Advertising, Firm Size and Profitability in the Service Sector (2001)

INTRODUCTION Recent contributions to industrial economics and marketing strategy concentrate on external market forces and firm level strategies as alternative explanations for cross-sectional variations in profit rates. While the marketing strategy literature focuses on controllable strategic decision variables as the primary determinant of profitability, the economics literature positions the external market environment as the more important factor. The question of which is more important in determining profitability bears directly on the issue of whether strategic choices or market environment is more important in determining success. Richard Schmalensee (1985) developed a conceptual framework that can be used to analyze the relative importance of firm strategy and external market environment in determining cross sectional profit variation. Schmalensee's (1985) methodology specifies profit rate as a function of both continuously measured strategy variables and industry fixed effects. A comparison of the relative explanatory power available from continuously measured strategy variables with that provided by industry fixed effects (captured by dummy variables) can provide important insights regarding the relative importance of firm marketing strategy and external market in explaining cross sectional profit variation. Should industry fixed effects dominate firm strategy variables in explaining profit rate variation, we would conclude that the external market environment is the most important determinant of profitability. While numerous studies have utilized the industry fixed effects approach to study cross sectional profit rate variation for manufacturing industries, we know of no prior research that utilizes this methodology to examine variation in profit rates across service industries. Historically one might argue that the highly localized nature of service industries precluded an examination of service industry profitability at the national level. Service sector profitability was considered to be a function of local market conditions rather than the specific service industry in which the firm operated. The past several decades have witnessed the emergence of national firms in a number of service industries. While hotel franchises have been operating on a national level for several decades, national service firms have recently emerged in industries as diverse as auto repair, hospitals, doctor's offices, accounting firms and motion picture theaters. The increased importance of national service firms raises the possibility of national competition in markets that were previously viewed as exclusively local or regional. As service markets become more national, issues related to marketing strategy and external market become important in analyzing profit rate variation across the service sector. The purpose of this paper is to analyze the determinants of profit rate variation in the U.S. service sector using the framework developed by Schmalensee (1985). The topic addresses important marketing issues related to firm strategy and market environment as alternative determinants of profitability. Moreover, the data used allow for the specification of profit rate models across a broad range of firm sizes, thereby facilitating an analysis of the determinants of profitability for a wide variety of service firms. The importance of firm size in explaining profitability is prominent in the works of Michael Porter (1985 & 1998). PREVIOUS LITERATURE The growing importance of service industries to the U.S. economy has been widely documented in academic literature and in the popular press. Cook, Goh and Chung (1999) report that whereas 64% of the U.S workforce was employed in services in 1965, eighty percent of total employment is expected to be in services by early in the twenty first century. Moreover, there is evidence to suggest that the face of service industries is changing in the U. …