Is Failure Good?

IS FAILURE GOOD?

Anne Marie Knott

Department of Management and Organization

Robert H. Smith School of Business
University of Maryland
4515 Van Munching Hall
College Park, MD 20742
(301)405-9542
aknott@rhsmith.umd.edu

Hart E. Posen

The Wharton School

University of Pennsylvania
2068 Steinberg Hall-Dietrich Hall
Philadelphia, PA 19104-6370
(215)898-1235
hposen@wharton.upenn.edu

December 18, 2004

Knott AM, Posen HE. 2005. Is Failure Good? Strategic Management Journal 26(7): 617-641)

The authors would like to thank the Mack Center for Technological Innovation for financial support. We
would also like to thank Bill Barnett, John de Figueredo, Loretta Mester, Philip Strahan, Sid Winter,
participants in the Strategy Research Forum, the Fuqua strategy seminar, the HBS entrepreneurial
management seminar, the HBS Strategy Conference, the NYU Global Research Initiative seminar,
Reginald H. Jones Center Brown Bag seminar, and two anonymous reviews for helpful comments.

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Is Failure Good?

IS FAILURE GOOD?

Abstract

Approximately 80 to 90% of new firms ultimately fail. The tendency is to think of this failure as
wasteful. We however examine whether there are economic benefits to offset the waste. We characterize
three potential mechanisms through which excess entry affects market structure, firm behavior and
efficiency, then test them in the banking industry. Results indicate that failed firms generate externalities
that significantly and substantially reduce industry cost. On average these benefits exceed the private
costs of the entrants. Thus failure appears to be good for the economy.

Keywords: failure, entry, efficiency, spillovers, selection, competition

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1. Introduction
The entrepreneur who seeks private benefit in the face of long odds and succeeds is a sung hero in
the innovation literature. When successful, the entrepreneur’s innovation generates economic benefits
above and beyond her private benefits. By filling unmet needs or satisfying old needs in new ways, the
entrepreneur fuels a process of creative destruction (Schumpeter 1942). This process increases social
welfare either by displacing less effective incumbents or by forcing incumbents to match the entrant’s
innovation.
But what about entrepreneurs who fail? While they suffer private losses, does their failure
generate any economic benefits to offset those losses? It seems possible that the same creative
destruction process fueled by successful ventures may also be fueled by unsuccessful ventures. In short,
the process may be blind to the outcome of a particular venture. If so, then failed entrepreneurs may be as
heroic as successful entrepreneurs.
In fact, there is some preliminary evidence to that effect. In a longitudinal study of Texas sales
tax receipts, Hicks (1993) found that employment growth and wages increased as the half-life (the length
of time to achieve a 50% decrease in the population) of firms decreased. Thus at first glance, it appears
that failure may be beneficial. However, while the benefits are intriguing, the direction of causality is
unclear. Even if failure “causes” growth, the causal mechanism is not obvious. A policy of arbitrarily
killing off firms to achieve the benefits is most certainly ill-advised.
The primary goal of this paper is to determine if the economic benefits are real. Does excess
entry generate these benefits or are they merely artifacts of a process that jointly produces entry, failure
and growth? If the benefits are real, the secondary goal is to understand the causal mechanisms producing
them. This understanding may lead to policies that stimulate “beneficial failure”.
To examine the broad question, we focus on three potential mechanisms through which failure
(excess entry) might affect market structure and thereby efficiency growth. The first mechanism is a
selection effect--firms surviving from a larger pool (more excess entry) ought to perform better on
average than the same number of firms surviving from a smaller pool (Demsetz 1973, Jovanovic 1982).
The second mechanism is a competition effect—the more firms in an market, the greater the stimulus to
innovation (Barnett and Hansen 1996, Peretto 1999, Aghion, Harris, Howitt and Vickers 2001, Knott
2003). The third mechanism is a spillover effect—the knowledge produced by excess entrants while
“wasted”, in that it is no longer appropriable by the failed firm, may be captured by survivor firms
through spillovers. The effects of interest here are the durable effects of excess entry, i.e., the effects due
to firms that enter, but then fail.
This paper characterizes the potential impact of each of the three mechanisms and then conducts
an empirical test of the relative power of each mechanism in explaining the economic impact of failed

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firms. This test is conducted in the banking industry post-deregulation. The industry was chosen because
it is fragmented, has a substantial knowledge component, and is marked by substantial failure.
Fragmentation is important because it allows us to compare differences across markets while controlling
for technology. The knowledge component is important because the failure mechanisms rely on
efficiency improvements. These improvements become more likely as knowledge and human capital
come to dominate physical capital.
We examine banking efficiency for all fifty states plus the District of Columbia over the period
1984-1997. Analysis is done in two stages. In the first stage, we characterize the annual efficiency of
each firm relative to a non-moving frontier. In the second stage, we model firm efficiency in each year as
a function of the three mechanisms plus a set of controls. The approach we take is similar to that taken in
studies examining the micro-level components of aggregate productivity growth (see Bartelsman and
Doms 2000 for a review).
The paper proceeds as follows. First we review the failure literature to extract hypotheses about
the economic impact of failure. This review yields three mechanisms. We characterize the impact of
each of these mechanisms on cost dynamics. Following that we discuss the banking industry and the
empirical model that appends the mechanisms to traditional models of banking efficiency. We conclude
with results and discussion.

2. Excess Entry and Failure

Approximately 10% of all firms in the United States fail each year (U.S. Small Business
Administration 1999). However the rate of new firm creation is roughly 11% of existing firms, so the
stock of firms grows at a net rate of 1%. These aggregate numbers appear rather tame—suggesting that
each firm faces a 10% hazard rate, and also suggesting that there is a healthy rate of churn—old
entrenched firms being replaced by vibrant young firms.
However these aggregate numbers mask interesting dynamics. Failure is disproportionately
drawn from new firms. Data from the U.S. Census Business Information Tracking Series (Headd 2003)
indicate that 51% of firms exit within their first four years. Thus failure risk looms large for entrants, and
is relatively non-existent for established firms. Moreover the phenomenon looks less like churn than
competition for the right to produce in perpetuity.
The literature on failure examines the causal mechanisms for failure—who are the 10% and why
do they fail? We examine a very different question—is 10% the right number, or would the economy
(producers and consumers jointly) be better off with either higher or lower failure rates? Perhaps the
failure rate is too low--more failure will produce greater economic growth by creating more industries and
unseating less effective firms in established industries. Alternatively perhaps the failure rate is too high,

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because investments in failed new ventures produce no economic benefits and thus are merely a
misallocation of resources. If the failure rate is too low, perhaps we should subsidize entry. If the failure
rate is too high, perhaps we should tax entry, so that only firms assured of success will enter. Both the
amount question and the mechanism question have public policy implications—the amount question
determines whether intervention is warranted; the mechanism question determines the form intervention
should take.
We are far from answering the policy question of how to influence failure rates. However, we
believe we can begin the debate by tackling the question of whether failure produces any economic
benefits? If so, what are these benefits, and how substantial are they? Before we begin, we want to frame
the discussion and our empiricism, by reviewing the literature on failure.

2.1 Failure Mechanisms

Probably the best approach to reviewing the literature on failure is to work across disciplines, but
within level of analysis. There are two relevant levels: market (population), and firm (organization).
They are related in that market phenomena determine when failure is most likely to occur, while firm
phenomena determine who is most likely to fail.
Industry level studies. Studies of failure tend to find that industries have life cycles: an
emergent stage where demand is uncertain and potential firms are cautious, a growth stage where demand
exceeds supply and many firms enter, and a shake-out where demand stabilizes. The shakeout occurs
because market capacity grows in anticipation of continued demand growth. However when growth
subsides, capacity exceeds realized demand and firms compete for slots in the market. In evolutionary
economics (Nelson and Winter 1982, Klepper 1996) firms exit when their cost exceeds the decreasing
market price. The firms surviving the shakeouts are the ones with superior technical capability who
throughout the industry’s life invested in process innovation to drive down cost. The firms making these
investments expand output to fully capture the benefits of lower unit costs. The continuously shifting cost
curve combined with continuously expanding scale of these firms hastens the exit of later entrants or less
R&D intensive rivals. Thus evolutionary economics offers an endogenous model of industry evolution
that simultaneously predicts industry concentration and mortality rates. What evolutionary economics
fails to explain however is the fact that in most industries entry and exit continue in steady-state. This
steady-state churning is the phenomenon of interest here.
Population ecology takes equilibrium industry size as exogenous, but arrives at similar
conclusions to evolutionary economics regarding mortality. These are embodied in two density
hypotheses. The first hypothesis pertains to contemporaneous density. The more firms competing for a
given set of resources, the higher the mortality rate (Hannan and Freeman 1989, Carroll and Hannan

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1989). A second hypothesis pertains to the density at founding. This hypothesis holds that firms founded
during adverse environmental conditions suffer an initial period of high mortality, but firms surviving the
period have lower subsequent mortality than those founded in more munificent periods (Baum and
Mezias 1982, Swaminathan 1996, Delecroix and Rao 1994, Bamford, Dean, McDougall 2000). This is
because firms surviving a competitive environment are more fit than those chosen randomly.
What these industry-level studies share is an assumption of excess entry and a selection
hypothesis that high-performing firms will drive out lower-performing firms. An intriguing but distinct
question is why there is any excess entry. One very interesting study (Camerer and Lovallo 1999)
proposes that excess entry arises from hubris regarding entrepreneurs’ ranking in a capability distribution,
and then demonstrates the phenomenon experimentally. These experimental findings are corroborated by
empirical data (Wu and Knott 2004). We ignore issues of cause and degree of excess entry, and focus
exclusively on whether there are economic benefits from the excess.
Firm level studies. Firm-level studies of failure hold that there are firm life cycles and that these
affect mortality as do industry life cycles. Typically young firms have the highest mortality.1 In
organization theory, this observation is attributed to Stinchcombe (1965). His “liability of newness”
hypothesis holds that new firms have higher failure rates than older firms due to: (a) the cost of learning
new roles and tasks, (b) constrained resources, (c) lack of informal communications structures, and (d)
lack of formal connections with customers and suppliers. There is substantial empirical support for the
decrease in mortality associated with age. However it is unclear whether age or size (which is highly
correlated with age) is the driving factor (Hannan 1998).
An alternative interpretation of the same observation is that firms have heterogeneous but
unknown capability, and that they enter an industry as long as the expected value of profits exceeds the
entry costs (Jovanovic 1982, Lippman and Rumelt 1982). Once firms enter they learn how capable they
are, and the firms with inferior capability ultimately exit.
The converse of new firm liability is established firm advantage. Established firms accumulate
knowledge over time allowing them to become more efficient (Nelson and Winter 1982, Levinthal 1991,
Klepper 1996) and more consistent (inertial) (Hannan and Freeman 1989) as routines become
standardized (Nelson and Winter 1982). Alternatively this knowledge allows firms to better understand
their relative fitness (Jovanovic 1982) such that they can make informed exit decisions. The first three
studies suggest firms update their capability, the latter suggests firms merely update estimates about their
capability.

1
Young firms includes “adolescent firms” with adequate resources to sustain themselves through the first few years
(Fichman and Levinthal 1991).

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There is an extensive learning literature demonstrating that firms update their capability. What is
less clear from this literature is whether the updating is autonomous, or whether it requires deliberate
efforts and investment to reduce costs. Early literature (see Yelle 1979 for a review) showing the
relationship between cumulative manufacturing experience and reduction in unit cost was interpreted to
mean that learning was a costless byproduct of manufacturing experience. More recent work (Sinclair,
Klepper and Cohen 2000, Knott 2002) has begun to show that the effects of cumulative manufacturing
experience disappear when R&D activities are incorporated properly. In other words while knowledge
may accumulate as a byproduct of manufacturing activity, the exploitation of that knowledge requires
overt activity to incorporate it in new products or processes. If learning is autonomous then it should
depend only on the level of cumulative experience. The corresponding economic good hypothesis is
learning-by-doing or spillovers. If learning is overt, then we would expect it to increase with the level of
competitive pressure. The implicit hypothesis is competition. If only estimates of capability are updated,
then the implicit hypothesis is selection.
The general perspective shared by these literatures is that there is a pool of entrants with
randomly distributed capability endowments. More firms enter than the market can accommodate (excess
entry), and inevitably those with inferior capability will be forced to exit. There are three important
questions inherent in this phenomenon 1) why firms make these entry mistakes? 2) how many such
mistakes there will be? and 3) what is the economic impact of these mistakes? Camerer and Lovallo
(1999) tackle the first question. Economic Census data provide empirical answers to the second question.
We tackle the third question of economic impact. We do so from the perspective of those who survive.
Thus our work is a complement to the prior literature discussed above that considers failure from the
standpoint of those who fail.

3. Mechanisms
The literature thus suggests three hypotheses through which failure might generate economic
benefits. The first hypothesis is a selection effect--firms surviving from a large population (more excess
entry) ought to be better performers on average than firms surviving from a smaller population (Demsetz
1973, Jovanovic 1982). This occurs because the performance distribution of a large population is denser
than a small population. Hence if we draw the best n firms from two populations with identical
distributions, the nth firm from the larger population will be further to the right (higher performance) than
the nth firm from the small population. Excess entry thus simultaneously produces both high failure rates
and superior firms. This hypothesis suggests that failure is merely a byproduct of a phenomenon (excess
entry) that yields superior firms. Accordingly, the selection effect postulates a passive role of excess

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entry and failure. The excess entry does nothing to change the behavior of surviving firms. It merely
determines the distribution of firms that remain.
The second hypothesis is a competition effect. Unlike the selection effect, this hypothesis holds
that excess entry affects the behavior of survivors. In particular, recent work has shown analytically
(Peretto 1999, Aghion et al 2001, Knott 2003) and empirically (Geroski and Pomroy 1990, Blundell,
Griffith and Van Reenan 1995, Barnett and Hansen 1996, Nickell 1996, Hou and Robinson 2003) that the
rate of innovation in a market increases with the number of firms.2 3 Increasing the number of firms
increases the likelihood that a firm’s market position will be eroded, and this threat (associated with both
declining profitability and increased risk of failure) stimulates innovation (Barnett and Hansen 1996).
From this perspective, excess entry increases the competitive pressure in the market because it
temporarily inflates the number of firms. This excess competition leads to cost-reducing investment that
yields permanent benefits in the efficiency of survivors. This effect is consistent with the “density at
founding” hypothesis (Hannan and Freeman 1989, Carroll and Hannan 1989) discussed earlier. Firms
surviving a period of intense competition have higher fitness than firms that have been insulated from
competition. This effect is implicitly the hypothesis held by Porter in the Competitive Advantage of
Nations (1990). A highly competitive region forces innovation that makes surviving firms more fit for
global competition.
The effects discussed above are permanent benefits from competition. In addition to these
permanent benefits, we anticipate temporary responses to competition. The temporary effects involve
behaviors to maximize profits in the current period, such as removing slack and reducing prices (Vickers
1995). These temporary effects and the associated impact on profits are what trigger cost reducing
investment to better position the firm for future competition (permanent effects).
The third hypothesis is a spillover effect. While excess entry yields “wasted investment” in that
these investments are no longer appropriable by the failed firm, the value of the investments may be
captured by survivor firms through “spillovers”. These spillovers take on many forms: advertising
expenditures that expand demand for the product class, improvements in the technology supplied to the
industry, and training of industry employees. While these spillovers occur even in the absence of failure,
the excess entry may create a larger base of output over which the cumulative learning occurs.

2
Competition has been characterized both as cross-price elasticity and as the number of rivals. We define it here to
be the number of rivals. However the constructs are equivalent. Given a fixed distribution of consumer tastes,
increasing the number of equidistant firms will also increase cross-price elasticity.
3
An earlier received view in industrial organization economics (see Reinganum 1989) held that innovation is
increasing then decreasing in the level of competition--without any competition there is no incentive to invest, but
thereafter, expected returns decrease with the number of competitors. While there was some inter-industry evidence
that innovation increases then decreases with market concentration, those results disappeared in studies using panel
data along with controls for technology (See Cohen and Levin 1989 for a review).

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We examine the separate impact of each of these hypotheses. If only the selection effect holds,
then public policies to stimulate entry are misplaced. Rather, policies should focus on increasing the cost
of entry, such that only firms assured of having high efficiency will enter. Under the competition and
spillover effects however, entry by weaker firms alters the behavior and capability of survivors. If either
effect holds, public policy to stimulate entry may be welfare enhancing to the extent the public benefits
exceed the private costs of the failed firms’ investments.

4. Model
We model each of the three mechanisms to construct a test of their contributions to the economic
good effect. Before distinguishing between the three mechanisms, we outline some assumptions and
definitions that will be common across them.
The first thing we define is a measure for the economic benefits. Hicks (1993) used employment
growth and wages. Employment rates and wages are a function both of industry characteristics (labor
demand) and economy characteristics (labor supply). We prefer a measure that restricts attention to firm
characteristics. Accordingly, we look at firm efficiency. The advantage of an efficiency measure is that it
captures innovation, so long as innovation manifests itself either as lower cost for same demand, or same
cost for enhanced quality/demand.
We make some simplifying assumptions in characterizing the impact of excess entry, which we
relax in the empirics. First we assume that the populations of potential buyers and potential firms are
fixed, and that all innovation is process innovation. This allows us to work from a single inverse market
demand function, P(q), where P’(q) < 0 for all q . While we allow increases in demand, we assume these
arise from downward shifts in the aggregate cost function, C(q) where C(0) = 0, C’(q) > 0 and C”(q) > 0
for all q. Second, we assume that firms operate at the same scale. Accordingly, we can define the
carrying capacity of the market in terms of the number of equal-sized firms needed to satisfy demand.
We designate this market capacity as k. Note that k, the carrying capacity, can vary across markets and
over time. For example the New York market supports more firms than does the Wyoming market, and
the Arizona market in 2003 supports more firms than it did in 1980. We define the number of firms who
actually enter the market as n. Thus excess entry is defined as n-k firms. Finally, we assume that the
endowment of firms (their initial unit cost) is normally distributed, and we order firms i = 1 to n from best
performing (lowest cost) to highest cost. The cost of the worst performing, surviving firm is designated
ck, the cost threshold for the market. This basic framework forms the basis for comparing the three
mechanisms. We now discuss the logical consequences of this set of assumptions for each of the
mechanisms.

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4.1 Selection
The selection hypothesis holds that as the number of entrants, n, increases, the efficient
threshold, ck, determining which k firms survive is increased. This effect is illustrated in Figure 1. In the
baseline (Figure 1a), four firms enter the market. Arranging their unit cost from lowest to highest (left to
right) creates the aggregate cost curve, C1. This cost curve intersects demand, D, at q1, generating market
price, p1. If we allow excess entry (Figure 1b), then as additional firms enter, they compete on cost to
determine survivors. As in Figure 1a, firms are ordered from lowest to highest unit cost, but here Firms 6
and 8 have replaced Firm 4 because they had lower cost. Two other firms, 5 and 7, attempted to enter,
but found their cost to be higher than Firm 3. The new set of firms defines a new aggregate cost curve,
C2, with shallower slope. This reflects the fact that with competitive selection, survivor firms are
increasingly drawn from a smaller portion of the right tail of cost distributions. Because C2 is below C1,
output is increased (from q1 to q2), and price is decreased (from p1 to p2). The welfare contribution from
excess entry under this hypothesis is expressed as the present value of the annual surplus increase minus
the investments of the failed firms.
q2 k min ⎡ q1 k ⎤
∫0 P ( q )dq − ∑ c i ( q ) − ⎢ ∫ P ( q ) dq − ∑ c i ( q ) ⎥ − F (n − k ) (1)
i =1 ⎣⎢ 0 i =1 ⎦⎥
where F is the setup cost, n is the number of total entrants, and k is the number of surviving entrants.
Thus excess entry shifts the aggregate cost curve down and to the right. The extent of this shift is
a function of the distribution of the potential entrant pool and the probability of entry. This shift increases
both output and buyer surplus by displacing less efficient producers. The net effect on producer surplus is
ambiguous.
-------------------------------
Insert Figure 1 about here
-------------------------------
4.2 Competition
The competition hypothesis holds that entrants affect the strategic behavior of surviving firms. In
particular, the intensified competition stimulates strategic investment to reduce cost and thereby escape
competition (Barnett and Hansen 1996, Peretto 1999, Aghion et al 2001, Knott 2003). What distinguishes
this hypothesis from the prior one is that under the selection effect the unit costs of survivor firms remain
at their initial endowments. Aggregate cost decreases only because firms with less efficient endowments
are replaced with more efficient ones. Here, under the competition effect, the aggregate cost curve shifts
because the costs of existing firms decrease below their initial endowments. Competitive pressure to
remain in the market, and the eroding market position from shares stolen by the entrants (Mankiw and
Whinston 1986), stimulate cost-reducing investment. This competition effect is characterized in Figure 2.

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Here the original four entrants remain in the market but their costs are now lower due to cost-reducing
investments to better position them for future competition.
The baseline in Figure 2 (Figure 2a) is the same as that in Figure 1a. If we allow excess entry
(Figure 2b), then firms are under additional competitive pressure from these excess entrants. This
pressure stimulates investments to reduce cost. If we ignore selection effects, then the same four firms
supply market output, but the aggregate cost curve shifts down because each firm has lower cost than it
would in the absence of the additional competitive pressure. Again, because C2(q) is below C1(q), output
is increased (from q1 to q2), and price is decreased (from p1 to p2). The welfare contribution from excess
entry under the competition hypothesis is expressed as follows:
q3 k ⎡q1 k ⎤
∫0 P ( q )dq − ∑ c it ( q ) − ⎢ ∫ P ( q ) dq − ∑ c i (q )⎥ − F (n − k ) (2)
i =1 ⎣⎢ 0 i =1 ⎦⎥
where:
cit (q) = (1-γ)(cit-1 (q))
dγ /dn > 0; d2γ /dn< 0.
Thus competition shifts the aggregate cost curve down and to the right due to decreases in the
cost of each survivor firm. Because investment decisions are typically made annually in response to the
competition faced in the preceding period, the extent of these cost improvements is a function of the
cumulative number of excess entrants and the length of time they remain in the market. As in the
selection effect, this shift increases both output and buyer surplus.
-------------------------------
Insert Figure 2 about here
-------------------------------
4.3 Spillovers
The spillover hypothesis holds that the knowledge generated by failed firms is expropriated by
surviving firms. This expropriation takes place in the same manner as spillovers between surviving
firms—through employee turnover across firms, interactions with suppliers and customers, publications
in the trade literature, and patents (Hoetker and Agarwal 2003). It also becomes imbedded in the products
of failed firms and can become imbedded in inputs from suppliers. Following convention, we assume
that spillovers are a function of the cumulative activity of all firms in the market (Spence 1981,
Lieberman 1987)4.

4
Whereas spillovers are typically measured as the pool of industry R&D weighted by technological and geographic
proximity, (Jaffe 1986, 1988), our measure of spillovers (cumulative output) takes a form similar to that for learning
curve effects (Lieberman 1987). We wish to make two points regarding our measure. First, given industry R&D
intensity is fairly stable over time, relative pooled output will match relative pooled R&D. We prefer output to R&D

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This spillover effect is like the competition effect in that excess entry decreases the costs of
surviving firms. The distinction between the two hypotheses is subtle. Under competition firms are
driven to invest in innovation to maintain their competitive position—thus they actively reduce costs.
Under the spillover effect firms passively benefit from the cumulative activity of other firms in the
market. This occurs because the maximum size of the market determines the aggregate spending on
marketing and R&D, the innovative activity of suppliers and the number of employees with industry-
specific skills (the sources of spillovers).
Thus spillovers shift the aggregate cost curve down and to the right due to passive decreases in
the cost of each survivor firm. The extent of these cost decreases is a function of the cumulative output of
all entrants. The resulting shift in aggregate cost increases both output and buyer surplus such that:
q4 k ⎡q1 k ⎤
∫0 P ( q )dq − ∑ c it ( q ) − ⎢ ∫ P ( q ) dq − ∑ c i ( q ) ⎥ − F (n − k ) (3)
i =1 ⎣⎢ 0 i =1 ⎦⎥
where:
cit (q) = (1-ϕ)(cit-1 (q))

dϕ /d( ∑Q
t
t ) > 0; d2ϕ /d( ∑Q
t
t ) < 0.

In addition to the market-level effects on cost that we model here, there may be industry-wide
effects. These will be treated as exogenous shocks. In fact they too may be endogenous to aggregate
industry activity.

5. Empirical Approach
All three mechanisms predict lower aggregate cost with excess entry for a given market. They
differ only in the means through which lower cost is achieved. Accordingly, our empirical strategy
compares firm efficiency across markets and over time within the same industry. This approach allows us
to examine the effects of different levels of entry and exit while controlling for industry demand curve
and technology.
The empirical approach we take is similar to that in studies examining the micro-level
components of aggregate productivity growth (see Bartelsman and Doms for a review of studies in the
manufacturing sector; see Foster, Haltiwanger and Krizan 2002 for a recent study in the retail sector). We
extend those studies along four dimensions. First, we examine a new sector—financial services.
Financial services are important in that they are a large ($2.1 trillion in 2001) and growing (real annual

investment because in many instances innovation expenditures will not appear in an R&D line item. e.g., adopting
new manufacturing technology from suppliers. Second, we use the term spillovers rather than learning curves to
distinguish between intra-firm investments and rival investments.

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rate of 6.5% over the past ten years) sector of the economy. Moreover the fact that they are more labor
intensive than other sectors suggests that the patterns of productivity growth may differ from those in
sectors where vintage capital effects are important. Second, we introduce market effects. Previous studies
dealt with manufacturing industries where all firms share a common market, or retail, where the
heterogeneity in retail offerings limit market comparison. Third, we examine annual data whereas prior
studies have used census data and thus have looked at changes over the five-year period between
censuses. Finally and most importantly, we introduce a new factor—excess entry. When prior studies
have examined exit and entry they have done so in the context of reallocation effects—displacement of
old inefficient establishments with more efficient entrants. While reallocation is one component of the
excess entry phenomenon, it considers only the selection effects of successful entrants and failed
incumbents, whereas we also consider the externality on industry cost.
The empiricism in these micro-level studies is typically done in two stages. In an initial stage,
researchers develop estimates of establishment level efficiency in each period. In a subsequent stage they
recompose changes in aggregate productivity growth using contributions from entrants, exits and
continuing establishments. In general the studies have found 1) that there is considerable heterogeneity in
establishment productivity, 2) that relative productivity is durable—establishments with high relative
productivity in one period are likely to exhibit high relative productivity in subsequent periods, 3) that a
significant portion of productivity improvement (approximately 25%) arises from reallocation effects—
the displacement of low productivity establishments with higher productivity entrants, and 4) the most
significant source of productivity improvement is expansion of existing plants.
We begin our empiricism by replicating the approaches in the prior studies. We then extend the
empiricism to examine the impact of entry and exit on market structure and the impact of structure on
firm efficiency.

5.1 Industry
We conduct our tests in the banking industry following de-regulation. The industry was chosen
because it is fragmented with localized competition, has a substantial knowledge component (such that
cost improvement is feasible), and is marked by significant failure. Moreover, failure in the industry is
due to inefficiency rather than market selection over differences in product offerings (Berger and
Humphrey 1992). Thus industry gains from failure, if any, are likely to match the mechanisms we have
modeled.
Fragmentation is important because it allows us to compare discrete markets within the same
industry. Since the markets are in the same industry we assume that each market faces the same inverse
demand function and shares the same technology. Thus we can compare the changes in market structure

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(arising from excess entry) while controlling for other factors affecting cost across distinct industries. We
can also control for differences in level of demand through differences in economic conditions across
markets. Furthermore, because banking is regulated, we can obtain firm level panel data. We confine our
analysis to the period following deregulation because we can plausibly argue that knowledge obtained
prior to de-regulation is heavily depreciated, and thus can be ignored. The high failure and merger rates
post de-regulation support this contention (See Figure 3).
---------------------------------------------
Insert Figure 3 about here
---------------------------------------------
Our operational definition of market in the analysis is a state. In part this definition arises from a
data limitation. The unit of observation in the FDIC data is an insurance certificate. A separate certificate
is required for each state in which a bank operates5, but covers all branches for that bank operating within
the state. Ignoring for a moment the data limitation, there are two discrete definitions of market: the
state, representing certificate/headquarters level competition, or municipality, representing branch level
competition. A reasonable argument for not doing branch level analysis, even if data were available, is
that it is difficult to determine a relevant radius for competition. Consumers might choose a branch close
to their home or one close to their office, but they may also choose a bank based on the fact that it had
branches near both, suggesting aggregation to a metropolitan area. Continuing that logic, a state is merely
further aggregation, representing on average 7.1 Metropolitan Statistical Areas (MSA), 1.3 Primary
Metropolitan Statistical Areas (PMSA) or 0.4 Consolidated Metropolitan Statistical Areas (CMSA).
Given the difficulty choosing a level of aggregation for branch level competition, and given the fact that
the state captures headquarters competition, we define a market as a state.6
Bank failure. Exits from the banking industry take the form of failures and mergers. Studies of
failure in the banking industry during the period indicate that the firms which failed are those deemed
inefficient with respect to the new production function (Berger and Humphrey 1992). It is important to
note that the FDIC rarely allows banks to fail outright (their term is “paid outs”—banks close their doors
leaving the FDIC to compensate depositors). The majority of failures are resolved through forced
mergers between the “failed” institution and a healthier institution. Thus it is less likely that knowledge

5
Interstate branching was forbidden prior to June 1997 unless state legislation expressly approved it. The first state
to allow interstate branching was New York in 1992, under conditions of reciprocity. As of 1993 only four states
allowed interstate branching. Results are robust to excluding data post 1993.
6
As an additional test of reasonableness, Petersen and Rajan (2002) examine the distance between small firms and
the bank branch they use most frequently. They find that the distance capturing 75% of firms in 1990-1993 is 68
miles, and growing rapidly due to information technology. This implies a circumscribed area of 14524 miles, which
is greater than the land area of 10 states, and equal to 26.3% of the mean land area of all states excluding Texas and
Alaska. Thus state is a meaningful market boundary even for branch level competition.

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from the failed firms will be broadly expropriated by surviving firms. Exits may also take the form of
unforced mergers which act as another mechanism through which lower efficiency banks exit the
industry. In the case of mergers, both forced and unforced, the appropriable assets remain private, rather
than being dispersed. Figure 3 quantifies exits by each of the types.

5.2 Empirical Model

Analysis proceeds in two stages. In the first stage we model an industry cost frontier to collect
measures of efficiency for each firm in each year. In the second stage, we model firm efficiency (from
stage 1) as a function of the three failure benefit mechanisms.
Stage 1-Firm efficiency. We follow convention in studies of bank efficiency by modeling a
stochastic cost frontier using a translog cost function (Cebenoyan, Papaioannou and Travlos 1992,
Hermalin and Wallace 1992, Berger, Hancock and Humphrey 1993, Mester 1993). Stochastic frontier
analysis, developed by Aigner, Lovell and Schmidt (1977), is based on the econometric specification of a
cost frontier. The stochastic frontier model assumes that the log of firm i’s cost in year t, cit, differs from
the cost frontier, cmin, by an amount that consists of two distinct components: a standard normally
distributed error term eit, and a cost inefficiency term modeled as a non-negative random variable uit –
which we assume to take the form of a truncated normal distribution.7
We use the translog cost function to accommodate the complex array of bank inputs and outputs.
In addition, the translog form accommodates tradeoffs in both market strategies (product mixes and
prices), and operational strategies (input mixes).8 The basic translog cost function mimics the objective
function for firm i in year t that is minimizing total cost, cit, by choice of output levels, yit, taking input
prices, wit, as given:

cit = β 0 + ∑ β1 j yitj + ∑ β 2 k witk + 1 2 ∑ ∑ β 3 jj yitj yitj +

j k j j

+ 1
2 ∑∑β k k
4 kk witk witk + ∑ ∑ β 5 jk y itj witk + u it + eit
j k
(4)

where:
cit = log observed firm cost
j
y it = vector of log output levels - j indexes output elements

7
Other distributional assumptions are also possible, the most common of which are the half normal and exponential
distributions. All results are robust to these alternative distributions.
8
Note that the translog model used in panel studies of the banking literature does not include a fixed effect. The
objective of their studies, and ours, is to capture between firm differences in efficiency over time. The inclusion of a
fixed effect would remove mean firm efficiency differences and thus only capture variation within firms over time.
We remove mean firm differences in the second stage of our analysis in which we directly model the drivers of
heterogeneous firm efficiency.

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witk = vector of log input prices - k indexes input elements

u it = cost inefficiency with truncated normal distribution
eit = error term with normal distribution.

We pool data for all firms over fourteen years using the stochastic frontier model to capture firm-
year measures of cost inefficiency relative to a global cost frontier. We collect the estimates of the
expected value of firm-year cost inefficiency in stage 1, E(uit | eit), which for convenience we continue to
label as uit, and use the estimates as the dependent variable in stage 2 to test the failure mechanisms.
Stage 2 – Test of mechanisms. In a second stage, we model firm cost inefficiency, u it , as a

function of excess entry in a given market where, as per the discussion above, a market is operationalized
as a state. We utilize different models for the selection effect versus the competition and spillover effects.
Selection. We test the selection effect by characterizing a time varying cost threshold modeled as
t
the additive effect of cumulative entry, ∑A
1
s ,t −1 , the total number of firms that have entered state s from

1984 through year t, and firm inefficiency, u it . We use a logit model to estimate firm failure hazard as a

function of the cost threshold, and vectors of controls for state effects, firm level effects, and year effects:

⎛ t ⎞
P (exit )it = α 0 + α1 ⎜ ∑ As ,t −1 ⎟ + α 2uit + γ 1StateCtrlst + γ 2 FirmCtrlsit + Yeart + eit (5)
⎝ 1 ⎠
If there are selection effects, such that increasing the number of entrants improves the pool of
survivors, we expect the coefficients α1 and α 2 to be positive and significant. This would indicate that

cumulative entry drives exit, and that the mechanism for determining who exits is firm efficiency.9
Competition. We test the two remaining mechanisms jointly in a single equation for firm cost
inefficiency, u it .
t t
uit = β 0 + β1 E st + β 2 ∑ E st + β 3 ∑∑ ysit −1 + γ1 StateCtrlsst + γ 2 FirmCtrlsit + Yeart + λ i + eit (6)
1 1 i

We test the competitive effects by looking separately at current period excess competition, E st ,
t
and cumulative excess competition (competition), ∑E
i
st , for market s in year t. Current period excess

competition examines the immediate effects of increased competition. This allows us to characterize the
competitive pressure triggering the innovation response (Levitt and March 1988, Barnett and Hansen
1996). If incumbent firms respond tactically to entry by reducing slack, we expect β1 to be negative. If

9
We later compare α1 and α2 to detemine the marginal impact of an excess entrant on the industry cost threshold.

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they respond by reducing price, we expect β1 to be positive, reflecting lower price for a given level of
resource costs (equivalently higher cost to price ratio).
Cumulative excess competition examines the strategic effects of cost-reducing investment to
better position the firm for future competition. If firms respond strategically to entry through cost-
reducing investment, we expect β2 to be negative and significant. Note that if potential entrants discipline
the market through limit-pricing (discouraging entry by charging a low price) (Bain 1949, Milgrom and
Roberts 1982), then there should be no response to entry. In that case both β1 and β2 should be
insignificant.
Spillovers. Finally, we test the spillover effect by examining the cumulative output of all firms
t
over each year a firm is in a market (permanent plus ultimate failures), ∑∑ y
1 i
sit . The spillover effect is

distinguished from the competition effect by the fact that spillovers are assumed to accumulate passively
from learning by doing. In contrast, the competition effect presupposes an overt response to excess
rivalry. If surviving firms benefit from spillovers we expect β3 to be negative and significant. Note that
the spillover effect includes learning from incumbents as well as entrants, since there is no reliable means
to distinguish between them. Accordingly, we assess the entrants’ contributions mechanically by
applying β3 to the entrants’ output.
Equation 6 tests the competition and spillover effects discussed above, while controlling for time
varying market and firm characteristics, year effects, and firm fixed effects, λi . The year effects will

capture industry-wide shocks such as new technology. The firm fixed effects will capture fixed
differences between firms in addition to capturing fixed differences between markets, such as regulation
and taxation.

5.3 Data
The data for the study comes from the FDIC Research Database which contains quarterly
financial data for all banks filing the “Report of Condition and Income” (Call Report). Upon entry into
the market, each bank is allocated a unique certificate number by the FDIC – and we take the bank
(certificate number) as our fundamental unit of analysis. The FDIC classifies and compiles data on two
distinct types of banking entities: (a) Commercial banks, which include national banks and state chartered
banks (excluding Thrifts) insured by the FDIC; and (b) Savings banks which operate under state or
federal banking codes related to Thrift institutions. Commercial banks, which are the focus of this paper,
differ from Savings banks in that Saving banks have traditionally been limited in both the types of
deposits they could accept and the types of loans they could provide. Given the well known irregularities

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in the Thrift industry during the 1980s, we confine our analysis to commercial banks. We examine each
of the fifty states plus the District of Columbia for the period 1984 to 1997. This initial data set contains
694,587 firm-quarter observations. Following convention in the banking literature we aggregate to
annual data by averaging the quarterly data (Mester 1993). The final first stage data set comprises
170,859 firm-year observations.
While there is considerable debate as to the choice of inputs and outputs in the banking sector, a
review of the literature suggests that there is some convergence around a version of equation 4 that sees
physical capital, financial capital and labor as inputs to the production process and various forms of loans
(mortgages, other loans and securtities) as outputs (Wheelock and Wilson, 1995). We collect data to
construct seven variables related to banking efficiency in log thousands of constant 1996 dollars. The
dependent variable is total cost, cit, – total interest and non-interest expenses. The six independent
variables are divided between input prices, wit, and output quantities, yit. Input prices are: (a) labor price –
salary divided by the number of full time equivalent employees; (b) physical capital price – occupancy
and other non-interest expenses divided by the value of physical premises and equipment; (c) capital
price– total interest expense divided by the sum of total deposits, other borrowed funds, subordinated
notes and other liabilities. Output quantities are stocks ($1000) of: (d) mortgage loans; (e) non-mortgage
loans; and (f) investment securities.
In order to test the hypotheses in the second stage model, we gather aggregate state-year data on
entry and exit from the FDIC database to create the cumulative entry (additions), excess entry, cumulative
excess entry and cumulative output variables. We define entry as a new commercial banking institution
that comes into existence either by way of a new charter or the conversion of an existing charter.
Likewise, we define exit as an event that leads to the termination of a bank (certificate) either in the form
of a forced failure or merger, or an unforced merger. We define excess entry as the number of
institutions in excess of the carrying capacity of the market s in year t. Using the logic of efficient
markets, we measure this variable simply as the number of exits from market s in year t, where exits
include both failure and mergers.10 To the extent that optimistic firms remain in the industry during
periods of losses, this measure understates the excess. Cumulative excess is therefore the sum of the exits
over all years since 1984. In addition, in order to create the cumulative output for market s in year t, we
aggregate firm level output at the state level as the sum of mortgage, non-mortgage loans and investment
securities of all firms located in the state. These were the y1, y2 and y3 variables in the stage 1 analysis.

10
The important consideration here is the extent to which exits remove operational capacity from the market.
Descriptive data suggest that all exits, be they failures or mergers (FDA forced as well as unforced), remove branch
capacity, and thus we consider both types of exits as constituting excess entry.

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A number of firm level control variables are included in the model. In order to control for branch
scale effects not already accounted for in the first stage estimation, we include three variables: (a)
branch_count - number of branches operated by the bank (b), branch_size – the average size of a branch
measured in terms of total output in thousands of constant 1996 dollars, (c) cum_output_bank- the sum of
bank output over all branches and years in thousands of constant 1996 dollars.
Approximately one-third of banks are owned by a bank holding company that controls more than
one bank (certificate). For such banks, we include a dummy variable, holding_company, as well as a
number of measures of the size of the holding company: (c) hc_certificates – the number of additional
banks (certificates) held by the holding company; (d) hc_branches – the number of additional branches in
the bank holding company system beyond the number of branches in the observation certificate; (e)
hc_states – the number of additional states in which the holding company operates banks.
We control for economic differences across markets and over time using annual data on
population and housing starts. Permanent differences across states, e.g., regulatory conditions, are
subsumed by the firm fixed effects.
-------------------------------
Insert Table 1 about here
-------------------------------
6. Results
Stage 1 - Firm Cost Efficiency. Table 1 provides variable descriptions and summary statistics of
the data used in Stage 1. We estimate the stage 1 stochastic frontier model assuming a truncated normal
distribution for the inefficiency term and a normally distributed error term. Estimation is conducted using
maximum likelihood techniques. Results from the stage 1 analysis using equation 4 are given in Table 2.
The objective of the stage 1 analysis is to provide the firm-year cost inefficiencies that serve as the
dependent variable in stage 2. While a discussion of the estimated coefficients of the frontier model is
outside the scope of this paper, the coefficient estimates are consistent with expectations as: (a) total costs
appear to rise with output and increases in the price of capital, and (b) firms substitute labor and physical
capital in response to changing prices for these inputs. The more important result of the stage 1 frontier
estimation is the expected value of the inefficiency terms, uit. The distribution of the cost inefficiency is
given in Figure 4 and the mean value over time is depicted in Figure 5. The mean uit over the entire
period is 0.171, which indicates that the total cost for the mean firm is 18.6% above that of a firm on the
cost frontier. The data also indicate that while the mean cost inefficiency changes over time in response to
changing technologies and demand conditions, the general trend is toward increasing efficiency
(decreasing cost).
-------------------------------

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Insert Table 2 about here

-------------------------------
-------------------------------
Insert Figure 4 and 5 about here
-------------------------------
Comparison with longitudinal micro-data (LMD) studies. To provide more insight into the
dynamics of banking sector efficiency we mimic LMD studies and present a transition matrix of firm
efficiency (Table 3). The transition matrix characterizes how a firm’s efficiency in one period is related
to its efficiency in the subsequent period. The table decomposes firm efficiency into quintiles, then
depicts year-to-year movements across quintiles by comparing rows and columns. As an example, take
the row labeled 1. This represents the highest performing (lowest cost inefficiency) firms in a given year.
The table indicates that the majority of firms (78%) remain in the top (lowest cost) quintile in the
subsequent year, 15% drop one quintile, 2% drop two quintiles, less than 1% drop to each of the bottom
two quintiles, 2.7% merge with other firms and 0.5% fail outright.
-------------------------------
Insert Table 3 about here
-------------------------------
The table indicates three patterns of interest. First, relative firm efficiencies are fairly stable. The
highest percentages are along the diagonal, meaning that in general firms remain in the same cost quintile.
Second, failures and mergers increase with firm cost. The highest percentage of mergers and failures are
coming from the highest cost firms. Thus the table provides preliminary evidence of a selection effect as
the lowest performing firms are being driven from the market. These patterns (persistent heterogeneity
and selection effects) are similar to those found in LMD studies of other sectors. Third, new firms tend to
enter at the industry extremes, 27% enter the lowest cost quintile, while 60% enter the highest cost
quintile. Again, this pattern is shared with LMD studies in other sectors.
To complete the parity with prior LMD studies, we conduct an additional test of the reallocation
effects. We created distributed lag models for entering and exiting firms to track their efficiency
following entry and preceding failure. Figures 6 and 7 present graphical results of this analysis.11 Figure
6 presents the results for exiting firms. The results indicate that lower performing firms exit the industry,
confirming the preliminary results in the transition matrix. The new insight is that failing firms not only
have higher cost than the industry overall, but their cost deteriorates as they approach their exit year.
While these effects hold for both failures and mergers, they are more pronounced for failures. In fact,

11
Coefficient estimates are available from the authors.

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failing firms have cost inefficiencies that are twice the industry average resulting in a 26 percent increase
in overall cost.12
Figure 7 presents the results for entering firms. The results indicate that entering firms tend to
have higher costs than incumbent firms, and that their cost inefficiencies are twice the industry average in
the entry year (0). We further disaggregate the data into firms that survive more than five years, and
those that fail or merge within five years of entry. For surviving entrants, performance nearly matches
that of incumbents by the third full year. Entering firms that fail match surviving entrant’s performance
for the first three years, then show a dramatic reduction in efficiency, mimicking the results in Figure 6.
Interestingly, firms that merge within five years of entry are the poorest performing entrants. In general,
the results in Figure 7 indicate that those firms who entered in the highest cost quintile in Table 3 are
unlikely to recover.
-------------------------------
Insert Figures 6 and 7 about here
-------------------------------
Overall the micro-level components of banking efficiency seem to match the patterns found in
other sectors. There is considerable heterogeneity in banking efficiency (Figure 4), and the relative
efficiencies are durable (Table 3).

Stage 2 – Test of Mechanisms.

Having generated firm cost inefficiencies and showed comparability between the micro patterns
of aggregate efficiency improvement within banking and those in other sectors, we now proceed with the
formal tests of the excess entry mechanisms. We look first at test of selection effects and then at tests of
competition and spillovers effects. Summary statistics for the data supporting these tests are presented in
Table 4.
-------------------------------
Insert Table 4 about here
-------------------------------
Selection. Results for test of the selection effects using a pooled logit estimation of equation 5
are given in Table 5. The equation creates a measure of an evolving cost threshold by examining market
level effects (how much exit there will be) and firm level effects (which firm is most likely to exit). The
main results, presented in Model 4, indicate that both cumulative_additions and cost_inefficiency are

12
The cost inefficiency (in ln form) increases from the mean of 0.18 by approximately 0.18 to 0.35. This
corresponds to a 26 percent increase in costs.

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positive and significant. That is, an increase in either cumulative_additions or cost_inefficiency leads to
an increase in the probability of exit. An important question is that of the effect of excess entry on the
cost threshold for survival. To assess the economic significance of the selection effect, we equate the
marginal effects of cost_inefficiency and cumulative_additions at their means. This comparison indicates
that each additional entrant into a market lowers the cost threshold for survival, ck, (increases the exit
hazard for a given level of firm cost efficiency) in that market by 1.35%.
The control variables also suggest interesting patterns. The state level economic controls for
population growth and new housing growth are significant only in a model without the main variables.
The firm level variables indicate that the least efficient firms are the ones most likely to exit. This
matches intuition and as well as preliminary results from the transition matrix. They also indicate that
firms with riskier portfolios (higher percentage of real estate loans) have higher exit probabilities. Larger
scale (branch size and number of branches) decreases the probability of exiting, but ownership by a bank
holding company significantly increases the probability of exiting. This probability increases further with
the scale of the holding company (number of bank certificates, branches, and states of operation). This is
a rather counterintuitive result. However, further analysis (available from the authors) indicates that the
results pertain to unforced mergers (consolidating weak banks) rather than failures.
-------------------------------
Insert Table 5 about here
-------------------------------
Competition & Spillovers. Results for the test of competition effects using equation 6 are given
in Table 6. The equation considers both the immediate, tactical effects of current competition and the
strategic effects of cumulative exposure to excess competition. We test the tactical effects through the
variable excess_entry and test the strategic effects through the variable cumulative_excess_entry. We
examine the impact of each variable on firm cost inefficiency (negative coefficients decrease cost).
-------------------------------
Insert Table 6 about here
-------------------------------
Model 2 indicates that excess_entry is positive and significant, indicating that margins fall (costs
rise) with the number of current excess competitors. This suggests the immediate effect of excess
competition is to reduce price (same cost for lower output) rather than to remove slack. This result is
also consistent with the stealing share effect (Mankiw and Whinston 1986) where fixed costs are allocated
over lower firm output. While our primary interest is the strategic impact of cumulative excess
competition on firms’ innovative behavior (model 3), we show the results for current competition first to
demonstrate that 1) excess entry hurts performance, and 2) the degradation in performance appears to

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stimulate an immediate response. These results are consistent with those of Barnett and Hansen (1996)
and Barnett and Sorenson (2002) who show that firms respond to recent competition.
Turning next to the permanent effects, model 3 indicates that cumulative_excess_entry leads to
cost-reducing investment as the coefficient is negative and significant. We evaluated the marginal
contribution of an additional excess entrant at the mean value of the independent variables. This analysis
indicates that each excess entrant in a market yields a permanent 0.004 percent reduction in the mean cost
of each incumbent firm. Given the mean terminal value (1997) for cumulative excess entry in a market
was 336 firms, the implied cost reduction in each surviving firm was 1.34%.
Finally, we examine the spillover effect of passive contributions arising from the activity of failed
entrants (model 4). The coefficient on cumulative_output_market is negative and significant indicating
that each dollar of market output significantly reduces the costs of surviving firms. Again, we examined
the marginal effects of an additional entrant who ultimately exits, taking into account its mean output. On
average, each such entrant generated an output of $128 million for 7.4 years prior to exiting – the result of
which was a permanent reduction in the cost of each surviving firm by 0.0007%. In 1997, in each market,
the mean value of excess entry was 336 firms. Accordingly, the corresponding cost reduction in surviving
firms was 0.24%. This learning from failed firms is in addition to the learning from surviving firms. One
issue with interpretation is whether the excess entrants expanded the market, thereby increasing
cumulative experience, or whether they merely stole share. If the latter is true, then there is no net
spillover benefit from the excess entrants. However, our finding that excess competition stimulates price-
cutting indicates that output was expanded by the excess entrants. This suggests their experience does
increase the spillover pool.
A brief discussion of the control variables is also warranted. In all models we include controls for
market economic conditions and time varying firm attributes that might affect bank productivity. Looking
first at firm attributes, the coefficients on the branch_count (number of branches) and branch_size
(branch scale) are negative and significant. In contrast, the coefficient on cum_output_bank is positive.
If we evaluate each variable at its mean value in 1997, the net effect is negative – suggesting that larger
firms have lower costs.
At the holding company level, the results are ambiguous, highlighting the complex role of the
multi-unit structure – both in the provision of scale advantages, but also in influencing learning between
banks within a holding company, and perhaps buffering individual banks from the learning associated
with competitive interaction (Barnett, Greve and Park 1994). In particular, the holding company dummy
is negative and significant indicating a cost reduction associated with holding company ownership. The
holding company scale variables coefficients are mixed. While both hc_branches (number of branches)
and hc_states (number of states) are positive and significant, the hc_certificates (holding company

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certificate count) is negative and significant. Nevertheless, the net effect of holding company, evaluated
at mean 1997 levels, is negative - indicating that ownership by a holding company is on average
associated with lower cost.
Looking finally at market economic conditions, results indicate that increases in both population
and the number of housing starts decrease cost. The main conclusion however is that the competition and
spillover effects persist in the presence of these controls.
In sum, our results indicate support for all three mechanisms. First, we find that selection effects
are at work as additional entry increases the probability of exit for inefficient incumbents. Second, we
find that competition from excess entrants decreases price margins in the year of the entry – which in turn
leads to a long term effort on the part of incumbents to reduce costs over subsequent years. Third, excess
entrants improve the efficiency of incumbents by adding to the pool of spillovers.
Robustness. We have conducted a number of robustness checks on the results and in each case
the results are robust to alternative specifications. First, the specification of the stochastic cost frontier
model relied on the use of a truncated normal distribution of the cost inefficiency term. We tested the
sensitivity of the results to different distributional specifications. We ran models assuming both a half-
normal distribution and exponential distribution and the empirical results are robust to all such
specifications.
Second, a significant assumption of the cost frontier model specified in the first stage is that all
firms are drawn from the same cost inefficiency distribution. We relaxed this assumption and allowed for
heterogeneity in the cost inefficiency distribution. In particular, we modeled the stochastic cost
inefficiency term using a half normal distribution where the variance of the distribution was assumed to
be a function of the scale of the firm. The results are robust to this re-specification.
Third, an alternative explanation for the efficiency gains from excess entry is that all such gains
are driven by very efficient entrants displacing incumbents. While the descriptive results suggest this is
not the case – as entrants on average do not match the performance of incumbents (see Figure 7), we ran
our models on a restricted sample of incumbents--firms that were in the sample over the entire fourteen
year period. Our results are robust to this sample splitting, suggesting that performance improvements are
driven by the hypothesized mechanisms rather than reallocation effects.
Finally, in our analysis, we are concerned with the effect of excess entry on surviving firms’
costs. An alternative question is that of the effect of excess entry on the cost of all firms – including those
that exit (had they not done so). While this latter question is not our central concern, we estimated a
sample selection model to account for the fact that low efficiency firms are more likely to exit. From the
estimation of equation 5, we extracted the inverse mills ratio and included this as an additional variable in
estimation of equation 6. The results are robust to this alternative specification.

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7. Private Costs and Social Welfare Implications

Our empirical results indicate that failed entrants generate externalities that substantially reduce
industry cost. Failed entrants improve the quality of the survivor pool through the selection, competition
and spillover effects characterized in Figures 1 and 2. Accordingly, policies to subsidize entry may
enhance social welfare. One important question however is whether the social benefits from excess entry
exceed the private costs of the failed entrants. While formal welfare analysis is beyond the scope of this
paper, we provide some informal analysis to anticipate likely results. The informal analysis compares the
private costs of the excess entrants to the externalities they generate.
We estimate these private costs by summing firm operating profits (losses) over the tenure of
each firm. This approach assumes that all up-front and non-recoverable investments are either amortized
across accounting periods or are expensed in the final year. We collect separate estimates for three
categories of firms: 1) firms that enter and exit during the observation period, 2) firms whose founding
predates the observation period, but who fail during the observation period, and 3) mergers within a
holding company. Table 7 summarizes the mean private costs for firms in each category.
The table indicates that on average failed entrants (those who enter and exit during the
observation period) incur no private losses. In fact they actually exhibit net profits averaging $15.14
million over their tenure. This suggests that the hit and run opportunities proposed by contestability
theory (Baumol 1982) exist in this setting. The private gains plus the positive externality on survivor
costs indicate that the failed entrants enhance social welfare. Similar conclusions are drawn for firms
who merge. They exhibit net profits averaging $19.09 million over their tenure.
Results for the displaced incumbents (firms who enter before the observation period, but later
fail) are less conclusive. The data indicate that these firms incur private losses averaging $1.3 million
over the observation period. Since the entry of these firms predates the observation period, and since
Figure 6 indicates that firm costs increase in the years immediately preceding exit, these firms may in
truth enjoy private gains. Nevertheless we take the conservative stance that these losses are net losses.
We then compare the incumbent losses to the externality generated by their displacement. To do so, we
sum the economic value of the externality for the average entrant across the three mechanisms. The
externality for the selection effect was a 1.34% reduction in surviving firm cost; the externality for the
competition effect was 0.004% reduction in surviving firm cost, the externality for the spillover effect was
0.0007% in surviving firm cost. Thus the total externality is a permanent decrease in industry cost of
1.3447%. At the mean firm cost of $2.9 million, and the mean number of firms per market of 195, this
corresponds to an aggregate cost reduction from an excess entrant of $7.6 million. Since this reduction is
actually an annuity, the externality is the present value of that annuity stream. Given that even the single

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year aggregate savings of $7.6 million exceeds the cumulative losses ($1.3 million) of the failed
incumbent, it appears that displacing entrants also enhance welfare.

8. Discussion
Approximately 10% of all firms in the United States fail each year. Our question is whether the
efforts of these failed entrepreneurs are in vain. Do their efforts merely represent private losses, or are
there public gains to offset these losses?
We proposed three alternative mechanisms through which failure of excess entrants might benefit
consumers and surviving producers. These mechanisms (selection effects, competition effects and
spillover effects) were derived from failure theories in organization theory and evolutionary economics.
We tested all three mechanisms plus the effects of current excess competition in the banking industry
following deregulation. We found significant and substantial support for each effect. Thus we can say
that the economic benefits are real. Excess entry and subsequent failure increase aggregate industry
efficiency. Moreover these social benefits exceed the private costs of failed firms (indeed many exiting
firms have net gains). Thus, in this setting, excess entrants appear to enhance social welfare.
Our results were obtained in the banking industry. We chose this setting because the
fragmentation of banking markets allowed us to compare differences in market structure (arising from
failure) while controlling for other factors affecting market structures across industry. Because there are
few fragmented industries with firm-level panel data, it will be difficult to replicate this study in other
settings. Nevertheless it is worth speculating whether our results are unique to banking. Banking is a
service industry with high human capital (knowledge) intensity and low physical asset intensity. Low
asset intensity implies there are fewer sunk investments to inhibit adoption of more efficient practices.
Our results may be less pronounced in manufacturing industries where vintage capital inhibits adoption of
innovations. Fortunately, the newer industries, the ones accounting for the greatest excess entry and
failure, tend to be more like banking than manufacturing. Thus failure should increasingly provide the
benefits seen here.
The specification employed in this paper is not without caveats. Two are of note. First, our main
means of identification comes from variation in levels of entry and exit across states. Our specification
assumes that entry choice is exogenous in the sense that entrants are randomly assigned to states. Given
the fact that 94.3% of entry is by local entrepreneurs, this assumption seems plausible. Second, our
measure of excess competition is exits. To the extent that there are lags in the exit process, it is likely that
our measure understates the actual level of excess entry at any given time and thus underestimates the
magnitude of the failure benefits.

Page 26 5/9/2006
Is Failure Good?

Within the field of strategy, researchers have only recently begun to consider the joint effects of
competition driven innovation and selection. While progress has been made (Barnett and Hansen 1996),
prior research has sought to address these issues using high level measures of performance (e.g. profits or
survival). However, competition induced innovation by one rival is often met with innovation by other
rivals. Such innovation typically affects cost or price (quality improvement), but when matched by rivals
may have no net effect on profits. An efficiency based measure allows us to capture both cost reducing
and quality improving innovation even when there is no net impact on profits or survival. With this
study, we hope to reinforce research in strategy that utilizes operational measures of performance. The
frontier approach that we employ may be useful to strategy scholars in re-examining prior conclusions
regarding competition-driven innovation, selection and learning from studies that have used higher-level
performance measures.
The conventional view of creative destruction, which hails the entrepreneur, is one of macro-level
selection in which entrepreneurs need to be successful to generate economic benefits—the nimble entrant
displaces the ossified incumbent. We introduced a behavioral view of creative destruction whereby
entrepreneurial entry applies pressure to incumbent firms which triggers search and selection at a micro-
level inside the firm. The search and selection results in displacement of inefficient practices within
incumbents. In this view even the failed entrepreneur is heroic in that she prevents successful incumbents
from resting on their laurels.

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Table 1. Stage 1 Data Summary

Variable Description Obs Mean Std. Dev. Min Max
c cost 174869 7.98 1.27 -0.82 16.76
w1 price_labor 174673 2.97 0.28 -4.85 9.39
w2 price_physical capital 173999 -1.64 0.73 -9.93 5.63
w3 price_capital 173789 -3.54 0.41 -12.58 3.32
y1 mortgage 172503 9.47 1.58 -1.37 17.86
y2 other loans 173373 9.63 1.40 -0.70 18.55
y3 securities 173828 9.58 1.47 -1.27 17.51
Units: ln(thousand - 1996 dollars)

Variable c w1 w2 w3 y1 y2 y3
c 1
w1 0.1929* 1
w2 -0.0418* 0.2792* 1
w3 0.1464* 0.0921* 0.0452* 1
y1 0.8640* 0.1151* -0.1322* -0.0463* 1
y2 0.9146* 0.1493* -0.0594* 0.1201* 0.7711* 1
y3 0.7603* 0.0821* -0.0922* 0.0259* 0.6883* 0.6934* 1

Table 2. Results from Stage 1 Regression

Dependent Variable: ln(cost)

170859 observations
Coef. se Coef. se
w1 -8.691e-01** (30.644) w1w3 -2.312e-01** (61.988)
w2 -2.085e-01** (17.544) 1/2*w2sq -4.964e-03** (4.675)
w3 2.078e+00** (85.535) w2w3 -2.519e-02** (15.625)
y1 1.942e-02* (2.073) 1/2*w3sq 2.564e-01** (72.979)
y2 4.262e-01** (41.009) y1w1 3.230e-02** (22.174)
y3 2.784e-01** (30.382) y1w2 -7.015e-04 (0.969)
1/2*y1sq 9.331e-02** (165.733) y1w3 -3.159e-02** (24.569)
y1y2 -6.028e-02** (120.751) y2w1 -2.019e-02** (12.595)
y1y3 -2.049e-02** (39.425) y2w2 -9.330e-03** (10.312)
1/2*y2sq 1.225e-01** (165.107) y2w3 2.952e-02** (21.413)
y2y3 -5.541e-02** (95.188) y3w1 -3.038e-02** (21.670)
1/2*y3sq 8.827e-02** (190.369) y3w2 1.418e-02** (19.267)
1/2*w1sq 2.011e-01** (43.998) y3w3 1.620e-02** (12.903)
w1w2 3.016e-02** (16.267) Constant 5.320e+00** (54.442)
E(u it | e it ) 1.707e-01** 0.172

Absolute value of t statistics in parentheses

+ significant at 10%; * significant at 5%; ** significant at 1%

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Table 3. Year to year transition matrix of firm efficiency

Next Year
Quintile
Low Cost High Cost
1 2 3 4 5 Merge Fail Total

Enter 670 63 96 179 1507 0 0 2515

26.64 2.50 3.82 7.12 59.92 0.00 0.00 100

Low Cost 1 31,759 6,054 905 358 379 1,097 201 40,753
77.93 14.86 2.22 0.88 0.93 2.69 0.49 100

2 5,362 17,327 6,797 1,178 246 1009 86 32,005

This Year 16.75 54.14 21.24 3.68 0.77 3.15 0.27 100
Quintile
3 702 6,447 15,857 6,374 770 1,187 135 31,472
2.23 20.48 50.38 20.25 2.45 3.77 0.43 100

4 254 923 6,074 16,164 5,141 1,414 244 30,214

0.84 3.05 20.10 53.50 17.02 4.68 0.81 100

5 394 346 817 4,736 22,282 1,968 790 31,333

High Cost 1.26 1.10 2.61 15.12 71.11 6.28 2.52 100

Total 39,141 31,160 30,546 28,990 30,325 6,675 1,456 168,293

23.26 18.52 18.15 17.23 18.02 3.97 0.87 100

Note1: Includes firms in all states in the industry at any time from 1984 to 1997
Note2: Entrants are those entering as new certificates, but does not include conversions

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Table 4. Data summary stage 213

Observations: 136759

Obs Mean Std.Dev 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

1 cost_inefficiency - ln($000) 136759 1.55E-01 1.45E-01 1.00
2 excess_entry 136759 1.80E+01 1.51E+01 0.00 1.00
3 cum_excess_entry t-1 136759 1.05E+02 9.88E+01 -0.06 0.51 1.00
4 cum_additions t-1 136759 4.05E+01 4.93E+01 0.19 0.26 0.51 1.00
5 cum_output ($000) 136759 5.90E+08 8.31E+08 0.06 0.26 0.40 0.43 1.00
6 branches 136759 5.73E+00 2.61E+01 -0.01 -0.05 -0.02 0.04 0.10 1.00
7 branch_scale ($000) 136759 1.64E+05 1.12E+06 0.03 -0.01 -0.01 0.00 0.07 0.01 1.00
8 real_estate_pct 136759 4.88E-01 1.94E-01 -0.02 0.08 0.26 0.25 0.23 -0.01 -0.07 1.00
9 cum_output_bank 136759 1.73E+06 1.93E+07 0.00 -0.02 0.01 0.03 0.15 0.61 0.23 -0.04 1.00
10 hc_certificates 136759 3.71E+00 1.05E+01 0.07 0.06 0.02 0.03 -0.05 0.07 0.02 0.01 0.04 1.00
11 hc_offices 136759 3.93E+01 1.57E+02 0.06 0.00 0.04 0.05 0.01 0.22 0.07 0.01 0.12 0.62 1.00
12 hc_states 136759 4.10E-01 1.51E+00 0.08 -0.01 0.03 0.02 0.01 0.23 0.09 -0.01 0.16 0.72 0.78 1.00
13 population 136759 6.64E+06 6.07E+06 0.15 0.26 0.23 0.55 0.74 0.09 0.02 0.21 0.08 -0.04 0.01 -0.03 1.00
14 delta_population 136759 6.59E+04 1.19E+05 0.18 0.14 0.22 0.67 0.40 0.07 0.00 0.18 0.04 -0.01 0.04 0.00 0.76 1.00
15 permit 136759 3.47E+04 4.26E+04 0.16 0.19 0.15 0.54 0.34 0.07 0.00 0.14 0.03 0.00 0.04 -0.01 0.76 0.90 1.00
16 delta_permit 136759 -4.37E+02 9.13E+03 -0.03 -0.01 0.01 -0.18 -0.10 -0.01 0.00 -0.03 -0.01 0.01 0.00 0.01 -0.17 -0.26 -0.09 1.00
Units in counts or dollars unless otherwise stated

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Table 5. Test of Exit Hazard

Logistic Regression Results

Dependent Variable: probability(exitit)
(1) (2) (3) (4)

cum_additions t-1 2.032e-03** 1.563e-03**

(5.673) (4.346)

cost_inefficiency t-1 7.588e-01** 7.300e-01**

(13.100) (12.479)

branch_count -2.912e-03** -2.908e-03** -2.603e-03** -2.611e-03**

(5.214) (5.241) (4.689) (4.730)

branch_scale -1.793e-07** -1.871e-07** -1.750e-07** -1.807e-07**

(3.839) (3.922) (3.944) (3.997)

real_estate_pct 4.933e-01** 4.538e-01** 5.230e-01** 4.908e-01**

(6.387) (5.857) (6.826) (6.380)

holding_company 1.042e+00** 1.046e+00** 1.041e+00** 1.044e+00**

(33.428) (33.546) (33.360) (33.448)

hc_certificates 4.082e-03** 3.224e-03* 4.423e-03** 3.720e-03**

(3.222) (2.529) (3.495) (2.917)

hc_branches 9.209e-04** 9.206e-04** 9.506e-04** 9.506e-04**

(12.708) (12.749) (13.101) (13.134)

hc_states 6.557e-02** 6.954e-02** 5.571e-02** 5.915e-02**

(6.746) (7.179) (5.734) (6.094)

delta_population 7.143e-07** 9.023e-08 4.741e-07** 3.205e-09

(5.906) (0.529) (3.832) (0.019)

delta_permit -1.893e-06 -2.489e-06 -2.447e-06 -2.902e-06+

(1.122) (1.422) (1.440) (1.660)

year dummies sig. sig. sig. sig.

Constant -3.618e+00** -3.689e+00** -3.721e+00** -3.770e+00**

(53.869) (54.022) (55.066) (55.047)

Observations 136478 136478 136478 136478

Log_L -23169.138 -23153.303 -23096.873 -23087.544
Chi2 3849.524 3881.195 3994.054 4012.713
Prob > Chi2 0.000 0.000 0.000 0.000
Pseudo R_sq 0.077 0.077 0.080 0.080
Absolute value of z statistics in parentheses
+ significant at 10%; * significant at 5%; ** significant at 1%

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Table 6. Results from Stage 2 Regression

Regression Results
Dependent Variable: cost_inefficiency
Fixed Effects
(1) (2) (3) (4) (5)

excess_entry 1.488e-04** 1.952e-04**

(6.863) (8.844)

cum_excess_entry t-1 -4.671e-05** -3.953e-05**

(8.418) (6.877)

cum_output_mrkt -7.033e-12** -6.889e-12**

(8.258) (7.703)

branch_count -1.319e-04** -1.312e-04** -1.350e-04** -1.331e-04** -1.349e-04**

(6.053) (6.023) (6.196) (6.111) (6.192)

branch_size -1.246e-08** -1.245e-08** -1.256e-08** -1.244e-08** -1.250e-08**

(23.610) (23.591) (23.789) (23.569) (23.695)

cum_output_bank 7.273e-11** 7.295e-11** 6.556e-11* 1.042e-10** 9.773e-11**

(2.721) (2.730) (2.452) (3.860) (3.613)

holding_company -6.492e-03** -6.603e-03** -6.578e-03** -6.653e-03** -6.867e-03**

(6.141) (6.246) (6.224) (6.294) (6.499)

hc_certificates -5.841e-05 -6.777e-05 -5.232e-05 -4.421e-05 -5.164e-05

(0.933) (1.083) (0.836) (0.706) (0.825)

hc_branches 3.305e-05** 3.295e-05** 3.226e-05** 3.301e-05** 3.221e-05**

(9.323) (9.295) (9.100) (9.314) (9.088)

hc_states 2.643e-03** 2.657e-03** 2.678e-03** 2.521e-03** 2.570e-03**

(5.862) (5.893) (5.940) (5.589) (5.700)

population -7.339e-09** -8.048e-09** -5.062e-09** -4.637e-09** -3.696e-09**

(6.888) (7.520) (4.606) (4.161) (3.268)

permit -2.717e-07** -2.843e-07** -2.333e-07** -2.863e-07** -2.700e-07**

(11.440) (11.937) (9.650) (12.025) (11.049)

year dummy sig. sig. sig. sig. sig.

Constant 2.081e-01** 2.111e-01** 1.850e-01** 1.811e-01** 1.787e-01**

(27.462) (27.820) (22.176) (21.557) (21.242)

Observations 136759 136759 136759 136759 136759

R-squared 0.731 0.731 0.731 0.731 0.731
Absolute value of t statistics in parentheses
+ significant at 10%; * significant at 5%; ** significant at 1%

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Table 7. Private costs of exiting firms

Firm Category Number of Firms Mean Profits

Firms who enter and exit 790 $15.14 million

Incumbents who fail 153 $ -1.30 million

Incumbents who merge 637 $19.09 million

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Figure 1. Welfare increase from selection effect (hypothesis 1)

P P
S1

P1
S2
P2

f4 D D
f3 f8 f6 f3
f2 f2
f1 f1

Q Q
Baseline (k draws) Excess Entry (k+e draws)

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Figure 2. Welfare Increases from competition effect (Hypothesis 2)

P P
S1

P1 P1
S3
P3

f4 D f4 D
f3 f3
f2 f2
f1 f1

Q Q
Baseline (k draws) Excess Participation

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Figure 3. Banking failures following de-regulation

Banking Entry & Exit 1984-1997

700
600
500
enter
400
Count

merge
300
fail
200
100
0
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
Year

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Figure 4 . Histogram of firm-year efficiency metrics

Cost Inefficiency Density Function

8
6
Density
4 2
0

0 .5 1 1.5 2
cost_inefficiency

Figure 5 . Mean Cost Inefficiency

Mean of Cost Inefficiency

.2 .15
mean of u_tn_pl
.1 .05
0

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

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Figure 6. Exiting firm cost inefficiency histories

Exiting Firm Cost Inefficiency

Cost Inefficiency: Relative to firms more than 5
years from exit
0.20
fail 0.18
merge 0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
4 3 2 1 0
Years to Exit

Figure 7: Entering firm cost inefficiency history

Entering Firm Cost Inefficiency

Cost Inefficiency: Relative to incumbent firms and
entrants more that five years post entry
0.60
0.55
0.50 enter_survive
0.45 enter_merge
0.40 enter_fail
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
-0.05 0 1 2 3 4
Years from Entry

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