The Dynamics of Entry and Exit

Abstract

The relation between profits and the number of firms in a market is one of the essential topics in the field of industrial organization. Usually, the relation is modeled in an error-correction framework where profits and/or the number of firms respond to out-of-equilibrium situations. In an out-of-equilibrium situation one or both of these variables deviate from some long-term sustainable level. These models predict that in situations of equilibrium, the number of firms does not change and hence, entry equals exit. Moreover, in equilibrium entry and exit are expected to be equal to zero. These predictions are at odds with real life observations showing that entry and exit levels are significantly positive in all markets of substantial size and that entry and exit levels often differ drastically. In this paper we develop a new model for the relation between profit levels and the number of firms by specifying not only an equation for the equilibrium level of profits in a market but also equations for the equilibrium levels of entry and exit. In our empirical application we show that our entry and exit equations satisfy the usual errorcorrection conditions. We also find that a one-time positive shock to entry or profits has a small but permanent positive effect on both the number of firms and total industry profits.