We often speak of economic development as a phenomenon of sovereign national countries, but the process by which that happens is through what happens at individual firms in the economy. The decisions by firms to upgrade their products (services), export, and adopt new technology are the most important determinants of economic development. The incentives and conditions that shape these decisions are the subjects of my conversation with my guest on this episode. Eric Verhoogen is a professor of economics at Columbia University school of international and public affairs. He is one of the leading thinkers and researchers on industrial development.

TRANSCRIPT (edited slightly for context and clarity)

Tobi;

Usually, in the development literature, I know things have changed quite a bit in the last few years. But there is a lot of emphasis on cross-country comparisons and looking at aggregate data, and a lot less focus, at least as represented in the popular media on firms. And we know that, really, the drivers of growth and employment and the source of prosperity usually are the firms. The firms in an economy, firms are the ones creating jobs, they are the ones investing in technology, and doing innovation. So firms are really important.

One of the things you often hear a lot is that one of the reasons poor countries are poor is that the firms are not productive enough. So that's sort of my first question to you, how exactly do we define and also measure productivity, you know, for us to be able to distinguish why firms in the developed countries are more productive than the lower income countries?

Eric;

Yeah, this is a big important question. So I agree, in principle, that firm productivity is very key. So countries that are going to be doing well are countries that are populated by firms that are being very innovative, and their productivity is rising, they're learning how to do new stuff, they're producing new products, etc. And so there's a reason why people are very focused on this conversation about firm productivity. The sort of, I would say, dirty secret of economics is that it's very hard to measure productivity well, right? And so the productivity measures we have, I think, are very noisy, and most likely fairly biased. But basically, the way you estimate productivity is you run a regression of like sales on inputs, okay, so on how much you're spending on labour and how much you're spending on materials, and then the part that's left over, we call that productivity. So it's like unexplained sales, you know, sales that can't be explained by the fact that you're just purchasing inputs and purchasing workers.

But that is actually a very noisy measure of productivity. And so I've been working on a review paper, and a separate research paper kind of pointing out some of the issues with productivity estimation. So in principle, it's exactly what we want to know; in practice, it's very hard to measure. So one argument I was making in that paper is we should go to things that we can actually directly observe. Okay, so sometimes like technology adoption, we can often directly observe whether the firm has adopted this particular new technology, or if they're producing new products, we can directly observe that. Sometimes we can observe the quality of products that can be measured. Now, the standard datasets that we have typically don't have those things. It is possible now, in many countries, to follow manufacturing firms or even other sorts of firms, [to] follow them over time, which is great, at a micro level. But those that have the technology, they don't have quality, they do it now increasingly have like what products they're producing, often they don't have the product people are producing and so it's harder, you have to go out and you have to talk to people, you have to access new sorts of data, there's a lot more work, a lot more shoe leather - we'd say you wear out your shoe is going to talk to people trying to get access to other datasets in order to have these measures that you can observe directly.

But I think there's a big advantage to that. Just in terms of measurement. Like, can we measure these things, and record that technology quality and product innovation together? I'm not sure that's answering your question. But, you know, I mean, I totally agree that what firms are doing, that's crucial, right? So the big macro question is, why are some countries rich and some countries poor and how can we make poor ones richer? That's the big question. I think that's kind of too big to be able to say much about. The much more concrete thing, which we need to be focusing on is how can you make firms in countries more innovative and productive. That's the absolutely right question. But that's just hard. There are challenges and research about, you know, how you actually analyze that, and it has to do with these issues of measurement.

Tobi;

I understand the measurement problem, and of course, TFP, the residual, and so many things like that. But practically, I want to ask you, what can you say, maybe if you have a handy checklist or something? what distinguishes firms in rich countries from firms in poorer nations?

Eric;

Yeah. So let me say what I don't think first, and then I'll say what I think. So it's become increasingly common to say that firms in poor countries are just poorly managed. The firms in rich countries have better management, and the firms in poor countries have poor management, right? And partly that's coming from the influential paper by Nicholas - Nick Bloom - and others, and David McKenzie and John Roberts. You know, they had consultants go to some factories in India. In some they camped out for four months, some they were there for only one month, and the ones where they camped out for four months ended up doing better, right? And they say that that's because these consultants improve the management of the firms and management matters. And I do agree that sometimes these management practices matter, but I don't think... sort of, one kind of implication of that line of work is somehow, like, the firms in a developing country are just making mistakes. They haven't gone to business school in the United States, and so, therefore, they don't know what they're doing. And I think that's incorrect. I think that's incorrect. I think the problem is, firms in developing countries face many, many constraints that firms in rich countries don't face. Right. So often, for instance, gaining access to high-quality inputs can be very difficult, right? That you just don't have the supply chains domestically producing high-quality inputs. Often skilled workers are very expensive relative to unskilled workers, and even relative to the price that you might pay in rich countries. Having skilled workers, including skilled managers, is very expensive. In addition, you have all these frictions on trying to get your goods to market or trying to, you know, trying to access export markets, often there are, you know, their costs involved in that.

In addition, being productive requires know-how and often firms lack that know-how, right and so the question is, how do you get that know-how, you know, like, the distinction I'm trying to make is, it's not that they're making mistakes, it's just that they're doing the best they can given know-how they have, and given the constraints that they face. And so in that sense, I would sort of point to those constraints, right, those constraints both in know-how and both in the input and output markets, rather than just failure of management. So now, one of the constraints I should say, actually, so is often, you know, legal and regulatory institutions are much weaker in many countries. It is true in Nigeria, and it's true in many places, right? And so then that does create a complicating factor also when you're trying to do business with somebody, but you don't have the legal recourse of going to court to enforce whatever contract you write down. And so that creates friction. So then you have to do things differently in part because of that. And so you're likely to be much more based on, like, networks of various types. It might be ethnic networks, or it might be people that you know or that you have long-term relationships with. But then that means you can't necessarily just find the best supplier of something, you actually have to find someone that you trust, and that can complicate your life, basically, if you're trying to do business and develop.

Tobi;

So one thing I want us to discuss is the issue of firm upgrading. I mean, one of the things that have helped me in reading your work and taking this firm-level view of development is that, okay, on the one hand, if you look at a country like Korea, we can say the average income, the income per capita for Korea 40 years ago versus now and compare with say Nigeria, but also we can look at Korean firms 40 years ago versus where they are today. Today, Korea have global firms that are at the very frontier of technology. Companies like Samsung are innovating and making chips and making electronics and making smartphones and you compare with firms in Nigeria who have not been able to upgrade their products over that same period. And now what I want to ask you is how important is a firm's ability to upgrade productivity. I take your point on the measurement but controlling for that, how important is a firm's ability to upgrade its output? Its products on its productivity?

Eric;

No, no, I think upgrading is crucial. And upgrading in various ways, you know, more specifically technology, producing higher quality products, producing new products, new innovative products, you know, you might be reduc