Quantifying the Sources of Firm Heterogeneity

Colin Hottman, Stephen Redding, David Weinstein, "Quantifying the Sources of Firm Heterogeneity,"The Quarterly Journal Of Economics, March 2016, https://academic.oup.com/qje/article-abstract/131/3/1291/2461153

Their takeaway, ““…New and improved products (scope and turnover) account for 64% of firm growth in our three highest turnover sectors, but only 10% of firm growth in the three lowest turnover sectors. Although product upgrading alone accounts for 15% of firm growth in the three highest turnover sectors, it only accounts for 0.2% of firm growth in our three lowest turnover sectors. Taken together, these decomposition results are quite striking in their consistency about the sources of firm heterogeneity.Regardless of whether we examine firms in the cross section or in the time series, improvements in firm appeal followed by product scope are the most important drivers of firm sales for small and large firms alike. The role played by average marginal cost differences tends to be small and depend on the sample and decomposition method used. But we consistently find a positive contribution towards differences in firm size from the cost dispersion term. Finally, we see that although markup differences are unimportant determinants of firm sales for most firms, they do appear to be important for the very largest firms, something that suggests aggregate implications from the exploitation of market power by these firms……Our findings that firms supply multiple imperfectly substitutable varieties have important implications for the measurement of firm productivity, highlighting the role of assumptions about demand in the measurement of productivity for multiproduct firms. Conventional price indexes based on a weighted average of firm prices do not take into account that the theoretical price index for the firm depends on the number of products it supplies whenever consumers care about variety. Indeed, our counterfactual exercise indicates that the multiple varieties supplied by multiproduct firms reduce the aggregate consumer price index by around one third. Moreover, ignoring this effect introduces a systematic bias into the measurement of firm productivity, because larger firms supply more products than smaller firms. We find this bias to be quantitatively large. An increase in firm sales is associated with around a one third larger increase in true real output (using the exact price index) than in measured real output (using the conventional price index)…”

“.. The extent of multiproduct firms can be seen more clearly in Table IV, which shows the results of splitting the data by the number of UPCs supplied by a firm. Although single-product firms constitute about one third of all firms on average, these firms account for less than 1% of all output. In other words virtually all output is supplied by multiproduct firms. Moreover, the fact that over 90% of output is sold by firms selling 11 or more varieties and nearly two thirds of all output is supplied by firms selling more than 50 varieties suggests that single-product firms are more the exception than the rule. Large firms not only sell more products but also a lot more of each product. The penultimate column of Table IV documents that while the typical barcode sold by a single-product firm brings in $63,871 in revenue, the typical barcode sold by a firm selling over 100 barcodes brings almost twice as much ($122,045). In other words, large firms not only supply more products, they sell more of each product. If firms differed only in the fixed cost of adding new varieties, one would not expect to see large firms sell more of each variety. The fact that they do strongly suggests that large firms must also differ in the marginal cost or demand for their output. Finally, although the largest firms have nontrivial shares of particular product groups, these firms are small compared to the U.S. economy. Ninety-nine percent of firms in our sample have aggregate market shares (across all product groups) of less than 0.1% of total barcode sales. Even the largest firm only sells 3% of total barcode sales in our sample. Given that sales of packaged goods is only a fraction of total U.S. sales in all sectors, it is reasonable to conclude that no individual firm has the capacity to affect aggregate U.S. prices, expenditure, or welfare….”

“…We see in Table II that almost 90% of sales in a product group was produced by firms with sales in the top decile of sales.Table III provides a more detailed description of this firm heterogeneity by focusing on the 10 largest firms in each product group (where we weight the averages by the sales of the product group). Table III reveals an almost fractal nature of firm sales. Around two thirds of all of the sales of firms in each product group is produced by the 10 largest firms (which on average only account for 2% of firms in each product group). While on average half of all output in a product group is produced by just five firms, 98% of firms have market shares of less than 2%. Thus, the typical sector is characterized by a few large firms and a competitive fringe composed of firms with trivial market shares. A second striking feature of the data is that even the largest firms are not close to being monopolists. The largest firm in a product group on average only has a market share of 22%. Finally, the data reveal that firms in the top decile of sales are all multiproduct firms, supplying on average 68 different goods with the largest firms supplying hundreds of goods…”

The Evidence, “…One of the most striking facts displayed in this table is the degree of firm heterogeneity. This is manifest in the skewness of the size and barcode distributions. The largest firm in an industry typically sells 2,500 times more than the median firm. We see similar patterns in terms of product scope and sales per product. The firm with the most products typically has 97 times more products than the firm with the median number of barcodes, and the barcode with the most sales on average generates almost 900 times more revenue than the revenue of the median barcode…”

On large firms productivity relative to small firms, “…These results imply that about a quarter of the variation of firm-level real output one would obtain by using a conventional price index is simply due to the fact the conventional price index assumes that firms produce homogeneous output—an assumption that easily can be rejected. Moreover, studies based on conventional measures of firm prices understate the real output of large firms by a third relative to small firms, with implications for estimates of returns to scale and productivity….”

Core results, “…Our results point to differences in firm appeal as being the principal reason some firms are large and others are not. Depending on the specification considered,we find that 50-75% of the variance in firm size can be attributed to differences in appeal, about 20-25% to differences in product scope, and less than 20% to average marginal cost differences. If we use a broad measure of total firm appeal, which encompasses both firm appeal as well as scope, we find that total firm appeal accounts for almost all of firm size differences. We estimate substantially higher elasticities of substitution between varieties within firms than between firms (median elasticities of 6.9 and 3.9, respectively), implying that a firm’s introduction of new product varieties cannibalizes the sales of existing varieties. We estimate that the cannibalization rate for the typical firm is 0.50, roughly halfway between the extreme of no cannibalization (equal elasticities of substitution within and between monopolistically competitive firms), and the extreme of complete cannibalization (varieties perfectly substitutable within firms). We find that the typical sector comprises a few large firms with substantial market shares and a competitive fringe of firms with trivial market shares. Therefore most firms charge markups close to the monopolistic competition benchmark of constant markups, because they have trivial market shares and hence are unable to exploit their market power. However, the largest firm accounts on average for 22% of sales in a sector, and the median largest firm charges a markup between 24% and 100% higher than the average firm within the same sector. Using the estimated model to undertake counterfactuals, we find that these departures from the monopolistically competitive benchmark raise aggregate consumer price indexes by between 4% and 13%...”

Key quote, “…Our results point to demand differences (which could arise from quality or taste variation) as being the principal reason some firms are successful in the marketplace and others are not. Depending on the specification considered, we find that 50- 70% of the variance in firm size can be attributed to differences in firm appeal, about 20-25% to differences in product scope, and less than 25% to cost. When we turn to examine time-series evidence, the results become even more stark. Virtually all firm growth can be attributed to firm appeal, with most of the remainder due to product scope. These results suggest that most of what economists call differences in revenue productivity reflects differences in appeal (e.g., quality or taste) rather than cost….“…We show that if demand has a nested CES structure, conventional measures of real output will have a downward bias that rises with firm size with an elasticity of around one third. In other words, real output variation is substantially greater than nominal output variation. This bias also implies that true productivity differences are much larger than conventionally measured ones…”