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

SOURCE: Lindenberg, E., and S. Ross (1981). Journal of Business 54:1, © 1981 by The University of Chicago. All Rights Reserved.

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 = ₀ + ₁ (A/(p_kK)) + ₂ ((R&D)/(p_kK)) + (1 - ₃U)C4[₄M + ₅K + ₆ (A/(p_kK)) ] + ₇C4 + ₈G,

where the _i are coefficients to be estimated, A/(p_kK) is the ratio of advertising expenditures to the value of capital, R&D/(p_kK) 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 ₄, ₅, ₆, ₇ 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.