1 a Marshallian Model of Efficiency Profit Dynamics

In the literature of strategic management, most of the research on profitability focuses on conditions under which a firm can enjoy extraordinary profits in the long run, despite the efforts of its competitors. This paper extends this line of thinking by considering not only the role played by idiosyncratic resources in the final equilibrium, but also the dynamic process by which the sector approaches that equilibrium. Firm financial performance is assessed not only in terms of long run equilibrium levels of flow profitability, but also in terms of the present value the firm realizes over the trajectory as a whole. Firms are assumed to be price takers, so market power and strategic output restraint play no role in profitability – this is the sense in which the analysis relates to “efficiency profits.” The model analyzed is an elaboration of a simple Marshallian representation of competition in an industry. Each period is a Marshallian “short run,” over time the industry approaches some long run equilibrium. The main themes are familiar ones of evolutionary economics; profits drive growth and more efficient firms drive out less efficient ones; imitation may permit the inefficient to become efficient. A key feature of the present model is that firms compete not only in the market for final goods, but also for resources; so both input and output prices are endogenously determined. A key assumption – departing from textbook economics but converging with the “resource based view” (RBV) in strategic management – is that firm heterogeneity centrally involves idiosyncratic firm resources that are not simply the inputs that are available in the market. Resources are purchased in the market, but are specialized to the firm (and become “attached” to it) by virtue of sunk investments in some costly process of customization. Profits emerge (as a function of capability heterogeneity), and erode over time (as a function of the speed of capacity expansion and imitation, or of rules of endogenous capability development). The model shows how this happens, and also illustrates how profitability co-evolves with input prices, output prices and quantities. By computing model trajectories under a wide range of conditions, we explore how the evolutionary path and asymptotic level of profitability depends on a wide range of parameters. We show that the relative importance of one-off investments in resources directly affects the ability to sustain profits, as well as to the extent to which firms of differential efficiency can co-exist in equilibrium. We also show that sustainable profits are relatively limited parts of total industry profitability and that adjustment paths of industry evolution affect both profit NPV and the equilibrium profits in a sector.