Endogenous Firms’ Exit and the Equity Premium

This paper explores the impact of endogenous firm exit on the equity premium. Building on endogenous product creation under a monopolistic competition framework with heterogeneous firms, we posit that each firm is endowed with a specific productivity level drawn from a Pareto distribution. Firms with a productivity below a certain threshold exit the market. Positive aggregate productivity shocks lower this threshold, leading to increased firm entry and reduced exit rates. This, in turn, reduces the equity premium by lowering the risk compensation required for equity. To validate our theoretical framework, we employ a Bayesian VAR analysis as an empirical counterpart. By integrating these elements, we provide a comprehensive understanding of how endogenous firm dynamics and market structure contribute to the variability of the equity premium, presenting new insights into the relationship between market conditions and equity returns.