THE NATURE OF INDUSTRY

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THE NATURE OF INDUSTRY
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INTRODUCTION

• Several factors affect decisions such as how much
  to produce, what price to charge, how much to
  spend on RD, 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.

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Approaches to Studying Industry

• The Structure-Conduct-Performance (SCP) Paradigm
• Different structures lead to different conducts
  and different performances

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Market Structure

• Refers to factors such as
• The number of firms that compete in a market,
• The relative size of the firm (concentration)
• Technological and cost conditions
• Ease of entry or exit into industry
• Different industries have different structures
  that affect managerial decision making
  (Structural differences)

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• 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

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• 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)

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• 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

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• 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
• 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

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• 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 lt HHI lt 10,000
• Closer to 0 means industry has numerous
  infinitesimally small firms.
• Closer to 10,000 means little competition

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• HHI example
• 3 firms in an industry. 2 have sales of 10 each
  and the other with 30 sales.
• Total Industry Sales 50

Since the top three firms account for all
industry sales
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Limitation of Concentration Measures

• Market Definition National, regional, or local?
• Global Market Foreign producers excluded.
• Industry definition and product classes.

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• 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

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• 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

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• 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.

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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

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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 firms product may
  differ from the market elasticity of demand for
  the product

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• Markets where there are no close substitutes for
  a given firms product, elasticity of demand for
  the firms product will be close to that of the
  market
• Rothschild Index R Et/Ef
• Et market elasticity
• Ef firms elasticity
• Measures how sensitive a firms demand is
  relative to the entire market.
• When industry has many firms each producing a
  similar product, R will be close to zero

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• 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

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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 RD tend to vary across industries

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• 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 L2 ? 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

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Lerner Indices Markup Factors
Source Baye and Lee, NBER working paper 2212
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• 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

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• 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

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• 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

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• US Department of Justice considers industries
  with HHI gt 1800 to be highly concentrated and may
  block any merger that will increase the HHI by
  more than 100
• HHI lt 1000 are considered unconcentrated.

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• Conglomerate Mergers
• Integrating different product lines into a single
  firm
• Cigarette maker acquires a bread manufacturing
  firm.
• This is to reduce the variability of firms
  earnings due to demand fluctuations and to
  enhance the firms ability to raise funds in the
  capital market

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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.

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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

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

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PRICING STRATEGIES OF FIRMS WITH MARKET POWER
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• I. Basic Pricing Strategies
• Monopoly Monopolistic Competition
• Cournot Oligopoly
• II. Extracting Consumer Surplus
• Price Discrimination ? Two-Part Pricing
• Block Pricing ? Commodity Bundling
• III. Pricing for Special Cost and Demand
  Structures
• Peak-Load Pricing ? Price Matching
• Cross Subsidies ? Brand Loyalty
• Transfer Pricing ? Randomized Pricing
• IV. Pricing in Markets with Intense Price
  Competition

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Standard Pricing and Profits for Firms with
Market Power
Price
Profits from standard pricing 8
10
8
6
4
MC
2
P 10 - 2Q
1 2 3 4 5
Quantity
MR 10 - 4Q
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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.

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A Simple Markup Rule

• Suppose the elasticity of demand for the firms
  product is EF.
• Since MR P1 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.

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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 Kodaks price is margin above
  manufacturing costs.

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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 firms 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.

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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.

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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.

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Perfect Price Discrimination
Price
Profits .5(4-0)(10 - 2) 16
10
8
6
Total Cost 8
4
2
MC
D
1 2 3 4 5
Quantity
Assuming no fixed costs
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Caveats

• In practice, transactions costs and information
  constraints make this difficult to implement
  perfectly (but car dealers and some professionals
  come close).
• Price discrimination wont work if consumers can
  resell the good.

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Second-Degree Price Discrimination
Price

• 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

MC
10
8
5
D
4
2
Quantity
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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
  citizens discounts, regional international
  pricing.

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Implementing Third-Degree Price Discrimination

• Suppose the total demand for a product is
  comprised of two groups with different
  elasticities, E1 lt 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

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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
• Kodaks optimal third-degree pricing strategy is
  to charge a higher price in the US, where demand
  is less elastic.

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Two-Part Pricing

• When it isnt 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.

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How Two-Part Pricing Works

• 1. Set price at marginal cost.
• 2. Compute consumer surplus.
• 3. Charge a fixed-fee equal to consumer surplus.

Price
10
8
6
Fixed Fee Profits 16
Per Unit Charge
4
MC
2
D
1 2 3 4 5
Quantity
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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.

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An Algebraic Example

• Typical consumers demand is P 10 - 2Q
• C(Q) 2Q
• Optimal number of units in a package?
• Optimal package price?

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Optimal Quantity To Package 4 Units
Price
10
8
6
4
MC AC
2
D
1 2 3 4 5
Quantity
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Optimal Price for the Package 24
Price
Consumers 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
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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
MC AC
D
1 2 3 4 5
Quantity
52
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.

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An Example that Illustrates Kodaks 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

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Reservation Prices for Kodak Film and Developing
by Type of Consumer
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Optimal Film Price?
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).
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Optimal Price for Developing?
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.
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Total Profits by Pricing Each Item Separately?
Total Profit Film Profits Development Profits
16 Million 9 Million 25 Million
Surprisingly, the firm can earn even greater
profits by bundling!
58
Pricing a Bundle of Film and Developing
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Consumer Valuations of a Bundle
60
Whats the Optimal Price for a Bundle?
Optimal Bundle Price 10 (for profits of 30
million)
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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
Quantity
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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.

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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 gt 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 gt 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.

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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

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Upstream Divisions 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.

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Downstream Divisions Problem

• Demand for the final product P 10 - 2Q.
• Downstream divisions 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.

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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 divisions 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.

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Upstream Divisions Monopoly Profits
Price
Profit 8
10
8
6
4
2
MC AC
P 10 - 2Q
1 2 3 4 5
Quantity
MR 10 - 4Q
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Upstreams Profits when Downstream Marks Price Up
to 8
Price
Profit 4
10
Downstream Price
8
6
4
2
MC AC
P 10 - 2Q
1 2 3 4 5
Quantity
MR 10 - 4Q
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Solutions for the Overall Firm?

• Provide upstream manager with an incentive to set
  the optimal transfer price of 2 (upstream
  divisions marginal cost).
• Overall profit with optimal transfer price

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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
  firms prices.

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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 double-marginalization.
• Different strategies require different
  information.