No Firm Is an Island? How Industry Conditions Shape Firms’ Expectations 
Much of the recent research seeking to understand how firms form their expectations and how those expectations affect economic decisions focuses on the aggregate expectations of firms and their response to aggregate shocks. In principle, firms should be observing similar aggregate statistics and therefore forming similar beliefs about the future; however, disagreement among firms about future aggregate conditions is pervasive and large. The authors seek to explain this disagreement by showing that—consistent with an “island” model, in which firms form beliefs about the aggregate using the industry-specific information they are exposed to—firms rely on heterogeneous industry conditions, which are notoriously volatile, to help form beliefs about broader macroeconomic conditions. The source for their findings is a survey of approximately 3,000 French manufacturers that has been running quarterly since 1992.
Key Findings
- Firms’ aggregate expectations respond to industry shocks that have no aggregate effects, this response is pronounced and persistent.
- Firms’ expectations about their future own price changes respond gradually to both industry and aggregate variation; firms forecast errors are positively serially correlated, and changes in both industry and aggregate inflation predict these errors.
- The response of firms’ expectations is broadly consistent with their subsequent decisions; firms expect to raise prices quickly after increases in industry inflation, and they do raise them more quickly than they do after increases in aggregate inflation.
Implications
The finding that firms’ aggregate expectations respond to industry shocks that have no aggregate effects implies that firms confound underlying sources of volatility; that is, they attribute some of the industry variation they observe to aggregate forces that actually are not underlying their sectoral volatility. These results provide new evidence that firms’ expectations do not behave as they would under the full-information rational expectations hypothesis. The results also give direct micro-level empirical evidence supporting the mechanism of “island” models, in which firms observe signals that are combinations of idiosyncratic or industry shocks and aggregate shocks.
More generally, these results shed light on why there is so much disagreement among firms about aggregate economic conditions. Firms will respond strongly to signals from their industries, and if they attribute an aggregate component to this information, as the authors’ findings indicate they do, then this response combined with industry volatility could explain the magnitude of disagreement observed among firms.
Abstract
We study how firms’ expectations and actions are affected by both aggregate and industry-specific conditions using a survey of French manufacturing firms. We document an important new stylized fact. In response to industry-level shocks that have no aggregate effects, firms’ aggregate expectations respond persistently. This is consistent with “island” models, in which firms use the local prices they observe to make inferences about broader aggregate conditions. We then assess the extent to which these patterns are related to observable characteristics of firms and the industries in which they reside. Finally, we extend the analysis to firms’ expectations of their own future price changes and document how these respond to both industry and aggregate variation.