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Module 2 Nature of Industry

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295 views24 pages

Module 2 Nature of Industry

Uploaded by

Trúc Ly Cáp thị
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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+Managerial Economics & Business Strategy

Module 2:
The Nature of Industry

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
7-2
+
Overview
I. Market Structure
 Measures of Industry Concentration

II. Conduct
 Pricing Behavior
 Integration and Merger Activity

III. Performance
 Dansby-Willig Index
 Structure-Conduct-Performance Paradigm
7-3
+
Industry Analysis

 Market Structure: Factors that affect managerial


decisions
 Number and size of firms. Table 7-1
 Industry concentration.
 Technological and cost conditions.
 Demand conditions.
 Ease of entry and exit.

 Conduct
 Pricing.
 Advertising.
 R&D.
 Merger activity.

 Performance
 Profitability.
 Social welfare.
7-4

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
Si
C4  w1  w2  w3  w4 , where w1 
ST

 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.
7-5

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?

C4  0.2  0.2  0.2  0.2  0.8


 What is the HHI?

 2 2 2 2

HHI  10,000 .2  .2  .2  .2  .2  2,000
2

 Table 7-2
7-6

Limitation of Concentration
Measures
 Market Definition: National, regional, or local?
In many industries, the relevant markets are local and may be
composed of only a few firms. When the relevant markets are
local, the use of national data tends to understate the actual level
of concentration in the local markets.

 Global Market: Foreign producers excluded.


 Industry definition and product classes(industry
classification)

Notes: the HHI indexes reported in Table 7-2 are only


approximations, because the Census Bureau uses data on only the
top 50 firms in the industry rather than data on all firms in the
industry
7-7
+
Technology

 Industries differ regarding the technology used to produce


goods and services.
 Some industries are labor intensive;
 Some industries are capital intensive;
 Other industries use a combination of labor and capital.
7-8
+
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 (perfect competition)
and 1 (monopoly).

 When an industry is composed of many


firms, each producing similar products, the
Rothschild index will be close to zero.
7-9

Own-Price Elasticities of Demand and


Rothschild Indices
Elasticity Elasticity
Industry of Market of Firm’s Rothschild
Demand Demand Index
Food -1.0 -3.8 0.26
Tobacco -1.3 -1.3 1.00
Textiles -1.5 -4.7 0.32
Apparel -1.1 -4.1 0.27
Paper -1.5 -1.7 0.88
Chemicals -1.5 -1.5 1.00
Rubber -1.8 -2.3 0.78
+

 Table 7-4 (p279)

The more competition among producers in an industry, the


more elastic will be the demand for an individual firm’s
product.
7-11
+
Market Entry and Exit Conditions

 Barriers to entry
 Capital requirements.
 Economies of scale.
 Economies of scope
 Legal environment
 …

 Barriers to exit ?
7-12

II. 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.
7-13

Markup Factor
 From the Lerner Index, the firm can determine
the factor by which it should over MC.
Rearranging the Lerner Index

 1 
P  MC
1 L 
 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.
7-14

Lerner Indices & Markup Factors

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
+

 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?
7-16
+
Integration and Merger Activity
 Vertical Integration
 Where various stages in the production of a single product are
carried out by one firm.

 Horizontal Integration
 The merging of the production of similar products into a single firm.

 Conglomerate Mergers
 The integration of different product lines into a single firm.
+
Pros & cons of Horizontal
Integration
PROS CONS

 Lower costs =>  Destroyed value.


economics of scale /
scope  Legal repercussions.

 Increased differentiation.  Reduced flexibility.

 Increased market power.

 Reduced competition.

 Access to new markets.


+ DOJ/FTC Horizontal Merger
7-18

Guidelines
 Based on HHI = 10,000 S wi2, where

wi = Si /ST.

 Merger may be challenged if


 HHIexceeds 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...”
7-19
+
III. 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.
 Industries with large index values have poorer performance than
industries with lower values.
7-20

Dansby-Willig
Performance Index
Industry Dansby-Willig Index
Food 0.51
Textiles 0.38
Apparel 0.47
Paper 0.63
Chemicals 0.67
Petroleum 0.63
Rubber 0.49

A slight change in output in the chemical industry would increase


social welfare more than would a slight change in the output in any
of the other industries.
The textile industry has the lowest DW indexbest performance.
7-21
+
Example
The four-firm concentration ratios for industries X and Y are
89 percent and 62 percent, respectively, while the
corresponding Herfindahl-Hirschman indexes are 2,600
and 1,200.

The Dansby-Willig performance index for industry X is 0.6,


while that for industry Y is 0.8.

Based on this information, which would lead to the greatest


increase in social welfare: A slight increase in industry
X’s output, or a slight increase in industry Y’s output?
Approaches to Studying Industry
7-22

• The Structure-Conduct-Performance (SCP)


Paradigm: Causal View
Market
Conduct Performance
Structure

 The Feedback Critique


 No one-way causal link.
 Conduct can affect market structure.
 Market performance can affect conduct
as well as market structure.
 According to the causal view, this structure gives firms
+ market power, enabling them to charge high prices for their
products. The behavior (charging high prices) is caused by
market structure (the presence of few competitors). The high
prices, in turn, “cause” high profits and poor performance
(low social welfare). Thus, according to the causal view, a
concentrated market “causes” high prices and poor
performance.

 According to the feedback critique, the conduct of firms in an


industry may itself lead to a concentrated market. If the (few)
existing firms are charging low prices and earning low
economic profits, there will be no incentive for additional
firms to enter the market. If this is the case, it could actually
be low prices that “cause” the presence of few firms in the
industry. In summary, then, it is a simplification of reality to
assert that concentrated markets cause high prices. Indeed,
the pricing behavior of firms can affect the number of firms.

 FIGURE 7–1 The Five Forces Framework with Feedback


Effects (p287)
7-24
+
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.

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