by Anthony Savagar, discussion paper KDPE 1713, August 2017.
Traditionally macroeconomists assume that the number of firms in an economy adjusts instantaneously to arbitrage profits. This assumption ignores ‘slow’ fluctuations in firm entry and exit over the business cycle. This paper develops a model of firm dynamics in the macroeconomy with sunk costs that cause firms to respond slowly to economic shocks, hence entry and exit decisions are non-instantaneous. The resulting firm adjustment towards zero profit causes endogenous fluctuations in profits, competition and business allocation that helps to explain business cycle productivity dynamics.
The paper studies how firm entry determines macroeconomic productivity through division of resources and competitive pressure on markups. Recent research examines the importance of firm entry for macroeconomic productivity, but the arguments focus on instantaneous firm entry. I argue that this overlooks the changing allocation of business as firms adjust intertemporally. My contribution is to combine this dynamic firm entry with endogenous markups (markups determined by competition). The result is a new trade-off: an exiter reduces industry competition which reduces incumbents’ productivity, but exit reallocates business to incumbents who improve productivity through better returns to scale (vice-versa for entry which raises competition, but steals business reducing scale). The mechanism helps to clarify productivity puzzles. It explains that economic shocks cause exacerbated productivity responses that weaken as firms adjust, and entry/exit effects on competition prevent reversion to previous long-run outcomes.
The main finding is that firm competition from entry ameliorates short-run productivity volatility but in the long run productivity effects persist because of structural changes to competition.
You can download the complete paper here.