Interpreting High Returns to Microenterprise Investment

The average microenterprise in a developing country has very high marginal returns to capital (on the order of 100% annually), according to several recent studies. Financial constraints are part of the explanation for how these high returns persist. But, given these constraints, it remains to explain the limited self-financing by the households running these businesses. In particular, little is known about the elasticity of intertemporal substitution (EIS) of poor households, which describes how quickly households save in response to rates of return higher than their rate of time preference. If poorer households have a lower EIS, reflecting the difficulty of reducing their already low consumption to finance investment, then they will save slowly in response to high returns despite having a normal rate of time preference, or discount rate. However, separately identifying the EIS from the discount rate is difficult because it requires variation in the returns to capital, which is not present in many data sets. I examine extant data on microenterprises in Sri Lanka, including the results of a field experiment distributing grants to a random selection of firms, which aids in identifying households’ varying returns to capital. I document gradual investment by most firms in response to their very high returns. I estimate the EIS of these households to be 0.03, substantially lower than recent estimates around 0.7 for US and UK households. This explains why households are found with such high unexploited returns. The main implication is that households invest cash grants productively with persistent benefits rather than consuming them away shortly after receiving them. ∗ I have greatly benefited from the guidance of John Kennan. Michael Carter introduced me to this topic area. I received helpful questions and suggestions from Rasmus Lentz, Salvador Navarro, Karl Scholz, Yongseok Shin, Chris Taber, Jim Walker, and other participants in the labor economics summer workshop at UW-Madison. Brad Barham, Jennifer Alix-Garcia, Laura Schechter, and other participants in the UW-Madison Development workshops provided helpful feedback, as well as John Micklewright. Many thanks to Chris Woodruff for providing data and answering multiple inquiries.