DP2625 | Imperfect Competition, Market Size and Firm Turnover

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This paper is motivated by the empirical regularity that industries differ greatly in the level of firm turnover, and that entry and exit rates are positively correlated across industries. Our objective is to investigate the effect of sunk costs and, in particular, market size on entry and exit rates. We analyse a stochastic dynamic model of a monopolistically competitive industry. Each firm's marginal cost (or, alternatively, perceived quality) is assumed to follow a Markov process. We show existence and uniqueness of a stationary equilibrium with simultaneous entry and exit: efficient firms survive while inefficient ones leave the market and are replaced by new entrants. We perform comparative statics with respect to the level of sunk costs: entry costs are positively and fixed production costs negatively related to entry and exit rates. Another empirical prediction of the model is that the level of firm turnover is increasing in market size. The intuition is as follows. In larger markets, price-cost margins are smaller since the number of active firms is larger. This implies that the marginal surviving firm has to be more efficient than in smaller markets. Hence, in larger markets, the expected life span of firms is shorter. Moreover, firm profits and values are more skewed in larger markets. In the empirical part, the prediction on market size and firm turnover is tested on industries where firms compete in well-defined geographical markets of different sizes. We use data on local services (driving schools) in Sweden in the 1990s. The empirical results provide some support for the prediction that hazard rates are increasing with market size.