Markup Dispersion and Firm Entry: Evidence from Ethiopia*
| Date | 01 April 2021 |
| Author | Giorgia Giovannetti,Kaku Attah Damoah,Marco Sanfilippo |
| Published date | 01 April 2021 |
| DOI | http://doi.org/10.1111/obes.12384 |
299
©2020 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 83, 2 (2021) 0305–9049
doi: 10.1111/obes.12384
Markup Dispersion and Firm Entry: Evidence from
Ethiopia*
Kaku Attah Damoah,†Giorgia Giovannetti‡ and Marco
Sanfilippo§
†Department of Economics and Management, University of Florence, Florence, 50127, Italy
(e-mail: kakuattah.damoah@gmail.com)
‡Department of Economics and Management, University of Florence and European
University Institute, Firenze, 50014, Italy (e-mail: giorgia.giovannetti@unifi.it)
§Department of Economics and Statistics “Cognetti de Martiis”, University of Turin and
IOB, University of Antwerp, Antwerp, 2000, Belgium
(e-mail: marco.sanfilippo@uantwerpen.be)
Abstract
This paper examines whether and to what extent markups can influence structural transfor-
mation in a developing country by creating entry barriers. We exploit information from the
Ethiopian annual census of manufacturing establishments to estimate markups and their
dispersion at industry and woreda-industry-wide levels. We then analyse the relationship
between markup dispersion and firm entry rates in local markets. Results show that higher
markup dispersion significantly correlates with lower entry rates into a market, even in
the presence of expected positive average markups. Specifically, an increase in dispersion
from its median to the values at the 90th percentile of the distribution is related to a 4.2%
point lower entry rate. This result is robust to different estimation methods as well as to
different definitions of the key variables.
I. Introduction
New firms are the engine of economic growth.They enhance the process of creative destruc-
tion, whereby non-performing firms are replaced by new ones (Bartelsman, Haltiwanger
and Scarpetta, 2004). This process can spur aggregate productivity growth if the least pro-
ductive firms exit and the most productive ones enter the market (see, for instance, Aw,
Chen and Roberts, 2001). In some cases, the entry of new firms can stimulate incumbents
to innovate and to become more efficient (Aghion et al., 2009). Moreover, new entrants
reduce monopoly rents by competing away excess profits enjoyedby incumbents (Geroski,
JEL Classification numbers: D22, L22, O14, O25.
*We thank the Editor, James Fenske, three anonymous reviewers and Stefano Schiavofor helpful comments and
suggestions. We also thank participants of the following conferences and workshops: the c.MET05 XV Workshop,
the ICEED 2018 conference, the ASSET 2018 meeting and SIEPI 2019 workshopfor comments and discussions that
greatly improvedthe paper. Kaku Attah Damoah acknowledges financial support from the Department of Economics
and Management, University of Florence under the project, ‘International Competition, Market Power, and Firm
Productivity in Sub-Saharan Africa’.The usual disclaimer applies.
300 Bulletin
1995), and have the potential to generate a larger number of jobs (Hijzen, Upward and
Wright, 2010; Klapper and Richmond, 2011).
Despite the potential gains from firm entry, new business formation is still low in
developing countries where the scope for entry should be greater (Klapper, Amit and
Guill´en, 2010). What does then prevent entry? A first wave of literature emphasized that
the prospect of market growth and positive expected profit increases firm entry, while
sunk capital costs deter it (Austin and Rosenbaum, 1990; Bresnahan and Reiss, 1991;
Rosenbaum, 1993). Bresnahan and Reiss (1987) and Geroski (1995) point out that although
higher expected profits should spur new business formation, firm entry seems to react
slowly to high profits. Klapper, Laevenand Rajan (2006) and Bruno, Bytchkova and Estrin
(2013), on the other hand, claim that low firm entry can be attributed to unfavourable
business environment, excessive regulation and institutional challenges.
Against this background, this paper introduces a factor that has so far been neglected
in the literature, by showing that markup dispersion can deter firm entry in the presence of
high expected profits. The core of our argument rests on partial equilibrium analysis. We
exploit the fact that market power, that is, prices above marginal cost, is a distortion of the
first best equilibrium, and analyse the implications of market powerfor business dynamics.1
Markups may affect the mass of potential entrants in differentways. First, the incentives
of a potential entrant are influenced by its expected operating profits net of entry sunk cost,
that is, entry is a positive function of markups (Rosenbaum, 1993; Geroski, 1995). How-
ever,while a higher aggregate markup can make entry more appealing, the way markups are
distributed across firms can also influence the decision to enter a given market. The poten-
tial mechanisms through which a more dispersed distribution of markups can affect entry
are diverse, which leads to some ambiguity in the expected direction of this relationship.
A high dispersion in the distribution of markups may introduce uncertainty on postentry
expected profits. Following the seminal contribution by Dixit (1989a, b), extensive litera-
ture has analysed the effect of uncertainty on entry.When entr y investment is irreversible,
uncertainty about future markups may increase the risk of default. Potential entrants are
therefore less likely to commit to entry decisions adopting a ‘wait and see’ attitude. How-
ever,uncertainty can play in the opposite direction, fostering entry. Followingwhat has been
defined as the Oi-Hartman-Abel effect, this might happen if firms are able to expand to ex-
ploit positive outcomes and contract to insure against bad outcomes, which can make them
potentially risk-lovers (see, for instance, Bloom, 2014). Whether and to what extent these
potential mechanisms affect firms’ dynamics has much to do with the underlying causes
of markup dispersion, and with the specific characteristics of the markets. Ultimately, this
is therefore an empirical question that we address in the remaining of this paper.
The objective of this paper is to provide empirical support to the hypothesis that the
dispersion of markups can affect the formation of new enterprises. We also show to what
extent this relationship is mediated by firm heterogeneity, industry characteristics and
policy-related factors.
Our analysis is based on census-level information on formal manufacturing establish-
ments based in Ethiopia, covering a period of high economic growth in the country, that
1Using a rich data set on US firms, De Loecker, Eeckhout and Unger (2020) document a significant rise in market
power after the 1980s, which holds a negative correlation with several macroeconomic indicators that confirm its
harmful effects on economic growth.
©2020 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
To continue reading
Request your trial