1. THE NATURE OF INDUSTRY

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

3. Market Structure
Number of buyers, Buyer Power, the number of firms that compete in a market, producer power
The relative size of the firm (concentration)
Technological and cost conditions; Economies of scale, Economies of scope, cost synergies, transaction costs
Ease of entry or exit into industry, regulations
5. Type of product (homogeneous or heterogeneous)

4. Different industries have different structures that affect managerial decision

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

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

12. 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

13. 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

14. 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

15. 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

16. 1. Pricing behavior:
Lerner Index (L) = (P – MC)/P
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
If L = 0, then the P=MC
When L=1/2  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

17. 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

18. Types of integration:
Vertical : merging with your supplier to reduce transaction cost
Horizontal: merging similar companies to reduce cost and enjoy economies of scale or scope and market power
Conglomerate: merging firms in different industries to reduce the variability of firm’s earnings due to demand fluctuation

19. 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.

20. 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.

21. 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

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

23. Spectrum of Market Structures
Based on Power of Buyers and Sellers
Monopsony (highest power of buyers)
Perfect Competition (Low power of buyers and low power of sellers
Oligopoly (Cartel) (medium power of sellers, low power of buyers)
Monopoly (highest power of sellers, low power of buyers

24. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

25. Four Basic Market Types
1. Perfect Competition (no market power)
Large number of relatively small buyers and sellers
Standardized product
Very easy market entry and exit
Nonprice competition not possible

26. 2. Monopoly (absolute market power subject to government regulation)
One firm, firm is the industry
Unique product or no close substitutes
Market entry and exit difficult or legally impossible
Nonprice competition not necessary

27. 3. Monopolistic Competition (market power based on product differentiation)
Large number of relatively small firms acting independently
Differentiated product
Market entry and exit relatively easy
Nonprice competition very important

28. Oligopoly (market power based on product differentiation and/or the firm’s dominance of the market)
Small number of relatively large firms that are mutually interdependent
Differentiated or standardized product
Market entry and exit difficult
Nonprice competition very important among firms selling differentiated products

30. Pricing and Output Decisions in Perfect Competition

31. Unrealistic? Why Learn?
Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms.
It is a useful benchmark.
Explains why governments oppose monopolies.
Illuminates the “danger” to managers of competitive environments.
Importance of product differentiation.
Sustainable advantage.

32. Key assumptions of the perfectly competitive market
The firm operates in a perfectly competitive market and therefore is a price taker.
The firm makes the distinction between the short run and the long run.
The firm’s objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss.
The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

33. Setting Price
Market QM $ D S Pe
Firm Qf $ Df

34. Profit-Maximizing Output Decision
MR = MC.
Since, MR = P,
Set P = MC to maximize profits.

35. Graphically: Representative Firm’s Output Decision
Profit = (Pe - ATC)  Qf* MC $ Qf
ATC
AVC Pe
Pe = Df = MR
ATC
Qf*

36. A Numerical Example Given Optimal Price? Optimal Output?
C(Q) = 5 + Q2
Optimal Price?
Optimal Output?
MR = P = $10 and MC = 2Q
10 = 2Q
Q = 5 units
Maximum Profits?
PQ - C(Q) = (10)(5) - (5 + 25) = $20

37. The firm incurs a loss. At the optimum output level price is below average cost.
However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss.

38. Shutdown Decision Rule
A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs.
Operating results in a smaller loss than ceasing operations.
Decision rule:
A firm should shutdown when P < min AVC.
Continue operating as long as P ≥ min AVC.

39. Shutdown Point: the lowest price at which the firm would still produce.
At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution margin.
If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs.

40. Firm’s Short-Run Supply Curve: MC Above Min AVC
ATC $ Qf
AVC
P min AVC
Qf*

41. Long Run Adjustments?
If firms are price takers but there are barriers to entry, profits will persist.
If the industry is perfectly competitive, firms are not only price takers but there is free entry.
Other “greedy capitalists” enter the market.

42. Effect of Entry on Price?
Market QM $ D S Pe
Firm Qf $ Df S*
Entry
Pe*
Df*

43. Summary of Logic Short run profits leads to entry.
Entry increases market supply, drives down the market price, increases the market quantity.
Demand for individual firm’s product shifts down.
Firm reduces output to maximize profit.
Long run profits are zero.

44. Features of Long Run Competitive Equilibrium
P = MC
Socially efficient output.
P = minimum AC
Efficient plant size.
Zero profits
Firms are earning just enough to offset their opportunity cost.

45. Effect of an increase in DD in a PC market
Initial position P=AC (no economic profits= accounting profits cover opportunity cost) Demand increases Mkt price increases in the SR Firms have an incentive to produce more output with available capacity Firms make economic profits Profits attract entrants New entrants increase SS and reduce market price Price decreases unit P=AC Final Price is higher or lower depending on higher or lower input prices as output increases

46. As identical firms expand output and demand more inputs, price of inputs increase, increasing costs. Final price exceeds initial price
As firms expand output and demand more inputs, price of inputs decrease, decreasing costs. Final price is lower than the initial price

47. Effects of an increase in variable cost in a PC market
Initial situation P=AC Variable cost increases Firms have an incentive to produce less output with available capacity Firms have economic losses Firms exit market Market price increases (until P=AC) Final LR market price is higher to compensate for higher variable cost

48. Effect of an increase in Fixed costs in a PC market
Initial situation P=AC Fixed costs increase Market price does not change in the SR because MC is not affected Firms have economic losses Firms exit SS decreases, market price increases Market price increases until P=AC LR market price is higher to compensate for the higher fixed cost

49. Case: Trucking Industry
Higher gas prices  increasing costs  increase in price of transporting cargo
Some truckers add airfoils to their truck to compensate for higher gas prices
In the SR, the first truckers with airfoils earn profits
Profits induce other truckers to add airfoils or equivalent devices to their trucks
In the LR, airfoils or equivalents are necessary for survival but not sufficient for profits

50. Single firm serves the “relevant market.”
Monopoly Environment
Single firm serves the “relevant market.”
Most monopolies are “local” monopolies.
The demand for the firm’s product is the market demand curve.
Firm has control over price.
But the price charged affects the quantity demanded of the monopolist’s product.

51. Managing a Monopoly Market power permits you to price above MC
Is the sky the limit?
No. How much you sell depends on the price you set!

52. “Natural” Sources of Monopoly Power
Economies of scale
Economies of scope
Cost complementarities

53. “Created” Sources of Monopoly Power
Patents and other legal barriers (like licenses)
Tying contracts
Exclusive contracts
Collusion
Contract... I.
II.
III.

54. Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity. MC $ Q
ATC
Profit PM
ATC D QM MR

55. Given estimates of Optimal output? Optimal price? Maximum profits?
A Numerical Example
Given estimates of
P = 10 - Q
C(Q) = 6 + 2Q
Optimal output?
MR = Q
MC = 2
10 - 2Q = 2
Q = 4 units
Optimal price?
P = 10 - (4) = $6
Maximum profits?
PQ - C(Q) = (6)(4) - (6 + 8) = $10

56. Strategies to maintain a Monopoly market position
Apply “limit” pricing
Threaten with “predatory pricing”
Invest in excess capacity
Raise cost of rivals by advertising
Control key inputs
As on substitutes and complements
Integrate vertically and horizontally
Influence politicians and regulators

57. Why Government Dislikes Monopoly?
P > MC
Too little output, at too high a price.
Deadweight loss of monopoly.

58. Deadweight Loss of Monopoly$ Q
ATC MC
Deadweight Loss of Monopoly PM QM D MC MR

59. Arguments for Monopoly
The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power.
Encourages innovation.

60. Monopolistic Competition: Environment and Implications
Numerous buyers and sellers
Differentiated products
Implication: Since products are differentiated, each firm faces a downward sloping demand curve.
Consumers view differentiated products as close substitutes: there exists some willingness to substitute.
Free entry and exit
Implication: Firms will earn zero profits in the long run.

61. Managing a Monopolistically Competitive Firm
Like a monopoly, monopolistically competitive firms
have market power that permits pricing above marginal cost.
level of sales depends on the price it sets.
But …
The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist.
Free entry and exit impacts profitability.
Therefore, monopolistically competitive firms have limited market power.

62. Competing in Imperfectly Competitive Markets
Non-price variables: any factor that managers can control, influence, or explicitly consider in making decisions affecting the demand for their goods and services.
Advertising
Promotion
Location and distribution channels
Market segmentation
Loyalty programs
Product extensions and new product development
Special customer services
Product “lock-in” or “tie-in”
Pre-emptive new product announcements

63. Monopolistic Competition: Profit Maximization
Maximize profits like a monopolist
Produce output where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.

64. Short-Run Monopolistic CompetitionMC $
ATC
Profit PM
ATC D
Quantity of Brand X QM MR

65. Long Run Adjustments?
If the industry is truly monopolistically competitive, there is free entry.
In this case other “greedy capitalists” enter, and their new brands steal market share.
This reduces the demand for your product until profits are ultimately zero.

66. Long-Run Monopolistic Competition
Long Run Equilibrium
(P = AC, so zero profits) $ AC MC P* P1
Entry D MR D1 Q1 Q*
Quantity of Brand X
MR1

67. Monopolistic Competition
The Good (To Consumers)
Product Variety
The Bad (To Society)
P > MC
Excess capacity
Unexploited economies of scale
The Ugly (To Managers)
P = ATC > minimum of average costs.
Zero Profits (in the long run)!

68. Maximizing Profits: A Synthesizing Example
C(Q) = Q2
Determine the profit-maximizing output and price, and discuss its implications, if
You are a price taker and other firms charge $40 per unit;
You are a monopolist and the inverse demand for your product is P = Q;
You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

69. Marginal Cost C(Q) = 125 + 4Q2, So MC = 8Q.
This is independent of market structure.

70. Price Taker MR = P = $40. Set MR = MC. Cost of producing 5 units.
40 = 8Q.
Q = 5 units.
Cost of producing 5 units.
C(Q) = Q2 = = $225.
Revenues:
PQ = (40)(5) = $200.
Maximum profits of -$25.
Implications: Expect exit in the long-run.

71. Monopoly/Monopolistic Competition
MR = Q (since P = Q).
Set MR = MC, or Q = 8Q.
Optimal output: Q = 10.
Optimal price: P = (10) = $90.
Maximal profits:
PQ - C(Q) = (90)(10) -( (100)) = $375.
Implications
Monopolist will not face entry (unless patent or other entry barriers are eliminated).
Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.

72. Conclusion
Firms operating in a perfectly competitive market take the market price as given.
Produce output where P = MC.
Firms may earn profits or losses in the short run.
… but, in the long run, entry or exit forces profits to zero.
A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.
A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

73. Oligopoly
Oligopoly is a market dominated by a relatively small number of large firms
Unconcentrated markets have HH < 1,000
Products are either standardized or differentiated
Barrier to entry exist
Price, Output and profits depend on actions, reactions, and counteractions

74. Basic Oligopoly Models
“Sweezy” Oligopoly – A firm assumes that rivals will cut prices when it reduces its price but will not increase prices when it increases the price – result: Price rigidity
“Cournot” Oligopoly – A firm decides its output based on the output of rivals and vice versa – results: firms divide the market
“Betrand” Oligopoly – Firms compete by undercutting each other’s price – result: Price wars and no profits
“Stakelberg” Oligopoly: A firm moves first and commits to an output level before rivals. Rivals decide their output based on the leader’s output – results: staus quo

75. Cartel
Agreement among competing firms to fix prices, output and marketing. Occurs in oligopoly markets Can be explicit or Implicit Legal or illegal

76. Explicit Cartels
Pure – all firms join the cartel and all have the same costs and costs structure
Perfect – all firms join the cartel but firms have different costs and cost structures
Imperfect – Not all firms join and firms have the same or different costs and cost structures

77. Implicit Cartels
Firms coordinate strategies without explicit cooperation while recognizing their interdependence.
Firms play strategic games
Firms exploit gray area in anti-trust laws

78. Dynamics of an Explicit Cartel (Explicit collusion)
Initial position: producers behave competitively P=AC (no economic profits) Producers have an agreement to increase the price Producers set quota to control cheating Firms make economic profits As P>MC>AC, each producer has an incentive to produce more than the quota The cartel breaks down as each producer cheats The cartel has to adopt additional strategies to extend the life of the cartel

79. Some Strategies to facilitate strategic coordination
Hire a cartel enforcer
Centralize or consolidate trade of members and non-members
Control key inputs
Establish specifications and standards
Hire quota enforcers
Divide the market geographically
Limit market shares and set collusion terms other than price
Influence government so that it ‘regulates” industry
Pay for not producing or buy production from others

80. Case: Government as an Enforcer of coordination
Government imposes tax on producers
Variable cost rise, supply falls, PRP (price received by producers) fall and PPC (price paid by consumers) increase
This is equivalent to a government that figurative buys x for PRP and resells x for PPC

81. Mafioso Economics Merchants in a city compete and charge price = Po
"Mafioso Jane" tells merchants that they have to charge P1 (higher than Po) and threatens merchants if they do not obey
Merchants in general make more profits at higher price P1. They pay for a fee or “private tax” to "Mafioso Jane" for services rendered
"Mafioso Jane" acts as a cartel enforcer.
Merchants gain by having "Mafioso Jane" put order in the market and discipline cheaters
"Mafioso Jane" is acting like a government by regulating entry and imposing taxes