The Cost of Capital and the Market Power of Firms

RECENTLY, significant research has been conducted on the functioning of the capital market. One thrust of this research (e.g., Fama, 1970) has demonstrated that the capital market is highly efficient, i.e., the prices of securities at a point in time seem to reflect available information, and security prices seem to adjust quickly over time to new information. Another thrust (e.g., Sharpe, 1964; Lintner, 1965; Mossin, 1966; Jensen, 1972) has been the theoretical development and empirical testing of a specific model, the Capital Asset Pricing Model (CAPM), which precisely defines risk and return, gives an economic justification for diversification, and under specific assumptions draws the equilibrium conditions between risk and return in the capital market. Not withstanding serious econometric difficulties of estimation, these studies picture a highly efficient capital market in which capital funds are allocated based only upon risk and return considerations as determined by a rigorous evaluation of relevant information. The capital market depicted in this recent capital market literature would seem to differ from the capital market depicted in the literature of industrial organization economics. For example, Baumol (1967) and Hall and Weiss (1967) have argued that the major barriers to entry are not in the structure of output markets, but in the capital market. The argument is that to enter and compete effectively in many basic industries, such as automobiles, chemicals, etc., a large sum of capital is necessary, and the capital market will not allocate a large sum to a new entrant. Basically the capital market fails in its allocative function because investment opportunities, albeit opportunities with high profit potential, are "lumpy. " That is, investment opportunities cannot be financed in small discrete amounts by new entrants, but can only be financed in large amounts by existing firms insuring basic industries marked by large firms with high market shares. Both the capital market literature and the industrial organization literature are valuable reference points for those who would hope to understand the allocation of capital in the economy and the effects it has upon the condition of entry, level of price and level of output found in industrial markets. The general purpose of this paper is to begin a reconciliation of these literatures with respect to their disparate views of the capital market. Since capital market theory relates capital costs to risk, our specific purpose is to determine if the market power of firms, as measured by size and seller concentration, seems to reduce the riskiness of firms and therefore their capital costs. In section II the difference between book profits and capital costs is stated. In section III, with the aid of the Capital Asset Pricing Model, the relationship between capital costs and risk is presented. In section IV the data and sample of firms are described, and in section V the data analysis is presented, which does in fact suggest that the risk and capital costs of powerful firms are lower than for other firms. Conclusions are presented in section VI.