Efficiency, Market Power, and Profitability in American Manufacturing

Abstract

A significant, positive association between concentration and profitability is perhaps the most widely reported statistical relationship to be found in the literature of industrial organization [25]. According to conventional oligopoly theory, this reflects the ability of the leading firms in concentrated markets to collude tacitly or explicitly. Some economists, most notably Harold Demsetz [8;9] have challenged the conventional view. Demsetz argues that it is the superior efficiency of large firms which results in both high concentration and high profits. He supports this argument with evidence, replicated by Round [20] and Carter [4], that concentration increases the profits of large firms but not small firms. If the firms in an industry are equally efficient, effective collusion should raise the profits of small and large firms alike. The fact that it doesn't strongly suggests that efficiency, concentration, and profits are interrelated in American manufacturing. There are two bits of evidence which indicate the large-firm efficiency and collusive behavior coexist in much of American manufacturing. The first is the profitability studies of Imel and Helmberger [11], Gale [10], and Shepherd [21]. These studies suggest that, considered together, market share and concentration are both significantly positively related to profitability. If, as argued by McGee [15] and Weiss [25], market share is capturing the effect of lower costs (and/or superior products), concentration must be capturing the effect of collusive behavior. The second is Carter's [4] refinement of Demsetz's methodology. Carter regressed price-cost margins on concentration, capital intensity, and advertising intensity for large and small firms separately. He reports a positive concentration coefficient for large firms which is greater than that for small firms and which is significantly associated with large-firm profitability. The difference in the estimated coefficients may be taken as evidence of large-firm efficiency and the significance of the large-firm coefficient as evidence of collusive behavior. Whether the concentration-profits relationship derives largely from efficiency, as Demsetz believes, or largely from collusive behavior, as the conventional view would have it, is a more difficult empirical question. The answer has important implications for merger policies, remedies pertaining to tacitly collusive oligopolies, and legislative proposals