Two years ago Brookings held an event, “What Works in Development? Thinking Big and Thinking Small,” which survives today as a source for excellent working papers from some of my favorite development economists. Today I read Abhijit Vinayak Banerjee’s Big Answers For Big Questions: The Illusions of Macroeconomics, and was struck by a passage seeking to explain the gap in Total Factor Productivity between the US and India:
At least a part of the answer to the TFP puzzle seems comes from massive misallocation of resources within the same economy, something that is not picked up by any of the macro aggregates that are used in growth accounting exercises. These misallocations are not the product of any one distortion but rather the cumulative effect of many, many individual distortions resulting from both government failures and market failures. Banerjee and Duflo (2005) describe the evidence for these distortions in some detail drawing on range of micro-studies. They then carry out a heuristic exercise to assess whether the extent of observed misallocation is large enough to explain away the IndoUS TFP differences. Their answer, which they propose quite tentatively, since what they do is no more than a finger exercise, is yes: If we are willing to assume a model where there is some increasing returns at the firm level, the fact that the medium firms in India are too small and too numerous relative to what they would be in an efficient economy, can actually explain the entire TFP gap.
Hsieh and Klenow (2006) use data from firm-level annual surveys from the US, China and India to carry out a much more empirically founded version of the same exercise. They calibrate a model of monopolistically competitive differentiated firms using this data and show that the allocation of resources across firms within the same industry is indeed much more distorted in both India and China than in the US, and that in particular it is most productive firms that are too small in both those countries. If these countries could achieve US-level efficiency in the allocation of resources within the same industry, they calculate, TFP would go up by 30-45% in China and 45-50% in India. Clearly there may also be misallocation across industries, which would presumably add to this total.
Banerjee’s working paper adeptly sketches the limits of macro analysis, and the potential impact of micro-level intervention:
For example, it seems clear that fertilizer is massively underused in parts of Africa: the question is to what extent this is a result of an unwillingness to take risks, the unavailability of credit, the lack of the right internal or external incentives for long-range planning, distortions in the land market or a lack of understanding of the benefits of fertilizer. This is the kind of problem that is probably best addressed by a combination of theoretical thinking and experimental work, exemplified by the work of Duflo, Kremer and Robinson (2007) on fertilizer adoption in Kenya. Their results clearly suggest that a part of the problem is a lack of ability to commit to a long-range plan and that a simple contract that solves this commitment problem can massively increase fertilizer adoption.
This is no doubt only a part of the answer: And it is possible (though hardly obvious— there many NGOs in Kenya) that there is not enough implementation capacity in Kenya to provide the needed contract to everyone. On the other hand, once the need is well understood, there is no obvious reason why the market would not start to offer it.