Competitive Profits in the Long Run

Abstract

Profit rates differ across industries. Explanations have often relied on static models of imperfect competition. This paper develops a dynamic model of perfect competition to demon- strate that long-run average profit rates differ even across competitive industries when the effects of sunk costs on entry and exit are considered. The hypothesis that firms maximize their present expected values has few empirical implications for long-run average profit rates, but it does have implications for the behaviour of variables over time; for example, industries with high variability in the number of firms should exhibit low variability in firm values. Recent work in industrial organization theory has resulted in several useful dynamic competitive models of industry evolution. These models are of three types. The first, due to Jovanovic (1982), is a model of passive learning where producers, uncertain about their productivity, acquire noisy information about how efficient they are.6 The second, due to Ericson and Pakes (1989), is a model of active learning where producers invest to increase the probability that they will become more efficient. The third, exposited in Lambson (1991), differs from the learning models of industry evolution by assuming that producers know how productive they are and that they all have access to the same technologies, but that they are uncertain about future market conditions. (The description of a market condition includes all relevant exogenous factors; for example, a market condition may consist of a vector of input prices and an output demand curve.) These three approaches are not mutually exclusive; rather they attempt to capture different aspects of reality. This paper applies the third approach to the question of why profit rates differ across industries, even in the long run. In so doing, it explicitly takes into account the effects of sunk costs, entry, exit, and random market conditions on the determination of long-run average profit rates. The existence of sunk costs generates hysteresis, that is, effects