Regulatory Assessment Toolkit: A Practical Methodology for Assessing Regulation on Trade and Investment in Services by Martín Molinuevo; Sebastián Sáez

Author:Martín Molinuevo; Sebastián Sáez
Language: eng
Format: epub
Publisher: The World Bank

Estimated Markups

Some studies assess market contestability by estimating and comparing markups across sectors and countries. They follow the seminal paper by Roeger (1995), which proposes estimating markups by comparing the residuals obtained from countries’ sectoral production functions with those from their cost functions. In particular, he compares the primal with the dual Solow residuals. Solow’s primal residual refers to the part of the increase in the volume of production that cannot be explained by increases in the factors of production such as capital, intermediate products, and labor. This unexplained growth, or residual, is normally associated with technological progress or total factor productivity (TFP) growth. All production functions have a dual function, as they can be written not only in terms of products but also in terms of production costs and thus prices. Following an analogous explanation, Solow’s dual residual can be defined as the increase in marginal cost unexplained by increases in factor prices (wages, the cost of capital, the cost of intermediate products).17

In a world with perfectly competitive markets, the primal and dual residuals should be highly correlated. In practice, they are not.

Roeger finds that the difference between residuals is explained when the assumption of perfect competition is relaxed and firms can charge prices that exceed unit costs. He shows that by subtracting Solow’s dual residual (SRP) from Solow’s primal residual (SR), the markups charged in sector j in the country i can be estimated as follows:

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