Market Share and Rate of Return Author(s): Bradley T.

Gale Reviewed work(s): Source: The Review of Economics and Statistics, Vol. 54, No. 4 (Nov., 1972), pp. 412-423 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/1924568 . Accessed: 31/01/2012 02:49
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MARKET SHARE AND RATE OF RETURN

Bradley T. Gale *

THIS paper examinesthe effect of market

share on the rate of return of selected firms operating in different market environments. It will be shown that the effect of share on profiltabilitydepends on the degree of concentration and rate of growth in the industries in which the firm competes, and on the absolute size of the firm. One of the most important propositions of micro-economic theory is that under competitive conditions, rates of return tend toward equality. A casual look at the data will reveal that rates of return are not equal and that differences in rates of return often persist over time. Many studies have utilized industry concentration as a measure of market power and have analyzed the effect of concentration on industry profitability (a sizeable list may be found in Weiss (1971)). Three recent studies have looked at the effect of concentration on profitability using the firm as the unit of analysis (Federal Trade Commission (FTC), Hall and Weiss (1967), and Shepherd (1972)). Although share data is not generally available for most firms, the FTC study does examine the effect of "relative market share" (market share divided by the big four firm concentration ratio) on profitability in food manufacturing firms, while the Shepherd paper examines the effect of market share for a sample of large, nondiversifiedfirms. The more recent of the above studies emphasize additive multiple regression models. While these models attempt to control for the effects of some dimensions of market structure when focusing on the effect of a particular structure variable, they do not capture the interaction effects of structure variables on profitability. Two independent variables are said to interact
Received for publication September 30, 1971. Revision accepted for publication June 21, 1972. * I am indebted to Ronald G. Ehrenberg, Kenneth Gordon, Marshall C. Howard, James K. Kindahl, Thomas Muench, and George Treyz and two referees for comments and suggestions on an earlier draft of this paper and to Patricia M. Anderson for programming services and comments. [ 412 ]

if the effect of one independent variable on the dependent variable depends on the level of the other independent variable. Interaction effects may be analyzed in the following three ways (1) specifying an interaction model, (2) including interaction variables in an additive model, or (3) by estimating the parametersof an additive model for subgroups of the total sample. A version of the third method is employed in this study and will be discussed in section I. To illustrate this subgrouping method, suppose we divide our sample into two subsamples (A) firms in highly concentrated industries and (B) firms in lowly concentrated industries. As will be explained below, we expect that the slope coefficient from a regression of profitability on share in the high concentration subgroup will be much higher and more significant than the slope coefficientfrom the low concentrationsubsample. The primary goal of this paper is to develop and test a theory of the effect of firm share on profitability under various competitive situations. We have tried to integrate, formulate, and extend some elements of oligopoly theory and to test the resulting hypotheses. The hypothesis and finding that share affects rate of return is greatly strengthened by the more complex interaction hypotheses and findings.1 In carrying out this major goal we also examine the effects of both firm and industry growth on profits, develop new evidence on leverage as a measure of risk, comment on the controversy over the correct measure of profitability, and introduce the concept of market share as a so;urce of product differentiation. The paper contains four major sections. The first section develops the theoretical relationship between share and profitability. This discussion focuses on the interaction effects on profitability of share and the market environ' The interaction findings, especially the growth interaction, support the case for interpreting the data in this cross-section study as representing the effect of share on profitability. An examination of the dynamic process by which firms alter their market share positions would require time-series data. (See Gale, 1972.)

MARKET SHARE AND RATE OF RETURN ment variables. The second section describes the data sources, construction of variables, and sample selection criteria. Section III is an analysis of the statistical results and some concluding remarks are offered in section IV. I Theory and Model Effect of Share on Profitability We will analyze the effect of market share on profitability by considering in turn the following three questions: (1) What are the determinants of market share? (2) How do these determinants affect profitability? (3) How does market share, however attained, affect profitability? Given the schedule of relative prices, market shares of sellers in a differentiatedoligopoly are generally determined by the prevailing scheme of buyer preferences (Bain, 1968, p. 232). The prevailing scheme of buyer preferences reflects the cumulative effect of building customer loyalty. More generally, market shares in both homogeneous and differentiated oligopolies are determined by past and present rent-yielding intangible assets (unit-cost and market advantages) possessed by the firm. A firm having an advantage vis-'a-vis its major actual or potential competitors may exercise its advantage by either charging a higher price or by realizing a larger market share than its rival sellers. If there are economies of scale in production or marketing, the seller will tend to favor the large market share option as the most profitable way to exploit its advantage. Having a patent or being the first firm in a new industry may be viewed as strong advantages. We have reasoned that a firm's market share is mainly determined by the past and present rent-yielding intangible assets which it possesses. As these advantages increase both the share and the profitability of the firm will tend to increase. This effect will be more pronounced when economies of scale are present. Here, share does not cause profitability but merely proxies the presence of rent-yielding intangible assets. We turn now to ways in which market share, however attained, affects profitability. Suppose that the present share distribution in an industry is the result of past differences in product

413

design. In the past firms enjoying large market share have been able to design their product to attract a wider following of customers. If the current product designs are such that the large share firms no longer have a product differentia:tion advantage, what will be the relation between share and profitability? Large market share may be expected to yield high profitability (1) by giving the firm a sharebased product differentiation advantage, (2) by allowing the firm to participate in an oligopolistic group tight enough to effect some joint restriction of output, (3) by increasing the firm's bargaining power in this oligopoly situation and (4) by allowing the firm to take advantage of economies of scale. These effects represent the direct causal influences of share on profitability. Up until now we have used the term product differentiation advantage in the sense of consumer acceptance or customer loyalty based on advertising or product differences. Risk averse buyers may favor a large share firm. We shall refer to this as a sharebased product differentiationadvantage. In an oligopoly environment the large share firms tend to recognize their mutual interdependence and attempt to coordinate their market conduct so as to raise the industry profitability above what it would be in the absence of such coordination. While the firms have a common interest in increasing the industry rate of return, their interests conflict on the question of how this increased profitability should be allocated to the rival oligopolists. A firm with a large market share is in a position to bargain for a pattern of industry conduct which will reflect its own interests perhaps at the expense of smaller share firms.2 If we hold constant the market shares of rival oligopolists, an increase in a firm's share increases the ability of the group to jointly maximize profits and increases the bargaining power of the firm relative to its cooperative rivals.3
2 If one assumes that large share firms are likely to possess more liquid wealth than small share firms, this view is consistent with Fellner's discussion of the bargaining process among oligopolists. (See Fellner, 1965, p. 27.) 'In a regression of profitability on (1) share, (2) concentration, and (3) sales for all 106 firms, the respective signs and t-ratios were: (1) + 1.39; (2) - .22; and (3) + 1.43. This indicates that share is relatively important even when one controls for concentration. The correspond-

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THE REVIEW OF ECONOMICS AND STATISTICS would expect market share to have a positive effect on a firm's profitability.
Interacting Variables

Finally, if economies of scale in production or marketing exist, and have not been exhausted in the relevant range, the large share firm will be able to achieve a cost advantage over rivals operating at a lower rate of output. Thus, for all of the reasons given above, we
ing signs and t-ratios ((1) + 1.84; (2) + .25; and (3) +.96) from a subsample of 50 firms in concentrated industries indicate that the effect of share is positive and significant in concentrated industries even when one controls for concentration. Thus we feel that in our later results, the role of share as a proxy for concentration is of minimal importance.

The effect of share on profitability, however, will depend upon other industry and firm characteristics. In particular it will depend on (1) the level of concentration in the industries in which the firm competes, (2) on the rate of growth in industry demand and (3) on the absolute size of the firm. Our interaction hypotheses are illustrated in figures 1A, 1B, 1C, and 1D.

FIGURE 1. - PROFITABILITY AS A FUNCTION OF MARKET SHARE; INTERACTING WITH INDUSTRY CONCENTRATION, INDUSTRY GROWTH, AND FIRM SIZE

PROFITABILITY High Concentration /

PROFITABILITY

Moderate Growth

Growt /~~~~~~~~Rapid h

Low Concentration

MARKET SHARE Figure 1A PROFITABILITY Relatively Large Firms PROFITABILITY

MARKET SHARE Figure 1B

Large Firms in High Concentration Moderate Growth Industries

Relatively Small Firms

Other Firms

MARKET SHARE Figure IC

The relations depicted above reflect our ex ante hypotheses.

MARKET SHARE Figure 1D

MARKET SHARE AND RATE OF RETURN

Concentration: We expect the effect of share on profitability to be stronger in highly concentrated industries for two reasons. First, we have noted thaltin an oligopoly situation, a large market share will put a firm in a good bargaining position in the specification of coordinated seller conduct designed to enhance the industry's rate of return. The effect of share operating through this bargaining power will be strongeras industry concentrationand oligopoly profits increase. Second, economies of scale are one of the determinants of industry concentration. Therefore, the effect of share operating through cost advantages should be stronger in highly concentrated industries (assuming economies of scale are not exhausted in the relevant range) than it would be in unconcentrated industries where economies of scale are not as significant.

415

able (Williamson, 1967) we expect the advantages of large over small share firms to be greater in medium growth industries. Firm Size: Most of the mechanismsby which larger share leads to higher profitability are intensified as firm size increases. A share-based product differentiation advantage would tend to be enhanced by larger firm size. The ability of a firm to exploit patents profitably increases with firm size. In oligopolistic indusitries the bargaining power of large share firms is reinforced by overall firm size. Thus we expect the positive effect of share on profitability to increase as firm size increases.
Complex Interaction: Parts of the theory

outlined above may be brought together in one unified interaction hypothesis. Thus, we expect the effect of share on profitability will be greatest when the firm is large (has bargaining Industry Growth: We expect the effect of power) and competes in market environments share on profitability to be stronger in indus- which are conducive to oligopolistic coorditries experiencing a moderate rate of growth nation and may exhibit economies of scale than it would be in rapid growth industries. (highly concentrated, medium growth indusThis expectation is based on two separate lines tries). of reasoning. First, the ability of sellers to co- Model ordinate their efforts in an oligopoly situation To cap,ture the interaction effects of share is greater when industry growth is moderate. and the interacting variables on profitability In declining or slow growth industries oligopo- we will utilize the following model: listic coordination may break down as firms feel P = b1 + b2D2 + b3D3 + b4D1SH the pressure of high fixed costs. In rapid + b5D2SH + b6D3SH + U (1) growth industries firms will tend to sacrifice where current profits by failing to jointly maximize inP= profitability dustry profits as they compete for market D1, D2, D3 are zero-onedummyvariablesdeshare. This strategy is based on the assumption fined in table 1.5 SH = share. that having a bigger market share in the future will more than offset the current profit reduc- Our hypotheses focus on the absolute and tion.4 In moderate growth industries, however, relative sizes of the share slope coefficients. firms have a greater incentive to avoid price The hypotheses concerning relative size of slope rivalry which will probably reduce total in- coefficients may be summarized as follows: dustry profits. Interacting Variable Second, we hypothesize that small share concentration b4 < b6 firms are more flexible and better able to adapt industry growth b5 > b6 to changing market circumstances than larger Interacting Variable firms which tend to be more bureaucratic. As firm size b4 < b6 changes brought about by extremes in industry complex interaction b4 > b,; growth act to intensify the need to be adapt4For a discussion of oligopoly behavior in an expanding

economy where cyclical recovery will tend to push demand to levels higher than previous peaks see Modigliani (1958). Another related discussion may be found in Caves (1972, pp. 30, 31).

5 In general, D1 = one if the value of the interacting variable is less than or equal to its mean minus K standard deviations. D2= one if the value of the interacting variable is within K standard deviations of its mean. D3= one if the value of the interacting variable is greater than or equal to its mean plus K standard deviations.

416
Table 1.

THE REVIEW OF ECONOMICS AND STATISTICS

REGRESSION OF PROFITABILITY ON SHARE IN SEVERAL STRUCTURAL ENVIRONMENTS Regression Coefficients (standard errors in parentheses) Share Constant .115 .107 (.058) .140 .103 (.049)

2 .037 .266

No Interacting Variable (weighted)

Interacting Variable a Concentration D1 (48); D2 (9); D3 (49)

b

P b= .114 .115 .097

b2D2 + .011 (.036) .020 (.039) .000 (.017) .012 (.018) -.003 (.020) .004 (.022)
- .006

b3D3 + - .012 (.016) -.018 (.017) .039 (.020) .075

(.022)

b4D,SH + - .055 (.105) - .060 (.091) .090 (.093) .182 (.070) .088 (.073) .099 (.059) - .120 (.319)
- .124

b5D2SH + .089 (.357) - .003 (.345) .180 (.087) .200 (.076) .034 (.156)
- .012

b6D3SH .180 (.074) .211 (.061) .007 (.129) -.132 (.121) .432 (.185) .474 (.139) .105 (.109) .163 (.080) -.055
(.104)

R2 .087 .878 .101 .881 .073 .876 .045 .867 .102 .882

b6-b4 .235 (.128) .271 (.110)

-.173e

Weighted Industry Growth c Di (36); D2 (34); Weighted Sales Di (66); D2 (15); D3 (25)
Weighted Share

D3

(36) .082 .112

.110

(.155) _.332 e (.142) .344 (.199) .375 (.151) .225 (.337) .287 (.400) -.378
(.188)

-.062 (.037)
- .069

(.030)
- .142

(.144) 1.419 (2.448) 1.440 (2.347) .170

(.086)

.116
Weighted

Di (59); D2 (9) ; D3 (38) .117 .065 .051

(.027)
- .019

(.254)
- .145

(.027) Complex d
Di (15) ; D2 (43) ; D3 (48)

(.245) .049
(.033)

(.391) .323
(.161)

.045
(.033)

Weighted

.061 (.029)

.064 (.029)

.394 (.128)

.166 (.068)

- .060 (.069)

- .454 (.156)

a Di, D2, and Da are dummy variables based on the interacting variables. The number of firms for which each dummy variable equals one is given in parentheses for each interacting variable. bDl equals one if the value of the interacting variable is less than its mean minus 0.15 times its standard deviation. D2 equals one if the value of the interacting variable is between its mean minus 0.15 standard deviation and its mean plus 0.15 standard deviation. D3 equals one if the value of the interacting variable is greater than its mean plus 0.15 standard deviation. c The dummy variables based on industry growth are calculated as indicated in note 2 but using 0.5 standard deviation rather than 0.15 standard deviation. d Di equals one if the firm's weighted average concentration ratio is greater than the sample mean, and its sales are greater than the sample mean and its weighted average industry growth rate is within 0.5 standard deviations of the sample mean. D3 equals one if the firm's weighted average concentration ratio is less than the sample mean minus 0.15 standard deviation. D2 equals one for all firms not falling in either of the above categories. e For the industry growth interaction we calculate bo - b5.

We also treat share mathematically as a dummy variable which interacts with itself. This is done to allow for a possible curvilinear relation between share and profitability. That is, profitability may increase a;t an increasing or decreasing rate as share increases. This curvilinearity would combine with collinearity between share and two of the interacting variables to complicate the interpretation of our results. Since share is positively correlated with both concentration and sales, it is difficult to separate the curvilinearity and interaction effects. Nevertheless, share was introduced as an interacting variable here to obtain estimates of low and high share slope coefficients which may be used to control for the possible curvilinearity when we analyze the interaction effects.

Although we are mainly interested in the differences between share slope coefficients of two subgroups, equation (1) in effect breaks our sample into three subgroups. There are two rea.sonsfor employing this third subgroup. First, when the hypothesis relates to the difference between share slope coefficients in high and low subgroups, the medium subgroup acts as a buffer zone which makes the results less sensitive to our subgrouping limits.6 Second,
6 For example, if there were only two subgroups, the classification of a high share, high profitability outlier of medium concentration would have a strong influence on the concentration interaction hypothesis. Moving this firm from the high concentration subgroup would both decrease the high concentration share slope coefficient and raise the low concentration share slope coefficient. Thus by using a buffer zone we reduce the sensitivity of our results to the

MARKET SHARE AND RATE OF RETURN if the interaction effects are really continuous rather than discrete, the introductionof a buffer zone will tend to sharpen the statistical results.7 We turn now to a model which includes control variables.
Control Variables

417

Equation (1) can be expanded to control for additional firm and industry characteristics by introducing control variables in an additive fashion. For example consider equation (2):
P = bi + b4D,SH + b5D2SH + b6D3SH + b7D1 + b8D2 + b9S +b,oGI

(2) + bjiL+ bl2GF+ U where D1, D2, and D3 are based on concentration and S= sales GI = growth of industry L = leverage GF = growth of firm sales minus growth of industry shipments.

In this equation we do not capture the sharegrowth or the share-sales interaction. The estimated parameters of equation (2) appear in the third and sixth columns of table 2. Sales: Baumol (1967, p. 34) has argued that . . . at least up to a point, increased money capital will not only increase the total profits of the firm, but because it puts the firm in a higher echelon of imperfectly competing capital groups, it may very well also increase its earnings per dollar of investment even in the long run, after all appropriate capital movements are completed." Thus, if we use sales as a proxy for a firm's size expressed in money capital terms we would expect to find a positive effect of sales on profitability. Growth: We attempt ito control for changes in the demand of the firm relative to the industry and to control for changes in industry demands. Hall and Weiss (1967, p. 323) have
classification of firms since changing a firm from one subgroup to the next will now only affect one of the two share slope coefficients of interest. 'The specification of an optimum size buffer zone is an interesting problem which we have not as yet analyzed. How should one go about subgrouping the firms a priori so as to maximize the t ratio of (b6- b4) ? In the present study we have generally set out classification limits to yield a buffer zone containing about ten per cent of the sample.

noted that "Changes in industry output may reflect changes in demand or changes in cost that result in movements along the demand curve. Altho-ugh cannot distinguish between we these, we expect them to have similar effects on profitability. Either an increase in demand or a decrease in costs would result in increased profiltsunless it is fully anticipated." Thus, by introducing growth of industry shipments as an independent variable, we control for industry growth. To control for differences in profitability due to differential growth rates of firms within industries we introduce an interaction variable. For this variable we use the growth of firm sales minus the growth of industry shipments to control for the degree to which a firm is located in a rapid growth subsector of an industry. It will also reflect the firm's aggressiveness, growth orientation, and acquisitiveness. If the variable reflects mainly increases in demand that are not fully anticipated, we would expect it to be positively related to profitability. Risk: Haskel Benishay (1961, p. 86) has argued that leverage may represent either risk or safety, depending on the context in which it is used. We measure leverage as the ratio of common equity to total capital. The firms in our sample compete in a large cross section of industries and we do not use any other variables to control for differences in risk among industries. Suppose we assume (1) that there is an optimum leverage ratio which varies from industry to industry, (2) that it is positively related to industry risk, and (3) that the dispersion of optimum leverage ratios across industries is greater than the dispersion of actual about optimal leverage ratios.8 Then, in the context of equation (3) the ratio of common equity to capital is interpreted to represent the degree of risk in the industries in which the firm competes and should therefore
8 The observation, that variation in rates of return on debt is small relative to variation in rates of return on equity, suggests that leverage ratios adjust so that variations in risk to lenders are small relative to variations in risk to entrepreneurs. Since entrepreneurs place a lower value on security relative to rewards, this would indicate that high equity to capital ratios reflect high risk. We assume that there is default risk on corporate bonds (Smith, 1970) and that there is a risk associated with the possibility of being forced to sell in a depressed bond market.

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THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 2. REGRESSION OF PROFITABILITY ON SHARE AND ADDITIONAL INDEPENDENT VARIABLES

Regression Coefficients (standard errors in parentheses) Unweighted Regressions

Weighted Regressions -.006 .003 .015

Constant Share (Share)'2 Share * Low Concentration Dummy Share * Medium Concentration Dummy Share * High Concentratio Dummy Medium Concentration Dummy High Concentration Dummy Sales Industry Growth Leverage Growth of Firm Sales Minus Growth of Industry Shipments R2 b6 a a

bi b2

.019

.024

.035

.080 (.054) .290 (.151)

.098 (.045) .317 (.107)

-.024 -.034

b bs b6 b7
b8 b9

(.096) .182 (.324) .126 (.072) -.012 (.033) -.006 (.015) .031
(.020) .440

(.081) .044 .308 .160 (.058) -.001 (.035) -.017 (.015) .031
(.015) .483

.028
(.020) .449

.023
(.021) .420

.028
(.014) .506

.024
(.015) .449

bio b11
b12

(.122) .070
(.030) .288

(.121) .068
(.030) .286

(.129) .057
(.031) .292

(.121) .096
(.029) .252

(.119) .089
(.029) .246

(.125) .086
(.030) .242

(.081) -.283

(.080) .293

(.085) .286 .150

(.119)

(.087) .907

(.085) .910

(.090) .909 .194

(.100)

Difference between share slope coefficients in high concentration and low concentration environments.

be positively related to profitability, if share owners are risk averse. The relations among rate of return on equity, equity/capital, risk associated with the markets in which the firm competes (business risk), and risk to common shareholders associated with the percentage of debt capital (financial risk) are indicated in figure 2. Since our presentation is somewhatat odds with previous discussions of these relations, we will summarize briefly the differences between our discussion and those of Stigler, Hall and Weiss, Caves, and Shepherd. Stigler's interpretation of the risk-leverage relation is that positive risk aversion of lenders would lead one to expect the realized ra.te of
return on all capital to be larger, the lower the

inter-industry but he doesn't distinguish between inter-industry comparisons and intra-industry comparisons in his discussion of the relation of leverage to rate of return. If he is consideringthe inter-industrycase, Stigler's hypoithesisis the opposite of ours. If he is considering the intra-industry case, the conventional (non Miller-Modigliani) financial theory would suggest that if the level of business risk is held constant, the rate of return on equity would be larger, the lower the ratio of equity to capital. It is not clear, however, why the return on all capital should be larger in this case. If the competitorsare all in the same risk class, the rate of return on all capital should be the same. The rate of return on equity would depend on how this constant level of business
Although he does not test his hypothesis of the leverageprofitability relation, other measures of risk are employed on pages 62-64.

ratio of equiity to capital.9 Stigler's data is

'For Stigler's discussion (1963) of the relation of leverage and rate of return on all capital see pages 123-125.

MARKET SHARE AND RATE OF RETURN

THE ELLIPSES REPRESENT THE CONCENFIGURE 2. TRATION OF FIRMS IN INDUSTRIES OF DIFFERENT RISK CATEGORIES
RATE OF RETURN ON EQUITY

419

HIGH RISK INDUSTRIES INCREASING FINANCIAL RISK (INTRA-INDUSTRY DATA)

7K

7
/OW RISK INDUSTRIES

INCREASING BUSINESS RISK (INTER-INDUSTRY DATA)

EQUITY/CAPITAL

risk is packaged between bondholders and stockholders. The Hall and Weiss hypothesis suggests a zero relationship between return on equity and equity/assets in interindustry comparisons but a negative relationship for intraindustry comparisons. Having found a significantly positive relation in their interindustry data, they offer the after-the-fact explanation that relatively profitable firms take some of their exceptional returns in the form of reduced risk.10 Caves has offered an interpretation of the Hall-Weiss findings which extends their afterthe-fact explanation. Caves expects the traditional negative relationship between rate of return on equity and equity/assets if no other influences intrude. He reasons, however, that if the sample data includes large and small firms, with and without significant market power, the advantaged firms could enjoy both higher profitability and lower equity/assets. If one assumes that business risk has been held constant, the main diagonals of the elipses in figure 2 may be interpreted as risk-rate of return indifference curves. If the differential between advantaged and disadvantaged firms is large relative to the variation of equity to asset ratios about their mean in any given market power class, one would expect a positive rela'0See Hall and Weiss (1967 p. 328).

tion between rate of return and the equity to asset ratio unless one controlled for market power differences. Hall and Weiss did control for size, the market power variable mentioned by Caves, and still found a positive significant relation. When they initroducedconcentration as a series of class interval dummies rather than a continuous linear variable, the rate of return, equity/asset relationship, became negative. This result is consistent with the Caves interpretation if concentration dummies are the best way to control for market power differentials.'1 Shepherd used the standard error of a trend line fitted to profit rates as a measure of risk. He found that this measure of risk had an unexpected negative, though not significant, partial association with profit rates. Despite this finding, he also calculated a "variation-adjusted" rate of return by subtracting one-half of the standard deviation around trend from the mean profit rate.'2 While our paper focuses on market share, we have attempted to clarify the risk-structure-profitrelationship, and have noted that failure to adequately control for risk may well affect the profit-structure relationship, especially if advantaged firms take part of their benefits in the form of lower risk. Another study which will focus on risk is currently under way. Profitability Stigler has noted that despite the importance and antiquity of rate of return as a guide to investment, the precise concept of return has received remarkably little explicit discussion. Hall and Weiss agree that there is still room for controversy over the appropriaterate of return. They reason that rates of return on assets should differ between industries, even in perfectly competitive long-run equilibrium, but rates of return on equity should tend toward equality between industries.'3 Their inter"See Caves (1970, p. 289). We are currently devising an empirical test to discriminate between the Caves and Gale interpretations "See Shepherd (1970, pp. 28, 30, 33). Given the negative correlation between variation and profit rates, the variation adjustment procedure would imply either that investors are risk lovers or that high levels of variation are associated with low levels of risk. "See Hall and Weiss (1967, p. 321).

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THE REVIEW OF ECONOMICS AND STATISTICS stock plus common equity plus long-term debt plus short-term debt) for the same five-year period. Industry Characteristics Industry growth is calculated as 'theweighted average of the slope coefficients from a log linear regression of shipments on time in each of the four-digit industries in which the firm competes. The weights in each case are the percentage of a firm's employees in a four-digit SIC industry. Concentration is a weighted average of 1966 four-firm Census concentration ratios as adjusted by Shepherd (1970, p. 267) to correct for local and regional markets and broad and narrow industry definitions.

Firm to Industry Characteristics Share is calculated as the weighted average employee share as of 1967 in the four-digit inII Sampleand Construction Variables of dustries in which the firm competes. The firm The data used in this study are part of a large growth variable is calculated as the slope of a scale general purpose data bank on firms and log linear regression of the firm's sales on time, industries. The data bank was produced by a minus the industry growth variable described data processing and editing sequence designed above. to combine information from the following data files: (1) Standard and Poor's "Compustat," Sample (2) the U.S. Bureau of the Census' "Industry At each stage of the data processing, efforts Profiles," and (3) Dun and Bradstreet's "Dun's were made to ensure that the data sources being Market Identifiers." combined were compatible. First, we ran tests The Compustat data file contains twenty to compare ithe Compustat firm data with the years of balance sheet, income statement and Dun and Bradstreet firm data. Second, we adstock market data for over four hundred firms. justed some of the industry concepts of the Dun Industry Profiles is a ten-year data file on in- and Bradstreet data file to make them condustry characteristics for four hundred and form to the Indus'try Profiles definitions. nineteen four-digit Standard Industrial Clas- Third, since the Industry Profiles data do not sification (SIC) industries. To obtain industry cover all industries, we deleted firms for which characteristics for diversified firms we needed our weighted average variables did not repreinformation on how these firms are distributed sent at least fifty per cent of a firm's employees. across four-digit SIC industries. This infor- Finally, some of the Dun and Bradstreet firms' mation is contained in the Dun and Brad- employee data represent worldwide rather than street data file which contains for each firm, a United States employees. Since this would distribution of the firm's employees across cause an overstatement of employee share for four-digit SIC industries. these firms, an effort was made to screen them out. Upon the completion of the above deleFirm Characteristics tions a sample of 106 firms remained. Profitability is measured as the average of earnings available for common equity divided III Analysis of StatisticalResults by common equity for the five years 1963Our statistical results appear in tables 1 and 1967. Leverage is measured as the average of common equity divided by capital (preferred 2. Table 1 is based on equation (1) while table

pretation would, however, imply a world of too many resources earning a low rate of return on assets in industries with low percentages of equity capital, and too few resources earning a high rate of return on assets in industries with high percentages of equity capital. In contrast, our hypothesis would indicate that the low rates of return on assets in high debt industries reflect the low risk of these industries and thait risk adjusted rates of return on assets can be equalized without requiring "obviously unrealistic rates of return on equity" in high debt industries. It would seem that raltesof return on all types of capital should tend to equality, ceteris paribus. Much of the previous controversy over what is the appropriate way to measure profitability can be clarified by properly controlling for risk.

MARKET SHARE AND RATE OF RETURN 2 includes additional independent variables. Our discussion of the interaction effects will consider (1) share slope coefficients, (2) share slope coefficients with interaction and (3) the problem of curvilinearity-collinearity. This will be followed by a discussion of the control variables and their impact on the share slope coefficients. Interaction Effects Share Slope Coefficients: Table 1 shows that a simple regression of profitability on share with no interacting variable yields a positive significant (at a ninety-five per cent confidence level) slope coefficient. If, as we hypothesize, the effect of share on profitability does depend on the level of the interacting variable, the slope coefficient0.115 obtained from this simple regression will generally be a weighted average of the separate effects of share on profitability in each pair of subgroups. For each interacting variable the relation between b4, b6 and 0.115 is, as expected. Note that we present weighted regressions which attempt to alleviate the problem of heteroscedasticity.'4 In almost all cases, the standard errors of the share slope coefficients were smaller in the weighted regressions. Share Slope Coefficients With Interaction: We will discuss the effects of the interacting variables in the sequence in which they appear in the weighted regressions in table 1. We note that share has a significant effect in highly concentrated environments but not in unconcentrated environments. We also see that the linear combination b6-b4 is positive and significant in both the weighted and unweighted cases. This means that the effect of share on profitability is significantly greater in highly industries. Share has a significant concenltrated effect in medium growth industries but not in rapid growth industries. The linear combination b6-b5 is negative as expected in both cases but is significant only when the data are weighted. Shepherd notes in his paper that the
14 On the basis of our a priori reasoning, our analysis of the residuals of the unweighted equations, and the findings of Hall and Weiss (1967, pp. 323, 324), we assume that the variance of the residuals is roughly proportional to the reciprocal of the square root of share. We multiply all variables in each equation by the fourth root of share and use these transformed variables to estimate the weighted regression cofficients.

421

in'troduction of growth does not affect the structural coefficients.'5 Growth might well affect the structural coefficients from Shepherd's data if an interaction rather than an additive model were used. The effect of share is strong and significant in the large firm subgroup and positive but not significant in the small firm subgroup. The linear combination is positive as expected and significant. The results when share interacts with itself will be mentioned briefly in our section on curvilinearity. As explained earlier the complex interaction unites elements of the above three hypotheses into one unified hypothesis. b4 is greater than b5 and b5 is greater than b6. The linear combination b6-b4 is negative and significant as expected. At this point a word of caution on interpretation of the slope coefficients of the D2 and D3 variables seems in order. Remember tha,t the b2 and b3 coefficients are differential intercepts. b3 represents the amount by which the intercept of the D3 subgroup exceeds that of the Di subgroup. If the share slope coefficients of the two subgroups were equal (b4 = b6), b3 would indicate the difference in profitability between the two subgroups.'6 If D2 and D3 were excluded from our model we would in effect be assuming that the intercepts of the three subgroups were equal. Our sample is large enough that the degrees of freedom saved by estimating two less parameters are not nearly enough to offseitthe effect that this restrictive equal-intercepts assumption would have on our share slope estimates. Since we have enough degrees of freedom we include the D2 and D3 variables in all equations and ignore the problem of trying to save a degree of freedom in cases where one might feel a priori that the intercepts were equal. Curvilinearity-Collinearity: As indicated earlier, the share equation in table 1 was included to allow for a possible curvilinear relation between profitability and share. The results obtained when share was used as
15 See

Shepherd (1972).

16To see the difference in profitability between the two

subgroups when the slopes are unequal one can calculate the mean profitability in each subgroup by adding the product of the share slope coefficient and the average share in the subgroup to the intercept of the subgroup.

422

THE REVIEW OF ECONOMICS AND STATISTICS the comparison were among a group of firms with the same optimal leverage ratio. Based on our reasoning summarized in figure 2 it would seem the series of concentration dummies controlled for the inter-industrydifferences in the optimal equity to capital ratio. This explanation is supported by the positive correlation coefficienit 0.322 between weighted averof age concentration and equity to capital in our data. The equity to capital ratio coefficient in our study, however, is not sensitive to changes in the specification of the model. As noted it is positive and significant in all equations although it does decrease slightly when concentration dummy variables are included. The functional relation between variance of profitability and sales is similar to the relation of profitability variation and share (proportional to the reciprocal of the square root). Since share and sales are correlated, our weighted regressions partially control for the profitability variance-sales heteroscedasticity. One of the major effects of the weighting procedure is to tighten the confidence intervals of the share and sales slope coefficients. With the introduction of the control variables the difference between the high concentration and low concentration share slope coefficients is no longer significant in the unweighted equation but the slopes are significantly different in the weighted version.

the interacting variable in table 1 and when share squared is used in place of share in table 2 indicate that profitability increases at an increasing rate as share increases. It may be, however, that these results merely reflect that our interaction hypotheses are correct and that share is correlatedwith sales and concentration. If the findings represent a curvilinearity it will complicate the interpretation of our interaction effects when our interacting variables are correlated with share. The simple correlation coefficients of share and each of the interacting variables are: concentration 0.224, industry growth 0.005, and sales 0.361. Therefore, to see the interaction effect of industry growth one need only focus on the equation where industry growth is the interaction variable. XVhen analyzing the interaction effects of concentration and sales one must also take into account the fact that part of the difference in slope coefficients may be due to the curvilinearity rather than the interaction effect. Control Variables The coefficients and standard errors of our control variables appear in table 2. This table is designed to control for the effects of other variables while comparing the results of alternative specifications of the relation between share and profitability. Leverage, industry growth, and firm growth coefficientshave the expected sign and are significant in all equations. The sales coefficient has the expected sign in all cases and is significant in two of the three weighted regressions. These results are consistent with the findings of other studies. However, our interpretation of the results for the leverage variable differs from the interpretation of Hall and Weiss. Having hypothesized a zero relationship between the rate of return on equity and the equity to capital ratio, they found the relationship to be significantly positive in a multivariable equation which included concentrationas an independent variable. Their results thus support our hypo,thesis. When they introduced concentration by a series of class interval dummies rather than a continuous linear variable, the relationship between return on equity and the equity to assets ratio became negative as one would expect if

IV
Our main conclusions are that high market share is associated with high rates of return and that the effect of share on profitability depends on other firm and industry characteristics. The hypothesis that share affects rate of return is greatly strengthened by the more complex interaction hypotheses and findings which further refine the share profitability relationship. We found as expected that the effect of share on profitability tends to be greater when the firm is relatively large or when the competitive environment is characterized by high concentration or moderate growth. In addition to shedding new light on the effect of share on profitability, the findings of this study would seem to confirm our belief that interaction effects, which tend to be over-

MARKET SHARE AND RATE OF RETURN

looked in both theoretical and empirical studies of the firm and industry, play an important role in the determination of firm and industry performance. Theoretical and empirical consideration of interaction effects may currently be one of the most useful routes to a better understanding of firm and industry behavior and performance. An important by-product of this share-profitability study is our theoretical treatment and empirical findings on the relation of rate of return on equity, equity to capital ratio, industry risk and financial risk. We hypothesized and found the relation between rate of return on equity and the equity to capital ratio (a measure of risk in an inter-industry sample of firms) to be positive and significant. No public policy suggestions are offered due to the ever-present difficulty of separating elements of monopoly power from those of efficiency.
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