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Tobin's q

Another measure of performance, Tobin's q, is the ratio of the market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets (Tobin 1969). This measure of performance is not used as often as either rates of return or price-cost margins. If a firm is worth more than its value based on what it would cost to rebuild it, then excess profits are being earned. These profits are above and beyond the level that is necessary to keep the firm in the industry.

The advantage of using Tobin's q is that the difficult problem of estimating either rates of return or marginal costs is avoided. On the other hand, for q to be meaningful, one needs accurate measures of both the market value and replacement cost of a firm's assets.

It is usually possible to get an accurate estimate for the market value of a firm's assets by summing the values of the securities that a firm has issued, such as stocks and bonds. It is much more difficult to obtain an estimate of the replacement costs of its assets, unless markets for used equipment exist. Moreover, expenditures on advertising and research and development create intangible assets that may be hard to value. Typically, researchers who construct Tobin's q ignore the replacement costs of these intangible assets in their calculations. For that reason, q typically exceeds 1. Accordingly, it can be misleading to use q as a measure of market power without further adjustment.

The following table reports some of the measured values of q for some U.S. industries. The median value, 1.35, exceeds 1. Thus, either price is typically above competitive levels or these estimates of q are biased upward due to measurement problems.

Average Tobin's q, 1960-76

Industryq
Photo equipment
Chemicals
Food products
Tobacco
Apparel
Primary metals
Median
3.08
2.40
1.70
1.39
1.13
.85
1.35
SOURCE: Lindenberg, E., and S. Ross (1981). Journal of Business 54:1, © 1981 by The University of Chicago. All Rights Reserved.
It is possible to determine the degree of monopoly overcharge if Tobin's q can be calculated correctly. To do so, one must calculate how much earnings (excluding the return to capital) would have to fall for q to equal 1. For example, let em be the constant annual earnings of a monopoly and ec be the constant annual earnings of a firm under competition. The ratio of the market value of assets to the replacement cost of assets, q, equals the ratio of em to ec. For example, if q equals 2, earnings must fall by one-half before the firm is charging a competitive price.

Tobin's q and Industry Structure. If Tobin's q (the ratio of the market valuation of assets to the replacement cost of assets) is above 1, the firm is earning a rate of return higher than that justified by the cost of its assets. Such a return could not persist in the absence of long-run entry barriers.

Thomadakis (1977), Lindenberg and Ross (1981), Salinger (1984), Smirlock et al. (1984), and others investigate the relationship of Tobin's q to industry market structure. Lindenberg and Ross (1981) find that the q ratios of firms are stable over time and that firms with high q ratios tend to have unique products and factors of production, all of which contribute to earnings in excess of the minimum necessary to induce the firm to produce in the short run. Firms with low q ratios are typically in relatively competitive or tightly regulated industries. Lindenberg and Ross find a high correlation between price-cost margins and q, but a low correlation between q and concentration ratios.

Even if the estimate of q is biased due to measurement errors, it may be possible to analyze the relationship between q and market structure in a regression, as long as one adjusts for the measurement problems by adding variables like the advertising-sales ratio and research and development costs. This procedure is similar to that used in the price-average variable cost regressions.

Salinger (1984) estimates the relationship between q and barriers to entry, industry concentration, and unionization. Salinger makes several important methodological points. First, as Bain (1956) points out, without barriers to entry, there is no reason for market power to arise just because an industry is concentrated. Therefore, a relationship, arising from market power, between q and concentration should be present only when entry barriers exist. Second, if concentration arises because the most efficient firms get large, then there should be a negative effect on price from concentration. Finally, unions may capture any monopoly rents and would reduce the strength of the relationship between q and market power.

Salinger estimates a relationship between q and structural variables:

q = alpha0 + alpha1 (A/(pkK)) + alpha2 ((R&D)/(pkK)) + (1 - alpha3U)C4[alpha4M + alpha5K + alpha6 (A/(pkK)) ] + alpha7C4 + alpha8G,

where the alphai are coefficients to be estimated, A/(pkK) is the ratio of advertising expenditures to the value of capital, R&D/(pkK) is the ratio of research and development expenditures to the value of capital, U is the fraction of the work force that is unionized, M is the minimum efficient scale, and G is the industry growth rate.

Salinger cannot reject the hypotheses that the coefficients alpha4, alpha5, alpha6, alpha7 are zero. Therefore, the data do not support the view that these proxies for entry barriers raise profits. Salinger does find that industries that are growing rapidly earn high returns.

SOURCES:

Bain, Joe S. 1956. Barriers to New Competition. Cambridge, Mass.: Harvard University Press.

Lindenberg, Eric B., and Stephen A. Ross. 1981. "Tobin's q Ratio and Industrial Organization." Journal of Business 54:1-32.

Salinger, Michael A. 1984. "Tobin's q, Unionization, and the Concentration-Profits Relationship." The Rand Journal of Economics 15:159-70.

Smirlock, Michael, Thomas Gilligan and William Marshall. 1984. "Tobin's q and the Structure-Performance Relationship." American Economic Review 74:1051-60.

Thomadakis, Stavros B. 1977. "A Value-Based Test of Profitability and Market Structure." Review of Economics and Statistics 59:179-85.

Tobin, James. 1969. "A General Equilibrium Approach to Monetary Theory." Journal of Money, Credit, and Banking 1:15-29.

© 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission.





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