Endogenous growth with a firm size distribution that is skewed and heavy tailed as in the data

What is it about?

Empirical evidence clearly shows that the firm size distribution (FSD) is highly right-skewed, with the skewness apparently being driven by idiosyncratic stochastic processes of firm growth. However, the FSD of a given firm cohort is significantly right-skewed at birth but evolving over time toward a lognormal distribution of size. We study the firm size distribution arising from an endogenous growth model of quality ladders with expanding variety. We explicitly analyse the impact of successive cohorts of firms entering the market in the shape of the FSD, in order to capture the link between a rich dynamic environment of innovation and market structure. Our theoretical results qualitatively match the empirical evidence found both for the cohort and the total distribution, and which has been presented as a challenge for theory to explain. Moreover, by obtaining a total distribution with a gradually increasing average over a long time span, the model is able to address complementary empirical evidence that points to a total distribution subtly evolving over time.

Featured Image

Why is it important?

With this paper, our goal it to show how a simple model of endogenous growth with simultaneous vertical and horizontal R&D is able to account for several observed features of the FSD. We thereby establish a connection between endogenous growth theory and findings from firm-level studies of firm dynamics and innovation. In particular, we derive a highly-skewed fat-tailed FSD within a model where the only source of firm heterogeneity is the Poisson process of quality ladders (vertical R&D). In contrast, e.g., Thompson (2001) and Klette and Kortum (2004) combine the Poisson process with other stochastic features in order to introduce other dimensions of (exogenous) firm heterogeneity in their models. Our theoretical results qualitatively match the empirical evidence found both for the cohort and the total distribution, and still not addressed by the literature on endogenous growth and firm dynamics.