Firm dynamics: price-setting, returns, and intangible capital
Ho, Pak Shing
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This dissertation consists of three essays on firm dynamics, concentrating on nominal rigidities and their implications for monetary policy, the asset pricing implications of productivity growth, and firm dynamics with firm-specific intangible investment. In Chapter 1, I present a theoretical model in which price setting firms decide what to pay attention to and how much attention to pay, subject to cognition inability, in a world of sparsity-based bounded rationality as in Gabaix (2014). Unlike the rational inattention approach of Sims (2003) in which firms reset prices every period with a fixed amount of attention, the sparsity-based approach allows for the possibility that prices remain fixed for some time even if they can be adjusted every period at no physical cost and amounts of attention allocated can vary. Inaction in price setting arises if variations of both aggregate and idiosyncratic conditions are sufficiently small so that firms allocate zero attention to both conditions. Moreover, firms dynamically allocate more attention to one condition than the others if that condition is more variable than the others. The model qualitatively matches the price change behavior in micro data in which prices react quickly and by large amounts to idiosyncratic shocks, but only slowly and by small amounts to nominal shocks. Nominal shocks can give rise to very strong and persistent real effects when the uncertainty of aggregate condition is sufficiently low. This means monetary policy is less effective in an economy with higher volatility. Chapter 2 examines the asset pricing implications of technology innovation and productivity improvement. We provide new evidence about the link between firm-level total factor productivity (TFP) gap and the value premium. The TFP gap of a firm is the TFP level of a firm relative to that of its industry frontier. We estimate the firm-level TFP gap and show that it is strongly correlated to firm-level book-to-market ratio. Small productivity gap firms exhibit a low book-to-market ratio, that is, they are growth firms, and vice versa. We assume these firms are early innovators and keep track of the frontier closely and therefore expose more to the frontier risk. We show that a production-based asset pricing model with a creative destruction mechanism in which firms have growth options to upgrade their technology to the latest vintage or not can replicate the empirical relationship between TFP gaps and firm characteristics. The model implies that firms with lower opportunity costs to innovate are more likely to innovate. Moreover, such firms rely more on growth options and are more exposed to productivity shocks. If the shocks bear a negative price of risk, meaning technology improves during the course of a recession, then such firms yield relatively low expected returns. Holding such firms in a portfolio hedge against bad times. Chapter 3 investigates simple models of firm investment under uncertainty which usually lack an internal mechanism to propagate shocks. I, by contrast, build a firm investment model with a time-to-build feature in firm-specific intangible investment to generate internal propagation in macroeconomics. The firm-specific nature of intangible capital implies there is no market to trade it across firms, and therefore firms have to use factor inputs to produce this type of capital internally by themselves over time. Firms that are characterized by a higher intangible share exhibit a more hump-shaped impulse response with a more delayed peak even without explicitly adding adjustment cost components to the simple model. Producing intangible capital internally is a real friction and can be a micro-foundation of adjustment costs. Internal intangible capital accumulation provides a Q-theory style of firm investment. In addition, introducing firm-specific intangible capital also introduces a time-varying wedge between factor prices and marginal products. The degree of firm-specificity determines the size of the wedges.
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