BC32203 Ekonomi Industri Industrial Economics

The basics of Industrial Organization

Industrial Organization (IO)

Basic Microeconomics analyzes idealized models of firms and markets.

Industrial organization adds more realistic features to the ideal world of classical Microeconomics to make its principles more applicable in practice. Industrial organization (IO) definitions Industrial organization is concerned with the workings of markets and industries, in particular the way firms compete with each other. Luis Cabral (2000)

Industrial Organization
Definitions Industrial organization or industrial economics is the study of the operation and performance of imperfectly competitive markets and the behavior of firms in these markets. Church & Ware (2000)

Industrial Organization
The main Goal in industrial organization is to understand how firms strategically interact in welldefined markets Ideally, we want to be able to use observable variables to predict firm behavior, profits, and social welfare at the level of particular markets IO is particularly concerned with how government intervention influences firm behavior and market performance Antitrust policy, regulatory policies, patent policies, etc., are all important

Industrial Organization
Aim: Develop skills to make more informed decisions and judgments about issues relating to the industry become more efficient in analysing industries by identifying key issues. Objectives: To get an improved understanding of static and dynamic problems faced by firms: 1. internally, organizing production within the firm- The Theory of the Firm 2. externally, how firms compete in the marketplace - The Theory of Markets

A Brief History of Industrial Organization

Harvard Tradition (1940-1960; Joe Bain) Structure-Conduct-Performance paradigm Regressions on a cross section of industries to identify correlations (performance = f(concentration, barriers to entry)) Argued that high concentration was bad for consumers, and paved the way for much antitrust legislation Main weaknesses: (i) Assumes that structure (concentration) is exogenous. (ii) Assumes away important differences between industries.

A Brief History of Industrial Organization

Chicago School (1960-1980) More careful application of econometric techniques Use different market structures to understand different industries or markets Markets work!!! Monopoly is much more often alleged than confirmed When monopoly does exist, it is often transitory; entry (or just the threat of entry) is important

A Brief History of Industrial Organization

Game Theory (1980-1990) Emphasis on strategic decision making Modelled mathematically using Nash equilibrium concept Produces a huge proliferation of models are often very intuitive theoretically However, it is difficult to know which model is the right one for a real world industry

A Brief History of Industrial Organization

New Empirical I.O. (1990 - ) Integrates theory and econometrics into structural models More complex empirical models that are computationally intensive I.O economists have now a much richer toolbox to analyse markets

Method of Industrial Economics

There are two main approaches to the study of the New industrial organization: Structure-conduct-performance primarily descriptive method that gives an overview of industrial organization developed by Edward S. Mason (1939, 1949) and Joe S. Bain (1959) Price Theory uses microeconomic models to explain firm behavior and market structure developed by George J. Stigler (1968)

Structure-Conduct-Performance
There are two main approaches to the study of the New industrial organization: Structure-conduct-performance Performance the success of an industry in producing benefits for consumers depends on Conduct market behavior of the firms in the industry depends on Structure factors that determine the competitiveness of the market depends on basic conditions as technology and demand for a product.

Structure-Conduct-Performance

Structure-Conduct-Performance
SCP paradigm: Stable causal relationship between the structure of an industry, firm conduct and market performance. Typical SCP study consists of two steps: 1)Obtain a measure of performance through direct measurement (rather than estimation) and several measures of industry structure (concentration, barriers to entry, unionization etc). 2)Regress performance measures on the various structure measures to explain the differences in market performance across industries i i=+1CONC+2 B.E.i1+3 B.E.i2 +++1 B.E.iN+i

Structure-Conduct-Performance
Two main assumptions to establish a statistically and conceptually meaningful relationship between structure and market power:
1) The various industry structure measures are exogenous, i.e. structure affects performance but not the other way around. 2) Implied degree of symmetry in conduct holds across industries, i.e. changes in the structural variables must have the same average effect on market power in all markets.

Structure-Conduct-Performance in practice
Performance measures:
Rate of return ROI, ROS, ROE

key concern is whether the reported RoR captures economic or accounting profits

Price-cost margin or Lerner index=(p-mc)/p MC data is hard to come by, so most use AVC Tobins q which is the ratio of the firms market value to the replacement cost of its assets Need accurate measures of market value and replacement cost of capital, >1 greater implied profits

Structure-Conduct-Performance in practice
Concentration measures:
Herfindahl-Hirschman Index (HHI):

HHI si
i 1

Varies between 0(=perfect competition) and 1(=monopoly)

Takes into consideration the absolute number and size distribution of firms

Concentration Ratios:
Most common: CR4, CR8

CRm

s
i 1

Structure-Conduct-Performance in practice
Barriers to entry:

Minimum Efficiency Scale

Advertising Capital sunk capital investments

R&D
Unionization: unions may be able to extract higher wages hence reducing profits associated with mkt power

Buyer Power: just as seller concentration is important, buyer concentration may lead to lower prices and less mkt power for sellers

Price Theory
Price Theory: In recent years, three specific theoretical applications of price theory have won substantial support: Transaction costs the expenses of trading with others above and beyond the price (Ronald H. Coase,1937) Game theory uses formal models to analyze conflict and cooperation between firms and individuals (von Neumann and Morgenstern, 1944) Contestable markets markets in which many firms can enter rapidly if prices exceed costs and can exit rapidly if prices drop below costs (Demsetz, 1968; Baumol, Panzar, and Willig, 1982)

Game Theory
Game theory provides insights in industries with relatively few firms and strategic behavior is relevant. Competition among firms is viewed as a game of strategies. In the game firms compete to maximize their profits. Game theory describes how firms form their strategies and how these strategies determine the profits. A firms strategy is a complete plan of actions which describe firms behavior as a response to any feasible combination of other firms actions. A strategy might include, for example, firms choice of output, price, or advertising level.

Structure-Conduct-Performance: Critique
Measurement Problems
RoR 1. Capital is not valued appropriately; historical cost vs. replacement cost, book value vs. economic value 2. Depreciation is measured improperly; economic rental rate on capital after depreciation, econ vs. accounting depreciation 3. Valuing advertising and R&D

4. Adjusting for risk, debt vs. equity

5. Adjustments for inflation 6. Capitalized monopoly profits inappropriately included by using book value 7. Pre-tax instead of after-tax RoR often calculated

Structure-Conduct-Performance: Critique
Measurement Problems Price Cost Margins Instead of MC, AVC is used: PCM=(Sales Revenue-Payroll costs-Material costs)/Sales Revenue BUT substituting AVC for MC may cause serious bias.

Structure-Conduct-Performance: Critique
Measurement Problems
Tobins q 1. Avoid the problems with estimating RoR or MC 2. We need meaningful measures of both market value and replacement cost of firms assets 3. Firm value: equities+debt; issues with efficient market hypothesis, timing of evaluation

4. Hard to obtain estimate of replacement costs unless markets for used equipment exist
5. Much harder to evaluate intangible assets like advertising, R&D and human capital, usually ignore those and hence ratio>1

Structure-Conduct-Performance: Critique
Measurement Problems

Concentration Measures
1. How do we define a market? Economic vs. national statistic agency definition. 2. Boundaries of an economic market should include all the firms and their products that interact to determine prices, demandside (product) and supply-side (geographic) substitutes.

3. The importance of cross-price elasticities!!!

4. No import-export data

Structure-Conduct-Performance: Critique
Conceptual Problems
1. Long run vs. Short run Assumed stable relationship between mkt structure and long-run profitability 2. Symmetric Industry Effects

Elasticity of industry demand not included, assumed the same!!!!

3. What does a positive correlation between concentration and profitability mean?
More mkt power in concentrated industries or more efficient firms?

Implication is that a firms success is explained better by its own mkt share rather than just by industry concentration

Structure-Conduct-Performance: Critique
4. Causality

The SCP is estimated econometrically usually with crosssection multiple regression, across industries - Unidirectional causality Profits = f(concentration, Barriers, X)

- Later, other equations added to account for feed-back For example: Concentration = g(barriers, mkt size, Z) Advertising-sales ratio = h(concentration, profits, barriers)
And then simultaneous systems TSLS, see Strickland & Weiss for typical.

The Firm and Costs

The Firm
A firm is an organization that transforms inputs (resources it purchases) into outputs (valued products that it sells). The firm earns the difference between what it receives as revenue from selling the output and what it spends on inputs, which are used in manufacturing and selling. The firm decides the quantity of inputs to buy, how to combine the resources to make the output, and how and where to sell it. The firm makes a profit if it sells its output for more than the cost of producing and selling it.

Costs
Most firms try to maximize their profits. To maximize profit, a firm must produce its output at a quality level for which consumers are willing to pay the most and at the least possible cost, given technology and the price of inputs. Lecture 1 examines the second objective minimization of costs. The key issues are: Which are the main cost concepts? What properties of production processes could be characterized by costs? How the costs of a multi-product firm differ from the single-product firms ones?

Costs
There are variety of ways to measure costs, and some cost concepts are more appropriate for certain problems than others: Many of the predictions of economic theory revolve around concepts like marginal costs and profits. Theoretical work emphasizes that oligopoly behavior depends crucially on certain types of fixed costs.

Governments often regulate industries in which competitive entry leads to unusually high average costs.

Types of Costs
Costs,RM

MC

AC AVC

AFC
Output, q

Types of Costs / Jenis-jenis kos

A criterion for distinguishing costs is whether costs vary with output or not:

Fixed Cost (FC/KT) an expense that does not vary

with the level of output Sunk Cost the portion of fixed costs that is not recoverable Avoidable Costs/KH costs, including (non-sunk) fixed costs, that are not incurred if operations cease

Variable Costs/KB (VC(q)) costs that change with

the level of output, q

Types of Costs
Another criterion for distinguishing between cost concepts is their analytical meaning:

Total Costs (C(q)) the sum of all fixed and variable

costs: C(q)=FC+VC(q)

Marginal Cost (MC) the increment, or addition, to

cost that results from producing one more unit of output: MC=dC(q)/dq N.B. Because fixed cost does not change as the output increases, the increase in total cost when output increases is identical to the corresponding increase in variable cost.

Types of Costs
It is important to distinguish between the concept of marginal cost and the various concepts of average cost. There are three common types of average cost:

Average Total Cost (AC) total cost divided by output:

AC=C(q)/q

Average Variable Cost (AVC) variable cost divided

by output: AVC=VC(q)/q

Average Fixed Cost (AFC) fixed cost divided by

output: AFC=FC(q)/q N.B. AC is the sum of AVC and AFC:
AC (q) C (q) VC (q) FC VC (q) FC AVC (q) AFC (q) q q q q

Types of Costs
It is important to distinguish between the concept of marginal cost and the various concepts of average cost. There are three common types of average cost:

Average Total Cost (AC) total cost divided by output:

AC=C(q)/q

Average Variable Cost (AVC) variable cost divided

by output: AVC=VC(q)/q

Average Fixed Cost (AFC) fixed cost divided by

output: AFC=FC(q)/q N.B. AC is the sum of AVC and AFC:
AC (q) C (q) VC (q) FC VC (q) FC AVC (q) AFC (q) q q q q
Based on Carlton and Perloff (2000)

Types of Costs
Average Fixed Cost AFC=FC/q Total Variable Cost VC(q) Average Variable Cost AVC=VC/q Average Total Cost

Output q

Fixed Cost FC

Total Cost

Marginal Cost

C(q)=FC+VC(q) ATC=C(q)/q MC=dC(q)/dq

0 1 2 3 4 5 6 7 8 9 10

100 100 100 100 100 100 100 100 100 100 100

0 10 19 25 32 40 49 60 73 88 108

100
110 119 125 132 140 149 160 173 188 208

100 50 33.3 25 20 16.7 14.2 12.5 11.1 10

10 9.5 8.3 8.0 8.0 8.2 8.6 9.1 9.8 10.8

110 59.5 41.7 33 28 24.8 22.9 21.6 20.9 20.8

10 9 6 7 8 9 11 13 15 20

Types of Costs
Costs,RM

MC

AC AVC

AFC
Output, q

Cost Concepts
There are several complicated issues associated with the cost concepts: Non-output Cost Factors: The costs of production depend not only on how much is produced but also on how fast (Alchian, 1959) Opportunity Cost: The real cost of something is what one should give up to get it. The Short Run Versus the Long Run: Some factors could be varied at a lower cost if used for a longer period of time during which they have paid back part of their value. Expensing Versus Amortizing: When costs are counted as they are incurred, they are said to be expensed; when they are spread over the useful life of the machine, they are said to be amortized.

Non-output Cost Factors

Producing something quickly is more costly than producing it slowly. Variation in the rate of production over time also matters. For example, steady production of 60 units/hour for 10 hours might involve lower costs than 100 units/hour for 2 hours plus 50 units/hour for 8 hours total production is 600 units in either case. If a business is seasonal (for example, selling umbrellas) the relevant cost is not the cost of producing a specific output but rather the cost of producing the range of outputs experienced during the year.
$

AC 2

AC1

output range Output, q

Opportunity Cost
An actions opportunity cost is the value of the best forgone alternative use of the resources employed in that action. Opportunity costs can be used to determine whether it is profitable to continue an activity. If all costs are valued at their opportunity cost, then profit need only be zero to make remaining in business worthwhile. Opportunity cost attributes a normal profit (best possible profit from and alternative use of the resource) to all of the firms resources. The opportunity cost concept is very useful also in determining whether a firm should continue to use an asset it owns when that asset could be rented readily.

The Short Run Versus the Long Run

The short run is a time period so brief that some factors of production cannot be costlessly varied. The long run is a period of time sufficiently long that all factors of production can be costlessly varied. The distinction between short and long run is not precise. The firm must incur greater costs, adjustment costs, as it increases the speed at which it adjusts its operations. The long-run curve (LRAC) is the envelope of the short-run curves (SRAC): the long-run average cost is always at least as low as the short-run average cost.
$ SRAC1 Plant 1 SRAC3 Plant 3 LRAC

SRAC2 Plant 2

100

Output, q

Economies of Scale
A firms average costs may remain constant, rise, or fall as its output expands. If average cost falls as output increases, the firm is said to have economies of scale (or increasing returns to scale). If average cost does not vary with output, the firm has constant returns to scale If average cost rises with output, the firm has diseconomies of scale (or decreasing returns to scale) N.B. If a firm enjoys economies of scale at all output levels, then it is efficient for one firm to produce the entire market output.

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