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INDUSTRIAL ECONOMICS AND MANAGEMENT

SUBMITTED BY: ABHIGYAN CHATTERJEE

OBJECTIVES COVERED
Organizational forms 2) Profit maximization of industrial firms 3) Theory of profitability 4) Economics of scale 5) Financing industries and sources 6) Investment criteria- NPV, IRR
1)

SCOPE OF INDUSTRIAL POLICY AND HISTORY


Industrial economics is a distinctive branch of economics which deals with the economic problems of firms and industries, and their relationship with society. In economic literature it is known by several names with marginal differences such as Economics of Industries, Industry and Trade, Industrial Organization and Policy, Commerce and Business Economics etc. The name Industrial Economics was adopted in the early fifties perhaps through the writings of P.W.S. Andrews. Although this name is becoming popular day by day some authors, particularly in the American circle, prefer Industrial Organization as a title of the subject. At present there is no clear-cut consensus on the name of the subject. There are two broad elements of industrial economics. The first one, known as the descriptive element, is concerned with the information content of the subject. It aims 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. It would give him full information regarding the natural resources, industrial climate in the country, situation of the infrastructure including lines of traffic, supplies of factors of production, trade and commercial policies of the governments and the degree of competition in the business in which he operates. 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. The second element of the subject is concerned with the business policy and decision-making. This is the analytical part dealing with topics such as market analysis, pricing, choice of techniques, location of plant, investment planning, hiring and firing of labor, financial decisions, and 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.

How decision-making problems arise in industries? To answer this question, we have to go back to the core of economics. According to L. Robbins, Economics is

the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. As implicit in this definition, an economic problem arises because of scarcity of means and their alternative uses in relation to the needs of an individual or a group or society as a whole. For example, the income (i.e. resources) of a consumer is generally limited but his wants are unlimited. 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 resources like land, raw materials, labor, capital, etc. are scarce. Given such scarcity, he has to take decisions about production and distribution. There are several basic issues on which the producer will be taking decisions such as: what commodities he should produce, what should be the level of output of each, what type of technology he should adopt, where should he produce the goods, what should be the size of his factory, what price he would charge, how much wages he should pay, how much he should spend on advertisement, should he borrow from banks or elsewhere, etc. All such decisions explain the producers Behavior in the different market situations, which we endeavor to study in industrial economics. In microeconomics also we study producers behavior in relation to scarcity o resources. Because of this fact, some economists would regard industrial economics as being primarily an elaboration of, and development from the traditional theory of the firm taught under microeconomics. In fact, Stigler emphatically argued that the field of industrial economics does not really exist. It is nothing more than a slightly differentiated microeconomics. Tirol in the opening paragraph of his book considered industrial organization as study of the function of markets, a central concept in microeconomics.5 To view industrial economics as a development of microeconomics is quite understandable. Both are concerned with the economic aspects of firms and industries seeking to analyze their behavior and draw normative implications. However, there are some differences between the two. Microeconomics is a formal, deductive and abstract discipline. Industrial economics on the other hand is less formal, more inductive in nature. Microeconomics by and large assumes profit maximization as the goal of the firm and tells us to maximize it subject to given constraints. It is passive in approach. Industrial economics does not believe in single goal of profit maximization. It searches the goals of the firm from the revealed facts. It concentrates on the constraints which impede the achievement of the goals and tries to remove them. It is an active discipline in this sense. Microeconomics, being abstract, does not go into operational details of production, distribution and other aspects of the firms and industries. Industrial economics does go into the depth of such details. Further, the conclusions derived from the microeconomics may not be testable empirically and therefore we may not assess

their predictive efficiency. Industrial economics is free from such limitation because of its emphasis on empiricism. Public policy implications are taken care of in industrial economics but microeconomics may shun them if necessary. It is true that the theory of firm (i.e. microeconomics) provides the main theoretical basis for the study of industrial economics, but several important influences from outside have given a totally different character to industrial economics. In the light of such influences the conventional theory of the firm is bound to be revised. Recently, there has been considerable emphasis on managerial economics in business or industrial management. This branch of economics deals with the concepts and analysis of demand, cost, profit, competition and so on, that are appropriate for decision-making. Such topics are also covered in industrial Economics.

ECONOMIES OF SCALE
Despite the advantages of large scale operation there are also some diseconomies which provide some advantages of being small. Small companies often supply large companies with components and have the ability to provide specialist goods at low overheads. Small firms are also important in areas such as haulage, agriculture, retailing, building and professional services. In these areas it is possible to start with relatively small amounts of capital, makes rapid decisions, compete with firms of similar size and provide for the personal requirements of customers. Large organizations are more difficult to manage and these inefficiencies are known as diseconomies of scale. These disadvantages of large-scale production are an important factor in encouraging many businesses to remain small. Economies of scale are the advantages of being large which enable big companies to produce large outputs at low unit costs. Diseconomies of scale result from being too large or expanding too quickly. Do Relationship between size, risk and profit

In the 1970's and 80's size was very important to the successful business. Large organizations sought to benefit from economies of scale in order to be more efficient than the competition. Today size is still very important in global industries and companies like Coca-Cola, Nestle, Corus and Cadbury Schweppes are some of the biggest in the world. However, these companies have to accept that to stay big they have to act small - i.e. they have to be flexible and to build the sorts of relationships with customers that we traditionally associate with small companies. Every enterprise must aim for the scale of production which suits the business best. This level of output is achieved when unit costs are lowest for the output produced. Economies of scale come from a number of sources: Technical economies relate to using techniques and equipment more effectively to produce large outputs. For example, by developing a huge super factory like those that BIC is developing round the world it is possible to produce very efficiently. Large retailers are able to reduce costs such as rate and rental charges per square foot by selling from large retail units. Large companies are also able to benefit from employing specialist managers. Commercial economies relate to being able to buy and sell in vast quantities so as to spread out costs per unit. Marketing economies are concerned with being able to market to very large audiences. For example companies like McDonald's and Coca-Cola benefit from launching advertising campaigns with a global message. Financial economies are concerned with the ease of borrowing money and low cost of raising capital for large when compared with small companies. Large scale producers are also able to spread their risks by producing in lots of markets, and producing a range of different products.

As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1. Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due to expansion. There are factors that cause a producers average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase. Diseconomies of scale are the opposite. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these

factors reduces the long run average cost (LRAC) of production by shifting the short run average cost (SRAC) down and to the right. Economies of scale are also derived partially from learning by doing. Economies of scale is a practical concept that may explain real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail." The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country for example, it would not be efficient for leichtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly."

ECONOMIES OF SCALE AND RETURN TO SCALE

Economies of scale are related to and can easily be confused with the theoretical economic notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, and if that production function is homogeneous, returns to scale are represented by the degree of homogeneity of the function. Homogeneous production functions with constant returns to scale are first degree homogeneous, increasing returns to scale are represented by

degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one. If the firm is a perfect competitor in all input markets, and thus the perunit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown that at a particular level of output, the firm has economies of scale if and only if it has increasing returns to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale). If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range. The literature assumed that due to the competitive nature of reverse auction, and in order to compensate for lower prices and lower margins, suppliers seek higher volumes to maintain or increase the total revenue. Buyers, in turn, benefit from the lower transaction costs and economies of scale that result from larger volumes. In part as a result, numerous studies have indicated that the procurement volume must be sufficiently high to provide sufficient profits to attract enough suppliers, and provide buyers with enough savings to cover their additional costs. However, surprisingly enough, Shalev and Asbjornsen found, in their research based on 139 reverse auctions conducted in the public sector by public sector buyers that the higher auction volume, or economies of

scale, did not lead to better success of the auction. They found that Auction volume did not correlate with competition, or with the number of bidder, suggesting that auction volume does not promote additional competition. They noted, however, that their data included a wide range of products, and the degree of competition in each market varied significantly, and offer that further research on this issue should be conducted to determine whether these findings remain the same when purchasing the same product for both small and high volumes. Keeping competitive factors constant, increasing auction volume may further increase competition.

SOURCE OF INFRASTRUCTURE AND FINANCE


There is a need for large and continuing amounts of investment1 in almost all areas of infrastructure in India. This includes transportation (roads, ports, railways, and airports), energy (generation and transmission), communications (cable, television, fiber, mobile and satellite) and agriculture (irrigation, processing and warehousing). The key issue is, while the need exists, how these projects will get financed. In the past the government has been the sole financier of these projects and has often taken responsibility for implementation, operations and maintenance as well. There is a gradual recognition that this may not be best way to execute/finance these projects. This recognition is based on considerations such as: 1. Cost Efficiency: privately implemented and managed projects are likely to have a better record of delivering services which are cheaper 2. Of a higher quality. The India Infrastructure Report (2003) estimates that the Indian economys growth rate would have been higher by about 2.5% if the delays and cost overruns in public sector projects had been managed

efficiently. The report goes on to state that the predominant cause for such delays / overruns was not under-funding of the projects, but arose, on account of clearances, land acquisition problems, besides factors internal to the entity implementing the project. Equity Considerations: since it is hard to argue that every infrastructure project uniformly benefits the entire population of the country, it may be more appropriate to impose user charges which recover the cost of providing these services directly from the user rather than from the country as a whole (the latter is the effect if the government builds the project from its own pool of resources). If users are to be charged a fair price then the project acquires a purely commercial character with the government then needing to play the role only of a facilitator.

CHARACTERISTICS OF INFRASTRUCTURE FINANCE


Infrastructure projects differ in some very significant ways from manufacturing projects and expansion and modernization projects undertaken by companies. 1. Longer Maturity: Infrastructure finance tends to have maturities between 5 years to 40 years. This reflects both the length of the construction period and the life of the underlying asset that is created. A hydro-electric power project for example may take as long as 5 years to construct but once constructed could have a life of as long as 100 years, or longer. 2. Larger Amounts: While there could be several exceptions to this rule, a meaningful sized infrastructure project could cost a great deal of money. For example a kilometer of road or a mega-watt of power could cost as much as US$ 1.0 mn and consequently amounts of US$ 200.0 to US$ 250.0 mn (Rs.9.00 bn to Rs.12.00 bn) could be required per project.

3. Higher Risk: Since large amounts are typically invested for long periods of time it is not surprising that the underlying risks are also quite high. The risks arise from a variety of factors including demand uncertainty, environmental surprises, technological obsolescence (in some industries such as telecommunications) and very importantly, political and policy related uncertainties. 4. Fixed and Low (but positive) Real Returns: Given the importance of these investments and the cascading effect higher pricing here could have on the rest of the economy, annual returns here are often near zero in real terms. However, once again as in the case of demand, while real returns could be near zero they are unlikely to be negative for extended periods of time (which need not be the case for manufactured goods.) Returns here need to be measured in real terms because often the revenue streams of the project are a function of the underlying rate of Inflation.

TYPES OF RISK CAPITAL REQUIRED


There are two types of risk capital that are deployed in any project: 1. Explicit Capital: this is typically the equity that a developer or a sponsor commits to the project. Here while the downside is unlimited (to the full extent of the amount of money the sponsor has committed to the project), if the project does well, there is no limit on the upside either. The sponsor seeks to conserve his capital and maximize the returns on it by deploying unique and project specific skills and by managing the underlying risks associated with the project. Given a limited supply of capital, the promoter also tends to concentrate his energies and capital in a small number of relatively lumpy investments so that he does not spread himself and his resources too thinly. In a typical infrastructure project, the developer puts together a consortium of capital providers who not only commit capital to the overall project but also assume complete operational and financial responsibility for specific risks (such

as engineering, procurement and construction; operations and maintenance; and fuel supply), thus, lowering the capital requirements from the developer. 2. Implicit Capital: this is typically the risk capital (in the form of economic capital or tier 1/2 capital adequacy) that is committed by a lender to the project. Loans have the characteristic that while the downside is unlimited (i.e., to the full extent of the amount lent - as in case of equity/explicit capital but with the cushion of the explicit capital), the upside is limited to the rate of interest charged on the loan. Secondly, the loans typically involve much larger amounts of money relative to the equity investments. Given the fact that a typical lender raises money from retail deposits (or bond holders) he needs to hold a reasonably high amount of capital to assure his depositors that irrespective of the fate of the project, he will be able to meet his obligations. Assuming that the desired rating aspiration for the lender is AAA (i.e., the lender would like to assure its depositors of a near zero default risk) an unsecured loan to a typical ten year infrastructure project (rated, say A-, with an average maturity of six years) could require as much as 25% tier 1 capital to be committed to it. Since the capital is required to cover the lender against all the uncertainties surrounding a specific project, the lender seeks to reduce the amount of capital deployed by diversifying across projects (unlike the promoter who seeks to specialize and concentrate his exposure) and by ensuring that to the extent possible, the explicit capital (brought in by the promoter) is sufficient to cover the risks beyond the worst-case scenarios. The lender seeks to be compensated for this capital through the rate of interest charged on the project loan.

Methods/Criteria of Project Evaluation or Measures of project worth of Investment


A project is an investment activity where we expend capital resources to create a producing asset from which we can expect to realize benefits

over an extended period of time. Or a project is an activity on which we will spend money in expectation of returns and which logically seems to lend itself to planning, financing and implementation as a unit. A project should have the following characteristics. 1. It should have a specific starting point and specific ending point. 2. Its major costs and returns are measurable 3. It should have a specific geographic location 4. It should have a specific clientele group 5. It should have a well-defined time sequence of investment and production activities. Methods/Criteria of Project Evaluation: The methods/criteria more often used for evaluating a project are (1) Simple rate of return (SRR) (2) Payback Period (PBP) (3) Benefit Cost Ratio (BCR) (4) Net present Value (NPV) or Net Present Worth (NPW) and (5) Internal Rate of Return (IRR). The SRR and the PBP are the undiscounted measures while BCR, NPV and IRR are the discounted measures of project worth of Investment. Our concern is regarded with NPV and IRR criterias of investment Net present value is computed by finding the difference between the present worth of benefit stream less the present worth of cost stream. Or it is simply the present worth of the cash flow stream since it is a discounted cash flow measure of project worth along with internal rate of return. NPV = Present worth of Benefit Stream Present Worth of Cost Stream. Mathematically, it can be shown as
nn

NPV = Bn / (1 + i) - = Cn / (1 + i) t=1 t=1 Or NPV = Present worth of the cash flow stream. Mathematically,

NPV = (Bn - Cn ) / (1 + i) t=1 Where, Bn = benefits in each year of the project. Cn = Costs in each year of the project. n = number of years in a project i = interest (discount) rate Bn Cn = Cash flow in nth year of the project The project is profitable or feasible if the calculated NVP is positive when discounted at the opportunity cost of capital.

Internal Rate of Return (IRR) Internal Rate of Return (IRR) is that discount rate which just makes the net present value (NVP) of the cash flow equal zero. It is considered to be the most useful measure of project worth and used by almost all the institutions including World Bank in economic and financial analysis of the project. It represents the average earning power of the money used in the project over the project life. It is also sometimes called yield of the investment. Mathematically, IRR is that discount rate i such that
n

(Bn - Cn ) / (1 + i) = 0 i.e. NVP = 0 t=1 where Bn = Costs in each year of the project. Cn = Costs in each year of the project. n = number of years in the project.

i = interest (discount) rate.

A project is profitable or feasible for investment when the internal rate of return is higher than the opportunity cost of capital. The computation of IRR for project involves a trial and error method. Here alternative discount rates are used to the cash flow streams of the project under consideration till the NPV of the project reaches zero. However, it is not always possible to get a discount rate which makes the NPV exactly equal to zero through this trial and error method. We may get discount rate, which makes the NPV nearer to zero i.e. either positive or negative. Under such situation, we use interpolation to estimate the true value. Interpolation is simply finding the intermediate value between too discount rates we have chosen. The rule for interpolating the value of the internal rate of return lying between two discount rates too high on the one side and the too low on the other is. IRR = Lower discount rate _ Difference between the two discount rates (NPV at lower discount rate: Absolute difference between the NPVs of the two discount rates).

CONCLUSION
We have hereby discussed various dimensions related with industrial economics, maximizing profits and optimization of resources. By proper managerial use of economics the investment solutions and financing of industries can be successfully analyzed and applied.

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