Chapter 7 Lecture Notes
The Nature of Industry
1.
Factors Determining Market Structure
a. Firm Size: Measured by sales of typical firm
b. Industry Concentration: How much of the industry is controlled by largest firms
i. Concentration Ratio: Percentage of industry sales made by 4 largest firms
ii. Herfindahl-Hirschman Index: Square the share of each firm, add all the
resulting numbers, and multiply by 10,000.
1. Because each share is less than one, squaring the number makes it
smaller
2. However, squaring the share gives larger firms more weight.
3. Without multiplying by 10,000 the sum would be less than 1, but
would be 1 if there is only 1 firm, so the index is 10,000 when there is
only 1 firm.
4. If there are many very small firms the index will be near zero.
5. Multiplying by 10,000 typically keeps the index from being less than
1.
6. So, HHI near zero is very unconcentrated industry, and HHI near
10000 is a very concentrated industry.
iii. Some Examples
1. More Concentrated
a. Breakfast Cereals: C=82, HHI=3000
b. Breweries: C=91
c. Computers: C=81, HHI=2662
2. Less Concentrated
a. Concrete: C=11, HHI=57
b. Pallets: C=7, HHI=26
c. Jewelry: C=26, HHI=259
iv. Problems with Concentration measures
1. Excludes foreign firms
2. Indexes are for entire U.S., and some firms may dominate their local
markets
3. Product classifications can mask concentration: Example: Pepsi and
Coke control most of the softdrink market but not so much of the total
beverages market
4. Firms different in labor intensity: Example: Softdrink production
much more labor intensive than petroleum refining.
c. Demand and Market Conditions
i. Concentration may be because of low demand for the product, so the
concentrated industry does not much impact society.
ii. Rothschild Index: Measures how sensitive the demand for the firm’s product
is to price compared to how sensitive the demand for the industry’s product is
to price
𝐸
1. 𝑅 = 𝐸𝑇
𝐹
1
2. 𝑅 < 1 must hold because the demand facing the firm will always be
more price elastic than that facing the hold industry, as long as there is
some competiting
3. With a monopoly, R=1
4. R near zero, the price elasticity facing each firm is nearly infinitely
elastic (near perfect competition)
5. Examples
a. Little market power
i. Food: R=.26
ii. Textiles: R=.32
iii. Apparel: R=.27
b. Much market power
i. Tobacco: R=1
ii. Chemicals: R=1
iii. Petroleum: R=.88
d. Entry Barriers
i. Fixed Cost Capital Requirements
ii. Patents
iii. Economies of Scale (Can be from fixed cost of capital requirements)
2. Conduct
a. Pricing Behavior
i. Higher markup industries versus lower market industries
1. Lerner Index
a. Measure difference between price and marginal cost, as a
percentage of the price
𝑃−𝑀𝐶
b. 𝐿 = 𝑃
c. If price equals marginal cost, which it will in a perfectly
competitive market, then the Lerner index is zero
d. The higher the Lerner index, the greater the markup, which
implies the firm has more market power.
e. Examples:
i. Lower market power
1. Food: L=.26
2. Textiles: L=.21
3. Apparel: L=.24
ii. Higher market power
1. Tobacco: L=.76
2. Paper: L=.58
3. Chemicals: L=.67
b. Research and Development
i. Some firms spend more on research and development
ii. Examples: Pharmaceuticals much more, Auto more than average
c. Advertising
i. Some firms advertise more than others
ii. Examples: Procter and Gamble and Kellogg advertise more
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3.
Performance
a. Profits: (The invisible hand)
b. Other social measures
i. Dansby-Willig Performance Index: Sum of producer and consumer surplus
provided by an industry
ii. Non-market measures?
4. Mergers
a. Vertical Integration: Merge to combine inputs and outputs into the firm
i. May reduce transactions costs
ii. May reduce the holdup problem
b. Horizontal Integration: Merge to combine similar, but different products into one
firm
i. May increase market power
ii. May create economies of scale
iii. Takes advantage of economy of scope
c. Conglomerate: Merge disparate products into one firm
i. Not so clear why this occurs
ii. Many conglomerates are eventually broken up again
iii. Perhaps temporary profit in buying and selling business
iv. Perhaps additional political clout
5. Important Market Structures
a. Perfect Competition
b. Monopoly
c. Monopolistic Competition
d. Oligopoly
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Chapter 7 Questions
1. For the industry that most interests you,
a. evaluate the degree to which the industry is concentrated;
b. evaluate the degree to which the typical firm in the industry has market power
c. evaluate the degree to which there are barriers to entry
d. evaluate the degree to which the industry is vertically integrated
Note: It is not expected that you do much, if any, research. Just use the knowledge you
currently have, or do a small amount of research if you think you can easily get some
information. The point of this question is simply to have you think about the issues in this
chapter.
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