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Firms in conflict: adapt or perish

Michele Di Maio and Francesco Amodio

Being an entrepreneur is a difficult activity, and being an entrepreneur in a developing country is even more difficult. But being an entrepreneur in a developing country affected by a violent conflict situation seems almost impossible. In fact, it is not.

As surprising as it may seem, firms do indeed produce goods and services, sell these goods and services and in some cases even expand in conflict environments. There is a growing literature on the effects of violent conflicts on firms’ performance, as well as on the effect of firms’ behaviour on conflicts (although the latter group of studies is much smaller).

As we discussed in a previous post, the literature has shown that the effect of violent conflict on firms is highly heterogeneous, ranging from very negative to even positive. The question of effect prevails, as so often in economics, depends on the specific conditions of the case we are studying.

How conflict affects firms’ behaviour

While the various effects of violent conflict on firms are fairly well documented, much less is known about the possible mechanisms through which the conflict may affect firms’ performance. The direct negative effects of a conflict on firms’ activities include the physical destruction of firms’ assets and of public infrastructures, impediments to workers’ ability to reach the workplace, and the breakdown of domestic and international trade relations. More indirect effects are related to changes in demand conditions and in firms’ expectations about future economic conditions, which affect their production and investment decisions today.

 

Inputs, trade and conflict

In our forthcoming new working paper, we show that another important channel explaining the negative impact of a conflict on firms’ performance is the induced change in firms’ production decisions. Firm production requires the implementation of a set of complex activities, of which the combination of domestically and imported inputs is one of the most important.

These are delicate procedures that the conflict may interrupt at any time and that are very costly to modify. A violent conflict may indeed completely stop a firm’s operations. In order to survive, firms must adapt to the new conditions determined by the conflict. The ability of the firm to change its production process, organizational routines and selling strategies does in fact determine its probability of survival and possibility of success.

In our paper, we explore these issues in the context of the Second Intifada (2000–2006). The Israeli–Palestinian conflict represents an interesting case study illustrating how firms are affected by the conflict and how they react to that new situation. As shown in figure 1, the escalation of violence (measured as the number of Palestinian fatalities caused by the Israeli Defense Forces) between 2000 and 2002 is associated with a sizable contraction of Palestine’s real gross domestic product (GDP).

 

Figure 1.

In fact, the conflict also brought about more severe restrictions on the circulation of goods and individuals both within and across the borders of the Occupied Palestinian Territories. Figure 2 plots the evolution of Palestine’s real net balance of trade over the same period, showing how Palestinian imports decrease disproportionally more than exports. It is important to note that at least part of these imports are likely to be intermediate inputs that Palestinian firms use in their production processes.

 

Figure 2.

 

To explore in more detail these stylized facts, we looked at the micro-economic impact of the Israeli–Palestinian conflict. Using data for more than 14 000 firms over the period, we find that higher conflict intensity reduces the total and per-capita output value of Palestinian firms. In particular, our results indicate that an increase of 10 Palestinian fatalities at the district level is associated with a 3 per cent drop in the value of output for Palestinian establishments located in the district.

Furthermore, we provide evidence of a precise new mechanism explaining this result. We show that the conflict—by reducing international trade and access to the market for imported inputs—induces a sub-optimal input choice by Palestinian firms that are forced to substitute domestically produced inputs for imported inputs. In other words, firms willing to survive adapt to the new violent context by taking sub-optimal production decisions.

Our results show that at least part of the aggregate economic response to conflict seems to be caused by restrictions on the circulation of imported inputs and goods, which generate or exacerbate input misallocation. Despite the peculiarities of the specific setting we study, our research sheds light on distortions in firms’ access to input markets as an additional channel through which conflict affects economic outcomes.

 

Learning about firms’ behaviour in conflict environments

Adaptation is the key to survival in a conflict environment. A good example of this is the strategy adopted by Palestinian firms during the Second Intifada. Our analysis clearly indicates that the Israeli–Palestinian conflict has severely and negatively affected Palestinian firms’ performance. In order to survive, Palestinian firms had to adapt to a conflict situation that forced them to make sub-optimal input choices—namely, substituting imported inputs for inputs available locally.

Understanding why these choices are sub-optimal could suggest ways to mitigate the negative effects of violent conflicts on firms, not only in the case of the Israeli–Palestinian conflict but also in other contexts.

 

This blog post is published as part of a collaborative partnership between SIPRI and Economists for Peace and Security (EPS).

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