Title: Empirical IO Introduction and Overview Structure-Conduct-Performance paradigm
1Empirical IOIntroduction and
OverviewStructure-Conduct-Performance paradigm
Based on the lectures of Dr Christos Genakos
(University of Cambridge)
2- 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.
3OUTLINE
- 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
4Introduction 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
5A 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.
6A 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
7A 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
8A 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
9OUTLINE
- 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
10Why 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?
11OUTLINE
- 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
12(No Transcript)
13Structure-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
14Structure-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.
15OUTLINE
- 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
16Structure-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
17Structure-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
18Structure-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
19Structure-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
20OUTLINE
- 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
21Structure-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).
22Structure-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
23OUTLINE
- 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
24Structure-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
25Structure-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.
26Structure-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
27Structure-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
28Structure-Conduct-Performance Critique
29Structure-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 -
30Structure-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.
31Structure-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.
32Structure-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
33Next 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.