High Business Inequality, Very Low Productivity

Instead of supporting small firms, governments should encourage large firms to absorb the resources which small firms are using badly.

It is frequently said that Latin America is the region of the world with the greatest income inequalities. But these extreme levels of inequality are not limited to people: they also exist between firms and are a serious problem for productivity.

If Mexican manufacturing firms are arranged in order of productivity, firms in the least productive decile require four times more capital and labor resources per unit of production than the 10% most productive firms. These gaps are double those found between firms in the United States or China. Mexico is not an isolated case within Latin America. In countries as different as El Salvador and Uruguay, productivity gaps between firms are high by world standards. Excluding firms with less than 10 workers, the productivity gaps of firms in Colombia and Venezuela are six to one. And far from narrowing, the gaps between firms have widened in recent years.

The smallest firms are the most unproductive. The capital and human resources invested in firms with over 100 employees typically produce double the output than if they were spread over a dozen firms with 10 employees each.  In some countries the differences are substantially greater. In Brazil, El Salvador and Venezuela large firms are at least three times more productive than small ones.

What aggravates the problem is that –apart from their very low productivity– small firms are extremely numerous in Latin America, and so absorb a very large proportion of productive resources, especially labor. Although this is true in any economy (in the United States 54% of firms have 10 or fewer workers), in Latin American countries the excess of small firms is overwhelming: in Argentina 84% of firms have 10 or fewer workers, while in Mexico and Bolivia over 90% do not even have 10.

Latin America would make a huge gain in productivity if the resources of these less productive firms were reallocated to the more productive ones. By making a simple reallocation of resources among manufacturing companies, Mexico could double its industrial production, and El Salvador could increase it by almost 60%.

Outside the manufacturing sectors there seems to be even more room for improving productivity by reallocating resources. Retail trade, in which millions of Latin American workers have sought refuge due to the scarcity of better jobs, is a potential reserve of enormous gains: in Mexico and Brazil the productivity of this sector could be increased by around 260% and similar gains could be achieved in other services.

This suggests that instead of helping unproductive firms, it would be better to help large firms with high productivity to grow more and absorb the badly used resources of the small firms.

Obviously, this raises the question, what is preventing this process from taking place or, to put it another way, how can so many firms –especially small firms– survive with such low productivity? These are crucial policy questions which are the subject of an Inter-American Development Bank report titled “The Era of Productivity: How to Transform Economies from their Foundations” (Palgrave, 2010), which has been just released.