Slide.

2ème année de la Grande Ecole de l’Institut de Rabat

Semestre 3

Industrial Organization
Market Structure and Performance

1st Term 2017-2018

Slide.2

Plan for today

• The SCP paradigm
• Differences in profitability Across US industries
• The SCP and the Porter’s 5 forces
• Determinants of industry profitability
• Measures of concentration
• Interpretation of concentration measures
• Performance measures
• Empirical tests of the SCP paradigm

Industrial Organization
Slide.3

Plan for today

• The SCP paradigm (Harvard School) suggested a relationship between
Structure ,Conduct an Performance .
• Structure: the level of concentration, cost structure, etc.
• Competitive conducts: prices, investments, etc.
• Market performance: market power, allocative efficiency.
• Assumption : S⟶C, S ⟶ P and C ⟶ P
• S ⟶ C : for example, collusion is more likely when there is a few
number of firms.
• C ⟶ P : the stronger competition between firms is, the more efficient
the market is.
• S ⟶ P : the higher the concentration, the higher the markup.

Industrial Organization
Slide.4

Differences in Profitability Across Industries

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Slide.5

Differences in Profitability Across Industries

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Slide.6

Differences in Profitability Across Industries

Industrial Organization
Slide 2.7

The SCP and the Porter’s 5 forces

Porter’s five
forces
framework helps
identify the
attractiveness of
an industry in
terms of five
competitive forces

Source: Adapted with the permission of The Free Press, a Division of Simon & Schuster Adult Publishing Group, from Competitive Strategy: Techniques for Analyzing Industries and
Competitors by Michael E. Porter. Copyright © 1980, 1998 by The Free Press. All rights reserved

Industrial Organization
Slide.8

Determinants of Industry Profitability

Entry Barriers Rivalry
Economies of scale Industry growth
Customer switching costs Demand conditions (overcapacity)
Product differentiation (brand identity) Exit barriers (high fixed costs,
Capital requirements escalating commitment
Incumbency advantages independent of Product differentiation
size(experience curve) switching costs for buyers
Access to distribution Industry concentration
Restrictive Government policy
Expected retaliation
Buyer Power
Supplier Power Purchase volume/
Supplier concentration Bargaining leverage
Product differentiation/ Price sensitiveness
standardization Threat of backward integration
Suppliers’ switching costs Substitution Threat Buyer concentration
Purchase volume/ Price/performance of Product differentiated or
bargaining leverage substitutes commodity
Threat of forward integration Buyers’ switching Buyers’ switching costs
Substitute availability costs
Buyers’ propensity to
substitute Industrial Organization
 Slide.9

Measures of concentration
• There are a number of alternative concentration measures at industry level.
• Hannah and Kay (1977) suggest a number of general criteria that any
specific concentration measure should satisfy if it is to adequately reflect
the most important characteristics of the firm size distribution:
1. Suppose industries A and B have equal numbers of firms. Industry A should be
rated as more highly concentrated than industry B if the firms’ cumulative market
share (when the firms are ranked in descending order of size) is greater for
industry A than for industry B at all points in the size distribution.
2. A transfer of market share from a smaller to a larger firm should always increase
concentration.
3. There should be a market share threshold such that if a new firm enters the
industry with a market share below the threshold, concentration is reduced.
Similarly, if an incumbent firm with a market share below the threshold exits from
the industry, concentration is increased.
4. Any merger between two incumbent firms should always increase concentration.

Industrial Organization
Slide.10

Measures of concentration
Firm size distribution (sales data): six hypothetical industries I1-I6
I1 I2 I3 I4 I5 I6

Firme 1 5 066 1 644 2 466 7 412 3 564 5 066

Firme 2 3 376 1 644 2 466 3 706 3 564 3 376

Firme 3 2 250 1 644 2 466 1 854 3 564 2 250

Firme 4 1 500 1 644 2 466 926 1 500 1 500

Firme 5 1 000 1 644 2 466 464 1 000 1 000

Firme 6 666 1 644 2 466 232 666 666

Firme 7 444 1 644 116 444 938

Firme 8 296 1 644 58 296

Firme 9 198 1 644 28 198

Total 14 796 14 796 14 796 14 796 14 796 14 796

Industrial Organization
Slide.11

Measures of concentration
• n-firm concentration ratio CRn (ex: CR3):
– Measures the share of the industry’s n largest firms in some
measure of total industry size.
– The most widely used size measures are based on industry
sales, assets or employment data.
-
𝑆$ : is the share of i’th
𝐶𝑅- = . 𝑆$ largest firm in total
$)* industry sales.

𝑥$ xi is the size of firm i, and

𝑠$ = N is the number of firms in
∑(
$)* 𝑥$
the industry

No set rules for the choice of n.

–
• CRn for n = 3, 4, 5 or 8 are among the most widely quoted n-firm
concentration ratios.

Industrial Organization
Slide.12

Measures of concentration
• n-firm concentration ratio CRn (ex: CR3):

n-firm concentration ratio CRn

I1 I2 I3 I4 I5 I6
CR3 0.7226 0.3333 0.5000 0.8767 0.7226 0.7226
CR4 0.8240 0.4444 0.6667 0.9393 0.8240 0.8240
CR5 0.8916 0.5556 0.8333 0.9707 0.8916 0.8916

Industrial Organization
Slide.13

Measures of concentration
• Herfindahl–Hirschman (HH) index:
• Hirschman (1945) and Herfindahl (1950) both suggested a concentration
measure based on the sum of the squared market shares of all firms in the
industry.
( 𝑆$ : is the market share of
𝐻𝐻 = . 𝑠$1 firm and N the total
$)* number of firms.
• What is the HH of an industry with a monopolist ?
• What is the minimum possible value of the HH of an industry with with
N firms ?
– IHH < 0.10 : Not concentrated.
– 0.10 < IHH< 0.18 : Moderately concentrated. (Mergers might be challenged)
– IHH > 0.18 : Highly concentrated.
• HH index requires individual size data on all of the industry’s member firms.
• Even if individual data are not available for the smaller firms, a reasonable
approximation to HH is obtained using data on the larger firms only.

Industrial Organization
Slide.14

Measures of concentration

The concentration ratio is the ratio of the The Herfindahl–Hirschman Index

sales of the n largest firms in the industry (HHI) is the sum of the squared market
shares of the top N companies.
divided by the total sales of the industry.
– The higher the HHI, the more
– Ranges from 0 (perfect competition) concentrated
to 100 (monopoly)
– Advantages
– Advantages
• Easy to compute
• Easy to compute • Affected by mergers of the
– Disadvantages larger competitors
– Disadvantages
• Does not quantify market power
• Does not quantify market
• Does not consider the ease of entry power
into the market
• Does not consider the ease of
• Unaffected by mergers of the larger entry into the market
competitors

Industrial Organization
Slide.15

Measures of concentration
• Hannah and Kay index:
• Hannah and Kay (1977) suggest the following generalization of the HH
index:
(

𝐻𝐾 𝛼 = . 𝑠$4
$)*

• 𝛼 should be greater than zero, but not equal to one, because HK(1) = 1
for any firm size distribution.

Herfindahl–Hirschman and Hannah–Kay Indexes

I1 I2 I3 I4 I5 I6
HK(1.5) .4376 .3333 .4082 .5485 .4236 .4440

HH = HK(2) .2108 .1111 .1667 .3346 .1924 .2133

HK(2.5) .1076 .0370 .0680 .2158 .0906 .1084

Industrial Organization
Slide.16

Interpretation of concentration measures

• Choice of appropriate industry definition : Any industry definition is
arbitrary to some extent. Industry definitions should allow the
calculation of concentration measures that sensibly reflect economic
power.
• Defining the boundaries of the market (cf. Ch 2)
• Treatment of imports and exports
• Multi-product operations.

Industrial Organization
Slide.17

Performance measures
5678
• Lerner index: more difficult to compute. Instead:
5
• The average profit rate : ROE, ROA (issues : Depreciation,
Discretionary expenditure on items such as R&D and advertising,
Debt, Risk, Mergers (goodwill), …).
M : Market value of equity
• Tobin q : c
M Market value of Debt
D:

𝑀; + 𝑀= A : total assets valued at

r

𝑞 = replacement cost
𝐴?

Industrial Organization
Slide.18

Market Concentration and Market Power

• The value of Lerner index?
• Market power measured by the weighted average of each firm’s
margin, with weights given by the firms’ market shares:
( (
𝑝 − 𝑀𝐶$
𝐿 ≡ . 𝑠$ ⟺ 𝐿 ≡ . 𝑠$ 𝐿$
𝑝
$)* $)*
(
1 1 𝐻𝐻
We have : 𝐿$ = 𝑠$ 𝐿 ≡ . 𝑠$ 𝑠$ 𝐿 ≡
|𝜀| |𝜀| |𝜀|
$)*

This result suggests a relationship between Market Structure (H)

and Market Power (L).

Industrial Organization
Slide.19

Market Concentration and Market Power

Example:
• Consider two markets with identical demands. In one market, there
are two firms with identical market shares. In the other market, there
is one firm with a 70% market share and two small firms with 15%
each. Assuming that both markets are in a Cournot equilibrium,
where is market power the greatest?

Industrial Organization
Slide.20

Empirical Tests of the SCP Paradigm

• To prove the idea of the SCP paradigm, we need to show that
there is a relationship between structure and performance, that
is, a relationship between concentration and market power.
• This has been tested but only a weak relation was shown.
• Data issues:
• No measure of margins! use of ratios from accounting data
• Lots of firms playing on several markets: how to allocate the
numbers between the different markets where they play?

Industrial Organization
Slide.21

Empirical Tests of the SCP Paradigm

• If a link between concentration and market power was found, we
would have had an issue of interpretation:
• Collusion hypothesis (the one of SCP paradigm): a higher degree of
concentration implies more collusion between firms

• Efficiency hypothesis : starting from a symmetric situation, if a firm

reduces its marginal cost, concentration and market power both
increase.

Industrial Organization
Slide.22

Empirical Tests of the SCP Paradigm

• Bain (1951) tests the relationship between concentration and
profitability using data for 42 US manufacturing industries between
1936 and 1940.
• Profitability is measured using return on equity, and concentration is
measured using the CR8 .
• Average profitability is significantly higher in industries with CR8
above 70 per cent (at 9.2 per cent) than in those with CR8 below 70
per cent (at 7.7 per cent).
– Exploitation of market power leads to enhanced profitability
• Collins and Preston (1966) shows a positive relationship between
concentration (measured using CR4 ) and a price–cost margin
profitability measure, for a sample comprising 32 US four-digit (SIC)
food manufacturing industries observed in 1958.

Industrial Organization
Slide.23

Emprical Tests of the SCP Paradigm

Demsetz (1973,1974) rejects the SCP.
• Correlation between profitability and concentration is due to a relationship
between efficiency and profitability
Rates of return by size and concentration (weighted by assets)

Industrial Organization
Slide.24

Empirical Tests of the SCP Paradigm

• Policy Implications: (despite the controversy)
• Principle : Should be authorized only concentrations which...
– France : does not harm free competition (Lignes directrices 2005)
– European Commission : does not significantly hinder effective
competition, especially by creating or strengthening a dominant
position (Directives 2004).
– UK : does not reduce significantly competition ("Substantial
lessening of competition test", OFT mergers substantive
assessment guidance)
– USA : is not likely to substantially lessen competition ("SLC
test"); do not create or enhance market power [that is] the ability
to profitably maintain prices above competitive level for a
significant amount of time.

Industrial Organization
Slide.25

Exercise
The motorcycle industry consists of seven firms. Firms 1, 2, 3, 4 each
has 10% market share, and firms 5, 6, 7 each has 20% market share.
• Calculate CR4 for this industry.
• Calculate the HHI for this industry.
• Now, suppose that firms 1 and 2 merge, so that the new firm will have
a market share of 20%.
– Calculate the post merger HHI.
– Calculate the change in the HHI caused by the merger. That is,
calculate ΔHHI.
– Would the competition regulator challenge this merger? Provide
the rationale.

Industrial Organization