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 Competition Monop. Comp. Monopoly Oligopoly P MC 0 + + + SR + or + or + or + or LR 0 0 + or 0 + 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)]

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

Rate of Re turn

( economic )Income = Net Value of Assets

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.

MC LI = P P =
1. 2. 3. 4.

LI is a summary measure that is zero under the competitive ideal where P = MC MC is rarely available so AVC may be substituted Measuring elasticity may also be difficult 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:

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 Firm Market Share Market Rank Share Squared Share Squared 1 10% 100 25% 2 10% 100 25% 3 10% 100 25% 4 10% 100 5% 5 10% 100 5% 6 10% 100 5% 7 10% 100 5% 8 10% 100 5% 9 10% 100 10 10% 100 CR4 40 CR8 80 HHI #s Equivalent 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) 80 100 1000 10 2000 5 B Share Market Share Squared 625 625 625 25 25 25 25 25 C Share 55% 3025 2.25% 5.0625 2.25% 5.0625 2.25% 5.0625 2.25% 5.0625 2.25% 5.0625 2.25% 5.0625 2.25% 5.0625 : : : : 61.75 72.25 3126.25 3.2

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

 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 small but statistically significant effect of concentration on performance, such as price.