Firm Entry and Labor Market Dynamics

Abstract

Working Paper 2008-17 August 2008 Abstract: We present a model of aggregate fluctuations in which monopolistic firms face sunk costs to enter the production process and labor markets are characterized by search and matching frictions. Entrants post vacancies and are matched to idle workers. Our specification of sunk costs gives rise to a countercyclical net present value of a vacancy; it is always zero in models where entry is free. The model displays a strong degree of amplification and propagation. The time-varying value of a vacancy has implications for the surplus division between firms and workers over business cycle. In the data, we proxy this division using the ratio of corporate profits to output and workers' compensation to output. We document the cyclical behavior of profit's and labor's shares: Profit's share leads the cycle and is procyclical and more volatile than output. Labor's share inversely leads the cycle and is weakly countercyclical and smoother than output. Our model is consistent with the cross-correlations of both shares and the higher volatility of the share of profits. Regarding propagation and amplification, the model matches the persistence of vacancy creation and two-thirds of the observed volatility of market tightness relative to output. JEL classification: E24, E32, J32 Key words: search, matching, business cycles, income shares 1 Introduction Our paper analyzes the role of firm entry and exit, and product creation, in explaining the behavior of labor markets over the business cycle. To this end, we formulate a dynamic general equilibrium model in which monopolistic firms are required to pay a sunk cost of entry and labor markets are characterized by search and matching frictions. Upon entry, firms post vacancies to possibly match with an idle worker and begin production. In our economy, sunk entry costs result in a positive and countercyclical value of a vacant position. It is countercyclical as higher productivity allows firms to use fewer inputs to pay for the sunk cost. We examine the implications of sunk costs and monopolistic competition for (a) the propagation and amplification of technology shocks into the labor market and (b) the cyclical dynamics of firms' and workers' income shares. Sunk entry costs help propagate and amplify technology shocks into the labor market. They make vacancy postings and job creation adjust more slowly, as entrants react sluggishly to a shock. As in equilibrium the value of a vacant position is equal to the sunk cost, the latter amplify shocks as well: since it is relatively cheaper to enter the market in booms, the posting of vacancies reacts more strongly to a positive technology shock, and vice-versa. Monopolistic competition also plays a role and we show that it leads to more amplification and propagation relative to a perfectly competitive economy. The degree of market power matters because the prospect of higher profits increases the ability of firms to face the cost of entry. In turn, this affects vacancy creation, employment, and labor market conditions more generally. The core of search and matching models of the labor market (e.g Mortensen and Pissarides (1994)) is the surplus division between workers and firms. In the data, we proxy this division using two income shares: the ratio of corporate profits to output and the ratio of workers' compensation to output. We use the cyclical dynamics of these two shares as another dimension on which to judge our model. The profits' and labor's shares over the cycle behave rather different. The profits' share leads output, is procyclical, and volatile. The labor's share inversely leads the cycle, is (weakly) countercyclical, and smoother than output. Our model replicates cross-correlation pattern of both shares with output. Our profits' share is more volatile than the labor's share, but the labor's share is too volatile relative to the data. …