Entry, Exit, and Productivity Dispersion

This paper develops a dynamic stochastic general equilibrium model to analyze endogenous mechanisms of changes in the first and second moments of firm heterogeneity over the business cycle. In the model, monopolistic competition and endogenous firm entry generate procyclical marginal cost, which implies a procyclical selection mechanism (i.e., increase in a production cutoff during booms). As more firms enter during booms, competition increases in factor markets, resulting in an increase in factor prices. Such an increase in the production costs makes less productive firms shrink: an increase in the production cutoff. While this mechanism explains the countercyclical dispersion in firm-level productivity endogenously, it cannot account for the cyclical changes in the first moment (i.e., relative productivity of entering and exiting firms). We introduce initial uncertainty for entrants to generate empirically consistent movements of both first and second moments. We assume that entrants face additional uncertainty because it is more challenging to predict firm-specific productivity before they produce. Our results suggest that a part of countercyclical dispersion of productivity (at lease, 20%) can be endogenously generated in a model, without the help of the second moment shocks.