8) Firm Performance

Critically discuss, with reference to appropriate methodological approaches, the problems encountered in testing the relationships between market structure and industry performance.

Introduction- For many years SCP has been considered the best approach for links between structure and

performance. Although more recently has faced heavy criticism.- Talk about the development of other techniques to assess the variation in firm performance,

market power hypothesis and differential efficiency hypothesis.

How to measure structure and performance- First we need a robust measure of structure:

- Usually taken as the concentration and levels of barriers to entry- N firm concentration and Herfindahl-Hirschman Index

- Then measure of performance:- Both the use of Tobin’s Q and Price cost margin- Tobin’s Q is more useful

The Structure-Conduct-Performance Paradigm- Developed by Mason and Bain, explain the basic idea of the relationship between market

structure and strategic behaviour- Run through links between S-C-P- Criticisms of the SCP (Chicago school) and Demsetz (1973) development of the differential

efficiency hypothesis

Empirical evidence for SCP (market power) approach- Bain (1951), 42 manufacturing industries between 1936 and 1940- Collins and Preston (1966)- Clarke et al. (1984)

Empirical evidence for DEH- Demsetz (1973)- Ravenscraft (1983)- Smirlock et al (1984)- Libenberg and Kamerschen (2008)- Porter (1979)

Other Schools of Thought

- Discuss other schools of thought of the relationship between market structure and industry performance, including the New Industrial Organisation.

- Bresnahan and Lau (1982)- Rosse and Panzar (1977)

Evidence on the Persistence of Profit- Brozen (1971)

Conclusion

Answers should:- Outline the Structure Conduct Performance (SCP) approach to the relationship between

market structure and industry performance, noting that this approach concentrates mainly on industry-level factors rather than factors that operate at the level of individual firms.

- Consider appropriate empirical evidence on the SCP approach.

- Critically discuss the relative merits of the Market Power hypothesis and the Differential Efficiency hypothesis as explanations for variations in firm-level profitability.

- Consider the work produced by Schmalensee (1985) and others which recognises the importance of firm-level variations in profitability rather than industry-level variations.

- Discuss other schools of thought of the relationship between market structure and industry performance, including the Chicago School, the New Industrial Organisation and the Austrian school of thought.

Introduction

The performance of firms is one of the central research themes in industrial organization. There is a substantial body of empirical research that seeks to explain variations in performance between firms, most commonly measured by profitability. Early research, based mainly on the SCP (structure–conduct–performance) paradigm, identified structural industry-level variables such as concentration, economies of scale, and entry and exit conditions as the most important determinants of firm performance. However, this approach has been subject to intense criticism. Many of the structure–performance relationships identified in SCP-based empirical research are relatively weak. Some economists, including those associated with the Chicago school, argue market power deriving from monopolization is only a temporary phenomenon. A positive association between concentration and profitability may reflect an association between productive efficiency and firm size: the most efficient firms earn the largest profits, enabling them to grow at the expense of their competitors. If efficiency differences between firms are more important than industry structure in determining performance, attention should be directed less towards the industry and more towards the individual firm. Accordingly, later empirical research has sought to shift the focus of attention towards conduct or strategic decision making at a firm level (New Empirical Industrial Organization).

How to Measure Structure and Performance

In order to undertake a review of the empirical literature, it is important to develop a robust measurement of an industry’s structure and performance. Industry structure is usually defined by the number of sellers and buyer and their level of concentration. Concentration is calculated in a number of ways, but the most commonly used are the K-firm concentration ratio and the Herfindahl-

Hirschman index. The K-firm ratio is easily calculated as ∑i=1

k

si where si is the ith firm’s market share.

The more representative Herfindahl-Hirschman index is calculated as ∑i=1

k

si2 and places more weight

on market shares of the largest firms. The two most commonly used measures of performance are Tobin’s Q (1969) and the price-cost margin. Tobin’s Q is the ratio of a firm’s market value to the replacement cost of its capital, with a value of q greater than one denoting a firm’s market value above that of its book value, and vice versa for a q less than one. The price-cost margin is a ratio of profit to sales revenue, and can be calculated in two ways, as follows,

PCM=TR−TCTR

= P−ACP

where TR = total revenue, TC = total cost, P = price, Q = quantity and AC average cost. Of the two, Tobin’s Q is the most robust measure of performance, although the empirical results discussed later use a combination of both measures.

SCP vs DEH

Early empirical work on the link between structure and performance was heavily based around Bain’s (1951) structure – conduct – performance (SCP) model. The basic concept revolves around the formation of a relationship between the market structure and the strategic behaviour undertaken

by the firm. According to the model, the market environment (e.g. technology, elasticities, materials) has a direct impact on the market structure (e.g. buyers and sellers, concentration). The market structure then has a direct influence on the firm's economic conduct (price decisions, differentiation, R&D), which in turn affects its market performance (efficiency, progress, equity). This model postulates that a more highly concentrated market increases the opportunity for collusive behaviour, and thus by fixing prices artificially, all firms in the market will be able to earn profits above those earned in a less concentrated industry. This model therefore states that industry-level variables such as concentration, economies of scale, and entry and exit conditions are the main determinants of firm performance. However, this literature has subsequently been criticized for providing limited explanations as to why profitability varies between firms within an industry. Whilst this traditional school views the industry as the unit of analysis, the revisionist school developed by Schmalensee (1985) argues that the firm should be the unit of analysis as firm efficiency is central to the debate. This argument is also supported by the Chicago school that believe that market power deriving from monopolization is only temporary, except perhaps in the case of monopolies that are created and maintained by government. Thus, a positive association between concentration and profitability may reflect a positive association between productive efficiency and firm size. The larger market share a firm controls, the more efficient its practices can be, i.e. through the use of economies of scale, learn by doing etc. These opposing views have motivated an extensive empirical debate. The earliest studies follow the same arguments of the SCP, suggesting that concentration and other industry-level variables are important in determining performance, the market power hypothesis. Conversely, Demsetz (1973) points out that if the positive relationship between market concentration and profitability reflects the exercise of market power, then it should affect all firms equally. However, if the profitability of large firms in concentrated industries is higher than the profitability of small firms in concentrated industries, then the correlation between profitability and concentration is due to a relationship between efficiency and profitability. This has led to the formation of the differential efficiency hypothesis.

SCP Evidence

The predominant approach to resolve the conflicting interpretations has been to use cross-industry samples, and include both market share and concentration as determinants of firm profits. The presence of efficiency is taken to be associated with a positive and significant market share effect, that of collusion with a positive and significant concentration effect. The initial investigation into the links between structure and performance was undertaken by Bain (1951), using data on 42 US manufacturing industries between 1936 and 1940. Bain found that the average profitability is significantly higher in industries with CR8 above 70 per cent (at 9.2 per cent) than in those with CR8 below 70 per cent (at 7.7 per cent). These results are interpreted as indicating that exploitation of market power leads to enhanced profitability. Similar results were found by Collins and Preston (1966), reporting a quadratic relationship between concentration and profit. Later investigations were less conclusive, finding little evidence to support either hypothesis. For example, Clarke et al. (1984) do not find conclusive evidence for a within-industry positive relation between the profitability and market share of firms, or evidence that higher prices benefit all firms equally.

DEH Evidence

There are also a number of statistical investigations of profitability that have produced results inconsistent with the SCP theory, showing support for the differential efficiency hypothesis. Demsetz (1973) has found that profits of smaller firms are not higher in concentrated industries than they are in un-concentrated industries, though the profits of larger firms are. Demsetz argues against Bain’s view that highly concentrated industries are uncompetitive. An implication is that specific government policies intended to promote competition directed at highly concentrated industries are not required but equally, any policy of breaking up large incumbent firms risks sacrificing efficiency gains and could create long-terms disincentives for pursuit of efficiency. Ravenscraft (1983) supports this result in his review of 1975 data for 3,186 lines of business. Ravenscraft’s results show a positive link between price-cost margins and market share, but no such link between PCM and seller concentration, a result that is consistent with Smirlock et al.’s (1984) findings for the US manufacturing sector and Liebenberg and Kamerschen’s (2008) result for the South African auto insurance market. Porter’s (1979) study of 42 consumer goods industries produced striking results. The correlation between rates of return of leading firms and follower firms in the same industry is very low with a correlation statistic of only 0.14. If the profitability of all firms in an industry were affected alike by industry structure, as postulated by the market power hypothesis, then we would expect this correlation to be strong. This low statistic is consistent with firms’ profitability depending on their position within the industry and individual efficiency performance, as postulated by the differential efficiency hypothesis.

Other Schools of Thought

Much of this empirical work is based on links between structure and profitability, and the analysis of firm conduct is often underemphasized. These considerations have motivated a number of attempts to collect direct empirical evidence on the nature of competition, by observing conduct directly (Bresnahan and Lau, 1982; Rosse and Panzar, 1977). This approach has become known as the new empirical industrial organization (NEIO). NEIO makes direct observations of conduct in specific industries, and draws inferences about what these observed patterns of conduct might mean for structure. A number of further tests have been developed under this school of thought.

The revenue test of Rosse and Panzar (1977) involves estimating the sum of the elasticities of revenue with respect to each of the firm’s factor input prices. The sign and magnitude of this statistic indicate whether firms’ price-setting behaviour is consistent with the theoretical models of perfect competition, monopolistic competition or monopoly. The Rosse–Panzar H-statistic is defined as:

H=β1 +β2 +β3

If H = 1, conduct is in accordance with the model of perfect competition.If H < 0, conduct is in accordance with the model of monopoly.0 < H < 1 represents the intermediate case of conduct in accordance with imperfectly competitive market conditions.

The mark-up test of Bresnahan and Lau (1982) involves estimating a structural model incorporating demand and cost equations, linked by the profit-maximizing condition, marginal revenue equals marginal cost. An estimate of the firm’s price elasticity of demand again provides evidence about the nature of competition the firm perceives.

Persistence of Profit

Both the SCP and NEIO methodologies are based on assumptions of profit maximization and long-run equilibrium. In contrast, the persistence of the profit strand in the empirical industrial organization literature focuses on the process of adjustment towards equilibrium, by analysing time-series data on firm-level profit rates. Brozen (1971) criticizes Bain’s (1951) study, suggesting that a disequilibrium phenomenon was being observed (in the data used). If high profitability is the result of the exercise of market power by a monopolist in long-run equilibrium, then similarly high returns should be realized over a number of years. Brozen replicates Bain’s empirical analysis over a later period (1953 –57), and finds that in highly concentrated industries, average profitability was only 0.6 per cent above the average; and in un-concentrated industries, average profitability was 0.5 per cent below the average. This suggests that over time, profitability in the more profitable industries tends to fall, and profitability in the less profitable industries tends to rise. In other words, there is a tendency for profit rates to converge towards a common long-run average value. This finding lends support to the disequilibrium hypothesis.

The large range of empirical work on both sides of this debate indicate how it is very difficult to pinpoint the main determinants of profitability, whether simply market concentration will lead to higher levels of profit, or whether advancements in efficiency is the key. The earliest work focused heavily on the SCP paradigm, and thus concluded that the market power hypothesis answered the question of structure and performance. Since this, more empirical work has been focussed on the ability of efficiency to explain the changes in profit observed within an industry itself. The Chicago school has emphasised the importance to focus on firms as a unit of measurement and the NEIO has endeavoured to provide more analysis into the conduct of firms as an explanation of profitability.