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An entry model of import penetration.

I. Introduction

In an attempt to integrate the areas of industrial organization and international trade, Marvel [1980], Rhoades [1984], and Hilke and Nelson [1987] develop and test the determinants of import penetration across industries. A focal point of these papers is the relationship between domestic market structure characteristics and the level of imports. Marvel's empirical results show that concentration is positively associated with import levels. The theoretical argument behind this result is that monopoly pricing characterizes the performance of firms in domestically concentrated industries. The lure of monopoly rents is then predicted to attract imports.

However, Rhoades [1984] and Hilke and Nelson [1987] find little evidence that import shares are related to domestic concentration. Using 1967, 1972, and 1977 data, Rhoades finds a positive, significant relationship between the two variables in only two of eight tests. In a Federal Trade Commission study, Hilke and Nelson examine the relationship between various measures of imports and exports in a large multivariable model that includes Herfindahl indices and adjustments for minimum efficient plant scale across 360 industries. Consistent with Rhoades, they find no statistical relation between domestic concentration and imports in the years 1975, 1981, 1982, and 1983.

All of these papers relate the level of import penetration to the concurrent level of market concentration. But finding that these two variables have a positive relationship has two possible explanations: greater market concentration can lead to higher levels of import penetration or higher imports across industries can result in higher domestic concentration ratios if imports tend to displace the sales of small firms proportionately more than large firms. Caves [1988, p. 13] finds that "smaller enterprises disproportionately lose market shares to imports." The question of causation then becomes an important issue when relating import shares with the proportion of the market held by large firms.

This paper reexamines the relationship between domestic industry characteristics and import penetration. The need for additional evidence is supported by the conflicting results of the prior three studies: Marvel finds a strong relation between imports and concentration; Rhoades finds a statistically significant relation in only two of eight tests; and Hilke and Nelson maintain there is no relation between the two variables. Moreover, this paper takes a new approach in specifying the determinants of import penetration. This approach is taken from a well-defined area of industrial organization: the determinants of entry across industries.

The central premise of this paper is that the standard entry model can be used to analyze the determinants of two aspects on entry: increases in the number of firms across industries (domestic entry) and the increases in the level of import penetration (foreign entry). Importantly, the causation problem noted above does not occur in the model used here because it relates increases in import penetration to lagged levels of market concentration (just as number of new firms is conventionally related to lagged concentration in the prior studies of the determinants of domestic entry).

Two different models of entry, domestic and foreign, are specified and tested. Five of the eight variables used to explain domestic entry have a similar effect on foreign entry. Of the remaining explanatory variables, market concentration stands out as affecting domestic entry quite differently than it affects foreign entry. A comparison of the results of the two entry models provide additional insight into the role of entry barriers in determining the competitiveness of different market structures.

II. An Entry Model of Import Penetration

Orr [1974] and, more recently Duetsch [1984], develop models of the determinants of entry. Their independent variables are similar to the explanatory variables used in import studies. For example, concentration, market growth, industry size and capital intensity are used in both the Rhoades study of import penetration and the Duetsch study of entry. Despite the similarity of the independent variables used, explicitly applying the entry model to foreign entry requires a departure from the specifications used in prior import studies. In particular, the entry of domestic firms is analogous to increases in the levels of imports rather than simply the share of imports in the market at a point in time.

Looking at both the entry of new firms and increases in the level of imports allows a broader view of entry in this paper than the one used in other entry studies. The study of the determinants of entry is important because it contributes to our knowledge of the competitiveness of different market structures. However, limiting an entry study to just the entry of new domestic firms neglects other sources of potential competition faced by dominant firms. Entry that affects the competitiveness of a market comes from more than one source: not only can new domestic firms enter, but new foreign forms can enter; also, dominant firms can face loss of market shares from the expansion of fringe firms, either domestic or foreign.

The implications typically associated with entry barriers are compromised if barriers have different relationships with the different categories of entry. For example, if four-firm concentration ratios are inversely related to the entry of new firms across industries but are positively related to import penetration, then it is unclear whether concentration ratios give much information about the extent of barriers to entry that restrict the competitiveness of markets.

This study uses the entry model of Orr [1974], and its later extension by Duetsch [1984], as its initial reference point. (1) Variables that affect the entry decision of new firms (both domestic and foreign) and the expansion decision of fringe firms (both domestic and foreign) reflect the perceived benefits and costs associated with entry and expansion. From the benefit side, entry and expansion should be greater in markets that are large and growing; similarly, entry should be greater when incumbent firms are earning relatively high profit margins that are not derived from specialized, efficient operations.

The costs of entry by new firms and expansion by existing fringe firms are captured by variables reflecting entry costs. Concentration, capital intensity, and advertising requirements are traditionally given emphasis in discussion of these costs.

Entry of new firms or expansion of fringe firms can be inversely related to concentration if these players associate the threat of collusive retaliation with the existence of dominant firms in concentrated markets. In addition, large market shares that are associated with efficiency will not attract entry.

High capital requirements for large scale production can not only be a cost hurdle that limits the entry of new firms, it can also retard the expansion of the smaller firms in the industry. The role of advertising expenditures in determining entry or expansion of firms is more ambiguous since advertising can be used by dominant firms to hold market shares or used by new or fringe firms to increase market share.

Production characteristics can also affect entry conditions across industries. If large firms have greater scale economies than small firms, expansion of fringe firms or small-scale entry by new firms can be impeded. (2) Duetsch [1984] suggests two reasons for an entry-deterring effect of another production characteristics -- multi-plant operations. If a fringe firm produces in only one region, expansion may be difficult if it is at a cost disadvantage relative to multiproduct or multiregional firms. Fewer market niches exist when entering into a multiplant market. A similar argument applies to the disadvantage new entrants may face in industries that have multiplant firms. As an additional factor, established multiplant firms may be perceived as more likely to initiate selective price reductions when entry or expansion occurs in markets where price discrimination is practiced.

These theoretical arguments lead to the following empirical models of the determinants of entry by new domestic firms and the entry or expansion of foreign competitors:

[E.sub.i] = f[X.sub.i] and [M.sub.i] where

[X.sub.i] = [PR.sub.i], [GR.sub.i], [VS.sub.i], [ASR.sub.i], [CR4.sub.i], [SCAL.sub.i], [MULT.sub.i],

i = 1, 1,..., n.

[E.sub.i] represents domestic entry and is measured as the number of new entrants in the i-th industry; [M.sub.i] represents foreign entry and is measured as the increase in imports in the i-th industry; [PR.sub.i] is a profit index; industry growth is captured by [GR.sub.i]; [KSR.sub.i] is capital intensity; [ASR.sub.i] is advertising intensity; [CR.sub.i] represents the four-firm concentration ratio; economies of large scale production are represented by [SCAL.sub.i]; and [MULT.sub.i] is an index of multiplant activity.

III. Data and Results

The sample used in this study consists of four-digit manufacturing industry data for the years 1972 and 1977. There are 450 four-digit manufacturing industries. Industries were deleted from the sample when observations were not available at the four-digit level. (3) Positive ne tentry occurred in 203 industries over the period covered, while increases in import levels occurred in 242 industries. (4) Data on all variables except ASR and M are from the 1972 and 1977 census of manufacturers; data on the advertising and imports are taken from 1972 and 1977 input-output tables.

Following Orr [1972] and Duetsch [1984] net entry is adopted as the operational definition of domestic entry:

[E.sub.i] = [e.sub.i77] - [e.sub.i72], if [e.sub.i77] > [e.sub.i72].

[E.sub.i] = 0, if otherwise;

where, for example, [e.sub.i72] is the number of firms reported in the i-th industry in 1972. (5) Similarly, foreign entry and expansion is specified as:

[M.sub.i] = [m.sub.i77] - [m.sub.i72], if [m.sub.i77] > [m.sub.i72].

[M.sub.i] = 0, if otherwise;

where, for example, [m.sub.i72] is the value of imports in the i-th industry in 1972.

Following Duetsch [1984], the residuals from regressing industry price-cost margins on capital-sales ratios and advertising-sales ratios are used as profit indices across industries. Profit residuals are used because industry price-cost margins are defined as the ratio of value-added of plants less cost of materials divided by total sales; therefore, they do not account for the cost of capital or out-of-plant expenses like advertising costs. The productivity per worker of large firms relative to the productivity per worker of small firms, SCAL, is used as an index of scale economies and efficiency associated with other specialized factors. (6)

Following Orr [1972] and Duetsch [1984], the logged values for entry (both domestic and foreign), industry size, and capital intensity are used. Entry occurs over the period 1972 to 1977, all pre-entry variables are therefore measured for the year 1972. Variable definitions and means for the two samples are presented in Table 1.

Estimates of the determinants of domestic entry and foreign entry/expansion are presented in Table 2. The results of the domestic entry equation TABLE 1

Variable Definitions and Means
                                                 Mean    Mean
Variable   Definition                            N=203   N=242
   E       Net entry of firms; number of firms   149.66
           in 1977 minus the number of firms
           in 1972
   M       Increase in import levels from                168.2
           1972 to 1977, millions of dollars
   PR      Profit index: the residual of 1972    0.000   0.000
           price-cost margins regressed on
           capital-sales ratios and
           advertising-sales ratios
   GR      Growth: percentage in the value       0.816   0.736
           of shipments from 1972 to 1977
   VS      Value of 1972 shipments, millions     1976.2  1940.0
           of dollars
   KSR     Capital-sales ratio for 1972          0.366   0.386
   CR4     Four-firm concentration ratio         0.391   0.414
           in 1972
   ASR     Advertising-sales ratio for 1972      0.014   0.017
   SCAL    Value-added per employee of the       1.377   1.404
           four largest firms divided by value-
           added per employee of all smaller
           firms, 1972 values
   MULT    Number of plant in 1972 minus         0.360   0.241
           the number of firms in 1972
           divided by the number of firms
           in 1972


are practically the same as those reported by Duetsch [1984]. (7)

The entry of domestic, new firms betwen 1972 and 1977 is positively and significantly related to average industry profitability in 1972, industry growth between 1977 and 1972, and the size of the industry in 1972. Both market concentration and multiplant production in 1972 are

TABLE 2

Determinants of Domestic Entry and Foreign Entry and Expansion (t-ratios in parenthesis)
                               Foreign Entry
Independent   Domestic Entry    & Expansion
Variable          lnE              lnE
Constant           1.254           -1.279
                  (1.992)         (-1.560)
PR                 3.502            -.967
                  (2.784)          (-.581)
GR                  .488             .880
                  (2.438)          (3.091)
1nVS                .480             .628
                  (6.159)          (6.187)
1nKSR              -.281             .385
                 (-1.542)          (1.640)
ASR                 .946           -2.094
                   (.282)          (-.489)
CR4               -3.687            1.294
                 (-8.923)          (2.112)
SCAL                .163            -.015
                   (.674)          (-.052)
MULT              -1.091            -.915
                 (-4.100)         (-2.488)
[R.sup.2]           .52              .19
N                203              242


negatively and significantly related to the entry that occurs over the next five years. The coefficient of the capital intensity variable has the predicted sign, but is not significant at the 10 percent level of confidence. Neither advertising or the economies of scale variable show any statistically significant relationship with dometic entry.

Now turn to the estimated determinants of foreing entry and expansion. The first result that deserves mentioning is the value of R-squared. Our estimated equation explains 19 percent of the variation in increases in imports that occurred from 1972 to 1977. This stands in contract to the very low R-squares reported by Rhoades [1984]. (8)

Increases in imports from 1972 to 1977 are positively and significantly related to industry growth from 1972 to 1977, the size of the industry in 1972, and market concentration in 1972. Import sales appear to grow systematically in high volume, highly concentrated markets.

The only significant, negative determinant of increased levels of imports is the 1972 multiplant production index. There seems to be no statistical relationship between increases in import penetration and domestic industry profitability, domestic advertising intensity, or large firm/small firm labor productivity differentials. This finding suggests that once domestic markets are penetrrated, foreiggn producers expand their shipments in growth markets, even if the lure of profits is lacking.

A comparison of the determinants of entry by domestic frms and entry/expansion of forein firms gives a more general view of entry barriers in affecting market competitiveness. (9) Interestingly enough, pre-entry concentration is inversely related to domestic entry but is positively related to increases in foreign entry or expansion. The implication is that even if market concentration represents factors that result in less domestic entry, the competitiveness of the market may still be maintained since increases in imports tend to be greater in industries with more concentrated market structures.

Growth, industry size, advertising intensity, scale exonomies, and multiplant production incidence have consistent results in both the domestic entry and foreign entry/expansion regressions. Capital intensity is inversely related to domestic entry but is a positive determinant of increased levels of imports across industries, although the latter is significant only at the 15 percent level of confidence. The difference in the capital intensity results may be related to the role that comparative advantage plays in determining trade differentials across industries. A number of international trade studies find that net exports are inversely rrelated to capital intensity across industries, a result that is consistent with the positive sign on capital intensity in the foreign entry model. (10)

IV. Concluding Remarks

Marvel [1980, p. 106] observes that the relation between concentration and import shares is expected to persist even when imports have eliminated monopoly returns earned by U. S. firms. Rather than relying on a cross-sectional relation between current import levels and concentration, this paper directly tests the relationship between concentration and increases in imports across industries.

Consistent with Marvel's observation, it is found that increases in imports are positively related to the level of pre-entry concentration and that this relationship at least partially offsets the negative relationship between concentration and the entry of domestic firms. the expanded model of entry used in this paper implies that an analysis of the role of entry barriers in determining the competitiveness of market structures is incomplete unless both foreign entry and expansion by fringe firms are included in the analysis.

* University of Mississipi and Clemson University, respectively.

(1) Other studies of entry include McGuckin [1972], McDonald [1984, 1986], and Masson and Shaanan [1982, 1986].

(2) Mills and Schumann [1985] show evidence that small firms disproportionately absorb more industry output fluctuations than large firms. their results support the general thesis developed by Stigler [1939] that although large firms may have an efficiency advantage from scale economies, smaller firms may have their own efficiency niche that results from employing production methods that are more amenable to adjusting to demand fluctutations. If that is the case then scale economies might not be related to entry restriction.

(3) Advertising and import levels are drawn from input-output tables. these tables report data at three-digit level for 120 four-digit industries. These industries were not included in the sample.

(4) A list of the industries in each sample is available from the authors.

(5) Data for gross entry is not available across a wide sample of industries. In the two studies that use gross entry, Masson and Shaanan [1982] use a sample of 37 manufacturing industries while MacDonald [1986] uses a sample of 46 food manufacturing industries.

(6) A similar index is used by Allen [1983], and Chappell and Cottle [1985].

(7) An important exception to this statement is the significance of concentration. duetsch notes that it is surprising that concentration was not a significant deterrent to entry in his sample of US industries, but was a significant, negative determinant of entry in Orr's Canadian sample.

(8) Marvel [1980] uses a simultaneous equations model and therefore does not report a value for R-squared.

(9) Since we estimate the relation between increases in imports with lagged concentration the results in table 2 are not directly comparable to the results of prior imports studies that use import shares and concentration levels from the same years.

(10) Stern and Maskus [1981] show that capital intensity is inversely related to net exports in a three digit-industry sample that covers the years 1958-1976.

REFERENCES

Robert F. Allen, "Efficiency, Market Power, and Profitability in American Manufacturing," Southern Economic Journal, 49, 4, April 1983, pp. 933-39.

Richard E. Caves, "Trade Exposure and Changing Structures of U. S. Manufacturing Industries," in A. Michael Spence and Heather A. Hazard, eds., International Competitiveness, Cambridge, MA: Ballinger Publishing Co., 1988.

William F. Chappell and Rex L. Cottle, "Sources of Concentration Related Profits," Southern Economic Journal, 52, 4, April 1985, pp. 1031-37.

Larry L. Duetsch, "Entry and the Extent of Multiplant Operations," Journal of Industrial Economics, 32, 4, June 1984, pp. 477-88.

John C. Hilke and Philip B. Nelson, International Competition and the Trade Deficit, Washington: Federal Trade Commission, 1987.

Howard P. Marvel, "Foreign Trade and Domestic Competition," Economic Inquiry, 18, 1, January 1980, pp. 103-22.

Robert T. Masson and Joseph Shaanan, "Stochastic-Dynamic Limit Pricing: An Empirical Test," Review of Economics and Statistics, 64, 3, August 1982, pp. 413-22.

Robert T. Masson, "Excess Capacity and Limit Pricing: An Empirical Test," Economica, 53, 211, August 1986, pp. 365-78.

James M. McDonald, "Diversification, Market Growth, and Concentration in U.S. Manufacturing,"Southern Economic Journal, 50, 4, April 1984, pp. 1098-1111.

James M. McDonald, "Entry and Exit on the Competitive Fringe," Southern Economic Journal, 52, 3, January 1986, pp. 640-52.

Robert McGuckin, "Entry, Concentration Change, and Stability of Market Shares, Southern Economic Journal, 38, 3, January 1972, pp. 363-70.

David E. Mills and Laurence Schumann, "Industry Structure and Fluctuating Demand, American Economic Review, 175, 4, 1985, pp. 758-67.

Dale Orr, "The Determinants of Entry: A Study of the Canadian Manufacturing Industries," Review of Economics and Statistics, 56, 1, February 1974, pp. 58-66.

Stephen A. Rhoades, "Wages, Concentration, and Import Penetration: An Analysis of the Interrelationships," Atlantic Economic Journal, 12, 2, July 1984, pp. 23-31.

George Stigler, "Production and Distribution in the Short Run," Journal of Political Economy, 47, 3, June 1939, pp. 305-27.

Robert M. Stern and Keith E. Maskus, "Determinants of the Structure of U.S. Foreign Trade," Journal of International Economics, 11, 3/4, November 1981, pp. 207-24.
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Author:Chappell, William F.; Yandle, Bruce
Publication:Atlantic Economic Journal
Date:Mar 1, 1991
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