Econ 465: Industrial Organization

1
Econ 465 Industrial Organization

• Course Outline
• Microeconomic Review
• Chapter One The Business Sector and its
  Organization
• The Basic Theory of the Firm
• Industrial Organization from the Principles of
  Microeconomics
• Structure-Conduct-Performance Paradigm
• Chapter Two Elements of Market Structure
• Chapter Three The Large Corporation
• Chapter Four Market Conduct
• Chapter Six The Promotion of Competition and the
  Control of Monopoly (Optional)
• Chapter Five Market Performance
• Case Studies
• Introduction to Game Theory

2
Chapter One The Business Sector and Its
Organization

• Outline
• Defining the subject to be examined.
• Establishing the motive for the economic actor to
  be examined.
• Defining the economic actor to be examined.

3
Industrial Organization Defined

• Industrial Organization The study of the
  structure of firms and markets and of their
  interactions.
• Industrial Organization lies between macro theory
  (study of the entire economy) and micro-theory
  (study of individual people and firms). The
  focus of this class is how the environment firms
  are placed within impacts the decisions and
  outcomes firms achieve.

4
Approaches to Industrial Organization

• Structure-Conduct-Performance Paradigm
• Game Theory
• Price Theory
• Transaction Cost Theory
• Contestable Market Theory

5
Structure-Conduct-Performance Paradigm

• Market structure - the relatively stable features
  of the market environment that influence the
  rivalry among the buyers and sellers operating
  within.
• Market conduct - the policies that participants
  adopt toward the market with regard to the price,
  product characteristics, and other factors that
  impact market transactions.
• Market performance - a normative appraisal of the
  social quality of the allocation of resources
  that results from a markets conduct.

6
Examples of Market Structure Elements

• Seller concentration
• Product differentiation
• Barriers to entry of new firms

7
Examples of Market Conduct Elements

• Pricing behavior
• Integration and merger activity
• Research and development
• Advertising

8
Examples of Market Performance Elements

• Production efficiency
• Allocative efficiency
• Equity
• Product quality
• Profits

9
A Note on the S-C-P Paradigm

• The structure-conduct-performance paradigm seeks
  to show the relationship between the rules of the
  game (market structure), how the game is played
  (market conduct), and the outcome of the game
  (market performance).
• The paradigm is extremely flexible in how it is
  applied to a particular industry. In essence, the
  entire paradigm is simply a collection of case
  studies.
• One should note, though, that the paradigm lacks
  generality and theoretical rigor. Hence, other
  tools are necessary.

10
Game Theory

• Game Theory - a theoretical approach that uses
  formal models to analyze conflict and cooperation
  between firms and individuals.
• Game theory describes how firms form their
  strategies and how these strategies determine
  outcome (generally profits).
• Game theory was introduced by von Neumann and
  Morgenstern in 1944.

11
Do Enterprises Maximize Profits?

• Why is this question important?
• We wish to both explain and predict human
  behavior. Before we can hope to accomplish
  either objective, we must first establish the
  purpose of such behavior.

12
Do Enterprises Maximize Profits? cont.

• The argument for profit maximization
• In the long-run, assuming competition,
  inefficient firms will not be able to compete
  with efficient firms. In other words, firms that
  do not profit maximize will not survive over
  time.
• Problem Many firms participate in industries
  that are not competitive.

13
Do Enterprises Maximize Profits? cont.

• The work of Adolf A. Berle and Gardiner C. Means,
  as updated by Edward Herman.
• In 1900 23.8 of the largest 200 non-financial
  firms were controlled by management.
• In 1974 82.5 were controlled by management.
• In 1900 12.5 of the largest firms were
  controlled by majority stockholders.
• In 1974 1.5 were controlled by majority
  stockholders.

14
Do Enterprises Maximize Profits? cont.

• What are the objectives of management?
• Utility maximization
• Size and Growth
• Perquisites
• Risk avoidance
• Remember, managers cannot diversify as easily as
  shareholders.
• The empirical evidence suggests that firms
  controlled by management are less profitable and
  less likely to take risks.

15
Do Enterprises Maximize Profits? cont.

• A cursory examination of large corporations leads
  one to ask if anything is being maximized.
• Despite this observation, over time firms need to
  employ methods that limit costs and expand
  revenues if the survival of the firm is to be
  assured.
• Thus, in general, assuming profit maximization
  does not take one too far astray.

16
Industries in the Economy

• Having established motivation, exactly which
  economic actors are we seeking to examine?
• Industry the sellers of a particular product.
• Such a definition requires elaboration.

17
Industries in the Economy, cont.

• To be considered in a particular industry, a firm
  must be sensitive to the decisions of other firms
  in the marketplace. Furthermore, the firm should
  not be sensitive to decisions made by firms in
  other markets.

18
Industries in the Economy, cont.

• Problems in defining markets
• Defining the product being sold
• The DuPont Case
• Is Pepsi and Orange Juice in the same market?
• Is a Kia in the same market as a Lexus?
• The problem of geographic distance
• Is the price of gasoline in Bakersfield
  influenced by prices in Topeka, Kansas?
• The problem of international trade
• How concentrated is the U.S. automobile market?

19
How do we establish industry boundaries?

• The Cross-Price Elasticity
• Percentage change in sales for firm X /
  Percentage change in price of firm Z
• If sales of X are not very responsive to prices
  for Z, then these two firms are probably not in
  the same market.
• Note We do not rely on the observation that the
  two goods could be used for the same purpose.
• Additional Note We also do not ask people
  whether or not the goods are viable substitutes.