What Is an Industry?
An industry can also be viewed as a collection of firms offering goods or services that are close substitutes of each other. For example, an industry can be defined broadly (e.g., the healthcare industry, the transport industry) or more precisely (e.g., pharmaceuticals, medical diagnostics, automobiles, electric vehicles, SUVs.). How one circumscribes an industry depends on the kinds of analysis to be performed. In analyzing industry structure, it is generally better to define an industry as precisely as possible.
It is important to distinguish between the industry in which a company competes and the market it serves. For example, a company might compete in the aerospace industry but choose commercial aircraft or private jets as its served market. Or, a company may compete in the computer industry but choose to serve the software or hardware market. Defining the boundaries of the industry a company competes in is critical to delineate the size of the market, the drivers of demand, and potential competitors.
There are many industry classification systems. For example, the publications Fortune, Forbes, and Businessweek, have their own classification systems. The United States used to have an official Standard Industrial Classification (SIC) system, established in 1937 that designated industries using a four-digit SIC Code. In 1997, the United States Census Bureau replaced the SIC system with the North American Industry Classification System (NAICS), which places business establishments into specific industries. In performing an industry analysis, it is preferable to use the NAICS since all government statistics related to industries are now reported using this classification system (Jain, 2002; United States Census Bureau, 20018).
Different industries show varied returns over time. Some perform well in the short term but not so well in the long term. For example, the infrastructure (such as utilities and energy) and financial services industries (such as banks, investment funds, and insurance) perform better in the middle to long term (Fidelity, n.d.).
This difference in performance is due to a number of factors including the kind of market the industry operates in. One approach to determining the kind of market is to view industry as collection of firms that directly compete with each other and to examine their markets according to the degree of competition between the firms. The markets could be (1) perfect competition, where a large number of companies compete against each other, (2) an oligopoly, where a small number of firms compete against each other, or (3) a monopolistic competition, where a single firm dominates the market.
The number and size distribution of firms in an industry defines its industry structure. “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” (Jain, 2002).
Industry structure also influences the profitability of companies in that industry. Some industries are inherently more attractive than others because of an underlying structure that positively affects the performance of firms in those industries. (Porter, 1979)
Industry concentration therefore is an important aspect of competition. The concentration ratio (CR) of an industry is used as an indicator of the relative size of firms in relation to the industry as a whole. It is designed to measure industry concentration, and by inference, the degree of market control. This helps analysts understand the nature of the industry operates in which the organization operates.
A commonly used concentration ratio is the four-firm concentration ratio (CR4). It is calculated by adding the total sales for the four largest firms in the selected industry, then dividing that sum by the total sales of the industry, and converting that result to a percentage.
While there is no distinct concentration ratio that separates one market structure from another, these values can be used as indicators of market structure, as shown in the table below:
Degree of concentration
Ranges from perfect competition to oligopoly
Ranges from oligopoly to monopoly
There is of course nothing magical about using four firms to compute the concentration ratio; one can compute a five-firm concentration ratio (CR5), eight-firm concentration ratio (CR8), and so on. In general, the n-firm concentration ratio is the percentage of market output generated by the n largest firms in the industry.
The United States Census Bureau (2013) publishes concentration ratios for all industries every five years as the results of its census. It can also be found using FactFinder (Cramer, 2012). Concentration ratios provide an indication of the market structure of an industry; they do not provide a lot of detail about the competitiveness of the industry.
For example, an n-firm concentration ratio does not reflect changes in the size of the largest firms. The same concentration ratio can be achieved in a number of ways, as the relative size of the top n companies can vary. The oligopolistic industry is more competitive if four firms have nearly equal sales than if sales of one firm dominates the others (“Four-Firm Concentration Ratio, n.d.). The Herfindahl-Hirschman index (HHI), an indicator of the degree of competition among companies, addresses this issue.
HHI is applied in competition law and antitrust and is a commonly accepted measure of market concentration. It is calculated by squaring the market share of each firm competing in a market and then summing the resulting figures. It can range from close to zero to 10,000. Decreases in the Herfindahl index generally indicate a loss of market power and an increase in competition, whereas increases imply the opposite (Kenton, 2019).
The structure of an industry affects the conduct of industry members (sellers and buyers) which, in turn, affects industry performance (profitability). This principle is represented in the structure-conduct-performance (SCP) model. Structure refers to the concentration, ownerships structure, barriers to entry, exit, and vertical integration, etc. Conduct refers to the companies’ approach to pricing, R&D, capacity investments, etc. And performance refers to profits, value creation, shareholder returns, etc. Under this model, the market structure has a direct influence on the firm's economic conduct, which in turn affects its market performance (“Enduring Ideas,” 2008).
Cramer, S. (2012, Jul 27). Finding industry concentration ratios using the Economic Census & American FactFinder. [Video file]. Retrieved from https://www.youtube.com/watch?v=k3lKD446xag
Enduring ideas: The SCP framework. (2008, July). McKinsey Quarterly. Retrieved from https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/enduring-ideas-the-scp-framework
Fidelity. Sectors & industries—Performance. Retrieved from https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/si_performance.jhtml?tab=siperformance
Four-firm concentration ratio. (n.d.). AmosWeb Encylonomic Webpedia. Retreated from http://www.amosweb.com/cgi-bin/awb_nav.pl?c=dsp&k=four-firm+concentration+ratio&s=wpd
Jain, V. K., (2002). Note on industry structure. Document posted in University of Maryland Global Campus Course AMBA 607 online classroom, archived at http://info.umgc.edu/mba/public/AMBA607/IndustryStructure.html
Kenton, W. (Ed.). (2019, February 7). Herfindahl-Hirschman Index—HHI. Investopedia. Retrieved from https://www.investopedia.com/terms/h/hhi.asp
United States Census Bureau. (2013, September 3). Concentration ratios. Retrieved from https://www.census.gov/econ/concentration.html
United States Census Bureau. (2018, December 3). North American Industry Classification System. Retrieved March 18, 2019 from https://www.census.gov/eos/www/naics/