The Quality of the Legal System and Firm Size

55 Pages Posted: 28 Feb 2004

See all articles by Luc Laeven

Luc Laeven

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Christopher M. Woodruff

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS)

Date Written: February 2004

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.

Suggested Citation

Laeven, Luc A. and Woodruff, Christopher, The Quality of the Legal System and Firm Size (February 2004). Available at SSRN: https://ssrn.com/abstract=509582 or http://dx.doi.org/10.2139/ssrn.509582

Luc A. Laeven (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher Woodruff

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS) ( email )

9500 Gilman Drive
La Jolla, CA 92093-0519
United States
858-534-0590 (Phone)
858-534-3939 (Fax)

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