The Quality of the Legal System and Firm Size

Abstract

Employment in developing countries is disproportionately concentrated in very small firms. We examine the extent to which the distribution of firm size is related to the quality of the legal system using data from Mexico. We combine Lucas' (1978) model of firm size with Himmelberg, Hubbard and Love's (2001) consideration of idiosyncratic risk in a framework in which the distribution of entrepreneurial talent and aversion to idiosyncratic risk combine to determine the optimal size of firms. Our data allow us to focus on the differential impact of the legal system on proprietorships and corporations. Moreover, by focusing on firms in a single country, the data draw attention to the importance of variation in the administration of justice and the enforcement of legal verdicts. We find that Mexican states with more effective legal systems have larger firms. A one standard deviation improvement in the quality of the legal system increases the average firm size by about 10-15 percent. The impact of the legal system is greatest in sectors in which proprietorships dominate. This pattern is consistent with better legal systems increasing the investment of firm owners by reducing the idiosyncratic risk faced by owners. All of these findings are upheld when we instrument for the institutional variables using the log of indigenous population in 1900 and the active presence of the drug trade in the state.