Chapter 1 Industrial organization: an introduction 1.

.2 Static and dynamic views of competition y Neoclassical theory of the firm considers four main theoretical market structures: o Perfect competition o Monopolistic competition o Oligopoly o Monopoly. Perfectly competitive industry has six characteristics: o Large number of buyers and sellers. o Producers and consumers have perfect knowledge. o The products sold by firms are identical. o Firms act independently of each other and aim to maximise profits. o Firms are free to enter or exit. o Firms can sell as much output as they wish at the current market price. If the above conditions exist, a competitive equilibrium exists in which all firms earn only a normal profit. If any particular firm is unable to earn a normal profit due to it being unable to produce at maximum efficiency, the firm is forced to withdraw from the market. Therefore perfect competition imposes this discipline: all surviving firms are forced to produce efficiently as the current state of technology will allow. Competition often gives rise to a market structure comprising of a relatively small number of large firms who have sufficient market power to determine their own price and able to earn supernormal profit in the long run. Competition tends to lead to a decrease in the number of firms is due to economies of scale (occurs when firms grow). Natural monopoly single firm that can produce at a lower average cost than any other competing firms. Cost savings passed onto consumers via lower prices. However, monopolists exploit their market power and therefore restrict output and raise price damages consumer welfare. Monopolistic competition there are a large number of firms but emphasizes non-price completion as well as price completion. Oligopoly there are a small number of large firms. Firms recognise their interdependence changes in price or output by one firm will alter the profits of rival firms causing them to adjust their own prices and output levels. o Competition under oligopoly may come in price competition which could lead to significant losses through to collusion. Neoclassical theory of the firm is based on a static conception of competition long-run equilibrium. Schumpeter and the Austrian School of economists the fact that firms earns an abnormal (monopoly) profit does not constitute evidence that the firm is

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guilty of abusing its market (monopoly) power at the expense of consumers. Instead, monopoly profits play an important role in the process of competition; motivating and guiding entrepreneurs towards taking decisions that will produce an improved allocation of scare resources in the long run. Both Schumpeter and the Austrian School both recognize that knowledge/information is always imperfect. According to Schumpeter, competition is driven by innovation the introduction of new products and processes, the conquest of new markets for inputs or outputs or the reorganization of existing productive arrangements. o Entrepreneurs play a key role in driving forward technological progress (replacing old with new). Monopoly status is only temporary due to other innovators being able to enter the marker with different and better products therefore not capable of sustaining a stable long-run equilibrium as assumed in the neoclassical theory. (DYNAMIC). Austrian school also views competition as a dynamic process seeing the market as a configuration of decisions made by consumers, entrepreneurs and resources owners. o Entrepreneurs noticing missed opportunities for mutually advantageous trade to take place. They discover and act upon new information. Other decision makers may adjust their plans in line with what entrepreneurs do. Disequilibrium reflects imperfect information. Entrepreneur function adds to the flow of information adjustment towards a new and superior allocation of scare resources. Schumpeter entrepreneur actively initiates change. Austrian entrepreneur merely responds more quickly than other agents to new information being generated. A monopoly position is gained through the originality and foresight of the entrepreneur (Austrian) and as Schumpeter stated, monopoly profits are unlikely to be sustained. As information arrives and new trading opportunities open up, more entrepreneurs appear DYNAMIC.

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1.3 The structure-conduct-performance paradigm y Structure conduct performance paradigm (SCP). o The structure of a market influences the conduct of the firms operating in the market which in turn influences the performance of those firms. o Concerned with:  The size structure of the firms (one or many, concentrated or not)  The causes (above all the economies of scale) of this size structure.  The effects of concentration on competition.  The effects of competition on prices, investment and innovation.

The SCP is useful in a number of ways: o Allows the researcher to reduce all industry data into meaningful categories. o It is consistent with the neoclassical theory of the firm which also assumes that there is a direct link between market structure and firm conduct and performance. o Marker structure can be altered in order to improve conduct and performance providing that it is consistent with the acceptable standard. Fig. 1.1 SCP paradigm

Structure y y Characteristics are fixed in the short run tend to change relatively slowly. The number and size distribution of buyers and sellers. o An important determinant of the market power exercised by leading firms in the industry. o Distribution of market power might require measurement of buyer concentration (buyers may exercise discretion over the prices they pay) as well as seller concentration (share of industry sales, assets or employment). Entry and exit conditions. o Barriers to entry anything that places a potential entrant at a competitive disadvantage relative to an incumbent firm. o Entry barriers may derive from the product or production technology and cost structure. o Sunk cost investments barriers to exit which may act as a signal to stay and fight in order to preserve market share. This signal may also deter potential entrants. Product differentiation. o Changes in products may affect the shares of total market demand. Vertical integration and diversification. o Vertical integration the extent to which a frim is involved in different stages of the same production process. o Diversified firms produce a variety of goods/services for several distinct markets. o The extent to which a firm is vertically integrated or diversified will have implications on conduct and performance. o Vertically integrated firms have greater certainty in obtaining supplies or guaranteed distribution outlets. o Diversified firms may benefit from economies of scale and are less exposed to risk because losses in one market can be offset against profits elsewhere,

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Conduct y y Refers to the behaviour of firms. Business objectives. o Objectives that firms pursue often derive from structural characteristics of the industry in particular size firm distribution.

o Neoclassical assumes profit maximization while managerial emphasises non-profit objectives such as sales revenue and growth. Pricing policies. o Depends largely on the industrys structural characteristics. o Examples of pricing strategies on page 11. o Oligopolists want to avoid direct price competition. Product design, branding, advertising and marketing. o Influence the scope for non-price competition. o Determined by strategies implemented by incumbent firms. Research and development. o Obvious outlet for non-price competition between rival firms. o The extent of effectiveness of research and development are critical determinants of the pace of technological progress. Collusion. o An option open to firms wishing to avoid direct form of price and nonprice competition and therefore reach collection decisions on price, output, advertising and R&D. o Collusion may be explicit (through an arrangement i.e. cartel), or implicit/tacit (less formal agreement or understanding). Merger. o Horizontal between firms producing the same or similar products.  Has a direct implication for seller concentration in the industry concerned. o Vertical between firms at successive stages of a product process. o Conglomerate between firms producing different products.  Affects diversification. o Each type of merger has a feedback effect on market or industry structure.

Performance y Profitability o Neoclassical theory believes high/abnormal profits are the result of the abuse of market power by incumbent firms. o Chicago school argues that abnormal profits is the consequence of cost advantages or superior productive efficiency of certain firms allowing them to cut prices thus putting rivals out of business. o Schumpeter/Austrian abnormal profit is a reward for successful past innovation or the exercise of superior awareness by an entrepreneur. Growth o Profit maximising less relevant to firms who are pursuing objectives other than profit maximising. o An alternative performance indicator which can be used for comparison. Quality of products o Important performance indictor by individuals consumers, regulators or governments. Technological progress o A consequence of the level of investment in R&D, and the pace of technological prices may be used as a performance indicator.

o In the long run, technological progress is the most fundamental type of feedback effect due to its impact on demand (consumer tastes and preferences) and supply (technology and cost structures change). Productive and allocative efficiency o Productive extent to which a firm achieves maximum technologically feasible output from a given combination of inputs. The most cost effective combination of inputs to produce a given level of outputs. o Allocative whether social welfare is maximized at the market equilibrium.

Role of government policy y y Government policy can operate on structure, conduct and performance variables. To avoid consumer welfare from reducing, this suggests a role for government or regulatory intervention to promote competition and prevent abuses of market power. o Competition might be promoted by preventing a horizontal merger involving two large firms OR requiring the break-up of a large incumbent producer into two or more smaller firms. o A regulator might impose price controls, preventing a firm with market power from setting a profit-maximizing monopoly price. Legal restriction of collusion might be strengthened. o Government policy measures (fiscal, employment, environmental, macroeconomic) may have implications on firms performance. Measured using indicators such as profitability, growth, and productive or allocative efficiency. not sure if in syllabus

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SCP highly influential in the early development of industrial organization but has now been subject to criticisms. Criticisms: o Draws heavily on microeconomic and neoclassical theory of the firm. Does not always specify precise relationships between structure, conduct and performance. E.g. oligopoly theory is largely indeterminate and sometimes fails to produce clear and unambiguous conclusions. o Difficult to decide which variables belong where. E.g. product differentiation, diversification and integration are structure variables but are also strategies that firms can choose to adopt and therefore can be seen as conduct variables. o What do we mean by performance? Differences between objectives of different firms. E.g. firms are sacrificing potential profits in order to reduce risk by making more secure investments. o Definition of market/industry structure has many dimensions. SCP mainly measures structure by sell concentration because it is easier to measure. o Relationships between structure, conduct and performance are weak in terms of statistical significance. E.g. in industries with only a few large firms, collusion was simply assumed to take place.

o SCP o SCP criticised for overemphasising static models of short-run equilibrium. SCP only capable of providing a snapshot of the industry at a particular point in time. y Due to several criticisms, there was a shift away from the presumption that structure was the most important determinant of competition and some economists argued that the strategies (conduct) of firms were equally, if not more important. New industrial organization (NIO) theories that focus primarily on strategy and conduct. o Firms are seen as active decision makers, capable of implementing a wide range of diverse strategies. o Game theory deals with decision making in situations of interdependence and uncertainty is an important tool for NIO.  Some complain that anything could happen when game theory is used to analyse competition.

1.4 Strategic management: a short diversion y y Porters five forces model of the firms competitive environment is heavily SCP-influenced. The five forces: 1. Extent and intensity of completion  The intensity of competition depends on the number and size distribution of the industrys incumbent firms. i.e. where there are large numbers of similar sized firms, competition is expected to be more intense than if there is one/few firms that are dominant.  Other influences on the extent of competition include the rate of growth industry sales; incumbent firms costs structure, availability of spare capacity to meet potential increases in demand. 2. Threat of entrants  The perceived threat of entry is likely to be higher in industries where incumbents are highly profitable.  Government regulation also has a role to play.  Size of entry threat depends on economies of scale, the extent of product differentiation, brand loyalty, level of specificity of capital investments and the availability of access to distribution outlets. 3. Threat of substitute products and services  The availability of substitute products and services tends to increase the intensity of competition.  Availability of substitutes increases the price elasticity of demand fir existing products thus reducing the market power of incumbent firms.  Incumbents may respond through differentiate their product via branding and advertising.

4. Power of buyers  The power of buyers of a firm depends on their number and size distribution, and their level of dependence on the firms output.  If there are only a few buyers, or if close substitutes are available, buyers are likely to wield significant market power.  In order to secure their own supplies, buyers may integrate backwards (by taking over an input supplier) hence reducing their reliance on external suppliers. 5. Power of suppliers  Suppliers can exercise market power by raising price, reducing quality or even threatening to withhold suppliers providing if suppliers of important inputs into a firms production process are large in size and small in number. y y y y Porters five forces may confront a firm at any time. Essentially static (like SCP) and perhaps tends to underemphasize the problem of uncertainty caused by changes in a competitive environment. Competitive advantage is measured by the value a frim is able to create in excess of its costs. Porter introduces the concept of the value chain which disaggregates the firms into its strategically relevant activities. o Primary associated with physical creation of the product/service. o Support those that support primary activities and each other e.g. activities associated with the purchase of inputs, the management of human resources or improvement of technology through R&D. Porter argues that firms must select and follow a generic strategy in order to add value and gain a competitive advantage over rivals. y Generic strategy cost leadership, differentiation and focus. y In the case of differentiation, this may involve identifying a particular group of consumers and gearing the firms products towards its tastes/needs. *Shift from structure towards conduct. (External environment towards each firms unique attributes and strategies.) * y Kay (1993) argues that each individual firm is inherently different and therefore dismisses the notions of generic strategies. Instead firms develop distinctive capabilities in an attempt to gain a competitive advantage. y Innovation advantages from innovation can only be maintained if the firm has other capabilities that make imitation of the technology on its own insufficient to erode the firms competitive advantage. y Architecture firms internal organization. However if the market changes, such advantage gained internally can be eliminated. y Reputation a positive reputation can be sustainable for long periods making it difficult for potential entrants to compete.

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Firms can only maintain a competitive advantage if they can protect their strategies from imitation. Economic factors such as profitability and risk affects the speed of imitation rapid imitation is likely to exist if expected profitability is high. Strategic management has been criticised for placing insufficient emphasis on the interactions between firms and the level of the market/industry. y The focus is mainly on the strategic options available to the individual firm.