The Nature of Industry

1
Session 4

• The Nature of Industry

2
Overview

• I. Market Structure
• Measures of Industry Concentration
• II. Conduct
• Pricing Behavior
• Integration and Merger Activity
• III. Performance
• Dansby-Willig Index
• Structure-Conduct-Performance Paradigm
• IV. Preview of Coming Attractions

3
Industry Analysis

• Market Structure
• Number of firms, size, etc.
• Conduct
• Pricing, advertising, RD, etc.
• Performance
• Profitability, consumer surplus, social welfare.

4
The Structure- Conduct -Performance Paradigm

• The Causal View

Market Structure
Conduct
Performance

• The Feedback Critique
• No one-way causal link.
• Conduct can affect market structure.
• Market performance can affect conduct as well as
  market structure.

5
Industry Concentration

• Four-Firm Concentration Ratio
• The sum of the market shares of the top four
  firms in the defined industry C4 w1 w2
  w3 w4
• Herfindahl-Hirshmann Index (HHI)
• The sum of the squared market shares of firms in
  a given industry, multiplied by 10,000 HHI
  10,000 ? S wi2
• Limitations
• Market Definition National, regional, or local?
• Global Market Foreign producers excluded
• Industry definition and product classes

6
Industry Concentration

• Demonstration Problem 7-1
• Demonstration Problem 7-2
• Concentration of U.S. Industry
• Table 7-2, page 242

7
Rothschild Index

• A measure of the elasticity of industry demand
  for a product relative to that of an individual
  firm R ET / EF
• ET elasticity of demand for the total market
• EF elasticity of demand for the product of an
  individual firm.
• R has a value between 0 (perfect competition) and
  1 (monopoly).
• When an industry is composed of many firms, each
  producing similar products, the Rothschild index
  will be close to zero.

8
How Firms Differ

• Technology
• Demand and Market Conditions
• Rothschild Index
• Inside Business 7-2, page 249
• Demonstration Problem 7-3, page 247
• Potential for Entry

9
Own-Price Elasticities of Demand and Rothschild
Indices
10
Pricing Behavior

• The Lerner index
• L (P - MC) / P
• A measure of the difference between price and
  marginal cost.
• An index from 0 to 1.
• Markup factor
• Rearranging the above formula,
• P (1/(1-l)) MC
• 1/(1-L) is the markup factor.

11
Lerner Indices Markup Factors
12
Conduct

• Pricing Behavior
• Lerner Index
• Table 7-5, page 251
• Demonstration Problem 7-4, page 251
• Integration and Merger Activity
• Vertical Integration
• Horizontal Integration
• Conglomerate Mergers
• Trends in Mergers

13
Integration and Merger Activity

• Vertical integration
• Where various stages in the production of a
  single product are carried out by one firm.
• Horizontal integration
• The merging of the production of similar products
  into a single firm.
• Conglomerate mergers
• The integration of different product lines into a
  single firm.

14
DOJ/FTC Merger Guidelines

• Based on HHI 10,000 S wi2
• Merger may be challenged if
• HHI exceeds 1800, or would be after merger, and
• Merger increases the HHI by more than 100
• But...
• Recognizes efficiencies The primary benefit of
  mergers to the economy is their efficiency
  potential...which can result in lower prices to
  consumers...In the majority of cases the
  Guidelines will allow firms to achieve
  efficiencies through mergers without
  interference...

15
Performance

• Performance refers to the profits and social
  welfare that result in a given industry
• Social Welfare Consumer Surplus Producer
  Surplus
• Dansby-Willig Performance Index
• Ranks industries according to how much social
  welfare would improve if firms within each
  industry expanded output in the socially
  efficient manner.

16
Dansby-WilligPerformance Index
17
Conduct

• Research and Development
• Table 7-6, page 255
• Advertising
• Performance
• Profits
• Social Welfare
• Dansby-Willig Performance Index
• Demonstration Problem 7-5, page 257

18
Preview of Coming Attractions

• Discussion of optimal managerial decisions under
  various market structures, including
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
• Forms of Market Structure Worksheet page 4-1.