Empirical IO Introduction and Overview Structure-Conduct-Performance paradigm. Based on the lectures of Dr Christos Genakos (University of Cambridge). References and background readings:
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Based on the lectures of
Dr Christos Genakos (University of Cambridge)
Objectives: To get an improved understanding of static and dynamic problems faced by firms:
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:
Herfindahl-Hirschman Index (HHI):
Varies between 0(=perfect competition) and 1(=monopoly)
Takes into consideration the absolute number and size distribution of firms
Most common: CR4, CR8
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).
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
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.
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.
*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.