THE NATURE OF INDUSTRY

MARKET STRUCTURE

• FACTORS THAT AFFECT MANAGERIAL DECISIONS, INCLUDING THE NUMBER OF FIRMS

COMPETING IN A MARKET, THE RELATIVE SIZE OF FIRMS, TECHNOLOGICAL AND COST
CONSIDERATIONS, DEMAND CONDITIONS, AND THE EASE WITH WHICH FIRMS CAN ENTER OR
EXIT THE INDUSTRY.
 FIRM SIZE
• FIRM SIZE IS DEFINED AS EMPLOYEES PER
ESTABLISHMENT, EMPLOYEES PER COMPANY,
SALES PER FIRM, AND VALUE ADDED PER FIRM.
 INDUSTRY CONCENTRATION

• THE CONCENTRATION OF FIRMS IN AN INDUSTRY IS OF INTEREST TO ECONOMISTS, BUSINESS

STRATEGIST, AND GOVERNMENT AGENCIES.
 MEASURES OF INDUSTRY CONCENTRATION

• FOUR- FIRM CONCENTRATION RATIO

- IS THE FRACTION OF TOTAL INDUSTRY SALES PRODUCED BY THE FOUR LARGEST
FIRMS IN THE INDUSTRY. S1, S2, S3, AND S4 DENOTE THE SALES OF THE FOUR LARGEST FIRMS IN
AN INDUSTRY, AND LET ST DENOTE THE TOTAL SALES OF ALL FIRMS IN THE INDUSTRY. LET THE
FOUR-FIRM CONCENTRATION RATIO IS GIVEN BY

C4 =
S1+ S2 + S3 + S4
sT
• HERFINDAHL- HIRSCHMAN INDEX (HHI)
- THE SUM OF THE SQUARED MARKET SHARES OF FIRMS IN A GIVEN INDUSTRY
MULTIPLIED BY 10,000 TO ELIMINATE THE NEED FOR DECIMALS.
SUPPOSE FIRM I’S SHARE OF THE TOTAL MARKET OUTPUT IS WI = SI /ST, WHERE SI IS
FIRM I’S SALES AND ST IS TOTAL SALES IN THE INDUSTRY. THEN THE HERFINDAHL-HIRSCHMAN INDEX
IS

HHI = 10,000σ W2I

 TECHNOLOGY

• INDUSTRIES DIFFER REGARDING THE TECHNOLOGY USED TO PRODUCE GOODS AND

SERVICES.
― SOME INDUSTRIES ARE LABOR INTENSIVE;
―SOME INDUSTRIES ARE CAPITAL INTENSIVES:
―OTHER INDUSTRIES USE A COMBINATION OF LABOR AND CAPITAL.
 DEMAND AND MARKET CONDITIONS

• IN INDUSTRIES WITH RELATIVELY LOW DEMAND, THE MARKET MAY BE ABLE TO SUSTAIN ONLY
A FEW FIRMS.
• ROTHSCHILD INDEX
- PROVIDES A MEASURE OF THE SENSITIVITY TO PRICE OF 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

ET
R=
EF

WHERE ET IS THE ELASTICITY OF DEMAND FOR THE TOTAL MARKET AND EF IS THE ELASTICITY OF
DEMAND FOR THE PRODUCTION OF AN INDIVIDUAL FIRM.
 POTENTIAL FOR ENTRY

IN SOME INDUSTRIES, IT IS RELATIVELY EASY FOR NEW FIRMS TO ENTER THE MARKET; IN OTHERS,
IT IS MORE DIFFICULT. THE OPTIMAL DECISIONS BY FIRMS IN AN INDUSTRY WILL DEPEND ON THE
EASE WITH WHICH NEW FIRMS CAN ENTER THE MARKET.
NUMEROUS FACTORS CAN CREATE A BARRIER TO ENTRY, MAKING IT DIFFICULT FOR OTHER FIRMS
TO ENTER AN INDUSTRY. ONE POTENTIAL BARRIER TO ENTRY IS THE EXPLICIT COST OF ENTERING
AN INDUSTRY, SUCH AS CAPITAL REQUIREMENTS.
ECONOMIES OF SCALE ALSO CAN CREATE A BARRIER TO ENTRY. IN SOME MARKETS, ONLY ONE
OR TWO FIRMS EXIST BECAUSE OF ECONOMIES OF SCALE.
 PRICING BEHAVIOR

- FIRMS IN SOME INDUSTRIES CHARGE HIGHER MARKUPS THAN FIRMS IN OTHER INDUSTRIES.

• LERNER INDEX
- A MEASURE OF THE DIFFERENCE BETWEEN PRICE AND MARGINAL COST AS A FRACTION
OF THE PRODUCT’S PRICE.
LERNER INDEX IS GIVEN BY

WHERE P IS PRICE AND MC IS MARGINAL COST. THUS, THE LERNER INDEX MEASURES THE DIFFERENCE
BETWEEN PRICE AND MARGINAL COST AS A FRACTION OF THE PRICE OF THE PRODUCT.
 INTEGRATION AND MERGER ACTIVITY

INTEGRATION REFERS TO UNITING PRODUCTIVE RESOURCES. INTEGRATION CAN OCCUR

THROUGH A MERGER, IN WHICH TWO OR MORE EXISTING FIRMS “UNITE” OR MERGE INTO A
SINGLE FIRM.
MERGERS CAN RESULT FROM AN ATTEMPT BY FIRMS TO REDUCE TRANSACTION COSTS, REAP THE
BENEFITS OF ECONOMIES OF SCALE AND SCOPE, INCREASE MARKET POWER, OR GAIN BETTER
ACCESS TO CAPITAL MARKETS.
ECONOMIST DISTINGUISH AMONG THREE TYPES OF INTEGRATION, OR MERGERS: VERTICAL,
HORIZONTAL, AND CONGLOMERATE.
 VERTICAL INTEGRATION

VERTICAL INTEGRATION REFERS TO A SITUATION WHERE VARIOUS STAGES IN THE PRODUCTION

OF A SINGLE PRODUCT ARE CARRIED OUT IN A SINGLE FIRM.

VERTICAL MERGER IS THE INTEGRATION OF TWO OR MORE FIRMS THAT PRODUCE

COMPONENTS FOR A SINGLE PRODUCT.
 HORIZONTAL INTEGRATION

HORIZONTAL INTEGRATION REFERS TO THE MERGING OF THE PRODUCTION OF SIMILAR PRODUCTS

INTO A SINGLE FIRM. IT INVOLVES MERGING TWO OR MORE FINAL PRODUCTS INTO A SINGLE FIRM,
WHEREAS VERTICAL INTEGRATION INVOLVES MERGING TWO OR MORE PHASES OF PRODUCTION
INTO A SINGLE FIRM.

HORIZONTAL MERGER, BY ITS VERY DEFINITION, REDUCES THE NUMBER OF FIRMS THAT COMPETE IN
THE PRODUCT MARKET. THIS TENDS TO INCREASE BOTH THE FOUR – FIRM CONCENTRATION RATIO
AND THE HERFINDAHL – HIRSCHMAN INDEX FOR THE INDUSTRY, WHICH REFLECTS AN INCREASE IN THE
MARKET POWER OF FIRMS IN THE INDUSTRY.
 CONGLOMERATE MERGERS

CONGLOMERATE MERGERS INVOLVES THE INTEGRATION OF DIFFERENT PRODUCT LINES INTO A

SINGLE FIRM. IT IS SIMILAR TO A HORIZONTAL MERGER IN THAT IT INVOLVES MERGING FINAL
PRODUCTS INTO A SINGLE FIRM. IT DIFFERS FROM A HORIZONTAL MERGER BECAUSE THE FINAL
PRODUCTS ARE NOT RELATED.
 RESEARCH AND DEVELOPMENT

EARLIER WE NOTED THAT FIRMS AND INDUSTRIES DIFFER WITH RESPECT TO THE UNDERLYING
TECHNOLOGIES USED TO PRODUCE GOODS AND SERVICES. ONE WAY FIRMS GAIN A
TECHNOLOGICAL ADVAN (R& D) AND THEN OBTAINING A PATENT FOR THE TECHNOLOGY
DEVELOPED THROUGH THE R&D.
R. E. DANSBY AND R. D. WILLIG HAVE PROPOSED A USEFUL INDEX. THE DANSBY – WILLIG (DW)
PERFORMANCE INDEX MEASURES HOW MUCH SOCIAL WELFARE ( DEFINED AS RHE SUM PF
CONSUMER AND PRODUCER SURPLUS) WOULD IMPROVE IF FIRMS IN AN INDUSTRY EXPANDED
OUTPUT IN A SOCIALLY EFFICIENT MANNER.
THE DANSBY – WILLIG INDEX THUS ALLOWS ONE TO RANK INDUSTRIES ACCORDING TO HOW
MUCH SOCIAL WELFARE WOULD RISE IF THE INDUSTRY ALTERED ITS OUTPUT.
 PERFECT COMPETITION

IN MARKETS CHARACTERIZED BY PERFECT COMPETITION, THERE ARE MANY FIRMS, EACH OF

WHICH IS SMALL RELATIVE TO THE ENTIRE MARKET. IN PERFECTLY COMPETITIVE MARKETS, BOTH
CONCENTRATION RATIOS AND ROTHSCHILD INDEXES TEND TO BE CLOSE TO ZERO.
 MONOPOLISTIC COMPETITION

• IN A MARKET CHARACTERIZED BY MONOPOLISTIC COMPETITION, THERE ARE MANY FIRMS

AND CONSUMERS, JUST AS IN PERFECT COMPETITION. THUS, CONCENTRATION MEASURES ARE
CLOSE TO ZERO.
• A FIRM IN A MONOPOLISTICALLY COMPETITIVE MARKET 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 PRODUCTS.
 MONOPOLY

A MONOPOLY IS A FIRM THAT IS THE SOLE PRODUCER OF A GOOD OR SERVICE IN THE

RELEVANT MARKET. WHEN THERE IS A SINGLE PROVIDER OF 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.
 OLIGOPOLY

IN AN OLIGOPOLISTIC MARKET, A FEW LARGE FIRMS TEND TO DOMINATE THE MARKET. FIRMS IN
HIGHLY CONCENTRATED INDUSTRIES SUCH AS THE AIRLINE, AUTOMOBILE, AND AEROSPACE
INDUSTRIES OPERATE IN AN OLIGOPOLISTIC MARKET.