Empirical Models of Industry Dynamics with Endogenous Market Structure

Abstract

This article reviews recent developments in the study of firm and industry dynamics, with a special emphasis on the econometric endogeneity of market structure. The endogeneity of market structure follows from the presence of serially correlated unobservable shocks to the profitability of firms’ dynamic decisions, a feature common to many empirical settings. Methods that ignore endogeneity can lead to misleading parameter estimates and misleading counterfactual results. We pay particular attention to extensions of standard two-step methods that leverage instrumental variables to address endogeneity in both single-agent and oligopoly models. A first step set-identifies dynamic policy functions together with serial correlation parameters, and a second step quickly solves for profit function parameters using an extension of existing forward-simulation methods. We discuss how these new methods provide a general solution to initial-conditions problems and how they can yield practical estimation strategies.