Analysis of the Semiconductor Industry
Eugene Spektor
Econ 4355
Dr. Basker
Spring 2010
Background
The US Census Bureau defines the semiconductor industry with the NAICS code
334413, which includes the manufacturing of semiconductors and related devices such as
intergraded circuits, memory chips, transistors, and microprocessors. The rise of the industry
was spurred by a few key innovations: the commercialization of ”…the transistor in 1951, the
intergraded circuit in 1961, [the] semiconductor memory in 1968, and the microprocessor in
1971” (Stoelhorst). The adoption of personal computers and the internet in the 1980s and 90s
respectively, and today’s digital media continue to nourish the industry (Ellis).
In 1997, roughly 1000 companies’ value of shipments totaled nearly $78.5 billion and
four largest companies in the industry accounted for 52.5 percent of the market share (US Census
Bureau). In 2002, the number of companies increased slightly to 1045, but with a lower value of
shipments ($61.5 million) in total (US Census Bureau). Intel is the world’s largest
semiconductor supplier by revenue, capturing roughly 32 percent of the market in 1997 and 42
percent in 2002 (US Census Bureau, Intel).
Semiconductor Industry Trends
For the past 40 years, Moore’s Law has characterized the semiconductor industry.
Gordon Moore, one of Intel’s founders, believed that the number of transistors on a chip will
double approximately every two years and the cost of an integrated circuit would stay constant
(The Economist). The price per transistor would be cut in half, but the number of transistors
would double. However, this trend may come to an end within the next five years (eWeek).
Smaller transistors cost less, but the equipment needed to produce them is rising in cost (eWeek).
In order to achieve economies of scale, chipmakers must build larger manufacturing facilities
(The Economist). In other words, as transistor prices go down, fixed costs go up. This in turn
has spawned another trend.
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The semiconductor industry is becoming less vertically intergraded and more
deconsolidated and specialized (The Economist). The rising cost of production has led
chipmakers to spin off manufacturing to separate companies and continue to design chips (The
Economist). The companies could no longer achieve economies of scope, so they split.
However, splitting firms increases competition. This is evident in the industry because of the
high turnover among the top 10 semiconductor companies, with over half vanishing from the top
10 since the 1950s (Rhines). In fact, only Texas Instruments and Motorola have consistently
stayed in the top 10 since the 1950’s (Stoelhorst). The only noticeable consolidation that has
occurred is in the manufacturing-intensive portion of the industry (Rhines). The consolidation of
manufacturers would increase efficiency by achieving economies of scale, but it may also create
a barrier to entry due it the high capital costs needed for facilities. According to The Economist,
price rigging by manufacturers could occur but would be unlikely because they are too closely
intergraded with chip designers who already face steep competition and would not survive.
More importantly, it would be unreasonable to assume that foreign suppliers would have no
impact on domestic prices.
Chipmakers already tend to oversupply the market because they must spend billions
before actual demand is known and competition spurs them to use the latest technology, which
means they must routinely make new products and increase output (The Economist). The
government also encourages domestic oversupply in the interest of national security and jobs
(The Economist). The semiconductor business is also picking up in the east. Taiwan produces
over half of the world’s chips and more factories will be constructed in Asia in the next several
years than anywhere else in the world. (The Economist). All of this translates into further
oversupplying. Even if the firms in Taiwan went out of business, supply would still surpass
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demand (The Economist). All totaled, “Nearly 15 percent more chips and 50 percent more
transistors are shipped each year than the prior year” (Rhines). This staggering growth may
partially explain why semiconductor prices have been dropping. The industry is also nearing
maturity. The Economist reports that the industry’s “…annual growth has slid from double
digits in the mid-1990s to an average of around 5% since then. And since 2004 the profitability
of chip firms has dropped steadily as many chipmakers have lowered prices to expand their
markets.” All of these factors must be considered in order to make reasonable assumptions about
the domestic model of competition.
Semiconductor Industry Analysis
Several forms of competition can be eliminated before selecting one that best describes
the industry. The easiest one to discard is the monopoly model since there is obviously much
more than one supplier, domestically and abroad. A dominant firm with a competitive fringe
does not characterize the industry either. Assuming that the products are the same, no one firm
has a significantly lower production cost than all other firms. The factories that produce chips
and transistors may have economies of scale, but they will not have a significant advantage
against other firms for another five years, when machine costs increase, resulting in decreasing
returns to scale. Until then, many companies will still manufacture their own products. Even if
Intel is considered a dominant firm, predicting market demand in the semiconductor industry is
extremely difficult, as mentioned earlier. Oligopoly models such as Cournot and Stackelberg do
not hold water simply because there are numerous firms that have no way of controlling the
market price or the quantity produced. This is largely due to oversupply by domestic and foreign
companies who collectively and consistently overproduce. Also, while firms need a large capital
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investment to manufacture products, they do not need such a large investment to design chips, so
there is no significant barrier to entry.
The Bertrand model of perfect competition is arguably the best choice in describing the
industry. An important assumption is the homogeneity of all products. This is reasonable
because even when an innovation appears, other companies quickly capitalize on it. The high
supply of semiconductors and large number of firms means that all firms must set their prices
equal or close to the competitive prices and choose quantities based on those prices. If a firm
charges too high a price, there will be too many alternatives with the same features for
consumers to choose from and the firm will likely lose all sales. If the price is any lower than
the market price, firms will likely earn a loss or a relatively small profit. Finally, the
semiconductor industry is highly competitive. Constant pressure exists on companies to
innovate. If they do not, they will fade from the market, as evident from the high turnover ratio
mentioned earlier. If they do innovate, their ability to hold on to the market will depend on
whether or not they can mass produce their product and sell it at a lower or equal price than their
competitors eventually will. In fact, the price of semiconductors has continuously fallen ever
since the 1970’s (Sichel et al). There is also little ability to price discriminate as market price is
nearly impossible to set and resale is difficult to prevent. Conversely, the microprocessor
industry has significant differences from the whole semiconductor industry and therefore
warrants different conclusions.
Microprocessor Industry
The semiconductor industry cannot be analyzed effectively without acknowledging the
microprocessor. Together, semiconductor memory and microprocessors account for over 50
percent of the semiconductor industry (Stoelhorst). Intel first created the microprocessor in
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1971, but it mainly concentrated on semiconductor memory at the time (Stoelhorst). When
profitability switched from designing memory to mass producing it, Intel fell behind and decided
to concentrate more heavily on microprocessors (Stoelhorst). By 1977, Intel had a
microprocessor market share between 60 and 65 percent (Stoelhorst). In 1981, the personal
computer was the main application for the microprocessor, and Intel managed to convince IBM
to choose its product for IBM’s new pc’s (Stoelhorst). When the pc market exploded in 1992,
Intel became the largest semiconductor manufacturer in the world (Stoelhorst). Currently, Intel
makes up 82 percent of the world’s microprocessor revenue (The Economist). Intel and its
largest rival Advanced Micro Devices comprise 95 percent of the market share in
microprocessors (Goettler, Gordon). Intel however does not always appear to play by the rules.
Recently, the FTC filed a complaint against Intel for anticompetitive practices, alleging
that it “…illegally stifled competition and innovation in the microprocessor market…over the
past 10 years” (Carbone). The FTC believes that Intel violated Section 5 of the FTC Act,
“…which prohibits unfair methods of competition and deceptive acts and practice in commerce”
and that “…Intel engaged in illegal monopolization, attempted monopolization and monopoly
maintenance…” (Carbone).
Specifically, the FTC charged Intel of using rewards and threats on
several computer manufacturers such as Dell, HP, and IBM to coerce them to avoid using
microprocessors from AMD and other companies and attempted to prevent them from marketing
their products with non-Intel components (Carbone). On top of that, the FTC accused Intel of
“…secretly redesigned key compiler software that deliberately stunted the performance of
competitors' chips…” and “…told its customers and the public that software performed better on
its processors than on competitors'…” (Carbone). To remedy this, the FTC seeks to stop Intel
from using threats and “…other offers to encourage exclusive deals, hamper competition or
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unfairly manipulate the prices of its microprocessors…” and wants to prohibit Intel from
“…excluding or inhibiting the sale of competitive processors…” and from “…making or
distributing products that impair the performance…of non-Intel chips” (Carbone). These issues
where partially addressed in Intel’s settlement with AMD, which stipulated that “Intel will pay
AMD $1.25 billion and the two companies will share patent rights for the next five years,” and
that AMD will cancel “…all antitrust litigation against Intel” (Meyer). The factors listed create a
different picture of the microprocessor industry within the semiconductor industry.
Microprocessor Industry Analysis
The microprocessor industry resembles a few economic models but only fits the most
with one. Any market with only two firms is unlikely in perfect competition since each firm is
likely to choose a strategy that maximizes its profits. Once again, a monopoly should be ruled
out because AMD poses a significant challenge to Intel’s market, although, it is evident from
Intel’s actions above that it is certainly attempting to monopolize the market by sabotaging its
competitors. Obviously, Intel and AMD have not formed a cartel based on their relationship
above. Further evidence of this is that AMD has lost more money during its entire existence than
it has made (Ellis), which would be highly unlikely if it were colluding with Intel. It is worth
reiterating however, that Intel and AMD will share certain patent rights for the next five years.
An oligopoly better describes the two companies, specifically a Cournot duopoly. The
Stackelberg model does not fit as well because both companies routinely come up with new
products at similar times, especially if they share patents. Collectively, both firms have market
power since they comprise most of the market and each firm acts independently, but are affected
by one another’s actions. Still, a Cournot duopoly assumes no entry, and a dominant and fringe
firm model deals with this prospect more realistically.
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AMD and other firms make up the competitive fringe by holding a small share of the
market relative to Intel, the dominant firm, which holds 82 percent mentioned before. Several
reasons can be cited for this market structure. First, Intel in a way has lower costs than the fringe
firms in the microprocessor market. It achieves this by having entered the market early and has
gaining experience for decades. Second, it has had time to grow to an optimal size and achieve
economies of scale. Third, Intel’s microprocessor is perceived as a superior product because of
Intel’s strong branding. Most chipmakers are unknown to consumers, except for Intel, which
gives it an advantage over its competitors (Leopold et al). Therefore, Intel has some power in
setting price, while all other firms must take the price given, at least to some extent. Intel held
most of the microprocessor market since the 70’s, yet Intel’s prices were higher than AMD’s
until around the year 2000, when they started to match each other, even though the quality of
both companies’ products were roughly the same at least since the 1990’s (Goettler, Gordon).
Entry to the market can still reasonably occur. As stated before, production costs will increase
several years into the future to the point where chip designers will have to splinter from the
manufacturing business, but they can still enter the market. Evidence of this is reflected in the
microprocessor market in the 1990’s. When the computer industry soared, many firms probably
wanted to get into the market and make profits. As a result, the dominant firm would have to
reduce its profit margins to prevent too much competition from sprouting up. Indeed,
microprocessor prices fell in the 1990’s, partially due to declines in Intel’s profit margins
(Aizcorbe). The fringe keeps Intel from setting its prices too high, but Intel sets them low enough
to keep its dominant share. Most of the fall in prices of microprocessors is attributed to a
different trend in the industry, even though Intel causes a noticeable portion of it. If Intel were a
monopoly, consumer surplus could decrease by about 2.5 percent, but innovation could increase
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by 6.4 percent (Goettler, Gordon). Consumer surplus would decrease because Intel could raise
prices, but to combat the durability of its goods, Intel must constantly innovate. At the same
time, Intel’s high rate of innovation creates another competitive advantage.
Intel also has a high potential to price discriminate. First, because of its market position,
it can significantly manipulate the price. Second, Intel can probably identify different types of
consumers by the amount they order. If a customer orders relatively few amount of
microprocessors, the customer is probably a small business at most. If a relatively large amount
is ordered, the customer is a big business. Intel could also discriminate based on quality by
separating consumers by their preference for high and low quality products. Third, Intel has
some ability to prevent resale, as noted by its need to innovate. Intel is also vertically integrated
which means it controls its manufacturing process and can sell its product at a higher price to end
users. Unfortunately for Intel, it may not be able to hold its share of the market indefinitely.
Future Trends in the Semiconductor Industry
The semiconductor industry is moving away from the pc because growth is slowing in the
maturing in the pc market (Leopold et al). As the high turnover indicates, staying alive in the
semiconductor industry depends on a company’s ability to follow the market trend, and the
market will start moving toward embedding its electronics in devices other than pc’s, which is
what Intel aims to do (Leopold et al). Even so, Intel is highly focused on its computer products,
and hence, the company has little time to diversify into the quickly expanding embedded market
and elsewhere. Furthermore, “The competitive environment in the digital communications and
Internet market is different from what Intel is used to, and the company cannot claim the same
technology edge that it has enjoyed in processors for computing” (Leopold et al). If Intel fails to
seize a considerable amount of these new markets, “…it will no longer be the world’s biggest
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chip manufacturer in 10 years from now (Leopold et al). This of course will reduce Intel’s share
of the semiconductor and microprocessor industry, creating a more efficient market.
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