Part D. Statistical evidence on the impact(s) of m power

1. Part D. Statistical evidence on the impact(s) of m power • Twin hypotheses are: • Market profitability = f(market power) • Social harmfulness = f(market power) • But recall only the first of these is directly observable. The second is an implication of the first based on the view that any above normal profits must come from the exercise of market power and thus ‘harm’ consumers. industrypartd

2. L&W chapters • Chap 9 is very good, plus bits of 14 on the evidence with respect to innovation • On alternative interpretations L&W is not much use however industrypartd

3. And of course • Recall how these relationships are complicated by all sorts of non observed factors (statistical noise): p disc., durability, countervailing power, conjectures, etc etc • And NB: A positive statistical relationship does not necessarily demonstrate causality, ie doesn’t prove that market power ‘causes’ the higher profits. (See my discussion of this on Word version of my notes on market power, p4). Other plausible explanations have to be considered. industrypartd

4. Econometric evidence and debate • Take a large number of different markets and use regression analysis to examine; • Profitability = f(concentration, barriers, exit costs, differentiation etc) • Examine the size and significance of the estimated parameters of the relationship. • Easy in principle, but harder in practice for many reasons. industrypartd

5. Econometric problems • 1. The specification of the relationship. It is unlikely to be linear, but most tests assume linearity. • 2. We really need simultaneous equation models to allow for likelihood that profitability affects behaviour, such as spending on R&D, which affects market structure, and so on. When causality runs both ways single equation estimates are not reliable. • 3. How do we get reliable measures of the variables. Like barriers to entry and exit? Like the closeness of substitutes or countervailing power? Plus accounting profit is not the same as economic profit. • 4. How do you define and obtain data on the true economically relevant markets? (see earlier discussion of this in part a/b) industrypartd

6. Evidence on simultaneity • There is evidence of simultaneity in the relationship. Researchers have found a strong tendency for markets to ‘consolidate’ or concentrate over time as the product life cycle plays out. • The evidence is that this has to do with economies of scale in R&D and marketing (such as advertising). The outcome is both growing concentration levels and increasing profitability. There seems to be a reinforcement model at work, but not a causal model. Early entrants get bigger faster, they do (absolutely) more R&D/marketing, so accumulate R&D/marketing experience faster, so they tend to get even bigger until entry becomes non viable. • Research inter alia by Klepper/ Sutton/ Davies and Lyons….and the PIMS (US) database (profit impact of market strategies). industrypartd

7. And the result is • It is all very difficult and so the results are not very reliable despite being one of the most investigated relations in all of economics (see textbook for details of these issues) • Statistically significant results have been found, but not in all studies, and in any case when found the market power effects are not very large. • US evidence somewhat more positive than UK perhaps because UK is more open internationally speaking. industrypartd

8. Detailed case evidence • Note George’s study of the many reports of the MMC (monopolies and mergers commission) whose job it is to investigate dominant firm cases where a complaint of harm has actually been made. What do these studies tell us? • In roughly 14% of the cases investigated profits were judged to be ‘excessive’. Of course some judgements have been disputed but overall this is not exactly a rousing confirmation of the harmful hypothesis! • However a later study of 73 cases by Davies found that the MMC condemned something or other in 2/3rds of them. But interestingly the most common finding concerned vertical restraints (rpm, tie-ins) not excessive prices! industrypartd

9. Estimates of the Harberger loss • See textbook on this for details. • First, follow the derivation of the expression for the size of the Harberger triangle (H). • H = dP. dQ. ½ • Which can be manipulated to give us: • H = ½.R.ed.(p-c)² • Each element of which in principle we can measure or at least guesstimate. Results ? industrypartd

10. For the puzzled • d Means the change in (increased price and reduced quantity as a result of monopoly) • R is monopoly revenue • ed is elasticity of demand at the mon price • p-c is the price cost margin at the mon price • See textbook if still in trouble! industrypartd

11. Results for Harberger losses • Vary considerably because of different time periods, countries and samples. And of course different guesstimates of the unobservables. Some find significant losses (5/6% of output) and some such as Harberger himself find very small to negligible losses. Useful, but still lot of room for debate then. industrypartd

12. Posner losses • Recall Posner’s (questionable) idea discussed earlier that the losses of monopoly go beyond the H triangle to include all the costs of competing efforts to win m power. • Estimates of these losses (Cowling-Mueller) naturally produce bigger more dramatic outcomes. Ultimately the resources devoted to searching for monopoly will include, he argued, all the economic profits thought to be available! • See my notes on this and the textbook for an evaluation. Personally I do not find the logic compelling or the results meaningful. Paradoxically it makes competition the problem, not monopoly! It sees no redeeming features in competitive efforts. But you have to decide the issue for yourself. industrypartd

13. Organisational efficiency losses • Although intuitively appealing the impact of market power on org eff is by no means easy to establish empirically. It is true that public sector statutory monopolies in countries such as Britain had a poor reputation for efficiency but to what extent this was the result of monopoly as opposed to public ownership and poor labour relations is not clear. Having politicians and civil servants in charge, and powerful unions, undoubtedly had negative effects on efficiency as well. (see George on this issue) industrypartd

14. Org eff cont • Studies by Nickell of the UK manufacturing sector (72/86) found that higher levels of competition were associated on average with higher firm level productivity and faster productivity growth. But he also found that better corporate governance (outsider pressure from owners) reduced the significance of competitive pressures. So he concluded that the evidence was not conclusive against market power. • Plus remember if employees ‘benefit’ from less pressure then it is arguably not a deadweight social loss anyway! industrypartd

15. Olley & Pakes found evidence that entry and exit promoted faster productivity growth in the US telecoms equipment market as it was deregulated. This was driven by the higher productivity of new entrants compared to incumbents, who kept ‘inefficient’ old technology plants going on too long. • Other studies appear to confirm the role of new entrants adopting improved technological opportunities in driving productivity growth rather than the existing level of rivalry in a sector. Remember competition for rather than competition in? industrypartd

16. How many rivals is enough? • Researchers have studied the question of how many rivals it takes to produce enough competition to approximate the perfect competitive outcome. It turns out, if their evidence is good, that it doesn’t take very many. • A widely quoted study by Bresnahan and Reiss (1991) examined a large number of ‘local markets’ for plumbers, car repairs, doctors etc and found the following. • With three (non coop) rivals competition is about intense as it gets. You don’t need large numbers! industrypartd

17. Evidence on entry/ exit rates • What about entry rates? • There is a lot of evidence on entry levels, covered well in L&W chap 8.7. • Generally entry seems to happen and to do the job of keeping incumbents honest. industrypartd

18. Evidence on profit persistence • Do profits of market power persist for a long time? • Sure, some dominant firm profits persist for 10/20 years. IBM had a long run, Xerox had a good run, Intel and Microsoft are still on a run. (NB public sector mons persist but rarely profitably) • But dominant firm profits also decline, sometimes dramatically. IBM and Xerox both went through very sticky periods as entrants made good. Sears lost out to Wal Mart. GM and Ford to the Japanese invasion. BT to Vodaphone etc. • And look at the once mighty giants who are no longer contenders. Dunlop? Burroughs? ICI? Nat West Bank? industrypartd

19. Persistence of firm level profits • A study by Waring, 1996, looked at the sectoral determinants of firm level profit persistence. It found that firm profits persisted longer in sectors characterised by high skill levels, unionisation, switching costs, and high levels of R&D. • However this was taken to support a comp advantage view as opposed to a barriers to ‘entry’ view of profits (discussed further later).That is high firm level profits persisted because even existing rivals couldn’t easily imitate their success in R&D and in managing skills. industrypartd

20. Villalonga study 2004 • Looked at firm performance sustainability using a large sample and found that it was related to the intangibility of its asset stock as predicted by resource based advantage theory. However it is double edged sword. Intangibles can lock firms into poor performance because of the sunk cost effect. So it is a high risk strategy, producing both winners and losers wrt persistence. Very useful study. Check it out, it is on the web, under her name. (JEB&O 2004) industrypartd

21. Evidence on innovation/ m power • Is not very supportive of the mainstream hypothesis of ‘harm’. No doubt because it is a very complex issue. For example the issue of causality. The two things may be related but what causes what exactly? • Market structures may influence R&D investment and innovation, but innovation success and failure also drives market structures. Such interactions are very hard to capture in empirical studies. Particularly given measurement problems. We have seen that measuring structure is hard but measuring innovation outputs is even harder. industrypartd

22. See text book for summary of studies and findings. George concludes: no simple relationship is apparent. Many very competitive markets have a poor innovation record, some dominant firms have been very innovative (Pilkington, Intel). • R&D intensity is more driven by technological opportunities than by market structures. If anything, a moderate degree of market concentration seems best. Oligopolistic competition. industrypartd

23. Research findings • A particularly thorough study of innovation in the UK (1948-1983) by Geroski (1990) covering 4,400 significant innovations found some signs of a negative relationship between mp and innovation but the size of the effect was very small. The author therefore argued that the key to innovation dynamics was not market structure but evolving technological opportunities. industrypartd

24. More findings • An OECD funded study by Symionidis (1996) came to more or less the same conclusion. Although he looked at all the research from the Schumpeterian perspective (see earlier slide on this) in which size and market power are expected to be good for innovation. • So the research findings don’t lend much support to either school. Whatever the determinants of optimal innovation are they cannot be reduced to simplistic 2 dimensional cause and effect views. Markets vary too much to expect simplistic relationships to hold. For example the degree of product differentiability (demand fragmentation) is a factor which seems to influence the relationship according to Symionidis (quoting the work of Sutton). industrypartd

25. Innovation by leaders • New evidence on the monopoly/ innovation relationship. Dominant firms in seeking to protect their dominance have a greater incentive to invest in R&D than in markets where there is no dominant player! • Key is entry barriers. If these are not too high then the dominant firm has to worry about about someone else coming up with the next ‘big thing’. So the fact that dominant firms stay dominant might show that they are in fact competing hard to stay dominant. • Economist article, 22/5/04 (based on Economic Journal article by Etro, April 04) industrypartd

26. However re McKinsey • A McKinsey* study has recently concluded that there is such a thing as incumbent inertia. Or slowness to respond to environmental threats and oppos by innovating. • McK says this is due to ‘cultural lock in’ (inability to accept the world has changed) and incumbent fears of making difficult choices. • However not all incumbents suffer. Some incumbents are in fact very innovative. Intel, L’Oreal, Microsoft. So again ‘it is hard to generalise’ is the not very surprising message. • *‘Creative Destruction’ text, 2001 industrypartd

27. Performance and innovation • Foster and Kaplan, Creative Destruction, 2001, a McKinsey research project found: • Not all innovators were winners but that all winners were innovators! • Creative destroyers of the status quo. Dell, Microsoft, Intel, Corning, Monsanto, GE, Johnson and Johnson. industrypartd

28. Canadian study • A new, well designed, study of Canadian product markets based on new measures of specific marekt competitiveness has suggested the relationship can go either way, ie be positive or negative! It depends on very specific features of firm’s perceptions about competition and about specific innovation activities (for example process and product innovations). • This supports my view that we simply don’t have the knowledge to develop policies which are guaranteed to improve innovation and that we should be cautious about anti trust actions. • Research policy, 35/1, feb 2006, J Tang industrypartd

29. Don’t worry/ be happy • About the lack of clear cut memorable results. You have to remember that science isn’t a list of definitive results but a method of investigating complex controversial issues. We are moving down a learning curve, improving what we know, and discovering what we still don’t know, but not expecting to find easy answers. • Economics is therefore best seen as a way of thinking, a method, for developing and testing ideas not a neat set of clear cut answers. industrypartd

30. Conclusions on market power evidence • We know a lot less about the nature of the competitive process and impact of market power than we think. And we all need to be more modest until we know more. And we need to consider alternative ways of looking at business performance that do not assume to begin with it is all about seeking profits by means of exploiting market power. • George, generally more sympathetic than I am to the mainstream view, in fact comes to a rather similar conclusion (p302) industrypartd

31. Evidence on firm specific performance • Instead of looking at structural determinants of market level profits what about looking directly at drivers of individual firm level profits? Good idea. Estimate: • Firm specific profitability as a function of the market(s) in which it operates. Several large scale published studies have looked at this (see next slide). • And found that there is a statistically positive relationship, but that it does not account for a lot of the profit variation between firms. A lot of the variation seems to be firm specific, not market driven. industrypartd

32. Evidence on firm specific performance • Rumelt study (1991, updated 1999): industry effects account for 9/16% of variations in firm performance. • Porter/ McGahan 1997: huge US sample of firms over long period. Industry/ market sector accounted for up to 19% of firm level profits. • Porter/ McGahan 1999: industry effects on firm profitability are secondary to firm specific effects, by at least 2 to 1. • PIMS (profit impact of market strategies): big US data base on business performance. Market structure is relevant, but firm specific factors generally drive business perf. industrypartd

33. Marakon 2003 • Marakon consultants research (see web site) looked at 800 businesses over 10 years to 2002 using Total Shareholder Returns (TSR) as the measure of performance. • Industry sector wasn’t statistically important although some such as entertainment and computers did better than others such as chemicals and utilities. It was the individual businesses and their strategies that mattered. For example top performers relied more on organic growth and avoided growth for the sake of growth. industrypartd

34. INSEAD 2001 • Uses new data set on EVA from Stern Stewart and a different methodology to study relative effects of industry/ firm specific factors. It produces an interesting new result. • That a big proportion of firm specific effects on average is due to 2 best/2 worst performers. • Argues that only for exceptionally good/ bad firms does the distinction matter. For the majority industry (market) is the key performance driver. Restores the concept of structural determinants somewhat. • Hawawini et al, Insead research paper, 2001 • This has a good review of the empirical literature to date. industrypartd

35. Part D cont: Debating market power • From the evidence to its interpretation • Remember the earlier argument that traditional theory seems to assume something about the drivers of business profitability and its persistence (its all about market power) rather than seeking to investigate the issue and look at the wider evidence and alternative interpretations. industrypartd

36. Alternative interpretations • Looking for the brighter side of the market power debate. • The theory and evidence reviewed suggests at least a possibility that firm conduct is not solely (maybe not even largely) about seeking to capture profits by ‘harmful’ means (exploiting and protecting market power) but could be about creating and defending profits through developing superior firm specific qualities? • That is through developing comp. advantages. As per the Austrian school and others such as Porter/ Kay/ Peteraf. How might that work exactly? industrypartd

37. The Austrian view of competition • According to this school the textbook focus on ‘industry’ structure is misguided. It is the FIRM alone that matters, because ‘industry’ structure is a consequence of how firms compete not vice versa • Market structure is an outcome of competition between firms, the search for competitive advantage, not a determinant. It is endogenous not exogenous. Firm actions and relative success determines both market structure and average profitability. The idea that market structure drives profits is thus spurious. Firms are unique & heterogeneous. And everyone is competing with everyone else for resources/customers. • See for ex Hill/Deedes, J of Man. Studies, 1996 industrypartd

38. Firm specific comp advantage and business performance • What are these firm specific determinants of relative success and failure, and persistence, in value creation. • Are there any useful generalisations to be made about this, lessons to be learned, which can help to guide the strategy process and public policy? industrypartd

39. Create competitive advantage • Cheaper (lower cost) producer: ? • Better (superior perceived quality): ? • Newer (more innovative/up to date/fashionable): ? • Faster (speed to market): ? • More desirable/ distinctive (successful branding):? • Better reputation: ? • First mover advantages: ? • Provide your own examples of firms that compete successfully on this basis. industrypartd

40. Consumers and value • Note the obvious but absolutely fundamental point that a business can only create and capture economic value if what it does is valuable for consumers. • Basically in any market (comp or not) the total value created is divided between consumers (surplus) and suppliers (surplus). To capture any surplus as economic profit firms must ‘create’ it in the first place by identifying and attracting paying customers. In this sense firms do not ‘create value’ in a vacuum. They do it in conjunction with customers. • Point is there is a big difference between producing products and producing valuable products. industrypartd

41. Porter’s approach • In ‘Competitive Advantage’ Michael Porter argues that success depends basically on the individual organisation’s ability to organise and manage the cost and differentiation drivers involved in a particular market so as to produce a cost advantage or a differentiation advantage. (see next slide) • But this approach has problems and is incomplete as we discuss below. industrypartd

42. Competitive advantage • Porter describes two sorts of business advantage. • 1. Cost advantage: arises when one business achieves a lower overall cost structure than the average of its competitors in a particular market. A cost disadvantage is the opposite. This gives the business an opportunity to win market share or to extract a better profit from the market. That is to increase value creation. Think of Toyota. • 2. Differentiation Advantage: arises when one business achieves higher price margins (prices above market average) because its product/ service is perceived as superior compared to its rivals. Better quality, more fashionable, newer, faster to market, better reputation, more attractive, etc. These of course arise from investments which create significant costs but if done well can create benefits exceeding costs. Assets may differentiate the business: branding, quality, safety, originality, etc. Think of L’Oreal for example. Or Sony. industrypartd

43. Cost differences between businesses • Arise for a variety of reasons, or some combination of these reasons: • Scale differences. (Nokia v its competitors) • Experience differences. Some businesses are much further down the learning curve. (Intel) • Utilisation differences. Existing capacity may be better/ more fully used. (British Airways) • Location. Some locations are less expensive to produce in than others. • Economies of scope. Sony gets cost advantage from the broad scope of its products & businesses. Also L’Oreal. • Transaction costs: Toyota’s approach to managing its supply chain is renowned for its cost effectiveness. • And, see next slide for more on this industrypartd

44. Cost differences and organisation • As discussed more fully below another important source of cost differences is organisational design (architecture) and effectiveness. • Two businesses may have similar scale/ scope/ experience etc but one may simply be better organised than the other and more effective at managing its operations. Better at motivating and coordinating people and managing complex operations. This is called organisational architecture. • For example Wal Mart, RBS, AXA, BP, Toyota, and Dell are superbly organised and managed compared to many of their competitors. industrypartd

45. Therefore a successful ‘low cost’ producer may come about because a combination of superior plant/ firm scale, superior learning/ experience, superior utilisation levels, superior economies of scope, superior transactional effectiveness, or more effective organisation. • In examining a particular market (eg for PCs) a good place to start would be to consider what was driving cost differences amongst businesses (such as Dell, Compaq, HP etc) and how this influenced relative performance and the evolution of market shares. industrypartd

46. Cost differences and strategic differentiation • When comparing costs however it is important to compare like with like. Cost differences between firms can reflect important differences in strategic intentions or differences in the market niche being developed. • For example a business seeking competitive advantage through superior quality or product development may have ‘high’ costs because it is aiming for a sales advantage. Or a business seeking a distinctive market niche (Porsche) will have ‘higher’ costs than a mass market producer as PSA. • This shows the importance of defining the market properly and considering firm strategy when comparing costs. industrypartd

47. Differentiation differences between businesses • Differentiation advantage may arise from a variety of sources: • Product differentiation/ branding a la Coke or Nike • Quality based differentiation a la Toyota or George V • Speed to market with exciting new products a la Sony or Apple • Cutting edge innovators such as Glaxo or Aventis • Fashion based differentiation a la Armani or LV • Reputation based differentiation such as McKinsey or Harvard Business School • Differentiation based on understanding emerging market patterns and developing/ positioning the right products at the right time a la Airbus or Nokia industrypartd

48. Examples • Businesses with Comp advantage: consider on what exactly it might be based. • Toyota in mass market autos. • BMW in luxury autos. • LMVH in luxury goods. • Dell in desk top PCs • BA in airlines • Harvard for management education • Some of those with no comp advantage: • Fiat, Ford, Air Canada, Alitalia, …… industrypartd

49. Some questions about Porter • Why does the more successful firm not buy the less successful and teach it how to minimise costs? • Why does the successful firm not sell its expertise in cost reducing to less successful firms? • Why does the successful firm not cut its prices and drive its competitors out of business (dominance)? • Why does the unsuccessful firm not bid for the executive(s) in charge of cost/ diff drivers from the successful firm? (it happens, eg the battle between General Motors and Volkswagen for the services of cost guru Mr. Lopez) industrypartd

50. Porter’s SCA • Low cost/ differentiation may indeed be a proximate cause of CA but they cannot be the ultimate source. • Low cost positions, superior quality, speed to market, or whatever, must come from something or other the organisation has or does. From assets it has created, or processes it has developed. • For example in agriculture the superior returns achieved by some farmers derives from lower costs which derive ultimately from superior quality (ie more productive) land, a resource that is very hard to increase the supply of! • Nowadays Nokia’s or Dell’s superior returns come ultimately from something similar, something (scarce and hard to make more of) which allows them to do things which enable them to offer a better ‘value for money’ proposition to consumers. But what things exactly? industrypartd