____________________________________________________________________________________________________

1. Learning Outcomes

This module aims at discussing Structure, Conduct and Performance (SCP) Paradigm. After
learning this module you will understand:

 The concept of SCP paradigm

 The origin of SCP paradigm
 Theory and Modeling SCP
 Factors affecting SCP
 Empirical Evidence of SCP

2. Introduction

Firm behavior and market structure are principal components of Industrial Economics. These
components were more empathetically highlighted to a large extent by the work of a group of
economists at Harvard in the 1930s. In order to describe how key aspects of market structure relate
to each other, Edward Mason and his PhD student Joe S. Bain formulated a framework called the
Structure-Conduct-Performance (SCP) in 1959. This SCP hypothesis was popularized during
1960s with its empirical relationship between industry structure and performance and has led to the
implementation of most anti-trust legislation. Since then economists started using SCP paradigm
as an analytical framework to establish a relationship between market structures, market conduct
and market performance. This approach was summarized briefly by Stephen Martin and was
advocated that the central hypothesis (of the SCP framework) is that observable structural
characteristics of a market determine the behavior of firms within that market, and that the behavior
of firms within a market, affects structural characteristics, and determines measurable market
performance. The decades between early 1950s and the early 1980s had seen the SCP paradigm as
a dominant framework for empirical work in industrial economics. However, the influence of SCP
paradigm began to diminish in the 1980s with the development of game theoretical analysis of
oligopolistic markets.

In SCP paradigm, Structure refers to those set of factors that are somewhat stable over time. These
factors affect the behaviour of firms and consumers in a substantial way. The structure of the market
is also determined by the nature of the product and the available production technology. The way
in which buyers and sellers behave with each other in the market is known as “Conduct” in SCP
paradigm. Some of the important aspects of behavior in SCP paradigm are pricing behaviour,
strategic behavior, investment decision, collusive behavior etc. In SCP paradigm performance is
measured by comparing efficiency of firms in the industry. In order to measure efficiency different
ratios are used. Generally, profitability levels, output levels or technological progress of firms are
used while measuring efficiency.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
3. Structure-Conduct-Performance

In this section first we shall discuss the Origin followed by evolution of SCP paradigm. Then we
shall focus on its paradigm.

3.1 Origin and Evolution

The origin of the SCP paradigm dates back to the work of the Harvard University professor Edward
Mason in the 1930s. The empirical work of Edward Chamberlin opened the way for both Mason
and his student Joe Bain to explore how pricing and production policies of large firms are
determined. Mason started with the view that in order to determine the production and pricing
policy of a firm its market share plays a vital role. In the 1930s, both theoretical and empirical
approaches gained momentum in understanding pricing policies of firms. The theoretical approach
basically involved the use of degree of market imperfection to derive production and pricing policy
of a firm. Similarly, the empirical approach brought the relationship between observed prices and
other economic factors to focus on differences in market structure.

According to Mason empirical analysis is essential to ensure that the theories of the firm are useful
because these theories are based on mathematical models. In fact the relevance of theories cannot
be determined without empirical observations. Thus empirical observations are useful to test the
theories. Mason had a view that the price and production decisions of a firm are influenced by:

a. internal organization of the firm and

b. Market structure.

Internal organization indicates group relationships within the firm which exercises influence on the
firm's policy whereas market structure is a multidimensional concept that is specified and measured
by factors such as:

a. product characteristics
b. cost of production, and
c. The number and market shares of buyers and sellers in the market.

Factors such as industry life-cycle and the characteristic of the distribution channels also affect firm
behavior. Thus, elements of the SCP paradigm were seen in Mason’s work in the 1930s. Mason’s
future empirical-policy work was subsequently taken-up by his Ph.D. student, Joe S. Bain who used
industry level data. However, Mason was more in favour of case studies involving specific firms
or industries. But Bain’s work has proved to be more signification the field of industrial economics.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________

Structure refers to market structure. The variables such as seller concentration, degree of product
differentiation and barriers of entry are used to describe market structure. These variables can be
further classified into two classes, namely:

a. Intrinsic structural variables

b. Derived structural variables

Intrinsic structural variables are those variables that are determined by the nature of products and
technologies available for production and marketing whereas derived structural variables are those
variables that are determined by factors controlled by firms and government such as barriers of
entry, seller and buyer concentration and product differentiation.

Conduct refers to behavior of firm. Pricing strategies, collusion, advertising, research and
development and capacity investment are the variables used to determine firm behavior.
Performance refers to equilibrium evaluated in terms of allocative efficiency. Profitability and
price-cost margin are the most important variables used to evaluate performance.

In SCP paradigm, the drivers of market performance are the market forces i.e. the conditions
underlying the demand and supply sides of the market. The market forces determine market
structure, the factors of which are reported in the second box of fig. 1. The numbers of buyers and
sellers in a perfectly competitive market indicate that there are many buyers and sellers, none of
whom are able to influence price. However, much policy concern is focused towards markets with
few sellers. Product differentiation is the presence of different varieties of a product class to be
imperfect substitutes to the consumers. This arises from product characteristics such as product
design or from advertising etc. The theory of monopolistic competition recognizes this. The number
of buyers and sellers and the extent of product differentiation help in identifying the situation of
rivalry among actual buyers and sellers. Barriers to entry are more likely to indicate “costs of entry,”
i.e. the cost of investments needed to start supplying to a market. Barriers to entry were first
emphasized by Bain who conveyed information about the possibility of rivalry between potential
and actual sellers. As explained above “Conduct,” includes price behavior, which is the initial
primary focus of SCP paradigm as can be seen from fig. 1. Conduct also includes product strategy,
which in part determines the extent of product differentiation. Advertising and other marketing
efforts also determine the extent of product differentiation. Fig.1 shows various types of firm
conduct as feeding back to affect market structure. For instance, advertising may affect the cost of
entry and pricing policy may influence the payoff that is expected from entry. In Fig.1 firm conduct
also influences the demand side of the market. For example, pricing may affect the elasticity of
demand. Through the conduct-demand conditions feedback link market structure is affected by firm
conduct.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
The SCP paradigm also shows that firm conduct affects various dimensions of market performance
such as productive efficiency and allocative efficiency. Productive efficiency is the lowest
technologically possible production cost that is determined by firm conduct. Firm conduct also
determines the rate of technological progress.

4. Theory and Empirics of SCP Paradigm

4.1 Theory and Modeling SCP

Using Cournot’s duopoly model we can formalize the theoretical link between S-C-P of firms. The
Lerner’s index here is considered to establish the link with various available factors of firms. So
we can write Lerner’s index as:
P  MC
Li  … (1)
P

Where, Li : Lerner’s Index

P : Price
MC : Marginal Cost

The Lerner’s Index in its current form is not so popular to use. A more sophisticated version of
Lerner’s Index is being utilized by economists frequently. This can be written as:

LI 
Si
1  i  … (2)


Where, LI : Lerner’s Index (modified)

Si : Market share of ith firm
 : Price elasticity of demand
 dq j 
i : Conjectural variation   
 dq i 
In this modified version of Lerner’s Index, the output response of jth firm (rival firm) due to change
in output of ith firm is measured by the conjectural variation variable. The degree of collusion
between firms in the industry is also measured by this conjectural variation variable. The
conjectural variation variable is functionally dependent on seller concentration, entry barrier and
other industry or firm characteristics. Thus the conjectural variation function can be written as:

i   C j , B j , X i j  … (3)

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________

Where, Cj : a measure of seller concentration

Bj : a set of entry barrier measures
Xij : other industry or firm characteristics
i : The conjectural variation variable

The link between structure, conduct and performance is widely recognized and is observed in the
conjectural variation function in the Lerner Index. This link between structure and conduct is thus
observed in eq.3. From eq.2 and eq.3, we get:

LI 
Si

1   C , B , X … (4)
j j ij

This implies that, Lerner’s Index is functionally dependent not only on market share and price
elasticity but also on seller concentration, entry barrier and industry or firm characteristics. Thus
the relationship between them can be written as:

 
LI  L S i ,  , C j , B j , X i j … (5)
However, the Lerner’s Index is theoretical in nature, which is not observable in reality. We can
rewrite eq.5 by assuming correlation between the Lerner index and measures of profitability (  i )
at firm level as:
 
 i   f S i ,  , C j , B j , X i j … (6)
If we consider industry in place of firm, then eq.6 can be rewritten as:

 
 j   I C j , B j , X i j … (7)
The relationship itself highlights the profitability, which is being determined by concentration.

4.2 Factors affecting SCP

Entry barriers can be considered as a factor affecting the performance of firms in the SCP paradigm.
Entry barriers may either be structural or strategic. While structural barriers are exogenously
determined, strategic barriers are derived from strategies discouraging entry or forcing rival firms
to exit. Also scale economies and product differentiation are a part of structural barriers. Thus
quantifiable structural barriers of entry have been seen in most of the empirical literature on SCP.

The minimum efficient scale of production relative to size of market demand is one such entry
barrier. The minimum efficient scale of production can be defined as the ratio of sales of plants at
the midpoint of industry plant size distribution to total industry sales. Cost advantage ratio is

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
another measure of entry barrier. Cost advantage ratio is the ratio of value-added per worker in
plants below minimum efficient scale to that in larger plants.

One of the most widely used entry barriers in empirical SCP studies is product differentiation which
is defined as the ratio of advertising expenditure to sales. There are also some factors that affect
SCP in its empirical investigation. These include:
 buyer concentration
 industry growth
 ratio of imports to domestic production or consumption and
 geographic dispersion measures

4.5 Empirical Evidence of SCP

Initially the SCP paradigm was limited to book length studies of single industries. However, it was
Bain who published a comparative study of a small number of industries in 1956. But in Bain’s
work no formal statistical techniques were observed though it was possible by industrial economists
at a later stage to provide econometric analysis of cross-section samples of industry data.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
Fig.2: Bain Study: Concentration, Entry Conditions, and Profitability, 20 U.S. industries, 1947-
1951. Profitability measured as the after-tax rate of return as a percentage of stockholders’ equity,
concentration ratio the combined market share of the largest four firms.

Source: Martin, S. (2010)

The results from Bain’s study can be seen in Fig.2, which shows the relationship between
profitability and seller concentration of 20 US industries. According to Bain profitability is the
profit after taxes as a percentage of stockholders’ equity. The 4-firm seller concentration ratio
which is the sum of the market shares of the four largest firms in the industry is used to measure
seller concentration.
In Bain’s work it is observed as per the nature of barriers to entry each industry in the sample is
classified into one of three groups:
a. High barrier to entry,
b. Substantial barrier to entry, and
c. Low to moderate barrier to entry

The dashed line in Fig.2 of Martin, S. (2010) is the least-squares regression line relating
profitability to the concentration ratio. Martin, S. (2010) through this line shows that higher
concentration levels and higher profitability tended to go together in Bain’s sample. It also appears
that profitability tends to be higher in high entry-cost industries than in industries with low,
moderate, or substantial entry cost.
The causal relationships between market structure, conduct and performance have been observed
in the SCP paradigm. It has been proved empirically that market structure determines conduct and
conduct in turn determines performance. Market structure is also determined by a variety of other
factors that can be classified as either demand or supply factors (see fig. 1). Empirical industrial
economists who subscribe to the SCP paradigm point out that the causality between structure and
conduct can run the other way round. They have advocated that firm conduct such as predatory
behavior or entry deterrence can help in constructing the market structure. Some economists have
also explored empirically that the relationship between conduct and performance is weak.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
5. Summary

 The SCP paradigm was the brain child of Edward Mason and his PhD student Joe S. Bain
at Harvard University. .
 This SCP hypothesis was popularized during 1960s with its empirical relationship between
industry structure and performance and has led to the implementation of most anti-trust
legislation.
 Since then economists started using SCP paradigm as an analytical framework to establish
the relationship between market structures, market conduct and market performance.
 The SCP Paradigm comprises of three major elements as structure, conduct and
performance.
 Structure refers to market structure. Conduct refers to behavior of firm. Performance refers
to equilibrium evaluated in terms of allocative efficiency.
 The causal relationships between market structure, conduct and performance have been
observed in the SCP paradigm.
 In Lerner’s model the conjectural variation variable is functionally dependent on seller
concentration, entry barrier and other industry or firm characteristics.
 The link between structure, conduct and performance is widely recognized and is observed
in the conjectural variation function in the Lerner’s Index.
 Lerner’s Index is functionally dependent not only on market share and price elasticity but
also on seller concentration, entry barrier and industry or firm characteristics.
 Lerner’s index is empirically not possible always to compute due to several practical
limitations. Again firms produce many products and the index is computed only for one
product. Therefore, performance of firm with respect to various products will vary.
 Entry barrier can be considered as a factor affecting performance of firms in the SCP
paradigm. Entry barrier may either be structural or strategic. While structural barriers are
exogenously determined, strategic barriers are derived from strategies discouraging entry
or forcing rival firms to exit.
 Also scale economies and product differentiation are a part of structural barriers. Thus
quantifiable structural barriers of entry have been seen in most of the empirical literature
on SCP.
 Minimum efficient scale of production relative to market demand size is one such entry
barrier. Minimum efficient scale of production can be defined as the ratio of sales of plants
at the midpoint of industry plant size distribution to total industry sales.
 Cost advantage ratio is also another measure of entry barrier. Cost advantage ratio is the
ratio of value-added per worker in plants below minimum efficient scale to that in larger
plants.
 One of the most widely used entry barrier in empirical SCP studies is product
differentiation which is defined as the ratio of advertising expenditure to sales.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM
____________________________________________________________________________________________________
 Initially SCP paradigm was limited to book length studies of single industries. However, it
was Bain who published a comparative study of a small number of industries in 1956.
 The results from Bain’s study shows the relationship between profitability and seller
concentration of 20 US industries. According to Bain profitability is the profit after taxes
as a percentage of stockholders’ equity.
 The 4-firm seller concentration ratio which is the sum of the markets shares of the four
largest firms in the industry is used to measure seller concentration.
 The causal relationships between market structure, conduct and performance have been
observed in the SCP paradigm. It has been proved empirically that market structure
determines conduct and conduct in turn determines performance. Market structure is also
determined by a variety of other factors that can be classified as either demand or supply
factors.
 Empirical industrial economists who subscribe to the SCP paradigm point out that the
causality between structure and conduct can run the other way round. They have advocated
that firm's conduct such as predatory behavior or entry deterrence can help in constructing
the market structure.
 Some economists have also explored empirically that the relationship between conduct and
performance is weak.

BUSINESS ECONOMICS PAPER NO. : 6, INDUSTRIAL ECONOMICS

MODULE NO. : 7, SCP PARADIGM