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Managerial Economics & Business Strategy

Chapter 7
The Nature of Industry

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Overview
I. Market Structure

Measures of Industry Concentration


Pricing Behavior Integration and Merger Activity Dansby-Willig Index Structure-Conduct-Performance Paradigm

II. Conduct

III. Performance

IV. Preview of Coming Attractions


Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Industry Analysis
Market Structure

Number of firms, size, etc. Pricing, advertising, R&D, etc. Profitability, consumer surplus, social welfare.

Conduct

Performance

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

The Structure-ConductPerformance Paradigm


The Causal View
Market Structure Conduct Performance

The Feedback Critique


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

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Industry Concentration
Four-Firm Concentration Ratio

The sum of the market shares of the top four firms in the defined industry: C4 = w1 + w2 + w3 + w4 The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 S wi2 Market Definition: National, regional, or local? Global Market: Foreign producers excluded Industry definition and product classes

Herfindahl-Hirschman Index (HHI)

Limitations

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Rothschild Index
A measure of the elasticity of industry demand for a product relative to that of an individual firm: R = ET / EF

ET = elasticity of demand for the total market EF = elasticity of demand for the product of an individual firm. R has a value between 0 (perfect competition) and 1 (monopoly).

When an industry is composed of many firms, each producing similar products, the Rothschild index will be close to zero.
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Own-Price Elasticities of Demand and Rothschild Indices


Industry Food Tobacco Textiles Apparel Paper Chemicals Rubber Elasticity of Market Demand -1.0 -1.3 -1.5 -1.1 -1.5 -1.5 -1.8 Elasticity of Firms Demand -3.8 -1.3 -4.7 -4.1 -1.7 -1.5 -2.3 Rothschild Index 0.26 1.00 0.32 0.27 0.88 1.00 0.78

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Pricing Behavior
The Lerner Index
L = (P - MC) / P

A measure of the difference between price and marginal cost. An index from 0 to 1.

Markup Factor

Rearranging the above formula, P = (1/(1-L)) MC 1/(1-L) is the markup factor.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Lerner Indices & Markup Factors


Industry Food Tobacco Textiles Apparel Paper Chemicals Petroleum Lerner Index 0.26 0.76 0.21 0.24 0.58 0.67 0.59 Markup Factor 1.35 4.17 1.27 1.32 2.38 3.03 2.44

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Integration and Merger Activity


Vertical Integration

Where various stages in the production of a single product are carried out by one firm. The merging of the production of similar products into a single firm. The integration of different product lines into a single firm.

Horizontal Integration

Conglomerate Mergers

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

DOJ/FTC Merger Guidelines


Based on HHI = 10,000 S wi2 Merger may be challenged if
HHI exceeds 1800, or would be after merger, and Merger increases the HHI by more than 100

But...

Recognizes efficiencies: The primary benefit of mergers to the economy is their efficiency potential...which can result in lower prices to consumers...In the majority of cases the Guidelines will allow firms to achieve efficiencies through mergers without interference...

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Performance
Performance refers to the profits and social welfare that result in a given industry Social Welfare = CS + PS Dansby-Willig Performance Index

Ranks industries according to how much social welfare would improve if firms within each industry expanded output in the socially efficient manner.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Dansby-Willig Performance Index


Industry Food Textiles Apparel Paper Chemicals Petroleum Rubber Dansby-Willig Index 0.51 0.38 0.47 0.63 0.67 0.63 0.49

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Preview of Coming Attractions


Discussion of optimal managerial decisions under various market structures, including:

Perfect competition Monopoly Monopolistic competition Oligopoly

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003