On the Misuse of the Profits-sales Ratio to Infer Monopoly Power

A large literature tests the structure-conduct-performance paradigm by regressions which use the profits-sales ratio as the dependent variable. That ratio is used because, under constant returns, it is generally supposed that profits/sales equals the Lerner measure of monopoly power. Profits/sales ratios are also used to make inferences about monopoly power for individual firms. This paper shows, however, that unless proper account is taken of the valuation of capital and the treatment of capital costs, profits/sales will be a very substantially inaccurate surrogate for the Lerner measure. Such proper account requires Hotelling valuation of capital goods which real firms do not use. The full analytics of the problem are worked out and some theorems proved relating the error to the cost of capital, the growth rate of the firm, and the depreciation method used. Examples are used to show that the error is poten-^' tially enormous, and the error is shown in general to be related to the variables used on the right hand side of the regression studies referred to above. The conclusion is reached that such studies are totally worthless. That conclusion will doubtless spark a certain amount of controversy as did the conclusion of the parallel paper on the accounting rate of return on assets or equity (Fisher and McGowan, American Economic Review, March 1983).