1. EC2204- Business Economics
5: Industry Structure and Competition Analysis

2. Learning Outcomes
Upon completing this section, the student should be able to:
 Distinguish between the various market structures.
 Calculate concentration ratios.
 Interpret Herfindahl index values.
 Describe and illustrate Porters Five Forces.
 Distinguish between long and short-run conditions in perfect
competition.
 Calculate equilibrium conditions and profit maximizing levels of
output.
 Distinguish between long and short-run conditions in
monopolistic competition.

3. Market Structures
 The convention is to divide industries into categories according to the degree of
competition that exists between the firms within the industry. There are 4 such
categories:
1. At one extreme is perfect competition, where there are very many firms
competing. Each firm is so small relative to the whole industry that it has no
power to influence price. It is a price taker.
2. At the other extreme is monopoly, where there is just one firm in the industry,
and hence no competition from within the industry.
3. In the middle comes monopolistic competition, where there are quite a lot of
firms competing and where there is freedom for new firms to enter and exit the
industry, and
4. Oligopoly, where there are only a few firms and where entry of new firms is
restricted.

4. Categories of Market Structure
To distinguish more precisely between the four categories, the following must be
considered:
 How freely can firms enter the industry: is entry free or restricted? If it is
restricted, just how great are the barriers to the entry of new firms?
 The nature of the product. Do all firms produce an identical product, or do
firms produce their own particular brand or model or variety?
 The degree of control the firm has over price. Is the firm a price taker or can it
choose its price, and if it can, how will changing its price affect its profits?
 What we are talking about here is the nature of the demand curve it faces.
How elastic is it? If it puts up its price, will it lose
(a) all its sales (a horizontal demand curve), or
(b) a large proportion of its sales (a relatively elastic demand curve), or
(c) just a small proportion of its sales (a relatively inelastic demand curve)?

5. How do we distinguish the market structure?
•In Economics, the concentration ratio of an industry is used as an indicator of the
relative size of firms in relation to the industry as a whole.
•This may also assist in determining the market form of the industry.
•One commonly used concentration ratio is the four-firm concentration ratio, which
consists of the market share, as a percentage, of the four largest firms in the
industry.
•In general, the N-firm concentration ratio is the percentage of market output
generated by the N largest firms in the industry.
•The concentration ratio has a fair amount of correlation to the Herfindahl Index,
another indicator of firm size.

6. Concentration Ratios
Microprocessor (Pentium Chips) Major US Airlines
Company % Market Share Company % Market Share
Intel 86% Amercan 20.6%
Advanced Micro Devices (AMD) 9 United 20.4
Others 5 Delta 15.8
North-west 14.0
US Beer Sales Continental 10.5
Anheuser-Busch (Bud) 44.9% US-Airways 9.5
Miller 22.5 TWA 9.3
Coors 9.9 US Gasoline Market
Strobs 8.3 Shell 8.9%
Heilman 6.4 Chevron 8.3
Pabst 3.3 Texaco 7.8
Genessee 1.1 Exxon 7.8
Others 3.7 Amoco 7.5
Mobil 7.5

7. Concentration Ratios
Company % Market Share Company % Market Share
Read-to-Eat Cereal BP America 5.9
Kellog 35% Citgo 5.4
General Mills 25 Marathon 5.2
Post 12 Sun 4.2
Ralston 7 Phillips 3.5
Quaker 6 Unocol 3.5
Nabisco 4 Arco 3.1
Private Label 10 Conoco 2.6
Others 1 Others 19.5
Music (albums)
Soft Drinks Sony 23%
Coca-Cola 42% Warner 16
Pepsi 31 BMG 14
Dr Pepper 8 EMI 13
Seven-Up 4 Universal 11
Schweppes 3 Polygram 10
Others 12 Others 13

8. Calculating Concentration Ratios
You are asked to determine whether the Computer Industry
computer industry or the mobile phone Firm Dell HP Toshiba Freecom PNY Sony Apple IBM
industry is more competitive using a 4- Sales 337 384 696 321 769 358 521 880
firm concentration ratio. Mobile Phone Industry
Firm Vodafone 02 Samsung Nokia Motorola Meteor Erikson Eircom
Sales 556 899 565 782 463 477 846 911
Step 1: Order the firms in order of sales.
C omputer Industr y
IBM PNY Toshiba A pple HP Sony Dell Freecom
880 769 696 521 384 358 337 321
Mobile Phone Industr y
Eircom 02 Erik son N ok ia Samsung Vodafone Meteor Motorola
911 899 846 782 565 556 477 463
Step 2: calculate the total sales for both industries
Computer Industry
IBM PNY Toshiba Apple HP Sony Dell Freecom
880 769 696 521 384 358 337 321 4,266
Mobile Phone Industry
Eircom 02 Erikson Nokia Samsung Vodafone Meteor Motorola
911 899 846 782 565 556 477 463 5,499

9. Calculating Concentration Ratios
You are asked to determine whether the computer industry or the mobile phone
industry is more competitive using a 4-firm concentration ratio.
Step 3: calculate the total sales for the top 4 firms in each industry.
IBM PNY Toshiba Apple Computer
880 769 696 521 2,866
Eircom 02 Erikson Nokia Mobile Phone
911 899 846 782 3,438
Step 4: calculate 4-firm concentration ratio for both firms
Computer
2,866/4,266 = 67.2% (4-firm c- ratio)
Mobile Phone
3,438/5,499 = 62.5% (4-firm c- ratio)
Interpretation
The computer industry (67%) is more concentrated than the mobile phone industry (63%). As there
is an inverse relationship between concentration and competition, the mobile phone industry is more
competitive in this case. However, you should interpret the results with caution and your evidence
should be supported by case studies and further research.

10. Herfindahl Index
 It is a measure of the size of firms in relationship to the industry and an indicator
of the amount of competition among them.
 Named after economists Orris C. Herfindahl and Albert O. Hirschman, it is an
economic concept but widely applied in competition law and antitrust.
 It is defined as the sum of the squares of the market shares of each individual
firm: ie the average market share, weighted by market share.
 As such, it can range from 0 to 10,000 moving from a very large amount of very
small firms to a single monopolistic producer.
 Decreases in the Herfindahl index generally indicate a loss of market power and
an increase in competition, whereas increases imply the opposite.
where si is the market share of firm i in the market, and n is the number of firms. Thus, in a market
with two firms that each have 50 percent market share, the Herfindahl index equals 0.502 + 0.502 =

11. Herfindahl Index
 A small index indicates a competitive industry with no dominant players. I
 f all firms have an equal share the reciprocal of the index shows the number of
firms in the industry.
 When firms have unequal shares, the reciprocal of the index indicates the
"equivalent" number of firms in the industry.
 H index below 0.1 (or 1,000) indicates an un-concentrated index.
 H index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate
concentration.
 H index above 0.18 (above 1,800) indicates high concentration.

12. Market Structures
Monopolistic Competition Oligopoly Duopoly
Many buyers/sellers A few firms Pepsi/Coca-Cola
Differentiated product Air travel, Lager Industry
Free entry and exit Interdependence between firms
Barriers to Entry
Monopoly
Perfect Competition
Firm = Industry
Market stalls
Intel, ESB
Many firms
Downward sloping demand curve
Homogeneous Product
Barriers to Entry
Price taker
Supernormal profits earned in long-run
Perfectly Elastic Curve
Free entry and exit

13. Porter’s Five Forces
 If the goal in business is to maximise shareholder wealth, the managers will
seek a pricing and output strategy that maximises the present value of the
future profits of the firm.
 The determination of wealth-maximising strategy depends on the
production capacity, cost levels, demand characteristics, and the potential
for immediate and longer term competition.
 Michael Porter of Harvard Business School in 1979 developed a conceptual
framework for identifying the threats from competition in a relevant market.
 Incumbent firms attempt to secure competitive advantage through their
choice of management strategy.
 Porter’s Five Force framework conceptualises the forces that
determine the competitive intensity and therefore attractiveness of a
market.
 Attractiveness in this context refers to the overall industry profitability.
 An "unattractive" industry is one where the combination of forces acts to
drive down overall profitability.
 A very unattractive industry would be one approaching "pure competition".

14. Porter’s Five Forces
The threat of substitute products: The existence of close substitute products increases the
The threat of the entry of new competitors: Profitable markets that yield high returns will draw
propensity of customers to switch to alternatives in response to price increases (high
firms. The results is many new entrants, which will effectively decrease profitability. Unless the entry
The elasticity of demand). Threat of substitutes/ most industries, this is the major determinant of the
intensity of competitive complements For
rivalry:
of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level
•buyer propensity to substitute
competitiveness of the industry. Sometimes rivals compete aggressively new entrants
Threat of and sometimes rivals
(perfect competition).
•relative price performance of substitutes Barriers to entry
compete in non-price dimensions such as innovation, marketing, etc.
•existence of barriers to entry (patents, rights, etc.)
•buyer switching costs
•number of competitors
•economies of product differences
The bargaining power of suppliers: Suppliers of raw materials, components, and services (such as
•perceived growth
•rate of industry level of product differentiation
•brand equitythe firm can be a source of power over the firm. Suppliers may refuse to work with the
expertise) to
•intermittent industry overcapacity
•switching costs or excessively high prices for unique resources.
firm, or e.g. charge sunk costs
•exit barriers Level of competition
•capital requirements industry
supplier switching costs relative to firm switching costs
in
•diversity of competitorsrivalry Sustain
•access to distribution of customers: The ability of customers to put the firm under pressure and
degree of differentiation of inputs
Intensity of
The bargaining power and asymmetry Industry
•informational complexity Profitability
•absolute costthe customer's sensitivity to price changes.
presence of substitute inputs
advantages
itfixed cost allocation per value added
• also affects
•learning curve advantages firm concentration ratio
•supplieradvertising expense concentration ratio
concentration to
•buyerof
level concentration to firm by suppliers relative to threat of backward integration by firms
•expected forward integration in industries with high fixed costs
•threat of retaliation by incumbents
•bargaining leverage, particularly
•Economies of relative to selling price of the product
cost of inputs scale
government policies
•buyer volume
•Sustainable competitive advantage through improvisation
•buyer switching costs relative to firm switching costs Bargaining power of
buyers
•buyer information availability Buyer
concentration
•ability to backward integrate Bargaining power of suppliers
Number of Suppliers
•availability of existing substitute products
•buyer price sensitivity
•differential advantage (uniqueness) of industry products

15. Perfect Competition
 The main characteristics of Perfect Competition are:
 1. There are a very large number of sellers competing with each other. Each
seller contributes only a very small fraction of total supply. Therefore an individual
seller cannot significantly affect market price by altering his output.
 2. There are a very large number of buyers. The number of buyers is so large
that no individual buyer can significantly influence the market price by altering his
volume of purchases.
 3. The product is homogeneous i.e. there is no difference between the product
of one firm in the industry and the product of any other firm in that industry.
Therefore to consumers, the products of the different producers are identical.
 4. There is freedom of entry to, and exit from the industry i.e. there are no
restrictions preventing firms moving easily into, or out of a particular industry.

16. Perfect Competition
 The main characteristics of Perfect Competition are:
5. Perfect Knowledge - producers and sellers are fully aware of the rate of profit being made
by the other producers in the industry. All the buyers are assumed to have widespread
knowledge of the price being asked for the product in every section of the market.
6. Each producer has a perfectly elastic supply of the factors of production i.e. the producer
can employ more factors to increase his output without forcing up the level of factor
payments (rents, wages, interest) which currently prevail throughout the industry. This is a
reasonable assumption (following assumption 1) because each producer or seller forms a
very small element of total output or supply.
7. Each firm aims to maximise its profits. Profit maximization implies that each firm
produces an output where Price = Marginal Cost (P = MC). To produce more than this
quantity implies that P < MC, which is not the most profitable decision. To produce less
than where P = MC, implies that P > MC, and the firm could increase profits by expanding
output. In the short-run, a competitive firm may earn economic profits. In the long-run,
entry pushes price down to the minimum point of the average cost curve, so that economic
profits are zero.
8. Competitive firms cannot charge more than the market price of others, since their product is
identical to all others. Hence, competitive firms are price takers.

17. Perfect Competition (industry versus firm)
Firm Industry
MC S
P = D = MR = AR
P P
D
MR = MC
D
Q Q
q (firm) Q (industry)

18. Perfect Competition (Short-Run)
Firm ATC > AR, MR
MC ATC
Costs
AVC
P
D
P = D = MR = AR
Shut down Rule
MR = MC If P < AVC the firm shuts down
Q
q (firm)

19. Perfect Competition (Short-Run)
Firm ATC < P, AR, MR
MC
Firm making super-normal profits
(Shaded grey area)
ATC
P
D
Costs
P = D = MR = AR
MR = MC
Q
q (firm)

20. Perfect Competition (Long-Run)
The existence of supernormal profits (shaded grey area in previous slide) is a short-run
condition. Because of the assumption of perfect information potential entrants to the market
are attracted by the super-normal profits as there are no barriers to entry. The industry
supply curve expands to S1 and the market price falls to P1. When the market price falls, the
horizontal demand curve facing each existing firm, as well as each new entrant, also falls.
Each firm adjusts its output to it new profit maximising position where MR = MC. So in the
long-run MR = MC = AR = ATC in perfect competition.
Firm Industry
S
MC
S1
MR = MC = AR = ATC ATC
P
D
P P1
MR = MC
D
Q Q
q1 (firm) Q (industry)

21. Supply in Perfect Competition
Short-Run Long-Run
The Supply Curve is that portion of MC Curve The Supply Curve is that portion of MC Curve
above the AVC above the ATC
MC MC
ATC ATC
AVC
AVC
P
D D
MR = MC
D
Q Q
q (firm) q (firm)

22. Monopolistic Competition
The main characteristics are:
• many buyers and sellers.
• differentiated product.
• free entry and exit.
• no collusion among the firms.
• Each firm will view its demand curve as declining in its own price.
• A monopolistically competitive firm will have to have a pricing strategy,
unlike a purely competitive firm.
• Differentiation occurs when consumers perceive that a product differs
from its competition on any physical or non-physical characteristic,
including price. Examples: restaurants, dealer-owned gas stations, Video
rental stores, book & convenience stores, etc.

23. Monopolistic Competition (short-run)
In the Short-Run firms produce where MR = MC, price (P) on the demand curve, P > MC,
economic profits exist (shaded) as P > AC, there exists incentives for entry into this
industry. Entry in this industry steals customers, demand shifts inwards.
Super-normal profits
earned in short-run
Price MR = MC
(Shaded)
(monopolistic competition) But AR > AC
MC
AC
P
Average Costs (AC) not
minimised
MR = MC
D = AR
q MR

24. Monopolistic Competition (long-run)
The profit maximising level of output is where MR = MC, like monopoly. P= AC,
like perfect competition. Super-normal profits are zero as in perfect competition.
However, at the profit maximising level of output average costs are not minimised,
output is not at the least cost point on the average cost curve as in perfect
competition.
Price MR = MC
(monopolistic AR = AC
competition) P = AC
MC
AC
P
No super-normal profits earned
in long-run, because of the
assumption of no barriers to
Average Costs (AC)
entry
not minimised
MR = MC
D = AR
q MR

25. Sample Questions
Q1: For the industry: QS = 3000 + 200P and QD = 13500 - 500P. For the perfectly competitive firm:
FC = 50, MC = 15 - 4Q + 3Q2/10 and AVC = 15 - 2Q + Q2/10. Calculate (a) The optimal output
for this firm? (b) The total revenue of the firm at the profit maximising level of output. (c) The total
costs of the firm. (d) The profit of the firm,
Solution: Find equilibrium price. Set QS = QD
3000 + 200P = 13500 - 500P.
10500 / 700 = P so P = 15.
At this price, the firm produces where P = MC, (perfect competition)
so 15 = 15 - 4Q + 3Q2/10
4Q = 0.3Q2 so 4 = 0.3Q
(a) so Q = 4/0.3 = 13.33 (Optimal output)
Profit = TR - TC at this output. Profit = TR[P*Q] - [FC + VC]
(b) TR = 15*13.33 = 199.95
TC = 50 + VC
AVC = 15 - 2Q + Q2/10
VC = AVC*Q = 15 - 2Q + Q2/10 * Q = 15Q – 2Q2 + Q3/10
VC = 15(13.33) – 2(13.33)2 + (13.33)3/10 = 81.43
(c) TC = 50 + 81.43 = 131.43 (i.e. FC + VC)
(d) Profit = [TR – TC] = [199.95 – 131.43] = 68.52

26. Sample Questions
Q2: Determine the optimal output, Q, for the following firm where TR = 14Q, and TC =
48+Q+0.5Q2. Does the data show whether the firm is perfectly competitive, monopolistically
competitive, oligopoly or monopoly?
Solution: TR = 14Q,
TC = 48+Q+0.5Q2.
π = TR -TC
π = 14Q – [48+Q+0.5Q2]
π = -48 + 13Q -0.5Q2
∆π
= 13 − Q = 0
∆Q
∆π
=0
∆Q
so Q = 13 (optimal level of output where where π is maximised)
The firm is perfectly competitive because Price is a constant €14
As TR = P * Q,
TR =14Q

27. MCQ Questions
3.`Which is NOT a characteristic of an industry that displays perfect competition?
a. free entry
b. heterogeneous product
c. many sellers
d. free exit.
4. For a competitive firm, if MC is below price:
a. raise output to raise profit,
b. reduce output to raise profit,
c. raise price to raise profit,
d. reduce price to raise profit.
5. In a competitive industry, if costs of production rise, we anticipate that:
a. price will rise and quantity will stay about the same,
b. price will rise and quantity will rise.
c. price will rise and quantity will fall,
d. price will decline to make up for the fact that costs

28. Recall Our Learning Outcomes
You should now be able to:
 Distinguish between the various market structures.
 Calculate concentration ratios.
 Interpret Herfindahl index values.
 Describe and illustrate Porters Five Forces.
 Distinguish between long and short-run conditions in perfect
competition.
 Calculate equilibrium conditions and profit maximizing levels of
output.
 Distinguish between long and short-run conditions in
monopolistic competition.