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The Nature of Industry

Chapter 7

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Concentration Ratios Measures of how concentrated an industry is. 1. Four Firm Concentration Ratio

percentage of an industry’s revenue accounted for by the 4 largest firms

2. Herfindahl index or Herfindahl-Hirshman Index (HI or HHI) sum of the squared market share values (S1)2+ (S2)2+ (S3)2+...+ (Sn)2

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Calculate market share

TireMakers

Sales MarketShare

Top, Inc. 270 30%ABC, Inc. 225 ?Big, Inc. 180 20%XYZ, Inc 90 10%

Cheap, Inc 81 9%Tiny, Inc. 54 6%

Total 900 100%

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Calculate market share

TireMakers

Sales MarketShare

Top, Inc. 270 30%ABC, Inc. 225 225/900

*100Big, Inc. 180 20%XYZ, Inc 90 10%

Cheap, Inc 81 9%Tiny, Inc. 54 6%

Total 900 100%

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Calculate market share

TireMakers

Sales MarketShare

Top, Inc. 270 30%ABC, Inc. 225 25%Big, Inc. 180 20%XYZ, Inc 90 10%

Cheap, Inc 81 9%Tiny, Inc. 54 6%

Total 900 100%

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4-firm concentration ratio

Add market share of top 4 firms

4-firm CR = ?

30+25+20+10 = 85

TireMakers

Sales MarketShare

Top, Inc. 270 30%ABC, Inc. 225 25%Big, Inc. 180 20%XYZ, Inc 90 10%

Cheap, Inc 81 9%Tiny, Inc. 54 6%

Total 900 100%

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Another example of 4-firm concentration ratio

Add market share of top 4 firms

4-firm CR = ?

79+2+2+2 = 85

Industry X Sales MarketShare

Firm A 790 79%Firm B 20 2%Firm C 20 2%Firm D 20 2%15 other

firms eachwith:

10 1%

Total 1000 100%

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Disadvantage of 4-firm concentration ratio:

Doesn’t give extra weight to especially large firms

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Herfindahl Index

(S1)2+ (S2)2+ (S3)2+...+

(Sn)2 (30)2+(25)2+(20)2

+(10)2+ (9)2+(6)2 =

900+625+400 +100+81+36=

2142

Tire Makers

Sales Market Share

Top, Inc. 270 30% ABC, Inc. 225 25% Big, Inc. 180 20% XYZ, Inc 90 10%

Cheap, Inc 81 9% Tiny, Inc. 54 6%

Total 900 100%

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Herfindahl Index

HI = 6268

Industry X Sales MarketShare

Firm A 790 79%Firm B 20 2%Firm C 20 2%Firm D 20 2%15 other

firms eachwith:

10 1%

Total 1000 100%

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Herfindahl Index Increases if the number of firms decrease Gives extra weight to especially large firms

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Concentration Measures by SIC/NAICS Code Department of Census http://www.census.gov/epcd/www/concentration.html http://factfinder.census.gov/servlet/EconSectorServlet?caller=dataset&sv_name=*&_SectorId=31&ds_name=EC0700A1&_lang=en&_ts=314058002437

Retail Bakery (311811) 2002 4- firm CR = 4.0, HI=8.0

2007 4- firm CR = 3.7, HI=7.3 Soft Drink Manufacturing (312111)

2002 4- firm CR = 46, HI=7092007 4- firm CR = 58, HI=1,095

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Anti-trust Enforcement

Department of Justice /Federal Trade Commission Enforcement

FTC Horizontal Merger Guidelineshttp://www.usdoj.gov/atr/public/guidelines/horiz_book/hmg1.html

FTC Competition Enforcement Reports

http://www.ftc.gov/bc/caselist/index.shtml

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DOJ/FTC Horizontal Merger GuidelinesThe Guidelines describe the analytical process that the Agency will employ in determining whether to challenge a horizontal merger. First, the Agency assesses whether the merger would significantly increase concentration and result in a concentrated market, properly defined and measured. Second, the Agency assesses whether the merger, in light of market concentration and other factors that characterize the market, raises concern about potential adverse competitive effects. Third, the Agency assesses whether entry would be timely, likely and sufficient either to deter or to counteract the competitive effects of concern. Fourth, the Agency assesses any efficiency gains that reasonably cannot be achieved by the parties through other means. Finally the Agency assesses whether, but for the merger, either party to the transaction would be likely to fail, causing its assets to exit the market. The process of assessing market concentration, potential adverse competitive effects, entry, efficiency and failure is a tool that allows the Agency to answer the ultimate inquiry in merger analysis: whether the merger is likely to create or enhance market power or to facilitate its

exercise.

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The general standards for horizontal mergers are as follows:

a) Post-Merger HHI Below 1000. The Agency regards markets in this region to be unconcentrated. Mergers resulting in unconcentrated markets are unlikely to have adverse competitive effects and ordinarily require no further analysis.

b) Post-Merger HHI Between 1000 and 1800. The Agency regards markets in this region to be moderately concentrated. Mergers producing an increase in the HHI of less than 100 points in moderately concentrated markets post-merger are unlikely to have adverse competitive consequences and ordinarily require no further analysis. Mergers producing an increase in the HHI of more than 100 points in moderately concentrated markets post-merger potentially raise significant competitive concerns depending on the factors set forth in Sections 2-5 of the Guidelines.

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c) Post-Merger HHI Above 1800. The Agency regards markets in this region to be highly concentrated. Mergers producing an increase in the HHI of less than 50 points, even in highly concentrated markets post-merger, are unlikely to have adverse competitive consequences and ordinarily require no further analysis. Mergers producing an increase in the HHI of more than 50 points in highly concentrated markets post-merger potentially raise significant competitive concerns, depending on the factors set forth in Sections 2-5 of the Guidelines. Where the post-merger HHI exceeds 1800, it will be presumed that mergers producing an increase in the HHI of more than 100 points are likely to create or enhance market power or facilitate its exercise. The presumption may be overcome by a showing that factors set forth in Sections 2-5 of the Guidelines make itunlikely that the merger will create or enhance market power or facilitate its exercise, in light of market concentration and market shares.

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Case Study

February 20, 1986: Coca Cola announced intentions to

purchase Dr Pepper Pepsi announced intentions to buy Seven-

Up The FTC (Federal Trade Commission)

announced decision to oppose Pepsi withdrew; Coca Cola persisted

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Problems with using only CR and HI to proxy for level of competition

i) Often difficult to Define Relevant Market

FTC Argues relevant market is Carbonated Soft Drink (CSD) and local

This market is highly concentrated already and would increase with merger

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Case Study

Herfindahl no merger 37.42+28.92+5.72+4.62+3.02… = 2324

Producers in 1985 ShareCoca-Cola 37.4%PepsiCo 28.9Philip Morris (7-up) 5.7Dr. Pepper Co 4.6R.J. Reynolds (Sunkist, Canada Dry) 3.0Royal Crown Cola 2.9Proctor and Gamble (Orange Crush,Hines)

1.8

Others (supermarket brands) 15.7

FTC’s Ranking of Competitiveness: Concentrated

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Case Study

Herfindahl with merger 422+28.92+5.72+3.02… = 2668

Producers in 1985 ShareCoca-Cola + Dr. Pepper 37.4+4.6=

42.0PepsiCo 28.9Philip Morris (7-up) 5.7

R.J. Reynolds (Sunkist, Canada Dry) 3.0Royal Crown Cola 2.9Proctor and Gamble (Orange Crush,Hines)

1.8

Others (supermarket brands) 15.7

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Defense (Coca Cola) Case

Market definition: all potable beverages (HHI only 739 in all beverage consumption)

USE CROSS-PRICE ELASTICITIES TO HELP DETERMINE RELEVANT MARKET

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Problems with using only CR and HI to proxy for level of competitionii) Does not take into account Entry Barriers

FTC Argues that there are significant entry barriers

Access to bottlers; economies of scale; entry risky due to high sunk costs; limited number of buttons and spigots

Coca-Cola argues that there are few entry barriers

No specialized resources or talents; Kraft, Beatrice and Borden potential entrants

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Types of Barriers to Entry

1. Economies of Scale/ Economies of Scope

2. Legal Barriers Patents, Copyrights and Franchises

3. Inability of potential entrants to gain access to distribution network or resource (ex. Alcoa and Bauxite)

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Problems with using only CR and HI to proxy for level of competitioniii) Cannot necessarily equate more

concentration with less competition FTC notes that the Return on Stockholder’s

Equity for the major CSD producers is relatively high (problem with this argument is that it does not pertain to the consequences of the proposed merger)

Coca-Cola notes that the real price of CSDs has declined in the last two decades

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Problems with using only CR and HI to proxy for level of competitioniii) Cannot necessarily equate more

concentration with less competition Coca-Cola argues that due to the many

different product types and the inability to monitor secret price cutting, it is difficult to collude in the CSD industry.

FTC argues that many different product types and promotions would not inhibit the ability to raise the price of CSD concentrate.

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Problems with using only CR and HI to proxy for level of competition (and use this to argue against a merger)

iv) Merger may increase efficiency Coca-Cola argues that the merger will

reduce costs due primarily to economies of scale. These cost savings could result in lower prices to the consumer.

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Major Changes in CSD Industry Post-1985

1. 7-Up and Dr. Pepper merged in late 1986 and Cadbury-Schweppes purchased them in 1995. Cadbury-Schweppes also acquired a number of other brands including Canada-Dry, Sunkist, A&W, Crush and Hires.

2. Technological change results in greater economies of scale associated with bottling.

3. Coca-Cola and Pepsi vertically integrate by acquiring a number of their bottling companies.

4. Diet CSDs’ market share has increased (from 25.9% in 1999 to 30.2% in 2004).

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