Investment, Externalities & Industry Dynamics

We provide an alternative theoretical explanation for a number of empirical regularities relating to the dynamics of industry structrure (product life cycle) and changes in size and age distribution of firms over time. We explain why entry may continue over a considerable period of time, why shake out of firms occur in mature industries and why exiting firms are likely to be younger and smaller in size than incumbents. Unlike the existing theoretical literature, this explanation is not based on uncertainty, structural non-stationarity or incomplete information. We consider an infinite horizon, complete information, deterministic competitive industry with continuum of firms and stationary market demand. Firms have perfect foresight, may enter or exit the industry at any point of time and active firms undertake investment which reduces their future cost of production. Investment by active firms also leads to the growth of an industry-wide capital that reduces production cost of all firms (externality). The marginal cost curves are upward sloping and firms incur a fixed cost of staying in the industry. While all entering firms earn zero intertemporal net profit, their instantaneous net profit is typically negative when they are young and strictly positive when they mature. Positive profits may persist in the long run. Equilibrium prices decline over time while the level of positive industry-wide externality increases with time.The equilibrium path makes firms indifferent between alternative entry and exit decisions. Their investment levels after entry reflects their length of stay & the nature of industry environment (prices, externalities) over their period of stay in the industry. Heterogeneity emerges out of deliberate choice. The industry stabilizes in the long run