Terminology

Introduction to Industrial Economics

Lecture 1 9 February 2006

Industrial Economics (IE) Economics of Industry (EI) Industrial Organization (IO)

Definitions

What is Industrial Organization?

Industrial organization is concerned with the workings of markets and industries, in particular the way firms compete with each other. Luis Cabral (2000)

Definitions
Industrial organization or industrial economics is the study of the operation and performance of imperfectly competitive markets and the behavior of firms in these markets. Church & Ware (2000)

Definitions
The main reason for considering industrial organization as a separate subject is its emphasis on the study of the firm strategies that are characteristic of market interaction: price competition, product positioning, advertising, research and development, and so forth

Definitions
Moreover, whereas microeconomics typically focuses on the extreme cases of monopoly and perfect competition, industrial organization is concerned primarily with the intermediate case of oligopoly, that is, competition between a few firms. (Cabral)

Competition
Why is competition important? What is market structure? What determines market structure? How is competition related to market structure?

Market Structures
Four types of market structure: 1. Monopoly 2. Oligopoly 3. Monopolistic Competition 4. Perfect Competition How do these markets differ from one another?

Elements of Market Structure

Number and size distribution of firms Type of product produced (homogeneous /differentiated) Ease of entry and exit Information flow between buyers and sellers Control over prices by established firms

Market Structures
Monopoly Number of Firms Type of product Entry Exit Conditions Information Flows Strategic Interactions Control over Prices One Homogeneous / Differentiated Zero Perfect / Imperfect No Full (One Seller) Monopolistic Many Differentiated Limited Perfect / Imperfect No/Yes Limited (Differentiated) Oligopoly Few Homogeneous / Differentiated Limited Perfect / Imperfect Yes Limited (Few Sellers) Perfect Competition Many Homogeneous Free Perfect No Zero (Price Taker)

Examples
Market Structure Monopoly Monopolistic Oligopoly Industry Electricity generation, fixed line telephone textiles, restaurants, furniture, costume jewelry automobiles, steel, pharmaceuticals, cereals, soft drinks, beer stock markets, primary commodity markets

Perfect Competition

Brief History
Perfect Competition Jevons (1871), Edgeworth (1881), Clark (1899), Knight (1921) Monopoly Marshall (1890), Sraffa (1926) Imperfect Competition - Monopolistic Market: Chamberlin (1933), Robinson (1933), Sweezy (1939), Dixit & Stiglitz (1977) - Oligopoly Market: Cournot (1838), Bertrand (1883), Chamberlin (1933)

Modern Industrial Organization

1940s-1950s: Structure-Conduct-Performance (J.S.Bain & Edward Mason) Post-1980s: New Industrial Organization (Tirole, Laffont, Bresnahan)

SCP vs. NIO

SCP Empirical Industry Structure, Performance NIO Theoretical Market Conduct

Structure-ConductPerformance (SCP) Model

Relationship between: 1. Market structure 2. Firms behaviour (conduct) 3. Firms performance

Questions
What type of market structure do we observe? What determines this market structure? How does market structure affect the way firms compete? What are the effects of these on prices, quantity, innovation etc

SCP Summarized
Structure Concentration Firm sizes Entry and exit conditions Product differentiation Vertical integration Conduct Policy objectives Marketing strategies Pricing policies Research & development Performance Profitability Efficiency Product quality Technological progress

Basic Market Conditions Demand Supply Price Elasticity Technology Substitutes Raw Materials Market Growth Unionization Type of Good Product Durability Method of Purchase Location

Usefulness of the SCP Model

Provides a systematic way of analyzing markets & industries Consistent with microeconomic theorys approach Policy implications for regulation & competition policy targeting structure or/and conduct

Market Structure No of buyers & sellers Product differentiation Barriers to entry & exit Vertical integration Diversification Cost Structures Government Policies Antitrust policy Regulation Taxes & subsidies Trade regulations Price controls Wage regulations Investment incentives Employment incentives Macroeconomic policies

Conduct Pricing strategies Product strategies Advertising Research & Dev. Plant Investment Collusion Mergers Legal strategies

Performance Allocative efficiency Production efficiency Technological advance Quality and service Equity

1. Structure
Concentration market power of firms measured by market shares (sales, assets, employees) Product differentiation uniqueness of products (brands, actual or imagined) Size of firms in relation to market size and minimum efficiency scale (& exploitation of scale economies) Entry conditions entry barriers that places potential entrants at a disadvantage Vertical integration extent of upstreamdownstream integration of production

Conduct
Policy objectives profit, growth, sales or non-financial objectives Pricing objectives price in relation to MC, or other types e.g. price discrimination, predatory pricing, penetration pricing, limit pricing etc. Marketing strategies product differentiation, advertising Research and development innovation activities (product, process)

Performance
Profitability (producer surplus) Efficiency (scale of production) Product Quality Technical Progress (Innovation)

Explaining SCP
Theoretical SCP: Structure Conduct Performance Empirical SCP: Structure Performance However, Structure Conduct Performance

New Industrial Organization

Focus on firm behavior (conduct, strategies) as a determinant of both market structure and performance: Structure Conduct Performance Game theoretic approach to modeling dynamic strategic interactions Critique of NIO: anything can happen

Schmalensees Critique
Game theory has proven better at generating internally consistent scenarios than at providing plausible and testable restrictions on real behavior Until gametheoretic analysis begins to yield robust, unambiguous predictions or is replaced by a mode of theorizing that does so, any major substantive advances in industrial organization is likely to come from empirical research.

(Not so) New Developments

Baumols contestable markets - what matters is not actual competition but potential competition (new insights on relationship between market structure, conduct, performance) Coase theory of the firm - vertical integration & disintegration (new insights on structure & conduct e.g. vertical restraints)

Alternative Approaches
Austrian School & Schumpeterian Competition as a dynamic process Abnormal profit is an important part of the competitiveness process Abnormal profits drive innovation they provide rewards & incentives for innovation Creative destructive forces disequilbrium / punctuated disequilibria? Entrepreneur as initiator of change (Schumpeter) or merely responding to change (Austrian School)

Chicago School
Use of price theory models Markets take on structures that are efficient Government should not intervene in markets Different conclusions from SCP on various issues (e.g. entry barriers, sunk costs)

Methodology
Formal Theory (mathematical) Empirical: - statistical / econometric - case study Computer Simulation

Policy Issues
Policy objectives: social welfare, consumer welfare Market failures? Imperfect markets? Missing markets? Regulation? Competition policy?

References
LW, Chapter 1 WJ, Chapter 1