Review of Industrial Organization 12: 219–230, 1997. 219 c 1997 Kluwer Academic Publishers. Printed in the Netherlands. Specification and Testing the Profit-Concentration Relationship in Australian Manufacturing MITA BHATTACHARYA and HARRY BLOCH Department of Economics, University of Tasmania, Hobart, Australia 7001 Abstract. Research in the mainstream of industrial organization has tested the relationship between profit rates (an index of performance) and concentration (an index of structure) including other variables (e.g., capital intensity, advertising intensity, growth, measures for barriers toentry, import and export intensity). Specification of this relationship is often largely ad hoc and its testing is subject to a number of statistical criticisms. Major criticisms that require attention are: i) omission of the relevant explanatory variables, ii) simultaneous causality among variables, and iii) measurement error in the variables. This paper derives a profit-concentration relationship from a well known oligopoly model. Empirical analysis is carried out against a sample of Australian manufacturing industries for 1984–85. The resulting estimates suggest the importance of dealing with each of the specification and testing issues in explaining the profit-concentration relationship. Keywords: Oligopoly, price-cost margin, concentration, profitability. JEL Classification: D43, L13, L60. I. Introduction The structure-conduct-performance (SCP) paradigm has played an important role in industrial organization research since the pioneering work of Mason (1939). The theory predicts that market structure determines the conduct (strategy) of firms and this in turn determines industry performance. Empirical research during the last few decades has provided useful insights into the relationship between profitability (an index of performance) and various industry structural characteristics (see, for example the surveys in Scherer and Ross (1990, Ch. 11) and Schmalensee (1989). The relationship between profit and concentration is the most widely examined hypothesis in the SCP paradigm. Almost all studies find a positive (although some- times weak) association between these two variables. However, in Australia, the hypothesis of a significant positive association between profits and concentration is rejected in most studies. This paper develops a profit-concentration relation- The authors are grateful to John Stanton, Glenn Otto and anonymous referees of this journal for useful suggestions. Helpful comments from participants of 1995 Industry Economics Conference at the University of Melbourne and 1995 Ph.D. Conference in Economics and Business at the University of Western Australia are also appreciated.