Reconciling Conflicting Evidence

Latest research from the C. T. Bauer College of Business Department of Finance breaks new ground in understanding the interaction of stock markets with investment and production decisions of firms in industries such as airlines, telecommunications and others in which market power is consolidated among a relatively small number of organizations. This analysis is important for policy-makers, investors and academics interested in such industries.

Numerous industries known as oligopolies operate outside the realm of a perfectly competitive marketplace. Such industries try and maintain profits through tacit collusion enforced by the implicit threat of price wars and strategically deterring potential competitors by setting up huge production capacities.

But financial economists attempting to predict the relationship between firm behavior and stock market returns have until now typically utilized  models that operated with the assumption of competitive industries, said Praveen Kumar, Bauer College Interim Dean and Cullen Distinguished Chaired Professor of Finance.

“The longstanding approach in finance generally operates under an assumption that firms have no market power and there is little or no strategic interaction among them. In practice, of course, many (if not most) industries are oligopolies that are dominated by a relatively small number of firms,” Kumar said.

In “Capital Investment, Equity Returns and Aggregate Dynamics in Oligopolistic Production Economies,” forthcoming in the Review of Financial Studies, Kumar and Bauer Professor of Finance Hitesh Doshi have developed a novel theoretical framework combining asset pricing with oligopolistic behavior. The researchers used existing industry level data on capital, investment, output and productivity to create what Kumar said breaks “quantitative new ground.” They also show that their framework is better able to explain data compared with assumption of competitive markets.

Previous empirical research involving the relation of industry concentration (the fraction of the market dominated by the largest firms) and stock market returns was never consistent, Kumar said.

“Over the years, empirical studies have presented conflicting results, with some showing a positive relation of concentration and returns and others showing a negative relation," he said. "Our study presents a framework to help reconcile the conflicting evidence and develops predictions on the concentration-returns relation that are supported by the data.”

He added: "The new framework should make it easier to more accurately understand strategic behavior and stock market interaction among oligopolies. You cannot separate the stock market from how firms actually operate.”