Literature Related to Concentration as a Proxy of Market Power

According to IO's Joe Bain, concentration fosters collusion and this leads to high profitability.

This author agrees with Curry and George44 that the literature has not resolved the question of which index is the best to use to measure concentration. Lerner proposed his famous index, where margin divided by price is an indication of the departure from the competitive ideal. Concentration is strongly linked with the number of competitors, as in the case of Bain who uses the K-firm index (value product contributed by the first K larger firms). For Bain, concentration has an impact on the success of collusive behavior on higher margins. However, Bain recognizes that the correlation is quite poor. Concentrations of profits are clearly high or low, but with no linear relationship in the middle. This view is captured by Herfindhal who demonstrates that by using squared values the impact of smaller firms is less than proportionate.

Mann,45 Weiss,46 and Comanor and Wilson47 use "seller concentration and entry barriers." Curry analyzes several indexes of concentration.

Bain, Mann, and Qualls conclude that concentration and entry barriers impact profits. Bothwell disagrees with Bain: collusion (linked to concentration) and entry barriers do not correlate with margins. Scher-er's48 theory is that concentration has a negative impact on margins (scale economies have no impact). Rhoades and Cleaver49 present strong evidence that concentration correlates with margins.

Literature Related to Entry Barriers as Components of Market Power

Another variable is the height of the entry barriers, which consequently has an impact on the concentration index. Rumelt separates tangible and intangible entry barriers, demonstrating that tangible entry barriers have less impact than intangible entry barriers. Tangible entry barriers are used by Densetz who views "absolute or relative firm size" as an entry barrier, related to efficiency and innovation. In contrast, Sheperd,51 Gale,52 and Bothwell use "market share."

The financial situation of competitors also has an impact on entry barriers. Stigler,53 Fisher,54 and Hall55 use "risk differentials" to incorporate three risks: return volatility, financial leverage, and nondiversifiable risk. Bothwell uses "leverage," "profit variability," and "nondiversifiable risk: BETA." Higher risks generate higher returns.

Economies of scale is another important entry barrier. Bain uses the formula of "capital-output" = book value of assets/sales. Bothwell uses "scale economies" and "absolute capital requirement" (assets/sales). Holterman postulates that the "entry barrier" = size of the plant and that the height of entry barriers depends on the plant's size and advertising.

Intangible entry barriers are also used by Bain, such as "producer-consumer goods" as a dummy variable to incorporate differentiation. Bothwell and Holterman use "advertising intensity" with ad expenses. Comanor and Schmalensee use ad expenses as a proxy of "product differentiation." Schmalensee developed a sophisticated model that explains the relationship between advertising and monopolies (advertising may invite new entrants to enjoy friendly customers).

The impact of entry barriers on margins is a matter of dispute. For Bothwell, market share correlates with margin where firm size is a barrier to entry. Schmalensee, however, arrives to the opposite conclusion wherein market share barely has an impact on profits. Bothwell concludes that advertising correlates with margin. Bain disagrees and believes advertising and margin correlate because high differentiation increases high monopoly, and consequently high ad expenses are justified because they drive high margins.

Growth is another element that seems to correlate with entry barriers and margins according to Rhoades and Cleaver.

Bothwell demonstrates that Bain was wrong: risk premium does not correlate with margin. For Bothwell companies do not collude; the entry barriers of firm size and risk premium do not impact margins.

The impact of knowledge as an entry barrier is also a matter of debate. For Rumelt, knowledge always makes sense: diversification is based on economies of scope, idiosyncratic investments, and uncertain inimitability. Companies between 1949 and 1974 that diversified grew from 30 percent to 63 percent; this growth mostly occurred when these companies remained in related business (K matters). Densetz shows that efficiency and innovativeness are both linked to knowledge and impact on profits.

In summary, the literature identifies several components of market power, such as concentration, firm size, advertising, knowledge, growth, and others. However, there is not an index of market power as such.

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