Endemic Volatility of Firms and Establishments: Are Real Options Effects Important?

Abstract

Consider the intertemporal volatility of the number of firms and establishments within an industry over a relatively long span of time. Data from the U.S. manufacturing sector shows that this degree of endemic volatility varies widely across industries. Examining the determinants of this volatility is important in its own right as it reflects on the underlying forces governing entry and exit. In addition, data shows that the volatility of firms and establishments is significantly correlated with the volatility of the number of production and nonproduction workers employed in an industry. The primary focus of this paper is to evaluate the role played by the real options channel which suggests that sunk costs and uncertainty may be important determinants of the degree of volatility of the number of firms. We also control for other factors related to advertising intensity, industry growth and technological change. An advantage of the manufacturing industry dataset we use in this study is that it combines the annual timeseries data from the Annual Survey of Manufactures with data from the five-yearly Census of Manufactures. This allows us to construct measures of uncertainty about profits, sunk capital costs, technological change, among others. Our key findings are: (1) industries with higher sunk capital costs and profit uncertainty have significantly lower endemic volatility of the number of firms and establishments; and (2) these relationships are non-linear as suggested by theory with even small amounts of sunk costs or profit uncertainty contributing to significantly lower firm volatility. Our findings appear broadly consistent with the predictions of the real options channel. We highlight some implications of our findings for antitrust/competition policy and labor market dynamics.

Keywords: Firm and establishment volatility, sunk capital costs, profit uncertainty, technological change, antitrust/competition policy, employment dynamics

JEL Classification: L11, L40