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 unc ertainty and all firms are ex ante identical with perfect foresight. Atomis tic firms with upward-sloping marginal cost curves undertake investment in firm-specific cost reduction. They earn negative net profits in early perio ds, compensated later by strictly positive net profits; no entry occurs aft er the initial time period. Some firms may exit before others even while ot her firms earn positive net profits.