8) Firm Performance

Critically discuss, with reference to appropriate methodological approaches, the problems

encountered in testing the relationships between market structure and industry performance.

Introduction
- For many years SCP has been considered the best approach for links between structure and
performance. Although more recently has faced heavy criticism.
- Talk about the development of other techniques to assess the variation in firm performance,
market power hypothesis and differential efficiency hypothesis.
How to measure structure and performance
- First we need a robust measure of structure:
- Usually taken as the concentration and levels of barriers to entry
- N firm concentration and Herfindahl-Hirschman Index
- Then measure of performance:
- Both the use of Tobins Q and Price cost margin
- Tobins Q is more useful
The Structure-Conduct-Performance Paradigm
- Developed by Mason and Bain, explain the basic idea of the relationship between market
structure and strategic behaviour
- Run through links between S-C-P
- Criticisms of the SCP (Chicago school) and Demsetz (1973) development of the differential
efficiency hypothesis
Empirical evidence for SCP (market power) approach
- Bain (1951), 42 manufacturing industries between 1936 and 1940
- Collins and Preston (1966)
- Clarke et al. (1984)
Empirical evidence for DEH
- Demsetz (1973)
- Ravenscraft (1983)
- Smirlock et al (1984)
- Libenberg and Kamerschen (2008)
- Porter (1979)

Other Schools of Thought

- Discuss other schools of thought of the relationship between market structure and industry
performance, including the New Industrial Organisation.
- Bresnahan and Lau (1982)
- Rosse and Panzar (1977)
Evidence on the Persistence of Profit
- Brozen (1971)
Conclusion

Answers should:
- Outline the Structure Conduct Performance (SCP) approach to the relationship between
market structure and industry performance, noting that this approach concentrates mainly on
industry-level factors rather than factors that operate at the level of individual firms.
-

Consider appropriate empirical evidence on the SCP approach.

Critically discuss the relative merits of the Market Power hypothesis and the Differential
Efficiency hypothesis as explanations for variations in firm-level profitability.

Consider the work produced by Schmalensee (1985) and others which recognises the
importance of firm-level variations in profitability rather than industry-level variations.

Discuss other schools of thought of the relationship between market structure and industry
performance, including the Chicago School, the New Industrial Organisation and the
Austrian school of thought.

Introduction
The performance of firms is one of the central research themes in industrial organization. There is a
substantial body of empirical research that seeks to explain variations in performance between firms,
most commonly measured by profitability. Early research, based mainly on the SCP (structure
conductperformance) paradigm, identified structural industry-level variables such as concentration,
economies of scale, and entry and exit conditions as the most important determinants of firm
performance. However, this approach has been subject to intense criticism. Many of the structure
performance relationships identified in SCP-based empirical research are relatively weak. Some
economists, including those associated with the Chicago school, argue market power deriving from
monopolization is only a temporary phenomenon. A positive association between concentration and
profitability may reflect an association between productive efficiency and firm size: the most
efficient firms earn the largest profits, enabling them to grow at the expense of their competitors. If
efficiency differences between firms are more important than industry structure in determining
performance, attention should be directed less towards the industry and more towards the individual
firm. Accordingly, later empirical research has sought to shift the focus of attention towards conduct
or strategic decision making at a firm level (New Empirical Industrial Organization).
How to Measure Structure and Performance
In order to undertake a review of the empirical literature, it is important to develop a robust
measurement of an industrys structure and performance. Industry structure is usually defined by the
number of sellers and buyer and their level of concentration. Concentration is calculated in a number
of ways, but the most commonly used are the K-firm concentration ratio and the HerfindahlHirschman index. The K-firm ratio is easily calculated as
where si is the ith firms market
share. The more representative Herfindahl-Hirschman index is calculated as
and places
more weight on market shares of the largest firms. The two most commonly used measures of
performance are Tobins Q (1969) and the price-cost margin. Tobins Q is the ratio of a firms
market value to the replacement cost of its capital, with a value of q greater than one denoting a
firms market value above that of its book value, and vice versa for a q less than one. The price-cost
margin is a ratio of profit to sales revenue, and can be calculated in two ways, as follows,

where TR = total revenue, TC = total cost, P = price, Q = quantity and AC average cost. Of the two,
Tobins Q is the most robust measure of performance, although the empirical results discussed later
use a combination of both measures.
SCP vs DEH
Early empirical work on the link between structure and performance was heavily based around
Bains (1951) structure conduct performance (SCP) model. The basic concept revolves around
the formation of a relationship between the market structure and the strategic behaviour undertaken

by the firm. According to the model, the market environment (e.g. technology, elasticities, materials)
has a direct impact on the market structure (e.g. buyers and sellers, concentration). The market
structure then has a direct influence on the firm's economic conduct (price decisions, differentiation,
R&D), which in turn affects its market performance (efficiency, progress, equity). This model
postulates that a more highly concentrated market increases the opportunity for collusive behaviour,
and thus by fixing prices artificially, all firms in the market will be able to earn profits above those
earned in a less concentrated industry. This model therefore states that industry-level variables such
as concentration, economies of scale, and entry and exit conditions are the main determinants of firm
performance. However, this literature has subsequently been criticized for providing limited
explanations as to why profitability varies between firms within an industry. Whilst this traditional
school views the industry as the unit of analysis, the revisionist school developed by Schmalensee
(1985) argues that the firm should be the unit of analysis as firm efficiency is central to the debate.
This argument is also supported by the Chicago school that believe that market power deriving from
monopolization is only temporary, except perhaps in the case of monopolies that are created and
maintained by government. Thus, a positive association between concentration and profitability may
reflect a positive association between productive efficiency and firm size. The larger market share a
firm controls, the more efficient its practices can be, i.e. through the use of economies of scale, learn
by doing etc. These opposing views have motivated an extensive empirical debate. The earliest
studies follow the same arguments of the SCP, suggesting that concentration and other industry-level
variables are important in determining performance, the market power hypothesis. Conversely,
Demsetz (1973) points out that if the positive relationship between market concentration and
profitability reflects the exercise of market power, then it should affect all firms equally. However, if
the profitability of large firms in concentrated industries is higher than the profitability of small firms
in concentrated industries, then the correlation between profitability and concentration is due to a
relationship between efficiency and profitability. This has led to the formation of the differential
efficiency hypothesis.
SCP Evidence
The predominant approach to resolve the conflicting interpretations has been to use cross-industry
samples, and include both market share and concentration as determinants of firm profits. The
presence of efficiency is taken to be associated with a positive and significant market share effect,
that of collusion with a positive and significant concentration effect. The initial investigation into the
links between structure and performance was undertaken by Bain (1951), using data on 42 US
manufacturing industries between 1936 and 1940. Bain found that the average profitability is
significantly higher in industries with CR8 above 70 per cent (at 9.2 per cent) than in those with CR8
below 70 per cent (at 7.7 per cent). These results are interpreted as indicating that exploitation of
market power leads to enhanced profitability. Similar results were found by Collins and Preston
(1966), reporting a quadratic relationship between concentration and profit. Later investigations were
less conclusive, finding little evidence to support either hypothesis. For example, Clarke et al. (1984)
do not find conclusive evidence for a within-industry positive relation between the profitability and
market share of firms, or evidence that higher prices benefit all firms equally.

DEH Evidence
There are also a number of statistical investigations of profitability that have produced results
inconsistent with the SCP theory, showing support for the differential efficiency hypothesis. Demsetz
(1973) has found that profits of smaller firms are not higher in concentrated industries than they are
in un-concentrated industries, though the profits of larger firms are. Demsetz argues against Bains
view that highly concentrated industries are uncompetitive. An implication is that specific
government policies intended to promote competition directed at highly concentrated industries are
not required but equally, any policy of breaking up large incumbent firms risks sacrificing efficiency
gains and could create long-terms disincentives for pursuit of efficiency. Ravenscraft (1983) supports
this result in his review of 1975 data for 3,186 lines of business. Ravenscrafts results show a
positive link between price-cost margins and market share, but no such link between PCM and seller
concentration, a result that is consistent with Smirlock et al.s (1984) findings for the US
manufacturing sector and Liebenberg and Kamerschens (2008) result for the South African auto
insurance market. Porters (1979) study of 42 consumer goods industries produced striking results.
The correlation between rates of return of leading firms and follower firms in the same industry is
very low with a correlation statistic of only 0.14. If the profitability of all firms in an industry were
affected alike by industry structure, as postulated by the market power hypothesis, then we would
expect this correlation to be strong. This low statistic is consistent with firms profitability depending
on their position within the industry and individual efficiency performance, as postulated by the
differential efficiency hypothesis.
Other Schools of Thought
Much of this empirical work is based on links between structure and profitability, and the analysis of
firm conduct is often underemphasized. These considerations have motivated a number of attempts
to collect direct empirical evidence on the nature of competition, by observing conduct directly
(Bresnahan and Lau, 1982; Rosse and Panzar, 1977). This approach has become known as the new
empirical industrial organization (NEIO). NEIO makes direct observations of conduct in specific
industries, and draws inferences about what these observed patterns of conduct might mean for
structure. A number of further tests have been developed under this school of thought.
The revenue test of Rosse and Panzar (1977) involves estimating the sum of the elasticities of
revenue with respect to each of the firms factor input prices. The sign and magnitude of this statistic
indicate whether firms price-setting behaviour is consistent with the theoretical models of perfect
competition, monopolistic competition or monopoly. The RossePanzar H-statistic is defined as:
H=1 +2 +3
If H = 1, conduct is in accordance with the model of perfect competition.
If H < 0, conduct is in accordance with the model of monopoly.
0 < H < 1 represents the intermediate case of conduct in accordance with imperfectly competitive
market conditions.

The mark-up test of Bresnahan and Lau (1982) involves estimating a structural model incorporating
demand and cost equations, linked by the profit-maximizing condition, marginal revenue equals
marginal cost. An estimate of the firms price elasticity of demand again provides evidence about the
nature of competition the firm perceives.
Persistence of Profit
Both the SCP and NEIO methodologies are based on assumptions of profit maximization and longrun equilibrium. In contrast, the persistence of the profit strand in the empirical industrial
organization literature focuses on the process of adjustment towards equilibrium, by analysing timeseries data on firm-level profit rates. Brozen (1971) criticizes Bains (1951) study, suggesting that a
disequilibrium phenomenon was being observed (in the data used). If high profitability is the result
of the exercise of market power by a monopolist in long-run equilibrium, then similarly high returns
should be realized over a number of years. Brozen replicates Bains empirical analysis over a later
period (1953 57), and finds that in highly concentrated industries, average profitability was only 0.6
per cent above the average; and in un-concentrated industries, average profitability was 0.5 per cent
below the average. This suggests that over time, profitability in the more profitable industries tends
to fall, and profitability in the less profitable industries tends to rise. In other words, there is a
tendency for profit rates to converge towards a common long-run average value. This finding lends
support to the disequilibrium hypothesis.
The large range of empirical work on both sides of this debate indicate how it is very difficult to
pinpoint the main determinants of profitability, whether simply market concentration will lead to
higher levels of profit, or whether advancements in efficiency is the key. The earliest work focused
heavily on the SCP paradigm, and thus concluded that the market power hypothesis answered the
question of structure and performance. Since this, more empirical work has been focussed on the
ability of efficiency to explain the changes in profit observed within an industry itself. The Chicago
school has emphasised the importance to focus on firms as a unit of measurement and the NEIO has
endeavoured to provide more analysis into the conduct of firms as an explanation of profitability.