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The explanation for the positive relationship between concentration and profitability is one of the most controversial topics in the field of industrial organization. The interest in this topic is due primarily to the conflicting antitrust policy implications originating from two competing hypotheses: the market power (collusion) hypothesis and the efficiency hypothesis. Tests of these hypotheses have focused, to a large extent, on the determinants of incumbents' profitability. The most widely used test has been criticized for being insufficiently discriminating and, therefore, inappropriate for determining the validity of the hypotheses.
The current paper presents an alternative approach. It examines the competing hypotheses by focusing on the behavior of potential entrants. A key premise is that potential entrants respond differently to incumbents' Ricardian rents and to incumbents' monopoly rents. Ricardian rents, resulting from superior efficiency, should have little impact on potential entrants, i.e., usually they do not induce entry; however, monopoly rents, resulting from market power, should attract entry, ceteris paribus.
The current test is thus performed by comparing the entry response to adjusted and unadjusted profitability measures. The adjusted measure is obtained by removing the component of profitability attributable to concentration from the unadjusted measure. The removed component represents Ricardian rents, according to the efficiency hypothesis, and monopoly rents, according to the market power hypothesis. These differing interpretations result in contrasting predictions regarding the explanatory power of the adjusted and unadjusted measures of profitability. The empirical framework is based on a recursive model with a sample of U.S. oligopolistic industries. Previewing the results, the findings are for the most part supportive of the market power hypothesis.
LITERATURE REVIEW
There has been substantial debate on the correct interpretation of the positive correlation characterizing the performance-concentration relationship. Proponents of the market power hypothesis (MPH) argue that the positive relationship reflects higher prices resulting from the exercise of market power.1 Proponents of the efficiency hypothesis (EH) claim that the positive relationship can be explained by the superior efficiency of the largest firms in the industry. Enhanced profitability in concentrated industries results from lower costs rather than higher prices [Demsetz,1974] and, therefore, represents economic rents.
A common methodology for testing the hypotheses involves the use of a performance equation, such as price-cost margins with concentration and firm market share...