Prof. Wihana Kirana Jaya PhD.Faculty of Economics & Business

Universitas Gadjah Mada

Introduction to Industrial organization

Learning objectives:

1.Static and dynamic views of competition2.The structure–conduct–performance paradigm3.The Chicago school approach to the study of

competition

Terminology

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

What is Industrial Organization?

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

Church & Ware (2000): “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.”

Why do we study Industrial Organization?

“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 …”

“…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)

Central questions in IOHow firms behave in marketsWhole range of business issues

price of flowers; payment to be official sponsor of major events

which new products to introducemerger decisionsmethods for attacking or defending markets

Strategic view of how firms interactHow should a firm price its product given the

existence of rivals?How does a firm decide which markets to enter?At the heart of all of this is strategic interaction

TopicsOligopoly theoryConcentrationBarriers to entryPricing & auctionsProduct differentiation & advertisingResearch & DevelopmentVertical integrationDiversificationCompetition policy & regulation

Static & Dynamic View of Competition

1. Static view (Neoclassical theory) 4 main theoretical market structures: perfect

competition, monopolistic competition, oligopoly, and monopoly

Perfect Competition: Jevons (1871), Edgeworth (1881), Clark (1899), Knight (1921)

Monopoly: Marshall (1890), Sraffa (1926) Imperfect Competition:

- Monopolistic Market: Chamberlin (1933), Robinson (1933), Dixit & Stiglitz (1977)- Oligopoly Market: Sweezy (1939), Cournot (1838), Bertrand (1883), Chamberlin (1933)

…continued

2. Dynamic view (Schumpeter & Austrian school)

An abnormal profit is an important part of the competitiveness process: drive innovation (provides rewards & incentives for innovation)

Competition is driven by innovation (Schumpeter) Monopoly status is only a temporary phenomenon Entrepreneurs play an important role in the

economy (by noticing missed opportunities through information): entrepreneur as initiator of change (Schumpeter) or merely responding to change (Austrian School)

ModernIndustrial Organization

1940s-1950s:Structure-Conduct-Performance(J.S.Bain & Edward Mason)

Post-1980s:New Industrial Organization(Tirole, Laffont, Bresnahan)

SCP vs. NIO

SCP NIOEmpirical Theoretical

Industry Market

Structure, Performance

Conduct

New Industrial OrganizationFocus 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

(Not so) New DevelopmentsBaumol’s contestable markets

what matters is not actual competition but potential competition (new insights on relationship between market structure, conduct, performance)

Coase theory of the firmvertical integration & disintegration (new insights on structure & conduct e.g. vertical restraints)

The Structure-Conduct-Performance Paradigm

Static & dynamic view of competition Industrial Organization

Mason (1939, 1949) & Bain (1951, 1956, 1959) are credited with the development of the SCP paradigm

The SCP paradigm: the structure of market influences the conduct of the firms operating in the market, which in turn influences the performance of those firms. However, various feedback effects are also possible: from performance back to conduct; from conduct to structure; and from performance to structure (Philips, 1976; Clarke, 1985)

Supply condition

Technology & cost structureFactor marketsOrganizational structureLocation

Demand condition

Tastes & preferencePrice elasticity of demandAvailability of substitutesMethod of purchase

Structure

Number & size distribution of buyers & sellersEntry & exit conditionsProduct differentiationVertical integrationDiversification

PerformanceProfitabilityGrowthQuality of products & servicesTechnological progressProductive efficiencyAllocative efficiency

Government PolicyCompetition policy Wage & price controlsRegulation Trade policyTaxes & subsidies Regional policyEnvironmental policy Macroeconomic policyEmployment policy

ConductBusiness objectivesPricing policiesProduct design & brandingAdvertising & marketingResearch & DevelopmentCollusionMerger

The Structure-Conduct-Performance Paradigm

Technological progress

StructureThe number and size distribution of buyers and sellers is

an important determinant of the market power exercised by the leading firms in the industry, and the discretion these sellers exercise over their own prices.

Entry and exit conditions include barriers to entry, which can be defined loosely as anything that places a potential entrant at a competitive disadvantage relative to an incumbent firm

Product differentiation refers to the characteristics of the product. How similar is each firm’s product to those of rival firms? To what extent is each firm’s product unique?

Vertical integration and diversification. Vertical integration refers to the extent to which a firm is involved in different stages of the same production process. Diversified firms produce a variety of goods or services for several distinct markets.

ConductBusiness objectives. The objectives that firms pursue often

derive from structural characteristics of the industry: profit maximization, the maximization of non-profit objectives such as sales revenue, growth or managerial utility (Baumol, 1959; Marris, 1964; Williamson, 1963).

Pricing policies. The extent of a firm’s discretion to determine its own price depends to a large extent on the industry’s structural characteristics.

Product design, branding, advertising and marketingResearch and development. Together with advertising and

marketing, investment in research and development provides an obvious outlet for non-price competition between rival firms.

Collusion (price, advertising, R & D budget, output levels)Merger (horizontal & vertical)

PerformanceProfitability. The neoclassical theory: high or abnormal

profits are the result of the abuse of market power by incumbent firms. The Chicago school: abnormal profit may be the consequence of cost advantages or superior productive efficiency. The Schumpeterian or Austrian views: abnormal profit is a reward for successful past innovation, or the exercise of superior foresight or awareness by an entrepreneur.

Growth. Profitability is a suitable performance indicator for a profit-maximizing firm, but may be less relevant for a firm that pursues other objectives, such as sales, growth or managerial utility

Quality of products and service might be considered an important performance indicator by individual consumers or consumer groups, regulators or governments.

…continuedTechnological progress is a consequence of the level of

investment in research and development, and the pace of technological progress may be considered a relevant performance indicator

Productive and allocative efficiency. Productive efficiency refers to the extent to which a firm achieves the maximum technologically feasible output from a given combination of inputs, and whether it chooses the most cost effective combination of inputs to produce a given level of output. Allocative efficiency refers to whether social welfare is maximized at the market equilibrium. Productive and allocative efficiency are both regarded by economists as important performance indicators.

Usefulness of the SCP Paradigm

Provides a systematic way of analyzing markets & industries

Consistent with microeconomic theory’s approach

Policy implications for regulation & competition policy – targeting structure or/and conduct

The Role of Government Policy

To promote competition and prevent abuses of market power, e.g.:Preventing horizontal merger Impose price control, legal restrictions on

permissible forms of collusion, punishments for unlawful collusion

Other government policy measures (fiscal policy, employment policy, environmental policy, and so on)

…continuedThe Chicago school (1970s and 1980s):

Against government intervention in markets in order to promote competition (Reder, 1982) pro market, pro-competition and anti government

Large firms become large as a result of having operated efficiently, and therefore more profitably, than their smaller counterparts.

Criticisms of the S-C-P ParadigmThe SCP paradigm draws heavily on

microeconomic theory and the neoclassical theory of the firm.

It is often difficult to decide which variables belong to structure, which to conduct and which to performance.

Strategic Management Approach

Several tools developed in the IO literature have contributed to the growth of the sub-discipline of strategic management. Example: Porter’s five forces model of the firm’s competitive environment is heavily SCP-influenced.

In contrast to many economists, management strategists tend to emphasize the distinctive internal characteristics of firms, in order to explain how a competitive advantage can be acquired and sustained

According to Kay, the main sources of distinctive capability: Innovation. Successful innovation provides a firm with

advantages over its competitors. Architecture. Architecture refers to the firm’s internal

organization. Reputation. If a firm has a reputation for providing good

quality and service, this helps add value and generate sales.

Suppliers

Substitutes

Potential rivalry

Buyers

Industry competitors:

Rivalry among existing firms

Porter’s Five Forces Model

Supplier power

Buyer power

Threats from potential entrants

Threats from substitute products & services