale, by entrepreneurs who pick up their skills and market knowledge in the more advanced parts of the economy. Enterprise surveys in Africa by John Sutton of the London School of Economics indicate that it is often entrepreneurs with experience in importing activities who found modern domestic firms. Domestic subsidiaries of multinational firms or state-owned enterprises – which are repositories of skilled workers and managers – are also a source of such firms.
The challenge is to create an economic environment in which there are incentives for local talent and capital to invest in firms in the modern, tradable parts of the economy. Sometimes, it is enough to remove certain of the more stifling government regulations and restrictions. At other times, governments need more proactive strategies – such as tax incentives, special investment zones, or hyper-competitive currencies – to raise the profitability of such investments.
The details of appropriate policies will depend, as usual, on local constraints and opportunities. But every government needs to ask itself whether it is doing enough to support the expansion of capacity in the modern sectors that have the greatest potential to absorb workers from the rest of the economy.