Industrial Economics

Fall 2008

Industry Structure and Performance

•The traditional approach to the relationship between market structure and performance:

“Structure-conduct-performance” paradigm

•It was introduced by Mason (1939, 1949)

•Original applications of SCP: Bain (1951, 1956).

• Two stages of SCP:

1. A measure of performance is obtained through direct measurement.

2. Measures of structure are used to explain the difference in market performance across industries.

Structure:

Number and size of firms;

Their cost and demand conditions;

Condition of entry;

Degree of regulation

Conduct:

Decision about pricing and production

Investment

Marketing and product design

Performance:

Efficiency

Profitability

Equity

Employment effects

Rate of innovation

Measures of market concentration

1. Concentration ratio:

n

iin sCR

1

Firm i has rank i in descending order.

CR4: Share of the industry sales, assets, etc. accounted by four largest firms.

CR8:Share of the industry sales, assets, etc. accounted by eight largest firms.

A value close to zero : low concentration (largest n firms supply a small share of the market).

A value close to 1: High concentration

2. Herfindahl-Hirschman index: It can be calculated by sum of squared market shares of each firm in the industry.

2

i

sHHI

Table 1. Turkish non-life insurance industry (1995-2005)

Year Number of Firms Total Assets (Million $)

Total Premiums (Million $)

C4 HHI

1995 39 1036.33 911.05 0.408 0.065 1996 38 1236.38 972.54 0.449 0.071 1997 42 1308.95 1102.91 0.422 0.065 1998 41 1499.86 1330.50 0.414 0.067 1999 40 1945.50 1315.52 0.488 0.081 2000 39 2271.39 1910.70 0.448 0.076 2001 36 1484.03 1279.98 0.461 0.078 2002 36 1611.32 1621.04 0.428 0.075 2003 39 2632.55 2540.12 0.445 0.077 2004 32 3634.54 3799.79 0.458 0.080 2005 31 5843.97 4723.66 0.563 0.116

Note: C4 and HHI are based on total assets

• Problems with the measures of concentration:

1. Many factors affect seller concentration measures. E.g.: Profitability may affect the degree of concentration in an industry by affecting entry. However, SCP assumes that structure determines performance. That is, SCP should be tested by using exogeneous measures of structure.

2. Definition of the relevant economic market is hard. E.g. If plastic bottles compete with glass bottles, CR in the glass bottle industry may reveal very little about market power in that industry.

Here, the concentration measure should include firms in both industries.

Measures of Performance

There are several performance indicators at the firm, industry and national level.

1.Measures of profitability:

i.Profit rate: Profits /Total real K employed

ii.Rate of return: ROE =Accounting Profit/Shareholders’ equity

iii.Bain’s excess profit rate: Economic profit/value of the investment in firm

iv. Tobin’s q: q=Firm’s market value/cost of replacing the total assets

Firm’s market value: Value of its shares on the stock market

Firm’s total assets: Buildings, equipment, inventories, outstanding debts.

What if q>1; q=1 ?

v. Lerner index: Measures the excess of the firm’s price over its MC. Since MC data are not generally available, we usually use AVC.

L=(p-MC)/p or L=(p-AVC)/p

In applications: L= [TS-(CM+PR)]/TS

TS: Total sales; CM: Costs of materials, PR: Payroll costs

2. Measures of productivity: Total factor productivity

TFP index : Q/(aL+bK), a+b=1

3. Efficiency: It is another way to assess performance.

Productive efficiency has two main components: Technical efficiency and factor price efficiency

Technical efficiency: Deriving a maximum level of output from any given set of input, for a given state of technology.

Factor price efficiency: Measures the ability to use the best combination of inputs given their relative prices.