Industrial Economics

BY
ASFAW ABADI (MSc)

MAY, 2021
ARBA MINCH, ETHIOPIA
 CHAPTER ONE
1. Scope and Conceptual Framework of Industrial Economics
1.1 What is industrial economics?
Industrial economics is a distinctive branch of economics, which deals
with the economic problems of firms and industries, and their
relationship with society.
How decision-making problems arise in industries?
To answer this question, we have to go back to the core of economics.
• In this situation he has to adopt some criterion to achieve maximum
gain from his limited income.
• This is the problem of utility maximization in the theory of consumer
behavior. Similarly, for a producer, the sources like land, raw
materials, labor, capital, etc., are scarce.
• Given such scarcity, the producer has to take decisions about
production and distribution.
• All such decisions explain the producer's behavior in the different
market situations, which we endeavor to study in industrial
economics.
microeconomics industrial economics

formal, deductive and abstract discipline less formal and more inductive in nature

doesn't believe in a single goal of profit maximization.

assumes profit maximization as the only it searches the goals of the firm from the revealed facts and tries
goal of firms and tries to maximize it subject to remove the constraints which impede the achievements of
to the given constraints goals

being abstract, it doesn't go in to

operational details of production, it goes in to the depth of such details
distribution and other aspects of firms and
industries

conclusions may not be testable empirically free from such limitations because of its
and hence we may not assess the predictive emphasis on empricism
efficiency

it may shun public policy implications if public policy implications are taken care of.
necessary

theory of the firm here is the basis for theory of the firm need to be revised
industrial economics
• The term industrial organization is commonly viewed as
synonymous with industrial economics.
• Carlsson (1989) made clear distinction between them.
• He reasons that the main concern of industrial organization has
become the structure of industries at a particular point of time.
• By contrast, industrial economics encompasses both industrial
organization and industrial dynamics.
• Industrial dynamics is primarily concerned with the evolution of
industry as a process in time both at the macro level, the sector
or industry level, and the firm level.
Carlsson argues that there are four main themes which encompass
the subject matter of industrial dynamics:
1. The nature of economic activity in the firm and its connection to
the dynamics of supply and therefore economic growth,
particularly the role of knowledge.
2. How the boundaries of the firm and the degree of
Interdependence among firms change over time and what role this
interdependence plays in economic growth.
3. The role of technological change and the institutional framework
conducive to technological progress at both macro and micro
levels.
4. The role of economic policy in facilitating or obstructing
adjustment of the economy to changing circumstances
(domestically as well as internationally) at both micro and macro
levels - industrial policy.
Coming to the conclusion of this section, we may say that
 Industrial economics is predominantly an empirical discipline
having micro and macro aspects.
 It has a strong theoretical base of microeconomics.
 It provides useful applications for industrial management and
public policies.
 Elements of industrial economics
There are two broad elements of industrial economics:
 Descriptive and
 Analytical elements
Descriptive element is concerned with the information content of
the subject.
It is aimed at providing the industrialist or businessman with a
survey of the industrial and commercial organizations of his own
country and of the other countries with which he might come in
contact.
In short, it deals with the information about the competitors,
natural resources and factors of production and government rules
and regulations related to the concerned industry.
• Analytical element of the subject is concerned with the business
policy and decision-making.
• It deals with topics such as market analysis, pricing, choice of
techniques, location of plant, investment planning, hiring and
firing of labour, financial decisions, product diversification and
so on.
• It is a vital part of the subject and much of the received theory of
industrial economics is concerned with this.
• However, this does not mean that the first element, i.e.
descriptive industrial economics, is less important.
• The two elements are interdependent, since without adequate
information no one can take proper decision about any aspect of
business.
1.2 Some Basic Concepts in the Study of Industrial Economics
• The Firm
• A firm is an organization owned by one or jointly by a few or
many individuals which is engaged in productive activity of any
kind for the sake of profit or some other well-defined aim.
• Most of the firms owned by private individuals in manufacturing
trade and services will aspire for profits but there may be some
other such as government companies where profit motivation
will be secondary or missing altogether.
• The industry
• The conventional definition of the term industry is a group of
firms producing a single homogeneous product and selling it in a
common market.
• However, the restriction of a single homogeneous product is not
met in practice.
• Most of the firms produce many outputs which may or may not
be substitutable for each other. In this situation, the conventional
definition has no operational sense.
• A better approach to define the industry is to call it “a group of
sellers or of close substitute outputs who supply to a common
group of buyers”.
• In other words, we may take it in simpler terms as a group of
firms producing closely substitute goods for a common group of
buyers.
 The Market
This is defined as a closely interrelated group of sellers and
buyers for a commodity.
The term is not equivalent to the industry since in the latter
case we will be looking only at the seller‟s side of the market.
In practice it may be difficult to define the precise boundary
for a market.
A market is said to be imperfect if there is lack of information
about it, there are entry barriers to it and the product is not
uniform.
 Market power
• Market power - refers to the influence that any particular
buyer or seller can exercise over the price of a product.
• It indicates the degree to which a business firm is able to
earn larger than normal profits.
• Market structures range from highly competitive, in which
there are so many buyers or sellers that none can influence
the market price, to the other extreme in which a single
buyer or seller faces no competition and therefore wields
great market power.
• Market power is inversely related to both the degree of
competition in the market and the ease of entry and exit.
 Contestable market
• Contestable market- is a market in which competitive outcomes
can be observed.
• Its fundamental feature is low barriers to entry and exit; a
perfectly contestable market would have no barriers to entry or
exit.
• Contestable markets are characterized by 'hit and run' entry.
• If a firm in a market with no entry or exit barriers raises its
prices above marginal cost and begins to earn abnormal profits,
potential rivals will enter the market to take advantage of these
profits.
• When the incumbent firm(s) responds by returning prices to
levels consistent with normal profits the new firms will exit.
• In this manner even a single-firm market can show highly
competitive behavior.
1.3 Approaches to Industrial Economics
1.3.1 The Structure-Conduct–performance (SCP) paradigm –
Harvard tradition
1.3.2 SCP paradigm extension; comments and alternative
theories: the Chicago school of thought
1.3.1 The Structure-Conduct–performance (SCP) paradigm –
Harvard tradition
1.3.1.1 The Structure-Conduct–performance (SCP) paradigm
Industrial economists have developed generally accepted principles
applicable to all markets, all industries, and all economies.
The central questions addressed by industrial economics are
(1) is there market power and if so, how do you measure it?
(2) How do firms acquire and maintain market power?
(3) What are the implications of market power?
(4) What is the role of public policy as regards market power?
• The Structure Conduct Performance (SCP) paradigm is the first
wave of industrial economics.
• Many of the issues in this area of economics data goes back to
Adam Smith in the 18th century.
• More recently, Cournot in the first half and Marshall in the
second half of the 19th century laid foundations, that remain
appropriate concerns in industrial economics today.
• Joe Bain and Edward Mason (both from Harvard) and
sometimes called the “Harvard tradition” developed the concept
of “Structure-Conduct-Performance” Paradigm.
• To do a complete analysis of an industry, market, or
economy, there is a three-part paradigm consisting of
market structure, conduct, and performance sometimes used
by industrial economists.
• The market structure of an industry is concerned with the
number and size distribution of buyers and sellers
(concentration ratios), the nature of the product
(differentiated or homogeneous), and conditions of entry
(cost structure and barriers to entry).
• Market conduct is the pricing behavior (independent or
collusive), the product strategy and policy (independent or
collusive), and the promotional activities, (advertising,
research, and development) operating within the market.
• Market performance is the productive and allocative
efficiency (price, cost, and profit levels and trends) and the
industry progressivity (technological change) of the market.
Now let as discuss the elements of this model in detail.
Market Structure
Market Structure refers to the organizational characteristics of
buyers and sellers in a particular market.
It means the pattern or form or manner in which the
constituent parts of a market (i.e. buyers and sellers) are
arranged/ linked together.
It is specified in terms of the organizational characteristics
which determine the relations:
(a) of sellers in the market to each other;
(b) of buyers in the market to each Other;
(c) of the sellers to the buyers; and
(d) of sellers established in the market to the new potential
firms which might enter the market.
The following four main features of the market structure have been
suggested by Bain, which are important to understand the concept
precisely and to measure it:
The Degree of Seller Concentration: This is the number and size
distribution of firms producing a particular commodity or types of
commodities in the market.
The Degree of Buyer Concentration: This shows the number and
size distribution of buyers for the commodities in the market.
The Degree of Product Differentiation: This shows the
difference in the products of different firms in the market.
The Condition of Entry to the Market: This shows the relative
ease with which new firms can join the category or sellers (i.e.
firms) in the market.
When significant barriers to entry exist, competition may cease to
become disciplining force on existing firms, and we are likely to see
performance that departs from the competitive ideal.
• If there is only one firm then we get the form of monopoly
market; if few then oligopoly; and if there large then we
encounter with the perfect competition.
• In each case the process of output and price determination will
be different. Similarly, how differentiated goods and the large
number of sellers generate the conditions for monopolistic
competition is another example showing the importance of the
market structure.
• Market structure is a multidimensional concept. So, it is difficult
to measure it through a single variable.
• In practice a set of variables related to different aspects of it are
used simultaneously to measure the market structure.
 Market Conduct
Market conduct is defined as the patterns of behavior that firms
follow in adopting or adjusting to the market in which they operate
to achieve the well-defined goal or goals.
Given the market conditions and the goals to be pursued the firm
will be acting alone or jointly to decide about the price levels for
the products, the types of products and their quantities, product
design and quality standards, advertisement, etc.
Firms may also devise the ways for interactions, cross-adaptation
and coordination among the competing group of sellers in the
market.
In general, market conduct includes the pattern of behavior
followed by firms in the industry when adapting to a particular
market situation. It includes:
1. Pricing behaviors of the firm or group of firms: - This
includes a consideration of whether price charged tend to maximize
individual profits, whether collusive practices in use tend to result
in maximum group profits or whether price discrimination is
followed.
2. Product policy of the firm or group of firms - For example, is
product design frequently changed? Is product quality consistent
or variable? What variety of products is made available?
3. Sales promotion and advertising policy of the firm or group
of firms –How is the volume of this activity how important are
sales promotions and advertising in the firm or industry‟s market
policy? determined?
4. Research, development, and innovation strategies employed
in the firm or group-
how substantial are expenditures for these purposes?
To what extent is new technology available to smaller firms?
5. Legal tactics used by the firm or group- Legal actions to gain
competitive advantage.
Are patent and trade mark rights strictly enforced or defended?
Are patent rights licensed to others at fair rates?
Attempts to get use rights to new technology to establish and
defend some degree of monopoly power.
 Market Performance
Market performance is the end result of the activities under taken
by the firms in pursuit of their goals.
High profitability, high rate of growth the firm, increase in the
sales, increase in the capital turnover, increase in the employment
etc. are some variables on the basis of which we can judge the
market performance of the individual firms depending on their
respective goals.
Generally, good market performance is a multidimensional concept
which includes the following elements:
1. Resources should be allocated in an efficient manner within
and among firms such that these resources are not needlessly
wasted and that they are responsive to consumer desires.
How effectively are resources allocated across industries and
products?
2. Technical or operational efficiency--how closely do existing
firms, as a group, achieve lowest possible costs?
 Are they large enough to capture scale economies?
 Is there too much unused capacity?
 Are they located to minimize transport costs?
 Is there labor efficiency?
3. Exchange Efficiency - refers to the costs of arranging
transactions (transaction costs), such as
 Inspection of goods to pair buyers and sellers--this is reduced if
there are grades and standards that allow trading on the basis of
description.
 Information flows (related to market transparency)
 Ability to trade openly
 Various forms of vertical coordination, including vertical
integration.
Include pricing efficiency - i.e., the degree to which prices
accurately and rapidly transmit changes in supply and demand to
participants in the market.
This affects allocative efficiency by inducing adjustments in
consumption and production as supply and demand change.
Allows matching of supply and demand and adjusts consumption
to social scarcity.
4. Profit Rates: normal profit is the indicator good market
performance. Profit serves as the:
• Returns to management and risk taking
• Returns to capital investment
• Signal to guide resource allocation in the economy.
Chronic excess profits representing a failure of the market system:
• Indicate too few resources are flowing into the industry
• May be a result of concentrated market structure and high
barriers to entry.
• May have undesirable income distribution
• Chronic sub -normal profits may indicate a sick or declining
industry.
5. Level of Output
The level of output is separate from profit levels because
output level not necessarily directly related to profit levels in
real world.
We are usually concerned with underproduction, but can also
have situations of overproduction.
Key question becomes one of allocative efficiency--whether
more or fewer resources are allocated to this industry than are
warranted by their social opportunity cost.
6. Producers should be technologically progressive; that is,
they should attempt to develop and adopt quickly new
techniques that will result in lower costs, improved quality, or
greater diversity of new and better products.
Progressiveness indicates the extent to which an industry is
generating and rapidly adopting new technologies and new
organizational arrangements that reduce costs or improve
products and services relative to consumer wants.
7. Product Suitability- involves matching products with
consumer preferences.
The performance and safety characteristics of products that are
supplied have to be reliable.
The quality level of products should be neither too high nor too low
relative to consumer desires.
It is also related to progressiveness--designing new products and
new handling methods to satisfy better changing consumer
demands.
For example, for Food industry
• Freshness condition of food-- not deteriorated if consumers are
willing to pay for the extra care to assure the freshness.
• Safety of food products
• Nutritional integrity of products
8. Production resources should be organized in such a way to
encourage an equitable distribution of income.
• Although the notion of equity is a valve –laden concept, we can
say that profits should be no higher in the long-run than
necessary to invoke the productive use of resources in a
particular endeavor.
• In addition, price stability should be encouraged because of the
perverse ways in which inflation changes the distribution of
income.
9. Producers should operate in a manner that encourages continued
full employment of productive resources. It can be argued that
unused resources are wasted resources, especially when they are
perishable as in the case of human capital.
10. Participant Rationality-deals with adequate market
information to make rational choice and avoidance of
misinformation.
The need to provide market participants with a reasonable
opportunity to make comparisons may require certain mandatory
coordination and impartial types of information.
E.g., Inspection, Grading, Standards of identity, Standardized
containers and packing (truth in packaging law), Standardized
quotations (e.g., unit prices, standard mileage estimates), price
posting, market news, product tests.
Participants in the market should have a reasonable opportunity to
be well informed and should exercise freedom of choice rationally
in their own interests (except when private advantage obviously
conflicts with social welfare).
11. Conservation- refers to the extent to which a firm or industry
promotes the conservation of natural resources.
No needless depletion or inefficient extraction plus exploration.
Condemns both exhaustion of renewable resource to the point
where it cannot be sustained or wasteful extraction of
nonrenewable resources.
12. Labor Relations - covers equal opportunity, working
conditions, wage levels and wage structure, work rules.
Norm includes fair treatment (no race, sex discrimination), mutual
fair treatment, reasonable communication and respect.
13. Unethical Practices: firms should not engage in the
production and distribution of undesirable products/services.
What is ethical is culturally determined, which poses problems
when different cultures try to trade, either within a country across
ethnic groups or internationally.
Examples
• Undisclosed danger -- related to food safety
• Fraud and misrepresentation -- related to advertising
• Adulteration
Other aspects of good performance can be enumerated including
external effects and costs of sales promotion.
For the society as a whole, performance of an industry may be
judged on the basis of its contribution in increasing the welfare of
the masses.
• The relationship between Structure, conduct and
performance
• The material presented in the above section clearly indicates the
existence of prior relationship between the three main concepts
of industrial economics viz.
• Market structure, market conduct and market performance.
• The link between these three which is evident in the theory of
the firm is that market structure of an industry determines or
strongly influences the crucial aspects of its market conduct
which in turn directly or indirectly determines certain important
dimensions of its performance.
1.3.2 SCP Paradigm Extension; Comments and Alternative
Theories: The Chicago School of Thought
Dear Student: Here below we will see the critic against the
traditional theory regarding the relationship between Structure,
Conduct and Performance.
One critic with in the SCP paradigm against the initial SCP theory
is the linearity of the relationship.
This linear S-C-P model presumes a very simple direct and one-
way causal relationship. However, in actual world industrial
relationships are not so simple and linear. Therefore, it can be said
that the traditional premise that unidirectional running from
structure‐conduct-performance is unsound. In some cases, analysis
of conduct is superfluous.
Individual firms will be unable to influence the price determined by
the market.
Fig. 1.2 shows how the SCP approach may be adapted to incorporate
these more complex linkages, but the essential causality still flows from
structural criteria.
1.4 The conceptual Framework of Industrial Economics
Market structure, conduct and ultimately performance are also influenced
by certain fundamental market and environmental conditions.
1.5 The Chicago School
• Since the 1970s there has been increasing recognition that SCP
fails to give adequate insights into many issues within the field
of industrial economics. In this category one may include: the
Chicago School. The works of these economists are not radical
departures from the SCP paradigm. However, the Chicago
School gives high accord to conduct.
• The Chicago school criticized the SCP model for being non
theoretical. It further criticizes the SCP paradigm as having
diverged to great an extent from the basic neoclassical price
theory.
• The Chicago school argues that even if their (SCP) empirical
work was based on more realistic assumptions, Bain et al came
up with nothing more powerful in predictive ability than the
traditional perfect competition model.
• There are two major ways in which Chicago school differs
from Harvard school: these are with respect to the
methodological front and policy intervention.
1. On the Methodological front: Chicago school relay much
more heavily in their analysis on standard (often
competitive) economic theory, which contrasts with the
sometimes-crude theoretical analysis employed by early
Harvard writers.
2. Policy Intervention: Therefore, according to Harvard school
there is the need to identify circumstances requiring
government intervention, the Chicago school, however, was in
general more antipathetic to government intervention.
 CHAPTER TWO
THE THEORY OF THE FIRM
– The Neoclassical Theory of the Firm: Brief Revision of
Perfect Competition and Monopoly Market Structures
• The perfectly competitive market is characterized by absence of
• Rivalry between firms:
• Market barriers:
• Product differentiation.
Theoretical foundations of Industrial Economics
 – The Modern Theory of the Firm
• Managerial Theory
• The focus of this topic is on the firm particularly the relationship
between owners and managers and the possible deviation of
objectives.
The theory is based on three major principles/ Premises:
1. In a firm, the ownership (by shareholders) is distinct from
control (exercised by managers);
2. Because of this separation, it is possible to conceive a divergence
of objectives (not interest) between owners and controlling
manager; hence the possibility of having a growth objective or
revenue maximization objective instead of profit maximization.
3. Firms operate in an environment that affords them an area of
discretion (freedom) in their behavior.
According to Baumol (1967), reasons why hired managers may be
more preoccupied by sales or revenue maximization instead of
profit maximization are indicated as follows:
1. Sales performance is equated with the performance in market
share and market power.
2. The typical performance report of a firm is in terms of sales not
profit.
3. The financial market and retail distributors are more responsive
to a firm with rising sales.
 • Principal Agent Theory/ Agency Theory
• This theory examines situations in which there are two main
actors, a principal who is usually the owner of an asset, and the
agent who makes decisions, which affect the value of that asset,
on behalf of the principal.
Agency theory deals with:
1. In a firm, the ownership is distinct from control (exercised by
managers).
2. Because of this separation, it is possible to conceive a divergence
of interests between owners and controlling managers: hence the
possibility of having a growth objective or revenue maximization
objective instead of profit maximization.
3. Firms operate in an environment that afford them an area of
discretion in their behavior.
4. It focuses on the contractual aspects of the relationship, and often
adopts game theoretic methods.
5. Information asymmetry: There is information asymmetry between
principals and agents.
6. Moral Hazard: Conflict of interest and the existence of information
asymmetry leads to the problem of moral hazard.
Shirking (unwilling to do). is the moral hazard arising from the
employment contract.
7. Unbounded Rationality: Agency theory is based on the assumption of
unbound rationality, which refers to the ability of those designing the
contract to take all possible, relevant, future events into consideration.
8. The main difference between principal agent theory and transaction
cost theories is that the former focuses on the contract, the latter on
transaction.
Policy implication: The policy implication of the agency theory is that
there will be no government intervention.
 • Transaction Cost Theory
• The neoclassical school is based on the assumption of zero
transaction cost.
• In general, transaction costs are the costs of running the
economic system.
• These costs arise from the establishment, use maintenance, and
change of:
a. Institutions in the sense of law;
b. Institutions in the sense of rights;
c. Transaction costs arising from informal activities connected with
the operation of the basic form informal activities.
Market transaction Costs: Market Transaction Costs is defined to
include:
a. Cost of screening and selecting a buyer or seller
b. The cost of preparing contracts which is the cost of obtaining
information on the good or service;
c. The costs of concluding contracts that is the cost of bargaining
and negotiating a contract
d. Cost of monitoring and enforcing the contractual obligations.
Managerial Transaction Costs: The concern is with the costs of
implementing the labor contracts that exist between a firm and its
employees.
Political Transaction Costs
Features/Characteristics/ of Transactions
• Following Williamson (1979), both economic and political
transactions can be characterized by the following critical
features:
1. Uncertainty,
2. The frequency with which transactions occur, and
3. The degree to which transaction - specific investments are
involved.
 – The Growth of the Firm
• Introduction
• Why Do Firms Need to Grow in the First Place?
Issues that have to be considered in addressing the above question
include:
1. Alternative motive/ objectives of a firm that induce a firm to
work;
2. Growth as a natural process;
3. Inherent drive for market power;
4. External pressure/ market competition/ that shape the behavior
of firms.
1. There are alternative motives or objectives that induce firms to
work and hence to grow.
• Motives or objectives are important aspects in the theory of the firm
since the objectives are
i, Which will be the bases to judge the efficiency of firms and
ii, Which regulate the conduct of the firm (and hence growth in the
market).
2. Growth as a Natural process
• Growth is an empirically established trend daily observed
phenomenon.
3. External pressure/Market Competition
• Development Needs: Which are the basis for demand for a
product/service do change over time.
• Dynamisms of Competition: Competition is dynamic not a static
one.
 • Dowine’s Theory (The Theory of Profit Constraint)
• The theory is concerned with the way in which alternative forms
of market structures and the “Rules of the game” lead to the
divergence of efficiency and the rate of technological progress
among firms.
• Some firms have greater efficiency than the industry average
while some have lower efficiency.
• Efficiency variation is attributed to variation in technical
progress.
• Firms with superior technology are assumed to be more efficient.
At point „G‟ the capacity and the market growth curves intersect (Downie‟s
Equilibrium point). An efficient firm will be able to sustain higher rate of
growth than an inefficient firm because of initial higher rate of profit: rapidly
growing market (customer expansion curve) and expanding capacity of
production. Hence, financial constraints, (Specifically profitability, which is the
source of own finance) play the crucial role in the process of the growth of the
firm in Downie Framework.
Criticism
1. Downies theory ignores the possibility that inefficient firms
might react positively and aggressively to declining market share.
2. The argument that new customers are attracted through price-
reduction ignores non-price competition strategy such as
advertisement, new product development, etc.
3. The model has not taken into account the managerial restraint,
which plays very important role in limiting the growth of the firm.
4. The model undermines the role of other sources of financing:
Issuing of new shares, borrowing from banks, issuing bonds and
related others.
 Penrose’s Theory (The Theory of Management
Constraint)
• Penrose suggested that growth of firm continues unless some
factors restrain opportunities for expansion. These restrains can
be of two types:
1. Internal Constraints:
• Managerial Capacities:
• Financial restraints: Adequate resources are required to invest
for expansion.
• Penrose treated financial constraint as relatively less important
compared to managerial restraints.
2. External obstacles:
These refer to:
a. Competition from rivals leading to narrow market;
b. Patent or other restrictions on the adoption of new technologies;
c. Lack or shortage of inputs, escalation of costs of major inputs,
etc.
Limitations of the Penrose’s Theory
• The theory gave marginal attention to financial and external
constraints. That is one should not undermine the role of
financial and external constraints. If these problems are sever
they can be real hindrances.
• Management is not a perfect substitute to the other inputs.
Rather management is a capacity to manage and deal with such
problems.
 • Marris’s Theory (The Integrated Theory of Growth)
• Two main features of this theory are
1. It is an integrated theory because Marris has integrated
Downie‟s and Penrose‟s approaches.
All the 3 constraints, financial, market demand & managerial
restraints are integrated and made operative in the Marris‟s model;
2. It is a Managerial theory of the firm, as it is based on the
resumption of separation of ownership and control.
• Compatibility of objectives: no wide Divergence of objectives
of owners and managers.
 Chapter Three
Market Concentrations
• Market concentration means the situation when an industry or
market is controlled by a small number of leading producers who
are exclusively or at least very largely engaged in that industry.
It is also known as degree of seller's concentration in the
market.
• Two variables that are of relevance in determining such situation
are:
(i) The number of firms in the industry, and
(ii) Their relative size distribution.
The major elements of market concentration, such as
• Concentration in the ownership of the industry,
• Concentration of decision-making power, and
• Concentration of the firms in a particular location or region,
etc may have considerable impact on the market performance of
the firms such as profitability, price-cost margin, growth,
technological progress and content.
THEORIES OF CONCENTRATION
• Market concentration is a feature of the imperfect competition
where one or few firms dominate the entire industry.
• Let us assume that there are few large firms along with many
smaller firms selling a homogenous product at a uniform single
price. This is what we call „Homogenous Oligopoly’.
 Since larger firms‟ decisions affect the industry as a whole,
they therefore face counter policies from the rivals and so are
interdependent on each other in this respect. This is an
important feature of the oligopolistic or concentrated
industries.
A small firm, however, acts more or less independently since
its policies are not going to affect the other firms significantly.
Let us now examine the situation when firms are selling a
differentiated product with different prices.
• Concentration Vs Market Share: if a large firm makes changes
in its price or quantity of output, it will affect the market shares
of all other firms in the market.
• Bishop analyzed this situation using the concepts of price
elasticity and cross elasticity of demand.
• Size distribution Vs Concentration: inequality in the size
distribution of the firms is a crucial factor for market
concentration.
Concentration Vs Market Conduct: there are some other effects
of the number and size distribution of the firms on business
conduct.
Firms want to watch over the activities of other firms.
For this purpose, a firm has to devote considerable managerial
efforts to collect information about various aspects of the rival
firms‟ activities such as prices, products, sales activities,
investment, etc. the cost of such information increases with the
increase in the number of firms of equal size.
However, if the market is concentrated, only large firms are to be
watched for this purpose.
Concentration Vs Price Stickiness: there is another important
aspect of concentrated markets.
If the market has some price variations across the firms due to
product differentiation, customers would search for the lowest price
supplier.
If the number of suppliers is large, the search cost for the consumer
will be high.
In the case of concentrated markets, since there are few firms
dominating the market, the cost of search for the consumers is low.
The oligopolistic firms know this fact very well.
They may, therefore, keep their prices almost at the same level to
protect their individual interest. This may be one of the reasons for
sticky prices in such a market.
Generally, what we have tried to see is that concentration has
important implication for the behavior of the firms.
Sources of market concentration
I. Barriers to Entry
• These factors are called „barriers to entry‟ and are classified in to three
categories.
A) Absolute cost advantages: this results from:
• Control of superior production techniques by established firms
maintained either by patents, or by secrecy;
B) Product differentiation advantage (or barriers to new firms): this
arises from:
• Ownership or contractual control of favorable distributive outlets by
established firms, and Advertisement, marketing strategies, and other
conditions favorable to the established firms.
C) Scale economy barriers: they arise:
• the real economies of scale accrue to the established firms by virtue
of their having attained the minimum efficient size absolute and in
relative term to the size of the market.
• II. Barriers to Exit
• We may say that certain imperfections in the market backed
by some institutional forces (patents, licenses, controls) and
technological forces (economies of scale) cause
concentration in the market.
However, as seen in reality, there are some market obstacles
that restrict firms from exit. Sunk costs, compensation to
employees, long term contractual obligations, and social
pressure of employment maintenance are some of the
barriers to exit.
• Measures of Market Concentration and Monopoly Power
• These two terms, i.e. monopoly power and market concentration, are closely
interrelated and cannot be separated from each other in the measurement
process.
• Before discussing the indexes, it will be useful here to mention some general
conditions or requirements which should be satisfied by each one of them.
This helps us in screening the indexes while marking the final choice for
empirical work.
• The conditions are:
• The measure must yield an unambiguous ranking of industries by
concentration.
• Consider Fig. 3.1 in which concentration curves, i.e. the graphs between
cumulative number of firms from largest to smallest and cumulative
percentage of market supply, are shown by I1, I2 and I3 for three industries
separately.
• I1 is above I2 and I3 everywhere. It means the industry which is represented
by I1 is more concentrated than the other two. However, there is ambiguity
in the ranking of the second and third industries represented by I2 and I3.
Figure 3.1; Hypothetical cumulative number of firms
(Largest to smaller concentration curves)
• The concentration measure should be a function of the combined
market share of the firms rather than of the absolute size of the market
or industry.
• If the number of firms increases then concentration should decrease.
However, if the new entrant is large enough, then concentration may
go up.
• If there is transfer of sales from a small firm to a large one in the
market, then concentration increases.
• Merger activities increase the degree of concentration.
• Let us review them briefly before making a final comment in this
regard.
• The concentration ratio: concentration ratio is the most popular and
simplest index for the measurement of market concentration or
monopoly power. It is measuring the cumulative market share held by
some of the largest „m‟ firms. Mathematically;
• 𝐶= 𝑚 𝑖=1 𝑃𝑖 , 𝑚 = 4,8,12, … , 20, . ..
• Where; Pi=qi/Q is the market share of the ith firm in descending order.
The normal practice is to take the four‐firm (the four big firms), m = 4
concentration ratio but if the total number of firms operating in the
market is large enough then one has to compute the 8‐firm or even
20‐firm concentration ratio to assess the situation.
• The higher the concentration ratio the greater the monopoly power or
market concentration exists in the industry.
•
•
•
• Limitations of concentration ratio
• It doesn‟t take the entire concentration curve in to account. i.e., it
doesn‟t include all firms.
• The ranking of industries depends on the point chosen whether 4
firm or 8 firm ratios for example. Thus, there is ambiguity in the
ranking of industries.
• The concentration ratio depends on how the market is defined.
• A broad market would tend to reduce the computed concentration
ratio whereas a narrow one would usually have the opposite effect.
• It may not be comparable with other industries or countries data.
• It doesn‟t reflect the presence or absence of potential entry of firms
to the industry.
• It doesn‟t show the entire number and size distribution of firms.
• Advantages of concentration ratio
• Widely used in industrial economics
• Simple to compute
• Readily available for the manufacturing sector
• Consistent with the economic theory
• The Hirschman-Herfindahl Index
• It is the sum of the squares of the relative sizes (i.e.; market shares) of the
firms in the market, where the relative sizes are expressed as proportions of
the total size of the market.
𝑛 𝑞𝑖 2
• Symbolically, Herfindahl Index (H) = 𝑖=1 𝑄
𝑞
• Where; Pi = 𝑖 , qi is output of the ith firm and Q is total output of all the firms
𝑄
in the market, and n is the total number of firms in the market.
• This index takes account of all firms in the market (i.e. industry).
• The maximum value for the index is one where only one firm occupies the
whole market. This is the case of a monopoly.
• The index will have minimum value when the n firms in the market hold an
identical share. This will be equal to l/n, that is
𝑛 1 2 1 2 1 1
• H= 𝑖=1 𝑛 =𝑛 = 𝑛 2 =
𝑛 𝑛 𝑛
• H decreases as n increases.
• The index is simple to calculate.
• It takes account of all the firms and their relative sizes; it is therefore,
popular in use and consistent with the theory of oligopoly because of its
similarity to measures of monopoly power.
3.4 Concentration and Market Performance of a Firm
• Concentration and Profits: a firm derives market power or
monopoly power in the situation of concentration.
• Such market power via market conduct activities or directly
leads to an increase in the profitability of the firms.
• Concentration and Price Cost Margin: price cost margin is
another way to define profitability.
• This is a short-term view of profitability based on current sales
and cost figures.
• Empirical studies, particularly that of Collins and Preston,
supported the positive relationship between concentration and
price cost margin for American industries.
• Concentration and Growth of the Firm: there are two different
streams of thoughts to explain the causal relationship between
concentration and growth. .
• Concentration and Technological Change: the few firms who enjoy
monopoly power in a concentrated industry are large enough.
• They have stability, financial resources, and ability to initiate the
process of research and development and gain the benefits from them.
• Dasgupta and Stiglitz have shown the situation when market
concentration and innovative activities are positively correlated.
5. Concentration and Business Stability: stability in business can be
judged by persistency of higher profits, sales volume or market share.
The greater the market powers of the firm the more the stability of the
firm. Thus, business stability is positively correlated to concentration.
 CHAPTER 4
Industrial Location Analysis
• Industrial location plays a vital role in the performance of a firm.
• In setting up a factory a manufacturer has to take three
interrelated decisions simultaneously:
• The scale of operation;
• The technique to be adopted, which involves the selection of
the appropriate combination of the factors of production;
and
• The location of the factory.
4.1 The General Determinants of Industrial Location
• How to make the choice for this?
• A large number of factors have to be considered simultaneously
while taking the decisions of industrial location, such as
a) Technical,
b) Economic and Infrastructural Factors
c) Other factors
• Which exert pull and pressure on location of the factory in
varying magnitudes.
 A) Technical Factors
• These are the physical factors which are more or less
geographical in nature related to soil, raw materials, people,
climate, etc. The important factors in this category are:
• Availability of land.
• Nature and quality of raw materials from land, e.g. forest
products, agricultural inputs, minerals, and semi-finished
products from existing industries.
• Geographic situation of the factory site in relation to the transport
facilities by rail, road, water and air.
• Quantity and quality of human resources.
• Energy resources.
• Availability of water for drinking and industrial uses.
• Waste disposal facilities.
• Climate
 – B) Economic and Infrastructural Factors
• Input prices, taxes, markets, skills of labor forces, availability of adequate infra-
structural facilities, finance, etc., constitute together the category of economic
factors. The general list of factors for this would be as follows:
• Local markets.
• Situation in relation to export markets.
• Costs of land and buildings.
• Costs of infra-structural facilities such as transport charges, power tariffs, water-
rates, etc.
• Salaries and wages in relation to skills.
• Taxes and subsidies.
• Cost and availability of finance.
• Structure of existing industries.
• Industrial relations and trade union activities around the proposed location sites.
• Demographic factors such as age and sex composition of local population,
• Literacy, professional skills, etc.
c) Other Factors
• All other miscellaneous location factors may be put in this category,
viz;
1. Government policies towards location of new plants, and
2. Personal factors.
• Personal factors also play important role in location decision, a
manufacturer may prefer to locate his factory at his birth place-
disregarding all economic factors.
4.2 Approaches to Industrial Location Analysis
• In this regard significant contributions were made by geographers and the
economists; their approaches however were different.
• The geographers, by and large, adopted intuitive conceptual base and case
studies approach to arrive at some generalization about the industrial locationl
patterns.
• The economists, on the other hand, followed a more formal, abstract or
deductive approach for location analysis, an integration of these two diversified
approaches led to develop some operational models for location studies.
• The Geographical Contributions
• The discipline geography examines the form of the earth, its physical features,
natural and political divisions, climate, production, and population, etc.
We are trying to present a brief review of a few selected works having some
theoretical relevance, they are
– The Central Place Theory
– Renner's theory
– Rawstron's Principles
A) The central Place Theory
• This was the first systematic geographical theory of location.
• It was developed by Walter Christaller mainly to determine the
number, size, and distribution of town and cities.
• Using certain simplified assumptions, Chris taller was able to
demonstrate graphically the spatial arrangement between hinterland
(RURAL) and central places, mainly service centers.
• In simplest terms, his theory proposed that towns with lowest level of
specialization would be equally spaced and surrounded by
hexagonally shaped hinterlands.
• The major limitation of this theory is that it fails to encompass the
development of belts of industrial concentration and the
agglomerative tendencies which are common features of the modern
industrial structures.
b. Renner's Theory
• Renner developed some general principles concerning industrial
location. He classified industry into four categories viz;
 Extractive
 Reproductive
 Fabricative
 Facilitative
• To undertake anyone of these, six ingredients are required raw
material, market, labor and management, power, capital and
transportation.
• Keeping in mind these ingredients, Renner postulated the law of
location for fabricative (i.e. manufacturing) industry according
to which any manufacturing industry tends to locate at a point
which provides optimum access to its ingredients.
It will, therefore, locate near to:
• Raw Materials, if it uses perishable or highly condensable
raw substances, or
• Market, where the processing adds fragility, perishability,
weight, or
• Bulk to the raw materials or where its products are subject
to rapid changes in style, design, or technological character; or
• Power, where the mechanical energy costs of processing are
the chief items in the total cost; or
• Labor, where its, wages to skilled workers are a large item
in the total cost.
Apart from the above tendencies or laws, Renner gave a scheme for,
industrial symbiosis (relation). Three different types were mentioned for
this:
(a) Disjunctive symbiosis where different industries having no organic i.e.
economic or technical connections among themselves, gain advantages by
existing together at a particular place;
(b) Conjunctive symbiosis where different industries with some organic
connection among themselves (i.e. inter-connections) are located together;
and
(c) Con industrialization which is an advance stage of the conjunctive
symbiosis leading thereby to a huge industrial belt of interconnected
industries.
• Renner's approach on industrial location is quite realistic as it tries to
bring together the major determinants for that. However, he has not been
able to go into deep in analyzing the effects of spatial cost variation and
industrial symbiosis, i.e. agglomeration (combination) on industrial
location. He merely describes the tendencies of industrial location based
on these factors.
c. Rawstron's Principles
• Rawstron has developed his theory of industrial location in terms
of three restrictions which impede (hinder) the choice of
location for a factory.
• The restrictions are the principles of location in his model. These
are:
• Physical restriction,
• Economic restriction, and
• Technical restriction.
• The physical restriction will be operative when some raw
materials mainly natural resources are to be produced or
procured at the proposed site for the plant.
• The economic restriction embodies the concept of spatial
margins to profitability. The cost of production, i.e. the sum of
expenditure on labor, materials, land, marketing and capital,
varies from place to place resulting in a spatial variation in
profitability for a firm.
• Unlike most authors, Rawstron does not identify transport as a
separate cost item but takes it as a factor for spatial variation in
the cost of other items and hence of profitability.
• The sum of costs arising solely from the choice of location is
defined as the location cost by Rawstron. It plays crucial role in
locational decision making.
The technical restriction examines the effect of the level of technology
on location.
• Rawstron's emphasis on technical restriction to location is consistent
with this.
• Location decisions will be important with stable technology.
• In the case of changing technology it may be difficult to link the
choice of plant location with the choice of technology since the latter
is uncertain.
• Generally, the effect of technological change is felt through some
change in input requirement and hence on cost of production.
• On the whole, Rawstron's contribution to the geographical studies on
industrial location has been a pioneering one.
• The emphasis on cost-structure for industrial location makes his
approach more important than the other geographical studies on the
subject of industrial location based on minimum transport cost.
The Economic Theories of Industrial Location
• Some of the pioneering works from some celebrated economists
in the field of industrial location are discussed in this section,
such as
a) Weber's Theory
b) Tord Plander's theory of Market Area
c) Losch's Theory of Central Place
A) Weber's Theory
• In his theory he followed Launhardt's principle of industrial
location based on minimum transport cost.
• The factors considered by him were divided into two groups;
• Those influencing inter - regional location of industries (i.e.
regional factors) and
• Those influencing intra-regional location (i.e. agglomerating
factors).
• He found three general factors which vary regionally;
 Raw material costs,
 Transport costs and
 Labor costs.
• The fluctuations in raw material costs were however included within
transport costs.
• The approach followed by Weber was to explain industrial location in
terms of transport cost first and then to examine the effects of
changes in labor cost and agglomerative factors on it.
• He made some simplifying assumptions for his analysis such as
• The locations of raw materials including fuel are fixed
• Situation and size of consuming canters are given; and
• There are several fixed labour supply centers; labor is immobile
and unlimited in supply at fixed wage rate.
• The institutional factors like taxation, interest, insurance, etc.,
are insignificant locational factors.
• The economic culture and political system are treated to be
uniform and stable across the locations.
• On the whole Weber assumed perfect competition for his
model.
• Weber started his analysis with the proposition that a manufacturing unit tends to
locate at the place where cost of transportation is minimum, i.e. the location where
the number of ton-miles of raw materials and finished product to be moved per ton
of product would be minimum.
• Weber used the locational triangle of Launhardt to find the place of minimum
transport cost.
• He assumed a simple spatial situation in which there is only one consumption
Center(C) and two fixed supply centers (M1 and M2) for two most important raw
materials.
• According to him, the least cost point will be located within the
triangle CMM2 such as the one shown by P.
• The three corner points of the triangle will be pulling the location
point (P) towards themselves.
• If the pull of anyone corner is greater than the sum of the pulls of the
other corners, production will be located at the point or corner of
origin of the dominant force.
• Let x and y be the requirements of materials M1 and M2, in tons per
ton of output and let one unit of output, i.e. finished product be
transported from point P to C.
• The distances of the corner points from the production point (P) are
unknown.
• Let them be a, b and c between P and M1, M2, and C points
respectively.
The total ton-miles of transport per unit output would then be ax + by + c.
• This is to be minimized in order to find the position of point P, i.e. the location of
production.
• The distances a, b and c and hence the point P are easy to be found by applying the
theorem of parallelogram of forces in geometry.
• An industry may be material-oriented or market-oriented from location point of
view.
• Weber used the 'material index' for identifying such nature of the industry.

• Industries displaying a high material index i.e. MI > 1 are attracted

towards the sources of raw materials such as iron and steel industry,
• Industries displaying a material index less than one i.e., MI < 1 are
attracted towards the place of consumption.
• The assumption of a uniform transportation rate, was relaxed by Weber by
converting the weight to be transported into an ideal weight which is defined as a
product (or a function) of actual weight and the rate of transportation cost, for a
material or finished product.
 Let t1, t2 and t3 be the transportation rates per ton-mile for material M1, M2 and
finished product respectively, which is explained in the figure 4.1.
• The total transport cost per ton of finished product would be then equal to t1ax
+ t2by + t3c.
• The location of production point (P) within the triangle CM1M2 can be determined
now by minimizing this cost instead of the sum of ton-miles as mentioned earlier.
 According to Weber an industry will choose a cheap labour site if the labour cost
saving is greater than the increment in transport cost at this site above the
minimum possible transport cost.
• Weber used the isodapanes to explain the effect of labor cost on the least-transport-
cost location of a plant.
• An isodapane is the locus of the points having equal additional transport cost
around the least-transport cost location.
• There will be several isodapanes forming rings around the location fill different
levels of incremental transport cost as shown in Fig. 4.2.
• Let P1be the least-transport-cost location and L1be a cheap labor site.
• Further, let us presume that there will be a saving of labour cost by
Birr. 4 if plant is located at L1 instead of at P1.
• Should the location be shifted from P1 to L1? For illustration, the
isodapanes around P1 are drawn for incremental transport cost of
Birr.1, Birr. 2, Birr. 3, Birr. 4 and Birr.5.
• Point L1 lies with the isodapane of Birr. 4. It implies that it is
economical to shift the location from P1 to L1.
• If labor source making a saving of Birr. 4 in cost of production lie
outside the isodapane of Birr. 4, such as shown by L2, it would mean
a loss in shifting the location from the least-transport-cost location P1
to the labour centre L2.
• In general, let d1 and d2 be the total ton-miles of transport services
per ton of product at P1 and L1 sites respectively, and let W1 and W2
be the hourly wage rates at these two sites respectively,' h' is the
number of man-hours required to produce one ton of product and 't' is
the cost of transportation per ton-mile.
• The cost of production and transport at site P1 would be (tdl +W1h)
and at site L1 it would be (td2 + W2h).
• The cheap labor site (L1) would be chosen if (tdl +W1h) > (td2 +
W2h) Or(w1-w2) h > t (d2 - dl) i.e., saving in labour cost exceeds
the increment in transportation cost.
• For every level of saving in labour cost there will be a critical
isodapane within which the cheap labour cost site must lie for
economic viability from location point of view.
• To measure the importance of labour as a location factor, Weber used
the average cost of labour per unit weight of product as an index.
Greater the labour cost index more will be the industry's susceptibility
to move from the least transport-cost site.
• As an improvement over the simple labour Cost index.
• Weber suggested to use the industry's coefficient of labor.
• This is defined as the labour cost per ton of location weight, where
• A high coefficient of labour means a strong attraction to the cheap
labour location.
• Weber's analysis of industrial location is indeed a pioneering one.
• It has paved the way for development of programming models for
industrial location.
• Many economists have used this analysis as the basic framework for
their location theory and empirical works. Even then this theory is not
free from criticisms.
B) The Market Area Theory of Tord Palander
• Tord Palander started his market area theory of industrial
location analysis by posing two different but interrelated
questions.
• Given the price and location of materials and the situation of the
market, where will production take place?
• Given the place of production, the competitive conditions,
factory costs, and transportation rates, how does price affect the
extent of the area in which a particular producer can sell his
goods?
• To demonstrate how the market boundary between firms can be determined,
Palander took a simple case of two firms making the same product and
selling that in a linear market, which is depicted in figure. 4.3, the firms
are located at two different places, A and B, which are on a horizontal line
which defines the market area of the firms.
• Let the prices charged by the firms at their locations be and respectively.
• These are shown by the vertical distance AA' for firm A and BB' for firm B.
• The consumers who are situated away from the location points of the firms
will be paying higher prices for the product of the firms.
• The addition in price will be the transportation cost.
• Let ta and tb be the average transport costs for the product per unit distance
for the two firms respectively.
• The price for the product at a point other than location would be α + ta AX
for firm A and β+ tb BX for firm B, and
• AX and BX are the distances of the point from the location of firm A and
firm B respectively.
• The gradients are linear because of fixed transport rates for the
product over distance.
• Just above point X, the gradient lines of firm A and firm B intersect.
This implies that consumers would be paying same price for the
product of the firms.
• The point X defines the boundary between the market areas of the two
firms.
• Example
• Let α=Birr.100, β=Birr.90,ta=tb=Birr.2 and AB=100km.
• So, AX=[(90-100) / (2+2)]+[2/(2+2)][100]
• = -2.50+50
• = 47.5 km
• Firm A can sell only up to 47.50 kilometers toward firm B.
• The rest of the distance between- them, i.e. 52.50 kilometers defines the market area
of firm B.
• The determinants of market boundary or area for the firm are prices at the
locations, transport rates, and the distance between the firms.
• Given the location of the firms and hence the distance between them, the boundary
of their market areas will depend on the relative magnitudes of the location price (α
and β) and the transport rates (ta and tb).
• There may be several combinations of these variables.
• For each combination there will be one boundary between the firms.
• For example if α > β and ta = tb, it will give us one boundary, and if α > β and ta >
tb, then we will have the other, and similarly various other situations can be
examined for determination of the market areas of the firms.
• On relaxing the assumption of linear market, the market boundary for the firms will
be defined by a line showing the locus of the points of equal delivered prices for
both the firms.
• The gradients of delivered prices for the firms will be spreading in all directions in
the horizontal plane from their respective locations.
• The intersections of the gradients of the two firms will give the market boundary
line for them.
• Palander calls such boundary line as 'isotante'.
• The shape and situation of the isotante depend on the relative magnitudes of
location prices and transport rates for the firm.
• The market area of a firm will be extended to greater distance if its factory price and
transport cost are lower or decline.
• The size of market area will influence the profit of the firm.
• Palander's analysis is not a mere extension of the Weber's work.
• He made valuable contribution to locational analysis by adding the market area
dimension to it.
• He did not accept the agglomeration analysis of Weber but emphasized much on
dynamic aspects of locational factors.
c). Central Place Theory of Losch
The advocator of central place theory August Losch started his analysis on a
broad homogeneous plain with uniform resource endowment. This rejects
all cost difference factors affecting industrial location.
In such situation, the right approach to decide about the location is to
maximize total revenue.
An individual locates his plant at that particular site, where revenue is
maximum.
The maximization of revenue implies profit maximization because of the
assumption of uniform cost conditions across the locational plain in Losch
model.
To explain his theory, let us take a simple situation in which there is only one
producer who is located at a central place.
He sells his product around the location point in circular belt, the extent of
which depends on the economies of scale accruing to the producer and the
transportation, i.e. distribution cost of the product.
The demand for the product falls with distance.
The maximum extent of the market area for the producer is given by the
distance when demand falls to zero because of high price for the product.
This is shown by OF in figure 4.4
• The circle with OF as radius defines the market area for the producer. 0 is the
location of the producer at which OQ is the demand for his product.
• The producer being only one in the market makes profits.
• This attracts other competitors in the industry.
• They put up their plants in the area.
• There is no restriction for that.
• The resources are available.
• The entry of new producers gradually reduces the market area of the existing firms.
• Their markets will not continue to be circular but somehow irregular in shape.
• However, when distribution of the firms in the plain is uniform the market area for
each one of them will be hexagonal.
• The profits for each firm will be minimal at this stage.
• Each industry will have a system of hexagons of its own.
• The superimposition of hexagons of different industries produces a common
production centre surrounded by the sub-centers of productions in orderly sequence.
• Losch's theory is a general spatial equilibrium theory, and it is not giving any thing
about the factors which determine the location of individual firms.
• The rejection of cost differences as locational factors is a major weakness of
Losch's theory.
 CHAPTER FIVE
Diversification, vertical integration and merger
Introduction
Diversification, Vertical Integration and Merger are three important elements of
market structure. All the three are no doubt different but closely interlinked. We
will therefore study them together in the coming discussion.
Definitions
A. Diversification
In order to define the concept diversification, let us start with a simple
situation.
Suppose a firm produces some varieties of a product which are close substitutes
for each other in the market, if the firm adds one more variety of the product
then it is not diversification.
We may simply call it product variation or differentiation.
 However, if the firm produces a totally different product which is not a
substitute for the existing products in the market then it is called
diversification.
• A firm producing margarine starts producing soap, for example. This
comes under diversification.
 when a leather tanning firm starts manufacturing boots and other
leather goods, we will then call it diversification because here the
products are different as a result of which the market 'area' for the firm
expands from one class of consumers to another one.
 Diversification is thus "the spreading of its operations by a business
over dissimilar economic activities".
• According to Penrose, a firm is said to diversify, whenever, without
entirely abandoning its old lines of product, it embarks upon the
production of new products, including intermediate products, which
are sufficiently different from the other products it produces to imply
some significant difference in the firm's production and distribution
programmes.
• In the process of diversification, a firm makes significant changes in
its 'areas' of operations related to technological base, market areas
and productive activities in which it has acquired experience or
knowledge in the past.
Four different possibilities have been mentioned by Penrose for this:
• When there are additional products within the firm's existing techno-
logical bases and market areas;
• When there are products involving the existing technological bases
but destined to new market areas;
• When there are products which involve altogether new technological
bases for the existing markets; and
• When there are new products with new technological bases for new
market areas.
When a firm introduces new products there will be a change in
productive services and marketing areas or activities.
Diversification thus cannot be conceived of changes in the products
only; it implies the other two aspects of the change also, i.e. changes
in the technological base and market areas.
B. Vertical Integration
It refers to operations by a firm in two or more industries
representing successive stages in the flow of materials or products
from an earlier to a later stage of production or vice versa.
Thus, it is a type of diversification but it may be looked as 'vertical
concentration', and if the process takes place by merging of two
different firms then it is 'vertical merger'. How ever, vertical
integration is a popular term for all these.
Essentially, it is the integration among the intermediate products
used introduction of a commodity.
It may be initiated in either way i.e. a firm itself starts manu-
facturing all of them or different firms producing goods at
different stages of the process merge together.
C. Merger
The term merger refers to amalgamation or integration of two or
more firms.
The firms under different ownership and management controls
come under a unified one through merger.
The terms 'acquisition' and 'takeover' are also used for merger,
which implies that a firm acquires assets or stocks in part or full, of
other firm or firms to get operational control over them.
In legal sense, there is difference between these terms but from the
point of view of the economic analysis they are alike.
 The important feature of merger is the transfer of control of
business activity from one firm or firms to another.
Situations of merger:
(1) A horizontal integration or merger of firms whose products are
viewed by buyers as identical that is their products have high cross
elasticity of demand and supply;
(2) A vertical integration or merger of firms where there is a
successive functional link between their products, that is, the output of a
firm is input for the output of another firm at higher stage of production.
There may be such integration between a producing and a marketing firm
for the same commodity or commodities; and
(3) A conglomerate integration or merger of firms which are
producing altogether different products, i.e., which are not substitutes
for each other (zero cross elasticity of demand and supply) such as
merging of a cloth making firm and a drug manufacturing one.
The amalgamated firm in this situation will be a market-diversified
firm.
Diversification is also implied in the situation of vertical merger.
8.2. Motives for Diversification, Vertical Integration and Merger
I. Diversification
• Motives for diversification depend on its types.
• The types of diversification as observed in practice and motives for
them are the following:
1. Lateral Diversification: When a firm produces different goods
which diverge from the same process or source or which are used as
materials for the same process or market.
 For example, a leather tanning firm will have lateral diversification
when it starts making boots and shoes leather garments and suitcases
itself, because all such businesses diverge from leather tanning
business.
• Similarly, a meat seller will have lateral diversification if it starts
selling hides, horns, bones and even raw wool.
• A soap manufacturer may start margarine and chemical manufacturing
itself which are used in soap making and thus indulge in lateral
diversification.
Reasons for lateral diversification
• A firm may resort to lateral diversification because of the following
reasons:
• When production of one commodity necessarily involves
production of another, say, in by-products form, there would be a
natural scope for lateral diversification in order to avoid wastages
and gain advantages from the business.
Production of mutton and wool, bitumen, lubricants, paraffin, raw
chemicals, etc., together with petroleum refining, coal, coke, and their
by-products such as benzene, etc., is few examples of this situation.
• When market demand for the existing products is declining or
stagnant, a firm has to diversify its business laterally in order to
maintain its earnings or to increase it.
• Better utilization of existing facilities such as managerial talents,
R&D activities and certain categories of machines, etc., may be
looked as a motive for lateral diversification.
• The market complementarity or interlocking pattern in seasonal
demands also leads to lateral diversification say, for example,
one may produce colours and water sprayers together for
festivals.
This type of diversification when done through merger brings more
market power by reducing competition and through extension of
operations in different industries.
• To maintain the rate of growth, without being accused of mono-
polizing. This type of diversification is very much suitable and
actually being followed all over the world.
• Lateral diversification is an effective barrier to entry to reduce
potential competition.
2. Conglomerate Diversification: In this type of diversification, the
products need not to have diverged from the same product or source, or
converge at the same process or market as is the situation in the case of
lateral diversification.
The products will be quite unrelated. At this stage we can simply
express that all motives of lateral diversification will also be motives of
conglomerate diversification.
• In brief, it
• Helps in extension of market power of the firm
• Brings stability in earnings through cross-subsidization, i.e. loss of
one product is covered by the gain from other
• Causes an increase in the barriers to entry
• Provides more options for risk taking for the sake of profits
• Maintains the process of growth
• Gives pecuniary gains to the firm
• Provides better utilization of some facilities, etc.
3. Vertical Diversification: This is vertical integration in fact.
It involves diversification in to process of manufacturing or
distribution which precedes or succeeds those in which the firm is
already engaged. It can be either 'backward integration' or
'forward integration'.
• Backward integration is seen where a firm starts manufacturing
products previously purchased from others in order to use them in
making its original product line.
 A milk product company may have its own dairy farm and
similarly, a bakery may have its own flour mill and so on.
• Forward integration occurs when the firm moves nearer to the
final market for its product and carries out a function which was
previously undertaken by its customers.
 A shoe making firm may start its own distribution or selling
shops, a flour mill may start making its own bakeries; a spinning
mill may also start weaving activities and like that-are few
examples of forward integration.
Vertical diversification, whether initiated by a firm itself or occurring by
merging of two or more firms has several motives some of which are as
follows:
• It provides security to the firm.
• Vertical diversification or integration provides economies of linked
processes and, thus, the efficiency of the firm goes up due to improve-
ments in capacity utilization.
• There will be economies in marketing such as saving of
transportation, advertisement, procurement and selling costs.
• There may be saving by eliminating 'the middle man' and his 'un-
necessary' profit margin in the process of production.
• On the whole the firm gets more market power through its size or
absolute cost advantages or pecuniary gains through vertical integra-
tion.
It gives strength to the barriers to entry and, therefore, reduces
competition in the market.
4. Diagonal Diversification or Integration:
It consists of the provision within same organization of
auxiliary goods and services required for the several main
processes or lines of production of the organization.
 For example a firm may have its own power house to
generate electricity or machine tool making units since such
things are required for running almost every processing
activity.
The motives of diagonal diversification or integration will be
more or less the same as for lateral and vertical diversification.
Among them the major one will be:
• mopping up of excess capacity
• Reduction of the risks.
• The motives of all types of diversification can now be
summarized in condensed form as:
– Profitability or earning motive which implies fuller
utilization of resources/capacities at the disposal of the
firm;
– Stability motive which implies reduction of risks and
uncertainties through assured supplies of resources and
markets for main line of production;
– Growth motive which means expansion of productive
capacities without being charged for being
monopolizing, and in the face of market limitations; and
– Market power motive which is assured through increase
in barriers to entry as a result of diversification.
• In general, a new industry will have higher degree of
diagonal and vertical integration but a mature industry
will resort to more lateral diversification. ?????
• This is because, in the case of a new industry, auxiliary
services may not be available at all, so the firms have to
make for their provision within its organization.
• For a mature industry like textiles the demand for such
services will be large enough, so independent units may
come into existence for their supplies in an efficient way.
II. Vertical Integration
The motives for vertical integration have already been discussed above under vertical
diversification.
 One point we must make clear here, whenever there is vertical integration between
two or more firms, it means vertical integration between their products.
 Such integration between products exists in the situation of vertical diversification
which we have discussed earlier.
 The condition of vertical integration between the firms for vertical integration in the
products may not necessary.
 However, when we talk of vertical integration, in reality it implies integration
between the firms.
 The integration in their products is implicitly obvious here.
 Increase in profits or profitability either by fuller utilization of resources and saving
of costs through backward or forward integration may be looked as principal
motives of vertical integration.
 The other two general motives, i.e., stability and growth are equally sustained
through vertical integration.
 The motives of the firms involved in vertical integration play important role in
determining the price and quantity of output of the industry to which they belong.
III. Merger
• As indicated earlier, merger implies diversification except
horizontal integration between the firms.
• The motives of diversification will therefore be equally
applicable to merger also. However, there are some other
important motives of merger -which are not linked with
diversification as we will see below in the list of general
motives for all types of merger.
• Increase in Profitability: This may be possible either
through increased degree of diversification of the combined
firm or through other consequences of merger such as
increased efficiency and market power.
• Stability in Earnings: Profit rates of individual firms
whether they are in the same industry or in others may
fluctuate widely as they are exposed to a greater degree of
risks.
• When they merge together there may be little variation in
their combined profit rate. This means the get stability in
earnings by merger.
• The variability of profit rates is generally measured through
their variance or standard deviation.
 The variance of profit rates of the combined or merged
firms will be lower than the variance of the profit rates for
individual firms.
• A simple situation for this is when one firm is having
negative profit rate, the other one positive.
• When both merge together, there will be likely a stable
positive profit rate for them. This is what we may take as
cross-subsidization motive for the sake of stability and
reduction of risks.
• It may be emphasized here that a reduction in variability of
profit rate is a possible but not a necessary outcome, of
merger.
• There may be situations when there is an increase in it as it
consequence of unforeseen business uncertainties after
merger.
• Stock market gains: firms would like to merge together if there is a
difference in the earning-price ratio or market price for there shares in
the stock market.
There will be mutual gain for them by merger in this situation.
• Efficiency Motive: This motive may be stronger in the case of hori-
zontal and vertical mergers.
As a result of such integration one can expect economies of scale in a
variety of ways, such as reduction in inventory requirements,
transportation and distribution costs, duplicate R&D activities, cheaper
raw materials due to increased size of purchases, better management, etc.
In the case of conglomerate merger such economies of scale are doubtful
but there may be better management and more pecuniary gains.
• Market Power Motive: This may be a major motive of merger, as
fulfillment of the other motives like profitability, reduction in risks,
growth, etc., which are complementary to the market power motive
becomes easier and almost certain.
For conglomerate mergers the following factors are mentioned as
sources for market power:
• extended monopoly power,
• encouraged cross-subsidization,
• increased deep pocket advantages,
• increased entry barriers,
• increased non-economic reciprocity arrangements,
• increased macro-concentration, and
• increased size of power groups.
 Growth Motive: This is a possible outcome of merger.
A firm grows by expanding itself in the market or by acquiring
some existing firm or through merger. Combined firm after merger
will command more assets, more sales and more market power.
8.3 Implication for Public Policies
Diversification and integration, whether vertical, horizontal or
conglomerate, are important market strategies which affect the
competitive environment of an industry and economy as a whole.
When a firm diversifies, it has certain well-defined motives for that. Its
actions will not be unnoticed by its rivals.
when only few large firms control the market and put barriers to entry
for new competitors, it leads to an increase in market concentration so
that we may say that diversification explicitly or implicitly causes
market concentration.
For horizontal and conglomerate mergers, there is greater
probability of their causing market concentration, so, they are
strictly regulated through-public laws.
A public policy is designed to achieve some chosen objectives or
goals.
These may be, say, for example:
(1) To diffuse economic power;
(2) To have efficient allocation of scarce resources; and
(3) To ensure economic freedom of mass participation in the
economy.
All mergers and diversification policies of the individual firms in
the market are to be evaluated in the light of such social goals.
If the policies are in conflict with such goals they are to be
checked and controlled effectively.
Most of the governments appoint Antitrust or Monopoly and
Restrictive Trade Practices Commissions for this purpose.
There will be a set of rules or guidelines which will be imple-
mented by such commissions to regulate mergers and
diversification strategies of the firms by maintaining a balance
between private and public interests.
 CHAPTER SIX
Advertising debate
 Advertising is a mass paid communication, the ultimate purpose
of which is to impart information, develop attitudes and induce
action beneficial to the advertiser.
 It can take many forms: media advertisements, direct mail,
leaflets, or sponsorship.
The content of an advertisement can vary considerably.
It can simply display the name of the product or it may compare the
product with that of rivals.
It may provide detailed information about the product's attributes,
or may simply enhance its image.
 Advertising is one of many forms of promotional activity.
 Instead of advertising, a firm might promote sales by employing
more sales representatives, by altering the product's packaging,
or by widening wholesale and retail margins.
6.1 Why advertise?
• Whereas marketing aims to identify markets that will purchase a
product (business) or support an idea and then facilitate that purchase,
advertising is the paid communication by which information about the
product or idea is transmitted to potential consumers.
• More specifically, there are three generic objectives of
advertisements:
 communicate information about a particular product, service, or
brand (including announcing the existence of the product, where to
purchase it, and how to use it),
 persuade people to buy the product, and
 Keep the organization in the public eye (called institutional
advertising).
• Most advertising blends elements of all three objectives.
 Typically new products are supported with informative and
persuasive advertisement, while mature products use
institutional and persuasive ads (sometimes called reminder ads).
• Advertising frequently uses persuasive appeals, both logical and
emotional (that is, it is a form of propaganda), sometimes even
to the exclusion of any product information.
• More specific objectives include increases in short or long term
sales, market share, awareness, product trial, mind share, brand
name recall, product use information, positioning or
repositioning, and organizational image improvement.
• Examples of the ideas, informative or otherwise, that advertising
tries to communicate are product details, benefits and brand
information.
6.2 How much advertising?
• A profit maximizing firm engages in advertising up to the point at
which the expected marginal benefit from advertising equals the
expected marginal cost of advertising.
• The intensity of advertising varies according to the nature of product
to be advertised and the market characteristics that affect the
efficiency and cost-effectiveness of advertising.
 Advertising is more suitable for promoting consumer goods than
industrial products because it involves mass communication.
 The markets for consumer products are generally larger and
geographically scattered.
 Industrial buyers are likely to be smaller in number and require more
detailed information than can be provided by an advertisement.
 Consumer durable goods have a longer life, are often more complex
products, and tend to involve a greater outlay than consumer non
durables.
• An error of judgment in purchasing a durable good has a greater effect
on the consumer's welfare.
• Consequently, consumers require more information than can be
communicated effectively via advertising.
• The more complex the product, the greater the use consumers make of
alternative information sources.
 Consumers have evolved 'rules' that influence their purchasing
behavior seek out information for durable goods, do not bother for
non-durable goods.
 With durable goods, advertising is also likely to be less effective in
promoting sales than competition on the basis of price products.
• The importance of product type can be illustrated by introducing the
concept of search (Stigler, 1961).
• When knowledge is imperfect, consumers can improve their decisions
by searching for information on product characteristics, product
availability and alternative prices.
• Search can take 'several forms - visiting or telephoning sales outlets,
surveys of available literature, and verbal enquiries.
• However, the incremental benefit received by the consumer is
likely to decline as the amount of search increases.
• This can be illustrated by considering a consumer wishing to purchase
a car.
• The greater the number of dealers(seller) already contacted (searched),
the less likely it is that contacting an additional dealer will locate a
better offer and, even if a better offer is found, it is likely to be only
marginally better.
 Recognizing also that the collection of information is costly, search is
worthwhile only up to the point where the expected marginal benefits
equal the expected marginal costs.
• The optimal levels of search for durable and non-durable goods are compared in
Figure 6.1.
• For exposition, it is assumed that the marginal costs of search (CC) are constant and
the same for both types of good.
• The marginal benefit functions differ (DD for the durable good, NN for the non-
durable) since the potential discounts on the durable goods are likely to be much
larger in absolute terms.
• Given the higher unit price and the larger expected savings from identifying a lower
priced source, the optimal level of search for the durable good will be higher (OY
compared to OX).
 The optimal amount of search may also be lower for goods that are purchased
frequently, or which account for a relatively low proportion of a consumer's total
expenditure.
 For inexpensive goods, efforts to use sources of information other than advertising
are unwarranted - and, in the case of frequently purchased goods, the consequences
of a mistaken purchase are relatively short-lived.
 Therefore, in both cases, it is often rational for the consumer to make a decision
between products with unknown characteristics on the basis of advertising
messages.
• Nelson (1974) takes the analysis further.
 Search goods are those consumer goods whose qualities can be
evaluated effectively before purchase (such as books or compact
discs).
 The qualities of experience goods can only be evaluated effectively
after purchase (such as food at restaurant, shampoo and photographic
film).
 Whilst advertising has a role in informing consumers about the
features of search goods, it can only signal the existence of experience
goods.
• Higher levels of advertising are likely in the latter case since
advertising may be the only source of information available to the
consumer.
 Higher levels of advertising for experience goods should
also be positively associated with product quality.
 High advertising may be interpreted by consumers as
evidence of product quality and a firm's intention to remain
in the market.
 Furthermore, where product characteristics change rapidly,
there will be a need to advertise to increase consumers'
awareness.
 Advertising levels will also be relatively high where the
entry of new firms is rapid.
 New entrants must counteract the influence of past
advertising by existing firms: heavy advertising is required
to inform consumers of the attributes of their own products.
6.3 Debates on advertising
• Advertising is a prominent feature of modern economic
life. Consumers encounter advertising messages as they
watch TV, read magazines, listen to the radio, surf the
internet, or simply walk down the street.
• And the associated advertising expenditures can be huge.
What, then, do economists have to say about advertising?
 The traditional view of advertising is that it persuades people to buy a
firm's product, so increasing the firm's market power.
• Advertising not only distorts consumer choice, but uses resources
which could have been used elsewhere.
• Society's welfare is reduced firms enhance their profits at the expense
of consumers.
• Many firms advertise their goods or services, but they are wasting
economic resources.
• By increasing product differentiation and encouraging brand loyalty
advertising may make consumers less price sensitive, moving the
market further from perfect competition towards imperfect
competition (see monopolistic competition) and increasing the ability
of firms to charge more than marginal cost.
• This intensifies competition, as consumers can be made aware quickly
when there is a better deal on offer. In general, there two main
divergent views of advertising emerged, including the persuasive
view, and informative view.
• The 'advertising as persuasion' view
• Advertising will not only bring benefits to the firm in the form of
increased sales, it will also have an impact on the environment within
which the firm operates and the prices charged to consumers.
• The traditional view - advanced, among others, by Bain (1968) and
Comanor and Wilson (1974) –is that advertising works by persuasion,
and results in increases in both market power and prices (the process
is summarized in the following figure)
• The advertising as persuasion view implicitly assumes that
advertising distorts consumers' preferences.
• By altering consumers' preferences to favour the advertised
product, demand for the 'product becomes less sensitive to price
changes.
 Advertising also has the effect of reducing the cross elasticity
of demand between the advertised product and its close
substitutes.
• The 'advertising as information' view
• This alternative view, adopted by Stigler (1961), Telser (1964) and
Nelson (1974b, 1978), stresses the role of advertising in providing
information.
• In an environment where knowledge is imperfect and uncertainty
abounds, advertising plays an important part in reducing consumers'
ignorance.
• The advertised product thus faces a more elastic demand.
• Advertising (and other forms of promotional activity) can make
consumers more responsive to price changes and price differentials,
increasing their concern to buy the 'right' alternative.
• With demand more price-elastic, it follows that the profit-maximizing
price will be lower.
• If consumers are more responsive to price signals, firms will be under
more pressure to offer attractive prices.
• Prices will also be lower because of the increased competition brought
about by a reduction in entry barriers.
 CHAPTER SEVEN
• Invention, innovation and diffusion
The major elements of innovation or technological change, such as,
• New products,
• New methods of production,
• New markets and
• New forms of industrial organization etc,
In the modern world,
• An individual wants to be more creative,
• A firm or corporation strives for the progressiveness of its business
and
• A government works for the collective security and welfare of
masses.
• Innovation is an important weapon for all these. In fact, survival of
mankind depends to a great extent on innovation, particularly in the
fields of material requisites of life.
 What are the sources of innovation?
• Innovation in business is achieved in many ways, with
much attention now given to formal (R&D) for
"breakthrough innovations."
• But innovations may be developed by less formal on-the-
job modifications of practice, through exchange and
combination of professional experience and by many other
routes.
• The more radical and revolutionary innovations tend to stem
from R&D, while more incremental innovations may
emerge from practice - but there are many exceptions to
each of these trends.
The process of innovation: Concepts and Relationships
• The terminology of innovation consists of a set of interrelated terms.
• The first and perhaps the most important one is the concept of invention.
• An invention is the creation of the new technology.
The process of adopting an invention in a practical use is called
innovation. It is the implementation of a new or significantly improved idea,
good, service, process or practice that is intended to be useful.
• If the existing product line is changed by a firm, i.e. it introduces a new
product with or without displacement of the old ones, and then it is defined
as product-innovation.
• If a new method is initiated to produce existing products then it is process
innovation. Both of these are the elements of 'technological innovation'.
• When a firm makes changes in its marketing strategy we define that as
'market-innovation'.
The entrepreneur or manager when performs the act of innovation is called
'innovator'.
Innovation occurs when the entrepreneur believes that it is worthwhile to
commercialize the invention.
• Schumpeter identifies five types of innovation, viz
1) The introduction of a new good
2) The introduction of a new method of production,
3) The opening of a new market
4) The conquest of a new source of supply of raw materials
5) The carrying out of the new organization
• Another useful concept related to the innovation process is
'imitation'.
• It is a situation when an innovation is copied by others.
• That is, the innovation spreads across the market. In other words, we
call it 'diffusion of the innovation'.
• Such diffusion may be rapid or slower depending on the market
situation, but it will be easier or safer than the act of innovation.
7.2 Stages of Technological Change
• Let us examine each stage in the process of change in some details for
full understanding.
• The first stage (Invention) is carried on by individuals or corporate
bodies like research institutes, universities, government bureaus and
companies- the source of invention.
• The Second stage (innovation) is a logical extension of invention.
Process innovation arises when relative prices of factors of production
change.
Product innovation is necessitated because of a variety of reasons.
• The third stage (Diffusion) is the imitation of innovation. The
innovation, initiated by an innovator, spreads in the market. The rate
of diffusion depends on market structure.
7.3 Measurement of Innovation Activities
• We need precise measurement of innovation like any other
economic activity.
• There is no unique method for this.
• Researchers in the field tackled the problem by measuring
either the inputs (i.e. total cost or some component of it in
money or physical terms) put in the process of R&D or the
output of this activity.
• The simplest and widely used method is to take the
statistics of R&D expenditure, absolute or a proportion of
total annual budget of the firm, as a measure of innovation
activity.
The Theory of Technological Innovation
• Perfect competition and monopoly were taken as two extreme
contrasting situations to analyze the link between innovational
motivation and market power.
 To test this link, the major hypothesis was put forward by Schumpeter
who argued that a monopoly firm has a greater demand for
innovations because its market power increases its opportunity to
gain from them.
• Competitive pressure school and
• Monopoly profit school.
• The competitive pressure school argues that in an atomistically
competitive situation, with its strong tendency for a uniform normal
rate of profit, there will be great pressure and hence inducement
for making cost-saving innovations.
• Such pressure diminishes as market power of the firm increases and
so the rate of innovation will be inversely related to the degree of
market power.
In brief, we may say that R&D activities of a firm depend on
• market structure,
• size of the firm,
• technological opportunities,
• nature of elasticity of demand for the products of the firm,
• the degree of diversification,
• growth of market, and
• Expected return on R&D investment.
Dasgupta and Stiglitz Models
• Dasgupta and Stiglitz jointly produced exhaustive theoretical material related to the
relationship between industrial structure and the nature of innovating activities.
• The basic stand taken by them in their analytical framework is Neo-Schumpeterian
in nature where, except in the short run, both market structure and the nature of
inventive activity are endogenous.
• They are determined by some more basic factors, such as the technology of
research, demand conditions, the nature of capital market, i.e. market rates of
interest and the ability of firms to borrow to finance R&D outlays, and the legal
structure related to patent rights.
• As one may infer from these conclusions, the extreme ends of market structure, e.g.
pure monopoly and perfect competition, may not provide significant incentives for
R&D activities.
• The type of market structure between these two extreme forms such as duopoly,
oligopoly and monopolistic competition are likely to provide the incentives as well
as competition for R&D activities of the firms.
7.5 Innovation and Employment
• Although innovation leads to benefits for society, it does not necessarily follow that
every member of society gains.
• Analysis of the effects of innovation on the employment of factors of production
will identify groups likely to suffer a loss of welfare as a result of change.
Figure 5.1 shows the impact of a process innovation in a perfectly competitive
industry.
• Demand and supply curves for the product are shown in the upper part of the
diagram.
• Initially the market price and output are OPl and OQl respectively.
• The corresponding derived demand curve for labour (Nl) is shown below the
horizontal axis. (It might equally well have shown the derived demand for
capital).
• Before the process innovation, OLl units of labour are required to produce
quantity OQl. The process innovation, by reducing marginal cost, shifts both
the demand for labour schedule and the market supply curve to N2 and S2
respectively.
• If the effect of the new production method leaves the capital - labour ratio
unchanged then the demand for both factors of production increases.
• In this example, labour demand will increase from OLl to OL2, with a similar
increase in the demand for capital.
• Alternatively, if the change results in a higher capital-labour ratio, then the
demand for labour will fall. This is shown by the post-innovation demand
for labour curve N3 in Figure 8.1, with employment falling to OL3.
• Assuming perfect knowledge and homogeneous factors of production
the reduction in welfare suffered by displaced factors will be
transitory as they will be rapidly re - absorbed into the economy.
• With imperfect knowledge, it may take time for displaced factors to
find alternative employment. Also, the expanding industries may
require different labour skills.
• Technological unemployment can arise if the growing sector requires
skills highly specific to the new technology but displaced labour is
skilled in more traditional trades. When skills become redundant, the
value of human capital is reduced. Social problems may also arise,
particularly if the industries adopting labour-saving innovations are
regionally concentrated.
THE END !!!!