Air Pollution and Firm Dynamics : the Case of Chinese Manufacturing

We study how air pollution affects firm dynamics: entry, exit, innovation, and (aggregate) productivity. Using an instrumental variable strategy, we find that air pollution significantly reduces entry and innovation and raises exit. Moreover, air pollution leaves firms with higher productivity entering and staying in the market, which corresponds to the selection effect. Although air pollution lowers the productivity of incumbent firms (productivity effect), the effects on aggregate productivity are muted due to the selection effect. We build and estimate a quantitative firm dynamics model to rationalize such facts and quantify the importance of four channels: (1) productivity effect, (2) selection effect, (3) regulation effect, and (4) the migration response to air pollution. The welfare implications for alleviating air pollution are discussed