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IncrementalMarkups–ACriticalReviewofTheoryandPractice

CommentsonAnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry‐LBNL‐

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SummaryInthepaperAnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry(MarkupPaper)theauthorsproposeto“calculatethechangeinfinalconsumerpricesdoetominimumefficiencystandardsfocusingonastandardeconomicmodel.”1Theyfurthergoonto“findthattheratioofmanufacturerpricetofinalconsumerpricepriortoastandardtendstoexceedtheratioofthechangeinmanufacturerpricetothechangeinfinalconsumerprice”.Or,moresimply,thatthemarkupthroughthedistributionchannelgoesdownfollowingachangeinapplianceefficiencystandards.TheUSDepartmentofEnergy(DOE),insettingminimumapplianceefficiencystandards,thenusesthisIncrementalMarkup.Thisanalysisreliesonamodelofindustrybehaviorbasedonperfectcompetitionasanormativestandard,i.e.thedistributionprocessforairconditioningandheatingequipmentwillfunctioninthefutureaspredictedbytheperfectcompetitionmodel.Forthistobecredibleandusefulforfutureprojectionsbypolicymakers,theproposedmodelmustmeetallofseveralconditions:

Applicability:alltheconditionsoftheperfectcompetitionmodelmustbemet Exclusivity:noothermodelwithdifferentprojectionscanbeapplicable Sufficiency:thereisenoughdataforthemodel Accuracy:theprojectionsfromthemodelaredemonstratedtobecorrect

Inthispaper,wewillshowthatnoneoftheseconditionsapply.Thereisanalternativemodelofindustryorganizationthatcharacterizesthedistributionprocessforairconditioning,andheatingequipmentthatbetterfitstheactualoperationofthemarket.Thisraisesquestionsabouttheapplicabilityandexclusivityofaperfectcompetitionparadigm.Inaddition,theliteratureonindustrystructureandprofitsamplydemonstratethatnomodelhasstrongpredictivepowerandthatallsuchmodelshavemajordataflawsquestioningboththeirsufficiencyandaccuracy.

1Dale,Larry;Millstein,Dev;Coughlin,Katie;VanBuskirk,Robert;Rosenquist,Gregory;Lekov,AlexandBhuyan,Sanjib:AnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry,LawrenceBerkeleyNationalLaboratoryLBNL‐52791,January2004,Abstract

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Assuch,theproposaltousetheIncrementalMarkupanalysisfailsnotone,butalloftheconditionsandshouldnotserveasthebasisforpolicyprojections.ThereisnoaprioritheoreticalsupportfortheDOEpositionthatmarginswill,infact,convergetosometheoreticalvalue.Inaddition,DOEproposesnoevidencetoshowthatmarginsormarkupsdo,infact,behaveinthismanner.Inthispaper,wewilldevelopanalternativetheoreticalexplanationforwhymargins/markupsneednotconvergeandforwhyfirmscouldearnprofitsbeyondtheirlong‐termcostofcapital.Second,wewillshowthatactualpricingbehaviorbyheatingventilatingandairconditioning(HVAC)distributor/wholesalerandcontractorsisconsistentwithconstantmarkupsacrossallproductsandthatthesemarkupshaveremainedstableovertime.Thecombinationoftheoreticfoundationandactualexperienceindicatesthattheuseofasingle,standardmarkupforbothbaseequipmentandincrementalcostadditionsistheappropriatebasisforforecastingfuturecosts.DistributionChannelsandSegmentsforResidentialAirConditioningandHeatingProductsBeforedelvingintoadiscussionoftheunderlyingeconomictheory,itwillbehelpfultounderstandthedistributionchannelsandend‐customermarketsegmentsforairconditioningandheatingproducts.ThisisespeciallythecasesincetheultimateusebyDOEofmarkupsthroughthedistributionchannelistoprojectactualpricespaidbyend‐usersforairconditioningandheatingequipment.TherearethreebroadsegmentsoftheHVACindustry:

Residential(includingfurnaces,airconditionersandheatpumps–thereisaparallelprocessforboilersthatisnotincluded)

CommercialUnitary(includingsinglepackageairconditionersandheatpumps)

Applied(includingchillersandrelatedairhandlers)Whilethereissomeoverlapinchannelsandcustomersacrossthesesegments,thisisaconvenientbreakdownthatiswidelyusedintheHVACindustry.TheproductsintheAppliedsegmentarelargelynotcoveredbyDOEefficiencystandardsandarenotpartofthisdiscussion.Toputthesesegmentsintoperspective,theResidentialsegmentincludesapproximateannualproductionof3‐4millionairconditionersandheatpumpsand3milliongasfurnaces.TheCommercialUnitarysegmentincludesapproximateannualproductionof200‐300thousandairconditionersandheatpumps.ResidentialTheResidentialsegmentislargelycomprisedofwarmairfurnaces(electric,gas,oilorotherfuels)andsplitsystemairconditionersandheatpumps.Theseproductsare

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principallyusedinhomes,althoughsomeoftheseproductsareusedinverylightcommercialapplications.TheyaresoldthroughDistributor/WholesalerstoinstallingHBACcontractorsandtheneitherdirectlytohomeownersortoremodelersorhomebuilders.TheResidentialsegmentincludesapproximatelyxxxmillionsplit‐systemcondensingunitsandheatpumpsandxxxmilliongas,electricandoilfurnacesannually.Distributor/Wholesaler/Contractor‐ResidentialDistributionofresidentialairconditioningandheatingequipmentmovesthroughtwolargelydistinct,butsuperficiallysimilar,channels:

Manufacturer‐aligneddistributorsand Multi‐manufacturerwholesalers

Mostofthelargerairconditioningandheatingequipmentmanufacturershavecloseddistributionfortheirprincipalnamebrands(Carrier,Trane,York,Lennox,etc.)intheresidentialsegment.Forthesenamebrands,themanufacturerhasdistributorswhosellvirtuallyonlythatnamebrandofequipment(plusancillarysuppliesandsomecomplimentaryspecialtyitems).Lennoxgoesastepfurtherandsellsresidentialscaleequipment.Thesedistributorsadvertisethenamebrandandhavesomeequityintheirlocalterritoryandmanufacturerrelationship.Mosthavegeographicterritoryagreementsofsomeform.Inturn,agroupofcontractorsalignwiththedistributor/manufacturerpair,usuallyreferredtoas“dealers”.Thedealersadvertisetheiralliance,oftenaspartoftheirname,andpurchasethevastbulkoftheirequipmentfromasingledistributorinthischannel.Whiledealerscanswitchtheiralliance,thisisaslowandcostlyprocessrequiringre‐brandingthedealer,switchingliterature,changingcreditarrangements,cleaningoutinventoryandretrainingtheinstallationandservicestaff.Basedontheestimated2008marketsharesbymanufacturerquotedbyDOE,thecompanieswithaligneddistributionhave62‐68%marketsharesforgasfurnaces,heatpumpsandcentralairconditioners.2Thissomewhatoverstatesthetotalpercentofthemarketusingaligneddistributionsincethesemanufacturersalsohavesomebrandstheysellthroughthealternativechannel.Thealternativechannelissalesthroughmulti‐manufacturerwholesalerswhocarryairconditioningandheatingequipmentfrommultiplemanufacturers.Thesewholesalershavesomewhatgreaterflexibilityinswitchingthemanufacturertheyrepresentorthepercentofsalesbetweenseveralmanufacturers.Inturn,non‐dealeraffiliatedcontractorsoftenpurchasefromthesenon‐alignedwholesalers.Thesecontractorshavegreaterflexibilityinselectingamanufacturerforanygivenprojectandmayhavemoreflexibilityinselectingbetweenwholesalers.Thischannelhastheremainderofthefurnace,heatpumpandairconditionermarket.

2USDepartmentofEnergy,TechnicalSupportDocumentEERE‐2011‐BT‐STD‐0011‐0012,June2011

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EndUser–ResidentialAttheresidentialenduserlevel,therearethreeprincipalsegments:emergencyreplacement,largehomeownerprojectsandproductionbuilders(salesofairconditioningandheatingequipmenttothemobilehomearenotcoveredbythissegment).Replacementsalesarepurchasesbyhomeownerstoreplaceexistingheatingorairconditioningequipment.Mostoften,theseareforfailedunitswhereimmediatereplacementisnecessary.Largehomeownerprojectsincluderemodelingofanexistinghomeorconstructionofanewhomewherethehomeownerwhowill(ordoes)occupythehomeisanintegralpartoftheconstructionprocess.Productionbuilderscoverresidentialdeveloperswhobuildhomesregularlyforresaletohomeowners.Eachoftheseindividualsegmentshasadifferentsetofdecisionmakersand,therefore,adifferentmixofcriteriaforselectingairconditioningandheatingequipment.Intheemergencyreplacementsegment,thehomeowneristhepurchaserandselectsacontractorwhoactuallyprovidesandinstallstheheatingorairconditioningsystem.Thereisalmostalwaystimepressuretofindandinstallthereplacementunit,limitingthehomeowner’sabilitytoshopandtorequestproposalsfrommultiplecontractors.Inaddition,thehomeownerpurchasesairconditioningandheatingequipmentinfrequentlysothehomeownerisrarelyfamiliarwiththesuppliers,thealternativeheatingandcoolingoptionsorthelikelycostofasystem.Thehomeownerisatasubstantialdisadvantagetothecontractorsinthedegreeofinformationabouttheprice,qualityorothermattersinvolved.Itisalsotypicalforthehomeownertogetapackagepriceincludingalllabor,equipment,supplies,etc.,sothehomeownerhasnorealinsightintothepriceofequipment.Thehomeowneroftendoesnotselectthelowestpricewithactualselectiondependingonperceivedquality,speedandotherfactors.Incidentally,contractorsinthissegmentalsohavelittleinsightintotheircompetitors’pricingsincetheyonlyrarelyseethecompetitorsproposals.Eveniftheydoseecompetitorpricing,itistypicallyonlyatotalincludingbothlaborandmaterials.Inthelargeprojectsegment,thehomeownerisdealingwithahomebuilderorremodelingcontractorwhoservesasanintermediarywiththeairconditioningandheatingsubcontractor.Virtuallyallofthecharacteristicsofthepurchaseprocessherearedifferentfromthatofemergencyreplacement,otherthanthehomeowner’sgenerallackofknowledgeandfamiliaritywithairconditioningandheatingequipmentandthatthepurchaseisforasinglehouse/project.Thehomebuilderorremodelingcontractorgenerallyselectstheairconditioningandheatingsubcontractorbasedonacombinationofprice,reliability,relationshipandthelike.Thehomeownermayormaynotbegivenachoicebetweendifferentcontractors,manufacturers,efficienciesorotheroptions.Theairconditioningandheatingsubcontractortypicallyquotesatotalinstalledpricetothehomebuilderorremodelingcontractor.

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Intheproductionbuildersegment,thehomebuilderistheprincipaldecisionmaker.Thehomebuilderconstructsanumberofhousesaspartofasingleprojectandsolicitsbidsforthetotalpackageofhomes.Iftheprojectisbigenough,themanufacturerordistributor/wholesalermaybecomeinvolvedtoquoteaspecialequipmentprice.Thisistheonlysegmentwherethereisreasonableparityofinformationbetweenthepurchaser(thehomebuilder)andtheremainderofthedistributionchannel(contractors,distributors,manufacturers).Eachpartyinthisprocessdealswiththeotheronaregularbasisandthehomebuilderhastheopportunitytocheckpricesforequipmentacrossvariousmanufacturersandcontractors.Thesizesofthesegmentsfluctuatewiththeeconomyandthenewconstructioncycle.Onalong‐termaverage,theemergencyreplacementsegmentisapproximately50%ofairconditioningandheatingshipments.Largehomeownerprojectsrepresentapproximately30%ofshipmentsandproductionbuildersrepresenttheremaining20%.CommercialUnitaryTheCommercialUnitarysegmentislargelycomprisedofsinglepackageairconditionersandheatpumps(commonlyreferredtoas“rooftop”units).TheseuseadirectexpansiontechnologysimilartoResidentialproductsandCommercialUnitaryproductstypicallyhavegreatercapacityandcombinetheevaporatorandcondensercoils,fansandcompressorsinasinglecabinet.Distributor/Wholesaler/Contractor–CommercialManufacturersofCommercialUnitaryairconditionersandheatpumpsusetheirResidentialdistributor/wholesalerchannelforCommercialUnitaryequipment.Inaddition,somemanufacturerssupplementtheResidentialdistributor/wholesalerchannelwithmanufacturer‐ownedofficesandindependentsalesrepresentativeswhohandleAppliedequipment.AbreakdownbetweentheResidentialdistributor/wholesalerandtheAppliedofficechannelsisnotavailablealthoughthemajorityofsalesaretocontractorsspecializinginpackagedairconditioningequipmentandsheetmetalductingratherthantocontractorsspecializinginAppliedchillersandpiping.Thedistributor/wholesalermakeupoftheCommercialUnitarysegmentisalmostexclusivelymadeupofaligneddistributors.MostoftheresidentialHVACmanufacturerswhousenon‐alignedwholesalershaveaminorpresenceinthecommercialsegment.Ingeneral,becauseoftheirprotectedgeographicterritoriesandtheiralignmentwithspecificcontractors,distributorsareinapositiontoprovidemoreserviceandsupporttocontractorsthandowholesalers.ThisserviceandsupportisnecessaryforCommercialUnitaryequipmentbecauseofthegreaterengineeringrequirementsformanycommercialprojects,theinclusionof

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accessoriesorvariationsintheequipmentorder,thecomplexitiesofjob‐sitedeliveryandthegreatercreditexposureforlargerjobs.Smallercommercialprojectstendtobedonebycombinedresidential/commercialHVACcontractorswhoaretraditionallyaffiliatedwithadistributorandmanufacturerbrand.Theservicesofferedbythedistributorareimportanttothosecontractorsandhelppromoteaffiliation.Manyofthesecontractorsalsohaveactiveservicebusinessesdoingroutinemaintenanceandsmallupgradesandrepairsforregularend‐usecustomers.Largercommercialprojects(bothUnitaryandApplied)fallintotwomajorsegments:planandspecandvalueengineered.Whilecontractorsmaydoboth,thosewiththeskillsnecessarytodovalueengineeringtrytofocustheirbusinessawayfrompanandspecwork.Inplanandspecprojects,thegeneralcontractor(or,occasionally,theowner)issuesasetofdetailedspecificationsandasksmultiplecontractorsforquotes.Typicallythelowestbidsetsthepricefortheproject,althoughthecontractoractuallyawardedtheprojectmaynothaveoriginallybeenthelowestbidder.HVACcontractorsoftenrequestspecialquotesforequipmentfortheseprojectsbecauseoftheircompetitivenature.Itiscommonforthedistributor(ormanufactureriftheprojectisbigenough)toputoutapriceforthejobpackagedtoallaffiliatedcontractorsbiddingthatjob.Thissegmentistheonlytrulypriceclearingone,withvisiblebiddingpatternsandrelativelyvisiblepricing(althoughdissemblingontheactualfinalpriceofaprojectisnotuncommon).Asaresult,thissegmentcanbehighlycompetitiveandmostcontractorstrytoavoiditwhenatallpossibleThevalueengineered(sometimesreferredtoasdesign‐build)segmentincludescontractorsandprojectswheretheHVACcontractorworkswiththegeneralcontractororownertodesignasystemmeetingtheproject’sneeds.Thisapproachisoftenfasterthanthemulti‐stepdesign,plan,bid,buildprocessofplanandspecwork.Itoftencanresultinbothlowercostsforthejobandhighermarginstothecontractorbecauseofspecialknowledgeandconstructionexpertise.Pricinginthissegmentisalmostalwaysforatotalinstalledpackagewherethebreakdownoflabor,materials,equipmentandmarginsisobscuredfromthecustomer.Thechoiceofcontractorisusuallybuiltuponpastrelationshipsandtheperceptionofcompetitiveprice.Itisnottypicaltobidtheprojecttomultiplecontractors,althoughtheremaybegeneraldiscussionandbudgetideasfromseveralcontractorsbeforethefinaloneisselectedtodotheactualdesignandpricing.EndcustomersforCommercialUnitaryequipmentvaryfromsmallretailcompaniestomulti‐facilityowningchainsanddevelopers.SmallerendusersareverysimilartoresidentialcustomersinthattheypurchaseHVACequipmentrarelyandhavenorealideaofthemarketplaceandtheexpectedpriceorotherfactorsforaproject.Theymaketheircontractorselectiononthelocalrelationship,perceptionofquality,timingandperceivedvalue.Largercustomersareinthemarketplacemore

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frequentlyandmayhavegreatervisibilityintotheexpectedpricelevelsinthemarket.However,theactualselectionofcontractorsisfrequentlybasedonacombinationofpriceandawidevarietyofotherfactors.Pricingisalmostalwaysforcompletepackageswithoutseparatepricingforindividualitems,suchasequipment.EconomicTheoryIntheMarkupPaper,theauthorsbasetheirargumentontheeconomictheoryofperfectcompetition:“(the)basicmodelassumesperfectcompetitionandconstantmarginalcostcurves.”3Thecoreimplicationoftheargumentisthatthereisnoabilityfortheaggregateoffirmstoearnprofitsabovethenormalcostofcapital.Asaresult,allsellersinaggregatewillonlybeabletoraisepricestoincorporatetheirvariablecosts:“Thismodelofmarkupdeterminationinthecaseofperfectcompetitionandconstantcostsimpliesthattheincreaseinfinalpricethataconsumerseeswillequalthosechangesincostsassociatedwiththeincreasingcostofagood.”4Fromthere,theauthorsproposemethodstoestimatetheincrementalcostsandcomputeanincrementalmarkup.

Theargumentandtheconclusionsdependonthepropositionthatfirmsinaggregateareconstrainedinsomemannersothattheycannotearnprofitsabovetheirnormalcostofcapital.Theauthorsrecognizethisintheirdiscussionof“ImpactofMarketPoweronMarkups”5wheretheyconcedethattheirproposedmethodofcalculatingmarkupsfailswhena“firmfacesinelasticresidualdemand”,i.e.whenacompanyorgroupofcompaniescancontinuetoincreasesalesand/orincreasepricessothattotalrateofreturnincreasesbeyondthenormalcostofcapital.

Asonewouldexpectofafundamentalconceptineconomics,therehasbeenconsiderablediscussionintheliteratureoverthetheory,theapplicabilityandthecalculationofsupplyanddemandfunctions.TheswingingpendulumbetweenthebeliefthatmarketsaremostlycompetitiveornotiscurrentlyswingingawayfromperfectcompetitionwiththerecentNobelawardtoJeanTriolefortheinfluxofgametheoryintotheoperationofmarkets.6

Thebasicnotionbehindperfectcompetitionisthatthereisastableprice/volumepointwhereconsumersarepurchasingasmuchastheywantandsuppliersaremaximizingtheirprofits.Nopurchaserorsuppliergainsanadvantagebydeviatingfromthispointbecausethepurchasercannotbuyforlessorthesuppliercannotsellformore.Fromthesuppliers’standpoint,anysupplierwouldlooseallitsbusinessifitraisedpricesbeyondthisstablelevel.Inconcepttheconditionsforsuchamarket

3Daleet.alia.p14ibid.p35ibid.pp6‐86Foradiscussionoftherise,fallandriseofnon‐marketbasedideasintheoreticaleconomics,see:www.economicprincipals.com/issues/2014.10.19/1658.html

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include:7

Manyfirms,eachsmallinrelationtothemarket,andwithlong‐runaveragecoststhatbegintoincreaseatascalesmallenoughtoensurethepreservationofcompetitionamongmanyfirms;

Nobarrierstoentryorexit; Manybuyers,eachaccountingforasmallshareofdemand; Perfectinformation; Homogeneousproducts; Single‐productfirmsonly; Noindivisibilitiesorimmobilitiesinthefactorsofproduction; Easysubstitutabilityamongfactorsofproduction; Noexternalitiesinproductionorconsumption.

ThequestionsfacingtheMarkupPaperare,thus:

Question1:Underwhatcircumstancesdoestheperfectcompetitionparadigmapplyinrealsettings?

Question2:Howmanyorwhichoftheconditionsforperfectcompetitionmustexistfortheconclusionsabouttheinabilitytoraisepricesabovevariablecosts8tohold?

Question3:Dothenecessaryconditionsapplyinthecaseofanyspecificindustryunderanalysis?

Question4:Inwhatcircumstances(ifany)isthereevidencethatfirmscanachieveprofitsinexcessoftheirvariablecosts?

Question5:Doanyoftheconditionswherethereisevidenceofpricingabovevariablecostsapplytoaspecificindustry?

Clearlytodrawanynormativeconclusionsormakeanypredications,questionnumber3abovemustbetrueandquestionnumber5mustbefalse.

ExampleofPerfectCompetitionandItsLimits

Anexamplemaybehelpfultoprovidesomecontextonwhatamarketarguablymeetingtheperfectcompetitionconditionsisandhowrestrictivethoseconditionsare.Themarketforstockstradedonmajorexchangesisaboutasclosetoaperfectlycompetitivemarketasonecanimagine.Theproducts,sharesofstock,areessentiallycommodities,therearehugenumbersofbuyersandsellers,thereareessentiallynobarrierstoentryorexitandtherearerulesdesignedtoensureperfectinformation.Inaddition,modernfinancialtheoryhasdevelopedtoolsandconcepts

7ThisparticularlistcomesfromPeterF.Fisher;TheStrangeCareerofMarginalCostPricing,JournalofEconomicIssues,Vol.XXIVNo.4December1990,althoughtherearemultiplesimilarversions.8Alldiscussionsofvariablecostusetheeconomicdefinitionincludingthecostofcapital,notacommonlanguagedefinition

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tomeasuretheprecisevalueofinterest:financialreturn.9Allavailableempiricalevidencesupportstheconclusionthatperfectcompetitionorsomethingveryclosetoitoccurs.Thereisessentiallynoevidencethatinvestorsinwidelytradedcommonstockscanearnreturnsabovethatindividualinvestor’sriskweightedcostofcapital.10

However,ittakesonlyasmallstepawayfromthepublicstockmarketbeforetheconclusiononexcessreturnsdisintegrates.Empiricalstudiesofhedgefunds,notjustindividuallybuteveninaggregate,haveshownpositiveexcessreturns(orpositivealphas).11Statisticalstudiesofhedgefundmanagersshowpositivealphasof3.7%peryearupto1.25%permonthandthatpositivealphaspersistovertime.Thesearesubstantialreturnsrelativetothe5‐6%annualreturnmeasuredfortheUSstockmarketasawhole.Economictheorysaysthataninfluxofnewentrantswillarbitrageawaythesereturns,butsofarthereisnoevidencethatthisishappening(thereturnsdonot,however,gotoinvestors–mostarecapturedbyfundmanagerfees).

Whatthisdemonstratesisthebrittlenatureoftheassumptionsbehindperfectcompetitionandthenotionthatprofitabovecostsofcapitalarenotpossible.Thefactthatonefinancialmarketmayexhibittheexpectedcharacteristicsfromcompetitiondoesnotimmediatelyextendtoarelatedone.Applicabilityinonefinancialmarketdoesnotextendtoanother.Thepowerofanalogyisweak.Anyclaimthatperfectcompetitionexistsmust,therefore,beproveninthespecificmarketplaceinquestion.Analogyisnotenough.

EmpiricalSupportfortheModelofPerfectCompetition

Onecriticaltestofanytheoryiswhetherityieldstestablehypothesesandwhetherthosehypothesesare,infact,true.Likethefinancialmarketsituation,thepredictionfromtheperfectcompetitionhypothesisisthatfirmsbothindividuallyandinaggregatewillnotbeabletoearnprofitsbeyondtheircostofcapitaloveranyextendedperiodoftime.Thedataonthistopicishighlyequivocalfortworeasons.First,thereissignificantquestionabouttheavailabilityandaccuracyofthedatanecessarytoperformtheanalyses.Second,theresultsshowthatthereappeartobenumerousconditionswherefirmsdo,infact,earnconsistentprofitsabovethecost

9TheCapitalAssetPricingModel(CAPM)anditssuccessorvariantsdefinereturninrelationtovariabilityversusamarketcomposite(Beta)andexcessreturngeneratedbyinvestorskill(Alpha).Thisissomethingofasimplificationbutisreasonableforthediscussionhere.Theliteratureonthistopicisvast.

10Again,theempiricalliteratureontheabsenceofexcessreturnsinbroadlytradedstockmarketsisvoluminous.Thispaperwilltakethatconclusionasgiven.

11Stultz,RenéM.;HedgeFunds:Past,PresentandFuture,OhioStateFisherCollegeofBusiness,FisherCollegeofBusinessWorkingPaperSeries,February2007,providesaliteraturereviewofstudiesonhedgefundreturns.Thedatainthisstudyprecedethefinancialcrashof2008.ThecontinuedprofitabilityofthetradingoperationsatfirmslikeGoldmanSachsandthecontinuedexistenceofsomelargehedgefundsinthefaceofDarwinianfocusonperformanceprovideatleastanecdotalevidencethatsuperiorperformancecontinues.

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ofcapital.Atbest,theavailableevidencesaysthattheremightbesomecircumstanceswheretheperfectcompetitionhypothesisholdstruebutthatthedatacertainlydoesnotsupportastatementthatthehypothesiswillnecessarilyholdtrueinall,orevenmost,situations.

Thefirstconsiderationisthedataquestion.Thecompleteapproachtotesttheperfectcompetitioneconomicreturnhypothesiswouldbetotakerateofreturnoncapitaldatafromallfirmswithinanindustryandanalyzethosereturnsoveranextendedperiodoftime.Asapracticalmatter,thisapproachhasnotbeenpossible.First,realcompaniesoftenhavemultiplelinesofbusinessandboththeperfectcompetitiontheoryandtheexamplefromcapitalmarketsshowthatthedefinitionofanindustryneedstobeverynarrow.Soitisnotatallclearthatrelevantdataexists,eveninprinciple,totestthehypothesis.Analystshavegenerallyresortedtovariousgovernmentdatasetsatwidelyvaryinglevelsofindustryandfirmaggregation,allwithsignificantlimitations.

Thesecondconsiderationistheactualresultsofthestudiesonprofitability.Studiesforfirmandindustryprofitabilityhaveinvestigatedwhetherfirmsize,industryconcentration,effectsofscaleindependentoffirmsize,effectsofadvertisingandotherfactorsleadtodifferencesinprofitability.Inaddition,manyofthestudiesseektounderstandwhetherindustryconditionsorfirmspecificelementshavethegreatesteffectsonprofitability.

Fortheperfectcompetitionmodeltobetrueasamatterofrequirementforfuturebehavior,allofthesestudieswouldneedtofindthattherewasnovariationintherisk‐adjustedrateofreturnunderanycircumstances.Eachindividualcompanyandtheindustryasawholeshouldallearntherisk‐adjustedrateofreturn.Onthecontrary,thebulkofthestudiesfindtheopposite.Awiderangeoffactorscancauseindividualfirmstodivergefromexpectednorm.Forexample:

CollinsandPrestonestablish,inastudyof418fourdigitSICcodesintheUSCensusofManufacturersfor1958and1963,thatindustryconcentrationbearsonprice‐costmarginsandalsofindthattherearesubstantialvariationsinresultsbetweenconsumerandproducergoodsmanufacturersandbetweenhighandlowdifferentiationconsumergoods.Inaddition,concentration,geographicdispersionandcapital‐outputratiohaveonlylimitedexplanatorypowerforprofitability,implyingthatthereisavariationinprice‐costratioandthatthisvariationremainsunexplained.12

GortandSingamsettifindthatthereisessentiallynorelationshipbetweentheindustryafirmisinand/orthelevelofconcentrationintheindustryonprofitabilityfor507manufacturingcompanies.13

12Collins,NormanR.andPreston,LeeE.Price‐CostMarginsandIndustryStructure,TheReviewofEconomicsandStatistics,Vol.51,No.3(August,1969)pp.271‐286

13Gort,MichaelandSingamsetti,Rao;ConcentrationandProfitRates:NewEvidenceonanOldIssue,ExplanationsinEconomicResearch,Volume3,Number1,NationalBureauofEconomicResearch,1976

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Porterfinds,inastudyof42consumergoodsindustriesthatprofitabilityoffirmsinanindustrycanvarysignificantlydependinguponthestrategicgroupafirmbelongsto.Thisstudydefinesgroupsasleadersandfollowers,althoughPorterrecognizesthattherecouldbemanyotherfactorsthatcouldcreateagroup.14

Ravenscraftfindsthatprofitabilitybylineofbusinessisnotrelatedtoindustryconcentrationandisrelatedtofirmmarketshareforasampleof3186linesofbusinessinmanufacturingfirmsin1975.Themultivariablemodelforprofitabilityatthelineofbusinesslevelhaslowexplanatorypower,withanR2of20%orlower.15

Schmalensetestsforfirm,industryandmarketshareeffectsonprofitabilityandconcludesthatindustrystructure(concentration)hasthegreatesteffectalthoughthisaccountsforonlyapproximately20%ofthetotalprofiteffect.ThesampleincludeslineofbusinessresultsforUSmanufacturingcompanies.16

Schmalensealsoteststhenotionofindustryconcentration(characteristicoftheindustrymatters)versusfirmefficiency(marketshareofthefirmmatters)andfindsthatindustrymattersmorethansharealthoughneitherexplainsmuchofprofitbehavior.Thesamplecoverstwoyearsandthestatisticalresultsdiffergreatlybetweentheyears.Inaddition,therangeofprofitsarelargeinthedatasample,withonestandarddeviationat±30%plus,indicatinglargedifferencesinprofitabilityacrossfirms.17

CubbinandGeroskifindthat“mostfirms’profitabilityexperiencediffersconsiderablyfromthoseoftheirclosestrivals”basedonasampleof217largeUKfirmsovertheperiodof1951‐1977.Inadditiontheyfindthattherearefirmswithinindustriesthatseem“toinhabitmarketnichesbetterprotectedthanthoseonaverageintheirindustry”andthatthereis“evidencepointingtowardsthenotionthatreturnsarenotequalizedacrossallfirmsandsectorseveninthelongrun.”18TheyalsonotethattheirfindingsarenotentirelyconsistentwithSchmalense’s.

RobertHallmeasuresthe“markupratio”ofvalueaddedandconcludesthatthe“hypothesisofcompetitionisrejected”.19StefanNorrbinquestionsthesefindingsformanufacturingindustriesbutdoesfindseveralindustrieswith

14Porter,MichaelE.;TheStructurewithinIndustriesandCompanies’Performance,TheReviewofEconomicsandStatistics,Vol.61,No.2(May1979)pp214‐227

15Ravenscraft,DavidJ.;Structure‐ProfitRelationshipsattheLineofBusinessandIndustryLevel,TheReviewofEconomicsandStatistics,Vol.65,No.1(February1983),pp22‐31

16Schmalense,Richard;DoMarketsDifferMuch?,TheAmericanEconomicReview,Vo.75,No.3(June1985)pp341‐351

17Schmalense,Richard;CollusionVersusEfficiency:TestingAlternativeHypotheses,TheJournalofIndustrialEconomics,Vol.35,No.4pp399‐425

18Cubbin,J.andGeroski,P.;TheConvergenceofProfitsintheLongRun:Inter‐FirmandInter‐IndustryComparisons,TheJournalofIndustrialEconomics,Vol.35,No.4,June1987,p427andp436

19Hall,RobertE.;TheRelationbetweenPriceandMarginalCostinU.S.Industry,JournalofPoliticalEconomyVol.96.No.5(October1988),p939

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positivemarkupratios,atthetwodigitSIClevel,suchasforMachineryandStone,ClayandGlass.Thereisalsosubstantialvariationinmarkupratioacrossindustriesimplyingthatnoteachindustryearnsonlyeconomicratesofreturn.20

BhuyanandLopezdemonstratethatoligopolyconditionsprevailinvariousfoodandtobaccoindustriesatthefourdigitSIClevelintermsof“welfarelosses”relativetoperfectcompetition.21

HolianandRezainvestigatethedifferenteffectsofaccountingversuseconomicprofitdataonprofitabilityfor331firmsinaSternStewartdatabasefortheyears1989‐2003.Theyfindthatfirmeffectsaremoreimportantthanindustryonesalthoughneitherhasverystrongcorrelationforaccountingprofits(adjR2=.168)whileeconomicprofitdatahasconsiderablygreaterexplanatoryvalue(adjR2=.504).22

Thisisonlyasmatteringoftheempiricalworkondeterminantsonindustryandfirmprofitability.

Basedontheempiricalevidence,itisnotpossibletosaywithanyconfidencethatanindustry,collectionoffirmsorlineofbusinesswithstructureAwillhaveprofitcharacteristicsB.AttemptstocreategeneralprinciplesacrossanyorallformsofA,Bremainilldefined.

ImplicationsforAssessmentofCompetitioninaSpecificSituation

ReturningtotheQuestionsposedabove,theanswertoQuestion1,thegeneralapplicabilityoftheperfectcompetitionparadigm,isthatsuchapplicabilityisnotgenerallysupportedbytheempiricaldata.Inaddition,theanswertoQuestion2,underwhatcircumstancesisitapplicable(orhowcanitbemodifiedtobecomeapplicable),isthatwedonotknow,againbasedontheempiricalevidence.Severalhypothesesremainineffectonwhatdeterminesprofitabilityandnonehasverystrongexplanatorypower.

MichaelSpencesummarizesthedilemmaindiscussingcontestablemarkettheory:

Asstudentsofmicroeconomictheoryknow,theconditionsunderwhichperfectlycompetitiveoutcomesarelikelyorpossibleareratherstringent.Theconditionsincludeconstantordiminishingreturnstoscale,orscale

20Norrbin,StefanC.;TheRelationbetweenPriceandMarginalCostinU.S.Industry:AContradiction,JournalofPoliticalEconomyVol.101.No.6(December1991),p1162

21BhuyanSanjibandLopez,RogobertoA.;WelfareLosesUnderAlternativeOligopolyRegimes:TheU.S.FoodandTobaccoManufacturingIndustries,JournalofAgricultureandAppliedEconomics,27(2),December.1995,p582

22Holian,MattandReza,Ali;FirmandIndustryEffectsinAccountingversusEconomicProfitData,EconomicsBulletin,vol.30(3)pp2189‐2196,2010.Note:SternStewartisacommercialcompanyadvocatingtheuseofeconomicvalueanalysis.Theauthorparticipatedintrainingforacompetingsysteminthelate1980sandcanattestthattheconversionfromaccountingprofitiscumbersomeandnotamenabletogeneralusedespitethegreateraccuracyfoundinthisstudy.

13

economiesthataresmallinrelationtothesizeofthemarket.Fornormativepurposes,theabsenceofexternalitiesatthelevelofcostsisalsoessential.

Perfectcompetitiontheoryservestwofunctionsineconomics.Itissometimesareasonableapproximationtorealityinthedescriptivesense,andperhapsmoreimportantlyitisawelfarestandard.Intheabsenceofexternalities,perfectlycompetitiveequilibriaareParetooptimal.Theproblemisthatsuchequilibriadonotexistincertainmarketenvironments.Andevenwhentheydo,itissometimeshardtobelievethatthecompetitivemodelaccuratelydescribeswhatistakingplace.23

Anyattempttoapplyperfectcompetitiontheorytoaspecificsituationneedstodemonstrate,foreachandeverysituation,thatalloftheunderlyingassumptionshold.Thereisverylittletonoevidencethatthisoccursintherealworld.Aresorttoanalogyhasnoempiricalandlimitedtheoreticalsupportasameansorpredicatingprofitabilityfromoneindustrytoanother.

AlternativetoPerfectCompetitionTheory

Thestringentformofperfectcompetitionrequiresabinaryanswertotheunderlyingassumptions.Eithertheseassumptionsaretrue,inwhichcasetheperfectcompetitionmodelholds,ortheyarenotanditfails.Asapracticalmatter,asSpencepointsout,thesituationisrarelythatblackandwhite.OneresponsehasbeenthePorterFiveForcesModelthatlooksatthefactorsaffectingcompetitionandprofitabilityascontinuums.24Theconceptualexplanatorypowerofthisconceptiswellrecognizedandaidsintheunderstandingthatcompetitionisnotbinary.However,theseforcesarenotcontinuousvariables.Itisnotpossibletobuildametricevaluatingeachoftheseforcesandthencalculatethedegreetowhichanindustryisorisnotcompetitive.25TheimplicationsofthePorterapproachpartiallyexplainthedifficultyinfindingempiricalrelationshipsinactualindustrydata.

23Spence,Michael;ContestableMarketsandtheTheoryofIndustryStructure:AReviewArticleContestableMarketsandtheTheoryofIndustryStructurebyWilliam.J.Baumol,JohnC.Panzar,RobertD.Willig,JournalofEconomicLiterature,Vol.21,No.3(September1983),pp981‐982

24Porter,MichaelE.;HowCompetitiveForcesShapeStrategy,HarvardBusinessReview,March,197925Acolleagueoftheauthor’sattemptedsuchanexerciseinthelate1980sasapartofastrategymethodologyandabandonedtheattemptasbothquestionableintheoryandunrealisticallycomplexinpractice.

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ApplicationofMarkupTheoryintheAirConditioningandHeatingIndustry

TheauthorsoftheMarkupPapercontendthattheperfectcompetition(lowmarketpower)modelappliesinthecaseofthedistributionchannelsforairconditioningandheatingequipment.Theirsupportforthisis:

1. Thelargenumberofparticipantsatthewholesaleandcontractorlevels262. ReferencetotheNorrbinstudy(above)27–notetheNorrbinstudynowhere

mentionsanyindustriesotherthanmanufacturingsoitsapplicabilityinthissituationisnotobviousandtheNorrbinstudydoesnotactuallyclaimthatindustriescanbepresumedcompetitive

3. Unsupportedstatementthatwholesaleandretailappliance(sic)marketshavelowbarrierstoentry28

4. Analysisofwholesalermarkupsacrossstateswheretheyfindaconstantmarkupof1.3929

Nowheredotheauthorsperformanyactualempiricalanalysisofcompetitiveconditions,profitormargintrendsineitherthewholesaleorthecontractingsectors.Asdiscussedlater,thestate‐by‐stateanalysisisactuallymorecompatiblewithalternativetheories.

Sotheauthorsareresortingtoelementsofeconomictheorythathavenoempiricalsupportasactualdeterminantsofprofitlevelsinindustry.Aswehaveseen,thereislittleornoevidencethatindustrystructurecharacteristicssuchasnumberofparticipantsorentrybarriersactuallycorrelatewithprofitability.TheirresponsetoQuestion3,applicabilityoftheory,issimplyassertion.Thisishardlysufficientinthefaceoftheoryanddataquestioningtheperfectcompetitionhypothesestodemonstrateinanyconvincingfashionthattheirconceptsapply.

AlternativeExplanationinHVAC

Sincetheempiricalconditionsdonotallowabstract,aprioriapplicationofempiricaltheoryinspecificsituations,anyprocessofestimatingmarkupsinanindustrymustlookatthefactsforthatsituation.Questions4&5abovebecomerelevant:Arethereconditionsthatcouldimplytheopportunityforfirmstopriceaboveriskadjustedeconomicprofitandarethoseconditionsmoreorlesslikelytoapplyinthissituationthanaretheassumptionsforperfectcompetition?

Inthecaseofthedistributionchannelforairconditioningandheatingequipment,Porter’sconceptofstrategicgroupmakessense,providingatheoreticalfoundation

26Daleet.al.p127ibid.p928ibid.p9,notethatthemarketsinquestionareforairconditioningandheatingequipmentnotappliances,althoughthismaysimplybeamatterofinadvertentusage

29ibid.p10

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forpredictingprofitpatterns.Analysisofactualpricingpracticesbyindustryparticipantsshowsthattheyarenotconsistentwithaconceptofincrementalmarkups.Theactualdataonmarginsisincomplete,withthedatathatexistssuggestingthatfirmsmanagetomaintainconsistentmarginsovertimeandacrossbusinesscycles.

Thecombinationofthetheoreticalfoundationandtheempiricaldataindicatesthatthefuturepricingbehaviorthroughouttheairconditioningandheatingdistributionchannelisnotlikelytofollowincrementalmarkups,aspositedintheMarkupPaper,andismorelikelytocontinuefollowingpastpatterns,inthiscaseconsistentaveragemarkups.

Attheleveloftheory,thetwodistinctsegmentsatthewholesalelevel:manufacturer‐aligneddistributorsandmulti‐manufacturerwholesalersarestrategicgroupsasdefinedbyPorter.ThebasicconceptisthatthecompetitiveconditionsunderthePorterfiveforcesaredistinctbetweenthegroups.Therefore,theremaybecircumstanceswheretheconditionsdonotrequireareversiontotheprofitresultsexpectedunderperfectcompetition.30Porterspecificallydiscussesmobilitybarrierswhichpreventfirmsfromenteringagroupeitherfromoutsidetheindustryorfromwithintheindustrybutoutsidethegroup.Portergoesontopositthatthepresenceofmobilitybarriersprovide“anexplanationforwhysomefirmsinanindustrypersistentlyearnhigherprofitsthanothers”31Porteralsodiscussesinter‐firmrivalrynotingthatmarketinterdependencewilltendtopromoterivalrybuttotheextentthatfirmsarecompetingforcustomersindifferentsegments,thiswilltendtodiminishrivalry.32Itisapparentthatthemanufacturer‐alignedchannelofdistributorsandtheirassociatedcontractorsformastrategicgroupinthePortersenseinsidethebroaderairconditioningandheatingdistributionprocess.Moreover,thelocalnatureoftheairconditioningandheatingdistributionprocess(contractorshaveverysmallgeographicrangeandaligneddistributorshaveassignedterritories)effectivelycreatemyriadlocalgroupsofaligneddistributorsandcontractors.Theapparentlackofconcentrationinthechannel,impliedbythelargenumberoffirmsis,infact,achimeraandmissesthemoreconcentratednatureofthelocalizedgroups.

Inordertoestablishthatthemanufactureralignedstrategicgroupcanhavetheopportunitytoearn“consistentlyhigherprofits”,itmustbeclearthattheoverallcompetitiveintensityofthegroupislowerthanfortheremainingindustry:

1. Mobilitybarriers

30 Whilenotdiscussedhere,thereisampleevidencethatprofitresultsabovelevelspredictedunderperfectcompetitioncanoccurwithoutcollusion.Nothinginthisdiscussionshouldbetakentoimplythatcollusionorothersimilaractivitiestakeplaceatanystageoftheairconditioningandheatingindustries.

31Porter,StructureWithinIndustryandPerformance,p21632ibid.p218

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2. Threatofsubstitutes3. Powerofcustomers4. Powerofsuppliers5. Internalrivalry

Firstmobilitybarriersintoandwithinthemanufacturer‐alignedgrouparerelativelyhigh.Distributorshavedistributionagreementswiththemanufacturertowhichtheyarealignedthatlimittheabilityofnewdistributorstocomeintoalocalmarket.Similarly,bothresidentialandcommercialcontractorshavemoreandlessformalrelationshipswithasinglealigneddistributor.Itisnotinamanufacturer’sinteresttofloodaneffectivedistributor’sterritorywithanewdistributionentrant.Whilethismightincreasetotalsales,theinvestmenttoenroll,trainandsupportadistributorishigh.Encroachmentonadistributor’sterritoryalsoproducesloud,vigorouscomplaintsfromallthemanufacturer’sdistributorswhobelievetheyhaveanequityinterestintheirterritory.Similarly,therearelimitstothenumberofcontractorsanaligneddistributorwillchoosetosupport.Eachcontractorrequirestraining,certificationandotherinvestment.Thedistributorwillattempttomanageitsportfolioofcontractorssothatthereiseffectivebutnotexcessivecoverageoftheterritory.Thethreatofsubstitutesintheairconditioningandheatingindustryis,essentially,nil.Thechannelforairconditioningandheatingequipmentcarriesvirtuallyalltheproductsthattypicallymeetthecomfortconditioningneed.Insmallregionsofthecountry,thereissomesubstitutionbetweenwarmairheatingandboilers,whichuseaseparatechannel,butthisisinsignificantonanationalscale.Thepowerofcustomersforthemanufacturer‐alignedchannelisalsorelativelylowsincemuchoftheresidentialmarketisinemergencyreplacementsegment.Herethecustomeristhehomeownerwhoisataverydistinctdisadvantagerelativetothecontractor.Purchasesareinfrequent,pricingisopaque,timepressureishightomakeadecision,andqualityishardtodiscern.Allofthesecombinetogivethecontractorconsiderablepowerrelativetothehomeowner.Littleofthecommercialmarketisinplanandspecworkwherecustomerpowerisrelativelyhigh.Customerpowerremainsweakintheothercommercialsegments.Conversely,thepowerofthemanufactureratleastappearstoberelativelyhighsincethealigneddistributorshavenorealoptions.Inpractice,theneedtokeepthetotalchannelsatisfiedtendstolimitthemanufacturer’spower.Fromagametheoryperspective,theserelationshipsareoneswhichcontinueandwherethe“game”isplayedrepeatedly.Thistendstoproduceasolutionthatissatisfactorytoallpartiesratherthanencouragingthemanufacturertoexercisepowerandextractallofthevalue.33

33Theauthorhasobservedandparticipatedinmanufacturer/distributornegotiationsintheairconditioningandheatingindustryandinsimilaronesfromtheperspectiveofbothsides.In

17

Finally,therivalrybetweenfirmsismoderate.Contractorscomplainbitterlyandoftenabouthowhighlycompetitivetheirmarketis.Thisisverytrueintheproductionbuilderandplanandspecsegmentswheredemandfluctuatesgreatlyandthehomebuilder,generalcontractororlargecommercialownerhaveconsiderablepower.However,theobjectivelevelofinternalrivalrybetweencontractorsdeclinesintheothersegments.Contractorsrarelyknowthecomparativepricelevelofferedbytheircompetitorsandpriceisrarelythedecidingfactorinthesensethatlowpricedoesnotnecessarilywinajob.Thecriticalactivityforacontractorinthissegmentistogetinvitedtopropose.Sorivalryismorelikelytotaketheformofadvertisingandpromotionthanpricecompetition.Allofthisiscontraststhemanufacturer‐alignedsegmentwiththegeneralone.Inthebroadermarketatthecontractorlevel,entrybarriersarelowandthepowerofthecustomerstartstoincrease.Howeverthethreatofsubstitutesisstilllowandthepowerofthemanufacturerdeclinessincethecontractoroftenhaschoicebetweenbrandsatasinglewholesalerandhasmoreflexibilitytochoosebetweenmultiplewholesalers.Atthewholesalerlevel,customerpowerisrelativelyweekastherearealargenumberofcontractorsandveryfewmakeupasignificantportionofthewholesaler’sbusiness.Thepowerofthesupplierismoderatesincewholesalershaveconsiderableinvestmentininventoryandsalesliterature,etc.soswitchingispossiblebutnoteasy.Thereremainsnoeffectivethreatofsubstitutes(infactthethreatfromboilersislowesthereasmanycarryboilers).InternalrivalryisrelativelyhighastheInternetandotherfactorshavetendedtomakepricingmoretransparentincreasingthepotentialforcompetitionbetweenwholesalers.Insum,thedistributionprocessforairconditioningandheatingequipmentcontainstwostrategicgroups:themanufacturer‐aligneddistributorsplustheirassociatedcontractorsandthemulti‐linewholesalersandtheremainingcontractors.Thecompetitiveintensitiesofthetwosegmentsaredifferentleadingtoalikelyinferencethatthemanufacturer‐alignedchannelhasthepotentialtoearnconsistentlyhigherprofits–economicprofitsthatwouldnotbeexpectedtobeatorgotozeroasrequiredundertheperfectcompetitionmodel.TheanswerstoQuestions4&5areyesandyes.ActualPricingandMarkupPracticesShoreyConsultingconductedasurveyofHVACdistributor/wholesalersandHVACcontractorsinNovember2014todeterminetheactualpricingpracticesofbothgroups.Thepurposewastoascertainwhetherpricingwasforapackageofproductsandserviceswhereairconditionersandheatpumpsmightbeasmallcomponentofthetotalpriceandhowthedistributor/wholesalersandHVACcontractorsactuallydeterminedtheirmarginstructure.

general,eachsideinthenegotiationhasascribedsignificantbargainingpowertotheotherirrespectiveoftheactualsituation.

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Theresultsofthatsurveycanbestbesummarizedbyonedistributor,whorepliedwhenpresentedwiththeDOEconceptofincrementalmarkupsasadescriptionofactualpractice:“thatisthestupidestideaIhaveeverheard.”Bothdistributor/wholesalersandHVACcontractorsmanagetoconstanttargetmarginpercentagesacrosstheirwholebusinessesanddonotvarymarginsforindividualproducts.Theyallrespondthatmanufacturerpriceincreases(orraredecreases)arepassedthroughwiththeirtraditionalmarkups.Distributor/WholesalerFordistributor/wholesalers,thecommonpracticeistoworkoffalistpricesheetandthengiveastandarddiscounttoacontractor.Theamountofthediscountmayvarybetweencontractorsdependingonhistoricalpurchasingvolumeorotherfactors,withthediscountisconsistentacrossallproducts.Theremaybecircumstanceswhereindividualprojectsgetspecialpricing,oftenwithconcessionsfromthemanufacturer,butthisisinexceptionalsituations.Thedistributor/wholesalerthenmanagesthebusinesstopreservemarginpercentage.Wheneverthedistributor/wholesalerseesapriceincrease,thisincreaseispassedthroughtocustomerswiththestandardmargin:“Anytimewehaveapricingincrease,weabsolutelypassitontothedealer.Alldaylong,wepassthecostontotheconsumer.Whenweseea30/40%increase,sodothey.”“Wealwayslookatmarginpercentage,neverabsolutedollars.Manufacturerscometousallthetimewithpriceincreases.Onceweagreeonapricefromthemanufacturerweputitinourpricesheetatalevelthatwillpreserveour%margin.Ifwehavethesensethatthemanufacturersareallraisingtheirpricestogetherbecauseofgovernmentregulationsorwhatever,wesimplymarkuptheincreasetoholdourmarginandpassitontoourdealers.Thedealersareallmargindriven,too.That’salltheycareabout.So,intheend,theconsumerpaysforallincreases.”“Oursoftwaresystempublishesourmargineveryday.Weliveandbreathemargin.Oursalesrepsareincentedarounddollarsofrevenue,butourtopmanagementteamisincentedaroundgrossmargins.”Thusthepricingprocess(listpriceswithstandarddiscounts),managementbehavior(focusonmaintainingpercentagemargin)andpastpractices(passingthroughpriceincreaseswhilemaintaininghistoricpercentagemargin)areconsistentwithaconstantmarginforbothbaseequipmentandforincreasedcostsduetoefficiencyimprovements.Thereisnoindicationorsupportforthenotionthatfuturemarginpercentageswilldeclinewithincreasedequipmentpricestomaintainconstanteconomicprofit.Rather,managementinformationsystemsandperceivedfirmeconomicsarealignedwithmaintainingastableaveragemarginovertime.Contractor

19

ThemanagementprocessesforHVACcontractorsaresomewhatdifferentfromdistributor/wholesalers,yettheactualstabilityofmarginsisthesame.Thetypicalcontractorprocessistoestimateallthecostsofajobandthenaddastandardmargin.Thismayormaynotbetheactualbidpricefortheproject,whichisbasedonwhatthecontractorthinksthejobwillsellfororonafinalpricenegotiation.Thereisnodifferentialmarkupforeachpieceoftheproject(equipment,sheetmetal/piping,additionalsupplies,buy‐outitems,labor,etc.).OnelargecommercialHVACcontractorcommented:“Weaddupallofourcostsandhopethattheycomeoutbelowthepriceneededtowin.Ifwecan,wevalue‐engineertheprojecttolowerthetotalcost.Ourmarginiswhatisleftover.Hopefullyitispositive.Thegoalincontractingistofindnichesandprojectswhereyoucanmakeyourtargetmargin.”CommercialHVACcontractorshaveabsorbedsignificantcostincreasesinthepast,yethavemaintainedconsistentmargins.EstimatedtotalinstalledcostofacommercialHVACprojectdependsuponwhetherductworkisincluded.Formostprojects(newconstructionandremodeling),ductworkisanintegralpartoftheproject.Onlyindirectreplacementofafailedunitisductworkexcluded.Theincrementalcostsfora7.5tonairconditionerattheproposedstandardlevelarebetween12%(includingductwork)and26%(excludingductwork).Thecostincludingductworkfora7.5tonprojectisapproximately$15,000(2003)34whileDOEestimatesthetotalinstalledcostofapproximately$8,000(2013)excludingductworkandanincreasedinstalledcostofapproximately$2200.35Thecostofsheetmetal,themajorcomponentofthecostofductworkhasundergonesignificantpricevariations,ofteninshortperiodsoftime,increasing13%duringtheconstructionseasonof2004and9%duringtheseasonof2008.36Thecontractorsinterviewedforthisstudyhadnochangeintheirpricingormarginpracticesasaresultofthisductworkpricefluctuation.OneofthekeyreasonsforthestabilityofmarginsinHVACcontractingisthattheestimatingapricingproceduresarebasedontoolsthathaveonlyasinglemarginforanentireproject.Forexample,themajorestimatingandproposalprogramsponsoredbythecontractors’tradeassociationhasonlyasingle,standardmarkupfield.37ItwouldbeincrediblydifficulttocreateandimbeddedadifferentialmarkupforHVACequipmentrelativetoallotheraspectsofaprojectwithasinglemarkupfieldintheestimatingandbiddingprocess.Contractorsandthedevelopersofthe

34StateofMichigan,StateTaxCommission,2003STCAssessor’sManual,Volume2,UIP3,Page435DOETSDEERE‐2013‐BT‐STD‐0007‐0027,Table8.2.11,Volume8p.15(note:theDOEcostincreasesarebasedonthedisputedmarkupsand,thus,understatetheactualcostincrease)

36USBureauofLaborStatistics,ProducerPriceIndexWPU107337Right‐SuiteTMsponsoredbytheAirConditioningContractorsofAmerica(ACCA),www.wrightsoft.com

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estimatingprogramalsoreportthatthemarginfieldtendstobepopulatedwhentheprogramisinstalledsothatthemarginpercentageisnevervaried.Incrementalmarginsthatvariedfromstandardpracticewouldrequiremajor,complexandunlikelychangesincontractorbehavior.EmpiricalEvidenceforConsistentMarginsTheempiricalevidenceonmarginsatboththedistributor/wholesalesandcontractorlevelsintheairconditioningandheatingchannelislimitedbothintimeseriesandincoverage.Whatevidencethereisindicatesthatgrossmarginsremainremarkablysteadyovertime.Anidealanalysisofmarginbehaviorwouldincludelongitudinaldataonmarginsbyproductlineforwholesalersandbylaborversusequipmentforcontractors.Nothingclosetothislevelofdataexists.ThereissomeUSCensusBureaudatathatprovidesandindicationofcontractorandwholesalermarginsovertimeinfive‐yearintervals.Inaddition,therearepubliclytradedwholesalersinplumbingandrelatedfieldsthatcanprovidesomeproxyinformation.Unfortunately,noneofthedataisavailableinadisaggregatedformthatcorrespondstothetwostrategicgroups.TheCensusdataforwholesalersandcontractorsiscontainedintheEconomicCensusofWholesaleTradeandofConstructionconductedeveryfiveyearsintheyearsendingin2and7.Thisdatacontainsgrossmarginsforwholesalersandvalueaddedmarginsforcontractors.TheCensusdataforwholesalersisavailableforairconditioningandheatingwholesalers(NAICS42373,SIC5075)from1992onand,atahigherlevelofaggregation,forNAICSHardware,Plumbing,AirConditioningandHeating(NAICS4237,SIC507)from1977.TheCensusdataforPlumbing,AirConditioningandHeatingcontractors(NAICS23820,SIC1711)isavailablethrough1977.Itisalsopossibletocreateaproxyforcontractorgrossmarginbysubtractinglaborfromvalueaddedtogetagrossmarginoverlaborandmaterials.Allofthedatashowpatternsofconsistentgrossmarginsovertime.TheCensusdataforwholesalersshowsstablemarginsacrossthefive‐yearperiodsexceptfortheslightdipin1997(Figure1).ThecompositeofpubliclytradedIndustrialandBuildingMaterialsWholesalersshowsasimilarsetofpatterns(Figure2).FurthertheMarkupPaperconsidersgrossmarginsforwholesalersin1977acrossstatesandfindsthemtobequiteconstant.Sincewholesalerstendtooperateinlimitedgeographicterritoriesanddonotcompetewithoneanother,theconsistencyacrossstatesprovidesadditionalindicationofacommonsetofpricingpractices.Thesemarginsholdtrueacrosseconomiccycles(1982wasaveryweakyearforhousing,1977and2002werestrongonesand19987,1992,1997and2007wereaboutaverage.)Allofthisdatasupportsthepropositionthatthereisastablepatternofgrossmargins.ThemodelproposedintheMarkupPaperwouldhavepredictedthatmarginsdeclinedin2006withtheadventofthelatestresidentialairconditionerstandardsand,clearly,thathasnothappened.

21

Marginsforcontractorsshowsimilarconsistency.Thevalueaddedmargin(RevenuelessValueAdded÷Revenue,whereValueAddedisRevenueless

22

purchases,essentiallylaborandprofit)remainsstableoverthe30‐yearperiodexceptfortheanomalyin2002(Figure3).

Themostrecent(2005)studyoftheairconditioningcontractingindustryinitiallyquotedbyDOE38alsosupportstheexistenceofstablegrossmarginsovertime.TheGrossMarginforResidentail/LightCommercialandCommercial/Industrialcontractors(theclosestproxytoinstalling,notservicecontractors)was32.32%in1994and33.73%in2004.39ConclusionsTheUSDepartmentofEnergyusesmarkupsinordertodeterminethefinalcosttoconsumersofnew,moreenergyefficientproductsthatresultfromminimumefficiencystandards.TheMarkupPaperproposestoconvertfromanaveragemarkuptoanincrementaloneforthehighercostsoftheefficiencyimprovements.Thesupportforthisdecisionisanappealtomicroeconomictheoryandanobservationonthenumberofairconditioningandheatingwholesalersandcontractors.However,theMarkupPapertakesatheoreticalmodelofperfectcompetition,withsubstantiallimitsonitsapplicability,andwithnoempirical

38Daleet.al.B‐639AirConditioningContractorsofAmerica(ACCA),FinancialanalysisfortheHVACRContractingIndustry,2005Edition,2005.Washington,DC

23

supportintheparticularcaseofairconditioningandheatingwholesalersandcontractors(oranyempiricaldataoutsideofmanufacturers)andclaimsapplicability.

Question IncrementalMarginConcept

AverageMarginConcept

Question1:Underwhatcircumstancesdoestheperfectcompetitionparadigmapplyinrealsettings?

Generalapplicabilitynotsupportedbyempiricaldata.Applicabilitymustbeprovedineachspecificsituation.

Applicabilityofperfectcompetitionnotnecessary.Historicalexperienceisasubstitute.

Question2:Howmanyorwhichoftheconditionsforperfectcompetitionmustexistfortheconclusionsabouttheinabilitytoraisepricesabovevariablecoststohold?

Rulesforwhenandunderwhatcircumstancesperfectcompetitionmodelapplieshavenotbeendevelopedordemonstratedempirically.Applicabilitymustbedemonstratedcasebycase.

Notnecessary

Question3:Dothenecessaryconditionsapplyinthecaseofanyspecificindustryunderanalysis?

EmpiricalproofofconvergenceofactualprofitstoeconomiccostofcapitalnotprovidedbyDOE.Simpleresorttoindustryconcentrationhasbeendemonstratedempiricallynottocorrelatewithprofitconvergence.

Notnecessary

Question4:Inwhatcircumstances(ifany)isthereevidencethatfirmscanachieveprofitsinexcessoftheirvariablecosts?

Notnecessary TheoryofStrategicGroupsprovidesalternativeexplanationofbehavior,positingcircumstanceswhereprofitsabovethecostofcapitalcanbesustained.

Question5:Doanyoftheconditionswherethereisevidenceofpricingabovevariablecostsapplytoaspecificindustry?

Actualpricingbehaviornotanalyzed.

Empiricaldatashowsstablemarginsovertime.Actualpricingpracticesasreportedbydistributor/shoelsaersandcontractorsconsistentwithaveragemargins.

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Thispaperdemonstratesthelimitationsoftheperfectcompetitionmodelandtheempiricalevidencethatperfectcompetitioncannotbeassumedtooccurinpracticesothatanaprioriassumptionofperfectcompetitionisunwarranted.Inaddition,thispaperprovidesanalternativetheory,StrategicGroups,thatfitstheactualoperatingconditionsatboththewholesaleandcontractorlevel.Theempiricalevidenceforbothwholesalersandcontractorsshowsthattheymaintainaveragemarkupsconsistentlyacross30‐yeartimehorizons,implyingconsistencyinpricingpractices.Theactualpricingandestimatingbehaviorinbothindustriessupportsaconclusionthatincrementalmarkupsareanunlikelyresult.Therefore,theMarkupPaperdoesnotsupporttheuseofincrementalmarkupsinthefaceofmorecompellingtheoryandactualempiricalbehavioralandfinancialresults.ContinuingtouseincrementalmarkupsinDOEanalysesoftheHVACindustrynowfliesinthefaceofboththeoryandempiricalevidence.