THE NATURE OF INDUSTRY

1. THE NATURE OF INDUSTRY

2. INTRODUCTION • Several factors affect decisions such as how much to produce, what price to charge, how much to spend on R&D, advertising etc. • No single theory or methodology provide managers answers to these questions • Pricing strategy/ advertising etc. for a car maker will differ from food manufacturers • In this section we examine the important differences that exists among industries.

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

4. Market Structure Refers to factors such as • The number of firms that compete in a market, • The relative size of the firm (concentration) • Technological and cost conditions • Ease of entry or exit into industry Different industries have different structures that affect managerial decision making (Structural differences)

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 Since the top three firms account for all industry sales

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

12. Market Definition: National, regional, or local? If there are 50 same size gas stations in the US, one in each state, each firm will have 1/50 market share. C4 = 4/50  market for gas is not highly concentrated. What good is this to a consumer in Blaine, Washington, since the relevant market is her local market? • Geographical differences among markets lead to biases in concentration measures

13. Global Market: Foreign producers excluded. This tends to overstate the true level of concentration in industries in which significant number of foreign producers serve the market e.g. C4 for beer producers in US = 0.9 but this ignores the beer produced by many breweries in Mexico, Canada, Europe etc. The C4 based on both imported and domestic beer would be considerably lower

14. Industry definition and product classes: There is considerable aggregation across product classes. e.g. Soft drink industry is dominated by Pepsi and Coca-Cola yet the C4 for 2004 is 47%. Quite low. The C4 contains many types of bottled and canned drinks including lemonade, iced tea, fruit drinks etc.

15. 3. TECHNOLOGY • Some industries are labor intensive while others are capital intensive • In some industries, firms have access to identical technologies and therefore similar cost structures • In others, only 1 or 2 firms may have superior technology giving them cost advantages over others • Those with superior technology will completely dominate the industry

16. 4. 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

17. 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

18. 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

19. 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

20. 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 When L=0.5  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

21. Lerner Indices & Markup Factors Source: Baye and Lee, NBER working paper # 2212

22. 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

23. 3 types of integration: Vertical Integration: Various stages in the production of a single product are carried out by a single firm e.g. Car manufacturer produces its own steel, uses the steel to make car bodies and engines. Reduces transaction cost

24. Horizontal Integration: Merging production of similar products into a single firm e.g. 2 banks merge to form one firm to enjoy cost savings of economies or scale or scope and enhance market power. When social benefits of this merger is relatively small compared to social cost of concentrated industry, government may block this type of merger

25. 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.

26. Conglomerate Mergers Integrating different product lines into a single firm Cigarette maker acquires a bread manufacturing firm. This is to reduce the variability of firm’s earnings due to demand fluctuations and to enhance the firm’s ability to raise funds in the capital market

27. 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.

28. Approaches to Studying Industry • The Structure-Conduct-Performance (SCP) Paradigm: Causal View 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 Market Structure Conduct Performance

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

30. 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

31. 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

32. 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

33. 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

35. PRICING STRATEGIES OF FIRMS WITH LITTLE OR NO MARKET POWER

36. Pricing and Output Decisions in Perfect Competition • The Basic Business Decision: entering a market on the basis of the following questions: • How much should we produce? • If we produce such an amount, how much profit will we earn? • If a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?

37. 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.

38. 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.

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

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

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

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

43. 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.

44. MC $ AVC Loss Qf Should this Firm Sustain Short Run Losses or Shut Down? Profit = (Pe - ATC)  Qf* < 0 ATC ATC Pe = Df = MR Pe Qf*

45. 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.

46. Contribution Margin (CM): the amount by which total revenue exceeds total variable cost. • CM = TR – TVC • If the contribution margin is positive, the firm should continue to produce in the short run in order to defray some of the fixed cost.

47. 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.

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

49. S1 S2 SM 25 43 18 20 30 10 Short-Run Market Supply Curve • The market supply curve is the summation of each individual firm’s supply at each price. Market Firm 1 Firm 2 P P P 15 5 Q Q Q

50. 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.