The macroeconomic institutions literature has demonstrated the importance of institutions in promoting economic development and growth. Economists are now digging deeper to understand the microfoundations of this growth at the level of individual firms. A feature of developing economies is that fledgling firms find it more difficult to grow than their counterparts in developed countries and remain small throughout their lives. Seeking to explain this feature, a popular hypothesis is that small firms find it difficult to grow because capital markets do not function efficiently and so firms are credit constrained. But if this were true then small developing country firms should exhibit high productivity at the margin. Recent detailed econometric work at the firm level has found that firm level productivity in developing countries is in fact quite low.
A new literature proposes that firms in developing countries are unproductive due to poor management, an idea first introduced by Penrose (1959) but only tested recently through the emergence of appropriate data. This new literature argues that firms in developing countries remain small because, in the presence of weak contract enforcement institutions, it is difficult for them to incentivize managers appropriately. As a result managerial decisions are restricted to the families who own the firms, limiting the potential for firm growth. A striking predictor of firm size in developing countries is the number of male members in the family that owns the firm. Although progress has been made recently in understanding the importance of institutions for managerial effectiveness, many questions remain open. For example, what is the external validity of the findings for management effectiveness in the sectors where this research has been undertaken? What are the links to established theories of management? Can field experiments be used to discover the most effective management practices?
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