Transcript PROFITS AND CONCENTRATION

G604, Profit-Concentration
Lectures
Spring 2006, 10 January 2006
Eric Rasmusen, [email protected]
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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. 221222) 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
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that part of the industry must decrease.
Herfindahl Index
H = s_1^2 +s_2^2 + …. + s_n^2
Shares
H
C4
100
10,000
100
1x100
100
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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
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positive accounting profits.
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 (N+1) to cover their
fixed costs.
If N=1, the industry is a natural monopoly, highly
concentrated, and even if that firm is a price-taker
it can earn large positive profits.
If N=100, 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 <c .
We will assume that N K <Q , so the low-cost
firms cannot supply the entire market.
The competitive price will be P=c , 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 P=c , 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 P=c . 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 P=c-\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-12
then it has no opportunity cost to the firm, which
must use it or lose it.
THE BAIN
REGRESSION
Profitability = alpha + beta*concentration
What problems are there?
MARTIN: BROZELL PROBLEMS:
1. Disequilibrium? No.
2. Bias in industry selection. No.
3. Firm selection bias. Industries with small
firms would not be included. That's OK.
We’ll 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 vehicles
Washing machines
Steel works and rolling mills
Cast iron pipe
Wire
Doors and shutters, metal
Are these independent disturbances? No. The price of
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iron is in all of them.
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
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UNLEVERAGED.
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
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equity would be - 15%.
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 onetime, will eat up the profit. If they are onetime fixed costs, they won’t 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 + beta*concentration +
gamma*market_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? NoRHS variable.
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THREE CONCEPTS YOU
SHOULD KNOW FOR
EMPIRICAL WORK IN
I.O
Conjectural Variation
The Lerner Index
Tobin's q
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