a study on profitability

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Final Year Project

A STUDY ON PROFITABILITY- CONCENTRATION

RELATIONSHIP IN PAKISTAN MANUFACTURING INDUSTRY

FAIZAN HANIFBB-3-05-3014

SUPERVISED BYMr. IMTIAZ ASKARI

KARACHI INSTITUTE OF ECONOMICS AND TECHNOLOGY


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ACKNOWLEDGEMENT

I am thankful to my Project supervisor Mr. Imtiaz Askari, whose guidance,

support and experience benefited me in the completion of this project. I am

grateful to my supervisor for providing me such a practical oriented chance to

understand the theory of profitability. He provided me information and support

which has led me towards the completion of this project.

Last but not the least; I would render great thanks to my parents and friends who

had directly cooperated with me throughout the period of my research.


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TABLE OF CONTENTS

1. Introduction

2. Literature Review

3. Variables

4. Model

5. Methodology

6. Result

7. Conclusion

8. Recommendation

Appendix:

A-1 Data A-2 Reference


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INTRODUCTION

I probed and elucidate a study on profitability- concentration relationship in

Pakistan manufacturing industry. This study includes 3 Industries i.e Cement,

Textile and Sugar. The study uses a Multiple Regression Technique. The

theoretical framework is developed on the basis of literature survey that was

inclusive of all the required dependent and independent variables necessary for

the study.

This study tests two competing hypotheses concerning the link between market

concentration and profitability: the structuralist view that concentration facilitates

the exercise of market power, and the Demsetz-led counter-argument that

concentration and profitability jointly stem from the superior efficiency of large

firms in such markets. The test is based on the application of multiple regression

analysis for a cross-section of 3 Pakistans manufacturing industries for 2001-

2006. Separate regressions are run on two different groupings of firms: the

number one firms and the rest, these groupings being chosen to represent

strategic groups.


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LITERATURE REVIEW

There is strong evidence that the market share of an entity has a U-shaped

relationship with profitability. The paradigm postulates that market characteristics

(e.g. concentration and barriers to entry) will have an influence on the conduct of

firms, which in turn will influence the performance of firms within that market.

Performance is determined by the conduct of firms, which in turn is determined

by the structural characteristics of the market. These structural characteristics

relate to concentration and barriers to entry. The theory dictates that higher

levels of concentration and higher barriers to entry are expected to be associated

with higher profitability. [SIMON FEENY]

Firms which make up the market structure exhibit peculiar behavior which is

determined in shape of features like market share, their concentration in a

geographic region, industry growth, how much they spend on research and

development, advertisement, and their size in the pertinent industry. Firms

having good such feature are in better position to take advantage by

implementing their strategies for profit making. [PANT]

There are series of measure that show how profitable a firm is such as Gross

Margin, Operating Margin and Berry ratio. Gross income reflects in parts the

value added by a company, Operating income is a measure of the reward that a

company earns for its functions. Berry ratio to measure a firms profitability.

[LEAHY]


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Market share shows the extent of a firms control over the market and it indicates

its position in the market. Market share is defined as the sales of the company

divided by the sales of the industry then multiply this ratio by 100 to get market

share in percentages. A positive relationship has been reported between market

share and rate of return in a number of empirical studies. [GALE]

There is a huge literature overseas, particularly in the United States (US), which

tests the hypothesis that the elevation of price above costs will tend to be greater

in concentrated markets.1

since prices and costs are generally difficult to observe

and compare, many studies make use of the price-cost margin (PCM). Any

factors which are associated with market concentration, and which lead to higher

prices and/or lower costs, will result in a positive association between

concentration and the PCM (Clark, Davies and Waterson, 1984).

This view was later challenged by Demsetz (1973, 1974) and his supporters, who

argued that some industries become concentrated because of the superior

efficiency of large firms. By gaining economies of scale or other advantage

certain firms grow large, causing the market to become concentrated, and earn

high profits, which leads the industry average profitability to be higher.2Hence

efficiency provides the link between market concentration and elevation of price

above costs. This view implies that rising concentration should be associated

with a growing disparity in the profitability of large and small firms, in contrast to

the market power hypothesis, under which higher prices should benefit all firms

equally (since both large and small firms are assumed to be equally efficient).


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The competing hypotheses of market power and efficiency as determinants of

inter-industry variations in PCMs have been tested in several studies (e.g.,

Demsetz, 1973; Allen, 1983; Chapple and Cottle, 1985; and Martin, 1988). The

usual approach is to include among the independent variables measures of

market concentration and large firm relative efficiency in cross-section analysis.

This view implies that rising concentration should be associated with a growing

disparity in the profitability of large and small firms, in contrast to the market

power hypothesis, under which higher prices should benefit all firms equally

(since both large and small firms are assumed to be equally efficient).

Industries are composed of groups of firms, each group following similar

strategies, and each being insulated to some degree from new entrants and firms

in other groups by a generalized from of entry barriers called mobility barriers.

These barriers prevent the strategies of successful firms from being imitated by

outsiders, thereby preserving their higher profits. The profitability of firms in a

strategic group depends on three factors: industry-wide market features which

influence the profits of all firms; the amount of protection offered by entry

barriers; and the amount of rivalry (or lack of it) with other groups.

Variations in PCMs between industries appear to arise both from relative

efficiency and market power effects. Leading firms earn higher profits partly

because of greater efficiency. In Demsetzs view, such efficiency reflects not

only economies of scale, but generally any superiority in performance which

enables firms to grow at the expense of rivals.


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However, unless protected by patent, copyright or trademark, Demsetz argues

that these efficiency advantages will soon be replicated by rivals, subject to

delays arising from imperfect information and other market frictions.

Market power effects are associated both with the market shares of leading firms,

and with group interactions, such that market power enjoyed by one group may

spread through spillover effects to others within the industry. Leading firms seem

to enjoy higher profits when their market share is high, and when the presence of

high mobility barriers appears to blunt rivalry both from new entrants and

between groups, allowing them to price independently.

It was found that the price-cost margins of leading firms are larger when: own

market share is larger, number two firms market share is smaller, other strategic

groups within the industry have higher margins, own relative efficiency is high,

and plant scale economies are large in relation to market size. The first three

factors support market power explanations of the profitability-concentration

relationship; the last two factors imply that market concentration and profitability

are jointly related to the superior efficiency of large firms. [MICHAEL PICKFORD

AND MARCUS WAI]

Movements in profit margins or price cost mark-ups are an important component

of changes in prices. In recent years profit margins have undoubtedly accounted

for a significant part of the increase in prices perhaps as a much as a third.

Given this, the behavior of mark-ups over the business cycle is of interest to

anyone concerned with the behavior of prices in the short to medium run. It is

also of interest because of the potential implications for the real economy. A


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number of recent macroeconomic models identify counter-cyclical movements in

the mark-up as a simple transmission mechanism by which changes in nominal

demand can lead to pro-cyclical movements in employment in the absence of

nominal rigidities.

There are two main results. First, average mark-ups are significantly greater

than one in all but a few manufacturing industries, and profit margins are

positively associated with both firm market share and industrial concentration,

and display a significant degree of persistence.

Second, mark-ups are found to be pro-cyclical, and the pro-cyclicality exhibited

by firm profit margins is found to only partly reflect movements in the standard

determinants of margins. Once the latter are controlled for, profit margins still

display a pro-cyclical pattern. This finding suggests that price pressures increase

during recovery periods and decrease during recessions. It also raises doubts

about macroeconomic models that assume that demand shocks may affect

employment via counter-cyclical mark-ups. [ IAN SMALL]


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VARIABLES

The industry sample consisted of 3 industries i.e Cement, Textile and Sugar.

Demsetz (1973) was the first to consider the determinants of profitability for

different size classes of firms in each industry. Chapple and Cottle (1985)

extended his approach by placing it within the mainstream market structure-

conduct-performance paradigm, where industry PCMs are a function of market

concentration and various other structure and conduct variables. To incorporate

relative efficiency they split each industry into two groups.

The dependent variable is the price-cost margin (PCM). We measured it as the

gross return on sales:

PCMij= SALESij - COST OF SALESij

SALESij

Where i denotes the industry and j the firm group.

The independent variables can be divided into two groups, the first designed to

control for industry- wide differences between industries, and the second relating

to differences between groups.


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The following control variable was used:

Market growth (MGR): even competitive industries can earn supernormal profits

when in disequilibrium states. Hence MGR, measured as the percentage change

in turnover between 2001- 2006, was included to control for variations in industry

profitability induced by disequilibrium. For example, rapid growth, by causing

demand to surge ahead of investment in additional capacity, might lead to

abnormally high profit rates. This variable helps to correct, in a crude way, for

the use of cross-section data to estimate long-run relationships. Other sources

of deviations from long-run equilibrium will be captured by the error term.

Other factors likely to cause PCMs to vary between industries could not be

controlled for because of lack of data and other difficulties. These were: price

elasticity of demand and risk (both positively associated with PCMs), and rent-

seeking and X-inefficiency (where high values should raise costs and reduce

PCMs). Also, US studies usually find a stronger profitability-concentration

relationship for consumer goods industries compared to producer goods

industries, apparently reflecting the greater scope for product differentiation with

the former (Collins and Preston, 1969). However, this effect might be captured

by the ASR variable, since differentiation is linked to advertising, which typically

is higher in consumer goods industries.


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The second groups of independent variables were used to represent each of the

three intra-industry groups:

Market power(CR): market power was measured by sales-based concentration

ratios calculated for each group. CR1 and CR2 are equivalent to the market

shares of those firms; Because group shares sum to one, only two of the three

ratios can be incorporated in the model at one time to avoid multicollinearity.

Group characteristics: the theory of strategic groups suggests that, holding all

else constant, the market power exercised by one group should be greater, the

greater the market power exercised by the other groups in the industry. This

implies, for example, that the market power of the leading firm, measured by

PCM1, should be positively associated with the price-cost margins of the number

two (PCM2). Hence PCM2 is included as determinants of PCM1.


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THE MODEL

The following two models were developed for each industry:

For strategic group 1:

PCM1 = 0 + 1PCM2 + 2CR1 + 3CR2 + 4MGR +

For strategic Group 2:

PCM2 = 0 + 1PCM1 + 2CR1 + 3CR2 + 4MGR +

Where,

PCM1 = Price cost margin of strategic group 1

PCM2 = Price cost margin of strategic group 2

CR1 = Market share or market power of strategic group 1

CR2 = Market share or market power of strategic group 2

MGR = Growth rate of the industry

= Error term, and

0, 1, 2, 3 and 4 are the respective coefficients.


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METHODOLOGY

The study comprised of 3 industries i.e Cement, Textile and Sugar and in each

industry a sample of over 15 companies was taken. Each industry was divided

into two strategic groups. First strategic group comprised of the top 4 to 5 market

leaders and the remaining companies in that industry made up the second

strategic group. Regression was run separately on each strategic group in each

industry respectively.

This study tests two competing hypotheses concerning the link between market

concentration and profitability: the structuralist view that concentration facilitates

the exercise of market power, and the Demsetz-led counter-argument that

concentration and profitability jointly stem from the superior efficiency of large

firms in such markets. The test is based on the application of multiple regression

analysis. Separate regressions are run on three different groupings of firms: the

number one firms and the rest, these groupings being chosen to represent

strategic groups.


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RESULT

The result of each strategic group in every industry is as follows:

CEMENT INDUSTRY

STRATEGIC GROUP 1

After running regression for strategic group 1 we get:

STRATEGIC GROUP 2



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SUGAR INDUSTRY:

STRATEGIC GROUP 1


STRATEGIC GROUP 2



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TEXTILE INDUSTRY

STRATEGIC GROUP 1


STRATEGIC GROUP 2



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The adjusted R2s for all three equations are high, indicating that the independent

variables explain over half of the variance in the dependent variables. R2s and

the t-statistic are all highly significant. The F-statistics are also significant and

the probability is also under 10%.

The following diagnostic tests were performed on the equations. The application

of Whites test for heteroscedasticity found that all three accepted the null

hypothesis that the residuals were homoscedastic. The Durbin-Watson (D-W)

Statistic was also used to test for autocorrelation, but the tests were inconclusive

as the findings belong to the quadrant of indecision.


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CONCLUSION

We find that the price-cost margins of leading firms are larger when: own market

share is larger, number two firms market share is smaller, and other strategic

groups within the industry have higher margins, own relative efficiency is high,

and the market is growing as a whole. The first three factors support market

power explanations of the profitability-concentration relationship; the last two

factors imply that market concentration and profitability are jointly related to the

superior efficiency of large firms.

Using group concentration ratios as conventional measures of market power

reveals that the PCMs of number one firms are positively influenced by their own

market shares (CR1), and negatively influenced by the market shares of number

two firms (CR2), both at the one percent level of significance.

Leading firms earn higher profits partly because of greater efficiency. Such

efficiency reflects not only economies of scale, but generally any superiority in

performance which enables firms to grow at the expense of rivals.

The market will then become more concentrated, and the higher profits of the

leading firms will push up the industry average, causing concentration and

profitability to be related.

Market power effects are associated both with the market shares of leading firms,

and with group interactions, such that market power enjoyed by one group may

spread through spillover effects to others within the industry. Leading firms seem

to enjoy higher profits when their market share is high, and when the presences


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of high mobility barriers appear to blunt rivalry both from new entrants and

between groups, allowing them to price independently.


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RECOMMENDATIONS


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APPENDIX 1

a study on profitability

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