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Growth of Micro-Enterprises: Empirical evidence from Ethiopia

Article · March 2007

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 Growth of Micro-Enterprises: Empirical evidence from Ethiopia

Mulu Gebreeyesus†
Ethiopian Development Research Institute (EDRI)

First Draft – February, 2007

Abstracts

The role of micro and small enterprises (MSEs) in employment and income generation is
increasingly recognized and has become a major playing field for policy makers and donors
with dual objective of enhancing growth and alleviating poverty. This study investigates
some key determinants of success and particularly employment expansion among micro-
enterprises based on a survey covering 974 randomly selected businesses in six major towns
in Ethiopia. Empirical literature on MSEs growth is scant in the sub-Saharan Africa and the
gap is even more evident when it comes to micro-enterprises. Growth of micro-enterprises
measured in terms of employment since start is affected by a variety of factors. Firm’s initial
size and age are inversely related with growth providing evidence that smaller and younger
firms grow faster than larger and older firms and consistent with the learning hypothesis but
contrary to the Gibrat’s law. Entrepreneurs with some business experience and high school
complete and with some college years grow faster. Firms in manufacturing and service
sectors, located at traditional market and those male-headed grow rapidly than their
counterparts. Firms with business license also grow faster than those operating without
license. In the absence of formal source of credit, informal networks such as, trade credit and
other informal sources enhance business expansion. Policies and support programs that aim
at promoting MSEs, therefore, need to take account of the heterogeneity nature of these
enterprises and entrepreneurs.

----------------------------
†
The author is also a Research Associate at Department of Economics, Gothenburg University, Sweden. His e-
mail addresses are: mulu_yesus@yahoo.com or mulu.gebreeyesus@economics.gu.se

1
1. Introduction
The role of micro and small enterprises (MSEs, hereafter) in income and employment
generation is increasingly recognized, unlike to the previous pessimist notion that these are
not linked to the modern and formal sector and would disappear once industrial development
is achieved. In developing countries the informal sector, in which most of the MSEs lay, is a
large source employment and livelihood of particularly the urban population. According to
ILO (2002) estimations informal employment (outside of agriculture) defined as employment
that comprised of both self-employment in informal enterprises (i.e. small and/or
unregistered) and wage employment in informal jobs (i.e. without secure contracts, worker
benefits, or social protection) represents nearly half or more of the total non-agricultural
employment in all regions of the developing world. It ranges from 48% in North Africa, to
51% in Latin America, 65% in Asia and 72% in sub-Saharan Africa. The informal sector is
also a larger source of employment for women than men in developing countries, for
example in sub-Saharan Africa 84% of women non-agricultural workers are informally
employed compared to 63% of male non-agricultural workers.

In the face of increasing pressure from globalization, the informal sector activity and
employment tend to expand in both developed and developing countries in the last two
decades (ILO, 2002). 1 The emphasis of the policy makers and donors on MSEs is partly
justified for their potential for enhancing pro-poor growth. Recently, a number of sub-
Saharan Africa (SSA, hereafter) countries adopted poverty reduction strategies that mainly
emphasize promotion of MSEs as a major way to reduce poverty particularly among the
urban dwellers. Consequently, governments and the donor community increase their
involvement with MSEs assistance programs that include; improving availability of credit,
vocational training programs and short trainings to entrepreneurs and their workers, and
facilitating markets services among others.

In Ethiopia, the case country of this study, a nation wide urban informal sector survey by the
Central Statistical Agency (CSA, hereafter) in 1996 indicates that the urban informal sector
consisted of 584,911 micro enterprises that gave employment to 730,969 people. 2 Another
survey by CSA in 1999 shows the urban informal sector employment increased to about 1.15
million comprising about 50.6 percent of the 2.88 million total urban employments. Women
employment accounts for about 58% of the employment in the informal sector.

The Ethiopian government recognizes the significance of this sector and shows its dedication
to promote the MSEs development by the Issuance of National Micro and Small Enterprises
Strategy in 1997 and the Establishment of the Federal Micro and Small Enterprises
Development Agency. Ethiopia’s industrial development strategy issued in 2003 also singled
out the promotion of MSEs development as one of the important instruments to create

1
The reason for the expansion of micro and small activities might be different between the developed and
developing countries. Increasing global competition might force firms to reorganize production into small-scale,
decentralized and flexible economic units particularly in Europe and North America. Liberalization and trade
opening could be a reason for the expanding informal sector in the developing and other transition countries.
2
The definition adopted by CSA for its survey on informal sector is unincorporated enterprises mainly engaged
in market production, with less than 10 persons engaged, no book account or registration/license.

2
productive and dynamic private sector. The promotion of this sector is justified on the
grounds that enhancing growth with equity, creating long-term jobs, providing the basis for
medium and large enterprise and promoting exports etc. The strategy puts a means to support
the MSEs such as, infrastructure, financial facilities, supply of raw materials, and training
(Ageba and Ameha, 2004).

The efficacy of such interventions, however, depends on identifying the key problems and
targeting the potentially successful entrepreneurs. An examination of the characteristics of
the entrepreneurs and enterprises with high potential to survive and grow is therefore
essential. 3 In this regard, only few studies are available in SSA. The commonly cited studies
in relation to MSEs in Africa (Liedholm and Mead, 1993; and McPherson, 1996 and related
articles) provide some evidence on the characteristics of the fast growing firms based on six
countries most of them in the Southern Africa (Swaziland, Zimbabwe, Lesotho, Botswana,
Malawi, and Kenya). 4 These studies rely on MSEs surveys that covered businesses with
employment less than 50. The empirical gap on determinants of firm growth is even more
evident when it comes to micro enterprises.

This paper explores the determinants of firm growth among micro-enterprises and
contributes to the so far scant empirical literature in the following ways. It is based on a new
survey that was held by the Ethiopian Development Research Institute (EDRI) in 2003 and
covering all non-agricultural activities except street vending. Unlike to the above cited
studies, it relies on data set that only covers enterprises with 10 and fewer workers, which
means the smaller end of the MSEs range. According to the customary definitions these are
considered as micro-enterprises. 5 It is obvious that the smaller the business in size the harder
the challenge to survive and grow. However, neither of the studies cited above examined the
micro-enterprises category separately, implicitly assuming that there is no important
difference on the factors affecting growth between the micro and small enterprises.
Moreover, this study examines extra explanatory factors such as, various measures of
financial constraints and formality of business (firms operate with business
registration/license), in addition to initial size, age, location, sector, demographic character
and human capital of the owner. It incorporates all these factors into one regression, which
might previously have been tested separately in different studies. It also provides evidence of
any difference on the impact of the growth determinants across narrow size groups, i.e.
disaggregating the firms into 1-4 workers and 5-10 workers.

The remaining part is organized as follows. The next section discusses the data sources and
gives descriptive analysis on owner and business characteristics and growth differentials by
different categories. Section three reviews the existing literature on the determinants of
MSEs growth. Section four sets the empirical frame work and discusses the results. Section
five summarizes the results.

3
The terms such as firm, enterprise, business or establishment are used synonymously in this study.
4
These studies rely on micro and small enterprises surveys undertaken as part of the GEMINI projected in the
Michigan State University in the 1990s.
5
Enterprises with less than 10 workers are usually classified as micro enterprises, for example the European
Community defines micro as firms that have 0-9 workers and small firms with 10-99 workers.

3
2. Data and the Descriptive

2.1 Data and some characteristics of the enterprises

The data source of this study is a survey conducted by the Ethiopian Development Research
Institute (EDRI) on businesses with 10 and fewer workers in 2003. The survey was done on
selected six major towns (Addis Ababa, Awassa, Bahir Dar, Jimma, Mekelle, and Nazreth)
based on the population of the MSEs. A total sample of 1000 enterprises (250 from Addis
Ababa and 150 from each other town) was selected from all non-agricultural activities and
data was obtained for 974 enterprises. 6 The questionnaire is wide and includes questions
related to background of the owner, history of the enterprise, finance, marketing, business
development service, rules/regulations, infrastructure issues, relationship with suppliers and
clients and questions related to the investment climate.

Table 1 gives the distribution of the sample across location, sector, gender and education of
the owners. The data set covers a wide variety of non-agricultural activities in trade, service
and manufacturing. 7 The majority of enterprises are engaged in trade and service constituting
45% and 36% respectively. Manufacturing is also important component (19%) of the MSEs
mainly covering production activities such as, wood and metal work, bakery and tailoring.
Most of the enterprises are very small. Measuring the number of workers as the sum of
working owners, paid and unpaid workers and based on 2002 employment, 69% the
businesses have fewer than five workers. 8 Further disaggregating, one-worker establishments
constitute about 18%. Firms that have 5 to 10 workers are about 30% and there are 6
establishments with more than 10 workers. Most of the enterprises are also young, whereby
45% of the establishments are five and fewer years old and 36% of the establishments 6-12
years old.

The vast number of businesses is headed by men accounting for 74%, but only 22% by
female. Majority of the women-headed businesses tend to concentrate on activities such as,
retail trading, beauty salon, bars and restaurants, and local drink brewing. A great proportion
of the owners (about 42%) have some high school education and about 15% some years of
education above high school. Owners with some primary education and illiterate constitute
for about 29% and 12% respectively.

6
The sampling method involves the following major steps. First, six major towns were selected based on
population densities, extent of micro-enterprise activities, and regional representation. Second, the number of
enterprises from each category of activities and the proportion for each city were identified based on previous
surveys on the major micro-enterprises activities. Finally 1000 enterprises were randomly selected, 250 from
Addis Ababa and 150 from each other town (Ageba and Wolday, 2004).
7
The trade category includes sales of all goods, local drink, construction materials, clothes and shoes, music or
video, electronic equipments, vegetables and fruits, drug stores, stationary, animal fodder, and general food
items sales. Services on the other hand covers barberry and beauty salon, bicycle rent and repair, car and horse
cart repair, tyre repair, taxi service, photo studio, shoe repair, advertising promotion and broker services,
bar/restaurants and hotel. Manufacturing includes activities such as, bakery, tailor, grain mill, wood and metal
work, soap manufacturing and boat production. The businesses that excluded from the survey are more or less a
street vending, and those capital intensive businesses such as, goldsmiths and jewelry shops.
8
In our calculation of employment we did not include causal workers as about 80% of the establishments
reported that they do not normally hire casual workers.

4
Table 1 Distribution of the firms: city, sector, size, organization type, and owner gender

City
Addis
Ababa Awassa Bahir Dar Jimma Mekele Nazareth Total
N 240 141 145 147 150 151 974
% 0.25 0.14 0.15 0.15 0.15 0.16 100

Sector
trade/shops service Manufacturing
N 439 349 186 974
% 0.45 0.36 0.19 100

Current Size
One worker 2-4 workers 5-10 workers >10
N 172 493 302 6 973
% 0.18 0.51 0.31 0.006 100

Age category

<=5 years 6-12 years 13-29 years above 29

N 439 347 141 47 974
% 0.45 0.36 0.14 0.05 100

ownership by gender
Female Male Mixed
N 226 722 26 974
% 0.223 0.74 0.027 100

Education of the owner

High school Some
Illiterate Elementary High school complete college
N 113 287 119 310 145
% 0.12 0.29 0.12 0.32 0.15

Most of the owners, i.e. 87% have started their business from scratch. Only about 9% have
reported that they inherited the business. The average start-up capital for those started from
scratch was about 16,784 Birr, approximately 2000 USD at current rate (the table is not
reported here for brevity). The main source of finance for the owners started from scratch
was internal source. Personal saving constitutes about 70% of the total required start-up
capital (see Table 2). The next bigger external source is grant and borrowing from relatives
accounting for 21.4%. Bank loan and borrowing from Micro Finance Institutions (MFIs)
account for no more than 2% of the start-up capital. This shows that micro and small firms
hardly depend on formal source of finance to start business. The formal banking sector is
neither a source of finance for operation of these small businesses. Only 10.5% of the
businesses reply that they have ever received credit from banks. The most frequent sources of
credit are friends and relatives (27.2%), suppliers (14.9%), Iqub (12.6%), in order. 9 This

9
Iqub is a traditional form of rotating saving and credit.

5
shows that friends and relative are the main source of finance not only for start-up capital but
also for running the business. Trade credit (from suppliers) is also the second important
source of financing micro enterprises in Ethiopia.

Table 2 Source of capital of the business

% of each source of start-up
capital of those firms started % of firms that ever received
from scratch credit from each source
Mean % (N)
personal saving 69.7
subscription by partners 0.80
Iqub 2.04 12.6 (123)
support from NGOs/govt 1.57 0.8 (8)
saving & credit associations 0.17 0.7 (7)
from friends/relatives 21.4 27.2 (265)
Formal banks 1.48 10.5 (102)
borrowing from MFIs 0.39 5.0 (49)
Money lenders 1.4 (14)
Suppliers 14.9 (145)
Other sources 2.30

100 (974)
*The numbers in parentheses represents the number of firms in the category.

2.2 Employment growth and mobility of firms across size categories

We next look at the dynamics of the establishments in terms of employment expansion.

Table 3 reports the employment at start, current employment, and growth by different
categories. The total employment in the sample establishments rose from 2842 when start to
3565 current, and this is 25% growth for the entire duration in their business. Dividing the
growth of employment of each firm to the number of years in business gives annual average
growth of 9% since start-up. This is by far high growth but since our data excludes not only
those exit due to failure but also those increased their size above 10 workers, the net
expansion in employment might be biased either way. Our finding is comparable to that of
MSEs employment growth in five African countries, except Kenya reported in Liedholm
(2002). The annual average growth of employment since start for Botswana, Malawi,
Swaziland and Zimbabwe ranges between 6.6% and 10.5%.

Employment growth decreases by size. The annual average growth for the one-worker
establishments is 19% tripled of the next size class (2-4) and above 12 times than the 5-10
size category. We have also calculated average annual growth by age group. The younger
establishments with 5 and fewer years old have grown by about 14% annual average. This is
more than double than the 6-12 age group and more than four-times the age group 13-29.
Hence, firm growth decreases with age of the firm. The negative relationship between growth
and both size and age is supporting evidence for the learning process argued by Jovanovic
(1982). In terms of employment growth manufacturing is the most dynamic sector followed
by service. Manufacturing firms grew by 13% of annual average followed by service with

6
11% annual average. Trade sector, however, grew by only 6.2% annual average, which is
almost half of the growth rate in the other two sectors. Firm growth is also different across
gender ownership. Male owned firms grew by 10.6% annual average, while that of female
owned grew by only 4.5%.

Table 3 Employment growth by size, age, sector and gender of the owner

Young firms
All firms (age<=10)
annual
Employ- Employ- Total average annual
ment at ment Growth growth average
Category start now (%) (%) N growth N

One worker 269 525 95 19.2 268 23.1 200

Size 2-3 workers 1396 1888 35 6.8 529 8.1 388
5-10 workers 1043 1082 04 1.5 166 2.0 122
>10 134 70 -48 -12.9 7 -27.9 3

<=5 years 1208 1404 16 13.9 439 13.9 439

Age 6-12 years 1054 1359 29 6.3 347 6.6 274
13-29 years 425 575 35 3.8 141
above 29 155 227 46 2.2 43

trade/shop 1121 1366 22 6.2 439 7.2 312

Sector service 1147 1428 24 11.0 347 12.9 269
manufacturing 574 771 34 13.0 184 16.5 132

Gender male owned 2151 2794 30 10.6 748 12.7 567

female owned 691 771 12 4.5 222 5.1 146

Total 2842 3565 25 9.2 970 11.1 713

The overall growth rate from start to end might be to some extent biased where the growth
rates are calculated from the year of establishment to the present. We calculated the growth
of young firms those established in the last 10 years separately to assess if the growth
differential across different categories of enterprises sustains. The main findings remain
almost similar (see, column 8 in Table 3). Firm growth decreases with size and age. For
example, the firms with one-worker grew with annual average 23% and this is about 3 times
than the firms in the size category of 2-4 and 10 times that of small firms (5-10). The sector-
wise difference is also evident in this young group of firms that is manufacturing growth is
higher followed by service. Male-headed firms’ growth is also more than double that of
female-head.

The next obvious question is that how many of the businesses are able to transit from one to
another size class in either direction. Based on the initial size category when start business
we calculated percentage of firms that able to transit to other size category at the end of the
period. Of course, there is one limitation to this approach because of the fact that there is a
difference in starting year among the firms in concern. Table 4 gives the transition of the
establishments across size classes from start to the current period. The four categories are one

7
worker, 2-4 workers, 5-10 and above 10 workers. In general most of the firms, i.e. about
69%, did not change their size category in the given time period. However, a large number of
one-worker businesses have increased their size, i.e. about 38% of one-worker establishments
at start grew to the next size class (2-4) and 7% of them to the higher size class (5-10) at the
end of the period. This is counter to the previous notion that for a one-person firm, self-
employment may be alternative to working for another firm, thus the person may have no
desire or know-how to grow (Biggs and Srivastava, 1996; Mead and Liedholm, 1998). About
25% of the micro-firms with 2-4 workers at start have also evolved to the small firm category
with 5-10 workers at the end of the period. A downsizing of about 11% has been also
observed among the small firms.

Table 4 Transition across different size categories

Size category 2003

>10
One worker 2-4 workers 5-10 workers
workers total

150 101 18
One worker 269
(0.56) (0.38) (0.07)
21 375 133
Size 2-4 workers 529
(0.04) (0.71) (0.25)
category at
2 16 146 4
start 5-10 workers 168
(0.01) (0.10) (0.87) (0.02)
1 5 2
>10 workers 8
(0.13) (0.63) (0.25)
total 173 493 302 6 974
Note that the numbers outside parentheses represent number of enterprises, while numbers in parentheses are
ratios.

3. What determines employment growth in MSEs? The Literature

The standard neo-classical economics posits size is determined by the same factors that affect
long-term average cost of firms, such as technology and market size. According to this
model, which relies on perfect competitive market assumption, extra labor is added until the
value of the marginal product of the last labor is equal to the wage paid to that worker.
However, this static-cost theory doesn’t have definite prediction on the size distribution of
firms but impacts on supply and demand for the product.10 The ‘Law of the Proportionate
Effect’ or Gibrat’s law which is based on a stochastic-theory then came to be a departure for
analyses related to size distribution and growth of firms. According to Gibrat’s law firms
grow each year following random drawing from a distribution of growth rates thus small and
large firms have on average identical growth chances. Hence, growth is independent of
current size. However, the growing empirical evidences show that there is significant
negative relationship between firm growth and firm size, which is contrary to Gibrat’s law
(Evans, 1987; Hall, 1987; Kumar, 1985; Dunne and Hughes, 1994). These studies have also

10
In the empirical literature, the fact that firms in different sectors and locations face different product demands,
and costs might affect growth prospect is taken into account by entering sector and location dummies into the
firm growth equations.

8
reported an inverse relation between firm growth and firm age evidence that younger firms
grow faster than larger firms.

Failure of the Gibrat’s law gave a way to a ‘learning theory’ by Jovanovic (1982), which
proposes managerial efficiency and learning by doing as key factors that determine firm
growth. According to this model the potential entrants are assumed to know the mean and
standard deviation of the costs of all firms but not of their own. Firms learn about their
efficiency level after entry and update their prior expectations through experience. Those
experiencing high cost decide to exit but those with better efficiency tend to survive and
grow. The Jovanovic model also predicts that firm growth is inversely related to size and age.
This is because as firm ages and grows becomes more confident about its costs then the
variance and mean of its growth rate should decrease.

The Jovanovic model is referred as ‘passive learning’ model reflecting the criticism that it
keeps the efficiency parameter, i.e. ability of the manager, fixed. Ericson and Pakes (1995)
extend this learning model to accommodate capital formation as a way of altering the
efficiency parameter. According to this ‘active-learning’ model firms invest on R&D and
human and physical capital will be more efficient and grow faster than others. The
implication for MSEs in developing countries is that the entrepreneurs’ human capital such
as, education and experience are important determinants of firm growth.

Several empirical studies indicate that other entrepreneur/firm characteristics might affect
business expansion. Socio-demographic backgrounds of the entrepreneur for example,
entrepreneur/owner age, sex, marital status are important determinants of the entrepreneur’s
ability and aggressiveness (for review, Kiggundu, 2002). Formality of the business might
also affect firm growth prospect. Business registration and license are means of formalizing
the business. Formalizing a business entails both costs and benefits to the registered. There
are two types of costs from being formal. These are fiscal and transaction costs at which the
first include taxes and other fees required by the authorities and the transaction cost might
arise due to the monetary and time cost involved in registering. The business may, however,
benefit from formalizing its business. Banks will consider loan applications only from those
run their business formally. Access to import and foreign exchange and government
programs for example, business service, finance, training, or public procurements also put
registration as pre-requisite. These benefits might affect the productivity and the growth
prospect of the micro and small firms. There is little empirical evidence on the effect of
formality on firm expansion.

Managers in Africa, including micro enterprises in our data set, perceive credit access among
the key obstacles and often put among the primary list that obstacle business growth,
although the existing empirical evidences so far have not been strong enough to support this
claim (Biggs and Srivastava, 1996). A number of empirical studies test the sensitivity of
investment to internal financial resources such as, profits in the absence of external
resources. The availability of internal financial resource has been found to affect investment
on manufacturing sector in Africa positively, but the effect is marginal contrary to the
existing notion (see, Gunning and Mengistae 2001, Bigsten and Söderbom 2006). The effect
of financial constraint might be through channels other than investment. For example in

9
Kenya two-third firms say they would respond to liquidity shock by reducing production and
size (Biggs and Srivastava, 1996), thus credit access might also affect the growth and
survival decision of firms.

On the argument that few firms obtain credit is not sufficient to prove constraints, since
certain firms may not have the demand, Bigsten et al. (2003) investigates credit constraint in
six African manufacturing sector using direct evidence that whether firms had a demand of
credit and whether their demand was satisfied. They found that small firms are less likely to
be given loan than large firm, i.e. close to two-thirds of the micro firms appear constrained,
but only 10 percent of the large firms. This shows that MSEs are more adversely affected by
the market imperfection, asymmetric information and agency cost involved in credit markets.

The overwhelming empirical evidence in SSA in relation to firm growth and its determinants
have been the series of studies carried out on the manufacturing sector based on the RPED
surveys. Majority of these studies found a negative relation between growth and initial firm
size and age (for example, Gunning and Mengistae 2001, Sleuwaegen and Goedhuys 2002,
Ramachandran and Shah 1999, Mazumdar and Mazaheri 2003). Bigsten and Gebreeyesus
(forthcoming) also found similar results for the Ethiopian manufacturing sector with 10 and
above employees using census data set between 1996 and 2003.

There are few studies on the determinants of firm growth among MSEs in Africa. Liedholm
and Mead (1993), McPherson (1996), and Parker (1995) examine the characteristics of the
fast growing business using MSEs survey on six SSA countries, Swaziland, Zimbabwe,
Lesotho, Botswana, Malawi, and Kenya. Liedholm (2002) provides review of these empirical
studies and its own empirical result of the pooled data of all these six countries. The
summary is given below.

All found that firm growth is inversely related to initial size and age, supporting the empirical
regularity that smaller and younger firms grow faster. MSEs operating in manufacturing and
service grow faster than those in trade (Liedholm and Mead, 1993; Liedholm, 2002), but
McPherson (1996) found no clear sectoral difference of growth in a more disaggregated
sector. Businesses located in rural towns and villages and home based are less likely to grow
than their counterparts (Liedholm and Mead, 1993; Liedholm, 2002) and MSEs operating in
traditional markets grow faster than home-based firms (McPherson, 1996). Male-headed
enterprises grow more rapidly than female-headed, even after controlling for the effects of
other factors such as, sector, location etc. (McPherson, 1996; Liedholm and Mead, 1993;
Liedholm, 2002). Human capital of the proprietor such as, education and previous experience
affect firm growth. McPherson (1996) found completion of high school positively affect
MSEs growth in Zimbabwe and Botswana but not significant in Swaziland. Parker (1995)
also found positive effect of high school completion on firm growth in Kenya. Both these
reported that completion of primary school have no effect on firm growth. Vocational
training is found to affect MSEs expansion only in Lesotho (McPherson, 1996). Parker
(1995) reports that entrepreneurs with previous business experience grow faster than those
who were previously unemployed, in Kenya.

10
4. The Empirical Framework and Results

4.1 The empirical framework

Following Evans (1987) the firm growth equation that relates firm growth to its initial size
and other controls can be specified as;

(ln S t ' − ln S t )
= β 0 + β1 ln(S t ) + β 2 ln At + ∑ γ i X i + ut (1)
A

where St’ and St represent the firm’s current and beginning size respectively, A denotes age,
X indicates other control variables, and u is the log-normally distributed errors term with
mean zero and possibly a non-constant variance. The coefficients for size and age allow
testing alternative theories of firm growth, where β1 = 0 implies no dependence of growth on
size and evidence for Gibrat’s law, where as if β1 < 0 and β 2 < 0 then smaller and younger
firms grow faster thus supports the learning model prediction.

Size is measured in terms of employment, representing the number of regular workers that
include all working owners, paid workers, or unpaid workers in the business on a regular
basis. Measuring firm size in terms of sales, profits or fixed asset other than employment
might be appealing, but susceptible to measurement errors. First, the dataset used in this
study rely on a recall basis. Therefore firms would be unable to accurately report their sales
or profits, since most of MSEs do not keep records. Moreover, unlike to sales or fixed assets
employment is not affected by inflation. Age is measured in years from the birth of the firm
to the time of the survey.

In addition to initial size and age of the firm six broad categories of variables that might have
effect on MSEs expansion are considered. These are sector, location, human capital,
demographic factors, formality of the firm, and access to finance. Summary statistics of all
these variables is given in Table 5. Sectoral difference will be captured using a broad sector
classification of the enterprises such as, manufacturing, service and trade. Two dummies
representing manufacturing and service sectors are included, while trade is the control
category. Two types of location dummies are also incorporated. One dummy that represents
location at traditional markets (a shop whether at commercial district, non-commercial
district, or road side) in contrast to home and other locations based business and other
regional/city dummies with Addis Ababa as a reference city.

Under the human capital three sets of variables are considered. First, the proprietors’
education level is categorized into five classes such as, illiterate, elementary education, high
school education, high school complete, and some college years, with illiterate as reference
group. Second, vocational training dummy representing if the proprietor had access to
vocational training before or after start the business and business experience of the owner
before starting the current business, measured in number of months (but in logarithmic form)
are also included. Some demographic character of the proprietor such as, entrepreneur’s

11
gender, age, and marital status are also considered. Entrepreneurial gender and marital status
are both dummy variables and take 1 if the owner is female and married respectively, while
age is in logarithmic form.

Formality of the business can be captured by two separate variables from our data set, having
business registration and license. According to the existing business law in Ethiopian, a
business should renew its license annually but not registration, thus having business license
better captures formality of the business. The dummy business license takes one if the
business have license and zero otherwise.

Table 5 Summary statistics of the main variables in the regression

Variable Mean Std. dev. N
Annual average employment growth from initial to current period
((lnSt-lnSt0)/age) 0.046 0.156 973
Annual average employment growth in the last three years 0.151 0.374 974

ln(initial size) 0.841 0.662 974

ln(age of the business) 1.804 0.977 974

Have business license 0.753 0.432 974

ln(previous business experience, in months) 3.086 1.906 974

Elementary (1-8) 0.295 0.456 974
High school (9-11) 0.122 0.328 974
High school complete (12) 0.318 0.466 974
Some college years (above high school) 0.149 0.356 974
Have vocational training 0.152 0.359 966

Female-headed business 0.229 0.420 974

Owner married 0.628 0.483 974
ln(owner age) 3.539 0.335 974

Ever have credit from bank & MFIs 0.151 0.358 974
Ever have supplier (trade) credit 0.149 0.356 974
Ever have other informal credit (relatives/friends, Iqub etc.) 0.362 0.481 974
Need credit but unable to borrow due to various reasons 0.672 0.470 974

Manufacturing 0.191 0.393 974

Service 0.358 0.480 974
Location at traditional market 0.714 0.452 974

The data constitute various variables related to business financing such as, whether the
entrepreneur start operation with bank loan or other source, if the business have ever received
any credit from formal banks or informal sector, whether the owner have applied to banks for
loan, if rejected why, and if never applied what the main reason was. In this study two sets of
variables are used to assess the credit effect on firm growth. First, we include three different

12
dummies that represent various source of finance in the business life time such as, if the firm
ever used formal bank credit (both banks and microfinance institutions), if the firm ever used
trade credit (i.e. loans from suppliers upon product purchase), and other informal sources
(e.g. relatives/friends, Iqub). Second, we examined directly if a firm had credit demand but
unable to satisfy due to different reasons following Bigsten et al. (2003). Constrained or
unsatisfied credit demand is here defined as firms that were rejected their application for loan
or those need credit but did not apply for various reasons, for example due to inadequate
collateral, borrowing process is too difficult, did not think would get one, already have
indebted, afraid might not be able to repay or do not know where to go.
The growth of a firm is calculated as the logarithmic difference between the current and
initial employment divided by age of the enterprise. Calculating growth between the end
points i.e. between current and initial size has its own limitation as this might mask the
fluctuations in the middle time span. The transitory fluctuations in size or transitory
measurement errors in observed size could bias the growth regression (Davis, Haltiwanger,
and Schuh, 1996). Due to the cross-section nature of our data, the major discussion will still
rely on the growth calculation of initial to current change in size. However, the data set also
contains annual data of increased and reduced workers in the last three years prior to survey
period. We therefore test the robustness of our results taking annual average growth of size in
the last three, which is based on annual employment change. Moreover, fluctuations of size
do not seem to be a big problem in our data. In the survey instrument we had a question that
asks what was the highest employment that business ever had and in which year. According
to the respondents, about 70% of the observations the highest employment ever had is equal
to their current size, and some 11% reported a difference of one worker to the current size.
McPherson (1996) also found no significant fluctuations of size in the middle years among
MSEs in Zimbabwe.

The other statistical problem in such a model is the effect of sample censoring due to exit.
Small firms that have slow or negative growth are more likely to exit than are the larger
firms. Thus the proportional rate of growth conditional on survival will be small for larger
firms. Ignoring this problem might result in downward bias estimate in the relationship
between growth and size of firms. However, this bias turns out to be insignificant in many
previous studies (McPherson 1996, Evans 1987, Hall 1987). Moreover, our data is also
censored from above. The observations included in survey are only those businesses with 10
and less workers. This means not only firms those exited but also increased their workers
number above 10 are absent from the data. We believe this might in some level compensate
the bias that might arise from exiting firms due to failure. Heteroskedasticity might be
another problem in the growth and size relations. We address this problem by estimating
heteroskedasticity-consistent standard error using the White (1982) method.

4.2 Empirical Results

Table 6 gives the OLS estimation results for all firms and disaggregating the data by size into
enterprises with 1-4 and 5-10 workers. All the reported standard errors are
heteroskedasticity-robust standard errors. Both initial size and age are inversely related to
firm growth and significant. The inverse relation sustain in a separate regression of the firms
with 1-4 workers (micro) and firms with 5-10 workers (small). This gives evidence that

13
smaller and younger firms grow faster than large firms, and consistent with the learning
hypothesis but contrary to the Gibrat’s law.

Previous business experience of the owner affects growth significantly and positively in all
the regressions. Entrepreneurs with high school complete and with some college years also
grew faster. However, in the disaggregated size regression only some college education
found to be significant for growth in the micro firms with 1-4 workers. 11 Neither elementary
school nor some high school years have any significant effect in any of the regressions. This
is consistent with the results reported by McPherson (1996) and Parker (1995) in some sub-
Saharan countries. Vocational training is also not significant in either of the regressions.
Unlike to other previous studies demographic factors such as, marital status and owners’ age
have no significant effect. Firm growth, however, differs systematically by the owner gender.
In the all firms regression female-headed firms grew slowly than the male-headed firms. We
have still found significant difference among female- and male-headed firms in the small
firm’s category with 5-10 workers, but not in the micro firms with 1-4 workers. This means
when the size of the firm increases the women perform less than their counterpart. Other
studies in sub-Saharan Africa have also found that female-headed firms grow slowly than
male-headed.

A number of justifications have been argued as to why the female-headed firms grow slowly
than male-headed firms. Women concentrate in small growing sectors for example trading
and service. This is true and might seem plausible reason but we shouldn’t find significant
difference once location and sectors are controlled for. The other argument is that women
have dual, i.e. domestic and productive, responsibility than men, thus the business objective
of women might be different than men. In this context, women might be risk averse than
male maintaining their welfare and survival of the household (Mead and Liedholm, 1998).

The growth of firms is also affected by the sector in which the business operates. Firms in
manufacturing and service are growing faster than those in trade. The systematic difference
of growth by sector holds in the small firms with 5 and above workers but not for the micro
firms with 1-4 workers. This is obvious as the micro firms are dominated by trade other than
manufacturing or service. Firms located at traditional markets grow faster than those located
at home and other areas. McPherson (1996) and Liedholm and Mead (1993) have found
similar results.

Formality of the firm affects firm growth positively. This is consistent with the hypothesis
that firms operating formally will be in better position to grow as these facilitate them engage
in the government programs such, public procurement, finance, training, business services
and bank loans. The firms with business license grow faster in the separate regression for the
micro firms but not for the small firms. This might be due to the fact that unlike the micro
firms the variation of possession of business license might not be important predicting
growth differential among the small firms’ category since most of them (above 90%) have
business license.

11
Our classification as micro and small firms in this sub-section is just a matter of convenience to differentiate
the size classes between 1-4 and 5-10 respectively.

14
Table 6 Determinants of employment growth, empirical results
Micro firms Small firms
All firms (1-4 workers) (>=5 workers)
Dependent variable annual robust robust
average growth since start Coef. se. Coef. se. robust se. Coef.

ln(initial size) -0.076*** 0.012 -0.120*** 0.022 -0.148*** 0.016

ln(age) -0.024*** 0.008 -0.017** 0.009 -0.059*** 0.017

Have business license 0.032*** 0.011 0.024** 0.012 -0.015 0.028

Owner human capital

ln(previous experience) 0.008*** 0.002 0.006*** 0.003 0.007** 0.003
Elementary (1-8) -0.010 0.012 -0.016 0.014 0.011 0.017
High school (9-11) 0.017 0.019 0.012 0.019 0.037 0.041
High school complete (12) 0.026** 0.013 0.013 0.016 0.029 0.020
Some college 0.043** 0.021 0.055** 0.025 -0.006 0.027
Have vocational training 0.008 0.022 -0.008 0.023 0.027 0.029
Demographic factors
Female-headed business -0.023* 0.012 -0.002 0.015 -0.038*** 0.014
Owner married 0.009 0.012 0.007 0.012 -0.027 0.020
ln(owner age) 0.020 0.020 0.015 0.022 0.003 0.032
Credit access variables
Have credit from bank & MFIs 0.001 0.011 0.002 0.012 -0.008 0.019
Have trade credit 0.026** 0.013 0.022 0.014 0.004 0.020
Have informal credit 0.020** 0.010 0.015* 0.009 0.031* 0.019
Need credit but unable to borrow -0.008 0.011 -0.002 0.013 -0.005 0.016
Sector (reference trade)
manufacturing 0.042*** 0.013 0.003 0.015 0.034*** 0.014
service 0.039*** 0.011 0.017 0.014 0.045*** 0.016

Location at traditional market 0.013* 0.008 0.018** 0.008 0.024* 0.013

City location (reference AA)

Awassa 0.032** 0.016 0.028* 0.018 0.023 0.024
Bahr Dar 0.016 0.017 -0.005 0.016 0.010 0.025
Jimma -0.017 0.018 -0.015 0.019 0.010 0.027
Mekelle 0.003 0.015 0.002 0.018 -0.019 0.019
Nazreth 0.004 0.018 0.020 0.021 -0.006 0.027
_cons -0.025 0.076 -0.003 0.083 0.335 0.115

N 965 660 305

R-squared 0.16 0.21 0.48
F-test F(24, 940)=3.5 F(24, 635) = 2.76 F(24, 280)=7.74
***, **, and * represent one percent, five percent and ten percent level of significance respectively.

15
We have also included different dummy variables to capture credit constraint among MSEs,
if any. In neither of the regressions the access to formal source of credit such as, from banks
and MFIs is significant, implying that banks and MFIs do not seem to support MSEs
expansion. This is apparent given that 85% of the businesses in our sample have never
received credit form these formal sources (see Table 3). Both the trade (supplier) credit and
other informal sources, however, affect growth positively and significant in the all firms
regression. In the size disaggregated regressions, trade credit affects marginally the micro
firms, while the other informal source category is significant for both size classes. This
shows that in the absence of formal source of credit informal networks appear more
appealing for MSEs. Hence, firms with better network to borrow from informal sources such
as, relatives, friends, and suppliers better loosen credit constraints and grow faster.
Fafchamps (1997) found that trade credit is important source of business finance in
Zimbabwe and argues that this is because unlike to bank loans, trade credit and other
informal sources are not guaranteed by any form of collateral.

The other financial dummy variable captures credit constraint directly, whereby credit
constrained firm is defined as a firm applied for credit from formal sector but was rejected or
never applied for credit due to various reasons other than no need for credit or high credit
cost (interest rate). The coefficient is negative but not significant in either of the regressions.
This might be due to the subjective nature of the question it self as the entrepreneurs are
responding their current perception why they got rejected or never applied for credit. The
current perception, therefore, might not be systematically related with the firms’ overall
growth performance of its entire life period. To address this concern and of course as means
to check the robustness of the results, we estimated another regression at which the
dependent variable is annual average employment growth over the last three years prior to
the survey period with the same set of explanatory variables (see, Table 7).

The survey instruments constitute the firms’ addition and reduction of workers by year for
three recent years prior to the survey period, i.e. for 2002, 2001 and 2000. We calculated the
average growth of firms in the recent three years, by dividing the net addition of worker to
the firm in each of these recent years to the average size of the firm, i.e. (initial size + current
size)/2, and then averaging across these years. We use the same explanatory variables and the
reported standard errors are also heteroskedasticity robust.

Our main interest in this sub-section is not to provide overall robustness check. This will not
be correct because three years growth might not represent the firms’ overall performance as
these are very short for many of the MSEs in the data. Bearing this limitation in mind some
points are worth noting from the result reported in Table 7. As usual initial size and age are
found to be significant and negatively related to growth. Previous business experience and
high school completion have also continued to impact firm growth positively. Firms
operating in manufacturing and service grow faster than those in trade. However, business
license, shop location and gender of the owner difference are not significant in this short
period regression.

16
Table 7 Determinants of employment growth, in the last recent three years
Dependent variable annual average growth in the last three All firms
years Coef. robust se.

ln(initial size) -0.108*** 0.020

ln(age) -0.023** 0.013

Have business license 0.046 0.030

Owner human capital

ln(previous experience) 0.016*** 0.006
Elementary (1-8) 0.006 0.036
High school (9-11) 0.005 0.049
High school complete (12) 0.072* 0.039
Some college 0.034 0.044
Have vocational training 0.052 0.036
Demographic factors
Female-headed business -0.029 0.028
Owner married 0.018 0.031
ln(owner age) 0.002 0.049
Credit access variables
Have credit from bank & MFIs 0.049 0.039
Have trade credit -0.022 0.032
Have informal credit -0.010 0.026
Need credit but unable -0.080*** 0.030
Sector (reference trade)
manufacturing 0.151*** 0.035
service 0.058** 0.027

Location at traditional market 0.041 0.028

city location (reference AA)

Awassa 0.116*** 0.048
Bahr Dar -0.077** 0.039
Jimma -0.102*** 0.042
Mekelle 0.000 0.039
Nazreth -0.082** 0.039

_cons 0.148 0.176

N 966
R-squared 0.12
F-test F( 24, 941)=4.1
***, **, and * represent one percent, five percent and ten percent level of significance respectively.

17
Surprisingly, the financial variables effect dramatically changes when firm growth is
calculated only for the recent three years. Unlike to the entire period growth regression,
access to informal financial source is not significant in affecting recent firm growth. The
formal sector credit is not also significant. However, the direct measure of credit constraint
has now become significant and negatively related to growth. The current perception of the
managers that they are credit constrained matches with the firms’ last recent three years
expansion decision. Thus, time dimension might be important when handling perception
measures such as this type – credit constraint. Unlike to the previous regression results, most
of the city dummies have now become significant, implying that in the last three years micro
enterprises located in Awassa grow faster than Addis Ababa, where as those located in Bahr
Dar, Jimma and Nazreth grow slower than Addis Ababa.

5. Summary and Concluding Remarks

This study aimed at investigating the key determinants of success and particularly
employment expansion among micro enterprises, based on a survey consisting 974 randomly
selected businesses in six major towns in Ethiopia. The survey covers wide variety of
activities trade, service and manufacturing with 10 or fewer workers, of which 18% are one-
worker establishments and 51% with only 2-4 workers.

In the descriptive part we showed that the average annual employment growth rates of the
enterprises in the sample since start-up was 9.1% per year. The annual average growth for the
one-worker establishments is 19% tripled of the next size class (with 2-4 workers) and above
12 times than the enterprises with 5-10 workers. The younger establishments with 5 and less
years old grew by about 14% annual average, which is more than double than the 6-12 age
group and more than four-times the age group 13-29. This shows that the smaller and
younger firms grow faster than their counterpart. Growth rate also differs by sector, in which
the enterprise operates. Manufacturing shows higher growth rate (13%) followed by service
(11%) in contrast to trade (6.2%). Male-headed firms’ growth (10.6%) is more than double
that of female-headed firms (4.5%) annual average.

We have also examined the mobility of firms across size groups, in four size classes. Most of
the enterprises are stagnant i.e. about 69% did not change their size category. However, about
38% of enterprises that start with one-person grew to the next size class (2-4) and 7% to the
higher size class (5-10). The transition from one-person enterprise to upper size classes is
particularly contrary to the notion that the one-person enterprises have no appetite and ability
to grow. Significant share of the firms (25%) with 2-4 workers have also evolved to the
upper size category with 5-10 workers.

We formally tested the determinants of firm growth (employment expansion)

econometrically in an extended fashion that include a wide variety of factors that might affect
business growth. We considered six broad categories of variables; sector, location, human
capital, demographic factors, formality of the firm, and access to finance in addition to initial
size and age of the firm. Both initial size and age are negatively related with growth. This
gives evidence that smaller and younger firms grow faster than large firms, and consistent
with the learning hypothesis but contrary to the Gibrat’s law. Entrepreneurs with some

18
business experience and high school complete and with some college years grew faster.
Promoting human capital formation would therefore, help increasing the prospect of micro
enterprises as a learning process is involved in the micro enterprises growth.

Firms in manufacturing and service grew faster than those in trade. Firms located at
traditional markets also grew rapidly than those located at home and other areas. Female
headed firms grew slowly than male-headed ones. These are consistent with the previous
empirical results on growth of MSEs reported in some SSA countries, and have interesting
implications to policy making.

Policies and support programs need to consider the heterogeneous nature of the micro and
small enterprises. Different categories of MSEs have different contributions and different
potential for growth and poverty alleviation. For the large number of MSEs that do not
expand in terms of employment and concentrate on survival type of activities, survival might
be their main objective. This by it self should not be discouraged as it supports a large
number of very poor families but the type required assistance might be different from others.
The enterprises with high potential to grow might require additional support beyond working
capital that might include access to finance for long-term investment, marketing service, and
targeted training among others.

Most of the MSEs support programs put advancement of women as one of their objective.
Unfortunately women-owned enterprises are concentrated on commercial activities with low
growth prospect. These programs should take account of the nature of activities; therefore,
increase the involvement of women in the sectors with high potential for growth than merely
on commercial activities. Enterprises located at commercial district and road side or with
shop grow faster than those home based. Agglomeration such as, creating commercial centers
and cooperative marketing arrangements could improve business expansion.

Formality of the firm has also found to affect firm growth positively. This is consistent with
the hypothesis that firms operating formally will be in better position to grow as these
facilitate them engage in the government support programs and access to bank loans.
Improving the regulatory environment could increase the number of firms operating
formally, and in turn help enterprises grow fast.

Finance is always a challenge to MSEs as the formal banking sector is hardly supporting
them. In neither of the regressions the access to formal source credit such as, from banks and
MFIs, is significant implying that banks and MFIs. Both the trade credit and other informal
sources, however, affect firm growth positively and significantly. In the absence of formal
source of credit informal networks appear more appealing for MSEs. Hence, supporting
alternative channels (for example, trade credit and saving and credit associations) that do not
involve collateral requirements and strange procedures might help businesses to grow.

19
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