1. Economists use two methods to determine how concentrated a market is
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Concentration Ratio (CR)
- calculate the percentage concentration of the largest firms in the market
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CR4 - the total percentage of the four largest firms in the market
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CR8 - the total percentage of the 8 largest firms in the market
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Uses sales data
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If concentration ratio is 0%, no firm has a market share; purely competitive
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If concentration ratio is 100%, the four largest firms completely dominated the market
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Problem - if the concentration ratio is 100%, is this a monopoly or four firms with a market share of 25%
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Herfindahl Index
- for each firm, take the percent market share and square, add all firms together
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:
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Localized markets
- a market covers a small area and isolated from other markets
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The concentration ratio or Herfindahl index is calculated for whole market
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A firm can dominate a local market
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Example - cement production seems to be in a competitive market
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Cement is bulky and has high transportation costs, thus, these firms may be monopolies at the local level
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Interindustry competition
- a product in the market may compete with products from other markets
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Example: Breakfast cereals seems to be a concentrated industry
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If these companies raise the price too much, consumers may switch to other breakfast foods
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International competition
- a concentrated industry may be competing with other large companies from other countries
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 = 49.40 2 + 22.90 2 + 10.00 2 + 8.20 2 + 2.30 2 + 7.2 2 = 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.
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1. Incentives to enter or exit a market
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Expected profitability - firms enter the market if the net present value of profits is positive for a level of risk
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Market growth - a firm may enter a market if consumers' demand is growing
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Firms exit a market if industry is earning a loss
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U.S. statistics
2. Barriers to entry - a structural characteristic that prevents a company to enter a market
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Economies of scale - as a firm expands production, its long-run average costs fall
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One firm produces at q 1
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A monopoly protects itself by increasing barriers to entry
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Sunk costs – a fixed cost that creates economies of scale
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Market quantity is Q c, and the market price is close to AC(q)
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Three scenarios
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If q 1 almost equals Q c, a new firm may not enter this market
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If q 1 is approx. 25% of Q c, this market could support four firms
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If q 1 is small relative to Q c, then this market is similar to a competitive market
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Absolute Cost Advantage - new firms have greater long-run average costs
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Why?
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Firm controls a crucial input
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Firm could borrow investment funds
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Firm has a patent or license
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Firm has access to superior technology
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Firm has talented managers
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Capital costs - connected with economies of scales
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Firms finance expansion with capital
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Firm issues stocks and/or bonds, or could borrow from banks
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Larger companies can garner more capital for lower costs
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Small companies borrow within their own region
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Why?
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Large firms have lower risk
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Transaction costs are lower for larger firms
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A more concentrated banking industry favors large firms
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Product differentiation -gives a firm a touch of monopoly power
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Sunk expenditures by consumer
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Firms create differentiated products
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Consumer must
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Learn product
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Quality of product
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Invest in product
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Example: Office software
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Microsoft is the standard
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Swapping files
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Software features
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Training and consulting
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Compatible data files
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Microsoft has four barriers to entry
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Copyright protection
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Sunk cost for operating system
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Sunk cost for office software
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Standard for software, games, and programs
3. Government grants exclusive franchise
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Natural monopoly – gov. grants right for one company to provide service
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Source of revenue
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Government grants exclusive right to a firm
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Government shares in profits
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Example 1: Gambling casinos
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Example: 2 Distribution of alcohol
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Government redistributes rent
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Intellectual property rights
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Copyrights
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Trademarks
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Patents
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Monopolies can cause a problem
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Rent seeking behavior – individual, organization, or firm seeks income by capturing economic rent through manipulation of economic environment
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Russia – companies pay bribes to government officials
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U.S. – companies pay campaign contributions to politicians
4. Barriers to exit - a firm pays a cost to exit an industry
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1. Mergers - parent corporation acquires another corporation by becoming the majority shareholder
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Horizontal merger - a firm buys a competitor and consolidates its business
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Vertical merger - a firm buys different stage of production in same industry
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Conglomerate mergers - a firm buys a company in a completely different market / industry
2. Motives for a merger
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Increases market power
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Horizontal merger - increase in market power
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Vertical merger - increases the entry barriers
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Conglomerate - reduces competition
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Efficiency gains
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Financial motives
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Risk Reduction
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Conglomerate mergers are diversifying their products and services
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Diversification reduces risk to changing markets
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Vertical and horizontal mergers may not reduce risk
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Empire building - an entrepreneur wants to build a financial empire
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Failing firm - a strong firm buys and merges with a failing firm
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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
4. Example
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A purely competitive industry has a demand of P = 200 - Q, and MC = AC =50. What are output and price?
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Competitive market, P = MC, so P = 50
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Quantity is Q = 200 - 50 = 150
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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?
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