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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)/P
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=0.5  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.
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 STRATEGIES
OF FIRMS WITH
LITTLE OR NO MARKET
POWER
Pricing and Output Decisions
in Perfect Competition
• The Basic Business Decision: entering a
market on the basis of the following
questions:
– How much should we produce?
– If we produce such an amount, how much profit
will we earn?
– If a loss rather than a profit is incurred, will it
be worthwhile to continue in this market in the
long run (in hopes that we will eventually earn a
profit) or should we exit?
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.
Should this Firm Sustain Short Run
Losses or Shut Down?
Profit = (Pe - ATC)  Qf* < 0
ATC
MC
$
AVC
ATC
Pe
Loss
Pe = Df = MR
Qf*
Qf
Shutdown Decision Rule
• A profit-maximizing firm should
continue to operate (sustain shortrun 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.
• Contribution Margin
(CM): the amount by
which total revenue
exceeds total variable
cost.
• CM = TR – TVC
• If the contribution
margin is positive, the
firm should continue
to produce in the
short run in order to
defray some of the
fixed cost.
• 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
Short-Run Market Supply Curve
• The market supply curve is the summation
of each individual firm’s supply at each
price.
P
Firm 1
Market
Firm 2
P
P
S1
S2
SM
15
5
10
18
Q
20
25
Q
30
43Q
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
Effect of Entry on the Firm’s
Output and Profits?
MC
$
AC
Pe
Df
Pe*
Df*
QL Qf*
Q
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.
• In the long run, the price in the
competitive market will settle at the point
where firms earn a normal profit.
– Economic profit invites entry of new firms
which shifts the supply curve to the right, puts
downward pressure on price and reduces
profits.
– Economic loss causes exit of firms which shifts
the supply curve to the left, puts upward
pressure on price and increases profits.
• Observations in perfectly competitive
markets:
– The earlier the firm enters a market, the
better its chances of earning above-normal
profit (assuming a strong demand in the
market).
– As new firms enter the market, firms that want
to survive and perhaps thrive must find ways to
produce at the lowest possible cost, or at least
at cost levels below those of their competitors.
– Firms that find themselves unable to compete
on the basis of cost might want to try competing
on the basis of product differentiation instead.
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
Marginal Revenue Like a
Monopolist
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
MR
Elastic
Inelastic
50
Q
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
–
The
–
–
Good (To Consumers)
Product Variety
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)!
Optimal Advertising
Decisions
• Advertising is one way for firms with market
power to differentiate their products.
• But, how much should a firm spend on
advertising?
– Advertise to the point where the additional
revenue generated from advertising equals the
additional cost of advertising.
Optimal Advertising
Decisions
– Equivalently, the profit-maximizing level of
advertising occurs where the advertising-to-sales
ratio equals the ratio of the advertising
elasticity of demand to the own-price elasticity
of demand.
EQ , A
A

R  EQ , P
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 longrun.
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.