DP6275 How (not) to measure competition

Author(s): Jan Boone, Henry van der Wiel, Jan C. van Ours
Publication Date: May 2007
Keyword(s): competition, concentration, measures of competition, price cost margin, profit elasticity, profits
JEL(s): D43, L13
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=6275

We introduce a new measure of competition: the elasticity of a firm's profits with respect to its cost level. A higher value of this profit elasticity (PE) signals more intense competition. Using firm-level data we compare PE with the most popular competition measures such as the price cost margin (PCM). We show that PE and PCM are highly correlated on average. However, PCM tends to misrepresent the development of competition over time in markets with few firms and high concentration, i.e. in markets with high policy relevance. So, just when it is needed the most PCM fails whereas PE does not. From this we conclude that PE is a more reliable measure of competition.