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 = 100 ² = 10,000

     • Pure competitive market - market share is 0%

       • Herfindahl Index = 0 ² = 0

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

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.

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 q ₁

   • A monopoly protects itself by increasing barriers to entry

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

   • Market quantity is Q ^c, and the market price is close to AC(q)

• Three scenarios

  • If q ₁ almost equals Q ^c, a new firm may not enter this market

    • Market has an entry barrier

  • If q ₁ is approx. 25% of Q ^c, this market could support four firms

  • If q ₁ is small relative to Q ^c, then this market is similar to a competitive market

    • Low entry barrier

2. 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

    • 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

3. 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

4. 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

5. 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, P ₁ = MC ₁ = AC ₁

  • Social welfare is a maximum

• A monopoly dominates the industry after the merger

  • Merger reduces MC and AC to MC ₂ and AC ₂, which is an efficiency gain

  • Monopoly uses its power to reduce production to q ₂

  • 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