Technological Change, Entry, and Stock-Market Dynamics: An Analysis of Transition in a Monopolistic Industry

Abstract

We consider the share-price dynamics induced by changes in technological progress (perhaps due to the introduction of a new technology or institutional reforms) and the resultant entry of firms. The focus is not so much in comparing the steady states before or after the change, but rather on the transitional dynamics of the industry or economy as it adjusts. The model is one with efficient markets and perfect foresight where fundamentals drive the stockmarket value. Should we expect technological progress to lead only to increases in the level of the stockmarket (monotonic dynamics), or should we expect nonmonotonic behavior of boom followed by partial bust (a U-shaped or overshooting dynamic)? Is it possible to have share values falling even when the underlying technology is improving? We model a stylized monopolistic industry or economy in a continuous-time generalequilibrium setting with no uncertainty and perfect foresight. We adopt a model of entry found in Sanghamitra Das and Satya P. Das (1997), Datta and Dixon (2000), and Marta Aloi and Dixon (2001), in which the cost of entry is increasing in the flow of entry (due to some congestion effect or other externality). The flow of entry is determined by an intertemporal arbitrage condition that equates the cost of entry with the present value of incumbency. This gives rise to a dynamic zero-profit condition: the present value of incumbents in each instant is equal to the cost of entry. We first consider the case of a step increase in the level of technology with no other underlying growth. When an unanticipated technological improvement occurs, it causes a stock-market boom: there is a jump in the share value, the current profitability of incumbents, and an increase in the flow of entry. However, eventually entry drives the profit level back to zero, and shares decline back to the initial value. The initial boom is followed by a bust. We next consider the case of an economy with constant exponential technology growth. What happens when the pace of technological change unexpectedly increases? There is an upward jump in the stock-market value of firms. This can overshoot the new balancedgrowth path, with the possibility that there will be a U-shaped dynamic: the initial boom is followed by a slump before tracking back to the higher growth rate. If the initial jump overshoots the new balanced-growth path, there is a downward pull of share prices toward the new balanced-growth path, which may dominate. This stock-market behavior reflects the behavior of entry: after an initial rush, there is a temporary slowdown before eventually getting back on track. A similar pattern can occur if the change is anticipated. We believe that this might be some part of the explanation of the behavior of the stock market in the late 1990’s(although real life is much more complicated [see Jeremy Greenwood and Boyan Jovanovic, 1999]). The initial technological change causes a bonanza of profitable investment opportunities, resulting in high profits for incumbents and many new firms being set up. The increase in entry reduces profitability, and this may cause the flow of entry to reduce, if only in the short run. Finally, however, the long-run growth opportunities begin to come through, and the economy gets onto the new higher growth path.