What is the Impact of Increased Business Competition?

This paper studies the impact of a reform that reduces entry costs for firms. We provide novel empirical evidence on the response of firms’ entry, employment, and exit behavior. To do so, we use as a natural experiment a reform in Portugal that significantly reduced entry time and costs. We find that the reform had an expansionary impact: firm entry and employment increased by 25% and 4% per year, respectively. Moreover, around 60% of the increase in employment came from incumbent firms expanding their size, with most of the rise occurring among the firms that were the most productive before the reform. Standard models of entry, exit, and firm dynamics, which assume a constant elasticity of substitution, are inconsistent with our findings about the heterogeneous response of incumbents to the reform. We show that a model with heterogeneous firms and variable markups accounts for our evidence. In this framework, the most productive firms face a lower demand elasticity and increase their employment in response to the entry of new firms.