The Quality of the Legal System, Firm Ownership, and Firm Size

Employment in developing countries is disproportionately concentrated in very small firms. We examine the extent to which the distribution of firm size is related to the quality of the legal system using data from Mexico. We find that Mexican states with more effective legal systems have larger firms. A one-standard deviation improvement in the quality of the legal system increases the average firm size by about 10-15 percent. Our data allow us to focus on the differential impact of the legal system on proprietorships and corporations. We show that theoretically, where entrepreneurs face idiosyncratic risk, the legal system will have a larger impact on firm size among proprietorships than among corporations. The data are consistent with this expectation, suggesting that one channel through which better legal systems impact firm size is by reducing the idiosyncratic risk faced by entrepreneurs and increasing the investment in their firms. All of these findings are upheld when we instrument for institutional variables using the log of indigenous population in 1900 and the active presence of the drug trade in the state.