Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter 7 The Nature of Industry

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview I. Market Structure n Measures of Industry Concentration II. Conduct n Pricing Behavior n Integration and Merger Activity III. Performance n Dansby-Willig Index n Structure-Conduct-Performance Paradigm IV. Preview of Coming Attractions

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Industry Analysis Market Structure n Number of firms, size, etc. Conduct n Pricing, advertising, R&D, etc. Performance n Profitability, consumer surplus, social welfare.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 The Structure-Conduct- Performance Paradigm The Causal View Market Structure ConductPerformance The Feedback Critique n No one-way causal link. n Conduct can affect market structure. n Market performance can affect conduct as well as market structure.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Industry Concentration Four-Firm Concentration Ratio n The sum of the market shares of the top four firms in the defined industry: C 4 = w 1 + w 2 + w 3 + w 4 Herfindahl-Hirshmann Index (HHI) The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 w i 2 Limitations n Market Definition: National, regional, or local? n Global Market: Foreign producers excluded n Industry definition and product classes

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Rothschild Index A measure of the elasticity of industry demand for a product relative to that of an individual firm: R = E T / E F n E T = elasticity of demand for the total market n E F = elasticity of demand for the product of an individual firm. n R has a value between 0 (perfect competition) and 1 (monopoly). When an industry is composed of many firms, each producing similar products, the Rothschild index will be close to zero.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Own-Price Elasticities of Demand and Rothschild Indices

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Pricing Behavior The Lerner Index L = (P - MC) / P n A measure of the difference between price and marginal cost. n An index from 0 to 1. Markup Factor n Rearranging the above formula, P = (1/(1-L)) MC n 1/(1-L) is the markup factor.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Lerner Indices & Markup Factors

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Integration and Merger Activity Vertical Integration n Where various stages in the production of a single product are carried out by one firm. Horizontal Integration n The merging of the production of similar products into a single firm. Conglomerate Mergers n The integration of different product lines into a single firm.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 DOJ/FTC Merger Guidelines Based on HHI = 10,000 w i 2 Merger may be challenged if HHI exceeds 1800, or would be after merger, and Merger increases the HHI by more than 100 But... n 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...

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Performance Performance refers to the profits and social welfare that result in a given industry Social Welfare = CS + PS Dansby-Willig Performance Index n Ranks industries according to how much social welfare would improve if firms within each industry expanded output in the socially efficient manner.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Dansby-Willig Performance Index

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Preview of Coming Attractions Discussion of optimal managerial decisions under various market structures, including: n Perfect competition n Monopoly n Monopolistic competition n Oligopoly