Our core concern in AMBA 607 is how managers in a firm create value for the firm's owners and
other stakeholders. There are at least three determinants of firm performance:
- The firm's macro environment (economy, technology, society, regulation, etc.)
- The firm's immediate industry environment (competition, rivalry, buyers, suppliers, etc.)
- The firm's resources, capabilities, and the actions of its decision makers.
Among other important topics, we shall study firms' industry environments during Weeks 1 and
2. The two analytical approaches we will use to analyze a firm's industry environment are
"industry life cycle analysis" and the "five forces analysis" framework. To understand a firm's
industry environment, we must understand the industry's underlying structure. This note is about
industry structure and its use in industry analysis. We begin by trying to understand the
definition of "industry" and then go on to look at different aspects of industry structure, including
its uses and measurement issues.
What is an Industry
An industry is a collection of firms offering goods or services that are close substitutes of each
other. Alternatively, an industry consists of firms that directly compete with each other. For the
purpose of industry analysis, an industry can be defined rather broadly (the beverage industry) or
more precisely (the carbonated soft drink industry). How one defines and circumscribes an
industry depends on the kinds of analysis to be performed. In “industry analysis”, it is generally
better to define an industry as precisely as possible. For example, in discussing companies like
Coca-Cola and Pepsi, one would want to define the boundaries of the “carbonated soft drink
industry” rather than that of the “beverage industry”. Once the industry is defined as the
“carbonated soft drink industry”, other beverages (bottled water, milk, beer, juices, etc.) can be
treated as substitutes in five forces analysis.
There are many industry classification systems. The Fortune magazine uses its own
classification system that divides all industries into some seventy broad industry groups. Other
publications, such as Forbes, and Business Week, have their own classification systems. In the
United States, we used to have an official “Standard Industrial Classification” (SIC) system, and
one could designate an industry by a two-digit or four-digit SIC Code. In 1997, the U.S. Census
Bureau replaced the SIC system with NAICS (North American Industry Classification System)
that places business establishments into specific NAICS industries. NAICS was designed to be
used in all NAFTA countries to enable comparisons of business activities across United States,
Canada, and Mexico. In doing industry analysis, it is preferable to use the NAICS since all
government statistics related to industries are now reported using this classification system. To
learn more about NAICS, visit the Census Bureau Web site at:
http://www.census.gov/epcd/www/naics.html. Table 1 shows the basic structure of the NAICS
classification system.
Table 1
NAICS Structure (1997)
Classification
NAICS Code NAICS Description (U.S.)
Level
31-33 Manufacturing Sector
Beverage and tobacco product
312 Subsector
manufacturing
3121 Beverage manufacturing Industry Group
31211 Soft drink and ice manufacturing Industry
312111 Soft drink manufacturing National Industry
What is Industry Structure
The term “industry structure” refers to the number and size distribution of firms in an industry.
The number of firms in an industry may run into hundreds or thousands. The existence of a large
number of firms in an industry reduces opportunities for coordination among firms in the
industry. Hence, generally speaking, the level of competition in an industry rises with the
number of firms in the industry. The size distribution of firms in an industry is important from
the perspective of both business policy and public policy. If all firms in an industry are small in
size, relative to the size of the industry, it is a fragmented industry. If a small number of firms
controls a large share of the industry’s output or sales, it is a consolidated industry. The type of
competition in fragmented industries is generally very different from that in consolidated (or
concentrated) industries.
We will be particularly interested in the behavior of oligopolies, industries in which a very small
number of firms accounts for a very large share of the industry’s output. In the United States,
industries have been becoming ever more consolidated over time. In fact, over half of all U.S.
industries today are oligopolies.
The structure of an industry affects the conduct of industry members (sellers and buyers) which,
in turn, affects industry performance (profitability). This is the STRUCTURE-CONDUCT-
PERFORMANCE (S-C-P) Model from industrial organization economics (Scherer, 1996).
Uses of Industry Structure
As indicated above, the concept of industry structure is useful in both business policy and public
policy. We will discuss each use briefly.
Business Policy and Strategy:
By looking at the structure of an industry, one can often learn a lot about competition, rivalry,
entry barriers, and other aspects of competitive dynamics in that industry. Analysis of industry
structure is an integral part of “industry analysis” in strategic management. In the “five forces
analysis” framework, you will have a chance to estimate industry concentration while analyzing
the fifth force – industry rivalry.
As indicated by the S-C-P Model, industry structure impacts an industry’s economic
performance. And, according to Michael Porter (1979), industry structure also impacts the
profitability of companies in that industry. Under this view, some industries are inherently more
attractive than others because of their underlying structure (and other factors), which positively
impacts the performance of firms in those industries.
Fragmented industries generally have commodity-type products (e.g., primary metal) and exhibit
low entry barriers. Low entry barriers in an industry encourage the entry of new competitors into
the industry whenever profits are high. These entries lead to excess capacity in the industry and
industry members begin competing on price to utilize their capacity and to maintain their market
shares. As a result, such industries often experience boom-and-bust cycles and price wars. In
such a situation, everyone’s profits are hurt and some companies leave, are acquired by larger
competitors, or are forced out of the market.
From the viewpoint of incumbents, a consolidated (concentrated) industry typically has a more
attractive industry structure, though the nature and extent of competition in consolidated
industries is indeterminate, i.e., hard to predict. Such industries typically exhibit high entry
barriers, differentiated products, established brand preferences, and often high profitability. In
some consolidated industries, incumbents fight with each other tooth and nail and hurt industry
profitability as well as their own. In other consolidated industries, incumbents compete on non-
price factors and tend not to disrupt industry structure through unilateral competitive actions.
What kind of competition and rivalry would eventually evolve in an industry is thus hard to
predict.
Direct competitors cannot engage in any kind of coordination of their business or competitive
activities with each other; that is illegal under most countries’ antitrust laws. While most
countries do have antitrust laws, their enforcement varies considerably across nations. (The
United States has some of the strictest anti-trust laws in the world and generally enforces them
stringently. Different administrations have, however, had different attitudes toward enforcement
of the nation’s antitrust laws.). In economics, coordination among direct competitors is called
“collusion”, which as we know is illegal. What may happen in real practice is that, since major
companies in consolidated industries tend to know each other well and also generally know how
they would respond to different competitive moves, they may so design their competitive moves
as to not directly hurt others’ interests. In some industries, a company may assume a leadership
position over time, and when it makes a competitive move others may take their cues from the
actions of the leader.
Public Policy:
The U.S. Department of Justice and the Federal Trade Commission (FTC) use estimates of
industry concentration to decide on applications submitted to it by companies wanting to merge
with, or acquire, other companies. Public policy on horizontal mergers and acquisitions is
designed to ensure that a merger will not lessen competition in industry. The public policy view
is that reduced competition in an industry hurts consumers’ interest and/or encourages some
dominant firms to adopt anti-competitive trade practices. The Justice Department’s case against
Microsoft over the last several years has been exactly about that.
In 1986, PepsiCo wanted to acquire 7-UP and Coca-Cola Dr. Pepper. At the time, Coca-Cola and
Pepsi already controlled a very high share (66%) of the carbonated soft drink industry. If the two
acquisitions were to be allowed to take place, the share of market controlled by the two
companies would have risen even higher, a level far in excess of FTC guidelines. FTC did not
allow the acquisitions to go through (Oster, 1994). In presenting their case, Coca-Cola even tried
to tell the FTC that they belonged to the beverage industry, in which their share of market was
relatively small, but FTC did not buy the argument.
In Europe, the European Union (EU) has similar mechanisms to safeguard the interests of
consumers and industry members. In a recent case, while the U.S. Federal Trade Commission
approved the merger between GE and Honeywell, the EU blocked the merger. Most other
countries have similar mechanisms designed to restrict the emergence of monopolies and to
avoid restrictive trade practices by dominant firms.
Oligopoly
A key characteristic of an oligopoly (a highly concentrated industry) is that competitors are
mutually interdependent; a competitive move by one company will almost certainly affect the
fortunes of other companies in the industry and they will generally respond to the move – sooner
or later. Major companies in oligopolies have typically grown up with each other over time and
often know how they would respond to a competitive action by them. Smart companies in
oligopolies often do not want to disrupt the industry structure by making sudden competitive
moves, which would hurt everyone in the industry. Consider for example, the breakfast cereal
and cigarette industries, both of which are highly consolidated. When was the last time an
incumbent took a sudden, unilateral competitive action in these industries? By maintaining
industry structure, they encourage a more civilized kind of rivalry within the industry and
maintain the profitability of the industry, as well as their own.
In some oligopolies, incumbents often engage in a high level of competitive, unilateral actions
forcing other industry members to respond in kind. This generally hurts the interests of the
industry as well as their own. Consider, for example, the airline industry. If a major airline
announces a fare cut on some sector, chances are that other airlines competing in the sector
would also cut their fares almost immediately, thus hurting their as well as the industry's
profitability. (Airlines instantly know each other’s fares for different routes from their
participation in computerized reservation systems. There are literally hundreds fare changes each
day, often in response to each other’s actions).
Sheth and Sisodia (2001) have recently come up with an interesting thesis about the growing
consolidation industry. Their “rule of three” says that three major competitors will dominate
every industry, with small specialty players filling niche markets; companies caught in the
middle will exit the industry or be swallowed by larger players.
Measurement of Industry Concentration
A good, intuitive measure of the number and relative power of firms in an industry is the
industry's concentration ratio. The four-firm concentration ratio, often denoted by CR4, is
the combined share of market of the four largest firms in the industry. A CR4 of 40% or higher
represents a consolidated industry. Most industries when they reach a CR4 of 40% or so begin to
exhibit oligopolistic behavior. The larger the percentage, the more consolidated the industry. A
CR4 of 70% or 80% represents a highly consolidated industry. There is of course nothing
magical about using four firms to compute the concentration ratio; one can compute five-firm
concentration ratio (CR5), eight-firm concentration ratio (CR8), and so on.
CR4 can be estimated by adding the market shares of the top four firms in the industry being
considered. The U.S. Census Bureau does a census of all industries every five years and
publishes concentration ratios for all industries. See Table 2 for examples of CR4 for different
industries based on value of shipments.
Table 2
Four-Firm Concentration Ratios (1997) – Manufacturing Sector
NAICS
Industry # Cos. CR4
Code
311 Foor Production 21,958 14.3%
31123 Breakfast Cereal Mfg 48 82.9
Beverage and Tobacco Product
312 2,237 45.1
Mfg.
312111 Soft Drink Mfg. 388 47.2
31212 Breweries 494 89.7
31221 Cigarette Mfg. 9 98.9
313 Textile Mills 3,863 13.8
313113 Thread Mills 44 69.5
331 Primary Metals Mfg. 4,076 13.8
Nonferrous Metals (Excl.
3314 698 24.3
Aluminum)
Primary Smelting/Refining of
331411 9 94.5
Copper
332 Fabricated Metal Product Mfg. 58,516 3.5
Cutlery & Flatware (Excl.
332211 163 64.6
Precious)
Computer & Peripheral
3341 1,870 37.0
Equipment Mfg.
Communications Equipment
3342 2,078 36.5
Mfg.
Audio and Video Equipment
3343 521 29.8
Mfg.
3344 Semiconductor and Other Mfg. 5,652 34.3
3361 Motor Vehicle Mfg. 325 82.4
3363 Motor Vehicle Parts Mfg. 4,767 41.6
Source: U.S. Census Bureau
Another measure of industry concentration is the Herfindahl Index, which actually provides a
better understanding of industry concentration than CR4. It is also the measure used by the FTC
in deciding on merger and acquisition applications. The Herfindahl Index is calculated by taking
the sum of the squares of the market share of every firm in an industry.
Bibliography
De Kluyver, C. (2000). Strategic thinking: An executive perspective. Upper Saddle River, NJ:
Prentice Hall.
Oster, S.M. (1994). Modern competitive analysis. New York, NY: Oxford University Press.
Porter, M.E. (1979, March-April). How competitive forces shape strategy. Harvard Business
Review, 57(2).
Scherer, F.M. (1996). Industry structure, strategy, and public policy. Reading, MA: Addison-
Wesley.
Sheth, J., & Sisodia, R. (2001). The Rule of three: Surviving and thriving in competitive markets.
New York, NY: The Free Press.
U.S. Department of Justice. (1997). Horizontal merger guidelines. Retrieved July 26, 2002 from
http://www.usdoj.gov/atr/public/guidelines/horiz_book/hmg1.html.
