Two important questions:

i)
ii)

How much market power do particular firms

(industries) exercises?
What are the major factors that determine market
power?

Theories of Price Mark-ups and profits.

Table 8.1

SCP
SCP paradigm, an industrys performance its success in
producing benefits for consumers depends on the
conduct or behaviour of sellers and buyers, which
depends on structure of market.
A typical SCP study has two main stages. First, one
obtains measure of performance (through direct
measurement rather than estimation) and several
measures of industry structure.
Second
econometricians
studies
cross-industry
observations to regress the performance measures of
structure so as to explain the difference in market
performance.
- The rate of return: Profits earned per dollar of
investment
- The price-cost margin; How much price is higher
than MC. In same case AC is taken as substitute of
MC.
Rate of Return
The relationship between Rates of Return and Economic
Profits.
Important distinction between economic and accounting
profits.
- Capital Cost- A flow variable rather than a stock
variable.

- A well developed rental market helps to

calculate rental rate of capital and economic
profits.
- For implicit rental rate of capital, capital
asset should be valued at replacement cost.

What matters to investors is the return after depreciation

has been calculated.
= R Labour Cost Material Cost Capital Cost
= R L.C. M.C. ( + ) PK.K
= earned rate of return, = rate of
depreciation.
= R Labour Cost Material Cost - PkK
PkK
The relationship between Rates of Return and Price.
By how much would price or revenues have to fall in a
highly profitable industry in order for that industry to
earn a normal rate of return?
Let r* = r + 0.5; The firms invested capital earn excess
revenues of 5 percent times the value of its capital above
what it would earn if it were in a competitive industry, if
the firms revenue in R*, then its rate of return is
r* = [ R* - LC MC - PkK] / PkK = r + .05
Substituting the value of r

R R* = - .05 PkK
Thus to get normal rate of return, the Revenues would
have to fall by 5 percent of the value of capital.

The industries that earn a rate of return of 1.5 times

higher than the revenue earned by competitive industries
would be charging a price that are only 5 percent above
those that generate a normal return.
Pitfalls in calculating Rate of Returns
There are eight pitfalls
Accounting definition Vs. economic definition
Problems to measure depreciation
Valuing problems of R and D and Advertising
Adjustment for inflation
Monopoly Profits may be inappropriately included in
the calculated rate of return
o Before tax and after tax rate return
o Adjustment for risk
o The issue of debt
o
o
o
o
o

Comprising Rate of Return

Table 8.2

Price Cost Margin

P MC
P

= - _1_

MC is rarely available. Researchers. Use Price Average

variable cost margin instead of the appropriate price
margin cost margin.
AVC = R LC - MC
Q
This creates serious bias
MC = V + ( + ) Pk K
Q
Using V instead of MC means
P V = - 1 + ( + ) PkK
P

P.Q.
Bias = ( + ) PkK
PQ
- Measures of Market Structure
- Industry concentration
- 4 Firms concentration and 8 firms concentration
- HHI Index
Table 8.3
Table 8.4

- Barriers to Entry as one of the Structural Factor

Entry barrier proxies include MES firm size, advertising
intensity and capital intensity as well as subjective
estimates of the difficulty of entering specific industries.
With no long-run barriers to entry or exit, rates of return
across industries should coverage.
-

Unionization
Higher profits Higher wages Higher prices

- The Relationship of Structure to Preference

Table 8.5
Table 8.6

- Price Cost Margins and Industry Structure

P V = 0.16 + 0.10 C4 + .08 PkK/PQ + Other variable
P
(.01)* (.02)*
(0.02)*
* = Standard errors
- Modern Structure Conduct Performance Analysis
- Sutton Theory: What happens to competition as
market size grows. Does the market become less
concentrated.
- Does other dimensions of the product such as
quality, promotional activity, and R and D change.
- Sutton analysis markets in which the product is
either homogenous or heterogeneous and considers
the cost of entering the market or altering certain
attributes or products.
- Exogenous Sunk cost Vs Endogenous Sunk Cost
Figure 8.1
Figure 8.2

- Modern Approaches to measuring performance

Figure 8.3
Table 8.7