Firm Dynamics with Infrequent Adjustment and Learning

Abstract

We propose an explanation for the rapid post-entry growth of surviving firms found in recent studies. At the core of our theory is the interaction between adjustment costs and learning by entering firms about their efficiency. We show that linear adjustment costs, i.e., proportional costs, create incentives for firms to enter smaller and for successful firms to grow faster after entry. Initial uncertainty about profitability makes entering firms prudent since they want to avoid incurring superfluous costs on jobs that prove to be excessive ex post. Because higher adjustment costs imply less pruning of inefficient firms and faster growth of surviving firms, the contribution of survivors to growth in a cohort's average size increases. For the cohort of 1988 entrants in the Portuguese economy, we conclude that survivors' growth is the main factor behind growth in the cohort's average size. However, initial selection is higher and the survivors' contribution to growth is smaller in services than in manufacturing. An estimation of the model shows that the proportional adjustment cost is the key parameter to account for the high empirical survivors' contribution. In addition, firms in manufacturing learn relatively less initially about their efficiency and are subject to larger adjustment costs than firms in services.

Keywords: Adjustment costs, learning, young firms

JEL Classification: E24, L11, L16