May 16, 2017    5 minute read

Developing Countries And The Resource Misallocation Loop

Stagnant Growth    May 16, 2017    5 minute read

Developing Countries And The Resource Misallocation Loop

A growing body of empirical research in developmental economics is dedicated to identifying the factors that harm the business environment in developing countries.

Factors such as low productivity, poor policies and incentive systems laid out by institutions are important to identify, as they diminish the efficiency of developing economies and hinder the Darwinian mechanisms that allow competition to drive out weak businesses. This results in misallocated resources, which enables efficient and inefficient firms to operate in the same geographical location simultaneously.

Consequently, growth stagnates as small inefficiencies across firms aggregate to large, industry-wide inefficiencies that ultimately account for economic differences between entire nations.

Does Management Matter in Developing Countries?

One specific factor that can help shed light on the determinants of productivity at the firm level is a company’s management practices. However, economists are divided over whether management matters in the grand scheme of things.

One reason for economists’ scepticism over the importance of management is that they assume rational choices are made. Accordingly, agents in an economy make operational decisions based on a cost-benefit analysis. Thus, a firm owner who believes that the cost of enhancing management practices would be higher than the cost of labour used to compensate for poor management would rationally choose not to invest in better management.

Another reason why economists doubt the importance of management is because management practices are principally a qualitative variable, the precise effects of which are hard to analyse.

However, the first assumption does not incorporate the possibility that a manager might grossly underestimate the real benefits of investing in better practices. Furthermore, the second argument is contradicted by a growing body of research that suggests an existing positive correlation between better management practices and higher efficiency.

Nicholas Bloom’s Experiment

One such piece of empirical evidence is a randomised experiment conducted by Nicholas Bloom relating to large Indian textile firms. The experiment selected 17 Indian cotton producing companies, and randomly allocated their 28 plants to treatment and control groups.

During the experiment, all plants received one month of free management consulting from a large, international consulting firm funded by Stanford University and the World Bank. For both the treatment and control groups, the first month was spent identifying areas for improvement in management practices and delivering a report comprising the specific problems faced by each plant.

However, the treatment group was provided with additional four months of intensive support to help implement as many of the recommendations as possible, while the control group was not provided with any support.

In effect, data analysis of the differences between the two groups shows that treatment plants experienced significant increases in quality, inventory, and production output, with the overall productivity increasing 11%, or a $230,000 increase in annual profitability.

Furthermore, over time, positive spillover effects from treatment plants were observed in the control plants. Furthermore, as illustrated in Figure 2, the green line shows the increase in the share of management practices adopted by the plants that belonged to the treatment firms that were not part of the experiment. The orange line, however, shows there was practically no change in management practices among plants in the control group firms that were not a part of the experiment.

A Lack of Information

The significant increase in productivity poses the question of why better management had not been previously implemented.

The above experiment conducted surveys that revealed a lack of information about modern management practices and standard operating procedures is the reason. Many firms in developing countries lack a clear understanding of the quality of their product relative to their competitor’s, and the potential of gains to be acquired through improved quality control.

This shows how the rational choice assumption cited previously does not stand up to scrutiny, since in order for firm owners to make rational choices they must have access to accurate information. According to the experiment, this is not the case.

Furthermore, the last result is a vivid example of the informational frictions that prevent competitive forces from taking out inefficient firms. In other words, in a setting where few firm owners understand the true potential of investing in efficient management techniques, the ones that do realise this potential acquire a competitive advantage, and therefore drive out the competition by employing the extra revenue strategically.

Limited Spans of Control

While this is how things should work, it does not correspond to reality, as all the firms from the sample have operated for 20 years in the market. Why, then, do poorly managed firms survive?

The truth is that the problem of resource misallocation runs beyond poor management tactics and the necessity of employing consulting firms to increase efficiency.

A big reason for why competitive forces do not drive out weaklings is the limited span of control that firm owners have sometimes due to an unreliable legal system, which encourages businesses to appoint family members to crucial roles.

In other words, in environments that have many opportunities to profit outside of the law, outsiders are viewed with suspicion.Therefore, delegating responsibilities is often constrained by the number of family members in a given firm. This is supported by the fact that the size of the studied firms directly correlated with the number of male family members related to the owners.

Limited spans of control prevent successful firms from expanding, which limits the competitive market forces and helps less productive firms stay in the industry. This results in a vicious cycle that stagnates economic growth in developing countries, as resource misallocation results in low average productivity levels, weak competitive forces, and additional misallocation in the long run.

 

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