Cost-Reducing Investment, Competition, and Industry Dynamics

We demonstrate the possibility of shake-out of firms and emergence of interfirm heterogeneity along the (socially optimal) dynamic equilibrium path of a competitive industry with free entry and exit, even when there is no uncertainty and all firms are ex ante identical with perfect foresight. Atomistic firms with upward-sloping marginal cost curves undertake investment in firm-specific cost reduction. They earn negative net profits in early periods, compensated later by strictly positive net profits; no entry occurs after the initial time period. Some firms may exit before others even while other firms earn positive net profits.