# Age-Size Eects in Firm Growth and Productive E ciency: The Case of Manufacturing Establishments in Ethiopia

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Age-Size E®ects in Firm Growth and Productive E±ciency: The Case of Manufacturing Establishments in Ethiopia Taye Mengistae August 1998 Abstract Several studies in developed economies have reported that the rate of growth of small ¯rms decreases with ¯rm age as well as size. This result is consistent with Jovanovic's (1982) version of the passive learning model of competitive selection and is con¯rmed by data on a random sample of manufacturing ¯rms in Ethiopia. This paper uses the Ethiopian data to test three other implications of the Jovanovic model. These link age-size e®ects in ¯rm growth to an underlying distribution of of ¯rms by technical e±ciency, but have not been investigated empirically before. I ¯nd, ¯rst, that the same e®ects as detected in the Ethiopian data are matched by time-invariant inter- ¯rm di®erences in technical e±ciency. Secondly, the data exhibit age-size e®ects in technical e±ciency as well, whereby bigger ¯rms are more e±cient given age and older ¯rms are more e±cient given size. Thirdly, ¯rm age and ¯rm size mainly proxy for owner human capital variables in as far as they explain e±ciency scores. In other words, it is not the case that some ¯rms are more e±cient than others because they are bigger or older but the other way round: some ¯rms are bigger or longer lived than others because they have proved to be more e±cient. Advantageous location is a major source of technical e±ciency but is signi¯canlty less important than entrepreneurial human capital. Among the human capital variables considered, the level formal schooling completed has by far the strongest in°uence on e±ciency scores. The owner's access to business networks and his or her ethnicity also have signi¯cant e®ects. On the other hand, there is no evidence that e±ciency depends on any one of pre-ownership employment experience in the current industry, occupational following of parents or prior vocational training. Key words: Productive E±ciency, Firm Growth, Size Distribution of Firms, Entrepreneurship, Market Selection, Ethiopia.

JEL Classi¯cation: D24, D92, L11, M13. 1. INTRODUCTION Data on a random sample of manufacturing ¯rms in Ethiopia con¯rm ¯ndings of earlier studies in developed economies that the rate of growth of small ¯rms decreases with initial ¯rm size and initial ¯rm age. The result is consistent with Jovanovic's (1982) version of the passive learning model of the dynamics of owner- managed ¯rms, and has often been interpreted as evidence in its favour against alternative models of selection and growth.1 However, the possibility remains that the same age-size e®ects signal forces other than passive learning.2 If age- size e®ects detected in the growth of group of ¯rms are indeed outcomes of passive learning in exit or expansion decisions, then the underlying production data must exhibit permanent and systematic inter-¯rm di®erences in technical e±ciency: the current e±ciency of a ¯rm must be predicted by e±ciency in the past while in- creasing in the current size and age of the ¯rm. Moreover, we should be able to trace age-size e®ects in e±ciency to the latter's dependence on entrepreneur- ial human capital (Lucas, 1978)3 or locational advantage (Jovanovic, 1982) as arguably the most enduring of a ¯rm's characteristics. This paper reports results of a further analysis of the Ethiopian data in what, I believe, is the ¯rst attempt to test these further implications of the passive learning model. It accordingly deals with three questions. First, are there time- invariant inter-¯rm e±ciency di®erences in the sample to match the observed age-size e®ect in growth? Secondly, is there a matching age-size e®ect in ¯rm level technical e±ciency? Thirdly, do human capital and location variables su±- ciently explain age-size e®ects in e±ciency? The case for passive learning as an important feature of the life cycle of owner managed ¯rms is stronger if each of these questions is answered in the a±rmative. 1 The result with respect to the Ethiopian data is reported in full in a separate paper (Mengis- tae, 1997). Earlier reports of the same result for ¯rm growth in developed countries include Evans (1987), Dunne , Roberts and Samuelson (1989), Variam and Kraybill (1992) and Dunne and Hughes (1994). 2 Other formulations of the passive learning model are Lucas (1978) and Lippman and Rumelt (1982) the relation of which to the Jovanovic model and other models of competitive selection is discussed in Mengistae (1997). 3 The idea that entrepreneurial human capital or `management ability' is a major determinant of inter-¯rm di®erences in technical e±ciency is , of course, a very old one (e.g., Marchak and Andrew, 1944) and was the theme of contributions of Mundlak (1961) and Hoch (1962) to the problem of estimation of industry level production functions. The passive learning model brings out the dynamic implication of the same di®erences to ¯rm growth and longevity. 2

The seminal contribution of Farrel (1957) has led to a well developed method- ological and empirical literature on the measurement of e±ciency.4 However, no previous study has examined the relationship between measured e±ciency dif- ferences and growth performance in the sample of ¯rms investigated.5 On the other hand, none of the studies that have reported age-size e®ects in ¯rm growth while testing selection models has attempted to link the e®ects to the underly- ing distribution of e±ciency levels although the essence of every selection model is a distinctive hypothesis regarding such a link. Finally, it is a feature of the existing literature on ¯rm level e±ciency that variables are often chosen on an ad-hoc basis as possible determinants of e±ciency scores. Existing models of se- lection are examples of a theoretical perspective that bounds or order the list of potential sources of e±ciency among a ¯rm's characteristics. In particular, the passive learning model establishes a hierarchy between ¯rm size and ¯rm age on the one hand and entrepreneurial human capital and location on the other in the determination of ¯rm level e±ciency scores: to the extent that age-size e®ects in e±ciency signal passive learning they merely proxy for human capital or location variables. The rest of the paper is organised as follows. Section II sets out the economet- ric framework by recasting the relevant propositions of the Jovanovic model in terms of variance component formulations of the ¯rm level production function. Section III gives an overview of the theoretical and empirical literature on the de- terminants of inter-¯rm di®erences in technical e±ciency. The data are described in Section IV. Section V reports the results a summary of which concludes the paper in Section VI. 4 Major contributions since Farrel are Aigner and Chu (1968), Aigner, Lovell and Schmidt (1977), Meeusen and van den Broeck (1977), Pitt and Lee (1981) and Battese and Coeli (1988). Bauer (1991) and Green (1993) provide the latest reviews of the literature on the subject. See also Fersund et al (1980) and Schmidt (1986) for earlier reviews. 5 Liu (1993) is the ¯rst empirical study so far that I know of to have analysed inter-¯rm di®erences in e±ciency in the context of models of selection . The main ¯nding of the study is that the time path of the mean level of technical e±ciency is higher for incumbents than for fresh entrants which, in turn, is greater than the average e±ciency of failing ¯rms. This result is consistent with passive learning model. However, the study does not directly examine the link between e±ciency and growth performance among surviving ¯rms, which is the focus of this paper. 3

2. MEASURING INTER-FIRM DIFFERENCES IN TECHNI- CAL EFFICIENCY. In Jovanovic's formulation of the passive learning model age-size e®ects in ¯rm growth and survival arise from permanent but competitive inter-¯rm cost dif- ferences. Each incumbent and potential entrant, i, of an industry faces a cost function that is identical to the industry average or frontier up to multiplication by a strictly positive transformation, » (:), of a random error composed of two additive components µi and !it . The second of these components, !it , registers a purely temporary ¯rm speci¯c cost shock and is assumed to be distributed i.i.d normal with mean zero and variance ¾!2 . The component,µi , is a ¯xed measure of the cost disadvantage of the ¯rm such that the larger is its value the higher is the cost of production of a given output relative to the cost that is average or minimum to the industry. However, its true value is unknown to the ¯rm, which only knows that the same value is a random draw from the distribution N(¹µ ; ¾µ2 ) common to all potential entrants. Draws from the distribution are in- dependent across ¯rms and each ¯rm knows the distribution as well as the exact form of » (:). Because µi is unknown, production decisions are based on what the ¯rm estimates it to be given past realisations of » (µi + !it ). Production thus coincides with a process of Bayesian updating of estimates in the course of which the ¯rm gradually discovers the true extent of its competitive advantage. Under the regularity conditions of the model, the precision of estimates increases with the duration of the ¯rm's stay in the current industry. Firms for which the true value of µi is too high experience a series of bad cost shocks, update their cost estimates upwards accordingly, and are eventually forced to exit. Firms for which µi is relatively low experience a better series of shocks, stay put and grow. For ¯rms that do survive the selection process, the rate of growth decreases in ¯rm size and ¯rm age. Let cit be the total cost of production of output q by ¯rm i during period t. Let c (:) be a strictly convex cost function with that is average or frontier to the industry. The ¯rm level cost function assumed in the Jovanovic model is cit = c(q)» (µi + !it ) (1) By the principle of duality µi is a monotonic and strictly decreasing transformation of a ¯rm speci¯c productivity parameter ui while !it is a similar transformation of a purely temporary and ¯rm speci¯c random productivity shock ºit . I will assume that the production function underlying equation (1) can be written as 4

qit = h(z; ¯) exp(ui + ºit ) (2) where qit is the output of ¯rm i during period t for a given vector of inputs z, ¯ is a vector of parameters and » (µi + !it ) = ±[exp(ui + ºit )]; (3) ±0 < 0 For comparability of results with those of previous empirical work, I will further assume that the production function is Cobb-Douglas and estimate m X yit = ¯0 + ¯j xjit + ui + ºit (4) j=1 where m is the number of factor inputs, yit is the log of qit and xjit is the log of zjit . Because µi is assumed to be a random draw from a known common distribu- tion, so is ui . I will denote the variance of ui by ¾u2 . I will also assume that ºit is white noise with variance ¾º2 . In the absence of any restriction on the value of ui , the sum of the ¯rst two terms on the right hand side of equation (4) de¯nes the average production function of the industry from which the deviation of the production technique of ¯rm i given output is measured by ui . A key prediction of the passive learning model is that ui is correlated with ¯rm size and, therefore, with input levels x. I will refer to equation (4) together with the assumption that there is indeed such correlation as the ¯xed e®ects av- erage production function model of inter-¯rm e±ciency di®erences.6 This follows Hsiao's (1986) distinction between the ¯xed-e®ects and random-e®ects speci¯ca- tions of variance component models on the basis of whether or not individual e®ects are correlated with regressors. The covariance estimator of this model is BLUE while the corresponding GLS estimator is biased and inconsistent (Mund- lak, 1978). On the other hand the GLS estimator is consistent and attains the Cramer-Rao lower bounds under the alternative random e®ects average produc- tion function model. Since the covariance estimator is also consistent in the case of the latter model, a Hausman (1978) test of the ¯xed e®ects average production function model is a way of testing whether e±ciency depends on ¯rm size. One 6 This is the formulation used in early work on the modelling of inter-¯rm e±ciency di®erence, namely, Mundlak (1961), Hoch (1962) and Timmer (1971). 5

way of testing for the permanence of inter-¯rm e±ciency di®erence is to con- duct the Breuch-Pagan (1980) Lagrange Multiplier test of the OLS formulation of equation (4) against the random e®ects average production function model. Alternatively, we may carry out a likelihood ratio test of the OLS model against the ¯xed e®ects model. This follows from the fact that estimators of the parame- ters of equation (4) are BLUE only if the restriction of no ¯rm e®ects is valid in both the ¯xed e®ects and random e®ects formulations of the average production function. The restriction amounts to that ui = 0 in the ¯xed e®ects model and to that ¾u2 = 0 in the random e®ects model. In both cases it means E("it "is ) = 0 for all t 6= s, where "it = ui + ºit .This in turn implies that E("2it ) = ¾º2 . Together with the assumption that ui is uncorrelated with input levels the restriction ui · 0 makes equation (5) a random-e®ects production frontier model. In this case the equation becomes the stochastic frontier introduced into the liter- ature by Aigner et al (1977) and Meeusen and van den Broeck (1977). With addi- tional distributional assumptions about ui the random-e®ects production frontier can be estimated by maximum likelihood, which is more e±cient than Feasible GLS, since the latter cannot use the restriction that ui is nonpositive.7 The as- sumption most commonly used is one of ui is half-normal, ui is truncated normal, or ui is negative exponential. For computational convenience, I shall assume in the rest of the paper that ui is exponential with parameter ¸. Given the random e®ects frontier model, the technical ine±ciency of ¯rm i is measured by exp ui . Battese and Coeli (1988) have proposed an unbiased and consistent predictor of j ui j which is given for the unbalanced panel case by bi + ª ei = E(ui ="i1 ; :::; "iTi ) = E u b i [Á(E bi =ª b i )=©(E bi =ª b i )] (5) where, bi = ¡ E b i ¸ + (1 ¡ ¡b i )ei ; b i = 1 + (¾ ¡ bu =¾ bº ); Ti X ei = Ti¡1 eit ; t=1 q bi ª = b"2 ¾ bi; ¡ Á(:) is the standard normal pdf, ©(:) is the standard normal cdf; eit is the residual corresponding to the observation on ¯rm i at time t, Ti is the number of observa- 7 This amounts to saying that GLS cannot discriminate between the average production func- tion and production-frontier formulations of inter-¯rm e±ciency di®erences. 6

tions on ¯rm i; and the hat symbol over ¸, ¾u , ¾À , and ¾" indicates the maximum likelihood estimate of the corresponding parameter. The measure of ine±ciency in the ¯xed e®ects average production function model is b i = max(u ® bi ) ¡ u bi (6) where ubi are estimated ¯rm ¯xed e®ects. The likelihood ratio test of the random e®ects frontier model against the alternative that "it = ui +ºit is distributed iid normal with mean zero and variance ¾º2 is a test for the existence of permanent inter-¯rm di®erences in technical e±ciency. The LM test of the random e®ects average production function model against the OLS alternative performs the same function. The F-test of the random e®ects frontier model against the ¯xed e®ects model tests the null that ui is independent of ¯rm size. In the remaining sections of the paper I will refer to equation (4) under the Gauss-Markov assumptions as `Model I', to the random-e®ects frontier production model as `Model IIA', to the random-e®ects average production function model as `Model IIB' and to the ¯xed e®ects model as `Model III'. I will estimate Model I by ordinary least squares on pooled cross-section and time series data for each of seven industries. The data are an unbalanced panel of annual observations over a three-year period which are describes in Section IV. Models IIA and IIB will be estimated by maximum likelihood and Feasible GLS respectively for each industry.8 3. IDENTIFYING FIRM SPECIFIC SOURCES OF TECHNI- CAL EFFICIENCY. There are three alternative approaches to the analysis of inter-¯rm e±ciency di®erences. The oldest of these was ¯rst used by Timmer (1971), who regressed estimated Farrel measures of technical e±ciency on ¯rm characteristics of interest by ordinary least squares. As pointed out by Kumbhakar et al. (1991) this may not be appropriate since the dependent variable is bounded between zero and one. A better method is to apply limited dependent variable techniques of estimation 8 The extension of balanced panel techniques of estimation of the random e®ects model to the case of unbalanced panels is discussed in Hsiao (1986) and Baltagi (1995). Pitt and Lee (1981) derive the likelihood function of Model IIA for the balanced panel case with normal-half-normal error terms while Seale(1990) obtains the likelihood function of the same model for unbalanced panel data. See Green (1991) for the likelihhod function of the unbalanced panel case with the norma-exponential error terms assumed here. 7

as is done, for example, in Martin and Page(1983), Kalirajan(1990) and Reif- schneider and Stevenson (1991). Alternatively, we can replace the Farell measure as the dependent variable by a score of e±ciency that is a positive, monotonic transformation of the former but is unrestricted in range (Lovell, 1993). The problem with this approach is that, if input levels are correlated with technical e±ciency contrary to what Models IIA assumes, they will also be correlated with the very ¯rm characteristics that are expected to explain the variation in e±- ciency. Parameter estimators of the production frontier will therefore be biased. Since the bias might carry over to predictions of e±ciency, the technique should be used only if the Hauseman test decisively rejects the ¯xed e®ects model. The second approach to the analysis of technical e±ciency was ¯rst used in Pitt and Lee (1981). It avoids the bias inherent in the ¯rst approach by including ¯rm characteristics among the regressors in the estimation of the production frontier. In this case, the appropriate speci¯cation of the frontier of Model IIA is yit = H(x; c : ¯; a) + ºit + ui (7) where c is a vector of ¯rm characteristics and a is the vector of the correspond- ing coe±cients. The role of individual characteristics in explaining e±ciency is then assessed by means of the usual speci¯cation tests and by looking at what happens to the estimate of ¾u2 as we include the characteristics in the speci¯ca- tion of the frontier. Unfortunately the approach is likely to lead to a problem of multicollinearity. The rationale for its use is, after all, that input levels are su±ciently correlated with the ¯rm characteristics now added to the speci¯cation of the production function. The third approach consists in the ordinary least squares regression of esti- mates of ¯rm ¯xed e®ects of Model III on ¯rm characteristics. It was again ¯rst used by Pitt and Lee(1981). The method is not subject to the omitted variable problem of the ¯rst approach or the multicollinearity problem of the second. It is therefore the best available method when the random-e®ects formulation is comfortably rejected in favour of ¯xed e®ects. Its advantage disappears, though, when input levels are uncorrelated with individual ¯rm e®ects. In this case pre- dictions of ¯rm level e±ciency based on the approach will be less e±cient than their random-e®ects alternatives. Only results of the ¯rst and the third approach will be reported later in this paper. As expected the inclusion of ¯rm characteristics in the speci¯cation of the frontier production functio under Model IIA led to a serious multicollinearity problem. On the other hand, a choice could not be made between the ¯rst and third approaches. This was because scores of e±ciency had to be regressed on 8

¯rm characteristics over the full sample of ¯rms while production functions were estimated for subsamples of individual industries. As will be reported later, the random-e®ects model was rejected in favour of the ¯xed e®ects model for some industries but not for others. The use of only one of the two in the regression of e±ciency scores pooled across industries could not therefore have been justi¯ed. The score of relative technical e±ciency used in applying the ¯rst approach is denoted by DPANU and is de¯ned as the deviation of the Battese-Coeli predic- tor, u ei , from the industry sample mean. The transformation is strictly increasing in the Battese-Coeli predictor but is unbounded in range. It also has the added role of ¯ltering out the bias possibley arising from systematic inter-industry dif- ferences in sampling error.9 Since the bias is also potentially present in the use of the third approach, a similar transformation of estimated ¯rm ¯xed e®ects, denoted by SCOREF, is used as a dependent variable instead of individual ¯rm e®ects. The variable SCOREF is de¯ned as the deviation of ¯rm ¯xed e®ects from the industry sample mean of the e®ects expressed in units of the industry standard deviation. The Battese-Coeli predictor, u ei , will be denoted by PANU as a dependent variable. Firm-¯xed e®ects will be denoted by FIXED. The choice of regressors is based on two of the implications of the passive learning model. The ¯rst of these is that there are age-size e®ects in e±ciency. The second is that ¯rm age and ¯rm size proxy for entrepreneurial human capital and locational advantage in as far as they explain e±ciency scores. Greater e±ciency leads to higher ¯rm size or longevity and not the other way round. If the ¯rst proposition is correct then owner human capital and location variables should entirely explain observed inter-¯rm e±ciency di®erences with due allowance for sampling error. If the second proposition is correct, the regression of e±ciency scores on ¯rm age and ¯rm size only should have at least as much explanatory power as the alternative regression of the same scores on human capital and location variables, since entrepreneurial human capital and location advantage can only be observed imperfectly. The coe±cients of age-size variables would not also be as highly signi¯cant in an equation in which human capital and location variables are included. A result to the contrary means one or both of two things. One is that we fail to fully observe owner human capital or location advantage. The second is that not all the observed age or size e®ects in e±ciency can be attributed to passive learning. In particular a size e®ect that survives the full control for variation in entrepreneurial human capital and location advantage would suggest alternative sources such as economies of scale and competitive 9 The addition of industry dummies in the e±ciency score regressions no doubt helps to minimise the bias. However, there is no guarantee that it will eliminate it entirely. 9

di®usion.10 Likewise, age e®ects that would fail to disappear when we fully control for human capital and location may signal other sources such as the in°uence of ¯rm age on replacement costs of capital and, hence, on e®ective choice of technique.11 Inter-¯rm e±ciency di®erences are competitive in the passive learning model. However, this is an assumption that is unlikely to hold in my data. Firms in the sample are distributed across industries that may di®er signi¯cantly in terms of the `competitive pressure' faced by the individual ¯rm. That the mean ¯rm level of e±ciency of an industry depends on this particular factor is indeed the theme of much of the empirical literature on e±ciency analysis that seeks to assess the impact of trade or regulatory policy on the performance of particular industries. I therefore include industry dummies as the third set of regressors in the e±ciency score equations. As already pointed out the coe±cients of this set of variables may well be biased due to systematic inter-industry di®erences in sampling error if the dependent variable is either FIXED or PANU. However the bias should not be present when the dependent variables are replaced by SCOREF or DPANU. I have grouped measures of owner human capital into three sets of variables: namely, measures of schooling, indicators of informally acquired skills and indica- tors of access to business networks. The variables in the ¯rst set have been used in numerous studies of the determinants of ¯rm level technical e±ciency such as Kalirajan (1990) which found that years of formal schooling was a signi¯cantly positive in°uence on e±ciency among commercial rice farms in the Philippines. If the implication of passive learning to the relationship between e±ciency and ¯rm longevity holds, this result is also con¯rmed by Bates(1990), who found the probability of survival to increase in years of owner schooling for a sample of U.S. small businesses. To my knowledge the prior employment experience of the ¯rm owner in the current industry is the only variables in the second set to have been used in a previous study of e±ciency.12 However, Bates (1990), Lentz and La- band(1990) and Holz-Eakin et al. (1994) examined the role of some of the other 10 The distinction between passive learning, competitive di®usion and scale economies as sources of size e®ects in ¯rm growth and e±ciency is discussed in Mengistae (1997). 11 Pitt and Lee (1981) advance this factor as a possible explanation to their ¯nding that younger ¯rms were more e±cient in the sample of Indonesian weaving ¯rms they studied. Their argument is broadly consistent with Lambson's (1991) thesis that age e®ects in ¯rm level e±ciency and growth performance can arise under competitive conditions even in the absence of passive or active learning if ¯rms di®er in sunk costs and have to make production and exit-entry decisions under market uncertainty. 12 The age of the owner and the number of years of the owner's prior experience in the industry of the current business are two of the variables that Martin and Page (1983) used in explaining technical e±ciency in two Ghanian industries. 10

variables in the determination of size or longevity among small businesses in the US. In the Letnz and Laband study, family background measured as whether the owner was a `second generation' business owner was found to be more important than formal schooling as a determinant of business success as measured by ¯rm size. On the average second generation business owners ran bigger ¯rms than ¯rst generation owners when years of schooling, business assets at start up and the length of pre-ownership experience in the current industry were all controlled for. In contrast, the in°uence of years of schooling was not statistically signi¯cant, which the authors interpreted to imply that the skills that second generation owners acquired by virtue of being brought up in the environment of a family business was a better asset to a business career than formal education.13 This ¯nding contradicts that of Bates, who found family -background variables to have had little or no in°uence on ¯rm size. Holtz-Eakin et al., report that the same variables also failed to explain variation in the probability of business survival.14 There are three variables in the third set one of which is the ethnicity of the owner and the others indicate his or her access to business networks as sources of information or other forms of business support. To my knowledge, none of these variables has been used in a previous study of ¯rm level e±ciency. However, Fairly and Meyer (1994) found that owner ethnicity was a signi¯cant determinant of the size of immigrant owned ¯rms in the US, when owner age, years of education and years of immigration were controlled for. Their interpretation of the result is that it may suggest that business information and mutual support networks tend to form along ethnic lines and that some ethnic groups are better than others in terms of `ability to transfer information to and from co-ethnics'15 Alternatively, the result may signal ethnic externality in the formation of business skills (Bor- jas, 1992). This is in the sense that the skill of a family generation may depend not only on parental investment in the formal or informal training of children but also on `the average quality of the ethnic environment' in which the same investment is made, i.e., on what Borjas calls `ethnic capital'. If there is indeed such an externality, then the same amount of investment in the `education' of children results in di®erent levels of skill formation across ethnic groups. More- over, if the externality is strong enough ethnic di®erences in skills and patterns of comparative advantages in trades or occupations will persist across generations.16 13 See also Laband and Lentz (1983) for details of the underlying argument. 14 Holz-Eakin et al. found the age of the owner to be a signi¯cant determinant of ¯rm survival. 15 Their interpretation draws on some of the sociology literature on the determinants of entre- preneurial success such as Zimmer and Aldrich (1987) and Aldrich and Waldinger (1990). 16 Borjas' argument is based on a narrowed down version of Coleman's (1988) concept of \social capital\ and is very much in the spirit of the endogenous - growth literature (e.g. Romer,1986; 11

4. DATA. 4.1. Source. The data are drawn from the results of the 1993 wave of the Addis Ababa Indus- trial Enterprises Survey for the design and implementation of which the author was responsible.17 The survey covered a random selection of 220 ¯rms in several manufacturing industries in the Addis Ababa region of Ethiopia. The sample consisted of 190 private ¯rms and 30 public enterprises. The survey instrument was a questionnaire in 10 modules of which 9 were administered to ¯rm owners or general managers in a face- to- face interview by a member of the research team. The data used in this particular study were generated by questions selected from four of the nine modules, namely, those dealing with (a ) production, cost and employment ¯gures, (b) current capital stock and recent ¯xed investment, (c) history of establishment of the ¯rm and the employment history and family back- ground of the owner and (d) owner participation in business networks and social organisations. Data used in the estimation of industry level average or frontier production functions were generated by questions in the ¯rst two of the four modules. Data on owner human capital and location variables used in e±ciency score regressions were generated by the last two modules. The latter include the age of the ¯rm, indicators of the location of the ¯rm relative to suppliers, clients and competitors; the age, sex, marital status and ethnicity of the owner; the highest level of formal education attained by the owner; the major occupation of the parents of the owner; the pre- ownership employment status of the owner; the length of pre- ownership experience of the owner in the current industry of the ¯rm; the owner's participation in apprenticeship and formal vocational training programmes prior to the establishment of the ¯rm; the owner's participation in informal credit or social organisations; and the owner's rating of relatives, friends, and other business people as alternative sources of business information. 4.2. Age-Size E®ects in Firm Growth. A related paper of mine (Mengistae, 1997) shows that the rate of ¯rm growth in my sample decreases in initial ¯rm age and size. A summary of this result is and Lucas ,1988) . 17 The round is the ¯rst in a survey series designed to generate panel data sets on various aspects of enterprise development in manufacturing industries in Ethiopia and is a join project of the Department of Economics of the Addis Ababa University , the Centre for the Study of African Economies of the University of Oxford and the Free University of Amsterdam. 12

presented in Table 1 for the full sample of ¯rms over the period 1989-93, which is also the period of the production data analysed in this paper. In each row of the table is my estimate of Gibrat's equation of ¯rm size for the indicated time interval. In each case the dependent variable is the log of end-of-period employment size of the ¯rm, CSIZE. The regressors are the log of beginning- of-period employment size, SIZE; the log of beginning-of-period age of the ¯rm, AGE; and an ownership dummy variable, PUBLIC, which assumes a value of unity for public enterprises. A coe±cient of less than one for SIZE implies that the rate of ¯rm growth decreases in size. An inverse relationship between growth and age is indicated by a negative coe±cient for AGE. Public enterprises are included in the estimation of the growth equations as well as the estimation of the average or frontier production functions reported below. However, the e±ciency score regressions to be reported later refer only to privately owned ¯rms. 4.3. Production Variables. The estimated production functions reported in the following section are based on a panel of annual data on the volume of production, number of employees and capital stock for the years 1989, 1991 and1993. Output is de¯ned as annual valued added expressed at 1993 prices based on the Addis Ababa retail price index18 . Value added in turn is de¯ned as annual production less the cost of raw materials and utilities. Labour services is measured by annual man-hours. Annual energy consumption is used as a proxy for annual capital services. Both input variables are the same as those used in Pitt and Lee (1981) whose ¯ndings I will be comparing with mine in some of the discussion in Section V. An alternative measurement for capital services, ¯rst proposed by Hoch (1962) and more recently used in a frontier production function analysis of e±ciency by Seale(1990), is depreciation plus annual interest charges on capital stock at the going bank long term lending rate, which I also tried to use. However the coe±cient of capital generally turned out to be negative.19 Each of the production functions speci¯ed in Section II is estimated separately for six four- digit industries and a seventh category of ¯rms in a miscellany of industries of which the most important are the weaving, chemicals, rubber and paper industries. The six four digit industries are: food (SIC 1541), wood work (SIC 3610), garments (SIC 1810 ), knitting (SIC 1730), leather products (SIC 1920 ), and metal work (SIC 2811). Not all ¯rms in the sample were in operation 18 There are no o±cial producer prices for non-agricultural output in Ethiopia at the moment. 19 It is interesting that the same outcome was reported by Hoch. 13

in 1989 approximately a ¯fth of them having been set up in 1990 or later. This and the omission of ¯rms with missing values for one of the three variables of the production function resulted in 515 observations on 198 ¯rms out of what could have been a total of 660 observations. Table 2 provides descriptive statistics of the production variables used by industry. The variables are : LABOUR , de¯ned as the log of total annual man-hours; CAPITAL, de¯ned as the log of annual consumption of energy at1993 prices; and OUTPUT, de¯ned as the log of annual value added at 1993 prices. 4.4. Data on Firm Characteristics. Descriptive statistics of regressors of the e±ciency score equations are given in Table 3. The variable LNSIZE represents ¯rm size and is de¯ned as the log of the average employment size of the ¯rm in 1989, 1991 and 1993. LNAGE is the log of the age of the ¯rm in 1993. AGESQ is the square of LNAGE. The loca- tion variables in the table are: SURROUND, which is a dummy variable equal to 1 if the main business premise of the ¯rm is in the middle of those of the ¯rm's competitors; OWPREM, which is a dummy variable equal to 1if the ¯rm owns its business premises; and GOVRENT, which is a dummy variable equal to1 if the ¯rm's premises are rented from the central government. Non-residential urban land and property in Ethiopia is mostly government owned following the nationalisation law of 1975. Fifty one per cent of private ¯rms in the sample own their business premises. Some of these are ¯rms which operated on own property prior to the nationalisation and were allowed to keep ownership of the premises by the new law. Others are establishments set up after the nationalisation on converted residential property, usually having failed to secure sites in the now government owned industrial areas. There are two forms of access to such areas at the moment. One is renting buildings owned by the central government. The second is tenancy to local or municipal authorities. The ¯rst is the case with 25 per cent of ¯rms in the sample. Another 24 per cent operate on premises rented from the local authority. Buildings rented from the central government are larger, better designed, better provided for in infrastructure, and of closer proximity to business centres compared to those under municipality ownership, which in turn are better suited for business than privately owned premises.. The allocation of tenure to government or municipal property is purely one of admin- istrative rationing at rents that are generally believed to be far below current opportunity cost. My hypothesis is therefore that tenants of the central govern- ment ( GOVRENT) generally have an advantage in location over those operating 14

on own property (OWPREM) or on municipal property. If it indeed exists, such an advantage should be revealed through higher technical e±ciency. The variable SURROUND is an alternative measure of locational advantage. Its use is justi- ¯ed by the fact that business premises in Addis Ababa are heavily concentrated in particular parts of the region each of which has come to be regarded as `the home' of a particular industry and is presumably the preferred location of poten- tial entrants to the industry. Proximity to a larger number of competitors is one possible indicator of access to such established sites. 4.5. Owner Human Capital Variables. The de¯nition of the human capital variables included is as follows : LNEXPER=log of the number of years of experience the owner had in the present industry prior to setting up or acquiring the ¯rm ; APPRENT=a dummy variable equal to 1 if the owner had ever been an apprentice; PRIMARY=a dummy variable equal to 1 if the owner had completed primary school as his or her highest level of formal education ; SECOND= a dummy variable equal to 1 if the owner had completed secondary school as his or her highest level formal education ; COLLEGE=a dummy variable equal to 1 if the owner had completed a regular course in an institution of higher education ; VOCATION= a dummy variable equal to 1 if the owner had completed a regular vocational course in an institution of formal education ; OWNBUS= a dummy variable equal to 1 if the career of at least one of the parents of the owner was running a non-farm business ; PUBEMP= a dummy variable equal to 1 if the career of at least one of the parents of the owner was as a public sector employee ; PRIEMP= a dummy variable equal to 1 if the career of at least one of the parents of the owner was as an employee of private non-farm ¯rm; The variables PRIMARY, SECOND, COLLEGE and VOCATION are ex- pected to capture the in°uence of formal education of the owner on e±ciency scores. The Ethiopian education system consists of six years of primary school followed by six years of secondary school at the end of which successful candidates may proceed to programmes of tertiary education lasting 2 years or more in uni- versities, polytechnics or junior colleges . Formal vocational training programmes last between two and four years and are o®ered by comprehensive high schools or specialised technical colleges .Twelve per cent of owners of ¯rms in the sample 15

had not completed primary school when they started their businesses, 27 per cent had completed primary school but had not proceeded to secondary classes or had dropped out before sitting for the school leaving certi¯cate examination , 45 per cent had completed secondary school and 16 per cent had completed a course of tertiary education. Just over 20 per cent had full-time vocational training. More than 50 per cent of owners in the sample started their career as young apprentices , mostly in the ¯eld of the present ¯rm . The variable APPRENT should capture the in°uence of business skills that they might have picked up in the course of this experience. The variable LNEXPER is intended to represent skills that may have been acquired in the entire pre-ownership employment ex- perience of the owner in the present industry as an employee, a self-employee , an apprentice or as an occasional helping hand in a family enterprise. Approxi- mately 70 per cent of owners in the sample had some kind of experience in the industry prior to starting or acquiring the current ¯rm , the most important form of experience being wage-employment in another ¯rm ( 34 per cent ) followed by self-employment (21 per cent ) and `working and learning the trade at home' (19 per cent ). In one sense, the variables OWNBUS, PUBEMP and PRIEMP also belong to the category of experience variables. However, unlike LNEXPER or APPRENT they are not limited to experience in the ¯eld of the current ¯rm and should pick up the impact of parental occupation on the formation of business related skills. Only about 5 per cent of owners of ¯rms in the sample had a parent who owned a manufacturing establishment. However, 35 per cent of them had a parent who ran a trade or service business. The parents of another 39 per cent were traditional small farmers. About a ¯fth of owners had a parent who worked as an employee of a private ¯rm or in the public sector. The regressors relating to the ethnicity of owner and his or her access to business or social networks are the following : FELLOW= a dummy variable equal to 1 if the owner of the ¯rm ranked relatives or friends as the most important sources of information to his or her business ; AMHARIC= a dummy variable equal to 1 if the owner of the ¯rm belongs to the Amaharic ethnic group ; GURAGE= a dummy variable equal to 1 if the owner of the ¯rm belongs to the Gurage ethnic group ; In order to asses the access of ¯rms to business networks, ¯rm owners were asked in the survey to identify what they regarded as the most important source of information to their business from a list of possibilities that I have grouped into 16

the variable FELLOW and `other business' The latter groups the responses `other business men as clients', `other businessmen as suppliers', and `other business men in the same industry' which together account for 56 per cent of the responses against 26 per cent responses under FELLOW. My hypothesis is that those who use relatives or friends as their most important source of business information have no or restricted access to business networks and are, therefore , at a disadvantage which should translate to lower scores of e±ciency of their ¯rms than those whose most important sources of information are `other business men'. In the light of the discussion in Section III, the two ethnicity variables, AMHARIC and GURAGE may perform one or both of two functions. On the one hand, they can indicate externality in the formation of entrepreneurial skills of ¯rm owners in the sense of Borjas (1992).On the other, they may be measuring the owners' access to business networks in as far as these are formed along ethnic lines. Either way, the hypothesis is that the ethnicity of the owner is a signi¯cant in°uence on the e±ciency score of the ¯rm. Forty per cent of ¯rm owners in the sample belong the Amharic ethnic group against 32.6 per cent who belong to the Gurage ethnic group. The popular wisdom in Ethiopia at present is that the Gurage have exceptional business acumen and a greater tendency to form mutual business support schemes along kinship lines. A Gurage is therefore gen- erally perceived to have a greater chance of succeeding in a business venture than a member of any other ethnic group in Ethiopia. If this is indeed the case the e±ciency scores of ¯rms under Gurage ownership should be higher other things being equal. The last set of regressors in the e±ciency score regressions consists of industry dummies which I de¯ne as follows : FOOD= a dummy variable equal to 1 for ¯rms producing food products (i.e. ,SIC 1541); WOODWOR= a dummy variable equal to 1 for ¯rms producing furniture (i.e., SIC 3610); GARMENT= a dummy variable equal to 1 for ¯rms producing wearing ap- parel excluding knitwear (SIC 1810); KNITTING= a dummy variable equal to 1 for ¯rms producing knitwear (SIC 1730); LEATHER= a dummy variable equal to 1 for ¯rms producing leather products (SIC 1920);and METALWOR= a dummy variable equal to 1 for ¯rms producing structural metal products (SIC 2811) . 17

5. RESULTS. 5.1. Testing for Inter-Firm Di®erences in Technical E±ciency. The pooled-data least squares estimation results of Model I are reported by in- dustry in Table 4 . They are the basis for testing the hypothesis that there are time invariant in inter-¯rm di®erences in technical e±ciency to match the age-size e®ects in growth detected in the data. The goodness of ¯t of the model is com- parable in every case to those reported in many other least square estimates of the Cobb-Douglas function on manufacturing micro data of developing countries including those of Haddad (1993), Liu (1993), Page(1980), Pitt and Lee (1981), Seale(1990) and Tybout and Corbo (1991). A common result of these studies is that the elasticity of output with respect to labour input is several times larger than output elasticity with respect to capital, which is also the case reported here. Table 5 reports results of the ML estimation of Model IIA. Results of the Feasible GLS estimation of Model IIB are reported in Table 6. Estimation results of Model III are given in Table 7. The null that there are no inherent inter-¯rm di®erences in technical e±ciency is rejected in favour of each of the three models. Beginning with tests based on Model IIA, the likelihood ratio test rejects Model I , or the restriction that ¾u2 = 0, at the 5 per cent level for all industries except one. Indeed , the estimate of ¾u2 exceeds that of ¾À2 in two of the industries and is only slightly the smaller variance component in the rest. The same restriction is rejected even more decisively in relation to Model IIB by the Breuch-Pagan LM test for which the test statistic is signi¯cant at almost any level in all the industries. The estimate of ¾u2 is also greater than that of ¾À2 in ¯ve of the industries and is far from being `swamped' by the purely temporary component in the other two. A similar result is obtained with respect to Model III where the null of no ¯rm ¯xed e®ects is rejected by the likelihood ratio test at the 1 per cent level or less for every industry. 5.2. Age-Size E®ects In Firm Level E±ciency. As already pointed out, the Hauseman test of Model IIB against Model III in e®ect tests for a size e®ect in technical e±ciency when size is measured by the scale of input usage. The test rejects the random e®ects formulation only for three of the seven industries. However, age-size e®ects in e±ciency are evident in Table 8, regardless of whether e±ciency scores are based on the ¯xed e®ects model or on the random e®ects formulation. The scores of e±ciency used in the 18

regressions of the ¯rst two columns of Table 8 are based on estimates of Model III. Those used in the regressions reported in the last two columns ot the same table are based on estimates of Model IIA. In all columns of the table ¯rm e±ciency increases in size. Older ¯rms are also more e±cient until some age threshold is reached beyond which e±ciency seems to decrease with age. Both outcomes are consistent with the predictions of the passive learning model . The result that bigger ¯rms are more e±cient is also consistent with the ¯ndings of Pitt and Lee (1981) in their study of Indonesian weaving ¯rms. The result that e±ciency increases with ¯rm age below some threshold age is consistent with the ¯ndings of Martin and Page (1983) for a sample of ¯rms in the Ghanian wood industry and with those of Haddad(1993) for a sample Manufacturing ¯rms in Morocco. However, it contradicts the result of Pitt and Lee who detected a negative age e®ect in e±ciency. One possible explantation of the Pitt and Lee result is that their sample is truncated in age above the threshold level detected here. It is, of course, also possible that their suggested explanation that the e®ect is due to sunk costs impeding choice of technique by older ¯rms is correct at least for their sample. 5.3. Firm Characteristics and E±ciency. That the age-size regressors in the e±ciency score equations of Table 8 do indeed mainly proxy for entrepreneurial human capital and locational advantage is sug- gested by Tables 9 and 10. This result comes out more forcefully in the random e®ects model than in the ¯xed e®ects formulation. Table 9 reports results of the regression of scores of e±ciency on ¯rm characteristics including ¯rm age and ¯rm size. The age-size variables are excluded from the regressions of Table 10. The F-test fails to reject the exclusion at the 5 per cent level in all cases. Moreover, contrary to what we see in Table 8, neither age nor size is any longer signi¯cant in the regressions based on the random e®ects regression of Table 9. The in°u- ence of age on ¯xed e®ect e±ciency scores reported in Table 8 also disappears in Table 9 as we add human capital and location variables. However, the e®ect of size on ¯xed e®ect e±ciency scores persists between the two tables which may be an indication that some of the size e®ect registered in the ¯rst two columns of Table 8 may be a result of sources other than di®erences in entrepreneurial human capital or location. Turning to the e®ect of individual location variables, we see from both Tables 9 and 10 that `advantageous location' is a stronger in°uence on ¯xed e®ect e±- ciency scores than it is in the random e®ects model. This is particularly the case 19

in the regressions in which the score is SCOREF. In this case all the three location variables are statistically signi¯cant, have the expected sign and are of the same order of magnitude as those of LNAGE in the corresponding regression in Table 8. Changing the dependent variable to FIXED does not alter the result much except that the standard errors of the coe±cient of SURROUND become con- siderably larger. The regression results based on ranodm e®ect e±ciency scores are consistent with those of the ¯xed-e®ect model in terms of the signs of esti- mated coe±cients (columns 3 and 4). However, only one of the location variables, namely, GOVRENT, is signi¯cant in this case. The ¯xed-e®ects and random- e®ects speci¯cations are in almost full agree- ment when it comes to the role of owner human capital variables. First, in both cases levels of formal education exert a far stronger in°uence on e±ciency than any of location or other human capital variables. The coe±cient of each of the variables, PRIMARY, SECOND and COLLEGE is positive, signi¯cant at the one per cent level and greater in magnitude than that of any of the other human capital or location variables. Secondly, skills that ¯rm owners may have acquired informally prior to setting up their businesses as indicated by APPRENT or LNEXPER does not seem to in°uence technical e±ciency in either case. The same applies to technical skills acquired through formal training as indicated by VOCATION. If anything the negative signs of the coe±cients of the three vari- ables suggest that ¯rms whose owners have had longer pre-ownership experience and vocational training are less e±cient. A possible explanation for this is that owners that have had the longest pre ownership career in an industry as trainees or employees tend to set up a business of their own in the same industry or tend to stay put less because they are convinced of their competitive advantage over new comers than because their relative e±ciency would be even lower elsewhere.20 Probably for the same reason, I ¯nd that ¯rms of `second generation' businessmen are less e±cient than those of `¯rst generation' ¯rm owners. The coe±cient of the variable OWNBUS is negative and signi¯cant in the regression of ¯rm ¯xed e®ects in Table 9, while the variable PUBEMP is positive and signi¯cant in the regressions of PANU and DPANU. The result is consistent with those of Bates (1990) and Holtz-Eakin et al.(1993) but contrary to what Lentz and Laband (1990) reported. The coe±cient of FELLOW is signi¯cant and has the expected sign in all the equations of Tables 9 and 10. The result suggests that technical e±ciency is higher the greater is the access of the owner to business networks extending beyond 20 We not that our result that LNEXPER is not a signi¯cant in°uence on technical e±ciency contrasts with the ¯ndings of Martin and Page(1983)for a sample of industrial ¯rms in Ghana. 20

relatives or friends. I also ¯nd that the ethnicity of the owner is correlated with a ¯rm's e±ciency. As I noted earlier, this may be due to ethnicity determining the quality or extent or scope of the business networks the owner is able to access. Alternatively it may re°ect the e®ect of ethnicity as a source of externalities in the formation of the owner's skills. Of the two ethnicity variables considered, AMHARIC is negative and signi¯cant in all the four equations suggesting that ¯rms run by Amaharic business men are doing generally worse than other ¯rms. However, the other variable, GURAGE, is negative and not signi¯cant, which does not popular view of the Gurage as the most likely to `succeed in business' among all the ethnic groups in Ethiopia at least in relation to manufacturing businesses. I ¯nally note that the evidence for an industry e®ect in ¯rm level e±ciency is rather mixed. The relevant results in this connection are those of the regression of SCOREF or DPANU on ¯rm characteristics since coe±cients of estimates of industry dummies in the other regressions are clearly biased for industry e®ects due to systematic inter-industry di®erences in sampling error. Using the SCOREF or DPANU, we see that there are signi¯cant industry e®ects in e±ciency according to the ¯xed e®ects model but practically none according to the random e®ects formulation. 6. SUMMARY AND CONCLUSION. Using data on a sample of manufacturing ¯rms in Ethiopia, this paper reports further evidence in favour of Jovanovic's version of the passive learning model of competitive selection. Several studies of ¯rm growth in developed economies have found that the probability of survival of ¯rms increases in ¯rm size and age while the growth rate of a ¯rm conditional on survival decreases in both variables.. This result is consistent with the Jovanovic model and, as reported in a companion paper, is also supported by the data analysed in this paper. The main contribution of the paper is the testing of three other implications of the passive learning model for the ¯rst time. The ¯rst is that age-size e®ects in growth or survival imply permanent inter-¯rm di®erences in technical e±ciency. The second is that there are age-size e®ects in ¯rm level e±ciency whereby older ¯rms are more e±cient given size, and bigger ¯rms are more e±cient given age. The third is that the direction of causation is not from ¯rm age or size to e±ciency, but the other way round. Age-size e®ects in ¯rm level e±ciency should, at least in part, be traced to the in°uence on e±ciency of more enduring ¯rm characteristics such as entrepreneurial human capital and location. 21

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