2.1 Incumbent Firm Profits
An important stream of industrial organization research relates to the determinants of market structure and the set of firms that are present in an industry (see Einav and Levin
2010). Market power is tied to profitability and market structure, and entry or exit barriers are important because of their effects on (potential) entrants and exits (see Lahti
2006). Bain (
1956) identified barriers to entry that can shape the costs for firms. These can relate to the absolute cost advantage of incumbent firms, which can find lower-cost ways of production and capital accumulation; scale economies of incumbent firms; and product differentiation advantages of incumbent firms, which have the resources for activities such as research and development, or marketing and advertising to grow market share. Ultimately, some entry barriers may be more or less effective at preventing entry, which thereby can contribute to different profit trends in incumbent firms.
In addition to the entry decision, the performance of both new and incumbent firms can be useful to understand how markets and competition may evolve. One way to examine this is through profit dynamics over time. Greiner (
1972) suggested a model of firm growth that occurs in phases, with each next growth phase being tied to a “crisis” of some kind, that provides context on how the persistence of profits could matter. The ability of a firm to navigate and emerge successfully from a crisis in this Greiner framework can be related to how it mobilizes resources that are internal and external to the firm (see Belitski and Desai
2019).
The first phase reflects growth through creativity and is marked by a crisis of leadership. The firm experiences growth through direction, lining up to crisis of autonomy in the second phase. The third phase is marked by growth through delegation, which can result in a crisis of control in the firm. Next, as the firm is maturing and experiences growth through coordination, it can face a crisis of red tape. For example, a firm may be moving into new activities that expand oversight of its activities. And, a mature firm grows through collaboration, which can lead to crisis related to growth and other crises.
This sequence implies that each crisis can represent an opportunity that could deepen the advantage or disadvantage of a firm: for example, in strengthening or creating relationships; leveraging new capital; accessing new knowledge; or gaining other types of resources. As a firm grows, it may require different or greater resources to overcome the next crisis, which places a greater value on the track record of the firm (see Belitski and Desai
2019).
Greiner’s growth and crisis implications may be relevant to the context of firm profits in several ways: Firms with high profits should have more financial resources to withstand a crisis if capital is one of the resources that is necessary to do so. This implies that the firm may be able to respond by making investments (e.g., a crisis related to direction could mean that a firm considers if investment in new production capacity or new product development is needed) or to absorb a period of losses (e.g., if a crisis requires short-term losses during product development or investment). Also, firms with persistent profits may be better able to finance both scenarios than are firms with limited resources: a period of proactive investment and a period of absorbing losses.
Profit persistence is the subject of comparative empirical research, with cues from Mueller’s foundational work (
1986,
1990). A core question in this line of work has been: Will deviating profits return to the normal level over time? Empirical studies across varied contexts (Geroski and Jacquemin
1988; Schwalbach et al.
1989; Cubbin and Gerosky
1990; Yurtoglu
2004) have offered insight as well as some inconsistent findings (see Bentzen et al.
2005). Research on profit persistence has asked about the drivers of profits in incumbent firms; this research focuses often on the firm and industry conditions (Yurtoglu
2004; Schwalbach et al.
1989; Waring
1996) such as firm size, market share, and firm growth (see Gschwandtner
2012). This line of inquiry has been marked by studies at the industry level (Jenny and Weber
1990), or at a country-level (Yurtoglu
2004; Mueller
2003; Maruyama and Odagiri
2002; Kambhampati
1995), or including a small set of countries (Yamawaki
1989).
2.2 Incumbent Firm Profits, Entry, and Entry Regulation
The relationship between entry and the profit persistence of incumbent firms warrants greater attention in the empirical research (see Porter
1981; Dean et al.
2006) and is a meaningful question for study. Following a dynamic Schumpeterian view, entry or even the threat of entry could create competitive pressures on incumbent firms. Entry is theorized to discipline markets competitively (see Dean et al.
2006; Eklund and Lappi
2018), when new firms compete with incumbent firms for resources, suppliers, intermediaries, and buyers, as well as for market share and gains from innovation.
The role of entry itself in the process of creative destruction is often explicitly linked in contemporary research, but the role of the factors that can shape entry in this process is less clear. The importance of regulations—i.e., that institutional conditions matter—emerges as a point of convergence in a large body of research on economic outcomes broadly (Ketteni and Kottaridi
2019; Cette et al.
2016; Aghion et al.
2009; Williamson
2000) and entrepreneurship specifically (Stenholm et al.
2013; Djankov et al.
2002). Entry has been shown to be shaped by the institutional environment, in which regulations play a large role. Regulations have been linked not only to the rate of entry but also to the type, nature, and outcomes of entrepreneurial activities (Audretsch et al.
2019; Estrin et al.
2016; Klapper et al.
2006). A wide variety of settings across regulatory regimes can play a role in deterring or encouraging entry.
The origins and benefits or costs of regulation are theorized in contrasting ways among public interest and public choice perspectives (see Pigou
1938; Buchanan
1986; Stigler
1971). Regulation can play an important role by changing the cost structure that faces a firm and, in this way, setting out terms for the firm. When firms face crises that lead to growth, as theorized by Greiner (
1972), their ability and even mechanisms to respond could be affected by regulation.
Business regulation governs firm activities, including the requirements to create a new firm (e.g., entry regulation), treatment of labor (e.g., labor regulation), research and development (e.g., intellectual property protections), financing and access to capital (e.g., bank regulation), security of property (e.g., land tenure and property rights regulation), and so on. Though many regulatory arrangements are important, we focus on entry regulation because it is in principle relevant to all new business activity as it governs the process of market entry. We therefore examine how entry regulation affects profit persistence.
Klapper et al. (
2006) note that more complex entry regulation could create greater entry barriers and discourage the emergence of new firms, which could have a “chilling” effect on incumbent firms and mute the potential disciplining effect of competition. This could allow incumbent firms to maintain high profits. Yet at the same time, how various institutional and regulatory conditions might create or alleviate barriers to entry is not straightforward. In fact, recent research on the effect of regulations on entry demonstrates the non-monolithic nature of regulation (Audretsch et al.
2019; Charron et al.
2014) and that different types of regulations can matter (Eklund and Lappi
2018) at different times.
Entry regulation has been studied in single industries in a country (see Schivardi and Viviano
2011; Bertrand and Kramarz
2002) as well as comparatively across countries (see Djankov et al.
2002). Our interest is in the comparative cross-country research,
1 which is concerned with empirical effects on various entrepreneurial outcomes and points to mixed findings, often negative, for a range of outcome measures (Audretsch et al.
2019; Acs et al.
2008; Ardagna and Lusardi
2010; Ho and Wong
2007; Klapper et al.
2006).
In a cross-country study that linked entry regulation with incumbent firm outcomes and new firms, Klapper et al. (
2006) assessed the impact of entry regulation on the rate and average size of new firm entry and on productivity growth in incumbent firms; the authors consider that “costly entry regulations are a form of protection that has the most deleterious effect on the performance of seasoned incumbents” (
2006: 594). Bartelsman et al. (
2004) studied the process of creative destruction in driving productivity effects across 24 countries. They found important differences across industrialized countries, transition economies of Central and Eastern Europe, and the emerging economies of Latin America and East Asia. In addition, the nature of a particular industry is important: Klapper et al. (
2006) find that the role of relative entry into industries with “naturally” high entry is disproportionately higher in the presence of low national regulatory barriers (
2006: 605). They also found that high entry costs matter more in richer countries, which are also likely to be the countries that can more effectively enforce regulations.
Two recent studies point to heterogeneity of regulation as an important consideration. Audretsch et al. (
2019) studied multiple types of regulation, including entry, across implementation arrangements, such as paperwork, time needed to comply, and financial cost. They find heterogeneous influence of entry regulation on entrepreneurship. Eklund and Lappi (
2018) analysed the effect of product market regulation on profit persistence, including: components that are related to state control; barriers to entrepreneurship; and barriers to trade and investment. Their approach—which uses clusters representing policy regimes—finds that barriers to entrepreneurship are not significant for profit persistence but that barriers to trade and investment are positive and significant. Both Eklund and Lappi (
2018) and Audretsch et al. (
2019) point to the need to consider the multidimensionality of regulation. We therefore empirically investigate the role of entry and dimensions of entry regulation in explaining the profit persistence of incumbent firms.