Misallocation in Economies with Financial Frictions and Firing Costs

Abstract

Emerging economies are characterized as having underdeveloped financial markets. Furthermore, many of these economies have employment protection laws that make it costly for firms to fire workers. Understanding the interaction between these features is key for evaluating financial and labor policy reforms since they have a direct impact on the allocation of resources and aggregate productivity. This paper quantifies the effect on aggregate productivity of an improvement in financial development in economies with firing costs. I develop a small open economy model with heterogeneous firms that face collateral constraints and have to pay firing costs. I calibrate the model using census plant-level data from the manufacturing sector in Chile. I find that aggregate productivity increases by 2.5 percent following a financial reform that makes Chile's level of financial development comparable to that of the United Kingdom. Ignoring firing costs underestimates the impact of the reform, predicting an increase in productivity of 0.3 percent. Acknowledging firing costs introduces two reasons why the financial reform has a stronger impact. First, firms with high past employment hoard labor and, as a result, demand more capital, which makes them more likely to be financially constrained. Second, an increase in wages following the reform increases the effective firing cost and hence discourages firms with low past employment from hiring. As a result, these firms demand less capital than they would if there were no firing costs and are less likely to be financially constrained. Finally, I study the effect on productivity of the interaction between these two frictions when evaluating labor and financial reforms. I do this for a range of economies with plausible initial levels of financial development and firing costs.