Lack of Selection and Poor Management Practices: Firm Dynamics in Developing Countries

As recently shown by Hsieh and Klenow (2012), firm dynamics differ substantially across countries. While firms in the US experience substantial growth during their life-cycle, firms in developing countries, especially in India, barely expand. We present a tractable microfounded endogenous growth model to explain these differences. At the heart of the theory are two sources of heterogeneity across countries. First, we explicitly allow firms to register as formal firms or stay in the informal sector. While informality comes with the benefit of not being subject to taxes and regulation, informal firms are subject to government audits and the risk of being shut down. This lowers the marginal return of technology adoption and informal firms have an incentive to stay small. Second, we incorporate the recent state-of-the-art advances from Bloom and Van Reenen (2010) that managerial practices differ across countries and incorporate managers as a necessary input to run multi-product establishments. Better managers will induce a steeper life-cycle profile as it allows firms to scale up easily and to expand into new product lines. While the model has rich implications for firms' life-cycle, it still has a tractable analytic solution, which we can easily confront with the micro-evidence and calibrate successfully to the data of Hsieh and Klenow (2012).