Is Failure Good

Strategic Management Journal
Strat. Mgmt. J., 26: 617–641 (2005)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.470
IS FAILURE GOOD?
ANNE MARIE KNOTT1 * and HART E. POSEN2
1
Robert H. Smith School of Business, University of Maryland, College Park, Maryland,
U.S.A.
2
The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania, U.S.A.
Approximately 80–90 percent of new firms ultimately fail. The tendency is to think of this failure
as wasteful. We, however, examine whether there are economic benefits to offset the waste. We
characterize three potential mechanisms through which excess entry affects market structure,
firm behavior, and efficiency, then test them in the banking industry. Results indicate that failed
firms generate externalities that significantly and substantially reduce industry cost. On average
these benefits exceed the private costs of the entrants. Thus failure appears to be good for the
economy. Copyright  2005 John Wiley & Sons, Ltd.
INTRODUCTION venture. If so, then failed entrepreneurs may be as

heroic as successful entrepreneurs.
The entrepreneur who seeks private benefit in the In fact, there is some preliminary evidence to
face of long odds and succeeds is a sung hero that effect. In a longitudinal study of Texas sales
in the innovation literature. When successful, the tax receipts, Hicks (1993) found that employment
entrepreneur’s innovation generates economic ben- growth and wages increased as the half-life (the
efits above and beyond her private benefits. By length of time to achieve a 50% decrease in
filling unmet needs or satisfying old needs in new the population) of firms decreased. Thus, at first
ways, the entrepreneur fuels a process of cre- glance, it appears that failure may be beneficial.
ative destruction (Schumpeter, 1942). This process However, while the benefits are intriguing, the
increases social welfare either by displacing less direction of causality is unclear. Even if failure
effective incumbents or by forcing incumbents to ‘causes’ growth, the causal mechanism is not obvi-
match the entrant’s innovation. ous. A policy of arbitrarily killing off firms to
But what about entrepreneurs who fail ? While achieve the benefits is most certainly ill advised.
they suffer private losses, does their failure gener- The primary goal of this paper is to determine if
ate any economic benefits to offset those losses? the economic benefits are real. Does excess entry
It seems possible that the same creative destruc- generate these benefits or are they merely artifacts
tion process fueled by successful ventures may also of a process that jointly produces entry, failure and
be fueled by unsuccessful ventures. In short, the growth? If the benefits are real, the secondary goal
process may be blind to the outcome of a particular is to understand the causal mechanisms producing
them. This understanding may lead to policies that
Keywords: failure; entry; efficiency; spillovers; selection; stimulate ‘beneficial failure’.
competition To examine the broad question, we focus on
∗
Correspondence to: Anne Marie Knott, Robert H. Smith School three potential mechanisms through which failure
of Business, University of Maryland, 4515 Van Munching Hall,
College Park, MD 20742, U.S.A. (excess entry) might affect market structure and
E-mail: aknott@rhsmith.umd.edu thereby efficiency growth. The first mechanism is
Copyright  2005 John Wiley & Sons, Ltd. Received 7 April 2004
Final revision received 25 January 2005
618 A. M. Knott and H. E. Posen
a selection effect—firms surviving from a larger EXCESS ENTRY AND FAILURE

pool (more excess entry) ought to perform bet-
ter on average than the same number of firms Approximately 10 percent of all firms in the United
surviving from a smaller pool (Demsetz, 1973; States fail each year (U.S. Small Business Admin-
Jovanovic, 1982). The second mechanism is a istration, 1999). However, the rate of new firm
competition effect—the more firms in a mar- creation is roughly 11 percent of existing firms,
ket, the greater the stimulus to innovation (Bar-
so the stock of firms grows at a net rate of
nett and Hansen, 1996; Peretto, 1999; Aghion
1 percent. These aggregate numbers appear rather
et al., 2001; Knott, 2003). The third mechanism
tame—suggesting that each firm faces a 10 percent
is a spillover effect—the knowledge produced by
hazard rate, and also suggesting that there is a
excess entrants while ‘wasted’, in that it is no
healthy rate of churn—old entrenched firms being
longer appropriable by the failed firm, may be
replaced by vibrant young firms.
captured by survivor firms through spillovers. The
However, these aggregate numbers mask inter-
effects of interest here are the durable effects of
esting dynamics. Failure is disproportionately
excess entry, i.e., the effects due to firms that enter,
drawn from new firms. Data from the U.S. Cen-
but then fail.
sus Business Information Tracking Series (Headd,
This paper characterizes the potential impact of
each of the three mechanisms and then conducts 2003) indicate that 51 percent of firms exit within
an empirical test of the relative power of each their first 4 years. Thus failure risk looms large for
mechanism in explaining the economic impact of entrants, and is relatively non-existent for estab-
failed firms. This test is conducted in the bank- lished firms. Moreover, the phenomenon looks less
ing industry post deregulation. The industry was like churn than competition for the right to produce
chosen because it is fragmented, has a substantial in perpetuity.
knowledge component, and is marked by substan- The literature on failure examines the causal
tial failure. Fragmentation is important because it mechanisms for failure: Who are the 10 percent
allows us to compare differences across markets and why do they fail? We examine a very different
while controlling for technology. The knowledge question: Is 10 percent the right number, or would
component is important because the failure mech- the economy (producers and consumers jointly) be
anisms rely on efficiency improvements. These better off with either higher or lower failure rates?
improvements become more likely as knowledge Perhaps the failure rate is too low—more failure
and human capital come to dominate physical will produce greater economic growth by creating
capital. more industries and unseating less effective firms
We examine banking efficiency for all 50 states in established industries. Alternatively perhaps the
plus the District of Columbia over the period failure rate is too high, because investments in
1984–97. Analysis is done in two stages. In the failed new ventures produce no economic benefits
first stage, we characterize the annual efficiency and thus are merely a misallocation of resources. If
of each firm relative to a non-moving frontier. In the failure rate is too low, perhaps we should sub-
the second stage, we model firm efficiency in each sidize entry. If the failure rate is too high, perhaps
year as a function of the three mechanisms plus we should tax entry, so that only firms assured of
a set of controls. The approach we take is similar success will enter. Both the amount question and
to that taken in studies examining the micro-level the mechanism question have public policy impli-
components of aggregate productivity growth (see cations—the amount question determines whether
Bartelsman and Doms, 2000, for a review). intervention is warranted; the mechanism question
The paper proceeds as follows. First we review determines the form intervention should take.
the failure literature to extract hypotheses about We are far from answering the policy question of
the economic impact of failure. This review yields how to influence failure rates. However, we believe
three mechanisms. We characterize the impact of we can begin the debate by tackling the question
each of these mechanisms on cost dynamics. Fol- of whether failure produces any economic benefits.
lowing that we discuss the banking industry and If so, what are these benefits, and how substantial
the empirical model that appends the mechanisms are they? Before we begin, we want to frame the
to traditional models of banking efficiency. We discussion and our empiricism, by reviewing the
conclude with results and discussion. literature on failure.
Copyright  2005 John Wiley & Sons, Ltd. Strat. Mgmt. J., 26: 617–641 (2005)
Is Failure Good? 619
Failure mechanisms initial period of high mortality, but firms surviving

the period have lower subsequent mortality than
Probably the best approach to reviewing the liter-
those founded in more munificent periods (Baum
ature on failure is to work across disciplines, but
and Mezias, 1992; Swaminathan, 1996; Delacroix
within level of analysis. There are two relevant lev-
and Rao, 1994; Bamford, Dean, and McDougall,
els: market (population) and firm (organization).
2000). This is because firms surviving a compet-
They are related in that market phenomena deter-
itive environment are more fit than those chosen
mine when failure is most likely to occur, while
randomly.
firm phenomena determine who is most likely to
What these industry-level studies share is an
fail.
assumption of excess entry and a selection hypoth-
esis that high-performing firms will drive out
Industry-level studies lower-performing firms. An intriguing but distinct
question is why there is any excess entry. One very
Studies of failure tend to find that industries have interesting study (Camerer and Lovallo, 1999) pro-
life cycles: an emergent stage where demand is poses that excess entry arises from hubris regard-
uncertain and potential firms are cautious, a growth ing entrepreneurs’ ranking in a capability distri-
stage where demand exceeds supply and many bution, and then demonstrates the phenomenon
firms enter, and a shake-out where demand stabi- experimentally. These experimental findings are
lizes. The shake-out occurs because market capac- corroborated by empirical data (Wu and Knott,
ity grows in anticipation of continued demand 2005). We ignore issues of cause and degree of
growth. However, when growth subsides, capac- excess entry, and focus exclusively on whether
ity exceeds realized demand and firms compete there are economic benefits from the excess.
for slots in the market. In evolutionary economics
(Nelson and Winter, 1982; Klepper, 1996) firms
exit when their cost exceeds the decreasing market Firm-level studies
price. The firms surviving the shake-outs are those
with superior technical capability who throughout Firm-level studies of failure hold that there are
the industry’s life invested in process innovation firm life cycles and that these affect mortality
to drive down cost. The firms making these invest- as do industry life cycles. Typically young firms
ments expand output to fully capture the benefits have the highest mortality.1 In organization the-
of lower unit costs. The continuously shifting cost ory, this observation is attributed to Stinchcombe
curve combined with the continuously expanding (1965). His ‘liability of newness’ hypothesis holds
scale of these firms hastens the exit of later entrants that new firms have higher failure rates than older
or less R&D-intensive rivals. Thus evolutionary firms due to: (a) the cost of learning new roles
economics offers an endogenous model of indus- and tasks; (b) constrained resources; (c) lack of
try evolution that simultaneously predicts industry informal communications structures; and (d) lack
concentration and mortality rates. What evolution- of formal connections with customers and suppli-
ary economics fails to explain, however, is the fact ers. There is substantial empirical support for the
that in most industries entry and exit continue in decrease in mortality associated with age. How-
steady state. This steady-state churning is the phe- ever, it is unclear whether age or size (which is
nomenon of interest here. highly correlated with age) is the driving factor
Population ecology takes equilibrium industry (Hannan, 1998).
size as exogenous, but arrives at similar conclu- An alternative interpretation of the same obser-
sions to evolutionary economics regarding mortal- vation is that firms have heterogeneous but un-
ity. These are embodied in two density hypotheses. known capability, and that they enter an industry
The first hypothesis pertains to contemporaneous as long as the expected value of profits exceeds
density. The more firms competing for a given set the entry costs (Jovanovic, 1982; Lippman and
of resources, the higher the mortality rate (Hannan Rumelt, 1982). Once firms enter they learn how
and Freeman, 1989; Carroll and Hannan, 1989).
A second hypothesis pertains to the density at 1
Young firms include ‘adolescent firms’ with adequate resources
founding. This hypothesis holds that firms founded to sustain themselves through the first few years (Fichman and
during adverse environmental conditions suffer an Levinthal, 1991).
capable they are, and the firms with inferior capa- (3) What is the economic impact of these mis-
bility ultimately exit. takes? Camerer and Lovallo (1999) tackle the first
The converse of new firm liability is estab- question. Economic Census data provide empirical
lished firm advantage. Established firms accu- answers to the second question. We tackle the third
mulate knowledge over time, allowing them to question of economic impact. We do so from the
become more efficient (Nelson and Winter, 1982; perspective of those who survive. Thus our work
Levinthal, 1991; Klepper, 1996) and more con- is a complement to the prior literature discussed
sistent (inertial) (Hannan and Freeman, 1989) as above that considers failure from the standpoint of
routines become standardized (Nelson and Win- those who fail.
ter, 1982). Alternatively this knowledge allows
firms to better understand their relative fitness
(Jovanovic, 1982) such that they can make inform- MECHANISMS
ed exit decisions. The first three studies sug-
gest firms update their capability; the latter sug- The literature thus suggests three hypotheses
gests firms merely update estimates about their through which failure might generate economic
capability. benefits. The first hypothesis is a selection effect:
There is an extensive learning literature demon- firms surviving from a large population (more
strating that firms update their capability. What excess entry) ought to be better performers on
is less clear from this literature is whether the average than firms surviving from a smaller pop-
updating is autonomous, or whether it requires ulation (Demsetz, 1973; Jovanovic, 1982). This
deliberate efforts and investment to reduce costs. occurs because the performance distribution of a
Early literature (see Yelle, 1979, for a review) large population is denser than a small population.
showing the relationship between cumulative man- Hence if we draw the best n firms from two pop-
ulations with identical distributions, the nth firm
ufacturing experience and reduction in unit cost
from the larger population will be further to the
was interpreted to mean that learning was a cost-
right (higher performance) than the nth firm from
less byproduct of manufacturing experience. More
the small population. Excess entry thus simultane-
recent work (Sinclair, Klepper, and Cohen, 2000;
ously produces both high failure rates and supe-
Knott, 2002) has begun to show that the effects
rior firms. This hypothesis suggests that failure
of cumulative manufacturing experience disappear
is merely a byproduct of a phenomenon (excess
when R&D activities are incorporated properly.
entry) that yields superior firms. Accordingly, the
In other words, while knowledge may accumu- selection effect postulates a passive role of excess
late as a byproduct of manufacturing activity, the entry and failure. The excess entry does nothing to
exploitation of that knowledge requires overt activ- change the behavior of surviving firms. It merely
ity to incorporate it in new products or processes. If determines the distribution of firms that remain.
learning is autonomous then it should depend only The second hypothesis is a competition effect.
on the level of cumulative experience. The cor- Unlike the selection effect, this hypothesis holds
responding economic good hypothesis is learning- that excess entry affects the behavior of survivors.
by-doing or spillovers. If learning is overt, then In particular, recent work has shown analytically
we would expect it to increase with the level of (Peretto, 1999; Aghion et al., 2001; Knott, 2003)
competitive pressure. The implicit hypothesis is and empirically (Geroski and Pomroy, 1990; Blun-
competition. If only estimates of capability are dell, Griffith, and Van Reenan, 1995; Barnett and
updated, then the implicit hypothesis is selection. Hansen, 1996; Nickell, 1996; Hou and Robinson,
The general perspective shared by these litera- 2003) that the rate of innovation in a market
tures is that there is a pool of entrants with ran- increases with the number of firms.2,3 Increasing
domly distributed capability endowments. More
firms enter than the market can accommodate 2,
Competition has been characterized both as cross-price elas-
(excess entry), and inevitably those with inferior ticity and as the number of rivals. We define it here to be the
capability will be forced to exit. There are three number of rivals. However, the constructs are equivalent. Given
a fixed distribution of consumer tastes, increasing the number of
important questions inherent in this phenomenon: equidistant firms will also increase cross-price elasticity.
(1) Why do firms make these entry mistakes? 3
An earlier received view in industrial organization economics
(2) How many such mistakes will there be? and (see Reinganum, 1989) held that innovation is increasing then
the number of firms increases the likelihood that Rather, policies should focus on increasing the cost
a firm’s market position will be eroded, and this of entry, such that only firms assured of having
threat (associated with both declining profitability high efficiency will enter. Under the competition
and increased risk of failure) stimulates innovation and spillover effects, however, entry by weaker
(Barnett and Hansen, 1996). From this perspective, firms alters the behavior and capability of sur-
excess entry increases the competitive pressure in vivors. If either effect holds, public policy to stim-
the market because it temporarily inflates the num- ulate entry may be welfare enhancing to the extent
ber of firms. This excess competition leads to cost- the public benefits exceed the private costs of the
reducing investment that yields permanent benefits failed firms’ investments.
in the efficiency of survivors. This effect is con-
sistent with the ‘density at founding’ hypothesis
(Hannan and Freeman, 1989; Carroll and Han- MODEL
nan, 1989) discussed earlier. Firms surviving a
period of intense competition have higher fitness We model each of the three mechanisms to con-
than firms that have been insulated from com- struct a test of their contributions to the economic
petition. This effect is implicitly the hypothesis good effect. Before distinguishing between the
held by Porter (1990) in the Competitive Advan- three mechanisms, we outline some assumptions
tage of Nations. A highly competitive region forces and definitions that will be common across them.
innovation that makes surviving firms more fit for The first thing we define is a measure for
global competition. the economic benefits. Hicks (1993) used employ-
The effects discussed above are permanent ben- ment growth and wages. Employment rates and
efits from competition. In addition to these perma- wages are a function both of industry character-
nent benefits, we anticipate temporary responses to istics (labor demand) and economy characteristics
competition. The temporary effects involve behav- (labor supply). We prefer a measure that restricts
iors to maximize profits in the current period, such attention to firm characteristics. Accordingly, we
as removing slack and reducing prices (Vickers, look at firm efficiency. The advantage of an effi-
1995). These temporary effects and the associated ciency measure is that it captures innovation, so
impact on profits are what trigger cost-reducing long as innovation manifests itself either as lower
investment to better position the firm for future cost for same demand, or same cost for enhanced
competition (permanent effects). quality/demand.
The third hypothesis is a spillover effect. While We make some simplifying assumptions in char-
excess entry yields ‘wasted investment’ in that acterizing the impact of excess entry, which we
these investments are no longer appropriable by relax in the empirics. First we assume that the pop-
the failed firm, the value of the investments may ulations of potential buyers and potential firms are
be captured by survivor firms through ‘spillovers.’ fixed, and that all innovation is process innova-
These spillovers take on many forms: advertising tion. This allows us to work from a single inverse
expenditures that expand demand for the product market demand function, P (q), where P (q) < 0
class, improvements in the technology supplied to for all q. While we allow increases in demand,
the industry, and training of industry employees. we assume these arise from downward shifts in
While these spillovers occur even in the absence of the aggregate cost function C(q), where C(0) =
failure, the excess entry may create a larger base of 0, C (q) 0 and C (q) 0 for all q. Second,
output over which the cumulative learning occurs. we assume that firms operate at the same scale.
We examine the separate impact of each of these Accordingly, we can define the carrying capacity
hypotheses. If only the selection effect holds, then of the market in terms of the number of equal-
public policies to stimulate entry are misplaced. sized firms needed to satisfy demand. We designate
this market capacity as k. Note that k, the carrying
capacity, can vary across markets and over time.
decreasing in the level of competition—without any competition
there is no incentive to invest, but thereafter expected returns For example, the New York market supports more
decrease with the number of competitors. While there was some firms than does the Wyoming market, and the Ari-
inter-industry evidence that innovation increases then decreases zona market in 2003 supports more firms than it
with market concentration, those results disappeared in studies
using panel data along with controls for technology (See Cohen did in 1980. We define the number of firms who
and Levin, 1989, for a review). actually enter the market as n. Thus excess entry
is defined as n − k firms. Finally, we assume that the failed firms.

the endowment of firms (their initial unit cost) is
normally distributed, and we order firms i = 1 to q2 k
min
n from best performing (lowest cost) to highest P (q)dq − ci (q)

cost. The cost of the worst-performing, surviving 0 i=1
firm is designated ck , the cost threshold for the  q1 

k
market. This basic framework forms the basis for −  P (q)dq − ci (q) − F (n − k) (1)
comparing the three mechanisms. We now discuss i=1
0
the logical consequences of this set of assumptions
for each of the mechanisms. where F is the set-up cost, n is the number of total
entrants, and k is the number of surviving entrants.
Selection Thus excess entry shifts the aggregate cost curve
down and to the right. The extent of this shift
The selection hypothesis holds that as the num- is a function of the distribution of the potential
ber of entrants, n, increases, the efficient threshold, entrant pool and the probability of entry. This
ck , determining which k firms survive is increased. shift increases both output and buyer surplus by
This effect is illustrated in Figure 1. In the baseline displacing less efficient producers. The net effect
(Figure 1a), four firms enter the market. Arranging on producer surplus is ambiguous.
their unit cost from lowest to highest (left to right)
creates the aggregate cost curve, C1 . This cost
Competition
curve intersects demand, D, at q1 , generating mar-
ket price, p1 . If we allow excess entry (Figure 1b), The competition hypothesis holds that entrants
then as additional firms enter they compete on cost affect the strategic behavior of surviving firms.
to determine survivors. As in Figure 1(a), firms are In particular, the intensified competition stim-
ordered from lowest to highest unit cost, but here ulates strategic investment to reduce cost and
Firms 6 and 8 have replaced Firm 4 because they thereby escape competition (Barnett and Hansen,
had lower cost. Two other firms, 5 and 7, attempted 1996; Peretto, 1999; Aghion et al., 2001; Knott,
to enter, but found their cost to be higher than Firm 2003). What distinguishes this hypothesis from the
3. The new set of firms defines a new aggregate prior one is that under the selection effect the
cost curve, C2 , with shallower slope. This reflects unit costs of survivor firms remain at their ini-
the fact that with competitive selection survivor tial endowments. Aggregate cost decreases only
firms are increasingly drawn from a smaller por- because firms with less efficient endowments are
tion of the right tail of cost distributions. Because replaced with more efficient ones. Here, under
C2 is below C1 , output is increased (from q1 to the competition effect, the aggregate cost curve
q2 ), and price is decreased (from p1 to p2 ). The shifts because the costs of existing firms decrease
welfare contribution from excess entry under this below their initial endowments. Competitive pres-
hypothesis is expressed as the present value of the sure to remain in the market, and the eroding
annual surplus increase minus the investments of market position from shares stolen by the entrants
P P
C1
p1
C2
p2
f4 D D
f3 f8 f6 f3
f2 f2
f1 f1
q1 Q q2 q3 Q
Baseline (k draws) Excess Entry (k+e draws)
Figure 1. Welfare increase from selection effect (Hypothesis 1)

P P
C1
p1 p1
C3
p3
D f4 D
f4
f3 f3
f2 f2
f1 f1
q1 Q q1 q2 Q
Baseline (k draws) Excess Participation
Figure 2. Welfare increases from competition effect (Hypothesis 2)
(Mankiw and Whinston, 1986), stimulate cost- Spillovers

reducing investment. This competition effect is
characterized in Figure 2. Here the original four The spillover hypothesis holds that the knowl-
entrants remain in the market but their costs are edge generated by failed firms is expropriated by
now lower due to cost-reducing investments to bet- surviving firms. This expropriation takes place in
ter position them for future competition. the same manner as spillovers between surviving
The baseline in Figure 2 (Figure 2a) is the same firms—through employee turnover across firms,
as that in Figure 1(a). If we allow excess entry interactions with suppliers and customers, publica-
(Figure 2b), then firms are under additional com- tions in the trade literature, and patents (Hoetker
petitive pressure from these excess entrants. This and Agarwal, 2003). It also becomes imbedded
pressure stimulates investments to reduce cost. If in the products of failed firms and can become
we ignore selection effects, then the same four imbedded in inputs from suppliers. Following con-
firms supply market output, but the aggregate cost vention, we assume that spillovers are a function
curve shifts down because each firm has lower cost of the cumulative activity of all firms in the market
than it would in the absence of the additional com- (Spence, 1981; Lieberman, 1987).4
petitive pressure. Again, because C2 (q) is below This spillover effect is like the competition
C1 (q), output is increased (from q1 to q2 ), and effect in that excess entry decreases the costs of
price is decreased (from p1 to p2 ). The welfare surviving firms. The distinction between the two
contribution from excess entry under the competi- hypotheses is subtle. Under competition firms are
tion hypothesis is expressed as follows: driven to invest in innovation to maintain their
competitive position—thus they actively reduce
q3 costs. Under the spillover effect firms passively

k
P (q)dq − cit (q) benefit from the cumulative activity of other firms
i=1
in the market. This occurs because the maximum
0
 q1  size of the market determines the aggregate spend-

k ing on marketing and R&D, the innovative activity
−  P (q)dq − ci (q) − F (n − k) (2) of suppliers, and the number of employees with
0 i=1 industry-specific skills (the sources of spillovers).
Thus competition shifts the aggregate cost curve

4
down and to the right due to decreases in the Whereas spillovers are typically measured as the pool of indus-
try R&D weighted by technological and geographic proximity
cost of each survivor firm. Because investment (Jaffe, 1986, 1988), our measure of spillovers (cumulative out-
decisions are typically made annually in response put) takes a form similar to that for learning curve effects
to the competition faced in the preceding period, (Lieberman, 1987). We wish to make two points regarding our
measure. First, given industry R&D intensity is fairly stable over
the extent of these cost improvements is a function time, relative pooled output will match relative pooled R&D.
of the cumulative number of excess entrants and We prefer output to R&D investment because in many instances
the length of time they remain in the market. As in innovation expenditures will not appear in an R&D line item,
e.g., adopting new manufacturing technology from suppliers.
the selection effect, this shift increases both output Second, we use the term spillovers rather than learning curves to
and buyer surplus. distinguish between intra-firm investments and rival investments.
Thus spillovers shift the aggregate cost curve or retail, where the heterogeneity in retail offer-
down and to the right due to passive decreases in ings limit market comparison. Third, we examine
the cost of each survivor firm. The extent of these annual data whereas prior studies have used cen-
cost decreases is a function of the cumulative out- sus data and thus have looked at changes over the
put of all entrants. The resulting shift in aggregate 5-year period between censuses. Finally, and most
cost increases both output and buyer surplus such importantly, we introduce a new factor—excess
that: entry. When prior studies have examined exit and
entry they have done so in the context of realloca-
q4
k tion effects—displacement of old inefficient estab-
P (q)dq − cit (q) lishments with more efficient entrants. While real-
0 i=1 location is one component of the excess entry phe-
 q1  nomenon, it considers only the selection effects of

k
successful entrants and failed incumbents, whereas
−  P (q)dq − ci (q) − F (n − k) (3) we also consider the externality on industry cost.
i=1
0 The empiricism in these micro-level studies is
typically done in two stages. In an initial stage,
In addition to the market-level effects on cost researchers develop estimates of establishment-
that we model here, there may be industry-wide level efficiency in each period. In a subsequent
effects. These will be treated as exogenous shocks. stage they recompose changes in aggregate pro-
In fact they too may be endogenous to aggregate ductivity growth using contributions from entrants,
industry activity. exits, and continuing establishments. In general
the studies have found (1) that there is consider-
able heterogeneity in establishment productivity,
EMPIRICAL APPROACH (2) that relative productivity is durable—establish-
ments with high relative productivity in one period
All three mechanisms predict lower aggregate cost are likely to exhibit high relative productivity in
with excess entry for a given market. They dif- subsequent periods, (3) that a significant portion
fer only in the means through which lower cost of productivity improvement (approximately 25%)
is achieved. Accordingly, our empirical strategy arises from reallocation effects—the displacement
compares firm efficiency across markets and over of low productivity establishments with higher
time within the same industry. This approach productivity entrants, and (4) the most significant
allows us to examine the effects of different lev- source of productivity improvement is expansion
els of entry and exit while controlling for industry of existing plants.
demand and technology. We begin our empiricism by replicating the
The empirical approach we take is similar to that approaches in the prior studies. We then extend
in studies examining the micro-level components the empiricism to examine the impact of entry and
of aggregate productivity growth (see Bartelsman exit on market structure and the impact of structure
and Doms, 2000, for a review of studies in the on firm efficiency.
manufacturing sector; see Foster, Haltiwanger, and
Krizan, 2002, for a recent study in the retail sec-
Industry
tor). We extend those studies along four dimen-
sions. First, we examine a new sector—financial We conduct our tests in the banking industry
services. Financial services are important in that following deregulation. The industry was chosen
they are a large ($2.1 trillion in 2001) and growing because it is fragmented with localized competi-
(real annual rate of 6.5% over the past 10 years) tion, has a substantial knowledge component (such
sector of the economy. Moreover, the fact that they that cost improvement is feasible), and is marked
are more labor intensive than other sectors sug- by significant failure. Moreover, failure in the
gests that the patterns of productivity growth may industry is due to inefficiency rather than mar-
differ from those in sectors where vintage capital ket selection over differences in product offerings
effects are important. Second, we introduce market (Berger and Humphrey, 1992). Thus industry gains
effects. Previous studies dealt with manufacturing from failure, if any, are likely to match the mech-
industries where all firms share a common market, anisms we have modeled.
Fragmentation is important because it allows is difficult to determine a relevant radius for com-
us to compare discrete markets within the same petition. Consumers might choose a branch close
industry. Since the markets are in the same indus- to their home or one close to their office, but they
try we assume that each market faces the same may also choose a bank based on the fact that it
inverse demand function and shares the same tech- had branches near both, suggesting aggregation to
nology. Thus we can compare the changes in a metropolitan area. Continuing that logic, a state is
market structure (arising from excess entry) while merely further aggregation, representing on aver-
controlling for other factors affecting cost across age 7.1 Metropolitan Statistical Areas (MSA), 1.3
distinct industries. We can also control for dif- Primary Metropolitan Statistical Areas (PMSA),
ferences in level of demand through differences or 0.4 Consolidated Metropolitan Statistical Areas
in economic conditions across markets. Further- (CMSA). Given the difficulty in choosing a level
more, because banking is regulated, we can obtain of aggregation for branch-level competition, and
firm-level panel data. We confine our analysis to given the fact that the state captures headquarters
the period following deregulation because we can competition, we define a market as a state.6
plausibly argue that knowledge obtained prior to
deregulation is heavily depreciated, and thus can
Bank failure
be ignored. The high failure and merger rates post
deregulation support this contention (see Figure 3). Exits from the banking industry take the form
Our operational definition of market in the anal- of failures and mergers. Studies of failure in
ysis is a state. In part this definition arises from the banking industry during the period indicate
a data limitation. The unit of observation in the that the firms which failed are those deemed
FDIC data is an insurance certificate. A separate inefficient with respect to the new production
certificate is required for each state in which a function (Berger and Humphrey, 1992). It is impor-
bank operates,5 but covers all branches for that tant to note that the FDIC rarely allows banks
bank operating within the state. Ignoring for a to fail outright (their term is ‘paid outs’—banks
moment the data limitation, there are two dis- close their doors, leaving the FDIC to compensate
crete definitions of market: the state, represent- depositors). The majority of failures are resolved
ing certificate/headquarters level competition; or through forced mergers between the ‘failed’ insti-
municipality, representing branch-level competi- tution and a healthier institution. Thus it is less
tion. A reasonable argument for not doing branch-
level analysis, even if data were available, is that it 6
As an additional test of reasonableness, Petersen and Rajan
(2002) examine the distance between small firms and the bank
branch they use most frequently. They find that the distance
capturing 75 percent of firms in 1990–93 is 68 miles, and
5
Interstate branching was forbidden prior to June 1997 unless growing rapidly due to information technology. This implies a
state legislation expressly approved it. The first state to allow circumscribed area of 14,524 miles, which is greater than the
interstate branching was New York in 1992, under conditions land area of 10 states, and equal to 26.3 percent of the mean
of reciprocity. As of 1993 only four states allowed interstate land area of all states excluding Texas and Alaska. Thus state is a
branching. Results are robust to excluding data post 1993. meaningful market boundary even for branch-level competition.
Banking Entry & Exit 1984-1997

700
600
500
enter
Count
400
merge
300
fail
200
100
0
1984
1985
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1986
Year
Figure 3. Banking failures following deregulation

likely that knowledge from the failed firms will The basic translog cost function mimics the objec-
be broadly expropriated by surviving firms. Exits tive function for firm i in year t that is minimizing
may also take the form of unforced mergers which total cost, cit , by choice of output levels, yit , taking
act as another mechanism through which lower- input prices, wit , as given:
efficiency banks exit the industry. In the case of
mergers, both forced and unforced, the appropri- cit = β0 + β1j yitj + β2k witk
able assets remain private, rather than being dis- j k
persed. Figure 3 quantifies exits by each of the
types. + 1/2 β y y +
j j
3jj it it
j j

Empirical model + 1/2 β4kk witk witk
k k
Analysis proceeds in two stages. In the first stage
+ β5j k yitj witk + uit + eit (4)
we model an industry cost frontier to collect mea-
j k
sures of efficiency for each firm in each year. In
the second stage, we model firm efficiency (from where:
stage 1) as a function of the three failure benefit
mechanisms. cit = log observed firm cost;
yitj = vector of log output levels—j indexes out-
put elements;
Stage 1: Firm efficiency witk = vector of log input prices—k indexes input
We follow convention in studies of bank effi- elements;
ciency by modeling a stochastic cost frontier using uit = cost inefficiency with truncated normal
a translog cost function (Cebenoyan, Papaioan- distribution;
nou, and Travlos, 1992; Berger, Hancock, and eit = error term with normal distribution.
Humphrey, 1993; Mester, 1993; Hermalin and We pool data for all firms over 14 years using
Wallace, 1994). Stochastic frontier analysis, the stochastic frontier model to capture firm–year
developed by Aigner, Lovell, and Schmidt (1977), measures of cost inefficiency relative to a global
is based on the econometric specification of a cost cost frontier. We collect the estimates of the
frontier. The stochastic frontier model assumes expected value of firm–year cost inefficiency in
that the log of firm i’s cost in year t, cit , dif- Stage 1, E(uit |eit ), which for convenience we con-
fers from the cost frontier, cmin , by an amount that tinue to label as uit , and use the estimates as the
consists of two distinct components: a standard dependent variable in Stage 2 to test the failure
normally distributed error term eit , and a cost inef- mechanisms.
ficiency term modeled as a non-negative random
variable uit —which we assume to take the form
of a truncated normal distribution.7 Stage 2: Test of mechanisms
We use the translog cost function to accommo- In a second stage, we model firm cost inefficiency,
date the complex array of bank inputs and outputs. uit , as a function of excess entry in a given mar-
In addition, the translog form accommodates trade- ket where, as per the discussion above, a market is
offs in both market strategies (product mixes and operationalized as a state. We utilize different mod-
prices), and operational strategies (input mixes).8 els for the selection effect versus the competition
and spillover effects.
7
Other distributional assumptions are also possible, the most
common of which are the half normal and exponential distribu-
tions. All results are robust to these alternative distributions. Selection
8
Note that the translog model used in panel studies of the bank-
ing literature does not include a fixed effect. The objective of We test the selection effect by characterizing a
their studies, and ours, is to capture between-firm differences time-varying cost threshold modeled as the addi-
in efficiency over time. The inclusion of a fixed effect would
t
remove mean firm efficiency differences and thus only capture tive effect of cumulative entry, As,t−1 , the total
variation within firms over time. We remove mean firm differ- 1
ences in the second stage of our analysis in which we directly number of firms that have entered state s from
model the drivers of heterogeneous firm efficiency. 1984 through year t, and firm inefficiency, uit . We
use a logit model to estimate firm failure hazard and significant. Note that if potential entrants dis-
as a function of the cost threshold, and vectors cipline the market through limit-pricing (discour-
of controls for state effects, firm-level effects, and aging entry by charging a low price) (Bain, 1949;
year effects: Milgrom and Roberts, 1982), then there should be
t no response to entry. In that case both β1 and β2
should be insignificant.
P (exit)it = α0 + α1 As,t−1 + α2 uit
1
+ γ1 StateCtrlst + γ2 F irmCtrlsit Spillovers

+ Y eart + eit (5) Finally, we test the spillover effect by examin-
ing the cumulative output of all firms over each
If there are selection effects, such that increasing year a firm is in a market (permanent plus ultimate
the number of entrants improves the pool of sur-
t
failures), ysit . The spillover effect is distin-
vivors, we expect the coefficients α1 and α2 to be 1 i
positive and significant. This would indicate that guished from the competition effect by the fact that
cumulative entry drives exit, and that the mecha- spillovers are assumed to accumulate passively
nism for determining who exits is firm efficiency.9 from learning by doing. In contrast, the competi-
tion effect presupposes an overt response to excess
rivalry. If surviving firms benefit from spillovers
Competition we expect β3 to be negative and significant. Note
We test the two remaining mechanisms jointly in that the spillover effect includes learning from
a single equation for firm cost inefficiency, uit : incumbents as well as entrants, since there is
no reliable means to distinguish between them.

t
t
Accordingly, we assess the entrants’ contributions
uit = β0 + β1 Est + β2 Est + β3 ysit−1 mechanically by applying β3 to the entrants’ out-
1 1 i
put.
+ γ1 StateCtrlsst + γ2 F irmCtrlsit Equation 6 tests the competition and spillover
+ Y eart + λi + eit (6) effects discussed above, while controlling for time-
varying market and firm characteristics, year
We test the competitive effects by looking sep- effects, and firm fixed effects, λi . The year effects
arately at current period excess competition, Est , will capture industry-wide shocks such as new
and cumulative excess competition (competition), technology. The firm fixed effects will capture
t fixed differences between firms in addition to cap-
Est , for market s in year t. Current period turing fixed differences between markets, such as
i
excess competition examines the immediate effects regulation and taxation.
of increased competition. This allows us to charac-
terize the competitive pressure triggering the inno- Data
vation response (Levitt and March, 1988; Barnett
and Hansen, 1996). If incumbent firms respond tac- The data for the study come from the FDIC
tically to entry by reducing slack, we expect β1 to Research Database, which contains quarterly finan-
be negative. If they respond by reducing price, we cial data for all banks filing the ‘Report of Con-
expect β1 to be positive, reflecting lower price for dition and Income’ (Call Report). Upon entry
a given level of resource costs (equivalently higher into the market, each bank is allocated a unique
cost to price ratio). certificate number by the FDIC—and we take
Cumulative excess competition examines the the bank (certificate number) as our fundamental
strategic effects of cost-reducing investment to bet- unit of analysis. The FDIC classifies and com-
ter position the firm for future competition. If piles data on two distinct types of banking enti-
firms respond strategically to entry through cost- ties: (a) Commercial banks, which include national
reducing investment, we expect β2 to be negative banks and state chartered banks (excluding Thrifts)
insured by the FDIC; and (b) Savings banks, which
9
We later compare α1 and α2 to determine the marginal impact operate under state or federal banking codes related
of an excess entrant on the industry cost threshold. to Thrift institutions. Commercial banks, which
are the focus of this paper, differ from Savings carrying capacity of the market s in year t. Using
banks in that Saving banks have traditionally been the logic of efficient markets, we measure this vari-
limited in both the types of deposits they could able simply as the number of exits from market s in
accept and the types of loans they could provide. year t, where exits include both failure and merg-
Given the well-known irregularities in the Thrift ers.10 To the extent that optimistic firms remain in
industry during the 1980s, we confine our anal- the industry during periods of losses, this measure
ysis to commercial banks. We examine each of understates the excess. Cumulative excess is there-
the 50 states plus the District of Columbia for fore the sum of the exits over all years since 1984.
the period 1984–97. This initial data set con- In addition, in order to create the cumulative out-
tains 694,587 firm–quarter observations. Follow- put for market s in year t, we aggregate firm-level
ing convention in the banking literature we aggre- output at the state level as the sum of mortgage,
gate to annual data by averaging the quarterly data non-mortgage loans, and investment securities of
(Mester, 1993). The final first-stage data set com-
all firms located in the state. These were the y1 , y2
prises 170,859 firm–year observations.
and y3 variables in the Stage 1 analysis.
While there is considerable debate as to the
A number of firm-level control variables are
choice of inputs and outputs in the banking sec-
included in the model. In order to control for
tor, a review of the literature suggests that there is
some convergence around a version of Equation 4 branch scale effects not already accounted for
that sees physical capital, financial capital, and in the first-stage estimation, we include three
labor as inputs to the production process and variables: (a) branch count—number of branches
various forms of loans (mortgages, other loans operated by the bank; (b) branch size—the aver-
and securities) as outputs (Wheelock and Wil- age size of a branch measured in terms of total
son, 1995). We collect data to construct seven output in thousands of constant 1996 dollars;
variables related to banking efficiency in log (c) cum output bank—the sum of bank output
thousands of constant 1996 dollars. The depen- over all branches and years in thousands of con-
dent variable is total cost, cit —total interest and stant 1996 dollars.
non-interest expenses. The six independent vari- Approximately one-third of banks are owned by
ables are divided between input prices, wit , and a bank holding company that controls more than
output quantities, yit . Input prices are: (a) labor one bank (certificate). For such banks, we include
price—salary divided by the number of full- a dummy variable, holding company, as well as
time equivalent employees; (b) physical capital a number of measures of the size of the hold-
price—occupancy and other non-interest expenses ing company: (c) hc certificates—the number of
divided by the value of physical premises and additional banks (certificates) held by the holding
equipment; (c) capital price—total interest ex- company; (d) hc branches—the number of addi-
pense divided by the sum of total deposits, other tional branches in the bank holding company sys-
borrowed funds, subordinated notes and other lia- tem beyond the number of branches in the observa-
bilities. Output quantities are stocks ($1000) of: tion certificate; (e) hc states—the number of addi-
(d) mortgage loans; (e) non-mortgage loans; and tional states in which the holding company oper-
(f) investment securities. ates banks.
In order to test the hypotheses in the second- We control for economic differences across mar-
stage model, we gather aggregate state–year data kets and over time using annual data on population
on entry and exit from the FDIC database to cre-
and housing starts. Permanent differences across
ate the cumulative entry (additions), excess entry,
states, e.g., regulatory conditions, are subsumed by
cumulative excess entry, and cumulative output
the firm fixed effects.
variables. We define entry as a new commercial
banking institution that comes into existence either
by way of a new charter or the conversion of an
existing charter. Likewise, we define exit as an
10
event that leads to the termination of a bank (cer- The important consideration here is the extent to which exits
remove operational capacity from the market. Descriptive data
tificate) either in the form of a forced failure or suggest that all exits, be they failures or mergers (FDA forced as
merger, or an unforced merger. We define excess well as unforced), remove branch capacity, and thus we consider
entry as the number of institutions in excess of the both types of exits as constituting excess entry.
RESULTS on the cost frontier. The data also indicate that

while the mean cost inefficiency changes over time
Stage 1: Firm cost efficiency in response to changing technologies and demand
conditions, the general trend is toward increasing
Table 1 provides variable descriptions and sum-
efficiency (decreasing cost).
mary statistics of the data used in Stage 1. We esti-
mate the Stage 1 stochastic frontier model assum-
ing a truncated normal distribution for the ineffi- Comparison with longitudinal micro-data (LMD)
ciency term and a normally distributed error term. studies
Estimation is conducted using maximum likeli- To provide more insight into the dynamics of
hood techniques. Results from the Stage 1 anal- banking sector efficiency we mimic LMD studies
ysis using Equation 4 are given in Table 2. The and present a transition matrix of firm efficiency
objective of the Stage 1 analysis is to provide (Table 3). The transition matrix characterizes how
the firm–year cost inefficiencies that serve as the a firm’s efficiency in one period is related to
dependent variable in Stage 2. While a discus- its efficiency in the subsequent period. The table
sion of the estimated coefficients of the frontier decomposes firm efficiency into quintiles, then
model is outside the scope of this paper, the coef- depicts year-to-year movements across quintiles by
ficient estimates are consistent with expectations comparing rows and columns. As an example, take
as: (a) total costs appear to rise with output and the row labeled 1. This represents the highest-
increases in the price of capital; and (b) firms sub- performing (lowest cost-inefficiency) firms in a
stitute labor and physical capital in response to given year. The table indicates that the majority
changing prices for these inputs. The more impor- of firms (78%) remain in the top (lowest cost)
tant result of the Stage 1 frontier estimation is quintile in the subsequent year, 15 percent drop
the expected value of the inefficiency terms, uit . one quintile, 2 percent drop two quintiles, less than
The distribution of the cost inefficiency is given in 1 percent drop to each of the bottom two quintiles,
Figure 4 and the mean value over time is depicted 2.7 percent merge with other firms and 0.5 percent
in Figure 5. The mean uit over the entire period is fail outright.
0.171, which indicates that the total cost for the The table indicates three patterns of interest.
mean firm is 18.6 percent above that of a firm First, relative firm efficiencies are fairly stable.
Table 1. Stage 1 data summary
Variable Description Obs. Mean S.D. Min. Max.
c cost 174,869 7.98 1.27 −0.82 16.76

w1 price labor 174,673 2.97 0.28 −4.85 9.39
w2 price physical capital 173,999 −1.64 0.73 −9.93 5.63
w3 price capital 173,789 −3.54 0.41 −12.58 3.32
y1 mortgage 172,503 9.47 1.58 −1.37 17.86
y2 other loans 173,373 9.63 1.40 −0.70 18.55
y3 securities 173,828 9.58 1.47 −1.27 17.51
Units: ln(thousand, 1996 dollars).
Variable c w1 w2 w3 y1 y2 y3
c 1
w1 0.1929∗ 1
w2 −0.0418∗ 0.2792∗ 1
w3 0.1464∗ 0.0921∗ 0.0452∗ 1
y1 0.8640∗ 0.1151∗ −0.1322∗ −0.0463∗ 1
y2 0.9146∗ 0.1493∗ −0.0594∗ 0.1201∗ 0.7711∗ 1
y3 0.7603∗ 0.0821∗ −0.0922∗ 0.0259∗ 0.6883∗ 0.6934∗ 1
∗
Significant at 5%
Table 2. Results from Stage 1 regression
Dependent variable: ln(cost)

170,859 observations
Coeff. S.E. Coeff. S.E.
w1 −8.691e − 01∗∗ (30.644) w1w3 −2.312e − 01∗∗ (61.988)

w2 −2.085e − 01∗∗ (17.544) /2w2w2
1
−4.964e − 03∗∗ (4.675)
w3 2.078e + 00∗∗ (85.535) w2w3 −2.519e − 02∗∗ (15.625)
y1 1.942e − 02∗ (2.073) 1
/2w3w3 2.564e − 01∗∗ (72.979)
y2 4.262e − 01∗∗ (41.009) y1w1 3.230e − 02∗∗ (22.174)
y3 2.784e − 01∗∗ (30.382) y1w2 −7.015e − 04 (0.969)
/2y1y1
1
9.331e − 02∗∗ (165.733) y1w3 −3.159e − 02∗∗ (24.569)
y1y2 −6.028e − 02∗∗ (120.751) y2w1 −2.019e − 02∗∗ (12.595)
y1y3 −2.049e − 02∗∗ (39.425) y2w2 −9.330e − 03∗∗ (10.312)
/2y2y2
1
1.225e − 01∗∗ (165.107) y2w3 2.952e − 02∗∗ (21.413)
y2y3 −5.541e − 02∗∗ (95.188) y3w1 −3.038e − 02∗∗ (21.670)
1
/2y3y3 8.827e − 02∗∗ (190.369) y3w2 1.418e − 02∗∗ (19.267)
/2w1w1
1
2.011e − 01∗∗ (43.998) y3w3 1.620e − 02∗∗ (12.903)
w1w2 3.016e − 02∗∗ (16.267) Constant 5.320e + 00∗∗ (54.442)
E(uit |eit ) 1.707e − 01∗∗ 0.172
Absolute value of t-statistics in parentheses.

∗
significant at 5%; ∗∗ significant at 1%
Cost Inefficiency Density Function

8
6
Density
4 2
0
0 .5 1 1.5 2
cost_inefficiency
Figure 4. Histogram of firm-year efficiency metrics
The highest percentages are along the diago- selection effects) are similar to those found in
nal, meaning that in general firms remain in the LMD studies of other sectors. Third, new firms
same cost quintile. Second, failures and mergers tend to enter at the industry extremes, 27 percent
increase with firm cost. The highest percentage enter the lowest cost quintile, while 60 percent
of mergers and failures are coming from the enter the highest cost quintile. Again, this pattern
highest-cost firms. Thus the table provides prelim- is shared with LMD studies in other sectors.
inary evidence of a selection effect as the lowest- To complete the parity with prior LMD studies,
performing firms are being driven from the mar- we conduct an additional test of the reallocation
ket. These patterns (persistent heterogeneity and effects. We created distributed lag models for
Mean of Cost Inefficiency
.2 .15
mean of u_tn_pl
.1 .05
0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Figure 5. Mean cost inefficiency
Table 3. Year-to-year transition matrix of firm efficiency
Next year quintile

Low cost High cost
1 2 3 4 5 Merge Fail Total
Enter 670 63 96 179 1507 0 0 2515

26.64 2.50 3.82 7.12 59.92 0.00 0.00 100
Low cost 1 31,759 6,054 905 358 379 1,097 201 40,753
77.93 14.86 2.22 0.88 0.93 2.69 0.49 100
This year 2 5,362 17,327 6,797 1,178 246 1009 86 32,005

quintile 16.75 54.14 21.24 3.68 0.77 3.15 0.27 100
3 702 6,447 15,857 6,374 770 1,187 135 31,472

2.23 20.48 50.38 20.25 2.45 3.77 0.43 100
4 254 923 6,074 16,164 5,141 1,414 244 30,214

0.84 3.05 20.10 53.50 17.02 4.68 0.81 100
5 394 346 817 4,736 22,282 1,968 790 31,333

High cost 1.26 1.10 2.61 15.12 71.11 6.28 2.52 100
Total 39,141 31,160 30,546 28,990 30,325 6,675 1,456 168,293

23.26 18.52 18.15 17.23 18.02 3.97 0.87 100
Includes firms in all states in the industry at any time from 1984 to 1997.
Entrants are those entering as new certificates, but do not include conversions.
entering and exiting firms to track their efficiency Figure 6 presents the results for exiting firms. The
following entry and preceding failure. Figures 6 results indicate that lower-performing firms exit
and 7 present graphical results of this analysis.11 the industry, confirming the preliminary results
in the transition matrix. The new insight is that
11
Coefficient estimates are available from the authors. failing firms not only have higher cost than the
Exiting Firm Cost Inefficiency

Cost Inefficiency: Relative to firms more than 5
years from exit
0.20
fail 0.18
merge 0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
4 3 2 1 0
Years to Exit
Figure 6. Exiting firm cost inefficiency histories
Entering Firm Cost Inefficiency

Cost Inefficiency: Relative to incumbent firms and
entrants more that five years post entry
0.60
0.55
enter_survive
0.50
0.45 enter_merge
0.40 enter_fail
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
- 0.05
0 1 2 3 4
Years from Entry
Figure 7. Entering firm cost inefficiency history
industry overall, but their cost deteriorates as they entry. For surviving entrants, performance nearly
approach their exit year. While these effects hold matches that of incumbents by the third full year.
for both failures and mergers, they are more pro- Entering firms that fail match surviving entrants’
nounced for failures. In fact, failing firms have cost performance for the first 3 years, then show a
inefficiencies that are twice the industry average,
dramatic reduction in efficiency, mimicking the
resulting in a 26 percent increase in overall cost.12
Figure 7 presents the results for entering firms. results in Figure 6. Interestingly, firms that merge
The results indicate that entering firms tend to have within 5 years of entry are the poorest-performing
higher costs than incumbent firms, and that their entrants. In general, the results in Figure 7 indicate
cost inefficiencies are twice the industry average that those firms who entered in the highest cost
in the entry year (0). We further disaggregate the quintile in Table 3 are unlikely to recover.
data into firms that survive more than 5 years, Overall the micro-level components of banking
and those that fail or merge within 5 years of efficiency seem to match the patterns found in
other sectors. There is considerable heterogeneity
12
The cost inefficiency (in ln form) increases from the mean
of 0.18 by approximately 0.18 to 0.35. This corresponds to a
in banking efficiency (Figure 4), and the relative
26 percent increase in costs. efficiencies are durable (Table 3).
Stage 2: Test of mechanisms is a rather counter-intuitive result. However, fur-

ther analysis (available from the authors) indi-
Having generated firm cost inefficiencies and cates that the results pertain to unforced merg-
showed comparability between the micro patterns ers (consolidating weak banks) rather than fail-
of aggregate efficiency improvement within bank- ures.
ing and those in other sectors, we now proceed
with the formal tests of the excess entry mecha-
nisms. We look first at tests of selection effects and Competition and spillovers
then at tests of competition and spillovers effects. Results for the test of competition effects using
Summary statistics for the data supporting these Equation 6 are given in Table 6. The equation
tests are presented in Table 4. considers both the immediate, tactical effects of
current competition and the strategic effects of
Selection cumulative exposure to excess competition. We
test the tactical effects through the variable excess
Results for test of the selection effects using a entry and test the strategic effects through the
pooled logit estimation of Equation 5 are given variable cumulative excess entry. We examine the
in Table 5. The equation creates a measure of an impact of each variable on firm cost inefficiency
evolving cost threshold by examining market-level (negative coefficients decrease cost).
effects (how much exit there will be) and firm-level Model 2 indicates that excess entry is posi-
effects (which firm is most likely to exit). The main tive and significant, indicating that margins fall
results, presented in Model 4, indicate that both (costs rise) with the number of current excess
cumulative additions and cost inefficiency are pos- competitors. This suggests the immediate effect
itive and significant. That is, an increase in either of excess competition is to reduce price (same
cumulative additions or cost inefficiency leads to cost for lower output) rather than to remove slack.
an increase in the probability of exit. An impor- This result is also consistent with the stealing
tant question is that of the effect of excess entry share effect (Mankiw and Whinston, 1986), where
on the cost threshold for survival. To assess the fixed costs are allocated over lower firm output.
economic significance of the selection effect, we While our primary interest is the strategic impact
equate the marginal effects of cost inefficiency and of cumulative excess competition on firms’ inno-
cumulative additions at their means. This compar- vative behavior (Model 3), we show the results
ison indicates that each additional entrant into a for current competition first to demonstrate that
market lowers the cost threshold for survival, ck , (1) excess entry hurts performance, and (2) the
(increases the exit hazard for a given level of degradation in performance appears to stimulate
firm cost efficiency) in that market by 1.35 per- an immediate response. These results are consis-
cent. tent with those of Barnett and Hansen (1996) and
The control variables also suggest interesting Barnett and Sorenson (2002), who show that firms
patterns. The state-level economic controls for respond to recent competition.
population growth and new housing growth are Turning next to the permanent effects, Model
significant only in a model without the main vari- 3 indicates that cumulative excess entry leads to
ables. The firm-level variables indicate that the cost-reducing investment as the coefficient is neg-
least efficient firms are the ones most likely to ative and significant. We evaluated the marginal
exit. This matches intuition as well as prelimi- contribution of an additional excess entrant at the
nary results from the transition matrix. They also mean value of the independent variables. This
indicate that firms with riskier portfolios (higher analysis indicates that each excess entrant in a
percentage of real estate loans) have higher exit market yields a permanent 0.004 percent reduc-
probabilities. Larger scale (branch size and number tion in the mean cost of each incumbent firm.
of branches) decreases the probability of exit- Given the mean terminal value (1997) for cumu-
ing, but ownership by a bank holding company lative excess entry in a market was 336 firms, the
significantly increases the probability of exiting. implied cost reduction in each surviving firm was
This probability increases further with the scale 1.34 percent.
of the holding company (number of bank cer- Finally, we examine the spillover effect of pas-
tificates, branches, and states of operation). This sive contributions arising from the activity of failed
634
Table 4. Data summary Stage 2a Observations: 136,759
Copyright  2005 John Wiley & Sons, Ltd.

Mean S.D. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
1 cost inefficiency—ln($000) 1.55E − 01 1.45E − 01 1.00

A. M. Knott and H. E. Posen
2 excess entry 1.80E + 01 1.51E + 01 0.00 1.00

3 cum excess entryt−1 1.05E + 02 9.88E + 01 −0.06 0.51 1.00
4 cum additionst−1 4.05E + 01 4.93E + 01 0.19 0.26 0.51 1.00
5 cum output ($000) 5.90E + 08 8.31E + 08 0.06 0.26 0.40 0.43 1.00
6 branches 5.73E + 00 2.61E + 01 −0.01 −0.05 −0.02 0.04 0.10 1.00
7 branch scale ($000) 1.64E + 05 1.12E + 06 0.03 −0.01 −0.01 0.00 0.07 0.01 1.00
8 real estate pet 4.88E − 01 1.94E − 01 −0.02 0.08 0.26 0.25 0.23 −0.01 −0.07 1.00
9 cum output bank 1.73E + 06 1.93E + 07 0.00 −0.02 0.01 0.03 0.15 0.61 0.23 −0.04 1.00
10 hc certificates 3.71E + 00 1.05E + 01 0.07 0.06 0.02 0.03 −0.05 0.07 0.02 0.01 0.04 1.00
11 hc offices 3.93E + 01 1.57E + 02 0.06 0.00 0.04 0.05 0.01 0.22 0.07 0.01 0.12 0.62 1.00
12 hc states 4.10E − 01 1.51E + 00 0.08 −0.01 0.03 0.02 0.01 0.23 0.09 −0.01 0.16 0.72 0.78 1.00
13 population 6.64E + 06 6.07E + 06 0.15 0.26 0.23 0.55 0.74 0.09 0.02 0.21 0.08 −0.04 0.01 −0.03 1.00
14 delta population 6.59E + 04 1.19E + 05 0.18 0.14 0.22 0.67 0.40 0.07 0.00 0.18 0.04 −0.01 0.04 0.00 0.76 1.00
15 permit 3.47E + 04 4.26E + 04 0.16 0.19 0.15 0.54 0.34 0.07 0.00 0.14 0.03 0.00 0.04 −0.01 0.76 0.90 1.00
16 delta permit −4.37E + 02 9.13E + 03 −0.03 −0.01 0.01 −0.18 −0.10 −0.01 0.00 −0.03 −0.01 0.01 0.00 0.01 −0.17 −0.26 −0.09 1.00
a
Units in counts or dollars unless otherwise stated.
Strat. Mgmt. J., 26: 617–641 (2005)

Table 5. Test of Exit Hazard
Logistic regression results

Dependent variable: probability(exitit )
(1) (2) (3) (4)
cum additionst−1 2.032e − 03∗∗ 1.563e − 03∗∗

(5.673) (4.346)
cost inefficiencyt−1 7.588e − 01∗∗ 7.300e − 01∗∗
(13.100) (12.479)
branch-count −2.912e − 03∗∗ −2.908e − 03∗∗ −2.603e − 03∗∗ −2.611e − 03∗∗
(5.214) (5.241) (4.689) (4.730)
branch scale −1.793e − 07∗∗ −1.871e − 07∗∗ −1.750e − 07∗∗ −1.807e − 07∗∗
(3.839) (3.922) (3.944) (3.997)
real estate pct 4.933e − 01∗∗ 4.538e − 01∗∗ 5.230e − 01∗∗ 4.908e − 01∗∗
(6.387) (5.857) (6.826) (6.380)
holding company 1.042e + 00∗∗ 1.046e + 00∗∗ 1.041e + 00∗∗ 1.044e + 00∗∗
(33.428) (33.546) (33.360) (33.448)
hc certificates 4.082e − 03∗∗ 3.224e − 03∗ 4.423e − 03∗∗ 3.720e − 03∗∗
(3.222) (2.529) (3.495) (2.917)
hc branches 9.209e − 04∗∗ 9.206e − 04∗∗ 9.506e − 04∗∗ 9.506e − 04∗∗
(12.708) (12.749) (13.101) (13.134)
hc states 6.557e − 02∗∗ 6.954e − 02∗∗ 5.571e − 02∗∗ 5.915e − 02∗∗
(6.746) (7.179) (5.734) (6.094)
delta population 7.143e − 07∗∗ 9.023e − 08 4.741e − 07∗∗ 3.205e − 09
(5.906) (0.529) (3.832) (0.019)
delta permit −1.893e − 06 −2.489e − 06 −2.447e − 06 −2.902e − 06+
(1.122) (1.422) (1.440) (1.660)
year dummies sig. sig. sig. sig.
Constant −3.618e + 00∗∗ −3.689e + 00∗∗ −3.721e + 00∗∗ −3.770e + 00∗∗
(53.869) (54.022) (55.066) (55.047)
Observations 136,478 136,478 136,478 136,478
Log L −23169.138 −23153.303 −23096.873 −23087.544
Chi2 3849.524 3881.195 3994.054 4012.713
Prob>Chi2 0.000 0.000 0.000 0.000
Pseudo R sq 0.077 0.077 0.080 0.080
Absolute value of z statistics in parentheses

+
significant at 10%; ∗ significant at 5%; ∗∗ significant at 1%
entrants (Model 4). The coefficient on cumula- the market, thereby increasing cumulative expe-
tive output market is negative and significant, indi- rience, or whether they merely stole share. If
cating that each dollar of market output signifi- the latter is true, then there is no net spillover
cantly reduces the costs of surviving firms. Again, benefit from the excess entrants. However, our
we examined the marginal effects of an additional finding that excess competition stimulates price-
entrant who ultimately exits, taking into account cutting indicates that output was expanded by
its mean output. On average, each such entrant the excess entrants. This suggests their experience
generated an output of $128 million for 7.4 years does increase the spillover pool.
prior to exiting—the result of which was a per- A brief discussion of the control variables is
manent reduction in the cost of each surviving also warranted. In all models we include controls
firm by 0.0007 percent. In 1997, in each market, for market economic conditions and time-varying
the mean value of excess entry was 336 firms. firm attributes that might affect bank productiv-
Accordingly, the corresponding cost reduction in ity. Looking first at firm attributes, the coefficients
surviving firms was 0.24 percent. This learning on the branch count (number of branches) and
from failed firms is in addition to the learning branch size (branch scale) are negative and signif-
from surviving firms. One issue with interpre- icant. In contrast, the coefficient on cum output
tation is whether the excess entrants expanded bank is positive. If we evaluate each variable
Table 6. Results from Stage 2 regression
Regression results
Dependent variable: cost inefficiency
Fixed effects
(1) (2) (3) (4) (5)
excess entry 1.488e − 04∗∗ 1.952e − 04∗∗

(6.863) (8.844)
cum excess entryt−1 −4.671e − 05∗∗ −3.953e − 05∗∗
(8.418) (6.877)
cum output mrkt −7.033e − 12∗∗ −6.889e − 12∗∗
(8.258) (7.703)
branch count −1.319e − 04∗∗ −1.312e − 04∗∗ −1.350e − 04∗∗ −1.331e − 04∗∗ −1.349e − 04∗∗
(6.053) (6.023) (6.196) (6.111) (6.192)
branch size −1.246e − 08∗∗ −1.245e − 08∗∗ −1.256e − 08∗∗ −1.244e − 08∗∗ −1.250e − 08∗∗
(23.610) (23.591) (23.789) (23.569) (23.695)
cum output bank 7.273e − 11∗∗ 7.295e − 11∗∗ 6.556e − 11∗ 1.042e − 10∗∗ 9.773e − 11∗∗
(2.721) (2.730) (2.452) (3.860) (3.613)
holding company −6.492e − 03∗∗ −6.603e − 03∗∗ −6.578e − 03∗∗ −6.653e − 03∗∗ −6.867e − 03∗∗
(6.141) (6.246) (6.224) (6.294) (6.499)
hc certificates −5.841e − 05 −6.777e − 05 −5.232e − 05 −4.421e − 05 −5.164e − 05
(0.933) (1.083) (0.836) (0.706) (0.825)
hc branches 3.305e − 05∗∗ 3.295e − 05∗∗ 3.226e − 05∗∗ 3.301e − 05∗∗ 3.221e − 05∗∗
(9.323) (9.295) (9.100) (9.314) (9.088)
hc states 2.643e − 03∗∗ 2.657e − 03∗∗ 2.678e − 03∗∗ 2.521e − 03∗∗ 2.570e − 03∗∗
(5.862) (5.893) (5.940) (5.589) (5.700)
population −7.339e − 09∗∗ −8.048e − 09∗∗ −5.062e − 09∗∗ −4.637e − 09∗∗ −3.696e − 09∗∗
(6.888) (7.520) (4.606) (4.161) (3.268)
permit −2.717e − 07∗∗ −2.843e − 07∗∗ −2.333e − 07∗∗ −2.863e − 07∗∗ −2.700e − 07∗∗
(11.440) (11.937) (9.650) (12.025) (11.049)
year dummy sig. sig. sig. sig. sig.
Constant 2.081e − 01∗∗ 2.111e − 01∗∗ 1.850e − 01∗∗ 1.811e − 01∗∗ 1.787e − 01∗∗
(27.462) (27.820) (22.176) (21.557) (21.242)
Observations 136,759 136,759 136,759 136,759 136,759
R2 0.731 0.731 0.731 0.731 0.731
Absolute value of t statistics in parentheses

∗
significant at 5%; ∗∗ significant at 1%
at its mean value in 1997, the net effect is states) are positive and significant, hc certificates
negative, suggesting that larger firms have lower (holding company certificate count) is negative and
costs. significant. Nevertheless, the net effect of hold-
At the holding company level, the results are ing company, evaluated at mean 1997 levels, is
ambiguous, highlighting the complex role of the negative—indicating that ownership by a hold-
multi-unit structure—in the provision of scale ing company is on average associated with lower
advantages, in influencing learning between banks cost.
within a holding company, and perhaps in buffer- Looking finally at market economic conditions,
ing individual banks from the learning associated results indicate that increases in both population
with competitive interaction (Barnett, Greve, and and the number of housing starts decrease cost.
Park, 1994). In particular, the holding company The main conclusion, however, is that the compe-
dummy is negative and significant, indicating a tition and spillover effects persist in the presence
cost reduction associated with holding company of these controls.
ownership. The holding company scale variables In sum, our results indicate support for all
coefficients are mixed. While both hc branches three mechanisms. First, we find that selection
(number of branches) and hc states (number of effects are at work as additional entry increases
the probability of exit for inefficient incumbents. for the fact that low-efficiency firms are more
Second, we find that competition from excess likely to exit. From the estimation of Equation 5,
entrants decreases price margins in the year of the we extracted the inverse mills ratio and included
entry—which in turn leads to a long-term effort on this as an additional variable in estimation of
the part of incumbents to reduce costs over sub- Equation 6. The results are robust to this alterna-
sequent years. Third, excess entrants improve the tive specification.
efficiency of incumbents by adding to the pool of
spillovers.
PRIVATE COSTS AND SOCIAL
WELFARE IMPLICATIONS
Robustness
We have conducted a number of robustness checks Our empirical results indicate that failed entrants
on the results and in each case the results are robust generate externalities that substantially reduce in-
to alternative specifications. First, the specification dustry cost. Failed entrants improve the qual-
of the stochastic cost frontier model relied on the ity of the survivor pool through the selection,
use of a truncated normal distribution of the cost competition and spillover effects characterized in
inefficiency term. We tested the sensitivity of the Figures 1 and 2. Accordingly, policies to subsidize
results to different distributional specifications. We entry may enhance social welfare. One important
ran models assuming both a half-normal distribu- question, however, is whether the social bene-
tion and exponential distribution and the empirical fits from excess entry exceed the private costs of
results are robust to all such specifications. the failed entrants. While formal welfare analy-
Second, a significant assumption of the cost sis is beyond the scope of this paper, we provide
frontier model specified in the first stage is that some informal analysis to anticipate likely results.
all firms are drawn from the same cost ineffi- The informal analysis compares the private costs
ciency distribution. We relaxed this assumption of the excess entrants to the externalities they
and allowed for heterogeneity in the cost inef- generate.
ficiency distribution. In particular, we modeled We estimate these private costs by summing
the stochastic cost inefficiency term using a half- firm operating profits (losses) over the tenure of
normal distribution where the variance of the dis- each firm. This approach assumes that all up-front
tribution was assumed to be a function of the scale and non-recoverable investments are either amor-
of the firm. The results are robust to this respeci- tized across accounting periods or are expensed
fication. in the final year. We collect separate estimates
Third, an alternative explanation for the effi- for three categories of firms: (1) firms that enter
ciency gains from excess entry is that all such and exit during the observation period, (2) firms
gains are driven by very efficient entrants dis- whose founding predates the observation period,
placing incumbents. While the descriptive results but who fail during the observation period, and
suggest this is not the case—as entrants on aver- (3) mergers within a holding company. Table 7
age do not match the performance of incum- summarizes the mean private costs for firms in
bents (see Figure 7), we ran our models on a each category.
restricted sample of incumbents—firms that were The table indicates that on average failed
in the sample over the entire 14-year period. Our entrants (those who enter and exit during the
results are robust to this sample splitting, suggest- observation period) incur no private losses. In
ing that performance improvements are driven by fact they actually exhibit net profits averaging
the hypothesized mechanisms rather than realloca-
tion effects. Table 7. Private costs of exiting firms
Finally, in our analysis, we are concerned with
the effect of excess entry on surviving firms’ costs. Firm category Number Mean
An alternative question is that of the effect of of firms profits
excess entry on the cost of all firms—including
Firms who enter and exit 790 $15.14 million
those that exit (had they not done so). While Incumbents who fail 153 −$1.30 million
this latter question is not our central concern, we Incumbents who merge 637 $19.09 million
estimated a sample selection model to account
$15.14 million over their tenure. This suggests We proposed three alternative mechanisms
that the hit and run opportunities proposed by through which failure of excess entrants might
contestability theory (Baumol, 1982) exist in this benefit consumers and surviving producers. These
setting. The private gains plus the positive exter- mechanisms (selection effects, competition effects,
nality on survivor costs indicate that the failed and spillover effects) were derived from fail-
entrants enhance social welfare. Similar conclu- ure theories in organization theory and evolu-
sions are drawn for firms who merge. They exhibit tionary economics. We tested all three mecha-
net profits averaging $19.09 million over their nisms plus the effects of current excess compe-
tenure. tition in the banking industry following deregu-
Results for the displaced incumbents (firms who lation. We found significant and substantial sup-
enter before the observation period, but later fail) port for each effect. Thus we can say that the
are less conclusive. The data indicate that these economic benefits are real. Excess entry and sub-
firms incur private losses averaging $1.3 million sequent failure increase aggregate industry effi-
over the observation period. Since the entry of ciency. Moreover these social benefits exceed the
these firms predates the observation period, and private costs of failed firms (indeed many exit-
since Figure 6 indicates that firm costs increase in ing firms have net gains). Thus, in this setting,
the years immediately preceding exit, these firms excess entrants appear to enhance social wel-
may in truth enjoy private gains. Nevertheless fare.
we take the conservative stance that these losses Our results were obtained in the banking indus-
are net losses. We then compare the incumbent try. We chose this setting because the fragmenta-
losses to the externality generated by their dis- tion of banking markets allowed us to compare dif-
placement. To do so, we sum the economic value ferences in market structure (arising from failure)
of the externality for the average entrant across the while controlling for other factors affecting mar-
three mechanisms. The externality for the selec- ket structures across industry. Because there are
tion effect was a 1.34 percent reduction in sur- few fragmented industries with firm-level panel
viving firm cost; the externality for the competi- data, it will be difficult to replicate this study in
tion effect was 0.004 percent reduction in surviv- other settings. Nevertheless it is worth speculat-
ing firm cost; and the externality for the spillover ing whether our results are unique to banking.
effect was 0.0007 percent in surviving firm cost. Banking is a service industry with high human
Thus the total externality is a permanent decrease capital (knowledge) intensity and low physical
in industry cost of 1.3447 percent. At the mean asset intensity. Low asset intensity implies there
firm cost of $2.9 million, and the mean number are fewer sunk investments to inhibit adoption of
of firms per market of 195, this corresponds to an more efficient practices. Our results may be less
aggregate cost reduction from an excess entrant pronounced in manufacturing industries where vin-
of $7.6 million. Since this reduction is actually tage capital inhibits adoption of innovations. For-
an annuity, the externality is the present value of tunately, the newer industries, the ones accounting
that annuity stream. Given that even the single- for the greatest excess entry and failure, tend to be
year aggregate savings of $7.6 million exceeds more like banking than manufacturing. Thus fail-
the cumulative losses ($1.3 million) of the failed ure should increasingly provide the benefits seen
incumbent, it appears that displacing entrants also here.
enhance welfare. The specification employed in this paper is not
without caveats. Two are of note. First, our main
means of identification come from variation in
levels of entry and exit across states. Our spec-
DISCUSSION ification assumes that entry choice is exogenous
in the sense that entrants are randomly assigned
Approximately 10 percent of all firms in the United to states. Given the fact that 94.3 percent of entry
States fail each year. Our question is whether is by local entrepreneurs, this assumption seems
the efforts of these failed entrepreneurs are in plausible. Second, our measure of excess competi-
vain. Do their efforts merely represent private tion is exits. To the extent that there are lags in the
losses, or are there public gains to offset these exit process, it is likely that our measure under-
losses? states the actual level of excess entry at any given
time and thus underestimates the magnitude of the Bag seminar, Dan Schendel, and two anonymous
failure benefits. reviewers for helpful comments.
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Strategic Management Journal

Strat. Mgmt. J., 26: 617–641 (2005)

INTRODUCTION venture. If so, then failed entrepreneurs may be as

a selection effect—firms surviving from a larger EXCESS ENTRY AND FAILURE

Failure mechanisms initial period of high mortality, but firms surviving

is defined as n − k firms. Finally, we assume that the failed firms.

n from best performing (lowest cost) to highest P (q)dq − ci (q)

firm is designated ck , the cost threshold for the  q1 

Figure 1. Welfare increase from selection effect (Hypothesis 1)

Figure 2. Welfare increases from competition effect (Hypothesis 2)

(Mankiw and Whinston, 1986), stimulate cost- Spillovers

Thus competition shifts the aggregate cost curve

Banking Entry & Exit 1984-1997

Figure 3. Banking failures following deregulation

+ γ1 StateCtrlst + γ2 F irmCtrlsit Spillovers

RESULTS on the cost frontier. The data also indicate that

Table 1. Stage 1 data summary

Variable Description Obs. Mean S.D. Min. Max.

c cost 174,869 7.98 1.27 −0.82 16.76

Units: ln(thousand, 1996 dollars).

Table 2. Results from Stage 1 regression

Dependent variable: ln(cost)

Coeff. S.E. Coeff. S.E.

w1 −8.691e − 01∗∗ (30.644) w1w3 −2.312e − 01∗∗ (61.988)

Absolute value of t-statistics in parentheses.

Cost Inefficiency Density Function

Figure 4. Histogram of firm-year efficiency metrics

Mean of Cost Inefficiency

Figure 5. Mean cost inefficiency

Table 3. Year-to-year transition matrix of firm efficiency

Next year quintile

Enter 670 63 96 179 1507 0 0 2515

This year 2 5,362 17,327 6,797 1,178 246 1009 86 32,005

3 702 6,447 15,857 6,374 770 1,187 135 31,472

4 254 923 6,074 16,164 5,141 1,414 244 30,214

5 394 346 817 4,736 22,282 1,968 790 31,333

Total 39,141 31,160 30,546 28,990 30,325 6,675 1,456 168,293

Exiting Firm Cost Inefficiency

Figure 6. Exiting firm cost inefficiency histories

Entering Firm Cost Inefficiency

Figure 7. Entering firm cost inefficiency history

Stage 2: Test of mechanisms is a rather counter-intuitive result. However, fur-

Table 4. Data summary Stage 2a Observations: 136,759

Copyright  2005 John Wiley & Sons, Ltd.

1 cost inefficiency—ln($000) 1.55E − 01 1.45E − 01 1.00

2 excess entry 1.80E + 01 1.51E + 01 0.00 1.00

Strat. Mgmt. J., 26: 617–641 (2005)

Logistic regression results

(1) (2) (3) (4)

cum additionst−1 2.032e − 03∗∗ 1.563e − 03∗∗

Absolute value of z statistics in parentheses

Table 6. Results from Stage 2 regression

excess entry 1.488e − 04∗∗ 1.952e − 04∗∗

Absolute value of t statistics in parentheses

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