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Markov-Perfect Industry Dynamics: A Framework for Empirical Work.

By Richard Ericson and Ariel Pakes

Abstract

This paper provides a model of firm and industry dynamics that allows for entry, exit, and firm-specific uncertainty generating variability in the fortunes of firms. It focuses on the impact of uncertainty arising from investment in research and exploration. It analyzes the behavior of individual firms in an evolving market place and derives optimal policies, including exit. Then it adds an entry process and aggregates the optimal behavior of all firms, including potential entrants, into a rational expectations Markov-perfect industry equilibrium and proves ergodicity of the equilibrium process. Numerical examples illustrate the detailed characteristics of the stochastic process generating industry structures. Copyright 1995 by The Review of Economic Studies Limited.

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