Abstract

The vast majority of firms in developing economies are micro and small enterprises owned by families whose members also provide the labour to the units. Often, they fail to grow in size even with the relaxation of credit constraints. In this paper, we show that frictions in the labour market leading to monitoring costs tend to reduce the growth of the firm via two channels: (1) it forces the entrepreneur to devote more time on monitoring hired labour from outside family which curtails her time on productive activities leading to failures of firm's projects. (2) The need to pay a premium wage over the market rate in order to incentivize workers makes it costlier for the firm to expand in size via hiring outside labour. In this framework, we show that possibility of an inverted U- shaped relationship between the credit supply and the size of the firm, measured by hiring of non family labour, indicating frictions in the labour market may outweigh the effects of the easing of borrowing constraints of the firm. We then use a unique data-set comprising large nationally representative surveys of small and micro-enterprises in Indian manufacturing and find support for the existence of such a non-monotonic relationship attributed to both frictions in the credit and labour markets.

Highlights

  • An important stylized fact in low income countries is the presence of a large number of very small household enterprises in the informal sector which mostly employ family labour

  • We begin with a basic specification, where we regress the number of hired workers against loans, inverse productivity and wage premium and the interaction effects

  • For an owner-managed small firm, the hiring of a non-family worker is a non-trivial decision and involves a trade-off between the greater profits and productivity benefits that the firm can enjoy with a larger size and the opportunity cost of the firm’s owner in monitoring the worker’s effort and as a consequence, increasing wages of non-family workers to provide greater incentive for them to be productive

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Summary

Introduction

An important stylized fact in low income countries is the presence of a large number of very small household enterprises in the informal sector which mostly employ family labour. Such firms rarely make the transition to the formal sector or grow in size by hiring labour from the outside market (Gollin, 2008; Woodruff, 2012).. Such firms rarely make the transition to the formal sector or grow in size by hiring labour from the outside market (Gollin, 2008; Woodruff, 2012).1 The presence of such a large number of micro sized household enterprises in developing countries along with their lack of growth is often attributed to credit constraints that do not allow these firms to increase in size (Hurst and Lusardi, 2004). While credit constraints play an important role in determining the size of a firm, they cannot be the full explanation of why household enterprises in low income countries do not grow in size, and why owner-entrepreneurs do not become employers of wage labourers.

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