ECON 330 Lecture 4 Thursday, September 27

Please bring a pen and a piece of paper to class. Please see me after class if you are still trying to add Ec330 to your FALL 12 schedule.

Today’s lecture Industry concentration Structure Conduct Performance Paradigm Introduction to perfect competition (Ch 6)

A short history of Industrial Organization

Two approaches to IO The Structure-Conduct-Performance (SCP) paradigm. Dominated research 1930s to almost late 1970s. Game theory. Driven the theoretical research in IO since late 1970s. Strategic interactions capture the essence of imperfect competition.

The SCP theory: The terms explained (S) Market Structure Number of sellers (market or industry concentration), degree of product differentiation, barriers to entry (C) Firms’ conduct (behavior) Pricing, advertising, R&D (P) Performance Efficiency, technological progress, profits

The SCP hypothesis is … CAUSALITY: S  C  P Market structure explains conduct and performance CAUSALITY: S  C  P Market structure determines conduct With few firms, firms can collude more easily, and raise prices. Conduct determines industry and firm performance. Profits, efficiency etc. High prices have negative welfare effects.

The early studies in the S-C-P framework: Joe Bain (1956) “Barriers to New Competition” . Bain uses data on profitability and concentration from different industries

RELATIONSHIP BETWEEN STRUCTURE AND PERFORMANCE Bain compares industries with CR8 > 70% to those with CR8 < 70%. He finds that … The average rate of return for industries with CR8 > 70% is 11.8% compared to 7.5% for industries with CR8 < 70%.

But what is CR8?

Measuring industry concentration Two commonly used measures or indexes are:   Concentration Ratio: CRn The market share of the top n firms Commonly reported as CR4 and CR8 CR4 = 0.71 means that … the biggest 4 firms in the industry have a 71% market share. Information given by these indices is partial: it doesn’t take into account the whole distribution of market shares.

• Herfindahl-Hirschman Index (HHI) – For an industry with N firms, HHI = where si is the market share of the ith firm. – The HHI captures both the average firm size and the inequality of size between firms

EXAMPLE Industry A 10 firms, each firm has 10% market share Industry B 11 firms, one firms has 90% market share, each of the remaining firms has 1%. Both industries have (almost an) equal number of firms, but the size distribution is very different.

US market share data for three paper product markets 1994

Now back to the SCP and some more empirical results

Mann (1966). reproduces many of Bain's results Mann (1966)* reproduces many of Bain's results. He also shows that industries with "high entry barriers" (according to his own subjective evaluation) earn higher profits than other industries. *Michael Mann, “Seller Concentration, Barriers to Entry, and Rates of Return in Thirty Industries, 1950-1960” published in The Review of Economics and Statistics Vol. 48, No. 3 (Aug., 1966) higher/lower?

Industry profit rate(%) Mann’s results ----------------------------------------- "very high barrier" auto 15.5 chewing gum 17.5 cigarettes 11.6 average 16.4 "substantial barrier" steel 10.8 soap 13.3 average 11.1 "moderate to low barrier" glass container 13.3 razors 8.5 average 11.9

The S-C-P paradigm : Where L = Lerner Index = (P – MC)/P, other stuff = R&D expenditures, MES, Adv/Sales, etc. If b1 > 0, then concentration  high prices  profit

Harold Demsetz, 1973, "Industry Structure, Market Rivalry, and Public Policy" The SCP argument: Higher concentration facilitates collusion and the exercise of market power by large firms, and generates high profits.

Demsetz’s argument The positive relationship (more concentration  higher profits) arises because larger firms are more efficient. They increase industry concentration and earn higher profits.

Average industry profits across different industries will not resolve these competing hypotheses. But the two theories offer differing prediction regarding the profits of large firms versus small firms within an industry.

Consider a concentrated industry Consider a concentrated industry. If high industry profits are due to collusion, both small and large firms will have high profit rates. If high profits arise from the exercise of market power by the large firms, then the small firms should benefit even more (when the large firms restrict output and raise the price, the small firms don't have to restrict output and yet receive a higher price).

The efficiency hypothesis (Demsetz) says that more efficient firms grow and become large firms. They have lower costs and/or better products. Therefore they earn higher profits than small firms.

In a competitive market, low costs of the large firms will hurt the smaller firms. So the efficiency hypothesis (Demsetz) says that large firms have higher profit rates than small firms, and this difference increases with the degree of concentration.

Harold Demsetz, 1973, "Industry Structure, Market Rivalry, and Public Policy" The average rate of return by industry concentration and by firm size. size class (1<2<3<4) CR4 1 2 3 4 average ----------------------------------------------------------- 10-20 6.7 9.0 10.8 10.3 9.2 20-30 4.5 9.1 9.7 10.4 8.4 30-40 5.2 8.7 9.9 11.0 8.7 40-50 5.8 9.0 9.5 9.0 8.3 50-60 6.7 9.8 10.5 13.4 10.1 60+ 5.3 10.1 11.5 23.1 12.5

Observations More concentrated industries tend to have higher profits than less concentrated industries Large firms tend to have higher profits than smaller firms The difference between large firms and small firms tend to grow with the degree of industry concentration