INDUSTRIAL ECONOMICS I (INTRODUCTION)

1. INDUSTRIAL ECONOMICS I(INTRODUCTION) Approaches

2. Structure-Conduct-Performanceapproach • 2.1 What is Structure ?(in industrial economic context. Based on Paul R. Ferguson and Glenys J. Ferguson’s, Industrial Economics; Issues and Perspectives. 2nd ed. 1994, Macmillan, London). • Structure describes the characteristics and composition of markets and industries in an economy. At its most aggregated level, it relates to the relative importance of broadly defined sectors of the economy.

3. Structure • In the context of industrial economics, structure focuses on the relative size (and trends) of the primary industry (e.g. agriculture and extractive industries), secondary (industrial), and tertiary (service) sectors.

4. Structure • 2. Structure can also refer to the number and size distribution of the firms in the economy as a whole. • Examples: • For instance, data on firms can be collected based on the total output provided by the largest 100 firms in the economy. • Looking at the Fortune magazine, the provides an annual directory of the largest 500 firms in the US for instance. • The UK’s Financial Times ranks Europe’s top 500 firms in term of market capitalization. • All these could have a far-reaching political and economic implications if such firms became progressively more dominant.

5. Structure • 3). Structure also relates to the importance and characteristics of individual markets within the economy. • Here structure describes the environment within which firms in a particular market operate. • It can be identified by considering the number and size distribution of buyers and sellers (market concentration), • or to the extent to which products are differentiated, • or how easy it is for other firms to enter the market, • or to what extent firms are integrated or diversified.

6. STRUCTURE-Concentration Ratio • This may also assist in determining the market structure of the industry. • The concentration ratio of an industry is used as an indicator of the relative size of firms in relation to the industry as a whole • It is calculated as the sum of the percent market share of the top n firms.

7. STRUCTURE-Concentration Ratio • One commonly used concentration ratios the four-firm concentration ratio, or C4, which consists of the market share, as a percentage, of the four largest firms in the industry. • Example:

8. STUCTURE - Herfindahl-Hirschman Index - HHI • What Does Herfindahl-Hirschman Index - HHI Mean?A commonly accepted measure of market concentration. It is calculated by squaring the market share of each firm competing in a market, and then summing the resulting numbers. The HHI number can range from close to zero to 10,000. The U.S. Department of Justice uses the HHI for evaluating mergers.

9. STUCTURE - Herfindahl-Hirschman Index - HHI • The HHI is expressed as: HHI = s1^2 + s2^2 + s3^2 + ... + sn^2 (where sn is the market share of the ith firm). The closer a market is to being a monopoly, the higher the market's concentration (and the lower its competition). If, for example, there were only one firm in an industry, that firm would have 100% market share, and the HHI would equal 10,000 (100^2), indicating a monopoly. Or, if there were thousands of firms competing, each would have nearly 0% market share, and the HHI would be close to zero, indicating nearly perfect competition.

10. STUCTURE - Herfindahl-Hirschman Index - HHI • Investopedia explains Herfindahl-Hirschman Index - HHIThe U.S. Department of Justice considers a market with a result of less than 1,000 to be a competitive marketplace; a result of 1,000-1,800 to be a moderately concentrated marketplace; and a result of 1,800 or greater to be a highly concentrated marketplace. As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns.

11. Conduct • 2.2 Conduct(based on Ferguson and Ferguson) • Conduct refers to the behavior (actions) of the firms in the market, based on the decisions firms make and the way the decisions are taken. • It focuses on how firms set prices, i.e. whether independently or in collusion with others in the market.

12. Conduct • How firms decide on their advertising and research budgets, and how much expenditure is devoted to these activities, are also typical considerations. • These factors are more difficult to identify empirically than either structural or performance characteristics.

13. Performane • 2.3 Performance • The economist’s concern is with the performance of firms. • The essential question here is whether or not firms’ operations enhance economic welfare . • The usual consideration is how well firms satisfy consumer requirements in the current time period.

14. Performance • That is; are they productively efficient?, taking into consideration factors such as avoiding wasteful use of available factors of production. • Are they allocatively efficient? In producing the ‘right’ goods and in the ‘right’ quantities.

15. Performance • Here we also have to consider aspects of performance such as the relationship between prices and costs, and the level of profits earned. • In situations where tastes do not change and where consumers and producers are perfectly informed, economic welfare would be maximized when the Pareto marginal conditions are fulfilled. This requires firms to set price equal to marginal cost.

16. Performance • In the neoclassical model of perfect competition, firms maximize profits by equating price and marginal cost, which results in a price and output combination that is both productively and allocatively efficient. • In the market which matches neoclassical models of monopoly, oligopoly or monopolistic competition, performance is expected to be inferior in such markets.

17. Performance • Although firms may be productively efficient, the level of output is unlikely to meet the requirements of allocative efficiency. This arises because firms in such markets possess a degree of market (or monopoly) power : that is, they may have some discretion in determining the prices at which to sell their output. • Here, unlike in the model of perfect competition, they are able to raise price above marginal cost.

18. Performance • Pricing can be an indicator of current or past performance, yielding few insights into how well firms will perform in satisfying consumer wants over time. • Some may consider technological progressiveness as a desirable performance characteristics, the essential concern of the SCP approach has been with effects on current economic welfare.

19. Structure-Conduct- Performance Approach • Performance (success of the industry in producing benefits to the consumers) depends on the conduct (behavior) of firms, which in turn depends on the structure ( factors that determines the competitiveness of the market). - [Carlton and Perloff, 2000].

20. Relationship among Structure-Conduct- Performance Basic Conditions Consumer DemandProduction Elasticity of Demand Technology Substitutes Raw Materials Seasonality Unionization Rate of Growth Product Durability Location Location Lumpiness of orders Scale economies Method of Purchase Scope economies Government Policy Regulation Antitrust Barriers to entry Taxes and Subsidies Investment incentives Employment incentives Macroeconomic Policies Performance Price Production Efficiency Allocative efficiency Equity Product quality Technical Progress Profits Structure Numbers of buyers and sellers Barriers to entry of new firms Product differentiations Vertical Integration Diversification Conduct Advertising R&D Pricing Behavior Plant investment Legal tactics Product Choice Collusion Merger and Contracts

21. Structure-Conduct- Performance Approach • The diagram shows how basic conditions and government policy interacts. • Relationship among the 5 boxes are rather complex.

22. Structure-Conduct- Performance Approach • E.g. • Government regulation affect the number of sellers in the industry, firms may influence government to achieve higher profits.

23. Structure-Conduct- Performance Approach • E.g. • If entry barriers lead to monopoly and monopoly profits new industry may develop new substitute products that effect demand for the original products.

24. Structure-Conduct- Performance • It is a descriptive approach • It provides the overview of the industries • Empirical researchers rely on this paradigm which typically use data at the industry level.

25. Critical Review of the SCP Paradigm • The SCP approach -based exclusively upon neoclassical theory- has long been central to the study of industrial organization. • SCP postulates causal relationships between the structure of a market, the conduct of firms in that market and the economic performance.

26. Critical Review of the SCP Paradigm • It has been used to provide the theoretical justification for competition policy - i.e. which encompasses measures designed either to promote a more competitive environment or to prevent a reduction in competition. • Here SCP has provided a rationale for measures intended to modify (or to prevent) the development of market structures likely to promote behavior and performance detrimental to the public interest.

27. Critical Review of the SCP Paradigm • In recent years the SCP approach has been subjected to widespread criticisms; • Some suggests that the relationships between structure, conduct, performance are more complex than originally envisaged.

28. Critical Review of the SCP Paradigm • It is argued that the technique is too loosely derived from its theoretical underpinnings, and this led to various developments, including attempts to link SCP more rigorously (if more narrowly) back to the neoclassical theory.

29. Critical Review of the SCP Paradigm • Others have disputed the relevance of neoclassical microeconomics to the study of industry. They consider that the SCP approach gives limited perspectives on the operations of markets, and that it provides a poor and even misleading basis for policy formulations.

30. Chicago School • Work of an influential group of economist comes from the Chicago School- University of Chicago – best known member, Milton Friedman. • Criticized the SCP approach – taking the key link from structure in terms of seller concentration, has effects on firms conduct and hence performance.

31. Chicago School • They see profit as a superior reward to efficiency rather than as a result of the monopoly power. • Believe competition will always occur unless government intervene.

32. Chicago School • Central idea of the Chicago school – aside from government policy there is no significant degree of monopoly power that will exist in the market. • In the long term market will become competitive in the absence of government intervention. • If firms has substantial monopoly power – it is a short term idea.

33. Chicago School • Those markets that have monopoly is only those granted by the state. • Another way of doing this is by patent rights – or government-granted monopoly rights. • In absence of resource allocation through government intervention we can use the perfectly competitive model.

34. Chicago School • This is a close approximation to market price and output in the long run – even where perfect competition do not exist. • Accepts the reality of advertising – even though it does not exist in PC. • Firms will choose ideal level of advertising • If choose more, other firms would enter. • If choose less, charge lower price and capture market share.

35. Other Approaches • Game Theory Approach • Empirical Approach.

36. Assignment . • Write a literature review on structure-conduct –performance paradigm, using not less than 10 journal articles. • compare and contrast critically the works of the various authors highlighting on the issues, objectives, methodologies used and their findings. • Then choose an industry of your own interest, write and analyze the structure of the industry using various available methods.

37. Assignment . • The assignment must be type-written, double-spacing, font number 12 and ‘times new roman’. • The full assignment must not be more than 30 pages, including references. • Margin • - 1½ ins. On the left. • - 1 ins. On the right, top and bottom. • * Presentation will be seriously considered in the distribution of marks.

38. Reference • Carlton, Dennis W. and Jeffrey M. Perloff; 2000. Modern Industrial Organization; 3rd Edition; Addison-Wesley Publishing Company, New York.