CHAPTER 7
The Nature of Industry
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
Chapter Overview
• Market structure
–
–
–
–
–
Firm size
Industry concentration
Technology
Demand and market conditions
Potential for entry
• Conduct
–
–
–
–
Pricing behavior
Integration and merger activity
Research and development
Advertising
• Performance
– Profit
– Social welfare
• The structure-conduct-performance paradigm
– Causal view
– Feedback critique
– Relation to the Five Forces Framework
7-2
Introduction
Chapter Overview
• Chapter 6 focused on the optimal way to
acquire the efficient mix of inputs, and how to
solve various principal-agent problems that
arise within the firm.
• This chapter provides an overview of the
nature of various industries.
– How concentrated are sales in one industry
relative to another?
– How do price-cost margins vary by industry?
– How do advertising and R&D expenditures vary by
industry?
7-3
Market Structure
Market Structure
• Market structure factors that impact
managerial decisions:
– Number of firms competing in an industry.
– Relative size of firms (concentration).
– Technological and cost conditions.
– Demand conditions.
– Ease of firm exit or entry.
7-4
Industry Concentration
Market Structure
• Measures the size distribution of firms within
an industry.
– Are there many small firms?
– Are there only a few large firms?
7-5
Market Structure
Measuring Industry Concentration
• Measures of industry concentration
– Four-firm concentration ratio:
𝑆1 + 𝑆2 + 𝑆3 + 𝑆4
𝐶4 =
𝑆𝑇
– Herfindahl-Hirschman index (HHI):
𝑁
𝐻𝐻𝐼 = 10,000
𝑖=1
𝑆𝑖
𝑆𝑇
2
7-6
Market Structure
Measuring Industry Concentration in Action
• Suppose an industry is composed of six firms.
Four firms have sales of $10 each, and two firms
haves sales of $5 each. What is the four-firm
concentration ratio for this industry?
• Answer:
– Total industry sales are 𝑆𝑇 = $50.
– Sales of the four largest firms are $40.
– The four-firm concentration ratio is: 𝐶4 =
$10+$10+$10+$10
= 0.80
$50
– The four largest firms in the industry account for 80
percent of total industry output.
7-7
Market Structure
Measuring Industry Concentration In Action
Industry
C4
(percentage)
HHI
Distilleries
70
1,519
Fluid milk
46
1,075
Motor vehicles
68
1,744
Snack foods
53
1,984
Furniture and related products
11
62
Semiconductor and other electronic
components
34
476
Soft drinks
52
891
7-8
Market Structure
Limitations of Concentration Measures
• Factors that impact and limit industry
concentration measures include:
– Global markets.
– National, regional and local markets.
– Industry definitions and product classes.
7-9
Technology and Costs
Market Structure
• Industries differ in regard to the technologies
used to produce goods and services.
– Labor-intensive industries.
– Capital-intensive industries.
• Within a given industry if the available
technology is:
– the same, firms will likely have similar cost
structures.
– different, one firm will likely have a cost advantage.
7-10
Market Structure
Demand and Market Conditions
• Industries with
– low demand may imply few firms.
– high demand may imply many firms.
• Elasticity of demand varies from industry to
industry.
– The Rothschild index measures the sensitivity to
price of a product group as a whole relative to the
sensitivity of the quantity demanded of a single
firm to a change in its price.
𝐸𝑇
𝑅=
𝐸𝐹
7-11
Market Structure
Demand and Market Conditions in Action
• The industry elasticity of demand for airline
travel is -3, and the elasticity of demand for an
individual carrier is -4. What is the Rothschild
index for this industry?
• Answer:
– The Rothschild index is:
𝑅=
−3
−4
= 0.75
7-12
Market Structure
Demand and Market Conditions In Action
Industry
Own Price Elasticity
of Market Demand
Own Price Elasticity
of Demand for
Representative Firm
Rothschild
Index
Food
-1.0
-3.8
0.26
Tobacco
-1.3
-1.3
1.00
Textiles
-1.5
-4.7
0.32
Apparel
-1.1
-4.1
0.27
Paper
-1.5
-1.7
0.88
Chemicals
-1.5
-1.5
1.00
Petroleum
-1.5
-1.7
0.88
7-13
Potential for Entry
Market Structure
• Optimal decisions by firms in an industry will
depend on the ease with which new firms can
enter the market.
• Several factors can create barriers to entry (or
make entry difficult).
– Capital requirements.
– Patents.
– Economies of scale.
7-14
Conduct
Conduct
• Behavior of firms:
– Price markup over costs.
– Integration and merger.
– Advertising expenditures.
– Research and development expenditures.
7-15
Pricing Behavior
Conduct
• Lerner index
– A measure of the difference between price and
marginal cost as a fraction of the product’s price.
𝑃 − 𝑀𝐶
𝐿=
𝑃
rearranging this equation yields
1
𝑃=
𝑀𝐶
1−𝐿
, where
costs.
1
1−𝐿
is the markup factor over marginal
7-16
Pricing Behavior in Action
Conduct
• A firm in the airline industry has a marginal
cost of $200 and charges a price of $300.
What are the Lerner index and markup factor?
– The Lerner index is
𝑃 − 𝑀𝐶 $300 − $200 1
𝐿=
=
=
𝑃
$300
3
• The markup factor is
1
1
=
= 1.5
1−𝐿 1−1
3
7-17
Conduct
Pricing Behavior In Action
Industry
Lerner Index
Markup Factor
Food
0.26
1.35
Tobacco
0.76
4.17
Textiles
0.21
1.27
Apparel
0.24
1.32
Paper
0.58
2.38
Chemicals
0.67
3.03
Petroleum
0.59
2.44
7-18
Integration and Merger Activity
Conduct
• Integration
– Uniting productive resources of firms.
– Can occur during the formation of a firm.
• Merger
– Two or more existing firms “unite,” or merge, into a
single firm.
• Reasons firms merge:
–
–
–
–
Reduce transaction costs.
Reap benefits of economies of scale and scope.
Increase market power.
Gain better access to capital markets.
7-19
Types of Integration
Conduct
• Vertical integration
– Various stages in the production of a single
product are carried out in a single firm.
• Horizontal integration
– Merging two or more similar final products into a
single firm.
• Conglomerate mergers
– Integration of two or more different product lines
into a single firm.
7-20
Research and Development
Conduct
• Research and development
– Expenditures made by firms to gain a
technological advantage, with the aim of acquiring
a patent.
Company
Industry
R&D as Percentage
of Sales
Bristol-Meyers Squibb
Pharmaceuticals
19.7
Ford
Motor vehicle and parts
4.1
Goodyear Tire and Rubber Rubber and plastic parts
2.0
Kellogg
Food
1.5
Proctor & Gable
Soaps and cosmetics
2.5
7-21
Conduct
Advertisement
• Advertisement
– Expenditures made by firms to inform or persuade
consumers to purchase their products.
Company
Industry
Advertising as
Percentage of
Sales
Bristol-Meyers Squibb
Pharmaceuticals
4.9
Ford
Motor vehicle and parts
3.2
Goodyear Tire and Rubber Rubber and plastic parts
2.5
Kellogg
Food
9.2
Proctor & Gable
Soaps and cosmetics
11.7
7-22
Performance
Dansby-Willig Performance Index
• Ranks industries according to how much social
welfare would improve if the output in an
industry were increased by a small amount.
Industry
Dansby-Willig Index
Food
0.51
Rubber
0.49
Textiles
0.38
Apparel
0.47
Paper
0.63
Chemicals
0.67
Petroleum
0.63
7-23
The Structure- Conduct-Performance Paradigm
Structure-Conduct-Performance
• Structure:
– Factors like technology, concentration and market
conditions.
• Conduct:
– Individual firm behavior in the market. Behavior
includes pricing decisions, advertising decisions and
R&D decisions, among other factors.
• Performance:
– Resulting profit and social welfare that arise in the
market.
• Structure-conduct-performance paradigm
– Model that views these three aspects of industry as
being integrally related.
7-24
The Structure- Conduct-Performance Paradigm
The Casual View
• Market structure “causes” firms to behave in a
certain way.
• … this behavior, or conduct, “causes”
resources to be allocated in certain ways.
• … this resource allocation leads to “good” or
“bad” performance.
7-25
The Structure- Conduct-Performance Paradigm
The Feedback Critique
• There is no one-way causal link among
structure, conduct and performance.
– Firm conduct can affect market structure;
– Market performance can affect conduct and
market structure.
7-26
The Structure- Conduct-Performance Paradigm
Five Forces Framework
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Level, Growth,
and Sustainability
Of Industry Profits
Industry Rivalry
Concentration
Price, Quantity, Quality,
or Service Competition
Degree of Differentiation
Switching Costs
Timing of Decisions
Information
Government
Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products Network Effects
or Services
Government
Price/Value of Complementary
Restraints
Products or Services
7-27
Overview of the Remainder of the Book
Looking Ahead
• Perfect competition
– Many, small firms and consumers relative to market.
– Firms produce very similar products.
– No market power (P = MC).
• Monopoly
– Sole producer of good or service.
– Market power (P > MC).
• Monopolistic competition
– Many, small firms and consumers relative to market.
– Firms produce slightly different products.
– Limited market power.
• Oligopoly
– Few, large firms tend to dominate market.
– Price/marketing strategies are mutually interdependent with
other firms in the industry.
7-28
Conclusion
• Modern approach to studying industries involves
examining the interrelationship between
structure, conduct and performance.
• Industries dramatically vary with respect to
concentration levels.
– The four-firm concentration ratio and HerfindahlHirschman index measure industry concentration.
• The Lerner index measures the degree to which
firms can markup price above marginal cost; it is
a measure of a firm’s market power.
• Industry performance is measured by industry
profitability and social welfare.
7-29
Managing in Competitive,
Monopolistic, and
Monopolistically
Competitive Markets
Four Basic Market Types
1.
Perfect Competition (no market power)
–
–
–
–
Large number of relatively small buyers and sellers
Standardized product
Very easy market entry and exit
Nonprice competition not possible
2.
Monopoly (absolute market power subject to
government regulation)
–
–
–
–
One firm, firm is the industry
Unique product or no close substitutes
Market entry and exit difficult or legally impossible
Nonprice competition not necessary
3.
Monopolistic Competition (market power
based on product differentiation)
– Large number of relatively small firms acting
independently
– Differentiated product
– Market entry and exit relatively easy
– Nonprice competition very important
4. Oligopoly (market power based on product
differentiation and/or the firm’s dominance of
the market)
– Small number of relatively large firms that
are mutually interdependent
– Differentiated or standardized product
– Market entry and exit difficult
– Nonprice competition very important among
firms selling differentiated products
Pricing and Output Decisions
in Perfect Competition
Unrealistic? Why Learn?
• Many small businesses are “price-takers,” and decision
rules for such firms are similar to those of perfectly
competitive firms.
• It is a useful benchmark.
• Explains why governments oppose monopolies.
• Illuminates the “danger” to managers of competitive
environments.
– Importance of product differentiation.
– Sustainable advantage.
• Key assumptions of the perfectly competitive market
– The firm operates in a perfectly competitive market and
therefore is a price taker.
– The firm makes the distinction between the short run and
the long run.
– The firm’s objective is to maximize its profit in the short run.
If it cannot earn a profit, then it seeks to minimize its loss.
– The firm includes its opportunity cost of operating in a
particular market as part of its total cost of production.
Setting Price
$
$
S
Pe
Df
D
QM
Market
Firm
Qf
Profit-Maximizing Output
Decision
• MR = MC.
• Since, MR = P,
• Set P = MC to maximize profits.
Graphically: Representative
Firm’s Output Decision
Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe = Df = MR
Pe
ATC
Qf*
Qf
A Numerical Example
• Given
– P=$10
– C(Q) = 5 + Q2
• Optimal Price?
– P=$10
• Optimal Output?
– MR = P = $10 and MC = 2Q
– 10 = 2Q
– Q = 5 units
• Maximum Profits?
– PQ - C(Q) = (10)(5) - (5 + 25) = $20
• The firm incurs a loss. At
the optimum output level
price is below average
cost.
• However, since price is
greater than average
variable cost, the firm is
better off producing in
the short run, because it
will still incur fixed costs
greater than the loss.
Shutdown Decision Rule
• A profit-maximizing firm should continue to
operate (sustain short-run losses) if its
operating loss is less than its fixed costs.
– Operating results in a smaller loss than ceasing
operations.
• Decision rule:
– A firm should shutdown when P < min AVC.
– Continue operating as long as P ≥ min AVC.
• Shutdown Point: the lowest price at which the
firm would still produce.
• At the shutdown point, the price is equal to the
minimum point on the AVC. This is where selling
at the price results in zero contribution margin.
• If the price falls below the shutdown point,
revenues fail to cover the fixed costs and the
variable costs. The firm would be better off if it
shut down and just paid its fixed costs.
Firm’s Short-Run Supply Curve: MC
Above Min AVC
ATC
MC
$
AVC
P min AVC
Qf*
Qf
Long Run Adjustments?
• If firms are price takers but there are barriers to
entry, profits will persist.
• If the industry is perfectly competitive, firms are
not only price takers but there is free entry.
– Other “greedy capitalists” enter the market.
Effect of Entry on Price?
$
$
S
Entry
S*
Pe
Pe*
Df
Df*
D
QM
Market
Firm
Qf
Summary of Logic
• Short run profits leads to entry.
• Entry increases market supply, drives down
the market price, increases the market
quantity.
• Demand for individual firm’s product shifts
down.
• Firm reduces output to maximize profit.
• Long run profits are zero.
Features of Long Run Competitive
Equilibrium
• P = MC
– Socially efficient output.
• P = minimum AC
– Efficient plant size.
– Zero profits
• Firms are earning just enough to offset their
opportunity cost.
Effect of an increase in DD in a PC
market
Initial position P=AC (no economic profits= accounting
profits cover opportunity cost)
Demand increases
Mkt price increases in the SR
Firms have an incentive to produce more output with
available capacity
Firms make economic profits
Profits attract entrants
New entrants increase SS and reduce market price
Price decreases unit P=AC
Final Price is higher or lower depending on higher or lower
input prices as output increases
• As identical firms expand output and
demand more inputs, price of inputs
increase, increasing costs. Final price
exceeds initial price
• As firms expand output and demand more
inputs, price of inputs decrease, decreasing
costs. Final price is lower than the initial
price
Effects of an increase in variable cost in a PC
market
Initial situation P=AC
Variable cost increases
Firms have an incentive to produce less
output with available capacity
Firms have economic losses
Firms exit market
Market price increases (until P=AC)
Final LR market price is higher to compensate
for higher variable cost
Effect of an increase in Fixed costs in a
PC market
Initial situation P=AC
Fixed costs increase
Market price does not change in the SR because MC
is not affected
Firms have economic losses
Firms exit
SS decreases, market price increases
Market price increases until P=AC
LR market price is higher to compensate for the
higher fixed cost
Case: Trucking Industry
• Higher gas prices  increasing costs  increase
in price of transporting cargo
• Some truckers add airfoils to their truck to
compensate for higher gas prices
• In the SR, the first truckers with airfoils earn
profits
• Profits induce other truckers to add airfoils or
equivalent devices to their trucks
• In the LR, airfoils or equivalents are necessary for
survival but not sufficient for profits
Monopoly Environment
• Single firm serves the “relevant market.”
• Most monopolies are “local” monopolies.
• The demand for the firm’s product is the
market demand curve.
• Firm has control over price.
– But the price charged affects the quantity
demanded of the monopolist’s product.
Managing a Monopoly
• Market power permits
you to price above MC
• Is the sky the limit?
• No. How much you sell
depends on the price
you set!
“Natural” Sources of
Monopoly Power
• Economies of scale
• Economies of scope
• Cost complementarities
“Created” Sources of
Monopoly Power
•
•
•
•
Patents and other legal barriers (like licenses)
Tying contracts
Exclusive contracts
Collusion
Contract...
I.
II.
III.
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Q
A Numerical Example
• Given estimates of
• P = 10 - Q
• C(Q) = 6 + 2Q
• Optimal output?
•
•
•
•
MR = 10 - 2Q
MC = 2
10 - 2Q = 2
Q = 4 units
• Optimal price?
• P = 10 - (4) = $6
• Maximum profits?
• PQ - C(Q) = (6)(4) - (6 + 8) = $10
Strategies to maintain a Monopoly
market position
•
•
•
•
•
•
•
•
Apply “limit” pricing
Threaten with “predatory pricing”
Invest in excess capacity
Raise cost of rivals by advertising
Control key inputs
As on substitutes and complements
Integrate vertically and horizontally
Influence politicians and regulators
Why Government Dislikes
Monopoly?
• P > MC
– Too little output, at too high a
price.
• Deadweight loss of
monopoly.
Deadweight Loss of Monopoly
$
MC
Deadweight Loss
of Monopoly
ATC
PM
D
MC
QM
MR
Q
Arguments for Monopoly
• The beneficial effects of economies of scale,
economies of scope, and cost
complementarities on price and output may
outweigh the negative effects of market power.
• Encourages innovation.
Monopolistic Competition: Environment and
Implications
• Numerous buyers and sellers
• Differentiated products
– Implication: Since products are differentiated,
each firm faces a downward sloping demand
curve.
• Consumers view differentiated products as close
substitutes: there exists some willingness to
substitute.
• Free entry and exit
– Implication: Firms will earn zero profits in the
long run.
Managing a Monopolistically Competitive Firm
• Like a monopoly, monopolistically competitive
firms
– have market power that permits pricing above
marginal cost.
– level of sales depends on the price it sets.
• But …
– The presence of other brands in the market makes the
demand for your brand more elastic than if you were a
monopolist.
– Free entry and exit impacts profitability.
• Therefore, monopolistically competitive firms
have limited market power.
Competing in Imperfectly
Competitive Markets
• Non-price variables: any factor that managers can control, influence, or
explicitly consider in making decisions affecting the demand for their goods
and services.
–
–
–
–
–
–
–
–
–
Advertising
Promotion
Location and distribution channels
Market segmentation
Loyalty programs
Product extensions and new product development
Special customer services
Product “lock-in” or “tie-in”
Pre-emptive new product announcements
Monopolistic Competition:
Profit Maximization
• Maximize profits like a monopolist
– Produce output where MR = MC.
– Charge the price on the demand curve that
corresponds to that quantity.
Short-Run Monopolistic
Competition
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand X
Long Run Adjustments?
• If the industry is truly monopolistically
competitive, there is free entry.
– In this case other “greedy capitalists” enter, and
their new brands steal market share.
– This reduces the demand for your product until
profits are ultimately zero.
Long-Run Monopolistic Competition
Long Run Equilibrium
(P = AC, so zero profits)
$
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
Monopolistic Competition
The Good (To Consumers)
– Product Variety
The Bad (To Society)
– P > MC
– Excess capacity
• Unexploited economies of
scale
The Ugly (To Managers)
– P = ATC > minimum of
average costs.
• Zero Profits (in the long
run)!
Maximizing Profits: A Synthesizing Example
• C(Q) = 125 + 4Q2
• Determine the profit-maximizing output and
price, and discuss its implications, if
– You are a price taker and other firms charge $40
per unit;
– You are a monopolist and the inverse demand for
your product is P = 100 - Q;
– You are a monopolistically competitive firm and
the inverse demand for your brand is P = 100 – Q.
Marginal Cost
• C(Q) = 125 + 4Q2,
• So MC = 8Q.
• This is independent of market structure.
Price Taker
• MR = P = $40.
• Set MR = MC.
• 40 = 8Q.
• Q = 5 units.
• Cost of producing 5 units.
• C(Q) = 125 + 4Q2 = 125 + 100 = $225.
• Revenues:
• PQ = (40)(5) = $200.
• Maximum profits of -$25.
• Implications: Expect exit in the long-run.
Monopoly/Monopolistic Competition
• MR = 100 - 2Q (since P = 100 - Q).
• Set MR = MC, or 100 - 2Q = 8Q.
– Optimal output: Q = 10.
– Optimal price: P = 100 - (10) = $90.
– Maximal profits:
• PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.
• Implications
– Monopolist will not face entry (unless patent or other entry
barriers are eliminated).
– Monopolistically competitive firm should expect other
firms to clone, so profits will decline over time.
Conclusion
• Firms operating in a perfectly competitive market
take the market price as given.
– Produce output where P = MC.
– Firms may earn profits or losses in the short run.
– … but, in the long run, entry or exit forces profits to zero.
• A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power is
not eliminated.
• A monopolistically competitive firm can earn profits
in the short run, but entry by competing brands will
erode these profits over time.
Oligopoly
• Oligopoly is a market dominated by a relatively
small number of large firms
» Unconcentrated markets have HH < 1,000
• Products are either standardized or differentiated
• Barrier to entry exist
• Price, Output and profits depend on actions,
reactions, and counteractions
Basic Oligopoly Models
• “Sweezy” Oligopoly – A firm assumes that rivals will cut
prices when it reduces its price but will not increase
prices when it increases the price – result: Price rigidity
• “Cournot” Oligopoly – A firm decides its output based on
the output of rivals and vice versa – results: firms divide
the market
• “Betrand” Oligopoly – Firms compete by undercutting
each other’s price – result: Price wars and no profits
• “Stakelberg” Oligopoly: A firm moves first and commits to
an output level before rivals. Rivals decide their output
based on the leader’s output – results: staus quo
Cartel
Agreement among competing firms to fix prices,
output and marketing.
Occurs in oligopoly markets
Can be explicit or Implicit
Legal or illegal
Explicit Cartels
• Pure – all firms join the cartel and all have the
same costs and costs structure
• Perfect – all firms join the cartel but firms have
different costs and cost structures
• Imperfect – Not all firms join and firms have the
same or different costs and cost structures
Implicit Cartels
• Firms coordinate strategies without explicit
cooperation while recognizing their
interdependence.
• Firms play strategic games
• Firms exploit gray area in anti-trust laws
Dynamics of an Explicit Cartel (Explicit
collusion)
Initial position: producers behave competitively P=AC (no
economic profits)
Producers have an agreement to increase the price
Producers set quota to control cheating
Firms make economic profits
As P>MC>AC, each producer has an incentive to produce
more than the quota
The cartel breaks down as each producer cheats
The cartel has to adopt additional strategies to extend the
life of the cartel
Some Strategies to facilitate strategic
coordination
• Hire a cartel enforcer
• Centralize or consolidate trade of members and nonmembers
• Control key inputs
• Establish specifications and standards
• Hire quota enforcers
• Divide the market geographically
• Limit market shares and set collusion terms other than
price
• Influence government so that it ‘regulates” industry
• Pay for not producing or buy production from others
Case: Government as an Enforcer of
coordination
• Government imposes tax on producers
• Variable cost rise, supply falls, PRP (price received
by producers) fall and PPC (price paid by
consumers) increase
• This is equivalent to a government that figurative
buys x for PRP and resells x for PPC
Mafioso Economics
• Merchants in a city compete and charge price = Po
• "Mafioso Jane" tells merchants that they have to charge
P1 (higher than Po) and threatens merchants if they do
not obey
• Merchants in general make more profits at higher price
P1. They pay for a fee or “private tax” to "Mafioso Jane"
for services rendered
• "Mafioso Jane" acts as a cartel enforcer.
• Merchants gain by having "Mafioso Jane" put order in the
market and discipline cheaters
• "Mafioso Jane" is acting like a government by regulating
entry and imposing taxes