Dynamic panel models of firm growth and profit

This paper unifies the growth and profit strands in the industrial organization literature, by testing both the Law of Proportionate Effect and the Persistence of Profit hypothesis within a two-equation model capturing the bi-directional relationship between growth and profit. The model is estimated over a large panel data set comprising firms in five European countries. While there is an inverse cross-sectional relationship between firm size and growth, dynamic panel estimations show no indication of mean-reversion in firm sizes. Survivorship bias may explain the discrepancy between the cross-sectional and dynamic panel results. There is mixed evidence concerning persistence of growth, but lagged profit exerts a strong upward pull on current growth. In the profit equations, the inclusion of a lagged growth term in the profit equation tends to increase the numerical estimates of short run persistence, though the evidence of a direct link between lagged growth and current profit is limited.