these benefits of formality and grow, they concurrently invest more in the types of intangible assets that allow them to better manage risks and growth in productivity, output and employment terms.<sup>13</sup> Regarding the effect of risk on resource reallocation, Bloom et al. (2012a) show that the dynamics in enterprise output following exogenous uncertainty shocks arise from three complementary enterprise decision channels: labor, capital, and the misallocation of factors of production. An increase in uncertainty provides an option value from waiting, increasing the returns to inaction and leading to significant falls in hiring, investment and output.<sup>14</sup> When uncertainty increases, most firms pause hiring, as labor cost adjustments make hiring or firing mistakes more costly. The labor force drops as worker attrition continues without replacement hires. Investment similarly falls, with a drop in the capital stock as existing capital depreciates without being replaced. Finally, increased uncertainty also reduces TFP (Total Factor Productivity) growth by reducing the degree of resource reallocation in the economy. As firms reduce expansion and contraction with the uncertainty shock, any desirable productivity-enhancing reallocation across firms (with unproductive firms contracting and productive firms expanding) is also slowed down.

Regarding the effect of risk on innovation across firms, Bloom and colleagues (2013b) show how a downside shock or unanticipated adversity, such as an increase in import competition from lower-cost countries, can cause enterprises to innovate relatively more if factors of production are trapped inside the enterprise, leading to a natural friction or adjustment cost constraining reallocation of factors of production between firms. The case study examples given all relate to the presence of different types of KBC, such as skilled engineers and R&D and design capabilities, skilled employees whose human capital is specific to the firm and will be lost if they move to other firms, brand capital, and organizational resources. When the shock reduces the price of one or more of the products that the firm produces, the opportunity cost goes down for the trapped inputs within the firm. This behavior has been confirmed across countries that faced a large increase in import competition: individual firms that faced more import competition exhibited a bigger increase in innovation, increasing their R&D expenditure, patenting and adoption of IT (Bloom et al. 2012b).

Caggese (2012) finds that an increase in exogenous uncertainty has a large negative effect on innovation of entrepreneurial firms, with the negative effect being stronger for less diversified entrepreneurial firms – and with no effect of exogenous uncertainty on innovation of more diversified publicly-owned firms.<sup>15</sup> 13 Hsieh and Klenow (2013) examine the importance of resource misallocations that prevent young efficient firms from growing and that punish larger firms over the enterprises’ life cycle. Comparing the life cycle of manufacturing enterprises in India and Mexico to the US, they conclude that differences in “within-firm TFP” (that part of aggregate TFP growth that does not come from cross-industry or within-industry cross-enterprise resource reallocation) –as successful US firms grow and accumulate intangible capital and complementary assets while Indian and Mexican firms exhibit little growth in terms of TFP, output and employment, and concurrently also exhibit lower post-entry investment in intangible capital– account for an important part of the gap in aggregate TFP between poor and rich countries. Bollard, Klenow and Sharma (2013) similarly report the importance of “withinfirm TFP”, namely the productivity growth within existing large plants rather than reallocation across plants, in accounting for the rapid productivity growth in Indian manufacturing from 1993 to 2007.

> 14 They find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%.

> 15 Based on a panel of 11,417 Italian manufacturing firms over 1992-2001, a 1% increase in uncertainty lagged one period leads to a 0.69% fall in the frequency of innovations of all entrepreneurial firms, and a 0.92% fall for the group of less diversified/smaller entrepreneurial firms.

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