Riskiness Choice and Endogenous Productivity Dispersion over the Business Cycle

Cross-sectional productivity dispersion is countercyclical, at the plant level and at the firm level. I incorporate a firm’s project choice decision into a firm dynamics model with business cycle features to explain this empirical .finding both qualitatively and quantitatively. In particular, all projects available have the same expected flow return and differ from one another only in the riskiness level. The endogenous option of exiting the market and limited funding for new investment jointly play an important role in motivating firms’ risk-taking behavior. The model predicts that relatively small firms are more likely to take risk and that the cross-sectional productivity dispersion, measured as the variance/standard deviation of firm-level profitability, is larger in recessions.