A PAPER Propose as a prerequisite to the Managerial Economics Subject




Jl. Raya Tanjung Barat No. 11 Jakarta Selatan

INTRODUCTION Managers of firms do not make decisions in vacuum. Numerous factors affect decisions such as how much output to produce, what price to charge, how much to spend on research and development, advertising, and so on. But, no single theory or methodology provides

manager with the answer to these questions. The optimal pricing strategy for an automobile manufacturer generally will differ from that of a computer firm.

MARKET STRUCTURE Market structure factors that effect managerial decisions including the number of firms competing in a market, the relative size of the firm, technological and cost conditions, demand conditions, and the ease with which firms can enter or exit the industry. Industry Concentration Another factor that affects managerial decisions is the size distribution of firms within an industry; that is, are there many small firms within an industry or only a few large firms? As we know, some industries dominated by a few large firms, while others are composed of many small firms. Concentration ratio measures how much of the total output in an industry is produced by the largest firm in the industry. The most common concentration ratio is the for-firm concentration ratio (C4). The four-firm concentration ratio is the fraction of total industry sales produced by the four largest firms in the industry. The four-firm concentration ratio is given by: C4 =  ST

S1, S2, S3, and S4: the sales of the four largest firms in industry

ST: the total sales of all firms in industry Equivalently, the four-firm concentration ratio is the sum of the market shares of the top four firms: C 4= w1 + w2 + w3 + w4

w1 = S1/ST w2 = S2/ST w3 = S3/ST w4 = S4/ST When an industry is composed of a very large number of firms, each of which is very small, the four-firm concentration ratio is close to zero. When four or fewer firms produce all of an industry s output, the four-firm concentration ratio is 1. The closer the four-firm concentration ratio is to zero, the less concentrated is the industry; the closer the ratio is to 1, he more concentrated is the industry.

Demonstration Problem 1
Suppose an industry is composed of six firms. Four firms have sales of $ 10 each, and two firms have sales of $ 5 each. What is the four-firm concentration ratio for the industry? Answer: Total Industry sales are ST = $ 50. The sales of the four largest firms are: S1 + S2 + S3 + S4 = $40 Therefore, the four-firm concentration ratio is C4 = = 0.80

This means that the four largest firms in the industry account for 80 percent of total industry output.

Another measure of concentration is the Herfindahl-Hirscham index. The HerfindahlHirscham index (HHI) is the sum of the squared market shares of firms in a given industry multiplied by 10.000. The Herfindahl-Hirscham index (HHI) is: HHI = 10,000 w12 Where: w : Si/ST Si : firm i : sales ST : total sales

Demonstration Problem 2
Suppose an industry consists of three firms. Two firms have sales of $10 each, and one firm has sales of $30. What is the Herfindahl-Hirschman index for this industry? What is the fourfirm concentration ratio? Answer: Since the total industry sales are ST= $50, the largest firm has a market share of w1 = 30/50 and the other two firms have a market share of 10/50 each. Thus, the Herfindahl-Hirschman index for this industry is:

HHI = 1.000





= 4,400

The four-firm concentration ratio is 1, since the top three firms account for all industry sales.

Limitation of Concentration Measures TABLE 1 Industry Breakfast cereals Breweries Cookies and crackers Distilleries Electronic computers Fluid milk Games and toys Hosehold refrigerators and home freezers Jewelry (excluding costume) Luggage Men s and boy s clothing Motor vehicles Pens and mechanical pencils Ready-mixed concrete Semiconductors Snack foods Soap and detergent Soft drinks Tires Women s and girl s clothing Wood containers and pallets

C4 83 90 60 60 45 21 43 82 13 52 42 82 65 7 34 63 65 47 73 14 6

HHI 2.446 N/A 1.383 1.076 728 205 564 2.025 81 1.419 846 2.506 1.375 29 414 2.619 1.618 800 1.814 111 16

Global Markets. The four-firm concentration and the Herfindahl-Hirschman indexes are based on the definition of the product market that excludes foreign import. This tends to overstate

the true level of concentration in industries in which a significant number of foreign producers serve the market. For example, the four-firm concentration ratio for the brewery industries. The top four US firm s account for 90 percent of industry sales. However, this figure ignores beer produced by the many well-known breweries in Mexico Canada, Europe, Australia, and Asia. National, Regional, and Local Markets. Another deficiency is that they are based on figures for the entire United States. In many industries, the relevant markets are local and may be composed of only a few firms. When the relevant markets are local, the use of national data tends to understate the actual level of concentration in the local markets. Industry Definitions and Product Classes. The geographic definition of the relevant market (local or national) can lead to bias in a concentration ratio. Consider the four-firm concentration ratio for soft drinks, which is 47 percent. This number is low when one considers how Coca-Cola and Pepsi dominate the market for cola.

Technology Technology is also important within a given industry. In some industries, firms have access to identical technologies and therefore have similar cost structure. In other industries, one or two firms have access to a technology that is not available to other firms. The firms with superior technology will have an advantage over other firms. Demands and Market Conditions Industries also differ with regard to underlying demand and market conditions. In industry with relatively low demand, the market may be able to sustain only a few firms. In industries where demand is great, the market may require many firms to produce the quantity demanded. The elasticity of demand for products tends to vary from industry to industry. One measure of the elasticity of industry demand for a product is Rothschild index. The Rothschild index provide a measure of the sensitivity to price of the product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

The Rothschild index is given by: R= ET : the elasticity of demand for the total market EF : the elasticity of demand for the product of an individual firm. Demonstration Problem 3
The industry elasticity of demand for airline travel is -3, and the elasticity of demand for an individual carrier is -4. What is the Rothschild index for this industry?

The Rothschild index is


= 0.75

Potential for Entry In some industries, it is easy for e new firm to enter the market, in the other hand, it is more difficult. Numerous factors can create a barrier to entry. One potential barrier to entry is the explicit cost of entering an industry. Another is patent and economics scale.

CONDUCT Pricing Behaviour Firms in some industries charge higher markups than firms in other industries. To illustrate the fact, some economists introduce Lerner Index. Lerner Index is a measure of the difference between price and marginal cost as a fraction of the product s price. Lerner index is given by: L= P MC : Price : Marginal Cost When a firm sets its price equal to marginal cost of production, the Lerner index is zero. When a firm charges a price that is higher than marginal cost, the Lerner index is greater than zero. When firms do not rigorously compete for the consumers through price competition, the Lerner index is closer to 1. We can rearrange the formula for the Lerner index to obtain P= MC

1/1-L is markup factor. It defines the factors by which marginal cost is multiplied to get the price of the good.

Demonstration Problem
A firm n the airline industry has a marginal cost of $200 and charges a price of $300. What are the Lerner index and markup factor? Answer: The Lerner index is

L= =

= =


The markup factor is

Integration and Merger Activity Integration refers to the uniting of productive resources. Integration can occur through a merger, in which two or more existing firms unite, or merge, into a single firm. There are three types integration or merger: Vertical integration Refers to a situation where a various stages in the production of single product are carried out in a single firm. For instance, an automobile manufacturer produces its own steel. Horizontal integration Refers to the merging of the production of similar products into a single firm. For example, two computer firms merged to a single firm. Conglomerate Mergers The integration of different product lines into a single firm. For instance, a cigarette maker and a cookie manufacturer merge into a single firm.

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