There is broad agreement that differences in aggregate total factor productivity (TFP) constitute a large fraction of the existing cross-country differences in per-capita income. That is, not only do poor countries have fewer productive resources, such as physical and human capital, but they also employ them less effectively than rich countries. The current consensus is that TFP differences account for upwards of 50% of income inequality. (1) Existing attempts to explain this fact emphasize lags in technology diffusion, geography, vested interests and other institutional failures, and several other causes. We believe, however, that a potentially critical source of inefficiency has so far been largely overlooked by the TFP literature: failures of meritocracy.
Individuals are manifestly heterogeneous in their decision-making skills. Differences across countries in the accuracy with which the best decision makers are selected for managerial responsibilities--differences in meritocracy--can result into differences in the returns countries reap from their productive resources-differences in TFP. Meritocracy can fail spectacularly in the public sector (Caselli and Morelli 2004). But meritocracy can also fail in the private sector. This paper studies the macroeconomic causes and consequences of an important private-sector non-meritocratic practice: the inter-generational transmission of managerial responsibilities in family firms, a Phenomenon that we call dynastic management. (2)
As we document in Section II, the incidence of dynastic management is the most striking difference in corporate-governance arrangements between rich and poor countries, as the latter rely much more on the dynastic family firm, where ownership and control are passed on across generations of the same family. We argue that this systematic difference may be a proximate source of TFP differences: even allowing for self-selected initiators of family businesses, as long as managerial talent is not perfectly correlated across generations, assets will sooner or later end up "in the wrong hands," that is those of a managerially inept descendant. If most firms in an economy are managed dynastically, therefore, aggregate TFP may be negatively affected.
But why is dynastic management more prevalent in some countries than others? In our model, we focus on financial frictions. First, financial frictions hinder the working of the market for corporate control, which is a key determinant of the incidence of dynastic management. Untalented heirs of family firms would like to transfer control to new talented owners (or hire talented managers). However, when financial markets are underdeveloped, it is difficult for talented outsiders to obtain financing to take over incumbent firms. Furthermore, untalented firm owners have little scope for preventing outside managers from appropriating the firm's profits, that is, it is difficult to separate ownership and control. In addition, poorly working financial markets hinder capital mobility. In principle, talented entrepreneurs could bid up the interest rate and drive untalented managers out of capital markets, but financial frictions dampen this mechanism. As a result of both effects, the incidence of dynastic management will be more severe in developing countries precisely because they suffer from less developed financial markets. (3,4)
We study a growth model where dynastic management arises endogenously as a consequence of financial frictions, and look at the consequences of this failure of meritocracy for TFP, capital accumulation, and other macroeconomic variables. A plausible parametrization of our model is able to generate a cross-country dispersion of TFP which is roughly one-third as large as the one observed in the data. Interestingly, both the market for control and capital mobility appear to significantly contribute to the overall effect of financial frictions. …