07 - The Nature of Industry Flashcards
Market Structure
Structural differences among industries in a market.
Factors such as: Number of firms Relative size of firms - concentration Technical and cost conditions Demand conditions Ease of entry/exit
Concentration
The number and relative size of firms in an industry.
Are there many small firms or just a few large firms?
The Four-Firm Concentration Ratio and Herfindahl-Hirschman Index (HHI) help illustrate concentration in an industry.
Four-Firm Concentration Ratio
The fraction of total industry sales produced by the four largest firms.
Equivalently, the sum of the market shares of four largest firms.
Most popular ratio but crude representation. It ignores firms after the 4th. Industry of 5 and 50 firms could have same ratio eg.
Ratio closer to 0 means many firms
Ratio closer to 1 means fewer firms
Herfindahl-Hirschman Index (HHI)
The sum of the squared market shares of ALL firms in an industry, multiplied by 10,000.
By squaring before adding, large firms are given more relative weight in the assessment.
Ratio range is 0 - 10,000
Closer to zero means many small firms
Value of 10,000 means a single firm.
C4 vs HHI
Limitations
C4 only considers 4 largest and HHI includes all firms. HHI places greater weight on relatively larger firms.
Census Bureau only reports on top 50 firms so raw data for HHI may not be complete.
Concentration ratio limitations
Results of C4 and HHI may be over stated if global companies participate in relevant market.
Results may be under stated if there are many national and regional firms but only a few or one local firm is relevant to buyers. Local utilities are example.
Broad or narrowly defined product classes can skew results. Many beverages classified as soft drinks.
Technology implications
Some industries depend more on labor while others depend more on technology. Comparing ratios of sales per employed person describes level of tech dependency between industries.
Within an industry, a firm with tech not available to competitors will dominate the industry.
Demand and Market Condition implications
Level of:
Demand
Information
Elasticity
Low demand markets may only sustain a few firms. Large demand markets may require many firms to produce adequate supply.
Informed customers increases competitiveness in market.
Many substitutes leads to high elasticity and more competitive environment. The product elasticity of demand for unique products will be close to elasticity of market demand.
Monopolized Industry Demand
The elasticity of product demand is equal to the elasticity of market demand.
Rothschild Index
A measure of the sensitivity to price of the product group as a whole relative to the sensitivity of the quantity demanded of single firm to a change in its price.
The elasticity of demand for total market over elasticity of demand the product of single firm.
Values between 0 and 1
Closer to 0 means EOPD > EOMD.
Closer to 1 means EOPD near = EOMD.
Potential for Entry/Exit
Barriers to Entry:
Explicit costs such as capital investments.
Patent protections
Economies of Scale
Industry Conduct
Conduct differences of industries.
Industries vary by:
Markup - pricing behavior
Susceptibility to mergers and takeovers
Investment in:
Marketing
R&D
Product development
Lerner Index
A measure of pricing behavior.
Measures the difference between price and marginal cost as a fraction of the price of the product. L= (P-MC)/P
Range 0 - 1
Closer to 0 when firms set price close to MC
Closer to 1 when firms set higher prices
Closer to 0 means more competition.
Markup Factor
The factor by which MC is multiplied to derive price of the good.
If Learner Index is 1/2, then the markup factor is 2.
Merger and Integration activity
Integration results in fewer firms - Motivated by desire to gain: Economies of scale or scope Reduce transaction costs Increase market power Gain better access to capital markets
Mergers may be friendly or hostile
Vertical
Horizontal
Conglomerate
Vertical Integration
Various stages (phases) of product production carried out within single firm.
May take place by merging with suppliers or customers.
Usually driven by desire to reduce transaction costs.
Horizontal Integration
Merging of multiple similar final products into single firm.
Main motivations are:
Gain savings of economies of scale and scope.
To increase market power.
The social benefits of increased efficiency must be weighed against increase in market power which reduces competition.
Federal Trade Commission and the Antitrust Division of the U.S. Dept. of Justice
Horizontal Merger Guidelines
HHI > 2500 Highly Concentrated
HHI < 1400 U concentrated
HHI > 2500 and incr > 200 - highly likely
HHI 1500-2500 and incr. 100-200 possible
HHI > 2500 and incr. 100-200 possible
Antitrust suit decision factors
Suit may NOT be filed if:
Evidence of significant foreign competition
Emergence of new technology
Increased efficiency at high market benefit
One or more parties in financial crisis.
Suit MORE likely if:
Great increases in scale that significantly increase barriers to entry.
Conglomerate Merger
Integration of different product lines into a single firm.
Motivated by:
Improved cash flows in cyclical demand markets. Should be last resort move.
Leveraging the superior performance of an exceptional CEO.
Capitalize on distribution and supply chain commonalities.
Cons : reduction in specialization
Research and Development
And
Advertising
R&D is means to achieve technological advantage and securing patents.
Firms may be evaluated by the ratio of R&D (or adv.) spending to sales.
The Nature of Industry can be described in 3 broad terms.
Structure
Conduct
Performance
Industry Performance
As measured by profits and social welfare in an industry.
Profits
Profits are independent of sales revenue. Big firms do not automatically make big profits.
One if the measures of industry performance.
Social Welfare
The combined impact of consumer and producer surplus.
Both consumer and producer surplus represent value for the market.
One of the measures of industry performance.
Dansby-Willig (DW) index
Measure of how much social welfare (consumer + producer surplus) would improve given an increase of output. Range 0 - 1
Closer to 0 means little increase in welfare. Surplus is maximized to begin with. Low values mean good performance.
Closer to 1 means great increase in welfare with more production. High values mean poor performance.
Structure - Conduct - Performance overview and wholistic paradigm.
Structure:
Concentration, Technology and Market Conditions
Conduct:
Pricing, Marketing and R&D decisions
Performance:
Profits and Social Welfare in a market.
All factors integrally related in Structure-Conduct-Performance Paradigm.
Causal View
Simple measure of the SCP paradigm.
Asserts that market structure CAUSES resources to be allocated in ways that lead to GOOD or POOR performance and thus high or low social welfare.
A highly concentrated industry creates market power with low competition leading to higher prices which then reduce social welfare.l
A one way causal explanation. Too simple.
Feedback Critiques
A more commonly accepted measure of the SCP paradigm.
Any state of structure, conduct or performance can impact the nature of the other two.
eg. Low pricing regardless of concentration my inhibit further entry.
Structure - Conduct - Performance assessment per the Feedback Critique relationship with the Five Forces Framework,
The five forces of Entry, Supplier and Customer Power, Rivalry and Substitution and Complements capture elements of the Structure and Conduct of firms. The level and growth of sustainable profits are akin to the elements of performance.
Perfect Competition
Many firms Firms small relative to market No technological advantages Produce homogeneous product mix Many substitutes No market power No single firm's action have impact on market Concentration and Rothschild indices close to zero.
Monopoly
A single firm environment Restriction of supply Pricing above marginal cost C4 = 1 HHI = 10,000 Rothschild = 1 or unity
Monopolistic Competition
Many firms and customers
C4 and HHI close to zero
Differentiated products
High advertising expenditures
Oligopoly
A few firms dominate the market.
Conduct of one firm impacts the other firms resulting in mutual interdependence.
All decisions made in the context of possible competitor reactions an subsequent decisions.
