The selection of firms based on productivity: different roles of entry and overhead cost

This paper investigates the different roles of entry cost and overhead cost in the productivity-based selection of firms into production. It also discusses the implications for the resource allocations of the aggregate economy. Using an analytically tractable model with entry and exit, we show that reducing entry cost will increase average firm productivity by encouraging more entries of firms, whereas reducing overhead cost will decrease it by adversely lowering the selection standard. From the perspective of improving the allocation of production resources, our findings suggest that the various policies designed to reduce the costs of setting up new businesses are more important than the policies designed simply to reduce operation costs.