The Nature of Industry

Murat Issabayev, PhD, Associate Professor of Economics

Date: October 27 – November 3, 2022
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 Introduction
• Normally, the managers of firms make decisions such as:
✓how much output to produce
✓What price to charge
✓Research and Development Expenditure
✓Advertising expenditures and so on
▪ There exist several factors that affect managerial decisions
▪ For optimal price strategy is not same for all goods, R&D differ across
industries etc.

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 MARKET STRUCTURE
• It refers to factors that affect managerial decisions such as
✓Number of firms competing in the market
✓The relative size of the firms (concentration)
✓Technological and cost conditions
✓Demand conditions
✓Entry and exit decisions

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 FIRM SIZE
• From Table – 7.1 above we can see that the largest US firms in certain
industries.
• The size is measured by the number of sales (in millions)
✓What are drivers of differences in sales across industries?
✓Why do firm’s relative size change over time?
✓Do firms become large as a result of merging with other firms?

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 INDUSTRY CONCENTRATION
▪ Are there many small firms or only a few large firms within an
industry?
▪ It is important as optimal decisions a manager makes depend on
degree of competition in the given industry.
▪ Some industries are dominated by a few large firms, while others by
many small firms.
▪ Two measures to describe the degree of concentration within an
industry: Concentration Ratios (CR) and Herfindahl-Hirschman Index
(HHI).

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 Market Structure

Industry Concentration

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 Industry Concentration
• The most common CR ratio is 𝑪𝟒.
• When an industry consists of too many small firms, the 𝑪𝟒 ≅ 𝟎
(industry is less concentrated, too much competition among firms for
the right to sell to consumers).
• Similarly, when 4 or fewer firms produce all of an industry’s output,
the 𝑪𝟒 = 𝟏 (industry is more concentrated, little competition among
firms) .

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Industry Concentration

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Industry Concentration

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 Market Structure

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 Industry Concentration
• From Table -7.2 above we can see considerable variation among
industries in the degree of concentration.
• For instance, the Top-4 producers of electronic computers account for
87% of the industry’s total output (considerable concentration).
• On the other hand, the Top-4 producers of ready-mix concrete
account for only 23% of the total market.
• The industries with high 𝑪𝟒 tend to have higher HHI, but NOT always.
• For example, according to the 𝑪𝟒, the motor vehicle industry is more
concentrated than the snack food industry. However, the HHI for the
snack food industry is higher than that for the motor vehicle industry.

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 Market Structure

Industry Concentration
• The reasons for two measures of concentration to differ:
• 𝑪𝟒 includes ONLY the Top-4 firms within the industry. The fifth largest
is not counted.
• HHI includes ALL the firms in the industry.
• The HHI is based on squared market shares, while the 𝑪𝟒 is not.
• Consequently, the HHI places a greater weight on firms with large
market shares than does the 𝑪𝟒.

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 Market Structure

Limitations of Concentration
Measures
• The HHI indexes reported in Table 7–2 are only approximations because the
Census Bureau uses data on only the top 50 firms in the industry rather than data
on all firms in the industry.
• Global market: Census Bureau doesn’t take into account the foreign firms in the
US market. Thus, these measures overstate the true level of concentration.
• National, Regional, and Local Markets: When the relevant markets are local, the
use of national data tends to understate the actual level of concentration in the
local markets. Thus, geographical differences among markets can lead to biases in
concentration measures.
• Industry Definitions and Product Classes: Consider C4 for soft drinks, which is 52
percent in Table 7–2, which may seem surprisingly low when one considers how
The value of the Herfindahl-Hirschman index lies between 0 and 10,000. A
Coca-Cola and Pepsi dominate the market for cola. However, C4 for soft drinks is
based value
on a of 10,000 arises when a single firm (with a market share of w1 = 1) exists
much more broadly defined notion of soft drinks.
in the industry. A value of zero results when there are numerous infinitesimally
small firms.
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 Market Structure
Technology
• Industries differ in regard to the technologies used to produce
goods and services.
• Labor-intensive industries (beverage industry ~15 workers for each $5
million in sales)
• Capital-intensive industries (petroleum-refining industry ~1 worker for
each $5 million in sales)
• Within a given industry if the available technology is:
• the same, firms will likely have similar cost structures.
• different/superior, one firm will likely have a cost advantage.

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 Market Structure
Demand and Market Conditions
• In industries with relatively low demand, the market may be able to sustain
only a few firms.
• In industries where demand is large, the market may require many firms to
produce the quantity demanded.
• Ex: Organic food vs. regular food
• The information accessible to consumers also tends to vary across
markets. The information about a plain ticket is easier to access than that
about the best deal on a used car.
• The elasticity of demand for products tends to vary from industry to
industry. Moreover, the elasticity of demand for an individual firm’s
product generally will differ from the market elasticity of demand for the
product. In some industries, there is a large discrepancy between an
individual firm’s elasticity of demand and the market elasticity.

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 Market Structure
Potential for Entry
• Optimal decisions by firms in an industry will depend on the ease
with which new firms can enter the market.
• Several factors can create barriers to entry (or make entry difficult).
• Capital requirements (explicit costs) (e.g., opening a bank)
• Patents/licence (e.g., energy plant)
• Economies of scale (e.g., telecom companies). In some markets, only one or
two firms exist because of economies of scale. If additional firms attempted
to enter, they would be unable to generate the volume necessary to enjoy
the reduced average costs associated with economies of scale.

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 Conduct
Conduct
• Behavior of firms:
✓Price markup over costs: Some industries charge higher
markups than other industries.
✓Integration and merger: Some industries are more
susceptible to mergers or takeovers than others.
✓Advertising expenditures: tend to differ across industries
✓Research and development expenditures: also tend to differ
across industries

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 Conduct
Pricing Behavior

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Pricing Behavior

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Pricing Behavior

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 Conduct
Pricing Behavior in Action

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 Conduct
Pricing Behavior in Action

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Pricing Behavior

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 Conduct
Integration and Merger Activity
• Merger/acquisition
• Two or more existing firms “unite,” or merge, into a single firm.
• Why do firms merge?
✓Reduce transaction costs.
✓Reap benefits of economies of scale and scope.
✓Increase market power.
✓Gain better access to capital markets.
• Many managers fear mergers and acquisitions because, WHY?
• They are uncertain about the impact of a merger on their positions

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 Conduct
Types of Integration
• Vertical integration (transaction cost reduction)
• Various stages in the production of a single product are carried out in a
single firm.
• A vertical merger is the integration of two or more firms that produce
components for a single product.
• An automobile manufacturer that produces its own steel, uses the steel to
make car bodies and engines, and finally sells an automobile.

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 Conduct
Types of Integration
• Horizontal integration (scale economies and market power)
• Merging two or more similar final products into a single firm. (e.g.,
two computer firms merged) Anti-trust authorities, HHI index...
• In 2005, IBM sold PC hardware business to Lenovo.
• Conglomerate mergers
• Integration of two or more different product lines into a single firm.
Similar to horizontal but final products are different.
• Example: The merger between the Walt Disney Company and the
American Broadcasting Company.
• Because a conglomerate merger is one between two strategically
unrelated firms, it is unlikely that the economic benefits will be
generated for the target or the bidder. As such, conglomerate mergers
seldom occur today.
• Examples of conglomerates are Berkshire Hathaway, Amazon,
Alphabet, Facebook, Procter & Gamble, Unilever, Johnson & Johnson,
and Warner Media. All of these companies own many subsidiaries

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 Conduct
Research and Development
• Research and development (R&D)
• R&D Expenditures are made by firms to gain a technological
advantage, with the aim of acquiring a patent.
• The optimal amount to spend on R&D will depend on the
characteristics of the industry.

Company Industry R&D as Percentage of

Sales
Bristol-Meyers Squibb Pharmaceuticals 19.7
Ford Motor vehicle and parts 4.1
Goodyear Tire and Rubber Rubber and plastic parts 2.0
Kellogg Food 1.5
Proctor & Gable Soaps and cosmetics 2.5

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 Conduct
Advertisement
• Advertisement
• Expenditures made by firms to inform or persuade consumers to
purchase their products.
• An increase in competition influences on advertisement
expenditures.
Company Industry Advertising as Percentage
of Sales

Bristol-Meyers Squibb Pharmaceuticals 4.9

Ford Motor vehicle and parts 3.2
Goodyear Tire and Rubber Rubber and plastic parts 2.5

Kellogg Food 9.2

Proctor & Gable Soaps and cosmetics 11.7

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 PERFORMANCE
• Refers to the profits and social welfare that result in a given industry.

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 PERFORMANCE
• From Table 7–6 we can see the differences in profits across firms in
different industries.
• Ford’s sales were among the highest in the group, yet its profits as a
percentage of sales were second lowest in the group.
• So, “big” firms do not always earn big profits.
• Thus, as a manager, it would be a mistake to assume that as your firm
is large, then your company will automatically earn huge profits.

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 Managing in different market structures
• Perfect competition
• Too Many small firms and consumers relative to entire market.
• Firms produce very similar products.
• No market power (P = MC), price-takers.
• Monopoly
• Sole producer of good or service.
• Market power (P > MC).
• Monopolistic competition
• Many, small firms and consumers relative to market.
• Firms produce slightly different products.
• Limited market power.
• Oligopoly
• Few, large firms tend to dominate market.
• Price/marketing strategies are mutually interdependent with other firms in the
industry.

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 Perfect Competition

• The firms have access to the same technologies and produce similar
products, so no firm has any real advantage over other firms in the
industry.
• Firms in perfectly competitive markets have NO market power; that
is, no individual firm has a perceptible impact on the market price,
quantity, or quality of the product produced in the market.
• In perfectly competitive markets, both CR indexes tend to be close to
zero.

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 Monopoly
• For there is a single firm providing a good or service in a market,
there is a tendency for the seller to capitalize on the monopoly
position by restricting output and charging a price above marginal
cost.
• Because there are no other firms in the market, consumers cannot
switch to another producer in the face of higher prices.
• Consequently, consumers either buy some of the product at the
higher price or go without it. In monopolistic markets, there is
extreme concentration index.

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 Monopolistic Competition
• In a monopolistic competition market, there are many firms and
consumers, just as in perfect competition.
• Thus, concentration measures are close to zero.
• Unlike in perfect competition, however, each firm produces a product
that is slightly different from the products produced by other firms;
• Ex: restaurants in a city.

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 Monopolistic Competition
• In a monopolistically competitive market, a firm has some control
over the price charged for the product.
• By raising the price, some consumers will remain loyal to the firm due
to a preference for the particular characteristics of its product.
However, some consumers will switch to other brands.
• Hence, firms in monopolistically competitive industries often spend
considerable sums on advertising in an attempt to convince
consumers that their brands are “better” than other brands and keep
them.

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 Oligopoly
• In an oligopolistic market, a few large firms tend to dominate the
market. Ex: Firms in highly concentrated industries such as the airline,
automobile, and aerospace industries.
• The changes in price or marketing strategy by one firm in an
oligopolistic market affects not only its own profits, but also the
profits of the other firms in the industry.
• Consequently, when one firm in an oligopoly changes its conduct,
other firms in the industry have an incentive to react to the change by
altering their own conduct. Thus, the distinguishing feature of an
oligopolistic market is mutual interdependence among firms in the
industry.

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 Oligopoly
• The interdependence of profits in an oligopoly gives rise to strategic
interaction among firms.
• For example, suppose the manager of an oligopoly is considering increasing
the price charged for the firm’s product.
• To determine the impact of the price increase on profits, the manager must
consider how rival firms in the industry will respond to the price increase.
• Thus, the strategic plans of one firm in an oligopoly depend on how that
firm expects other firms in the industry to respond to the plans, if they are
adopted. For this reason, it is very difficult to manage a firm that operates in
an oligopoly. Because large rewards are paid to managers who know how to
operate in oligopolistic markets.

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