Project 3

Learning Topic

Industry Structure What Is an Industry?

An industry can also be viewed as a collection of firms

offering goods or services that are close substitutes of each

other. For example, an industry can be defined broadly (e.g.,

the healthcare industry, the transport industry) or more

precisely (e.g., pharmaceuticals, medical diagnostics,

automobiles, electric vehicles, SUVs.). How one circumscribes

an industry depends on the kinds of analysis to be performed.

In analyzing industry structure, it is generally better to define

an industry as precisely as possible.

It is important to distinguish between the industry in which a

company competes and the market it serves. For example, a

company might compete in the aerospace industry but

choose commercial aircraft or private jets as its served

market. Or, a company may compete in the computer industry

but choose to serve the software or hardware market.

Defining the boundaries of the industry a company competes

in is critical to delineate the size of the market, the drivers of

demand, and potential competitors.

There are many industry classification systems. For example,

the publications Fortune, Forbes, and Businessweek, have

their own classification systems. The United States used to

have an official Standard Industrial Classification (SIC) system,

established in 1937 that designated industries using a four-

digit SIC Code. In 1997, the United States Census Bureau

replaced the SIC system with the North American Industry

Classification System (NAICS), which places business

establishments into specific industries. In performing an

industry analysis, it is preferable to use the NAICS since all

government statistics related to industries are now reported

using this classification system (Jain, 2002; United States

Census Bureau, 20018).

Industry Structure

Different industries show varied returns over time. Some

perform well in the short term but not so well in the long

term. For example, the infrastructure (such as utilities and

energy) and financial services industries (such as banks,

investment funds, and insurance) perform better in the middle

to long term (Fidelity, n.d.).

This difference in performance is due to a number of factors

including the kind of market the industry operates in. One

approach to determining the kind of market is to view

industry as collection of firms that directly compete with each

other and to examine their markets according to the degree

of competition between the firms. The markets could be (1)

perfect competition, where a large number of companies

compete against each other, (2) an oligopoly, where a small

number of firms compete against each other, or (3) a

monopolistic competition, where a single firm dominates the

market.

The number and size distribution of firms in an industry

defines its industry structure. “If all firms in an industry are

small in size, relative to the size of the industry, it is a

fragmented industry. If a small number of firms controls a

large share of the industry’s output or sales, it is a

consolidated industry. The type of competition in fragmented

industries is generally very different from that in consolidated

(or concentrated) industries” (Jain, 2002).

Industry structure also influences the profitability of

companies in that industry. Some industries are inherently

more attractive than others because of an underlying

structure that positively affects the performance of firms in

those industries. (Porter, 1979)

Industry concentration therefore is an important aspect of

competition. The concentration ratio (CR) of an industry is

used as an indicator of the relative size of firms in relation to

the industry as a whole. It is designed to measure industry

concentration, and by inference, the degree of market control.

This helps analysts understand the nature of the industry

operates in which the organization operates.

A commonly used concentration ratio is the four-firm

concentration ratio (CR4). It is calculated by adding the total

sales for the four largest firms in the selected industry, then

dividing that sum by the total sales of the industry, and

converting that result to a percentage.

While there is no distinct concentration ratio that separates

one market structure from another, these values can be used

as indicators of market structure, as shown in the table

below:

Four-Firm Concentration Ratio and Market Structure

CR4 Degree of concentration Market structure

0%–

40%

Low concentration Ranges from perfect

competition to oligopoly

40%–

70%

Medium concentration Oligopoly

CR4 Degree of concentration Market structure

70%–

100%

High concentration Ranges from oligopoly to

monopoly

There is of course nothing magical about using four firms to

compute the concentration ratio; one can compute a five-firm

concentration ratio (CR5), eight-firm concentration ratio

(CR8), and so on. In general, the n-firm concentration ratio is

the percentage of market output generated by the n largest

firms in the industry.

The United States Census Bureau (2013) publishes

concentration ratios for all industries every five years as the

results of its census. It can also be found using FactFinder

(Cramer, 2012). Concentration ratios provide an indication of

the market structure of an industry; they do not provide a lot

of detail about the competitiveness of the industry.

For example, an n-firm concentration ratio does not reflect

changes in the size of the largest firms. The same

concentration ratio can be achieved in a number of ways, as

the relative size of the top n companies can vary. The

oligopolistic industry is more competitive if four firms have

nearly equal sales than if sales of one firm dominates the

others (“Four-Firm Concentration Ratio, n.d.). The Herfindahl-

Hirschman index (HHI), an indicator of the degree of

competition among companies, addresses this issue.

HHI is applied in competition law and antitrust and is a

commonly accepted measure of market concentration. It is

calculated by squaring the market share of each firm

competing in a market and then summing the resulting

figures. It can range from close to zero to 10,000. Decreases

in the Herfindahl index generally indicate a loss of market

power and an increase in competition, whereas increases

imply the opposite (Kenton, 2019).

The structure of an industry affects the conduct of industry

members (sellers and buyers) which, in turn, affects industry

performance (profitability). This principle is represented in the

structure-conduct-performance (SCP) model. Structure refers

to the concentration, ownerships structure, barriers to entry,

exit, and vertical integration, etc. Conduct refers to the

companies’ approach to pricing, R&D, capacity investments,

etc. And performance refers to profits, value creation,

shareholder returns, etc. Under this model, the market

structure has a direct influence on the firm's economic

conduct, which in turn affects its market performance

(“Enduring Ideas,” 2008).

References

Cramer, S. (2012, Jul 27). Finding industry concentration

ratios using the Economic Census & American FactFinder.

[Video file]. Retrieved from https://www.youtube.com/watch?

v=k3lKD446xag

Enduring ideas: The SCP framework. (2008, July). McKinsey

Quarterly. Retrieved from

https://www.mckinsey.com/business-functions/strategy-and-

corporate-finance/our-insights/enduring-ideas-the-scp-

framework

Fidelity. Sectors & industries—Performance. Retrieved from

https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/s

tab=siperformance

Four-firm concentration ratio. (n.d.). AmosWeb Encylonomic

Webpedia. Retreated from http://www.amosweb.com/cgi-

bin/awb_nav.pl?c=dsp&k=four-

firm+concentration+ratio&s=wpd

Jain, V. K., (2002). Note on industry structure. Document

posted in University of Maryland Global Campus Course

AMBA 607 online classroom, archived at

http://info.umgc.edu/mba/public/AMBA607/IndustryStructure.htm

Kenton, W. (Ed.). (2019, February 7). Herfindahl-Hirschman

Index—HHI. Investopedia. Retrieved from

https://www.investopedia.com/terms/h/hhi.asp

United States Census Bureau. (2013, September 3).

Concentration ratios. Retrieved from

https://www.census.gov/econ/concentration.html

United States Census Bureau. (2018, December 3). North

American Industry Classification System. Retrieved March 18,

2019 from https://www.census.gov/eos/www/naics/

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