Returns to Scale, Firm Entry, and the Business Cycle

Abstract

I document that fewer firms with high returns to scale tend to get started in recessions, and that financial conditions at birth are critical for the formation of such businesses. A version of a firm dynamics model with financial frictions and the ability of potential entrepreneurs to choose their returns to scale can account for the data. In the estimated model, financial frictions slow the rate at which businesses with high returns to scale grow disproportionately; this discourages such firms from entering during recessions. The “missing generation” of firms with high returns to scale delays recoveries in the aftermath of economic crises.

Keywords: Business cycles, firm dynamics, financial frictions

JEL Classification: E22, E32