Entrepreneurship and the Business Environment in Africa: An Application to Ethiopia

Transcription

1 DISCUSSION PAPER SERIES IZA DP No Entrepreneurhip and the Buine Environment in Africa: An Application to Ethiopia Zuzana Brixiova Mthuli Ncube Augut 2013 orchungintitut zur Zukunft der Arbeit Intitute for the Study of Labor

2 Entrepreneurhip and the Buine Environment in Africa: An Application to Ethiopia Zuzana Brixiova African Development Bank and IZA Mthuli Ncube African Development Bank Dicuion Paper No Augut 2013 IZA P.O. Box Bonn Germany Phone: ax: Any opinion expreed here are thoe of the author() and not thoe of IZA. Reearch publihed in thi erie may include view on policy, but the intitute itelf take no intitutional policy poition. The IZA reearch network i committed to the IZA Guiding Principle of Reearch Integrity. The Intitute for the Study of Labor (IZA) in Bonn i a local and virtual international reearch center and a place of communication between cience, politic and buine. IZA i an independent nonprofit organization upported by Deutche Pot oundation. The center i aociated with the Univerity of Bonn and offer a timulating reearch environment through it international network, workhop and conference, data ervice, project upport, reearch viit and doctoral program. IZA engage in (i) original and internationally competitive reearch in all field of labor economic, (ii) development of policy concept, and (iii) diemination of reearch reult and concept to the intereted public. IZA Dicuion Paper often repreent preliminary work and are circulated to encourage dicuion. Citation of uch a paper hould account for it proviional character. A revied verion may be available directly from the author.

3 IZA Dicuion Paper No Augut 2013 ABSTRACT Entrepreneurhip and the Buine Environment in Africa: An Application to Ethiopia 1 Since mid-2000, Ethiopia ha been one of the fatet growing countrie in the world. However, productive entrepreneurhip in high-value added activitie ha made limited contribution to thi growth, in part becaue of a weak buine environment. Moreover, the low-productive firm in the informal ector till account for a large hare of employment. Reflecting thee fact, thi paper preent a model of cotly entrepreneurial tart-up in an economy with a large informal ector and rigid buine environment where an equilibrium outcome can be a low-kill, low-productivity trap. By fotering productive tart-up and killed employment, creation of an enabling buine environment could help move the Ethiopian economy into high-productivity equilibrium. JEL Claification: L26, J24, J48, O17 Keyword: entrepreneurhip, SME tart-up, low productivity trap, multiple equilibria, Africa Correponding author: Zuzana Brixiova African Development Bank 15 Avenue du Ghana P.O. Box Tuni-Belvedère Tuniia z.brixiova@afdb.org 1 The author thank Emerta Aaminew and Andrea Wörgötter for comment and input into the earlier verion (AfDB Working Paper No. 117). The paper wa preented at the African Economic Conference (Addi Ababa, 2009), the IZA/World Bank Conference on Employment and Development (Cape Town, 2010) and the 2011 Conference of South African Economic Society (Stellenboch). The view expreed are thoe of the author and do not necearily reflect thoe of the African Development Bank.

4 I. Introduction Policymaker in Africa have long recognized the private ector, including entrepreneurhip, to be a key part of development agenda for their countrie and the continent. Depite thi recognition, contribution of productive entrepreneurhip to growth and employment ha been limited, epecially in low income and fragile countrie. While entrepreneurhip a uch ha not been limited in Africa, the productive, high value-added type ha been motly miing (Rogeron, 2001). One of the reaon ha been lower competitivene in a number of African countrie, temming in part from an overall weaker buine environment than in other region. Raiing competitivene through improving the buine environment i thu a top policy priority in Africa. In Ethiopia, the private ector gained more prominence in 1991, after the ocialit Derg regime wa replaced. The ubequent government introduced market reform with a view to timulate growth through a vibrant private ector, epecially mall and medium enterprie (SME). Two decade later, however, the record ha been mixed. While Ethiopia ha been among the fatet growing countrie in the world ince the mid-2000, public enterprie and low productive firm in the informal ector employ majority of the population. Highly productive SME can be found motly in elected ector and region. In um, the rapid growth driven by public invetment, agriculture and a few exceptional ector notwithtanding, a large part of the country experience high unemployment, low productivity, low-paid job, and poverty. Developing the country private ector and productive SME i thu a key policy challenge. Thi paper develop a model of cotly entrepreneurial tart-up in an economy with rigid buine environment and a large and dualitic informal ector. Thi line of reearch contribute to cloing a gap in the entrepreneurhip and development literature, which conit motly of empirical tudie and urvey, but theoretical underpinning ha been motly lacking. The model extend and applie the framework of Brixiová (2013) to the cae of a low income country. The model alo build on Snower (1996) who howed for developed countrie that labor market failure, including imperfect information, lead to uboptimal outcome. Such failure are even more prevalent in low-income countrie uch a Ethiopia where the buine environment i weak and the labor market including upporting intitution underdeveloped. Specifically, entrepreneur are dicouraged from earch for a productive buine opportunity becaue of the weak buine environment and the potential difficultie in finding killed worker. Similarly, worker are not alway aware of killed vacancie. The product and labor market imperfection hamper development of the highly-productive private ector employing killed labor. In linking the model with data and other evidence on buine environment, we draw on Ncube (2005). The paper focue on entrepreneurial tart-up of highly-productive firm, a their abence contraint output and job growth in Ethiopia. We how how under a weak buine environment the economy can end up in a low productivity trap, with the informal ector accounting for all private ector output and employment. The emphai on firm creation and the incluion of the informal ector, which characterize Ethiopia and other low-income countrie, ditinguih thi framework from that of Snower (1996) who analyzed vacancie in exiting firm in the formal ector in advanced economie. It alo differ from that of Gelb et al. (2008) by conidering how regulation, in particular unclear property right, can impact the entrepreneurial earch and drive 2

5 firm to the informal ector. The model reflect key tylized fact of the Ethiopian urban labor market. We utilize it to examine policie that could upport development of highly productive SME in the formal ector and move the economy into high productivity equilibrium. The paper i organized a follow. After thi Introduction, Section II highlight tylized fact on the SME ector and the urban labor market in Ethiopia. Section III preent the model and examine the impact of a better buine environment on SME tart-up. Section IV confront the reult with empirical evidence from other developing countrie. Section V conclude. II. Growth and SME Contraint in Ethiopia: The act Since Ethiopia introduced market reform in 1991, it economy ha been characterized by mix of market incentive and central planning. The heavy role of the tate ector in the non-agricultural output and low job creation in the formal private ector make the country akin to an early-tage tranition economy. At the ame time, Ethiopia exhibit characteritic of a typical low income country, uch a a large and dualitic informal ector; high hare of agriculture in the output; and the lack of enabling buine environment, among other. The paragraph below highlight main fact about challenge to growth and productive entrepreneurhip in the country. Growth and Productivity Trend At average annual growth of 10.4 percent during , Ethiopia wa one of the fatet growing countrie in Sub-Saharan Africa (SSA) and globally during thi period (Table 1). However, growth wa driven motly by modernization of agriculture (which account for 80 percent of employment), commodity boom, public invetment, and with the exception of financial intermediation expanion of low value-added ervice (Geiger and Moller, 2013). or the mot part, performance of the manufacturing ector and high-value added ervice remained ubdued. 2 The manufacturing ubector contributed le than 4 percent of output in Table 1: Real GDP Growth: Ethiopia and other SSA countrie Growth (%) SD Growth (%) SD Angola Ethiopia Rwanda Equatorial Guinea Liberia Ghana Uganda Mozambique Tanzania Nigeria After the government provided technology package and upport ervice to mallholder farmer, yield have rien. Agricultural wa booted by expanion in the area under cultivation. During the 2003/ /09 agricultural production grew annually at 9.3 percent while cultivated area expanded at 4.7 percent (AfDB et al., 2012). 3

6 Source: Author calculation baed on the AfDB and IM databae. Depite the growth urge, productivity growth ha remained low and wide productivity gap between Ethiopia and Eat Aia economie (e.g., China or India) a well a ome African frontier market (e.g., Mozambique or Uganda) perited (igure 1). igure 1a. Labor Productivity Index igure 1b. Productivity Level in Ethiopia, in Ethiopia (1991 = 100), / Mozambique, and Uganda, 1991 and / China 900 Ethiopia 400 India 800 Ethiopia 350 Mozambique Ghana Uganda 600 Uganda Source: Author calculation baed on the ILO databae and the AEO / Labor productivity i meaured a GDP (in 2000 US$) per worker. Ethiopia growth wa baed on high level of public invetment (in infratructure, public enterprie), while private ector driver of growth have been neglected. 3 Growth accounting revealed that public invetment accounted for mot of the growth recorded ince mid-2000, and pecifically for 2/3 in 2011/2012 (IM, 2012, and Geiger and Moller, 2013). In contrat, in the ret of SSA expanion ha been driven by commodity price, both public and private invetment, and robut private conumption. More important, the heavy reliance of the Ethiopia economic performance on public invetment and the burden it ha put on the country public finance have rien quetion about utainability of the country growth. In fact, projection already indicate growth lowdown for 2013 and 2014 (AfDB et al, 2013). To achieve high and utained growth and reach middle-income tatu by 2025, the private ector will need to drive growth. Buine Environment and SME Contraint The Ethiopian private ector ha evolved in tage. 4 irt, central planning-baed policy of the ocialit Derg regime during dicouraged private ector activitie. In contrat, the ubequent government favored implementing market reform, to cut bureaucratic procedure and encourage rapid growth of the private ector (Geda and Degefe, 2002). GDP (2000 US$) per worker in the L A IM tated in it 2012 country report Ethiopia purue a public ector-led growth trategy that focue on promoting growth through high public invetment (IM, 2012, page 4). 4 The private ector include all agent in the economy not formally claified a in the public ector that i agent involved in the government, tate-owned enterprie or paratatal, and independent public agencie. 4

7 Two decade later, productive entrepreneurhip bloom only in a few ector (leather, flower) and i limited elewhere, while the hare of the tate ector in indutrial output ha tagnated around 50 percent ince Mot SME are private, but very mall, informal and low productivity firm, operating motly in ervice, predominate. 5 Going forward, dynamic private ector will need to play more prominent role for growth to accelerate or at leat be utained. The lack of an enabling buine environment eem to be one of the factor behind a uppreed private ector in the country. By the buine environment, we mean intitution and policie that affect firm entry, urvival, growth and exit. Since our analyi focue on new firm, we pay of coure attention to barrier to entry, while recognizing that the expected profit and difficultie to exit alo influence deciion at the tart-up phae. The two main barrier to firm creation are the adminitrative burden related to tarting a buine and acce to finance, while the government interference and the tax ytem impact the expected profit and firm urvival (Lopez-Garcia, 2006) The private firm creation in Ethiopia i impeded by a number of tructural obtacle, including credit contraint and trade barrier, a weak judiciary and regulatory framework, and complicated land regitry. In the 2013 World Bank Doing Buine report, Ethiopia ranked a #127 out of 185 countrie, a decline from #97 in On a poitive ide, the government ha implified buine regitration and invetment licening procedure and ha undertaken other change to regulatory intitution that notably reduced the cot of doing buine (World Bank, 2013). On a le poitive ide invetor protection eem to have weakened. The country alo continue to exhibit weaknee in the category Starting a Buine (ranking a #163 out of 184 countrie), motly due to very high tart-up cot and required minimum capital (igure 2 and Table 2). Table 2. Indicator of Starting a Buine: Ethiopia and Other African Countrie Ethiopia Average SSA Average EAC Rwanda Mauritiu Madagacar Rank (out of 184) Procedure (#) Time (day) Cot (% of income per capita) Min. Capital (% of income per capita) Source: Author calculation baed on World Bank Doing Buine The thriving leather indutry i one of the exception. In the early 2000, leather-how indutry ha gained a ubtantial hare in the dometic market, with it growth being driven by new entrant and expanion of incumbent (Sonobe et al., 2009). Recently, with the government upport, Ethiopia ha been uccefully exporting high-value, finihed leather product into OECD economie (USAID, 2009). 6 The World Bank Doing Buine indicator, while widely ued, have alo received their hare of criticim a a meaure that would guide government reform prioritie. or example, Pineheiro-Alve and Zambujal-Oliviera (2012) that the indicator how limited conitency and precriptive power for policy making, in part becaue many of them depend on 1-2 variable. Arrunada (2007) argue that beide tatitical weaknee, the indicator focu only on cot on regulatory intitution and do not adequately capture the benefit including information they generate. Acknowledging thee weaknee, Hanuch (2012) poit that government can neverthele ue Doing Buine report for reform and find that indicator related to cot have the larget potential for fotering growth. 5

8 The information on barrier to tart-up from the Doing Buine are complemented by thoe of the 2011 Ethiopia Enterprie Survey of the World Bank, where acce to finance and to land were key obtacle for mall (with 1-19 employee) and medium-ized (with employee) firm. Specifically, 40 percent of mall and 30 percent of medium-ized firm reported acce to finance a key obtacle to their operation. About one out four of the firm viewed acce to land a a key obtacle to their activitie. urther, more than 20 percent of the country SME identified tax rate and tax adminitration a a major contraint to their operation. Acce to electricity wa alo viewed a a barrier. Thee meage were echoed in the Global Competitivene Report, where invetor identified (i) acce to finance, (ii) corruption, and (iii) inefficient government bureaucracy a three mot problematic factor for doing buine. 7 igure 2a. Cot of Starting a Buine igure 2b. Paid-in Minimal Capital (% of income per capita) (% of income per capita) Ethiopia Uganda SSA Eritrea Ethiopia Eritrea Kenya Tanzania Sudan Burundi Rwanda SSA MENA Source: World Bank Doing Buine Skill Mimatche The urban labor market ha been characterized by high unemployment, epecially among youth (igure 3), while the exit rate from the unemployment pool to the private ector have been low. On the upply ide, the contributing factor included a rapidly growing urban population, which more than doubled between 1990 and 2007, from about 6 to 13 million and the declining public ector. Only about half of the total urban population employed in the formal ector wa in the private ector. The regional ditribution wa alo uneven, with mot of the private ector concentrated in and around Addi Ababa (Ethiopian Central Statitical Office, variou report). 8 7 SME contraint can alo vary acro ector and location within the country, a documented in Dollar et al. (2005) and other. Egan (2008) utilized example of mall buine owner in retail clothing indutry in Addi Ababa to demontrate main contraint to efficiency and profitability for exiting SME in thi ector. He found them to be corruption, the lack of finance and human reource. Sutton and Kellow (2010) map enterprie acro variou ector. 8 To put Ethiopia private ector in perpective, a comparion with regional peer and other tranition economie may be ueful. In Tanzania, the private ector ha been the main driver of growth, and it accounted for about 70 6

9 The Ethiopian labor market ha been alo characterized by mimatche between kill upplied by the educational ytem and thoe demanded by the private ector, a evidenced by high unemployment rate of young people with high chool and higher education (igure 3). Moreover, 1/5 of vacancie in the early 2000 remained unfilled, due to the lack of killed worker or their unwillingne to relocate from the urban to the rural area (World Bank 2007a). The kill hortage have been amplified by a cumberome matching proce where due to the lack of functioning labor market office killed worker are not aware of vacancie. In turn, employer poting the vacancie may not know about available killed worker. The exiting employment exchange are rarely ued, a job eeker earch through relative, top by at work ite, or tart their own enterprie. In addition to carcity of job, the declining vacancy-tounemployment ratio poted by agencie reflect the reduced trut of firm in agencie ervice (Denu et al, 2005). igure 3. Total and Youth Unemployment Rate by Urban Center, youth unemployment rate (% of relevant L) Correl. Coef. = 0.82 Addi Ababa unemployment rate (% of L) Source: Central tatitical office and author calculation. 1/ Urban center have above 2000 inhabitant. Large and Dualitic Informal Sector Similarly to other low-income countrie, the informal ector account for a large hare of the Ethiopian economy World Bank (2009) found the informal ector to account for percent of employment in the urban area. The majority of SME operate in the informal ector, which conit motly of low-productive competitive and largely undifferentiated -- firm concentrated in manufacturing and trade. Some highly productive SME alo operate there, in particular mall-cale manufacturing firm. 9 Thi more dynamic tier, amounting to about 20 percent of the informal ector, employ more killed worker. The informal ector in Ethiopia i thu dualitic, albeit more tagnant than in, for example, Mexico (World Bank, 2007b). The percent of non-agricultural GDP in 2000 (World Bank, 2002). In mot tranition countrie, which tarted changing from plan to market in early 1990, the private ector accounted for mot of output by the mid Gebreeyeu (2008) find marked difference in productivity acro different manufacturing firm, in Ethiopia. 7

10 overall low productivity of the informal ector reult in a wage gap with the formal ector (etimated at about 1/3 in 2004). III. The Model and Policy Analyi The main contribution of thi paper i preenting a imple theoretical model illutrating the role of an enabling buine environment for timulating productive entrepreneurhip and linking the model with the evidence for Ethiopia. The model, conitent with the tylized fact above, i an extended verion of Brixiová (2013) and Snower (1996). 10 In contrat to thee model, our framework include an informal ector with both elf-employed worker and low-productive firm, reflecting the dual nature of the ector. urther, we examine the multiple equilibria that can arie during private ector development. Other key feature of the model are (i) cotly earch of entrepreneur for buine opportunitie; (ii) inefficiencie in matching earching entrepreneur and worker; and (iii) weak buine environment that hamper tart-up. III.1 The Environment The population i normalized to one. There are two type of agent, entrepreneur and worker, with population hare µ and 1 µ, repectively. They live for one period, are endowed with one unit of time and w amount of conumption good, and have rik neutral preference, E(c), where c denote conumption good and E the expectation agent form at the beginning of the period. Entrepreneur At the beginning of the period, entrepreneur earch for opportunitie to open firm in the private 2 ector. Thi earch cot them γ x / 2, γ > 0, unit of the conumption good and reult in the probability x of finding a buine opportunity with productivity per worker z. In order to turn a buine opportunity into a highly-productive firm, the entrepreneur hire n number of killed worker. 11 Denoting m p a number of entrepreneur earching for killed worker, the matching of the aggregate killed vacancie, V = m n, with killed worker, N, can be decribed a: p h = Amin[ N ; V ] = Amin[ N ; m n p ] (1) where h i the total number of matche and A denote matching efficiency. Entrepreneur with a N high-productivity buine opportunity find killed worker with probability ρ = Amin[,1]. 12 V 10 Brixiová and Égert (2012) analyzed tranition economie and Brixiová (2013) developing countrie. Snower (1996) tudied developed countrie. Our model fall into category of earch model pioneered by Diamond (1982), Mortenen (1982), and Piaridie (1985) and developed further by Mortenen and Piaride (1994) among other. 11 Thi aumption reflect that productive firm form relationhip mainly with productive worker. afchamp et al., 2006, examined employee-employer matched data for 11 African countrie and confirmed thi alo for Ethiopia. 12 A Snower (1996) point out, when firm are imperfectly informed about the availability of killed worker, even kill that are ueful to all firm are not general ince not all firm have acce to thee worker. Such kill are alo not pecific ince more than one firm uually ha acce to a killed worker. 8

11 A < 1 to reflect imperfection in the matching proce. Thee can include tranportation bottleneck or imperfect information where killed worker do not know about available vacancie and earching entrepreneur are not aware about earching worker. Labor market meaure that raie the matching efficiency include information diemination and, more generally, job earch upport, etablihment of a national job databae, and quality of labor market placement office. Tranport infratructure and upply of affordable houing are alo important, a they help overcome regional mimatche by linking job and worker from different location. After finding the highly-productive buine opportunity and killed worker, entrepreneur decide whether to operate in the formal or informal ector. In the formal ector, they pay tart-up cot c (e.g. licening fee) and produce output according to y = β zn. The output thu depend alo on the quality of the buine environment in the formal ector, β, 0 β irm in the formal ector pay profit tax τ and earn after-tax profit: π = ( 1 τ )( β z n w n c) (2) where w i the wage of killed worker employed by a private firm in the formal ector. It i determined through wage bargaining. The government monitor tax collection and incur monitoring expenditure K. Entrepreneur operating in the informal ector do not pay profit taxe. The buine environment I I in the informal ector, β, i le favorable than in the formal ector, that i 0 < β < β < 1. I I The output of the highly-productive firm in the informal ector, y = β zn and the wage rate, I w, which reflect productivity, are alo lower than thoe in the formal ector. When the government detect a tax evading firm -- with probabilityφ (0,1) -- it conficate the firm entire profit. The expected profit of a firm in the informal ector amount to: π I I I = ( 1 φ)( β zn w n ) (3) rom (2) and (3) the entrepreneur will operate in the informal ector if the after-tax profit in the I formal ector i le than the expected profit in the informal ector, that i if π < π. To put I differently, profit of the entrepreneur employing killed worker i π = max[ π ; π ]. 14 Thoe entrepreneur who do not find highly-productive opportunitie or killed worker open low-productivity firm in the informal ector, with productivity per worker of. A with the z u 13 More generally, β reflect quality of formal intitution. Amoro (2009) how empirically that difference in intitutional quality help explain difference in entrepreneurhip acro countrie. 14 Our model thu reflect obervation of Dethier at al. (2011) that not only can better buine environment caue firm to be more efficient, but that alo that inherently more efficient firm chooe better buine environment. 9

12 I highly-productivity firm, their actual productivity i lowered by the buine climate factor β, 0 < β I < 1. The entrepreneur employ unkilled worker, nu, where 0 < n u < n. Since they are alo ubjected to tax monitoring and full confication for tax evaion, their profit amount to: π u I = ( 1 φ)( β zunu wu n u ) (4) w u where i the wage on an unkilled worker in a low-productivity firm, which equal the income, b, of the elf-employed in the informal ector, and φ i the probability of being detected. In um, z > zu > b > 0 are productivity level in high-productivity firm, lowproductivity firm, and of elf-employed worker, repectively. 15 Worker When acquiring kill demanded in the highly productive private firm, worker incur cot, 2 k( q) = θq / 2 whereθ > 0 i the cot parameter. Their effort reult in probability q of obtaining kill 16 V and probability ξ = Amin[,1] of finding a job in a highly productive firm. Worker N who do not obtain kill or do not find killed job work in the informal ector, either a elfemployed or in a low-productive firm. In both cae they earn income b <. While the market for unkilled worker i perfectly competitive, wage for the killed worker are et through decentralized Nah bargaining between the killed worker and the highlyproductive private firm. If bargaining doe not lead to an agreement, the worker would receive income from elf-employment in the informal ector, b. The outcome of decentralized bargaining depend on the relative trength of the killed worker and the firm, α : w h = α( β z π ) + (1 α b ; h=, I (5) h u ) I Since β > β, the wage of the killed worker in the formal ector exceed that of the ame worker in the informal ector, in line with productivity difference. The wage gap between h killed and unkilled job, α( β z π b), i again wider for the formal ector worker. The Labor Market Clearing Condition u The characterization of the environment i completed by the labor market equilibrium condition. Denoting m u a the hare of entrepreneur running low-productivity firm and employ the unkilled worker, the market clearing condition for the entrepreneur i: w 15 or analyi of how ize of firm change with productivity change and development, ee Gollin (2008). 16 x (and q) are between 0 and 1. Depite their effort, worker (entrepreneur) occaionally fail to acquire kill (find buine opportunitie). 10

13 µ = m + m h u, h =, I (6) h h Similarly, denoting n = m n, h=,i, to be the total number of killed labor employed in the high-productivity private ector (either in the formal of the informal ector), and n u = munu a total unkilled labor in the low-productivity informal private firm, and n i a total number of elf-employed in the informal ector, the labor market equilibrium condition for worker i: h 1 µ = n + nu + ni, h =, I (7) III.2 Multiple Equilibria In the following paragraph, we derive equilibrium condition baed on (2) (7) and how that the economy ha multiple equilibria a low productivity trap and high productivity equilibrium. An equilibrium in thi economy i defined a an allocation of entrepreneur and worker and wage rate uch that: (i) each entrepreneur chooe the effort x put into earch for buine opportunitie; (ii) each worker chooe effort q put into acquiring kill; (iii) wage rate i et through Nah bargaining a in (5); and (iv) labor market clearance condition are met. 17 Propoition 1 In equilibrium, the marginal cot of entrepreneur earch for a buine opportunity equal the net profit from earch, while the worker marginal cot of acquiring kill equal the expected difference between a killed wage and alternative income, given by: 18 (1 µ ) q γx = ρ( π π u ) = Amin ;1 ( π π u ) (8) µ xn µ xn θ q = ξ ( w b) = Amin ;1 ( w wu ) (1 ) q (9) µ w = pw + ( 1 p) w I, and (10) p = I 1 if π π 0 otherwie (11) w h where, h=, I, i pecified in (5). Proof. Equation (8) and (9) can be obtained by olving entrepreneur and worker problem detailed in Annex I, together with the labor market clearing condition (6) and (7). In (8), γx 0 17 It i traightforward to how that depending on the parameter, the model either ha (i) a unique lowproductivity equilibrium where worker and entrepreneur exert zero effort or (ii) one low productivity and one high productivity equilibrium with poitive effort by worker and entrepreneur. 18 In (8) and (9), the number of killed vacancie i V, h =, I, where i the number of = µxn m p = µ x entrepreneur who found highly productive buine opportunity that to operate in ector h. Similarly, the number of killed worker earching i N = ( 1 µ )q ; h =, I. 11

14 denote the marginal cot of entrepreneurial earch and Equation (11) determine that the highly productive private firm will operate in the formal ector a long a profit from doing o i equal or exceed the expected profit in the informal ector. The wage of killed worker are then et by (10) and (5). The equilibria are formed at the interection of the entrepreneur earch curve and worker training curve. Equation (8) (11) can lead to 2 equilibria: a low productivity trap, where entrepreneur do not exhort any effort to create productive firm and high productivity equilibrium with poitive effort by entrepreneur. Low Productivity Trap The firt equilibrium i the low productivity trap, where under a hortage of private firm, i.e. µ xn < ( 1 µ ) q the buine environment (i.e. tax rate, tart up cot, earch cot) i uch that π < π u. (8) how that entrepreneur will not earch for highly productive buine opportunitie, i.e. x = 0. rom (9), worker will not acquire kill i.e. q = 0. The economy will thu conit of low-productive firm and unkilled worker, operating in the informal ector. 19 High Productivity Equilibrium The econd, high productivity equilibrium, lie above the low productivity trap and comprie both poitive entrepreneurial earch and worker learning effort (x, q>0). A pre-condition for reaching thi equilibrium i a buine environment conducive enough o that profit in the highly productive private firm employing killed worker exceed thoe in le productive firm with unkilled worker, i.e. π π u > 0. In thi equilibrium, the economy conit of both high and low productivity private firm a well a elf-employed worker in the informal ector. III.3 Policy Analyi In thi ection, we relate the key parameter of our model to evidence on the buine environment in Ethiopia. A Ncube (2005) undercore, the type of education and the environment that individual are expoed to are critical for their entrepreneurial aptitude. In the Ethiopian public univeritie, entrepreneurhip i till in it early phae of development and concentrated motly in buine chool and agricultural college. Entrepreneurhip promotion center are alo carce. The country thu need to integrate entrepreneurhip in the curricula while etablihing center of entrepreneurial excellence (Gerba, 2012). or each potential entrepreneur, the entrepreneurhip proce tart with earch for buine opportunity. After uch opportunitie are identified, the entrepreneur need to turn them into productive firm. At thi tage, they can be hampered by cumberome regitering and licening procedure, tringent hiring regulation, and the lack of killed worker, among other factor. The ability of the legal framework to protect property right i equally important, a it influence 19 Specifically, in an economy with no highly productive private firm, all entrepreneur and worker operate in the informal ector, either running low productivity firm or being elf-employed and earning income b. 12

15 the expected profit and hence effort that entrepreneur put into earch. The entrepreneur alo conider the tate of the financial infratructure, control of corruption, effectivene of the government, and efficiency of adminitration during their tart-up phae (Ncube, 2005). The challenging buine climate including high tax rate, weak monitoring of tax evaion and trong bargaining power of killed worker may alo drive high productivity firm into the informal ector. By lowering effective productivity, all thee factor then alo lower wage of killed worker and dicourage them from acquiring kill. Improving the Buine Environment Section below thu examine the impact of improving the buine environment on (i) entrepreneur earch for highly-productive buine opportunitie; (ii) their deciion to operate in the informal ector and (iii) worker effort to acquire kill. Propoition 2. A hortage of killed vacancie, ( 1 µ ) q < µxn and a better buine environment (e.g. higher β and lower γ and τ ) will encourage entrepreneur to intenify their earch effort (x) for productive buine opportunitie, leading worker to acquire additional kill. π π π Proof. rom (2) > 0 and, < 0. rom (8) the entrepreneurial earch effort x β τ γ x become x = A( π π u ) / γ in the cae of hortage of killed vacancie. Hence > 0 and β x x q, < 0. rom (9) then > 0. γ τ x A more intene earch by entrepreneur and additional learning effort by worker will reult in a higher number of productive firm, increaed output, and additional productive employment. Policy maker hould thu have trong incentive for preferring the equilibrium with poitive earching and learning effort (e.g., x, q >0) to the one with no effort (x=q=0) and facilitate it through creating an enabling buine climate. Propoition 3. A better buine environment (e.g. higher β and lowerτ ) will encourage entrepreneur to operate in the formal ector, i.e. p = 1. π π Proof. Thi reult follow directly from > 0, < 0 and from (11). β τ Reforming Property Right Unclear property right, which imply a poibility of expropriation (where β = 0 ), are an important component of the buine climate in Ethiopia. Denoting probability of expropriation a ψ, the efficiency coefficient in the production function change to β = ( 1 ψ ) β + ψ 0. Entrepreneur are more likely to opt for the informal ector, a the expected profit in the formal 13

16 ector i reduced by the poibility of expropriation. Even if they do not opt for the informal ector, the entrepreneur will lower their earch effort. The revere alo hold if improvement to property right are ufficiently large, entrepreneur who would otherwie opt for the informal ector will increae their earch effort and opt for the formal ector. Due to friction in matching, earch cot, and weaknee in the buine climate (including property right), the equilibrium condition (8) (11) lead to uboptimal outcome in term of worker and firm effort and the number of productive SME, killed employment and output. Becaue of weak buine environment, entrepreneur under-invet in earching for buine opportunitie relative to the effort they would exhort in a more conducive climate. The impact of the low number of private firm on employment i amplified by imperfect information in the labor market. Worker are uncertain about finding killed job and under-invet in training. Beide hampering entrepreneur earch for buine opportunitie, the challenging buine climate, weak monitoring of tax evaion and bargaining power of worker may drive high productivity firm into the informal ector. By lowering productivity, thee factor alo lower wage of killed worker and dicourage them from acquiring kill. III.4 Illutrative Numerical Solution To illutrate the impact of policie uch a improved functioning of the labor market, A, and a better buine environment, β, a well a lower cot of earch for buine, γ, and reduced profit tax τ, thi ection provide a numerical example. The baeline parameter are et in Table 3; thee value were et to yield the hare of informal ector employment in total employment of 50 percent and of formal ector firm in total firm of 29 percent. 20 Table 3. Baeline Parameter Parameter A µ φ θ γ I β β α n b nu z z τ u Value The indicative elaticity of informal ector employment to change in each of the buine environment variable ( A, τ, γ, β ) i calculated by changing value of thee variable by 20 percent and computing the new informal employment rate: The reult in Table 4 confirm that improvement in the buine climate would raie number of highly-productive firm and high-killed/high-wage employment. In the example, the 20 percent improvement would lower low-killed/low-wage employment in the informal ector by 27 percent, with a correponding increae in employment in the formal ector. Another effective way of raiing productive, formal ector employment are improvement in the labor market functioning, including through proviion of information and reducing cot of job earch. A Table 4 illutrate, reduced cot of entrepreneurial earch would increae number of highly productive firm and killed employment (in either formal or informal ector). 20 Parameter are choen to match the limited available information. or example, the wage of unkilled worker in the informal ector amount to percent of the wage of the killed worker, and the wage gap between killed worker in the formal and informal ector. 2005, i 30 percent. 14

17 Table 4. Elaticitie of Key Outcome w.r.t. Change in the Buine Environment Variable New value New hare of formal firm New hare of informal employment Elaticity of informal and unkilled employment to 20 % change in variable % of total % change A τ γ β IV. Confronting the Reult with Stylized act from Developing Countrie Thi ection eek to ummarize available evidence from developing countrie regarding the impact of the buine environment on entrepreneurial tart-up. Area conidered are: (i) procedure to tart a buine; (ii) tax regime and rate; (iii) quality of the regulatory environment; and (iv) the rule of law. IV.1 Procedure for Starting a Buine and Tax Regime The impact of the buine climate on new firm entry and productivity in developing countrie ha been hown empirically at the national and firm level (agio and Koning, 2003; Klapper, Lavean and Rajan, 2005; Dollar et al., 2005; Lopez-Garcia, 2005; Mitra, Murayev and Schafer, 2009; and Baliamoune-Lutz, 2009). The Doing Buine 2013 reconfirm the role of the environment for tarting a buine and the tax regime in determining the entry and growth of SME. igure 4a how that eaier procedure to tart a buine and an enabling tax regime may be accompanied by higher SME entry in developing countrie. Thi ugget that Ethiopia could raie it private firm creation epecially by eaing procedure on tarting a buine. urther improvement in the tax regime could be alo helpful for developing the private ector. IV.2 Quality of Regulation and the Rule of Law Beyond Doing Buine databae, the World Bank Governance Indicator databae can provide additional inight into factor that encourage buine tart-up. The indicator of the regulatory quality reflect perception of the ability of the government to formulate and implement ound policie and regulation that upport private ector development. Similarly, the rule of law indicator meaure perception of enterprie about the extent to which ociety adhere to law and can enforce contract, uch a property right. igure 4a. SME Start-up and Regulation for Starting Buine & Paying Taxe 1/ 15

18 New Buine Entry Denity Starting a Buine Paying Taxe Source: Author calculation baed on World Bank Entrepreneurhip and Doing Buine databae. 1/ Correlation coefficient for entrepreneurhip with (i) tarting a buine and (ii) paying taxe are 0.34 and 0.29, repectively, at 1% ignificance level. igure 4b. SME Start-up and Regulatory Quality & the Rule of Law 1/ New Buine Entry Denity Regulatory Quality 2 Rule of Law Source: Author calculation baed on the World Bank Entrepreneurhip and Governance databae. 1/ Correlation coefficient for entrepreneurhip and (i) regulatory quality and (ii) the rule of law are 0.61 and 0.62, repectively, at 1% ignificance level. Note: The ample conit of 96 developing and emerging market countrie (including 22 African countrie) from the World Bank Entrepreneurhip Databae. New Buine Entry Denity i the number of newly regitered companie per 1,000 working-age people a recorded in Both tarting buine and paying taxe are expreed a cloene to the frontier, in percent, with 100 % being at the frontier, for period Value for the governance indicator range from -2.5 to 2.5, for period Weak property right can be particularly damaging to private firm creation a they directly raie poibility of loe, including through expropriation. Even without expropriation, profitability i reduced due to increaed uncertainty. Data in igure 4b how that weaker adherence to rule of law i aociated with fewer entrepreneurial tart-up in developing countrie. In addition, a poitive correlation can be een between the quality of regulation and firm tart-up. 16

19 In Ethiopia, thee obervation provide jutification for further trengthening of the rule of law, epecially property right, and improving the regulatory environment, epecially tart up procedure. Other element/more general reform for creating an enabling entrepreneurhip condition alo need to be in place. Thee include macroeconomic and political tability, acce to credit, and an educational ytem that would intill entrepreneurial attitude from early on. A alo hown in our model, training for both entrepreneur and worker, accompanied by help with job or entrepreneurial earch, are alo likely to timulate entrepreneurial tart-up. V. Concluion In thi paper, we firt preented everal tylized fact about Ethiopia growth, undercoring that the impreive rate may not be utainable unle the future growth i more broad-baed and private ector-led. High-value added entrepreneurhip in particular could play a greater role in raiing the economy output and productivity. Utilizing the World Bank Doing Buine Report 2013, Africa Competitivene Report 2013, and the World Bank 2011 Enterprie Survey of Ethiopia, among other ource, we alo documented ome of the main obtacle that Ethiopian entrepreneur face, epecially at the tart-up tage. Reflecting thee fact, we then developed a model of entrepreneurial tart-up where an equilibrium outcome could be a low-kill, lowproductivity trap. We howed that an improved buine environment would foter creation of high-productivity private firm, leading to increaed aggregate output and employment. Many African countrie would benefit from addreing the remaining obtacle to private ector activitie, uch a high cot of tarting a buine, weak property right, burdenome profit tax rate, untable tax regime, and limited acce to finance. In the cae of high-tech SME, kill hortage among entrepreneur and worker may need to be tackled to foter innovation and high value-added activitie. Stronger intitution, including buine ervice provider and thoe channeling information about buine and funding opportunitie would alo encourage productive entrepreneurhip. Thee and other contraint to entrepreneurhip in variou African region, countrie, and ector could be a topic for further reearch. 17

20 Annex I -- Entrepreneur and Worker Optimization Problem At the beginning of the period, firm and worker decide how much effort to put into earch for buine opportunitie and training, repectively. The entrepreneur deciion to earch for a buine opportunity and open a highly-productive private firm i: max E( c) 2 x.t. c + w + xρπ + (1 xρ) π u (A1) 2γ c > 0; 0 x 1. N where ρ = Amin ; 1 i the probability that the entrepreneur who found highly productive V I buine opportunity alo find killed worker and π = max[ π ; π ] implie that the entrepreneur operate in either the formal ector or the informal ector. Similarly, the worker deciion to obtain training can be decribed by: max E ( c).t. 2 q c + w + qξw + (1 ξq) b (A2) 2θ c>0; 0 q 1. V where ξ = Amin[ ;1] i the probability that the killed worker will find a killed job and N I w = pw + ( 1 p) w, with p denoting probability that the firm which employ the killed worker operate in the formal ector. The worker take thi probability a given. 18

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