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