Introduction Class 1
Economics of I-O Industrial economics is a branch of applied microeconomics which seeks to understand the causes and effects of various market structures on pricing and product choices. As such, the aim is to teach you how to apply economic theory to analyze various industries in the economy.
OLigopoly, concentration, barriers to entry, pricing, product differentiation and advertising, research and development. All affect performance of the industry Today’s class: –Static and dynamic views of competition –SCP paradigm –Strategic management
Static view of competition Neoclassical theory of the firm: –Perfect competition –Monopolistic competition –Oligopoly –Monopoly
Perfectly Competitive Industry 6 main characteristics –Large number of buyers and sellers –Perfect knowledge –Identical product –Independently acting firms –Free entry and exit conditions –Can sell as much output as they wish at current market prices
Competitive equilibrium Normal profits All surviving firms are forced to produce as efficienly as possible Inefficient firms drop out Abnormal profits are forced to be reduced down due to market conditions
Reality … Competition forces the structure to include relatively small number of large firms Market powers and abnormal profits Competition leads to a decrease in the number of firms in the long run beacuse: –As firms grow, firms enjow economies of scale and average costs fall Marshall (1890); Sraffa (1920): Theory of monopoly Chamberlein (1933); Robinson (1933): Theory of imperfect competition. –Monopolistic competition –Oligopoly
Dynamic view of Competition Austrian school Schumpeter (1928), (1942) The fact that a firm earns an abnormal profit does not imply that the firm is abusing its market power at the expense of its consumers Knowledge or information is imperfect Competition is driven by innovation: new products, new processes, etc. Innovator becomes monopoly, earns monopoly profits Others catch up Not capable of sustaining long run equilibrium
S-C-P Structure conduct performance Bain (1951) Structure affects conduct which in turn affects performance
Why is the structure–conduct–performance paradigm so widely used in order to study the conduct and performance of firms and industries? The SCP paradigm allows the breakdown of complex industry-level data into meaningful categories. It is grounded within the neoclassical theory of the firm, which assumes direct links between market structure, firm conduct and performance. By defining a workable or acceptable standard of performance, it is useful for policy analysis.
Forward and reverse causation between structure, conduct and performance. Forward causation assumes that market structure is determined exogenously by the basic supply and demand conditions. Firms are seen as passive entities, leading performance to flow directly from conduct. Reverse causation implies that firms make strategic choices, such as building new factories and investing in innovation, which not only influence performance but also have longlasting effects on market structure.
Chicago School and SCP Paradigm In contrast to SCP proponents, markets and industries have a natural tendency to revert to competition without the need for intervention or assistance from government policy.
Collusion Hypothesis and Efficiency Hypothesis The collusion hypothesis argues that a positive association between concentration and protability is evidence of collusion or other abuses of market power designed to enhance profits. The efficiency hypothesis argues that a positive relationship between concentration and profitability reflects a natural tendency for efficient firms to be successful and to become dominant in their industries.
Strategic Management Porter’s diamond model Value chain Distinctive capabilities; core competencies The strategic management literature emphasises the distinctive internal characteristics of firms in order to explain how a competitive advantage can be acquired and sustained. The focus of the firm is to maximise firm value through the choice of effective management strategies.
Figure 1.2 Porter’s five forces model Source: Adapted from Porter (1980), p. 4.
With reference to case study 1.1, assess the extent to which competition has increased in European banking in recent years. What effect has this had on the performance of banks? Competition in European banking has increased in recent years. Deregulation, which created the single market in financial services and the Euro, reduced the barriers to trading in financial services. Consequently, foreign-owned banks and non-bank institutions such as supermarkets and telecommunications firms have entered the European Banking industry. The increased competition has led to increased pressure on banks to maximise shareholder value. Banks have sought to achieve this by lowering costs and finding new ways of increasing revenues with the introduction of new types of products and services.