The Validity of Profits-Structure Studies with Particular Reference to the FTC's Line of Business Data

Abstract

The simple proposition that consumerdamaging collusion is more likely to occur when there are fewer competitors has given rise not only to legal restrictions of economic activity thought to restrict output, but also to an enormous amount of empirical work attempting to relate market concentration to the exercise of monopoly power.' Most such studies measured market structure by an index of concentration (for example, four-firm concentration or Herfindahl) and performance by accounting profit (for example, net profit divided by assets) or price-cost margins (sales less direct costs divided by sales). From the positive, statistically significant correlations often found between greater concentration and profit (with other factors presumably accounted for), some researchers conclude that increases in concentration are anticompetitive and that concentration, therefore, is bad. The concentration-profits studies have been criticized essentially on two grounds. One is that the positive relationship is not indicative of collusive behavior. In particular, Oliver Williamson (1968), John McGee (1971), Harold Demsetz (1973, 1974), and Sam Peltzman (1977) point out that higher profits could result from efficiencies experienced by large firms, which resulted both in greater market shares and high levels of concentration. Analytical arguments show that higher profits logically follow as much from lower costs that are associated with higher levels of concentration, as from collusion-determined higher prices. Some empirical evidence that supports this belief is presented by Demsetz, Peltzman, and Bradley Gale and Ben Branch (1982). However, their findings have been contested on the grounds that the data used are biased or inadequate, or that the researchers have not demonstrated that the observed higher-profits/greater-concentration relationship was caused by lower costs.2 The second criticism is that available data provide an inadequate basis for such conclusions. The concentration numbers are based, usually, on industries defined by the Commerce Department's Standard Industrial Classifications (SIC). The SIC definitions tend to be supply (production) rather than demand determined, include nonhomogeneous products, and exclude sales of similar products that are included in different SIC groups or are imported. The profit data are taken from accounting reports that provide poor measures of economic values. Weiss (1974) describes many of these problems. However, he does not believe that these shortcomings invalidate the studies. As Weiss (1979) concludes: