EC2204- Business Economics5: Industry Structure and Competition Analysis
Learning OutcomesUpon completing this section, the student should be able to: Distinguish between the various market structures. Calculate concentration ratios. Interpret Herfindahl index values. Describe and illustrate Porters Five Forces. Distinguish between long and short-run conditions in perfect competition. Calculate equilibrium conditions and profit maximizing levels of output. Distinguish between long and short-run conditions in monopolistic competition.
Market Structures The convention is to divide industries into categories according to the degree of competition that exists between the firms within the industry. There are 4 such categories:1. At one extreme is perfect competition, where there are very many firms competing. Each firm is so small relative to the whole industry that it has no power to influence price. It is a price taker.2. At the other extreme is monopoly, where there is just one firm in the industry, and hence no competition from within the industry.3. In the middle comes monopolistic competition, where there are quite a lot of firms competing and where there is freedom for new firms to enter and exit the industry, and4. Oligopoly, where there are only a few firms and where entry of new firms is restricted.
Categories of Market StructureTo distinguish more precisely between the four categories, the following must be considered: How freely can firms enter the industry: is entry free or restricted? If it is restricted, just how great are the barriers to the entry of new firms? The nature of the product. Do all firms produce an identical product, or do firms produce their own particular brand or model or variety? The degree of control the firm has over price. Is the firm a price taker or can it choose its price, and if it can, how will changing its price affect its profits? What we are talking about here is the nature of the demand curve it faces. How elastic is it? If it puts up its price, will it lose(a) all its sales (a horizontal demand curve), or(b) a large proportion of its sales (a relatively elastic demand curve), or(c) just a small proportion of its sales (a relatively inelastic demand curve)?
How do we distinguish the market structure?•In Economics, the concentration ratio of an industry is used as an indicator of therelative size of firms in relation to the industry as a whole.•This may also assist in determining the market form of the industry.•One commonly used concentration ratio is the four-firm concentration ratio, whichconsists of the market share, as a percentage, of the four largest firms in theindustry.•In general, the N-firm concentration ratio is the percentage of market outputgenerated by the N largest firms in the industry.•The concentration ratio has a fair amount of correlation to the Herfindahl Index,another indicator of firm size.
Concentration RatiosMicroprocessor (Pentium Chips) Major US AirlinesCompany % Market Share Company % Market ShareIntel 86% Amercan 20.6%Advanced Micro Devices (AMD) 9 United 20.4Others 5 Delta 15.8 North-west 14.0 US Beer Sales Continental 10.5Anheuser-Busch (Bud) 44.9% US-Airways 9.5Miller 22.5 TWA 9.3Coors 9.9 US Gasoline MarketStrobs 8.3 Shell 8.9%Heilman 6.4 Chevron 8.3Pabst 3.3 Texaco 7.8Genessee 1.1 Exxon 7.8Others 3.7 Amoco 7.5 Mobil 7.5
Concentration RatiosCompany % Market Share Company % Market Share Read-to-Eat Cereal BP America 5.9Kellog 35% Citgo 5.4General Mills 25 Marathon 5.2Post 12 Sun 4.2Ralston 7 Phillips 3.5Quaker 6 Unocol 3.5Nabisco 4 Arco 3.1Private Label 10 Conoco 2.6Others 1 Others 19.5 Music (albums) Soft Drinks Sony 23%Coca-Cola 42% Warner 16Pepsi 31 BMG 14Dr Pepper 8 EMI 13Seven-Up 4 Universal 11Schweppes 3 Polygram 10Others 12 Others 13
Calculating Concentration Ratios You are asked to determine whether the Computer Industry computer industry or the mobile phone Firm Dell HP Toshiba Freecom PNY Sony Apple IBM industry is more competitive using a 4- Sales 337 384 696 321 769 358 521 880 firm concentration ratio. Mobile Phone Industry Firm Vodafone 02 Samsung Nokia Motorola Meteor Erikson Eircom Sales 556 899 565 782 463 477 846 911 Step 1: Order the firms in order of sales. C omputer Industr y IBM PNY Toshiba A pple HP Sony Dell Freecom 880 769 696 521 384 358 337 321 Mobile Phone Industr y Eircom 02 Erik son N ok ia Samsung Vodafone Meteor Motorola 911 899 846 782 565 556 477 463 Step 2: calculate the total sales for both industries Computer Industry IBM PNY Toshiba Apple HP Sony Dell Freecom 880 769 696 521 384 358 337 321 4,266 Mobile Phone IndustryEircom 02 Erikson Nokia Samsung Vodafone Meteor Motorola 911 899 846 782 565 556 477 463 5,499
Calculating Concentration Ratios You are asked to determine whether the computer industry or the mobile phone industry is more competitive using a 4-firm concentration ratio. Step 3: calculate the total sales for the top 4 firms in each industry. IBM PNY Toshiba Apple Computer 880 769 696 521 2,866 Eircom 02 Erikson Nokia Mobile Phone 911 899 846 782 3,438 Step 4: calculate 4-firm concentration ratio for both firms Computer 2,866/4,266 = 67.2% (4-firm c- ratio) Mobile Phone 3,438/5,499 = 62.5% (4-firm c- ratio)InterpretationThe computer industry (67%) is more concentrated than the mobile phone industry (63%). As thereis an inverse relationship between concentration and competition, the mobile phone industry is morecompetitive in this case. However, you should interpret the results with caution and your evidenceshould be supported by case studies and further research.
Herfindahl Index It is a measure of the size of firms in relationship to the industry and an indicator of the amount of competition among them. Named after economists Orris C. Herfindahl and Albert O. Hirschman, it is an economic concept but widely applied in competition law and antitrust. It is defined as the sum of the squares of the market shares of each individual firm: ie the average market share, weighted by market share. As such, it can range from 0 to 10,000 moving from a very large amount of very small firms to a single monopolistic producer. Decreases in the Herfindahl index generally indicate a loss of market power and an increase in competition, whereas increases imply the opposite. where si is the market share of firm i in the market, and n is the number of firms. Thus, in a marketwith two firms that each have 50 percent market share, the Herfindahl index equals 0.502 + 0.502 =
Herfindahl Index A small index indicates a competitive industry with no dominant players. I f all firms have an equal share the reciprocal of the index shows the number of firms in the industry. When firms have unequal shares, the reciprocal of the index indicates the "equivalent" number of firms in the industry. H index below 0.1 (or 1,000) indicates an un-concentrated index. H index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate concentration. H index above 0.18 (above 1,800) indicates high concentration.
Market Structures Monopolistic Competition Oligopoly Duopoly Many buyers/sellers A few firms Pepsi/Coca-Cola Differentiated product Air travel, Lager Industry Free entry and exit Interdependence between firms Barriers to Entry MonopolyPerfect Competition Firm = IndustryMarket stalls Intel, ESBMany firms Downward sloping demand curveHomogeneous Product Barriers to EntryPrice taker Supernormal profits earned in long-runPerfectly Elastic CurveFree entry and exit
Porter’s Five Forces If the goal in business is to maximise shareholder wealth, the managers will seek a pricing and output strategy that maximises the present value of the future profits of the firm. The determination of wealth-maximising strategy depends on the production capacity, cost levels, demand characteristics, and the potential for immediate and longer term competition. Michael Porter of Harvard Business School in 1979 developed a conceptual framework for identifying the threats from competition in a relevant market. Incumbent firms attempt to secure competitive advantage through their choice of management strategy. Porter’s Five Force framework conceptualises the forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one where the combination of forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition".
Porter’s Five Forces The threat of substitute products: The existence of close substitute products increases theThe threat of the entry of new competitors: Profitable markets that yield high returns will draw propensity of customers to switch to alternatives in response to price increases (highfirms. The results is many new entrants, which will effectively decrease profitability. Unless the entryThe elasticity of demand). Threat of substitutes/ most industries, this is the major determinant of the intensity of competitive complements For rivalry:of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level •buyer propensity to substitutecompetitiveness of the industry. Sometimes rivals compete aggressively new entrants Threat of and sometimes rivals(perfect competition). •relative price performance of substitutes Barriers to entrycompete in non-price dimensions such as innovation, marketing, etc.•existence of barriers to entry (patents, rights, etc.) •buyer switching costs•number of competitors•economies of product differencesThe bargaining power of suppliers: Suppliers of raw materials, components, and services (such as •perceived growth•rate of industry level of product differentiation•brand equitythe firm can be a source of power over the firm. Suppliers may refuse to work with theexpertise) to•intermittent industry overcapacity•switching costs or excessively high prices for unique resources.firm, or e.g. charge sunk costs•exit barriers Level of competition•capital requirements industrysupplier switching costs relative to firm switching costs in•diversity of competitorsrivalry Sustain•access to distribution of customers: The ability of customers to put the firm under pressure and degree of differentiation of inputs Intensity ofThe bargaining power and asymmetry Industry•informational complexity Profitability•absolute costthe customers sensitivity to price changes. presence of substitute inputs advantagesitfixed cost allocation per value added• also affects•learning curve advantages firm concentration ratio•supplieradvertising expense concentration ratio concentration to•buyerof level concentration to firm by suppliers relative to threat of backward integration by firms•expected forward integration in industries with high fixed costs•threat of retaliation by incumbents•bargaining leverage, particularly•Economies of relative to selling price of the product cost of inputs scale government policies•buyer volume•Sustainable competitive advantage through improvisation•buyer switching costs relative to firm switching costs Bargaining power of buyers•buyer information availability Buyer concentration•ability to backward integrate Bargaining power of suppliers Number of Suppliers•availability of existing substitute products•buyer price sensitivity•differential advantage (uniqueness) of industry products
Perfect Competition The main characteristics of Perfect Competition are: 1. There are a very large number of sellers competing with each other. Each seller contributes only a very small fraction of total supply. Therefore an individual seller cannot significantly affect market price by altering his output. 2. There are a very large number of buyers. The number of buyers is so large that no individual buyer can significantly influence the market price by altering his volume of purchases. 3. The product is homogeneous i.e. there is no difference between the product of one firm in the industry and the product of any other firm in that industry. Therefore to consumers, the products of the different producers are identical. 4. There is freedom of entry to, and exit from the industry i.e. there are no restrictions preventing firms moving easily into, or out of a particular industry.
Perfect Competition The main characteristics of Perfect Competition are:5. Perfect Knowledge - producers and sellers are fully aware of the rate of profit being made by the other producers in the industry. All the buyers are assumed to have widespread knowledge of the price being asked for the product in every section of the market.6. Each producer has a perfectly elastic supply of the factors of production i.e. the producer can employ more factors to increase his output without forcing up the level of factor payments (rents, wages, interest) which currently prevail throughout the industry. This is a reasonable assumption (following assumption 1) because each producer or seller forms a very small element of total output or supply.7. Each firm aims to maximise its profits. Profit maximization implies that each firm produces an output where Price = Marginal Cost (P = MC). To produce more than this quantity implies that P < MC, which is not the most profitable decision. To produce less than where P = MC, implies that P > MC, and the firm could increase profits by expanding output. In the short-run, a competitive firm may earn economic profits. In the long-run, entry pushes price down to the minimum point of the average cost curve, so that economic profits are zero.8. Competitive firms cannot charge more than the market price of others, since their product is identical to all others. Hence, competitive firms are price takers.
Perfect Competition (industry versus firm) Firm Industry MC S P = D = MR = AR P P D MR = MC D Q Q q (firm) Q (industry)
Perfect Competition (Short-Run) Firm ATC > AR, MR MC ATCCosts AVC P D P = D = MR = AR Shut down Rule MR = MC If P < AVC the firm shuts down Q q (firm)
Perfect Competition (Short-Run) Firm ATC < P, AR, MR MC Firm making super-normal profits (Shaded grey area) ATC P DCosts P = D = MR = AR MR = MC Q q (firm)
Perfect Competition (Long-Run)The existence of supernormal profits (shaded grey area in previous slide) is a short-runcondition. Because of the assumption of perfect information potential entrants to the marketare attracted by the super-normal profits as there are no barriers to entry. The industrysupply curve expands to S1 and the market price falls to P1. When the market price falls, thehorizontal demand curve facing each existing firm, as well as each new entrant, also falls.Each firm adjusts its output to it new profit maximising position where MR = MC. So in thelong-run MR = MC = AR = ATC in perfect competition. Firm Industry S MC S1 MR = MC = AR = ATC ATC P D P P1 MR = MC D Q Q q1 (firm) Q (industry)
Supply in Perfect Competition Short-Run Long-Run The Supply Curve is that portion of MC Curve The Supply Curve is that portion of MC Curve above the AVC above the ATC MC MC ATC ATC AVC AVCP D D MR = MC D Q Q q (firm) q (firm)
Monopolistic CompetitionThe main characteristics are:• many buyers and sellers.• differentiated product.• free entry and exit.• no collusion among the firms.• Each firm will view its demand curve as declining in its own price.• A monopolistically competitive firm will have to have a pricing strategy, unlike a purely competitive firm.• Differentiation occurs when consumers perceive that a product differs from its competition on any physical or non-physical characteristic, including price. Examples: restaurants, dealer-owned gas stations, Video rental stores, book & convenience stores, etc.
Monopolistic Competition (short-run)In the Short-Run firms produce where MR = MC, price (P) on the demand curve, P > MC,economic profits exist (shaded) as P > AC, there exists incentives for entry into thisindustry. Entry in this industry steals customers, demand shifts inwards. Super-normal profits earned in short-run Price MR = MC (Shaded) (monopolistic competition) But AR > AC MC AC P Average Costs (AC) not minimised MR = MC D = AR q MR
Monopolistic Competition (long-run)The profit maximising level of output is where MR = MC, like monopoly. P= AC,like perfect competition. Super-normal profits are zero as in perfect competition.However, at the profit maximising level of output average costs are not minimised,output is not at the least cost point on the average cost curve as in perfectcompetition. Price MR = MC (monopolistic AR = AC competition) P = AC MC AC P No super-normal profits earned in long-run, because of the assumption of no barriers to Average Costs (AC) entry not minimised MR = MC D = AR q MR
Sample QuestionsQ1: For the industry: QS = 3000 + 200P and QD = 13500 - 500P. For the perfectly competitive firm: FC = 50, MC = 15 - 4Q + 3Q2/10 and AVC = 15 - 2Q + Q2/10. Calculate (a) The optimal outputfor this firm? (b) The total revenue of the firm at the profit maximising level of output. (c) The totalcosts of the firm. (d) The profit of the firm,Solution: Find equilibrium price. Set QS = QD 3000 + 200P = 13500 - 500P. 10500 / 700 = P so P = 15.At this price, the firm produces where P = MC, (perfect competition) so 15 = 15 - 4Q + 3Q2/10 4Q = 0.3Q2 so 4 = 0.3Q (a) so Q = 4/0.3 = 13.33 (Optimal output) Profit = TR - TC at this output. Profit = TR[P*Q] - [FC + VC] (b) TR = 15*13.33 = 199.95 TC = 50 + VC AVC = 15 - 2Q + Q2/10 VC = AVC*Q = 15 - 2Q + Q2/10 * Q = 15Q – 2Q2 + Q3/10 VC = 15(13.33) – 2(13.33)2 + (13.33)3/10 = 81.43 (c) TC = 50 + 81.43 = 131.43 (i.e. FC + VC) (d) Profit = [TR – TC] = [199.95 – 131.43] = 68.52
Sample QuestionsQ2: Determine the optimal output, Q, for the following firm where TR = 14Q, and TC =48+Q+0.5Q2. Does the data show whether the firm is perfectly competitive, monopolisticallycompetitive, oligopoly or monopoly? Solution: TR = 14Q, TC = 48+Q+0.5Q2. π = TR -TC π = 14Q – [48+Q+0.5Q2] π = -48 + 13Q -0.5Q2 ∆π = 13 − Q = 0 ∆Q ∆π =0 ∆Qso Q = 13 (optimal level of output where where π is maximised)The firm is perfectly competitive because Price is a constant €14 As TR = P * Q, TR =14Q
MCQ Questions3.`Which is NOT a characteristic of an industry that displays perfect competition?a. free entryb. heterogeneous productc. many sellersd. free exit.4. For a competitive firm, if MC is below price:a. raise output to raise profit,b. reduce output to raise profit,c. raise price to raise profit,d. reduce price to raise profit.5. In a competitive industry, if costs of production rise, we anticipate that:a. price will rise and quantity will stay about the same,b. price will rise and quantity will rise.c. price will rise and quantity will fall,d. price will decline to make up for the fact that costs
Recall Our Learning OutcomesYou should now be able to: Distinguish between the various market structures. Calculate concentration ratios. Interpret Herfindahl index values. Describe and illustrate Porters Five Forces. Distinguish between long and short-run conditions in perfect competition. Calculate equilibrium conditions and profit maximizing levels of output. Distinguish between long and short-run conditions in monopolistic competition.