Inter-industry Analysis of Structure and Performance: Evidence from New Zealand
Abstract
We investigate the relationship between industry structure and industry performance using Structure-Conduct-Performance (SCP) model for a large panel data set of industries in New Zealand. We used a system of linear equations that allow us not only to determine the two-way cause-and-effect relationship among the SCP variables but also to take into account endogeneity of the SCP variables. The trend analysis carried out in this paper indicates a higher industry concentration in most of the industries in New Zealand. Our analysis reveals declining levels of industry concentration only in the Financial sector and Utilities sector between 2010 and 2015. Our empirical estimation results show that there is a significant positive two-way causal relationship between market structure and conduct, and a significant two-way causal positive relationship between market structure and performance. We find that process-led and product-led innovation provide the incumbent firms additional product diversification opportunities than geographical diversification scope, which in turn have asymmetric impact on the structure, conduct, and performance of the industries. Thus, our findings imply that in smaller economies such as New Zealand those industries which have a higher level of relative research and development intensities have higher market shares and understanding the unique attributes of such industries is critical to developing policy and regulation to support a dynamic and growing economy.
Keyword: Competition, market conduct, market performance, New Zealand
1. Introduction
The study of industries’ Structure, Conduct, and Performance (SCP) has long been of interest to scholars for a variety of reasons. As a broad descriptive model rather than a structural model, the SCP framework allows the identification and understanding of those attributes that influence industries’ economic performance and the nature of causal links between those attributes and performance (Manolis, Gassenhiemer, and Winsor, 2004). Traditionally, the industrial economists assumed a one-way causal relationship between industry structure and industry performance via industry conduct, treating industry structure as exogenous and determined by basic market conditions such as technology and demand. More recent studies suggest a feedback effect in which industry performance affects both conduct and structure, and conduct, in turn, affects structure (Domney et al., 2005). At the empirical level, this calls for accounting for endogeneity in the econometric analysis using the SCP framework for better understanding of the industry-level competition (Resende, 2007).
In this paper, we undertake an investigation of the SCP relationships for a large sample of New Zealand industries, by means of a simultaneous equations approach, taking into account endogeneity of the SCP variables in the econometric analysis. The motivation for yet another study of this type is twofold. First, earlier studies have explored the manufacturing industries in New Zealand[1] and to the best of our knowledge did not examine a large heterogeneous industrial landscape. Secondly, these studies did not explicitly recognize that industries are increasingly responding to pressures exerted by global, national, and local environmental regulations. A well-governed industry takes a long-term view that integrates environmental and social responsibilities in analysing risks, discovering opportunities and allocating capital in the best interests of stakeholders. This pragmatic outlook expected of industries claim to provide sustainable growth opportunities for future competitive advantage (Porter and Kramer, 2006). This implies that regulations produce heterogeneous impacts on the SCP variables and these factors are worth examining to uncover industry dynamics. In this context, an important empirical question arises: Do those industries that complement their cost cutting and differentiation strategies with more holistic strategies that include sustainability priorities perform better or otherwise?
The New Zealand government uses a command-and-control approach, in particular, the Resource Management Act 1991 to regulate industries’ conduct. The Commerce Act 1986 regulates the process of competition in New Zealand. This act covers anti-competitive conduct in markets within New Zealand, and also overseas business activity insofar as New Zealand markets are affected. Specific regulations relating to electricity, telecommunication, and dairy sectors are in the Electricity Industry Reform ACT 1998 and Part 4A of the Commerce Act, the Telecommunication Act 2001 and Dairy Industry Restructuring Act 2001. These sectors are also regulated within the generic framework provided by the Commerce Act, with specific regulations providing additional provisions for the achievement of competition objectives within these industries.
Despite the overarching influence of the Commerce Act, a number of complex changes and arrangements have been made in regard to streamlining regulations of some industries, for instance, in 2002, the government directed the gas industry to develop self-governance measures to ensure efficient operations of markets. In 2003, the government determined that the electricity industry self-governance model has failed and it established an Electricity Commission to oversee electricity market. In March 2014, the New Zealand government introduced an Environmental Reporting Bill in its Parliament with the aim of creating a national environmental reporting system. InSeptember 2015, the Environmental Reporting Act 2015 was passed into law. In the same spirit, the New Zealand Stock exchange has revised its Corporate Governance Code 2017, which will come into effect on the 1st October 2017, it requires an issuer to include its consideration of material environmental, social, and governance (ESG) factors and practices in their non-financial reporting. In this context, the industries in New Zealand are facing exceptional pressures to implement market-oriented operational strategies that complement the environmental and social sustainability priorities and be accountable for their actions. The main premise of this paper is that, regardless of the regulatory nature of the market, the complexity of the environmental regulations is an additional cost, and just like customer switching costs, it has a significant implication for the market power and conduct which will have a positive (negative) effect on industries’ profitability (Kieschnick et al., 2013; Deloof, 2003).
The rest of the paper is organized as follows. Section 2 provides a review of literature and development of hypotheses. Section 3 explains the sources of data, variables, and methodology. Section 4 reports the results, and Section 5 provides the conclusions and suggestions for future research.
2. Literature Review and hypothesis development
New Zealand was a relatively late entrant into the major world markets. As late as 1960, two thirds of the exports income was earned from the UK and the USA (Akoorie and Enderwick, 1992). New Zealand’s economy did not cope well with the oil prices shock in the 1970s, and later when the UK joined the EU it appeared to have lost one of its major export market for agricultural products. Several of the New Zealand industries that competed internationally were export-dependent and resource-based in the sense that their output was much larger than the domestic demand (Cartwright,1993). The trade negotiations in the 1980s intensified the international trade and New Zealand's exports to the European Community (EC) rose to 21 per cent. This was relatively higher than exports to Australia and Japan with 17 per cent each, and the USA at 15 per cent (Akoorie et al., 1993). By the mid 1980's, however, the New Zealand’s economy was growing at a rate significantly below the OECD average (OECD, 2015), and was weighed down by the State sector, absorbing 20% of gross investment and 12% of the Gross Domestic Product. As an illustration, 10% of the national income in 1986 was spent on the Post Office, the Lands and Survey Department, the New Zealand Forest Service and the Ministry of Energy, with the post-tax return on investment being negligible.
In New Zealand, the industrial sector changed significantly as a result of a large-scale deregulation and economic reforms that started in 1984. The Government's initial approach to reform the State sector was based on the concepts of corporatization (or commercialization), deregulation, and privatization. The 1986 State-Owned Enterprises (SOEs) and Companies Act and the State-Owned Enterprises Act 1987 consolidated the incorporation of 14 SOEs, to be run as commercial enterprises with minimal political intervention (Williams, 1992). Deregulation of various industries began with the financial, broadcasting and transport sectors being amongst the first to feel the effects of free market economic policies. Among the SOEs deregulated were electricity generation and distribution, postal and the telecommunications services. The main objective was to enhance contestability and commercial efficiency of these SOEs while the government continued its control via regulations (Williams, 1992). For example, the New Zealand government sold 51.6% of Auckland Airport shares by public floatation, and 66% of Wellington Airport to a private entity, Infratil NZ Ltd. These were also followed by a large scale of privatization in the Energy sector (Gerald, 1999; Domney et al., 2005). Hamilton (1991) report that concentration of business assets increased rapidly from 1979 through 1989.
However, the most controversial piece of the government regulation was the removing of the courts’ power to ruminate rates charged by a natural monopoly, and placed them in the hands of the Minister of Commerce, giving him the sole power to step in to regulate all monopoly profits. As such, starting from 1986, the takings of monopoly profits were legal in New Zealand unless the government of the day stepped in to regulate a specific offender. For instance, until the 1990s, no legal barriers prevented the owners of an infrastructure facility from raising the prices, and hence the value of the businesses. It seems that whether the regulatory risk metamorphosed into a political risk or not, depended upon the ruling politicians on whether they were on their side. As such, a company’s management could raise prices, profits and assets values with impunity and customers would have no recourse except to wait for the next general election. According to Williams (1992) even after deregulation, SOEs often enjoy a de facto dominant position in the markets in which they operate. For example, Telecom (now known as Spark)- the biggest telecommunication company in New Zealand, continues to enjoy a monopoly in the local loops of its Public Switched Telephone Network, which endows it with considerable strategic leverage in complementary market segments. Nillesen and Pollitt (2011) provide a comprehensive review of ownership unbundling and its consequences in the Electricity sector in New Zealand. They report that ownership bundling did not achieve its objectives of facilitating greater competition in the electricity supply industry, but it did lead to lower costs and higher quality service. Indeed, Chan et al. (2017) report that state ownership in New Zealand is negatively associated with firm profitability compared to private ownership using both cross-sectional and time series approach.
With regard to access to external financing of the Industries, Bertram (2004) documents interesting changes in the makeup of sharemarket in New Zealand. The agriculture, primary processing, manufacturing, engineering, and construction sectors that represented 75% of total sharemarket capitalization in the 1980s reduced their industrial representation in the benchmark index to only 21% by 2000. In contrast, the finance and investment companies’ shares surged from 5% of the sharemarket capitalization in 1980 to 28% in 1990 fuelled by the wave of takeovers that swept through the New Zealand economy. From only 5% in 1980 and 6% in 1990, the utilities and transport sectors’ shares of sharemarket capitalization increased to 44% by 2000. Despite these changes, Smith et al. (2012) report that the industries’ use of debt financing (instead of equity financing) led to an increase in relative-to-industry sales growth but a decrease in relative-to-industry economic performance. They conclude that New Zealand firms’ use of debt indicated their aggressive approach in competing in their product markets, even though this strategy came at the cost of lower relative-to industry profitability. In the next section, we explain the SCP model and its usefulness in exploring the changes in the industries’ underlying forces in New Zealand.
2.1 Structure, Conduct, Performance (SCP) Model
The SCP framework was introduced by Bain (1968). It is a commonly used theoretical framework in the industrial organization literature, for an understanding of the impact of industry’s competition on firms’ market power, conduct and performance (Lee, 2012; Resende, 2007; Delome et al., 2002). It is not a structural model for inter-industry analysis per se. According to Panagiotou (2006), the SCP framework assumes that there exists a stable causal relationship between three variables: structure, conduct, and performance. The term structure refers to the external environment, which includes a number of firms operating in an entire industry (buyers and sellers). The term conduct refers to product, pricing, R&D, advertising and promotion, and innovation strategy of the firms serving industry. Lastly, the term performance refers to the quantity (output) and performance (profitability) of the firms serving an industry (Nabieu, 2013; Lee, 2012)[2].
Intuitively, market conditions influence industry structure and firms would have to adjust their conduct accordingly to survive in the tough competitive conditions, which would, in turn, affect their economic performance. Market structure influences the firms’ conduct with regard to their pricing, selling and advertising, employees and supplier relations, and investment policies (e.g., capital intensive or labour-intensive methods of production) that in turn affect the top-line (sales) and bottom-line (net profit) of firms. Heterogeneity in firms’ conduct given market structure, directly and indirectly, affects the industry level performance. A feedback effect ensues as market participants learn about other firms’ competitive behaviour suggesting that industry performance affects both conduct and structure. Hence, there is a three-way cause-and-effect relationship among structure, conduct, and performance variables.
According to industrial organization literature, in an oligopolistic market structure, there are a few firms in the industry, and their monopoly power and profitability depend on how these firms interact. If the firms’ interaction is more cooperative than competitive, firms could charge prices well above marginal cost and earn very large profits. In some oligopolistic industries, firms do cooperate but in others they compete aggressively even though this means lower profitability. For instance, in the capital intensive industrial sectors, the scale economies may make it unprofitable for a few firm to coexist in the market and they create entry barriers preventing new firms from entering such an industry sector. Because fewer firms can survive in such a competitive industry, the larger more dominant firms can exert their market power to influence the price or the quantity and drive out the smaller and weaker firms from the industry. Thus, in an oligopolistic structure, pricing, output, advertising and investment decisions involve important strategic consideration, which could be complex. It is expected that the market concentration will decrease the cost of collusion between firms and results in an increase in the market shares and higher net profits for a few firms however because of the strategic considerations their impact on market conduct is not clear.