Industrial Subsidies and Technology Adoption in General Equilibrium.

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Journal of Economic Dynamics & Control 30 (2006) 1589–1614

www.elsevier.com/locate/jedc
Industrial subsidies and technology adoption

in general equilibrium
Roberto M. Samaniego
Department of Economics, George Washington University, 1922 F St NW Suite 208,
Washington, DC 20052, USA
Received 1 October 2004; accepted 15 September 2005
Available online 2 May 2006
Abstract
Industrial subsidies to failing establishments are common across developed economies. The
paper constructs a dynamic general equilibrium model with a view to study the effects of this
policy. Interestingly, subsidies to failing plants may increase productivity and accelerate the
diffusion of new technologies. In spite of this, labor productivity, employment and income
decrease, as resources are devoted to maintaining and updating establishments that would
otherwise have closed.
r 2006 Elsevier B.V. All rights reserved.
JEL classification: E62; H25; J6; L5; O33; O38
Keywords: Industrial subsidies; Investment-specific technical change; Technology adoption; Plant lifecycle;
Failing plant
1. Introduction
A significant portion of public expenditure in many countries is directed towards

the support of production units and, while some of these outlays support R&D and
Tel.: +1 202 994 6153; fax: +1 202 994 6147.

E-mail address: roberto@gwu.edu.
0165-1889/$ - see front matter r 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.jedc.2005.09.016
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1590 R.M. Samaniego / Journal of Economic Dynamics & Control 30 (2006) 1589–1614
other innovative activities, more often than not they are directed towards establish-
ments that are unproductive.
The paper asks what are the quantitative effects of industrial subsidies to failing
establishments. This question is of interest for several reasons. First, such policies
may have a significant effect on aggregate productivity via changes to the
composition of the establishment pool. Second, an extensive literature examines
the aggregate effects of labor market regulations, particularly those that impose
penalties upon establishments that are reducing their workforce. This is partly
because differences in institutional firing costs have been pinpointed as a likely cause
of the divergent labor market outcomes of the US and Europe.1 However, several
authors have observed that Western European plants that were failing and needed to
reduce their payrolls in recent decades were less likely to be taxed than subsidized.2
Consequently, the effect of industrial support upon employment is of particular
interest. Third, a policy that directly affects the establishment lifecycle could have
significant implications for plant dynamics. Hazard rates, job flows and patterns of
technological adoption are just some features that could be affected.
In the paper, I develop a general equilibrium model of establishment dynamics.
Surviving units gradually fall behind the best practice technology, and may choose in
each period whether to upgrade, continue dropping behind, or shut down. Into this
environment I introduce industrial support to failing establishments.
Interestingly, subsidies have the effect of increasing the average productivity of
plants in operation. This is because an establishment’s optimal technology adoption
rule follows an ðS; sÞ policy, censored by the decision to exit in the face of sufficiently
adverse conditions. As a result, subsidies that enable plants to survive longer allow
more of them to enter the stage of their life at which renewing their technology
becomes optimal. Thus, the underlying determinants of technological adoption are
an important part of the response of the economy to industrial support. Nonetheless,
the economy spends a lot of resources on keeping alive plants that would otherwise
have shut down, and this results in a reduction in both output and employment on
the aggregate.
That the details of the plant lifecycle might be related to the aggregate effects of
public finance regimes has not been raised in the literature. Fuest and Huber (2000)
and Restuccia and Rogerson (2004) study the effects of industrial subsidies: however,
their models lack any lifecycle dynamics, and their subsidies are not directed towards
failing plants – indeed there is no notion of a failing plant in those models.
Samaniego (2006a) articulates such a notion to study the effects of firing costs upon
exit, but does not consider industrial subsidies nor technology adoption.
Section 2 provides an overview of industrial subsidies, and Section 3 introduces
the theoretical model. Section 4 characterizes the equilibrium behavior of the model,
and Section 5 outlines the calibration procedure. Section 6 studies the effects of
industrial support in the context of the model.
1
See Bentolila and Bertola (1990) and Lazear (1990), inter alia.
2
See Ford and Suyker (1990), Leonard and Van Audenrode (1993), OECD (1996), Murphy and
Pretschker (1998) and Fuest and Huber (2000).
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R.M. Samaniego / Journal of Economic Dynamics & Control 30 (2006) 1589–1614 1591
2. Industrial subsidies
In order to model industrial support, I first provide an overview of the structure of

subsidy regimes in recent decades. Due to data availability, in what follows I limit
myself to a discussion of industrial subsidies in the OECD. Subsidy data are from
Ford and Suyker (1990), and are based upon national accounts.
Summary statistics on the time-series and cross-sectional variation in subsidies as
a proportion of output are reported in Figs. 1 and 2, respectively.3 Direct industrial
subsidies varied from 0.5% of GDP in the US to about 7% in Ireland. However, the
relative prevalence of industrial subsidies in Europe compared to the rest of the
OECD is evident. For this reason, I concentrate upon industrial subsidies as they
were common in Europe in recent decades.
Leonard and Van Audenrode (1993) and Murphy and Pretschker (1998) find that
the majority of industrial transfers can be classified as either direct income support
or investment subsidies, with income support comprising roughly half. Effective
income subsidies are likely to be somewhat larger than reported due to extensive
government ownership of companies throughout Europe during the period of
interest, as well as government procurement. However, I conclude conservatively
that industrial support primarily takes the form of direct income transfers, and that
these range up to 3% of GDP.
Who benefits from subsidies? Two common justifications for the existence of
industrial support are the alleviation of credit constraints and the promotion of
certain industries or classes of establishments that might contribute disproportio-
nately to productivity growth. This would suggest that subsidies should be directed
towards comparatively young and/or productive establishments. However, the
evidence suggests that the beneficiaries of explicit support are more likely to be
unproductive – see Ford and Suyker (1990), OECD (1996). For instance, Leonard
and Van Audenrode (1993) examine microeconomic data from Belgium, finding that
the probability of being subsidized declines sharply with productivity growth at the
firm level. At the same time, it is interesting to note that they do not find that any of
the observable firm characteristics they consider – particularly size – is a significant
determinant of subsidies.4 This suggests the fact that a firm is in difficulty is the main
determinant of support.
To sum up, the following stylized facts appear to characterize typical industrial
subvention regimes:
1. the main class of subsidies is income support;

2. income support is directed primarily towards failing establishments;
3. the cross-sectional variation of income support across the OECD is about 0–3%
of GDP.
3
Fig. 1 might suggest a decrease in industrial subsidies beginning around 1987. Murphy and Pretschker
(1998) supply data up to 1993, which is not reported as it is not directly comparable. However, they find no
evidence of a downward trend in support.
4
The exception is that certain industries that they regard as being politically well-represented have a
higher incidence of subsidization.
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Fig. 1. Industrial subsidies across the OECD, 1970–1988. Source: Ford and Suyker (1990).
8.0
7.0
6.0
5.0
% of GDP
4.0
3.0
2.0
1.0
0.0
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ay
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Be a
Po d
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Fig. 2. Industrial subsidies by country, 1970–1988. Source: Ford and Suyker (1990).
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3. Model economy
In what follows, I describe the structure of the model economy. The model is
related to that of Hopenhayn (1992). The innovations are the inclusion of
investment-specific technical change, and the approach to plant exit, which is
similar to Samaniego (2006a). This endows the model with the notion of a ‘failing
plant’ which, as argued, is central to the question of industrial subsidies.
3.1. Production
3.1.1. Establishments
There is a continuum of heterogeneous plants of endogenous mass that live in
discrete time, discounting the future at rate i. At any point in time t a plant is
characterized by the vintage of its technology v, and by an idiosyncratic productivity
shock zt 2 ½z; z̄. It produces a quantity of a homogeneous good according to the
production function
a
gtz zt kt k nat n , (1)
where nt is labor input and kt is capital, for which it pays a wage wt and a rental rate
rv;t , respectively. gz is an exogenous productivity growth factor. An establishment’s
future shock ztþ1 is drawn from a distribution f ðztþ1 jzt Þ.
Vintage v does not directly enter the production function. Rather, v denotes the
type of capital that the establishment uses. Let iv;t and K v;t denote aggregate
investment and capital of type v, respectively. The aggregate stock of each type of
capital evolves as follows:
K v;tþ1 ¼ ð1 dÞK v;t þ qv iv;t . (2)
Here, qv ¼ gvq
is an index of investment-specific technical change that differs across
vintages. In equilibrium, different vintages of capital will command different interest
rates, and this is how vintage matters for establishment payoffs.
3.1.2. Technical change

The technological composition of the aggregate economy may improve in either of
two ways. Incumbents may upgrade their vintage v, or new plants may be
constructed.
At the beginning of each period, before the revelation of zt , existing plants
have the option of upgrading their technology to any level below the frontier qt .
If an establishment wishes to attain a technology qpqt , it must incur a cost
kðq; tÞ ¼ kgaz z t q1az . Similarly, there is a cost of entry zðq; tÞ ¼ zgaz z t q1az to start a new
plant with technology q. Each new plant begins production the period after it is
created, whereupon its initial idiosyncratic shock z is drawn from a distribution cðzÞ.
In the remainder of the paper, I set az ¼ 1=ð1 ak Þ: this structure provides the
aggregate economy with stationarity. In what follows it will also be convenient to
index technologies by their age t ¼ t v rather than by vintage v. Thus, an
establishment’s ‘type’ is a pair ðt; zt Þ. Let mt : N ½z; z̄ ! Rþ be the measure over
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types. The evolution of mt follows a transition function G, so that mtþ1 ¼ Gðmt Þ. G is

an equilibrium object in that it must be consistent with the various optimal decision
rules regarding entry, exit and updating. The aggregate state is thus described by
xt ¼ ðfK t;t g1
t¼0 ; mt Þ, evolving according to G and Eq. (2).
3.1.3. Establishment failure

Aside from the process governing zt , establishments are subject to an additional
source of idiosyncratic uncertainty. Each period, before the revelation of zt (and
before the decision to update has been made), they draw some f 2 Rþ [ f1g from a
cumulative distribution function F. f represents a payment that the plant must make
in order to survive into the subsequent period, and may be thought of as including
any fixed costs of operation as well as other shocks such as legal entanglements,
plant breakdowns, strikes, natural or other disasters, unforeseen changes in
technology or industry conditions that require investment in learning new methods,
etc. I term these ‘continuation shocks.’ Payments all involve purchasing an
appropriate number of units of labor, so that a draw of f involves a continuation
payment of fwt . Draws are independently distributed across establishments and over
time.
In equilibrium, plants whose continuation values are lower than the continuation
shock will optimally choose to close. A ‘failing plant’ is defined as one that would
optimally shut down, since its net continuation value is negative. Support to a failing
plant will constitute a transfer that is able to compensate for this deficiency.
Timing is as follows. At the beginning of each period, plants draw a continuation
shock f and decide whether or not to continue. If they survive, they decide whether
or not to update their technology to a different vintage. Finally, they observe the
value of zt , and produce.
3.1.4. Corporate redistribution

All plants are subject to a proportional tax y on profits – so all costs and revenues
are multiplied by a factor 1 y. Tax revenue is used to subsidize failing plants. Let
Cðt; zt Þ be the continuation value for an establishment of type ðt; zt Þ, and let
X ðf; t; zt Þ be its optimal exit rule in the face of continuation shock f – so that
(
1 if ð1 yÞfwtþ1 4Cðt; zt Þ;
X ðf; t; zt Þ ¼
0 if ð1 yÞfwtþ1 pCðt; zt Þ:
Again, a failing plant is one that has drawn a continuation shock f and for whom
X ðf; t; zt Þ ¼ 1.
Instead of closing, failing establishments receive a transfer Tðf; t; zt Þ that covers
their losses up to a certain point:
8
<0
> if ð1 yÞfwtþ1 oCðt; zÞ;
Tðf; t; zt Þ ¼ ð1 yÞfwtþ1 Cðt; zÞ if Cðt; zÞpð1 yÞfwtþ1 pð1 þ xÞCðt; zÞ;
>
:0 if ð1 yÞfwtþ1 4ð1 þ xÞCðt; zÞ:
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Any shortfall between the value of the firm and a large continuation shock is covered
by the subsidy, up to a proportion x of the continuation value. If a plant is faced with
a continuation shock ð1 yÞfwtþ1 4ð1 þ xÞCðt; zÞ, transfers would be insufficient to
avoid exit, so none are made.
Given x, the tax rate y is set to satisfy a balanced budget condition:
ZZ
Tðf; t; zt Þ dmt ðt; zt Þ dFðfÞ ¼ yPðmt Þ, (3)
where Pðmt Þ is total pre-tax profits when the measure is mt . That all transfers are
between plants in keeping with Leonard and Van Audenrode (1993) who note that, in
most Western European countries, net transfers to corporations were close to zero.
Section 6 explores the sensitivity of the results to this assumption.
3.2. Households
There is a ½0; 1 continuum of infinitely lived households. Preferences over streams

of consumption fct g1 1
t¼0 and leisure fl t gt¼0 take the form
X
1
E bt ½log ct þ Lðl t Þ, (4)
t¼0
where l t 2 ½0; X and ct X08t. Define household labor input as ht ¼ X l t .

Households are involved in several activities. They supply labor to a competitive
market, and earn additional income from renting capital and from the dividends of
any plants they own. Finally, they choose consumption and investment in each
vintage of capital, as well as creating new plants. The price of the consumer good is
normalized to equal one in each period. The budget constraint is
X
1 X
1 X
1
ct þ it;t þ mt;t zðqt ; tÞpð1 yÞPðmt Þ þ wt ht þ K t;t rt;t , (5)
t¼0 t¼0 t¼0
where mt;t ¼ new plants and ht ¼ hours spent working.
4. Model solution
4.1. Equilibrium
As specified, the economy is non-stationary due to the presence of exogenous

growth. However, it possesses a balanced growth path on which output grows by a
factor gy ¼ gaz z g1a
q
z each period, whereas the capital stock grows by a factor g g .
y q
Labor, the level of entry, and the measure are constant over time. The results of King
et al. (2002) imply we can redefine the variables in question with respect to this path
and apply standard recursive methods to the solution of the model.
Let W be the value function of a surviving plant, with C as the expected value of
operating the plant at the beginning of the subsequent period. Let U be the expected
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value of updating. Then,

Pðt; zt Þ ¼ maxfzt kak nan wt n rðtÞkg, (6)
k;n
Cðt; zt Þ ¼ maxfUðzt Þ; Eztþ1 W ðt þ 1; ztþ1 Þg, (7)

0
Uðzt Þ ¼ max
0
fEztþ1 W ðt0 ; ztþ1 Þ ð1 yÞkgð1a
q
z Þt
g, (8)
t X0
W ðt; zt Þ ¼ ð1 yÞPðt; zt Þ
Z
gy
þ maxf0; Cðt; zt Þ ð1 yÞfwtþ1 g dFðfÞ. ð9Þ
1þi
It will be useful to denote U as the optimal updating rule; t^ as the target technology
age; and X as the plants’ optimal shut-down rule:
Uðt; zt Þ ¼ arg max yUðzt Þ þ ð1 yÞEstþ1 W ðt þ 1; ztþ1 Þ,
y2f0;1g
0
t^ ðzt Þ ¼ arg max
0
fEztþ1 W ðt0 ; ztþ1 Þ ð1 yÞkgð1a
q
z Þt
g,
t X0
X ðf; t; zt Þ ¼ arg max x ½Cðt; st Þ fwtþ1 .

x2f0;1g
The household maximization problem lends itself to a recursive representation:

V ðxt Þ ¼ max fln ct þ LðX ht Þ þ bV ðxtþ1 Þg (10)
ct ;ht ;fmt;t g;fit;t g
subject to the constraints in (5), the laws of motion for capital (2) and the law of
motion for the measure,5 where once more xt ¼ ðfK t;t g1 t¼0 ; mt Þ. Problem (10) is
standard except for the presence of entry and of multiple types of capital. Optimal
entry requires that the following equation holds, with equality if mt 40 for any given
t:
Z
W ðt; zÞ dcðzÞpzgqð1az Þt for all tX0. (11)
Let h equal labor supplied by the household, and let n ðt; zÞ be the employment
policy of a given type given the wage. Also let k ðt; zÞ be optimal capital use.
Definition. A stationary equilibrium is a value function W for the plant and V for
the household; exit and updating rules X , U and t ; employment and capital rental
rules n and k ; household decision rules regarding consumption c , labor h , and
entry fmt g; prices w and frt g; an aggregate state x ¼ ðfK t g; m Þ, a law of motion for
the state G and a tax rate y that satisfy:
1. Optimality: given prices, the decision rules c ; h ; n ; k ; X ; U ; t ; fmt g and value

functions W ; V solve (9) and (10).
5
See Eq. (20) in the Appendix.
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2. Stationarity: ct ¼ c , ht ¼ h , wt ¼ w , mt;t ¼ mt , rt;t ¼ rt , K t;t ¼ K t and

m ¼ Gðm Þ, where G satisfies Eq. (20).
3. Feasibility:
Z X
1 X
1
zt k ðt; zÞak n ðt; zÞan dm Xc þ it þ mt zgð1a
q
z Þt
t¼0 t¼0
Z
ðt;zÞ
þ kgqð1az Þt U ðt; zÞ dm . ð12Þ
4. Labor market clearing:

Z ZZ
h ¼ n ðt; zÞ dm þ fð1 X ðf; t; zÞÞ dm dF,
Z
K t ¼ k ðt; zÞ dm 8t.

5. b ¼ gy =ð1 þ iÞ.
6. Government budget balance: Eq. (3) is satisfied.
Observe that Euler equation for capital of type t in steady state is

1
rt ¼ 1 þ d gtq . (13)
b
Eq. (13) is the equilibrium relation whereby, caeteris paribus, newer technologies are
more advantageous. Investment-specific technical change implies that an efficiency
unit of capital is cheaper for plants with more advanced technologies, since the
opportunity cost of investment in newer technologies is lower.
While an existence proof for this model is intractable, it is worth commenting on
the subject. Related general equilibrium models with heterogeneous establishments
generally require a condition on the income effect of labor supply to guarantee
existence, and cannot necessarily guarantee that entry and exit will exist in
equilibrium – see Hopenhayn and Rogerson (1993). In this environment, there must
be entry in equilibrium, as the value of entering is bounded above zero for any given
wage w. Even if death is certain (so that Fð1Þ FðRþ Þ ¼ 1), a ‘fly-by-night’
equilibrium in which plants operate for one period only could still exist. Also, given
that gq 41, for any positive wage there will be some exit. Hence, any stationary
equilibrium will have both entry and exit in this environment.
4.2. The ðS; sÞ structure of updating
The following statements characterize the structure of exit and updating in the steady
state of this economy. They will prove useful in deriving the equilibrium transition
function G, and in forming an algorithm to compute the steady-state measure.6
6
Proofs, located in the Appendix, hinge upon a demonstration that the model of plant dynamics is
equivalent to a vintage capital model in equilibrium, net of a change of variables. While this result has been
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Fig. 3. Optimal decision rules in the calibrated economy. Contour plots are the hazard rates, whereas the
black line represents the updating threshold.
Proposition 1. If a plant of type ðt; zÞ updates, then one with ðt0 ; zÞ, t0 4t does also:
U ðt; zÞ is increasing in t.
Proposition 2. t ðt; zÞ ¼ 0 for all ðt; zÞ: all updating is to the frontier, and all entrants
adopt the frontier technology.
In combination, Propositions 1 and 2 characterize the plant’s updating rule as

being of the ðS; sÞ form, conditional upon idiosyncratic productivity and censored by
the optimal exit rule – see Fig. 3. This corresponds to the empirical observation that
investment is ‘lumpy,’ and moreover that the ‘lumps’ appear to coincide with periods
of plant-wide technical change.7 Plants are born on the vertical axis of the type-
space, at a point depending on their draw from cðzÞ. As their technologies age, they
proceed towards the right, also moving up or down depending on changes to their
idiosyncratic productivity. Dotted contour lines indicate the probability that a plant
of type ðt; zÞ encounters a continuation shock that renders it unprofitable. If at any
point a plant crosses into the area above and to the right of the unbroken black line,
(footnote continued)
widely hinted at in the literature by the fact that the terms ‘capital-embodied technical change’ and
‘investment-specific technical change’ are sometimes used interchangeably, I am not aware of a
demonstration of their ‘equivalence.’
7
See Milgrom and Roberts (1990), Cooper et al. (1993), Cooley et al. (1997) and Sakellaris (2004).
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it updates its technology, returning to the vertical axis but still subject to f in terms of
the evolution of its idiosyncratic productivity.
The following assumption on f yields additional results.
RZ
Assumption 1. 1 f ðztþ1 jzt Þ dztþ1 is weakly decreasing in zt 8Z.
Proposition 3. U ðt; zÞ is increasing in z: if a plant of type ðt; zÞ prefers to update, one of
type ðt; z0 Þ does so too for z0 4z.
Proposition 4. The exit rule X ðf; t; zÞ is increasing in t, and decreasing in z.
5. Calibration
I calibrate the model to post-war US data on aggregates, as well as job flows and
plant dynamics, broadly following the procedure of Kydland and Prescott (1982). I
use US data for the following reasons. First, industrial subsidies have been
comparatively rare in the US, so that it serves a useful benchmark. Second, although
such data are available for some other European countries, the most comprehensive
data on job flows and investment patterns are for the US. Third, the related
literature on labor market regulation typically uses US data for purposes of
calibration. I set x ¼ y ¼ 0 in the benchmark economy.
Shocks z were taken over a grid of 20 points. Given a particular grid, multiplying
it by any factor affects only the size and not the relative composition of the economy.
I choose values evenly spaced over an interval ½z; 1.
The functional forms for the primitives of the model are as follows:
The process f is specified as a random walk over the grid of z values with normal
disturbances: ln ztþ1 ¼ ln zt þ tþ1 , where t Nð0; s2 Þ. Since there are boundaries
on zt , the normal distribution of t is truncated appropriately. This form of f
satisfies Assumption 1.
The distribution c over initial shocks is set to decline linearly starting at z until it
reaches zero at a point c̄. This choice reflects the fact that plants are generally
born smaller than average. As a result, in combination, f and c can be interpreted
as a stochastic learning process.
Following Hansen (1985) and Rogerson (1988), I set Lðl t Þ ¼ ll t . This structure
identifies total labor input with total employment.
Given F, one can solve the value function and obtain a probability Dðzt ; tÞ
that a given type of plant is faced with a shock that is too large for it to survive.
I proceed in reverse: I choose a simple functional form for D that depends
on a reduced number of parameters, compute value functions, and then
infer the form of F that yields the conjectured death function D. This greatly
simplifies the task of calibrating the model. In particular, I choose the simple
linear form
Dðzt ; tÞ ¼ minfmaxfo1 o2 log Cðzt ; tÞ; 0g; 1g.
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This implies that the probability of an insurmountable shock decreases linearly

with the plant’s (log) continuation value, with bounds imposed to ensure that D
lies in the unit interval. This, combined with the parametrization of c, is
consistent with the finding of Evans (1987) among others that hazard rates are
decreasing in age.8
Observe that the probability that a failing establishment is subsidized is

Z ð1þxÞCðt;zÞ=ð1yÞwt Z ð1þxÞCðt;zÞ=ð1yÞwt
o2
dFðfÞ ¼ dz
Cðt;zÞ=ð1yÞwt Cðt;zÞ=ð1yÞwt z
¼ o2 logð1 þ xÞ,
which does not depend on type and hence is not correlated with size. This is
consistent with the findings of Leonard and Van Audenrode (1993).9
Thus, the parameters to be matched are gq ; gz ; ak ; an ; l; d; z; o1 ; o2 ; z; c̄; s
and k.
Using data on the relative price of capital, Cummins and Violante (2002) find
that gq ¼ 1:026. On the other hand, post-war economic growth per head in
the US was about 1.02%. I choose gz so that the growth rate of output in the
economy matches this statistic given gq . This implies that investment-specific
technical change is responsible for about 60% of economic growth, as in Greenwood
et al. (1997).
The discount factor is chosen to be consistent with a 7% annual interest rate as is
common in the real business cycle literature. The income shares are set to ak ¼ 0:3
and an ¼ 0:6, which leaves 10% of GDP as profits. This is approximately the
figure obtained by adding equity, interest and proprietary income in the US National
Income and Product Accounts. The physical depreciation rate d can be derived
from the Euler equation: using the data in Greenwood et al. (1997), I find that
d ¼ 3:9%.
The disutility of labor l is chosen so that employment is 60%, which is roughly the
employment-to-population ratio reported in Rogerson (2002). In turn, I set the cost
of entry z to match the average plant size in the Longitudinal Research Database, as
reported in Hopenhayn and Rogerson (1993).
The remaining six parameters are o1 ; o2 ; z; c̄; s and k, which determine the
dynamics of surviving plants and the distribution of shut-downs. The six statistics
8
With this form for D, the corresponding form for F is
8
>
> 0 xpeðo1 1Þ=o2 ;
<R o2
x
FðxÞ ¼ eðo1 1Þ=o2
dz eðo1 1Þ=o2 oxpeo1 =o2 ;
>
> z
:
1 x4eo1 =o2 :
9
When x is very large, the most productive firms may be such that x is sufficient to insure that they never
exit. In this case, the probability of support will decline slightly with size above a certain threshold.
However, this only occurs for very large values of x.
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Table 1
Parameter values
Parameter Value
gq 1.026
gz 1.007
ak 0.3
an 0.6
o1 0.11
o2 0.044
l 1.254
b 0.954
d 0.039
z 0.42
c̄ 0.73
s 0.023
z 12.2
k 6
I match are:10
1. the 5-year plant hazard rate,

2. the 5-year hazard rate of plants aged 6 years or less,
3. job creation as a proportion of employment,
4. the proportion of job creation due to birth,
5. the proportion of job destruction due to exit,
6. the proportion of plants at which investment is ‘lumpy,’ in that the plant
in question increases its capital stock by at least 30% from one period to
the next.
The rationale for matching these particular statistics is broadly as follows. o1 and
o2 should be closely related to the extent of shutdowns and to the magnitude of job
turnover that they account for. The size of the young and the amount of job turnover
they generate are connected the initial distribution of shocks, and hence to z and c̄ as
well as F. In turn, s affects the amount of overall job turnover, while s will also be
related to cross cohort differences in behavior (plant closures in particular) since it is
linked to the rate at which the idiosyncratic productivity of young establishments
spreads away from the initial distribution. Finally, k determines incentives to update,
and hence should be related to the lumpiness of capital.
Table 1 lists the resulting parameter values, and Table 2 displays some steady-state
statistics of the model economy. The matches are quite tight. Observe that k is about
10
The algorithm I use is simulated annealing: see Bertsimas and Tsitsilkis (1993). Data are drawn from
Davis and Haltiwanger (1992), Dunne et al. (1989), Evans (1987), Doms and Dunne (1998) and the US
National Income and Product Accounts.
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Table 2
Matched statistics
Statistic US data Model
Exit 36% 36%

Exit, age differences 91% 92%
Job creation 10% 10%
Job creation from birth 16% 17%
Job destruction from exit 23% 23%
Lumpy investors 8% 9%
Lumpy investment 25% 30%
Plants, 0–6, that are ‘small’ 74% 80%
Employment 60% 60%
Average size 62 62
Continuation employment 4–6% 4.6%
Average updating delay (years) – 4.5
Average technology age (years) – 6.3
half of z: starting up is about twice as costly as updating. That both occur in

equilibrium is because there is a non-degenerate distribution over z which differs
between startups and continuing plants.
The calibration of F is such that 4.6% of employment is devoted to keeping
establishments in operation. Although it is hard to precisely identify an empirical
counterpart to this statistic, the proportion of employment in Business Services in
the post-war US National Income and Product Accounts has averaged 4.1%, or
5.9% if one includes Miscellaneous Professional Services also. I conclude that the
value in the calibrated economy is empirically reasonable. This is important, as the
quantitative influence of policies that affect the decision to exit will be closely related
to this magnitude.
6. Policy experiments
In this Section 1 compare the behavior of the benchmark economy to one in which
y and x are non-zero. Given a choice of x, I select y so the balanced budget condition
is satisfied. I do this for a variety of levels of x, covering the empirically relevant
range of 0–3% of GDP. This corresponds to values of x between zero and 70%. In
turn, this involves corporate tax rates y ranging from zero up to 30%, which is
significant but not excessive.
6.1. Results
The results are quite striking. Fig. 4 shows that subsidies lead to a decrease in
employment over most of the empirically reasonable range of subsidies. This is in
spite of the fact that the direct effect of the subsidies – to cover more continuation
payments – is to increase employment. Only when subsidies are very large does this
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80 4
% Drop in Consumption
60 3
Subsidy ξ
40 2
20 1
0 0
0 1 2 3 0 1 2 3
61 6.5
Continuation Emp, %
60 6
Employment, %
59 5.5
58 5
57 4.5
0 1 2 3 0 1 2 3
6.5 15
Average z, % Increase
Average age τ
6 10
5.5 5
5 0
0 1 2 3 0 1 2 3
Subsidies, % of GDP Subsidies, % of GDP
Fig. 4. Effects of industrial subsidies on aggregates.
direct effect begin to dominate. At the same time, consumption is eroded by over 3%
of its steady-state value.
These aggregate effects are due to a substantial decrease in overall labor
productivity. At the same time, it is not the case that plant productivity decreases. In
fact, Fig. 4 shows that both the quality of the average technology in use and the
average idiosyncratic shock are higher under industrial support. As a result, the
average plant size increases substantially, as seen in Fig. 5. However, the average
number of plants decreases commensurately. Resources that are devoted towards
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200 80
Plant mass decrease, %

Average Plant Size
60
150
40
100
20
50 0
0 1 2 3 0 1 2 3
40 40
Failure Rate, %
Exit rate, %
30 30
20 20
10 10
0 1 2 3 0 1 2 3
Average Age upon Updating
10.5 4.5
Job creation rate, %
10 4
9.5 3.5
9 3
0 1 2 3 0 1 2 3
Fig. 5. Effect of industrial subsidies on plant dynamics.
keeping plants in operation crowd out those used to create startups. Since startups
are typically small, this affects the size distribution.
That subsidies to failing firms might encourage the use of newer technologies may
appear surprising, considering that plant types have an equal probability of being
subsidized regardless of type. The reason has to do with the details of the lifecycle
dynamics. Recall that plants follow an ðS; sÞ updating policy, censored by their
optimal exit rules. The older a plant’s technology, the more likely it is to enter the
updating area of the type-space, while at the same time being more likely to fail.
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A consequence of this ðS; sÞ structure is that subsidies to failing plants encourage

updating, as older plants are also those more likely to update.
The reason why z is higher on average under the policy is also related to the details
of the lifecycle. Under the policy, rates of entry and exit decrease (the two are equal
in equilibrium). The fact that entrants are less productive than average yields the
result.
Support to failing establishments decreases hazard rates directly. However, rates
of failure – the proportion of plants that receive a continuation shock that exceeds
their continuation value – significantly exceed hazard rates. For example, when
subsidies amount to 3% of GDP, 5-year exit rates drop to around 20%, whereas
failure rates are closer to 30%. Still, it may appear surprising that failure rates
decrease. This is because the general equilibrium effect of industrial subsidies is to
lower wages, so that lower costs imply that incumbents are able to survive larger
continuation shocks than before.
How do industrial subsidies affect job flows? The decrease in plant turnover has a
commensurate impact on job turnover, which declines by about 10% for subsidies of
empirically reasonable magnitude. In steady state the decrease in exit is matched by a
decline in rates of entry, and both of these are important determinants of job flows –
see Figs. 5 and 6. Thus, as in models of employment protection through firing costs,
30 10.5
Job Creation from Birth, %
Job dest. from exit, %
20 10
10 9.5
0 9
0 1 2 3 0 1 2 3
Subsidies, % of GDP
16 32
Lumpy Investment, %
Lumpy investors, %
14
30
12
28
10
8 26
0 1 2 3 0 1 2 3
Fig. 6. Effect of industrial subsidies on job flows and investment behavior.

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there appears to be a trade-off between the duration of jobs and the total number of
jobs – see Hopenhayn and Rogerson (1993). This supports the proposition by
Leonard and Van Audenrode (1993) that industrial subsidies – and possibly other
forms of product market regulation – stand as a candidate explanation for the
phenomenon of ‘eurosclerosis’ as much as do firing costs and other forms of labor
market regulation.
Patterns of investment also change under the policy, with the proportion of
investors who undergo a comparatively large adjustment in each period increasing.
Again, this is because industrial support targets the old, who are closer to the region
of the type-space in which updating is optimal. However, the proportion of plant-
level investment accounted for by these episodes decreases over most of the range of
policies considered. The fact that plants are of lower t and higher z on average under
the policy implies that the average updating lag decreases under the policy, following
the same pattern as the proportion of investment that is lumpy. Plants update more
often and, as a result, each episode of updating involves a comparatively smaller
adjustment.
6.2. Robustness
Could it be that the financing scheme, rather than the subsidy scheme, is
responsible for these results? To answer this question, I repeated the experiments
under two alternative scenarios. Under one, the subsidy scheme is as before, but it is
financed via a lump sum tax on households ðx40; y ¼ 0Þ. In another, there are no
industrial subsidies: instead, profits are taxed as before, and the proceeds are
redistributed to households ðx ¼ 0; y40Þ. Fig. 7 reports the results. On their own,
profit taxes turn out to have only a weak effect on job turnover, plant turnover and
investment behavior. It is the subsidy scheme that has by far the greatest influence on
the structure of the model economy.
It is interesting to observe that both schemes contribute to the decrease in
employment. This is because the profit tax decreases the rewards to entry, which
suppresses employment. There is also a direct effect: because of decreasing returns to
scale in the production function, higher taxes decrease the optimal scale of
production at incumbents. While average size does increase with the tax in general
equilibrium, this direct effect is offsetting so that the increase in average size is
considerably less pronounced than in Fig. 5. At the same time, the effect of the
subsidy scheme on employment is stronger than that of the tax scheme over most of
the empirically relevant range.
6.3. Concluding remarks
The paper proposes a model of plant dynamics to analyze the effects of policies
that affect establishments differently depending on their stage of their lifecycle. The
most empirically notable policy of this class is industrial subsides to failing
establishments. I find that the details of the lifecycle – and patterns of technology
adoption in particular – are important for the aggregate effects of such policies.
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Fig. 7. Comparison of the model with industrial subsidies to failing plants, financed by lump sum taxes
(full line), and the model with profit taxes that are redistributed to households (dotted line).
The results suggest that the quantitative analysis of policies that directly affect
establishment dynamics should be pursued in an environment in which these
dynamics are rich. Technology adoption is one factor that allows these dynamics to
be endogenous, and not simply the results of an exogenous stochastic process. The
endogenous response of plant dynamics to policy is shown here to be a potentially
important channel for their aggregate effects.
The present model is put forward as a benchmark for the aggregate effects of
industrial subsidies. The model economy does not contain an ‘upside’ for industrial
subsidies: however, there are reasons why the current results are likely to be robust to
extensions that do have this feature.
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First, the policy literature often cites credit constraints as a rationale for the
existence of industrial support. However, the empirical and theoretical literature on
credit constraints identifies the most constrained with young establishments, whereas
subsidies tend to be directed towards the old. As a result, the present framework
should capture the main effects of industrial subsidies of empirically relevant forms.11
Second, Fuest and Huber (2000) suggest that, if unions appropriate a large portion
of rents, entry may be suboptimally low, and that transfers to firms may ameliorate
this inefficiency. This channel too is unlikely to be of quantitative importance,
however. As noted, net transfers to industry seem to be about zero, so industrial
support does not constitute a net transfer from households. Consequently, any
effects of industrial support will not have to do with redistribution to industry but
rather between firms – which involves paying close attention to the determinants of
their heterogeneity, as here. Moreover, this redistribution would have to have a large
effects on payoffs close to birth to influence entry behavior. Although hazard rates
do decrease with age, empirically this difference is not large.12
In this paper I have concentrated on industrial subsidies to failing firms. An aspect
of industrial policy that the paper has not addressed, however, is the fact that a
significant portion of industrial support in certain countries may be directed towards
particular industries that may be ‘failing.’ In related work on labor market rigidities,
Samaniego (2006b) shows that, when the rate of technical change varies across
industries, policy may affect the equilibrium industry structure of the aggregate
economy, arguing that this channel has the unusual property that it may affect long
run rates of economic growth. Industrial subsidies that target particular industries
should clearly have this effect, and it would be interesting to extend the model in
order to quantify the potential effects of targeted industrial subsidies upon growth
rates – especially to the extent that political considerations direct subsidies towards
sectors that are ‘failing.’
Finally, the model is also suitable for thinking about other aspects of industrial
policy. In particular, an endogenous growth extension along the lines of Krusell
(1998) would yield a natural environment for the analysis of an aspect of industrial
policy that I have omitted here: subsidies to research and development.
Acknowledgment
This paper is a substantial revision of a chapter of the author’s dissertation at the

University of Pennsylvania. Thanks are due to Richard Rogerson for his valuable
11
In any case, as mentioned in an earlier footnote, for high values of x the current implementation of
subsidies does in fact favor the small.
12
In results not reported here, I repeated the experiments above by modeling union bargaining in the
following manner. Compared to an undistorted environment, unions bargain over wages and employment,
the outcome being a discrepancy between the marginal product of labor and the actual wage rate. I took
this wedge parametrically as a ‘reduced form outcome’ of a union bargaining setup. I set this wedge to be
about 10%, which is in the range of empirically plausible union wage premia. In that extension, subsidies
have the same effect as here.
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suggestions, as well as Boyan Jovanovic, Rafael Rob, Randall Wright, an

anonymous referee, and participants at the annual meetings of the Society for the
Advancement of Economic Theory 2003 in Rodos and the 2004 Conference on
Computation in Economics and Finance at the Universiteit van Amsterdam. All
remaining errors are the author’s.
Appendix A. Proofs
In this Appendix I report proofs of the propositions stated in the text and discuss
how they are used to compute the stationary equilibrium for a given parameter profile.
Without loss of generality in the following proofs I set y ¼ 0. This is because the tax
rate only affects the value function by multiplying all costs and benefits by ð1 yÞ.
First, observe that the steady-state Euler equation implies that

1
rt ¼ 1 þ d gtq
b
so that capital is relatively more expensive to rent for plants with older technology.
Solve for the optimal kt and define the following:
1=ð1ak Þ
s t ¼ zt ,
a =ð1ak Þ 1=ð1ak Þ
C ¼ ðakk ak Þrð0Þak =ð1ak Þ ,
an
a¼ ,
1 ak
gE ¼ gaqk =1ak .
With this change of variables, the value function can be specified as follows:
Cðt; st Þ ¼ maxfUðst Þ; Estþ1 W ðt þ 1; stþ1 Þg, (14)
0
Uðst Þ ¼ max fEstþ1 W ðt0 ; stþ1 Þ kgt
E g, (15)
0 t pt

a
W ðt; st Þ ¼ max Cst gt
E n wt n
n
Z
þb maxf0; Cðt; st Þ fwtþ1 g dFðfÞ . ð16Þ
Let U be the optimal updating rule and X be the plants’ optimal shut-down rule,
defined as follows:
Uðt; st Þ ¼ arg max yUðst Þ þ ð1 yÞEstþ1 W ðt þ 1; stþ1 Þ,
y2f0;1g
X ðf; t; st Þ ¼ arg max x ½Cðt; st Þ fwtþ1 .

x2f0;1g
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Proofs all employ standard recursive methods. Let v be a uniformly continuous

function and let B be the Bellman operator. W is the fixed point v : Bv ¼ v of
Cðt; st ; vÞ ¼ maxf0; Uðst ; vÞ fj pt ; Eztþ1 vðt þ 1; stþ1 Þ fj wt g, (17)
0
Uðst ; vÞ ¼ max fEztþ1 vðt0 ; stþ1 Þ kgt
E g, (18)
0t pt

a
Bvðt; st ; vÞ ¼ max Cgt
E st nt wn
n
Z

þb max 0; Cðt; st ; vÞ fwtþ1 dFðfÞ . ð19Þ
Let U be the optimal updating rule and X be the plants’ optimal exit rule. Then,
Uðt; st ; vÞ ¼ arg max yUðst ; vÞ þ ð1 yÞEstþ1 vðt þ 1; st Þ,
y2f0;1g
X ðf; t; s; vÞ ¼ arg max x ½Cðt; st ; vÞ fwtþ1 .

x2f0;1g
Assume that w and p are positive and finite. The following results are useful:
Lemma 5. The plant’s value function exists, is unique, is strictly decreasing and strictly
convex in plant age t.
Lemma 6. Under Assumption 1, W is strictly increasing in z.
Proof of Lemma 5. It is straightforward to show that the recursive system described
above satisfies Blackwell’s sufficient conditions for being the unique fixed point of
the Bellman operator defined over the appropriate function. By the contraction
mapping theorem, for any O that is compact under the uniform norm, if v 2 O and
Bv 2 O then W 2 O. This applies to the claim that W is weakly decreasing, as well as
to the claim of convexity.13 In addition, considering an open set O O, if Bv 2 O for
any v 2 O =O (which is closed), then W 2 O (as the limit cannot be in O =O). This
applies to the claims of strictness. &
Proof of Lemma 6. Assume that v is increasing in z. Then, Estþ1 vð; st Þ – the value of
not updating – is increasing in s also – as is U – because f ðjzÞ is increasing in s.
Consequently, Bv is also, as the instantaneous payoff is strictly increasing in s.
Arguments identical to those in Lemma 1 yield strictness. &
Proof of Proposition 1. Observe that U does not depend on t. Hence, since the
alternative to updating is decreasing in t, the updating rule must be increasing. &
13
Consider v decreasing in t. Then, U and C are either constant in or decreasing in t, as is the rest of Bv.
The same applies to the claim of convexity, since the supremum of any set of convex functions must itself
be convex.
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Proof of Proposition 2. Rewrite the Bellman equation with a change of variables

x gt
E .
~ x; st ; vÞ ¼ maxfUðst ; vÞ; Es vðxg1 ; stþ1 Þg,
Cðj; tþ1 E
~ t ; vÞ ¼ max fEz vðx0 ; stþ1 Þ kx0 g,

Uðs tþ1
0px p1
0
Bvðx; st Þ ¼ ðCxst Þ1=ð1aÞ wa=ð1aÞ ½aa=ð1aÞ a1=ð1aÞ

Z
þ b maxf0; Cðt; st ; vÞ fwtþ1 g dFðfÞ.
This defines a contraction as before. Let W ~ be the fixed point. It is easily shown
that
R the fixed point is increasing and convex in x, since 1=ð1 aÞ41. Thus,
W~ ðx0 ; e
sÞ df ðe s kx0 must be strictly convex in x0 , as W
sjsÞ de ~ ðx0 ; e
sÞ df ðe
sjsÞ de
s is the
weighted sum of strictly convex functions. Consequently,
Z
max W ðx0 ; e
sÞ df ðe s kx0
sjsÞ de
0px p10
only allows boundary solutions 0 and 1. However,

Z Z
0 0
lim W ðx ; e
s Þ df s
ð~ jsÞ s
de kx ¼ W ð0; e
sÞ df ðe
sjsÞ de
s
x0 !0
Z
o W ðxg1 ; e sÞ df ðe
sjsÞ de
s8x40
so that inertia is always more profitable than reversion to x ¼ 0 (equivalent to

t ¼ 1) and the result follows. Observe that this last argument also proves that
plants will never ‘downgrade’ their capital.
The second result follows from the fact that the problem above only has corner
solutions. The problem in (11) has the same structure. Expected profits from entering
with t ¼ 1 are zero. &
Proof of Proposition 3. Let Dðt; st Þ ¼ Uðst Þ Esþ1 W ðt; stþ1 Þ. Then

Dðst Þ ¼ Estþ1 max CgE stþ1 na max gt s
E tþ1 n a
n n
( ( )
X 0; Dðstþ1 Þ fj wtþ1
þb Estþ2 max
j
þEstþ1 W ð1; stþ1 Þ; Estþ1 W ð1; stþ1 Þ fj wtþ1
( ))
0; Dðst Þ fj wtþ1 þ Estþ1 W ðt þ 1; stþ1 Þ;
max .
Estþ1 W ðt þ 1; stþ1 Þ fj wtþ1 :
Taking W as given, this expression can be rewritten for D in the form of Eq. (19) to
define a contraction that satisfies Blackwell’s conditions and which can be
shown to be increasing in s because both W and the static labor maximization
problem are. &
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Proof of Proposition 4. Corollary of the monotonicity results in Lemmata 5

and 6. &
Now I describe the definition and computation of the steady-state measure m. Let
Ið:Þ be the indicator function that equals one if the argument is true and zero
otherwise. The transition function G that describes how the measure mt evolves over
time must satisfy the condition that
Z
mtþ1 ðT; ZÞ ¼ M t Iðztþ1 2 ZÞIð0 2 TÞ dcðztþ1 Þ
ZZ
þ Iðt þ 1 2 TÞIðztþ1 2 ZÞð1 Uðt; zÞÞ
ð1 X ðf; t; zÞÞf ðztþ1 jzÞ dmt dFðfÞ

ZZ
þ Ið0 2 TÞIðztþ1 2 ZÞUðt; zÞ
ð1 X ðf; t; zÞÞf ðztþ1 jzÞ dmt dFðfÞ, ð20Þ

where T Z is any subset of the idiosyncratic state space. In a stationary
equilibrium, X ; U and M will be constant, and m will be the fixed point of this
functional.
To compute m I adopt an iterative procedure. Define a measure m11 such that
Z
m11 ðT ZÞ ¼ M 1ð0 2 TÞ dc1 ðZÞ,
where c1 ¼ c. This is the measure if all plants die after one period. Let m12 be the
measure computed according to X and U on the assumption that all updating results
in death and that all plants die after two periods. Similarly, define m1i . Define
m1 ¼ limi!1 m1i .
Now, let cjþ1 to be the mass of establishments using technology of age zero in mj ,
so that
ZZZ
1
cjþ1 ðZÞ ¼ cj ðZÞ þ Iðztþ1 2 ZÞUðt; zÞð1 X ðf; t; zÞÞf ðztþ1 jzt Þ dmt dFðfÞ,
M
mj1 : mj1 ðT ZÞ ¼ M1ð0 2 TÞcj ðZÞ,

cjþ1 – which is the distribution of establishments in m1 who are using the most recent
technology either through birth or updating – can be used to repeat the above
procedure and generate a sequence of measures fmji g1 i¼0 for any j. Define
mj ¼ limi!1 mji . The steady-state measure will be m limj!1 mj . Existence is implied
by the results of Hopenhayn and Prescott (1992).
The advantage of using a discretized state space is that the algorithm is easy to
implement and fast to run (on a Pentium III it takes seconds). m can be approximated
to any desired degree of precision by computing mji for sufficiently large values
of i and j. In practice I use i ¼ j ¼ T. Usefully, employing this algorithm
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for i ¼ j ¼ T 0 oT is equivalent to tracking the activities of all plants that are younger
than T 0 , making it simple to isolate different age groups.
These results imply that the following simple algorithm can be used to compute
the stationary equilibrium. Given a wage w, value functions and decision rules can be
computed using standard recursive methods. w is selected so that the free entry
condition is satisfied. With the resulting decision rules, the measure m can be
computed net of a constant which is the level of entry M. This is chosen so as to
equalize labor demand and labor supply. &
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Journal of Economic Dynamics & Control 30 (2006) 1589–1614

Industrial subsidies and technology adoption

JEL classification: E62; H25; J6; L5; O33; O38

A signiﬁcant portion of public expenditure in many countries is directed towards

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In order to model industrial support, I ﬁrst provide an overview of the structure of

1. the main class of subsidies is income support;

3.1.2. Technical change

types. The evolution of mt follows a transition function G, so that mtþ1 ¼ Gðmt Þ. G is

3.1.3. Establishment failure

3.1.4. Corporate redistribution

There is a ½0; 1 continuum of inﬁnitely lived households. Preferences over streams

where l t 2 ½0; X and ct X08t. Deﬁne household labor input as ht ¼ X l t .

where mt;t ¼ new plants and ht ¼ hours spent working.

As speciﬁed, the economy is non-stationary due to the presence of exogenous

value of updating. Then,

Cðt; zt Þ ¼ maxfUðzt Þ; Eztþ1 W ðt þ 1; ztþ1 Þg, (7)

X ðf; t; zt Þ ¼ arg max x ½Cðt; st Þ fwtþ1 .

The household maximization problem lends itself to a recursive representation:

1. Optimality: given prices, the decision rules c ; h ; n ; k ; X  ; U ; t ; fmt g and value

2. Stationarity: ct ¼ c , ht ¼ h , wt ¼ w , mt;t ¼ mt , rt;t ¼ rt , K t;t ¼ K t and

4. Labor market clearing:

Observe that Euler equation for capital of type t in steady state is

4.2. The ðS; sÞ structure of updating

In combination, Propositions 1 and 2 characterize the plant’s updating rule as

This implies that the probability of an insurmountable shock decreases linearly

Observe that the probability that a failing establishment is subsidized is

1. the 5-year plant hazard rate,

Statistic US data Model

Exit 36% 36%

half of z: starting up is about twice as costly as updating. That both occur in

Fig. 4. Effects of industrial subsidies on aggregates.

Plant mass decrease, %

A consequence of this ðS; sÞ structure is that subsidies to failing plants encourage

Fig. 6. Effect of industrial subsidies on job ﬂows and investment behavior.

6.3. Concluding remarks

This paper is a substantial revision of a chapter of the author’s dissertation at the

suggestions, as well as Boyan Jovanovic, Rafael Rob, Randall Wright, an

X ðf; t; st Þ ¼ arg max x ½Cðt; st Þ fwtþ1 .

Proofs all employ standard recursive methods. Let v be a uniformly continuous

X ðf; t; s; vÞ ¼ arg max x ½Cðt; st ; vÞ fwtþ1 .

Proof of Proposition 2. Rewrite the Bellman equation with a change of variables

~ t ; vÞ ¼ max fEz vðx0 ; stþ1 Þ kx0 g,

Bvðx; st Þ ¼ ðCxst Þ1=ð1aÞ wa=ð1aÞ ½aa=ð1aÞ a1=ð1aÞ

only allows boundary solutions 0 and 1. However,

so that inertia is always more proﬁtable than reversion to x ¼ 0 (equivalent to

Proof of Proposition 3. Let Dðt; st Þ ¼ Uðst Þ Esþ1 W ðt; stþ1 Þ. Then

Proof of Proposition 4. Corollary of the monotonicity results in Lemmata 5

ð1 X ðf; t; zÞÞf ðztþ1 jzÞ dmt dFðfÞ

ð1 X ðf; t; zÞÞf ðztþ1 jzÞ dmt dFðfÞ, ð20Þ

mj1 : mj1 ðT ZÞ ¼ M1ð0 2 TÞcj ðZÞ,

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1. Optimality: given prices, the decision rules c ; h ; n ; k ; X ; U ; t ; fmt g and value

2. Stationarity: ct ¼ c , ht ¼ h , wt ¼ w , mt;t ¼ mt , rt;t ¼ rt , K t;t ¼ K t and