Cost Reducing Investment, Competition and Industry Dynamics

We demonstrate the possibility of shake-out of firms and emergence of inter-firm 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 profit 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 profit.