two assignments
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chapter6.pdf
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Title: The Nature of Industry
Contents
Introduction .................................................................................................................................3
Check Your Understanding .........................................................................................................3
Question 1 ........................................................................................................................................... 3
Question 2 ........................................................................................................................................... 3
Market Structure .........................................................................................................................3
Features Defining Market Structure .............................................................................................4
Firm Size ............................................................................................................................................. 4
Technology .......................................................................................................................................... 4
Barriers of Entry ................................................................................................................................... 4
Industry Concentration ................................................................................................................4
Herfindahl-Hirschman Index ........................................................................................................5
Demand Conditions.....................................................................................................................5
Check Your Understanding .........................................................................................................6
Question 3 ........................................................................................................................................... 6
Question 4 ........................................................................................................................................... 6
Integration and Mergers ..............................................................................................................6
Vertical ................................................................................................................................................ 7
Horizontal ............................................................................................................................................ 7
Conglomeration ................................................................................................................................... 7
Check Your Understanding .........................................................................................................7
Question 5 ........................................................................................................................................... 7
Question 6 ........................................................................................................................................... 7
Performance ...............................................................................................................................8
Check Your Understanding .........................................................................................................8
Question 7 ........................................................................................................................................... 8
Question 8 ........................................................................................................................................... 8
Approaches to Studying Industry.................................................................................................8
Check Your Understanding .........................................................................................................9
Question 9 ........................................................................................................................................... 9
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Question 10 ......................................................................................................................................... 9
Problem Statements....................................................................................................................9
Problem 1 ............................................................................................................................................ 9
Problem 1 Solution ............................................................................................................................ 10
Problem 2 .......................................................................................................................................... 10
Problem 2 Solution ............................................................................................................................ 10
Problem 3 .......................................................................................................................................... 10
Problem 3 Solution ............................................................................................................................ 11
Summary ..................................................................................................................................11
Review Questions .....................................................................................................................12
Question 1 ......................................................................................................................................... 12
Question 2 ......................................................................................................................................... 12
Question 3 ......................................................................................................................................... 12
Question 4 ......................................................................................................................................... 12
Question 5 ......................................................................................................................................... 13
What’s Next ..............................................................................................................................13
References ...............................................................................................................................13
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Introduction
Various factors affect the managerial decision-making process, such as output levels, price, and how much to allocate toward expenditures for research and development, and advertising among others.
Industries differ in their features, that is they have different aspects that define internal movements and behaviors. As such, the optimal decisions of a manager differ by industry.
Check Your Understanding
Question 1
Is the following statement true or false?
Managers in different industries are responsible for understanding the features of their industry.
Answer
The statement is true. Managers in different industries are responsible for understanding the features of their industry.
Question 2
Is the following statement true or false?
Managers in different industries make the same optimal managerial decisions.
Answer
The statement is false. Managers in different industries cannot make the same optimal managerial decisions. Numerous factors affect decisions such as how much output to produce, what price to charge, and how much to spend on research and development, advertising, and so on.
Market Structure
The market in which a company operates gives form to the decisions that the manager makes.
1. Perfect Competition: It is generally characterized by many firms that produce a homogenous product.
2. Monopoly: It is generally characterized by a major dominant firm.
3. Monopolistic Competition: It is generally characterized by several firms that produce slightly differentiated products.
4. Oligopoly: It is generally characterized by a few large firms.
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Features Defining Market Structure
Features such as the number and size of firms that compete in a market, the nature of consumer demand, technology, costs of operating in that market, and the ease with which firms can enter or exit the industry define the structure of a market.
Firm Size
Firms that are larger relative to their competition tend to have a larger market share than their competitors. As such, they can make different decisions regarding how they manage their operations.
Technology
Technology is a crucial part of competitiveness in an industry. If, relative to its competitiveness, a firm has access to technology that increases the productivity of capital or labor, or reduces costs, that firm will have the competitive advantage in that industry. If the firm has a significant technological advantage, its competitive advantage in the industry will be considerable. Firms can gain technological advantages by investing in research and development.
Barriers of Entry
The easier it is for firms to enter into a particular industry, the more firms will exist in that industry. Conversely, the higher the barriers for entry, the fewer the number of firms that exist in that industry.
Examples of barriers for entry include: initial cost of capital, legal restrictions such as patents, and economies of scale.
Industry Concentration
The distribution of firms by size in an industry affects the makeup of the industry. Whether there are few or many small industries, or few or many large industries affects how managers do their business.
Concentration ratios are frequently used to measure industry concentration. They measure the percentage of total output in a particular industry that is produced by the largest firms in that industry. Two of the most commonly used industry concentration ratios include: the four-firm concentration ratio and the Herfindahl-Hirschman index (HHI).
The four-firm concentration ratio captures the percentage of sales accrued by the four largest firms in a particular industry.
The four-firm concentration ratio is defined by:
Where,
𝐶4 = 𝑆1 + 𝑆2 + 𝑆3 + 𝑆4
𝑆𝑇 or 𝐶4 = 𝑤1 + 𝑤2 + 𝑤3 + 𝑤4
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S 1 to S 4 are the sales of the four largest firms in a particular industry;
When C 4 equals zero, the industry is not concentrated that is there are many sellers; when C 4 equals 1, the industry is highly concentrated that is there are few sellers. More sellers means more competition while fewer sellers means less competition.
Herfindahl-Hirschman Index
Herfindahl-Hirschman index (H H I) is calculated by,
HHI values closer to zero indicate competitive markets that is many sellers. HHI values closer to 10,000 indicate few sellers. Generally, industries with high HHI values have high C 4 values.
Although the concentration ratios mentioned are informative, they have the following drawbacks:
a. They do not take into account competition from foreign firms in domestic markets
in the calculation of S T.
b. Concentration ratios are typically cast at the national level which may not reflect
industry concentration realities at lower levels of disaggregation like the city level.
c. The types of products (product classes) that are or are not included in an industry
affects the number of companies and sales that are counted as part of the
industry. Thus, affect the values of concentration ratios.
Demand Conditions
When demand is low, only a few firms can be sustained; however, an industry with a high base of consumer demand could attract several firms. Depending on the number of substitutes in the particular industry, the elasticity of demand for the products of particular firms influences how firms maintain market shares and thus the concentration ratio in that industry.
The Rothschild index, whose value lies between 0 and 1, is a common measure of how price sensitivity of quantity demanded for an individual firm compares to the entire market. It is given by,
𝐻𝐻𝐼 = 𝑤𝑖 2 ∗ 10,000
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Where E base T is the elasticity of demand of an individual firm and E base F is the elasticity of demand for the entire market.
• What does it indicate when R is closer to 1?
The price sensitivity of quantity demanded for an individual firm is almost equivalent
to the price sensitivity measured market-wide – which indicates fewer firms are
present.
• What does it indicate when R is closer to 0?
The price sensitivity of quantity demanded measured at the firm level is greater than
that the market-wide measurement – which indicates many firms are present.
Check Your Understanding
Question 3
Which of the following is true about concentration ratios?
• They account for imports
• They are a measure of national industry concentrations
• Do not depend on product classes
• None of the above
Answer
Concentration ratios are a measure of national industry concentrations.
Question 4
Is the statement true or false?
If the value of the Herfindahl-Hirschman index for a particular industry is 0.01, the barriers for entry into that industry are probably low.
Answer
The statement is true. If the value of the Herfindahl-Hirschman index for a particular industry is 0.01, the barriers for entry into that industry are probably low.
Integration and Mergers
The process of combining productive resources is referred to as integration. Integration can occur at the onset of a firm’s formulation. The integration process can also occur via a merger whereby at least two firms merge to form a single firm.
Mergers can arise for various reasons: to help reduce costs, to help achieve economies of scale, to increase market share, or to help access markets. When two firms voluntarily enter into a merger process, it is regarded as a friendly merger. Hostile mergers occur when one firm moves to merge with another firm that does not want to enter into a merger.
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Vertical
A vertical merger occurs when one firm that produces a particular final product merges with a firm that produces an input or part for its final product; this is usually done to reduce transaction costs. For example, a potato chip company merging with a potato farming operations.
Horizontal
Horizontal happens when a firm that produces a particular final product merges with a firm that produces a similar or related final product. The benefits that could be derived from horizontal mergers include the generation of economies of scale and to gain market share. For example, two computer manufacturing firms merging to form one computer manufacturing firm.
Conglomeration
Conglomeration occurs when a firm that produces a particular product merges with a firm that produces a dissimilar or unrelated product. Companies could benefit by, for example, using revenue from one product class to support the operations of another product class.
Check Your Understanding
Question 5
Which of the following is not a form of integration?
• Vertical integration
• Conglomerations
• Horizontal integration
• Duopoly
Answer
Duopoly is not a form of integration.
Question 6
If the markup factor is large, then:
• The Lerner Index is equal to zero
• Price is larger than marginal cost
• Marginal cost is larger than price
• The Lerner index is equal to 1
Answer
If the markup factor is large, then price is larger than marginal cost.
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Performance
Gauges of industry performance include profits and social welfare. We know the established measurement of profit is the difference between total revenue and total cost. Similarly, we also have measurement for social welfare which itself is the sum of consumer and producer surplus.
What would happen to social welfare if companies in a particular industry increased their output in a socially efficient manner? The Dansby-Willig (DW) performance index tries to measure this.
If the value of the DW index is zero, then an increase in industry output would not increase social welfare, which means social welfare is maximized. When the DW index is greater than 0, then there is room to improve social welfare by altering output.
Check Your Understanding
Question 7
Is the following statement true or false?
The Dansby-Willig Index is useful as a profit measurement.
Answer
The statement is false. Dansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.
Question 8
Is the following statement true or false?
When the DW Index is positive, consumer welfare has been maximized.
Answer
The statement is false. When the DW index is greater than 0, then there is room to improve social welfare by altering output.
Approaches to Studying Industry
As we have discussed, market structure, firm behavior or conduct, and performance all matter in understand the topology of an industry.
The structure of an industry involves factors such as technology, concentration, and demand or market conditions. Conduct involves pricing, advertising, research and development investment decisions. Performance is concerned with profits and social welfare.
Tab 1: The Causal View
The Structure-Conduct-Performance (SCP) Paradigm: Causal View of industry outcomes assumes that the structure of markets influences firms toward a certain behavior. So the manner in which firms choose to allocate their resources determines their market performance.
Tab 2: The Feedback Critique
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The feedback critique asserts that market structure, conduct and performance influence each other. For example, technological innovations can create firm concentration which can eventually influence market structure and pricing.
Check Your Understanding
Question 9
Is the following statement true or false?
Firm concentration could affect firm conduct.
Answer
The statement is true. Firm concentration could affect firm conduct.
Question 10
Is the following statement true or false?
The feedback view is that industry is embedded with causal interactions between components that affect industry outcomes.
Answer
The statement is true. The feedback view is that industry is embedded with causal interactions between components that affect industry outcomes.
Problem Statements
Problem 1
You are a manager of a company that produces a particular good X. In the production of good X, your company uses a component made by the Green Pepper Company. The Chairmaker Company is a company operating in an industry outside of your company’s industry. The Herfindahl-Hirschman Index is close to zero in the Chairmaker Company’s industry. A merger with the Green Pepper Company could lead to savings of $225,000. While a merger with the Chairmaker Company is estimated to lead to an increase in revenues of $225,000.
Your company can only conduct one merger. Which merger would you advise your company to pursue and why?
Tip 1
Peer 1: Go with the Green Pepper Company because it will be cheaper to make your product.
Peer 2: Go with the Chairmaker Company because your company will get to participate in another industry.
Tip 2
Watch the video Measuring Market Concentration to find your solution.
Tip 3
Refer to the lecturette section on firm concentration.
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Problem 1 Solution
A Herfindahl-Hirschman Index value that is close to zero means that there is a lot of competition in that industry. Therefore, the Chairmaker Company is operating in a competitive industry. A merger with them will expose your company to more competition and might also mean that the revenue estimate may not always hold. It is better to vertically integrate in order to capture the cost savings which you are sure you will be able to capitalize on.
Problem 2
Suppose you have been asked to justify why your company should use its net cash reserves to invest in research and development rather than pursue a merger. What would be the main points of your case?
Tip 1
Peer 1: Research and development would lead to better insights about your product which could add value to consumers.
Peer 2: Research and development would lead to the creation of more job which would be good for society.
Tip 2
Refer to the link, Firms & Technological Change to find your solution.
Tip 3
Refer to the Lecturette section on market structures and technology.
Problem 2 Solution
Your company should invest in research and development (R&D) because competitive advantages are derived from the innovations that come out of R&D. Those competitive advantages could allow the company to achieve the same benefits as a merger, if not more, internally.
Problem 3
If the Dansby-Willig performance index is 2.5, make a case as to why you would or would not increase output?
Tip 1
Peer 1: I think you should decrease output because The Dansby-Willing performance index is positive.
Peer 2: I think you should increase output because profits can increase 2.5 times.
Tip 2:
Select the link and read the content to get a hint.
The Competitive Market or Industry Analysis: Slide 19
Tip 3:
Refer to the lecturette section on performance.
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Problem 3 Solution
When the Dansby-Willing performance index is greater than zero, welfare has not been maximized. Therefore, there could be more producer surplus to accrue.
Summary
Key learning points in this module include:
• Various factors affect the managerial decision making process, such as: output levels, price, and how much to allocate toward expenditures for research and development, advertising etc.
• Market structures are influenced by: barriers for entry, demand conditions, technology, industry concentration, and firm size.
• The four main classifications of market structures are: perfect competition, monopoly, monopolistic competition, and oligopoly.
• Two of the most commonly used industry concentration ratios include: the four-firm concentration ratio and the Herfindahl-Hirschman index (HHI).
• The four-firm concentration ratio captures the percentage of sales
accrued by the four largest firms in a particular industry.
• The industries with high higher Herfindahl-Hirschman indices have high
four-firm concentration ratio values.
• If the firm has a significant technological advantage, it will have considerable
competitive advantage in the industry.
• The Lerner index is a measure of the relative difference between price and marginal
cost, it is measure of markup.
• The process of combining productive resources is referred to as integration.
• There are three types of mergers: vertical, horizontal, and conglomerations.
• A vertical merger occurs when one firm that produces a particular final
product merges with a firm that produces an input or part for its final
product.
• A horizontal merger occurs when a firm that produces a particular final
product merges with a firm that produces a similar or related final product.
• A conglomeration occurs when a firm that produces a particular final
product merges with a firm that produces a dissimilar or unrelated final
product.
• Industry structure is shaped by technology, firm concentration, demand, or market
conditions.
• Conduct involves pricing, advertising, research and development, and investment
decisions.
• Performance is concerned with profits and social welfare.
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Review Questions
Question 1
Differentiate between perfect competition and monopolistic competitive market structure.
Answer
Perfectly competitive market structures are characterized by many sellers producing a homogenous product whereas monopolistic competitive markets have a number of sellers with some differentiation in the products they make.
Question 2
List three factors that influence market structure.
Answer
Factors that influence market structure include firm size, industry concentration, technology, demand conditions, and barriers for entry.
Question 3
Suppose an industry is composed of 10 firms. The first four firms have sales of $100,000 each, the next two firms have sales of $90,000 each, and the last four firms have sales of $120,000 each. What is the four-firm concentration ratio for this industry?
Answer
Therefore, four-firm concentration ratio is 0.452.
Question 4
If Price is twice marginal cost, what is the likely value of the Lerner Index?
Answer
So, upon rearranging the Lerner Index we can represent price as:
Therefore,
Four firm concentration ratio = 𝑆1 + 𝑆2 + 𝑆3 + 𝑆4
𝑆𝑇 =
$120 ,00+$120,000+$120 ,000+$120 ,000
$1,060,000 =
0.452
𝑃 = 2 ∗ 𝑀𝐶
𝑃 = 1
1 − 𝐿 ∗ 𝑀𝐶
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Question 5
List three types of mergers.
Answer
Vertical Integration, Horizontal Integration, and Conglomerations.
What’s Next
In Module 7 we will examine managerial decisions in three market environments: perfect competition, monopoly, and monopolistic competition. Each of these market structures provides a manager with different decision parameters toward the goal of maximizing profits.
References
Baye, M. R., & Prince, J. T. (2013). Managerial economics and business strategy (8th edition). New York, NY: McGraw-Hill Education.
2 = 1
1 − 𝐿
1 − 𝐿 ∗ 2 = 1
2 − 2𝐿 = 1 → 2 − 1 = 2𝐿 → 1 = 2𝐿 → 1
2 = 𝐿
