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Microeconomic Roots of Growth

February 19, 2014

In Ukraine, wages and value-added per employee grew steadily until the economic crisis. But employment decreased.

Digging into the details
  • While growth is measured by changes in aggregate gross domestic product (GDP), GDP estimates are compiled from representative surveys of firms in sub-sectors.
  • Productivity growth drives aggregate economic growth, wages and job creation, and its components can only be properly understood at the level of the firm. Which firms in what industries are raising productivity, growing and hiring, and where are they located?
  • Are new firms entering the economy, and do more productive firms grow and the least efficient shrink?

Feeding into the big, nation-wide calculations of growth are the smaller, people-scale engines of productivity. These are the workers and firms that make goods and services and are at the foundations of any country's economy. The World Bank has developed a number of new tools that can analyze some of these ground-level components of growth. This information can help guide policy-making, steer investment, and reveal successes. 

Business performance

Businesses make profits, which attracts capital to them and allows them to invest. They also create jobs and pay wages. In fact, it is the sum of profits (returns to capital) and remuneration of work (returns to labor) that makes up the macroeconomic measure of GDP value-added. 

Many policy-makers want to know where the new jobs are, whether their number is growing quickly, how skilled workers need to be to get them, and how productivity gains are contributing to the country's development. An analytical tool developed at the World Bank -- called the Business Diagnostics and Dynamics (BuDDy) tool -- helps analysts understand formal sector enterprise dynamics, including the pace at which industries are raising productivity and creating jobs.  The tool helps officials and World Bank economists collaborate to understand what companies or industries are growing, what types of businesses are creating jobs, and where they are located within the country. If businesses are growing in output or value-added, it helps determine whether they are doing so by adding machinery (capital) or labor, or by innovating. It also helps policy-makers identify the extent to which healthy “selection” is occurring in the economy: some inefficient firms should be shrinking and going out of business, but new productive firms should survive.  What are the productivity levels and characteristics of firms that are shrinking or folding? Are they in a particular geographic region? Are they young or old, big or small?

The tool uses business census and national accounts survey data conducted by individual countries. This data gives detailed information about the characteristics of individual firms: their products, location, age, size, ownership and whether they export. It also tells analysts about their sales, cost structures, labor costs, operating profits, capital assets and investments. This information helps analysts understand more about the relationship between firm dynamics and changes in wages or employment. For example, do investing firms grow and hire? Do efficient firms grow? Do inefficient firms shrink and downsize labor?

The tool is still in development, but it has been applied to a number of countries, including Ukraine, Romania, Moldova, Kenya, and Uganda and work is underway for Bulgaria, Kyrgyz, Rwanda and Nigeria. The image above shows the trend of jobless growth in Ukraine: wages and value-added per employee grew steadily until the 2008 economic crisis. Workers were both improving their productivity and getting paid more on average. But employment was shrinking. When the crisis hit, wages plummeted and employment declined. This suggest that firms were passing on a share of productivity gains to their workers (in the form of higher wages), but that they were dissuaded (perhaps by labor market rigidities) from expanding their workforce in good times.  When the crisis hit, firms seemed to first cut wages and then shed jobs.

The image below describes a dynamic in Romania. There, it is clear that leading manufacturing industries in any given county pay much higher wages than their neighboring industries. This suggests that leading manufacturing firms are able to use wages to attract the higher-skilled workers in particular geographic areas. More importantly for policy-makers, it also suggests that the country's manufacturing is geographically diverse, with specialized industries spreading out across the country in clusters, each demanding a different set of institutions, infrastructure and skills form local governments.

In Romania, county-level data shows a wide gap in wages between the leading industries and other industries.

Trade competitiveness

It is generally understood that in today’s globalized world, a country’s economic success is not only determined by domestic factors, but by how its industries fit into the international marketplace. Indeed, in the last quarter-century, as countries have moved away from import-substitution policies protecting specific domestic industries, they have looked to competitive exports as a source of growth. While policies that promote openness to trade are vital in this process, so is ensuring that individual firms within a country can compete on the world stage.

Firms in developing countries face a range of hurdles that are not found – or are not as severe -- in developed countries: macroeconomic policies that distort market entry and competition, poor infrastructure, inefficient logistics services, low-skilled labor. Part of the World Bank’s trade agenda is to help countries minimize these hurdles, so their entrepreneurs can have a fighting chance. Healthy firms, in turn, help an economy grow.

One tool used by World Bank economists is expressly designed to assess the environment that shapes a firm’s day-to-day choices. The Trade Competitiveness Diagnostic Toolkit structures an inquiry into a country’s trade policies, infrastructure, and business environment. It helps countries identify economic biases caused by tariffs, exchange rate and tax regimes, and other regulations. It helps countries assess deficiencies in backbone services, such as telecommunications, correct poor coordination between border control agencies, and identify policies that might promote the development of more efficient services to support trade, such as logistics and transport services. And, finally, it helps countries pinpoint ways to improve the business environment for exporting companies, such as promoting technology creation, streamlining product-related regulations, and developing special economic zones.

These are just two examples of the techniques that World Bank economists use to examine some of the microeconomic-level factors affecting economic growth. They also can look at the contribution of government spending to the business environment, for example, the relationship between education and firm success, or the impact of foreign direct investment on innovation. There are many angles, many perspectives and many moving parts to successful, private-sector-led growth.