RoyaltyStat Blog

Oligopoly Profit Markup

Posted by Ednaldo Silva

Quem mostrá esse caminho longe? Sung by Cesária Évora (1941-2011).

Corporate profits should concern policymakers, including tax legislators and tax administrators.

In economic theory, high profits converge toward an entrepreneurial average because of the expected inter-industry flow of investments. According to Stigler’s (1963, p. 54) hyperbole: “There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries.”

Reality is not abiding to economic romantics (like Stigler).

Despite longstanding anti-trust institutions, economic concentration and the existence of oligopolies are facts of life.

An adverse effect of oligopolies is the persistence of high profit markups (or high profit margins), that is, the non-convergence of high profit ratios towards the romantic profit of enterprise equality in all industries.

In this blog, I selected a group of 29 major US corporations engaged in researching, producing and distributing chemicals and allied products (including pharmaceuticals) and show that their operating profit markup is high and stable over 70 years. I created the relevant dataset using the canonical criteria:

     a) Standard Industrial Classification (SIC): 2800-2891;

     b) Country of Incorporation: United States;

     c) Operating Profit Before Depreciation (OIBDP): Positive from 1950 to 2019.

Subsets of companies within this group can show that corporations producing and distributing pharmaceuticals report extremely high profit markups. [Companies with such public influence showing persistent high profit markups should be regulated like utilities.]

Operating profits would be higher than the reported accounts if research and development (which create “trade” intangibles such as patents) and detailing and advertising expenses (which create marketing intangibles such as trademarks and customer lists) become capitalized on the company’s balance sheet. See OECD (2017), ¶ 6.7. 

Profit Markup

I estimated the profit markup per company by using an econometric model that can be traced to Cournot in 1838. See Stigler (1957), footnote 19.

My interest in studying corporate profits started in 1986, inspired by the published research of Mueller (1986, 1990). However, Mueller utilized a first-order autoregressive model that breaksdown if the regression slope coefficient is close to one. See Goldberg (1958), § 2.4 (Linear first-order difference equations) regarding the mathematical properties of a first-order autoregressive model. 

Another disadvantage of the first-order autoregressive model, adopted by Mueller (1986, 1990) and his research colleagues, is that this model lacks economic content because it can be converted into a series of moving average random errors.

As praxis, I use Standard & Poor’s Global (Compustat) data, we let revenue R = REVT, total cost C = XOPR, and operating profit before depreciation P = OIBDP (same account as EBITDA).

Total cost (XOPR = COGS + XSGA) is the sum of the cost of goods sold (COGS) and selling, general and administrative expenses (XSGA).

To simplify exposition, I have not adjusted COGS to remove the effect of the change in inventory profit or loss to make the accounting concept of COGS more consistent with the microeconomic concept of variable cost.

The Compustat annual company data are distributed under paid subscription in the RoyaltyStat website, to which I have added important online transfer pricing analytical tools, including the regression function that produced the calculations written on the table below.

I combined the specified Compustat mnemonics to obtain:    

     (1)      R = C + P

     (2)      P = µ R + U, where µ is the profit margin and U is a random uncertainty. 

     (3)      R = λ C + V

where the profit markup λ = (1 − µ)−1 and V = (1 − µ)−1 U.

After estimating λ using regression analysis, the profit margin can be obtained by indirect least squares (ILS):   

     (4)      µ = (λ – 1) / λ.

See https://blog.royaltystat.com/transfer-pricing-methods-based-on-operating-profits

The table below shows the operating profit markups of the selected 29 companies in alphabetical order, and the bar chart shows the operating profit markups sorted from high to low. I do not report the intercept because they tend to be insignificant.

The t-Statistics of the profit markup (λ) are corrected by using the Newey-West algorithm. See Zeileis (2004) and Hill, Griffiths & Lim (2018), § 9.5.2 (HAC [heteroskedasticity and autocorrelation consistent] Standard Errors), pp. 448-450.

Tax authorities should monitor the persistence of high oligopoly profits to establish a group ceiling as a test of reasonableness of inter-group transfer pricing adjustments. The US group ceiling is equivalent to taxing the combined (country consolidated accounts in which intra-group transactions are eliminated) US operating profits before a reasonable allowance for depreciation.

References

Carter Hill, William Griffiths & Guay Lim, Principles of Econometrics (5th edition), Wiley, 2018 [2007].

Dennis Mueller, Profits in the Long Run, Cambridge University Press, 1986.

Dennis Mueller (editor), The Dynamics of Company Profits (An International Comparison [Canada, France, Germany, Japan, United Kingdom, United States]), Cambridge University Press, 1990.

Samuel Goldberg, Introduction to Difference Equations, John Wiley, 1958. 

OECD, Transfer Pricing Guidelines (2017). https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm

Tibor Scitovsky, Papers on Welfare and Growth, George Allen & Unwin, 1964. (P. 202: “I should like to recall to you the meaning of oligopoly power. We think of competition as a force that tends to eliminate [excess] profits; and of monopoly or oligopoly power as something that restrains competition and thereby prevents the elimination of [excess] profits. Oligopoly power, therefore, is the power to restrain competition.”)

George Stigler, “Perfect Competition, Historically Contemplated,” Journal of Political Economy, Vol. 65, No. 1 (Feb., 1957). Stable URL: http://www.jstor.org/stable/1824830?origin=JSTOR-pdf

George Stigler, Capital and Rates of Return in Manufacturing Industries, Princeton University Press, 1963.

Achim Zeileis, “Econometric Computing with HC and HAC Covariance Matrix  Estimators,” Journal of Statistical Software, Vol. 11, Issue 10, November 2004. Accessed: https://www.jstatsoft.org/article/view/v011i10/v11i10.pdf

 

Company Name

GVKEY

Count

λ

t-stat

R2

All 29 Companies

 

1881

1.3586

43.3872

0.9815

Air Products and Chemicals Inc.

1209

70

1.3400

45.1324

0.9945

Ashland Global Holdings Inc.

1794

70

1.0566

124.0298

0.9961

Baxter International Inc.

2086

70

1.3117

48.946

0.9938

Bristol-Myers Squibb Co.

2403

70

1.4102

54.2729

0.9913

Cabot Corp

2593

57

1.1651

87.0562

0.9972

Clorox Co

3121

54

1.2853

159.4298

0.9991

Colgate-Palmolive Co.

3170

70

1.3711

50.0528

0.9924

DuPont De Nemours Inc.

4060

70

1.1555

46.9211

0.996

Ecolab Inc.

4213

70

1.2610

161.9278

0.9997

Eli Lilly and Co.

6730

59

1.4229

53.9455

0.9954

Ferro Corp.

4622

70

1.1020

98.3928

0.9976

FMC Corp.

4510

70

1.1794

45.1686

0.9873

Grace (W R) & Co.

5250

69

1.1252

121.311

0.9962

H.B. Fuller Co.

4926

58

1.1475

108.2036

0.9992

Hexcel Corp

5608

52

1.2652

37.2879

0.9943

Hexion Inc.

2316

70

1.1147

84.6132

0.998

International Flavors & Fragrances Inc

6078

62

1.2622

131.0352

0.9985

Johnson & Johnson

6266

70

1.4854

77.6124

0.998

Merck & Co Inc.

7257

70

1.4602

24.2782

0.9878

NewMarket Corp.

4462

70

1.2063

114.9475

0.9965

Olin Corp

8123

66

1.1694

83.9577

0.9974

Pfizer Inc.

8530

70

1.7125

85.1361

0.996

PPG Industries Inc.

8247

70

1.1843

104.0561

0.9982

Procter & Gamble Co.

8762

69

1.3262

107.8185

0.9974

RPM International Inc

8902

51

1.1455

354.3292

0.9998

Sensient Technologies Corp

11012

52

1.2296

104.1957

0.997

Sherwin-Williams Co

9667

59

1.1946

76.2684

0.9989

Stepan Co

10056

60

1.1036

101.6541

0.9988

Union Carbide Corp.

10857

65 

1.1087 

54.8202 

0.985 

Profit Markup of 29 Companies

 

Published on Sep 8, 2020 4:53:00 PM

Ednaldo Silva (Ph.D.) is founder and managing director of RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

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Topics: OECD Profit Indicators