Industrial Organization: Markets and Policy

• Industrial Organization is the economics of markets and industries, including their participants and public policy, according to Stigler.
• Industrial Organization is concerned with the study of imperfect competition.
• Imperfect competition involves decisions about price, product design, promotion, advertisement, market entry timing, and entry strategy.
• The field focuses on the structure and boundaries of markets, expanding the classical model with imperfections.
• Industrial Organization examines the drivers of firm and market organization, including descriptive analysis and modeling of strategic behavior.
• It covers public policy, regulation, antitrust law, and market operation.
• Keywords in this field include theory of the firm, oligopoly, concentration, barriers to entry, pricing and auctions, product differentiation and advertising, research and development, mergers, vertical integration, diversification, competition policy, and regulation.

Major Contributors to Industrial Organization

• Adam Smith, Alfred Marshall, and Auguste Cournot are major contributors in the field of economic theory.
• Joseph Schumpeter is known for his concept of "creative destruction."
• Edward Chamberlin wrote "The Theory of Monopolistic Competition."
• Joan Robinson authored "The Economics of Imperfect Competition."
• Edward Mason founded the field, focusing on measuring and explaining industry structures.
• Ronald Coase wrote "The Nature of the Firm" (1937), contributing to transaction cost economics.
• John von Neumann contributed to game theory.
• George Stigler contributed on information economics and regulatory capture.
• Joseph Bain developed the SCP paradigm.
• Herbert Simon studied bounded rationality, satisficing, psychology, and economics in corporate decisions.
• William Baumol examined sales revenue maximization and contestable markets.
• John C. Nash developed the equilibrium concept.
• Harold Demsetz focused on well-defined property rights and efficient markets.
• Oliver Williamson studied transaction cost economics (TCE), opportunism, bounded rationality, and asset specificity.

Why Study Industrial Organization?

• Study antitrust and IO
• The Sherman Act of 1890 was the first antitrust law.
• Section 1 of the Sherman Act prohibits contracts, combinations, and conspiracies in restraint of trade.
• Section 2 of the Sherman Act makes illegal any attempt to monopolize a market.
• Adam Smith discussed collusion among rival firms and monopoly power.
• The Clayton Act of 1914 limits specific business practices like rebates, tying, exclusive contracts, interlocking directorates, and mergers.
• The Federal Trade Commission Acts (FTC, 1914) contributes to limiting specific business practices.
• The U.S. Steel case in 1921 , "the law does not make mere size an offense,” provided a major stimulus to the development of industrial organization.

Methodology for Industrial Organization

• Initially, there was a lack of proper models of actual pricing behavior.
• Imperfect competition is difficult to analyze using traditional methods.
• A general framework is needed for analyzing and comparing industries, not just describing them.

Evolution of Industrial Organization

• Early focus was on whether firm size or industry structure leads to illegal behavior.
• The focus evolved to reveal structural features and identify links between structure, firms' conduct, and market outcomes.
• The SCP paradigm focuses on structure, performance, and outcome.
• Statistical studies found links between higher concentration and profitability along with advertising.

1st Chicago School

• There were large industry studies, such as Bain (1956).
• Manufacturing industries contributed more to GDP.
• The goal was to find what can be done to achieve good market performance?
• Henry Simons studied industrial deconcentration.
• Deconcentration proposals were made in the 1950s and 60s.
• The Hart Bill (1967) was not ratified.

Rise and Fall of SCP

• From 1945 to the late 1960s, the SCP framework was the major influence on antitrust policy
• In the Alcoa case (1945), a 90% market share led to a Supreme Court ruling of monopolization.
• American Tobacco, Ligget & Myers, and R. J. Reynolds had 75% total share in 1946, leading to monopolization concerns.
• Concerns arose that SCP could reflect efficient firms gaining large market share
• Little attention was given to strategic interaction.
• In the SCP framework, structure is exogenous.
• Intensive price competition may couple with high concentration, contradicting SCP.

The (2nd) Chicago School

• Rising concern over flaws in both the SCP approach and the stemming public policy (Brown Shoe, Utah Pie cases)
• Efficiency critique market structure is endogenous.
• Formal economic models were used.
• Good approximation assumption – perfect competition is good for imperfectly competitive industries
• Posner, Bork, Peltzman (2nd Chicago School): vertical relationships, good economic reasons for restrictive practices, actually increasing consumer benefits.
• In the '70s there were court cases of General Dynamics, Kodak, IBM, Zenith Corp.
• There was a need to examine the logic and reasonability of a firm's conduct - no consistent framework developed yet.

New Industrial Organization

• Game theory by Von Neumann and Morgenstern (1944), Nash (1951), Reinhard Selten, John Harsanyi, Michael Spence, Thomas Schelling.
• Game theory allows the modeling and analysis of firm behavior in imperfectly competitive markets.
• Schmalensee, 1982: C+P variables have an effect on structure, causality is bidirectional, strategy is as important as structure conduct and strategy is in the focus.
• Firms are considered active decision-makers.
• There is a wide range of stategies

Alternative Theories of the Firm

• Strategic management.
• Neoclassical model of the firm. -Managerial theories of the firm.

Strategic Management

• Aims to describe how firms obtain and sustain competitive advantages over rivals
• Instead of focusing on the external environment, there is focus on a company's internal operations.
• Distinctive features, each company possesses distinct qualities and strategies for conduct and performance.
• innovation, architecture (organisation of the firm), reputation are all types of these qualities
• Strategic management does not emphasise interactions between firms - complementary to traditional IO models.

Porter’s Five Forces Model

• Competitive advantage is based on value over costs
• Porter value chain: primary activities creation of product, support activities (R&D, HR, procurement).
• Generic strategy: add value and gain an advantage, cost leadership or differentiation.

The (neo)classical theory of the firm

• There is a classical approach to profit maximization.
• Perfect information and rational decision makes make the decision.
• Analysis occurs at the margin.
• There is classification of markets.

Criticism of The (Neo)Classical Theory of the Firm

• Classical approach has it's limitations to profit maximisation - there are other organisational goals...
• Uncertainty and imperfect information cause people to try and anticipate changes and foresee the future.
• Organisational complexity.
• Decision-making utilizes simple rules- Hall and Hitch, 1939/1991, markup pricing).

Separation of Ownership from Control - Managerial Theories

• Single owner companies (sole proprietorship), partnerships, corporations.
• Corporations have shared capital ownership, limited liability of shareholders.
• A rise of corporations meant economic need for larger firms.
• There were teams of specialised experts, and a manager board
• Bulk of economic activity is undertaken by corporations
• Teams of specialised experts, manager board(no single decision maker)
• Interests of managers and owners don't always coincide causing Managerial theories of corporate behaviour
• Financing comes from capital markets

Baumol's Sales Revenue Maximization Model

• Baumol (1959): managers are primarily interested in maximizing their organizations’s sales revenue, subject to satisfying a minimum profit constraint
• A good indicator of performance CEO power (influence, status) is linked closely to sales Raising finance from capital markets depends on this
• Minimum profit constraint: financing, stakeholders' satisfaction (manager's job security requirement

Marris's Growth Maximization Model

• Future growth maximisation: balance between growth of demand (short run profit) and growth of capital.
• There are price policies, advertisement, R&D,limits of growth exist.
• Managerial constraints of growth too quick growth through diversification reduces profitability.
• Valuation ratio : market capitalization/book value of assets Borrowing (Debt/Capital ratios), etc.
• Financial constraints on growth (Debt/Capital ratios).

Williamson's Managerial Utility Maximization Model

• Expense preference behaviour: managerial utility function.
• But π= π(S) so πD = π(S) M T πο - diminishing returns to S implies a concave (sad smiley shaped) function constrained maximization problem with functions vs.
• A managerial firm tends to overspend on its staff in comparison with a profit-maximizing firm.

The Behavioural Theory of the Firm

• Cyert and March (1964): firmis defined as an organizational structure and decision making process loose boundaries, all stakeholders
• Bounded (and not global)rationality (Simon, 1959) and No one has complete information Conflicts, bargaining, coalitions Side-payments organizational slack
• Satisfaction rules of thumb.

Coasian View of The Firm - Transaction Cost

• Markets: coordination of resources allocation through the price mechanism...why firms exist?
• Robertson: positions of within markets are like 'islands of conscious power in this ocean of unconscious cooperation'
• A firm: economizes on transaction costs of processing information) by coordination and centralized allocation. Search, Negotiation and Government.

Agency Theory

• Separation of ownership from control in modern corporations involves managers as agents: may not always act in the best interests of shareholders is their principals
• Principal-agent problem: a principal hires an agent, but has imperfect information a firm's shareholders (principal) and its managers agent), the firm employer principal.
• Performance based remuneration instead of fixed wages Firm as team-based production: Metering problem shirking or free-riding.

Agency Theory

• Adverse selection and moral hazard: the way performance based remuneration is allocated instead of fixed wages
• Firm as team-based production leads to metering problems or shirking and free-riding
• Firm as a nexus of contacts – wider concept, firm links contractual relationship
• Resource based theory of the firm - firm acts as a repository for the skills, knowledge and experience that have accumulated over time
• Apply knowledge to the production of goods and services, the most important of a firm's resources

Key Concepts

• Law of Diminishing Returns.
• Short-run and long-run Production Functions.
• Economies of scale and the minimum efficient scale.
• Economies of scope.
• Demand, revenue and elasticity.
• Profit maximization.

Production functions

• Long run production function Q=A-F(K,L)
• Short run production function q=F(K,L)=g(L)
• Economies of scale and the minimum efficient scale Law of Diminishing Returns. Marginal product of labour, MPL=dQ / dL Average product of Labour, APL=Q/L

Production Costs and Cost Functions

Total Cost (TC). Fixed Costs (FC). Variable costs (VC). Average Cost (AC)=TC/q. Marginal Cost (MC)=ATC/Aq.

• Real~ are Economies of Scale: savings in costs arising from large scale production.
• Diseconomies of Scale: the forces which cause large firms to experience increased per unit costs.

Economies of Scale

• Increasing returns to scale mean that when output increases more than proportionally to input increases.
• Constant returns to scale.
• Decreasing returns to scale.
• Real economies are where there are average cost savings.
• Pecuniary economies are due to with changes in factor prices, larger firms finding it easier to raise the price.
• External economies are related to the expansion of the industry.

Managerial Diseconomies

• Happens due Strained communications between tiers of the structure of managment..
• Or just in general, complex organisational structure
• Due to size: greater size growing transport shipping costs scarcity of factor inputs, shortage and growing costs.

Cost Concepts for Multiproduct Firms

• Knowledge As common input.
• Bulk purchasing of (common) inputs.
• Consumer data management, spreading the costs of marketing, finance, distribution.
• Economies of Scope occur with multiple products cost savings.

Measurement of Concentration

• Aggregate, macro level concentration. Industry Concentration reflects the importance of the largest firms.
• Mergers Increase concentration, Transfer of Market Share from Small To Larger Firms Should Increase Concentration. Firms cumulative market share is decisive.

Concentration Measures

• n-Firm Concentration Ratio The First.
• Variance of the Logarithm of Firm Sizes Entropy Coefficient.