Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Entry Cost, Financial Friction, and Cross-Country Differences in Income and TFP

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Entry Cost, Financial Friction, and Cross-Country Differences in Income and TFP

Article excerpt

Working Paper 2010-16 September 2010

Abstract: This paper develops a model to assess the quantitative effect of entry cost and financial friction on cross-country income and total factor productivity (TFP) differences. The main focus is on the interaction between entry cost and financial friction. The model is calibrated to match establishment-level statistics for the U.S. economy assuming a perfect financial market. The quantitative analysis shows that entry costs and financial frictions together can generate a factor ten of the differences in income per capita and a factor five of the differences in TFP, and a large part of the differences are accounted for by the interaction between entry cost and financial friction. The main mechanism is that financial friction amplifies the effect of entry cost by boosting the effective entry cost.

JEL classification: 011, 043

Key words: entry cost, financial friction, GDP per capita, TFP

1 Introduction

Income per capita differs by a factor of thirty between rich and poor countries. Research on growth accounting finds out that most of the differences come from the cross-country differences in total factor productivity (TFP). (1) On the other hand, many poor countries have poor developed financial markets as well as large costs to the opening of new businesses. Both of these two factors have been found to be negatively correlated with income per capita across country. (2) The goal of this paper is to quantify the importance of financial frictions and entry costs for cross-country differences in income per capital and TFP.

There are a number of studies that have examined either the effects of financial frictions or the effects of entry costs on cross-country differences. The objective of this paper is to investigate whether there is any interaction between entry costs and financial frictions and how such interaction may affect cross-country income and TFP differences. Intuitively, underdeveloped financial markets may amplify the effect of entry cost since entrepreneurs can not borrow to overcome the high barriers. In contrast, better developed financial market may have little effects on how entry costs affect output and TFP.

To explore this issue, this paper develops a model to incorporate both financial friction and entry cost, and then use the calibrated model to explore how the effect of entry cost on cross-country income and TFP differences change with financial market conditions. We discover that financial friction amplifies the effect of entry cost on economic development. Moreover, the interaction between financial friction and entry cost is quantitatively important in accounting for the cross-country income and TFP differences.

The model developed in this paper builds on the industry model studied by Hopenhayn (1992) and Hopenhayn and Rogerson (1993). In the model establishments have different levels of productivity and the technology is subject to decreasing return to scale with a fixed production cost. We assume that capital and labor have to be paid before production takes place. An establishment can save or borrow from the financial market to fulfill the need for working capital. The financial market is imperfect and an establishment can only borrow up to a fraction of its expected discounted life-time profits. The existing establishments may exit if it is hit by a death shock or the value of production is smaller than the savings. In contrast, new establishments can enter after paying an upfront entry cost which can be borrowed from the financial market subject to a similar borrowing constraint facing by the existing establishments.

The model is calibrated to match the establishment level statistics in the U.S. economy assuming a perfect financial market for the U.S. The calibrated model is then used to analyze the cross-country differences in income per capita and TFP. To perform the analysis, we vary entry costs in the range observed in the data and vary the friction in the financial market to obtain variations in external finance to GDP ratios that are comparable to the data. …

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