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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
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


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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