This proposal is for a theoretical and empirical investigation of the distribution of aggregate economic activity across firms and plants. The investigators have developed a theory of the efficient allocation of resources in the economy that is able to rationalize a set of robust facts on scale dependence in firm dynamics and firm size distributions. In particular, their theory provides an explanation of why small firms grow faster and exit more than large firms, and why the size distribution of firms has thinner tails than a Pareto distribution with shape coefficient one (a common benchmark). Furthermore, their analysis led to the discovery of a new set of stylized facts on the relationship between the degree of scale dependence and factor proportions. The investigators show how industry level forces can determine the patterns of firm dynamics even in the presence of substantial within-industry firm level heterogeneity. This approach is extended in four ways. First, the project allows for greater firm heterogeneity. Combining the theory with available models of costly entry and the evolution of firm specific heterogeneity, that lead to the presence of selection effects, allows the investigators to reach conclusions on whether observed entry patterns are evidence of inefficiencies. With this extension the investigators will also address the evidence on the relationship between firm dynamics and the age of the firm. Second, the investigators propose to extend their approach to address the phenomenon of shakeouts in new and growing industries. So far, their model has emphasized productivity shocks as the only source of uncertainty in the economy. Extending their model to include taste shocks will allow the investigators to address the expansion of an industry and the associated patterns of entry and exit. Both of these extensions require the use of numerical methods. Third, the investigators will extend their theory to include considerations of ownership and control that would allow them to address differences between establishments and enterprises. Fourth, the investigators propose to finish their current research by further documenting the relationship between industry specific factors and scale dependence in firm dynamics and firm sizes. This will involve the purchase of more data from the US Census to identify the relative importance of firm versus narrowly defined industry heterogeneity.
Broader Implications: The fact that the growth and exit of firms is related to both their size and their age, and that these relationships are also manifested in the shape of the size distribution of firms begs several questions. Is this the result of inefficiencies in the resource allocation process? If so, which inefficiencies are the most important? And finally, what forms of government intervention are best designed to alleviate these inefficiencies and improve aggregate economic performance? The aim of this proposal is to develop an efficient benchmark against which observed firm size distributions can be contrasted in order to assess the impacts and potential sources of inefficiencies in the resource allocation mechanism. Once inefficiencies are diagnosed, appropriate policies - ranging from anti-trust policy to improved contract enforcement, and to subsidized lending to small business- can be prescribed.
