﻿ Production Economics - Lecture 6
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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(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)

• 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

• 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

• Interest rates are lower

• Firm has a patent or license

• Competitors cannot legally produce without permission

• 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

• Effort by sales force

• Offer warranties

• Product style

• Quality

• 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

• 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

• 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

• 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:

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

• What is the change in welfare?

• Graph the problem

• 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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