The Misconception of Entrepreneurship in Developing Countries

The Argument
Here are two reasons the poor may be particularly likely to find large opportunities:
(1) They haven’t yet been given a chance, so their ideas are probably fresher and less likely to have been tried already.

(2) The market so far has mostly ignored the bottom of the pyramid. As a result, it is argued, innovations that better the lives of the poor have to be the low-hanging fruit, and who better than the poor themselves to think of what they could be?

A billion entrepreneurs
Muhammad Yunus, founder of Grameen Bank, and many others often describe the poor as natural entrepreneurs. They believe that micro-finance can give anyone a shot at being successful. This glazes over the barriers of seeing this through to a reality.

The poor operate very small and unprofitable businesses
The paradox of the poor and their business is that “they are energetic and resourceful and manage to make a lot out of very little. But most of this energy is spent on businesses that are too small and utterly undifferentiated from the many others around them. As a result, their operators have no chance to earn a reasonable living”

The low profitability of businesses run by the poor explains why microcredit does not seem to lead to a radical transformation in the clients’ lives.

Two Types of Technology: sustainable growth vs diminishing returns
“Consider yourself as a shopkeeper: once you have set aside some room in your home for a shop and have committed to working there a few hours a day, your profits will be much higher if you have enough goods to fill up the shelves and keep you busy than if you have next to nothing (as many shops seem to). But once your shelves are full, any further expansion probably would not have enough marginal return to pay off the very high interest rates on the loan you might use to make it happen.”

Production technology is the relation between the amount of investment in a firm, and its overall returns. Think of it as a graph where the y-axis is production and the x-axis is investment. Consider two lines on this graph:

1) a business with sustainable growth. This line is approximately linear: you gain increased production value proportional to your investment

2) a business with marginal returns. Initial investments cause a very large increase in production (enter micro-financing), but further investments carry diminishing returns, which puts a cap on production value. This line is the story of the shopkeeper.

For most poor people, the growth of their business looks like line #2

The Barrier: inability to scale production technology
“The very small scale of many of these businesses explains why their overall returns are often so low, despite the high marginal return. But it brings to light a new puzzle. The fact that marginal returns are high means that it is easy to grow the overall returns–just put more money into the business. So why aren’t all the small businesses growing really fast?”

They could not be growing because of (1) their limitations on borrowing (discussed in the next section), (2) they don’t choose to borrow, or (3) they choose to save the profit.

The difficulty arises because the amount that has to be saved to invest in a higher production technology (for example: automatic sewing machines) is mostly out of reach given the low returns of their business.

MFIs are not suited to fill this space because these investments carry more risk, and requires larger loans.

The Financial Limits of MFIs
“we are far from seeing the equivalent of the micro-finance revolution for small and medium firms; nobody has yet figured out how to do it profitably on a large scale.”

“Ultimately, this problem stems from the structure of banks. Because they are, by nature, large organizations, it is hard for them to provide incentives to their employees to screen the firms, monitor projects, and make worthwhile investments. For example, if they decide to punish loan officers for default (which, to a point, they must), loan officers start looking for the absolutely safest projects, which are unlikely to be small, unknown firms.”

It could be that “perhaps there is a natural graduation process: start by borrowing from an MFI, grow your business, then move on to a bank”

However, “the structure of [MFIs], which is the source of its success in lending to the poor, is such that we cannot count on it to be a stepping-stone for larger businesses to be created and financed. Finding ways to finance medium-scale enterprises is the next big challenge for finance in developing countries”

The Conclusion: entrepreneurship is very difficult for the poor
“If our diagnosis is correct, the reason that the poor do not grow their businesses is that, for most of them, it is too hard: They cannot borrow to [invest in higher production technologies], and saving up to get there will take too long unless their businesses have extremely high overall returns.”

“Furthermore, once a micro-entrepreneur realizes that she is probably stuck in the low part of the S-shaped curve and will never be able to make that much money, it may be difficult for her to be fully committed to her business.”

“In the same way that the poor may save less than the middle class because they know that their savings will not be enough to reach a consumption goal they are really looking forward to, they may not invest as much (not only money but also emotions and intellectual energy) in their business because they already know that they can’t make a real difference.”

MFIs that have tried basic education of business at weekly meetings have mostly failed. This could be because it is not a lack of knowledge, but a lack of enthusiasm that is preventing growth. However, small ‘rule of thumbs’ have proven to have an impact, because they work within the intellectual resources the poor are willing to invest in their business.

The Misconception:
“This evidences makes us seriously doubt the idea that the average small business owner is a natural “entrepreneur,” in the way we generally understand the term, meaning someone whose business has the potential to grow and who is able to take risks, work hard, and keep trying to make it happen even in the face of multiple hardships. We are, of course, not saying that there are no genuine entrepreneurs among the poor–we have met many such people. But there are also many of them who run a business that is doomed to remain small and unprofitable.”

Therefor, the services of Village Enterprise are innovative because they provide grants rather than loans, and do not receive a financial return, while also providing training and mentoring.

All quotes are from Poor Economics by Abhijit V. Banerjee and Esther Duflo

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