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CHAPTER 8: Industry Structure & Performance

1. This chapter considers the not-so-easy transition from theory to empirical verification.

2. Two difficulties with this are:

(i) Old time S-C-P was weak on theory

(ii) Modern IO strong on theory difficult to verify

3. Economists seek answers to two questions.

(i) How much market power to particular firms or industries exercise?

(ii) What are the major factors that determine market power? (Through structure or

efficiency/innovation)

Empirical History

Industry narrative case studies

Traditional S-C-P that aggregate data across industries

Modern new empirical IO focusing again on specific industries

Modified Table 8.1: Predictions based on Market Structure

P MC SR LRCompetition 0 + or - 0

Monop. Comp. + + or - 0

Monopoly + + or - + or 0

Oligopoly + + or - + or 0

Predictions based on Creating Value from Competitive Advantage

Differentiation + + or - + or 0

Cost Leadership + or 0 + or - + or 0

1. The SCP approach is based on the generalization that price-cost margins and profits vary with the

number of rivals and the size of entry barriers.

2. Long-run positive profit under differentiation or cost leadership is sustainable only if there is

continuous improvement through innovation.

In order to investigate the relationship between structure and performance, measures or metrics of

structure and performance are required.

Measures of performance most often consider measures of market power examining price, cost, and

profit and may include:

Rate of return

Price-cost margin

Tobins q [(market value of firm)/(replacement cost of assets)]

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I. Rate-of-Return

Long-run (economic) profits will be positive under the bad structures of monopoly and oligopoly.

Profits will also be positive for firms achieving a competitive advantage.

Need to adjust accounting profit and then compare to some benchmark to determine level of profit.

Profit = Revenue labor cost material cost capital cost

1. The difficulty in this performance measure is in the capital cost.

2. Capital cost is the rental rate of capital (earned rate of return + depreciation) times the value of

assets.

3. Solving the equation above for earned rate of return so that profit equals zero yields

( )Re

Net economic Income

Value of Assets Rate of turn =

An abnormally high rate of return would signal market power. There are two issues:

1. Is the rate of return measured correctly?

Must adjust accounting measures

Depreciation

Value of assets may have capitalized monopoly profits

Risk, tax, and debt considerations

2. Is the source of the market power bad structure and conduct or good conduct (through

innovation)?

How would you evaluate a high rate of return for Microsoft?

II. Price-Cost Margins

The typical performance measure used here is the Lerner Index.

1 P MC

PLI

= =

1. LI is a summary measure that is zero under the competitive ideal where P = MC

2. MC is rarely available so AVC may be substituted

3. Measuring elasticity may also be difficult

4. Interpretation may also be ambiguous

High FC Low MC firms may have high LI but low rates of return

Inefficient incumbent firms with market power engaging in limit pricing or predatory pricing

will have low LI.

MEASURES OF MARKET STRUCTURE

In most SCP studies, industry concentration is the structural variable most used. In addition,

concentration measures are used by the FTC for merger guidelines.

Note:

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1. The Cournot model predicts that higher concentration would lead to higher prices.

2. However, market power that comes with high concentration may not be exercised due to:

Contestability

Limit pricing

Creating network externalities

3. Efficient performance may lead to higher concentrations.

Competitive advantage through market innovation leads to market power

Economies of scale will affect structure

4. Nonetheless, power can be corrupting

5. Concentration is not sufficient for poor market performance.

Concentration in Individual Markets

Consider three industries below.

A B C

Firm Market Share Market Share Market Share

Rank Share Squared Share Squared Share Squared

1 10% 100 25% 625 55% 3025

2 10% 100 25% 625 2.25% 5.0625

3 10% 100 25% 625 2.25% 5.0625

4 10% 100 5% 25 2.25% 5.0625

5 10% 100 5% 25 2.25% 5.0625

6 10% 100 5% 25 2.25% 5.0625

7 10% 100 5% 25 2.25% 5.0625

8 10% 100 5% 25 2.25% 5.0625

9 10% 100 : :

10 10% 100 : :

CR4 40 80 61.75

CR8 80 100 72.25

HHI 1000 2000 3126.25

#s Equivalent 10 5 3.2

Rankings of Market Power:

CR1 : C, B, A

CR4 : B, C, A

CR8 : B, A, C

HHI : C, B, A

Herfindahl-Hirschmann Index (HHI) takes into account the distribution of market shares. [ranges from

0 to 10,000]

Numbers Equivalent (N) = (HHImonopoly) / (HHIindustry)

= 10,000 / (HHIindustry)

Structure Measurement Problems:

1. CR and HHI measures may yield contradictory messages, though CR4 and HHI are highly

correlated.

2. Definition of relevant market is a fundamental problem

Product type dimension

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Geographic area dimension

Close substitutes are important, but not always obvious

If market definition is too narrow market power definition will be biased up

If market definition is too broad market power definition will be biased down

3. Structure affects Profits AND Profits affect Structure

Consider market definitions for the following:

1. Cellophane (U.S. v. du Pont, 1956)

2. Computers (mainframes and PCs)

3. Automobiles (cars, trucks, SUVs, vans)

4. Beverages (soda, sports drinks, milk)

5. Buses, train, airplane, auto

6. Flooring (wood, ceramic, linoleum under different NAICS codes)

7. Glass containers, metal cans (different codes)

Problems and Issues in Market Definition and NAICS codes:

1. Data collected by surveys of companies. Classified by similarity of production processes.

Classifications emphasize producer substitutability more than consumer substitutability.

2. Imports are often ignored in NAICS codes and concentration measures.

3. Data are national when relevant market is local.

4. Vertical relationships (e.g., franchising) may mask market power at distributing or retailing stage

(e.g., bottled and canned soft drink industry)

DETERMINANTS OF MARKET STRUCTURE

How does an industry become concentrated? Should the public be concerned? Do the answers depend

on how the industry became concentrated?

1. Economies of scale and scope - first of 20th century was more concentrated than last 2 decades.

Efficiency increases concentration.2. Market size big markets have more room for more firms

3. Bad conduct predatory practices or barriers to entry

4. Government policy regulatory agencies often closed off entry (e.g., now defunct Civil

Aeronautics Board)

5. Mergers

Empirical Evidence:

Studies of individual industries have found a smallbut statistically significant effect of concentration on

performance, such as price.