Firm Dynamics, Markup Variations, and the Business Cycle

This paper suggests that the interaction between firms’ entry and exit decisions and variation in the degree of competition gives rise to endogenous procyclical movements in measured total factor productivity (TFP). Based on this result, the paper suggests a simple structural method for the decomposition of variations in TFP into those that originate either endogenously from this interaction or from exogenous shocks. Moreover, the paper analyzes how such an interaction affects (i) the measurement of the volatility of exogenous shocks in the U.S. economy and (ii) the magnification of shocks over the business cycle. The analysis is based on a model in which net business formation is endogenously procyclical. The variations in the number of operating firms lead to endogenous countercyclical variations in markup levels along the cycle. The results in this paper support the view that a significant fraction of the movements in measured TFP results from the interaction between variations in the number of firms and the degree of competition. Accounting for this interaction implies that a substantially smaller proportion of the volatility of output is due directly to technology shocks.