1. Managerial Economics & Business Strategy
Chapter 7
The Nature of Industry

2. 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.

3. 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

4. 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.

5. 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.

6. 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

7. 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?

8. 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.

9. 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.

10. 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

11. 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.

12. Own-Price Elasticities of Demand and Rothschild Indices

13. 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.

14. 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.

15. 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.

16. Lerner Indices & Markup Factors

17. 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.

18. 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.

19. 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...”

20. 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.

21. 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.

22. 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.

23. Dansby-Willig Performance Index

24. 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.

25. 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

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

27. 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.