What Capital Is Missing in Developing Countries?

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Citation Bruhn, Miriam, Dean Karlan, and Antoinette Schoar. “What Capital Is Missing in Developing Countries?” American Economic Review 100.2 (2010): 629–633.

As Published http://dx.doi.org/10.1257/aer.100.2.629

Publisher American Economic Association

Version Final published version

Citable link http://hdl.handle.net/1721.1/75778

Terms of Use Article is made available in accordance with the publisher's policy and may be subject to US copyright law. Please refer to the publisher's site for terms of use. American Economic Review: Papers & Proceedings 100 (May 2010): 629–633 http://www.aeaweb.org/articles.php?doi 10.1257/aer.100.2.629 =

What Capital is Missing in Developing Countries?

By Miriam Bruhn, Dean Karlan, and Antoinette Schoar*

What capital is missing in developing coun- David Thesmar 2007 suggest the importance tries? We put forward “managerial capital,” of the financial (system) for economic growth. which is distinct from human capital, as a key Human capital is the second traditionally missing form of capital in developing countries. studied input factor in the production function. And it has also been curiously missing in the Most of this research has focused on how dis- research on growth and development. We argue tortions in labor markets or education affect in this paper that lack of managerial capital has productivity. For an example of the emerging broad implications for firm growth as well as literature that documents the effect of labor for the effectiveness of other input factors. A market distortions on firm productivity, see large literature in development economics aims Chang-Tai Hsieh and Peter Klenow 2009 or to understand the impediments to firm growth, Erik Bartelsman, John Haltiwanger and( Stefano) particularly in small and medium enterprises. Scarpetta 2009 . Standard growth theories have explored the However,( the) role of managerial capital importance of input factors such as capital and for production has largely been ignored in the labor in the production function of firms and debate on development and growth.1 Classic countries. At the micro level, empirical studies macro growth models like Robert Solow 1956 such as Suresh de Mel, David McKenzie and relegate managerial or “soft” inputs into( the) Christopher Woodruff 2008 , Abhijit Banerjee residual of the production function, the error et al. 2009 , and Dean( Karlan) and Jonathan term. Famously, Moses Abramovitz 1956 Zinman( 2009) have estimated the impact of called it also the “ignorance term.” Modern( ) access to (finance) for capital constrained micro- growth theory, in contrast, such as Paul Romer enterprises see Karlan and Jonathan Morduch, 1990 or Philippe Aghion and Peter Howitt 2009, for a (review . At the macro level, papers (1992) are more explicit in modeling endog- by Robert King ) and Ross Levine 1993 , enous( ), technical progress as a function of tech- Raghuram Rajan and Luigi Zingales (1998), nological innovation. While this literature and Marianne Bertrand, Antoinette Schoar,( and) acknowledges the importance of entrepreneurial activities and R&D investments for productiv- ity and growth, they mainly focus on how the * Bruhn: Development Research Group, The World economic environment affects the incentives to Bank, 1818 H Street N.W., Washington, DC 20433, engage in innovation. e-mail: [email protected] . Karlan: Department of( Economics, Yale University, Innovations) for Poverty One could incorporate the idea of manage- Action, MIT Jameel Poverty Action Lab, Financial Access rial capital into endogenous growth theory by Initiative, 27 Hillhouse Avenue, New Haven, CT 06511, making it part of the intercept shifter, A, in the 1 e-mail: [email protected] . Schoar: MIT Sloan School production function: y Akα l ( −α). As such it of( Management, Massachusetts) Institute of Technology, = NBER, ideas42, 50 Memorial Drive E52-433 Cambridge, is central for the productivity of other inputs. If MA 02142, e-mail: [email protected] . Thanks to the man- we assume that managerial capital is an impor- agement and( staff of IPPC. Thanks to the) field research man- tant component of A, this production function agement team at Innovations for Poverty Action, including suggests that high levels of other inputs do Alissa Fishbane, Javier Gutiérrez, Ashley Pierson, Douglas not lead to high levels of output if managerial Randall, and Anna York, Ximena Cadena at ideas42, and Kiyomi Cadena at the World Bank for excellent research capital is particularly low. In fact, there is an assistance. Thanks to the Government of the State of Puebla, via the Consejo para el Desarrollo Industrial, Comercial y de Servicios, the Knowledge for Change trust 1 One exception is the literature on family firms that fund of the World Bank, and the Bill and Melinda Gates investigates how the involvement of family members affects Foundation via the Financial Access Initiative for funding. the quality of managerial decisions within these firms, but All opinions and errors in this paper are those of the authors this evidence is only indirect see Francesco Caselli and and not of any of the donors or of the World Bank. Nicola Gennaioli 2003 or Bertrand( and Schoar 2006 . ) 629 630 AEA PAPERS AND PROCEEDINGS MAY 2010

­earlier tradition in micro theory that models the The second channel through which manage- importance of managerial capital and its alloca- rial capital can affect firms is through its effect tion across firms. The seminal papers by Robert on the amount and type of physical and labor Lucas 1978 and Sherwin Rosen 1982 propose inputs that a firm buys or rents. The decision that “talent( for) managing” is an important( ) factor to access inputs like capital or labor in itself of production. Lucas 1978 assumes that there requires managerial inputs to forecast the capital is a wide distribution( of managerial) ability in needs of the firm, plan the process by which to the economy and derives an endogenous firm approach lenders, invest the obtained resources, size distribution based on a neoclassical pro- etc. This second channel suggests that resource duction function. Managerial capital is assumed constraints themselves are a function of mana- to be complementary to other firm inputs and gerial capital. The literature on management leads to a convex distribution of returns. Rosen styles in the United States context suggests that 1982 , in an extension of the Lucas model, individual managers are central in shaping their (explicitly) focuses on the internal managerial firm’s capital structure, investment strategy, and structure of firms and explains an observable overall business plan see Bertrand and Schoar relationship between firm size, earnings, and 2003; or Morten Bennedson( et al. 2009 . firm profitability. This focus on managerial capital allows) us Despite these early proponents of managerial to shed new light on the interpretation of many capital in the theory literature, little empirical previous studies of small and medium enter- work has been done to understand the nature of prise SME growth. For example, the very high managerial capital and to document its impact on returns( to capital) that were found in papers such firm productivity. For development economics it as de Mel, McKenzie, and Woodruff 2008 or is therefore important to investigate if manag- McKenzie and Woodruff 2008 could be( a com) - ers and firm owners who are often managers as bination of returns to capital( ) plus managerial well indeed lack the( organizational and mana- inputs that are provided through the experiment. gerial) abilities to manage an effective operations If these small businesses have limited access scale-up. Such managerial skills may require not only to capital but also to management either training or experience in other well-run resources, the experiment itself might solve the firms or might be acquired through outside con- planning problem for these firms as well as the sulting inputs or a combination of these .2 capital constraints by significantly reducing the We argue that( managerial capital can) affect burden of accessing bank finance or convincing the production function of firms in two distinct a lender about the firm’s creditworthiness. This ways. The first channel is based on the idea that managerial capital gap can be quite significant firms with better managerial inputs are able to in many situations. Anecdotally we know from improve the marginal productivity of their other many developing countries that the success of inputs, for example labor, physical capital, etc. small business lending strongly depends on hav- Better managers may motivate and retain work- ing a well trained set of loan officers who are ers better, may make fewer mistakes in how able to assess the capital needs of the business. they employ physical capital, such as maintain- In many cases small business owners rely on the ing machinery, or may identify better marketing loan officer and the bank to suggest the right or pricing strategies when selling their services. loan size and even what to invest in and how to This channel resembles the traditional view of expand the business.3 how heterogeneity in productivity affects firm output. 3 Such an interpretation could imply that those with higher managerial capital should have lower returns to capital increases, if they were able to solve their credit 2 The idea that managerial talent might be formed constraint problem but those with lower managerial capi- through training and prior experience is echoed in the lit- tal were not. De Mel, McKenzie, and Woodruff find the erature on managerial backgrounds in the United States. opposite using digital span recall as a proxy measure of Results have shown that successful entrepreneurs come managerial capital. The circumstances of that study, in par- from large well-run firms, e.g., Paul Gompers, Josh Lerner, ticular the micro-size of the firms and the post-tsunami con- and David Scharfstein 2005 , or that CEOs are shaped text, suggest alternative relationships between managerial or by the early career experiences( ) they are exposed to as in human capital and returns to financial capital; thus we do not Schoar 2010 . consider this evidence dispositive against the above theory. ( ) VOL. 100 NO. 2 What Capital is Missing in Developing Countries? 631

I. Empirical Evidence on the Importance of They find that a simple, rule-of-thumb based Managerial Capital approach to teaching does better than a more intricate training program. The results suggest Several recent papers suggest that man- that an improvement in these skills increases agement education, as well as management sales, and in particular helps to reduce months practices, are of lower quality in developing of very poor sales outcomes. countries than in developed countries. Azam Bruhn, Karlan, and Schoar 2010 examine Chaudry 2003 reports the results from an whether lack of managerial knowledge( ) can be International( Finance) Corporation survey con- alleviated by providing consulting services to ducted in 78 different countries that asked firms supplement the managerial skills of the business to assess the quality of locally educated MBAs owners. They conducted a randomized control the firm had hired. Firms in lower income trial in Mexico, where small businesses were countries were more likely than firms in higher paired with a consultant from one of a number of income countries to say that these MBAs were local management consulting companies for the inadequately prepared overall and that they period of one year. Consultants were asked to i had lower technical skills. Nicholas Bloom and diagnose the problems that prevented the firms( ) John Van Reenen 2010 collected a measure from growing, ii suggest solutions that would of management practices( ) for firms in a num- help to solve the( ) problems, and iii assist the ber of countries. Firms from non-Organization firms in implementing the solutions.( ) The cost of for Economic Cooperation and Development the consulting service was highly subsidized. (OECD) countries scored significantly below Early results show that the consulting ser- firms from OECD countries on this manage- vices had a positive effect on firms’ productivity. ment practices measure. Productivity increased significantly, measured However, these cross-country studies and our as either the residual from a productivity regres- discussion above provide at best circumstantial sion or return on assets. Monthly firm sales and evidence of the impact of managerial capital. To profits also are higher in the treatment group than carefully test the importance of the proposed in the control group 78 percent and 110 percent, management channel, we ideally need to find respectively . The estimated( effects are economi- exogenous variation in the access to managerial cally large but) are only significant at the ten per- capital across firms. Two studies, Karlan and cent level, likely because the data is noisy and the Martin Valdivia forthcoming and Alejandro sample size is relatively small 433 firms in total . Drexler, Greg Fischer,( and Schoar) 2010 , con- The described impact of consulting( services) duct field experiments that introduce( exogenous) is much larger than the estimates of improved variation in managerial capital across microen- access to capital for small businesses found in terprises through business training. The former the literature. De Mel, McKenzie, and Woodruff paper reports on a randomized control trial of 2008 estimate a return to capital of five per- an entrepreneurship training program in Peru. cent( per) month for Sri Lankan microenterprises, The training consisted of classroom-style inter- McKenzie and Woodruff 2008 find 20–33 per- active lectures for preexisting clients of a group cent monthly return to capital( ) in Mexico, and lending microcredit program for women. The Christopher Udry and Santosh Anagol 2006 lessons focused on basic business and record- find 60 percent annualized return to capital( in) keeping skills and targeted micro and not small Ghana. However, the estimated impact of mana- and medium enterprises. The authors find that gerial capital seems reasonable since Bloom and business knowledge increased, but that no con- Van Reenen 2010 find about a 30 percent varia- sistent improvements occurred for business rev- tion in management( ) practices between the best enue, profits, or employment although there is and the worst countries, which translates into some suggestive evidence of ( stronger impacts much larger productivity differences. for those with less interest in receiving training as self-reported in a baseline survey, and some II. Conclusions suggestive evidence of an increase in the rev- enues during bad months . Drexler, Fischer, and The experiments described above test not only Schoar 2010 test different) approaches of teach- whether managerial capital is a limiting fac- ing record( keeping) skills to micro entrepreneurs. tor in the growth of firms but also whether this 632 AEA PAPERS AND PROCEEDINGS MAY 2010

­knowledge can be taught in the first place. They ­Allocation and Selection.” National Bureau of cannot separately analyze the above two ques- Economic Research Paper 15490. tions. In other words, lack of managerial capital Bennedsen, Morten, Kasper Meisner Nielsen, could indeed be a hindrance to growth, but failure Francisco Perez-Gonzalez, and Daniel Wolfen- to find a result in these studies would not disprove zon. 2007. “Inside the Family Firm: The Role that, since it may simply mean that the program of Families in Succession Decisions and Per- was not effective in teaching managerial skills or formance.” Quarterly Journal of Economics, that managerial skills are innate skills and simply( 122(2): 647–91. not teachable . The early studies discussed above Bertrand, Marianne, and Antoinette Schoar. suggest that managerial) capital seems to matter 2003. “Managing with Style: The Effect of and is at least in part teachable. Of course, the Managers on Firm Policies.” Quarterly Jour- results also indicate that there is a lot of hetero- nal of Economics, 118(4): 1169–1208. geneity in the treatment effects and the possible Bertrand, Marianne, and Antoinette Schoar. approaches to training. 2006. “The Role of Family in Family Firms.” Going forward we envision that we need Journal of Economic Perspectives, 20(2): much more research to better understand the 73–96. importance of managerial capital. First, what Bertrand, Marianne, Antoinette Schoar, and is the impact of managerial capital, and what David Thesmar. 2007. “Banking Deregula- is the precise channel by which it interacts with tion and Industry Structure: Evidence from the other inputs in the production function? Second, French Banking Reforms of 1985.” Journal of can managerial capital be taught, and how? Finance, 62(2): 597–628. Short-term training and consulting services as Bloom, Nicholas, and John Van Reenen. 2010. described above might not be the most effective “Why do management practices differ across form of management training. Managerial capi- firms and countries?” Journal of Economic tal might be developed through work experience Perspectives, 24(1): 203–24. or exposure in the family. Bruhn, Miriam, Dean Karlan, and Antoinette Lastly, much remains to be learned about the Schoar. 2010. “The Impact of Offering Con- operational practicalities of teaching manage- sulting Services to Small and Medium Enter- rial skills. Several development organizations prises: Evidence from a Randomized Trial in provide business development services, includ- Mexico.” Unpublished. ing training and consulting, to SMEs. Yet little Caselli, Francesco, and Nicola Gennaioli. 2003. data has been generated that rigorously demon- “Dynastic Management.” National Bureau of strates the impact of any of these approaches. Economic Research Working Paper 9442. With more consistent data and experimentation, Chaudhry, Azam. 2003. “The International researchers should be able to learn more about Finance Corporation’s MBA Survey: How not only whether such initiatives work, but how Developing Country Firms Rate Local Busi- and why they work. ness School Training.” The World Bank Pol- icy Research Working Paper 3182. References De Mel, Suresh, David McKenzie, and Chris- topher Woodruff. 2008. “Returns to Capital Abramovitz, Moses. 1956. “Resource and Output in Microenterprises: Evidence from a Field Trends in the United States since 1870.” Amer- Experiment.” Quarterly Journal of Econom- ican Economic Review, 46(2): 5–23. ics, 123(4): 1329–72. Aghion, Philippe, and Peter Howitt. 1992. “A Drexler, Alejandro, Greg Fischer, and Antoinette Model of Growth through Creative Destruc- Schoar. 2010. “Financial Literacy Training and tion.” Econometrica, 60(2): 323–51. Rule of Thumbs: Evidence from a Field Exper- Banerjee, Abhijit, Esther Duflo, Rachel Glenner- iment.” Unpublished. ster, and Cynthia Kinnan. 2009. “The Miracle Gompers, Paul, Josh Lerner, and David Scharf- of Microfinance? Evidence from a Random- stein. 2005. “Entrepreneurial Spawning: Pub- ized Evaluation.” Unpublished. lic Corporations and the Genesis of New Bartelsman, Eric J., John C. Haltiwanger, and Ventures, 1986 to 1999.” Journal of Finance, Stefano Scarpetta. 2009. “Cross-Coun- 60(2): 577–614. try ­Differences in Productivity: The Role of Hsieh, Chang-Tai, and Peter J. Klenow. 2009. VOL. 100 NO. 2 What Capital is Missing in Developing Countries? 633

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