ECONOMICS OF INDUSTRY

Chapter One: Introduction

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 1.1. DEFINITION: WHAT IS INDUSTRIAL ECONOMICS?
 Industrial economics is a distinct branch of economics
 It deals with the economic problems of firms and
industries along with their relationship with the society
 It is also known by many names with marginal
differences such as:
- ‘Economics of Industry’
- ‘Industrial Organization and Policy’
- ‘Business Economics’
- ‘Industry and Trade’ and so on
 If industrial economics studies firms and industries, the
question remains ‘what is firm?’ and ‘what is industry?’
 A firm/enterprise/company/organization is the basic 2

decision making entity

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 It converts all kinds of factors of production generally
into marketable outputs
 A firm may comprise many establishments and divisions
within
 An industry, on the other hand, is the aggregation of firms
selling goods that are in some sense similar
 In other words, an industry is a group of firms producing
similar or substitutable products
 As a subject matter, Industrial Economics addresses the
basic question of what to produce, how to produce and
for whom to produce in the context of industries or firms
 Industries face such economic problems because
resources are scarce and hence the industrialist has to
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make decisions about production and distribution of
products
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 Industrial Economics also gives insights into how
firms organize their activities as well as their
motivation
 In many microeconomics courses, profit maximization
is taken as given, but many industrial economics
courses examine alternative objectives, such as
growing market share
 Industrial economics concentrates on the constraints
which come in the way of achieving the preset goals
 When it comes to scope of industrial economics, there
are two broad elements
 Descriptive element: is concerned with the information
about the competitors, natural resources and factors of4
production and government rules and regulations
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 It aims at providing the industrialist/businessperson
with a survey of the industrial and commercial
organizations of his own country and of other
countries with which he might come in contact
 Analytical element: is the second element of the
subject that is concerned with the business policy and
decision making
 It deals with topics like; market analysis, pricing,
choice of techniques, location of plant, investment
planning, hiring and firing of labor, financial
decisions, product differentiation, and so on
 It is a vital part of the subject and much of the
received theory of industrial economics is concerned 5
with this
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 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 make proper decisions or take proper
actions about any aspect of business
 Moreover, industrial economics analyzes industries, markets,
and the behavior of firms within those markets
 It deals with supply side economics

 The interdependence between firms within markets and the

links that exist between market conditions and firm’s
performance are also the concern of the subject matter of
Industrial Economics
 From macroeconomic perspective, we need to study
Industrial Economics because it is instrumental to the
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formulation and implementation of industrial policies that
are essential for sustainable development of a nation
 1.2. APPROACHES TO INDUSTRIAL ECONOMICS
1.2.1. The Structure–Conduct–Performance Paradigm
 According to S-C-P paradigm, there is a priori
relationship between the three concepts; market structure,
market conduct and market performance
 The link between these three which is evident in the theory
of the firm is that the performance of an industry is
determined or strongly influenced by the crucial aspects of
the market conduct of the firms
 The conduct of firms in turn is directly or indirectly
determined by certain important dimensions of the market
structure
 This link gives us the basic framework for the study of the
economic behavior of the firms and industry in the market
 The structure of an industry depends on some basic 7

market conditions, such as technology, demand for a

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 For example, in an industry with a technology such
that the average cost of production falls as output
increases, the industry tends to have only one firm, or
possibly a small number of firms
 The SCP paradigm is considered a pillar of industrial
organization theory, and it has been since its
conception a starting point when analyzing markets
and industries, not only in Economics, but also in
business management
 Functionally, the relationship on which the SCP
paradigm is based is given as: P =ƒ(C) and, C=ƒ(S)
Basic Condition
Structure
8
Conduct
Performance
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1. Basic Conditions
 The concept of the basic conditions operates on both sides of the
market, i.e., supply and demand
 On the demand side, the basic conditions include:
 The size of the market
 The growth of the market
 The dependence on seasons and the business cycle
 The elasticity of demand
 The availability of substitutes
 Tastes and preferences
 On the supply side, the basic conditions encompass:
 The nature of relevant technology
 High or low elasticity of input substitution
 The durability of the product
 Location and ownership of essential raw materials
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 Number and location of firms
 Distribution, advertisement, marketing
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 Jointly, there are public policies that affect both the
supply and demand sides
 These include:
 Taxes and subsidies
 International trade rules
 Regulation and price controls

2. Market Structure
 Market structure refers to how the different constituents
of the market, such as sellers and buyers, are linked
together
 Market structure is the organizational and other
characteristics of a market
 We tend to focus on those characteristics of a market
10
which affect the degree of competition between firms and
their pricing decisions
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 The major elements of market structure describe
ways in which markets depart from the conditions
that describe perfect competition
 Market structure has certain basic aspects; namely,
Internal aspects (the number and size of buyers and
sellers) and
External aspects (the conditions of entry and exit)
 To understand the market structure, one needs to be
first comfortable with the following concepts:
A. The degree of seller concentration: this refers to the
number and size distribution of firms producing a
particular commodity or types of commodities in a
market 11
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 In perfect competition market model, we assume that
there are:
Very large number of buyers and sellers
Standardized product
Free entry and free exit
Complete and perfect knowledge of the market by
both buyers and sellers
 Thus, no single firm is able to influence the price of
the product in such a market
 A competitive industry will in the long run supply a
product at a price equal to its opportunity cost
B. The degree of buyer concentration: this shows the 12
number and size distribution of buyers of the
commodities in the market
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C. The degree of product differentiation: this shows the
difference in the products of different firms in the market
 In competitive market, rivals sell a homogeneous product

 This is never the case in the real world though

 Products are always differentiated in some way

 As differentiation increases, the products of different

suppliers become poorer substitutes for one another and
hence the producer becomes more and more like a
monopolist
 This would increase the power of the producer to control
its selling price
 Thus, we can say that there is a direct link between market
power (the power to control prices) and product variety
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 More variety implies more power to control prices, and so
likely to get P > MC
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D. The condition of entry to or exit from the market: this
shows the relative ease with which new firms can join
the category of sellers in the market or leave it
 The role of entry is important in that, with entry, even
the most complete monopoly is open to competition
from new entrants
 The issues to consider when entering include:
 What will be the scale of production that is
economical for entry?
 What is the investment size to begin new business?
 How is the exit condition?
 What sort of selling effort/advertisement will be
needed for a successful operation? 14

 How will established firms react to the new entrant?

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 Entry conditions help explain the number and size
distribution of firms that operate in a market
 So entry condition affects conduct and performance in
its own way
3. Market Conduct
 The Market Conduct refers to the pattern of behavior
that firms follow in adopting or adjusting to the market
in which they operate to achieve well defined goal(s)
 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 product
 The types of products and their quantities 15

 Their design and quality standards

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 Generally speaking, market conduct refers to the decisions,
policies and strategies of firms and/or producers with
regards to:
 Pricing behavior and/or policies
 Investment
 Research and development and
 Various forms of strategic alliances with other firms
 The choice of tactics and strategies reflects the behavior of
the firm in the given market situation
 In general, the entire process of reacting to the market
situation in pursuit of the desired goal is called the ‘market
conduct’
 Market conduct is a subject that becomes meaningful only
when competition is imperfect 16

 Under perfect competition, a firm can sell all its products at

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 In such circumstances, a firm has no incentive to
advertise, to react to what rivals do, or to attempt to
discourage entry
 When the competition is imperfect, however, the behavior
or conduct of the firm is quite different
 For example, if independent firms can coordinate their
actions, they may be able to restrict group output and
raise the price of their product above the marginal cost of
production by forming collusion
 The best example of coordinated action is Oil Producing
and Exporting Countries (OPEC)
 In some kinds of markets, established producers may be
able to discourage the entry of new firms by either: 17
 Holding down the price so that entry is less attractive, or
 Raising the costs of production for actual/potential rivals
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4. Market Performance
 Performance refers to whether or not firm’s operations
enhance economic welfare
 Once the structure and conduct of a market are
determined, we can make predictions as to how the
market along with the firms in it will behave
 Market performance is the success of a market in
producing benefits for the society at large
 Performance indicator variables include:
 Profitability
 Growth of the firm
 Quality of products or services
 Technological progress and innovation
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 Productive and allocative efficiency

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 Profitability: The neoclassical theory assumes high or
abnormal profits are the result of the abuse of market
power by incumbent firms
 On the other hand, it has also been argued by the
Chicago school that abnormal profit may be the
consequence of cost advantages or superior
productive efficiency on the part of certain firms,
that have consequently been able to achieve
monopoly status by cutting prices and driving rivals
out of business
 To the extent that profitability influences firms’
decisions to continue in or exit from a market, this
performance indicator has direct implications for 19
future structure
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 Growth: Profitability is a suitable performance indicator
for a profit-maximizing firm, but may be less relevant for
a firm that pursues other objectives, such as sales or
growth
 Growth of sales, assets or employment might represent a
useful alternative performance indicator, by which the
performance over any period of firms that were unequal
in size at the start of the period can be compared
 Quality of products and services: might be considered an
important performance indicator by individual consumers
or consumer groups, regulators or governments
 Technological progress: is a consequence of the level of
investment in research and development, and the pace of
technological progress may be considered a relevant 20
performance indicator
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 In the long run, technological progress produces perhaps
the most fundamental type of feedback effect due to its
impact on the basic conditions of demand and supply
 Productive and allocative efficiency: Productive efficiency
refers to the extent to which a firm achieves the maximum
technologically feasible output from a given combination
of inputs, and whether it chooses the most cost effective
combination of inputs to produce a given level of output
 Allocative efficiency refers to whether social welfare is
maximized at the market equilibrium
 Productive and allocative efficiency are both regarded by
economists as important performance indicators
NB: at societal and national level, performance indicators
include employment creation, equity, etc by the market 21
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1.2.2. The Chicago School of Thought
 The Chicago School, which gives a great deal to
Conduct, criticized the SCP model for being non–
theoretical and for having diverged to a great extent
from the basic neoclassical price theory
 This school argues that even if their (SCP’s) empirical
work was based on more realistic assumptions, it came
up with nothing more powerful in its predictive ability
than the traditional perfect competition model
 The logic of the Harvard Tradition (SCP paradigm) is
the empirical association that exist between performance
and structure
 It should, however, be noted that such empirical
association does not suggest causation between the 22

variables
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 According to the SCP, high concentration (a small number of
firms accounting for a large part of market) was believed to
lead to collusion and hence higher profits thereby calling for
some sort of intervention to counter collusion (antitrust
legislation) as a remedy
 However, the Chicago school argued that where concentration
was high, firms tended to be large and larger firms tended to
be more efficient and it was this efficiency that led to higher
profits
 So, if greater efficiency was the cause for higher profits, there
is no need for government intervention
 In fact, intervention would be counter–productive

 The Chicago school sees the world as one in which competitive

forces generally hold sway (rule) and argue that monopoly
may be benign, or even beneficial, to economic welfare 23
 Therefore, the Chicago School has a conservative attitude
towards government intervention
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1.2.3. Institutional Economics
 One of the key concepts of the new institutional economics is
transaction costs
 Institutional arrangements give the process of exchange
arrangement of transactions, and these transactions involve
costs
 Institutions emerge and persist when the benefits they
confer/grant are greater than the transaction costs involved
in creating and sustaining them
 Transaction costs encompass before exchange costs
associated with search and negotiation; and after exchange
costs of monitoring and enforcing them
 Without the concept of transaction costs, it might be
impossible to understand how an economic system works
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 Poorly constructed institutions are identified as a source of
higher transaction costs
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 Individuals shape institutions based on their desirability
to the group, selecting those institutions that lower
aggregate transaction costs
 Using formal price theory analysis, the transaction costs
approach uses differences in transaction costs to explain
why structure, conduct and performance vary across
industries
 According to the transaction cost school, institutions that
lower the costs of transactions are the key to the
performance of the economies as much as for industries
 It is also pointed out that an assignment of property
rights matters because of positive transaction costs
 Property rights are defined as a set of rights to take
permissible actions to use, transfer, or otherwise exploit25
the property
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 When transaction costs are absent, the initial assignment
of property rights does not matter from the point of view
of efficiency
 This is because the property rights can be voluntarily
adjusted and exchanged to promote increased production
 The problem is when transaction costs are substantial

 Indeed, usually, the transaction costs are substantial

 In the case of substantial transaction costs, the allocation

of property rights is critical
 In the historical growth process, there is a trade–off
between economies of scale and specialization, on the one
hand, and transaction costs on the other
 In a small, closed, face–to–face peasant economy,
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transaction costs are low
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 However, the production costs are high in a small
economy because specialization and division of labor are
severely limited by the extent of market defined by the
personalized exchange process in the small community
 In a large complex economy, as the network of
interdependence widens, the impersonal exchange
process gives considerable scope for all kinds of
opportunistic behavior (cheating, shirking, and moral
hazard) and the costs of transacting can be high
 The question is ‘how these institutions affect market
structure, and then, the existence and performance of
firms?’
 According to Coase, the use of the market place involves
costs 27

 These costs help to determine market structure

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 For example, where the cost of buying from other firms
is relatively low, a firm is more likely to buy supplies
from others than produce the supplies itself
 There are four concepts related to transactions

1. Markets and firms are alternative means for

completing related sets of transactions
 For example, a firm can either buy a product or a
service or produce it
2. The relative costs of using markets or firms’ own
resources should determine the choice
3. The transaction cost of writing and executing complex
contracts across a market vary with the
characteristics of the human decision makers who are28
involved with the transaction on the one hand, and the
objective properties of the market, on the other
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4. These human and environmental factors affect the
transaction costs across markets and within firms
 Under what circumstances will transaction costs be lower
when internalized than when left to be negotiated in an
external market?
 The factors can be either environmental factors or human
factors
 The key environmental factors are uncertainty and the number
of firms
 Whereas, the key human factors are bounded rationality and
opportunism
 Bounded rationality is the limited human capacity to
anticipate or solve complex problems
 Bounded rationality is a precondition for opportunism
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 In a world of great uncertainty, it may be too difficult or costly
to negotiate contracts that deal with all possible contingencies
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 As a result, firms may produce internally even though it
would be cost effective to rely on markets
 When the number of firms is small and individuals are
opportunistic, firms may not want long term contracts for
fear of being victimized in the future
 For example, a firm that relies on another firm to supply a
factor that is essential to its production may be vulnerable to
blackmail because it cannot operate if its supply is stopped
 This problem is likely to be important if there are few
alternative supplies
 Thus, reliance on markets is more likely when (1) there is
little uncertainty and (2) there are many firms (competition)
and limited opportunities for opportunistic behavior
 When these conditions are reversed, firms are more likely to
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produce for themselves than to rely on markets