Approaches to Industrial Economics

1. The Structure-conduct –performance paradigm

2. Chicago School of Thought
3. Institutional Economics
1. The Structure-conduct –performance paradigm
The central questions addressed by industrial
economics are:-
(1) is there market power and if so, how do you measure it?
(2) How do firms acquire and maintain market power?
(3) What are the implications of market power?
(4) What is the role of public policy as regards to market power?

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 Cont’d….
1. The market structure
-It means the pattern or form or manner in which the constituent parts of
a market (i.e. buyers and sellers) are arranged/ linked together.
-is concerned with the
Nature /Degree of Sellers and Buyers Concentration:.
Condition of Entry to the Market:
Degree of Product Differentiation
Degree of Vertical Integration-
Degree of Diversification
Eg. If there is only one firm (monopoly market); two- firm industry (i.e.
duopoly), if few (oligopoly); and if there large ( perfect competition). In
each case the process of output and price determination will be different.
If there is unique product( monopoly market); if differentiated
(monopolistic competition); and if there homogenous ( perfect
competition).
**Market structure is a multidimensional concept. So it is difficult to
measure it through a single variable
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 Cont’d…
2. Market Conduct
• behavior that firms follow in adopting or adjusting to the market in which they
operate to achieve the well defined goal or goals
How would they conduct their business?
o They may ignore each other and pursue their objective independently
o may join together and share the total profits
o they may be involved in the dirty games of competing

1. Pricing behaviors of the firm or group of firms:-

collective pricing/price discrimination
2. Product policy of the firm or group of firms –
For ex:- is product design/ quality frequently changed? consistent or variable?
3. Sales promotion and advertising policy of the firm or group of firms
4. Research, development, and innovation strategies employed in the firm or group
how substantial are expenditures for these purposes? To what extent is new technology available to
smaller firms?
5. Legal tactics used by the firm or group-
Legal actions to gain competitive advantage. Are patent and trade mark rights strictly
enforced or defended? Are patent rights licensed to others at fair rates?
6. Collusion , Merger and contracts By Dejene.T
 Cont’d…
3. Market Performance
• -is the end result of the activities under taken by the firms in pursuit of their goals.
• It can judged based on the following variables
– High profitability,
– high rate of growth of the firm,
– increase in the sales,
– increase in the capital turnover,
– increase in the employment etc.
market performance is a multidimensional concept which includes
1. Allocating in an efficient
 manner within and among firms
2.Technical / operational efficiency
 how closely do existing firms, as a group, achieve lowest possible costs?
3. Exchange Efficiency-
 the reduced costs of arranging transactions
4. Profit Rates:
 normal profit is the indicator of good market performance.
5. Level of Output By Dejene.T
 Cont’d….
6. Technological progress - extent to generate and rapidly adopt to
new technologies
7. Product Suitability- involves matching products with consumer
preferences.
8. Equitable distribution of income.
9. Continued full employment of productive resources.
10. Participant Rationality-deals with adequate market
information to make rational choice and avoidance of
misinformation.
11. Conservation- refers to the extent to which a firm or industry
promotes the conservation of natural resources
12. Labor Relations- covers equal opportunity, working conditions,
wage levels and wage structure, work rules.
13. Unethical Practices: firms should not engage in the production
and distribution of undesirable products/services
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 The relation ship between S-C-P
the traditional SCP approach
Structure ͢ Conduct ͢ Performance
• But the traditional premise is unidirectional
More complex relationship
• Structure ← Conduct ← Performance
– performance to conduct (reinvested monopoly profits can
finance greater R&D, advertising, and low profits encourage
collusion), and
– from conduct to structure (R&D, mergers, advertising, and affect
structure).
• Structure ← Performance
– performance to structure (e.g., high profits from efficiency
increase market share and affect
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 Institutional Economics
• Institutions- humanly devised formal and informal rules that is constrain
or shape human interactions.
• Argues that appropriate legislation as well as legal and administrative
services facilitates the growth of industry
• Hence the role of state is central
transactions have costs.
• Transaction costs are the expenses of trading with others above and
beyond the price, such as the cost of writing and enforcing contracts.
– These costs include those of information, negotiation, monitoring, coordination
and enforcement of contracts.

• According to the transaction cost school, institutions that lower the costs
of transactions are the key to the performance of the economies.
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 Chicago school
• Suggest that high profit may be a sign not of
market power, but of efficiency.
Causation runs from lower product cost →→ low
product price →→ high number of customers
→→ High market share and profit
They don’t support the intervention of government

Qn_ :From Institutional school and Chicago school

which thought is better ?
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 THE THEORY OF THE FIRM
• Objectives
 To clarify what different theories have been developed regarding the firm.
 To understand what life cycles the firm undergoes in its development.
 To identify as to how the firm grows according to different theories.
2.1. The Life cycle of a firm
• When the industry was small, each firm produced all successive steps of the
production process, so that all firms were vertically integrated
• In the larger industry, each firm does not handle each stage of production itself, but
buys services or products from specialized firms.
• as the industry grows, firms vertically disintegrate
• I. Growth- have greater need for the external finance and have smaller debt capacity
compared to maturity , the first six months
• II. Maturity- older, stable, highly profitable, borrow easily at low cost, specialized firm
• As an industry matures further, new products often develop and reduce much of the
demand for the original product, so the industry shrinks in size. As a result, firms
again vertically integrate. By Dejene.T
 2.2. Modern Theories of the Firm

Managerial theory of firm

Principal Agent theory
Transaction cost theory
2.2.1. Managerial Theory of the Firm
• This consider firm as ‘coalition’ of (managers, shareholders, workers, suppliers,
customers, tax collectors) whose members have conflicting goals that must be
conceivable/feasible to survival of firms

• The Three major principles around managerial theory are as follows.

– 1. In a firm, the ownership (by shareholders) is distinct from control (exercised by managers)

– 2. Because of this separation, it is possible to conceive of a divergence of interests of owners and

controlling managers.
– 3. Firms operate in an environment that affords them an area of discretion/choice in their
behavior.
structure
• shareholder(owners)→Board of Directors → top management
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 Reasons why the hired managers may be more preoccupied by sales or revenue maximization than by profit
maximizing include the following.
– If sales fail to rise, it indicates reduced market share and then it leads to increased vulnerability to the
actions of competitors.
– The firms’ sales are considered as an indicator of companies’ performance.
– Financial markets and distributors are responsive to rising sales.

• Divergence of managers from owners permit managers to maximize their own utility s.t.
minimum profit constraint
• Minimum profit is necessary
– A. for dividend policy
– B. for undertaking investment
– C. for keeping good reputation with banks
– D. for avoiding fall in price of shares
Two models of managerialism
I. Baumals Model: sales maximization is goal of the manager
II. Marris Model: growth rather than sales
Marris, formalized the hypothesis that managerial control would lead to growth as an objective,
showing that shareholders were a less important constraint on such firms than financial markets.

• Marris model is dynamic in a sense that it incorporate growth Like Baumol’s model, Marris
model assumes that mangers will act to maximize
By Dejene.Ttheir utilities rather than profits
 2.2.2. The Principal-Agent Theory

Two main actors, a principal (owner of an asset)

and agent (who makes decisions on behalf of the
principal ).
• To explain rn bn Principal and agent turn to
Williamson’s theory. There are two branches
• 1. Monopoly view- views contract as source of
monopoly power
• 2. Efficiency view- views contract as means of
economizing
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• Principal-agent theory sees the firm as does neoclassical theory as
a legal entity with a production function, contracting with
outsiders (including suppliers and customers) and insiders
(including owners and managers
• Difference bn PAT and TCT
• 1. PAT focuses on contract while TCT focuses on transaction
2. PAT assumes unbounded rationality while TCT assumes
bounded rationality.
• Unbounded rationality refers to the ability of those designing the
contract to take all possible, relevant, future events into
consideration.

*Where the objectives of the agent are different- problem of moral

hazard (the possibility that, once there is a contract, the agent may
behave differently from how he or she would have behaved had he
or she not had the contract).By Dejene.T
There are a number of ways to control moral hazard
managers could be paid a salary plus a bonus
development of efficient ways of monitoring the
performance of individual managers (or management
teams),
providing incentive contracts which reward agents
only on the basis of results
bonding (where the agent makes a promise to pay the
principal a sum of money if inappropriate behavior by
the agent is detected) and mandatory retirement
payments.
the principal to become his or her own agent-The
most obvious solution to the problems
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 Transaction Cost Theory
• Rights of ownership (or property rights) to a good or service must be able to be
established before a market for that good or service can exist. Transaction
costs(cost of carrying out the transaction i.e cost of enforcing property rights).
• If property rights over a good cannot be established, then transaction cost
theory is inappropriate.
• According to Coase, it is due to the existence of transaction costs that firms
exist.
• It is where transactions b/n individuals would be too difficult/ expensive an
organization is needed.
• If an organization could coordinate transactions at a lower cost than market
transactions,- then firms emerge to do this coordination.
• transactions can be internalized
– if the costs of making an exchange are greater > gains which that exchange would bring
= that exchange would not take place

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 Benefit of internalizing transaction
1. Reducing transaction costs,
2 . Enables the exploitation of economics of scale or economies of scope-
determines the size of a firm.
• Under what circumstances will transaction costs be lower when internalized than
when left to be negotiated in an external market?
• Williamson identified 3 factors
1. Bounded Rationality- imperfect ability to solve complex problems.
• Happens when-
– 1. when the information itself is imperfect (i.e. there is uncertainty
– 2. when there is imperfect ability to process the available information
2. Opportunism- how people will respond to conflicts, given the existence of
bounded rationality. Eg finding loopholes/gaps in contract
3. Asset Specificity- refers either to physical or human elements in the
transaction.
• refers to assets, involving non-trivial investment, that are specific to particular
transactions
(e.g. skills in an employer-employee contract).
• But, bounded rationality is a precondition for opportunism. So, opportunism and
bounded rationality are likely to giveBy rise
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to internalization.
 The Growth of the Firm
 
Growth is an important dimension of a firm
Maximization of growth –
1. Goal of the firm or
2. An instrument to achieve some other goal like maximization of profit or sales or managerial
utility, etc.
• Why do firms grow at all? Is it a natural process? Are there market forces which
compel a firm to grow over time?

• To bring growth in the country,→ → → create production capacity- → → → via the

establishment of new factories or by expanding the existing factories. - → → → it
implies an increase in competition among the sellers. -- → → → every firm losses its
market power completely as we find in perfect competition → → → the existing firm
expand themselves and block entry of new firm
• Hence it is natural inducement/stimulas which the market provides to the existing
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firms for growth.
 1. Downie’s Theory
 According to Downie, alternative forms of market structure and conventions govern business
behavior.
• This means rules of the game affect the dispersion of efficiency between firms and the rate of
technical progress.

• The source of variation in efficiency -technical processes.- comes past innovation and
accumulated skill/ experience

• The means of the growth are capacity of production and customers

A. To expand capacity,- finance is needed-
(wc raised either internally or externally and depend on rate of profit
B. On customer side, an efficient firm- may sustain a price reduction -
thus attract new customers - which affect less efficient firms adversely

• *There are now two opposing trends in the growth process of the firm.
– The capacity side of the growth varies positively with the rate of profit and
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– the market side i.e. the rate of customer expansion varies inversely with the rate of profit
 3. Marris Theory
•  His theory is applicable to a corporate firm owned by shareholders but controlled by mangers
Marris growth of the firm can best be explained with the help of the following relationships. 1. The
Steady-State Growth Condition. Situation when all characteristics of the firm grow at the same
constant exponential rate over time.
 This implies that DD and SS grows overtime at the same time.
2. The Growth-in-Demand Function- if DD reach saturation then firm will be stagnant
 To avoid this , marries advocated Diversification
3. The Growth-of-Supply Function: means an increase in the assets (fixed as well as current) of the
firm

• The growth rate of assets will be simply the ratio of new investment of capital employed.
• The new investment ----depends on finance available.
• A firm can raise finance primarily through three sources:
– i, retained /reserved earnings,
– ii. barrowings including bonds and debentures, and
– iii. the issue of new equity shares.

4. The Cost-of-Expansion Function

Acc. Marris Growth of the firm occurs through diversification
Diversification is directly related to Capital output ratio but inversely related to Profit margin.
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 Chapter 3. Market Concentration

•  Objectives
– To acquaint/explain the meaning of market concentration to students.
– To highlight different theories of concentration
– To identify different measures of concentration so that better measures of
concentration can be singled out.
– To find out the factors that determine market concentration
3.1. Nature of Market Concentration
Is important element of market structure
Plays dominant role in determining behavior of firm

Defn MC- situation when industry/mkt is controlled by a small number of leading

producers who are exclusively or at least very largely engaged in that industry.
It shows degree to which production of a particular good or service is confined to
a few large firms.
Two variables are relevant in determining market concentration.
a) number of firms in industry, and b) their relative size distribution.
Ceteris Paribas, a market is said to be more concentrated the fewer the number of
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firms in the production or the more unequal the distribution of market shares.
 3.2. Theories of concentration

•  MC- is a feature of the imperfect competition where one or few firms dominate the
entire industry.
• To understand the mechanism by which MC determines the economic behavior let
see the ff theoretical models
• 1. Let’s assume that there are few large firms along with many smaller firms selling
a homogeneous product at a uniform single price
• Assume total supply= Q units and market demand function be
• P= f(Q) = f(q1+q2+----------qi+--------qn) ----------------- (1)
• Where P= product price, qi=out put of ith firm, i = 1, - - - - n and
• The revenue function for the ith firm is given by
• RI=P.qi --------------------------------------- (2)
Ri p Q
Differentiating
qi
 P  qi . equation (2)
Q qi
  …………………… (3)
• EquationRi3can qi Q dp 
P 1 be. written
.  as
qi Q P dQ 
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--------------------------------(4)
 3.2. Theories of concentration

qi
•  Where, Qis the market share of the ith firm. Assume
that eQ is the market quantity elasticity of price.
eQ = dp Q
------ (5)
.
dQ P
• Substituting equation (5) in equation (4), we get
Ri
 1  qi .eQ (i  1,    n, )
= p Q
qi
……….. (6).
• This equation shows that MR for the ith firm depends
on product price (p), market
qi
share in output for the
 Q
firm ) and quantity elasticity of price ( eQ).
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• If the firms are of uneven sizes then the average marginal revenue
is given asq 1 q2 q n
Q
AMR = (MR1) + Q (MR2) + ( MRN)------(7)
Q

Substituting MR1 and MR2 ------from equation (7) into equation (6),
we get
2
n  qi  
1     eQ  MR = P (1 + H. eQ)
Q
MR) = P i 1 
or --------(8)
n

  qi

 Q
i 1

2



=H

H is the Herfindahl Index of Concentration

• This equation indicates that average marginal revenue depends on

product price (p), concentration index (H) and the elasticity
coefficient (eQ) By Dejene.T
• If all n firms are of equal size then H= 1/n which
tends to zero as n becomes greater and greater as in
competitive situation. In this case, MR will be almost
equal to price (p) i.e. MR=P(1+0.eQ) MR=P(1)=P
• If there is only one firm, then, H= = 1. This is the case
of monopoly, extreme of market concentration.
• 2. Lets now assume the situation when firms are
selling differentiated products with different prices.
• The responsiveness of changes in quantity of outputs
as a result of the price change is given the price
elasticity of demand for the firm and the cross
elasticity of demand for the other firms.

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 qi pi
• Price elasticity of demand. Ep = .
pi qi

qj pi
Cross elasticity of demand Eij = .
pi qj
Where j stands for remaining n-1 firms
When total market demand for the closely substituted
goods is constant,
 an increase in the ss of any variety means a decrease in
the total ss of all other varieties by the same magnitude.
 Thus, when the firm gets 5 percent increase in its sales,
it means 5 percent reduction in the sales of all other
firms.
 And if there are n-1 remaining firms so each one will get
percent decrease in the sales by one percent decrease in
the price of ith firm. By Dejene.T
This means eij = -  . This shows the relationship
5
n 1

between own elasticity and cross elasticity,

5
 n 1
as eij= - where n is the number of firms
assumed to be equal in size. ep
n 1

• If n is very large, eij will be very low tending

towards zero.
 The impact on other firms becomes negligible.
However, for a small group of firms i.e.
concentrated industries, eij will be considerably
high.
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 3.3. Measure of concentration

1. Concentration Ratio (CR)

The most popular and perhaps simplest index
• This ratio indicates the share of the market or
industry held by some of the largest firms.
• The market share may be ( in production or sales
or employment or any other ).
• In symbolic form
M

C =  pi, i 1
m = 4, 8, 10, 12, - - 20
• Where pi=market share of ith firm in descending order.
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• The higher CR, the greater MC( Monoplypower).
• Limitations
• 1. It does not take the entire concentration curve into
account;-it indicates at a point of the curve
• 2. It depend on how the market is defined- broad
market- tend to reduce computed CR
• Narrow-have the opposite effect.
• 3. Ratios do not reflect the presence of or absence of
potential entry of firms.
• Advantage
• 1. Simple to use-widely used
• 2. Consistent with economic notion of monopoly
theory By Dejene.T
 2. The Hirschman-Herfindahl Index
• It is the sum of the squares of the relative sizes (i.e. market shares)
of the firmsn in the market,
H = 
i 1
( pi ) 2

Where
 pi = , qi/Q,
 qi is output of ith firm and
 Q is total output of all the firms in the market, and
 n is the total number of firms in the market.
This index takes account of all firms in the market
• The maximum value for index is one where only one firm occupies
the whole market. This is the case of monopoly, that is,
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 2
• H =
n
1
   1
i 1  1 

• The index will have minimum value when the n firms in the
market hold on identical share. This is equal to that i
2
1
n

H=     1n
n
i 1

H decreases as n increases
• Advantage
• 1. The index is simple to calculate.
• 2. It takes account of all firms and their relative sizes.
• 3. Consistent with the theory of oligopoly because of its
similarity to measures ofBymonopoly
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 The Entropy Index
 
• This index is the recent index of market concentration. The formula is
n
1
E= log
pi
i 1 pi 0≤ E≤ logn

• Where E is defined as Entropy Coefficient, pi is the market share of ith firm and n the number of firms.
E measures the degree of uncertainty faced by the firm in the market.
• For a monopoly firm (n=1) the E takes the value of zero - no uncertainty and maxm concentration.
Thus, we find opposite (inverse) relationship bn E, and the degree of market concentration.

• If there are n firms, all equal in size, then,

E=  1 x log n = log n
n

i 1
n

Advantage
The population of the firms for which Entropy Coefficient is to be computed can be decomposed or
disaggregated into several groups, such as on their
o basis of sizes,
o regions, products and
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o the classification of the industry, etc.