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IncrementalMarkups–ACriticalReviewofTheoryandPractice
CommentsonAnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry‐LBNL‐
52791
SummaryInthepaperAnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry(MarkupPaper)theauthorsproposeto“calculatethechangeinfinalconsumerpricesdoetominimumefficiencystandardsfocusingonastandardeconomicmodel.”1Theyfurthergoonto“findthattheratioofmanufacturerpricetofinalconsumerpricepriortoastandardtendstoexceedtheratioofthechangeinmanufacturerpricetothechangeinfinalconsumerprice”.Or,moresimply,thatthemarkupthroughthedistributionchannelgoesdownfollowingachangeinapplianceefficiencystandards.TheUSDepartmentofEnergy(DOE),insettingminimumapplianceefficiencystandards,thenusesthisIncrementalMarkup.Thisanalysisreliesonamodelofindustrybehaviorbasedonperfectcompetitionasanormativestandard,i.e.thedistributionprocessforairconditioningandheatingequipmentwillfunctioninthefutureaspredictedbytheperfectcompetitionmodel.Forthistobecredibleandusefulforfutureprojectionsbypolicymakers,theproposedmodelmustmeetallofseveralconditions:
Applicability:alltheconditionsoftheperfectcompetitionmodelmustbemet Exclusivity:noothermodelwithdifferentprojectionscanbeapplicable Sufficiency:thereisenoughdataforthemodel Accuracy:theprojectionsfromthemodelaredemonstratedtobecorrect
Inthispaper,wewillshowthatnoneoftheseconditionsapply.Thereisanalternativemodelofindustryorganizationthatcharacterizesthedistributionprocessforairconditioning,andheatingequipmentthatbetterfitstheactualoperationofthemarket.Thisraisesquestionsabouttheapplicabilityandexclusivityofaperfectcompetitionparadigm.Inaddition,theliteratureonindustrystructureandprofitsamplydemonstratethatnomodelhasstrongpredictivepowerandthatallsuchmodelshavemajordataflawsquestioningboththeirsufficiencyandaccuracy.
1Dale,Larry;Millstein,Dev;Coughlin,Katie;VanBuskirk,Robert;Rosenquist,Gregory;Lekov,AlexandBhuyan,Sanjib:AnAnalysisofPriceDeterminationandMarkupsintheAirConditioningandHeatingEquipmentIndustry,LawrenceBerkeleyNationalLaboratoryLBNL‐52791,January2004,Abstract
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Assuch,theproposaltousetheIncrementalMarkupanalysisfailsnotone,butalloftheconditionsandshouldnotserveasthebasisforpolicyprojections.ThereisnoaprioritheoreticalsupportfortheDOEpositionthatmarginswill,infact,convergetosometheoreticalvalue.Inaddition,DOEproposesnoevidencetoshowthatmarginsormarkupsdo,infact,behaveinthismanner.Inthispaper,wewilldevelopanalternativetheoreticalexplanationforwhymargins/markupsneednotconvergeandforwhyfirmscouldearnprofitsbeyondtheirlong‐termcostofcapital.Second,wewillshowthatactualpricingbehaviorbyheatingventilatingandairconditioning(HVAC)distributor/wholesalerandcontractorsisconsistentwithconstantmarkupsacrossallproductsandthatthesemarkupshaveremainedstableovertime.Thecombinationoftheoreticfoundationandactualexperienceindicatesthattheuseofasingle,standardmarkupforbothbaseequipmentandincrementalcostadditionsistheappropriatebasisforforecastingfuturecosts.DistributionChannelsandSegmentsforResidentialAirConditioningandHeatingProductsBeforedelvingintoadiscussionoftheunderlyingeconomictheory,itwillbehelpfultounderstandthedistributionchannelsandend‐customermarketsegmentsforairconditioningandheatingproducts.ThisisespeciallythecasesincetheultimateusebyDOEofmarkupsthroughthedistributionchannelistoprojectactualpricespaidbyend‐usersforairconditioningandheatingequipment.TherearethreebroadsegmentsoftheHVACindustry:
Residential(includingfurnaces,airconditionersandheatpumps–thereisaparallelprocessforboilersthatisnotincluded)
CommercialUnitary(includingsinglepackageairconditionersandheatpumps)
Applied(includingchillersandrelatedairhandlers)Whilethereissomeoverlapinchannelsandcustomersacrossthesesegments,thisisaconvenientbreakdownthatiswidelyusedintheHVACindustry.TheproductsintheAppliedsegmentarelargelynotcoveredbyDOEefficiencystandardsandarenotpartofthisdiscussion.Toputthesesegmentsintoperspective,theResidentialsegmentincludesapproximateannualproductionof3‐4millionairconditionersandheatpumpsand3milliongasfurnaces.TheCommercialUnitarysegmentincludesapproximateannualproductionof200‐300thousandairconditionersandheatpumps.ResidentialTheResidentialsegmentislargelycomprisedofwarmairfurnaces(electric,gas,oilorotherfuels)andsplitsystemairconditionersandheatpumps.Theseproductsare
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principallyusedinhomes,althoughsomeoftheseproductsareusedinverylightcommercialapplications.TheyaresoldthroughDistributor/WholesalerstoinstallingHBACcontractorsandtheneitherdirectlytohomeownersortoremodelersorhomebuilders.TheResidentialsegmentincludesapproximatelyxxxmillionsplit‐systemcondensingunitsandheatpumpsandxxxmilliongas,electricandoilfurnacesannually.Distributor/Wholesaler/Contractor‐ResidentialDistributionofresidentialairconditioningandheatingequipmentmovesthroughtwolargelydistinct,butsuperficiallysimilar,channels:
Manufacturer‐aligneddistributorsand Multi‐manufacturerwholesalers
Mostofthelargerairconditioningandheatingequipmentmanufacturershavecloseddistributionfortheirprincipalnamebrands(Carrier,Trane,York,Lennox,etc.)intheresidentialsegment.Forthesenamebrands,themanufacturerhasdistributorswhosellvirtuallyonlythatnamebrandofequipment(plusancillarysuppliesandsomecomplimentaryspecialtyitems).Lennoxgoesastepfurtherandsellsresidentialscaleequipment.Thesedistributorsadvertisethenamebrandandhavesomeequityintheirlocalterritoryandmanufacturerrelationship.Mosthavegeographicterritoryagreementsofsomeform.Inturn,agroupofcontractorsalignwiththedistributor/manufacturerpair,usuallyreferredtoas“dealers”.Thedealersadvertisetheiralliance,oftenaspartoftheirname,andpurchasethevastbulkoftheirequipmentfromasingledistributorinthischannel.Whiledealerscanswitchtheiralliance,thisisaslowandcostlyprocessrequiringre‐brandingthedealer,switchingliterature,changingcreditarrangements,cleaningoutinventoryandretrainingtheinstallationandservicestaff.Basedontheestimated2008marketsharesbymanufacturerquotedbyDOE,thecompanieswithaligneddistributionhave62‐68%marketsharesforgasfurnaces,heatpumpsandcentralairconditioners.2Thissomewhatoverstatesthetotalpercentofthemarketusingaligneddistributionsincethesemanufacturersalsohavesomebrandstheysellthroughthealternativechannel.Thealternativechannelissalesthroughmulti‐manufacturerwholesalerswhocarryairconditioningandheatingequipmentfrommultiplemanufacturers.Thesewholesalershavesomewhatgreaterflexibilityinswitchingthemanufacturertheyrepresentorthepercentofsalesbetweenseveralmanufacturers.Inturn,non‐dealeraffiliatedcontractorsoftenpurchasefromthesenon‐alignedwholesalers.Thesecontractorshavegreaterflexibilityinselectingamanufacturerforanygivenprojectandmayhavemoreflexibilityinselectingbetweenwholesalers.Thischannelhastheremainderofthefurnace,heatpumpandairconditionermarket.
2USDepartmentofEnergy,TechnicalSupportDocumentEERE‐2011‐BT‐STD‐0011‐0012,June2011
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EndUser–ResidentialAttheresidentialenduserlevel,therearethreeprincipalsegments:emergencyreplacement,largehomeownerprojectsandproductionbuilders(salesofairconditioningandheatingequipmenttothemobilehomearenotcoveredbythissegment).Replacementsalesarepurchasesbyhomeownerstoreplaceexistingheatingorairconditioningequipment.Mostoften,theseareforfailedunitswhereimmediatereplacementisnecessary.Largehomeownerprojectsincluderemodelingofanexistinghomeorconstructionofanewhomewherethehomeownerwhowill(ordoes)occupythehomeisanintegralpartoftheconstructionprocess.Productionbuilderscoverresidentialdeveloperswhobuildhomesregularlyforresaletohomeowners.Eachoftheseindividualsegmentshasadifferentsetofdecisionmakersand,therefore,adifferentmixofcriteriaforselectingairconditioningandheatingequipment.Intheemergencyreplacementsegment,thehomeowneristhepurchaserandselectsacontractorwhoactuallyprovidesandinstallstheheatingorairconditioningsystem.Thereisalmostalwaystimepressuretofindandinstallthereplacementunit,limitingthehomeowner’sabilitytoshopandtorequestproposalsfrommultiplecontractors.Inaddition,thehomeownerpurchasesairconditioningandheatingequipmentinfrequentlysothehomeownerisrarelyfamiliarwiththesuppliers,thealternativeheatingandcoolingoptionsorthelikelycostofasystem.Thehomeownerisatasubstantialdisadvantagetothecontractorsinthedegreeofinformationabouttheprice,qualityorothermattersinvolved.Itisalsotypicalforthehomeownertogetapackagepriceincludingalllabor,equipment,supplies,etc.,sothehomeownerhasnorealinsightintothepriceofequipment.Thehomeowneroftendoesnotselectthelowestpricewithactualselectiondependingonperceivedquality,speedandotherfactors.Incidentally,contractorsinthissegmentalsohavelittleinsightintotheircompetitors’pricingsincetheyonlyrarelyseethecompetitorsproposals.Eveniftheydoseecompetitorpricing,itistypicallyonlyatotalincludingbothlaborandmaterials.Inthelargeprojectsegment,thehomeownerisdealingwithahomebuilderorremodelingcontractorwhoservesasanintermediarywiththeairconditioningandheatingsubcontractor.Virtuallyallofthecharacteristicsofthepurchaseprocessherearedifferentfromthatofemergencyreplacement,otherthanthehomeowner’sgenerallackofknowledgeandfamiliaritywithairconditioningandheatingequipmentandthatthepurchaseisforasinglehouse/project.Thehomebuilderorremodelingcontractorgenerallyselectstheairconditioningandheatingsubcontractorbasedonacombinationofprice,reliability,relationshipandthelike.Thehomeownermayormaynotbegivenachoicebetweendifferentcontractors,manufacturers,efficienciesorotheroptions.Theairconditioningandheatingsubcontractortypicallyquotesatotalinstalledpricetothehomebuilderorremodelingcontractor.
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Intheproductionbuildersegment,thehomebuilderistheprincipaldecisionmaker.Thehomebuilderconstructsanumberofhousesaspartofasingleprojectandsolicitsbidsforthetotalpackageofhomes.Iftheprojectisbigenough,themanufacturerordistributor/wholesalermaybecomeinvolvedtoquoteaspecialequipmentprice.Thisistheonlysegmentwherethereisreasonableparityofinformationbetweenthepurchaser(thehomebuilder)andtheremainderofthedistributionchannel(contractors,distributors,manufacturers).Eachpartyinthisprocessdealswiththeotheronaregularbasisandthehomebuilderhastheopportunitytocheckpricesforequipmentacrossvariousmanufacturersandcontractors.Thesizesofthesegmentsfluctuatewiththeeconomyandthenewconstructioncycle.Onalong‐termaverage,theemergencyreplacementsegmentisapproximately50%ofairconditioningandheatingshipments.Largehomeownerprojectsrepresentapproximately30%ofshipmentsandproductionbuildersrepresenttheremaining20%.CommercialUnitaryTheCommercialUnitarysegmentislargelycomprisedofsinglepackageairconditionersandheatpumps(commonlyreferredtoas“rooftop”units).TheseuseadirectexpansiontechnologysimilartoResidentialproductsandCommercialUnitaryproductstypicallyhavegreatercapacityandcombinetheevaporatorandcondensercoils,fansandcompressorsinasinglecabinet.Distributor/Wholesaler/Contractor–CommercialManufacturersofCommercialUnitaryairconditionersandheatpumpsusetheirResidentialdistributor/wholesalerchannelforCommercialUnitaryequipment.Inaddition,somemanufacturerssupplementtheResidentialdistributor/wholesalerchannelwithmanufacturer‐ownedofficesandindependentsalesrepresentativeswhohandleAppliedequipment.AbreakdownbetweentheResidentialdistributor/wholesalerandtheAppliedofficechannelsisnotavailablealthoughthemajorityofsalesaretocontractorsspecializinginpackagedairconditioningequipmentandsheetmetalductingratherthantocontractorsspecializinginAppliedchillersandpiping.Thedistributor/wholesalermakeupoftheCommercialUnitarysegmentisalmostexclusivelymadeupofaligneddistributors.MostoftheresidentialHVACmanufacturerswhousenon‐alignedwholesalershaveaminorpresenceinthecommercialsegment.Ingeneral,becauseoftheirprotectedgeographicterritoriesandtheiralignmentwithspecificcontractors,distributorsareinapositiontoprovidemoreserviceandsupporttocontractorsthandowholesalers.ThisserviceandsupportisnecessaryforCommercialUnitaryequipmentbecauseofthegreaterengineeringrequirementsformanycommercialprojects,theinclusionof
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accessoriesorvariationsintheequipmentorder,thecomplexitiesofjob‐sitedeliveryandthegreatercreditexposureforlargerjobs.Smallercommercialprojectstendtobedonebycombinedresidential/commercialHVACcontractorswhoaretraditionallyaffiliatedwithadistributorandmanufacturerbrand.Theservicesofferedbythedistributorareimportanttothosecontractorsandhelppromoteaffiliation.Manyofthesecontractorsalsohaveactiveservicebusinessesdoingroutinemaintenanceandsmallupgradesandrepairsforregularend‐usecustomers.Largercommercialprojects(bothUnitaryandApplied)fallintotwomajorsegments:planandspecandvalueengineered.Whilecontractorsmaydoboth,thosewiththeskillsnecessarytodovalueengineeringtrytofocustheirbusinessawayfrompanandspecwork.Inplanandspecprojects,thegeneralcontractor(or,occasionally,theowner)issuesasetofdetailedspecificationsandasksmultiplecontractorsforquotes.Typicallythelowestbidsetsthepricefortheproject,althoughthecontractoractuallyawardedtheprojectmaynothaveoriginallybeenthelowestbidder.HVACcontractorsoftenrequestspecialquotesforequipmentfortheseprojectsbecauseoftheircompetitivenature.Itiscommonforthedistributor(ormanufactureriftheprojectisbigenough)toputoutapriceforthejobpackagedtoallaffiliatedcontractorsbiddingthatjob.Thissegmentistheonlytrulypriceclearingone,withvisiblebiddingpatternsandrelativelyvisiblepricing(althoughdissemblingontheactualfinalpriceofaprojectisnotuncommon).Asaresult,thissegmentcanbehighlycompetitiveandmostcontractorstrytoavoiditwhenatallpossibleThevalueengineered(sometimesreferredtoasdesign‐build)segmentincludescontractorsandprojectswheretheHVACcontractorworkswiththegeneralcontractororownertodesignasystemmeetingtheproject’sneeds.Thisapproachisoftenfasterthanthemulti‐stepdesign,plan,bid,buildprocessofplanandspecwork.Itoftencanresultinbothlowercostsforthejobandhighermarginstothecontractorbecauseofspecialknowledgeandconstructionexpertise.Pricinginthissegmentisalmostalwaysforatotalinstalledpackagewherethebreakdownoflabor,materials,equipmentandmarginsisobscuredfromthecustomer.Thechoiceofcontractorisusuallybuiltuponpastrelationshipsandtheperceptionofcompetitiveprice.Itisnottypicaltobidtheprojecttomultiplecontractors,althoughtheremaybegeneraldiscussionandbudgetideasfromseveralcontractorsbeforethefinaloneisselectedtodotheactualdesignandpricing.EndcustomersforCommercialUnitaryequipmentvaryfromsmallretailcompaniestomulti‐facilityowningchainsanddevelopers.SmallerendusersareverysimilartoresidentialcustomersinthattheypurchaseHVACequipmentrarelyandhavenorealideaofthemarketplaceandtheexpectedpriceorotherfactorsforaproject.Theymaketheircontractorselectiononthelocalrelationship,perceptionofquality,timingandperceivedvalue.Largercustomersareinthemarketplacemore
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frequentlyandmayhavegreatervisibilityintotheexpectedpricelevelsinthemarket.However,theactualselectionofcontractorsisfrequentlybasedonacombinationofpriceandawidevarietyofotherfactors.Pricingisalmostalwaysforcompletepackageswithoutseparatepricingforindividualitems,suchasequipment.EconomicTheoryIntheMarkupPaper,theauthorsbasetheirargumentontheeconomictheoryofperfectcompetition:“(the)basicmodelassumesperfectcompetitionandconstantmarginalcostcurves.”3Thecoreimplicationoftheargumentisthatthereisnoabilityfortheaggregateoffirmstoearnprofitsabovethenormalcostofcapital.Asaresult,allsellersinaggregatewillonlybeabletoraisepricestoincorporatetheirvariablecosts:“Thismodelofmarkupdeterminationinthecaseofperfectcompetitionandconstantcostsimpliesthattheincreaseinfinalpricethataconsumerseeswillequalthosechangesincostsassociatedwiththeincreasingcostofagood.”4Fromthere,theauthorsproposemethodstoestimatetheincrementalcostsandcomputeanincrementalmarkup.
Theargumentandtheconclusionsdependonthepropositionthatfirmsinaggregateareconstrainedinsomemannersothattheycannotearnprofitsabovetheirnormalcostofcapital.Theauthorsrecognizethisintheirdiscussionof“ImpactofMarketPoweronMarkups”5wheretheyconcedethattheirproposedmethodofcalculatingmarkupsfailswhena“firmfacesinelasticresidualdemand”,i.e.whenacompanyorgroupofcompaniescancontinuetoincreasesalesand/orincreasepricessothattotalrateofreturnincreasesbeyondthenormalcostofcapital.
Asonewouldexpectofafundamentalconceptineconomics,therehasbeenconsiderablediscussionintheliteratureoverthetheory,theapplicabilityandthecalculationofsupplyanddemandfunctions.TheswingingpendulumbetweenthebeliefthatmarketsaremostlycompetitiveornotiscurrentlyswingingawayfromperfectcompetitionwiththerecentNobelawardtoJeanTriolefortheinfluxofgametheoryintotheoperationofmarkets.6
Thebasicnotionbehindperfectcompetitionisthatthereisastableprice/volumepointwhereconsumersarepurchasingasmuchastheywantandsuppliersaremaximizingtheirprofits.Nopurchaserorsuppliergainsanadvantagebydeviatingfromthispointbecausethepurchasercannotbuyforlessorthesuppliercannotsellformore.Fromthesuppliers’standpoint,anysupplierwouldlooseallitsbusinessifitraisedpricesbeyondthisstablelevel.Inconcepttheconditionsforsuchamarket
3Daleet.alia.p14ibid.p35ibid.pp6‐86Foradiscussionoftherise,fallandriseofnon‐marketbasedideasintheoreticaleconomics,see:www.economicprincipals.com/issues/2014.10.19/1658.html
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include:7
Manyfirms,eachsmallinrelationtothemarket,andwithlong‐runaveragecoststhatbegintoincreaseatascalesmallenoughtoensurethepreservationofcompetitionamongmanyfirms;
Nobarrierstoentryorexit; Manybuyers,eachaccountingforasmallshareofdemand; Perfectinformation; Homogeneousproducts; Single‐productfirmsonly; Noindivisibilitiesorimmobilitiesinthefactorsofproduction; Easysubstitutabilityamongfactorsofproduction; Noexternalitiesinproductionorconsumption.
ThequestionsfacingtheMarkupPaperare,thus:
Question1:Underwhatcircumstancesdoestheperfectcompetitionparadigmapplyinrealsettings?
Question2:Howmanyorwhichoftheconditionsforperfectcompetitionmustexistfortheconclusionsabouttheinabilitytoraisepricesabovevariablecosts8tohold?
Question3:Dothenecessaryconditionsapplyinthecaseofanyspecificindustryunderanalysis?
Question4:Inwhatcircumstances(ifany)isthereevidencethatfirmscanachieveprofitsinexcessoftheirvariablecosts?
Question5:Doanyoftheconditionswherethereisevidenceofpricingabovevariablecostsapplytoaspecificindustry?
Clearlytodrawanynormativeconclusionsormakeanypredications,questionnumber3abovemustbetrueandquestionnumber5mustbefalse.
ExampleofPerfectCompetitionandItsLimits
Anexamplemaybehelpfultoprovidesomecontextonwhatamarketarguablymeetingtheperfectcompetitionconditionsisandhowrestrictivethoseconditionsare.Themarketforstockstradedonmajorexchangesisaboutasclosetoaperfectlycompetitivemarketasonecanimagine.Theproducts,sharesofstock,areessentiallycommodities,therearehugenumbersofbuyersandsellers,thereareessentiallynobarrierstoentryorexitandtherearerulesdesignedtoensureperfectinformation.Inaddition,modernfinancialtheoryhasdevelopedtoolsandconcepts
7ThisparticularlistcomesfromPeterF.Fisher;TheStrangeCareerofMarginalCostPricing,JournalofEconomicIssues,Vol.XXIVNo.4December1990,althoughtherearemultiplesimilarversions.8Alldiscussionsofvariablecostusetheeconomicdefinitionincludingthecostofcapital,notacommonlanguagedefinition
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tomeasuretheprecisevalueofinterest:financialreturn.9Allavailableempiricalevidencesupportstheconclusionthatperfectcompetitionorsomethingveryclosetoitoccurs.Thereisessentiallynoevidencethatinvestorsinwidelytradedcommonstockscanearnreturnsabovethatindividualinvestor’sriskweightedcostofcapital.10
However,ittakesonlyasmallstepawayfromthepublicstockmarketbeforetheconclusiononexcessreturnsdisintegrates.Empiricalstudiesofhedgefunds,notjustindividuallybuteveninaggregate,haveshownpositiveexcessreturns(orpositivealphas).11Statisticalstudiesofhedgefundmanagersshowpositivealphasof3.7%peryearupto1.25%permonthandthatpositivealphaspersistovertime.Thesearesubstantialreturnsrelativetothe5‐6%annualreturnmeasuredfortheUSstockmarketasawhole.Economictheorysaysthataninfluxofnewentrantswillarbitrageawaythesereturns,butsofarthereisnoevidencethatthisishappening(thereturnsdonot,however,gotoinvestors–mostarecapturedbyfundmanagerfees).
Whatthisdemonstratesisthebrittlenatureoftheassumptionsbehindperfectcompetitionandthenotionthatprofitabovecostsofcapitalarenotpossible.Thefactthatonefinancialmarketmayexhibittheexpectedcharacteristicsfromcompetitiondoesnotimmediatelyextendtoarelatedone.Applicabilityinonefinancialmarketdoesnotextendtoanother.Thepowerofanalogyisweak.Anyclaimthatperfectcompetitionexistsmust,therefore,beproveninthespecificmarketplaceinquestion.Analogyisnotenough.
EmpiricalSupportfortheModelofPerfectCompetition
Onecriticaltestofanytheoryiswhetherityieldstestablehypothesesandwhetherthosehypothesesare,infact,true.Likethefinancialmarketsituation,thepredictionfromtheperfectcompetitionhypothesisisthatfirmsbothindividuallyandinaggregatewillnotbeabletoearnprofitsbeyondtheircostofcapitaloveranyextendedperiodoftime.Thedataonthistopicishighlyequivocalfortworeasons.First,thereissignificantquestionabouttheavailabilityandaccuracyofthedatanecessarytoperformtheanalyses.Second,theresultsshowthatthereappeartobenumerousconditionswherefirmsdo,infact,earnconsistentprofitsabovethecost
9TheCapitalAssetPricingModel(CAPM)anditssuccessorvariantsdefinereturninrelationtovariabilityversusamarketcomposite(Beta)andexcessreturngeneratedbyinvestorskill(Alpha).Thisissomethingofasimplificationbutisreasonableforthediscussionhere.Theliteratureonthistopicisvast.
10Again,theempiricalliteratureontheabsenceofexcessreturnsinbroadlytradedstockmarketsisvoluminous.Thispaperwilltakethatconclusionasgiven.
11Stultz,RenéM.;HedgeFunds:Past,PresentandFuture,OhioStateFisherCollegeofBusiness,FisherCollegeofBusinessWorkingPaperSeries,February2007,providesaliteraturereviewofstudiesonhedgefundreturns.Thedatainthisstudyprecedethefinancialcrashof2008.ThecontinuedprofitabilityofthetradingoperationsatfirmslikeGoldmanSachsandthecontinuedexistenceofsomelargehedgefundsinthefaceofDarwinianfocusonperformanceprovideatleastanecdotalevidencethatsuperiorperformancecontinues.
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ofcapital.Atbest,theavailableevidencesaysthattheremightbesomecircumstanceswheretheperfectcompetitionhypothesisholdstruebutthatthedatacertainlydoesnotsupportastatementthatthehypothesiswillnecessarilyholdtrueinall,orevenmost,situations.
Thefirstconsiderationisthedataquestion.Thecompleteapproachtotesttheperfectcompetitioneconomicreturnhypothesiswouldbetotakerateofreturnoncapitaldatafromallfirmswithinanindustryandanalyzethosereturnsoveranextendedperiodoftime.Asapracticalmatter,thisapproachhasnotbeenpossible.First,realcompaniesoftenhavemultiplelinesofbusinessandboththeperfectcompetitiontheoryandtheexamplefromcapitalmarketsshowthatthedefinitionofanindustryneedstobeverynarrow.Soitisnotatallclearthatrelevantdataexists,eveninprinciple,totestthehypothesis.Analystshavegenerallyresortedtovariousgovernmentdatasetsatwidelyvaryinglevelsofindustryandfirmaggregation,allwithsignificantlimitations.
Thesecondconsiderationistheactualresultsofthestudiesonprofitability.Studiesforfirmandindustryprofitabilityhaveinvestigatedwhetherfirmsize,industryconcentration,effectsofscaleindependentoffirmsize,effectsofadvertisingandotherfactorsleadtodifferencesinprofitability.Inaddition,manyofthestudiesseektounderstandwhetherindustryconditionsorfirmspecificelementshavethegreatesteffectsonprofitability.
Fortheperfectcompetitionmodeltobetrueasamatterofrequirementforfuturebehavior,allofthesestudieswouldneedtofindthattherewasnovariationintherisk‐adjustedrateofreturnunderanycircumstances.Eachindividualcompanyandtheindustryasawholeshouldallearntherisk‐adjustedrateofreturn.Onthecontrary,thebulkofthestudiesfindtheopposite.Awiderangeoffactorscancauseindividualfirmstodivergefromexpectednorm.Forexample:
CollinsandPrestonestablish,inastudyof418fourdigitSICcodesintheUSCensusofManufacturersfor1958and1963,thatindustryconcentrationbearsonprice‐costmarginsandalsofindthattherearesubstantialvariationsinresultsbetweenconsumerandproducergoodsmanufacturersandbetweenhighandlowdifferentiationconsumergoods.Inaddition,concentration,geographicdispersionandcapital‐outputratiohaveonlylimitedexplanatorypowerforprofitability,implyingthatthereisavariationinprice‐costratioandthatthisvariationremainsunexplained.12
GortandSingamsettifindthatthereisessentiallynorelationshipbetweentheindustryafirmisinand/orthelevelofconcentrationintheindustryonprofitabilityfor507manufacturingcompanies.13
12Collins,NormanR.andPreston,LeeE.Price‐CostMarginsandIndustryStructure,TheReviewofEconomicsandStatistics,Vol.51,No.3(August,1969)pp.271‐286
13Gort,MichaelandSingamsetti,Rao;ConcentrationandProfitRates:NewEvidenceonanOldIssue,ExplanationsinEconomicResearch,Volume3,Number1,NationalBureauofEconomicResearch,1976
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Porterfinds,inastudyof42consumergoodsindustriesthatprofitabilityoffirmsinanindustrycanvarysignificantlydependinguponthestrategicgroupafirmbelongsto.Thisstudydefinesgroupsasleadersandfollowers,althoughPorterrecognizesthattherecouldbemanyotherfactorsthatcouldcreateagroup.14
Ravenscraftfindsthatprofitabilitybylineofbusinessisnotrelatedtoindustryconcentrationandisrelatedtofirmmarketshareforasampleof3186linesofbusinessinmanufacturingfirmsin1975.Themultivariablemodelforprofitabilityatthelineofbusinesslevelhaslowexplanatorypower,withanR2of20%orlower.15
Schmalensetestsforfirm,industryandmarketshareeffectsonprofitabilityandconcludesthatindustrystructure(concentration)hasthegreatesteffectalthoughthisaccountsforonlyapproximately20%ofthetotalprofiteffect.ThesampleincludeslineofbusinessresultsforUSmanufacturingcompanies.16
Schmalensealsoteststhenotionofindustryconcentration(characteristicoftheindustrymatters)versusfirmefficiency(marketshareofthefirmmatters)andfindsthatindustrymattersmorethansharealthoughneitherexplainsmuchofprofitbehavior.Thesamplecoverstwoyearsandthestatisticalresultsdiffergreatlybetweentheyears.Inaddition,therangeofprofitsarelargeinthedatasample,withonestandarddeviationat±30%plus,indicatinglargedifferencesinprofitabilityacrossfirms.17
CubbinandGeroskifindthat“mostfirms’profitabilityexperiencediffersconsiderablyfromthoseoftheirclosestrivals”basedonasampleof217largeUKfirmsovertheperiodof1951‐1977.Inadditiontheyfindthattherearefirmswithinindustriesthatseem“toinhabitmarketnichesbetterprotectedthanthoseonaverageintheirindustry”andthatthereis“evidencepointingtowardsthenotionthatreturnsarenotequalizedacrossallfirmsandsectorseveninthelongrun.”18TheyalsonotethattheirfindingsarenotentirelyconsistentwithSchmalense’s.
RobertHallmeasuresthe“markupratio”ofvalueaddedandconcludesthatthe“hypothesisofcompetitionisrejected”.19StefanNorrbinquestionsthesefindingsformanufacturingindustriesbutdoesfindseveralindustrieswith
14Porter,MichaelE.;TheStructurewithinIndustriesandCompanies’Performance,TheReviewofEconomicsandStatistics,Vol.61,No.2(May1979)pp214‐227
15Ravenscraft,DavidJ.;Structure‐ProfitRelationshipsattheLineofBusinessandIndustryLevel,TheReviewofEconomicsandStatistics,Vol.65,No.1(February1983),pp22‐31
16Schmalense,Richard;DoMarketsDifferMuch?,TheAmericanEconomicReview,Vo.75,No.3(June1985)pp341‐351
17Schmalense,Richard;CollusionVersusEfficiency:TestingAlternativeHypotheses,TheJournalofIndustrialEconomics,Vol.35,No.4pp399‐425
18Cubbin,J.andGeroski,P.;TheConvergenceofProfitsintheLongRun:Inter‐FirmandInter‐IndustryComparisons,TheJournalofIndustrialEconomics,Vol.35,No.4,June1987,p427andp436
19Hall,RobertE.;TheRelationbetweenPriceandMarginalCostinU.S.Industry,JournalofPoliticalEconomyVol.96.No.5(October1988),p939
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positivemarkupratios,atthetwodigitSIClevel,suchasforMachineryandStone,ClayandGlass.Thereisalsosubstantialvariationinmarkupratioacrossindustriesimplyingthatnoteachindustryearnsonlyeconomicratesofreturn.20
BhuyanandLopezdemonstratethatoligopolyconditionsprevailinvariousfoodandtobaccoindustriesatthefourdigitSIClevelintermsof“welfarelosses”relativetoperfectcompetition.21
HolianandRezainvestigatethedifferenteffectsofaccountingversuseconomicprofitdataonprofitabilityfor331firmsinaSternStewartdatabasefortheyears1989‐2003.Theyfindthatfirmeffectsaremoreimportantthanindustryonesalthoughneitherhasverystrongcorrelationforaccountingprofits(adjR2=.168)whileeconomicprofitdatahasconsiderablygreaterexplanatoryvalue(adjR2=.504).22
Thisisonlyasmatteringoftheempiricalworkondeterminantsonindustryandfirmprofitability.
Basedontheempiricalevidence,itisnotpossibletosaywithanyconfidencethatanindustry,collectionoffirmsorlineofbusinesswithstructureAwillhaveprofitcharacteristicsB.AttemptstocreategeneralprinciplesacrossanyorallformsofA,Bremainilldefined.
ImplicationsforAssessmentofCompetitioninaSpecificSituation
ReturningtotheQuestionsposedabove,theanswertoQuestion1,thegeneralapplicabilityoftheperfectcompetitionparadigm,isthatsuchapplicabilityisnotgenerallysupportedbytheempiricaldata.Inaddition,theanswertoQuestion2,underwhatcircumstancesisitapplicable(orhowcanitbemodifiedtobecomeapplicable),isthatwedonotknow,againbasedontheempiricalevidence.Severalhypothesesremainineffectonwhatdeterminesprofitabilityandnonehasverystrongexplanatorypower.
MichaelSpencesummarizesthedilemmaindiscussingcontestablemarkettheory:
Asstudentsofmicroeconomictheoryknow,theconditionsunderwhichperfectlycompetitiveoutcomesarelikelyorpossibleareratherstringent.Theconditionsincludeconstantordiminishingreturnstoscale,orscale
20Norrbin,StefanC.;TheRelationbetweenPriceandMarginalCostinU.S.Industry:AContradiction,JournalofPoliticalEconomyVol.101.No.6(December1991),p1162
21BhuyanSanjibandLopez,RogobertoA.;WelfareLosesUnderAlternativeOligopolyRegimes:TheU.S.FoodandTobaccoManufacturingIndustries,JournalofAgricultureandAppliedEconomics,27(2),December.1995,p582
22Holian,MattandReza,Ali;FirmandIndustryEffectsinAccountingversusEconomicProfitData,EconomicsBulletin,vol.30(3)pp2189‐2196,2010.Note:SternStewartisacommercialcompanyadvocatingtheuseofeconomicvalueanalysis.Theauthorparticipatedintrainingforacompetingsysteminthelate1980sandcanattestthattheconversionfromaccountingprofitiscumbersomeandnotamenabletogeneralusedespitethegreateraccuracyfoundinthisstudy.
13
economiesthataresmallinrelationtothesizeofthemarket.Fornormativepurposes,theabsenceofexternalitiesatthelevelofcostsisalsoessential.
Perfectcompetitiontheoryservestwofunctionsineconomics.Itissometimesareasonableapproximationtorealityinthedescriptivesense,andperhapsmoreimportantlyitisawelfarestandard.Intheabsenceofexternalities,perfectlycompetitiveequilibriaareParetooptimal.Theproblemisthatsuchequilibriadonotexistincertainmarketenvironments.Andevenwhentheydo,itissometimeshardtobelievethatthecompetitivemodelaccuratelydescribeswhatistakingplace.23
Anyattempttoapplyperfectcompetitiontheorytoaspecificsituationneedstodemonstrate,foreachandeverysituation,thatalloftheunderlyingassumptionshold.Thereisverylittletonoevidencethatthisoccursintherealworld.Aresorttoanalogyhasnoempiricalandlimitedtheoreticalsupportasameansorpredicatingprofitabilityfromoneindustrytoanother.
AlternativetoPerfectCompetitionTheory
Thestringentformofperfectcompetitionrequiresabinaryanswertotheunderlyingassumptions.Eithertheseassumptionsaretrue,inwhichcasetheperfectcompetitionmodelholds,ortheyarenotanditfails.Asapracticalmatter,asSpencepointsout,thesituationisrarelythatblackandwhite.OneresponsehasbeenthePorterFiveForcesModelthatlooksatthefactorsaffectingcompetitionandprofitabilityascontinuums.24Theconceptualexplanatorypowerofthisconceptiswellrecognizedandaidsintheunderstandingthatcompetitionisnotbinary.However,theseforcesarenotcontinuousvariables.Itisnotpossibletobuildametricevaluatingeachoftheseforcesandthencalculatethedegreetowhichanindustryisorisnotcompetitive.25TheimplicationsofthePorterapproachpartiallyexplainthedifficultyinfindingempiricalrelationshipsinactualindustrydata.
23Spence,Michael;ContestableMarketsandtheTheoryofIndustryStructure:AReviewArticleContestableMarketsandtheTheoryofIndustryStructurebyWilliam.J.Baumol,JohnC.Panzar,RobertD.Willig,JournalofEconomicLiterature,Vol.21,No.3(September1983),pp981‐982
24Porter,MichaelE.;HowCompetitiveForcesShapeStrategy,HarvardBusinessReview,March,197925Acolleagueoftheauthor’sattemptedsuchanexerciseinthelate1980sasapartofastrategymethodologyandabandonedtheattemptasbothquestionableintheoryandunrealisticallycomplexinpractice.
14
ApplicationofMarkupTheoryintheAirConditioningandHeatingIndustry
TheauthorsoftheMarkupPapercontendthattheperfectcompetition(lowmarketpower)modelappliesinthecaseofthedistributionchannelsforairconditioningandheatingequipment.Theirsupportforthisis:
1. Thelargenumberofparticipantsatthewholesaleandcontractorlevels262. ReferencetotheNorrbinstudy(above)27–notetheNorrbinstudynowhere
mentionsanyindustriesotherthanmanufacturingsoitsapplicabilityinthissituationisnotobviousandtheNorrbinstudydoesnotactuallyclaimthatindustriescanbepresumedcompetitive
3. Unsupportedstatementthatwholesaleandretailappliance(sic)marketshavelowbarrierstoentry28
4. Analysisofwholesalermarkupsacrossstateswheretheyfindaconstantmarkupof1.3929
Nowheredotheauthorsperformanyactualempiricalanalysisofcompetitiveconditions,profitormargintrendsineitherthewholesaleorthecontractingsectors.Asdiscussedlater,thestate‐by‐stateanalysisisactuallymorecompatiblewithalternativetheories.
Sotheauthorsareresortingtoelementsofeconomictheorythathavenoempiricalsupportasactualdeterminantsofprofitlevelsinindustry.Aswehaveseen,thereislittleornoevidencethatindustrystructurecharacteristicssuchasnumberofparticipantsorentrybarriersactuallycorrelatewithprofitability.TheirresponsetoQuestion3,applicabilityoftheory,issimplyassertion.Thisishardlysufficientinthefaceoftheoryanddataquestioningtheperfectcompetitionhypothesestodemonstrateinanyconvincingfashionthattheirconceptsapply.
AlternativeExplanationinHVAC
Sincetheempiricalconditionsdonotallowabstract,aprioriapplicationofempiricaltheoryinspecificsituations,anyprocessofestimatingmarkupsinanindustrymustlookatthefactsforthatsituation.Questions4&5abovebecomerelevant:Arethereconditionsthatcouldimplytheopportunityforfirmstopriceaboveriskadjustedeconomicprofitandarethoseconditionsmoreorlesslikelytoapplyinthissituationthanaretheassumptionsforperfectcompetition?
Inthecaseofthedistributionchannelforairconditioningandheatingequipment,Porter’sconceptofstrategicgroupmakessense,providingatheoreticalfoundation
26Daleet.al.p127ibid.p928ibid.p9,notethatthemarketsinquestionareforairconditioningandheatingequipmentnotappliances,althoughthismaysimplybeamatterofinadvertentusage
29ibid.p10
15
forpredictingprofitpatterns.Analysisofactualpricingpracticesbyindustryparticipantsshowsthattheyarenotconsistentwithaconceptofincrementalmarkups.Theactualdataonmarginsisincomplete,withthedatathatexistssuggestingthatfirmsmanagetomaintainconsistentmarginsovertimeandacrossbusinesscycles.
Thecombinationofthetheoreticalfoundationandtheempiricaldataindicatesthatthefuturepricingbehaviorthroughouttheairconditioningandheatingdistributionchannelisnotlikelytofollowincrementalmarkups,aspositedintheMarkupPaper,andismorelikelytocontinuefollowingpastpatterns,inthiscaseconsistentaveragemarkups.
Attheleveloftheory,thetwodistinctsegmentsatthewholesalelevel:manufacturer‐aligneddistributorsandmulti‐manufacturerwholesalersarestrategicgroupsasdefinedbyPorter.ThebasicconceptisthatthecompetitiveconditionsunderthePorterfiveforcesaredistinctbetweenthegroups.Therefore,theremaybecircumstanceswheretheconditionsdonotrequireareversiontotheprofitresultsexpectedunderperfectcompetition.30Porterspecificallydiscussesmobilitybarrierswhichpreventfirmsfromenteringagroupeitherfromoutsidetheindustryorfromwithintheindustrybutoutsidethegroup.Portergoesontopositthatthepresenceofmobilitybarriersprovide“anexplanationforwhysomefirmsinanindustrypersistentlyearnhigherprofitsthanothers”31Porteralsodiscussesinter‐firmrivalrynotingthatmarketinterdependencewilltendtopromoterivalrybuttotheextentthatfirmsarecompetingforcustomersindifferentsegments,thiswilltendtodiminishrivalry.32Itisapparentthatthemanufacturer‐alignedchannelofdistributorsandtheirassociatedcontractorsformastrategicgroupinthePortersenseinsidethebroaderairconditioningandheatingdistributionprocess.Moreover,thelocalnatureoftheairconditioningandheatingdistributionprocess(contractorshaveverysmallgeographicrangeandaligneddistributorshaveassignedterritories)effectivelycreatemyriadlocalgroupsofaligneddistributorsandcontractors.Theapparentlackofconcentrationinthechannel,impliedbythelargenumberoffirmsis,infact,achimeraandmissesthemoreconcentratednatureofthelocalizedgroups.
Inordertoestablishthatthemanufactureralignedstrategicgroupcanhavetheopportunitytoearn“consistentlyhigherprofits”,itmustbeclearthattheoverallcompetitiveintensityofthegroupislowerthanfortheremainingindustry:
1. Mobilitybarriers
30 Whilenotdiscussedhere,thereisampleevidencethatprofitresultsabovelevelspredictedunderperfectcompetitioncanoccurwithoutcollusion.Nothinginthisdiscussionshouldbetakentoimplythatcollusionorothersimilaractivitiestakeplaceatanystageoftheairconditioningandheatingindustries.
31Porter,StructureWithinIndustryandPerformance,p21632ibid.p218
16
2. Threatofsubstitutes3. Powerofcustomers4. Powerofsuppliers5. Internalrivalry
Firstmobilitybarriersintoandwithinthemanufacturer‐alignedgrouparerelativelyhigh.Distributorshavedistributionagreementswiththemanufacturertowhichtheyarealignedthatlimittheabilityofnewdistributorstocomeintoalocalmarket.Similarly,bothresidentialandcommercialcontractorshavemoreandlessformalrelationshipswithasinglealigneddistributor.Itisnotinamanufacturer’sinteresttofloodaneffectivedistributor’sterritorywithanewdistributionentrant.Whilethismightincreasetotalsales,theinvestmenttoenroll,trainandsupportadistributorishigh.Encroachmentonadistributor’sterritoryalsoproducesloud,vigorouscomplaintsfromallthemanufacturer’sdistributorswhobelievetheyhaveanequityinterestintheirterritory.Similarly,therearelimitstothenumberofcontractorsanaligneddistributorwillchoosetosupport.Eachcontractorrequirestraining,certificationandotherinvestment.Thedistributorwillattempttomanageitsportfolioofcontractorssothatthereiseffectivebutnotexcessivecoverageoftheterritory.Thethreatofsubstitutesintheairconditioningandheatingindustryis,essentially,nil.Thechannelforairconditioningandheatingequipmentcarriesvirtuallyalltheproductsthattypicallymeetthecomfortconditioningneed.Insmallregionsofthecountry,thereissomesubstitutionbetweenwarmairheatingandboilers,whichuseaseparatechannel,butthisisinsignificantonanationalscale.Thepowerofcustomersforthemanufacturer‐alignedchannelisalsorelativelylowsincemuchoftheresidentialmarketisinemergencyreplacementsegment.Herethecustomeristhehomeownerwhoisataverydistinctdisadvantagerelativetothecontractor.Purchasesareinfrequent,pricingisopaque,timepressureishightomakeadecision,andqualityishardtodiscern.Allofthesecombinetogivethecontractorconsiderablepowerrelativetothehomeowner.Littleofthecommercialmarketisinplanandspecworkwherecustomerpowerisrelativelyhigh.Customerpowerremainsweakintheothercommercialsegments.Conversely,thepowerofthemanufactureratleastappearstoberelativelyhighsincethealigneddistributorshavenorealoptions.Inpractice,theneedtokeepthetotalchannelsatisfiedtendstolimitthemanufacturer’spower.Fromagametheoryperspective,theserelationshipsareoneswhichcontinueandwherethe“game”isplayedrepeatedly.Thistendstoproduceasolutionthatissatisfactorytoallpartiesratherthanencouragingthemanufacturertoexercisepowerandextractallofthevalue.33
33Theauthorhasobservedandparticipatedinmanufacturer/distributornegotiationsintheairconditioningandheatingindustryandinsimilaronesfromtheperspectiveofbothsides.In
17
Finally,therivalrybetweenfirmsismoderate.Contractorscomplainbitterlyandoftenabouthowhighlycompetitivetheirmarketis.Thisisverytrueintheproductionbuilderandplanandspecsegmentswheredemandfluctuatesgreatlyandthehomebuilder,generalcontractororlargecommercialownerhaveconsiderablepower.However,theobjectivelevelofinternalrivalrybetweencontractorsdeclinesintheothersegments.Contractorsrarelyknowthecomparativepricelevelofferedbytheircompetitorsandpriceisrarelythedecidingfactorinthesensethatlowpricedoesnotnecessarilywinajob.Thecriticalactivityforacontractorinthissegmentistogetinvitedtopropose.Sorivalryismorelikelytotaketheformofadvertisingandpromotionthanpricecompetition.Allofthisiscontraststhemanufacturer‐alignedsegmentwiththegeneralone.Inthebroadermarketatthecontractorlevel,entrybarriersarelowandthepowerofthecustomerstartstoincrease.Howeverthethreatofsubstitutesisstilllowandthepowerofthemanufacturerdeclinessincethecontractoroftenhaschoicebetweenbrandsatasinglewholesalerandhasmoreflexibilitytochoosebetweenmultiplewholesalers.Atthewholesalerlevel,customerpowerisrelativelyweekastherearealargenumberofcontractorsandveryfewmakeupasignificantportionofthewholesaler’sbusiness.Thepowerofthesupplierismoderatesincewholesalershaveconsiderableinvestmentininventoryandsalesliterature,etc.soswitchingispossiblebutnoteasy.Thereremainsnoeffectivethreatofsubstitutes(infactthethreatfromboilersislowesthereasmanycarryboilers).InternalrivalryisrelativelyhighastheInternetandotherfactorshavetendedtomakepricingmoretransparentincreasingthepotentialforcompetitionbetweenwholesalers.Insum,thedistributionprocessforairconditioningandheatingequipmentcontainstwostrategicgroups:themanufacturer‐aligneddistributorsplustheirassociatedcontractorsandthemulti‐linewholesalersandtheremainingcontractors.Thecompetitiveintensitiesofthetwosegmentsaredifferentleadingtoalikelyinferencethatthemanufacturer‐alignedchannelhasthepotentialtoearnconsistentlyhigherprofits–economicprofitsthatwouldnotbeexpectedtobeatorgotozeroasrequiredundertheperfectcompetitionmodel.TheanswerstoQuestions4&5areyesandyes.ActualPricingandMarkupPracticesShoreyConsultingconductedasurveyofHVACdistributor/wholesalersandHVACcontractorsinNovember2014todeterminetheactualpricingpracticesofbothgroups.Thepurposewastoascertainwhetherpricingwasforapackageofproductsandserviceswhereairconditionersandheatpumpsmightbeasmallcomponentofthetotalpriceandhowthedistributor/wholesalersandHVACcontractorsactuallydeterminedtheirmarginstructure.
general,eachsideinthenegotiationhasascribedsignificantbargainingpowertotheotherirrespectiveoftheactualsituation.
18
Theresultsofthatsurveycanbestbesummarizedbyonedistributor,whorepliedwhenpresentedwiththeDOEconceptofincrementalmarkupsasadescriptionofactualpractice:“thatisthestupidestideaIhaveeverheard.”Bothdistributor/wholesalersandHVACcontractorsmanagetoconstanttargetmarginpercentagesacrosstheirwholebusinessesanddonotvarymarginsforindividualproducts.Theyallrespondthatmanufacturerpriceincreases(orraredecreases)arepassedthroughwiththeirtraditionalmarkups.Distributor/WholesalerFordistributor/wholesalers,thecommonpracticeistoworkoffalistpricesheetandthengiveastandarddiscounttoacontractor.Theamountofthediscountmayvarybetweencontractorsdependingonhistoricalpurchasingvolumeorotherfactors,withthediscountisconsistentacrossallproducts.Theremaybecircumstanceswhereindividualprojectsgetspecialpricing,oftenwithconcessionsfromthemanufacturer,butthisisinexceptionalsituations.Thedistributor/wholesalerthenmanagesthebusinesstopreservemarginpercentage.Wheneverthedistributor/wholesalerseesapriceincrease,thisincreaseispassedthroughtocustomerswiththestandardmargin:“Anytimewehaveapricingincrease,weabsolutelypassitontothedealer.Alldaylong,wepassthecostontotheconsumer.Whenweseea30/40%increase,sodothey.”“Wealwayslookatmarginpercentage,neverabsolutedollars.Manufacturerscometousallthetimewithpriceincreases.Onceweagreeonapricefromthemanufacturerweputitinourpricesheetatalevelthatwillpreserveour%margin.Ifwehavethesensethatthemanufacturersareallraisingtheirpricestogetherbecauseofgovernmentregulationsorwhatever,wesimplymarkuptheincreasetoholdourmarginandpassitontoourdealers.Thedealersareallmargindriven,too.That’salltheycareabout.So,intheend,theconsumerpaysforallincreases.”“Oursoftwaresystempublishesourmargineveryday.Weliveandbreathemargin.Oursalesrepsareincentedarounddollarsofrevenue,butourtopmanagementteamisincentedaroundgrossmargins.”Thusthepricingprocess(listpriceswithstandarddiscounts),managementbehavior(focusonmaintainingpercentagemargin)andpastpractices(passingthroughpriceincreaseswhilemaintaininghistoricpercentagemargin)areconsistentwithaconstantmarginforbothbaseequipmentandforincreasedcostsduetoefficiencyimprovements.Thereisnoindicationorsupportforthenotionthatfuturemarginpercentageswilldeclinewithincreasedequipmentpricestomaintainconstanteconomicprofit.Rather,managementinformationsystemsandperceivedfirmeconomicsarealignedwithmaintainingastableaveragemarginovertime.Contractor
19
ThemanagementprocessesforHVACcontractorsaresomewhatdifferentfromdistributor/wholesalers,yettheactualstabilityofmarginsisthesame.Thetypicalcontractorprocessistoestimateallthecostsofajobandthenaddastandardmargin.Thismayormaynotbetheactualbidpricefortheproject,whichisbasedonwhatthecontractorthinksthejobwillsellfororonafinalpricenegotiation.Thereisnodifferentialmarkupforeachpieceoftheproject(equipment,sheetmetal/piping,additionalsupplies,buy‐outitems,labor,etc.).OnelargecommercialHVACcontractorcommented:“Weaddupallofourcostsandhopethattheycomeoutbelowthepriceneededtowin.Ifwecan,wevalue‐engineertheprojecttolowerthetotalcost.Ourmarginiswhatisleftover.Hopefullyitispositive.Thegoalincontractingistofindnichesandprojectswhereyoucanmakeyourtargetmargin.”CommercialHVACcontractorshaveabsorbedsignificantcostincreasesinthepast,yethavemaintainedconsistentmargins.EstimatedtotalinstalledcostofacommercialHVACprojectdependsuponwhetherductworkisincluded.Formostprojects(newconstructionandremodeling),ductworkisanintegralpartoftheproject.Onlyindirectreplacementofafailedunitisductworkexcluded.Theincrementalcostsfora7.5tonairconditionerattheproposedstandardlevelarebetween12%(includingductwork)and26%(excludingductwork).Thecostincludingductworkfora7.5tonprojectisapproximately$15,000(2003)34whileDOEestimatesthetotalinstalledcostofapproximately$8,000(2013)excludingductworkandanincreasedinstalledcostofapproximately$2200.35Thecostofsheetmetal,themajorcomponentofthecostofductworkhasundergonesignificantpricevariations,ofteninshortperiodsoftime,increasing13%duringtheconstructionseasonof2004and9%duringtheseasonof2008.36Thecontractorsinterviewedforthisstudyhadnochangeintheirpricingormarginpracticesasaresultofthisductworkpricefluctuation.OneofthekeyreasonsforthestabilityofmarginsinHVACcontractingisthattheestimatingapricingproceduresarebasedontoolsthathaveonlyasinglemarginforanentireproject.Forexample,themajorestimatingandproposalprogramsponsoredbythecontractors’tradeassociationhasonlyasingle,standardmarkupfield.37ItwouldbeincrediblydifficulttocreateandimbeddedadifferentialmarkupforHVACequipmentrelativetoallotheraspectsofaprojectwithasinglemarkupfieldintheestimatingandbiddingprocess.Contractorsandthedevelopersofthe
34StateofMichigan,StateTaxCommission,2003STCAssessor’sManual,Volume2,UIP3,Page435DOETSDEERE‐2013‐BT‐STD‐0007‐0027,Table8.2.11,Volume8p.15(note:theDOEcostincreasesarebasedonthedisputedmarkupsand,thus,understatetheactualcostincrease)
36USBureauofLaborStatistics,ProducerPriceIndexWPU107337Right‐SuiteTMsponsoredbytheAirConditioningContractorsofAmerica(ACCA),www.wrightsoft.com
20
estimatingprogramalsoreportthatthemarginfieldtendstobepopulatedwhentheprogramisinstalledsothatthemarginpercentageisnevervaried.Incrementalmarginsthatvariedfromstandardpracticewouldrequiremajor,complexandunlikelychangesincontractorbehavior.EmpiricalEvidenceforConsistentMarginsTheempiricalevidenceonmarginsatboththedistributor/wholesalesandcontractorlevelsintheairconditioningandheatingchannelislimitedbothintimeseriesandincoverage.Whatevidencethereisindicatesthatgrossmarginsremainremarkablysteadyovertime.Anidealanalysisofmarginbehaviorwouldincludelongitudinaldataonmarginsbyproductlineforwholesalersandbylaborversusequipmentforcontractors.Nothingclosetothislevelofdataexists.ThereissomeUSCensusBureaudatathatprovidesandindicationofcontractorandwholesalermarginsovertimeinfive‐yearintervals.Inaddition,therearepubliclytradedwholesalersinplumbingandrelatedfieldsthatcanprovidesomeproxyinformation.Unfortunately,noneofthedataisavailableinadisaggregatedformthatcorrespondstothetwostrategicgroups.TheCensusdataforwholesalersandcontractorsiscontainedintheEconomicCensusofWholesaleTradeandofConstructionconductedeveryfiveyearsintheyearsendingin2and7.Thisdatacontainsgrossmarginsforwholesalersandvalueaddedmarginsforcontractors.TheCensusdataforwholesalersisavailableforairconditioningandheatingwholesalers(NAICS42373,SIC5075)from1992onand,atahigherlevelofaggregation,forNAICSHardware,Plumbing,AirConditioningandHeating(NAICS4237,SIC507)from1977.TheCensusdataforPlumbing,AirConditioningandHeatingcontractors(NAICS23820,SIC1711)isavailablethrough1977.Itisalsopossibletocreateaproxyforcontractorgrossmarginbysubtractinglaborfromvalueaddedtogetagrossmarginoverlaborandmaterials.Allofthedatashowpatternsofconsistentgrossmarginsovertime.TheCensusdataforwholesalersshowsstablemarginsacrossthefive‐yearperiodsexceptfortheslightdipin1997(Figure1).ThecompositeofpubliclytradedIndustrialandBuildingMaterialsWholesalersshowsasimilarsetofpatterns(Figure2).FurthertheMarkupPaperconsidersgrossmarginsforwholesalersin1977acrossstatesandfindsthemtobequiteconstant.Sincewholesalerstendtooperateinlimitedgeographicterritoriesanddonotcompetewithoneanother,theconsistencyacrossstatesprovidesadditionalindicationofacommonsetofpricingpractices.Thesemarginsholdtrueacrosseconomiccycles(1982wasaveryweakyearforhousing,1977and2002werestrongonesand19987,1992,1997and2007wereaboutaverage.)Allofthisdatasupportsthepropositionthatthereisastablepatternofgrossmargins.ThemodelproposedintheMarkupPaperwouldhavepredictedthatmarginsdeclinedin2006withtheadventofthelatestresidentialairconditionerstandardsand,clearly,thathasnothappened.
21
Marginsforcontractorsshowsimilarconsistency.Thevalueaddedmargin(RevenuelessValueAdded÷Revenue,whereValueAddedisRevenueless
22
purchases,essentiallylaborandprofit)remainsstableoverthe30‐yearperiodexceptfortheanomalyin2002(Figure3).
Themostrecent(2005)studyoftheairconditioningcontractingindustryinitiallyquotedbyDOE38alsosupportstheexistenceofstablegrossmarginsovertime.TheGrossMarginforResidentail/LightCommercialandCommercial/Industrialcontractors(theclosestproxytoinstalling,notservicecontractors)was32.32%in1994and33.73%in2004.39ConclusionsTheUSDepartmentofEnergyusesmarkupsinordertodeterminethefinalcosttoconsumersofnew,moreenergyefficientproductsthatresultfromminimumefficiencystandards.TheMarkupPaperproposestoconvertfromanaveragemarkuptoanincrementaloneforthehighercostsoftheefficiencyimprovements.Thesupportforthisdecisionisanappealtomicroeconomictheoryandanobservationonthenumberofairconditioningandheatingwholesalersandcontractors.However,theMarkupPapertakesatheoreticalmodelofperfectcompetition,withsubstantiallimitsonitsapplicability,andwithnoempirical
38Daleet.al.B‐639AirConditioningContractorsofAmerica(ACCA),FinancialanalysisfortheHVACRContractingIndustry,2005Edition,2005.Washington,DC
23
supportintheparticularcaseofairconditioningandheatingwholesalersandcontractors(oranyempiricaldataoutsideofmanufacturers)andclaimsapplicability.
Question IncrementalMarginConcept
AverageMarginConcept
Question1:Underwhatcircumstancesdoestheperfectcompetitionparadigmapplyinrealsettings?
Generalapplicabilitynotsupportedbyempiricaldata.Applicabilitymustbeprovedineachspecificsituation.
Applicabilityofperfectcompetitionnotnecessary.Historicalexperienceisasubstitute.
Question2:Howmanyorwhichoftheconditionsforperfectcompetitionmustexistfortheconclusionsabouttheinabilitytoraisepricesabovevariablecoststohold?
Rulesforwhenandunderwhatcircumstancesperfectcompetitionmodelapplieshavenotbeendevelopedordemonstratedempirically.Applicabilitymustbedemonstratedcasebycase.
Notnecessary
Question3:Dothenecessaryconditionsapplyinthecaseofanyspecificindustryunderanalysis?
EmpiricalproofofconvergenceofactualprofitstoeconomiccostofcapitalnotprovidedbyDOE.Simpleresorttoindustryconcentrationhasbeendemonstratedempiricallynottocorrelatewithprofitconvergence.
Notnecessary
Question4:Inwhatcircumstances(ifany)isthereevidencethatfirmscanachieveprofitsinexcessoftheirvariablecosts?
Notnecessary TheoryofStrategicGroupsprovidesalternativeexplanationofbehavior,positingcircumstanceswhereprofitsabovethecostofcapitalcanbesustained.
Question5:Doanyoftheconditionswherethereisevidenceofpricingabovevariablecostsapplytoaspecificindustry?
Actualpricingbehaviornotanalyzed.
Empiricaldatashowsstablemarginsovertime.Actualpricingpracticesasreportedbydistributor/shoelsaersandcontractorsconsistentwithaveragemargins.
24
Thispaperdemonstratesthelimitationsoftheperfectcompetitionmodelandtheempiricalevidencethatperfectcompetitioncannotbeassumedtooccurinpracticesothatanaprioriassumptionofperfectcompetitionisunwarranted.Inaddition,thispaperprovidesanalternativetheory,StrategicGroups,thatfitstheactualoperatingconditionsatboththewholesaleandcontractorlevel.Theempiricalevidenceforbothwholesalersandcontractorsshowsthattheymaintainaveragemarkupsconsistentlyacross30‐yeartimehorizons,implyingconsistencyinpricingpractices.Theactualpricingandestimatingbehaviorinbothindustriessupportsaconclusionthatincrementalmarkupsareanunlikelyresult.Therefore,theMarkupPaperdoesnotsupporttheuseofincrementalmarkupsinthefaceofmorecompellingtheoryandactualempiricalbehavioralandfinancialresults.ContinuingtouseincrementalmarkupsinDOEanalysesoftheHVACindustrynowfliesinthefaceofboththeoryandempiricalevidence.