The Structure of EU Industry and Services - Oxford Textbook of Marketing

8/8/2019 The Structure of EU Industry and Services - Oxford Textbook of Marketing

1/32

The Structure of EU Industry and Services

Contents

1. Objectives2. 1 Introduction3. 2 The competitive environment 4. 2.1 Globalization5. 2.2 Deindustrialization and structural change6. 3 Industrial structure in a European context 7. 3.1 Trade, specialization, and integration8. 3.2 Trade, investment flows, and multinational activity9. Spreading R&D costs10. 4 EU mergers, concentration, and size of firm11. 4.1 Mergers and acquisitions12. 4.2 Concentration13. 4.3 Size of firm14. 5 Structural change, competition, and efficiency15. 5.1 Competition and price-cost margins16. 5.2 Competition and price convergence17. 6 Structure and competition in the pharmaceutical industry: a case study18. 7 Structural challenges and outlook19. 7.1 Macroeconomic dimension20. Automated hotels in a country with 12% unemployment 21. 7.2 Corporate dimension22 . 8 Summary23 . Further reading24 . Discussion questions

Section: Customers, Markets, and Marketing ObjectivesThe objectives of this chapter are:

1. to show that the changing nature of competition in Europe can be appereciated only in the context of the forces of globalization and deindustrialization;

2. to provide a guide to the important factors that partly determine such structural change; 3. to provide an understanding of the nature of EU trade and the effect of the introduction of The single market

programme ( SMP) on such Trade flows; 4. to provide an insight into the dynamics of EU industry and services by discussing the forces that affect industrial

structure; 5. to show, by investigating the effect of carious trade and structural forces on price margins and price convergence

across the EU, how competitiveness is affected by the changes noted above; 6. to explain and clarify the more immediate macro- and corporate-level factors that will determine the EU's future

competitiveness .

1 IntroductionF

OR many marketing managers economists are an irritant whose main value is to be the source of old andrather weak jokes about their unwillingness to make definitive predictions . However, many marketingmanagers recognize the value of economics and indeed would agree that the use of economics and economicmeasurement techniques is being increasingly recognized as an important element in marketing and otherareas of business analysis . Economic analysis and quantitative techniques allow the major factors affectingmarket growth and other business issues to be related to each other in a coherent and consistent way and in aform which can be used for the evaluation of marketing plans (Greenway 1999: 58) . Section 2 shows howeconomic factors determine the nature of the competitive environment within which individual firms have tooperate as they market their products . The following sections will consider what determines these economicfactors and the pharmaceutical industry will be used as an example .


2/32

2 The competitive environmentTwo major influences on the development of I the modern competitive environment have been globalizationand deindustrialization . These two influences are considered in the following sections .

2.1 Globalization

Over the last two decades of the twentieth century most of the world's nations experienced an acceleration inthe pace of economic change . The period saw a convergence of forces that led to a rapid growth of interdependence between countries, while at the same time causing important structural shifts to occur withinthose same nations . These interrelated changes resulted in a business environment where the only constant factor is change itself . For a fuller understanding of the general trends in the world economy and the way that such underlying factors facilitated economic change in Europe, we need to look more closely at the concepts of globalization and structural change that is, the international and intranational aspects of economic behaviour .

From a macroeconomic perspective, globalization involves the growing interdependence of countriesworldwide, which results in an acceleration in the volume of goods and services trans acted internationally . Such movements of goods and services are also accompanied by increased flows of international capital andthe rapid diffusion of technology across national boundaries . Therefore, the process of globalization can beseen as a continuous adaptation by firms to the changing global environment . Some firms that serve mainly

the domestic market come under pressure from foreign competitors, while other firms react by aiming at worldwide intra-firm division of labour that is, they become multinational in their production and distributionstrategies . In this context it is interesting to note that, if multinational companies aim at worldwide intra-firmoperations, this will tend to increase worldwide trade, whilst, if such activity is established within ageographically concentrated area (i .e. within trading blocs such as the EU, N AFT A, or APEC), sometimes knownas global localization , then this could lead to a fall in international trade . It is the dynamic interaction betweenmacro and microeconomic forces noted above that often decides the changing pattern of world trade andproduction .

The pace of globalization trends has been determined to a great extent by the interaction of technological,organizational, and policy changes . First, the progress in computer/communications technology has meant that companies are able to coordinate production activities across international borders in search of low-cost locations . At the same time, the costs of transportation have fallen, making it possible for companies tooperate competitively in many areas of the world . These changes have spilled over to financial markets, wherethe diffusion of telematics and communication technologies have allowed markets to overcomerthe barriers of space and time, thus affecting the volume of capital transactions . Secondly, there have been significant changes in the organization and operation of many firms . An increasing number of domestic and internationalcompanies have become less hierarchical in structure, with decision-making being delegated downwards tooften semi-autonomous subunits that are closer to the actual market . Organizational changes such as these,together with communications technology, have also made it possible for companies to distribute R&D andmarketing facilities worldwide . Thirdly, no major movement towards globalization can occur without political/policy changes . In this context, the liberalization of flows of trade and services by such organizationsas the WTO (G ATT), IMF, and OECD has accelerated since the 1970s.

What have been the symptoms of rapid globalization? First, the ratio of world exports to world GDP hadreached 24 per cent by 1996, having doubled since 1950, and increased by as much as a quarter over theperiod 1986 96 . Similarly, the average daily turnover in the world's main foreign exchange markets grew from$1,880 billion in 1986 to $ 1.4 trillion by 1996 . The amounts of foreign direct investment ( FDI) outflows haveincreased fivefold over the same period . Obviously, the degree of globalization does differ across thecontinents . For example, the ratio of exports to GDP for North America in 1996 was 12 per cent, while thefigures for Europe (including intra European trade) was 3 0 per cent, and for Developing Asia (China and theNICs) the figure rose to 4 0 per cent .

In the European context, we can look at the process of globalization in two ways: first, at increased tradebetween the countries of the EU i .e. intra-EU trade and, secondly, at increased trade between all EUcountries and the outside world-i .e. extra-EU trade . We have seen above that, on the basis of intra-European


3/32

trade, the whole area has been internationalized for many years . This is also reflected in the share of EUmerchandise exports (extra-EU trade) to world exports, which stood at 24 per cent in 1996 indicating theimportance of the EU as a major trading bloc .

Growing interdependence between nations and trading blocs is seen as being beneficial for many reasons . It isargued that the integration of global markets via trade and FDI flows will create growth and employment, willact as a vital mechanism for the transmission of new ideas and new production and marketing techniques, andwill improve management practices worldwide . In this way, improved benefits are expected for consumers,since goods and services can be produced in the least cost locations while simultaneously giving more choiceto consumers . Also, financial benefits accrue from the growth of a world market for capital, in that countriesand firms can raise money on different world financial centres using a greater range of sophisticated financialinstruments . On a microeconomic level, globalization will bring competition to the doorstep of domesticcompanies, forcing them to compete or die . This will significantly increase competition, which, in turn, willincrease efficiency in the allocation of resources .

The trend towards the globalization of the economy is, therefore, multidimensional . Despite the trends notedabove, it must be remembered that three-quarters of the world's production of goods and services are stillconsumed within national economies and that world-outward FDI of the advanced countries is only 7 per cent of their domestic fixed investment, which indicates how important domestic savings are in the investment process . Similarly, globalization to date has not involved large international movements in labour, sinceresidents born abroad comprise only between 5 and 10 per cent of the workforce of large industrializedcountries . However, to say that these figures prove that integration of global markets is not a realphenomenon is to ignore the important changes that have already occurred over the last decade in particular .

The integration of global markets will heighten competition in markets worldwide . Ironically, it will tend toincrease competition between nations in some markets while at the same time making nations cooperatethrough pooling of knowledge and joint venturing in other markets . Globalization based on the increasingactivity of multinational companies will also alter the concept of what national production means . Some writers,such as K . Ohmae ( 1990), have pointed to the fact that national governments will have to attract investment for the development of their economies independently of the origin of that capital . Similarly, Reich ( 1991) haspointed to the increasing conceptual problems that arise when trying to distinguish between thecompetitiveness of nations and that of international companies . For example, the competitiveness of the EU-owned corporations is not the same as EU competitiveness, since foreign companies that undertake

production, research, and marketing in the EU may be more competitive than EU companies operating abroad . The factors noted above mean that the future of global competitiveness will have critical repercussions ondomestic/regional interests, as national governments organize themselves on a more regional basis to achieveglobal influence . At the same time, governments have to cope with the increasingly complex task of providingmodern economic and industrial policies to provide a suitable domestic economic environment in which bothdomestic and foreign multinationals can operate . Achieving the correct blend of independence andinterdependence will be at the core of national policies for the foreseeable future .

2.2 Deindustrialization and structural change

The increasing integration of the world economy noted above has coincided with a longer-term phenomenonthat can also help to shine light on the nature of the competitiveness of nations . This revolves around thecontinuing structural changes that affect economies as they mature . A brief analysis of this concept will helpplace competitiveness and structural change in the EU in their proper perspective . Basically, as an economymatures, there is a shift in the sectoral composition of its total output (value added), and employment from theagriculture sector shifts towards manufacturing and then services . For the more advanced countries, the most significant change over the last forty years of the twentieth century involved the continuing shift in the share of output and employment from manufacturing to services as per capita income rose .

When we look at the value added by the manufacturing sector as a percentage of GDP (current prices), wefind that there was a fall in the ratio in all major economies after 1960. For example, taking the main industrialcountries together, we find that manufacturing comprised 3 0 per cent of their combined GDP in 1960 but only


4/32

20 per cent by 1995, while the share of the service sector rose from 53 to 66 per cent over the same period . For the EU, the share of manufacturing fell from 33 to 23 per cent, and the share of services rose from 47 to68 per cent in the same period . The greatest change occurred in the U SA, where the share of manufacturingfell from 28 to 19 per cent, and the share of services rose from 57 to 72 per cent .

These statistics seem to indicate that the shift from manufacturing to service reflects a shift in the pattern of domestic spending away from manufacturing and towards services . This conclusion seems to be confirmed bysectoral changes in employment, as shown in Figs. 5.1 and 5 .2. Here we see that the share of manufacturingemployment in total civilian employment fell significantly from 1970, while, conversely, the share of employment in services rose strongly at the same time . These trends seem to follow the pattern for the shareof output (value added) discussed above,and appear to confirm the hypothesis that such shifts probably reflect the changing pattern of domestic spending, as per capita income rises as the more income-elastic services aresubstituted for manufacturing .

However, this analysis is not wholly correct, as the current value of a given output is composed of the price of each unit of output multiplied by the number of units produced . Therefore, the current value of total output can change from year to year, not only because more units are produced but because the price of each unit has changed . To get a clearer picture of the real changes that is, whether the number (volume) of units of output has increased we need to adjust the value figures for changes in prices that is, calculate output at constant prices . This has been done in Fig. 5.3. This shows us that after 1970 the value added inmanufacturing as a share of GDP at constant prices (i .e . volume) did not fall significantly in the industrialcountries or in the EU, while there was a some what sharper fall in the U SA, and even a rise in the ratio forJapan until the early 1990s.

The above analysis indicates that, in volume (i .e. constant prices) terms, there has not been a very significant shift in real expenditure from manufacturing to services either in the major industrial countries or in the EU . The question that naturally arises is why should the shares of manufacturing in money GDP fall (and in servicesrise), while the shares of manufacturing and services at constant prices do not show the same extreme shifts . The answer is to be found in the changes in the relative movements in the prices of manufacturing andservices over the period . In the major industrial countries, the average growth of productivity in servicesbetween 1960 and 1996 was only 1.6 per cent per year (EU 1.5 per cent), while that of manufacturing was 3 .5per cent (EU 3 .1 per cent) . These productivity differences resulted in a relatively high cost/price structure inthe less tradeable service sector, while the influence of new technology and global competition was more

severe on more tradeable manufacturing, thus bringing costs and prices down relative to those of services . These price changes tended to exaggerate the real structural shifts in value added .

What we can conclude at this stage is, first, that deindustrialization (as measured by value added at constant prices) is a phenomenon that is occurring at a slower rate in the major economies, including the EU, thanshown by the money figures alone . However, trends since 1970 do still show a slow decline in the share of realvalue added in manufacturing . In other words, real expenditure on services has not risen consistently fasterthan real expenditure on manufacturing . Secondly, that productivity in manufacturing has increased at a ratethat is twice that of services . Thirdly, that the significant shifts in employment from manufacturing to servicesmust therefore be due to the difference in productivity between the two sectors . Research by Rowthorn andRamswamy ( 1997) indicates that, of the 9 .6 per cent drop in the share of manufacturing employment in OECDcountries between 1970 and 1994, some 6 .3 per cent (i .e. 65 per cent of the drop) was due to higherproductivity in manufacturing industry than services .

Despite the picture presented above, it is also true that the pace and timing of the deindustrialization processcan differ across the globe, as seen in Fig. 5.3. For example, the share of manufacturing in real value addedactually rose in Japan until the early 1990s and fell more rapidly in the U SA. The EU experienced only a slowdecline . These factors seem to reflect the fact that domestic expenditure seems to have been shifting fromservices to manufacturing in Japan, while in the U SA the shift of expenditure has been the reverse, with theEU's experience showing a more constant pattern . However, the reason for these trends may come fromanother source . For example, Japan has had a healthy trade surplus in manufactured goods since the 1970s,while the U SA has experienced a growing trade deficit in manufactures . This tends to indicate that the pace of deindustrialization may be determined not only by shifts in domestic expenditure within nations but also by the


5/32

nature and success of manufactures in export markets, which can slow down the deindustrialization process, asin Japan, or accelerate it, as in the U SA. Again, the EU has had a relatively steady surplus on trade inmanufactured goods, which has helped keep the manufacturing sector's real value added relatively constant .

We can, therefore, see that deindustrialization is not necessarily a symptom of the failure of a nation's or atrading bloc's manufacturing sector, but is a natural outcome of a long-term process of economic development,where productivity in manufacturing rises more rapidly than services, thus leading to a shift of labour to theservice sector . The pace of deindustrialization can vary in different countries or blocs for reasons linked to bothexpenditure and trade patterns . In each country, the weight of various sectors in the economy partly reflectsthis trend, as seen in Table 5 .1. Here, figures for the sectoral share of GDP and employment are shown for theEU, the U SA, and Japan . Some countries, such as Belgium, UK, France, Sweden, or Luxembourg, have tendedto shift resources towards the services sector some what earlier than countries such as Spain, Italy, Portugal,or Finland . The reasons behind the speed of transition are complex and related to a country's stage of development and to specific country-based factors . What is obvious is the fact that the EU is a heterogeneousgroup of economies bound together within a trading bloc . The convergence of such economies is, by definition,a complex and difficult process .

Comparing the EU with the U SA, we find that there are still more resource shifts to be experienced in the EU if it is to follow the U S trend, while the discussions on how to manage future deindustrialization or hollowing-out is also a worry for Japan . Such shifts inevitably occur not only in the major industrial countries but also in thenewly industrialized economies of East Asia, where the share of labour in total employment began to shift frommanufacturing to services in the late 1980s. Another factor revolves around the role of the fast growing market services (i .e. non-government) sectors, such as distribution services, finance and business services, etc ., whichwill probably be the area of growth if the EU follows the U S /Japanese pattern .

It should be noted here that, when we discuss the concept of deindustrialization with its shifts of resourcesfrom industry to services, it is necessary to remember that we should not underestimate the interlinkagesbetween the sectors . For example, the faster-growing transport, communication, finance, insurance, andbusiness services all benefit from the purchase of technologically sophisticated intermediate investment goodsfrom manufacturing . It has been calculated that some 25 per cent of the service industry depends directly onmanufacturing . For example, the production of goods places increasing demand on services such as R&D,design, marketing, and distribution . Therefore, there is a more sophisticated interlinkage betweenmanufacturing and services than is often imagined .

3 Industrial structure in a European contextTHE impact of the processes of globalization and deindustrialization described above has had an important overall effect on the structure of European industries and hence on the nature of industrial competition in theregion . To investigate the matter further, it is necessary to examine the different elements that make up theindustrial structure of the region . At this stage it is worth pointing out that the EU is by no means ahomogeneous entity, as we have already seen in Table 5 .1 , but for this study we need to concentrate on thecommon elements that define the region as a whole in order to try to compare its performance with other mainplayers such as the U SA and Japan . The most obvious place to begin to understand the dynamics of EUcompetitiveness would be to investigate the relationship between trade and the degree of productionspecialization within the EU .

3 .1 Trade, specialization, and integration

In terms of intra-EU trade, we see can see from Table 5 .2 that some members of the EU tend to be moregeared to trading within the EU than others . For example, the trade intensity of economies such as the UK andGermany tend to be less EU centred, while countries such as Spain, the Netherlands, and Portugal tend to bemore Euro-centric in their trading habits . Given these differences, an examination of the EU as one bloc showsthat exports from EU countries to other members of the Union as a proportion of their total exports of goodsand services that is, total intra-EU exports increased over the period 1986 93 . Although not shown in thistable, intra-EU trade in manufacturing rose strongly from 58 to 68 per cent, and services from 45 to 5 0 percent over the period) . The US share of exports to the EU has remained the same, while an increasing


6/32

proportion of Japan's total exports has been geared towards the EU . On the import side, we see that importsinto EU countries from other EU countries as a proportion of all EU imports have remained steady, as has theproportion of total U S and Japanese imports that came from the EU . It might be useful at this stage to enquirewhether these figures give us any clue as to whether the single market programme ( SMP) has led to a net trade creation for the EU .

Trade creation is the situation where the removal of trade barriers within the EU replaces a country's localproduction with more efficient imports from within the EU, leading to an increase in overall welfare . Tradediversion occurs when the barriers to trade that still exist between the EU and outside countries lead EUcountries to switch their imports from more efficient outside countries to countries within the EU, thusdecreasing overall welfare . The idea here is that the lowering of trade barriers within the EU can make thegoods of EU countries more attractive to each other, thus resulting in increased trade flows between them . However, the remaining trade barriers between the EU and countries outside might result in some of the tradepreviously done with countries outside the EU (extra-EU trade) being diverted to countries within the EU . A cursory glance at Table 5 .2 shows that between 1986 and 1992 the share of EU imports in total imports didnot change within the triad (EU, U SA, and Japan) that is, trade diversion was minimum . At the same time, thefigures show that the EU had become more open as a destination for both EU and triad exports that is, tradecreation had taken place . These tentative conclusions are based on the period 1986 92, since the change instatistical reporting after 1993 created difficulties in comparing pre- and post- 1993 figures . However, the tableseems to indicate that net trade creation appears to have taken place as a result of the SMP.

Although the above analysis has given us an insight into trade flows in general, it has not provided a sectoralanalysis of competitive conditions in the EU . To provide this type of information, it is necessary to take thediscussion down to the level of the industry concerned . Inter-industry trade refers to the situation where somecountries within the EU tend to specialize in the production and export of products of industries where theyhave a comparative advantage (that is, those in which they are relatively more efficient), while importing fromother countries the products of different industries in which these countries have a comparative advantage . Insimple terms, this type of trade involves an exchange of products from different industries . On the other hand,intra-industry trade is based on the exchange, between countries, of products that are classified as being inthe same industry; that is, it involves trade in similar products .

Inter-industry trade carries efficiency gains, because each country can specialize in commodities in which it isrelatively more efficient so lowering prices and benefiting consumers . However, this sort of trade may entail

redistributive effects, since production may have to close down in less efficient industries, leading to a fall inincomes or unemployment in those sectors . The cost of adjustment is also high for companies, since it may not be easy to shift resources from one industry to another .

Intra-industry trade also carries benefits in that consumers of various countries have a greater variety of products from within a given industry to choose from, as countries continue to exchange a large range of products from within the confines of the same industry . In this case, the redistribution and adjustment costsare less, because resource shifts are not so large, since it is less likely that the whole of an industry willdisappear as a result of competition . Also, adjustment costs are lower, since companies are involved in shiftingresources to similar products within the industry rather than closing down altogether . A study of the nature of inter/intra-EU trade will, therefore, give a clearer view of the structure and nature of competition in the EU .

Before analysing these trends, it would be beneficial to discuss the forces that determine the nature of EU

trade flows and hence the nature of inter- and intra-EU trade . First, as was intimated earlier, trade flows arepartly determined by comparative advantage, in that countries with different relative endowments of resourcescan specialize in certain commodities and then exchange these internationally . Secondly, trade flows are alsosensitive to changes in transport costs, since, as transport costs fall, the volume of trade will expand, oftenaffecting the location of such trade . For example, before transport costs fall significantly, production may tendto be located somewhere near the centre of the EU, where the main market lies, but, as costs fall, locatingproduction on the periphery of the EU becomes more feasible . Thirdly, the potential benefits derived frominternal economies of scale can stimulate trade flows in those companies whose domestic market may havepreviously been too small to sustain the outputs necessary to enjoy such economies .


7/32

Fourthly, the volume and nature of trade patterns are also determined by technological factors . Countries that tend to have firms that are technology/R&D intensive may become more internationally specialized and thusincrease their ability to engage in profitable worldwide exports . A fifth, and increasingly important factor that has a powerful effect on trade is the trend towards product differentiation . As average incomes rise, there is awell-known tendency for consumers to demand a greater range of goods . At the same time, technologicalprogress and increased R&D expenditure mean that firms discover new product specifications that are different from other products even in the same industry .

Some products may be differentiated because of their clearly perceived quality differences, while others maybe very similar in quality/price but be differentiated by some other characteristics for example, colour range,and so on all designed to meet the increasing demand for variety . Finally, the role of national governments intrade creation should not be forgotten . For example, the opening-up of the EU through the SMP has meant that governments have had to dismantle trade control and decrease other regulatory constraints that previously inhibited trade . The influences of the above factors on the relative growth of interand intra-industrytrade varies . For example, any growth in the importance of comparative advantage would tend to enhanceinter-industry trade, while, the greater the influence of technology/R&D as incomes rise, the more likely it isthat intra-industry trade will be stimulated .

With the above theoretical framework in place, we can now trace the pattern of trade within the EU over the1990s in order to clarify the competitive forces at work . Table 5 .3 shows the shares of inter- and intra-industrytrade in different trade categories in 1994 and the change in the shares between 1987 and 1994 . In 1994inter-industry trade accounted for 38 .5 per cent of total trade within the EU, while the share of intra-industrytrade in similar or homogeneous products was 19.2 per cent and trade in differentiated products stood at 42 .3per cent .

Table 5 .3 indicates that EU inter-industry trade (that is, trade between countries in products of different industries) declined significantly over the 1987 94 period, while intra-industry trade (that is, trade betweencountries in the products of the same industries) rose . The intra-trade category has been divided into twohomogeneous and differentiated products . The former category includes products of the same industry that are very similar in price and quality, while the latter includes products that are quite different in terms of priceand quality . Over the period, both increased their share of EU trade, but particularly the differentiatedcategory . On average, inter-industry trade accounted for more than half the trade mainly, but not exclusively,in economies with lower levels of economic development for example, Greece, Ireland, and Portugal while

intra-industry trade, both in similar and particularly in differentiated products, was higher in the moredeveloped economies of the EU . Although not shown on Table 5 .3, it should be noted that inter-EU-industrytrade is located mostly in sectors such as food and beverages, mining, non-metallic minerals, and textiles,which account for one-third of manufacturing value added . On the other hand, intra-trade is located mostly insectors such as electrical and non-electrical machinery, motor vehicles, chemicals, scientific instruments,televisions, video recorders, and so on, and accounts for two-thirds of manufacturing value added .

While the analysis above has pinpointed the importance of inter- and intra-industry trade across the EU, weneed to take a closer look at the nature of the products being traded in order to provide us with a clue as tothe specialization process in terms of quality products . Table 5 .4 shows that in 1993 4 high-price/quality goodsrepresented more than 4 0 per cent of exports in countries such as Ireland, Germany, Denmark, the UK, andFrance, while low-price/quality products represented more than 25 per cent of total exports in Portugal,Greece, Spain, and Italy . The influence of multinational investment in assembly and technology industries in

Ireland has been important in placing the country in the high-quality category . If we want to look at whichtypes of products are being traded between nations, rather than what each nation produces, then we shouldinvestigate the trade balance in different types of products . The countries with the strongest trade balance inhigh price/quality goods are Ireland, Germany, and France, whereas the UK, the Netherlands, Benelux, andDenmark tend to have the strongest trade balance in medium price/quality goods . Spain, Greece, Italy, andPortugal appear to have positive trade balances in the low price/quality range .

EU countries also show a tendency to have particular strengths/specializations in the products of certainindustries . For example, trade balances tend to show that the UK has strengths in the electrical machineryindustry, particularly in the medium- to high-quality range . Portugal has particular strengths in textiles, wood,


8/32

and paper, especially the medium -and low-quality range . Germany is the only EU country that does not showstrong industrial specialization in any one area . Its major strengths are to be found in the products of manyindustries, most of which are in the high-quality category .

A final point of interest is to investigate whether the development of the SMP has affected the structure of production (value added) in the different countries . In other words, has the structure of manufacturingproduction and exports tended to converge across EU countries as a result of the freeing of trade from variousrestrictions? Comparisons of 1985 and 1994 figures tend to show that the structure of value added and exportshas become more similar across EU countries, a conclusion that seems to contradict the analysis of Krugman(1995) that the elimination of barriers would lead to more specialization and an increasing dissimilarity in thestructures of output and exports . However, it is possible that, after an initial convergence, there might be amove to greater country specialization once more .

3 .2 Trade, investment flows, and multinational activity

The trade flows described above are inextricably bound up with international flows of capital between nations . One of the most important forms of capital flow that involves industry and services directly is that designatedas foreign direct investment ( FDI). FDI is a long-term investment relationship involving significant control by aparent company investor in one country over another enterprise located in another country . Technically

speaking, FDI has three components: equity capital, reinvested earnings, and other capital . Figures for FDIinclude the value of shares held by a home-based parent company in an affiliated foreign enterprise, providedthat the value of such shares exceeds 10 per cent of the total value of the voting capital of the affiliateenterprise . FDI also includes any retained profits earned by the affiliated company together with any long orshort-term borrowing between parent and affiliated company . In effect, the direction and character of FDIflows are intimately bound up with the operation and strategies of multinational enterprises (MNEs) .

In more practical terms, FDI usually takes the form of a parent company in one country setting up a brandnew subsidiary company abroad that is, a greenfield investment or a company acquiring, or merging with,a company based in another country . Whichever way the FDI takes place, it results in substantial changes tothe location and strategy of companies and hence the flows of goods and services in a global environment . Historically speaking, the relationship between trade and FDI in the manufacturing sector has been simple, inthat companies have usually supplied home markets first, and then, through exports, licensing, and other

methods, begun to sell their products abroad . When a firm finds it can extend its market and improve itsprofits by producing abroad, it will begin to engage in FDI. In this way, FDI becomes a substitute for trade . However, if domestic manufacturing firms are searching for low-cost inputs for example, labour they mayengage in international production immediately via FDI and thus create new trade .

In both these situations, trade and FDI can be viewed as options for the manufacturing sector . However, it hasbeen more difficult for services to follow the manufacturing pattern that is, from domestic production totrade, and then on to overseas production . This is because services often need to be delivered to the customerin the locality where it is demanded in the first instance . In other words, services have traditionally been less

tradeable across boundaries than goods . This may account for the shift in world FDI stock towards servicesover the last fifteen years of the twentieth century, as affiliate service companies were set up abroad orthrough international takeovers and mergers in the service sector . However, it should be noted that the rapiddevelopment of information-intensive services in recent years has begun to make some of these services moretradeable . For example, telecommunications and information-technology (IT) developments can mean that service companies in one country can export their services overseas via these links without setting upsubsidiary companies abroad through FDI.

The importance of FDI may be gauged by realizing that in 1995 the total outward stock of FDI in the worldeconomy stood at $2,73 0 billion (Table 5 .5). The additions to such a stock that is, the flows of FDI grew at aphenomenal rate of 24 .7 per cent per annum in 1984 9, before falling to 12.7 per cent per annum in 1990 5as a result of the slowdown of the world economy in the early 1990s. These growth rates of FDI outstrippedthe growth of trade in goods and services, which showed yearly growth rates of 14.3 and 3 .8 per cent over the


9/32

same periods . In 1995 the value of the total stock of FDI was equivalent to 48 per cent of the world's grossfixed capital formation (G FCF) and 11 per cent of world GDP for that year .

Table 5 .5 also helps to show that the bulk of the world's stock of FDI (92 per cent) is concentrated in thedeveloped countries, and also that, over the period 1984 95, some 9 1 per cent of the total annual averageoutflows, and 66 per cent of the total annual average inflows, of the world's FDI came from, or went to,developed countries . In other words, the bulk of the flows involved the developed countries investing in eachother . From the context of the EU, we can calculate from the table that this region accounted for 44 per cent of the total world outward stock of FDI in 1995 . Between 1984 and 1995 the EU accounted for 32 per cent of the world's average annual inflows, and 5 1 per cent of the world's average annual outflows, of FDI.

Figures for 1996 show that the total inflow of FDI into the EU was 66,822 million ecus, of which 4 0,947 millionecus, or 6 1 per cent came from within the EU and 39 per cent from outside the EU (3 0 per cent from the U SA). These figures help to show the extent of the intra-investment activity in the EU . Of the cumulative FDI inflowsbetween 1984 and 1996, some 65 per cent were in the service sectors, whilst about 3 0 per cent went tomanufacturing . This follows from the dominance of the service sectors in most economies and the fact that,since services are less tradeable, it is not surprising that FDI and multinational activity have often been theonly way to supply foreign markets . For example, the impact of the SMP on German outward FDI between1987 and 1992 was to increase it by ($ 13.7 billion) or 17.5 per cent . Of this amount, the contribution of distribution ($2 .9 billion) and finance and other services ($8 .9 billion) have dominated, indicating theimportance of such services in intra-EU investment (Pain and Lansbury 1997) .

The rationale behind such FDI flows (that is, that firms prefer to produce abroad rather than export) iscomplex, although the groundwork for such rationale was laid down in the work of Dunning ( 1995) . Heindicates that such decisions often depend on three conditions . First, ownership-specific advantages: i .e . a firmmay possess assets that are internal to the firm that provide a cost advantage over a local rival in a foreigncountry (for example, it may have a better processing technique or capital resources) . Secondly, locationaladvantages: a firm may locate a subsidiary overseas in order to overcome trade barriers or to take advantageof cheaper foreign factors of production or foreign markets . Thirdly, internationalization advantages: a firmmay prefer to set up a subsidiary abroad to ensure stability of supplies or to protect the quality of service .

These basic ideas have been modified through the 1990s as the nature of economies has changed . Forexample, ownership-specific advantages have tended to be seen less in terms of traditional assets such as

capital and more in terms of knowledge based assets . This idea revolves around firm specific activity such asproduction processes, product innovation, and other activities that involve intangible assets such asmarketing, management skills, and R&D . These types of assets are easily transferred back and forth betweendifferent locations at little cost and can, therefore, give firms significant advantages . For example, a multiplant MNE firm need make only a single investment in R&D, which it can spread over many overseas plants, whilst independent firms must make their own R&D investment (see Insert) . Such MNEs can enjoy joint input sharedacross various plants, which gives economies of scale to the firm rather than at the specific plant level . Twoother examples of the idea of a knowledge-based firm specific asset can be seen in a situation where a singlemulti-plant firm can locate production near a market and, using knowledge-based assets, customize theproduct to that market with the help of its specific knowledge of computer techniques, brand imaging, etc . Similarly, knowledge-based assets also encourage firms to engage in FDI rather than licensing foreign locals toproduce the product or service . This is partly because licensing has the risk that quality may not be maintainedor that technical secrets may be lost . Interestingly, the level of FDI and its industrial pattern seem to be

determined partly by knowledge-based factors such as expenditures on R&D and patents . The work of Krugman ( 1995) has pointed out that theories that try to explain the location of FDI and MNEactivities in terms of the classical comparative advantage lines need to realize the fact that modern competitionoccurs within imperfect markets and is based to a great extent on product differentiation . This means that FDIand MNE activities may be more strongly related to the interaction between, on the one hand, the advantagesof knowledge-based firm-specific assets that facilitate product differentiation, and the structure of barriers totrade between large blocs such as the EU and N AFT A, on the other . It is interesting that the integration of theEU market has not necessarily led to rapid concentration of production in a smaller number of plants, as has


10/32

happened in large markets such as the U SA. This may be partly due to the activity of knowledge-based MNEsoperating in an area such as the EU with its diverse national markets and consumer preferences .

We can see some of the complexity of motives for FDI if we investigate the trends in EU FDI. For example, thelocation of outward FDI flows from German firms tends to have been influenced by the development of theSMP. German firms have tended to divert FDI towards the EU as a result of the SMP. Within the EU, theirlocation decisions have been more sensitive to cost factors for example, labour costs and tax burdens . However, investment outside the EU has been determined more by market pull and the existence of specializedproducts .

Meanwhile, the motivations for Japanese FDI in the EU has been largely due to the existence of EU barriers tooutside trade and the strength of its legislation-for example, dumping regulations . Once inside the singlemarket, the Japanese have located according to cost conditions, such as labour flexibility and labour costs . Asfar as the UK is concerned, it has been successful in attracting labour intensive FDI because of its lower labourcosts especially in the non-manufacturing industry but poor in attracting capital intensive investment,especially from high-tech, producers for whom labour costs are not as important . This is disappointing,especially when one of the major sources of UK technical progress is FDI.

Finally, it is interesting to note that, despite labour flexibility and low labour costs in the UK, there has been notendency to exploit economies of scale at home and then increase exports to the EU, instead of investing inother members of the EU . This tends to substantiate the fact that outward investment has an important role tohelp open up markets, thus allowing the UK to exploit whatever knowledge-based firm-specific benefits it hasover local firms abroad . An idea of the major EU companies who engage in multinational activity can be seenby scrutinizing the top twenty EU companies by capitalization, as shown in Table 5 .6. Although they aredominated by goods industries, a quarter of the companies shown are in the fast-growing banking andinsurance-sectors .lt would be beneficial at this stage to realize that one important feature of internationalproduction through FDI is that of intra-firm trade across international boundaries . In other words, the flows of goods and services between parent firms and their affiliates and vice versa, as well as the export and import between the affiliates themselves, are an important part of a nation's trade flows and determine the structureand competitiveness of their economies .

An idea of such MNE activity can be gauged from the latest figures available for the numbers of parent firmsand their affiliates worldwide, as seen on Table 5 .7. In total there were in 1995 some 38,747 parent companies

operating abroad with 265,55 1 affiliates . The sales of foreign affiliates in 1995 were $6, 022 billion which wasgreater than the world's export of goods and non-factor services at $4,7 07 billion. The 100 largest MNEsranked by foreign assets abroad accounted for 33 per cent of global FDI stock and in 1995 employed 12 millionor 16 per cent of the 73 million people employed by all MNEs worldwide . An overwhelming 88 per cent of parents originated in the developed regions, while the affiliates were more spread out among the regions of the world . Table 5 .7 provides a further breakdown of the FDI/MNE situation in the EU . Here we see the mainlocation of foreign affiliates and the share of total FDI inflows in EU countries . The activity of thesemultinationals and their effects on different EU economies can be striking . For example, intra firm exports byMNE's can make up quite a high proportion of total exports of some countries . We can measure this proportionby adding the value of the exports of parent MNE firms based in a country to the exports of any foreigncompany affiliates also resident in that country . If we compare this figure to the country's total exports thenwe can have an idea of the role of intra-MNE trade in total trade . The figures for exports are as follows: U SA 36%, Sweden 38%, France 34%, and Japan 25% . The figures for imports are 43%, 9%, 18%, and 14%

respectively . The main conclusion here is that FDI investment has helped to create powerful trade flowsbetween various sectors of the same company, which has implications for a country's total trade and thecompetitiveness of its industries and services .

Together with the growth of intra-firm exports, we find that the relationship between different parts of the firmhas also changed . For example, the flows between parent and affiliates and vice versa have become lessimportant and the flows between affiliate and affiliate have increased . In other words, the affiliates of largeMNEs are forming closer links with each other in certain regions of the world . The most complete insight intothis process may be seen by investigating the global trade flows between U S parent companies and theiraffiliates . At the world level we see that the share of affiliate to affiliate trade as a percentage of all intra-firm


11/32

trade (i .e . parent to affiliates + affiliates to parent + affiliate to affiliate) for U S MNEs between 1977 and 1993rose from 3 0 to 44 per cent . If we look at U S MNEs in the EU, we find that the figures rose slightly from 68 to71 per cent over the same period . These figures show that the intrafirm trade of U S MNEs has been relativelyhigh in Europe, even before the SMP. The intra-firm integration already apparent in the EU is spreading todeveloping Asia, where the figures in 1977 and 1993 for U S MNEs were 23 and 35 per cent respectively . Usingthe U SA as an example, we can see that the general trend will be for more intraaffiliate integration across theMNEs of most major countries .

Interestingly, the above analysis included MNEs in all sectors . The case of intra-firm exporting in manufacturingis more well known, as parts and intermediate products are sent from one affiliate to another for processing orassembling that is, tradeable flows are created . On the other hand, the parts of the service sector that arerelatively tradeable are normally produced abroad by setting up identical clones in the other country and theamount of intra-firm division of labour is quite underdeveloped (with the exception of financial services) . However, the rapid technological developments in telecommunications and computers may make someservices more tradeable-for example, financial services, professional services, consulting and engineering R&D,and information-intensive industries as a whole . This means that, instead of having to engage in FBI to set upaffiliates abroad, some of these services can be exported from their home base that is, become moretradeable . This may create a new set of international flows in services without necessitating any movement of capital or labour .

Spreading R&D costs

One of the reasons why BMW bought the Rover Car Company was so that it could spread the costs of R&Dover a bigger market . These costs have been escalating in recent years and sales of the BMW models were nolonger large enough to generate enough income to cover these costs . (It was also, of course, a quick way of obtaining an established brand name .)

4 EU mergers, concentration, and size of firmTo understand the linkages between FDI and MNE activity in both a world and an EU context, it is necessary tounderstand that mergers and acquisitions (M& As) are a popular way for firms to restructure in order toimprove their international competitiveness . By selling off divisions/subsidiaries they do not need, andacquiring other subsidiaries, they can often enhance their effectiveness . Such reorganizations are a quick wayof acquiring established brand names, supplier networks, and technical expertise . Although the value of FDIand M& As is not identical, they tend to follow each other, since they have one important common element . They both include foreign equity investment, a feature that was discussed above when we defined the termFDI. While much of the investment flow is designed to set up new production sites abroad, a significant amount is also used to take over foreign companies or merge with them, creating an instant MNE .

4 .1 Mergers and acquisitions

M& A activity can be defined in two ways . A merger is usually defined as a situation where two companiesagree to join to become one entity . However, the definition of an acquisition is a little more complicated .

Majority cross-border acquisitions refer to business combinations where the investor acquires at least 5 0 percent of the voting securities of the resulting business, and, in general, this means that the deal has involved achange of ownership . Minority cross-border acquisitions refer to the situation where less than 5 0 per cent of

the voting shares are acquired . The latter often occurs when companies forge links with the aim of diversifying,engaging in loose cooperative activities, or forming joint ventures . The total value of world cross-border(majority plus minority) M& As doubled between 1988 and 1995 . By the latter year, the EU accounted for 48per cent of the world's M& As as compared to 35 per cent for Japan and 3 0 per cent for the U SA.

In 1995, if we take mergers plus majority acquisitions only, the sectoral distribution of the world's M& As wereas follows: primary sector (9 per cent), secondary sector (4 1 per cent), and tertiary sector (5 0 per cent) . Within the secondary sector, the greatest share of world M& A activity was to be found in food, drink, andtobacco ( 10 per cent) and in chemicals and pharmaceuticals ( 13 per cent) . In the tertiary industries thedominant area for M& A was banking and finance ( 13 per cent) . Between 1988 and 1995 the growth of majority


12/32

M& As was particularly active in chemical, pharmaceutical, and finance sectors . If we also include figures forminority control in the M& A figures, then sectors such as electrical engineering in the secondary sector, andthe utilities and the media in the tertiary sector, become important, reflecting the increasing cooperativeactivity between enterprises in such sectors .

The share of EU M& A in the worldwide total more than doubled between the mid- 1980s (2 0 per cent) and1995 (48 per cent), so that many of the world trends shown above are also relevant to the EU case . Of the EUtotal share of world M& As in 1995 of 48 per cent, 32 per cent were basically intra-EU mergers and 16 per cent extra-EU. During the 1990s, mergers and majority acquisitions accounted for around 6 0 per cent of total M& A activity in the EU . This figure decreased over the decade, reflecting the growth of minority ownership as therelationship between firms becomes more complex .

Table 5 .8 shows the breakdown of M& As across the EU and the nationality of the partners . It also shows thosecountries whose companies were active acquisitors (bidders) and those countries whose companies werevulnerable to mergers and takeovers (targets) . What becomes obvious from this table is that over the period1986 95 some 7 0 per cent of all EU M& As were purely domestic occurrences, with such M& As beingparticularly important in the restructuring in the largest economies such as Germany, France, and the UK . Secondly, the smaller countries on average tended to have a greater proportion of EU-based M& As. Thirdly,the countries most active in M& A activity with firms outside the EU were the UK, Ireland, Austria, and Sweden,while the larger economies of Germany, France, and Italy were much less involved in such activity . Finally, it isinteresting to note that the most aggressive bidders in EU cross country mergers were the UK, France, and theNetherlands, while the target countries were pre-dominantly Germany, Italy, and Spain .

The sectoral breakdown of M& As shows that up to the late 1980s most restructuring through M& As occurred inthe manufacturing sector, while during the first half of the 1990s the service sectors became increasingly moreimportant . In 1995 . for example, the total number of M& A operations in services ( 2,600) exceeded thenumber in manufacturing ( 2,300), as the effects of the SMP began to filter down to the less tradeable servicesector . Within this sector, the M& A activity in banking and finance comprised some 18 per cent of both nationaland EU cross-border M& As, while the distribution/hotels section accounted for 8 percent of all national M& Asand a more impressive 17 per cent of EU cross-border M& As. However, some 7 0 per cent of M& A activity inthe service sector was primarily domestic as compared to 6 0 per cent for manufacturing, which may reflect thefact that the SMP changes have been slower to be implemented in services than manufacture . However,buoyant M& A activity in the banking and finance sector tends to show that national and international mergers

in services may grow together in the future . For example, since 1989 large national mergers in banking(TSB/Lloyds Bank (UK 1995) and Midland Bank/H SBC Holdings (UK 1992)) and insurance (U AP/ Axa ( France1996)) have also been followed by increasing interest in international mergers, as evidenced by the 1997activities shown between B AT/Zurich and Generalli Assicurazioni/ Assurances Gnrales de France in insurance,and Merita/Nordbanken in banking .

The rapid change in the market environment brought about by deregulation led to an increasingly moreefficient European capital market, with more companies being quoted on the exchanges and more capitalavailable for investment . At the same time, there was a more effective market for corporate control asinstitutional investors such as pension funds and insurance companies became more dominant . These featuresallowed companies that wanted to diversify and restructure to take advantage of the more efficient market forcorporate restructuring . One such mode of restructuring is external to the firm-that is, through mergers,acquisitions, joint ventures, or equity participation . This activity grew rapidly in the 1990s and the pattern is set

to continue in the future . The natural question that remains is the extent to which the growth of M& As in the EU has gone hand in handwith changes in the structure of various sectors . To investigate this a little further, it would be beneficial tolook briefly at the trends in concentration ratios and firm size across the EU and to ask whether these haveaffected EU competitive environment . This latter proposition will be investigated after we have discussedconcentration and firm size .

4 .2 Concentration


13/32

Concentration ratios are normally defined in terms of a four- or five-firm ratio . In other words, it measures thecombined production of either the four (C4EU) or the five (C5EU) largest producers in a specific industry as ashare of total EU production of that industry . Statistical tests have shown that the difference in the predictiveresults obtained from using either of the ratios is small, so that they can be used as alternatives . From aninternational perspective, comparable data for the manufacturing sector for 1995 show that the C4EUmeasurement for the EU (2 1.8) was lower than for the U SA (35 .7) and Japan (55 .4) . Given that the U S (and toa lesser extent the Japanese) manufacturing sector is roughly comparable to that of the EU, then one might expect EU concentration levels to rise as the EU market becomes more integrated under the SMP movement . Obviously, concentration will differ between different industries, and to measure this it may be beneficial todivide the manufacturing industry into two main categories . The first type of industry (type 1) is where theproducts are relatively homogeneous and where the influence of scale economies is important . This means that the predominant form of competition is through price (as in shipbuilding, cement, cotton, wood products, etc .). The second type of industry (type 2) is not restricted to the use of price competition as the only competitiveweapon . Instead, this type depends more on advertising and/or R&D and uses these as their main competitiveweapon . This type may be predominantly advertising intensive (type 2 A) (food, confectionery, beer, tobacco,etc .), or predominantly R&D intensive (type 2R) (chemicals, telecommunications equipment, office machinery,electrical machinery, aerospace, etc .), or a mixture of both (type 2 AR) (pharmaceuticals, soaps, detergents,radio and television, motor vehicle) . As far as EU manufacturing industry is concerned, in 1995 type I covered52 per cent of manufacturing industry, type 2 A13 per cent, type 2R 25 per cent, and type 2 AR14 per cent of EU manufacturing .

Research on concentration ratios across EU industry has shown that sixteen out of the twenty most concentrated industries (C5EU > 33 .3%) are in type 2 industries, indicating the high advertising and R&D-related costs of product differentiation . This trend is shown when the concentration ratios of the EU arecompared with those in the U SA (i.e. US C4/EU C4). We find that U S /EU concentration ratios are relativelyhigher for both type 1 (2.08) and types 2 ( 1. 36), but, as can be seen, the gap is smaller for the latter type . Inparticular, the EU's R&D-intensive industries (type 2R) are the most concentrated/integrated ( 1.1 5) ascompared to those in the U SA, followed by type 2 AR (1. 27) and type 2 A (1.67) . However, if, in the future, theEU moves towards the U S industrial pattern, the pressure for increases in concentration may come from type 1 and type 2 A industries .

Absolute levels of concentration and the growth of concentration in the different types of industries within theEU between 1987 and 1993 are shown in Table 5 .9. Here we see that the C4EU ratio was much lower in the

type 1 industries than in type 2, with R&D-intensive industries (2R) and advertising and R&D industries (2 AR)being more concentrated . The growth in concentration was positive for all types, but particularly so in theR&D-driven (2R) sector . These trends show that, in the industrial sector, the sectors that depend mostly oneconomies of scale that is, plant-based economies are not the most concentrated across Europe, since, asthe market grows, the minimum efficient scale becomes smaller relative to the size of the market and so thedegree of concentration remains small . However, those sectors that are based on advertising and R&D tend tobe more concentrated, partly because their success depends on creating greater product differentiation that is, either perceived or actual changes in quality . This means that they invest more heavily in advertising andR&D expenditures, which then become strategic weapons in such industries to enable them to improve theirmarket share . The need for large firm-based outlays in such industries tends to contribute to higher levels of concentration in type 2 sectors in the EU (Davies and Lyons 1996) .

In terms of services, increased concentration has been experienced in distribution and road freight transport as

a result of the SMP, although the highly regulated services such as telecommunications, airlines, or retailbanking have experienced less European-wide concentrations although more national concentration .Theindustrial restructuring shown by the level and change in industrial concentration shown above is, to someextent, related to the evolution of firm size across the EU . The argument here is that the increase inconcentration and size of firms may signify efficiency gains as reflected by the growth in the size of plants(production economies) and/or growth of assets shared by the whole firm (research, financial, or advertisingeconomies) . The opening of the EU market will exaggerate these features, as firms are able to benefit fromaccess to specialized knowledge available from other countries of the EU . Firms in the manufacturing sector, aswe have seen, where the goods are more tradeable, may grow relatively more as a result of plant-based


14/32

economies, while firms in the service industry may be more likely to grow as a result of setting up foreignestablishments to spread their knowledge and skills abroad .

4 . 3 Size of firm

On an absolute level, the distribution of firms by size according to turnover/persons per enterprise variesacross the EU, as seen in Fig 5 .4. Countries can be grouped into three categories . The southern countries,Greece, Spain, Italy, and Portugal, have the smallest average enterprise size in the EU, especially in the retailtrade and craft sectors . Germany, Luxembourg, the Netherlands, and Austria have the highest average size of enterprise, twice the size of the southern countries . Belgium, Denmark, France, Ireland, Finland, Sweden, andthe UK are in a middle position .

If we look at the sectoral distribution of enterprises in the EU (Table 5 .10 ), we find that the larger firms arelocated in the traditional capital intensive industries (energy and extraction industries) and also in themanufacturing sectors (chemical and metal manufacturing) and the other services (air transport, banks, andinsurance) . The smaller size of company is clearly located in the construction sector, and in services such asthe trade, hotel, restaurant, and catering sectors .

Within this pattern, there are great differences . For example, in Luxembourg the importance of larger firms in

the financial sector exceeds the EU average, while the importance of larger manufacturing firms in Germanindustry exceeds the EU average . In manufacturing, the most significant cross-country difference can be seenby taking the gross value-added (GV A) figures for the average company . In Germany in 1992 the figure was7.4 million ecus per company, while in France (4 .9 million ecus), UK (4 .8 million ecus), and Italy (3 .3 millionecus) the figure was much less . Over the period 1985 92 the growth in size of German GV A was 15.4 per cent,similar to Italy ( 15.4 per cent) but above France (7 .7 per cent) and the UK (- 0.2 per cent) . The difference inthe average size of firms has, therefore, remained largely unchanged . The relatively larger size of Germanfirms ranged across the motor-vehicle, chemicals, and engineering industries as well as in the more traditionalfood, textiles, and clothing . The impact of the SMP has not been great in this area, as those sectors that weremore sensitive to the SMP have not registered higher growth of firm size . This means that the changes in thesize of firms have been due more to the nature of competition within each sector . For example, the size of firmhas increased in the advertising-intensive industries (type 2 A) across the main EU countries, as firms hope togain economies of advertising and product development .

From the above account, one would expect some relationship between concentration data and the evolution of firm size across member states of the EU . Basically speaking, at the EU level, the more concentrated theindustry within individual member states and/or the higher the intra-EU multinationality, then the higher theconcentration . In other words, if individual member countries are experiencing an increase in concentration, it is not surprising that the overall EU concentration levels will increase . However, the overall EU concentrationlevel could also increase if more companies operated as multinationals across the EU, since their activity wouldbegin to dominate the EU industry as a whole . At the level of the member state, the concentration level wouldrise if the mean size of business grew more rapidly than industry size .

Let us now put these ideas into practice . We can see from Table 5 .9 that, for the member states, theconventional industries (type 1) and also the technologically intensive industries (type 2R) seemed toexperience slower growth in the size of firms than in the size of the industry between 1987 and 1993, since thenational concentration ratios tended to fall in these sectors . However, in the advertising-intensive sector (type2 A) we find that the growth of firm size was faster than industry growth, thus leading to an increase innational concentration ratios . However, what is interesting is that, if we look at the European concentrationlevels (C4EU), we find that the concentration ratios rose slowly for most sectors but very rapidly for thetechnologically intensive industry .

These facts tend to indicate two things . First, that between 1985 and 1993, the growth of EU concentrationratios in all sectors was generally above the growth of national concentration ratios, indicating a general shift towards concentration on the EU level . This movement was much more pronounced for the technologically


15/32

intensive sectors, which moved strongly towards concentrative activity at the EU level, probably reflecting crossborder multinational activity in this sector, as suggested in the above analysis .

Secondly, there was a strong growth in the size of firms in the advertising-intensive sectors, with concentrationratios growing positively on both national and EU levels . Again, this relates to a situation where thosecompanies in the advertising -and R&D-intensive sectors seem to be the ones that are sensitive to growth andconcentration, possibly reflecting the fact that these sectors have high fixed costs of R&D (spending on newproducts and processes) and advertising (spending on reputation and brand development) . With the increasingopenness of the EU market, the main benefits may be for these types of sectors, where competition is verymuch in terms of product differentiation . They will then invest even more in R&D and advertising across thewhole firm in order to gain an increased EU market share . This, in turn, leads to a larger size of company andincreased concentration at the EU level .

for many years strong brands have been the focus of major takeover bids by international companies . Forexample, in 1988 the Swiss company Nestl acquired the British company Rowntree-Mackintosh in order togain a strong foothold in the European confectionery market . It was recognized that there were significant financial advantages in buying brands such as Kitkat, Rolo, and Quality Street . (Chapter 20, p . 484)

Allied to the drive for geographic expansion, whether global or regional, is the increasing incidence of strategicalliances . (Chapter 18, p . 448)

5 Structural change, competition, and efficiencyTHERE seems little doubt that the development of the SMP has provided the platform for an increase inconcentrative activity both at the national and the EU levels . However, it can be argued that the growth of companies and the concentrative power that often accompany such power can have two possible effects . First,the SMP may result in the rationalization of firms by allowing them to benefit from plant/firm economies . Secondly, it also opens up the possibility for the abuse of monopoly power as a result of mergers, acquisitions,and concentrative power in general .

There are two main ways of assessing whether the development of the SMP and the structural features notedabove have been beneficial in terms of improved efficiency and increased competitiveness . First, we can assesswhether the company price-cost margin has changed as a result of the SMP. Price-cost margins are defined asvalue added minus labour costs divided by value added (or sales) . A second way of confirming improved

efficiency and increased competitiveness would be if, other things being equal, there were evidence that priceswere converging across the EU . Such evidence would suggest that the implementation of the SMP has helpedto create a pan European market with increased competition .

5 .1 Competition and price-cost margins

Evidence of the effect of the SMP on price-cost margins tends to show that EU countries can be placed intothree categories: those with high margins (Italy, Belgium), medium margins ( France, Netherlands, the UK, andIreland), and low margins (Germany, Luxembourg, Denmark, and Greece) . The cross-country dispersion inmargins was not systematic up to 1987, but after that period the dispersion fell, indicating inter-countryconvergence of margins . In terms of the trends in the margins themselves, the evidence tends to show that,after 1987, there was an average reduction of 0.25 per cent per year in margins . Those manufacturing sectorswhere the margins fell were in vehicles, consumer electronics, textiles, and clothing sectors where there wererelatively moderate tariff barriers before the SMP. However, other sectors, such as pharmaceutical productsand electrical equipment, which also had some degree of barriers before the SMP, did not show clear margindecreases . Interestingly, advertising and R&D-intensive industries (types 2 A and 2R) did not experience a fallin price-cost margins . This may be because such markets are, as noted previously, in the branded/qualityconsumer goods sector, where advertising and R&D costs are naturally high, making it necessary for marginsand prices to be higher . Interestingly, we noticed earlier that such markets tended to exhibit elements of concentration, and this may also help to explain the tendency for price-cost margins to be higher a symptomof excess market power .


16/32

The experience of services tends to follow that of manufacturing but to a lesser degree, as the SMP has not been as fully effective in services as is the case with manufacture . There have been particular decreases inprices in telecommunications, banking, and airlines, largely because of competition at the national level . Forexample, the margins in retail banking have fallen with the lower prices of credit cards, etc . Similarly, marginshave fallen in the road freight industry, leading to an average of 6 per cent fall in real transportation costs overthe 1985 94 period . This change has allowed firms to search across the EU for lower costs of inputs . Some 42per cent of businesses reported that the decrease in inter-country barriers had been important in acceleratingpurchases of raw material from other EU markets .

The change in the level of competition, and therefore in price-cost margins as a result of the SMP, can begauged from Table 5 .11. Here we see that firms in manufacturing have been confronted by more competitivepressures than those in the service sectors . Manufacturing tends to have more competition (in terms of number of competitors as well as price and quality competition) from other EU countries than service industry,where the main thrust of competition is predominantly domestic . Nevertheless it should be remembered that the service sector is not homogeneous and that, in areas such as financial intermediation, there seems to havebeen much more active price competition from non-EU enterprises, as the global financial competitionintensifies .

5 .2 Competition and price convergence

It was noted above that, if prices across the EU tended to converge over time in Europe, then this could betaken as an indicator that the EU market had become more open to competition . Despite the fact that priceconvergence can occur at relatively high levels because of collusive behaviour (when oligopolistic firms cometogether to agree prices), it is nevertheless true that, on average, the general convergence of prices acrossnational borders can give some general idea as to whether the EU market is becoming more competitive . A study by the DRI (DRI Europe Ltd . 1997) attempts to answer this question by calculating price dispersioncoefficients (standard deviation of prices divided by the average) over time for the manufacturing and servicesectors and then assessing whether the price movement is converging towards the EU average price .

The conclusions of the survey show, first, that the levels of price dispersion increased as more member states joined the EU (i .e. EU6, EU9, EU12, and EU 15) . Secondly, if we take figures for the EU 12 between 1980 and1993, we find that there was a general trend towards price convergence, with price dispersal being lowest

among the more tradeable products or services . In general, the consumer and equipment goods industriesexperienced more convergence than did energy, services, and construction . Finally, of the eighty-sixproducts/services categories for which there was a clear change in price dispersion, some seventy eight casesshowed price convergence, while there were only eight cases where prices diverged . These seventy-eight cases accounted for 6 0 per cent of total private consumption in the EU .

The pace of such trends depends on the nature of individual economies and their industrial structure, thenature of competition within such industries, and the effect of government policies . For example, it is not surprising that price dispersion increased as more countries joined the EU, since the smaller core EU6/EU9had more similar economies to begin with, and had had more time to become more integrated . Also, thegreater convergence of prices in the consumer and equipment-goods manufacture is mainly due to the fact that they became more tradeable as time progressed . On the other hand, the energy sector did not experiencesuch a decrease in price dispersion, mainly because energy markets are not fully liberalized and they areaffected by different levels of taxation in different countries . In the service sector, price dispersion was higherthan for more traded goods and decreased more slowly over time . This is partly due to the fact that pricelevels in services are strongly related to GDP per capita, so that the convergence of service prices is likely tohave been slower because of the disparities of per capita GDP levels across the EU .

Price convergence in services is particularly important, given that it has been slower than the goods sector . The price dispersal measure for the EU 12 was 33 .7 for 1985 and had decreased to 28 .6 by 1993 . The fact that the figures for durable goods over the same period was 2 0.8 and 16.4 shows clearly that price disparity andthe degree of price convergence partly depend on whether the output of the sector is tradeable or not . Nevertheless, within the service sector, there was stronger price convergence in postal services, banking and


17/32


18/32

IN 1994 total sales of medicines within the EU were 5 1,850 ecus, which accounted for nearly 25 per cent of world output . Some 15 per cent of the medicines were prescribed within hospitals, 74 per cent were prescribedmainly by general practitioners (GPs), and 11 per cent were bought for self-medication by individuals .

On the production side, economies of scale and scope are present in the industry, although, unlike the heavychemical sector, pharmaceutical output is relatively small and often general-purpose rather then dedicatedplant can be used . Research economies are linked to size, since only firms whose annual sales are over 1,000 million ecus are capable of developing new active products . Economies of scope are present in the discoveryphase, since research in one area can often give rise to many different products . The sector is marketingintensive, in that patented products sold under brand names are promoted directly to physicians or in themedical press, while only products permitted for self-medication can be advertised to the final consumer . Finally, because the pharmaceutical sector is fragmented, manufacturers distribute their products throughspecialist wholesalers who sell to retailers, although hospital medicines and self-medication products oftenbypass the wholesaler . All in all in 1997, production accounted for some 3 0 40 per cent of the turnover, R&D10 15 per cent, and sales and marketing some 15 20 per cent, and the sector is one that is both advertisingand R&D intensive .

There were some 2,662 pharmaceutical companies in the EU in 1997, compared to 775 in the U SA and 1,556in Japan, with some half of them located in Germany . However, the forty-eight largest worldwide firmsdominated the industry; they produced some 65 per cent of the world market by value, and also accounted for85 per cent of the world's R&D in the industry . In the EU the pharmaceutical industry was still dominated bysome fifteen companies, which had sales of more than 1,000 million ecus, representing a third of the world'stotal of such firms . Five of the twenty lagest EU companies can be seen in Table 5 .6, and if we had includedthe Swiss companies Roche Holdings and Sandoz in this group, then they would have taken second and sixthpositions respectively . The market is relatively fragmented, in that no one individual company had more than 7per cent of sales within any individual state . On average, the top ten had between 25 and 3 0 per cent of theretail market and the top twenty-five had between 4 0 and 5 0 per cent of the market of member countries . If we take the EU as a whole, no firm had as much as 5 per cent of the market .

In terms of market share by product, the best selling medicine in any country normally has less than 5 per cent of the market, with the top fifty having 25 35 per cent and the top 100 having 4 0 50 per cent by value . Themajor market concentration by products was greatest in the UK in 1994 and least in Germany, although figuresfor concentration did fall between 1984 and 1994, indicating the entry of generic products . Although the

overall level of concentration is low for medicines, it is still possible to have one or two therapeutic areasdominated by a few medicines accounting for a large proportion of sales as, for example, happened withZantac/Tagamet for stomach ulcers, before their patents ran out . To summarize, the pharmaceutical industryhas been dominated by a few large companies for many years, and, although the national concentration ratioshave increased, it has been mainly by the growth of the top seventy-five firms rather than at the top-ten level .

However, despite the lack of a large change in concentration ratios, there has been a degree of M& A activity inrecent years . Between 1989 and 1994 some 3 12 M& As occurred in the EU pharmaceutical sector, with nearly40 per cent of them between firms of the same country (i .e. national), with Germany, Italy, and the UK undergoing the largest internal rationalization . Some 27 per cent of the M& As were intra-EU mergers, withFrench, Italian, and German companies being the most frequently targeted . Finally, about 33 per cent of EUM& As involved companies from outside the EU, and here again the main target countries in over 8 0 per cent of the cases were France, Germany, Italy, and the UK . Apart from the massive SmithKline-Beecham merger, the

majority of the acquisitions were below 6 0 million ecus, which is too small to support genuine innovation . Thisfits into the growth of concentration but only at the middle to lower end of the size scale and may reflect thefact that many family-controlled firms may be disappearing . Between 1983 and 1993 employment in thepharmaceutical sector rose by only 10 per cent, while labour productivity rose by 54 per cent, partly as a result of rationalization activities through mergers . The rationalization through mergers still continued through to1997, with the Hoffman-La Roche/Corange, Nycomed/ Amersham International deals, together with thepossibility of new relationships between such companies as Zeneca, Astra, Novo Nordisk, Rhone Poulenc, andPharma .


19/32

The role of FDI and of multinational activity in the pharmaceutical industry has been important since before theSecond World War as multinational companies have attempted to overcome import barriers by producinglocally. The number of companies with plants in the EU but outside their own country of origin remained quitesteady between 2 00 (1984) and 2 07 ( 1994) . Of the total of 2 07, some seventy originated from France,Germany, and the UK, and seventy-eight from the U SA. Since 1994 the rationale behind the location of pharmaceutical FDI in Europe has varied, and a 1997 study of U S companies operating in the EU found that nearness to the size of the local market, the quality of its specific skills, and government incentives, togetherwith past experience, were the main considerations . If we take these criteria, then France, Germany, and theUK appear to be very attractive locations for U S multinationals in terms of both production and research . However, it is unlikely that many new greenfield facilities will be built, as growth is more likely to occurthrough M& As. This strategy is designed to gain some economies of scale and scope, not only in production,but also in marketing and sales . Where R&D is concerned, the great benefit of mergers is to cut out costlyduplication of overlap ping research .

While the above account has delineated the structure of the pharmaceutical industry, it is also necessary toassess the nature of competition within the sector . To understand this we need to study the components of competitive strength in this sector and then the nature of competition in the different markets . We can assessthe first of these aspects by looking at the three main world markets the EU, the U SA, and Japan andenquiring as to whether there has been a change in the shares of each one in the other's market that is, ashift in competitive strength . Basically, the distribution of competitive strength has been stable . For example,over the period 1982 93, EU based companies' share of the EU market fell only slightly from 65 .6 to 6 1.4 percent . However, EU-based companies' share of the U S market increased from 10.1 to 2 1.9 per cent in the sameperiod, much of this due to the growth of UK companies (their share of the U S market rose from 9 .4 to 15.1 per cent) . EU penetration of the Japanese market is small, as over 8 0 per cent of that market is served by localproducers .

Basically speaking, EU companies have maintained their strength at home and penetrated more of the U S market . The lifeblood of the pharmaceutical industry revolves around new innovations and new products . Inthis respect, 4 0 per cent of most original and innovative products discovered in the pharmaceutical sectorbetween 1975 and 1994 originated in the EU, with over half of the EU number originating in Germany and theUK . The USA accounted for 26 per cent . If we take the top fifty pharmaceutical products in 1994 worldwide,twenty-four originated in the U SA and seventeen in the EU (eleven from the UK) .

We have looked at the competitive strength of the sector; it is now relevant to look at the nature of competition in this area . To do this it is necessary to understand that nearly all medicines start

Date post:	10-Apr-2018
Category:	Documents
Upload:	lagnajit-ayaskant-sahoo
View:	222 times
Download:	0 times

The Structure of EU Industry and Services - Oxford Textbook of Marketing

Documents