Ch 7

• Market Structure


  Basic characteristics shaped by demand and supply conditions
• Conduct


  How the industry operates
• Performance


  Welfare, efficiency, profitability
• Industry Analysis


  • Market Structure
  • Conduct
  • Performance
• Market Structure


  • Number and size of firms
  • Industry concentration
  • Technological and cost conditions
  • Demand conditions
  • Ease of entry and exit
• Conduct


  • Pricing
  • Advertising
  • R&D
  • Merger activity
• Performance


  • Profitability
  • Social welfare
• Industry Concentration


  Measures the size distribution of firms within an industry
• Four-Firm Concentration Ratio


  The sum of the market shares of the top four firms in the defined industry
• Herfindahl-Hirschman Index (HHI)


  The sum of the squared market shares of firms in a given industry, multiplied by 10,000
• Concentration Example


  • There are five banks competing in a local market, each with a 20% market share
• Rule of thumb: if C4 > 40%, oligopoly exists
• Most of these markets have become less concentrated over time
• D = suppressed to preserve proprietary information
• Not a perfect correspondence, but pretty close (not exactly HHI but close)
• Limitation of Concentration Measures

  • Global markets are excluded
  • National, regional and local markets are all treated as national markets
  • Industry definitions and product classes when defined broadly understate concentration compared to more narrowly defined product classes
• Concentration in Food Manufacturing

  • Animal Food and Baked Goods
  • Beverages and Tobacco
• Structure: 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 more balanced combination of labor and capital
  • Economies of scale may naturally lead to large firms and, possibly, concentration
  • If the available technology is the same, firms will likely have similar cost structures
  • If the available technology is different, one firm will likely have a cost advantage
• Structure: Demand and Market Conditions

  • Low demand may generate few firms
  • High demand may imply many firms
  • Information availability (e.g. internet pricing, competition)
  • Substitutability/elasticity/product differentiation
• Rothschild Index (R)


  Measures the elasticity of industry demand for a product relative to that of an individual firm
• Own-Price Elasticities of Demand & Rothschild Indices

  • Tobacco and chemical firms face few substitutes; much market power
  • Paper, petroleum, and rubber also quite high; limited substitutes
  • Food, textile, and apparel firms face many substitutes; little market power
  • Printing/publishing and leather intermediate
• These are broad sectors containing many 'industries'
• Note the very high firm elasticities in agriculture and services will yield low Rothschild indices: approaching perfect competition
• Construction will also have a low index
• Structure - Potential for Entry


  • Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market
  • Barriers to entry include capital requirements, patents and copyrights, economies of scale
• Conduct


  Behavior of firms
• Conduct: Pricing Behavior


  • Price markup over costs
  • Integration and mergers
  • Advertising expenditures
  • Research and development expenditures
• Lerner Index


  A measure of the difference between price and marginal cost (i.e., markup) as a fraction of the product's price
• Markup Factor


  The price as a multiple of marginal cost
• Pricing Behavior Example


  • A firm in the airline industry has a marginal cost of $200 and charges a price of $300
• Consider both consumer demand effects (overall elasticity) and competition
• Integration


  Uniting productive resources of firms
• 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
• Conduct: 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
• DOJ/FTC Horizontal Merger Guidelines

  • Based on HHI = 10,000 * sum of squared market shares
  • Merger may be challenged if HHI exceeds 1500, or would be after merger, and the merger increases the HHI by more than 100
  • More likely if HHI>2500
  • 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..."
  • May also recognize foreign competition, emerging new technology, or firm financial problems
• Conduct: Research and Development


  • R&D can generate technological advantage
  • Could generate a patent
  • Varies significantly among industries
  • Depends on characteristics of industry
• Company R&D as Percentage of Sales

  • Bristol-Myers Squibb (Pharmaceuticals): 24.4%
  • Ford Motor (Motor vehicle and parts): 5.1%
  • Goodyear Tire and Rubber (Rubber and plastic parts): 2.8%
  • Kellogg (Food): 1.0%
  • Procter & Gamble (Soaps and cosmetics): 2.7%
• Conduct: Advertising


  • Provides information to consumers
  • Differentiates product
  • Varies significantly among industries
  • Depends on characteristics of industry (e.g., selling to consumers or firms)
• Dansby-Willig Performance Index


  Measures by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner