Which firms suffer due to ethnic fractionalization?

Ethnic fractionalization has been a topic of interest among economists due to its potential impact on income level and growth. While the literature proposes both positive and negative effects of ethnic fractionalization, a key point that has been overlooked is that the proposed benefits of greater ethnic diversity are more applicable to large firms, while the negative effects are more applicable to small firms. This suggests that higher ethnic fractionalization may harm only the relatively small firms, while benefitting the relatively large firms or leaving them unaffected. This has far-reaching implications for how we think about ethnic fractionalization and its effects in the developing world .

To address this gap in the literature, a recent study by Khalid and Amin (2023) explores how ethnic fractionalization affects the level and growth rate of labor productivity of small vs. large firms. The analysis is based on firm-level survey data for manufacturing firms in 84 developing countries collected by the World Bank’s Enterprise Surveys.

One potential benefit of increased ethnic diversity in the workforce is that it can boost firm productivity by providing a more diverse set of perspectives, ideas, and skills.  People of different ethnicities differ in their productive abilities, innovative ideas, and problem-solving skills, which can lead to more efficient and effective solutions using their cognitive skills and abilities. A study by Alesina and Ferrara (2005) found that the efficiency of individuals in performing a task, solving a problem, or coming up with innovative ideas, relies more on their ability to offer a distinct perspective among group members, rather than on their own anticipated high scores. However, it is also argued that higher ethnic fractionalization can have negative impact on public spending, the provision of public goods, and institutional quality.

Ethnic diversity can impact public spending and the availability and quality of public goods due to different ethnic groups having varying preferences for the types and quantities of public goods to fund with tax dollars. This can lead to a “compromise” good that some citizens may be unwilling to fund, resulting in constrained public spending. As a result, public spending is constrained, as is the availability and quality of public goods. Additionally, the utility level of an ethnic group for a given public good may be reduced if other groups use it as well. As ethnic fractionalization grows, governments may become more interventionist and inefficient, negatively affecting the quality of public goods, the size of government, and levels of political freedom. Miyazaki (2022), Banerjee et al. (2005), Alesina et al. (1999) provide further insight into this issue.

So why does firm size matter? Regarding firm size, Khalid and Amin (2023) argue that the positive impact resulting from skill complementarities associated with greater ethnic diversity requires a knowledge-intensive and diverse manufacturing process. Large firms are clearly more likely to use complex, diversified, and knowledge-intensive and diverse manufacturing process. Large firms are better equipped to use complex, diversified, and knowledge-intensive production methods than small firms. They also benefit from dedicated human resource management departments that can help address the challenges of a diverse workforce. Large firms have more resources to deal with lower-quality institutions and poorer infrastructure availability that comes with higher ethnic fractionalization. They also have better access to institutions and stronger connections within the business ecosystem. Through vertical integration and subsidiaries, large corporations can partially mitigate the higher transaction costs associated with lower levels of trust in more ethnically fragmented countries.

Khalid and Amin’s (2023) research supports the notion that higher ethnic fractionalization is linked to lower labor productivity levels and growth rates. However, the negative effect is significantly mitigated by larger firm size. Figures 1 and 2 visually demonstrate this point, showing that higher ethnic fractionalization has a large and statistically significant impact on reducing labor productivity levels (Figure 1) and growth rates (Figure 2) in small and medium-sized enterprises (SMEs). In contrast, the impact on large firms is much weaker and statistically insignificant.

The study concludes that higher ethnic fractionalization has a significant negative impact on relatively small firms but has no effect on relatively large firms.  Furthermore, the study identifies higher production complexity, lower power supply quality, and higher corruption are some of the channels responsible for ethnic fractionalization’s differential impact on small and large firms. These findings hold up against alternative explanations that consider industry effects, country-specific factors, business environment, firms' characteristics such as age and financial constraints, and other definitions of small and large firms. The results also apply to instrumental variables (IV) estimation, which involves instrumenting ethnic fractionalization by the duration of uninterrupted human settlement in the country since pre-historic times.

Figure 1: Greater fractionalization has significantly negative effects on SMEs’ labor productivity level but no significant impact on large firms

Source: Based on World Bank’s Enterprise Surveys data on manufacturing firms in 89 developing countries. SMEs are firms that have 5-99 workers and large firms have 100 or more workers.

Figure 2: Greater fractionalization has significantly negative effects on SMEs’ labor productivity growth rate but no significant impact on large firms

Source: Based on World Bank’s Enterprise Surveys data on manufacturing firms in 89 developing countries. SMEs are firms that have 5-99 workers and large firms have 100 or more workers. The growth rate of labor productivity is defined over the last three years. The figure controls for the initial level of labor productivity (convergence effect).

The findings discussed above have several important implications. Firstly, policies aimed at mitigating the negative effects of ethnic fractionalization should be targeted towards small businesses, as they are more vulnerable to its negative impact. Secondly, the negative effects of ethnic fractionalization on smaller firms are likely to be much larger than previously estimated based on macro-level studies that do not differentiate between small and large firms. Thirdly, SMEs and micro firms are responsible for creating the majority of new jobs in the developing world. As these businesses are more affected by the negative impact caused by ethnic fractionalization, the consequences for job growth are likely to be more severe.  This is particularly concerning given the “jobless” growth phenomenon that exists in many countries today. These and related issues represent an exciting avenue for future research.

Further studies could explore the mechanisms through which ethnic fractionalization affects small businesses and the potential policy interventions that could mitigate its negative impact. By gaining a better understanding of these issues, policymakers and researchers can work towards creating a more inclusive and equitable business environment that supports job creation and economic growth.