Download THE NATURE OF INDUSTRY

THE NATURE OF
INDUSTRY
Approaches to Studying
Industry
• The Structure-Conduct-Performance (SCP) Paradigm:
• Different structures lead to different conducts and
different performances
Market Structure
1.
2.
3.
4.
5.
Number of buyers, Buyer Power, the
number of firms that compete in a
market, producer power
The relative size of the firm
(concentration)
Technological and cost conditions;
Economies of scale, Economies of scope,
cost synergies, transaction costs
Ease of entry or exit into industry,
regulations
Type of product (homogeneous or
heterogeneous)
• Different industries have different
structures that affect managerial
decision
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
why ?
Limitation of Concentration
Measures
• Market Definition: National, regional, or
local?
• Global Market: Foreign producers excluded.
• Industry definition and product classes.
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
If L = 0, then the P=MC
When L=1/2  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
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
Types of integration:
1. Vertical : merging with your supplier to
reduce transaction cost
2. Horizontal: merging similar companies to
reduce cost and enjoy economies of scale
or scope and market power
3. Conglomerate: merging firms in different
industries to reduce the variability of
firm’s earnings due to demand fluctuation
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.
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.
Spectrum of Market
Structures
Based on Power of Buyers and Sellers
1. Monopsony (highest power of buyers)
2. Perfect Competition (Low power of
buyers and low power of sellers
3. Oligopoly (Cartel) (medium power of
sellers, low power of buyers)
4. Monopoly (highest power of sellers, low
power of buyers
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 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.
• 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
Contract...
• Collusion
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
–
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)!
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.
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
non-members
• 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