Uploaded by Brian Schwarz

PSU - Microeconomics - Industry Analysis

Industry Analysis Guideline
The purpose of an industry analysis is to assess the profitability potential of the industry.
The steps in an industry analysis are:
• Identify the industry and describe its market.
• Classify the market structure of the industry.
• Evaluate the future profitability potential of the industry.
A. Introduction to the Industry and its Market
A. 1. Industry Definition and Description
The first task is to define the industry. An industry analysis often starts with a brief
introduction to the industry.
The U.S. Census Bureau classifies industries with the North American Industrial Classification
System (NAICS). NAICS can be accessed at the web page www.census.gov/naics.
A. 2. Market Conditions
General market conditions faced by an industry are often important factors in the choice of
conduct by firms and for the ability of firms to generate profits and meet expected
performance goals. Identifying relevant general market conditions requires an analysis of:
• Supply and demand conditions that define the market.
• The overall market environment. Environmental factors are often identified with a PEST
methodology. The PEST acronym stands for Political/Legal, Economic, Sociocultural, and
Technological factors.
B. Market Structure
Table 1: Classifications of Market Structure
Number of Sellers
Barriers to Entry
Market Structure
or Differentiated
Very High
B. 1. Market Definition and the Relevant Market
The Department of Justice (DOJ) and the Federal Trade Commission publish horizontal
merger guidelines that are an excellent reference source for market definition and defining the
relevant market for classifying the market structure of an industry. The publication Horizontal
Merger Guidelines can be accessed from the web page of the Antitrust Division of the DOJ at
http://www.usdoj.gov/atr or of the Federal Trade Commission at http://www.ftc.gov.
B. 2. Number of Sellers
How many sellers are there? This question can be answered in two ways. First, we can literally
count the number of sellers. Second, we can measure the concentration of the industry.
For a definition of sellers and buyers, see Guides for Advertising Allowances and Other Merchandising
Payments and Services 16 CFR 240.1 available from the Federal Trade Commission web page at
U. S. Census Bureau
Data to determine the number of sellers in an industry is available from the web page of the
U.S. Census Bureau at www.census.gov. The Economic Census provides data on
Establishment and Firm Size in a Subject Series based on 20 NAICS sectors (two-digit NAICS
codes). The 20 NAICS sectors are further subdivided into 96 subsectors (three-digit NAICS
codes), 313 industry groups (four-digit NAICS codes), and 1170 industries (five- and six-digit
NAICS codes).
B. 2. a. Concentration Measures
Market concentration measures are used to classify how competitive an industry is.
Concentration measures help us to understand how much market share is concentrated in the
hands of a small number of firms. An industry characterized by low concentration will have a
large number of firms with small market shares. An industry characterized by high
concentration will have a small number of firms with relatively high market shares. Industries
with high concentrations are more likely to have market power, i.e. the ability to set price.
Two commonly used concentration measures are the concentration ratio and the
Herfindahl-Hirschman Index.
B. 2. b. Classifying Industries
It is important to classify industries as to market structure because the greater the number of
sellers, the more likely the industry is competitive.
Classifying Industries with the CR4
Table 2: Classifying Industries with the CR4
CR4 = 0
0 < CR4 < 40
40 <= CR4 < 60
60 <= CR4
90 <= CR1
Interpretation of Market Structure
Perfect Competition
Effective Competition or Monopolistic Competition
Loose Oligopoly or Monopolistic Competition
Tight Oligopoly or Dominant Firm with a Competitive Fringe
Effective Monopoly (near monopoly) or Dominant Firm with a
Competitive Fringe
Classifying Industries with the HHI and The Antitrust Division of the Department of
Justice (DOJ)
Table 3: Classifying Industries with the HHI
HHI < 1000
1000 < HHI < 1800
1800 < HHI
Interpretation of Market Structure
Effective Competition or Monopolistic Competition
Monopolistic Competition or Oligopoly
Oligopoly, Dominant Firm with a Competitive Fringe, or Monopoly
B. 3. Product Characteristics
An important criterion for classifying market structure is whether the product is
homogeneous, differentiated, or unique.
Sources for identifying product characteristics are company provided information (web
pages and information packages); company advertising and promotional materials, corporate
reports of publicly held corporations, periodical articles and news, and trade associations.
B. 4. Barriers to Entry (BTE)
The final criterion for classifying market structure is the level of barriers to entry in the long
run. There are three types of barriers to entry:
• Natural Barriers (economies of scale, economies of scope, absolute cost advantages, capital
costs, etc.)
• Strategic Barriers (actions taken by firms such as product differentiation and increasing the
cost of entry)
• Legal Barriers (patents, licenses, laws and regulations, etc.)
B. 5. Identifying Market Structure
Given answers to the number of sellers, product characteristics, and barriers to entry, a
researcher can identify the market structure of an industry using Table 1.
C. Conduct
A firm's choice of marketing mix follows 4 P's.
C. 1. Pricing
One Price for all Consumers, Short-Run Profit Maximization
Price Discrimination: Different Prices for Different Consumers
C. 2. Product
Product Choice
Research & Development
C. 3. Promotion (Advertising)
The purposes of promotion include
• Shifting consumers' tastes and preferences in favor of a particular product or brand
• Providing information
C. 4. Place (Location)
D. Evaluating the Performance of an Industry
Industry performance is measured by its success in creating value for consumers.
An evaluation of industry performance depends upon whether performance is being judged
by return to an investor or value-created for a consumer. In general, high returns to an investor
are the result of the extraction of value from the consumer. In other words, the firms in the
industry have market power and can charge a price higher than marginal cost and earn
economic profits (profits in excess of a normal return). Firms in the industry are better off as
they earn higher profits, consumers are worse off because they buy less in quantity and pay
more in price.
D.1. Value-Creation
Value-creation can be based upon superior differentiation or superior cost.
Superior differentiation may be evidenced by
• High product quality and/or service
• Rapid technological advance
Superior cost may be evidenced by price competition in the industry that
• Arises from entry of firms with lower cost structures into the industry
• Results in exit of firms with higher cost structures from the industry
D.2. Market Power
Market power depends on market structure. In general, market power increases as market
concentration increases. Thus, industry performance measures generally increase as market
concentration increases.
D.3. Social Welfare
The total benefit to society (social welfare) of the production of a good or service considers
both the profits of the industry and the value created for consumers. Thus, a researcher
evaluating the performance of an industry must take care to consider both members of society.
An industry's total contribution to society's welfare is more than its own profits; measuring
industry performance should also include the benefits created for consumers.
E. Summary: Porter's Five Forces
Power of
Input Suppliers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Supplier Switching Costs
Government Restraints
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Switching Costs
Level, Growth,
and Sustainability
Of Industry Profits
Substitutes & Complements
Industry Rivalry
Price, Quantity,
or Service Competition
 Degree of
Power of
Buyer Concentration
Price/Value of Substitute
Products or Services
Customer Switching Costs
Government Restraints
Switching Costs
Timing of
Price/Value of
Surrogate Products or 
Price/Value of
Products or Services
Network Effects