Firm Heterogeneity, Market Power and Macroeconomic Fragility

Abstract

We study how firm heterogeneity and market power affect macroeconomic fragility, defined as the probability of long-lasting recessions. We propose a theory in which the positive interaction between firm entry, competition and factor supply can give rise to multiple steadystates. We show that when firm heterogeneity is large, even small temporary shocks can trigger firm exit and make the economy spiral in a competition-driven poverty trap. Calibrating our model to incorporate the well-documented trends in increasing firm heterogeneity in the US economy, we find that, relative to 2007, an economy with the 1990 level of firm heterogeneity is 1.5 to 2 times less likely to experience a deep recession.We use our framework to study the 2008–09 recession and show that the model can rationalize the persistent deviation of output and most macroeconomic aggregates from trend, including the behavior of net entry, markups and the labor share. Post-crisis cross-industry data corroborates our proposed mechanism. We conclude by showing that firm subsidies can be powerful in preventing quasi-permanent recessions and can lead to up to a 21% increase in welfare.

Keywords: firm heterogeneity, competition, market power, poverty traps, great recession

JEL Classification: E22, E24, E25, E32, L16