The Impact of Uncertainty and Sunk Costs on Firm Survival and Industry Dynamics

Abstract

In theory, uncertainty and sunk costs can influence industry dynamics through the option value and financing constraints channels. Empirical evaluation of these models in the context of industry dynamics are, however, at a nascent stage. Our empirical analysis, covering 267 U.S. manufacturing industries over a 30-year period, reveals that greater uncertainty (i) decreases the number of small firms and establishments in high sunk cost industries, (ii) has virtually no impact on larger establishments, (iii) results in a less skewed size distribution of firms and establishments in high sunk cost industries and (iv) marginally increases industry output concentration. Addressing the recent literature, we also control for technological change and our estimates show that technical progress decreases the number of small firms and establishments in an industry. While past studies have emphasized technological change as a key driver of industry dynamics, our results indicate that uncertainty and sunk costs play a crucial role. Our findings could be useful for the study of firm survival, models of creative destruction, evolution of firm size distribution, mergers and acquisitions and competition policy.

Keywords: Uncertainty, sunk costs, technological change, industry dynamics, firm size distribution, creative destruction, option value, financing constraints

JEL Classification: L11, D80, O30, G10, L40