Industry Equilibrium with Random Exit or Default

Abstract

An industry consisting of a large number of small (fixed size) firms subject to idiosyncratic productivity shocks is considered. At the moment of entry, a firm takes on debt. We demonstrate that in a competitive equilibrium, some firms exit and pay out their debt while others choose to default. The outcome depends on the realization of firm specific shocks. We solve for the long-run equilibrium price of output and borrowing rate and derive the stationary distribution of active firms for two scenarios of the initial distribution of productivity shocks. Dependence of equilibrium variables on the leverage is examined.