R&D investment patterns, financial constraints and macroeconomic conditions 

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Market selection, financial constraints and shock of demand


In this paper we build a agent-based model, in which heterogeneous firms try to survive market competition by making decisions of production with the presence of financial constraints and fluc-tuations of macroeconomic conditions. Contrary to arguments of « cleansing effect », our simulation results demonstrate that with deteriorating macroeconomic conditions market selection mechanism may not function as expected by neoclassical economic theories. The fact that a delay could exist between improvement in profitability due to rise in productive efficiency and reinforcement of fi-nancial robustness, and the existence of financial constrains brings on a discrepancy between the selection in terms of productive efficiency and financial robustness, and leads to a distortion in bank loan market compared to product market: a firm’s financing conditions depend directly on its financial solvency instead of its productivity level. Aggravating economic environment emphasizes the impact of financial frictions by worsening firms’ solvency. Consequently, as important explana-tory factors to the dysfunction of market selection mechanism, financial constraints combined with restrictive macroeconomic conditions could lead to negative effects regarding long-run aggregate productivity and output growth.
Keywords: firm dynamics; market selection mechanism; financial constraints.


The worldwide financial crisis in 2008 and subsequent economic recession have triggered off harmful impacts on employment and bankruptcy waves, due to drop in global demand and restriction of financing conditions. However, the effects of crisis and recession do not stop at the level of bankruptcy and unemployment.
The influence of restrictive economic environment on firm dynamics also has an important rel-evance to fundamental theories. Neoclassical economists believe that a capitalist market economy could deviate from its equilibrium, but such disturbance would be temporary and the market mech-anism would operate relatively quickly and efficiently to restore full employment equilibrium. If this economic analysis is correct, then government intervention, in the form of activist stabilization policies, would be neither necessary nor desirable. Even for one of actual mainstream economic thoughts – new classical equilibrium business cycle theory – the optimizing power of market forces is always incontestable. One of the essential features of this stream is the market efficiency, which represents at industry level the selection mechanism on firms’ productivity by market force: in an economy based on efficient market, only the most productive firms can survive.
Market selection mechanism denotes the process of eliminating less productive firms through market competition. The dysfunction of market selection mechanism discloses a profound issue related to aggregate productivity and output growth. If firms with higher productive efficiency are obliged to exit from the market, aggregate productivity growth may not reach the expected level. Hence aggregate output could underperform its optimal state.
Multiple empirical works prove that in most cases and with different degrees of efficiency, the theoretical market selection process works, even in presence of financial constraints (see e.g. Bellone et al. (2006)). Nevertheless, one counterexample exists, Nishimura et al. (2005) point out, the failure of the mechanism in question causes the decrease of Japanese productivity in 1997. Therefore, what are the effects of financial constraints on market selection mechanisms under aggravating macroeconomic conditions?
In this paper, following evolutionary stream, we introduce an agent-based discrete dynamical model, where heterogeneous firms try to survive market competition under impacts of fluctuating macroeconomic conditions. With distinct productivity level, firms produce a homogeneous product by means of capital stock and labor inputs. New firms enter into market contingent on the evolution of market profitability level. Incumbent firms failed in the competition or became insolvent have to exit from the industry. Determinants from both endogenous and exogenous environments influence firms’ dynamics: on the one side, they are subjected to financial constraints, which is a function of their financial robustness; on the other side, analyzed in separate scenarios, macroeconomic conditions such as aggregate demand fluctuates and disturbs the competition between firms.
We carry out simulations within a scenario where shock of global demand intervenes accom-panied by restriction of financing conditions. The results illustrate a plausible failure of market selection mechanism under impacts of distressed macroeconomic conditions. On the one hand, the existence of financial constraints results a discrepancy between the selection on productive efficiency and financial robustness and leads to a distortion in bank loan market in contrast to product market: a firm’s financial costs are linked directly to its financial solvency instead of its productivity level. The occurrence of such discordance between two markets stem from the fact that a delay could exist between improvement in profitability due to rise in productive efficiency and reinforcement of financial robustness. On the other hand, aggravating economic environment emphasizes the impact of financial constraints by worsening firms’ solvency situation. The joint effects of these two factors compel an increasing number of firms exit from market because of their financial fragility instead of their productivity, and there is no significant difference in terms of productivity between exiting firms and incumbents. Consequently, market selection process may not function, hence the growth of aggregate productivity could not reach its optimal level. Deteri-oration of macroeconomic conditions could modify the structure of market competition, which in turn impacts long-run aggregate productivity and output growth.
This paper contributes to economic theories related to firm dynamics and market efficiency. The dysfunction of market selection mechanism in the presence of both financial constraints and shock of global demand demonstrates a plausible failure of efficient market, under the impact of financial imperfection and deteriorating economic environment. Meanwhile, the results of this study challenge the arguments of « cleansing effects » (see e.g. Caballero and Hammour (1994)), which claim that during economic downturn firms with poor productivity will be eliminated from market, hence economic recession reinforces the market selection process. Our simulation results clearly show the contrary: in economic downturn exitors could include firms with both lower and equal productivity compared to incumbents. The functioning of market selection may be impeded when the economy is in distressed state.
With regard to economic policies, if the natural selection mechanism does not work in expected way where competition is purely oriented by productive efficiency, especially in period of tough economic conditions, more government intervention should be encouraged, especially those target-ing on easing firms’ financing conditions, in order to assist and support firms – in particular those with young age or small and middle size – to go through crisis.
This paper is organized as follows. The next section gives a brief review of existing research related to our topic. Subsequently we introduce the modeling in section three. Section four presents simulation results, followed by conclusion at the end.

Literature review

Firm dynamics and financial constraints

Among different factors, financial constraints play a vital role in explaining firm dynamics – growth and survival – through impacting on firms’ investment capacity. Both theoretical and empirical research works corroborate this standpoint. Fazzari et al. (1988) view financial constraints as an explanation for the dynamic behavior of aggregate investment. Evans and Jovanovic (1989) demonstrate that the liquidity constraints are essential in the decision to become an entrepreneur.
Clementi and Hopenhayn (2006) build a multi-period borrowing and lending relationship with asymmetric information. They argue that as a feature of optimal long term lending contract, borrowing constraints reduce with the increase of borrower’s claim in future cash flow. They also show a negative relationship between a firm’s value and its exit hazard rate. Based on this research framework, Brusco and Ropero (2007) try to realize improvement by adding the concept of durable capital and a stochastic liquidation value into the initial model. The introduction of durable capital permits to take into account the size as a factor of firms’ dynamics and investment decisions. The insertion of stochastic liquidation value allows to have a positive probability of liquidation under the first best. The results show that high stock of capital could reduce a firm’s chance of bankruptcy, improve its future expansion and lower its volatility.
For the empirical side, numerous studies are achieved on this topic. Carpenter and Petersen (2002) estimate data of American small companies and point out significant effects of internal finance availability on asset growth. Furthermore, they also demonstrate a positive relationship between access to external financing and growth rate of firms. Aghion et al. (2007) use a firm-level database to assess the role of financial development on firm entry, the size at entry and post-entry performance of new firms. They suggest that the access to external financing resources is more important for the entry of small firms, and this factor could improve the market selection mechanism by permitting the competition between small firms and large firms on a more equal balance. They equally demonstrate that financial development could help improve firms’ post-entry growth.
Based on French firms data, Musso and Schiavo (2008) use a composed and continuous measure of firm-level financial constraints to analyse the relationship between financial restrictions and firm dynamics. The estimate results show that financial constraints have a significant impact on the probability of firm survival, and access to external financing resources is propitious to ameliorate firms’ growth. Gertler and Gilchrist (1994) illustrate that liquidity constraints may explain why small manufacturing firms respond more to a tightening of monetary policy than do larger manufacturing firms. Perez-Quiros and Timmermann (2001) show that in recession smaller firms are more sensitive to the worsening of credit market conditions, which is measured by higher interest rates and default premium. Angelini and Generale (2005) find in their dataset of Italian firms that young firms have more financing restraints.

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Market selection mechanism and firm dynamics

Empirically there exist numerous studies trying to validate the efficiency of this market selec-tion mechanism. Their results show that in general the selection process of firm works. For instance, Baily et al. (1992) and Haltiwanger (1997) employ a longitudinal dataset and found that firm-level entry and exit patterns have significant impact on the overall productivity growth of U.S. manufacturing industry. Griliches and Regev (1995) based on Israeli manufacturing firms data show that the effects of a firm’s turnover on industry-level labour productivity were quite small. Bellone et al. (2006) study post-entry and pre-exit performance of French manufacturing firms for the period 1990-2002. The authors demonstrate that market selection process works properly across French firms, and market share reallocation across incumbents play a crucial role in improving productivity within French manufacturing firms.
However, in the theoretical area, two distinct schools of economic thought, neoclassic and evo-lutionary economics have different stances pertaining to the relationship between firm productivity level and its dynamics.
The central role of market in selection among heterogeneous firms is stressed in neoclassical microeconomic dynamic modelling where the heterogeneity at productivity level is incorporated into dynamic equilibrium framework. This approach begins with the research of Jovanovic (1982). The author establishes a model where the firm maximizes its expected discounted future cash flows, and makes its decisions of entry, continuation and exit based on the results of optimization. The firm dynamics is realized within following process: at the beginning firms are donated with a constant profitability parameter, which determines the distribution of their future profit stream. A new firm does not know its relative efficiency level, which is represented in its cost function, but discovers it through the process of Bayesian learning from its post-entry profit realization. As a result, young firms have higher failure probabilities and more volatile growth rates. The model equally allows to replicate industry dynamics patterns in which firm size distribution can be stable over time despite the introduction of fluctuation at firm level through entry rates, failure of entrants, or displacement of incumbents through the growth of successful entrants.
Evolutionists have another point of view relating to the topic. They emphasize more on the sources and processes of innovation which characterize firms’ heterogeneity and then impact their dynamics. Silverberg et al. (1988) build a self-organization model based on a number of be-havioural assumptions and a structure of feedback loops. The constructed system is characterized by the feature of a set of microeconomic diversity and disequilibrium. The simulation results demonstrate a distinct firm dynamics process: some firms could experience a short run loss but a long run gain in terms of market share, some other firms could lead into a vicious spiral towards bankruptcy.

Macroeconomic conditions

If the functioning of market selection mechanism is confirmed through both theoretical and empir-ical approach, its validation within the context of stringent economic conditions is still a debate in the research field.
Although there exist few research centered on this question, their results are totally contradic-tory. Caballero and Hammour (1994) establish a vintage model of creative destruction within a partial equilibrium. In their modeling a perfectly competitive industry experiences exogenous tech-nical progress, and reveal the positive standpoint of cleansing effect of recession through the angle of employment. From the results of simulation, job destruction is more sensitive than creation to the business cycle, which means outdated or unprofitable techniques and products are pruned out of the productive system. Therefore the economic recession display a positive effect in which market selection mechanism works properly by cleaning firms with weak productive performance out of the industry.
Another empirical study draws completely opposite conclusions. Nishimura et al. (2005) use a Japanese firm-level panel database in order to study the relationship between firms’ productivity level and their dynamics in terms of entry, survival and exit. They found that the natural selection mechanism did not work as expected during the recession of 1996 to 1997. Firms with higher pro-ductive efficiency exit from the market however inefficient ones stay. Such malfunction contributes considerably to a decrease in aggregate productivity level after 1996.
The clear contradiction between the conclusions of these two studies reveals the debate on the effects of macroeconomic fluctuations on functioning of market selection mechanisms. Few research works are done on this topic, which gives us the possibility to fill the gap by realizing studies related to the subject.


We establish an agent-based model in which firms are heterogeneous regarding productivity and financial conditions. In our modeling, the industry evolving in discreet time t = 1, 2, …, firms in this industry are denoted by i = 1, 2, …. By means of capital Kit and labor Lit, firms produce and sell a homogeneous product with different prices pit in a competitive market. Each period firms make their decisions in terms of production and investment, taking into account their financial constraints and fluctuations of macroeconomic factors.

Sequence of events

1. Aggregate demand varies in value according to its own growth rate.
2. The market demand to each firm is a function of aggregate demand level and the firm’s market share, which depends on the gap between it’s price and the weighted average price level of the market in previous period.
3. At the beginning of each period, firms estimate their turnover by observing the market demand. Based on their marginal cost of current period, each firm determines its price and deduces its production volume.
4. To achieve the desired quantity of production, each firm has to fix its capital level (the case of disinvestment is excluded), and then the quantity of its labor. With the existence of financing constraints, certain firms – restricted from borrowing enough funds to reach their desired assets level – have to produce less than their desired quantity. As a result, the demand of market will not be entirely satisfied.
5. In each period, if the industry remains relatively profitable compared to the cost of entry, new entrants are attracted to enter. A mechanism of market share reallocation between incumbents and new firms is introduced. Meanwhile, firms failing market competition quit the industry according to predefined criteria.

Table of contents :

0.1 General theme
0.2 Research questions
0.3 Research method
0.4 Thesis plan
1 Market selection, financial constraints and shock of demand 
1.1 Introduction
1.2 Literature review
1.2.1 Firm dynamics and financial constraints
1.2.2 Market selection mechanism and firm dynamics
1.2.3 Macroeconomic conditions
1.3 Model
1.3.1 Sequence of events
1.3.2 Production
1.3.3 Demand
1.3.4 Production decision
1.3.5 Equity, debt, assets and investment
1.3.6 Productivity
1.3.7 Financial constraints
1.3.8 Entry and exit
1.4 Simulation
1.4.1 Benchmark simulation
1.4.2 Quantitative analysis
1.4.3 Effects of financial constraints
1.4.4 Shock of demand
1.5 Conclusion
2 R&D investment patterns, financial constraints and macroeconomic conditions 
2.1 Introduction
2.2 Model
2.2.1 Sequence
2.2.2 Production
2.2.3 Market demand
2.2.4 Production decision
2.2.5 Balance sheet and investment
2.2.6 R&D investment and productivity
2.2.7 Financial constraints
2.2.8 Entry and exit
2.3 Simulation
2.3.1 Benchmark simulation
2.3.2 Deteriorating macroeconomic conditions
2.4 Conclusion
3 Economic stimulus, financial constraints and business cycle 
3.1 Introduction
3.2 Model
3.2.1 Sequence of events
3.2.2 Production
3.2.3 Demand
3.2.4 Production decision
3.2.5 Equity, debt, assets and investment
3.2.6 Productivity
3.2.7 Financial constraints
3.2.8 Entry and exit
3.3 Simulation
3.3.1 Calibration
3.3.2 Baseline simulation
3.3.3 Economic stimulus
3.4 Conclusion


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