Changes in firms’ behaviour and rates of investment lead to economic growth

This page lists evidence showing the relationship between changes in firms’ behaviour or  investment decisions and growth in the economy. The available evidence is organised by type of intervention, as listed below:

1) Improvements to Infrastructure

Dorosh et al. (2010) investigate the relationship between road connectivity and crop production in Sub-Saharan Africa. The authors find that agricultural production is highly correlated with proximity (as measured by travel time) to urban markets. Total crop production relative to potential production is 45% for areas within 4 hours travel time from a city of 100,000 people. In contrast, it is just 5% for areas more than 8 hours away. Low population densities and long travel times to urban centres sharply constrain production. Reducing transport costs and travel times to these areas would expand the feasible market size for these regions, and thus alter firms’ decisions about how much to produce. The authors use the estimated relationship between production and travel time to simulate the changes which could be expected if travel links were improved. A 1% reduction in travel time to the nearest city with 100,000 people or more could be expected to increase low-input crop production by 2.9%; for travel time to the nearest city with 500,000 people or more, this rises to 4.8%. The authors note that prices may fall as supply increases, making production less profitable. The effects on GDP may thus be lower than estimated, but the authors argue that they are so sizable that a significant positive effect is nonetheless to be expected.

Dercon (2008) also hypothesise that improvements in road quality can raise the production levels of farmers in rural areas. Gross domestic production and consumption must balance in the aggregate, but the beneficiaries of higher consumption cannot be determined from theory. Therefore, the authors test the welfare implications of road improvements in Ethiopian villages and find that access to all-weather roads increases consumption growth in these villages by 16.3%. These results are robust to changes in model specification and estimation methods.

2) Regulatory Reforms

A cross-country study by Eifert (2009) finds that, in the year immediately following one or more ‘Doing Business’ regulatory reforms, investment rates of firms in relatively poor countries accelerate by about 0.6 percentage points. Eifert hypothesises that this correlation may be explained by increased competition when reforms encourage more firms to enter the market, or by increased willingness to invest when measures of security such as contract enforcement improve. He also finds that relatively poor countries grow about 0.4 percentage points faster in the year following one or more of the regulatory reforms. This growth is likely to be associated with increased demand for investment goods by firms, given that the productivity gains associated with increased investment are typically assumed to lag by at least one year.

3) Foreign Direct Investment

Foreign direct investment (FDI) can be defined as investment made to acquire control or significant influence on the management of an enterprise operating in a country other than that of the investor; in general, investment which includes at least a 10% ownership of an enterprise is considered as FDI. Analysing trends in FDI across a range of Vietnamese provinces and cities in between 1993 and 2002, Tran Trong Hung (2005) finds that a 1% increase in FDI increases the GDP of each province by 0.105%.