Wouter Dessein (Columbia Business School)

Many industries are dominated by large and very profitable firms. What distinguishes many of these firms from smaller competitors is their investments in R&D and product quality. Why do smaller firms fail to upgrade their products? Why doesn’t entry eliminate profits? And do consumers benefit from the presence of large firms?

To answer these questions, we propose a theory of firm dynamics where new firms and customers arrive each period; firms operate a fixed-cost technology; and customers decide each period whether to stick with matched firms. Since firms sell an experience good, they can only slowly build up a customer base. We characterize the incentives for entry and product quality upgrading, the growth path of firms, consumer welfare, and the steady state distribution of firms.

We show that: (1) There is an incumbency advantage: Earlier entrants are larger and more profitable; no more entry occurs after some time; (2) Firms only upgrade product quality when they are sufficiently large; late entrants may never upgrade; (3) More intense competition or lower barriers-to-entry reduces firm concentration and negatively affect consumer welfare: less firms upgrade their product or they do so at a later time. We conclude our analysis by studying the costs and benefits of conglomerate behemoths: firms that enter new industries with an existing customer base at the expense of a less tailored product.