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SMEs growth and poverty: Do pro-SME policies work?

Thorsten Beck and Asli DemirgСЊР·-Kunt

The World Bank Group
Private Sector Development, Vice Presidency

February 2004

SARPN acknowledges the World Bank as a source of this document:
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This Note explores the relationship between the size of the small and medium-size enterprise (SME) sector and economic growth and pover ty reduction. A new study finds no support for the widely held belief that SMEs promote higher growth and lower pover ty. But it does provide some support for the view that the quality of the business environment facing all firms, large and small, influences economic growth.

To accelerate growth and reduce poverty, international aid agencies provide assistance targeted to small and medium-size enterprises (SMEs) in developing economies. The World Bank Group, for example, approved more than US$10 billion for programs supporting SMEs in the past five years. Does this pro-SME policy work?

The arguments for and against

Advocates of the pro-SME policy make three core arguments for its effectiveness. First, they argue that SMEs enhance competition and entrepreneurship and thus have economywide benefits in efficiency, innovation, and productivity growth. So direct government support of SMEs can help countries reap social benefits. Second, proponents often claim that SMEs are generally more productive than large firms but are impeded in their development by failures of financial markets and other institutions. Thus, pending financial and institutional improvements, direct government support of SMEs can boost economic growth and development. Finally, some argue that the growth of SMEs boosts employment more than the growth of large firms because SMEs are more labor intensive. So subsidizing SMEs may help reduce poverty.

Even as international donors channel a large and growing amount of aid to subsidizing SMEs, skeptics put forth four views questioning the efficacy of this policy. First, some emphasize the advantages of large firms. Large enterprises may exploit economies of scale and more easily undertake the fixed costs associated with research and development, boosting productivity. And empirical evidence from both industrial and developing countries shows that large firms offer more stable employment, higher wages, and more nonwage benefits than small firms, even after differences in workers’ education, experience, and industry are controlled for.

Second, skeptics challenge the assumptions underlying pro-SME arguments. Some research finds that SMEs are neither more labor intensive nor better at creating jobs than large firms. Moreover, recent work finds that underdeveloped financial and legal institutions do not hurt only SMEs. Indeed, research finds that such institutions constrain all firms from growing to their efficient size.

Third, skeptics question the validity of considering firm size to be an exogenous determinant of economic growth. According to this “institutional” view, natural resource endowments, technology, policies, and institutions help determine the industrial composition and optimal firm size in a country. For example, some countries may have endowments providing a comparative advantage in goods produced most efficiently in large firms, while others have a comparative advantage in goods produced most efficiently in small firms. Similarly, in countries open to international trade, the optimal firm size may be larger than in countries that are less open. And some argue that firm size reflects the margin between intrafirm transaction costs and market transaction costs, such that as market transaction costs fall relative to intrafirm transaction costs, the optimal firm size falls. For institutional and technological reasons, this margin varies across industries and countries. So in this view pro-SME policies could distort firm size and potentially hurt economic efficiency.

Fourth, some skeptics, taking a “business environment” view, doubt the crucial role of SMEs and instead emphasize the importance of the business environment facing all firms, big and small. Low entry and exit barriers, welldefined property rights, effective contract enforcement, and access to finance—all factors conducive to competition and private commercial transactions—may encourage SMEs. But these skeptics focus not on SMEs, but on the environment facing all businesses. So, like other skeptics, they question the policy of subsidizing the development of SMEs.

Much research has evaluated pro-SME arguments at the level of the firm, industry, or country. But cross-country studies of the relationship between SMEs and economic development have been hampered by the lack of comparable crosscountry data. A new study provides the first crosscountry evidence on the links between SMEs and economic growth and poverty reduction.

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