Heterogeneous firms under regional temperature shocks: exit and reallocation, with evidence from Indonesia

Are less productive firms in developing countries disproportionately affected by climate change both along the intensive and extensive margin? This paper provides an answer in the context of Indonesia using gridded daily weather data and the Indonesian firm-level survey, the Statistik Industri. In a heterogeneous firm model with capital-biased productivity, I incorporate the thermal stress channel and illustrate how less productive firms decides on production and re-optimize factor intensity as temperature increases. Empirically, I highlight the presence of survival bias intrinsic to firm-level intensive margin analysis. I found that: First, under heat shocks, the initially less productive firms are more likely to exit. Second, on the aggregate, resources reallocate from less to more productive firms within industries. Among surviving firms,, we observe factor substitution from unskilled to skilled workers, and firms switching from domestic to foreign intermediate input when temperature increases. The initially more productive firms that survived also incur output gain under heat shocks possibly due to shifts in market structure and/or selection. These evidence highlight the importance of incorporating the manufacturing sector in the damage functions of traditional Integrated Assessment Models such as DICE/FUND. It also provides a potential explanation as to why poor countries are more affected by temperature shocks from the perspective of firm size distribution. ∗I thank my advisors Gordon Hanson and Richard Carson for advice and encouragement, Laura Beaudin, Julie Cullen, Gordon Dahl, David Victor, Roger Gordon, Teevrat Garg, Mark Jacobsen, Jeff Shrader, Josh Graff-Zivin, and many others at the UCSD applied micro seminar and the WEAI for comments. I’m grateful to Sam Bazzi for generously sharing data. †Correspondence: Department of Economics, University of California at San Diego. Email: w6xie@ucsd.edu