Managerial Economics & Business Strategy Chapter 7 The Nature of Industry

Industry Structure and Performance Industries differ substantially in nature. An effective manager is able to adapt to the nature of the industry in which s/he operates. As the nature of industry changes so will the manager’s optimal decisions.

Overview I. Market Structure II. Conduct III. Performance Measures of Industry Concentration II. Conduct Pricing Behavior Integration and Merger Activity III. Performance Structure-Conduct-Performance Paradigm

Industry Analysis Market Structure –factors that affect managerial decisions: Number and size of firms –as well as change in a firm’s relative position can change over time. Industry’s viability can change (auto, steel, electronics). Industry concentration – are there many small firms or a few large firms? Four-firm Concentration ratio – how much of total output is produced by the four largest firms.

Industry Concentration Four-Firm Concentration Ratio The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales When an industry is composed of a large number of small firms the FFCR will be close to zero. With four or fewer firms in the industry the FFCR will be 1. With the FFCR close to zero the industry is not concentrated.

Industry Concentration Herfindahl-Hirschman Index (HHI) The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000  S wi2, where wi = Si/ST. The squaring aspect of the HHI weights firms with high market shares more heavily. HHI = 10,000  monopoly HHI = 0  PC

Example There are five banks competing in a local market. Each of the five banks have a 20 percent market share. What is the four-firm concentration ratio? What is the HHI?

Concentration in U.S. Industries Significant concentration in computers, breweries, automobiles, distilleries, and snack foods. Less concentrated are concrete, jewelry, electronic components, ladies apparel. High FFCR generally have high HHI. But there can be differences based on the HHI including all firms in an industry, and its use of squared market shares.

Limitations of Concentration Measures Exclude foreign imports – tends to overstate true level of industry concentration when many foreign firms serve a market. Based on data from the entire U.S. – in many industries the relevant markets are local. Using national data tends to understate the level of concentration. Definition of the industry – how broad an industry is defined. Broadly defined industries would tend to have lower concentration ratios – Beverages versus colas.

Industry Analysis Technological and cost conditions – differences according to labor and capital intensity give rise to different production techniques across industries. Different techniques result in different costs. Demand conditions – low demand implies few firms generally. Information available affects market conditions (airline tickets - internet; used cars – Ebay?). Price elasticity of demand varies between industries and many times between firms in an industry. The Rothschild Index

Measuring Demand and Market Conditions The Rothschild Index (R) measures the elasticity of industry demand for a product relative to that of an individual firm: R = ET / EF . ET = elasticity of demand for the total market. EF = elasticity of demand for the product of an individual firm. The Rothschild Index is a value between 0 and 1. When an industry is composed of many firms, each producing similar products, the Rothschild index will be close to zero. RI provides a measure of how sensitive an individual firm’s demand is relative to the entire market.

Own-Price Elasticities of Demand and Rothschild Indices

Conduct – behavior of firms tends to differ among industries Industry Analysis Ease of entry and exit – optimal decisions of firms in an industry will depend, in part, on the ease of entry. Barriers to entry – capital requirements; patents; economies of scale Conduct – behavior of firms tends to differ among industries Pricing - firms in some industries can charge higher mark-ups than in other industries. The Lerner Index – a measure of the difference between price and marginal cost as a fraction of the price of the product.

Conduct: Pricing Behavior The Lerner Index L = (P - MC) / P A measure of the difference between price and marginal cost as a fraction of the product’s price. The index ranges from 0 to 1. When P = MC, the Lerner Index is zero; the firm has no market power. A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power.

Markup Factor From the Lerner Index, the firm can determine the factor by which it should price over MC. Rearranging the Lerner Index The markup factor is 1/(1-L). When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC. When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost. The markup charged will vary depending on the nature of the market in which the good is sold.

Lerner Indices & Markup Factors

Integration and Merger Activity Integration – uniting productive resources. Can occur through merger or during the formation of a firm. Mergers – attempt to reduce transactions costs, realize economies of scale and scope, increase market power, or gain easier access to capital markets. Friendly versus hostile mergers Feared by managers in firms not maximizing profits or in some way mis-managed. Vertical Integration – various stages of production are carried out within a single firm. Reduces transaction costs associated with acquiring inputs.

Integration and Merger Activity Horizontal integration – merging production of a similar product into a single firm. Done to realize economies of scale or scope; enhance market power. Horizontal merger reduces competition and increases market power. Social benefits of reduced costs must be weighed against the social costs of more concentration.

DOJ/FTC Horizontal Merger Guidelines Based on HHI = 10,000 S wi2, where wi = Si /ST. Merger may be challenged if HHI exceeds 1800, or would be after merger, and Merger increases the HHI by more than 100. But... Recognizes efficiencies: “The primary benefit of mergers to the economy is their efficiency potential...which can result in lower prices to consumers...In the majority of cases the Guidelines will allow firms to achieve efficiencies through mergers without interference...”

DOJ/FTC Horizontal Merger Guidelines DOJ and FTC permit mergers in high HHI industries if: there is significant foreign competition, an emerging technology, increased efficiencies, one firm is having financial problems. Conglomerate mergers - The integration of different product lines into a single firm. Economic rationale is not clear – loss of specialization w/o offsetting synergies. Possibly merging products with counter-cyclical revenue flows. Dearth of management talent.

R&D and Advertising Advertising – intensity varies over different industries R&D – used to gain a technological advantage over competitors by developing patentable products and processes. Optimal Advertising and R&D spending depends on the characteristics of the industry in which the firm operates.

Performance Performance refers to the profits and social welfare that result in a given industry. Social Welfare = CS + PS = TS Dansby-Willig Performance Index - measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner. If the DW Index is zero there are no gains to TS if firms increase output. TS is maximized given industry demand and cost conditions. If DWI>0 the TS would increase if output increased.

Dansby-Willig Performance Index

Approaches to Studying Industry The Structure-Conduct-Performance (SCP) Paradigm: Causal View Market Structure Conduct Performance The Feedback Critique No one-way causal link. Conduct can affect market structure. Market performance can affect conduct as well as market structure.

Relating the Five Forces to the SCP Paradigm and the Feedback Critique Entry Entry Costs Speed of Adjustment Sunk Costs Economies of Scale Network Effects Reputation Switching Costs Government Restraints Level, Growth, and Sustainability Of Industry Profits Power of Input Suppliers Supplier Concentration Price/Productivity of Alternative Inputs Relationship-Specific Investments Supplier Switching Costs Government Restraints Power of Buyers Buyer Concentration Price/Value of Substitute Products or Services Relationship-Specific Investments Customer Switching Costs Government Restraints Industry Rivalry Substitutes & Complements Concentration Price, Quantity, Quality, or Service Competition Degree of Differentiation Switching Costs Timing of Decisions Information Government Restraints Price/Value of Surrogate Products or Services Price/Value of Complementary Products or Services Network Effects Government Restraints

Preview of Coming Attractions Discussion of optimal managerial decisions under various market structures, including: Perfect competition Monopoly Monopolistic competition Oligopoly

Conclusion Modern approach to studying industries involves examining the interrelationship between structure, conduct, and performance. Industries dramatically vary 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.