Industry Dynamics with Stochastic Demand

We study the dynamics of an industry subject to aggregate demand shocks where the productivity of a firm’s technology evolves stochastically over time. Each period, each firm, given the aggregate demand shock, the productivity of its technology, and the distribution of technology productivities in the economy, (i) chooses whether to remain in the industry or to exit to sell its resources to an entrant; and (ii) an active firm chooses how much capital and labor to employ, and hence output to produce. To characterize the intertemporal evolution of the distribution of firms, we discuss in particular how exit decisions, aggregate output, profits and distributions of firm productivities vary, (a) across different demand realization paths; (b) along a demand history path, detailing the effects of continued good or bad market conditions; and (c) for different anticipated future market conditions. Sufficient conditions are provide for worse demand realizations to lead to increased exit of low-productivity firms and then to improved distributions of firms at all future dates and states. Finally, it is shown that a downturn in demand can raise welfare due to the impact on exit decisions