‘Outside’ managers’ productivity, firm dynamics, and economy growth

In developed countries, many industrial giants have humble beginnings as small, family-owned businesses, but nonetheless expand to hundreds of thousands of employees over time by relying on professional managers running key operations. Why does this not occur to the same degree in India? This article explores how the lower productivity of ‘outside’ managers in developing economies impacts firm growth.

Why are the majority of Indian firms small, and managed by families? In developed countries, many industrial giants have humble beginnings as small, family-owned businesses, but nonetheless expand to hundreds of thousands of employees over time by relying on professional managers running key operations. Why does this not occur to the same degree in India or other developing countries? Does it have important implications for firm performance and aggregate economic growth?

Macroeconomic research on economic growth has immensely benefitted from many empirical microeconomic studies that measure the type of frictions faced by firms in developing countries. An early example of this fruitful cooperation is the literature on financial frictions, where both experimental and non-experimental empirical work suggests that firms in poor countries are severely constrained (Woodruff et al. 2008). A large body of macroeconomic research aims to quantify the aggregate implications of such frictions, taking general equilibrium effects into account (Buera et al. 2015).

In this tradition, we explore how the lower productivity of ‘outside’ managers in developing economies might determine limits to delegation and firm growth (Akcigit, Alp and Peters 2021). There is growing microeconomic evidence that managerial services might be the key missing input for many firms in poor countries, potentially due to weaker human capital or frictions within the firms (Bloom et al. 2013). While this evidence is fascinating, as macroeconomists, we seek to understand to what extent such considerations have important aggregate implications.

Micro-level managerial frictions hold back aggregate growth

In our theory, the need for managerial delegation takes centre stage. Because entrepreneurs only have a fixed amount of time to run their daily operations, their own managerial inputs become a bottleneck as the firm grows larger. To overcome this constraint, they can hire outside managers. Therefore, delegation and firm growth are complements, and frictions in the market for outside managers reduce firms’ incentives to grow large. Such frictions could, for example, take the form of contracts that prevent firms from properly incentivising their managerial personnel. We use well-identified microeconomic estimates to identify a structural model of firm growth – one of the first efforts to adopt this methodology to estimate a model for firm dynamics. By highlighting this new estimation methodology, we hope it will inspire other contributions in the field.

One key insight of our theory is that such managerial frictions at the micro level interfere with the process of creative destruction at the macro level.¹ In particular, stumbling blocks in the process of delegation keep firms small and reduce both aggregate innovation and economic growth.

Low productivity of outside managers, and why stagnant firms survive

Like most developing countries, the Indian manufacturing sector is dominated by small firms that neither exit nor expand. Our model illustrates that one reason why the Indian economy suffers from such lack of ‘selection’ which allows stagnant firms to survive, is that companies with growth potential do not have the incentives to expand, because they cannot hire outside managers efficiently. Thus, the abundance of small firms in India reflects not only the frictions small firms face when they want to expand, but also the lack of competitive pressure from larger firms. Quantitatively, we find that differences in the productivity of outside managers between the US and India can account for 11% of the difference in per capita income between these two countries.

Improvements to outside managers’ productivity is not enough to enable Indian firms’ growth

We also find that increasing outside managers’ productivity is not necessarily a quick fix, since there is a strong complementarity between the quality of outside managers and other factors affecting growth. Even if the quality of managerial delegation in India were increased to US standards, it would only increase the average firm size in India by around 3%. Conversely, if US firms used outside managers as unproductively as India, the consequences would be much more severe – average firm size would fall by almost 15%.

This disparity between India and the US shows that the productivity of outside managers is not the only determinant of firm growth. In India, companies face a much higher cost to expand in new product markets. As a result, other frictions, such as credit market imperfections and distortions to market entry, come into play. These other factors not only directly hamper firm growth, but also reduce the effects that any improvements in the delegation environment might have on companies’ incentives to expand. Hence, we find that a complementarity exists between the efficiency of delegating managerial tasks and other aspects affecting firm growth.

Finding the right policy mix to support firm growth

Our findings have important implications for policymakers: policies aimed at supporting small firms in developing countries, such as microfinance programmes, might have beneficial redistributive consequences but can prevent the reallocation of resources from small, stagnant firms to firms with greater growth potential. Hence, there might be unintended consequences that lower aggregate productivity in developing countries in the long run.

Note:

Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones.