Industry Dynamics: Aggregate Uncertainty, Heterogeneity, and the Entry and Exit of Firms

The aim of this paper is to investigate the relationship between heterogeneity at the firm level and the aggregate behavior of the industry as a whole. Empirical evidence on firm behavior documents the existence of widespread heterogeneity among firms in any industry, both cross- sectionally and over time. At the cross-sectional level, data indicates that industries are made up of firms of different sizes, ages, and productivity. These differences between firms imply that firm response to aggregate changes in the industry are varied and not exactly alike, as predicted by the representative firm models. It has also been noted that there exist differences in the evolution of firms with similar initial conditions, i.e., firms entering an industry at any given point in time follow very different capital growth paths. Whether these differences, be it at the cross-sectional level or over time, have a significant impact on the aggregate dynamics of the industry is the main focus of this paper. In the past few years, there has been an increase in interest in heterogeneous-agent models. The motivation for this has been the empirical observation of heterogeneity in the response of agents to aggregate changes. Thus, incorporating heterogeneity into models with aggregate uncertainty appears to be the logical next step. Incorporating heterogeneity allows us to evaluate whether heterogeneity at the microeconomic level plays a significant role in aggregate dynamics. Computing the equilibrium for such models has been a problem due to the lack of an analytical or close form solution. The trend has been towards using sophisticated computational techniques to arrive at the equilibrium. The use of computational methods has allowed us to solve and quantitatively analyze a whole range of models which would not have been possible otherwise. The purpose of the paper is to develop a dynamic model of firm and industry behavior that can be used to understand the relationship between firm-level decisions, aggregate uncertainty and the business cycle. The model developed assumes heterogeneous firms, and studies the investment behavior of these firms in response to aggregate shocks. It also looks at whether these differences at the microeconomic level have an impact on aggregate industry dynamics. Dropping the assumption of a representative firm also allows for the incorporation of firm entry and exit into this model. This enables us to study the changes in industry size and composition over time. This paper makes two contributions. First, it develops a model of investment behavior that reflects features observed in microeconomic data on firm behavior. It then studies the impact of these features on aggregate investment dynamics and the evolution of industries. In relaxing assumptions such as that of a representative firm, this paper provides a richer and more realistic framework within which to study investment dynamics. The second contribution of the paper is methodological. In the absence of an analytical solution, it develops a computational technique that allows for such a model to be solved for an approximate (numerical) equilibrium.