This is an accomplishment-based renewal of an extremely productive research program on the microeconomic sources of macroeconomic volatility. Under the previous grant the investigator demonstrated that fluctuations in productivity are induced by changes in product demand and factor supplies, rather than technology shocks. This result challenges a key assumption of real business cycle theory, an important school of thought in macroeconomics. This result has stimulated empirical and theoretical work by the investigator and others on demand driven business cycles. Renewed support permits the investigator to pursue this research agenda. The investigator also developed an innovative and powerful test of the assumption of a competitive industry. If an industry is competitive, then the Solow productivity residual (the difference between the rate of growth of output and the weighted growths of inputs) should be invariant to exogenous shifts in product demand and factor productivity. Under the previous grant the investigator was able to reject the invariance proposition for a large number of U.S. industries. This project explores what kind of equilibrium prevails in these industries. Preliminary research suggests that inputs and outputs behave as if the technology had increasing returns of scale. Future research examines evidence of externalities in industrial organization or, more specifically, whether one firm's efficiency rises when the firms it deals with have higher levels of activity. The investigator develops a new methodology for testing for the presence of increasing returns and thick-market externalities. Specifically, econometric methods are developed for testing for spontaneous noise in major aggregate economic variables. The presence of spontaneous movements in output is evidence of economies with increasing returns and thick-market externalities. This research makes significant contributions to our understanding of macroeconomic fluctuations and industrial organization. The research on economies with increasing returns is especially important because most empirical and theoretical work in industrial organization assumes competition with constant-returns-to-scale. Evidence of significant externalities within U.S. industries would also suggest that R&D expenditures are more important than previously believed.
