Slide 1Chapter OutlineIntroductionMarket StructureIndustry ConcentrationMeasuring Industry ConcentrationMeasuring Industry Concentration in ActionMeasuring Industry Concentration In ActionLimitations of Concentration MeasuresTechnology and CostsDemand and Market ConditionsDemand and Market Conditions in ActionDemand and Market Conditions In ActionPotential for EntryConductPricing BehaviorPricing Behavior in ActionPricing Behavior In ActionIntegration and Merger ActivityTypes of IntegrationResearch and DevelopmentAdvertisementDansby-Willig Performance IndexStructure-Conduct-PerformanceThe Casual ViewThe Feedback CritiqueFive Forces FrameworkLooking AheadConclusionCHAPTER 7The Nature of Industry© 2014 by McGraw-Hill Education. All Rights Reserved.Chapter Outline•Market structure–Firm size–Industry concentration–Technology–Demand and market conditions–Potential for entry•Conduct–Pricing behavior–Integration and merger activity–Research and development–Advertising •Performance –Profit –Social welfare•The structure-conduct-performance paradigm–Causal view–Feedback critique–Relation to the Five Forces FrameworkCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-2Chapter OverviewIntroduction•Chapter 6 focused on the optimal way to acquire the efficient mix of inputs, and how to solve various principal-agent problems that arise within the firm.•This chapter provides an overview of the nature of various industries.–How concentrated are sales in one industry relative to another?–How do price-cost margins vary by industry?–How do advertising and R&D expenditures vary by industry?Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-3Chapter OverviewMarket Structure•Market structure factors that impact managerial decisions:–Number of firms competing in an industry.–Relative size of firms (concentration).–Technological and cost conditions.–Demand conditions.–Ease of firm exit or entry.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-4Market StructureIndustry Concentration •Measures the size distribution of firms within an industry.–Are there many small firms?–Are there only a few large firms?Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-5Market StructureMeasuring Industry Concentration•Measures of industry concentration–Four-firm concentration ratio:–Herfindahl-Hirschman index (HHI):• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-6Market StructureMeasuring Industry Concentration in Action•Suppose an industry is composed of six firms. Four firms have sales of $10 each, and two firms haves sales of $5 each. What is the four-firm concentration ratio for this industry?•Answer:–Total industry sales are .–Sales of the four largest firms are $40.–The four-firm concentration ratio is:–The four largest firms in the industry account for 80 percent of total industry output.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-7Market StructureMeasuring Industry Concentration In ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-8Industry C4 (percentage)HHIDistilleries 70 1,519Fluid milk 46 1,075Motor vehicles 68 1,744Snack foods 53 1,984Furniture and related products 11 62Semiconductor and other electronic components 34 476Soft drinks 52 891Market StructureLimitations of Concentration Measures•Factors that impact and limit industry concentration measures include:–Global markets.–National, regional and local markets.–Industry definitions and product classes.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-9Market StructureTechnology and Costs•Industries differ in regard to the technologies used to produce goods and services.–Labor-intensive industries.–Capital-intensive industries.•Within a given industry if the available technology is: –the same, firms will likely have similar cost structures.–different, one firm will likely have a cost advantage.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-10Market StructureDemand and Market Conditions•Industries with–low demand may imply few firms.–high demand may imply many firms.•Elasticity of demand varies from industry to industry.–The Rothschild index measures the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-11Market StructureDemand and Market Conditions in Action•The industry elasticity of demand for airline travel is -3, and the elasticity of demand for an individual carrier is -4. What is the Rothschild index for this industry?•Answer:–The Rothschild index is: • Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-12Market StructureDemand and Market Conditions In ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-13Industry Own Price Elasticity of Market DemandOwn Price Elasticity of Demand for Representative FirmRothschild IndexFood -1.0 -3.8 0.26Tobacco -1.3 -1.3 1.00Textiles -1.5 -4.7 0.32Apparel -1.1 -4.1 0.27Paper -1.5 -1.7 0.88Chemicals -1.5 -1.5 1.00Petroleum -1.5 -1.7 0.88Market StructurePotential for Entry•Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market.•Several factors can create barriers to entry (or make entry difficult).–Capital requirements.–Patents.–Economies of scale.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-14Market StructureConduct•Behavior of firms:–Price markup over costs.–Integration and merger.–Advertising expenditures.–Research and development expenditures.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-15ConductPricing Behavior•Lerner index–A measure of the difference between price and marginal cost as a fraction of the product’s price.rearranging this equation yields, where is the markup factor over marginal costs.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.7-16ConductPricing Behavior in Action•A firm in the airline industry has a marginal cost of $200 and charges a price of $300. What are the Lerner index and markup factor?–The Lerner index is•The markup factor