Free Exit And Social Inefficiency

Abstract

Mankiw and Whinston (1986) show that free entry is socially excessive when firms have fixed costs and produce identical goods. That is because rival firms fail to externalize the business stealing costs they impose on their rivals. This paper extends that model by assuming that there are two states of demand. It is proven that weakly too few firms exit voluntarily when demand realizations are low and some of the fixed costs are recoverable. If there is any voluntary exit, social welfare could strictly rise by forcing more firms to exit the industry.