The vulnerability of small firms to price shocks may partly explain why fossil fuel subsidy removals in developing countries are so difficult to implement. This paper analyzes the effects of fuel and electricity price increases on profits of micro- and small-sized enterprises in Mexico. Using representative cross-sectional data, simulations of profit losses hint at potentially large short-term effects. First-order profit losses of a 1 per cent price increase are 0.2 per cent for fuels and 0.07 per cent for electricity, but are higher than 1 per cent for fuels in the transport sector. These effects are larger for formal than for informal firms, with energy-using low-profit firms being most vulnerable. Second-order impacts – predicted using estimated input-demand elasticities – indicate that firms react to price shocks by substituting labor for energy, while the self-employed appear to increase their own labor input. Reduced-form regressions show that some firms pass on higher fuel costs to customers.
