Firm Size, Life Cycle Dynamics and Growth Constraints in Mexico: Reduce informality, combat the undue use of market power in concentrated industries and strengthen access to financial services

Firm Size, Life Cycle Dynamics and Growth Constraints: Evidence from Mexico. Christian Saborowski, Florian Misch. IMF Working Paper No. 19/87. May 2, 2019. https://www.imf.org/en/Publications/WP/Issues/2019/05/02/Firm-Size-Life-Cycle-Dynamics-and-Growth-Constraints-Evidence-from-Mexico-46819

Summary: This paper examines the variation in life cycle growth across the universe of Mexican firms. We establish two stylized facts to motivate our analysis: first, we show that firm size matters for development by illustrating a close correlation with state-level per capita incomes. Second, we show that few firms grow as much as their U.S. peers while the majority stagnates at less than twice their initial size. To gain insights into the distinguishing characteristics of the two groups, we then econometrically decompose life cycle growth across firms. We find that firms that have financial access and multiple establishments and that are formal, part of diversified industries and located in population centers can grow at sizeable rates.

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I Introduction

Mexico’s low productivity growth in recent decades has puzzled many observers (Levy and Rodrik, 2017). Slow technology diffusion is unlikely to be the main explanation given that Mexico has benefited from large foreign investment inflows after opening up its economy as part of a series of sweeping structural reforms since the 1990s. A recent strand of work argues that Mexico’s productivity has been held back in part because the allocation of labor and capital is distorted (e.g. Levy, 2018; Misch and Saborowski, 2018).1

In this paper, we focus on within-firm growth as a complementary explanation for Mexico’s low productivity growth.2 We argue that individual firms do not invest enough, thus depressing firm growth and preventing firms from taking sufficient advantage of economies of scale. The paper calculates individual firm growth over the life cycle based on five waves of the Mexican Economic Census from 1993 to 2013, complemented by longitudinal firm identifiers constructed by Busso and others (2018) and expanded by INEGI staff. We then decompose our estimates of life cycle growth at the firm level to better understand the distinguishing features of firms that grow at sizeable rates compared to those that stagnate.

We establish two stylized facts to motivate our analysis. First, we show that firm size is positively correlated with state-level per capita incomes. The finding complements previous results at the cross-country level and highlights the close association between firm growth and economic development (Bento and Restuccia, 2018). Second, we show that there is a small minority of Mexican firms that does grow at rates similar to the average U.S. firm. While we confirm the finding of Hsieh and Klenow (2014) that the vast majority of Mexican firms stagnate at about 15-19 years of age, there are some firms that do grow continuously to several times their initial size by the age of 20-24.3 Given the close association between firm size and development, it is thus natural to ask what it is that allows this small minority of firms to perform well in an environment in which the majority does not.

We decompose firm life cycle growth into the contributions of individual firm characteristics using a simple regression framework in the second part of the analysis. Our findings suggest that Mexican firms that have financial access and multiple establishments and that are formal, part of diversified industries and located in population centers can grow at sizeable rates. The regressions predict that a firm that is both formal and has financial access would grow to some 2.4 times its initial size. Formal firms with financial access and multiple establishments, in turn, are predicted to grow to 3-4 times their initial size over their life cycles, an order of magnitude similar to that of the average U.S. firm (Hsieh and Klenow, 2014). We further illustrate that these ‘superstar’ firms tend to be very large firms in industries that form part of the North American supply chain.

We contribute to the existing literature in several ways. First, by using data that is perfectly comparable across Mexican states, our paper lends greater credibility to estimates in the literature that find evidence of a positive link between firm size and development. These include the findings by Bento and Restuccia (2017) and Bento and Restuccia (2018) who estimate an elasticity of establishment size with respect to GDP per capita of around 0.3.4 Second, we provide a more nuanced view on firm life cycle dynamics in Mexico than Hsieh and Klenow (2014). We document not only that the average Mexican firm grows less than the average U.S. firm, but also that firms that have managed to overcome a well identified set of distortions are able to grow at rates similar to the average U.S. firm. Third, our findings provide empirical evidence in support of the theoretical proposition that distortions that constrain productivity through misallocation of resources between more and less productive firms also depress investment by individual firms (Hsieh and Klenow, 2014, and Bento and Restuccia, 2017).5 We show that life cycle dynamics can indeed be decomposed into a very similar set of distortions to those identified in Misch and Saborowski (2018) as drivers of resource misallocation in Mexico.

From a policy perspective our findings highlight the importance of pushing ahead with structural reforms in priority areas. This includes efforts to reduce informality, combat the undue use of market power in concentrated industries and strengthen access to financial services. Furthermore, targeted infrastructure investments would help better connecting more remote regions to the major population centers in the country.

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V CONCLUSION
This paper focuses on within-firm growth as an explanation for Mexico’s low productivity growth. A recent strand of work argues that Mexico’s productivity has been held back in part because the allocation of labor and capital is distorted (e.g. Levy, 2018; Misch and Saborowski, 2018). In this paper, we argue that individual firms do not invest enough, thus depressing firm growth and preventing firms from taking sufficient advantage of economies of scale.

We establish two stylized facts to motivate our analysis: First, we show that firm size is positively correlated with state-level per capita incomes. The finding mirrors previous results at the cross-country level and highlights the close association between firm growth and economic development (Bento and Restuccia, 2018). Second, we show that there is a small minority of Mexican firms that do not grow at rates similar to the average U.S. firm while most of their peers stagnate at less than two times their initial size.

The remainder of the paper analyzes the distinguishing factors of the small minority of firms that manage to grow in an environment in which the majority does not. We decompose life cycle growth into the contributions of individual distortions using a simple regressions framework. Our findings suggest that Mexican firms that are formal, have multiple establishments and financial access, are part of diversified industries as well as located in population centers can grow at sizable rates. The regressions predict that a firm that is both formal and has financial access would see a cumulative growth rate of some 140 percentage points more than an informal firm without financial access. Formal firms with financial access and multiple establishments, in turn, are predicted to grow to 3-4 times their initial size over their life cycles, and thus by an order of magnitude similar to that of the average U.S. firm.

Our findings support the theoretical proposition that distortions that constrain productivity through misallocation also depress investment by individual firms (Hsieh and Klenow, 2014, and Bento and Restuccia, 2017). We show that life cycle dynamics can indeed be decomposed into a very similar set of distortions to those that have been identified as drivers of resource misallocation in Misch and Saborowski (2018).

From a policy perspective, our findings are consistent with continued emphasis on structural reforms. This includes efforts to reduce tax evasion, limit the use of market power in concentrated industries and strengthen access to financial services. Furthermore, targeted infrastructure investments that help to better connect the more remote regions to the major population centers in the country also matter for firm growth. We leave several issues to future work. These include a more detailed study of differences in the distribution of life cycle growth across cohorts and age groups. Another avenue could be to more explicitely examine the role of market power in driving life cycle growth.