# **6.1 Three theories of why firms die**

_Firm competition and firm-level shocks:_ A first view of firm death takes the firm as the decision-making unit, and comes from firm competition and industrial organization models of firm dynamics (e.g. Hopenhayn, 1992; Ericson and Pakes, 1995). Firm exit occurs for two main reasons in these models. The first is the entry of more productive competitors, which take away market share from less productive incumbents, ultimately leading them to close down. Secondly, firms face exogeneous shocks, such as shocks in the demand for the firm’s products. Firm closure is thus involuntary in this model, and is expected to lower the welfare and earnings of the firm owner since it arises from deteriorating firm conditions. In the absence of distortions and adjustment frictions, it will be the least productive firms which close down, resulting in an increase in aggregate productivity. However, distortions can allow some unproductive firms to remain in business and cause some more productive firms to exit (Bartelsman et al, 2013), weakening the extent to which firm death selects on productivity.

_Occupational choice and positive shocks to the entrepreneur’s outside options:_ the first view completely ignores the role of the firm owner or entrepreneur in decision-making. This may be appropriate for examining the death of larger firms with many owners, but for micro and small firms, the firm is tightly linked to the occupation of the owner, and it is rare for the firm to continue when the owner leaves.<sup>9</sup> This leads to examining firm death through theories of occupational choice (e.g. Evans and Jovanovic, 1989; Banerjee and Newman, 1993). In these theories individuals initially make their choice to be self-employed in a particular firm given their endowments of financial assets and human capital, and the prevailing returns to their skills and assets in alternative occupations. Business closure then occurs when relative returns change so that working in a wage job or starting a different firm becomes more attractive. This could occur through negative shocks to the existing firm, in which case we are back in the first theory, or through positive shocks to outside options such as an attractive wage job offer or idea for starting a different business. Firm closure is then voluntary, and will improve, or at least not lower, welfare and earnings of the firm owner. The extent to which firm death selects on productivity will depend on which types of entrepreneurs are most likely to receive these outside offers. Low productivity entrepreneurs may be close to the margin of preferring wage

> 9 For instance, in the SLMS, only 1.5 percent of owners who stopped operating their business from round to round had sold it, while only 2.9 percent said the firm was being operated by another family member. In the Lomé Informal Enterprise Survey, 1.2 percent of owners who were not running their business anymore had sold it, and 1.8 percent had passed it to a family member. In the Ghana Microenterprises Survey, 7.5% of the businesses that were not being operated anymore by the original owner were being run by another family member, while no business had been sold.

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