Topic three: The foundations of industry policy

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Topic three The foundations of industry policy

• Structure and performance

2
Overview

• Broad structure of Australian economy
• Measures of industry performance
• Measures of market structure
• Underlying influences on market performance

3
Broad structure of Australian economy

• Of total output non-government production
• Services 74 of output, 80 employment, 20 of
  imports and exports
• Manufacturing 17 of output, 14 of employment,
  50 exports and 75 imports
• Mining 5 of output, 1 employment, 20 exports
• Rural 4 of output, 5 employment, 10 exports
• Low manufacturing but high primary relative to
  most G7 countries
• Over 1,000,000 businesses, but less than 3,000
  employ more than 200 people or have more than
  200m assets. These account for 25 of employment
  and 50 of output

4
Industry performance
Notes As industry performance improves, we
expect firms economic profits to fall and prices
to fall (relative to marginal cost) So
performance measures usually based on profit or
price-based measures
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Measures of industry performance

• Rate of return r (Revenue non-capital costs
  depreciation) divided by the value of capital
• How to value capital replacement or historic
  cost?
• How to deal with intangible capital e.g.
  advertising
• Measuring depreciation
• Real versus nominal return
• Transferred monopoly profits in asset values
• Tax and risk
• Compared to what?

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Measures of industry performance

• Price-Cost Margins (Lerner index or PCM) (price
  minus marginal cost) divided by the price
• How to measure marginal cost average variable
  cost (AVC) often used as a proxy
• Issues of technology when AVC used (e.g. low MC
  up to capacity).
• Tobins q Market value of firm divided by
  replacement cost of firm
• How to measure replacement cost of firm
  (including intangible assets)

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Measures of market structure

• CR4 what is the share of industry sales for the
  four largest firms.
• Used by the ACCC in merger evaluation
• If CR4 is above 75 and share of merged entity is
  above 15
• Could use any number (CRx)
• Need to identify market In Australia market
  definition for trade practices is based on
  demand and supply substitution
• In same market if significant substitutes in
  demand OR in supply
• Controversial as depends on judgments about
  substitution

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Example National Mutual merger with Lend
Lease/MLC in 1998

• Four markets identified
• Wholesale funds management, CR4 31.4 before
  merger and 35.2 after
• Life Insurance, CR4 55 before merger and 60
  after
• Superannuation, CR4 40.3 before merger and
  46.8 after
• Retail investment products, CR4 43.1 before
  merger and 50.3 after

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Herfindahl-Hirschman Index (HHI)

• Equals the sum of squares of market shares of all
  firms
• So HHI of monopoly is 10,000
• HHI of duopoly of two equal firms is (50)2 (50)2
  5,000
• HHI if four firms with shares 15, 20, 25, and
  40 respectively is (15)2 (20)2 (25)2 (40)2
  2850
• Federal Trade Commission in US guidelines if
  HHI lt 1000 then unconcentrated, if HHI between
  1000 and 1800 then moderate concentration, if HHI
  gt 1800 then highly concentrated.
• Example Australian groceries (through
  supermarkets) estimates in August 2001
  Woolworths 41, Coles 33.5, Metcash 11.7, FAL
  3.7 so HHI gt 2954

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Underlying influences on market performance

• Number of existing firms in industry and stage of
  product life-cycle
• Underlying technology
• Barriers to new entry
• Product differentiation and barriers to customer
  switching

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Life cycle issues

• Industries often follow a life cycle with new
  product development, high short-term
  profitability, rapid entry, shake-out and
  maturation, then finally new development or
  decline

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Underlying technology

• If technology involves large capital costs then
  market may only fit a relatively small number
  of firms
• Extreme case is a natural monopoly where the
  technology involves decreasing average cost over
  all output and efficient production involves just
  one firm

13
Natural monopoly
Notes Competitive production will mean high
(inefficient) cost But a single firm may set a
too high price Efficient price (price MC) will
drive firm bankrupt
14
Barriers to new entry

• Best way to protect profits is to stop new firms
  entering but how!
• Monopoly control of essential input (e.g.
  electricity transmission, patents)
• Government entry controls
• Strategic barriers created through credible
  threats (e.g. If commit to excess capacity)
• In absence of barriers, new entry or threat of
  new entry can eliminate market power

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Product differentiation and customer switching
costs

• Differentiation and niche products can raise both
  market power and welfare
• Small customer switching costs can create
  significant market power
• Contracts can be used to limit competition
• If used to play off customers to create a barrier
  to entry
• If used by large customers and large firm to
  create barrier and harm smaller customers

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Lessons

• We have crude general measures of both market
  performance and market concentration
• While market concentration is important for
  performance it is only one of many factors
• Real analysis requires proper investigation of
  the market technology, entry barriers,
  limitations on customer switching, product
  differentiation