Sluggish firm entry over the business cycle causes measured TFP to vary endogenously in response to technology shocks. This arises be- cause 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 com- petition 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, pro- cyclical productivity fluctuations. The theorem applies to a growing number of macro models that incorporate dynamic firm entry and im- perfect competition, such that profits are nonzero in the short run but arbitraged in the long run.
I present a theory of firm entry and exit in the business cycle that links short-run productivity overshooting to long-run persistence, a dynamic observed in contemporary ‘productivity puzzles’. The theory emphasizes two mechanisms: (1) slow firm entry/exit and (2) firm pricing that reflects the number of competitors in the market. Given these mechanisms, economic contraction causes a short-run exacerbated fall in productivity (overshooting) because the negative shock is absorbed by incumbents due to slow exit responses. This weakens incumbents’ returns to scale, thus worsening productivity. However, the productivity overshooting recedes over time as firms exit which dynamically reallocates resources among incumbents, reviving the remainders returns to scale and thus productivity. This process of exit consolidating the market is not purely beneficial for productivity because the remaining firms face fewer competitors and thus charge higher markups which damages productivity. Therefore despite some reversion from the initial fall, there is a long-run persistent negative effect on productivity due to higher markups responding to the fall in number of firms. To analyze the trade-off between productivity improving dynamic reallocation and productivity degrading endogenous markups, I develop a continuous time, analytically tractable DGE model. The main mechanisms are dynamic entry so firms are slow to respond causing initial overshooting, and endogenous markups so pricing behaviour depends on the number of competitors firms face.
We analyze labor responses to technology shocks when firm entry is sluggish due to endogenous sunk costs. We derive closed-form solutions for transition dynamics which show that labor responses overshoot or undershoot their long-run responses depending on labor returns to scale at the firm level. If labor has increasing returns, it will initially overshoot its long-run level, then decrease as entry takes place. If labor has decreasing returns, it will initially undershoot its long-run level, then increase as entry takes place. If the firm creation channel is more regulated, the short-run overshooting or undershooting of labor persists for longer. If entry is unregulated, such that entry adjusts instantaneously (instantaneous zero profits), there is no short-run deviation.