- Preprint version (updated December 8, 2015)
Abstract. We develop and estimate a dynamic game of strategic firm expansion and contraction decisions to study the role of firm size on future profitability and market dominance. Modeling firm size is important because retail chain dynamics are more richly driven by expansion and contraction than de novo entry or permanent exit. Additionally, anticipated size spillovers may influence the strategies of forward looking firms making it difficult to analyze the effects of size without explicitly accounting for these in the expectations and, hence, decisions of firms. Expansion may also be profitable for some firms while detrimental for others. Thus, we explicitly model and allow for heterogeneity in the dynamic link between firm size and profits as well as potential for persistent brand effects through a firm-specific unobservable. As a methodological contribution, we surmount the hurdle of estimating the model by extending the Bajari, Benkard and Levin (2007) two-step procedure that circumvents solving the game. The first stage combines semi-parametric conditional choice probability estimation with a particle filter to integrate out the serially correlated unobservables. The second stage uses a forward simulation approach to estimate the payoff parameters. Data on Canadian hamburger chains from their inception in 1970 to 2005 provides evidence of firm-specific heterogeneity in brand effects, size spillovers and persistence in profitability. This heterogeneous dynamic linkage shows how McDonald’s becomes dominant and other chains falter as they evolve, thus affecting market structure and industry concentration.
Keywords: Dynamic discrete choice, market structure, industry dynamics, firm size spillovers, organizational forgetting, particle filter, serial correlation.