THE NATURE OF
INDUSTRY
INTRODUCTION
• Several factors affect decisions such as how
much to produce, what price to charge, how
much to spend on R&D, advertising etc.
• No single theory or methodology provide
managers answers to these questions
• Pricing strategy/ advertising etc. for a car
maker will differ from food manufacturers
• In this section we examine the important
differences that exists among industries.
Approaches to Studying
Industry
• The Structure-Conduct-Performance (SCP) Paradigm:
• Different structures lead to different conducts and
different performances
Market Structure
Refers to factors such as
1. The number of firms that compete in a
market,
2. The relative size of the firm
(concentration)
3. Technological and cost conditions
4. Ease of entry or exit into industry
Different industries have different
structures that affect managerial
decision making (Structural differences)
1.
Firm Size:
Some industries naturally give rise to
large firms than do other industries:
e.g. Industry = Aerospace,
Largest firm = Boeing
Industry = Computer, office equipment
Largest firm = IBM
2. Industry concentration:
Are there many small firms or only a few
large ones? (competition or little
competition?)
2 ways to measure degree of
concentration:
a. Concentration ratios
b. Herfindahl-Hirschman Index (HHI)
Concentration ratios measure how much of
the total output in an industry is produced
by the largest firms in that industry.
Most common one used is the four-firm
concentration ratio (C4) = the fraction of
total industry sales produced by the 4
largest firms in the industry
If industry has very large number of firms,
each of which is small, then is close to 0
When 4 or fewer firms produce all of
industry output, is close to 1
• Four-Firm Concentration Ratio
– The sum of the market shares of the top four
firms in the defined industry. Letting Si denote
sales for firm i and ST denote total industry
sales
Si
C4  w1  w2  w3  w4 , where w1 
ST
– The closer C4 is to zero, the less concentrated
the industry .
e.g. Industry has 6 firms. Sales of 4 firms = $10
and $5 for the other 2.
ST = 50
C4 = 40/50 = 0.8
 4 largest firms account for 80% of total
industry output
• Herfindahl-Hirschman Index (HHI)
– The sum of the squared market shares of firms
in a given industry, multiplied by 10,000 (to
eliminate decimals):
– By squaring the market shares, the index weights
firms with high market shares more heavily
– HHI = 10,000  S wi2, where wi = Si/ST.
0 <= HHI <= 10,000
Closer to 0 means industry has numerous
infinitesimally small firms.
Closer to 10,000 means little competition
HHI example
3 firms in an industry. 2 have sales of $10 each
and the other with $30 sales.
Total Industry Sales = $50
 30  2  10  2  10  2 
HHI  10000          4400
 50   50   50  
C4  1
Since the top three firms account for all industry sales
Limitation of Concentration
Measures
• Market Definition: National, regional, or
local?
• Global Market: Foreign producers excluded.
• Industry definition and product classes.
• Market Definition: National, regional, or
local? If there are 50 same size gas stations
in the US, one in each state, each firm will
have 1/50 market share. C4 = 4/50 
market for gas is not highly concentrated.
What good is this to a consumer in Blaine,
Washington, since the relevant market is
her local market?
• Geographical differences among markets
lead to biases in concentration measures
Global Market:
Foreign producers excluded.
This tends to overstate the true level of
concentration in industries in which
significant number of foreign producers
serve the market
e.g. C4 for beer producers in US = 0.9 but this
ignores the beer produced by many
breweries in Mexico, Canada, Europe etc.
The C4 based on both imported and
domestic beer would be considerably lower
Industry definition and product classes:
There is considerable aggregation across
product classes.
e.g. Soft drink industry is dominated by Pepsi
and Coca-Cola yet the C4 for 2004 is 47%.
Quite low. The C4 contains many types of
bottled and canned drinks including
lemonade, iced tea, fruit drinks etc.
3.
TECHNOLOGY
• Some industries are labor intensive while
others are capital intensive
• In some industries, firms have access to
identical technologies and therefore
similar cost structures
• In others, only 1 or 2 firms may have
superior technology giving them cost
advantages over others
• Those with superior technology will
completely dominate the industry
4.
Demand and Market Conditions
• Markets with relatively low demand will be
able to sustain only few firms
• Access to information vary from industry
to industry
• Elasticity of demand for products tend to
vary from industry to industry
• Elasticity of demand for a firm’s product
may differ from the market elasticity of
demand for the product
Markets where there are no close substitutes for a
given firm’s product, elasticity of demand for the
firm’s product will be close to that of the market
Rothschild Index = R =Et/Ef
Et = market elasticity
Ef = firm’s elasticity
Measures how sensitive a firm’s demand is relative
to the entire market.
When industry has many firms each producing a
similar product, R will be close to zero
5. Potential for Entry
Easier for new firms to enter some
industries than other industries.
Barriers to entry:
• Explicit cost of entering (Capital
requirements
• Patents
• Economies of scale: new firms cannot
generate enough volume to reduce
average cost
CONDUCT:
Conduct (behavior) of firms differ
across industries
1.
Some industries charge a higher markup
than others. (pricing behavior)
2. Some industries are more susceptible to
mergers or takeovers
3. Amount spent on R&D tend to vary
across industries
1.
Pricing behavior:
Lerner Index (L) = (P – MC)/MC
Gives how firms in an industry mark up
their prices over MC.
If firms vigorously compete, L is close
to zero.
P = (1/1-L)MC
When L=2  firms charge price that is
2x the MC of production
e.g Tobacco industry. L = 76%  P is
4.17x the actual MC of production
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
Source: Baye and Lee, NBER working paper # 2212
Markup Factor
1.35
4.17
1.27
1.32
2.38
3.03
2.44
2. Integration and Merger Activity
Uniting productive services.
Can result from an attempt by firms to
• Reduce transaction cost
• Reap the benefits of economies of
scale and scope
• Increase market power
• Gain better access to capital
markets
3 types of integration:
Vertical Integration:
Various stages in the production of a single
product are carried out by a single firm
e.g. Car manufacturer produces its own steel,
uses the steel to make car bodies and
engines.
Reduces transaction cost
Horizontal Integration:
Merging production of similar products into a
single firm
e.g. 2 banks merge to form one firm to enjoy
cost savings of economies or scale or scope
and enhance market power.
When social benefits of this merger is
relatively small compared to social cost of
concentrated industry, government may
block this type of merger
US Department of Justice considers
industries with HHI > 1800 to be highly
concentrated and may block any merger
that will increase the HHI by more than
100
HHI < 1000 are considered unconcentrated.
3. Conglomerate Mergers
Integrating different product lines into a
single firm
Cigarette maker acquires a bread
manufacturing firm.
This is to reduce the variability of firm’s
earnings due to demand fluctuations and
to enhance the firm’s ability to raise
funds in the capital market
Performance
• Performance refers to the profits
and social welfare that result in a
given industry.
• Social Welfare = CS + PS
– Dansby-Willig Performance Index
measure by how much social welfare
would improve if firms in an industry
expanded output in a socially efficient
manner.
Approaches to Studying Industry
• The Structure-Conduct-Performance (SCP) Paradigm:
Causal View
Market
Structure
Conduct
Performance
e.g.
Consider a highly concentrated industry. This structure
gives market power enabling them to charge higher
prices for their products. This conduct (behavior of
charging higher prices ) is caused by the market
structure (few competitors). The high prices cause
higher profits and poor performance (low social welfare)
Thus, a concentrated market causes high prices and poor
performance
• The Feedback Critique
– No one-way causal link.
– Conduct can affect market
structure.
– Market performance can affect
conduct as well as market
structure.
PRICING STRATEGIES OF
FIRMS WITH MARKET
POWER
I. Basic Pricing Strategies
– Monopoly & Monopolistic Competition
– Cournot Oligopoly
II. Extracting Consumer Surplus
– Price Discrimination
– Block Pricing


Two-Part Pricing
Commodity Bundling
III. Pricing for Special Cost and Demand
Structures
– Peak-Load Pricing
– Cross Subsidies
– Transfer Pricing
Price Matching
Brand Loyalty
Randomized Pricing



IV. Pricing in Markets with Intense Price
Competition
Standard Pricing and Profits for
Firms with Market Power
Price
Profits from standard pricing
= $8
10
8
6
4
2
P = 10 - 2Q
1
4
5
2
3
MR = 10 - 4Q
MC
Quantity
An Algebraic Example
• P = 10 - 2Q
• C(Q) = 2Q
• If the firm must charge a single price to
all consumers, the profit-maximizing price
is obtained by setting MR = MC.
• 10 - 4Q = 2, so Q* = 2.
• P* = 10 - 2(2) = 6.
• Profits = (6)(2) - 2(2) = $8.
A Simple Markup Rule
• Suppose the elasticity of demand
for the firm’s product is EF.
• Since MR = P[1 + EF]/ EF.
• Setting MR = MC and simplifying
yields this simple pricing formula:
P = [EF/(1+ EF)]  MC.
• The optimal price is a simple markup
over relevant costs!
– More elastic the demand, lower
markup.
– Less elastic the demand, higher
markup.
An Example
• Elasticity of demand for Kodak film is
-2.
• P = [EF/(1+ EF)]  MC
• P = [-2/(1 - 2)]  MC
• P = 2  MC
• Price is twice marginal cost.
• Fifty percent of Kodak’s price is
margin above manufacturing costs.
Markup Rule for Cournot
Oligopoly
•
•
•
•
Homogeneous product Cournot oligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firm’s demand is
given by EF = N x EM.
• Since P = [EF/(1+ EF)]  MC,
• Then, P = [NEM/(1+ NEM)]  MC.
• The greater the number of firms, the
lower the profit-maximizing markup
factor.
An Example
• Homogeneous product Cournot industry, 3
firms.
• MC = $10.
• Elasticity of market demand = - ½.
• Determine the profit-maximizing price?
• EF = N EM = 3  (-1/2) = -1.5.
• P = [EF/(1+ EF)]  MC.
• P = [-1.5/(1- 1.5]  $10.
• P = 3  $10 = $30.
First-Degree or Perfect
Price Discrimination
• Practice of charging each consumer the
maximum amount he or she will pay for
each incremental unit.
• Permits a firm to extract all surplus from
consumers.
Perfect Price Discrimination
Price
Profits*:
.5(4-0)(10 - 2)
= $16
10
8
6
4
Total Cost* = $8
2
MC
D
* Assuming no fixed costs
1
5
2
3
4
Quantity
Caveats:
• In practice, transactions costs and
information constraints make this difficult
to implement perfectly (but car dealers
and some professionals come close).
• Price discrimination won’t work if
consumers can resell the good.
Second-Degree
Price Discrimination
• The practice of
posting a discrete
schedule of declining
prices for different
quantities.
• Eliminates the
information
constraint present in
first-degree price
discrimination.
• Example: Electric
utilities
Price
MC
$1
0
$
8
$5
D
2
4
Quantit
y
Third-Degree Price Discrimination
• The practice of charging different
groups of consumers different
prices for the same product.
• Group must have observable
characteristics for third-degree
price discrimination to work.
• Examples include student discounts,
senior citizen’s discounts, regional &
international pricing.
Implementing Third-Degree
Price Discrimination
• Suppose the total demand for a product is
comprised of two groups with different
elasticities, E1 < E2.
• Notice that group 1 is more price sensitive
than group 2.
• Profit-maximizing prices?
• P1 = [E1/(1+ E1)]  MC
• P2 = [E2/(1+ E2)]  MC
An Example
• Suppose the elasticity of demand for Kodak
film in the US is EU = -1.5, and the elasticity
of demand in Japan is EJ = -2.5.
• Marginal cost of manufacturing film is $3.
• PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 =
$9
• PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3
= $5
• Kodak’s optimal third-degree pricing
strategy is to charge a higher price in the
US, where demand is less elastic.
Two-Part Pricing
• When it isn’t feasible to charge different
prices for different units sold, but
demand information is known, two-part
pricing may permit you to extract all
surplus from consumers.
• Two-part pricing consists of a fixed fee
and a per unit charge.
– Example: Athletic club memberships.
How Two-Part Pricing Works
Price
1. Set price at marginal
cost.
2. Compute consumer
surplus.
3. Charge a fixed-fee equal
to consumer surplus.
Fixed Fee = Profits = $16
10
8
6
Per Unit 4
Charge
MC
2
D
1
2
3
4
5
Quantity
Block Pricing
• The practice of packaging multiple
units of an identical product together
and selling them as one package.
• Examples
– Paper.
– Six-packs of soda.
– Different sized of cans of green beans.
An Algebraic Example
• Typical consumer’s demand is P = 10 2Q
• C(Q) = 2Q
• Optimal number of units in a package?
• Optimal package price?
Optimal Quantity To Package: 4
Units
Price
10
8
6
4
MC = AC
2
D
1
2
3
4
5
Quantity
Optimal Price for the Package:
$24
Price
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24!
10
8
6
4
MC = AC
2
D
1
2
3
4
5
Quantity
Costs and Profits with Block
Pricing
Price
10
Profits = [.5(8)(4) + (2)(4)] – (2)(4)
= $16
8
6
4
Costs = (2)(4) = $8
2
D
1
2
3
4
5
MC = AC
Quantity
Commodity Bundling
• The practice of bundling two or more
products together and charging one
price for the bundle.
• Examples
– Vacation packages.
– Computers and software.
– Film and developing.
An Example that Illustrates
Kodak’s Moment
• Total market size for film and developing is
4 million consumers.
• Four types of consumers
– 25% will use only Kodak film (F).
– 25% will use only Kodak developing (D).
– 25% will use only Kodak film and use only
Kodak developing (FD).
– 25% have no preference (N).
• Zero costs (for simplicity).
• Maximum price each type of consumer will
pay is as follows:
Reservation Prices for Kodak Film
and Developing by Type of
Consumer
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Optimal Film Price?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2
million = $16 Million.
At a price of $4, only types F, FD, and D will buy
(profits of $12 Million).
At a price of $3, all types will buy (profits of $12 Million).
Optimal Price for Developing?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
At a price of $6, only “D” type buys (profits of $6 Million).
At a price of $4, only “D” and “FD” types buy (profits of $8 Million).
At a price of $2, all types buy (profits of $8 Million).
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.
Total Profits by Pricing Each
Item Separately?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Total Profit = Film Profits + Development Profits
= $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling
Pricing a “Bundle” of Film and
Developing
Consumer Valuations of a Bundle
Type
F
FD
D
N
Film
$8
$8
$4
$3
Developing Value of Bundle
$3
$11
$4
$12
$6
$10
$2
$5
What’s the Optimal Price for a
Bundle?
Type
F
FD
D
N
Film
$8
$8
$4
$3
Developing Value of Bundle
$3
$11
$4
$12
$6
$10
$2
$5
Optimal Bundle Price = $10 (for profits of $30 million)
Peak-Load Pricing
• When demand
during peak times is
higher than the
capacity of the
firm, the firm
should engage in
peak-load pricing.
• Charge a higher price
(PH) during peak times
(DH).
• Charge a lower price
(PL) during off-peak
times (DL).
Price
MC
PH
DH
PL
MRH
MRL
QL
DL
Q
H
Quantit
y
Cross-Subsidies
• Prices charged for one product are
subsidized by the sale of another
product.
• May be profitable when there are
significant demand complementarities
effects.
• Examples
– Browser and server software.
– Drinks and meals at restaurants.
Double Marginalization
• Consider a large firm with two divisions:
– the upstream division is the sole provider of a key input.
– the downstream division uses the input produced by the
upstream division to produce the final output.
• Incentives to maximize divisional profits leads the
upstream manager to produce where MRU = MCU.
– Implication: PU > MCU.
• Similarly, when the downstream division has
market power and has an incentive to maximize
divisional profits, the manager will produce where
MRD = MCD.
– Implication: PD > MCD.
• Thus, both divisions mark price up over marginal
cost resulting in in a phenomenon called double
marginalization.
– Result: less than optimal overall profits for the firm.
Transfer Pricing
• To overcome double marginalization, the
internal price at which an upstream division
sells inputs to a downstream division should
be set in order to maximize the overall
firm profits.
• To achieve this goal, the upstream division
produces such that its marginal cost, MCu,
equals the net marginal revenue to the
downstream division (NMRd):
NMRd = MRd - MCd = MCu
Upstream Division’s Problem
• Demand for the final product P = 10 - 2Q.
• C(Q) = 2Q.
• Suppose the upstream manager sets MR =
MC to maximize profits.
• 10 - 4Q = 2, so Q* = 2.
• P* = 10 - 2(2) = $6, so upstream manager
charges the downstream division $6 per
unit.
Downstream Division’s
Problem
• Demand for the final product P = 10 - 2Q.
• Downstream division’s marginal cost is the
$6 charged by the upstream division.
• Downstream division sets MR = MC to
maximize profits.
• 10 - 4Q = 6, so Q* = 1.
• P* = 10 - 2(1) = $8, so downstream division
charges $8 per unit.
Analysis
• This pricing strategy by the upstream
division results in less than optimal profits!
• The upstream division needs the price to be
$6 and the quantity sold to be 2 units in
order to maximize profits. Unfortunately,
• The downstream division sets price at $8,
which is too high; only 1 unit is sold at that
price.
– Downstream division profits are $8  1 – 6(1) = $2.
• The upstream division’s profits are $6  1 2(1) = $4 instead of the monopoly profits of
$6  2 - 2(2) = $8.
• Overall firm profit is $4 + $2 = $6.
Upstream Division’s “Monopoly
Profits”
Price
Profit = $8
10
8
6
4
2
MC = AC
P = 10 - 2Q
1
2
3
4
MR = 10 - 4Q
5
Quantity
Upstream’s Profits when Downstream Marks
Price Up to $8
Price
Downstream
Price
Profit = $4
10
8
6
4
2
P = 10 - 2Q
1
2
3
4
5
MR = 10 - 4Q
MC = AC
Quantity
Solutions for the Overall
Firm?
• Provide upstream manager with an incentive
to set the optimal transfer price of $2
(upstream division’s marginal cost).
• Overall profit with optimal transfer price:
  $6  2  $2  2  $8
Pricing in Markets with
Intense Price Competition
• Price Matching
– Advertising a price and a promise to match any lower
price offered by a competitor.
– No firm has an incentive to lower their prices.
– Each firm charges the monopoly price and shares the
market.
• Randomized Pricing
– A strategy of constantly changing prices.
– Decreases consumers’ incentive to shop around as they
cannot learn from experience which firm charges the
lowest price.
– Reduces the ability of rival firms to undercut a firm’s
prices.
Conclusion
• First degree price discrimination, block
pricing, and two part pricing permit a firm to
extract all consumer surplus.
• Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
• Simple markup rules are the easiest to
implement, but leave consumers with the
most surplus and may result in doublemarginalization.
• Different strategies require different
information.