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What An Industry Economist Needs To Know∗

Stephen P. King
Department of Economics
RSSS
Australian National University
August 3, 2001

1 What is Industrial Economics?


Before exploring the question of what an industry economist nees to know,
it is necessary to inquire into the nature of their discipline. What is industry
economics?
This question is easier asked than answered. In the introduction to his
undergraduate text, Greer (1992) states his purpose as giving “the reader
a broad understanding of markets and their regulation” (p3). Scherer and
Ross (1990) similarly state that “in the field of industrial organization, we
seek to ascertain how market processes direct the activities of producers
in meeting consumer demands, how those processes breakdown, and how
they adjust, or can be adjusted, to make performance conform more closely
to some ideal or standard” (p2). Tirole (1988) is more terse. “To study
industrial organization is to study the functioning of markets” (p1).

I would like to thank Simon Grant for his helpful comments. In this paper I will use
the terms “industry economics” and “industrial organisation” interchangeably.

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The problem with these answers is that they could equally be used to
define the entire field of microeconomics. What then is the difference between
industry economics and microeconomics?
Stigler (1983) provides one possible answer: “there is no such subject
as industrial organization. The courses taught under this heading have for
their purpose the understanding of the structure and behavior of the in-
dustries . . . of an economy. . . . But this is precisely the content of economic
theory–price or resource allocation theory given the unfelicitous name of
microeconomics” (p1).
To claim that industry economics is simply the same as microeconomics,
however, is an unwarranted simplification. Differences exist, at least to the
eyes of the practitioners of both disciplines. One difference between microe-
conomics and industrial organization may involve technical content. Tradi-
tionally, industry economics has placed significantly less emphasis on formal
mathematical analysis than microeconomic theory. As Stigler (1983) notes,
“a less honorable reason for the separate field of industrial organization [is
that] much of its literature has been so nontheoretical, or even antitheoreti-
cal, that few economic theorists were attracted to it”(p1). This difference has
been significantly reduced by developments over the last twenty years. While
industry economists may be excused if they do not have a copy of Royden’s
“Real Analysis” on their shelves, they are obliged to be well acquainted with
most of the tools of modern micro theory.
If there is a significant difference between modern industry economics
and micro theory then it involves context more than analytical technique.
Industrial organization, even at its most abstract, is both policy driven and
drives policy. For example, a theoretical economist analysing the intricacies
of non-expected utility theory most likely would be surprised and horrified

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were they to be informed that their findings were being considered by a
government inquiry and would be used to justify forthcoming legislation.
The same economist, when considering the theory of oligopolistic interaction,
also may be horrified to learn that their findings were to be used in a policy
context. However, they should not be surprised.
Industry economics exists as a separate field because of its importance
for policy. However, the same could be said of many subfields of economics.
International trade theory may be characterised as applied general equilib-
rium modelling where the actors are called countries. Labour economics is
simply the micro theory of production with the emphasis placed on a partic-
ular factor. Even macroeconomics really can only claim its distinction as a
separate field due to its policy context and implications.
Industry economics is the application of microeconomic theory to policy
questions that involve firms or other multi-person productive units. When
viewed in this light, it is clear that there is not really a single discipline
called industrial organizations. Just as the policy questions that need to
be answered by applying microeconomic theory have diverged in the past
half century, so too the subfield of industry economics has splintered into
at least two specialisations. First there are those techniques that address
antitrust laws and industry specific regulations. Secondly, there are those
tools and results that relate to the internal structure of firms. Industry
economics is really an uneasy amalgamation of the subfields of “competition
and strategy” and “the theory of the firm”. This division has been driven by
recent developments in microeconomic theory and by the application of this
theory to policy issues that previously were only answerable at a superficial
level.

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2 Industrial economics as applied micro the-
ory
If industry economics is simply a branch of applied microeconomic theory,
then the question of knowledge for an industry economist is easily answered.
An industry economist needs to know microeconomic theory–or at least
that part of it that is relevant to their particular policy context. Following
Carlton and Perloff (1990), the three core elements that form the basis of
industry economic analysis can be classified as price theory, transactions cost
analysis and game theory.
Price theory refers to the traditional study of markets, perhaps best en-
capsulated by Varian’s (1992) well known text book. This theory is not
simply the core of industrial organization. It forms the basic knowledge that
needs to be understood by anyone who wishes to claim the title of economist.
“Transactions cost analysis emphasises that firms incur costs in transact-
ing business, such as the cost of writing and enforcing contracts” (Carlton
and Perloff 1990 p.3). It deals with issues such as contractual incompleteness
and internal firm structure, and includes the tools of principal-agent analy-
sis. At its most ambitious, the techniques of transactions cost analysis can
be used to analyse the boundaries and even the existence of firms (Coase
1937).
“Game theory is the study of multiperson decision problems. . . . As is
widely appreciated, for example, oligopolies present multiperson problems
– each firm must consider what the others will do” (Gibbons 1992 p.xi).
Game theory has emerged in the last twenty years as the dominant tool
for interfirm strategic analysis. Its success in explaining a variety of forms
of industry conduct has led to remarkable progress in industry economics.

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This success has also proved to be the Achilles heel of game theory. Used
with care and sensitivity, game theory can elucidate issues such as predatory
pricing, tacit collusion and the construction of entry barriers. However, in
less capable hands, game theory runs the risk of being able to explain any
phenomena or its converse, by the appropriate structuring of the underlying
game.
An industry economist needs more than a passing knowledge of each
of these analytic tools. Quite simply, without being able to apply these
tools in a rigorous fashion, it is impossible for an economist to read and
fully understand the literature published in any major industrial organization
journal. Even those industry economists specialising in empirical studies or
a specific policy area need to be reasonably expert in all of these tools. The
alternative is to run the risk of making unsubstantiated and unsustainable
policy conclusions.
As an example, consider the progress that has occurred on the issue of
contracts and entry barriers. In the late 1970s, common wisdom said that
it was impossible for an incumbent firm to tie customers to contracts that
both limited entry into an industry and made customers worse off than if
that entry had occurred (Bork 1978). The logic behind this conclusion was
simple. Unless the incumbent ensured that customers were at least as well
off under the contract as they would be with entry, the customers would not
sign. Why would the customers voluntarily agree to make themselves worse
off?
Unfortunately, this argument is totally inadequate. To show how it breaks
down has required fairly sophisticated analysis using all three of the above
theoretical tools, and has led to a number of path breaking articles (eg:
Aghion and Bolton 1987, and Rasmusen, Ramseyer and Wiley 1991). The

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argument can fail with one customer or many customers. Understanding how
and why it fails is one of the most important recent advances in competition
policy. Similar theoretical debates have undermined the case against resale
price maintenance (see Tirole 1988).
Finally, if for no other reason, industry economists need to be compe-
tent in price theory, transactions cost analysis and game theory to protect
themselves from those who are both competent and unscrupulous in the ap-
plication of these tools.
Consider the following example, loosely based on a submission to an in-
dustry commission inquiry. As the specific industry in question is irrelevant,
let us consider that the argument is applied to fruit retailers.

1. A fruit vendor in the South East of Melbourne is clearly operating in a


different market to a vendor in the outer Western suburbs. In general
the prices charged by one fruit vendor will only have an insignificant
effect on the business of the other vendor.

2. The key feature that separates these two fruit retailers is their geo-
graphical location.

3. By definition, fruit retailers cannot operate from the same location. A


fruit vendor that occupies one site holds a monopoly on that site.

4. As noted above, the key feature that determines the market for fruit
retailers is geographic location. But each vendor has a monopoly on
their location. Hence, by definition, each vendor is a monopolist.

5. As monopolists need regulation the government should step in and reg-


ulate the retail fruit market to enable fair and reasonable competition.

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This argument and its non sequitur would be worthy of Sir Humphrey
Appleby. It is easily dismissed. A fruit vendor operating at number seven,
Lonsdale Street, Dandenong may be the only trader on that site, but they
are clearly concerned about the fruit vendor located at number nine, Lons-
dale Street, Dandenong. Neither vendor is a monopoly seller in the relevant
market.
While it is easy to dismiss this argument when presented as above, it be-
comes more problematic when the argument is dressed up in grand sounding
terms such “sequential equilibrium” and “consistent conjectural variations”,
is surrounded by impressive tables and charts and is followed by a techni-
cal appendix that contains more Greek letters than English. The argument
will still be totally wrong, but at a minimum it will intimidate any industry
economist who is not sure of their own technical competence. At worst, the
argument will be accepted. To paraphrase Joan Robinson, it is important
for an industry economist to learn theory to protect themselves from other
industry economists.

3 Applications and specific theory


While competency in price theory, transactions cost analysis and game theory
is necessary for an industry economist, it is usually not sufficient. Almost
any policy question requires knowledge of specific theory, institutional ar-
rangements, and empirical facts.
To see the importance of specific theory, consider the controversy that
arose from the auction of satellite pay-TV licences in 1993 (Pearce 1993).
The auction process required a small application fee but did not require the
winning bidders to pay a deposit. When two relatively unknown firms were

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the highest bidders there was a shocked response from the media. When
neither bidder actually came forward with the relevant funds after being
cleared by the Australian Broadcasting Authority and the Trade Practices
Commission, the shock turned to outrage. The process resulted in significant
embarrassment for the government officials involved.
Why was the lack of a deposit so important? Anyone having a cursory
glance through the theoretical literature on auctions is unlikely to find “de-
posit” mentioned. Consequently, they may be led to the erroneous conclusion
that a deposit is unimportant in auctions. The error, however, lies in the
superficial reading of the literature. The theoretical literature on auctions
rarely considers the possibility of a significant time lag between the determi-
nation of the winner of an auction and the payment by that winner. However,
anyone with a thorough understanding of the literature would be able to de-
termine the consequences of such a delay. With the pay-TV auction, the
delay between the announcement of the winners and clearance by the ABA
and TPC was approximately two months. During that period, only the win-
ning bidders held the option to buy the pay-TV licences. In other words, the
time delay meant that the auction was not for two pay-TV licences. Rather
it involved giving away a two month option to buy these licences. In this
situation, it is not surprising that the winning bidders placed rather high
bids and then let them lapse.
The lesson from the above is clear. If an industry economist wishes to
design an auction, then they need to be extremely competent in auction the-
ory (McMillan 1994). Similarly, if an industry economist wants to implement
the access provisions of the Competition Policy Reform Bill 1995 then they
need to be comfortable with the large theoretical literature on access issues.
If they are considering the problem of price fixing under s.45A of the Trade

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Practices Act 1974, then that same economist needs to be familiar with the
large literature on tacit and explicit collusion. To do otherwise is to invite
disaster.

4 The facts
Before considering any specific policy an industry economist needs to be
aware of the relevant institutions and empirical facts. The interaction be-
tween institutions and competition differs over time and between countries.
Analysis that may be completely adequate for one country may be hopelessly
inadequate for another. Without a good understanding of their working en-
vironment the industry economist risks building neat but irrelevant solutions
to non-existent problems.
A simple example of the importance of institutional structures and his-
tory can be found in access pricing. The Efficient Components Pricing Rule
(ECPR) for access, otherwise known as the Baumol-Willig rule, has been
strongly advocated in the US (eg: Baumol and Sidak 1994). The rule has
been applied in California and recently received notoriety in the antipodes by
forming the central issue of dispute in a case brought under the New Zealand
Commerce Act (Clear Communications v Telecom New Zealand, see Ahdar
1995). The current interest in access pricing that has arisen in the wake of
the Hilmer report recommendations (Hilmer, et al 1993) has led to the con-
sideration of ECPR in Australia. The rule has some important limitations
(see Bureau of Transport and Communications Economics 1995). However,
to understand ECPR requires at least some knowledge of the history of US
regulation. Many of the relevant industries in the US involve privately-owned
utilities that are subject to price regulation on their final outputs. This is

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in contrast to Australia where industries such as telephone communications,
electricity and gas supply have often been government owned. ECPR is an
attempt to formulate an access rule that does not undermine any cross sub-
sidies that exist in current retail prices. While this is important in the US
context, it may have little relevance in the Australian debate, particularly as
one of the aims of the reform process is to remove such cross subsidies.
The relevant facts are not limited to institutional knowledge. An industry
economist also needs to be aware of any relevant empirical literature. There
is little point concentrating on aspects of policy that have been found to be
irrelevant in practice. Similarly, there are dangers in avoiding consideration
of those issue that have been shown to be significant through econometric
modelling.
Empirical industrial organization is developing at a rapid pace (see the
papers by Porter and Snyder in this volume). To read this literature an
industry economist needs at least some knowledge of modern econometric
techniques.

5 What does an industry economist need to


know?
An industry economist needs to know a lot. They need to be competent over a
wide theoretical literature. They need intimate knowledge of the theory that
relates to the question immediately to hand. They need a knowledge of the
history of the relevant industry and of the empirical literature surrounding
that industry and the tools which they wish to apply.
Clearly mastery of all the elements in this list is a tall order. The obvious
solution is to specialise. Rather than simply being an industry economist,

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it will often be necessary to become expert in some field. This may relate
to a policy, such as a specialist in the telecommunications industry or trade
practices law. Conversely it may relate to a set of empirical or theoretical
tools.
The set of knowledge that will bind these specialists together under the
rubric of industry economist will be the three necessary theoretical tools. An
industry economist needs to know and be expert in price theory, transactions
cost analysis and game theory. These tools provide both the basic principles
of industry analysis and the language which binds various industry specialists
together. By themselves they will rarely be adequate for consideration of
the policy questions that separate industrial organization from micro theory.
However, without any of these tools, the economist who wishes to address
issues of industry policy will be hopelessly ill-equipped.

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Ahdar, R., (1995) “Battles in New Zealand’s deregulated telecommunica-


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Baumol, W. and Sidak, J.G., (1994) Towards competition in local telephony,


MIT Press, Cambridge, MA.

Bork, R. (1978) The antitrust paradox - a policy at war with itself, Basic
Books, New York.

Bureau of transport and communications economics, (1995) “Interconnec-

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