Productivity or Unexpected Demand Shocks: What Determines Firm-Level Investment and Exit Decisions
Pradeep Kumar and Hongsong Zhang
[Abstract] The industrial organization literature encompasses that firms' capital investment and exit are driven by productivity alongside other deterministic factors, which determine firms' long-term expectation of profits. The short-term unexpected demand shocks, however, may also have an impact through channels such as credit constraints. In this paper, we investigate the roles played by unexpected demand shocks, besides productivity, on firms' capital investment and exit decisions. We propose a practical approach to recover unexpected firm-level demand shocks utilizing inventory data, based on the idea that within firm variation of inventory stock contains direct information about the demand shocks. This introduction of demand shock and inventory into the model also improves the estimation of productivity. The empirical results indicate that while productivity and demand shocks are both significant factors determining firm behavior, the former is more important for investment decision and the latter is more salient for firm exit. These findings confirm that the unexpected demand shocks, besides the persistent productivity, are necessary factors when analyzing capital investment and firm exit.