Chapter 1 (1).pptx Introduction to Industrial Economics

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CHAPTER ONE
INTRODUCTION
Chapter objectives: After reading this chapter you
must be able to know
•The meaning and scope of industrial economics
•The definitions and elementary description of some
basic concepts used in industrial economics
•The paradigm of SCP
•The framework for the study of industrial economics
Lecturer: Ahmed M. Elmi ( Atoshe)

Definition and Scope of Industrial Economics
What is industrial economics?
 It is one of the disciplines in economics that deals
with the economic problems of firms and industries,
and their relationship with society.
 It is also called:
 ‘Economics of Industry’
 “Industry and Trade”
 ‘Industrial Organisation and Policy’
 “Commerce and Business Economics’ and so on.
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Lecturer: Ahmed M. Elmi (Atoshe)

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1.0. Overview on historical Evolution of Industrial Economics
• The early theory of the firm which we might regard
as the mother of the contemporary industrial
economics was born as at this stage as an integral
part of the classical economics. Many of the issues in
this area of economics date back to Adam Smith in
the eighteenth century.
• More recently, Cournot in the first half, and Marshall
in the 2nd
half of the nineteenth century laid
foundations that which , remain appropriate
concerns in industrial economics of today.

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• There have been two major traditional concerns of
industrial economics.
First, there has been a focus on the functioning of
firms, and their performance; the determinants and
consequences of different market structures”, and
the relationship between behavior and performance
of firms) and the market structure within which firms
operate.
Second, the role of government in influencing the
organization of industry.

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• Although difficult to know the true beginning of
industrial economics because of non-availability of
data, it has come up to the present stage mainly during
the last 40 to 50 years.
• The subject has not yet grown to its maturity. In recent
years, industrial economics has changed dramatically.
Theories have been extended & developed, partly in
response to new ideas such as commitment, to new
empirical findings and partly to the arrival of new tools
such as computer simulations.

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How decision-making problems arise in industries?
• To answer this question, we have to go back to the
core of Economics.
• Economics is the science that studies human
behavior as a relationship between ends and scarce
means that 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.

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• For example, the income of a consumer is generally
limited but his/her wants are unlimited. In this
situation he/she has to adopt some criterion to
achieve maximum gain from his/her 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.

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• Given such scarcity, the producer 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/she should produce,
 what should be the level output of each input,
what type of technology he/she should adopt,
where should he/she produce the goods,

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what should be the size of his/her factory,
what price he/she should charge,
how much wages should pay,
how much he/she should spend on advertisement,
 should he/she borrow from banks or elsewhere,
etc…
• All such decisions explain the producer's behavior in
the different market situations, which we endeavor
to study in industrial economics.

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• In microeconomics also we study producer’s
behavior in relation to scarcity of resources. Because
of this fact, some economists would regard industrial
economics as being primarily an elaboration of, and
develop
ment from, the traditional theory of the firm
taught under microeconomics.
• Industrial economics is best defined as the
application of micro economic theory to the analysis
of firms, markets and industries.

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• Stigler (1968) argues that industrial economics does
not really exist as a separate discipline, that it is
simply differentiated microeconomics. But this
misses some points. The distinction arises from the
overriding emphasis, in industrial economics, on
empirical work and on implications for policy.

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• What makes industrial economics different from
microeconomics?
• Of course 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 analyses their behavior and draw
normative implications.
• However, there are some differences between the two.

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• Microeconomics is a formal, deductive and abstract
discipline where as Industrial econo
mics on the other
hand is less formal, more inductive in nature.
• Micro
economics assumes profit maximization as the goal
of the firm given constraints where as Industrial
economics does not believe in single goal of profit
maximization.
• Microecono
mics, being abstract, does not go into
operational details of production, distribution and other
aspects of the firms and industries where as Industrial
economics does go into the depth of such details.

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• Public policy implications are taken care of in
industrial economics but micro
economics may shun
them if necessary.
industrial economics with the concern of decision-
making in an industry from micro angle, but it has
macro dimension also. For a society as a whole the
resources for production are scarce just as in the
case of a producer.

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• With scarce resources, the problem exists to produce varieties of
goods and services in-the current period and in future also.
• What goods should be produced: consumer or capital? If capital
good are preferred, then the series of prob
lems faced by the
society may be: what types of capital goods; what type of factory
(large vs. small scale); where to produce (locational problem);
how to distribute them; etc. These are the questions which have
been posed earlier for an individual producer also. But, here we
have to examine them from the social angle.

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• The term industrial organization is commonly viewed as
synonymous with industrial economics.
• But,Carlsson (1989) made clear distinction between them. He
reasons that the main concern of industrial organization has
become the structure of industries at a particular point of time.
• By contrast, industrial economics encompasses both industrial
organization and industrial dynamics.
• Industrial dynamics is primarily concerned with the evolution of
industry as a process in time both at the macro level, the sector
or industry level, and the firm level.

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• It differs from industrial organization in that its
main focus of attention can vary from the firm, to
relationships between firms, to the links between
microeconomics and the macro economy.
• When the economist turns the attention to
industrial dynamics the area of investigation is
widened .

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• Conclusion:
• Industrial economics is predominantly an
empirical discipline having micro and macro
aspects.
• It has a strong theoretical base of
microeconomics.
• It provides useful applications for industrial
management and public policies.

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 There are two broad elements in industrial economics.
 Descriptive element
 Analytical part
 Descriptive Element: is concerned with the information
content of the subject. It would provide industrialist or
businessman full information regarding:
• the availability of 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 it
operates.

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• 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.
 Analytical element:is concerned with business policy and decision
making.
 market analysis
 Pricing
 choice of techniques
 location of plants
 investment planning
 hiring and firing of labour
 financial decisions
 product diversification and so on.

• Analytical element : 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.
• NB. The two elements are interdependent,
since without adequate information no one can
take proper decision about any aspect of
business
21

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• While the descriptive element of industrial economics
is concerned with the information content of the
subject, the analytical element is concerned with the
business policy and decision making.

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• Moreover, industrial economics:
– analyses industries, markets, and the behaviour of
firms within those markets.
– It deals with supply side economics.
– Thus, it is concerned with the economic problems
of the firms and their economic behaviour in
utilising economic resources at their disposal.
– The interdependence between firms within markets
and the links that exist between market conditions
and firm’s performance

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• Industrial Economics addresses the basic
question of:
 what to produce
 for whom to produce and
 how to produce in the context of industries or firms
• Industries face such problems because resources
are scarce and hence the industrialist has to take
decisions about production and distributions of
goods and/or services as they cannot produce
everything they want to produce at single firm
level or at higher aggregate level of the economy.

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The Rationale for Studying Industrial Economics
i. It is instrumental to the formulation and
implementation of industrial policies that are essential
for sustainable development of a nation.
 For example, it helps us:
 to choose between private and public enterprises
 to design strategies to promote investment in industrial
sector
 to regulate and/or deregulate public utility industries
 It also assists policy makers as how they can stimulate
technological progress through patent rights and subsidies.

Lecturer: Ahmed M. Elmi ( Atoshe) 26
ii. Studying industrial economics is useful for
generating research questions such as:
why do some firms advertise their products while
others do not?
Why do some firms expand while others contract
or keep their size constant?
Are barriers to entry more serious in some
branches of industry than in others?
 The questions are essential for further research
and development and hence deserve attention.

1.2. Some Basic Concepts in the study of Industrial Economics
i. The Firm
• A firm is an organization owned by one or jointly by a
few or many individuals which is engaged in productive
activity of any kind for the sake of profit or some other
well-defined aim.
• Most of the firms owned by private individuals in
manufacturing trade and services will aspire for profits
but there may be some other such as government
companies where profit motivation will be secondary or
missing altogether.

ii. The industry
• The conventional definition of the term industry is a
group of firms producing a single homogeneous product
and selling it in a common market. However, the
restriction of a single homogeneous product is not met in
practice.
• Most of the firms produce many outputs which may or
may not be substitutable for each other. In this situation,
the conventional defini
tion has no operational sense.

• A better approach to define the industry is to call it
“a group of sellers or of close substitute outputs who
supply to a common group of buyers”.
• In other words, we may take it in simpler terms as a
group of firms producing closely substitute goods for
a common group of buyers.
• In the terminology of the monopolistic competition
we are essentially talking about the “product group"
as a substitute word for the industry.

iii. The Market
• This is defined as a closely interrelated group of sellers and
buyers for a commodity. The term is not equivalent to the
industry since in the latter case we are looking only at the
seller’s side of the market.
• By including the buyer's side, the term becomes more
comprehensive connoting the composition of the buyers and
their geographical location along with the industry.
• A heterogeneous group of closely substitute goods will have a
market, but there may be markets within the market for every
homogeneous good.

Contestable market: is a market where barriers to
entry and exit, not market structure, determine price
and output decisions and a competitive price is set.
 It is a market in which competitive outcomes can
be observed.
Its fundamental feature is low barriers to entry and
exit;
 A perfectly contestable market would have no
barriers to entry or exit.

iv. Market power
• Market power- refers to the influence that any particular
buyer or seller can exercise over the price of a product.
• It indicates the degree to which a business firm is able to earn
larger than normal profits.
• Market structures range from highly competitive, in which
there are so many buyers or sellers that none can influence
the market price, to the other extreme in which a single buyer
or seller faces no competition and therefore wields great
market power.
• Market power is inversely related to both the degree of
competition in the market and the ease of entry and exit.

1.3.Approaches to Industrial Economics
1.3.1.The Market Structure-Conduct- Performance paradigm
(SCP paradigm)
• Joe Bain and Edward Mason developed the concept
“Structure-Conduct- Performance” paradigm in 1936,
dealing with the pricing policies of large-scale
enterprises.
• It is also called Harvard tradition
• According to this paradigm, there is a priori relationship
between the three concepts of industrial economics, market
structure, market conduct and market performance.

 The link between these three is that market
structure of an industry determines or strongly
influences the crucial aspects of its market conduct
which in turn directly or indirectly determines
certain important dimensions of its performance.
 This link gives us the basic framework for the study
of the economic behaviour of the firms and industry
in the market.
 As per this paradigm, the industrial structure, which
is exogenously given, determines the conduct of
firms and the performance of the industry.

 SCP approach state the unidirectional and
linear relationship between the three
variables:
Basic Condition  Structure  Conduct 
Performance
Functionally, the relationship on which the Harvard Tradition
of the SCP paradigm is based is given as: P =ƒ(C) and, C=ƒ(S).

Basic Conditions
The concept of the basic conditions operates on
both sides of the market, supply and demand.
On the demand side, the basic condition
includes:
 the size of the market
 the growth of the market as well as its dependence
on seasons and the business cycle
 the elasticity of demand and
 the availability of substitutes are also among the
basic demand factors acting as the basic condition.

• On the supply side:
 the basic condition encompasses the nature of relevant
technology-divisible or not
 high or low elasticity of input substitution; the
durability of the product, business attitudes, the value-
to-weight ratio, location and ownership of essential raw
materials
 number and location of firms, distribution,
advertisement, marketing
 degree of work force unionisation
 the legal and social factors such as regulatory
framework and availability of vital inputs may be
included.

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• Jointly, there are public policies that affect
both the supply and demand sides.
• These include:
taxes and subsidies
international trade rules
regulation and antitrust laws and price controls

Market Structure
 Market structure refers to how the different sellers
and buyers are linked together.
 The major elements of market structure describe
ways in which markets depart from the conditions
that describe perfect competition.
 Market structure has certain basic aspects;
 internal aspects (the number and size of buyers and
sellers) and
 External aspects (the conditions of entry and exit)
 To understand the market structure, one needs to be
first familiarised with the following concepts:

 The degree of seller concentration: this refers to the
number and size distribution of firms producing a
particular commodity or types of commodities in a
market.
• In perfectly competitive market model, we assume that
there are very large number of buyers and sellers,
standardized product, free entry, free exit and complete
and perfect knowledge.
• Thus, no single firm is able to influence the price of the
product in such a market.
• A competitive industry will in the long run supply a
product at a price equal to its average cost and
marginal cost. That is, P = AC=MC.

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• In contrast, a monopolised market is supplied by a
single seller, who is able to restrict output and hold
the price above the marginal cost of production i.e.
P > MC.
• There is only one seller in the market with zero or
almost negligible cross elasticity of demand for its
products.
• In this case, there is full market power over price
and quantity decisions.
• This implies that from the view point of the society,
imperfect markets such as Monopoly are inefficient
unlike the perfect competition model.

 The degree of buyer concentration:
– this shows the number and size distribution of
buyers of the commodities in the market.
– The essence of the matter is that concentration of
power in one part of a market will evoke balancing
concentrations of power in other parts of the
market.
– When a few large buyers bargain with a few large
sellers, it will be more difficult for sellers to hold
the price above the cost, keeping all other factors
constant.

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 The degree of product differentiation:
• this shows the difference in the products of different firms in the
market.
• In competitive market, rivals sell a homogeneous product.
• This is never the case in the real world. Products are always
differentiated in some way.
• As differentiation increases, the products of different suppliers
become poorer substitutes for one another and hence the producer
becomes more and more like a monopolist.
• This would increase the power of the producer to control its
selling price.
• Thus, we can say that there is a trade-off between market power –
the power to control prices – and product variety.
• More variety imply more power to control prices so likely to get P
> Mc

 The condition of entry to or exit from the market:
• this shows the relative ease with which new
firms can join the category of sellers in the
market or leave it.
• The role of entry is important in that with entry
even the most complete monopoly is open to
competition from new entrants.
• Entry conditions explain the number and size
distribution of firms that operate in a market.
• So entry condition affects conduct and
performance in its own right.

• Other related aspects of market structure relate to
The extent to which firms one vertically integrated
back to their sources of supply or forward to the final
markets,
The degree of diversification of individual firms,
Technological, geographical and institutional factors
present in the market and conditioning the behavior
and performance of the firms.

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Market Conduct
Market Conduct refers to the pattern of
behaviour that firms follow in adopting or
adjusting to the market in which they operate
to achieve well defined goal(s).
That is it is all about:
 pricing and output determination
 investment, marketing and
 product design by a firm or industry

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• Given the market conditions and the goals to be
pursued, the firm will be acting alone or jointly to
decide about:
– the price levels for the products
– the types of products and their quantities
– their design and quality standards
– advertisements and so on.
• Generally, market conduct refers to:
– the decisions, policies and strategies of firms and or
– producers with regards to pricing behaviour and or
– policies, investment, Research and Development and
various forms of strategic alliances with other firms.

• The entire process of reacting to the market
situation in pursuit of the desired goal is called the
‘market conduct’.
• Market conduct is a subject that becomes interesting
only when competition is imperfect.
• Under perfect competition, a firm can sell all its
products at the market price.
• In such circumstances, a firm has no incentive to
advertise, to react to what rivals do, or to attempt to
discourage entry. When the competition is imperfect,
however, the behaviour or conduct of the firm is
quite different.

• In general, market conduct includes the pattern of behavior
followed by firms in the industry when adapting to a particular
market situation. It includes:
i. Pricing behaviors of the firm or group of firms:- This includes
a consideration of whether price charged tend to maximize
individual profits, whether collusive practices in use tend to
result in maximum group profits or whether price
discrimination is followed.
ii. Product policy of the firm or group of firms - For example, is
product design frequently changed? Is product quality
consistent or variable? What variety of products is made
available?

iii. Sales promotion and advertising policy of the firm or group
of firms – how important are sales promotions and advertising
in the firm or industry’s market policy? How is the volume of
this activity determined?
iv.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?
v. 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?

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Market performance
• Market performance is the end result of the activities
under taken by the firms in pursuit of their goals.
• Market performance is all about allocative efficiency,
profitability, equity, employment effects and rate of
innovation of a firm.
• Society wants good performance from producers of
goods and services.
• Good performance is multidimensional embodying many
variables.
• Performance refers to whether or not firm’s operations
enhance economic welfare – Pareto optimality where
firms set prices equal to marginal cost.

• Generally, good market performance is a
multidimensional concept which includes the
following elements:
• Resources should be allocated in an efficient manner
within and among firms such that these resources
are not needlessly wasted and that they are
responsive to consumer desires. How effectively are
resources allocated across industries and products?

2. Technical or operational efficiency--how closely do
existing firms, as a group, achieve lowest possible
costs?
• Are they large enough to capture scale economies?
• Is there too much unused capacity?
• Are they located to minimize transport costs?
• Is there labor efficiency?

3. Exchange Efficiency-refers to the costs of arranging
transactions (transaction costs), v such as
• Inspection of goods to pair buyers and sellers--this is reduced
if there are grades and standards that allow trading on the
basis of description.
• Information flows (related to market transparency)
• Ability to trade openly
• Various forms of vertical coordination, including vertical
integration.
• Include pricing efficiency--i.e., the degree to which prices
accurately and rapidly transmit changes in supply and demand
to participants in the market.

4. Profit Rates: normal profit is the indicator good market performance.
Profit serves as the:
• Returns to management and risk taking
• Returns to capital investment
• Signal to guide resource allocation in the economy.
Chronic excess profits representing a failure of the market system:
 Indicate too few resources are flowing into the industry
 May be a result of concentrated market structure and high barriers
to entry.
 May have undesirable income distribution
• Chronic sub-normal profits may indicate a sick or declining industry.

5. Level of Output
• The level of output is separate from profit levels
because output level not necessarily directly related
to profit levels in real world.
6.Producers should be technologically progressive;
that is, they should attempt to develop and adopt
quickly new techniques that will result in lower costs,
improved quality, or greater diversity of new and
better products.

7. Product Suitability- involves matching products with consumer
preferences.
• The quality level of products should be neither too high nor too
low relative to consumer desires. It is also related to
progressiveness--designing new products and new handling
methods to satisfy better changing consumer demands.
For example for Food industry
• Freshness condition of food--food not deteriorated if
consumers are willing to pay for the extra care to assure the
freshness.
• Safety of food products
• Nutritional integrity of products

8.Production resources should be organized in
such a way to encourage an equitable
distribution of income.
9. Producers should operate in a manner that
encourages continued full employment of
productive resources.

10. Participant Rationality-deals with adequate market information to
make rational choice and avoidance of misinformation.
 The need to provide market participants with a reasonable
opportunity to make comparisons may require certain mandatory
coordination and impartial types of information.
E.g., Inspection, Grading, Standards of identity, Standardized containers
and packing (truth in packaging law), Standardized quotations (e.g.,
unit prices, standard mileage estimates), price posting, market news,
product tests.
 Participants in the market should have a reasonable opportunity to
be well informed and should exercise freedom of choice rationally in
their own interests (except when private advantage obviously
conflicts with social welfare).

11.Conservation- refers to the extent to which a firm
or industry promotes the conservation of natural
resources. No needless depletion or inefficient
extraction plus exploration.
12. Labor Relations- covers equal opportunity,
working conditions, wage levels and wage
structure, working rules. Norm includes fair
treatment (no race, sex discrimination), mutual fair
treatment, reasonable communication and respect.

13.Unethical Practices: firms should not engage in the
production and distribution of undesirable
products/services.
What is ethical is culturally determined, which
poses problems when different cultures try to
trade, either within a country across ethnic groups
or internationally. Examples
• Undisclosed danger--related to food safety
• Fraud and misrepresentation--related to advertising
• Adulteration

Critics and Alternative Theories
Critics from Within the SCP Paradigm
the linearity of the relationship among S, C and P.
 The linear S-C-P model assumes a very simple direct and
one-way causal relationship.
• In actual world, however, industrial relationships are
not so simple and linear.
• It need not be unidirectional running from the
structure to the performance but may operate in some
situations in the complete reverse way or may be
segmented or partial reversal showing cross links
between any two of the three aspects.

 The relationships among structure, conduct and
performance are complex and interactive.
• There is partial reversal of the direction of causality in
the sense that product differentiation may exclude
some firms and may thus alter market structure.
• In fact Scherer (1970) introduced the notion of a
simultaneous interdependence of the three elements of
the harmony. There are two aspects of such critics:
 Reverse causation, which may be complete reversed
causation, P→C→S or partial reversal, like P→C or
P→S or C→S;
 Simultaneous causation, where C→S and at the same
time S → C.

Framework of Industrial Economics
• Since the proponents of the Harvard tradition (the first
wave of industrial economics) accorded structure as
influential or even determinant role, their view came to
be known as a structuralists’ conception of Industrial
Economics.
• The essence of the structuralists approach (SCP
approach) is a presumption that industries having fewer
firms will tend to engage in conduct inconsistent with the
norms of perfect competition.
• Thus we observe, P > MC, strategies to deter the entry
of new firms, evidence of implicit or explicit collusion
among industry members, and so on.

Basic Conditions
1. Social and political choices; Technology Economies of
scale; Demand & Supplies; Elasticities, tastes etc.
,Input prices; business attitudes; product durability; regulation;
Market Structure
Concentration; Size distribution, Number of firms;
Barriers to entry; Monopolistic competition; Vertical
integration, etc.
Market Conduct
Price policy; Product policy, financial policy;
R&D activities; Advertisement; Collusion, etc.
Market Performance
Profitability; Growth rate; Technological
advance; Equity; etc.

• A major defect of the structuralists model is that
it is too simplistic, ignoring many of the
linkages, which can be argued to exist between
the elements.
• The problem is that it is based on linear
determinism.
• A general theme is that conduct is very often
not wholly determined by structure; firms have
a wide degree of discretion over their conduct,
and the decisions they make affect the structure
of the industry and indeed the basic conditions.

1.3.2.The Chicago School of Thought
• The Chicago School gives high accord to Conduct.
The method of analysis of this school relies on the
traditional standard perfect competition model.
• Criticized the SCP model for being non-theoretical
and for having diverged too great an extent from the
basic neoclassical price theory.
• The school argues that even if their (SCP) empirical
work was based on more realistic assumptions, it
came up with nothing more powerful in predictive
ability than the traditional perfect competition model.

• In the SCP paradigm, high concentration was believed to be
collusion and enhance high profit implying the need for
government intervention.
• But the Chicago school argues that when concentration is high,
firms tend to be large. Larger firms tend to be more efficient and
this greater efficiency leads to higher profit. Thus, nullifying
(making void) the reason as to how government should intervene.
• For thinkers of this school, competition is an ever – present
reality. This school is more antipathetic (strong dislike to
government intervention).
• According to this school, government may intervene only if the
reason to higher profit is the act of collusion of firms.

1.3.3.Institutional Economics
• The central message of the New Institutional Economics is
that institutions matter for economic performance.
• The fundamental idea is that transaction costs do exist,
are significantly large and they can shape the structure of
institutions and the specific economic choices people
make (i.e. Economic behavior of economic agents such as
firms).
• According to the transaction cost school, institutions that
lower the costs of transactions are the key to the
performance of the economies. These costs include those
of information, negotiation, monitoring, coordination
and enforcement of contracts.

• Under what circumstances will transaction costs be lower
when internalized than when left to be negotiated in an
external market?
• The factors can be either environmental factors or human
factors. The key environmental factors are uncertainty and the
number of firms whereas, the key human factors are bounded
rationality and opportunism.
• Bounded rationality is the limited human capacity to
anticipate or solve complex problems. Problems arise when
uncertainty is combined with bounded rationality, or where
the managers of the few firms in an industry behave
opportunistically.

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