We develop a model of firm size in which firms are unable to access as many consumers as they want. Newly arrived consumers match randomly with firms. Subsequently, consumers must pay search costs to be able to switch firms. This cost promotes an inertial tendency for consumers to remain with the ̄rm they currently buy from. Consequently, established firms enjoy a proprietary relationship with respect to their old customers while new entrants only have access to first time consumers, who are as yet unattached to any firm. As time goes on, firms acquire successive generations of new consumers, and their stock of loyal customers grows gradually. Thus, more senior firms command higher market shares.
We construct an industry model based on this hypothesis and show that the aggregate implications of the model are consistent with empirical facts about industry dynamics (e.g., Dunne, Roberts and Samuelson, (1988, 1989) or Davis and Haltiwanger (1992)): Larger and older firms are less likely to exit than younger and smaller firms. In our model this results from the fact that the option value of remaining operative in the aftermath of a high cost-shock is greater for an older firm than for a younger firm because the value of a cost turnaround is greater for the former (which has already accumulated a large customer-base) than for the latter (which has yet to do so). This enables older (and larger) firms to survive adverse cost-shocks
which force the exit of younger (and smaller) firms. For similar reasons, R&D expenditures are larger for larger firms, as per the empirical findings surveyed by Cohen and Lewis (1989).