1 The Nature of Industry

2 Later we will study industries called perfect competition, monopoly, monopolistic competition, and oligopoly. The differences in these industry types has to do with factors such as how many sellers there are in the industry, or market, technology and cost consideration, demand conditions and how easy it is to enter an industry. Let’s explore some of these topics next.

3 Measuring Market Structure

4 Concentration ratios In the real world of business we see the number of firms varies from industry to industry. In an attempt to find a numerical measure to indicate which industries are more like monopoly – one firm - and which are more like perfect competition – many firms, concentration ratios were devised. Concentration ratios typically use sales as the concept used in the numerical measure.

5 Concentration ratios CRn is the sales added across the n largest firms in an industry divided by the total industry sales(and then multiply the result by 100 to be in percentage terms). For example, CR4 is the sales of the 4 largest firms added together divided by total sales in the industry(generally, more than 4 firms). Examples a)Monopoly industry –> CR4 = 100, b)Industry with 4 firms of equal size (25% of sales for each) -> CR4 = 100. Can you tell which of the examples above has only one firm by just looking at the CR4? Of course not!

6 More examples: c)10 firms, each with 10% of market -> CR4 = 40, d)4 firms, each with 10%, and 30 firms, each with 2% -> CR4 = 40. Here we have two examples of industries where the CR4 is the same. But we see the remaining firms after the top 4 are very different in each example. You would see this by looking at the CR8, but not all the time. So, another measure has been added and the measure considers all the firms in an industry. The measure is the HHI

7 Herfindahl-Hirschman Index – HHI To get the HHI we need the market share of each firm in percentage terms. Then we square the market share of each firm. After this, simply add the squared market share of each firm to get the final number. Examples a)Monopoly -> HHI = = 10,000. This is as big as you can get. b)4 firms with 25% each -> HHI = = 2500 c)10 firms each with 10% -> HHI = 10 times 10 2 = d)4 firms with 10%, 30 firms with 2% -> HHI = 4 times 10 2 plus 30 times 2 2 = = 520.

8 Another way to get this is to take the market shares in fractional terms, square each share, add them all up and multiply by HHI The closer the HHI is to 10,000 the more the industry is like a monopoly. The closer to 0 the more the industry is like a competitive industry. Issues with CR4 or HHI How do we define a market? At issue is how narrow or broad do we define the industry. Is aluminum foil and waxed paper in the same market? What about that plastic wrap that gets all stuck together before you cover the food? Should that be included with the aluminum foil and waxed paper? The issue raised has to be settled before we can even calculate the CR4 or the HHI.

9 The Census Bureau looks at firms that have similar production processes and considers them to be in the same market. But, this method may not be useful if consumers do not consider different products with similar production processes to be substitutes for each other. The cross price elasticity of demand The cross price elasticity of demand is defined as the percentage change in the demand for good x given the percentage change in the price of good y. Example If the price of Pepsi (and only Pepsi in this example) goes up we would expect the demand for Coke to rise. So the cross price elasticity of demand is positive for substitutes and we would expect goods in the same market to have a high numerical value for the cross price elasticity.

10 Geography Most studies have considered concentration ratios for the country. Local ratios need to be considered. If you look at the services of real estate agents, then concentration ratios at the national level are probably small. But, in many towns there is only one agent. Local ratios could be large. Ratios at the national level do not include foreign firms that actually compete. This means that some industries will appear more concentrated toward monopoly when, in fact, if you include the foreign firms the ratios would be lower.

11 Vertical integration Goods and services are the end of a process of transforming inputs into those goods and services. Just think of a loaf of bread. The wheat needed to be grown. Then the wheat is sent on to millers. The miller sends on the “stuff” to the baker. From the baker the item might go to a distributor and then the retailer. The more that one firm is involved in all stages of the production process, the more vertically integrated the firm is said to be. With this in mind, there are some industries that are not vertically integrated and this would suggest low concentration. But this could be misleading because all the firms in the “stream” of production are tied to the main product.

12 The authors of our text use the example of Coke and Pepsi. There are many bottlers around the country and this leads to low concentration. But in the soft drink industry you and I know Coke and Pepsi are the dominant players. So, what have we done here? We listed numerical measures of concentration designed to show what type of market structure an industry might have. Plus, we indicated some ideas we need to be aware of as we look at these measures.

13 The link above is to a web site at the Department of Justice dealing with horizontal mergers – companies in the same line of business. Note section 1.5. Market Conditions Firms in an industry will have a demand for its product, while at the same time there is a demand for the product from all the firms as a group. With each there is an elasticity of demand. The Rothschild index is the elasticity of the total market - Et divided by the elasticity of the firm - Ef. If there are not many substitutes for a firm’s product you would expect the index to be 1 and if there are many substitutes you would expect the index to be closer to 0.

14 Entry into Industry Major League Baseball has a specific barrier to entry into the league. You have to get the approval of the other owners in the league. This is a significant barrier. Patents may limit the number of firms that can operate in an industry, as can capital requirements. The notion of a barrier to entry is significant because if there is an ability to restrict others then maybe existing firms can enjoy long term profits without fear of others stepping in and taking some of those profits.

15 Lerner Index

16 Lerner Index L = (P – MC)/P. This is a measure of the exercise of monopoly power. In perfect Comp. the L = 0 because (as we will see) P = MC. The Lerner Index = 0 in competition and is larger for Monopoly situations. The term P – MC is often called the Monopoly mark-up. By math we see LP = P – MC, or MC = P – LP = (1 – L)P, or P = [1/(1 – L)]MC, 1/(1 – L) is the mark-up factor. If L = 1 MC = P.

17 As a manager, this current section is designed to have you look at the world around you and observe some things. In the future you will learn about models of the world so you can put into perspective what you are observing. Along the way you will learn about rules of behavior. Behavior in this sense is what price should you charge for your services and what output level should you attempt to sell.