Empirical IO Introduction and Overview Structure-Conduct-Performance paradigm

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

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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

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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.

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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

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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

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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

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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?

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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
• ?iaß1CONCß2 B.E.i1ß3 B.E.i2 ß?1 B.E.iNei

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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.

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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
• Tobins q which is the ratio of the firms market
  value to the replacement cost of its assets
• Need accurate measures of market value and
  replacement cost of capital, gt1 greater implied
  profits

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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

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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

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Structure-Conduct-Performance in practice

• Barriers to entry
• Minimum Efficiency Scale
• Advertising
• Capital sunk capital investments
• RD
• 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

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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 its the presence of a large second or
third firm that greatly reduces price-cost
margins (Kwoka and Ravenscraft, 1985).

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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, RD 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
• ?iaCONCi ß2 B.E.i1ß3 B.E.i2 ß?1
  B.E.iNei
• Test significance of interaction none of the
  coef or sum significant

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OUTLINE

1. Introduction and a brief history of IO
2. The BIG Questions in IO
3. The Structure-Conduct-Performance paradigm
4. Structure-Conduct-Performance in practice
5. Structure-Conduct-Performance results
6. Structure-Conduct-Performance critique

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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 RD
• 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

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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.

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Structure-Conduct-Performance Critique

• Measurement Problems
• Tobins q
• Avoid the problems with estimating RoR or MC
• We need meaningful measures of both market value
  and replacement cost of firms assets
• Firm value equitiesdebt 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, RD and human capital, usually
  ignore those and hence ratiogt1

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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

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Structure-Conduct-Performance Critique

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Structure-Conduct-Performance Critique

• Conceptual Problems
• Long run vs. Short run
• Assumed stable relationship between mkt structure
  and long-run profitability
• 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 firms success is explained
  better by its own mkt share rather than just by
  industry concentration

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Structure-Conduct-Performance Critique
This critique is mostly associated with Demsetz
(1973, 1974) and is commonly known as the market
power versus efficiency debate. Demsetzs
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-profitab
ility relationship for large (and efficient)
firms and an insignificant concentration-profitabi
lity relation for small (and inefficient) firms.

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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.

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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
48279-88. 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

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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,
88227-250. Genesove, D. and Mullin, W. (1998)
Testing Static Oligopoly Models Conduct and
Cost in the Sugar Industry, 1890-1914, Rand
Journal of Economics, 29355-377.