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Industrial Organization

INTRODUCTION

Measurement of Industrial Concentration and Market Power Suppose there are N firms in an

industry Define si as the market share of firm i

which produces (or sells) qi

n-firm concentration ratio (CRn)Combined market share of the n largest firms.

Advantage: doesn’t require data on every firm Disadvantage: insensitive to distribution of shares

within the n firms and within the remaining N –n. E.g. if we find CR4 = 0.8, this could mean either .2+.2+.2+.2,

or .5+.1+.1+.1. In the first case, the remaining 20% of the market could be supplied by two firms or several hundred!

Misleading if N < n. E.g. any industry with 1-4 firms will always have CR4 = 1!

Hirschman-Herfindahl Index (HHI) Sum of the squares of

the shares of all the firms in the industry.

Advantages and disadvantages are reversed relative to CR.

Both HHI and CRn range from close to 0 (perfect competition) to 1 (pure monopoly).

Lerner Index of Monopoly Power (L) and Price-Cost Margin (PCM) L = (P-MC)/ P

PCM = (P-AVC)/P

The two are equal if we assume constant returns to scale (i.e. AVC = MC = c).

Range from zero for perfect competition to = 1/(demand elasticity) for monopoly

Data on MC or AC is hard to get, but we can calculate PCM = (TR-TVC)/TR = (PQ – cQ)/PQ = L

or (VA-emoluments)/value of output-- so PCM is also a measure of profitability

The “Structure-Conduct-Performance” Paradigm (Harvard School)

Dominant from 1950s-1970s Tries to establish an empirical

relationship between industry structure, conduct and performance

Still used extensively in studies of Indian industry

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Structural variables Number and size distribution of buyers and

sellers Degree of product differentiation

horizontal (differentiation by variety) vertical (differentiation by quality)

Entry barriers/incumbency advantages Cost advantages: economies of scale, experience,

knowhow, access to resources Legal barriers: patents, regulation, licensing

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Conduct variables Price Product strategy Advertising R&D Investment in capacity Mergers and acquisitions

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Performance variables Profits or PCM Tobin’s q Efficiency

Technical (productivity) Dynamic (productivity growth)

Employment, wages etc. Equity

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SCP HypothesisStructure Conduct Performance

Usually tested in a cross-industry regression such as:

PCM = f(Scale econ, Conc, K/O ratio, Advt exp/sales,R&D exp/sales, import competition…)

Most such studies find positive coefficients for these regressors (negative for import competition).

But critics pointed out statistical problems: Simultaneity: e.g. high profits can promote entry ( lower

Conc), advertising expenditure and R&D. Accounting profits not the same as economic profits

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1960s-80s: The Chicago School More efficient firms have higher market shares and higher

profits, so correlation between concentration and profitability (PCM) is evidence of efficiency, not market power or collusion.

Free market outcomes are generally competitive, even with a few firms, as long as free entry is allowed

Government restrictions are the main cause of durable monopoly power. Policies to correct market failure are costly and have unintended consequences

Applies standard micro-economic theory beginning with firm behaviour, not industry structure as in SCP.

Efficiency (social welfare) should be the only criterion of performance.

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New Industrial Organization (late 1970s onwards) Consumer theory: Microfoundations of demand for

differentiated products

Use of non-cooperative game theory to model strategic behaviour, with applications to

1. Producer theory: (conduct) by firms, which can influence industry structure (may reverse SCP causality)

2. Theory of antitrust (competition policy) 3. Market structure, innovation and R&D4. Theory of the internal organization of the firm 5. Theory of corporate finance/governance6. Theory of regulation

This course deals with 1, with some applications to 2. Course 803 deals with 3 and 4; course 608 with 6.

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