EC 500 Chapter 7 The Nature of Industry
Headline <ul><li>Microsoft Puts Halt to Intuit Merger </li></ul><ul><li>A few years ago, the U.S. Justice Department filed...
Overview <ul><li>I. Market Structure </li></ul><ul><ul><li>Measures of Industry Concentration </li></ul></ul><ul><li>II. C...
Industry Analysis <ul><li>Market Structure </li></ul><ul><ul><li>Number of firms. </li></ul></ul><ul><ul><li>Industry conc...
Approaches to Studying Industry  <ul><li>The  Feedback Critique </li></ul><ul><ul><li>No one-way causal link. </li></ul></...
Relating the Five Forces to the SCP Paradigm and the Feedback Critique <ul><li>Power of </li></ul><ul><li>Input Suppliers ...
Industry Concentration <ul><li>Four-Firm Concentration Ratio </li></ul><ul><ul><li>The sum of the market shares of the top...
Example <ul><li>There are five banks competing in a local market. Each of the five banks have a 20 percent market share. <...
<ul><li>Merger Guideline by DoJ. </li></ul><ul><ul><li>Highly concentrated if HHI > 1800 </li></ul></ul><ul><ul><li>Will b...
Limitation of Concentration Measures <ul><li>Market Definition: National, regional, or local? </li></ul><ul><li>Global Mar...
Measuring Demand and Market Conditions <ul><li>The Rothschild Index ( R ) measures the elasticity of industry demand for a...
<ul><li>If  E F  >>  E T , R is close to zero. </li></ul><ul><ul><li>When an industry is composed of many firms, each prod...
Own-Price Elasticities of Demand and Rothschild Indices
Market Entry and Exit Conditions <ul><li>Barriers to entry </li></ul><ul><ul><li>Capital requirements. </li></ul></ul><ul>...
Conduct: Pricing Behavior <ul><li>The Lerner Index </li></ul><ul><li>L = (P - MC) / P </li></ul><ul><ul><li>A measure of t...
Markup Factor <ul><li>From the Lerner Index, the firm can determine the factor by which it should over MC. Rearranging the...
Lerner Indices & Markup Factors
Integration and Merger Activity <ul><li>Vertical Integration </li></ul><ul><ul><li>Where various stages in the production ...
DOJ/FTC Horizontal Merger Guidelines <ul><li>Based on HHI = 10,000     w i 2 , where  </li></ul><ul><li>w i  = S i  /S T ...
Performance <ul><li>Performance refers to the profits and social welfare that result in a given industry. </li></ul><ul><l...
Dansby-Willig  Performance Index
Preview of Coming Attractions <ul><li>Discussion of optimal managerial decisions under various market structures, includin...
Answering the Headline   <ul><li>Given that Microsoft was unwilling to fight the battle in court, the safe strategy would ...
<ul><li>As we learned in this chapter, the Justice Department generally challenges mergers when the relevant Herfindahl-Hi...
Conclusion <ul><li>Modern approach to studying industries involves examining the interrelationship between structure, cond...
Homework <ul><li>Q.2, Q. 4 </li></ul><ul><li>Q.16 </li></ul>
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PPT note 7

  1. 1. EC 500 Chapter 7 The Nature of Industry
  2. 2. Headline <ul><li>Microsoft Puts Halt to Intuit Merger </li></ul><ul><li>A few years ago, the U.S. Justice Department filed suit to block software giant Microsoft’s planned acquisition of financial software maker Intuit. Estimated reports placed Microsoft’s share of the personal finance software market at about 20 percent, compared with Intuit’s 70 percent share. After spending over $4 million on merger plans, Microsoft announced one month later that it had decided to call off the deal. In addition to the lost $4 million, Microsoft paid Intuit over $40 million for backing out of the deal. </li></ul><ul><li>Do you think Microsoft should have spent $4 million on merger plans in the first place? Explain. </li></ul>
  3. 3. Overview <ul><li>I. Market Structure </li></ul><ul><ul><li>Measures of Industry Concentration </li></ul></ul><ul><li>II. Conduct </li></ul><ul><ul><li>Pricing Behavior </li></ul></ul><ul><ul><li>Integration and Merger Activity </li></ul></ul><ul><li>III. Performance </li></ul><ul><ul><li>Dansby-Willig Index </li></ul></ul><ul><ul><li>Structure-Conduct-Performance Paradigm </li></ul></ul><ul><li>IV. Preview of Coming Attractions </li></ul>
  4. 4. Industry Analysis <ul><li>Market Structure </li></ul><ul><ul><li>Number of firms. </li></ul></ul><ul><ul><li>Industry concentration. </li></ul></ul><ul><ul><li>Technological and cost conditions. </li></ul></ul><ul><ul><li>Demand conditions. </li></ul></ul><ul><ul><li>Ease of entry and exit. </li></ul></ul><ul><li>Conduct </li></ul><ul><ul><li>Pricing. </li></ul></ul><ul><ul><li>Advertising. </li></ul></ul><ul><ul><li>R&D. </li></ul></ul><ul><ul><li>Merger activity. </li></ul></ul><ul><li>Performance </li></ul><ul><ul><li>Profitability. </li></ul></ul><ul><ul><li>Social welfare. </li></ul></ul>
  5. 5. Approaches to Studying Industry <ul><li>The Feedback Critique </li></ul><ul><ul><li>No one-way causal link. </li></ul></ul><ul><ul><li>Conduct can affect market structure. </li></ul></ul><ul><ul><li>Market performance can affect conduct as well as market structure. </li></ul></ul><ul><li>The Structure-Conduct-Performance (SCP) Paradigm: Causal View </li></ul>Market Structure Conduct Performance
  6. 6. Relating the Five Forces to the SCP Paradigm and the Feedback Critique <ul><li>Power of </li></ul><ul><li>Input Suppliers </li></ul><ul><li>Supplier Concentration </li></ul><ul><li>Price/Productivity of Alternative Inputs </li></ul><ul><li>Relationship-Specific Investments </li></ul><ul><li>Supplier Switching Costs </li></ul><ul><li>Government Restraints </li></ul><ul><li>Power of </li></ul><ul><li>Buyers </li></ul><ul><li>Buyer Concentration </li></ul><ul><li>Price/Value of Substitute Products or Services </li></ul><ul><li>Relationship-Specific Investments </li></ul><ul><li>Customer Switching Costs </li></ul><ul><li>Government Restraints </li></ul>Entry <ul><li>Entry Costs </li></ul><ul><li>Speed of Adjustment </li></ul><ul><li>Sunk Costs </li></ul><ul><li>Economies of Scale </li></ul><ul><li>Network Effects </li></ul><ul><li>Reputation </li></ul><ul><li>Switching Costs </li></ul><ul><li>Government Restraints </li></ul>Substitutes & Complements <ul><li>Price/Value of Surrogate Products or Services </li></ul><ul><li>Price/Value of Complementary Products or Services </li></ul><ul><li>Network Effects </li></ul><ul><li>Government Restraints </li></ul>Industry Rivalry <ul><li>Switching Costs </li></ul><ul><li>Timing of Decisions </li></ul><ul><li>Information </li></ul><ul><li>Government Restraints </li></ul><ul><li>Concentration </li></ul><ul><li>Price, Quantity, Quality, </li></ul><ul><li>or Service Competition </li></ul><ul><li>Degree of Differentiation </li></ul>Level, Growth, and Sustainability Of Industry Profits
  7. 7. Industry Concentration <ul><li>Four-Firm Concentration Ratio </li></ul><ul><ul><li>The sum of the market shares of the top four firms in the defined industry. Letting S i denote sales for firm i and S T denote total industry sales </li></ul></ul><ul><li>Herfindahl-Hirschman Index (HHI) </li></ul><ul><ul><li>The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000   w i 2 , where w i = S i /S T . </li></ul></ul>
  8. 8. Example <ul><li>There are five banks competing in a local market. Each of the five banks have a 20 percent market share. </li></ul><ul><li>What is the four-firm concentration ratio? </li></ul><ul><li>What is the HHI? </li></ul>
  9. 9. <ul><li>Merger Guideline by DoJ. </li></ul><ul><ul><li>Highly concentrated if HHI > 1800 </li></ul></ul><ul><ul><li>Will block merger if it will increase more than 100. </li></ul></ul><ul><ul><li>Except when there is evidence of significant foreign competition, emerging new technology, increased efficiency, or having financial problems </li></ul></ul>
  10. 10. Limitation of Concentration Measures <ul><li>Market Definition: National, regional, or local? </li></ul><ul><li>Global Market: Foreign producers excluded. </li></ul><ul><li>Industry definition and product classes. </li></ul><ul><ul><li>NAICS (North American Industry Classification System) </li></ul></ul><ul><ul><ul><li>51 </li></ul></ul></ul><ul><ul><ul><li>513 </li></ul></ul></ul><ul><ul><ul><li>5133 </li></ul></ul></ul><ul><ul><ul><li>51332 </li></ul></ul></ul><ul><ul><ul><li>513321 </li></ul></ul></ul>
  11. 11. Measuring Demand and Market Conditions <ul><li>The Rothschild Index ( R ) measures the elasticity of industry demand for a product relative to that of an individual firm: </li></ul><ul><li>R = E T / E F . </li></ul><ul><ul><li>E T = elasticity of demand for the total market. </li></ul></ul><ul><ul><li>E F = elasticity of demand for the product of an individual firm. </li></ul></ul><ul><ul><li>The Rothschild Index is a value between 0 (perfect competition) and 1 (monopoly). </li></ul></ul>
  12. 12. <ul><li>If E F >> E T , R is close to zero. </li></ul><ul><ul><li>When an industry is composed of many firms, each producing similar products, R is close to zero. </li></ul></ul><ul><ul><li>This occurs with perfect competition. </li></ul></ul><ul><li>If E F = E T , R = 1. </li></ul><ul><ul><li>This occurs for monopoly firms. (tobacco, chemicals) </li></ul></ul><ul><li>If E F > E T , 0 < R < 1 </li></ul><ul><ul><li>The decrease in firm’s demand out of a price increase will be bigger than that of all other firms’ price increase. </li></ul></ul>
  13. 13. Own-Price Elasticities of Demand and Rothschild Indices
  14. 14. Market Entry and Exit Conditions <ul><li>Barriers to entry </li></ul><ul><ul><li>Capital requirements. </li></ul></ul><ul><ul><li>Patents and copyrights. </li></ul></ul><ul><ul><li>Economies of scale. </li></ul></ul><ul><ul><ul><li>Shape of Average Cost </li></ul></ul></ul><ul><ul><li>Economies of scope. </li></ul></ul><ul><li>Natural monopoly arguments </li></ul><ul><ul><li>AT&T in 1970s </li></ul></ul>
  15. 15. Conduct: Pricing Behavior <ul><li>The Lerner Index </li></ul><ul><li>L = (P - MC) / P </li></ul><ul><ul><li>A measure of the difference between price and marginal cost as a fraction of the product’s price. </li></ul></ul><ul><ul><li>The index ranges from 0 to 1. </li></ul></ul><ul><ul><ul><li>When P = MC, the Lerner Index is zero; the firm has no market power. </li></ul></ul></ul><ul><ul><ul><li>A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power. </li></ul></ul></ul>
  16. 16. Markup Factor <ul><li>From the Lerner Index, the firm can determine the factor by which it should over MC. Rearranging the Lerner Index </li></ul><ul><li>The markup factor is 1/(1-L). </li></ul><ul><ul><li>When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC. </li></ul></ul><ul><ul><li>Low Lerner Index -> Low markup factor </li></ul></ul><ul><ul><li>When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost. </li></ul></ul>
  17. 17. Lerner Indices & Markup Factors
  18. 18. Integration and Merger Activity <ul><li>Vertical Integration </li></ul><ul><ul><li>Where various stages in the production of a single product are carried out by one firm. </li></ul></ul><ul><li>Horizontal Integration </li></ul><ul><ul><li>The merging of the production of similar products into a single firm. </li></ul></ul><ul><li>Conglomerate Mergers </li></ul><ul><ul><li>The integration of different product lines into a single firm. </li></ul></ul>
  19. 19. DOJ/FTC Horizontal Merger Guidelines <ul><li>Based on HHI = 10,000  w i 2 , where </li></ul><ul><li>w i = S i /S T . </li></ul><ul><li>Merger may be challenged if </li></ul><ul><ul><ul><li>HHI exceeds 1800, or would be after merger, and </li></ul></ul></ul><ul><ul><ul><li>Merger increases the HHI by more than 100. </li></ul></ul></ul><ul><li>But... </li></ul><ul><ul><li>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...” </li></ul></ul>
  20. 20. Performance <ul><li>Performance refers to the profits and social welfare that result in a given industry. </li></ul><ul><li>Social Welfare = CS + PS </li></ul><ul><ul><li>Dansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner. </li></ul></ul>
  21. 21. Dansby-Willig Performance Index
  22. 22. Preview of Coming Attractions <ul><li>Discussion of optimal managerial decisions under various market structures, including: </li></ul><ul><ul><li>Perfect competition </li></ul></ul><ul><ul><li>Monopoly </li></ul></ul><ul><ul><li>Monopolistic competition </li></ul></ul><ul><ul><li>Oligopoly </li></ul></ul>
  23. 23. Answering the Headline <ul><li>Given that Microsoft was unwilling to fight the battle in court, the safe strategy would have been not to spend $4 million on the merger plans in the first place. Since Microsoft’s share of the financial software market was 20 percent and Intuit’s was 70 percent, Microsoft should have realized that the only way the merger would be allowed is if it received special consideration from the Justice Department because of an emerging new technology or increased efficiency as a result of the merger. </li></ul>
  24. 24. <ul><li>As we learned in this chapter, the Justice Department generally challenges mergers when the relevant Herfindahl-Hirschman index is greater than 1,800 and the resulting increase in the index as a result of the merger is more than 100. Based on the reported market shares of Microsoft and Intuit, the Herfindahl-Hirschman index for the personal finance software market was at least 5.300 before the proposed merger and would have increased to at least 8,100 after the merger. Thus, it seems that Microsoft should have realized that the Justice Department would attempt to block the merger. Spending $4 million attempting to justify the merger on technological or efficiency grounds was a gamble that did not pay off for Microsoft. </li></ul>
  25. 25. Conclusion <ul><li>Modern approach to studying industries involves examining the interrelationship between structure, conduct, and performance. </li></ul><ul><li>Industries dramatically vary with respect to concentration levels. </li></ul><ul><ul><li>The four-firm concentration ratio and Herfindahl-Hirschman index measure industry concentration. </li></ul></ul><ul><li>The Lerner index measures the degree to which firms can markup price above marginal cost; it is a measure of a firm’s market power. </li></ul><ul><li>Industry performance is measured by industry profitability and social welfare. </li></ul>
  26. 26. Homework <ul><li>Q.2, Q. 4 </li></ul><ul><li>Q.16 </li></ul>
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