A Value-Based Test of Profitability and Market Structure

TL;DR: In this article, the authors examine the future-oriented implications of market structure on profitability and the ability of a firm to maintain and extend its excess returns into the future by using a value-based test.

Abstract: T HE traditional hypotheses of industry organization relate various aspects of market structure to cross-sectional variation in profitability among industries or firms. It is presumed that association between profitability and structure indicates the existence of excess profits that would be absent under perfect competition. The fundamental causes of excess profits reaped by a whole industry are the existence of entry barriers, and the ability of firms within the industry to coordinate their output-price decisions. On the other hand, varying profitability among firms even within an industry may be due either to the superior "bargaining" position of the firm within a system of oligopolistic coordination or to superior efficiency in production and distribution. The relationship of structure and profitability, and the attendant interpretations, have been repeatedly examined at the level of ex post rates of return on capital. Such rates are by nature backward-looking since they register the average success of past investments. They do not, therefore, reveal the ability of a firm to retain and extend its excess returns into the future. In contrast to traditional studies this paper seeks to examine the future-oriented implications of market structure. A forward-looking index of profitability is a firm's market value. The basic issue which can be examined in the light of a value-based test of profitability and market structure is this: Does current structural position imply an ability on the part of the firm to maintain excess profits in the future? It must be noted that even if current structural position implies (or is implied by) superior efficiency, the ability of the firm to maintain such advantages into the future implies correspondingly a deficiency in the long-run competitive process since entry would presumably be expected to wipe out such efficiency differentials. It should also be clear that even if the basic question posed were answered in the negative, this would not imply that structural position is unrelated to ex post profits. Thus, the scope of the current work is complementary to traditional studies. The theoretical premises of the hypotheses are laid out in section B. Section C contains a description of specification for statistical tests. Section D presents empirical results and section E summarizes major conclusions.