THE STRUCTURE-CONDUCT-PERFORMANCE PARADIGM:

EXPLAINING, MEASUREMENT AND TESTING THE THEORY

1

CONTENT

1. Introduction

2. SPC-paradigm: The explanation

3. Measuring the “Structure Conduct Performance-

paradigm”

4. Variables of the “Structure Conduct Performance-

paradigm”

4.1 Market structure

4.1.1 Buyer and seller concentration

4.1.2 Product substitution

4.1.3 Entry conditions

4.2 Market conduct

4.2.1 Pricing strategies

4.2.2 Mergers

4.2.3 Collusive Behaviour

4.3 Market Performance

4.3.1 Profitability

4.3.2 Efficiency

5. Testing the “Structure Conduct Performance-paradigm”

6. Conclusion

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THE STRUCTURE-CONDUCT-PERFORMANCE PARADIGM:

EXPLAINING, MEASUREMENT AND TESTING THE THEORY

1. Introduction

The purpose of the essay is to look at efforts to measure the

Structure Conduct-Performance-paradigm, the explanation of the

paradigm, efforts to test the paradigm and the relationship

between the variables. It provides an overview between the

relationship between profits and the concentration (number of

firms needed to produce a certain level of output).

2. The SCP-paradigm: The explanation

The Structure Conduct Performance approach indicates that

market performance is determined by market conduct, which in

turn depends on market structure. The structure, conduct and

performance are interconnected through structural

characteristics against models of perfect competition,

monopolistic competition, oligopoly and monopoly. The table

below draws the linkage between the structural characteristics

and the models of perfect competition, monopolistic competition,

oligopoly and monopoly.

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Structure Conduct Performance

Structural

Characteristics

Market 1 Market 2

Number of firms

Number of buyers

Nature of product

Entry barriers

Many firms with small

market share

Many

Homogeneous

Low

Four firms with similar

market share

Few

Differentiated

SubstantialSource: Ferguson & Ferguson: (1996) Pages 15-16

The table shows that in market 1 the characteristics of a perfect

competition structure. Market conduct can be derived from the

structure meaning that in the case of a large number of firms

usually leads to industry competitors to determine their own

prices and levels of output. From a performance side it will mean

that prices tend towards equalising marginal cost (P=MC), thus

normal profits in the long run. Performance in particular markets

can also be influenced through structure, because structural

conditions provides sufficient information for performance to be

predicted.

The situation in market 2 differs from market 1 in the sense that

a small number of firms determine the price and level of output.

This usually leads to higher prices and lower levels of output. The

firms’ behaviour (conduct) such as pricing, advertising etc. are

collusively determined by the small number of firms. However,

market structure does not necessarily means collusive

behaviour. In an effort to keep acceptable levels of economic

performance, oligopolists will compete for market share in an

effort to keep price close to perfect competition (P=MC).

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3. Measuring the “Structure Conduct Performance-

paradigm”

The traditional way of measuring the market structure is by

making use of measures of market concentration, which focuses

on the number and size distribution of firms. “The fewer the

number of firms and/or the more disparate their size, the more

concentrated the market.” (Ferguson & Ferguson: 39) Market

concentration gives an indication of the degree of market power,

which is revealed, by the margin between price and marginal

cost. Price-cost margins are positively related to the Herfindahl-

Hirschman index.

Alternative measures of market concentration can be

summarised as follows:

A concentration curve can be constructed from firms

ranked in size order from the largest to the smallest and

plotted against their cumulative output. Measures of market

concentration seek to transform the number and size

distribution depicted by these firms into a single value.

Absolute measures combine the number of firms and their

size disparities of which the following are examples:

− Concentration ratio- measures the cumulative

market share of the largest number of firms.

∑=

=x

iix SCR

1

where S denotes market share.

A value close to zero indicates that the largest number of

firms supplies a small portion of the market share. A single

supplier will supply 100% of the market share, thus

monopolistic behaviour.

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− Herfindahl-Hirschman index- calculates the output of the

firm divided by the total output. This means the summing

of the squares of market share of all the firms in the

market.

∑=

=n

iiSHHI

1

2

where n denotes number of firms.

An index close to zero means there are a large number of

equal sized firms, and a value of one means monopoly.

− Hannah and Kay index- is basically the same as the

Herfindahl-Hirschman index except that market share is

raised to the power α which denotes any number of firms.

)1/(1

1

αα

−

=

= ∑n

iiSHK

A value between the range of 0.6 to 2.5 is suggested to

provide the most reliable results.

− Entropy index- indicates the market share weighted by the

logarithm of the market share.

∑=

=n

iii SSE

1

)/1log(

A value of zero suggests that there is only one firm in the

market. The maximum value in the case of firms with equal

market share is the log value of the number of firms in the

market.

− The 80 percent Occupancy Count- measures the

concentration number of the firms constituting 80% of

industry output.

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− The C5% - measures the cumulative market share of the

top 5% of firms in an industry. In the case of South Africa, it

provided a high degree of seller concentration.

Relative measures concentrates on the disparities in size of

firms operating in a particular market. The following two

measures serves as examples:

− Variance of the logarithms of firm size- measures the

difference between the logarithms of the firms in the

market.

∑ ∑= =

−=n

i

n

iii S

NS

NV

1 1

22

2 )log(1

)(log1

If the value is zero, all firms are equal in size.

− Gini-coefficient –measures the size of firms ranked from the

smallest to the largest as a percentage of the number of

firms in the market, plotted against the cumulative output

of these firms. The greater the deviation from the diagonal

line, the greater the inequality in firm size. Fourie and Smit

also used the Gini-coefficient to measure the impact of

import competition on concentration.

The summary measure: The Rosenbluth index gives

considerable weight to the number of firms in an industry,

thus relative more small firms.

)1(1 GininR −=

In using the Rosenbluth measurement, Leach concluded that

an opposite trend is shown compared to the other measures.

The variables of the “Structure Conduct Performance-paradigm”

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4.1 Market structure

Bain defines market structure as those characteristics within a

market that influence the nature of competition and pricing in

the market. The characteristics can be distinguished in terms of

concentration (number of firms) of which perfect competition and

imperfect competition are the significant components. In order to

measure the significance of market structure within the

paradigm; the market structure was viewed from the following

dimensions:

4.1.1 Buyer and seller concentration

Buyer and seller concentration measures proxies for market

power in terms of input (capital and labour) and output (sales)

possessed by the most significant firms according to size. Market

concentration can be expressed as a ratio of the number of

firms’ (n) of total sales )(

∑=

x

iiS

n

α

. From the perspective of

competitive power, it could be argued that seller concentration

does not necessarily reflect the true nature of competitiveness.

In cases where firms are locked in restrictive trade agreements,

been price leaders or through government legislation with regard

to prices and wages, the true nature of competition is disguised.

According to Galbraith, countervailing power should also be

considered. He based his argument on the fact that monopolists

and oligopolists (sellers) might sell to monopsonist and

oligopsonists (buyers), because the buyers could amalgamate in

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an effort to avoid exploitation and simultaneously share in

monopoly profits.

4.1.2 Product substitution

A firm’s ability to differentiate products plays an essential role in

market concentration. It will decrease or eliminate substitution

for similar products competing in the market. Differentiation

creates a situation where market structure departs from perfect

competition, because it creates a downward sloping demand

curve for those products. This means that as the price of a good

increases the desire to consume the good decreases. However,

should producers enforce product differentiation in order to

decrease the degree of product substitutability and the number

of producers are reduced, monopolistic or oligopolistic conditions

would occur.

4.1.3 Entry conditions

Entry conditions define the relationship between existing firms

and possible entrants in the market. The impact of new entrants

will rely on assumptions based on (a) business goals; (b) cost

advantages of existing firms; and (c) price vs. output behaviour

of existing firms. The degree of difficulty in entering a market

depends on product differentiating as well as advantages with

regard to costs and economies of scale. Bain suggested that

superior production technique; superior resources etc. also plays

a vital role in market entry. Demsetz argued that there are other

reasons for profit maximisation than collusion, which are therefor

strengthened by Bain’s suggestion.

4.2 Market Conduct

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Market conduct can be defined as patterns of behaviour by

enterprises in an effort to adjust to the markets in which they

operate (buy or sell). Pricing strategies, collusive behaviour

mergers etc. is few dimensions of market conduct.

4.2.1 Pricing strategies

The behaviour of firms in setting their prices also play a vital role

in the SCP- paradigm. Price strategies like price discrimination,

predatory pricing, price fixing are only a few examples.

Price discrimination refers to a situation where firms are selling

the same product at different prices to different customers. Price

fixing on the other hand refers to a situation where market

structure does not allow sellers to sell products at prices below

listed prices of manufacturers. The predatory pricing on the other

hand allow products to be sold at prices below production costs

(marginal cost or average cost). The main purpose of these

strategies is to acquire market share, thus monopolistic profits.

4.2.2 Mergers

Market conduct, of which market power results, can also be

viewed as a way in which the firms behave in order to increase

market share. Three different types of mergers can be identified

namely, horizontal mergers, vertical mergers and conglomerate

mergers. Horizontal mergers occur when firms in the same

industry combine. Vertical mergers occur when firms combine at

different stages of the production process. Conglomerate

mergers on the other hand combine unrelated firms.

4.2.3 Collusive Behaviour

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Imperfect competition in the market does not always depend on

the size of firms, but also on the behaviour of firms. In a market

with few competitors firms can decide whether to be non-co-

operative or co-operative. In order to minimise competition

amongst them; firms tend to co-operate engaging in collusion.

This creates a situation where firms jointly set prices and outputs

as well as sharing the market amongst them. Cartelisation is

another form of collusive behaviour. It comprises of a set of

independent firms that produces similar products working

together to raise prices and restricts output.

4.3 Market performance

Market performance can be defined as the outcome or comprises

of end results of firms in the market due to market structure and

market conduct. Profitability, efficiency, etc. are only a few

dimensions from which market performance can be measured.

However, in measuring market performance a few difficulties

might arise due to the lack of uniformity in the use of concepts

such as market, firm and profit. The inconsistency in data and

the introduction of restrictive government legislation increases

the degree of difficulty to measure market performance.

4.3.1 Profitability

Profitability measures the rate of return on capital, thus a key

indicator of market power. Vigorous competition amongst firms

for market power might lead to imperfect competition because of

incentives to become highly concentrated in an effort to gain

monopolistic profits. High rates of return on capital in the market

place usually reflect a market, which is in disequilibrium. Brozen

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also supports this argument, because he viewed the market

structure in such conditions to be monopolistic.

4.3.2 Efficiency

Efficiency when looked at from a marginal cost perspective

would mean that: “ Only when prices are equal to marginal costs

is the economy squeezing the maximum output and satisfaction

from its scarce resources of land, labour and capital”.

(Samuelson & Nordhuas: 139) In a perfect competition market

structure, the firm will set its production (performance) at a level

where the marginal cost equals the price, thus PMC = . In the

case of imperfect competition the firm will depart from marginal

cost been equal to price, thus PMC > or PMC < . Another form

of efficiency is technical progress. These technological-

considerations form one of the drives behind firms attaining

efficient sizes and effective degrees of seller concentrations.

5. Testing the “Structure Conduct Performance-paradigm”

Economists used different sets of data over different periods of

time in an effort to test the validity of the structure-conduct-

performance paradigm.

Joe S. Bain constructed one of the earliest theories with regard to

the paradigm. Bain argued that successful collusion between

firm’s results in joint profit maximisation. In drawing such

conclusion he used data from the 1930’s. In his analysis he used

42 industries divided into halves of most and less concentrated.

Stigler on the other hand argued that oligopolists wish to collude

in an effort to maximise joint profits. In an effort to substantiate

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his findings, he used a sample of 17 industries based on data

from 1953-1957. His results shown a relationship between profit

rates and a four firm concentration ratio to be in excess of 80%.

In contesting Bain’s theory, Mann used data from 1950-1960. He

used 21 industries, (half of Bain’s industries over a longer period)

and produced results similar to Bain’s. It could therefore be

argued that in using basically the same data in an overlapping

period (Bain 1953-1957: Mann 1950-1960) the theory of Bain

was justified for that spesific period. Weiss (1971) did a further

23 studies on the subject which resulted in a weak but positive

relationship between profitability and concentration.

However, two economists named Brozen and Demsetz cast

doubt over Bain’s theory. Brozen argued that in case of

successful collusion in concentrated industries, above average

profits should persist over time, suggesting that the market be in

disequilibrium. He argued that profit rates in above average

industries will decrease and in below average industries it will

increase. The conclusions were derived from the data Bain used

between 1936-1940 and Stigler’s data between 1953-1957. A

further study by MacAvoy, McKie and Preston led to the

argument that only industries with persistently high

concentration levels should be studied.

Demsetz approached the paradigm from another angle. He

argued that there are reasons other (examples; scales of

economy, efficiency, effectiveness etc.) than collusion for the

positive relations between profitability and concentration. He

justified his view by arguing that superior performance rewards

from a functional incentive based system.

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Spandau did testing from a South African perspective. He used a

sample of 26 three-digit manufacturing industries based on data

from the Census of Manufacturing, 1976. Spandau used a

different method of computing profitability in the sense that he

measured profitability as percentage of gross output expressed

as a measure of wages and not sales as used in standardised

accounting principles. Despite the different method used by

Spandau it was found that there is a correlation between

profitability and concentration.

Other economists such as Samuels and Smyth covering 186

companies between 1954-63 found a negative relation between

profit rates and firm size. Hart and Barron who found similar

results from 1951 data supported these findings.

6. Conclusion

Different types of concentration measures, of which absolute,

relative and summary measures, were used to draw conclusions

regarding the SCP-paradigm. The different measures led to

different conclusions, because of a lack of uniformed data. The

close relationship between the SCP-paradigm variables makes it

difficult to conclusively indicate whether structure leads to

performance or vice versa. However, it can be concluded that the

drive to be profitable forms an essential part of market

behaviour.

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