Different industry structures

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

There are different industry structures in this world. Each industry structure is unique and involves unique decisions making by the managers. One of the sources of firm's cash flow is the firm's decision in the product market. For different industry structure the production patterns, type of products, consumer demand etc are different, so as the cash flow from the product markets are different. For these cash flow each industry is involved in unique operating decisions by the managers. The decisions are for the future and future is always uncertain. These decisions are for future cash flows and thus are sources of risks.

An industry composed of stable few players posses a low risk because of some factors among which high barriers to entry is the prominent one. Industry which are more concentrated possess greater deterrence to prevent the new firms to enter into the industry. These firms have economies of scale and they produce larger volumes of output and they are the only suppliers of products in such type of markets. These firms require massive capital investments and very specialized inputs which firms of the concentrated industries can't afford. These few firms of the concentrated industries may possess the exclusive rights or patents rights and thus this exclusive capability is very difficult for new firms to achieve. Firms in these industries usually have large base of loyal customers. These firms may own or have control on the entire supply of raw materials. The government may give exclusive rights to one or few firms to produce and sell. The pricing strategy followed by these firms is they provide low benefits to customer and charge high price because they are the only supplier of the product. They normally follow the strategies 6, 7, and 8 on the strategic clock developed by.......

Contrary to the concentrated markets the firms in the competitive industries are involved in intense competition not only on the basis of price but on many factors like innovation customer value etc.One strategy that is followed by the managers of these firms is to lower the price of their products. By this they not only deter the new market entry but also impose a loss on the potential entrants. With this strategy the firms may have losses in the short run but in the long run when their, they may achieve economies of mass scale production. Due to increased competition among the firms in the competitive industries these firms strive for innovation and innovation is a source of risk. All these factors results in highly volatile future cash flows and increased risk is associated with them

I will focus my study on the risk patterns of the competitive and concentrated industries, the possible linkage between the industry structure and the stock returns. Literature relating to the measurement of industry concentration will also be provided.

The link between market structure and Stock returns.

A link originates from structure/conduct/performance paradigm originated from the work of Bain (1954).Bain linked in his work production behavior of an industry to a firm pricing behavior. This behavior than determine the firm's profitability and performance. For example consider the computer chip industry. Chips are quite complicated products .A computer chips manufacturing firm have high fixed costs because chips are customized and each one needs massive and expensive plants. This high fixed cost acts as a natural barrier to entry for the new firms who want to enter into the industry.(structure).With this barrier to entry the number of firms in the industry will be few and each one is capable to charge a high price for their products well above their marginal cost and they have no fear of a new entry(conduct).Because of this structure and conduct the firms in such industries will earn high profits(performance).

The S/C/P paradigm further suggests that firms in such high barriers to entry industries have higher expected returns whenever the number of firms in the industry changes (some are dropped because they can't compete with such higher barriers and other cant enter) or the pricing strategies they follow changes the risk patterns of the firms in such industries. Barriers to entry also give us a clue of the optimal response of firms to aggregate demand shocks. Industries constituted by firms having high capital investments that give them maximum deterrence to avoid the new entrants can respond to a positive demand shock either by increasing their prices of products or by increasing their outputs without any danger of a competitive entry. This behavior will increase their profitability. High profitability gives the firms some deeper pockets which insulate these firms' cyclical downturns and industry exit. These firms because of their structure, conduct, and performance show a low risk pattern and hence low expected returns from investor point of view.

The structure/conduct/performance paradigm is challenged by the efficient structure hypothesis(ESH) presented by Damstez(1973,1974).The main proposition of the hypothesis is that attaining market power is not random event and this is the result of high firms efficiency levels. Because of high efficiency levels firms grows into larger firms and that industry become more concentrated. Thus efficient structure hypothesis predicts that firms having high efficiency earn lower returns because they have lower distress risk or danger of exit.

The S/C/P and the ESH both suggest that firms in highly concentrated industries have high efficiency level and lower distress risk because of higher barriers to entry and hence they earn lower returns. This support the possibility that firms in highly concentrated industries are less exposed to the distress risk because they have grown larger because of their higher efficiency and can exercise their market power and posses high barriers to entry.

Kewei and David(2006) argue that barriers to entry in the product guard some incumbent firms from aggregate demand shocks and expose others. Thus a distress risk is perceived which varies as the industry structure changes. Industries having higher barriers to entry are associated with lower stock returns. This distress or industry entry is a source of risk and shows industry structure can affect the stock returns. Thus managers operating decisions are dependent upon the industry structure of the firm. These decisions are for future uncertain cash flows and thus a source of risk They affect the firm's profitability and hence its stock returns.

Keei and David(2006) empirically showed that that firms in the industry that are constituted by few big firms with higher barriers to entry earn lower returns than competitive industries even if they control for size, book to market, momentum and some other factors (inflation, GDP) on which returns can be predicted. They even found that annual returns of less concentrated industries are 4% higher than similar firms in highly concentrated industries. Their finding showed that firms in highly concentrated industries have experienced positive abnormal profitability and the abnormal profitability for less concentrated industries was negative.

They further linked this concentration premium with business cycle and to future economic conditions. They empirically showed that concentration premium grows as economy curtails and low hen the near-term GDP rate decreases. This shows hen the future economic activity looks blurred investors expect higher rate of return for their investment in more competitive industries because of higher risk.

Schumpeter (1912) in his Theory of Economic Development introduced the concept of 'Creative Destruction' He used the term creative destruction as a process involving a change in the present status quo of the existing firms due to innovation. Any innovative entry by a firm in an industry creates a force that will ensure the long term growth of the industry. But this innovative change may damage the value of existing firms of the industry. The existing firms were enjoying some degree of innovation. This new innovative entry will split this degree of innovation and will change the existing status quo of the big players and thus posing a source of risk as the number of innovative entries into industry increases.

Companies that were once industry standards and were the key dominant players for example XEROX in photocopier or Polaroid in the photography are now challenged by the new entries. Their present status and position have changed in the new era. Their dominance has vanished because the new entrants have cut their costs trough improved product designing as well as cost efficiency in the manufacturing. Presently one example is that of Wal Mart that have achieved dominance trough improved inventory management, innovative distribution, and improved personals management techniques. Others examples of creative destruction include obsoleteness of typewriters with photocopier. Mail services were replaced by the emails. Some newspapers like the Christian Science Monitor have repleced the traditional newpaers with the online newpapers thus proving a new innovative entry and threat to the traditional newspapers.

Schupeter(1942) in his book argued that innovation brings number of troubles and risks for irms.When a firm decides to go for information neede for innovation it is very hard to get correct and precise information.This information lies in the hands of people or sources who are outside the organization.Thus an objetive uncertainity is created as for as this inforation is concerned.This objective uncertainity is compounded ith firm's employyes behahrioal response to the changes or innovation to be brought.This change or innovation is a new unknown state and there is a common fear among the employees to enter into this unknown state.The employees may working on taken for granted things and are reluctant to accept the change because of their estiblished staerotypes.Further more there may be people in the organization who are antagonist to change because of their attachment(emotional socialetc) with the older ways of doing things or products.They combat any sort of innovation on legal,social,poltical or mores basis.Thus innovation by a frim is not only a risk to other firms but also to firm itself.This also give evidence of beharioural phenomena on the part of managers. involved with innovation.

Peter W.robert(1999) argues that if a firm earns higher profits then it must answer the question from where does these higher profits are coming? And what are the underlying factors of the persistent trend of these high profits. When differentiation takes place or when a new innovative product is introduced in the market at first it faces less competition and hence it earns higher profits. These higher profits attract other competing firms and they try to imitate the product as time passes by. Due to this increased competition in the industry profits are lowered, risk is increased and hence hence expected return from the investor's point of view increases.

(Knott & Posen 2003) empirically proved that innovation in an industry is positively correlated with number of firms in an industry. Their result showed that if an industry is homogenous, there are no additional profits beyond a third entry. But with entry of each additional firm, there is an increase of R&D intensity of the existing firms. Adding to its on R&D costs. This suggests that when the number of firms in an industry increases innovation increases and hence risk increases. It is an important evidence that increased competition is a source of risk and hence investors expect a high rate of return on their investment in less concentrated industries.

How to measure the industry concentration

It will be very difficult to measure the industry concentration or amount of competition among firms directly. However there is an indirect measure of industry concentration called the Herfindhal index named after two economist Orris C. Herfindahl and Albert O. Hirschman and is used to measure the relative size of firms in an industry and the competition among the firs in an industry.HHI is defined as sum of squares of percentages of sales or market sahres of firms within an industry.It is normally used for 50 firms in an industry however if there are less than 50 firms in an industry we can aslo used it as an indicator of industry concentration.

The formula for Hefifinadahl Hirschman Index is given as follows

The values of Hhi will decide about the concentartion or competition among the firms in an industry.If HHI value is high it means the industry is concentrated and is composed of few big players.If the value of HHI is lower it depicts industry characterised by more firms and high copetition.further these HHI values are compared ith a threshold value.If the value is closer or above that threshold the industry is highly concentrated.On the other hand if HHI values are very low as compared to the Threshold value the industry is involved in high copetion and is less concentrated. Different countries uses different threshold like in the U.S this limit is 0.18 and in EU it is 0.025.So a value closer to 0.18 or 0.025 will depicts a Highly concentrated industry. In Pakistan I don't know the threshold values but I have made this simple for me by comparing industries on the basis of individual HHI values.

Suppose we have an industry M having 19 firms. Among these 9 firms have 90% market share each firm having 10% share each while remaining 10% is shared equally by 10 firms. The HHI value for this industry ill be.

Comparing the HHI values of industry M and industry N it become obvious that Industry N is highly concentrated as compared to industry M. The higher HHI value of industry N shows it has some big players like the 5 firms having 90% of the total market share of Industry N.

The population includes all the industrial sectors of KSE_100 Index

The sampling will be done randomly which will be no probable convenient sampling and I will select the following industrial sector which will be a proxy for all the industrial sector of KSE_100 Index.

  • Cement industry
  • Automobiles part and accessories industry
  • Fertilizer industry
  • Cable and electrical goods industry
  • Pharmaceuticals industry
  • Refinery
  • Oil and gas exploration industry
  • Tobacco
  • Engineering

All the firms in a particular industry will be selected for analysis. Well these industries will be than categorized on the basis of the Herfindahl index. They will be then divided on the basis of the industry structure they belong.

Data collection and the Data analysis

First the industries will be sorted into their respective industry structure for this we will need the sales values of the firms. The other relevant data will be the stock market returns. I will collect data from 2003 to 2007.

Data sources

  • The KSE website
  • The business regards
  • Annual and Quarterly reports of the firms
  • Offices of the firms

Research Instrument

Analysis

Analysis will be both time series and cross sectional. First of all I will study the return behavior for individual firms from 2003 to 2007 according to the concentration values obtained from Herfindhal Hirschman Index. Then I will find the aggregate return behavior of the whole industry. Then we will compare the average return of different industries cross sectional.

Statistical tools

First I have to check the statistical significance of return behavior of industries according to their HHI values. for this I have to use the Z_test for two samples means. I will divide the industries into two groups on the basis of their HHI values. One group with high HHI values and other with low HHI values. For these two samples I will calculate the Z statistic.

Statistical model

I will use the Fama Macbeth regression model for analyzing the effect of my variables on the industry returns. It is similar to capital asset pricing model. It is a multivariate model to estimate the factors or parameters for industry returns. The form of model for the factors I have considered is given as follows.

Industry average returns=a+ß1 (HHI) +ß2 (log of average size) +ß3 (B/M) +ß4 (industry average beta)

This is the multivariate model I will use in my study to analyze the relationship of the independent variables with the dependent variables.

Researcher interference

Well as this is a hypothesis study so the researcher interference will be minimal.

Unit of Analysis

Unit of analysis in my case is industry as I will conduct a comparative study of different industries of Pakistan.

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.