We study the role of employment protection legislation (EPL) in explaining the relative small average size of Italian firms. We construct a simple model that shows that the smooth relation between size and growth probability is disturbed in proximity of the thresholds at which EPL applies differentially. We use a comprehensive dataset of all Italian firms between 1986 and 1998 to estimate the effects of EPL in terms of discouraging small firms from growing. We then construct a stochastic transition matrix for firm size that, together with the estimates, allows for a quantitative evaluation of the effects of EPL in the long run. Our results show that EPL does influence firm size distribution, but that its effects are quantitatively modest: average firm size would increase by less than 1% when removing the threshold effect. In terms of policy, these findings suggest that changes in EPL are not likely to have a large impact on the propensity of small firms to grow.
Published in 2008 in: Labour economics v.15, 3, pp. 482-511
