Identification and counterfactuals in dynamic models of market entry and exit

Abstract

This paper addresses a fundamental identification problem in the structural estimation of dynamic oligopoly models of market entry and exit. Using the standard datasets in existing empirical applications, three components of a firm’s profit function are not separately identified: the fixed cost of an incumbent firm, the entry cost of a new entrant, and the scrap value of an exiting firm. We study the implications of this result on the power of this class of models to identify the effects of different comparative static exercises and counterfactual public policies. First, we derive a closed-form relationship between the three unknown structural functions and the two functions that are identified from the data. We use this relationship to provide the correct interpretation of the estimated objects that are obtained under the ‘normalization assumptions’ considered in most applications. Second, we characterize a class of counterfactual experiments that are identified using the estimated model, despite the non-separate identification of the three primitives. Third, we show that there is a general class of counterfactual experiments of economic relevance that are not identified. We present a numerical example that illustrates how ignoring the non-identification of these counterfactuals (i.e., making a ‘normalization assumption’ on some of the three primitives) generates sizable biases that can modify even the sign of the estimated effects. Finally, we discuss possible solutions to address these identification problems. Copyright Springer Science+Business Media New York 2014