Microeconomics 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. 1 Microeconomics B. Market Structure Table 1: Classifications of Market Structure Criteria Number of Sellers Product Characteristics Barriers to Entry Perfect Competition Many Homogenous None Market Structure Monopolistic Oligopoly Competition Many Few Homogeneous Differentiated or Differentiated None High Monopoly One Unique 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 http://www.ftc.gov. 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 2 Microeconomics 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 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 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 3 Microeconomics 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. 4 Microeconomics 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 Packaging 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) 5 Microeconomics 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. 6 Microeconomics E. Summary: Porter's Five Forces Power of Input Suppliers Supplier Concentration Price/Productivity of Alternative Inputs Relationship-Specific Investments Supplier Switching Costs Government Restraints Entry Costs Speed of Adjustment Sunk Costs Economies of Scale Entry Network Effects Reputation Switching Costs Government Restraints Level, Growth, and Sustainability Of Industry Profits Substitutes & Complements Industry Rivalry Concentration Price, Quantity, Quality, or Service Competition Degree of Differentiation Power of Buyers Buyer Concentration Price/Value of Substitute Products or Services Relationship-Specific Investments Customer Switching Costs Government Restraints Switching Costs Timing of Decisions Information Government Restraints Price/Value of Surrogate Products or Services Price/Value of Complementary Products or Services Network Effects Government Restraints 7
