Impact of entry costs on aggregate productivity: financial development matters

This paper revisits the question: what is the impact of entry costs on cross-country differences in output and total factor productivity (TFP)? I argue that for the countries with low levels of financial development, the answer is the conventional one in the literature, that higher entry costs cause misallocation of productive factors and lower TFP. However, for countries with reasonably high levels of financial development, the conventional answer does not hold. Motivated by observations on cross-country data, I propose a new theory on the impact of entry costs on TFP. In my mechanism, two competing forces affect TFP when entry cost changes: A wealth-based selection force and a productivity-based selection force. This results in TFP being a hump-shaped function of entry costs. That is, entry costs are not inherently bad for TFP if their target is to deter low productivity individuals from starting businesses. I develop an analytically tractable model of firm dynamics with entry barriers and financial frictions and derive the sufficient conditions for the impact of entry cost on TFP in both wealth- and productivity-based selection phases.