Download Phillips

A Critique of Empirical Studies
of Relations Between Market
Structure and Profitability
Phillips, Almarin (1976), Journal of Industrial Economics,
24 (4): 241-249.
BADM 546, Group #1
(Meredith Blumthal, Wooje Cho, Barclay James, and
Kumar Sarangee)
The Purpose of the Study
To examine the previous empirical
studies of relations between market
structure and profitability
Model Specification Problems
Data and Measurement Problems
Econometric Identification Problems
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The Purpose of the Study
Background:
There have been a number of
empirical studies of the relations, and
the agreed argument from them is
that a positive relationship exists
between industrial concentration and
profitability.
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The Empirical Model
The equation in question in the studies:
(1)
   CR, B, D

Profitability: various measures
Market Structure
• CR: a measure of market concentration (supply)
• B: one or more measures of entry barriers (supply)
• D: the level (or rate of change) in market demand
(demand)
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Theoretical Problems
Critiques to the variable, CR
CR is not very sensitive to variation in N (# of firms)
CR4
• CR4 is a good proxy for a small N with higher value (near 1.00), but,
for a large N, fails to distinguish the different performance come from
different Ns (e.g. CR4 = .6 when N=7 or N=70)
• Fails to distinguish the relative size of the four largest firms (e.g. CR4
= .6 with .15, .15, .15, .15 vs. CR4 =.6 with .57. .01, .01, .01:
source: lecture slide set #4)
H (Herfindahl measure)
• Can solve a problem of CR4
• But, still cannot tell the different performance come from different Ns
(e.g. H=.2 with N=5 vs H=.2 with N=9)
 Since concentration can vary widely for any given N, the
behavioral theories as well as the structural theories raise
questions as to whether the equation (1) is properly specified
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Theoretical Problems
Critiques for the variable, B
Entry barriers are a necessary condition, but not a
sufficient condition for long-run economic
profitability
Once N reaches some appreciable number, the
partial effect of B should disappear, because
rivalry among existing firms replaces B.
 The model in equation (1) is rarely specified so as
to such problems in B.
Nothing in equation (1) approaches the
difference between consumer and producer
goods industries.
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Data Problems: Two ways of
measuring the profit variables
The price cost margin method:
VA  W
PCM 
S
(PCM: margin, VA: value added, W: wage and
salaries, S: value of shipments for a census-defined
industry)
The rate of return on capital method
Return on stockholders’ equity, or
Return on stockholders’ equity plus long-term debit, or
Return on assets
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Data Problems-1
Critiques to the price cost margin method:
VA-W comprise not just accounting profits, but
depreciation, indirect payment, rent and the untabulated input purchases.
S may be uncorrected for changes in inventories
 PCM is not a close substitute for the economic
concept of markup of price over marginal costs
Critiques to the rate of return on capital
method:
Calculated rate of return could be significantly
different by various depreciation practices.
Cannot distinguish expenditure in advertising and
R&D
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Data Problems-2
Critiques to CR measurement
Problems in market definition come from:
• Product differentiation
• Geographic locational differences
Critiques to B measurement

A/S (adverting-sales ratio): absence of consistent information on
full promotional expenditures
C/O (capital-output ratio): low C/O for entry, but high C/O for
efficient operation
MES (minimum efficient scale of plant): problem in industry
definition
C/O seem to be preferred as an entry barrier measure
Critiques to D measurement
Uses the change in output over some period of time as a proxy
for D: the change can occur from factors on the supply side
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Other Problems
Problems from using weighted average in
regression
The data for the largest firms control the
observations
The result can be biased if there is correlation b/w
size and the dependent variable or any of the
independent variables
Problems from assumption of linearity in the
equation (1)
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Econometric Identification
Problems
Not clear whether profitability is high because of
the existence of monopoly power or whether the
firms are large and the market is concentrated
because of differences in production efficiencies,
leading to high profitability
It is not clear how to interpret the data. Both
monopoly explanations and efficiency explanations
are consistent with the data).
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Conclusions
Market concentration may provide market power
and thus be the cause of higher profitability, or,
conversely, market concentration and higher
profitability may be the result of superior capabilities
and economic efficiencies by these firms.
Better theory, better data, and above all, better
econometrics are needed for better understanding
relations between market structure and profitability
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