1. THE NATURE OF INDUSTRY

2. INTRODUCTION
Several factors affect decisions such as how much to produce, what price to charge, how much to spend on R&D, advertising etc.
No single theory or methodology provide managers answers to these questions
Pricing strategy/ advertising etc. for a car maker will differ from food manufacturers
In this section we examine the important differences that exists among industries.

3. Approaches to Studying Industry
The Structure-Conduct-Performance (SCP) Paradigm:
Different structures lead to different conducts and different performances

4. Market Structure Refers to factors such as
The number of firms that compete in a market,
The relative size of the firm (concentration)
Technological and cost conditions
Ease of entry or exit into industry
Different industries have different structures that affect managerial decision making (Structural differences)

5. 1. Firm Size:
Some industries naturally give rise to large firms than do other industries:
e.g. Industry = Aerospace,
Largest firm = Boeing
Industry = Computer, office equipment
Largest firm = IBM

6. 2. Industry concentration:
Are there many small firms or only a few large ones? (competition or little competition?)
2 ways to measure degree of concentration:
a. Concentration ratios
b. Herfindahl-Hirschman Index (HHI)

7. Concentration ratios measure how much of the total output in an industry is produced by the largest firms in that industry.
Most common one used is the four-firm concentration ratio (C4) = the fraction of total industry sales produced by the 4 largest firms in the industry
If industry has very large number of firms, each of which is small, then is close to 0
When 4 or fewer firms produce all of industry output, is close to 1

8. 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
The closer C4 is to zero, the less concentrated the industry .
e.g. Industry has 6 firms. Sales of 4 firms = $10 and $5 for the other 2.
ST = 50
C4 = 40/50 = 0.8
 4 largest firms account for 80% of total industry output

9. Herfindahl-Hirschman Index (HHI)
The sum of the squared market shares of firms in a given industry, multiplied by 10,000 (to eliminate decimals):
By squaring the market shares, the index weights firms with high market shares more heavily
HHI = 10,000  S wi2, where wi = Si/ST.
0 <= HHI <= 10,000
Closer to 0 means industry has numerous infinitesimally small firms.
Closer to 10,000 means little competition

10. Total Industry Sales = $50
HHI example
3 firms in an industry. 2 have sales of $10 each and the other with $30 sales.
Total Industry Sales = $50
Since the top three firms account for all industry sales

11. Limitation of Concentration Measures
Market Definition: National, regional, or local?
Global Market: Foreign producers excluded.
Industry definition and product classes.

12. Market Definition: National, regional, or local
Market Definition: National, regional, or local? If there are 50 same size gas stations in the US, one in each state, each firm will have 1/50 market share. C4 = 4/50  market for gas is not highly concentrated. What good is this to a consumer in Blaine, Washington, since the relevant market is her local market?
Geographical differences among markets lead to biases in concentration measures

13. Global Market:
Foreign producers excluded.
This tends to overstate the true level of concentration in industries in which significant number of foreign producers serve the market
e.g. C4 for beer producers in US = 0.9 but this ignores the beer produced by many breweries in Mexico, Canada, Europe etc. The C4 based on both imported and domestic beer would be considerably lower

14. Industry definition and product classes:
There is considerable aggregation across product classes.
e.g. Soft drink industry is dominated by Pepsi and Coca-Cola yet the C4 for 2004 is 47%.
Quite low. The C4 contains many types of bottled and canned drinks including lemonade, iced tea, fruit drinks etc.

15. 3. TECHNOLOGY
Some industries are labor intensive while others are capital intensive
In some industries, firms have access to identical technologies and therefore similar cost structures
In others, only 1 or 2 firms may have superior technology giving them cost advantages over others
Those with superior technology will completely dominate the industry

16. 4. Demand and Market Conditions
Markets with relatively low demand will be able to sustain only few firms
Access to information vary from industry to industry
Elasticity of demand for products tend to vary from industry to industry
Elasticity of demand for a firm’s product may differ from the market elasticity of demand for the product

17. Markets where there are no close substitutes for a given firm’s product, elasticity of demand for the firm’s product will be close to that of the market
Rothschild Index = R =Et/Ef
Et = market elasticity
Ef = firm’s elasticity
Measures how sensitive a firm’s demand is relative to the entire market.
When industry has many firms each producing a similar product, R will be close to zero

18. Potential for Entry
Easier for new firms to enter some industries than other industries.
Barriers to entry:
Explicit cost of entering (Capital requirements
Patents
Economies of scale: new firms cannot generate enough volume to reduce average cost

19. CONDUCT: Conduct (behavior) of firms differ across industries
Some industries charge a higher markup than others. (pricing behavior)
Some industries are more susceptible to mergers or takeovers
Amount spent on R&D tend to vary across industries

20. 1. Pricing behavior:
Lerner Index (L) = (P – MC)/MC
Gives how firms in an industry mark up their prices over MC.
If firms vigorously compete, L is close to zero.
P = (1/1-L)MC
When L=2  firms charge price that is 2x the MC of production
e.g Tobacco industry. L = 76%  P is 4.17x the actual MC of production

21. Lerner Indices & Markup Factors
Source: Baye and Lee, NBER working paper # 2212

22. Integration and Merger Activity
Uniting productive services.
Can result from an attempt by firms to
Reduce transaction cost
Reap the benefits of economies of scale and scope
Increase market power
Gain better access to capital markets

23. Vertical Integration:
3 types of integration:
Vertical Integration:
Various stages in the production of a single product are carried out by a single firm
e.g. Car manufacturer produces its own steel, uses the steel to make car bodies and engines.
Reduces transaction cost

24. Horizontal Integration:
Merging production of similar products into a single firm
e.g. 2 banks merge to form one firm to enjoy cost savings of economies or scale or scope and enhance market power.
When social benefits of this merger is relatively small compared to social cost of concentrated industry, government may block this type of merger

25. US Department of Justice considers industries with HHI > 1800 to be highly concentrated and may block any merger that will increase the HHI by more than 100
HHI < 1000 are considered unconcentrated.

26. Conglomerate Mergers
Integrating different product lines into a single firm
Cigarette maker acquires a bread manufacturing firm.
This is to reduce the variability of firm’s earnings due to demand fluctuations and to enhance the firm’s ability to raise funds in the capital market

27. Performance
Performance refers to the profits and social welfare that result in a given industry.
Social Welfare = CS + PS
Dansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.

28. Approaches to Studying Industry
The Structure-Conduct-Performance (SCP) Paradigm: Causal View
Market Structure
Conduct
Performance
e.g.
Consider a highly concentrated industry. This structure gives market power enabling them to charge higher prices for their products. This conduct (behavior of charging higher prices ) is caused by the market structure (few competitors). The high prices cause higher profits and poor performance (low social welfare)
Thus, a concentrated market causes high prices and poor performance

29. The Feedback Critique No one-way causal link.
Conduct can affect market structure.
Market performance can affect conduct as well as market structure.

30. PRICING STRATEGIES OF FIRMS WITH MARKET POWER

31. I. Basic Pricing Strategies
Monopoly & Monopolistic Competition
Cournot Oligopoly
II. Extracting Consumer Surplus
Price Discrimination  Two-Part Pricing
Block Pricing  Commodity Bundling
III. Pricing for Special Cost and Demand Structures
Peak-Load Pricing  Price Matching
Cross Subsidies  Brand Loyalty
Transfer Pricing  Randomized Pricing
IV. Pricing in Markets with Intense Price Competition

32. Standard Pricing and Profits for Firms with Market Power
Price
Profits from standard pricing
= $8 10 8 6 4 2 MC
P = Q
Quantity
MR = Q

33. An Algebraic Example P = 10 - 2Q C(Q) = 2Q
If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR = MC.
10 - 4Q = 2, so Q* = 2.
P* = (2) = 6.
Profits = (6)(2) - 2(2) = $8.

34. A Simple Markup Rule
Suppose the elasticity of demand for the firm’s product is EF.
Since MR = P[1 + EF]/ EF.
Setting MR = MC and simplifying yields this simple pricing formula:
P = [EF/(1+ EF)]  MC.
The optimal price is a simple markup over relevant costs!
More elastic the demand, lower markup.
Less elastic the demand, higher markup.

35. An Example Elasticity of demand for Kodak film is -2.
P = [EF/(1+ EF)]  MC
P = [-2/(1 - 2)]  MC
P = 2  MC
Price is twice marginal cost.
Fifty percent of Kodak’s price is margin above manufacturing costs.

36. Markup Rule for Cournot Oligopoly
Homogeneous product Cournot oligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firm’s demand is given by EF = N x EM.
Since P = [EF/(1+ EF)]  MC,
Then, P = [NEM/(1+ NEM)]  MC.
The greater the number of firms, the lower the profit-maximizing markup factor.

37. An Example Homogeneous product Cournot industry, 3 firms. MC = $10.
Elasticity of market demand = - ½.
Determine the profit-maximizing price?
EF = N EM = 3  (-1/2) = -1.5.
P = [EF/(1+ EF)]  MC.
P = [-1.5/(1- 1.5]  $10.
P = 3  $10 = $30.

38. First-Degree or Perfect Price Discrimination
Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.
Permits a firm to extract all surplus from consumers.

39. Perfect Price Discrimination
Profits*:
.5(4-0)(10 - 2)
= $16 10 8 6
Total Cost* = $8 4 2 MC D
Quantity
* Assuming no fixed costs

40. Caveats:
In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).
Price discrimination won’t work if consumers can resell the good.

41. Second-Degree Price Discrimination
The practice of posting a discrete schedule of declining prices for different quantities.
Eliminates the information constraint present in first-degree price discrimination.
Example: Electric utilities MC
$10 $8 $5 D 2 4
Quantity

42. Third-Degree Price Discrimination
The practice of charging different groups of consumers different prices for the same product.
Group must have observable characteristics for third-degree price discrimination to work.
Examples include student discounts, senior citizen’s discounts, regional & international pricing.

43. Implementing Third-Degree Price Discrimination
Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2.
Notice that group 1 is more price sensitive than group 2.
Profit-maximizing prices?
P1 = [E1/(1+ E1)]  MC
P2 = [E2/(1+ E2)]  MC

44. An Example
Suppose the elasticity of demand for Kodak film in the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.
Marginal cost of manufacturing film is $3.
PU = [EU/(1+ EU)]  MC = [-1.5/( )]  $3 = $9
PJ = [EJ/(1+ EJ)]  MC = [-2.5/( )]  $3 = $5
Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

45. Two-Part Pricing
When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.
Two-part pricing consists of a fixed fee and a per unit charge.
Example: Athletic club memberships.

46. How Two-Part Pricing Works
Price
1. Set price at marginal cost.
2. Compute consumer surplus.
3. Charge a fixed-fee equal to consumer surplus. 10 8 6
Fixed Fee = Profits = $16
Per Unit
Charge 4 2 MC D
Quantity

47. Block Pricing
The practice of packaging multiple units of an identical product together and selling them as one package.
Examples
Paper.
Six-packs of soda.
Different sized of cans of green beans.

48. An Algebraic Example Typical consumer’s demand is P = 10 - 2Q
C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?

49. Optimal Quantity To Package: 4 Units
Price 10 8 6 4 2
MC = AC D
Quantity

50. Optimal Price for the Package: $24
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24! 10 8 6 4 2
MC = AC D
Quantity

51. Costs and Profits with Block Pricing
Price 10
Profits = [.5(8)(4) + (2)(4)] – (2)(4)
= $16 8 6 4
Costs = (2)(4) = $8 2
MC = AC D
Quantity

52. Commodity Bundling
The practice of bundling two or more products together and charging one price for the bundle.
Examples
Vacation packages.
Computers and software.
Film and developing.

53. An Example that Illustrates Kodak’s Moment
Total market size for film and developing is 4 million consumers.
Four types of consumers
25% will use only Kodak film (F).
25% will use only Kodak developing (D).
25% will use only Kodak film and use only Kodak developing (FD).
25% have no preference (N).
Zero costs (for simplicity).
Maximum price each type of consumer will pay is as follows:

54. Reservation Prices for Kodak Film and Developing by Type of Consumer

55. Optimal Film Price?
Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million.
At a price of $4, only types F, FD, and D will buy
(profits of $12 Million).
At a price of $3, all types will buy (profits of $12 Million).

56. Optimal Price for Developing?
At a price of $6, only “D” type buys (profits of $6 Million).
At a price of $4, only “D” and “FD” types buy (profits of $8 Million).
At a price of $2, all types buy (profits of $8 Million).
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.

57. Total Profits by Pricing Each Item Separately?
Total Profit = Film Profits + Development Profits
= $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling!

58. Pricing a “Bundle” of Film and Developing

59. Consumer Valuations of a Bundle

60. What’s the Optimal Price for a Bundle?
Optimal Bundle Price = $10 (for profits of $30 million)

61. Peak-Load Pricing
When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.
Charge a higher price (PH) during peak times (DH).
Charge a lower price (PL) during off-peak times (DL).
Price MC
MRH DH PH
MRL DL PL QL QH
Quantity

62. Cross-Subsidies
Prices charged for one product are subsidized by the sale of another product.
May be profitable when there are significant demand complementarities effects.
Examples
Browser and server software.
Drinks and meals at restaurants.

63. Double Marginalization
Consider a large firm with two divisions:
the upstream division is the sole provider of a key input.
the downstream division uses the input produced by the upstream division to produce the final output.
Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU.
Implication: PU > MCU.
Similarly, when the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD.
Implication: PD > MCD.
Thus, both divisions mark price up over marginal cost resulting in in a phenomenon called double marginalization.
Result: less than optimal overall profits for the firm.

64. Transfer Pricing
To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.
To achieve this goal, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):
NMRd = MRd - MCd = MCu

65. Upstream Division’s Problem
Demand for the final product P = Q.
C(Q) = 2Q.
Suppose the upstream manager sets MR = MC to maximize profits.
10 - 4Q = 2, so Q* = 2.
P* = (2) = $6, so upstream manager charges the downstream division $6 per unit.

66. Downstream Division’s Problem
Demand for the final product P = Q.
Downstream division’s marginal cost is the $6 charged by the upstream division.
Downstream division sets MR = MC to maximize profits.
10 - 4Q = 6, so Q* = 1.
P* = (1) = $8, so downstream division charges $8 per unit.

67. Analysis
This pricing strategy by the upstream division results in less than optimal profits!
The upstream division needs the price to be $6 and the quantity sold to be 2 units in order to maximize profits. Unfortunately,
The downstream division sets price at $8, which is too high; only 1 unit is sold at that price.
Downstream division profits are $8  1 – 6(1) = $2.
The upstream division’s profits are $6  1 - 2(1) = $4 instead of the monopoly profits of $6  2 - 2(2) = $8.
Overall firm profit is $4 + $2 = $6.

68. Upstream Division’s “Monopoly Profits”
Price
Profit = $8 10 8 6 4 2
MC = AC
P = Q
Quantity
MR = Q

69. Upstream’s Profits when Downstream Marks Price Up to $810 8 6 4 2
MC = AC
P = Q
Quantity
MR = Q

70. Solutions for the Overall Firm?
Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).
Overall profit with optimal transfer price:

71. Pricing in Markets with Intense Price Competition
Price Matching
Advertising a price and a promise to match any lower price offered by a competitor.
No firm has an incentive to lower their prices.
Each firm charges the monopoly price and shares the market.
Randomized Pricing
A strategy of constantly changing prices.
Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price.
Reduces the ability of rival firms to undercut a firm’s prices.

72. Conclusion
First degree price discrimination, block pricing, and two part pricing permit a firm to extract all consumer surplus.
Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.
Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.
Different strategies require different information.