Field experiment

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Suresh de Mel, David McKenzie and Christopher Woodruff♣

March 2008

Abstract Small and informal firms account for a large share of employment in developing countries. The rapid expansion of microfinance services is based on the belief that these firms have productive investment opportunities and can enjoy highreturns to capital if given the opportunity. However, measuring the return to capital is complicated by unobserved factors such as entrepreneurial ability and demand shocks, which are likely to be correlated with capital stock. We use a randomized experiment to overcome this problem, and to measure the return to capital for a sample of microenterprises. We accomplish this by providing cash and equipmentgrants to small firms in Sri Lanka, and measuring the increase in profits arising from this exogenous (positive) shock to capital stock. We find the average real return to capital to be 4.6 to 5.3 percent per month, substantially higher than the market interest rate. We then examine the heterogeneity of treatment effects to explore whether missing credit markets or missing insurance markets arethe most likely cause of the high returns. Returns are found to vary with entrepreneurial ability and with household wealth, but not to vary with measures of risk aversion or uncertainty. Treatment impacts are also significantly larger for enterprises owned by males, and indeed, we find no positive return in enterprises owned by females.

University of Peradeniya, World Bank, and Universityof California, San Diego, respectively. The authors thank Shawn Cole, Xavier Gine, Gordon Hanson, Larry Katz, Craig McIntosh, Jonathan Morduch, Edward Vytlacil, Bilal Zia, three anonymous referees and participants at various seminars for comments and Susantha Kumara, Jose Martinez and Jayantha Wickramasiri for outstanding research assistance. AC Nielsen Lanka administered the surveys on which thedata are based. Financial support from NSF grant # SES-0523167 is gratefully acknowledged. This paper was drafted in part while Woodruff was visiting LSE, whose support is also gratefully acknowledged.


1. Introduction Small and informal firms are the source of employment for half or more of the labor force in most developing countries. A central question for policymakers is whether thesefirms hold the potential for income growth for their owners, or whether they merely represent a source of subsistence income for low-productivity individuals unable to find alternative work. The rapid increase in development funding being channeled to microfinance organizations is based on belief that these firms can earn high returns to capital if given the opportunity. Evidence that some firmshave high marginal returns is suggested by the very high interest rates paid to moneylenders, and by literature which identifies the effect of credit shocks on those who apply for credit (see Banerjee and Duflo, 2005 for an excellent recent summary). However, the sample of firms who apply for credit or who belong to microfinance organizations does not represent the full universe of firms for anumber of reasons.1 We lack a credible estimate of returns among firms not borrowing from formal sources. In this paper we use a randomized experiment to identify the effect of incremental cash investments on the profitability of all enterprises, irrespective of whether or not they choose to apply for credit at market interest rates. We then examine the heterogeneity of returns in order to test whichtheories can explain why firms may have marginal returns well above the market interest rate. We accomplish this by surveying microenterprises in Sri Lanka and providing small grants to a randomly selected subset of the sampled firms. We purposely restricted our survey to firms with less than 100,000 Sri Lankan rupees (LKR, about $1000) in capital other than land and buildings. The grants were...
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