Managerial Economics &
Business Strategy
Chapter 7
The Nature of Industry
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Overview
I. Market Structure

Measures of Industry Concentration
II. Conduct


Pricing Behavior
Integration and Merger Activity
III. Performance


Dansby-Willig Index
Structure-Conduct-Performance Paradigm
IV. Preview of Coming Attractions
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Industry Analysis
• Market Structure

Number of firms, size, etc.
• Conduct

Pricing, advertising, R&D, etc.
• Performance

Profitability, consumer surplus, social welfare.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
The Structure-ConductPerformance Paradigm
• The Causal View
Market
Structure
Conduct
Performance
• The Feedback Critique



No one-way causal link.
Conduct can affect market structure.
Market performance can affect conduct as
well as market structure.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Industry Concentration
• Four-Firm Concentration Ratio

The sum of the market shares of the top four firms in the defined
industry: C4 = w1 + w2 + w3 + w4
• Herfindahl-Hirshmann Index (HHI)

The sum of the squared market shares of firms in a given
industry, multiplied by 10,000: HHI = 10,000  S wi2
• Limitations



Market Definition: National, regional, or local?
Global Market: Foreign producers excluded
Industry definition and product classes
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Rothschild Index
• A measure of the elasticity of industry
demand for a product relative to that of an
individual firm: R = ET / EF



ET = elasticity of demand for the total market
EF = elasticity of demand for the product of an individual firm.
R has a value between 0 (perfect competition) and 1 (monopoly).
• When an industry is composed of many
firms, each producing similar products, the
Rothschild index will be close to zero.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Own-Price Elasticities of Demand
and Rothschild Indices
Industry
Food
Tobacco
Textiles
Apparel
Paper
Chemicals
Rubber
Elasticity
of Market
Demand
-1.0
-1.3
-1.5
-1.1
-1.5
-1.5
-1.8
Elasticity
of Firm’s
Demand
-3.8
-1.3
-4.7
-4.1
-1.7
-1.5
-2.3
Rothschild
Index
0.26
1.00
0.32
0.27
0.88
1.00
0.78
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Pricing Behavior
• The Lerner Index
L = (P - MC) / P


A measure of the difference between
price and marginal cost.
An index from 0 to 1.
• Markup Factor


Rearranging the above formula,
P = (1/(1-L)) MC
1/(1-L) is the markup factor.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Lerner Indices & Markup
Factors
Industry
Food
Tobacco
Textiles
Apparel
Paper
Chemicals
Petroleum
Lerner Index
0.26
0.76
0.21
0.24
0.58
0.67
0.59
Markup Factor
1.35
4.17
1.27
1.32
2.38
3.03
2.44
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
DOJ/FTC Merger Guidelines
• Based on HHI = 10,000 S wi2
• Merger may be challenged if
• HHI exceeds 1800, or would be after merger, and
• Merger increases the HHI by more than 100
• But...

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...”
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Performance
• Performance refers to the profits and social
welfare that result in a given industry
• Social Welfare = CS + PS
• Dansby-Willig Performance Index

Ranks industries according to how much social welfare
would improve if firms within each industry expanded
output in the socially efficient manner.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Dansby-Willig
Performance Index
Industry
Food
Textiles
Apparel
Paper
Chemicals
Petroleum
Rubber
Dansby-Willig Index
0.51
0.38
0.47
0.63
0.67
0.63
0.49
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Preview of Coming Attractions
• Discussion of optimal managerial decisions
under various market structures, including:




Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999