1. Chapter 7 The Nature of Industry McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Market structure Conduct Performance
Chapter Overview
Chapter Outline
Market structure
Firm size
Industry concentration
Technology
Demand and market conditions
Potential for entry
Conduct
Pricing behavior
Integration and merger activity
Research and development
Advertising
Performance
Profit
Social welfare
The structure-conduct-performance paradigm
Causal view
Feedback critique
Relation to the Five Forces Framework

3. Chapter Overview
Introduction
Chapter 6 focused on the optimal way to acquire the efficient mix of inputs, and how to solve various principal-agent problems that arise within the firm.
This chapter provides an overview of the nature of various industries.
How concentrated are sales in one industry relative to another?
How do price-cost margins vary by industry?
How do advertising and R&D expenditures vary by industry?

4. Market Structure
Market Structure
Market structure factors that impact managerial decisions:
Number of firms competing in an industry.
Relative size of firms (concentration).
Technological and cost conditions.
Demand conditions.
Ease of firm exit or entry.

5. Industry Concentration
Market Structure
Industry Concentration
Measures the size distribution of firms within an industry.
Are there many small firms?
Are there only a few large firms?

6. Measuring Industry Concentration
Market Structure
Measuring Industry Concentration
Measures of industry concentration
Four-firm concentration ratio:
𝐶 4 = 𝑆 1 + 𝑆 2 + 𝑆 3 + 𝑆 4 𝑆 𝑇
Herfindahl-Hirschman index (HHI):
𝐻𝐻𝐼=10,000 𝑖=1 𝑁 𝑆 𝑖 𝑆 𝑇 2

7. Measuring Industry Concentration in Action
Market Structure
Measuring Industry Concentration in Action
Suppose an industry is composed of six firms. Four firms have sales of $10 each, and two firms haves sales of $5 each. What is the four-firm concentration ratio for this industry?
Answer:
Total industry sales are 𝑆 𝑇 =$50.
Sales of the four largest firms are $40.
The four-firm concentration ratio is: 𝐶 4 = $10+$10+$10+$10 $50 =0.80
The four largest firms in the industry account for 80 percent of total industry output.

8. Measuring Industry Concentration In Action
Market Structure
Measuring Industry Concentration In Action
Industry
C4 (percentage)
HHI
Distilleries 70
1,519
Fluid milk 46
1,075
Motor vehicles 68
1,744
Snack foods 53
1,984
Furniture and related products 11 62
Semiconductor and other electronic components 34
476
Soft drinks 52
891

9. Limitations of Concentration Measures
Market Structure
Limitations of Concentration Measures
Factors that impact and limit industry concentration measures include:
Global markets.
National, regional and local markets.
Industry definitions and product classes.

10. Market Structure
Technology and Costs
Industries differ in regard to the technologies used to produce goods and services.
Labor-intensive industries.
Capital-intensive industries.
Within a given industry if the available technology is:
the same, firms will likely have similar cost structures.
different, one firm will likely have a cost advantage.

11. Demand and Market Conditions
Market Structure
Demand and Market Conditions
Industries with
low demand may imply few firms.
high demand may imply many firms.
Elasticity of demand varies from industry to industry.
The Rothschild index measures the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.
𝑅= 𝐸 𝑇 𝐸 𝐹

12. Demand and Market Conditions in Action
Market Structure
Demand and Market Conditions in Action
The industry elasticity of demand for airline travel is -3, and the elasticity of demand for an individual carrier is -4. What is the Rothschild index for this industry?
Answer:
The Rothschild index is:
𝑅= −3 −4 =0.75

13. Demand and Market Conditions In Action
Market Structure
Demand and Market Conditions In Action
Industry
Own Price Elasticity of Market Demand
Own Price Elasticity of Demand for Representative Firm
Rothschild Index
Food
-1.0
-3.8
0.26
Tobacco
-1.3
1.00
Textiles
-1.5
-4.7
0.32
Apparel
-1.1
-4.1
0.27
Paper
-1.7
0.88
Chemicals
Petroleum

14. Market Structure
Potential for Entry
Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market.
Several factors can create barriers to entry (or make entry difficult).
Capital requirements.
Patents.
Economies of scale.

15. Conduct Behavior of firms: Price markup over costs.
Integration and merger.
Advertising expenditures.
Research and development expenditures.

16. Pricing Behavior Lerner index
Conduct
Pricing Behavior
Lerner index
A measure of the difference between price and marginal cost as a fraction of the product’s price.
𝐿= 𝑃−𝑀𝐶 𝑃
rearranging this equation yields
𝑃= 1 1−𝐿 𝑀𝐶
, where 1 1−𝐿 is the markup factor over marginal costs.

17. Pricing Behavior in Action
Conduct
Pricing Behavior in Action
A firm in the airline industry has a marginal cost of $200 and charges a price of $300. What are the Lerner index and markup factor?
The Lerner index is
𝐿= 𝑃−𝑀𝐶 𝑃 = $300−$200 $300 = 1 3
The markup factor is
1 1−𝐿 = 1 1− 1 3 =1.5

18. Pricing Behavior In Action
Conduct
Pricing Behavior In Action
Industry
Lerner Index
Markup Factor
Food
0.26
1.35
Tobacco
0.76
4.17
Textiles
0.21
1.27
Apparel
0.24
1.32
Paper
0.58
2.38
Chemicals
0.67
3.03
Petroleum
0.59
2.44

19. Integration and Merger Activity
Conduct
Integration and Merger Activity
Integration
Uniting productive resources of firms.
Can occur during the formation of a firm.
Merger
Two or more existing firms “unite,” or merge, into a single firm.
Reasons firms merge:
Reduce transaction costs.
Reap benefits of economies of scale and scope.
Increase market power.
Gain better access to capital markets.

20. Types of Integration Vertical integration Horizontal integration
Conduct
Types of Integration
Vertical integration
Various stages in the production of a single product are carried out in a single firm.
Horizontal integration
Merging two or more similar final products into a single firm.
Conglomerate mergers
Integration of two or more different product lines into a single firm.

21. Research and Development
Conduct
Research and Development
Research and development
Expenditures made by firms to gain a technological advantage, with the aim of acquiring a patent.
Company
Industry
R&D as Percentage of Sales
Bristol-Meyers Squibb
Pharmaceuticals
19.7
Ford
Motor vehicle and parts
4.1
Goodyear Tire and Rubber
Rubber and plastic parts
2.0
Kellogg
Food
1.5
Proctor & Gable
Soaps and cosmetics
2.5

22. Advertisement Advertisement
Conduct
Advertisement
Advertisement
Expenditures made by firms to inform or persuade consumers to purchase their products.
Company
Industry
Advertising as Percentage of Sales
Bristol-Meyers Squibb
Pharmaceuticals
4.9
Ford
Motor vehicle and parts
3.2
Goodyear Tire and Rubber
Rubber and plastic parts
2.5
Kellogg
Food
9.2
Proctor & Gable
Soaps and cosmetics
11.7

23. Dansby-Willig Performance Index
Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount.
Industry
Dansby-Willig Index
Food
0.51
Rubber
0.49
Textiles
0.38
Apparel
0.47
Paper
0.63
Chemicals
0.67
Petroleum

24. Structure-Conduct-Performance
The Structure- Conduct-Performance Paradigm
Structure-Conduct-Performance
Structure:
Factors like technology, concentration and market conditions.
Conduct:
Individual firm behavior in the market. Behavior includes pricing decisions, advertising decisions and R&D decisions, among other factors.
Performance:
Resulting profit and social welfare that arise in the market.
Structure-conduct-performance paradigm
Model that views these three aspects of industry as being integrally related.

25. The Structure- Conduct-Performance Paradigm
The Casual View
Market structure “causes” firms to behave in a certain way.
… this behavior, or conduct, “causes” resources to be allocated in certain ways.
… this resource allocation leads to “good” or “bad” performance.

26. The Structure- Conduct-Performance Paradigm
The Feedback Critique
There is no one-way causal link among structure, conduct and performance.
Firm conduct can affect market structure;
Market performance can affect conduct and market structure.

27. Substitutes & Complements
The Structure- Conduct-Performance Paradigm
Five Forces Framework
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

28. Looking Ahead Perfect competition Monopoly Monopolistic competition
Overview of the Remainder of the Book
Looking Ahead
Perfect competition
Many, small firms and consumers relative to market.
Firms produce very similar products.
No market power (P = MC).
Monopoly
Sole producer of good or service.
Market power (P > MC).
Monopolistic competition
Firms produce slightly different products.
Limited market power.
Oligopoly
Few, large firms tend to dominate market.
Price/marketing strategies are mutually interdependent with other firms in the industry.

29. 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.