Industrial Organization

Assoc. Prof. Daniela Popova, PhD

Autumn, 2012

What is industrial organization?

Defining the concepts
Industrialorganizationisthefieldofeconomics
thatbuildsonthetheoryofthefirminexamining
thestructureof,andboundariesbetween,firmsand
markets.
Industrialorganizationaddstotheperfectly
competitivemodelrealworldfrictionssuchas
transactioncosts,limitedinformation,andbarriers
toentryofnewfirmsthatmaybeassociatedwith
imperfectcompetition.Itanalyzesdeterminantsof
firmandmarketorganizationandbehavioras
betweencompetitionandmonopoly,including
fromgovernmentactions.
http://en.wikipedia.org/wiki/Industrial_organization

What is industrial organization?

Defining the concepts
Industrialorganizationfocusesonunderstanding
andevaluatingthebehaviorofbusinesses,the
marketsthattheyparticipatein,andtheinteraction
betweenthetwo.Thegoalistoincreasetheinternal
efficiencyofthebusinesssoitispoisedtocompete
moreeffectivelyinthemarketplace.Thisis
managedbynotonlyrefiningthestructureand
operatingprocessesofthebusiness,butalso
adaptingthemsotheycanmoreeffectivelyaddress
whatishappeningwithinthewidermarket.
http://www.wisegeek.com/whatisindustrialorganization.htm

What is industrial organization?

Defining the concepts
Industrialorganizationisconcernedwiththeworkings
ofmarketsandindustries,inparticularthewayfirms
competewitheachother.LuisCabral(2000)
Industrialorganizationorindustrialeconomicsisthe
studyoftheoperationandperformanceofimperfectly
competitivemarketsandthebehavioroffirmsinthese
markets.Church&Ware(2000)
www.cassey.com/io1.pdf

What is industrial organization?

Defining the concepts
WHATisIndustrialOrganization
StudyofHowfirmsbehaveinmarkets
Wholerangeofbusinessissues
priceofflowers;paymenttobeofficialsponsorof
majorevents
whichnewproductstointroduce
mergerdecisions
methodsforattackingordefendingmarkets
IndustrialOrganizationtakesaStrategicviewofhow
firmsinteract
http://www2.dse.unibo.it/barigozzi/corsi/IndustrialOrganization/P
epall01f.pdf

What is industrial organization?

Defining the concepts
ContemporaryIndustrialOrganization
WHAT:
Thestudyofimperfectcompetitionandstrategicinteraction
HOW:
Buildongametheoryfoundation
Deriveempiricallytestablepropositions
Econometricestimatesofrelationspredictedbytheory
WHY:
Motivatedlargelybyantitrustconcerns
Alsointerestinprivatesolutionstoinefficientmarket
outcomes

http://www2.dse.unibo.it/barigozzi/corsi/IndustrialOrganization/Pepall
01f.pdf

TheDemandforIndustrial
Thefieldofindustrialorganizationemergedafterthe
Organization

establishmentofnationalmarketsinmanufacturedgoods
attheturnofthecentury.Thesenationalmarketshad
twoimportantdistinguishingcharacteristics:(i)products
weredifferentiatedand(ii)oftentherewereonlyafew
relativelylargesuppliers.Thesefeaturessuggestthatthe
theoryofperfectcompetition,whichassumes
homogeneousproductsandlargenumbersofsmall
buyersandsellersisinapplicable.Ingeneralwewould
expectthatmarketsinwhichthereareonlyafewfirmsor
marketsinwhichproductsaredifferentiatedwillbe
characterizedbyfirmsthatarepricemakers,nottheprice
takersoftheperfectlycompetitivemodel.
Church&Ware(2000)

TheDemandforIndustrial
Organization
Bywithholdingsupply,largefirmswhichproduce
homogeneousproductsrecognizethatpriceswillincrease.
Afirmthatproducesadifferentiatedproductwillnot
experienceadeclineinsalestozeroifitraisesitsprice,
sincesomeconsumerswillstillpreferitsproduct,evenat
ahigherprice,thantheproductsproducedbyits
competitors.Inbothofthesecases,firmscorrectlyperceive
thattheyfacedownwardslopingdemandcurves.Small
numbersofcompetitorsorthepreferenceofconsumersfor
aspecificproductbestowssomedegreeofmarketpower
onfirms,andcompetitionwillbeimperfect.Marketpower
istheabilitytoprofitablyraisepriceabovemarginalcost.
Industrialorganizationisthestudyofthecreation,
exercise,maintenance,andeffectsofmarketpower.
Church&Ware(2000)

The different approaches to the

subject of industrial organization
- the descriptive approach:providinganoverviewof
approach:
industrialorganization,suchasmeasuresofcompetition
andthesizeconcentrationoffirmsinanindustry.
- the usage ofmicroeconomicmodels:explaininternal
firmorganizationandmarketstrategy.Astostrategic
firminteraction,noncooperativegametheoryhas
becomethestandardunifyingmethodofanalysis.
- the orientationtopublicpolicyastoeconomic
regulationandantitrustlaw
Thedevelopmentofindustrialorganizationasaseparate
fieldowesmuchtoEdwardChamberlin,EdwardS.
Mason,andJoeS.Bain.
http://en.wikipedia.org/wiki/Industrial_organization

For consideration
Read carefully different concepts of industrial
organization and write a short presentation on the new
industrial organization and its distinguishing features.

IndustrialOrganization:AStrategicApproach
By:Church,JefferyandRogerWare
ISBN:0071166459,926p.
Publisher:McGrawHill,2000.
Apdfcopyofthebookcanbedownloadedat:
http://homepages.ucalgary.ca/~jrchurch/page4/page5/page5.htm
l

A historical perspective
TheearlyideasforIndustrialOrganization are developed by
Schumpeter(1958).
Cournot(1838)wasthefirstinproposingasolutionconceptto
determinemarketpricesunderoligopolisticinteraction.By
meansofanexampleoftwoproducersofmineralwater
decidingproductionlevelsandcompetingindependently,
Cournotproposesthatthepricearisinginthemarketwillbe
determinedbytheinterplayofaggregatesupplyanddemand.
Also,suchapricewillbeanequilibriumpricewhenevery
producersproductiondecisionmaximizesitsprofits
conditionalontheexpectationovertheproductionoftherival.
Itisworthnotingthatthisequilibriuminvolvesapriceabove
themarginalcostofproduction.This concept of equilibrium is
precisely what Nash (1950) proposed as solution of a noncooperative game when we consider quantities as strategic
variables.

A historical perspective

http://pareto.uab.es/xmg/Docencia/IOen/IOIntroduction.pdf

A historical perspective
Next,Cournottacklesthecaseofcomplementary
products.Interestinglyenoughheassumedinthiscase
thatproducerswouldchoosepricesandappliedthesame
solutionconcept,namelyaNashequilibriumwithprices
asstrategicvariables.Inthiscase,theequilibriumpriceis
largerthanthemonopolyprice.
Cournotscontributionwaseitherignoredorunknown
for45yearsuntilBertrand(1883)publishedhiscritical
reviewwhereheclaimstheobviouschoicefor
oligopolistscompetinginahomogeneousproduct
marketsuchastheproposedbyCournotwouldbeto
collude,giventhattherelevantstrategicvariablesmust
bepricesratherthanquantities.Inparticular,in
Cournotsexample,theequilibriumpricewillequal
marginalcost,i.e.thecompetitivesolution.

A historical perspective
ThecriticismoftheCournotmodelcontinuedwith
Marshall(1920)andEdgeworth(1897).Marshall
thoughtthatunderincreasingreturns,monopolywas
theonlysolution;Edgeworthsmainideawasthatin
Cournotssetuptheequilibriumisindeterminate
regardlessofproductsbeingsubstitutesor
complements.Forsubstitutegoodswithcapacity
constraints(Edgeworth(1897))orwithquadratic
cost(Edgeworth(1922))heconcludesthatpriceswould
oscillatecyclingindefinitely.Forcomplementary
productstheindeterminationoftheequilibriumisat
leastveryprobable(Vives(1999)).

A historical perspective

A historical perspective
ThisdemolitionofCournotsanalysiswascalledtoan
endbyChamberlin(1929)andHotelling(1929)afterthe
observationthatneitherassumptionofquantitiesor
pricesasstrategicvariablesarecorrectinanabsolute
sense:
* EquilibriumintheBertrandmodelwitha
standardizedproductisquitedifferentfrom
equilibriumintheCournotmodel.TheCournotmodel
emphasizesthenumberoffirmsasthecriticalelement
indeterminingmarketperformance.Bertrandsmodel
predictsthesameperformanceasinlongrun
equilibriumofaperfectlycompetitivemarketifasfew
astwoproducerssupplyastandardizedproduct.

A historical perspective
* Thequalitativenatureofthepredictionsofthe
Cournotmodelarerobusttotheintroductionofproduct
differentiation.ThesamecannotbesaidoftheBertrand
model.(Martin(2002)).

A historical perspective
FromthatpointCournotsmodelservedasadeparture
pointtootheranalysis.Hotelling(1929),Chamberlin
(1933),andRobinson(1933)introducedproduct
differentiation.Hotellingssegmentmodelintroduces
differentpreferencesinconsumersandprovidesthe
foundationforlocationtheorybyassumingconsumers
buyingatmostoneunitofonecommodity;Chamberlin
andRobinsonconsideredalargenumberofcompetitors
producingslightlydifferentversionsofthesame
commodity(thusallowingthemtoretainsome
monopolypoweronthemarket)andassumedthat
consumershadconvexpreferencesoverthesetof
varieties.Stackelberg(1934)consideredasequential
timinginthefirmsdecisions,thusincorporatingthe
ideaofcommitment.

A historical perspective

A historical perspective
Someyearslater,vonNeumannandMorgenstern(1944)
andNash(1950,1951)pioneeredthedevelopmentof
gametheory,atoolboxthatprovidedthemostflourishing
periodofanalysisinoligopolytheoryalongthe1970s.
RefinementsoftheNashequilibriumsolutionlikeSeltens
subgameperfectequilibrium(1965)andperfect
equilibrium(1975),HarsanyisBayesianNashequilibrium
(196768),orKrepsandWilsonssequentialequilibrium
(1982)haveprovedessentialtothemodernanalysisofthe
indeterminacyofpricesunderoligopoly.
Also,thestudyofmechanismsallowingtosustain(non
cooperative)collusionwaspossiblewiththedevelopment
ofthetheoryofrepeatedgamesleadbyFriedman(1971),
AumannandShapley(1976),Rubinstein(1979),and
GreenandPorter(1984).

A historical perspective

TheStructureConduct
Accordingtothestructureconductperformance
Performance(SCP) approach

approach,anindustry'sperformance(thesuccessofan
industryinproducingbenefitsfortheconsumer)
dependsontheconductofitsfirms,whichthen
dependsonthestructure(factorsthatdeterminethe
competitivenessofthemarket).Thestructureofthe
industrythendependsonbasicconditions,suchas
technologyanddemandforaproduct.Forexample:in
anindustrywithtechnologythattheaveragecostof
productionfallsasoutputincreases,theindustrytends
tohaveonefirm,orpossiblyasmallnumberoffirms.
http://en.wikipedia.org/wiki/Industrial_organization

TheStructureConduct
Performance(SCP) approach
Componentsofthestructure,conduct,andperformance
modelforindustrialorganizationinclude:
modelforindustrialorganization
- basicconditions:consumerdemand,production,
elasticityofdemand,technology,substitutes,raw
materials,seasonality,unionization,rateofgrowth,
productdurability,location,lumpinessoforders*,scaleof
economies,methodofpurchase,scopeeconomies
- structure:numberofbuyersandsellers,barrierstoentry
ofnewfirms,productdifferentiation,verticalintegration,
diversification
* Orders are lumpy when sales occur relatively infrequently in large batches
as opposed to being smoothly distributed over the year. Lumpy orders reduce
the frequency of competitive interactions between firms.

TheStructureConduct
Performance(SCP) approach
- conduct:advertising,researchanddevelopment,
pricingbehavior,plantinvestment,legaltactics,
productchoice,collusion,mergerandcontracts
- performance:price,productionefficiency,allocative
efficiency,equity,productquality,technicalprogress,
profits
- governmentpolicy:governmentregulation,antitrust,
barrierstoentry,taxesandsubsidies,investment
incentives,employmentincentives,macroeconomic
policies

TheStructureConduct
Performance(SCP)paradigm
StructureConductPerformanceParadigmisan
approachusedtoanalyzetherelationamongmarket
performance,marketconduct,andmarketstructure.It
indicatesthatmarketstructuredeterminesthemarket
conduct,andtherebysetsthelevelofmarket
performance.Workingbackward,wefindthatmarket
performanceisdeterminedbymarketconduct,whichin
returndependsonmarketstructure.SCPhasbeen
appliedtoadiverserangeofproblems,fromhelping
businessesbecomemoreprofitabletohelping
understandthesubprimemortgagecrisisintheUnited
States.

TheStructureConduct
Performance(SCP)paradigm

TheStructureConduct
Performance(SCP)paradigm

TheStructureConduct
Performance(SCP)paradigm

TheStructureConduct
Performance(SCP)paradigm

TheStructureConduct
Performance(SCP)paradigm
Economistsareespeciallyinterestedinstudyingthe
SCP paradigmbecausetheythinkthatseller
concentrationaffectstheindustryssocialperformance.
Theeconomictheoristsexpressthateffectintermsof
higherprofitsearnedbythemonopoly.Ontheother
hand,IndustrialOrganizationeconomistsexpressthe
effectintermsoflocativeinefficiency.

TheStructureConduct
Performance(SCP)paradigm
However,economistswhousetheStructureConduct
Performance(SCP)approachdisagreeontheemphases
thattheygivetoeachofthethreeelements.Somegive
marketstructureandmarketconductanequal
importanceindeterminingmarketperformance.Others
arguethatmarketconductislargelydeterminedby
marketstructure,hence,marketperformancedepends
heavilyonmarketstructure,andthatleadsthemtopay
littleattentiontomarketconduct.
MarketStructureConductandPerformanceframework
wasderivedfromtheneoclassicalanalysisofmarkets.

OligopolytheoryversustheSCP
paradigm
IndustrialEconomicsdealswiththestudyofthe
behavioroffirmsinthemarket.Thefieldasaseparate
areawithinmicroeconomicsappearsafterthesocalled
monopolisticcompetitionrevolution,linkedtothe
namesofMason(1939)andBain(1949,1956)(Harvard
tradition).Barrierstoentrywasthecentralconcept
givingrisetomarketpower.Theapproachisessentially
motivatedbystylizedfactsarisingfromanempirical
traditionseekinghowthestructuralcharacteristicsofan
industrydeterminethebehaviorofitsproducersthat,in
turn,yieldsmarketperformance.Thisframeworkof
analysisistheStructureConductPerformance
paradigm(Scherer(1970); Schmalensee(1989); Martin
(2002)).

OligopolytheoryversustheSCP
paradigm
Thisparadigmdominatedtheevolutionofthefieldfor
threedecades.Duringtheseyearsresearchwasmainly
discursiveandinformalandindependentoftheformal
microeconomicanalysisofimperfectmarkets.Basically,
theSCPprovidedageneralframeworkallowingthe
implementationofpublicpoliciesfromempirical
regularitiesobservedinmanyindustries.Theearly
seventieswitnessedamajorrevolutionintheanalysis,
leadingtothesocallednewindustrialeconomics.

OligopolytheoryversustheSCP
paradigm
FollowingMartin(2002),threefactorsarebehindthis
evolution.(i)theconclusionsoftheformal
microeconomicmodelsarenotqualitativelydifferent
fromthoseoftheSCPparadigm.;(ii)empirical
economistsheldthatmarketstructureshouldbetreated
asendogenousratherthanexogenouswithrespectto
conductandperformance.Thisraisedtheneedfora
theoreticalfoundationoftheeconometricmodels(tobe
foundinthemicroeconomicmodelsofoligopoly);(iii)last
butnotleast,theapplicationofgametheorytothe
modelingofoligopolisticinteractionprovidedthe
definiteelementtoreplacetheSCPparadigmandplace
OligopolyTheory(understoodastheanalysisofstrategic
interactionsbeingcentraltothedeterminationofmarket
performance)andthestandingmethodology.

Business Dictionarys Meanings

- Oligopoly - marketsituationbetween,andmuchmore
commonthan,perfectcompetition(havingmanysuppliers)
andmonopoly(havingonlyonesupplier).Inoligopolistic
markets,independentsuppliers(fewinnumbersandnot
necessarilyactingincollusion)caneffectivelycontrolthe
supply,andthustheprice,therebycreatingaseller'smarket.
Theyofferlargelysimilarproducts,differentiatedmainlyby
heavyadvertisingandpromotionalexpenditure,andcan
anticipatetheeffectofoneanother'smarketingstrategies.
Examplesincludeairline,automotive,banking,and
petroleummarkets.
Oligopsony - marketsituationwherepresenceoffew
buyersandmanysupplierscreatesabuyer'smarket.
http://www.businessdictionary.com/

Theory about development

Thetwodecadesfromtheearly1970suntilthelate1980s
hasbeenthemostflourishingperiodoftheoretical
developmentinindustrialorganization.Themain
methodologicaldifferencewithrespecttotheSCP
paradigmisthatgametheoreticalmodelsarerather
specificandtheirpredictionsaboutequilibriumbehavior
oftennotrobusttominorchangesinthesetofunderlying
assumptions.During198090gametheorytookcenter
stagewithemphasisonstrategicdecisionmakingand
Nashequilibriumconcept.After1990,empiricalindustrial
organizationwiththeuseofeconomictheoryand
econometricsledtocomplexempiricalmodelingof
technologicalchanges,mergeranalysis,entryexitand
identificationofmarketpower.

Review questions
1. Describe the essence of theSCPparadigm and
components of this model for industrial organization.
2. Discuss the need of oligopoly theoryversustheSCP
paradigm.
3. Explain the different ideas for industrial organization
in a historical perspective.

Market structure
TheMarketstructureconsistsoftherelativelystable
featuresofthemarketenvironmentthatinfluence
rivalryamongthebuyersandsellersoperatingwithin
thismarket.Themainelementsthatinfluencemarket
structureare,sellerconcentration,product
differentiation,barrierstoentry,barrierstoexit,buyer
concentration,andthegrowthrateofmarketdemand.
Otherelementsofmarketstructureexist,buttheyare
usuallyunstableandthereforeignoredeitherbecause
theycantbemeasuredorbecausetheyarehardto
observe.

Elementsofmarketstructure
First, Sellerconcentration
Referstothenumberandsizedistributionoffirmsin
themarket.Themostwidelyuseddeviceisdetermining
sellerconcentrationistheConcentrationRatio.To
computetheconcentrationratio,thefirmsarerankedin
orderofsizeusuallymeasuredintermsofsale,
startingfromthelargestintheindustryatthetopand
goingdowntothesmallestfirmatthebottom.
Concentrationratiosareusuallygivenforthelargest4,
largest8,andsometimesthelargest20firms.Usually
industriesthatarehighlyconcentratedinoneadvanced
economytendtobehighlyconcentratedinanother.

Elementsofmarketstructure
Second,Productdifferentiation
Productdifferentiation
Adifferentiationordistinguishingaproductfromthe
productsofothercompetingfirms.Differentiationof
productsalongkeyfeaturesandminordetailsisan
importantstrategyforfirmstodefendtheirpricefrom
levelingdowntomarginalcost.
Whetherornotproducts(thataredescribedbycertain
featuresorcharacteristics)aredifferentiateddependson
consumerpreferences.Onesourceofproductdifferentiation
isheterogeneityamongconsumers.Consumerpreferences
arespecifiedontheunderlyingcharacteristicsspace.This
approachisoftencalledthecharacteristicsapproach*.
* Belleflamme, P., Martin Peitz. Industrial Organization: Markets and Strategies.

Cambridge University Press, 2010; http://203.128.31.71/articles/0521681596.pdf

Elementsofmarketstructure
Ithastheadvantage newproductintroductionandproduct
modificationscanbeanalysedwithoutambiguities.Such
ambiguitiesmayariseifpreferencesareonlydefinedover
products.Inaddition,consumerstypicallyareassumedto
makeadiscretechoiceamongproducts(andpossiblyan
outsideoption),i.e.theydecidewhichbrandorproductto
buyanddonotmixbetweendifferentproducts.This
approachisthereforecalledthediscretechoiceapproach.
thediscretechoiceapproach
Mostmodelsinthis
approachhavetheadditionalpropertythatconsumersbuy
zerooroneunitoftheproduct;however,alsomodelswith
variabledemandanddiscretechoicecanbeanalysed.An
alternativeapproachistomodeleachconsumerwitha
variabledemandforallproductsbuttoassumethatall
consumersareidentical.Thisiscalled therepresentative
consumerapproach.
consumerapproach

Elementsofmarketstructure
A) Horizontaldifferentiation
Horizontaldifferentiation
Whenproductsaredifferentaccordingtofeaturesthat
can'tbeorderedinanobjectiveway,orinotherwords,at
thesameprice,someconsumerswouldpreferthe
productwhileotherswouldpreferadifferentsubstitute.
Horizontaldifferentiationcanbedifferentiationincolors
(differentcolorversionforthesamegood),instyles(e.g.
modern/antique),orintastes.Atypicalexampleisthe
icecreamofferedindifferenttastes.Chocolateisnot
betterthanMango.
Horizontalproductdifferentiation is a situation in which
eachproductwouldbepreferredbysomeconsumers.

Elementsofmarketstructure
Ifforequalpricesconsumersdonotagreeonwhich
productisthepreferredone,productsarehorizontally
differentiated.
B) Verticaldifferentiation
Verticaldifferentiation
Verticaldifferentiationoccursinamarketwherethe
severalgoodsthatarepresentcanbeorderedaccording
totheirobjectivequalityfromthehighesttothelowest.
It'spossibletosayinthiscasethatonegoodis"better"
thananother.
Ifeverybodywouldpreferoneovertheotherproduct,
productsareverticallydifferentiated.

Elementsofmarketstructure
If forequalprices,allconsumerspreferoneovertheother
product,productsareverticallydifferentiated.
Weareinasituationofverticalproductdifferentiationifall
consumerspreferoneovertheotherproductifpricesareset
atmarginalcosts.
Although the distinction between horizontal and vertical
differentiation is useful for research purposes, it is not easy to
draw this distinction in practice. Indeed, as illustrated in case
below, many real-world products or services combine
elements of the two types of differentiation, as they are
defined by more than one characteristic (all consumers may
prefer to have more of each characteristic, which indicates
vertical differentiation, but they may differ in how they value
different characteristics, which indicates horizontal
differentiation).

Elementsofmarketstructure
C) Mixeddifferentiation
Mixeddifferentiation
Certainmarketsarecharacterizedbybothhorizontal
andverticaldifferentiation.Forinstance,apparel,and
shoeshavearichcombinationofshapes,colors,
materials,andappropriatenesstosocialevents.Insuch
markets,thedifferencesincolorsorshapesare
horizontaldifferentiation,whilethequalityofthe
materialsisusuallyperceivedasverticaldifferentiation.

Case 1.Coffeedifferentiation*
1.
Examplesforhorizontalandverticalproduct
differentiationareevenfoundinsomemarketsforraw
materials,whichatfirstglancemaylookliketheperfect
exampleofahomogeneousproductmarket.Takecoffee
(forthosewhoprefertea,thephenomenonislessrecent).
Coffeedrinkersinrichcountrieshavebeenmadeaware
(or,dependingonyourview,madebelieve)byspecialty
roastersincludingmassphenomenalikeStarbucksthat
originandtypeofcoffeematterfortaste.Thistrendhas
ledtoprizesforthebestcoffeeinvariouscompetitions
andprotectedtrademarks(andevendisputesalongthe
verticalsupplychainaboutthesetrademarks).

Case 1.Coffeedifferentiation*
1.
Thissuggeststhat,whilethecommoditymarketstillplays
animportantroleforcoffeeproducers,somegrowers
havedefinitelyleftthismarketandsteppeduptheladder
ofverticalproductdifferentiation(and,inaddition,have
horizontallydifferentiated).TakeforinstanceFazenda
Esperanca,whowonfirstprizeinBrazilsCupof
Excellencecompetitionforthe2006harvest.Itmadeclose
toUS$2000perbag(of60kg),morethantentimesthe
commoditypriceinanonlineauctioninJanuary2007(the
winningbidderscamefromJapanandTaiwan).
* Belleflamme, P., Martin Peitz. Industrial Organization: Markets and Strategies. Cambridge
University Press, 2010; http://203.128.31.71/articles/0521681596.pdf

Elementsofmarketstructure
Third,Barrierstoentry / Entry Deterrence
Asetofeconomicforcesthatcreateadisadvantageto
newcompetitorsattemptingtoenterthemarket.These
forcescouldbegovernmentregulationsuchasIPrights,
orpatent,ortheycouldbelargeeconomiesofscaleina
specificindustry,orhighsunkcostsrequiredtoenter
themarket.Sometimesfirmswithinaspecificindustry
adoptcertainpricingstrategiestocreatebarriersto
entry,oneofthemostwidelyadoptedstrategyislimit
pricingbyloweringpricestoalevelthatwouldforce
anynewentrantstooperateataloss,thisstrategyis
especiallyeffectivewhentheexistingfirmshaveacost
advantageoverpotentialentrants.

AlcoawasthesoleproducerofaluminumintheUnited
Case
2. Entry Deterrence
Statesfrom1912to1937andinthelatteryear,theUnited
AlcoaConvictedofMonopolization:JudgeLearnedHand
StatesDepartmentofJusticechargeditunderSection2of
RulesAggressiveCapacityExpansionIllegal
theShermanActwithmonopolization.Itsdominance
overtheperiod1912to1938issuggestedbyitsmarket
share.Exceptforthreeyearsitsmarketshareoverthis
periodalwaysexceeded80%.In1912itsmarketsharein
thesaleofvirginaluminumingotwas91%andfrom1934
to1938itsaveragemarketshareexceeded90%.
Competitionfromimportspeakedin1921whenAlcoas
marketsharedippedto68%.

Case 2. Entry Deterrence

Whataccountedforitsdominance?Earlierentryhadbeen
deterredbyintellectualpropertyrightsandperhaps
collusionandillegalcontractingpractices.Alcoaspatent
onaluminumexcludedanyotherproducerofaluminum
before1906andaprocesspatentexcludedanyother
producerfromusingitssubstantiallysuperiorproduction
processbefore1909.In1912Alcoaagreedtoaconsent
decreeenjoiningitfromenteringintoagreementswith
foreignproducersthatlimitedimportsintotheU.S.and
fromenteringorenforcingagreementswithpower
companiesnottosellelectricitytootheraluminum
producers.Butwhataccountedforitsdominanceafter
1912?Oneclue:in1912Alcoasproductioncapacitywas
42millionpoundsofingot,butby1934itscapacityhad
increasedalmost8timesto327millionpounds.

Case 2. Entry Deterrence

In1945,JudgeLearnedHandruledthatAlcoawasa
monopolistandthatithadunlawfullymonopolizedthe
marketforaluminumingotintheUnitedStates.Its
weapon:aggressiveexpansionofcapacity:
Itwasnotinevitablethatit[Alcoa]shouldalways
anticipateincreasesinthedemandforingotandbe
preparedtosupplythem.Nothingcompelledittokeep
doublingandredoublingitscapacitybeforeothers
enteredthefield.Itinsiststhatitneverexcluded
competitors;butwecanthinkofnomoreeffective
exclusionthanprogressivelytoembraceeachnew
opportunityasitopened,andtofaceeverynewcomer
withnewcapacityalreadygearedintoagreat
organization,havingtheadvantageofexperience,trade
connectionsandtheeliteofpersonnel.

Case 2. Entry Deterrence

Handsfindingraisestwointerestingsetsofquestions:
Howcanamonopolistraiseorcreatebarrierstoentry
topreserveitsdominance?Morespecificallyinthe
Alcoacase,howdidAlcoasinvestmentincapacitydeter
entry?UnderwhatcircumstancesisAlcoasthreatto
produceatcapacitycredible?
Whataretheefficiencyimplicationsofstrategic
behaviorthatdetersentry,preservingadominant
position?Eventhoughthecreationofentrybarriersis
anticompetitor,isitnecessarilyanticompetitive?More
specificallyintheAlcoacase,whatarethewelfare
effectsofpreemptiveinvestmentincapacitythatdeter
entry?Shouldanincumbentbecondemnedmerelyfor
expandingtomeetgrowingdemand?

Elementsofmarketstructure
Definitions of Church&Ware(2000)
An entry barrier as a structural characteristic of a market that
protects the market power of incumbents by making entry
unprofitable. Profitable entry deterrencepreservation of
market power and monopoly profitsby incumbents
typically depends on these structural characteristics and the
behavior of incumbents postentry.
Requirementsforprofitableentrydeterrence:
- ifproductsarehomogeneous,and
- ifbothincumbentandentranthavethesamecostfunctions
economiesofscaleandtheabilityoftheincumbentto
committoactsufficientlyaggressivelypostentry.

Elementsofmarketstructure
TheRoleofInvestmentinEntryDeterrence
CentraltothefindingthatAlcoamonopolizedthe
marketforprimaryaluminumwasAlcoasinvestment
incapacity.Investmentincapacitywasalsothebasis
foranunsuccessfulmonopolizationcomplaintagainst
DuPontbroughtbytheFederalTradeCommissionin
themarketfortitaniumdioxide.NutraSweets
aggressiveexpansionofitscapacityplayedaroleinthe
findingbytheCompetitionTribunalinCanadathat
thereweresubstantialbarrierstoentryintothe
productionofaspartame*.
* Aspartameisanartificial,nonsaccharidesweetenerusedasa
sugarsubstituteinsomefoodsandbeverages.

Elementsofmarketstructure
Twodifferentversionsthatanincumbentmightuse
capacitytodeterentry:
Thefirstisthatanincumbentwillinvestinexcesscapacity
whichitthenholdsinreserveuntilentry.Ifanentrant
shoulddareenter,theincumbentusesthiscapacitytomeet
demandwhenitlaunchesapricewar,soexcesscapacityis
asignalofpostentryaggression.Thesecondversionismore
subtle.Anincumbentmightoverinvestincapacitytolower
itsshortrunmarginalcostsofproduction*.Thisprovidesit
withacommitmenttoproducethelimitoutputifthereis
entry.However,thisvariantdoesnotnecessarilyimply
thatthefirmhasexcesscapacityintheabsenceofentry.
Giventhatcapacitycostsaresunk,evenamonopolist
mightfinditprofitabletoproduceatcapacity.

Elementsofmarketstructure
* Marginalcostsofproduction
Thechangeintotalcostthatcomesfrommakingorproducingone
additionalitem.Thepurposeofanalyzingmarginalcostisto
determineatwhatpointanorganizationcanachieveeconomiesof
scale.Thecalculationismostoftenusedamongmanufacturersasa
meansofisolatinganoptimumproductionlevel.

Thefirstversionhasbeencriticizedontheoretical
grounds:thethreattoutilizecapacitypostentrymaynot
becredible.Entrylikelymeansthatanincumbentwill
finditprofitmaximizingtoreduceitsoutput,notincrease
it.Thekeyissueinentrydeterrenceistheabilityofan
incumbenttomaintainorincreaseitsoutputpostentry.

Elementsofmarketstructure
Themoderntreatmentofentrydeterrencebeginswith
modelsbySpence(1977)andDixit(1980)thataddress
theissueofwhetherincumbentscouldorwouldinvest
incapacitytodeterentry.Thequestiontheyconsidered
iswhetherornotanincumbentcanstrategicallyinvest
incapacityinordertocrediblythreatentoact
aggressivelyproducethelimitoutputifthereis
entry.Thedifferencebetweenthetwoapproachesisthe
natureofthepostentrygame.Spenceassumesthat
firmspostentryarepricetakers.Dixit,ontheother
hand,assumesthatthepostentrygameisCournot.

Elementsofmarketstructure
Dixitdemonstrateshowandwheninvestmentsincapacity
canprovidethemeansforanincumbenttodeterentryby
crediblycommittingittobehaveaggressivelyifanentrant
shouldenter,therebyrenderingentryunprofitable.This
strategicapproachemphasizeshowthesunk
expenditures*oftheincumbentprovideitwithacost
advantagepostentrybyreducingitsvariablecosts.
* Sunkexpendituresareunrecoverablepastexpenditures.These
expenditures
shouldnotnormallybetakenintoaccountwhendeterminingwhether
tocontinueaprojectorabandonit,becausetheycannotberecovered
eitherway.Itisacommoninstincttocountthem,however.
http://economics.about.com/od/economicsglossary/g/sunkcosts.htm

Elementsofmarketstructure
StrategicInvestmentandMonopolization
TheAlcoadecisionrepresentsthehighwatermarkin
antitrustenforcementagainstdominantfirmsinthe
UnitedStates.Itseemedtoimplythatafirmthat
innovatesandestablishesanewmarketandthatby
virtueofcreatingthemarketwillhavealargemarket
sharewillbefoundguiltyofmonopolizationifit
expandscapacitytomaintainmarketshare.The
implicationappearstobetheparadoxthatantitrustlaw
requiresthatinnovatingfirmsnotcompetetoavoid
antitrustliability,butinsteadaretoencourageorinduce
entry.Afirmthatattainsdominanceevenifits
dominanceisduetoefficiencyanditseffectivenessasa
competitorcouldbeguiltyofmonopolization.

Elementsofmarketstructure
TheU.S.SupremeCourtinGrinnelldistinguished
betweenlawfulandunlawfulmonopolization.
AccordingtotheU.S.SupremeCourt:
Theoffenseofmonopolyunder2oftheShermanAct
hastwoelements:(1)thepossessionofmonopoly
powerintherelevantmarketand(2)thewillful
acquisitionormaintenanceofthatpoweras
distinguishedfromgrowthordevelopmentasa
consequenceofasuperiorproduct,businessacumen,or
historicalaccident.

Elementsofmarketstructure
Thisformulationrequiresmonopolyestablishingthat
afirmisamonopolistinanantitrustmarket.However,
merepossessionofmonopolypowerdoesnotestablish
liability.Insteadthefirmmusthavemonopolizedthe
marketnotbybeinganeffectivecompetitor,but
throughexclusionaryorpredatoryconduct.

Elementsofmarketstructure
InAspenSkitheU.S.SupremeCourtobservedthatIfa
firmhasbeenattemptingtoexcluderivalsonsome
basisotherthanefficiency,itisfairtocharacterizeits
behavioraspredatory.Moreover,exclusionary
behaviormustnotonlybeanticompetitor,itmustbe
anticompetitive:
itisrelevanttoconsideritsimpactonconsumersand
whetherithasimpairedcompetitioninanunnecessarily
restrictiveway.However,atleastinthefollowingcase,
theCourtgaveshortshrifttowhetherinvestmentsin
capacitymightultimatelybesociallyinefficient
throughtheireffectonentrybarrierseventhough
theyappeartobeconsistentwiththeexpectedbehavior
ofanefficientcompetitor.

Case 3.A
3. Movie Monopoly? Cinemas
in Las Vegas
Read the case study and think about:
1. What factors favor the transformation of the Syufy in
monopsonist?
2. Do you agree with the praise that Robert Syufy is a
local hero? Why?
3. Are there specific barriers to entry the Film Industry?
Indicate them.

Elementsofmarketstructure
Fourth,Barrierstoexit
Barrierstoexit
Asetofeconomicsforcesthatinfluencethefirms
decisionofexitingthemarket,suchforcesmakeit
cheaperfortheexistingfirmtostayinthemarketthan
toexitthemarket.Althoughsunkcostscouldbe
barrierstoentry,especiallywhenthesunkcostsaretoo
large,sunkcostscouldbeahugebarriertoexitaswell,
becauselargeinvestmentsinfixedplantand
equipmentscommitsthefirmtostayinthemarket.
Barrierstoexitincreasetheintensityofcompetitionin
anindustrybecauseexistingfirmshavelittlechoicebut
tostayandfightwhenmarketconditionshave
deteriorated.

Elementsofmarketstructure
Thelossofbusinessreputationandconsumergoodwill,
couldbeabarriertoexitespeciallyifthefirmis
planningonreenteringthemarketlater,orwhenthe
firmexitsaspecificmarketbutstilloperatinginother
markets.Insuchasituation,thedecisiontoleavethe
marketcanseriouslyhurtthereputationofthefirm
amongcurrentconsumersinothermarkets,andaffect
thegoodwillamongpreviouscustomers,notleastthose
whohaveboughtaproductwhichisthenwithdrawn
andforwhichreplacementpartsbecomedifficultor
impossibletoobtain.

Elementsofmarketstructure
Fifth,Buyerconcentration (Thenumberofbuyersina
market)
Buyerconcentrationisasequallyimportantasseller
concentration,especiallyinmarketswithafewbuyers.
ThetermwasusedbyMichaelE.Porterin1979inhis
FiveForcesAnalysis.Portersanalysisproposesthat
inmarketswithhighbuyerconcentration,thefirms
earnlowerlevelofprofitsthaninmarketswithlow
buyerconcentration.

Elementsofmarketstructure
Sixth, Thegrowthrateofmarketdemand
Thegrowthrateofmarketdemand
Themarketstructureinindustrieswitharelativelystatic
demandorlowgrowthrateofdemandisdifferentfrom
themarketstructureinindustrieswithanaccelerated
demandgrowth.Thatsbecausewhenthedemandgrows
fastenough,thefirmshavetheirhandsfulljust
expandingtheirproductioncapacities,inthiscase,ifnew
entrantsarecomingin,therewillbelittleincentiveto
fightformarketshare.Also,firmsarelikelytohonor
oligopolisticagreementswitheachother,andprofitstend
tobehigh.Alltheseelementsofmarketstructuretendto
bestableovertime.However,theyareallinterrelated.
Anychangeinonetendstobringaboutchangesin
another.Byrealizingthisrelationamongthedifferent
elementsofmarketstructure,itbecomeseasierto
understandwhymarketstructureschangeovertime.

Elementsofmarketstructure
Seventh,Conduct
Conduct
Conductmeanswhatfirmsdotocompetewitheach
other.Itincludespricing,advertising,researchand
developmentinvestment,decisionsonproduct
dimensions,mergerandacquisition,etc.Conductalso
canincludecollusionbothexplicitortacit.

Elementsofmarketstructure
Eighth, Performance
Performance
Theperformanceofanindustryorfirmismeasuredby
profitability.Profitisthedifferencebetweenrevenue
andcost,andrevenueisdeterminedbyprice.Thus
performancecanbeinfluencedthroughchangingcosts
orprices.Profitabilitycanalsobeaffectedbyafirms
agility(i.e.abilitytoadjusttothingslikechangesin
marketdemand).Researchanddevelopment,and
availabilityofcapitolandresourcesarefactorsthat
greatlyinfluencewhetherornotafirmisagile.The
abilitytomeasureperformancebetweenindustriesis
importantinunderstandingtheSCPrelationships.

Elementsofmarketstructure
Forexample,ifanindustryisdominatedbyonefirmor
carteldoesnotseehighercoststhanacompetitive
industryyethasmonopolyprices,thenthatnon
competitiveindustrywillseehigherprofits,whereasif
costsincrease,thenprofitabilitylevelswillberelatively
similar.Thiscomparisonisthedrivingforcebehind
antitrustlegislation.StructureConductPerformance
paradigm(SCPP)predictsthatperformanceincreases
withconcentrationoftheindustry.Thisisincontrast
withtheefficiencyhypothesisthatstatesthatafirms
performanceisbasedonhowwellandefficientlyit
producesitsproductfortheconsumer.

Elementsofmarketstructure
Ninth,SCPInteraction
SCPInteraction
TherearetwohypothesesintheStructureConduct
Performance(SCP)paradigm:thetraditionalstructure
performancehypothesisandefficientstructurehypothesis.
performancehypothesis
Thestructureperformancehypothesisstatesthatthedegreeof
Thestructureperformancehypothesis
marketconcentrationisinverselyrelatedtothedegreeof
competition.Thisisbecausemarketconcentration
encouragesfirmstocollude.Thishypothesiswillbe
supportedifpositiverelationshipbetweenmarket
concentration(measuredbyconcentrationratio)and
performance(measuredbyprofits)exist,regardlessof
efficiencyofthefirm(measuredbymarketshare).Thus
firmsinmoreconcentratedindustrieswillearnhigher
profitsthanfirmsoperatinginlessconcentratedindustries,
irrespectiveoftheirefficiency.

Elementsofmarketstructure
Theefficiencystructurehypothesisstatesthatperformance
Theefficiencystructurehypothesis
ofthefirmispositivelyrelatedtoitsefficiency.Thisis
becausemarketconcentrationemergesfrom
competitionwherefirmswithlowcoststructure
increaseprofitsbyreducingpricesandexpanding
marketshare.Apositiverelationshipbetweenfirm
profitsandmarketstructureisattributedtothegains
madeinmarketsharebymoreefficientfirms,butnotto
thecollusiveactivities,asthetraditionalSCPparadigm
wouldsuggest(MolyneuxandForbes,1995).

Elementsofmarketstructure
Tenth,Relationshipofstructuretoperformance
EarlystudiesbyBain(1951;1956)hypothesizeda
positiverelationshipbetweenindustryconcentration,
barrierstoentryandprofits.Thoughhisstudiesare
flawedinthemeasurementofprofitratesandchoiceof
industries(Brozen(1971)),laterpaperssupportedthis
hypothesis(Mann(1966);Weiss(1974)).

Elementsofmarketstructure
However,thedifferentialintheperformancemeasures
betweenconcentratedandnonconcentratedindustries
fellsubstantiallyovertime(Brozen(1971);Hubbardand
Petersen(1986)).Moreover,studiesbasedonmore
recentdatatendtofindonlyaweakrelationshiporno
relationshipbetweenthestructuralvariablesand
performance(Salinger(1984);KwokaandRavenscraft
(1985)).Asaresult,someeconometricstudiesbeganto
lookatotherfactorsimpactingindustryperformance.
Thesestudiescommonlyfoundthathighratesofreturn
andindustrygrowtharerelated.

Elementsofmarketstructure
Otherresearchersstudiedthestructureperformance
relationshipusingalternativemeasuresofperformance,
forexample,thespeedofadjustmentofcapital.They
foundthatthecapitaloutputratioispositivelyrelated
toconcentration.Theexplanationforthisphenomenon
hasnotbeenverified,butitispossiblethatinhighly
concentratedmarkets,therearemorespecializedcapital
whichismoredifficulttoadjust,thusinthesemarkets
highprofitstakelongertofallbacktotheindustry
average.Similarly,ifconcentratedindustriestakelonger
timetoreacttodemandchanges,then,allelseequal,
goodeconomicnewsshouldraisethevalueofa
companymoreinaconcentratedindustrythaninan
nonconcentratedindustry(LustgartenandThomadakis
(1980)).

Elementsofmarketstructure
Eleventh, Relationshipbetweenstructureandconduct
Conductisinfluencedbymarketstructuresincefirm
strategiesdifferwithcompetition.Inversely,conduct
caninfluencemarketstructurebecausefirmscanmake
entrycostendogenousbychoosingdifferentlevelsof
quality,advertisingandsoon,thusaffectthepotential
entrantnumber.

Elementsofmarketstructure
Twelfth, Relationshipbetweenconductand
performance
Conductisrelatedtoperformance.Forexample,
advertisingexpenditureisusuallyhigherinhighly
profitableindustries,becausefirmswithmoreprofits
canaffordhigheradvertisingcosts,andinordertokeep
theirprofitsandpreventnewentrantsintothe
profitablemarket,thesefirmswoulduseadvertising
investmentsasendogenoussunkcosts.Econometric
studieslinkingprofittomarketstructureoftenconclude
thatmeasuredprofitabilityiscorrelatedwiththe
advertisingtosalesratioandwiththeResearch &
Development (R&D)expenditurestosalesratio.

Elementsofmarketstructure
Thetopmanagers'perceptionsofthemarketstructure
andthefirm'sstrengthsandweaknessesjointly
determinetheirchoiceofcorporatestrategy(itslong
runplanforprofitmaximization)andorganizational
structure(theinternalallocationoftasks,decisionrules,
andproceduresforappraisalandreward,selectedfor
thebestpursuitofthatstrategy).Bothcorporate
strategyandorganizationalstructureinfluencethe
economicperformanceofthefirmandthemarketin
whichitsells.
Richard Caves, Harvard University, 1980

Conclusion
Inessence,withtheSCPPweseektofindtheanswerto
howfirmsinteractandcompetewitheachotherindifferent
situations,andtheresultsoftheseinteractions,andare
theseresultsconsistentwithanidealcompetitionornot.
Thatway,anargumentcanbesupportedonwhetherornot
actionshouldbetakentoalterthemarketstructureor
regulatemarketconduct.Itisinterestingthereissucha
debateontheemphasisonmarketstructurevs.market
conductontheinfluenceofperformancesinceitisclearthat
structureandconductarethemselvesinfluencedbyeach
other.JosephBainwasoneofthefirsttorealizethisandhis
workledtothereevaluationofpublicpolicythathadbeen
fosteredbytheSCPframework.Inindustrialorganization,
realworld,imperfectcompetitionisstudied,andthereare
somanydifferentexamplesthatthewaymarketsare
evaluatediscontinuallyevolvingandchanging.

THANK YOU FOR THE ATTENTION