Specification and testing the profit-concentration relationship in Australian manufacturing

Research in the mainstream of industrial organization has tested the relationship between profit rates (an index of performance) and concentration (an index of structure) including other variables (e.g., capital intensity, advertising intensity, growth, measures for barriers to entry, import and export intensity). Specification of this relationship is often largely ad hoc and its testing is subject to a number of statistical criticisms. Major criticisms that require attention are: i) omission of the relevant explanatory variables, ii) simultaneous causality among variables, and iii) measurement error in the variables. This paper derives a profit-concentration relationship from a well known oligopoly model. Empirical analysis is carried out against a sample of Australian manufacturing industries for 1984-85. The resulting estimates suggest the importance of dealing with each of the specification and testing issues in explaining the profit-concentration relationship.