Industrial Organization: SCP Approach

• These study notes cover midterm practice questions.

SCP Approach to Industrial Organization

• The Structure-Conduct-Performance (SCP) paradigm is foundational in industrial organization.
• Joseph Bain developed the theory in the 1950s.
• SCP examines how market structure determines firm conduct, which affects market performance.
• Market structure includes market concentration and entry barriers.
• Firm conduct includes pricing, advertising, and R&D.
• Market performance includes prices, innovation, and consumer welfare.
• The approach assumes a one-way causality: structure influences behavior and market outcomes.
• It's been argued that structure can also be endogenously determined by firm behavior.
• Chicago School theories and Game Theory emphasize strategic interactions.

Development of the SCP Paradigm

• The SCP paradigm emerged to analyze industrial competition and antitrust policy.
• The need for this systematic framework arose especially after World War II.
• Edward Mason introduced the idea that market structure affects firm behavior.
• Bain's empirical studies 1947-1951 on market concentration and entry barriers solidified the framework.
• High concentration and entry barriers correlate with higher profitability and reduced competition.
• SCP became the dominant approach in industrial organization and antitrust enforcement by the mid-20th century.

How SCP Studies Firms and Industries

• The SCP paradigm analyzes how market structure affects firm behavior and market outcomes.
• Researchers and policymakers use SCP to investigate relationships such as market concentration and profitability.
• They also study firm size, competitive strategies, advertising, R&D, and entry barriers.
• SCP helps regulators assess market power, monopolistic behavior, and antitrust policies.
• SCP studies have influenced merger guidelines, competition law enforcement (Sherman Act, Clayton Act).
• SCP also influences regulatory decisions in telecommunications and banking.

Factors Describing Market Structure in SCP

• Market concentration assesses the dominance of firms using indicators like the Herfindahl-Hirschman Index (HHI).
• The other indicator used is the n-firm concentration ratio (CR4, CR8).
• Barriers to entry include high capital requirements, economies of scale, legal restrictions, and brand loyalty.
• Product differentiation measures unique branding, features, or quality variations.
• Number of firms/market power influences pricing strategies and innovation.
• Vertical integration and diversification examine how firms control supply chains or expand into related markets.

Ways Market Structure Affects Conduct in SCP

• High market concentration leads to greater price-setting power.
• Monopolies/dominant firms set prices above marginal cost, potentially harming consumers.
• Entry barriers lead to reduced competition.
• Pharmaceutical patents prevent generic drug manufacturers from market entry.
• Product differentiation leads to non-price competition.
• Smartphone companies compete through branding, advertising, and product innovation.
• Low market concentration leads to more competitive pricing.
• Fast food companies keep prices relatively low due to strong price competition.
• Oligopolies have strategic interactions through collusion/competition.

Factors Describing Performance

• Profitability measures financial success, which is often linked to market power.
• Indicators include Return on Assets (ROA) and Return on Equity (ROE).
• Consumer welfare evaluates how market outcomes impact consumer prices, quality, and variety.
• Indicators include price levels, product variety, and consumer surplus.
• Efficiency examines how well resources are utilized.
• Productive efficiency means producing at the lowest cost.
• Allocative efficiency means resources are allocated to maximize consumer benefit.
• Innovation assesses investments in research & development (R&D).
• Indicators include R&D spending, patent registrations, and technological progress.

Limitations of the SCP Paradigm

• Causality Issue:
• SCP assumes one-way causality, but firm behavior shapes market structure.
• Static Framework:
• SCP does not account for strategic firm behavior and dynamic competition.
• Neglect of Firm-Specific Advantages:
• Focuses on industry-wide factors but overlooks firm-level capabilities.
• Empirical Challenges:
• Relies on statistical correlations that are not always causal.
• Exogeneity of Structure:
• Assumes market structure is externally determined, overlooking firm strategies.
• Lack of Dynamic Competition Consideration:
• The model primarily focuses on static relationships. Empirical Inconsistencies:
• Some highly concentrated industries exhibit competitive pricing and innovation.
• Endogeneity of Performance:
• Profitability and market outcomes may not just be a result of structure.

First Chicago School on Improving Market Performance

• Focuses on market deconcentration and strict antitrust enforcement improve market performance.
• Breaking up large firms leads to increased efficiencies and reduced competition
• Prevents vertical integration and restrictive business practices reduce market competition
• Price regulation in natural monopolies manages industries that tend toward monopolization.
• Market liberalization over direct government control reduces government intervention.
• The first Chicago School contrasts with the second Chicago School which argues market structures emerge naturally.

Contrasting Collusion and Efficiency Hypotheses

• The Collusion Hypothesis states high profitability results from anti-competitive behavior, which reduces competition.
• The Efficiency Hypothesis states firms achieve high profitability through innovation and economies of scale.

Main Flaws and Contradictions in the SCP Approach

• Exogeneity of Structure:
  • The SCP framework assumes market structure is externally determined.
  • It overlooks the role of firm strategies in shaping industry structure.
• Lack of Dynamic Competition Consideration:
• The model focuses on static relationships failing to account for continuous innovation.
• Empirical inconsistencies:
• Contradicts the assumption that concentration leads to reduced competition and higher prices.
• Endogeneity of Performance:
  • Market outcomes may not just be a result of structure, making causality difficult.

Resolving SCP Issues with New Industrial Organization (NIO)

• NIO incorporates Game Theory in order to analyze strategic interactions among firms.
• NIO moves beyond the SCP paradigm by incorporating feedback loops.

Strategic Management Literature

• It shifts the focus from market structure to internal firm capabilities and strategic positioning
• A framework for assessing industry competition identifies external pressures.
• (RBV) argues that firms achieve long-term success due to unique, inimitable capabilities

Porter's Five Forces Model

• These shape industry profitability by influencing competition and market dynamics:
  • The threat of new entrants
  • The bargaining power of suppliers
  • The bargaining power of buyers
  • The threat of substitutes Industry rivalry

Basis/Background of Managerial Theories

• Suggests that firms do not always prioritize profit maximisation
• Alternative goals can be sales revenue maximation or growth maximisation
• Another alternative goal is managerial utility maximization

Core Concept Behind Baumol's Sales Maximization Model

• Baumol argues that managers prioritize maximizing sales revenue rather than profits.
• Revenue growth enhances their job security, prestige, and influence within the firm.
• Firms need to maintain a minimum profit constraint to satisfy shareholders and ensure financial stability.

Core Concept Behind Marris's Growth Model

• Marris's model suggests that firms aim for managed growth.
• Managerial rewards include salaries, perks, and job security.
• Growth is constrained by financial constraints and managerial constraints.

Elements of Managerial Utility in Williamson's Model

• It suggests that managers prioritize their own utility over pure profit maximisation
• Managerial utility includes staff expenses, managerial perks and discretionary profit.

Fundamental Reason of Company Formation According to Coase

• Coase argued that firms existed in order to minimize transaction costs.
• Organizing production within a firm, managers can coordinate resources more efficiently.

Examples of the Principal-Agent Problem in the Corporate Context

• Managers (Agents) vs. Shareholders (Principals) – Managers may prioritise personal benefits.
• Employees (Agents) vs. Employers (Principals) – Workers may exert minimal effort (shirking) if compensation is not tied to performance.
• Executives (Agents) vs. Board of Directors (Principals) – CEOs may pursue short-term growth strategies.
• Sales Representatives (Agents) vs. Company (Principal) – Salespeople may focus on closing high-commission deals.

Realism Regarding the Assumptions of Perfect Competition

• Assumptions of perfect competition are unrealistic in real-world markets
• Including product differentation, market power, and perfect information.
• Several factors limiting free market entry act as barriers to entry

Real-World Industries Approximating Perfect Competition

• Markets come close by exhibiting many buyers and sellers, standardized products, and minimal barriers to entry.
• Commodities like wheat, corn, and rice are produced by many farmers.
• Stocks of major publicly traded companies are bought and sold in highly competitive exchanges,

Firm's Abnormal Profit in Perfect Competition and Industry Equilibrium

• Abnormal profit is only a short-term phenomenon and disappears due to free market entry and exit.
• Normal Profit Equilibrium is where firms only earn zero economic profit
• If firms begin incurring losses, some exit the market, reducing supply and stabilising prices.

Long-Run Industry Supply vs. Short-Run Industry Supply in Perfect Competition

• Factor Input Flexibility - This allows for supply to respond more significantly to price change over time.
• Greater flexibility to adjust output allows long run supply to be more elastic.

Productive and Allocative Efficiency Properties

• It's being compared under perfect competition, monopoly, oligopoly.
• Perfect competition is highly efficient
• Monopoly is inefficient.
• Oligopoly has mixed efficiency

Positive Factors of Monopolies for Social Welfare

• Monopolies can drive technological progress and improve social welfare through innovation incentives.
• High economies of scale make a single firm reduce costs.

Attainability by a Natural Monopoly in Regards to Allocative Efficiency

• Not Naturally, because natural monopoly sets P > MC to cover high fixed costs, leading to allocative inefficiency
• It doesn't achieve allocative efficiency on their own, but regulation can push them closer.

Survivorship Studies

• These studies determine whether survival is driven by efficiency of firms or structure.
• High turnover suggests intense competition, innovation, and market disruption.

Criteria For Concentration Measures According to Hannah and Kay

• Effective concentration measures ensure that it accurately represents competition levels and market power.

Advantages/Disadvantages

• The index is more sensitive to market power and better captures mergers.
• Main advantages and disadvantages are related to the n-firm concentration ratio as a measure of seller concentration.

The Herfindahl-Hirschman Index (HHI)

• The HHI provides a more satisfactory method for measuring seller concentration because of firm dominance. It weights dominant firms more heavily and includes all firms.

Construction of The Gini Coefficient to Measure Inequality

• Based on the Lorenz curve, calculating area between it and the line of perfect inequality
• Ranges from 0 to 1, indicating perfect equality and perfect inequality, respectfully.

The Rothschild Index

• In comparison to perfect competition, it measures pricing behavior (R).
• Higher R means greater pricing power while lower R means intense competition.

The Lerner Index

• This is a measurement for a firm's pricing power as compared to its marginal cost
• Bounds range from 0 (perfect competition) to 1 (perfect monopoly).

Deadweight Loss (DWL) Relevance to Consumer Welfare

• DWL is the loss of total economic surplus due to market inefficiencies, such as monopolies restricting output.

Shutdown and Break-Even Points for a Company

• Break-even points state that the firm earns zero economic profit but stays in business.
• Shutdown points require that the firm cannot cover variable costs, and ceases production.

Relevance of Interdependence in an Oligopolistic Market

• This is the action among firms which directly influence others that lead to strategic behavior
• Strategic interdependence requires that oligopolies engage in game-theoretic decision-making.

Barriers to Entry Examples in an Oligopolistic Market

• These barriers ensure for existing firms which maintain market dominance and limit competition.

Equilibrium Concept in A Oligopolistic Market

• It is complex, involving the relationship between strategic interdependence that naturally lead.
• Oligopolies can see different equilibrium outcomes which are dependent on the strategy.

Game Theory Influence

• Oligopolistic equilibrium mostly leads to Nash equilibrium, where firms choose their best strategy to stay competitive