Market Structure and Barriers to Entry
Lecture 6

 

Measuring Market Concentration

1. Economists use two methods to determine how concentrated a market is

  1. Concentration Ratio (CR) - calculate the percentage concentration of the largest firms in the market

    • CR4 - the total percentage of the four largest firms in the market

    • CR8 - the total percentage of the 8 largest firms in the market

    • Uses sales data

    • If concentration ratio is 0%, no firm has a market share; purely competitive

    • If concentration ratio is 100%, the four largest firms completely dominated the market

    • Problem - if the concentration ratio is 100%, is this a monopoly or four firms with a market share of 25%

  2. Herfindahl Index - for each firm, take the percent market share and square, add all firms together

    • Benefit - includes all firms in the market and can tell if market had a monopoly

      • Monopoly - market share is 100%

        • Herfindahl Index = 1002 = 10,000

      • Pure competitive market - market share is 0%

        • Herfindahl Index = 02 = 0

Market Concentration Ratio
(CR4)
Herfindahl Index
Beer 91 NA
Breakfast Cereals 78 2,521
Cement 11 63
Cigarettes 95 NA
Computers 85 2,662
Motor Vehicles 81 2,321
Women's dresses 13 84

Source: McDonnell and Brue (2008), p.452

2. Problems in defining the market:

  1. Localized markets - a market covers a small area and isolated from other markets

    • The concentration ratio or Herfindahl index is calculated for whole market

    • A firm can dominate a local market

    • Example - cement production seems to be in a competitive market

    • Cement is bulky and has high transportation costs, thus, these firms may be monopolies at the local level

  2. Interindustry competition - a product in the market may compete with products from other markets

    • Example: Breakfast cereals seems to be a concentrated industry

    • If these companies raise the price too much, consumers may switch to other breakfast foods

  3. International competition - a concentrated industry may be competing with other large companies from other countries

    • Example: Motor vehicles is a concentrated industry; they compete with car manufacturers from Japan, South Korea, and Germany

3. Example: Please calculated the Concentration Ratio and Herfindahl Index

Company Brands Market Share
Philip Morris (Altria) Marlboro, Basic, Virginia Slims, Benson & Hedges (in U.S.), Merit, Parliament, Alpine, Cambridge, Bristol, Bucks, Commander, English Ovals, Saratoga, Superslims 49.40%
R. J. Reynolds Camel, Doral, Winston, Salem, Vantage, More, Now, Century, Ritz, Monarch, Magna, Sterling 22.90%
BAT/Brown & Williamson GPC, Kool, Viceroy, Raleigh, Barclay, Belair, Capri, Richland, Pall Mall, Lucky Strike 10.0%
Lorrillard (Loews) Newport, Kent, True, Old Gold, Max, Style, Satin, Triumph, Montclair, Malibu, Riviera, Crowns, Special 10's, Bull Durham 8.20%
Liggett & Myers L & M, Lark, Chesterfield, Eve, Pyramid 2.3%
Other Peter Stuyvesant, Rothman's, Dunhill, Best Value, USA Gold, CT, Durant, Palace, Magic, First Class, Cabin, etc. 7.2%

Source: IRI Capstone 2002.

(a) Concentration Ratio (CR4) = 49.40 + 22.90 + 10.00 + 8.20 = 90.5

(b) Herfindahl Index = 49.402 + 22.902 + 10.002 + 8.202 + 2.302 + 7.22 = 3,189.1

Note: The Herfindahl Index is a tad higher than it should be. The "Other" category needs to replaced with the market share for each company in this category.

Entry Barriers

1. Incentives to enter or exit a market

  1. Expected profitability - firms enter the market if the net present value of profits is positive for a level of risk

    • Entering firms observe if firms are earning profits in the market

    • Firms may not enter a market if profits are falling over time

    • Mechanism

      • Market supply function shifts to the right

      • Market price falls until economic profits are zero

  2. Market growth - a firm may enter a market if consumers' demand is growing

    • If demand is not growing, then an entering firm has to steal consumers from other firms

  3. Firms exit a market if industry is earning a loss

    • Mechanism

      • Market supply function shifts to the left

      • Market price rises until economic profits are zero

  4. U.S. statistics

    • Entering firms tend to be small

    • Entering firms have high rates of failure

2. Barriers to entry - a structural characteristic that prevents a company to enter a market

  1. Economies of scale - as a firm expands production, its long-run average costs fall

    • One firm produces at q1

    • A monopoly protects itself by increasing barriers to entry

    • Sunk costs – a fixed cost that creates economies of scale

    • Market quantity is Qc, and the market price is close to AC(q)

Economies of Scale for a Natural Monopoly

  • Three scenarios

    • If q1 almost equals Qc, a new firm may not enter this market

      • Market has an entry barrier

    • If q1 is approx. 25% of Qc, this market could support four firms

    • If q1 is small relative to Qc, then this market is similar to a competitive market

      • Low entry barrier

  1. Absolute Cost Advantage - new firms have greater long-run average costs

    • An entrant can only enter a market if the market price is $40 or greater

    • A market price below $40 prevents new firms to enter the market

Absolute Cost Advantage

  • Why?

    • Firm controls a crucial input

      • Example 1: Aluminum Company of America (Alcoa)

        • Alcoa controlled the supply of bauxite

        • Competitors could not produce aluminum cheaply without bauxite

      • Example 2: DeBeers – controlled raw diamond market

        • Consolidated several large diamond mines

        • Formed cartel for diamond distribution

    • Firm could borrow investment funds

      • Large firms have access to the capital markets

      • Interest rates are lower

    • Firm has a patent or license

      • Competitors cannot legally produce without permission

    • Firm has access to superior technology

    • Firm has talented managers

  1. Capital costs - connected with economies of scales

    • Firms finance expansion with capital

    • Firm issues stocks and/or bonds, or could borrow from banks

    • Larger companies can garner more capital for lower costs

      • Can borrow from international investors

    • Small companies borrow within their own region

    • Why?

      • Large firms have lower risk

        • New companies have a high failure rate

      • Transaction costs are lower for larger firms

      • A more concentrated banking industry favors large firms

        • Small firms pay greater interest rate

  2. Product differentiation -gives a firm a touch of monopoly power

    • A firm could raise its price without losing customers

    • Advertising

    • Effort by sales force

    • Offer warranties

    • Product style

    • Quality

    • Example - advertising

      • Creates economies of scale

      • Increase capital cost to entry

      • Gives a company a cost advantage because advertising attracts consumers over time

  3. Sunk expenditures by consumer

    • Firms create differentiated products

    • Consumer must

      • Learn product

      • Quality of product

      • Invest in product

    • Example: Office software

      • Microsoft Office costs $100 - $400

      • Open Office is free

    • Microsoft is the standard

      • Swapping files

      • Software features

      • Training and consulting

      • Compatible data files

    • Microsoft has four barriers to entry

      • Copyright protection

      • Sunk cost for operating system

      • Sunk cost for office software

      • Standard for software, games, and programs

3. Government grants exclusive franchise

  1. Natural monopoly – gov. grants right for one company to provide service

  2. Source of revenue

    • Government grants exclusive right to a firm

    • Government shares in profits

    • Example 1: Gambling casinos

    • Example: 2 Distribution of alcohol

  3. Government redistributes rent

    • Example: Grant a phone company monopoly power for long distance

    • Use profits to subsidize local telephone service

  4. Intellectual property rights

    • Copyrights

    • Trademarks

    • Patents

  5. Monopolies can cause a problem

    • Rent seeking behavior – individual, organization, or firm seeks income by capturing economic rent through manipulation of economic environment

    • Russia – companies pay bribes to government officials

      • Gov. officials protect monopoly, enhancing its profits

    • U.S. – companies pay campaign contributions to politicians

      • Law makers pass favorable laws to monopolies

4. Barriers to exit - a firm pays a cost to exit an industry

  • Firms with large sunk costs will stay in market longer

    • Sunk cost - historical costs that cannot be recovered

      • Sunk costs are not included in the MR = MC decision

      • Example: An electric company invests in transmission lines and power plants

        • Company is not likely to leave this industry

        • Capital usually has a low salvage value

  • Permanent decrease in demand

  • Characteristics

    • Industries with many new entrants have high rates of exit

    • Example: New restaurants push the old restaurants out of the industry

Mergers

1. Mergers - parent corporation acquires another corporation by becoming the majority shareholder

  1. Horizontal merger - a firm buys a competitor and consolidates its business

    • Example: Coca-Cola decides to buy Pepsi corporation

  2. Vertical merger - a firm buys different stage of production in same industry

    • Example: Coca-Cola buys sugar cane mills that extract sugar from sugarcane

  3. Conglomerate mergers - a firm buys a company in a completely different market / industry

    • Example: Coca-Cola buys a company that makes tablet computers

2. Motives for a merger

  1. Increases market power

    • Horizontal merger - increase in market power

    • Vertical merger - increases the entry barriers

    • Conglomerate - reduces competition

  2. Efficiency gains

    • Economies of scale

    • Economies of scope

    • Reduces x-inefficiency

    • Note - layoffs are common after a merger especially within the acquired company

  3. Financial motives

    • A parent company could experience a stock price rise after a merger

    • Investors believe the company will be more profitable

  4. Risk Reduction

    • Conglomerate mergers are diversifying their products and services

    • Diversification reduces risk to changing markets

    • Vertical and horizontal mergers may not reduce risk

      • A firm's profits is related to acquired firms

      • Example: a company buys another hotel in a tourist destination that is experiencing declines in tourists

  5. Empire building - an entrepreneur wants to build a financial empire

    • Example: Harold Geneen, CEO of ITT

    • ITT bought many companies and corporations

  6. Failing firm - a strong firm buys and merges with a failing firm

    • Example: U.S government gave incentives for banks to acquire and to merger with failed banks during the 2008 Financial Crisis

  7. Aging Owners - a business owner may search for a buyer if he or she has no heirs to operate the company

3. Economics of a horizontal merger

  • Industry is competitive before the merger

    • Thus, P1 = MC1 = AC1

    • Social welfare is a maximum

Horizontal merger becomes a monopoly

  • A monopoly dominates the industry after the merger

    • Merger reduces MC and AC to MC2 and AC2, which is an efficiency gain

    • Monopoly uses its power to reduce production to q2

    • The red triangle is the deadweight loss

    • Consumers lose the green rectangle because prices are greater

    • The gray rectangle is the gain in efficiency

  • The merger has a positive effect if the efficiency gain exceeds the deadweight loss

4. Example

  • A purely competitive industry has a demand of P = 200 - Q, and MC = AC =50. What are output and price?

    • Competitive market, P = MC, so P = 50

    • Quantity is Q = 200 - 50 = 150

  • After several mergers, the market transforms into a monopoly. The mergers cause an efficiency gain, so MC = AC = 40. What happens to price and output?

    • The monopoly's production level is:

Monopoly's production level after mergers

  • The market price rises to P = 200 - 80 = 120

  • What is the change in welfare?

  • Graph the problem

Monopoly's production level after mergers

  • Competitive market

    • Consumers' surplus = ½ (200 - 50)(150 - 0) = 22,500

  • Monopoly

    • Consumers' surplus = ½ (200 -120)(80 - 0) = 3,200

    • Monopolist's profits

      • From consumer surplus = (120 - 50)(80 - 0) = 5,600

      • Gain in efficiency = (50 - 40)(80 - 0) = 800

    • Deadweight loss = ½ (120 - 50)(150 - 80) = 2,450

  • Unfortunately, the deadweight loss exceeds the gain in efficiency

 

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