Firm Dynamics with Infrequent Adjustment and Learning

Recent empirical findings have emphasized post entry growth of survivors, as opposed to exit of inefficient and small firms, as the main source of growth over time in the average size of a cohort of entering firms. One proposed explanation for the post entry growth of survivors is financing constraints. In this paper, we suggest an alternative explanation for the significant growth of survivors. At the core of our theory is the interaction of adjustment costs with learning by entering firms about their true efficiency. In our model, we consider the effect of linear and nonconvex adjustment costs, i.e., proportional and fixed costs, and conclude that for most configurations of adjustment costs firms will start small and grow rapidly after entry. Initial uncertainty about true profitability makes entering firms prudent since they want to avoid incurring superfluous costs on jobs that prove to be excessive ex post. Even though there is less pruning of inefficient firms, surviving firms will grow faster and therefore the survivors' contribution to growth in the cohort's average size will increase. With the purpose of measuring the effect of adjustment costs, we propose a decomposition of the change in a cohort’s average size into a survivor component and a selection component. Using data for the 1988 cohort of entrants in the Portuguese economy, we conclude that survivors have the highest contribution to changes in the cohort's average size. However, Manufacturing and Services are at opposite ends: initial selection is stronger and the survivor’s component is much smaller in Services than in Manufacturing. There is also evidence of inaction and lumpiness in labor adjustments, with significant differences across sectors. For a finite learning horizon version of the model, with positive dispersion in entry size, we conclude that adjustment costs can account for the high empirical survivors’ contribution. A calibration to the overall economy and the Manufacturing and Services cohorts suggests that proportional costs and the fixed entry cost are key parameters in matching the evidence on firm dynamics. Firms in Manufacturing learn relatively less initially about their efficiency, and are subject to much larger adjustment costs than firms in Services