Barriers to Entry, Concentration, and Tobin's Q Ratio

By Chen, K. C.; Hite, Gailen L. et al. | Quarterly Journal of Business and Economics, Spring 1989 | Go to article overview

Barriers to Entry, Concentration, and Tobin's Q Ratio


Chen, K. C., Hite, Gailen L., Cheng, David C., Quarterly Journal of Business and Economics


Barriers to Entry, Concentration, and Tobin's q Ratio

Abstract

In a well-developed capital market, rents will be

capitalized in the prices of the firm's outstanding

securities. To avoid the difficulties of using

accounting rates of return to measure rents, this paper

uses capitalized market values in relation to the

replacement cost of the firm's capital stock, a measure

known as Tobin's q. This measure is used to

investigate the relationship between barriers,

concentration, and profitability in the context of the

traditional theory that asserts concentration fosters

cooperative pricing and monopoly rents. In general,

evidence that is inconsistent with this theory is

found.

Introduction

One of the unresolved questions in industrial organization is the association between industry concentration and profitability. Generally, empirical studies have reported a weak positive correlation between concentration and profits.(1) Potential explanations for these findings have been categorized by Smirlock et al. [20] under the general headings of the traditional view and the efficient structure view.

The traditional interpretation dates to Bain [1]. This view does not attempt to explain how industries originally become concentrated, but takes the degree of concentration as given. Concentration per se is alleged to foster collusion and cooperative pricing that in turn give rise to monopoly rents. A potential problem with this explanation is that concentration is a necessary, but not sufficient, condition for above normal rates of return. It is easy to imagine technology, cost, and demand conditions that could result in industry output being supplied by one or a few firms. If there were no barriers to entry, however, these few producers would earn no monopoly rents, even though the industry would be viewed as concentrated. Thus, barriers to entry must accompany concentration to produce monopoly rents.

The contrary view attributed to Demsetz [7] holds that the profits-concentration relationship is a natural result of some firms in an industry being more cost efficient than their rivals. Thus, more efficient firms show higher profitability and gain market share, resulting in a more highly concentrated industry as submarginal firms exit.

Three tests of the hypotheses have been attempted in the literature. The first approach investigates whether high profits are earned by all firms in concentrated industries or by only the largest of such firms, e.g., Ravenscraft [15] and Smirlock [20]. Because most oligopoly models in which firms have different costs predict both higher market shares and profitability for the more efficient firms, a finding that market share is associated with rents is consistent with both the traditional and efficient structure hypotheses. The second approach tests whether changes in concentration are due to cost or price effects, e.g., Peltzman [14] and Chappell and Cottle [6]. Such tests generally support the Demsetz view that market share and profitability are natural consequences of cost advantages of some producers.

The third approach tests if the concentration-profits relationship holds only in the presence of barriers to entry, e.g., Salinger [16], or whether it holds when entry barriers are absent. The current paper fits this latter category. The paper investigates the effect of entry barriers and concentration on capitalized rents measured by the ratio of the market value of the firm to the estimated replacement cost of its capital stock, a measure referred to as Tobin's q. Generally, the highest q ratios are found for firms in industries that have been identified previously as having high barriers to entry. Somewhat surprisingly, q values vary inversely with concentration in the highest barrier category. …

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