G604, Profit-Concentration Lectures

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G604, Profit-Concentration Lectures
Spring 2006, 10 January 2006 Eric Rasmusen,
erasmuse_at_Indiana.edu
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Why Do Some Firms Have Higher Profit?
(ask students to answer) (why is this
interesting?)
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Does Concentration Create Monopoly Profit?
How would you address this question?
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PROFITS AND CONCENTRATION
It is not obvious how to measure
concentration. Tirole (p. 221-222) has a good
discussion of this. 3-firm concentration
ratio if 3 firms have 90 percent of the market,
the ratio is 90 percent. steel market shares
(70, 10, 10) car
(30, 30,30) (1a) Encaoua and Jacquemin (1980)
1. Symmetry between firms. If Apex and Brydox
switch places in market share, the index should
be unaffected. 2. If market share moves from
any firm to a bigger firm, the index must report
higher concentration. 3. If the number of
identical firms in the industry grows,
concentration measured for just that part of the
industry must decrease.
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Herfindahl Index

• H s_12 s_22 . s_n2
• Shares H C4
• 10,000 100
• 1x100 100 4
• 50,50 5,000 100
• 90,10 8,200 100
• 50, 50x1 2,550 50
• 25x4 2,500 100

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Measuring Profit
Return on equity Return on sales Return on
stock Return on capital
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PROFITS AND CONCENTRATION
Bain (1951, 1956) found that industry
concentration and profitability were correlated,
and he thought this was evidence that
concentration promotes collusion.
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PERFECT COMPETITION
The problem with Bain's reasoning is that a
competitive market should also have a
correlation between concentration and profits.
Demsetz (1973) pointed this out A simple
reason why firms have different sizes is that
fixed costs vary across industries. If
fixed costs are sunk, they won't show up in
current economic profits, which will be huge if
the fixed cost is big. They will have shown up
in big losses in the first year of operation,
however, so overall profits will be zero.
If fixed costs are recurring, then current
economic profits will be zero. If the accounting
system spreads a fixed cost across, say, two
years, but the revenues it generates are all
received in one year, then the company will have
positive accounting profits.
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INTEGER PROBLEMS
Economic profits might be positive and
higher with greater concentration. There
might be an integer problem. If an industry
has fixed costs, then for some number N, N
firms can operate profitably, but demand would
not be big enough for (N1) to cover their
fixed costs. If N1, the industry is a
natural monopoly, highly concentrated, and even
if that firm is a price-taker it can earn large
positive profits. If N100, then each
price-taking firm can earn a small profit, but
neither firm nor industry profit is as large.
Wal-Mart in small towns is an example.
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POSITIVE ECONOMIC PROFITS
Some firms might have lower costs. Suppose
an unlimited number of firms could operate in
an industry with a capacity of 1 and a marginal
cost of c , and that demand is perfectly
inelastic at amount Q . Number N of firms,
however, have capacities of K each and
marginal costs of c_0 ltc . We will assume
that N K ltQ , so the low-cost firms cannot
supply the entire market. The competitive
price will be Pc , and in the unique Nash
equilibrium, the low-cost firms will all produce
at capacity and earn positive profits.
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GAME THEORY DIGRESSION.
This is the Bertrand game with different
marginal costs and limited capacity. (A) Why
doesn't the Edgeworth paradox apply? The
high-cost firms prevent any low-cost firm from
raising its price above Pc , even though the
low-cost firms are all at capacity. (B) The
equilibrium described is weak, since consumers
are indifferent between low and high-cost firms
when they all charge Pc . Aren't there other
equilibria where the low-cost firms don't all
sell to capacity because not enough consumers
choose them? No, because any low-cost firm
that did not sell to capacity would reduce its
price to Pc-\epsilon . This deviation knocks
out all those conjectured other equilibria.
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PRICE THEORY DIGRESSION.
Are the low-cost firms actually earning economic
profits? The price exceeds their marginal cost,
to be sure, but shouldn't we call that extra
revenue a rent to their special technology and
limited capacity? Like a rent to land or
to a person's natural talents, the firm's
profits in this situation are not eliminated
by competition, rise or fall depending on the
marginal player in the market, and are based on
ownership of a non-produced resource, fixed in
quantity. On the other hand, we think of
profit as a return to a firm qua firm, as
opposed to inputs being purchased from outside.
If the firm's low-cost technology is
inalienable-- that is, it can't be bought or
sold aside from buying the entire firm-- then it
has no opportunity cost to the firm, which must
use it or lose it.
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THE BAIN REGRESSION

• Profitability alpha betaconcentration
• What problems are there?
• MARTIN BROZELL PROBLEMS
• Disequilibrium? No.
• 2. Bias in industry selection. No.
• 3. Firm selection bias. Industries with small
  firms would not be included. That's OK.
• Well look at some other problems.

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PROBLEM 1 Serial Correlation
This is not mentioned in Martin. Some
industries have high profits at the same time
because of omitted variables that are correlated.
So the data sample is really smaller than it
seems. Some observations are Motor
vehiclesWashing machinesSteel works and
rolling millsCast iron pipeWireDoors and
shutters, metal Are these independent
disturbances? No. The price of iron is in all of
them.

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PROBLEM 2 UNIT OF ANALYSIS

Bain used industries such as Cigarettes,
Soap, Paper Goods. He used government
definitions, throwing out some clearly wrong ones
(Cane sugar vs. Beet sugar) since demand, not
supply, is what is relevant here. He averaged
together the profitabilities of different firms.
Firms could be used instead. Which is better?
Can you do both?
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PROBLEM 3 RISK
(not in Martin) An omitted variable problem
More risky industries will need higher
returns. Leverage is also part of this. A firm
can get capital, by DEBT and by EQUITY. Equity is
what the owners put in, and debt is what they
borrow. Some people form a corporation by
putting in 1,000 dollars with which to buy
capital. They use it to buy sewing machines. The
corporation has 1,000 shares, with an initial
value of 1 dollar each. Each shareholder gets as
many shares as he put dollars into the company.
Each share has one vote for the choice of who
will be on the board of directors that runs the
company. The company has no debt, so we say it is
UNLEVERAGED.

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JUST EQUITY
If the company has net revenue ("net" meaning
after variable costs) of 200 in the first year,
the return on equity is 20. The return on
assets is the same, since the company has no
debt. If the company's net revenue had been
50, the return on equity would have been
5. The book value of the equity is 1000
dollars, and so is the market value, at the start
of the firm. Suppose the price of sewing
machines falls in half. The company's assets now
have a market value of only 500 dollars, so the
stock price will fall to 50 cents per share, and
the market value falls to 500 dollars. The book
value of equity is still 1000 dollars,
however. If the shareholders want to, they can
revise the book value. They do this by "writing
down" the assets by 500. But they do not have to
do that, and companies only write down assets
occasionally.

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DEBT
Suppose the price of sewing machines goes
back up, so the assets are worth 1000 again. The
directors decide to borrow 2000 from a bank, at
an interest rate of 15. The company is now
"highly leveraged". The company has revenues of
600 the next year, because it has tripled in
size and the return on assets is still 20. The
company must pay 300 in interest to the bank,
though, which leaves 300 in cash flow for the
shareholders. Thus, the return on equity is
30--bigger. Suppose the net revenue had been
150 (a 5 return on assets). The company must
pay 300 in interest to the bank, which leaves
-150 for the shareholders (the company would
have to sell some sewing machines to come up with
the money). The return on equity would be -
15.

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LEVERAGE

Leverage increases the riskiness of the company's
stock even though it does not increase the
riskiness of the company's assets. An
unleveraged company would have had a return on
equity of either 20 or 5. The leveraged company
has a return of either 30 or -15. Thus, any
company can affect the riskiness of its stock by
deciding how much debt to hold.
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RESIDUAL CLAIMANTS

The "residual claimants" of a company are the
people who get whatever profits are left over
once all the debts are paid. In this example,
they are the shareholders. The bank has first
claim on the cash flow, and the shareholders are
legally allowed to keep only money in excess of
the interest payments. The residual claimants
have the riskiest claims. The bank still runs
some risk---it could be that the company loses
1100 in one year, for example, so it cannot pay
the 300 in interest even if it sells off
assets-- but the bank's risk is less than the
shareholders'.
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ASYMMETRIES

1. The downside risk of the shareholders is
limited to losing the 1000 that they invested in
the company.2. The downside risk of the bank is
limited to losing the 2000 loan it made.3. The
upside gain of the shareholder is unlimited. If
the company earns 10,000, then after paying the
bank 300 in interest, the shareholders keep all
the excess.4. The upside gain of the bank is
limited to the 300 interest it was promised.
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PROBLEM 4 ACCOUNTING
Profit rates vary across industries because of
accounting rules and the types of expenses. The
problem arises because costs and revenues arrive
at different times. Suppose two firms each have
100 in capital. Firm 1 pays 50 for labor and
raw materials and gets 80 in revenue each year.
Profit is 30, and the return on capital is 30.
Over two years, total profit is 60. Firm 2 pays
50 for labor and 60 for raw materials inventory
in the first year, and gets revenue of 110.
Profit is 0 and the return on capital is 0.
Firm 2 pays 50 for labor and 0 for raw materials
in the second year, and gets revenue of 110.
Profit is 60 and the return on capital is 60.
Over two years, total profit is 60. Growing
industries will look less profitable.

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Survival Bias

Some firms died. Those remaining have to be
extra profitable. (Demsetz flavor) This is like
the problem of entry into an industry requiring a
fixed cost. If an industry or firm has a
differentiated product, it will price at greater
than marginal cost. (Differentiated Bertrand
model). If entry is free, fixed costs, recurring
or one-time, will eat up the profit. If they are
one-time fixed costs, they wont show up in the
accounting profits later.
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PROBLEM 5 THE DEMSETZ CRITIQUE (Simultaneity)

Suppose some firms have low costs. They will
grow, and the market becomes concentrated.
(Simultaneity Concentration depends on
profitability. ) To test this, do a regression
at the firm level Profitability alpha
betaconcentration gammamarket_share
industry_dummy If you run this, it turns out
that beta is insignificant. Does it matter that
market share is not independnet between
obeservations? No-RHS variable.
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THREE CONCEPTS YOU SHOULD KNOW FOR EMPIRICAL WORK
IN I.O

Conjectural VariationThe Lerner
IndexTobin's q