The Structure-Conduct-Performance Paradigm in a South African Setting

W. D. REEKIE*(1)IN THE LAST DECADE industrial economics has been in a state of turmoil. The reason is not hard to find. The structure, conduct,performance (SCP) model, which served the profession so well for close on half a century, has not only been challengedtheoretically but has also seen its empirical underpinnings, if not shattered, certainly fractured.This paper examines the state of the SCP paradigm and subjects it to test using South African data. The conventional modeldisplays (unsurprisingly) robustness under a standard profits: concentration test. It is (unexpectedly) still fairly securely intactwhen subjected to one of the more recent types of test applied elsewhere in recent years.The paper falls into four main parts. Section 1 summarizes the 'state of the art'. Section 2 describes the data and sample used in thisSouth African examination of the SCP paradigm. Section 3 displays our results, while Section 4 summarizes our conclusions andmakes proposals for further research.

1. The Structure-Conduct-Performance Paradigm: Disarray?Perfectly competitive equilibrium is a state when an apparent form of socially optimal behaviour by firms exists. The situation mayin reality be undesirable or unattainable but it has the virtue of a tractable and readily comprehensible theoretical base. Indiagrammatic form it implies the following:

Structure Conduct Performance

Perfect competition }—> Marginal cost pricing }—> Allocative efficiencyand equity

Non-perfectcompetition

}—> Departures from marginalcost pricing

}—> Inefficiency andpossible monopolyprofits

It is but a small step from a model of this kind to argue that monopoly profits will increase the more concentrated is the market. Bain(1951) was

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among the first to spell out this relationship explicitly. He argued that successful collusion between firms would approach or resultin joint profit maximization. The ability to collude would increase with concentration and so, other things being equal, monopolyprofit rates could be expected to increase with concentration as collusion became progressively more successful. (This statement,of course, rests on the implicit and unproven assumption that reaching and policing collusive agreements is hypothesis thatoligopolists wish to cheaper when firms are fewer in number. If they are few, then this fact and any profits are viewed, possiblyincorrectly, as proxies for the real economic problems of collusion and monopoly profits.)What empirical evidence is there to support the view that price marginal cost margins are greater in more concentrated industries?Is there any evidence to suggest that if such higher margins exist they are due to the desire of firms in concentrated industries tomaximize joint profits? The premise that there is a link between concentration and monopoly profit rests largely on quantitativestudies published during the 1950s and early 1960s, primarily using U. S. data (and in the 1970s using U. K. and European data).Nearly all the U. S. investigations used data from the 1950s, excluding Bain's pioneering work which was based on statistics drawnfrom the latter part of the 1930s. Bain selected 42 industries rejecting those where data were either unavailable or deemed to beunsuitable. Dividing his sample into two halves, most and least concentrated, he found a statistically significant differencebetween rates of return. This conclusion stimulated further, research and did not disprove the theory that concentration andsuccessful collusion are associated.A study by Stigler (1964), used a sample of 17 industries and 195357 data. Stigler commenced his article by accepting, for purposesof testing, 'the collude to maximize joint profits'. Stigler found some relationship between profit rates and four firm concentrationratios in excess of 80 per cent. But 'there is no relationship between profitability and concentration if . . . the share of the fourlargest firms is less than about 80 per cent.'Mann's (1966) study used 195060 data and produced results similar to Bain's. His 21 industries with eight fïrm concentration ratiosof over 70 per cent showed an average accounting return of 13,3 per cent and his nine industries of below the 70 per centconcentration level a return of 9 per cent a 4,3 per cent differential.

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Weiss (1971) cites a further 23 similar studies which had been published by 1969. The majority of these seemed to reveal a weak butnonetheless positive relationship between the two variables. Weiss concludes that 'practically all observers are now convincedthat there is something to the traditional hypothesis . . . I doubt that we

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need many more general concentration profits studies.'Two papers by Brozen and one by Demsetz, have, however, cast doubt on the empirical relationship between concentration andprofit rates. No one explicitly addressed the question of the persistence of high profit rates over time until Brozen in 1970. Brozenargued that if there is successful explicit or implicit collusion in concentrated industries then the above average profits flowing fromthe collusion should persist over time, other things being equal. The above average profits would represent a noncompetitiveequilibrium. On the other hand, if Bain's findings represented a disequilibrium situation, Brozen suggested that profit rates in aboveaverage return industries (whether concentrated or not) would decline and those in below average return industries would rise.(Industry entry would occur owing to the attraction of above average profits. Capacity growth and supply increases would resultin relative price falls, and rates of return would converge on the average. Conversely, capacity would contract and rates of returnrise in below average return industries.) Most of the industries in Bain's sample did indeed perform in a manner suggesting thatthey had initially been in a disequilibrium situation. Between 1936 and 1940 (the Bain study) and 1953 and 1957 (the Brozenreplication) the gap in rate of return between the two groups of industries fell to a statistically insignificant 1,1 per cent.Brozen carried out a similar exercise on Stigler's sample of industries (195357). Brozen replicated the study for 196266. Stigler'ssignificant (albeit weak) correlation coefficient fell to a trivial and nonsignificant level. Of the seven highly concentrated industries(out of eight) which had above average profit rates in the earlier period, rates of return fell in six. The below average profitability inthe remaining concentrated industry rose. Brozen also replicated the Mann study and found similar behaviour. Brozen's findingsproved unexpected and puzzling to many economists. In particular, he faced the challenge that he had examined industries whichwere concentrated during the period of the original studies, but which had ceased to be concentrated during the period of hisreplications. To the extent that this was true, Brozen argued, there is little cause for concern since, if the market concentrationdoctrine does hold true at any point in time, then market forces will themselves deconcentrate the industries and reduce themonopoly profits flowing from collusive behaviour.MacAvoy, McKie and Preston in their (1971) response to Brozen adopted the former view. They argued that only industries whichhad records of persistently high concentration levels should be examined. If this was done then persistently high rates of returnwould indeed be found. These authors helpfully provided a list of

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such industries. On examining the specified industries Brozen (1974) found that their rates of return were not even high(significantly above average), much less persistently so.There remains the initial problem of why Bain's original sample showed a significant difference in rates of return in veryconcentrated industries in one given period. Why should all concentrated industries simultaneously be in disequilibrium?While Brozen was arguing for a sceptical attitude towards broadbrush studies of the relationship between concentration andprofits, Demsetz (1973) was approaching the problem from another position. The earlier studies linked monopoly power andconcentration by postulating that fewness in the number of firms in the industry facilitates collusion to restrict output and price.Demsetz argued that there are reasons other than collusion for expecting a positive correlation between concentration andprofitability. An association between market concentration and rates of return should be expected from any workable incentivesystem that rewards superior performance.Superior ability in lowering cost or in improving products, be it the consequence of luck, entrepreneurial or managerial foresight orthe presence of scale economies, may well increase profits and draw sales from the unsuccessful towards the successful andefficient firms. Thus concentration and profitability could be associated for reasons totally unconnected with collusion andcontrived scarcity. Such situations may be (and Brozen's work suggests they are) eroded with the passage of time as new entrantsor existing competitors emulate or improve upon the activities of the successful firm. But unless the short term monopoly rewardsare nontrivial in both amount and duration there will be no incentive for firms to strive towards the performance which producesthem.These sources of profit and market share are specific to the firms which perform well in terms of productive efficiency orinnovation. Other firms in the same industry will not share in the higher profits from such sources. But, Demsetz argues, if the onlysource of higher profits is collusion, then higher profits should be enjoyed by all firms in the colluding industry. The issue thenbecomes one of ascertaining from which source the profits in concentrated industries arise.This can be done by examining the association between concentration and rates of return for those firms which are relatively smallin their respective industries. Since collusion presumably benefits all firms in the industry while superior efficiency benefits only

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those who can more readily attract custom, this reduces the likelihood of confusing the cause of any observed higher profitability.Demsetz's results (relating to the United States) failed to reveal the beneficial effects to small firms which an association of

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collusion with concentration would suggest. Smaller firms in concentrated industries were not more profitable than smaller firms inother industries, which is what would be expected if they could shelter under the collusive umbrella of larger firms.In summary, earlier studies found a small but significant correlation between market concentration and industry profit rates, butthese results have not been confirmed by recent work. Any such relationship which exists seems to be weaker and less stable thanearlier studies suggested. If a subset of industries is examined the relation does not persist more than a few years. The implicationof the hypothesis is that concentration facilitates collusion. If so, then smaller firms operating in concentrated industries shouldearn more than smaller firms elsewhere. But no correlation between the profitability of small firms and concentration ratios has beenfound. The fact that large firm profitability was still found by Demsetz to be apparently associated with concentration might be partof the source of the positive relationship between industry profits and concentration. In the earlier work cited by Weiss (1971)industry profits tended to be calculated by averaging the profits of only the large firms in the industries. The divergence betweenlarge and small firm profit rates which increases as concentration increases suggests that it is the relative competitiveness of thelarge firms which is rising as concentration increases, not their monopolistic power.

2. Application of South African Data to the Issue of SCP ValidityThe SCP paradigm is no longer undisputed. This is a remarkable volte face from the situation which ruled in 1971 when Weissargued that further testing was no longer required. There is thus intellectual excitement to be had in further examining the relevantissues using hitherto unused South African data. Of more practical consequence is the fact that Spandau (1977, p. 300) pointed outthat 'the relationship between market structure and market behaviour (and hence performance) . . . has not as yet been . . . tackled' inSouth Africa. This is of major importance to policy makers and bodies such as the Competition Board. Since, if concentration isindeed an issue in South African society, sensible decisions are difficult to take if Spandau is correct (1977, p. 301) in that '(we) arein particular ignorance as to whether a "critical" level of concentration exists, beyond which market dominance becomes harmful.'This paper traces the steps of the above debate using South African data. The source used was the Census of Manufacturing for1976 and the sample related to 26 (out of 30) 3 digit manufacturing industries. (For a full discussion of the Standard IndustrialClassification see Du Plessis, 1978). The measure of profitability employed was that of Net Output less

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Wages expressed as a percentage of Gross Output. One advantage of this measure is that it is not based on accountants' profitfigures. Accounting data must always be standardized prior to use by economists and there is little guarantee that suchstandardization will always be successful. Second, while this measure is not a rate of return equivalent, it is very close to theLearner Index of (P MC)fP. And, indeed, it is monopolistic departures from marginal cost pricing, rather than accounting profits,that the SCP model claims to explain.The measure of concentration used here was the number of firms accounting for at least 50 per cent of industry sales. This is lowerthan the 70 per cent and 80 per cent figures used by Du Plessis (1978) in his study of 1972 data. However, use of the 80 per centfigure provided us with similar results as did the 50 per cent measure. Apart from strength of result, there is good reason forbelieving the 50 per cent measure to be more meaningful in this study. Given the level of aggregation forced on us by the data, thatis a 3 digit level, then an 80 per cent boundary would include very many more firms responsible for small shares of 4 and 5 digitindustries than would the boundary actually selected.

3. Results(a) Concentration and ProfitabilityTable 1 lists the 26 industries examined, their concentration indices and their profitability figures. The first use made of thesefigures was to test for any statistical association. When ranked and the Spearman correlation coefficient obtained, it was found thatrs = 0, 634 and the corresponding t statistic was, at 4,02, significant at the 1 per cent level.Thus it appears that concentration and profitability are indeed associated in South African industry. Table 2 shows the nature anddirection of this association. This Table, akin to Bain's (1951) original study, was obtained by grouping the data in Table 1. Theindustries were subdivided into two sub samples of 13. The more highly concentrated half, with average profitability of 24, 01 percent, was more profitable than the less concentrated subsample at 20, 92 per cent. The difference in the subsample means wastested for significance. The resulting Student's t statistic was, at 1, 54, below the 5 per cent level of significance but well above itsminimum at the 10 per cent level. Such a formal test is merely a refinement, however. A glance at the top two rows of Table 2, andthe amalgamated figure of 27, 8 per cent shown for them in Table 3, as compared with the four bottom rows of Table 2 or the 20,2

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per cent and 20,8 per cent of Table 3 is sufficient to emphasize the economic, if not the statistical significance of the findings.(b) Decomposing Concentration and ProfitabilityTo this point our results have little novelty. The (traditionally expected)

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relationship between concentration and profitability has been shown to hold in South Africa as it has elsewhere. Now, however, wesubject the data to one of the tests which has raised doubts about the inferences to be drawn from such 'validations' of the SCPparadigm. In Table 3 the industries are grouped in a three by three table. In the first row appear the 7 highly concentrated, highlyprofitable industries, in row 2 the 10 moderately concentrated, less profitable industries and in row 3 the 9 diffuse, less profitableindustries. Profitability data for those three groups were then found on a size of establishment basis (regrettably firm data were notavailable) where size or scale was measured by employee size grouping.Table 1

No. of firms Accounting for atleast 50% of sales

Profitability (%) (net.outputless wages/gross output)

Food 76 18,7

Beverage industries 11 19,7

Tobacco products 1 23,1

Textiles 26 21,6

Wearing apparel, except footwear 60 19,2

Leather and leather products, leather substitutes and furexcept footwear and wearing apparel 16 20,4

Footwear 12 19,1

Wood and wood and cork products, except furniture 32 23,7

Furniture and fixtures, except primarily of metal 37 20,1

Paper and paper products 8 25,7

Printing, publis hing and allied industries 56 25,4

Industrial chemicals 7 22,9

Other chemical products 22 20,2

Rubber products 3 28,8

Plastic products not elsewhere classified 33 22,8

Pottery, china and earthenware 4 34,6

Glass and glass products 1 26,3

Other nonmetallic mineral products 43 29,6

Iron and steel basic industries 6 27,7

Non-ferrous metal basic industries 4 23,3

Fabricated metal products except machinery and equipment 119 19,1

Machinery, except electrical 54 19,1

Electrical machinery, apparatus, appliances and supplies 29 19,0

Motor vehicles, parts and accessories 33 13,4

Transport equipment, except motor vehicles and accessories 7 10,0

Professional and scientific and measuring and controllingequipment Not elsewhere classified, and Photographic andoptical goods 6 30,4

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Now recall the empirically substantiated arguments of Demsetz (1973) set out in Section 1. These run as follows:(a) firms which satisfy market demand (i.e. which perform well) whether

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through exploitation of scale economies and low cost production, innovation or entrepreneurial skills will be rewarded with a highmarket share and be highly profitable. The SCP paradigm is stood on its head, instead of structure leading to performance,performance is deemed to lead to structure; andTable 2

No. of firms accountingfor at least 50 % of gross

output

No. of industries (total26)

Average of industryaverage profit rates

Grouped average for 13industries

1-3 3 26,1 —

4-6 4 29,0 24,01

7-16 6 19,6 —

22-32 4 21,1 —

33-43 4 21,5 20,92

54 or more 5 20, 3 —

Table 3

No. of firms accountingfor at least 50 % of sales

No. of industries Grouped averagereturn

Grouped average return by employment size group(Unweighted) Employees

0-499 500-999 Over 1 000

1-6 7 27,8 26,1 25,9 28,7

7-32 10 20,2 20,3 23,5 18,2

33 and over 9 20,8 21,1 23,8 20,9

(b) if this is the case then larger firms in concentrated industries will make above average profits and smaller firms in such industrieswill not. However, had the conventional causal relationship of the SCP model held, and its underlying rationale of collusion beenvalid, then small firms in such industries would also have made above average profits.Rows 2 and 3 of Table 3 are consistent with both Demsetz's arguments and results. Row 1, however, is not. Large firms do makeabove average profits, above the average for their industry and for all industries. The figure of 28, 7 per cent is compatible witheither the traditional SCP view or the Demsetz:Brozen restatement. So is the fact that the remaining two figures of row 1, 26,1 percent and 25,9 per cent, are both below 28, 7 per cent. But they are not sufficiently far below to vindicate Demsetz and disprove theSCP thesis. Indeed both are well

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above the grouped average returns for the nonconcentrated industries.Thus on this evidence the SCP model is partially vindicated in the South African setting. The profitability of concentratedindustries, when neutralized for scale, innovation, and market share factors is still greater than for less concentrated industries.Owing to data deficiencies we have, unfortunately, not been able to replicate Table 2 for a period distant in time as did Brozen. Thismight well cause us to modify our inferences. Because if the outcome of Table 3 is indeed due to the collusive behaviourunderlying the SCP analysis then we must recall Stigler's pithy comment that colluders are parties to a gentleman's agreement wherethe participants 'seldom are, or long do'.

4. CommentThe importance to policy makers of the validity or invalidity of the SCP paradigm is immense. Antitrust policy in the US andcompetition policy in the UK and South Africa all, to a greater or lesser degree, rest on a belief in the validity of the structureperformance relationship. If it is valid then policies promoting more diffuse or preventing more concentrated industrial structures

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are justifiable. If, as the evidence of the last decade has suggested, the causality flows from performance to structure and,furthermore, if the market which induced the concentration will also induce deconcentration then government policy should be of a'hands off' or laissez-faire nature.If the above results are correct then it is possible to argue that neither interpretation can be simplistically accepted. Rather thecausal relationship could be inferred to flow in each direction simultaneously. Alternatively, the above results may be unique to theSouth African situation. Cartelization and concentration may be encouraged by other aspects of government policy inhibitingdomestic firms from expanding overseas and encouraging ever increasing growth at home.Scherer (19$0, pp. 1214) points out that the case for deconcentrated markets is dependent on political and libertarian arguments aswell as on the efficiency arguments implied by SCP analysis. This indeed is frequently expressed in the aims of South Africanpoliticians. For example the Minister of Economic Affairs, in Parliament at the time of the introduction of the 1979 Maintenance andPromotion of Competition Act, claimed that one of the objectives was 'the preservation of the free market system'.The challenge to the Competition Board is great indeed. The list of questions, on whose answers sensible policy making depends,is long. Does the SCP model have empirical support? Is the support from South African sources due to the underlying SCPanalysis ? If not, why is South Africa different from (say) the USA? Are other policy decisions responsible for the type of SouthAfrican result displayed

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in this paper?*(2) If so, should the Competition Board then direct its attention towards market structure or towards these other,apparently exogenous policies? Which solution is 'second best'? Would continuous inactivity be more or less harmful than actiondirected at (structural) symptoms?Industrial economics is in a state of flux worldwide: and in South Africa more rather than less so. The researcher in the area may,therefore, be witnessing the birthpangs of a new paradigm. For this writer to draw policy conclusions in such a situation from theabove evidence would thus not only be immodest, but dangerous. The well worn cliché that 'more research is needed' can seldomhave been so meaningful.University o f the Witwatersrand Johannesburg

ReferencesBAIN, J. S. (1951). 'Relation of profit rate to industry concentration: American manufacturing 1936-1940', Quarterly Journal ofEconomics, Vol. 65.BROZEN, Y. (1970). 'The antitrust task force deconcentration recommendation', Journal of Law and Economics, Vol. 13.BROZEN, Y. (1971). 'The persistence of high rates of return in high stable concentration industries', Journal of Law and Economics,Vol. 14.BROZEN, Y. (1974). 'Concentration and profits: Does concentration matter?' Antitrust Bulletin, Vol. XIX.DEMSETZ, H. (1973). 'Industrial structure, market rivalry and public policy', Journal of Law and Economics, Vol. XVI.Du PLESSIS, P. G. (1978). 'Concentration of Economic Power in the South African Manufacturing Industry', 1978 SAJE v46(3)p257-271.MANN, H. M. (1966). 'Seller concentration, barriers to entry and rates of return in thirty industries, 19501960', Review of Economicsand Statistics, Vol. 48.MACAVOY, P. W., McKIE, J. W. and PRESTON, L. (1971). 'High and stable concentration levels, profitability, and public policy: Aresponse', Journal of Law and Economics, Vol. 14.SPANDAU, A. (1977). 'Towards a New South African Competition Policy', 1977 SAJE v45(3) p299-308.SCHERER, F. M. (1980). Industrial Market Structure and Economic Performance. Chicago: Rand McNally.STIGLER, G. J. (1964). 'A theory of oligopoly', Journal of Political Economy, Vol. LXXII.WEISS, L. W. (1971). 'Quantitative studies of industrial organization' in M. D. INTRILIGATOR (ed.). Frontiers of QuantitativeEconomics. Amsterdam: North Holland.

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Endnotes1 Professor of Business Economics, University of the Witwatersrand, Johannesburg

2 The impact of corporate and fiscal legislation on concentration is alluded to in the Second Annual Report of the CompetitionBoard, 1981, paragraph 8, and is explicitly given (in the Fourth Annual Report, 1983, para. 14) as the reason why performance 'isnever unrelated to market structure' (emphasis added).

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