INDUSTRIAL ECONOMICS Prof. Wihana Kirana Jaya PhD. Faculty of Economics & Business Universitas Gadjah Mada

Introduction to Industrial organization Learning objectives: Static and dynamic views of competition The structure–conduct–performance paradigm 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 IO How firms behave in markets Whole range of business issues price of flowers; payment to be official sponsor of major events which new products to introduce merger decisions methods for attacking or defending markets Strategic view of how firms interact How 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

Topics Oligopoly theory Concentration Barriers to entry Pricing & auctions Product differentiation & advertising Research & Development Vertical integration Diversification Competition policy & regulation

Static & Dynamic View of Competition 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 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)

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 NIO Empirical Theoretical Industry Market Structure, Performance Conduct

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

(Not so) New Developments Baumol’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 firm vertical 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)

Technological progress The Structure-Conduct-Performance Paradigm Supply condition Technology & cost structure Factor markets Organizational structure Location Demand condition Tastes & preference Price elasticity of demand Availability of substitutes Method of purchase Technological progress Structure Number & size distribution of buyers & sellers Entry & exit conditions Product differentiation Vertical integration Diversification Conduct Business objectives Pricing policies Product design & branding Advertising & marketing Research & Development Collusion Merger Performance Profitability Growth Quality of products & services Technological progress Productive efficiency Allocative efficiency Government Policy Competition policy Wage & price controls Regulation Trade policy Taxes & subsidies Regional policy Environmental policy Macroeconomic policy Employment policy

Structure The 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.

Conduct Business 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 marketing Research 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)

Performance Profitability. 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.

…continued Technological 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)

…continued The 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 Paradigm The 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.

Porter’s Five Forces Model Suppliers Potential rivalry Supplier power Industry competitors: Rivalry among existing firms Threats from substitute products & services Threats from potential entrants Buyer power Substitutes Buyers