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CHAPTER 7

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The Nature of Industry

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Outline • Market structure

– Firm size – Industry concentration – Technology – Demand and market conditions – Potential for entry

• Conduct – Pricing behavior – Integration and merger activity – Research and development – Advertising

• Performance – Profit – Social welfare

• The structure-conduct-performance paradigm – Causal view – Feedback critique – Relation to the Five Forces Framework

7-2

Chapter Overview

Introduction • Chapter 6 focused on the optimal way to

acquire the efficient mix of inputs, and how to solve various principal-agent problems that arise within the firm.

• This chapter provides an overview of the nature of various industries. – How concentrated are sales in one industry

relative to another? – How do price-cost margins vary by industry? – How do advertising and R&D expenditures vary by

industry?

7-3

Chapter Overview

Market Structure • The Market Structure refers to the

characteristics of the market either organizational or competitive, that describes the nature of competition and the pricing policy followed in the market.

• The Market Structure describe the business environment that all buyers and sellers interact in it.

• What kind of Market Structure do you know? • What are the characteristics that help us to

categorize market structures?

7-4

Market Structure

Market Structure • Market structure factors that impact

managerial decisions are: – Number of firms competing in an industry. – Relative size of firms (concentration). – Technological and cost conditions. – Demand conditions. – Ease of firm exit or entry.

7-5

Market Structure

Industry Concentration • Measures the size distribution of firms within

an industry. – Are there many small firms? – Are there only a few large firms?

7-6

Market Structure

Measuring Industry Concentration • Measures of industry concentration – Four-firm concentration ratio: The fraction of total industry sales generated by the four largest firms in the industry.

!” = $% + $’ + $( + $”

$) Let S1, S2, S3, and S4 denote the sales of the four largest firms in an industry, and let ST denote the total sales of all firms in the industry.

7-7

Market Structure

Measuring Industry Concentration • Measures of industry concentration – Four-firm concentration ratio:

Equivalently, the four-firm concentration ratio is the sum of the market shares of the top four firms:

!” = w1 + w2 + w3 + w4 where w1 = S1/ST, w2 = S2/ST, w3 = S3/ST, and w4 = S4/ST

7-8

Market Structure

Measuring Industry Concentration • Measures of industry concentration – Herfindahl-Hirschman index (HHI): The sum of the squared market shares of firms in a given industry multiplied by 10,000.

!!” = 10,000′ ()*

+ ,( ,-

.

7-9

Market Structure

Measuring Industry Concentration • Measures of industry concentration – Herfindahl-Hirschman index (HHI): The sum of the squared market shares of firms in a given industry multiplied by 10,000.

!!” = 10,000′ ()*

+ wi ,

where wi = Si/ST

7-10

Market Structure

Measuring Industry Concentration Assume in following cases firms are sharing market equally. If N=1, then HHI=10000; If N=2, then HHI=5000; If N=4, then HHI=2500; If N=5, then HHI=2000 … If N=10, then HHI=1000

As number of firm gets bigger, HHI drops dramatically.

7-11

Market Structure

Measuring Industry Concentration in Action

• Suppose an industry is composed of six firms. Four firms have sales of $10 each, and two firms haves sales of $5 each. What is the four-firm concentration ratio for this industry?

• Answer: – Total industry sales are !” = $50. – Sales of the four largest firms are $40. – The four-firm concentration ratio is:

‘( = $10 + $10 + $10 + $10

$50 = 0.80 – The four largest firms in the industry account for 80

percent of total industry output.

7-12

Market Structure

Measuring Industry Concentration In Action

7-13

Industry C4 (percentage)

HHI

Distilleries 70 1,519 Fluid milk 46 1,075 Motor vehicles 68 1,744 Snack foods 53 1,984 Furniture and related products 11 62 Semiconductor and other electronic components

34 476

Soft drinks 52 891

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: – Global markets. In calculating C4 and HHI, the Bureau of the Census does not take into account the penetration by foreign firms into U.S. markets. This tends to overstate the true level of concentration in industries in which a significant number of foreign producers serve the market.

7-14

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: – Global markets. For example, consider the four-firm concentration ratio for the brewery industry. Based on Table 7–2, the top four U.S. firms account for 91 percent of industry sales. However, this figure ignores beer produced by the many well-known breweries in Mexico, Canada, Europe, Australia, and Asia. The four-firm concentration ratio based on both domestic and imported beer would be considerably lower.

7-15

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: – National, regional and local markets. In many industries, the relevant markets are local and may be composed of only a few firms. When the relevant markets are local, the use of national data tends to understate the actual level of concentration in the local markets.

7-16

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: –National, regional and local markets. • For example, suppose that each of the 50 states had only one

gasoline station. • If all gasoline stations were the same size, each firm would have

a market share of only 1/50. • The four-firm concentration ratio, based on national data, would

be 4/50, or 8 percent. • This would suggest that the market for gasoline services is not

very concentrated. • However, it does a consumer in central Texas little good to have

gas stations in 49 other states, since the relevant market for buying gasoline for this consumer is his or her local market.

• Thus, geographical differences among markets can lead to biases in concentration measures.

7-17

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: – Industry definitions and product classes. The definition of product classes used to define an industry also affects indexes. Specifically, in constructing indexes of market structure, there is considerable aggregation across product classes.

7-18

Market Structure

Limitations of Concentration Measures • Factors that impact and limit industry

concentration measures include: – Industry definitions and product classes. For example, consider the four-firm concentration ratio for soft drinks, which is 52 percent in Table 7-2. This number may seem surprisingly low when one considers how Coca-Cola and Pepsi dominate the market for cola. However, the concentration ratio of 52 percent is based on a much more broadly defined notion of soft drinks.

7-19

Market Structure

Technology and Costs • Industries differ in regard to the technologies

used to produce goods and services. – Labor-intensive industries. – Capital-intensive industries.

• Within a given industry if the available technology is: – the same, firms will likely have similar cost

structures. – different, one firm will likely have a cost advantage.

7-20

Market Structure

Demand and Market Conditions • Industries with – low demand may imply few firms. – high demand may imply many firms.

• Elasticity of demand varies from industry to industry. – The Rothschild index measures the sensitivity to

price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

! = #$#% 7-21

Market Structure

Demand and Market Conditions in Action

• The industry elasticity of demand for airline travel is -3, and the elasticity of demand for an individual carrier is -4. What is the Rothschild index for this industry?

• Answer: – The Rothschild index is:

! = #$#% = 0.75

7-22

Market Structure

Demand and Market Conditions In Action

7-23

Industry Own Price Elasticity of Market Demand

Own Price Elasticity of Demand for Representative Firm

Rothschild Index

Food -1.0 -3.8 0.26 Tobacco -1.3 -1.3 1.00 Textiles -1.5 -4.7 0.32 Apparel -1.1 -4.1 0.27 Paper -1.5 -1.7 0.88 Chemicals -1.5 -1.5 1.00 Petroleum -1.5 -1.7 0.88

Market Structure

Potential for Entry • Optimal decisions by firms in an industry will

depend on the ease with which new firms can enter the market.

• Several factors can create barriers to entry (or make entry difficult). – Capital requirements. – Patents. – Economies of scale.

7-24

Market Structure

Conduct – In addition to structural differences across

industries, the conduct, or behavior, of firms also tends to differ across industries.

– Think about firm’s behaviors. – How many behaviors can you list?

7-25

Conduct

Conduct • Behavior of firms: – Pricing strategies. – Integration and merging strategies. – Advertising strategies. – Research and development strategies.

7-26

Conduct

Pricing Behavior • Assume you are a producer: -How do you choose a price for a common product like an ice-cream or sandwich or T-shirt?

-How does you answer change if this product in new in market like “flying car” or “one week trip to moon” or “time travel machine”?

7-27

Conduct

Pricing Behavior • Market driven pricing method

Look at the price of similar good in the market and choose the price based on it.

• Cost driven pricing method Look at the cost of production of an additional unit and choose the price based on it.

• Mixed method

7-28

Conduct

Pricing Behavior • Lerner index – A measure of the difference between price and

marginal cost as a fraction of the product’s price.

! = # −%&# rearranging this equation yields

# = 11 − ! %&

, where (()* is the markup factor over marginal costs.

7-29

Conduct

Pricing Behavior in Action • A firm in the airline industry has a marginal

cost of $200 and charges a price of $300. What are the Lerner index and markup factor? – The Lerner index is

! = # −%&# = $300 − $200

$300 = 1 3

• The markup factor is 1

1 − ! = 1

1 − 13 = 1.5

7-30

Conduct

Pricing Behavior In Action

7-31

Industry Lerner Index Markup Factor

Food 0.26 1.35

Tobacco 0.76 4.17

Textiles 0.21 1.27

Apparel 0.24 1.32

Paper 0.58 2.38

Chemicals 0.67 3.03

Petroleum 0.59 2.44

Conduct

Integration and Merger Activity • Integration – Uniting productive resources of firms. – Can occur through a merger OR during the formation

of a firm. • Merger – Two or more existing firms “unite,” or merge, into a

single firm. • Reasons firms merge: – Reduce transaction costs. – Reap benefits of economies of scale and scope. – Increase market power. – Gain better access to capital markets.

7-32

Conduct

Types of Integration • Horizontal integration – Merging two or more similar final products into a

single firm.

7-33

Conduct

Types of Integration • Vertical integration – Various stages in the production of a single product are carried out in a single firm.

7-34

Conduct

Types of Integration

7-35

Conduct

Types of Integration • Vertical integration – Various stages in the production of a single

product are carried out in a single firm. • Horizontal integration – Merging two or more similar final products into a

single firm. • Conglomerate mergers – Integration of two or more different product lines

into a single firm.

7-36

Conduct

7-37

Conduct

Research and Development • Research and development – Expenditures made by firms to gain a

technological advantage, with the aim of acquiring a patent.

7-38

Company Industry R&D as Percentage of Sales

Bristol-Meyers Squibb Pharmaceuticals 19.7

Ford Motor vehicle and parts 4.1

Goodyear Tire and Rubber Rubber and plastic parts 2.0 Kellogg Food 1.5

Proctor & Gamble Soaps and cosmetics 2.5

Conduct

Advertisement • Advertisement – Expenditures made by firms to inform or persuade

consumers to purchase their products.

7-39

Company Industry Advertising as Percentage of Sales

Bristol-Meyers Squibb Pharmaceuticals 4.9

Ford Motor vehicle and parts 3.2

Goodyear Tire and Rubber Rubber and plastic parts 2.5

Kellogg Food 9.2

Proctor & Gamble Soaps and cosmetics 11.7

Conduct

Performance Performance refers to the profits and social welfare that result in a given industry. It is important for future managers to recognize that profits and social welfare vary considerably across industries. • Profits Table 7–6 highlights differences in profits across firms in different industries. Ford’s sales were among the highest in the group, yet its profits as a percentage of sales were second lowest in the group. One task in the next several chapters is to examine why “big” firms do not always earn big profits. As a manager, it would be a mistake to believe that just because your firm is large, it will automatically earn profits.

7-40

Performance

Performance

7-41

performance

Performance • Social Welfare

-Another gauge of industry performance is the amount of consumer and producer surplus generated in a market. -While this type of performance is difficult to measure, R. E. Dansby and R. D. Willig have proposed a useful index. -The Dansby-Willig (DW) performance index measures how much social welfare (defined as the sum of consumer and producer surplus) would improve if firms in an industry expanded output in a socially efficient manner.

7-42

Performance

Dansby-Willig Performance Index • Ranks industries according to how much social

welfare would improve if the output in an industry were increased by a small amount.

7-43

Industry Dansby-Willig Index Food 0.51

Rubber 0.49

Textiles 0.38

Apparel 0.47

Paper 0.63

Chemicals 0.67

Petroleum 0.63

Performance

Dansby-Willig Performance Index • Suppose you are the manager of a firm in the textile

industry. You have just learned that the government has placed the textile industry at the top of its list of industries it plans to regulate and intends to force the industry to expand output and lower the price of textile products. How should you respond? Answer:

• You should point out to government’s counsel that the textile industry has the lowest Lerner index out of the 10 major industries listed in Table 7–5; only $.21 of each $1 paid by consumers is markup. Furthermore, the Dansby- Willig index for the textile industry is the lowest of nine industries listed in Table 7–7. The efficient way for government to improve social welfare is to alter output in the other industries first.

7-44

Performance

Structure-Conduct-Performance • Structure: – Factors like technology, concentration and market

conditions. • Conduct: – Individual firm behavior in the market. – Pricing decisions, advertising decisions and R&D

decisions, among other factors. • Performance: – Resulting profit and social welfare that arise in the

market. • Structure-conduct-performance paradigm – Model that views these three aspects of industry as

being integrally related.

7-45

The Structure- Conduct-Performance Paradigm

The Casual View • Market structure “causes” firms to behave in a

certain way. • … this behavior, or conduct, “causes”

resources to be allocated in certain ways. • … this resource allocation leads to “good” or

“bad” performance.

7-46

The Structure- Conduct-Performance Paradigm

The Feedback Critique • There is no one-way causal link among

structure, conduct and performance. – Firm conduct can affect market structure; – Market performance can affect conduct and

market structure.

7-47

The Structure- Conduct-Performance Paradigm

Looking Ahead • Perfect competition

– Many, small firms and consumers relative to market. – Firms produce very similar products. – No market power (P = MC).

• Monopoly – Sole producer of good or service. – Market power (P > MC).

• Monopolistic competition – Many, small firms and consumers relative to market. – Firms produce slightly different products. – Limited market power.

• Oligopoly – Few, large firms tend to dominate market. – Price/marketing strategies are mutually interdependent with

other firms in the industry.

7-48

Overview of the Remainder of the Book

Conclusion • Modern approach to studying industries involves

examining the interrelationship between structure, conduct and performance.

• Industries vary dramatically with respect to concentration levels. – The four-firm concentration ratio and Herfindahl-

Hirschman index measure industry concentration. • The Lerner index measures the degree to which

firms can markup price above marginal cost; it is a measure of a firm’s market power.

• Industry performance is measured by industry profitability and social welfare.

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