Empirical IO Introduction and Overview Structure-Conduct-Performance paradigm

Empirical IOIntroduction and OverviewStructure-Conduct-Performance paradigm Based on the lectures of Dr Christos Genakos (University of Cambridge)

References and background readings: • Pepall, L. Richards, D., and Norman G (2005), Industrial Organization: Contemporary Theory and Practice, Thomson. • Church J. and R. Ware (2000), Industrial Organization: A Strategic Approach, McGrawHill. • Motta M (2004) Competition Policy: Theory and Practice, Cambridge University Press. • Perloff, Karp and Golan, (2007) Estimating Market Power and Strategies, Cambridge University Press. • Einav, Liran and Levin Jonathan (2010) Empirical Industrial Organization. A Progress Report, Journal of Economics Perspectives, 2, 145-162.

OUTLINE • Introduction and a brief history of IO • The BIG Questions in IO • The Structure-Conduct-Performance paradigm • Structure-Conduct-Performance in practice • Structure-Conduct-Performance: results • Structure-Conduct-Performance: critique

Introduction to Industrial Organization (IO) • A definition of IO: "Industrial organization is concerned with the workings of markets and industries, in particular the way firms compete with each other.“ Aim: • Develop skills to make more informed decisions and judgments about issues relating to the industry • become more efficient in analysing industries by identifying key issues. Objectives: To get an improved understanding of static and dynamic problems faced by firms: • internally, organizing production within the firm- The Theory of the Firm • externally, how firms compete in the marketplace - The Theory of Markets

A Brief History of Industrial Organization • Harvard Tradition (1940-1960; Joe Bain) • Structure-Conduct-Performance paradigm • Regressions on a cross section of industries to identify correlations (performance = f(concentration, barriers to entry)) • Argued that high concentration was bad for consumers, and paved the way for much antitrust legislation • Main weaknesses: (i) Assumes that structure (concentration) is exogenous. (ii) Assumes away important differences between industries.

A Brief History of Industrial Organization • Chicago School (1960-1980) • More careful application of econometric techniques • Use different market structures to understand different industries or markets • Markets work!!! • Monopoly is much more often alleged than confirmed • When monopoly does exist, it is often transitory; entry (or just the threat of entry) is important

A Brief History of Industrial Organization • Game Theory (1980-1990) • Emphasis on strategic decision making • Modelled mathematically using Nash equilibrium concept • Produces a huge proliferation of models are often very intuitive theoretically • However, it is difficult to know which model is the right one for a real world industry

A Brief History of Industrial Organization • New Empirical I.O. (1990 - ) • Integrates theory and econometrics into structural models • More complex empirical models that are computationally intensive • I.O economists have now a much richer toolbox to analyse markets

Why do we care? • Industrial Organization is centred around four questions: • Is there market power? • How do firms acquire and maintain market power? • What are the implications of market power? • Is there a role for public policy regarding market power?

Structure-Conduct-Performance framework • SCP paradigm: Stable causal relationship between the structure of an industry, firm conduct and market performance. • Typical SCP study consists of two steps: • Obtain a measure of performance through direct measurement (rather than estimation) and several measures of industry structure (concentration, barriers to entry, unionization etc). • Regress performance measures on the various structure measures to explain the differences in market performance across industries i • Πi=α+β1CONC+β2B.E.i1+β3 B.E.i2+…+βΝ+1 B.E.iN+εi

Structure-Conduct-Performance framework • Two main assumptions to establish a statistically and conceptually meaningful relationship between structure and market power: • The various industry structure measures are exogenous, i.e. structure affects performance but not the other way around. • Implied degree of symmetry in conduct holds across industries, i.e. changes in the structural variables must have the same average effect on market power in all markets.

Structure-Conduct-Performance in practice • Performance measures: • Rate of return • ROI, ROS, ROE • key concern is whether the reported RoR captures economic or accounting profits • Price-cost margin or Lerner index=(p-mc)/p • MC data is hard to come by, so most use AVC • Tobin’s q which is the ratio of the firm’s market value to the replacement cost of its assets • Need accurate measures of market value and replacement cost of capital, >1 greater implied profits

Structure-Conduct-Performance in practice Market Concentration: Assume there are n firms producing a homogeneous good, same mc, total output Profit for firm i is: Firms compete a la Cournot: Solve the n-firm equilibrium and rewrite: Generalize to allow for different mci:

Structure-Conduct-Performance in practice Concentration measures: Herfindahl-Hirschman Index (HHI): Varies between 0(=perfect competition) and 1(=monopoly) Takes into consideration the absolute number and size distribution of firms Concentration Ratios: Most common: CR4, CR8

Structure-Conduct-Performance in practice • Barriers to entry: • Minimum Efficiency Scale • Advertising • Capital – sunk capital investments • R&D • Unionization: unions may be able to extract higher wages hence reducing profits associated with mkt power • Buyer Power: just as seller concentration is important, buyer concentration may lead to lower prices and less mkt power for sellers

Structure-Conduct-Performance: results Hypothesis 1: market power should increase as concentration increases Weiss (1974) reviews literature prior to 1970s, most studies found a positive relationship, but the effect is small (10% increase in C4 resulted in 1.21% increase in price-cost margins). Schmalensee (1989) who surveys the literature after Weiss, cast doubt on the sign and whether the effect is statistically significant. There is some suggestion that the relationship between profitability and concentration is discontinuous; critical level of concentration 70% (Bain, 1951). Firm-level data studies confirm that link weak if it exists at all and it’s the presence of a large second or third firm that greatly reduces price-cost margins (Kwoka and Ravenscraft, 1985).

Structure-Conduct-Performance: results • Hypothesis 2: the larger the barriers to entry, the greater the exercise of market power • Effect of barriers to entry more robust and significant than concentration. • MES, capital intensity, R&D to sales, advertising to sales, all positively correlated with profits, though highly correlated with each other. • Increased buyer concentration lowers price-cost margins • Unionism has a significant negative effect on price-cost margins Salinger (1984) suggested that link between concentration and profits exists only if there are barriers to entry: Πi=α+CONCi [β2B.E.i1+β3 B.E.i2+…+βΝ+1 B.E.iN]+εi Test significance of interaction: none of the coef or sum significant

Structure-Conduct-Performance: Critique • Measurement Problems • RoR • Capital is not valued appropriately; historical cost vs. replacement cost, book value vs. economic value • Depreciation is measured improperly; economic rental rate on capital after depreciation, econ vs. accounting depreciation • Valuing advertising and R&D • Adjusting for risk, debt vs. equity • Adjustments for inflation • Capitalized monopoly profits inappropriately included by using book value • Pre-tax instead of after-tax RoR often calculated

Structure-Conduct-Performance: Critique Measurement Problems Price Cost Margins Instead of MC, AVC is used: PCM=(Sales Revenue-Payroll costs-Material costs)/Sales Revenue BUT substituting AVC for MC may cause serious bias.

Structure-Conduct-Performance: Critique • Measurement Problems • Tobin’s q • Avoid the problems with estimating RoR or MC • We need meaningful measures of both market value and replacement cost of firm’s assets • Firm value: equities+debt; issues with efficient market hypothesis, timing of evaluation • Hard to obtain estimate of replacement costs unless markets for used equipment exist • Much harder to evaluate intangible assets like advertising, R&D and human capital, usually ignore those and hence ratio>1

Structure-Conduct-Performance: Critique • Measurement Problems • Concentration Measures • How do we define a market? Economic vs. national statistic agency definition. • Boundaries of an economic market should include all the firms and their products that interact to determine prices, demand-side (product) and supply-side (geographic) substitutes. • The importance of cross-price elasticities!!! • Standard Industry Classification (or new North American ICS) either too general or too specific (51 sector, 513 subsector, 5133 industry group, etc) • No import-export data

Structure-Conduct-Performance: Critique

Structure-Conduct-Performance: Critique • Conceptual Problems • Long run vs. Short run • Assumed stable relationship between mkt structure and long-runprofitability • 2. Symmetric Industry Effects • Elasticity of industry demand not included, assumed the same!!!! • 3. What does a positive correlation between concentration and profitability mean? • More mkt power in concentrated industries or more efficient firms? • Implication is that a firm’s success is explained better by its own mkt share rather than just by industry concentration

Structure-Conduct-Performance: Critique This critique is mostly associated with Demsetz (1973, 1974) and is commonly known as the “market power versus efficiency” debate. Demsetz’s basic argument runs as follows. Industries become concentrated because more efficient firms grow at the expense of less efficient firms. A positive correlation between concentration and profitability at the industry level might simply be the result of a positive concentration-profitability relationship for large (and efficient) firms and an insignificant concentration-profitability relation for small (and inefficient) firms.

Structure-Conduct-Performance: Critique • Causality • The SCP is estimated econometrically usually with cross-section multiple regression, across industries • - Unidirectional causality • Profits = f(concentration, Barriers, X) • Later, other equations added to account for feed-back • For example: • Concentration = g(barriers, mkt size, Z) • Advertising-sales ratio = h(concentration, profits, barriers) • And then simultaneous systems – TSLS, see Strickland & Weiss for “typical”.

Structure-Conduct-Performance: References *Schmalensee, R. (1989) “Inter-industry studies of structure and performance”, Handbook of Industrial Organization, 951-1009. provides a comprehensive survey and assessment of SCP studies Geroski, P. (1981) “Specification and Testing the Profits-Concentration Relationship: Some experiments for the UK”, Economica 48:279-88. for UK evidence *Salinger (1990) “The concentration-Margins Relationship Reconsidered”, Brookings Papers on Economic Activity on Microeconomics, 287-321. for a careful, illustrative relative recent example. Geroski (1988) “In Pursuit of Monopoly Power: Recent Quantitative Work in Industrial Economics”, Journal of Applied Econometrics 3: 107-123. for the potential value of the SCP approach for policy and antitrust enforcement

Next time: New Empirical Industrial Organization (NEIO) and Industry Models of Market Power *Bresnahan, T. (1982) “The Oligopoly Solution is Identified”, Economic Letters, 10: 87-92. *Bresnahan, T. (1989) “Empirical Studies of Industries with Market Power”, Handbook of Industrial Organization, 1011-1057. Corts, K. (1999) “Conduct Parameters and the Measurement of Market Power”, Journal of Econometrics, 88:227-250. Genesove, D. and Mullin, W. (1998) “Testing Static Oligopoly Models: Conduct and Cost in the Sugar Industry, 1890-1914”, Rand Journal of Economics, 29:355-377.

Empirical IO Introduction and Overview Structure-Conduct-Performance paradigm