Industrial organization

Industrial organization

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Encyclopedia
Industrial organization is the field of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 that builds on the theory of the firm
Theory of the firm
The theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market.-Overview:...

 in examining the structure of, and boundaries between, firms and markets.

The subject has been described as concerned with markets that "cannot easily be analyzed using the standard textbook competitive model." Industrial organization adds to the perfectly competitive
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

 model real-world frictions such as transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

s, limited information
Information economics
Information economics or the economics of informationis a branch of microeconomic theory that studies how information affects an economy and economic decisions. Information has special characteristics. It is easy to create but hard to trust. It is easy to spread but hard to control. It...

, and barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...

 of new firms that may be associated with imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

. It analyzes determinants of firm and market organization and behavior as between competition and monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

, including from government actions.

There are different approaches to the subject. One is descriptive in providing an overview of industrial organization, such as measures of competition and the size-concentration
Concentration ratio
In economics, a concentration ratio is a measure of the total output produced in an industry by a given number of firms in the industry. The most common concentration ratios are the CR4 and the CR8, which means the four and the eight largest firms...

 of firms in an industry. A second uses microeconomic models to explain internal firm organization and market strategy. As to strategic
Strategy (game theory)
In game theory, a player's strategy in a game is a complete plan of action for whatever situation might arise; this fully determines the player's behaviour...

 firm interaction, non-cooperative
Non-cooperative game
In game theory, a non-cooperative game is one in which players make decisions independently. Thus, while they may be able to cooperate, any cooperation must be self-enforcing....

 game theory has become the standard unifying method of analysis. A third aspect is oriented to public policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...

 as to economic regulation and antitrust law.

The development of industrial organization as a separate field owes much to Edward Chamberlin
Edward Chamberlin
Edward Hastings Chamberlin was an American economist. He was born in La Conner, Washington.Chamberlin studied first at the University of Iowa , then pursued graduate-level studies at the University of Michigan, eventually receiving his Ph.D...

, Edward S. Mason, and Joe S. Bain.

Structure, conduct, performance


According to the structure-conduct-performance approach, an industry's performance (the success of an industry in producing benefits for the consumer) depends on the conduct of its firms, which then depends on the structure (factors that determine the competitiveness of the market). The structure of the industry then depends on basic conditions, such as technology and demand for a product.   • Dennis W. Carlton and Jeffery M. Perloff, 2004. Modern Industrial Organization, 4th edition, pp. 2-3. Description. For example: in an industry with technology that the average cost of production falls as output increases, the industry tends to have one firm, or possibly a small number of firms.

Components that make up the structure, conduct, and performance model for industrial organization include:
  • basic conditions: consumer demand, production, elasticity of demand, technology, substitutes, raw materials, seasonality, unionization, rate of growth, product durability, location, lumpiness of orders, scale of economies, method of purchase, scope economies
  • structure: number of buyers and sellers, barriers to entry of new firms, product differentiation, vertical integration, diversification
  • conduct: advertising, research and development, pricing behavior, plant investment, legal tactics, product choice, collusion, merger and contracts
  • performance: price, production efficiency, allocative efficiency, equity, product quality, technical progress, profits
  • government policy: government regulation
    Regulatory economics
    Regulatory economics is the economics of regulation, in the sense of the application of law by government that is used for various purposes, such as centrally-planning an economy, remedying market failure, enriching well-connected firms, or benefiting politicians...

    , antitrust
    Antitrust
    The United States antitrust law is a body of laws that prohibits anti-competitive behavior and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace. These competition laws make illegal certain practices deemed to hurt businesses or consumers or both,...

    , barriers to entry, taxes and subsidies, investment incentives, employment incentives, macroeconomic policies


Industrial organization
The subject of industrial organization applies the economics’ model of price theory to the real world industries. The goal of industrial organization study is to increase the understanding of how industries operate, improve the industries contribution to the economic welfare, and to improve government policy toward these industries.

Structure Conduct Performance Paradigm (SCPP)
SCPP is an approach used to analyze the relation among market performance, market conduct, and market structure. The SCPP indicates that market structure determines the market conduct, and thereby sets the level of market performance. Working backward, we find that market performance is determined by market conduct, which in return depends on market structure. SCP has been applied to a diverse range of problems, from helping businesses become more profitable to helping understand the subprime mortgage crisis in the United States.

Economists are especially interested in studying the SCPP because they tend to believe that seller concentration affects the industry’s social performance. The economic theorists express that effect in terms of higher profits earned by the monopoly. On the other hand, Industrial Organization economists express the effect in terms of locative inefficiency. However, economists who use the Structure Conduct Performance (SCP) approach disagree on the emphases that they give to each of the three elements. Some give market structure and market conduct an equal importance in determining market performance. Others argue that market conduct is largely determined by market structure, hence, market performance depends heavily on market structure, and that leads them to pay little attention to market conduct.

Market Structure Conduct and Performance SCP framework was derived from the neo-classical analysis of markets. The SCPP was the brainchild of the Harvard school of thought and popularized during 1940-60 with its empirical work involving the identification of correlations between industry structure and performance. This SCP hypothesis has led to the implementation of most anti-trust legislation. The Chicago school of thought followed this from 1960 to 1980. They emphasized on the rationale for firms becoming big, price theory and econometric estimation. During 1980-90 game theory took center stage with emphasis on strategic decision-making and Nash equilibrium concept. After 1990, empirical industrial organization with the use of economic theory and econometrics led to complex empirical modeling of technological changes, merger analysis, entry-exit and identification of market power.

Market structure
The Market structure consists of the relatively stable features of the market environment that influence rivalry among the buyers and sellers operating within this market. The main elements that influence market structure are, seller concentration, product differentiation, barriers to entry, barriers to exit, buyer concentration, and the growth rate of market demand. Other elements of market structure exist, but they are usually unstable and therefore ignored either because they can’t be measured or because they are hard to observe.

Elements of market structure

Seller concentration

Refers to the number and size distribution of firms in the market. The most widely used device is determining seller concentration is the Concentration Ratio. To compute the concentration ratio, the firms are ranked in order of size “usually measured in terms of sale”, starting from the largest in the industry at the top and going down to the smallest firm at the bottom. Concentration ratios are usually given for the largest 4, largest 8, and sometimes the largest 20 firms.
Usually industries that are highly concentrated in one advanced economy tend to be highly concentrated in another.

Product differentiation
A differentiation or distinguishing a product from the products of other competing firms. Differentiation of products along key features and minor details is an important strategy for firms to defend their price from leveling down to marginal cost.

Horizontal differentiation
When products are different according to features that can't be ordered in an objective way, or in other words, at the same price, some consumers would prefer the product while others would prefer a different substitute Horizontal differentiation can be differentiation in colors (different color version for the same good), in styles (e.g. modern/antique), or in tastes. A typical example is the ice cream offered in different tastes. Chocolate is not better than Mango.

Vertical differentiation
Vertical differentiation occurs in a market where the several goods that are present can be ordered according to their objective quality from the highest to the lowest. It's possible to say in this case that one good is "better" than another.

Mixed differentiation
Certain markets are characterized by both horizontal and vertical differentiation. For instance, apparel, and shoes have a rich combination of shapes, colors, materials, and appropriateness to social events. In such markets, the differences in colors or shapes are horizontal differentiation, while the quality of the materials is usually perceived as vertical differentiation.

Barriers to entry
A set of economic forces that create a disadvantage to new competitors attempting to enter the market. These forces could be government regulation such as IP rights, or patent, or they could be large economies of scale in a specific industry, or high sunk costs required to enter the market. Sometimes firms within a specific industry adopt certain pricing strategies
Pricing strategies
Pricing strategies for products or services include the following:-Competition-based pricing:Setting the price based upon prices of the similar competitor products.Competitive pricing is based on three types of competitive product:...

 to create barriers to entry, one of the most widely adopted strategy is limit pricing by lowering prices to a level that would force any new entrants to operate at a loss, this strategy is especially effective when the existing firms have a cost advantage over potential entrants.

Barriers to exit
A set of economics forces that influence the firms decision of exiting the market, such forces make it cheaper for the existing firm to stay in the market than to exit the market. Although sunk costs could be barriers to entry, especially when the sunk costs are too large, sunk costs could be a huge barrier to exit as well, because large investments in fixed plant and equipments commits the firm to stay in the market. Barriers to exit increase the intensity of competition in an industry because existing firms have little choice but to stay and fight when market conditions have deteriorated.
The loss of business reputation and consumer goodwill, could be a barrier to exit especially if the firm is planning on reentering the market later, or when the firm exits a specific market but still operating in other markets. In such a situation, the decision to leave the market can seriously hurt the reputation of the firm among current consumers in other markets, and affect the goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.

Buyer concentration
The number of buyers in a market. Buyer concentration is as equally important as seller concentration, especially in markets with a few buyers. The term was used by Michael E. Porter in 1979 in his “Five Forces Analysis”. Porter’s analysis proposes that in markets with high buyer concentration, the firms earn lower level of profits than in markets with low buyer concentration

The growth rate of market demand
The market structure in industries with a relatively static demand or low growth rate of demand is different from the market structure in industries with an accelerated demand growth. That’s because when the demand grows fast enough, the firms have their hands full just expanding their production capacities, in this case, if new entrants are coming in, there will be little incentive to fight for market share. Also, firms are likely to honor oligopolistic agreements with each other, and profits tend to be high.
All these elements of market structure tend to be stable over time. However, they are all interrelated. Any change in one tends to bring about changes in another. By realizing this relation among the different elements of market structure, it becomes easier to understand why market structures change over time.

Conduct
Conduct means what firms do to compete with each other. It includes pricing, advertising, research and development investment, decisions on product dimensions, merger and acquisition, etc. Conduct also can include collusion both explicit or tacit.

Performance
The performance of an industry or firm is measured by profitability. Profit is the difference between revenue and cost, and revenue is determined by price. Thus performance can be influenced through changing costs or prices. Profitability can also be affected by a firm’s agility (i.e. ability to adjust to things like changes in market demand). Research and development, and availability of capitol and resources are factors that greatly influence whether or not a firm is agile. The ability to measure performance between industries is important in understanding the SCP relationships. For example, if an industry is dominated by one firm or cartel does not see higher costs than a competitive industry yet has monopoly prices, then that non-competitive industry will see higher profits, whereas if costs increase, then profitability levels will be relatively similar. This comparison is the driving force behind anti-trust legislation.
SCPP predicts that performance increases with concentration of the industry. This is in contrast with the efficiency hypothesis that states that a firms performance is based on how well and efficiently it produces its product for the consumer.

SCP Interaction
Overview

There are two competing hypotheses in the SCP paradigm: the traditional “structure performance hypothesis” and “efficient structure hypothesis”.

The structure performance hypothesis states that the degree of market concentration is inversely related to the degree of competition. This is because market concentration encourages firms to collude. This hypothesis will be supported if positive relationship between market concentration (measured by concentration ratio) and performance (measured by profits) exist, regardless of efficiency of the firm (measured by market share). Thus firms in more concentrated industries will earn higher profits than firms operating in less concentrated industries, irrespective of their efficiency.

The efficiency structure hypothesis states that performance of the firm is positively related to its efficiency. This is because market concentration emerges from competition where firms with low cost structure increase profits by reducing prices and expanding market share. A positive relationship between firm profits and market structure is attributed to the gains made in market share by more efficient firms, but not to the collusive activities, as the traditional SCP paradigm would suggest (Molyneux and Forbes, 1995).

Relationship of structure to performance

Early studies by Bain (1951; 1956) hypothesized a positive relationship between industry concentration, barriers to entry and profits. Though his studies are flawed in the measurement of profit rates and choice of industries (Brozen 1971), later papers supported this hypothesis (Mann 1966; Weiss 1974).

However, the differential in the performance measures between concentrated and non-concentrated industries fell substantially overtime (Brozen 1971; Hubbard and Petersen 1986). Moreover, studies based on more recent data tend to find only a weak relationship or no relationship between the structural variables and performance (Salinger 1984; Kwoka and Ravenscraft 1985). As a result, some econometric studies began to look at other factors impacting industry performance. These studies commonly found that high rates of return and industry growth are related.

Other researchers studied the structure-performance relationship using alternative measures of performance, for example, the speed of adjustment of capital. They found that the capital-output ratio is positively related to concentration. The explanation for this phenomenon has not been verified, but it is possible that in highly concentrated markets, there are more specialized capital which is more difficult to adjust, thus in these markets high profits take longer to fall back to the industry average. Similarly, if concentrated industries take longer time to react to demand changes, then, all else equal, good economic news should raise the value of a company more in a concentrated industry than in an non-concentrated industry (Lustgarten and Thomadakis 1980).

Relationship between structure and conduct

Conduct is influenced by market structure since firm strategies differ with competition. Inversely, conduct can influence market structure because firms can make entry cost endogenous by choosing different levels of quality, advertising and so on, thus affect the potential entrant number.

Relationship between conduct and performance

Conduct is related to performance. For example, advertising expenditure is usually higher in highly profitable industries, because firms with more profits can afford higher advertising costs, and in order to keep their profits and prevent new entrants into the profitable market, these firms would use advertising investments as endogenous sunk costs. Econometric studies linking profit to market structure often conclude that measured profitability is correlated with the advertising-to-sales ratio and with the R&D expenditures-to-sales ratio.

Conclusion

In essence, with the SCPP we seek to find the answer to how firms interact and compete with each other in different situations, and the results of these interactions, and are these results consistent with an ideal competition or not. That way, an argument can be supported on whether or not action should be taken to alter the market structure or regulate market conduct. It is interesting there is such a debate on the emphasis on market structure vs. market conduct on the influence of performance since it is clear that structure and conduct are themselves influenced by each other. Joseph Bain was one of the first to realize this and his work led to the re-evaluation of public policy that had been fostered by the SCP framework. In industrial organization, real world, imperfect competition is studied, and there are so many different examples that the way markets are evaluated is continually evolving and changing. Thus every school of thought must be constantly re-evaluated as more data is generated.

Reference:

Carlton and Perloff, 2005, Modern Industrial Organization, 4th Edition, Pearson, Addison Wesley.

Charles C. Fisher. “What can economics learn from marketing’s market structure analysis?”. Contribution of Marketing MSA to Economics MSA. http://www.westga.edu/~bquest/1997/ecnmkt.html

Caves, E Richard (January 1992). “American Industry: Structure, Conduct, Performance”. Prentice Hall, 7th E. pp 3–36

Edwards, Allen and Shaik (2006), "Market Structure Conduct Performance (SCP) Hypothesis Revisited using Stochastic Frontier Efficiency Analysis," presentation at the American Agricultural Economics Association Annual Meeting, Long Beach, California.

Marion, Bruce. "Structure, Conduct, Performance Paradigm to Subsector Ananlysis." : Print.

Michael E. Porter, Interbrand Choice, strategy, and bilateral market power (Cambridge, MA: Harvard University Press, 1976).

Pepall, Lynne, Dan Richards, and George Norman. Industrial Organization Contemporary Theory and Empirical Applications. 4th ed. Malden, MA: Blackwll Publishing, 2008. Print.

Valantino Piana. “Product differentiation.” http://economicswebinstitute.org/glossary/product.htm

Weiss, Leonard W. “The Structure-Conduct-Performance Paradigm and Antitrust.” Apr., 1979 pp. 1104–1140. The University of Pennsylvania Law Review.
http://www.jstor.org/stable/3311794

Market structures


The common market structures studied in this field are the following:
  • Perfect competition
    Perfect competition
    In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

  • Monopolistic competition
    Monopolistic competition
    Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another...

  • Oligopoly
    Oligopoly
    An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...

  • Oligopsony
    Oligopsony
    An oligopsony is a market form in which the number of buyers is small while the number of sellers in theory could be large. This typically happens in a market for inputs where numerous suppliers are competing to sell their product to a small number of buyers...

  • Monopoly
    Monopoly
    A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

  • Monopsony
    Monopsony
    In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly, in which only one seller faces many buyers...


Areas of study


Industrial organization investigates the outcomes of these market structures in environments with
  • Price discrimination
    Price discrimination
    Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider...

  • Product differentiation
    Product differentiation
    In economics and marketing, product differentiation is the process of distinguishing a product or offering from others, to make it more attractive to a particular target market. This involves differentiating it from competitors' products as well as a firm's own product offerings...

  • Durable good
    Durable good
    In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...

    s
  • Experience good
    Experience good
    In economics, an experience good is a product or service where product characteristics such as quality or price are difficult to observe in advance, but these characteristics can be ascertained upon consumption...

    s
  • Secondary market
    Secondary market
    The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....

    s or second-hand markets, which can affect the behaviour of firms in primary markets.
  • Collusion
    Collusion
    Collusion is an agreement between two or more persons, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage...

  • Signalling
    Signalling (economics)
    In economics, more precisely in contract theory, signalling is the idea that one party credibly conveys some information about itself to another party...

    , such as warranties and advertising.
  • Mergers and acquisitions
    Mergers and acquisitions
    Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...

  • Entry
    Entry (economics)
    In economics, entry into a market means becoming a supplier of goods or services. Monopolies have an incentive to create barriers to entry....

     and Exit
    Exit (economics)
    Exit, in economics, means opting out of future transactions. A firm can secure its ability to exit, for instance, by only agreeing to contracts that containing a clause that allows for termination on terms it feels would be acceptable. In constitutional economics, it implies a right of secession...



A competitive market structure has the performance outcome of lower costs and lower prices, (Shepherd, W: 1997:4).

The subject has a theoretical side and a practical side. According to one text book: "On one plane the field is abstract, a set of analytical concepts about competition and monopoly. On a second plane the topic is about real markets, teeming with the excitement and drama of struggles among real firms" (Shepherd, W.; 1985; 1).

The extensive use of game theory
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

 in industrial economics has led to the export of this tool to other branches of microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

, such as behavioral economics and corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...

. Industrial organization has also had significant practical impacts on antitrust law and competition policy.

History of the field


A 2009 book Pioneers of Industrial Organization traces the development of the field from Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

 to recent times and includes dozens of short biographies of major figures in Europe and North America who contributed to the growth and development of the discipline.

Other reviews by publication year and earliest available cited works those in 1970/1937, 1972/1933, 1974, 1987/7 from 1968 on, 3 from 1937 to 1956, and 2009/c. 1900.

See also



  • Bertrand competition
    Bertrand competition
    Bertrand competition is a model of competition used in economics, named after Joseph Louis François Bertrand . It describes interactions among firms that set prices and their customers that choose quantities at that price....

  • Competition law
    Competition law
    Competition law, known in the United States as antitrust law, is law that promotes or maintains market competition by regulating anti-competitive conduct by companies....

  • Competition policy

  • Cournot competition
    Cournot competition
    Cournot competition is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Augustin Cournot who was inspired by observing...

  • Input-output model
    Input-output model
    In economics, an input-output model is a quantitative economic technique that represents the interdependencies between different branches of national economy or between branches of different, even competing economies. Wassily Leontief developed this type of analysis and took the Nobel Memorial...

  • Relevant market
    Relevant market
    In competition law the Relevant market defines the market in which one or more goods compete. Therefore, the Relevant market defines whether two or more products can be considered substitute goods and whether they constitute a particular and separate market for competition analysis.The relevant...


  • SSNIP
  • Important publications in industrial organization
  • Model of Industrial Organization


Journals