Abstract
Small and informal firms account for a large share of employment in developing countries. The rapid expansion of microfinance services is based on the belief that these firms have productive investment opportunities and can enjoy high returns to capital if given the opportunity. However, measuring the return to capital is complicated by unobserved factors such as entrepreneurial ability and demand shocks, which are likely to be correlated with capital stock. The authors use a randomized experiment to overcome this problem and to measure the return to capital for the average microenterprise in their sample, regardless of whether they apply for credit. They accomplish this by providing cash and equipment grants to small firms in Sri Lanka, and measuring the increase in profits arising from this exogenous (positive) shock to capital stock. After controlling for possible spillover effects, the authors find the average real return to capital to be 5.7 percent a month, substantially higher than the market interest rate. They then examine the heterogeneity of treatment effects to explore whether missing credit markets or missing insurance markets are the most likely cause of the high returns. Returns are found to vary with entrepreneurial ability and with measures of other sources of cash within the household, but not to vary with risk aversion or uncertainty.
Highlights
Small and informal firms are the source of employment for half or more of the labor force in most developing countries
Evidence that some firms have high marginal returns is suggested by the very high interest rates paid to moneylenders, and by literature which identifies the effect of credit shocks on those who apply for credit
In results reported in the online appendix, we find no relationship between the percentage invested and baseline household assets, years of schooling, digitspan scores, the baseline profit / sales and profit / capital stock ratios, or the coefficient of relative risk aversion estimated from the lottery exercise
Summary
Small and informal firms are the source of employment for half or more of the labor force in most developing countries. McKenzie and Woodruff (2008) undertake an experiment similar to that reported on here among a small sample of enterprises in Mexico with less than $900 of capital stock They find returns in the range of 20-30 percent per month, somewhat higher than the cross-sectional estimates in their earlier work. We show that the results are robust to accounting for potential spillovers on firms located near the treated firms, to attrition from the sample, and to measurement issues We use both the baseline data and the untreated panel to compare returns generated by OLS and random- and fixed effects regressions with those generated by the experiment. Our main specifications will include enterprise fixed effects to improve precision and account for such chance differences between treatment groups
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