Economic Analysis And Industrial Structure PDF

CHAPTER ONE FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE Meaning of Industrial Structure The term "structure of industry," as used in this book, refers to a selected number of characteristics of the output of a firm or a group of firms. These characteristics include, for example, co...

CHAPTER ONE FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE Meaning of Industrial Structure The term "structure of industry," as used in this book, refers to a selected number of characteristics of the output of a firm or a group of firms. These characteristics include, for example, cost conditions, con- centration, vertical integration, diversification, and entry barriers. Cost conditions describe the relation between the minimum cost of producing and distributing a particular good or service and alternative levels of total output of that product or service. Concentration refers to the num- ber and size distribution of firms producing a particular category of output. Vertical integration refers to the extent to which successive stages in the producing of a particular product or the performing of a service are performed by a single firm. Diversification refers to the extent to which a firm produces different kinds of output not vertically related to one another. Entry barriers are obstacles to a new firm wishing to engage in the production of a particular category of output. A more detailed consideration of the nature and significance of these and other sire more poly the unt a or the pres natio objectives pursued by business enterprises. Because there are many concepts of the firm, a precise definition is not possible. From an accounting point of view, for example, a firm is a collection of assets and liabilities. From the legal point of view, a firm is either a sole proprietorship, a partnership, or a company with limited liability. Although a firm has many characteristics in addition to those directly relevant to a study of industrial structure, all its characteristics 2 FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE NATURE OF THE FIRM'S OBJECTIVES 3 have one thing in common. They are the result of decisions made by For the benefit of readers unfamiliar with the meaning of present people controlling the operations of the firm. All its characteristics are value and the related concept of discounting, a brief digression is ap- related through the decision-making process. The choice of what to propriate.' Discounting, a fundamental concept in the decision-making produce, for example, influences the type of assets and liabilities a firm is a process of transforming anticipated future receipts or will acquire. The choice of legal form may influence the total amount outlays into equivalent "present values." In order to choose between of investment funds available to the firm and hence the level of its total alternative policies differing from each other in respect to the time path productive activities. The firm in the sense of a decision-making unit is of receipts and outlays associated with each policy, a decision maker of primary interest to economists, because they are interested in the must be able to compare receipts and payments occurring at different determinants of various characteristics of business enterprises and in points in time. the relationship between such characteristics, and these are the result of The discounted present value, P, of an amount of receipts or outlays, a decision-making process. V, which is expected to accrue after n periods, is defined as V Nature of the Firm's Objectives P= (1+r)* The structure of industry existing at any point in time may be viewed where r, called the "discount rate," reflects the decision-maker's own simply as the result of efforts by thousands of individual decision makers relative evaluation of current versus future receipts or payments. The to achieve certain objectives. Productive activity is the process of trans- discount rate is related to the rate of return on the firm's best alternative forming inputs into outputs. The firm, or rather its decision makers, investment opportunity. It may be related to the rate of interest at which will select from the alternatives available that combination of inputs and the decision maker can borrow additional funds, or at which he can lend outputs which best achieves the firm's objectives. A list of the many money; alternatively, the discount rate may be related to neither of alternative possible objectives pursued by a firm's decision makers these rates but instead may reflect the anticipated rate of return on the would occupy many pages. In the remainder of this section, several of internal use of the firm's own financial resources. If, for example, the the objectives considered to be of major importance in influencing busi- firm can borrow or lend any amount at a given rate of interest, i, the ness behavior, and hence industrial structure, are described. discount rate will equal this rate, because the best alternative to the use The first objective to be considered, that of maximizing profits, has of money in the firm is in these circumstances the rate of interest that for long occupied pride of place in economics textbooks concerned with would be saved by not borrowing the money or that would be earned by the behavior of the firm. The word "profits" has many different mean- lending the money. If the firm can lend at rate i, the "present value" of ings in everyday usage. In economic analysis, profits are the difference an amount of receipts, V, accruing one period from now is V/ (1 + i), between receipts from the sale of the firm's output(s) and the costs of because this expression indicates the amount of money which, if lent the inputs required to produce and distribute those outputs. A major now at a rate i would grow to equal V after one period. If the cost of distinction is made between profits as a concept in economic analysis borrowing money increases with the amount borrowed, the discount rate and "accounting profits" as measured by traditionally accepted methods is related to the marginal cost of borrowing, rather than to the average of business bookkeeping. In the case of economic profit, the costs of cost in terms of the interest rate paid on additional funds. If the firm inputs used by a firm are measured by their "opportunity cost," which cannot borrow or lend additional funds, the discount rate is related to is defined as the best return an input could earn outside the business, the marginal return of money in the most profitable internal use avail- whereas accounting profit measures input costs by the actual money able. In these circumstances the appropriate discount rate for determin- expenditure on inputs. Thus, for example, accounting profit includes the ing discounted present values itself depends upon the best internal use wages an owner-manager could earn by selling his services elsewhere, that can be made of the funds. In other words, the discount rate depends and also the interest owners of a business could earn elsewhere on the upon the optimal calculation and vice versa. funds they have invested in the business; economic profit, on the other hand, excludes these two items. "Profit maximization" may be inter- rollowing one the rendi interes die in a more de sid teamert of disconn thes preted as a desire to maximize the present value of the profits expected from the firm's productive activities over a specific period. may consult the articles by Baumol (4), Mishan (9), and Solomon (12) listed at the end of this chapter.  FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE NATURE OF THE FIRM'S OBJECTIVES Even in those cases in which the objectives of a firm's decision revenue maximizer will forgo current profits in order to expand current makers is not maximization of profits, the desire to make some profits sales revenues beyond the profit-maximizing level. However, current will nonetheless usually enter into the decision-maker's objectives for profits enable sales revenue to be expanded in later periods. The choice, one or both of the following reasons. First, making some profits may be in brief, is between larger current revenue and lower profits, necessary to enable the decision maker to achieve some other objective. growing at a slower rate through time; and smaller current sales rev- Second, all objectives are subject to the constraint of some minimum enue and higher profits, growing at a faster rate through time. The sales revenue maximizer will choose that combination of current sales benefits to the owners of the firm. This constraint may take the form of and growth rate which maximizes the present value of sales revenue. paid-out profits to owners, considered necessary perhaps by those cur- rently controlling the firm's operations in order to permit them to remain This combination may involve a positive growth rate of sales revenue, in control. If dividends fall below a certain level, control may be lost which implies a positive level of profits since profits are necessary to because existing shareholders either replace the managers or alterna- obtain finance for growth. tively sell out to new owners who in turn might install a new management Apart from the profit constraint that may be generated automatically in the hope that the latter would distribute higher dividends. The profit by a desire to finance expanded output and sales revenue in the future, constraint need not, however, necessarily involve paid-out profits; if there may be an additional constraint in the form of a minimum paid-out profits are retained in the business, thereby increasing the firm's net profit constraint considered necessary by the firm's decision-making unit in order to prevent take-over of the firm and loss of control by the assets and profit-earning potential, owners may experience benefits in present decision-making unit. With such a paid-out profit constraint, the the form of capital appreciation of ownership claims. locus of maximum attainable current-sales-growth-rate combinations is Rather than attempt to maximize profits, a firm's decision makers may reduced, and the optimal decision which satisfies the constraint will seek to maximize sales revenue, subject to the constraint that profits involve lower sales and/or growth. With the paid-out profits constraint, equal or exceed a certain amount. A number of reasons have been profits must be made, but the firm need not grow because retained advanced to explain why a firm's decision makers should be more con- profits may be zero. cerned with sales revenues than with profits. It has been argued, for A desire to maximize the present value of either profits or sales example, that in firms in which ownership is divorced from control, the revenue accruing from the use of the firm's assets may result in growth. remuneration of professional managers controlling the firm's operations Growth is in these circumstances a means towards achieving another is linked more closely with sales than with profits. The evidence obtained objective. A desire to maximize the growth rate of some aspect of the in a number of empirical studies* lends some support to this hypothesis. firm's operations itself is another possible objective. A number of vari- The higher correlation of executive remuneration with sales than with ations of this objective are possible, depending upon whether the growth profits will, it is argued, motivate managers to produce and market levels rate of paid-out profits, sales revenue, total assets, net assets, or some of output larger than those which maximize profits. other aspect of the firm is to be maximized. If decision makers pursue maximum sales revenue subject to a profit constraint, the crucial question is what determines the minimum In the case of growth objectives, the desire to make profits is inherent in the objective itself, because profits are necessary in order to finance acceptable amount of profit? In a single-period analysis of the sales- growth internally or to obtain additional outside finance. This applies revenue-maximizing objective, the profit constraint must be arbitrarily whether the objective is to maximize the growth rate of profits, sales imposed; thus, in the early literature dealing with this objective, it was revenue, or net assets. assumed that the profit constraint was imposed by the capital market and Decision makers may pursue other objectives which are variations on the need to pay owners a return comparable with that paid by other the theme of profit, sales revenue, or growth rate maximization. Instead firms in the economy. With a multiperiod analysis in which the decision- of attempting to maximize sales revenue subject to a profit constraint a maker's objectives are interpreted as the desire to maximize the present firm may, for example, wish to maximize profits subject to a self- value of sales revenue over a specified period of time, however, the imposed constraint in the form of a desire to achieve a certain level of profit constraint may be generated automatically by the desire to finance sales revenue. The sales revenue constraint may be imposed by a desire growth of sales revenue. For reasons to be explained later, a sales on the part of the firm's management to prevent the firm's market share from falling in absolute or relative terms. Alternatively, the firm may 2 See, for example, reference (8), J. W. McGuire et al.  FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE NATURE OF THE FIRM'S OBJECTIVES 7 wish to maximize profits or sales revenue subject to achieving a certain a single-period analysis, this proposition is explained by reference to growth rate of the firm's net assets. the fact that a profit-maximizing level of output equates the marginal The nature of a firm's objectives is fundamentally important in in- revenue and marginal cost of output, while a sales-revenue-maximiz- fluencing the characteristics of the firm's productive activities. It can be ing level of output equates the marginal revenue to zero. Provided shown, for example, that the behavior of a firm confronted by a par- that the marginal cost of producing output is positive at all levels of ticular set of environmental conditions will differ depending upon output, a profit-maximizing level of output will be one involving positive whether the firm's objective is profit, sales revenue, or marginal revenue, which in turn implies that total revenue can be in- maximization. For the sake of simplicity the following exposition as- creased by expanding output. A minimum-profit constraint sets a limit sumes that the funds available to the firm cannot be increased by to the extent to which a firm can expand output beyond the profit- resorting to outside finance; the reader isassured that the conclusions are not materially altered by dropping this assumption. ?TC Consider, first, the behavior of a firm if the objective is to maximize the present value of profits resulting from the use of the firm's assets. The firm will produce a level of output which maximizes current profits. T R If all these profits are paid out to the firm's owners at the end of the Revenue, Cost, first period, the stream of paid-out profits through time will consist of and the same level of paid-out profits, repeated in each successive period, Profit unless and until the firm's economic environment changes. Alternatively, the firm can retain some profits to finance growth of output and profits in each successive period. The firm can choose between lower paid-out - Profit constraint profits in any period, growing at a faster rate through time, and larger paid-out profits in any period, growing at a slower rate through time. ? e e, The problem of the firm with a profit-maximizing objective is to select Profit a growth rate (implicitly in this model, a retention policy) which Quantity maximizes the present value of paid-out profits over the period to which Figure 1-1 A Single-Period Constrained Sales Maximization Model the objective applies. Consider next the behavior of the firm if the objective is to maximize maximizing level. A single-period model of a firm maximizing sales the growth rate of output, sales revenue, profits, or some other variable. revenue subject to a minimum profit constraint is shown in Growth requires funds to finance growth and, in this example, profits 1-1. The firm's sales, or total revenue, is represented by curve TR, and are the only possible source of finance for growth. Funds for growth, its total costs by TC. Output Q, maximizes the firm's current profit. At and the attainable growth rate, will be maximized if the firm produces a this output, the slope of the total cost curve (equals marginal cost) is level of output which maximizes profits in the current period. Growth equal to the slope of the total revenue curve (equals marginal revenue). rate maximization and profit maximization (as defined above) lead to However, since TR is still increasing (marginal revenue is positive) as the same output decision in the current period. The growth rate maxi- output is increased, the firm expands output and produces and sells mizer will retain more profits than the profit maximizer; all profits over output Q., where further expansion of sales will decrease profits below and above those needed to satisfy a minimum paid-out profit constraint a minimum acceptable level. will be used by the growth maximizer to finance growth. The level of The reason why a firm whose objective is to maximize the present output produced by the firm in any given future period will, it follows, value of sales revenue will produce a larger output level than one whose be greater for a growth rate maximizer than for a profit maximizer, given objective is to maximize profits, is not immediately obvious. Why, it may the firm's economic environment. be asked, should the firm deliberately sacrifice current profits, which can Finally, consider the behavior of the firm if the objective is sales be used to finance increased future sales revenue, in order to expand revenue maximization. Such a firm will produce a larger level of output current sales revenue beyond the profit-maximizing level? The explana- than if the firm's objective were profit or growth rate maximization. In tion, in brief, is as follows: The present value of sales revenue depends 8 FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE 9 NATURE OF THE FIRM'S OBJECTIVES upon the size of current sales revenue and the rate at which this level of sales revenue grows through time. The latter rate depends on the cur- rent profits of the firm, because these provide the means to finance Growth growth of sales revenue in the future. Increasing the level of the firm's Rate of "Iso-present value". current output to the level which maximizes current profits increases Sales lines Revenue both current sales revenue and the rate at which this revenue can grow through time, because this growth rate is determined by the profits re- tained after dividends have been paid and which are therefore available P, to finance growth of output and sales in the next period. At the level of 8 max output which maximizes current profits, sales revenue is still increasing (marginal revenue is positive and equal to marginal cost), but the maxi- * ?, mum possible growth rate of sales revenue is constant, because this rate Current M + S. Sales depends on profits, which are constant at such an output level. It fol- S, S optimal Revenue lows that the present value of sales revenue can be increased by slightly increasing the level of output, because current sales revenue will be in- creased, yet the growth rate of sales revenue is not reduced. At levels of output larger than the profit-maximizing level, increasing the level of current sales revenue reduces profits and hence the attainable growth e, rate of sales revenue. In selecting an output level above the profit-maxi- mizing level, the sales revenue maximizer must choose between larger current sales revenue, growing at a slower rate, and smaller current sales revenue growing at a faster rate. The combination of current sales rev- enue and growth rate which maximizes the present value of sales rev- e, enues must involve a level of output at which further increases in cur- rent sales revenue will reduce the growth rate of sales revenue through ? TC Profit period) than a profit maximizer. ?TR \ Internally generated profit "constraint" Quantity represents levels of current sales revenue (hereafter abbreviated to Figure 1-2 A Multiperiod Sales Maximization Model Sc) is simply Figure 1-1 "turned on its side." In the top half of the diagram the vertical axis represents growth rate of current sales revenue revenue (hereafter abbreviated to Ps) will produce a larger scale of (hereafter abbreviated to g). Curve OM depicts, for an individual firm, output than a profit (and growth rate) maximizer, it is necessary to the maximum attainable g at different levels of S.. As the level of current introduce into the diagram "iso-present value" lines. It was pointed out output and S, are increased, profits and, because profits are required earlier that, given the discount rate of the decision maker, the present to finance growth, the maximum attainable g increase and reach a value of sales revenue, Ps, depends upon both the level of current sales maximum at level of current sales S,, then decline as sales are pushed revenue and the growth rate of that revenue. An "iso-present value" beyond the level which maximizes current profits. Eventually, at a level line will be defined as the locus of combinations of S, and g which of S, involving zero profits, the maximum attainable growth rate is zero. (given the decision-maker's discount rate) yield a constant level of Ps. In order to demonstrate that a maximizer of the present value of sales Holding S, at any particular level, an increase in g will tend to increase  FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE NATURE OF THE FIRM'S OBJECTIVES Psi similarly, holding & constant at a particular level, an increase in S. depending upon how "profits" are defined. Profits may, for example, will tend to increase P.. It follows that higher levels of S, must be com- refer to the mathematical expectation of profits, that is, to the sum of bined with smaller levels of g in order to yield a constant level of Ps; each possible outcome multiplied by its probability. Alternatively, the that is, an iso-present value line as defined above must slope down from firm may be concerned with the dispersion of possible outcomes around left to right in the top half of Figure 1-2. It must be noted that without this mean value,and may define relevant profitsas the ratio of the further information, the precise shape of an iso-present value line is not mean expected profits to the dispersion of the possible outcomes around known; it might be convex, concave, or a straight line. However, all the mean. Or, alternatively, some other characteristic of the probability that is required in the present context is the negative slope. There will be distribution of possible outcomes may beconsidered relevant by a an iso-present value line for every different value of Ps, such as P1, Pa, decision maker. In these circumstances it cannot be argued that any and so on, higher subscripts indicating higher values of Ps. particular measure of profits is more appropriate than another; the Diagrammatically, the problem of a firm which desires to maximize decision maker will adopt the measure he considers most appropriate, the present value of sales revenue is to select a point on OM which and behavior will be influenced by the measure chosen. The implications yields the greatest P,, which amounts to getting on to the highest pos- of uncertainty for objectives other than profit maximization, sible iso-present value line. Such a point will be one where an iso-present sales revenue or growth rate maximization, are similar. In each case, value line just touches, or is tangent to, OM; if the point involved an with uncertainty, a number of variations are possible depending upon intersection between an iso-present value line and OM this would auto- which characteristics of the probability distribution of possible outcomes matically imply that a move to another point on OM could increase Ps. are considered an appropriate index of the variable to be maximized by If, as has been argued above, iso-present value lines slope down from the decision maker in question. left to right, it follows that the point of tangency must lie on that por- The preceding analysis has stressed that behavior depends upon the tion of OM which is negatively sloped, that is, to the right of S,. The objectives pursued by decision makers, and that different objectives may point must therefore involve a level of current output and sales revenue imply differences in behavior.? It is appropriate at this stage to mention larger than the profit-maximizing level. A profit (or growth rate) briefly possible similarities between behavior resulting from the pursuit maximizer will, as argued earlier, select an output and sales revenue level of different objectives. A particular change in the economic environment which maximizes profits in the current period, that is, level Q, and S, in may lead decision makers pursuing different objectives to respond in the Figure 1-2. same direction, if not to the same extent. The existence of a profit con- It must be emphasized that any given objective, whether profit, sales straint in many firms' objectives may be responsible for such a situation; revenue, or growth rate maximization, applies to a specific time period if profits are being sacrificed in order to achieve some objectives, an in- considered relevant by the decision maker in question. Objectives may crease in costs will reduce profits below the level required to satisfy the differ merely in respect to the length of the time period to which they constraint and cause the level of the firm's output to change in the same apply. Profit-maximizing objectives which apply to time periods of dif- direction, whatever the objectives being pursued. In these circumstances ferent lengths, for example, are different objectives, capable of leading it is impossible to infer the nature of the underlying objective simply from to differences in behavior even though all other relevant considerations information on the direction of a response. Additional information is confronting the decision makers are the same. required for this purpose, and it becomes necessary to devise more It is appropriate at this point to consider in more detail the implica- elaborate operational tests to identify firms pursuing particular objec- tions, for decision-makers' objectives, of the existence of uncertainty tives. For example, an increase in a fixed cost?a cost which does not about the future. The profits anticipated in any future period as the result vary with the scale of a firm's output-will not cause a profit maximizer of a given pattern of behavior are not, in the presence of uncertainty, to change the level of his output. Because the total cost of producing single-valued magnitudes. The decision-maker's estimate of profits antici- any particular level of output is increased by the same amount, the pated in a future period may take the form of a probabilistic estimate, a slope of the total cost curve at any level of output (equals marginal range of possible values, each associated with a probability assigned by the decision maker himself, denoting the certainty with which the decision 3 The implications of the pursuit of objectives other than proft maximization maker expects that particular outcome. In these circumstances, any par- for resource allocation in a general equilibrium setting are dealt with in Chapter ticular objective, such asprofit maximization, takes on new variations Ten, in the section entitled Importance of Firms' Objectives.  FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE OPTIMUM-STRUCTURED FIRM 13 cost) remains unchanged, and with it the profit-maximizing level of distinguish a number of quite different concepts of the optimum-struc- output. On the other hand, an increase in a fixed-cost item will cause a tured firm can lead to confused reasoning, and it must be stressed that constrained sales revenue maximizer to reduce the scale of his output the concept is entirely dependent upon the objective one has in mind because the added costs will reduce profits at the old level of output A firm with a particular structure may be optimal from the point of view below the minimum acceptable level. If the additional cost item varies of achieving one objective, and at the same time may be nonoptimal with the scale of output, however, a profit maximizer will also change from the point of view of achieving a different objective. For example, the scale of his output, increasing output if marginal cost at the old what is optimal from the point of view of the decision maker controlling level of output is reduced, and reducing it if marginal cost at the old level a firm, concerned perhaps with maximizing profits, need not be optimal of output is increased. If a firm is observed to change the scale of its from the point of view of public policy makers concerned with the alloca- output in response to a change in a fixed-cost item, the inference is that tion of the nation's resources. That is, a type and level of output which profit maximization is not the firm's objective, or possibly that the cost maximizes the firm's profits need not coincide with the type and level of is not regarded as a fixed cost by the decision maker in question. As this output which makes the best use of the nation's resources. example suggests, operational tests to identify firms pursuing particular From the point of view of the decision-making unit controlling the objectives are difficult to devise, though not impossible. operations of a particular firm, the optimum-structured firm is a firm For some purposes, it is not necessary to know the precise nature of with characteristics which achieve the decision-maker's objectives better the objectives pursued by firms responding in the same direction to a than any other structure. If one is interested in the determinants of a particular change in the economic environment. This is the case if one is firm's behavior in practice, the objectives of the firm's decision-making interested only in predicting the direction of a response, instead of its unit are relevant, because actual structures will tend to reflect what the precise magnitude, which usually requires precise knowledge of firms' decision-making unit considers to be an optimal structure in the light of objectives. In these circumstances, a single objective can be attributed the decision-maker's economic environment. to the decision makers in order to yield valid predictions concerning In view of the possibility of different objectives when comparing dif- the direction in which they will respond to particular changes in their ferent decision-making units, it is not surprising that different firms have environment. The continued use of profit maximization as a basis for different structures in practice even though the environmental conditions predicting firms' behavior may sometimes be justified on these grounds. surrounding these firms are often very similar. If the objectives of dif- ferent decision-making units differ, there is no such thing optimum-structured firm, valid for all firms. Optimum-Structured Firm It must be emphasized that, considering an individual firm, the opti- mum-structured firm may differ at different points in time, even though The size of the firm is a multidimensional concept including both the decision-maker's objectives and environment remain unchanged. In stock and flow magnitudes. Dimensions of size include, for example, all those situations in which achievement of the decision-maker's objec- sales revenue, value added (sales minus purchases of raw materials, tive involves a positive rate of growth of some aspect of the firm's fuel and power), capital assets, number of employees, and other aspects operations, the structure of the firm is determined by the point in its of the firm's operations. A particular level of sales revenue is com- growth which it happens to have reached at a particular time. In these patible with different levels of value added, reflecting differences in the circumstances there is no optimum structure except at a point in time. vertical aspect of firm size, that is, the number of successive stages in Two firms which begin life at different points in time, each pursuing the the productive process performed by the firm. Specific levels of both same objective and operating in an identical environment, may con- sales revenue and value added are compatible with different degrees of tinue to differ at any given point in time despite the pursuit of identical diversification in terms of outputs, and also in terms of inputs combined objectives and despite identical environmental conditions. in producing particular outputs. In what follows, the term "structure" is In much of the literature on price theory, the term "optimum-sized used in preference to "size," since it conveys better the fact that size is firm" refers to that level of a firm's output which minimizes the long-run a multidimensional concept. average cost of producing the firm's product. This should not be inter- The optimum-structured firm is that structure of the firm which preted to mean that, from a firm's point of view, the best scale of its achieves certain objectives better than any other structure. Failure to operations is one which minimizes the unit cost of producing its product. 14 FIRMS, OBJECTIVES, AND INDUSTRIAL STRUCTURE RECOMMENDED READINGS 15 Only in the theoretical model of firm behavior which is designated per- a Market Economy (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1965), Part 3. fect competition is this the case. 7. Machlup, F., "Theories of the Firm: Marginalist, Behavioral, Man- In the model of perfect competition, the demand curve confronting agerial," American Economic Review, March 1967. the individual firm is horizontal. Coupled with the assumption of free- 8. McGuire, J. W., J. S. Y. Chiu, and A. O. Elbing, "Executive Incomes, dom of entry into the industry, this results in a situation in which the Sales and Profits," American Economic Review, September 1962. profit-maximizing level of the individual firm's output is, in the long run, 9. Mishan, E. J.,"A Proposed Normalisation Procedure for Public Invest- the level which minimizes the unit cost of producing the product. Pro- ment Criteria," Economic Journal, December 1967. ducing a level of output which minimizes unit cost is, in these circum- 10. Simon, H. A., "Theories of Decision-Making in Economics and Be- stances, a survival condition; only that level of output will yield the havioral Science," American Economic Review, June 1959. firm sufficient profits to induce the firm's decision makers to continue to "New Developments in the Theory of the Firm," American produce that product. Economic Review, Papers and Proceedings, May 1962. market situations, the profit-maximizing level of a firm's 12. Solomon, E., "The Arithmetic of Capital Budgeting Decisions," Journal output is not, in general, the level which minimizes the unit cost of the of Business, April 1956. 13. Williamson, John, "Profit, Growth and Sales Maximization," Economica, firm's product. This statement should not be misinterpreted. A firm February 1966. will wish to minimize the total cost, and hence the average cost, of 14. Williamson, O. E., The Economics of Discretionary Behavior: Man- producing any particular level of output it decides to produce; it will agerial Objectives in a Theory of the Firm (Englewood Cliffs, N. J.: not, however, necessarily decide to produce that level of output which Prentice-Hall, Inc., 1964). minimizes the average cost of producing the product. The profitability of any given output level depends, in addition to average cost, on the anticipated price received per unit. This price may be different at different levels of the firm's output for it depends upon the firm's anticipations regarding the reactions of other firms in the same and in other industries, to its own output decision. In selecting its output level, the firm must have regard to the behavior of anticipated price received unit cost of producing the product. This distinction is referred to again in Chapter 3. RECOMMENDED READINGS 1. Baldwine Theory be Monageria MinterprisE Quamera Bustaints, Economics, May 1964. 2. Baumol, W. J., Business Behavior, Value and Growth, rev. ed. (New York: Harcourt, Brace & World, Inc., 1967). -, "On the Theory of Expansion of the Firm," American Eco- nomic Review, December 1962. 4. - -, Economic Theory and Operations Analysis, 2d ed. (Englewood Cliffs, N. J.: Prentice Hall, Inc., 1965), Chapter 19. S. Cyert, R. M., and J. G. March, A Behavioral Theory of the Firm (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1963). 6. ?, and K. J. Cohen, Theory of the Firm: Resource Allocation in  CHAPTER TWO INDUSTRY SUBGROUPINGS Substitutability Criterion within some purpose, such a point in al co on ison or comparis in the structure of industry as a whole, that is, in certain characteristics of the output of all firms in the economy taken together. In such cases the question of dividing firms into subgroups does not arise. For many other purposes, however, it is necessary to consider characteristics of the output of subgroups of firms in an economy. This is the case, for example, if one wishes to make interindustry comparisons of structure within a given economy, or between economies, at a point in time, or at different points in time. Indeed, the notion of subgroups of firms, termed "industries," is part of everyday life. When one attempts to define an "industry," however, matters are not so simple. At first sight, the solution seems obvious, namely, to group together all those firms that produce the same product or service. This requires a definition of what constitutes the same product or service. Strictly, all firms produce different products because the products of two separate firms are produced at different geographical locations. Such a definition yields single-firm industries, and is too narrow for most purposes. At the other extreme, all products and services are the same in that they compete for consumers' purchasing power. Such a definition yields an economy-wide industry, and is too wide for most purposes. There must be some aspect which is common to all firms in an in- dustry, this much is clear. But there are many possible criteria for grouping firms into separate industries. Thus, one might group firms together according to common processes employed-printing, spinning, weaving, smelting. Alternatively, the grouping could be based upon the 17  INDUSTRY SUBGROUPINGS SUBSTITUTABILITY CRITERION 18 use of common raw materials-cotton, iron and steel, wool. Again, one case if the substitution effect of a rise in the price of Y tends to reduce might group together firms producing a product with identical physical the quantity of X demanded, but X is an inferior good so that the income characteristics. It is clear that one is likely to get different groupings of effect tends to increase the quantity of X demanded and more than firms depending upon whether the "same" product means physically offsets the substitution effect. identical, using the same process in its manufacture, or using the same Cross-elasticity of demand measures substitutability on the demand side, that is, from the point of view of purchasers. A number of econ- Economic theory indicates that, for a study of behavior, it is useful omists have stressed that the grouping together of firms into separate to define an industry as embracing those firms producing goods which industries should also take into account substitutability on the supply are close substitutes. A measure of the degree of substitutability between side. This means that irrespective of the extent to which consumers consider the products of the individual firms to be substitutes, firms should be grouped together if the output of one firm is considered a close buyers demand of X to the percentage change in the price of Y which substitute for the output of another firm from the producer's point of induces the change in the demand for X, the price of X and all other view. For example, a firm producing only left-handed golf clubs would factors which are capable of influencing the demand for X being held not be groupedwith firms producing only right-handed clubs if the constant. That is, cross-elasticity of demand measure of substitutability were employed, because few buyers consider the two products to be close substitutes. percentage change in the The firms would be grouped together, however, using a measure of quantity of X demanded substitutability on the supply side, if one producer could easily switch cross-elasticity of demand = -percentage change in the price of Y his resources over to the production of the other firm's product in the event of a change in the price charged by the latter firm. Thus, one If the sign of this expression is positive, the two, goods are termed might measure substitutability on the supply side with a concept similar substitutes; if the sign is negative the two goods are termed complements. to cross-elasticity of demand, such as the ratio of the percentage change Provided that the sign is positive, the greater the proportionate change in the amount of X which producers of X would be willing to supply, to in quantity of X demanded when the price of Y changes by a given a percentage change in the price of Y, all other things remaining un- amount, the greater the degree of substitutability between the two goods. changed. Alternatively, some other measure of elasticity of technical The effect of a change in the price of Y on the quantity of X de- substitution between different products might be employed manded, all other things remaining unchanged, can be hypothetically Although the measures of cross-elasticity of demand and supply look divided into an income effect and a substitution effect. If the numerator similar, it must be emphasized that they differ; one refers to the response of the above expression is the sum of these two effects, one has a mea- of potential buyers of X, and the other to the response of sellers of X, sure of gross cross-elasticity of demand accompanied by corresponding to a change in the price of Y, each response being measured in terms definitions of gross substitutes and complements. If, on the other hand, of the quantities of X demanded, and supplied, respectively. Neither of the numerator in the expression consists only of the substitution effect these measures, it should be added, necessarily reflects the change in of a change in the price of Y on quantity of X demanded, one has a the quantity of X actually bought and sold. This depends on the price measure of net cross-elasticity of demand, with corresponding definitions of X, which is assumed to remain constant in calculating the cross-elas- of net substitutes and complements. The choice between these two ticity measures, and also on the possibility of nonprice responses by the definitions of cross-elasticity of demand can affect the resulting definition producers of X. of the relationship between two goods. It is possible, for example, for Products can be operationally defined as substitutes or complements, two goods to be simultaneously gross complements and net substitutes. and measures of the degree of substitutability obtained, only after This would be the case if the substitution effect of a rise in the price of empirical information has been obtained regarding the response of Y tends to increase the quantity of X demanded, but the income effect tends to reduce the quantity of X demanded and more than offsets the substitution effect. Alternatively, it is possible for two goods to be simul- taneously gross substitutes and net complements. This would be the There must be no change in the prices or in the nonprice variables, such  INDUSTRY SUBGROUPINGS SUBSTITUTABILITY CRITERION 21 as level of advertising, for example, of other firms in response to a a set of values of the policy variables under its control, such as the price change in the price charged by a particular firm for its product. Reflec- it charges, and the level of its investment in production, advertising, and tion on this point immediately suggests the difficulties likely to be R&D activities, which best achieves the firm's objective, such as profit encountered in any attempt to obtain such information in practice. A maximization. If the profits which the firm expects to reap from a given problem confronting the social scientist is that he is unable to "hold all set of policy variables is influenced by the activities of other firms, then other things constant," and instead must rely upon statistical techniques the behavior of the firm depends also on the anticipated behavior of in an attempt to measure relationships such as cross-elasticities; these other firms. techniques, however sophisticated, yield estimates of a probabilistic All firms are likely to be affected in some degree by each others' ac- tions. However, any particular decision maker is likely to confine his Let us suppose, for the moment, that the required information could attention to only a few firms whose behavior he considers as a signifi- be obtained easily. That is, one could obtain, for any particular firm's cant influence on the result of his own policies. The task, if one is product Y, a list of precise cross-elasticities (of demand, and also of interested in behavior, is to discover which firms take each others' supply if considered appropriate) linking a change in the price of Y behavior into account in deciding upon their own individual policies and to resulting changes in the demand for each other product in the econ- to group them together accordingly, because the behavior of members of omy. These could be ranked, commencing with large cross-elasticities such a group will be related. indicating a closer substitute relationship between Y and another prod- The use of cross-elasticity measures of substitutability is simply a uct than between Y and products yielding smaller cross-elasticity method of discovering the degree to which firms are affected by each measures. A crucial problem remains. Where does one draw the line others' pricing behavior, in order to infer which firms are likely to take between successive cross-elasticity magnitudes, thereby deciding which each other into account in deciding upon their individual policies. It goods are to be regarded as the "same" and which "different," and should be emphasized that one could use some other measure of sub- therefore deciding also which firms are regarded as being members of stitutability instead of cross-elasticity of demand; the response of the the "same" industry? quantity of one firm's product demanded to a change in the level of Economic theory provides no precise answer to this problem. There is another firm's advertising outlays, prices remaining constant, could be no magic value of cross-elasticity measures which divides "close" sub- used, for example. Another point to bear in mind is that measures of stitutes from "distant" substitutes. The choice of locating the dividing substitutability, such as cross-elasticity of demand, refer to the extent line is a matter of opinion. A decision to draw the line where a definite to which one firm would lose or gain sales in response to a change in gap existed in the ranked cross-elasticity measures is just as arbitrary as another firm's price, assuming that the first firm did nothing in response drawing the line elsewhere, from the point of view of theoretical justifi- to the price change. This, and not the actual change in the quantity of cation of such decisions. the first firm's product demanded, which will depend upon the response In view of the difficulties of obtaining information about cross-elast- of the firm to the price change, is the relevant measure if one is attempt- icities, and the remaining element of arbitrariness involved in defining ing to measure the degree of substitutability between products. industry boundaries even if the required empirical evidence were ob- Of course, this increases the problems associated with any attempt to tained without cost, is it possible to conclude that the substitutability obtain measures of cross-elasticity, because reactions by firms producing criterion is inferior, from a practical point of view, when compared close substitutes for the product of a firm initiating a price change are with other possible criteria such as similarity of technological process, often likely to occur in practice. However, it is important to distinguish clearly between the use of cross-elasticity measures as an indicator of substitutability, and as an indicator of the type of behavior resulting is stressed in economics. from close substitutability. In the case of an industry composed of two The rationale of the substitutability criterion is as follows. Economic firms selling an identical product, for example, the cross-elasticity of theory is largely concerned with the behavior of individual decision- demand between the products of the two firms may be very large, yet, as making units, such as firms. The behavior of any individual firm de- indicated in the section of Chapter 4 entitled Importance of Assumed pends, among other things, on which other firms it takes into account Reactions Rather than Numbers, the behavior of the rivals and the in its decision making. The firm's decision-making problem is to select resulting price and production policies may take any of several forms.  INDUSTRY SUBGROUPINGS STANDARD INDUSTRIAL CLASSIFICATIONS 23 Again, the value of cross-elasticity of demand between the products of 001 Agriculture and Horticulture different firms can be interpreted as being zero under both monopoly 002 Forestry and pure competition, yet the behavior of firms in each of these two 003 Fishing market situations is completely different and represents two extreme The Minimum List Headings are in turn broken down into further limiting cases in price theory. A price change by a firm under conditions subdire and ricare, how are hire further subling as to a: of monopoly cannot affect the sales of other firms appreciably because by definition there are no close substitutes for the monopolist's product. In pure competition, a slight increase in price by one firm will remove that firm from the market, but this does not change the market price or demand for the output of any individual firm remaining in the market. Similarly, the 1967 edition of the United States Standard Industrial Although a price cut by one firm will tend to attract all the buyers in the Classification Manual lists ten alphabetical Divisions as follows: market and reduce sales of other firms to zero, some economists have argued that the rising marginal cost curves of individual sellers, which Division A. Agriculture, forestry, and fisheries are essential to the existence of pure competition, limit the ability of Division B. Mining any single seller to supply that demand, and that realizable cross-elas- ticity of demand between the products of two firms in pure competition is therefore zero. Professor E. H. Chamberlin, on the other hand, has argued that cross-elasticity of demand can be defined in a number of Division F. Wholesale and retail trade different ways, and that its value in pure competition can equal zero Division H Service, insurance, and real estate Division H. even without taking supply conditions into account. The degree of substitutability, as measured by cross-elasticities which DivisionJ:I.Conctasshable establishments Division do not include allowance for competitive responses, is important in determining whether there is likely to be a reaction of any kind by other firms in response to a change in the (price) strategy of one firm; it cannot indicate what type of reaction is likely, however, nor the effect of a given move on the part of one firm on the behavior of firms pro- Major Group of Agricultural produces and huning and trapping ducing close substitutes.' Major Group 0S sheris Standard Industrial Classifications Each Major Group is composed of a number of three-digit Industry Groups, each of which is further subdivided into a number of four-digit Many countries, and some international organizations such as the Industries. For example, Major Group 01, Agricultural production, is United Nations, have their own standard industrial classifications which further subdivided as follows: are used for purposes of official statistics concerning various aspects of Group No. Industry the domestic, or world, economies. The 1968 revised edition of the No. United Kingdom Standard Industrial Classification, for example, consists 011 FIELD CROPS of 27 Orders or major industrial groups as broad as Agriculture, For- 0112 Cotton estry, and Fishing; Mining and Quarrying; Food, Drink, and Tobacco; 0113 and so on. These in turn are divided into 181 subgroups, called Mini- 0119 mum List Headings. For example, within Order I, Agriculture, Forestry, 012 0122 Fruits and Tree Nuts and Fishing, the Minimum List Headings are as follows: 0123 013 1 Despite this, the literature dealing with attempts to classify behavior according 0132 Broiler chickens to cross-elasticities is voluminous. In this connection see references (1)-(3) and 0133 (5)-(8) listed at the end of this chapter...........