The dynamics of company profits: a latent growth model

Existing literature on profit dynamics focuses mainly on the erosion of profit differentials as a result of competitive pressures while largely ignoring the processes by which such differentials arise. Neoclassical models of competition and market equilibrium provide the theoretical base for such literature. We argue, on the contrary, for a view of competitive dynamics that encompasses both the emergence and the erosion of economic rents—a view rooted in strategic insights into how firms can create abnormal profits. Accordingly, we define a trend-based model explicitly acknowledging that firms differ in their ability to improve performance, which gives rise to heterogeneous profitability trends. We express the model as a multilevel latent growth curve, which allows us to address the significant challenges present in modeling profit dynamics. We employ such a model to analyze the dynamics of profitability in a sample of Spanish manufacturing firms from 1991 to 2008.