Profits and Economic Development

Source: Dan Schwab, Eric Werker, Harvard Business School BGIE Unit Working Paper No. 14-087, March 13, 2014

Are rents, or excess profits, good for development? …. On the one hand, rents seem to be a compelling feature of successful economic development. “Schumpeterian rents” can incentivize innovation and thus bring about the economic development Schumpeter was talking about, as the economy became more sophisticated and productive. “Without profit,” Schumpeter noted, “there would be no accumulation of wealth.” A different view of rents and development can be found in North, Wallis, and Weingast. North and co-authors argue that most societies in history—including today’s developing economies —are “natural states” in which a dominant coalition of elites carve up the economy into protected rents that can be collectively enforced. As these natural states become more consolidated, elites have an interest to promote specialization and trade in order to increase the amount of rents at play. By this mechanism, rents go part and parcel with political stability, and their presence is required if the economy is to develop. A third idea can be found in the voluminous access-to-finance literature. Financial sector development is a key correlate of economic development. Countries with less developed economies grow slower. In those countries, retained earnings are an important source of capital for new investment. It thus seems logical that an economy or industry that enjoys higher profits or rents should be able to fund a faster expansion. …. Taken together, these three conceptualizations highlight the crucial role for rents in economic development: as an incentive for innovation, a glue to keep elite interest in stability and expansion, and a source of capital for investment. Yet in spite of this logic there is a case to question the notion that high profits are good for economic development. …. Rents, as measured by a high-markup which is also an indication of low competition, seem to slow growth in productivity or output. The effect is strongest in poor countries. Higher rents are associated with a slower removal of tariffs, indicative of the channel in our model: firms rent-seek to prevent competition and maintain their high margins. This investment in rent-seeking may be in lieu of investment in innovation or new productive assets, which slows the overall growth of the sector. In industries in which high profits should be essential in generating growth, those sectors that would otherwise need external finance but in a country with weak financial markets, the negative impact of rents on growth is especially strong. We do not find evidence (although our data availability is limited) to support the alternative hypothesis most consistent with the data, that sectors with higher rents have inefficient managers. Finally, we find that countries with more rents in the manufacturing sector grow slower, even when other controls are introduced. ….
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