Sluggish firm entry over the business cycle causes measured TFP to vary endogenously in response to technology shocks. This arises because in the short-run absence of entry, incumbent firms utilize excess capacity and thus scale economies. To show this result, we develop a tractable business cycle model of dynamic firm entry, imperfect competition and endogenous sunk costs that qualitatively replicates many firm-dynamics, business-cycle facts. In this parsimonious setup, we derive a theorem that imperfect competition and dynamic firm entry are necessary and jointly sufficient conditions for endogenous, procyclical productivity fluctuations. The theorem applies to a growing number of macro models that incorporate dynamic firm entry and imperfect competition, such that profits are nonzero in the short run but arbitraged in the long run.
(Old title Explaining Productivity Puzzles with Frictional Firm Entry)
I analyze two opposing effects of firm dynamics on productivity over the business cycle. Consider net exit, on the one hand it real-locates resources to incumbents whose productivity improves through scale economies, on the other hand it reduces the competitive pressure incumbents face which depresses productivity. Contrarily net entry strengthens competition, thus increasing productivity, but worsens incumbents’ scale economies, thus decreasing productivity. I outline a theory that focuses on two industrial features (1) slow firm entry/exit and (2) firm pricing that depends on the number of competitors. In this environment a negative shock strikes incumbents due to slow exit responses. This weakens their scale thus worsening productivity but the effect recedes as exit occurs which reallocates resources to incumbents. However, the remaining firms face fewer competitors and thus charge higher markups which damages productivity. I analyze this trade-off between productivity improving resource reallocation and productivity degrading market power, by developing a continuous time, analytically tractable DGE model of endogenous firm entry/exit and endogenous markups.
We analyze labor responses to technology shocks when firm entry is sluggish due to endogenous sunk costs. We provide closed-form solutions for transition dynamics that show, when firm entry is slow to respond, labor will increase (decrease) relative to its long-run response if returns to labor input at the firm level are increasing (decreasing). Under stricter regulation (slower business churn), such short-run deviations of labor persist for longer. There is also potential for short-run productivity effects to differ from the long run.