A method to analyze profit differential between firms

A rather simple but crucial question in economics and management is why one firm makes more profit than another. However the answer remains unclear because of the large range of factors that might explain differential profit. In this paper we propose a decomposition of the profit differential between two firms by considering separately volume and price effects. On the volume side, we identify factors related to differences in management efficiency (technical and allocative), dominance of one firm technology over the other (productivity gaps) and size differences. On the price side, price differences among inputs and outputs prices explained by competitive advantages can also explain a big part of the profit gap. Our analysis encompasses a spatial framework where profits of two different firms are compared or a time framework by comparing profits of the same firm at two different dates. We first motivate the decomposition from a theoretical point of view and we next propose a practical and operational measure of each component based on Bennet indices. Profit differences are value measures (in money) which can be split into price and volume effects by economic indices. Individual component of the decomposition are analyzed and computed independently in a bottom-up approach before we finally show that the sum of all components allows recovering the full profit differential between two firms.