Empirical Uses of the Price-Cost Margin

Abstract

the direction of the relationship depends on other variables. Dorfman and Steiner [5] have shown that for a single firm, holding all variables other than price and advertising budget constant, at equilibrium its marginal value product of advertising would equal its price elasticity of demand or the reciprocal of the Lerner index for a single firm industry. The price-cost margin, (P -MC) /P, is thus theoretically related to market demand elasticity, the marginal value product of advertising, and under certain restrictive assumptions to concentration. These simple static equilibrium results have provided the basis for a number of empirical studies. Kamerschen [8] has used the ratio P/(P - MC) to calculate market elasticity. A number of authors (see articles by Collins and Preston [3] [4], McFetridge [io], Rhoades [I2], and Shepherd [I4] used the margin as a proxy for industry rate of return on sales. They related it to such variables as concentration, geographic dispersion of industries, industry size, growth rate, diversification and industry capital-output ratios. In general, they found a positive relation between concentration and price-cost margins, and this relation was stronger for consumer than producer goods. Some far-reaching proposals for antitrust policy have been based on such studies. Sherman and Tollison [I5] assumed constant short-run marginal cost equal to variable cost and used (P - MC) /P = I- (VC/P) as a measure of the degree of 'cost fixity' within an industry. They relate their measure of cost fixity to industry rates of return to test the hypothesis that advertising may be technologically induced by relative costs. The purpose of this note is to examine in detail uses of the price-cost margin as a measure of profitability. The empirical results indicate misspecification bias and errors in measuring the price-cost margin biased the relationship between concentration and price-cost margins. Differences in the margin across industries are explained predominately by capital-sales