Heat, Informality, and Misallocation: Firm Adaptation in the Short and Long Run

How do climate shocks shape resource allocation across firms? Rising temperatures might worsen allocative efficiency if large, productive firms face constraints in adapting. This paper assesses this question in India, an economy characterized by informality, misallocation, and extreme heat. The paper uses census data on 42 million non-farm establishments from 1990 to 2013 linked to granular climate histories to estimate the impact of heat on the firm size distribution. A 1 degree Celsius temperature shock reduces firm size by 11.6 percent, with losses concentrated among large, formal firms. Displaced workers reallocate to smaller, informal firms, generating allocative efficiency losses of up to 4.3 percent. In long difference estimates spanning several decades, the relationship reverses: large firms adapt and absorb labor, while small firms contract. This adaptation offsets nearly 60 percent of the short-run labor demand shock. These results highlight a general mechanism of climate adjustment: in the short run, shocks exacerbate misallocation by pushing labor into low-productivity firms, but in the long run, adaptation by larger firms restores efficiency.