Lack of Selection and Limits to Delegation: Firm Dynamics in Developing Countries∗

Firm dynamics in poor countries show striking differences to those of rich countries. While some firms indeed experience growth as they age, many firms are simply stagnant in that they neither exit nor expand. We interpret this fact as a lack of selection, whereby producers with little growth potential survive because innovating firms do not expand enough to force them out of the market. To explain these differences we develop a theory, whereby contractual frictions limit firms’ acquisition of managerial time. If managerial effort provision is non-contractible, entrepreneurs will benefit little from delegating decision power to outside managers, as they spend most of their time monitoring their managerial personnel. As the return to managerial time is higher in big firms, improvements in the degree of contract enforcement will raise the returns of growing large and thereby increase the degree of creative destruction. To discipline the quantitative importance of this mechanism, we incorporate such incomplete managerial contracts into an endogenous growth model and calibrate it to firm level data from India. Improvements in the efficacy of managerial delegation can explain a sizable fraction of the difference between plants’ life-cycle in the US and India.