In this paper we develop a model relating market share to average costs. We start
with a theoretical model of the factors that affect the firm's average cost curve,
partitioning these factors into (a) measurable firm and competitive environment characteristics,
and (b) unobserved factors that are either fixed, random, or follow a first-order
autoregressive process. We then link this theoretical model to an empirical model
in which we specify three average cost equations for the organizational areas of
purchasing, production, and marketing. Main effects for initial (lagged) market share
position, as well as their interactions with factors characterizing the firm's competitive
environment, represent the variables of key theoretical interest in our equations.
We estimate these equations using PIMS data, and control for fixed, contemporaneous,
and autoregressive unobservable factors. Our results suggest that market share can
often lead to market power in the form of lower average costs. However, the firm's
operating environment greatly moderates the effect of market share on average cost.
In particular, we find that market share position only leads to lower average costs
when the organizational unit operates in a competitive environment that gives it
both motivation and ability to realize power from its market share position.