Regulatory Barriers and Entry in Developing Economies* John Bennett, Brunel University Saul Estrin, London School of Economics $ September 28, 2007 Abstract We model the effects of two common entry barriers - licence fees and bureaucratic delay - on the entry of firms into an industry that is new to a given developing economy. We find that the effects vary significantly across barriers. A licence fee alone reduces both the number of first movers and the steady-state number of firms, but in combination with bureaucratic delay can have the opposite effects. This is because, although the delay between application and receipt of a licence is assumed the same for all firms, delay changes the balance of advantage between first and later movers. Keywords: Entry, Entry Barriers, Developing Economy JEL Classification: L50, 014 * We thank the Department for International Development for supporting this research under DFID/ESCOR project number R7844. Earlier versions of the paper were presented at the European Bank for Reconstruction and Development, London, February 2005; the Latin American and Caribbean Economic Association Annual Congress, Paris, October, 2005; and the ASSA meeting, Boston, January 2006. We are grateful to the participants, and in particular, Dan Berkowitz and Hadi Esfahani, for their comments. We also gratefully acknowledge comments and suggestions from Robin Burgess, Ravi Kanbur, Daniel Kaufmann, Mark Roberts, Stefano Scarpetta and Kathy Terrell. The usual disclaimer applies. $ Corresponding author: Management Department, London School of Economics, Houghton Street, London WC2A 2AE; tel. 020 7955 6605; email [email protected]
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Regulatory Barriers and Entry in Developing Economies* John Bennett, Brunel University Saul Estrin, London School of Economics$ September 28, 2007 Abstract We model the effects of two common entry barriers - licence fees and bureaucratic delay - on the entry of firms into an industry that is new to a given developing economy. We find that the effects vary significantly across barriers. A licence fee alone reduces both the number of first movers and the steady-state number of firms, but in combination with bureaucratic delay can have the opposite effects. This is because, although the delay between application and receipt of a licence is assumed the same for all firms, delay changes the balance of advantage between first and later movers. Keywords: Entry, Entry Barriers, Developing Economy JEL Classification: L50, 014 * We thank the Department for International Development for supporting this research under DFID/ESCOR project number R7844. Earlier versions of the paper were presented at the European Bank for Reconstruction and Development, London, February 2005; the Latin American and Caribbean Economic Association Annual Congress, Paris, October, 2005; and the ASSA meeting, Boston, January 2006. We are grateful to the participants, and in particular, Dan Berkowitz and Hadi Esfahani, for their comments. We also gratefully acknowledge comments and suggestions from Robin Burgess, Ravi Kanbur, Daniel Kaufmann, Mark Roberts, Stefano Scarpetta and Kathy Terrell. The usual disclaimer applies. $ Corresponding author: Management Department, London School of Economics, Houghton Street, London WC2A 2AE; tel. 020 7955 6605; email [email protected]
1 Introduction
A substantial literature exists that analyses new firm entry in developed economies
(see, e.g., Jovanovic, 1982; Evans, 1987; Dunn et al., 1989; Geroski, 1995, Eric-
son and Pakes, 1995, and Caves, 1998). Recently, research has also addressed the
issue of entry in developing countries, considering, mainly from the empirical per-
spective, the impact on the entry process of the comparatively weak institutional
framework typically found in these economies (see, e.g., Tybout, 2000; Roberts
and Tybout, 1996; Djankov et al., 2002; Klapper et al, 2006). In this paper, we
develop a simple model to consider the way that specific institutional features of
developing economies — licence fees for entry, and bureaucratic delays — influence
the scale and pattern of entry.1
At least since de Soto (1990), it has been suggested that high barriers to en-
try of new firms have led to relatively low entry in developing economies, with
damaging consequences for productivity growth (see, e.g., Roberts and Tybout,
1996). Bureaucratic constraints and corruption have also been argued to lead to
the emergence of the large informal sector often found in developing economies (de
Paula and Scheinkman, 2006), though some analysts of Latin America character-
ize the informal sector as entrepreneurial (Maloney, 2004). Djankov et al. (2002)
provide comparative data on 85 countries and find the average level of the regu-
latory barriers to be high in most developing economies. The barriers measured
1
include the number of procedures required to start a firm (which, between coun-
tries, varies from 2 to 21), the minimum time for start up (from 2 to 152 days), and
the official cost (from 0.5% to 460% of per capita GDP). Significantly, they find
that countries with heavier entry regulations have larger unofficial economies and
higher levels of corruption, though they do not explore the relationship between
entry rates and regulations. However, Scarpetta et al. (2002) find that the rate
of entry of small and medium enterprises is negatively related to the number of
regulations, especially those in the product and labour markets (see also Desai et
al., 2003). The entry regulations is investigated in a huge cross-country enterprise
sample by Klapper et al. (2004). They find that, for industries with high entry
rates in the US, relative entry is disproportionately lower in countries in which
regulation imposes greater costs. They conclude that entry regulations do hinder
entry, especially in industries that ‘naturally’ have higher rates of entry.
An important aspect of entry is its impact on productivity growth through
innovation (Bartelsman et al., 2004). Although product innovation is less likely to
be a major driver of growth in a developing economy, there is still much innovation,
usually taking the form of an imitation of processes and technologies in developed
countries (Hausmann and Rodrik, 2003). As with process innovation in developed
economies, imitation in a developing economy is risky, for entrepreneurs do not
know a priori whether the new technology will be profitable in the economic and
2
institutional environment of the particular country. To capture these features we
follow Hausmann and Rodrick in modelling an industry from its inception in the
developing economy concerned.
Our model examines the effects of licence fees and bureaucratic delays in an
industry that is new to the given developing economy. We consider the initial level
of entry and the steady-state solution obtaining after any subsequent entry or exit.
In Section 2 we specify the characteristics of the industry, before considering in
Section 3 the free-market solution with and without licence fees, the latter being
denoted ‘laissez faire.’ Consistent with the empirical work cited above, we confirm
that higher licence fees can restrict entry, typically reducing both first-mover entry
and the steady-state number of firms in the industry. We also find that weaker
property rights can lead eventually to more entry and a higher level of production
because first movers into the industry are less able to extract rents from successful
innovation.
In Section 4 we introduce the idea that there can be delay in the granting of a
licence: a time lag between the payment of a licence fee and the award of the right
to enter. This has a significant impact on the behaviour of firms in the model. In
equilibrium, entrepreneurs choose to divide into three groups. One group pays the
fee immediately, entering after the required lag, while a second group never buys
the licence. Those in the third group choose to ‘speculate’ on a licence, buying the
3
licence early, before the profitability of early entrants is revealed. Depending on
the level of profitability that is revealed, some or all of the speculators may enter
without further delay, while any remaining speculators never enter. Interestingly,
the option of speculation causes all entrepreneurs to eschew the option of delaying
the decision as to whether to purchase a licence until profitability is revealed. If the
licence fee is large enough, however, entry by first movers is discouraged. Section
5 concludes.2
2 The Industry
Our modelling framework is deliberately parsimonious to establish that quite com-
plex results, in terms of interactions between first and second movers, and as a
consequence of institutional weaknesses, are inherent to even the simplest of entry
processes in a developing economy. The underdeveloped character of the economy
being analyzed is represented by factor supply constraints and institutional defi-
ciencies. To consider innovation in this context we follow Hausmann and Rodrick
(2003) by assuming that while innovation in developing countries will typically
be through the imitation of existing production methods in developed economies,
such technology is not common knowledge. Rather, the transfer of technology to
new economic and institutional environments requires adaptations, and there is an
associated uncertainty about the future of profitability of the new ventures. Hence,
4
even in a developing economy, when entrepreneurs set up firms in a particular ‘new’
industry, the profitability is initially unknown.
Consider a new modern-sector industry, with no incumbent firms at time t = 0.
Any entrepreneur may innovate, setting up a firm to enter the industry and produce
at t = 1. Though information on the supply of entrepreneurs is limited, studies of
self-employment and latent entrepreneurship (see, e.g., Blanchflower et al., 2001)
do not suggest that entrepreneurship is a function of income per capita (see also
Casson et al., 2006). Thus, the supply of potential entrepreneurs is assumed large
relative to the number that actually set up firms in the industry in equilibrium.3
Entrepreneurs (and firms) are indexed i = 1, 2, ...
Entry by entrepreneur i at t = 1 requires a sunk cost k in learning and setting
up in the industry and the payment of fee f ≥ 0 for a licence. If k and f are
incurred at t = 1, the firm will also need to employ a unit of skilled labour in any
period t in order to produce. The output of any active firm i at time t is
yit = θ, t = 1, 2, ... (1)
θ is the realization, at t = 1, of a stochastic variable Θ which is uniformly distrib-
uted with support [0, 2θ̄]. Given that at least one entrepreneur sinks the learning
cost k at t = 1, the realization of θ becomes common knowledge at t = 2. Θ
captures the idea that, although the industry may exist in other countries, its
5
suitability to local conditions and institutions can only be discovered by experi-
mentation; it represents uncertainty related to the quality and reliability of inputs
and their productivity under local climatic conditions. Note that θ is not firm-
specific. Unlike in Jovanovic (1982) or Ericson and Pakes (1995), entrepreneurs
do not learn about their own abilities; rather, they learn about their environment.
Apart from θ at t = 1, the values of all variables and parameters in the model are
common knowledge.
In this simplified framework, we assume that (for a high enough θ) the limit on
the profitability of production activity comes from an increasing supply price of
skilled labour, rather than the product demand side. We assume output demand
to be perfectly elastic, with price fixed at unity, so yit can also be interpreted as
revenue. In effect, we are assuming that the industry produces a traded good in a
small open economy. The wage wt per unit of skilled labour at time t is
wt = δ + αnt, δ, α > 0, t = 1, 2, ... (2)
where nt is the total number of firms in the industry at t.
Any number of entrepreneurs can enter the industry at any time. For a first
mover (that is, an entrant at t = 1) θ is stochastic. Then, for a potential second
mover (that is, an entrant at t = 2) the realization θ is known. We assume,
however, that although the production function (1), including θ, can be observed
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by a second mover, methods of production can be only partially observed. A
second mover must therefore sink the learning/set-up cost (1 − γ)k, where 0 ≥
γ ≥ 1 is the spillover from the knowledge that a first mover acquires at t = 1.
These observations concerning second movers also apply to potential entrants at
t = 3, 4, ...
Since no information becomes available after θ is revealed at the beginning of
t = 2, there will be no reason for a firm to prefer to enter or exit in later periods,
rather than at the beginning of t = 2. Therefore, for t ≥ 3, nt = n2, yit = yi2, and
wt = w2. Writing πit and πjt for the respective profits at time t of a first mover i
and a second mover j, we have
πi1 = θ − δ − αn1 − k − f ; πit = θ − δ − αn2, t = 2, 3, ...;