Competition in transition economies: determinants of price-cost margins in private sector manufacturing in Eastern Europe.

• Author: Hersch, Philip L.

1. Introduction

   Policy makers in both East and West debate whether or not individual entrepreneurs are capable of making a meaningful contribution to the economic transition in Eastern Europe and the Republics of the former Soviet Union. Many argue that the environment is so unlike a market economy that newly created private enterprises formed by inexperienced and untrained "non" -businessmen can't possibly succeed in the transition environment without policies and programs--perhaps a "third way" between socialism and capitalism--specifically designed for these economies.(1) Without these special policies, large state owned monopolies would continue to dominate production and the private sector would not be capable of developing along the lines of a Western market economy. Others argue that once relative prices are liberalized and the macroeconomic environment stabilized the private sector will flourish leaving only the memory of socialist central planing [9; 15; 23]. Whether competitive forces materialize, and how quickly, is critical to the success of policies recommended and supported by international organizations advising the transition economy governments.

   To determine whether or not the private sector in transition economies is behaving anything like that of a well developed market economy, and therefore may be expected to make a significant contribution to the transition process in Eastern Europe, we examine the determinants of price-cost margins in private sector manufacturing of three transition economies: the Czech and Slovak Federal Republic (CSFR), Hungary and Poland.(2) We estimate a fixed-effects model, regressing firm price-cost margins on factors recognized in the literature to be important determinants in traditional market-type economies as well as factors specific to these three economies. We employ micro-level data from an enterprise level study conducted by the World Bank. Our results support advocates of rapid transition, in that the forces of market competition appear soon after the transition to a market economy begins.(3) Economic decisions in the private sector are quickly moving toward market-oriented solutions.

2. The Model

   Central to the traditional study of industrial economics is the role of market structure in influencing market outcomes, particularly market prices.(4) A standard empirical specification is to regress firm (or industry) price-cost margins, (Price-Marginal Cost)/Price, on measures of market concentration, firm market share, barriers to entry and other variables pertaining to market structure. The price-cost margin (PCM) itself is the Lerner index of market power and is postulated to be negatively related to the degree of market competition. Because marginal cost is rarely observable, average variable cost is generally substituted. Under this convention, multiplying PCM by q/q, the dependent variable becomes:

   PCM = (TR - VC)/TR

   = (Revenue - Labor Cost - Materials - Energy)/Revenue.

   Countless studies of Western markets have been undertaken with the results typically still open to interpretation and debate.(5) It is not unusual, however, to find a weak positive effect upon price cost-margins on the part of market concentration when market share is excluded from the regression equation. When market share is added concentration often becomes insignificant, with market share having a strong positive effect. These results suggest that market power effects, if they exist, are at the firm level, and not the result of the collective action of market rivals.(6) Alternatively, the positive effect of market share on PCMs could be the result of greater efficiency--efficient firms have both lower costs (higher PCMs) and greater market shares than their less efficient competitors. Recent work suggests both forces are at work.(7)

   With respect to the present study, pertinent questions to be answered include: 1) Do the standard results apply to the transitional market economies of Eastern Europe? 2) At what stage of market development do competitive forces begin to exert themselves? and 3) What characteristics unique to transitional economies influence price-cost margins?

   To answer these questions, the traditional model is expanded such that:

   PCM = f (Market Structure Variables, Transition Economy Characteristics),

   where the individual explanatory variables are discussed below. Using firm level data, the model is estimated individually for the CSFR, Poland and Hungary, and with the three countries pooled together. In all cases, the model is estimated using ordinary least squares, inclusive of industry fixed effects.

3. The Data Set

   We employ micro-level data from an enterprise level study by the World Bank. Data for each country are taken from three firm level surveys conducted by World Bank researchers in Poland (May 1991), in Hungary (September 1991) and in the CSFR (January 1992).(8) The surveys provide a snapshot of enterprise activities in each country at from 14 (CSFR) to 20 months (Hungary) into the formal transition process. Although still early in the transition process, it is likely sufficient time had elapsed for price liberalization, ownership changes and other policy changes moving the economies away from centrally planned socialism toward market oriented behavior to be apparent.

   The data set consists first of a random sample of firms for each country. These data represent small and medium enterprises (SMEs) as a whole in each country, cover a broad spectrum of manufacturing activities and are quite diverse geographically. A second group of data consists of random samples of SMEs from five specific industries.(9) Each enterprise responded to between 157 and 185 specific questions. For this study we focused on questions relating to determinants of price cost margins. Because of missing data, the sample size for the pooled model is 150.(10)

4. Explanatory Variables

   The cornerstone of most empirical studies of price-cost margins is some measure of market concentration, most often a concentration ratio or the Herfindahl-Hirschman Index. Not surprisingly, the market revenue data needed to construct these measures are not yet available for the countries under study. The World Bank survey, however, did ask the respondents to categorize the number of other firms now producing in their main domestic market as either none, 1-10, 11-50, 51-100, or more than 100.(11) We use these characterizations to proxy the number of domestic competitors as perceived by the firm managers. Four percent of the sample indicated they had no other competitors. However, even barring import competition, it would probably be incorrect to classify these firms as true monopolists. Most likely, the products of these firms are highly differentiated, but not unique.

   Preliminary regressions failed to reveal any statistical difference between 51-100 and more than 100 firms. Consequently, the five categories were collapsed into three dummy variables: [D.sub.c1] = 1 if the firm indicated it had no rivals and zero otherwise, [D.sub.c2] = 1 if the firm had between 1 and 10 rivals, and [D.sub.c3] = 1 if the firm had between 11 and 50 rivals. If traditional competitive forces are at work all three variables should have positive coefficients, when compared to markets with more than 50 firms. Further, if competitive forces increase monotonically with number of competitors, the ordering of the respective coefficients should be [D.sub.c1] [is greater than] [D.sub.c2] [is greater than] [D.sub.c3].

   Of course, fewness of rivals could understate competitive pressures if entry beers are low. Because the firms are small in terms of absolute size, it might be expected that entry would be relatively easy. This would be true if capital were readily available, but virtually all the firms in the sample cited access to capital as one of the major problems facing their business. From a pragmatic standpoint, access to capital is probably the major hindrance to new firm formation in these countries. Although one might suspect a difficulty in obtaining government permits to be another potential barrier, virtually no firms stated this to be a problem.(12)

   As noted earlier, studies on the determinants of price-cost margins in Western markets also include market share as an explanatory variable. Since aggregate market data (e.g., sales)...