L1 - Introduction to Industrial Economics

ECN4181 – Industrial Economics

Lecture 1

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Introduction to Industrial Economics

Contents – introduction to ECN4181

Course objectives

Topics

Suggested textbooks

Method of assessment

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Course objective

The course deals with the economic analysis of industry and

attempts to provide satisfactory explanations of the ways in

which economic forces operate within the industrial sector.

The course covers the applications of micro-economic theory

to the analysis of firms, markets and industries.

Central to this branch of economics is the "Structure-Conduct-

Performance" paradigm, and its reformulations. The course will

also cover industrial policy and competition policy aspects

relating to Malta within the EU context.

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Topics1. An introduction to Industrial Economics

2. The Structure-Conduct-Performance Paradigm

3. The Firm and Corporate Growth

4. Market Concentration

5. Diversification, Merger and Innovation

6. Pricing and Advertising

7. Monopolies

8. Foundations of Industrial Policy

9. Industrial Policy in Practice

10. State or Private Control

** Past Papers

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Suggested textbooksAny one of the following textbooks may be considered:

John Lipczynski and John Wilson (2001), Industrial Organisation: An analysis of competitive markets

Paul Ferguson and Glenys Ferguson (1994), Industrial Economics: issues and perspectives

Ken Heather (2002), The Economics of Industries and Firms

Throughout the course reference will be made to a number of suggested readings / references. A list of these suggested readings will be provided after each lecture.

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Method of assessment

Exam. Exam will not be limited solely to material covered in lectures but will also include material within the relevant textbook(s) or additional readings from text indicated throughout the course.

Assignment. As from this year, assessment will also be based on an assignment requiring an analysis of a local industry from an industrial organization point of view. More information (length, suggested plan, industries to choose from) on the assignment will be provided at a later stage.

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Contents– an introduction to Industrial

Economics

What is industrial economics?

Industrial organization vs. industrial economics

Industrial dynamics

Theoretical foundations of industrial economics

Objectives in industrial economics

Managerial/ business economics vs. industrial economics

Developments in neoclassical theory: Firms, Industries and Markets

Structure-Conduct-Performance

Developments outside neoclassical theory

Data collection and interpretation

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What is industrial economics? Definition: “The application of micro-economic theory to the

analysis of firms, markets and industries.” (Ferguson & Ferguson pg. 1)

Background: Prior to the 1950s, the economic analysis of industry was not

recognised as a distinctive branch of economics. In The Organization of Industry, Stigler (1968) argues that industrial economics does not really exist as a separate discipline, but is simply differentiated microeconomics.

This misses the point that Industrial Economics relies heavily on: Empirical work and research -see slides on “Data Collection & Interpretation”

Implications for policy

Even though emphasis has been on secondary/ industrial sector of the economy, there is no reason why study of the primary or tertiary sector should not also be included within Industrial Economics.

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What is industrial economics? The financial/ economic/ sovereign debt crisis has seen a

return of industrial policy. Examples:

UK: Industrial policy as a vehicle for creating high-skill jobs;

France: using industrial policy to keep industrial jobs;

Japan: creating of a new “Japan Inc” to deepen links between industry and state

World Bank: support of industrial policy to speed up structural change in developing nations;

McKinsey consulting advising government on how to do it right

Dani Rodrik (2010), The return of industrial policy

The Economist (2010), The global revival of industrial policy

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Industrial organization vs. industrial

economics

Often the term industrial organization is viewed as synonymous with industrial economics.

But industrial economics has 2 components (Carlsson 1989):

E.g. Industrial organization – presence of monopoly in the economy reduces society‟s welfare

E.g. Industrial dynamics – why monopoly developed, how long will it persist

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INDUSTRIAL ECONOMICS

INDUSTRIAL ORGANISATION: the study of a structure of

industries at a particular point in time

INDUSTRIAL DYNAMICS: the study of the evolution of industry

as a process in time at both the macro-level, the sector/ industry

level and the firm level

Industrial dynamics Therefore industrial dynamics varies from industrial organization

in that its main focus of attention can vary from the firm, to relationships between firms, to links between microeconomics and macro economy. The subject matter of industrial dynamics is: The nature of firm economic activity and its connection to the

dynamics of supply, and therefore economic growth, as well as the role of knowledge;

How firm boundaries and degree of firm interdependence change over time, and what role this interdependence plays in economic growth.

The role of technological change and the institutional framework conducive to technological progress at both macro and micro levels.

The role of economic policy in facilitating or obstructing adjustment of the economy to changing circumstances at both micro and macro levels – i.e. industrial policy

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Theoretical foundations of industrial

economics According to Knudsen et al (1993), in Rationality, Institutions and

Economic Methodology, it is important to differentiate according to whether the focus of analysis is on the decision-maker or on the transaction. If we consider the decision-maker (individual, household,

entrepreneur) the main interest is how groups of decision makers interact and respond to changes in market circumstances.

If we consider the transaction (which involves agreements between economic agents), the concern is with the nature of the agreement: whom it involves (managers, owners, other firms, the government), the form it takes, extent to which it can be monitored and policed effectively.

Knudsen adds that economic approaches differ according to their treatment of RATIONALITY, i.e. extent to which individuals possess information and are able to process it effectively.

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Theoretical foundations of industrial

economics MAXIMISATION RATIONALITY -> individuals have all the

information relevant to any decision, which they are able to utilise effectively to maximise profits or utility.

BOUNDED RATIONALITY -> individuals make decisions on the basis of partial information, where each decision is made separately on the basis of current information.

PROCEDURAL RATIONALITY -> here general behavioural „rules‟ (cultural or learned) are established and the lessons of the past are carried forward to help solve current problems. (i.e. coping with a complex and changing environment)

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Objectives in industrial economics

The broad objective of industrial economics is the

development of satisfactory explanations of the ways in

which economic forces operate within the industrial sector.

This is really identical to the broad objective of micro-

economic theory, but draws on a variety of theoretical

approaches...

The aim is therefore essentially the same as that of other

fields of economics... describe, explain and draw conclusions

about effectiveness with which scarce resources are used –

criteria against which to judge are required.

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Managerial/ business economics vs.

industrial economicsi. Managerial Economics assumes that the firm aims to

maximise profits – albeit constrained by other objectives (subject matter of upcoming lectures) – and then proceeds to examine the way in which decision rules and procedures of the firm SHOULD be formulated, to achieve the stated objective. Industrial Economics is POSITIVE (i.e. descriptive) not NORMATIVE (i.e. value judgements) and focuses on explaining the working of existing systems, and being able to predict the effect of changes in variables within that system.

ii. Managerial Economics is inter-disciplinary (i.e. integrates concepts across different disciplines, including management, economics but also mathematics – operations research, programming) while industrial economics is not inter-disciplinary to the same degree and in the same way.

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Developments in neoclassical theory:

Firms, Industries and Markets Starting point: In the one-product, perfect-competition market

model, the relationship between firm, industry and market is relatively straightforward:

INDUSTRY MARKET16

FIRM A FIRM B FIRM C

(same industry)

Product X (identical)

Sold in the same market


Firms, Industries and Markets But is this actually the case in reality? Many firms are large and multi-product, and hence produce in more than 1

industry and sell in more than 1 market.

Each industry, as conventionally understood, produces a range of different products, many of which are not close substitutes, and which are sold in a variety of different markets.

In reality we depart from the perfect competition model

INDUSTRY MARKET

A study of the “market” may provide too narrow a framework for the analysis of certain types of business behaviour (e.g. collusion, business innovation, responses to Government policy changes)

Hence the broader “industry” concept based on institutional or statutory reality is more helpful than a market framework

Similarly, the influence of potential competition on long-term business behaviour may be better analysed using a broader industrial framework.

Overall, both “market” and “industry”, and “market” and “firm” should be viewed as complementary rather than as competitive concepts in industrial analysis.

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Structure-Conduct-Performance The SCP paradigm dominated the study of industrial economics in

the post WWII period.

The development of theories of IMPERFECT COMPETITION by Chamberlin (1932, The Theory of Monopolistic competition) and Robinson (1933, Economics of Imperfect Competition) has focused attention on the structure of markets, rather than industries, as determinants of business and industrial behaviour.

This led to the notion that both business conduct and business performance of firms are dependent upon the structure of the markets in which they sell, i.e. Market Structure –> Market Conduct –> Market Performance Paradigm / model

SCP to be discussed in detail in Lecture 2

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Structure-Conduct-Performance However since the 1970s the SCP paradigm has been criticised as it may

provide a far less suitable analytical framework for large diversified enterprises than for small firms assumed to operate under perfect or near-perfect market conditions.

The behaviour and performance of small firms may be strongly influenced by the exogenously determined structure of the market in which they operate, but in the case of the large multiproduct firm, the extent of the influence of market structure on behaviour and performance is more questionable.

The atomistic market is now a rarity - in practice many firms possess the power to alter significantly the level of output and prices in a market. Through technical innovation, product diversification or merger, firms may transform the structure of a market, or indeed of many markets.

Furthermore the existence of market imperfections confer upon individual firms a considerable measure of discretion in the goals that they are able to pursue; profit maximisation and technical efficiency are no longer the essential goals for survival.19


Structure-Conduct-Performance

Therefore the Structure-Conduct-Performance framework is

weakened at 2 important points:

1. The conduct of large firms may change market

structure; that is, the assumed chain of causality is

reversed.

2. Discretion in the formation of business goals

further weakens the dependence of market

performance on market structure.

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Structure-Conduct-Performance New industrial economics attempts to sharpen the SCP approach by relating it

more rigorously to neoclassical theory – oligopoly, game theory (work by Spence, Stiglitz, Cowling)

Baumol‟s concept of contestability – (i.e. market served by a small number of firms, but which is nevertheless characterized by competitive pricing because of existence of potential short-term entrants; low barriers to entry and exit; 'hit and run' competition. e.g. Low-cost airlines) – competitive forces generally hold sway, so alternative explanations are required

Monopoly may be benign, but may also beneficial to economic welfare since it can lead to innovation (Chicago School – sometimes arguing for very little scope for government anti-trust policy)

Public choice theory (Buchanan) – extension of neoclassical theory to politicians and bureaucrats – those in power are assumed to seek to maximise their own welfare (traditionally, economists have argued that government corrects for market failure) – if politician‟s objectives are not always altruistic: government failure.

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Developments outside neoclassical

theory Companies are owned by shareholders, but run by a team of professional managers who

face an uncertain future and take decisions based on imperfect information.

Principal-agent theory – contracts between principal and agent which can be drawn up in order to align the agent‟s interests with those of the principal... e.g. tying salary with profit performance

Institutional economics – formal and informal social rules – institutional environment (political, social and legal ground-rules. e.g. property rights) and institutional arrangements (firms, political parties)

Uncertainty that characterise the real world of industrial economics... surprises can occur because the future is unknown. Qualitative over quantitative measurement of net effects.

Transaction cost theory (Arrow) – costs of running the economic system... costs involved in acquiring information and those involved in effecting transactions (e.g. purchase a house – locating a house, etc)

Austrian school – competition as a process rather than as the static market structure of perfect competition – economic agents may modify their behaviour – this might lead to conclusions and policy prescriptions which differ from those of the SCP analysis.

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Data collection and interpretation The collection of statistical data and its use in measuring economic variables and

testing economic relationships is a very important element in industrial analysis.

Normally data at market or at firm level will not be readily available for reasons of confidentiality, but many data types are available in aggregate form at national level.

Any sample used from a survey method should be “typical” of the population from which it is drawn, so that the results obtained from the sample also apply to its population. However the sample cannot be fully typical; therefore a method is needed to determine the MARGIN OF ERROR where sample data are assumed to apply to a population.

This margin of error can be estimated where the membership of the sample is determined on a RANDOM BASIS, that is, where every member of the population has a calculable probability of being included in the sample.

Hence in evaluating any empirical study based upon sample data, it is important to identify the size of the sample in relation to its population and the manner in which it was selected. Where the sample is relatively small and non-random, and where observable sources of bias in its selection exist, the conclusions of the study should be limited to the sample and not extended to the population at large from which it was drawn.

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Data collection and interpretation A further role of statistical analysis is to infer relationships from observations of variables, to

quantify the relationships wherever possible and to establish whether they are statistically significant or not. Techniques of multiple regression analysis have been developed. For example, we may wish to test the relationship between the number, and size distribution of sellers in markets (seller concentration) and the rates of profit sellers obtain.

The regression results must be subjected to examination according to the following criteria:

1. Have all explanatory variables been included in the analysis?

2. Have all the variables included in the analysis been defined in the most meaningful way?

3. Can all variables be quantified? Where they cannot, „less satisfactory‟ proxy variables may be used.

4. Are sufficient data of the required quality available to enable a satisfactory statistical test to be made? Problems may arise if sample sizes are too small or time series data relate to too short a time period.

5. Is the nature of the relationship between the explanatory variables and the dependent variable correctly specified? Sometimes, for specification purposes, linear relationships are assumed in correlation analysis, where non-linear relationships are more appropriate.

6. Are the explanatory variables correlated with each other? Where there is a high degree of correlation between two explanatory variables included within the same regression equation, the coefficients attached to them cannot be treated as reliable.

7. To what extent are the coefficients of the explanatory variables statistically significant, and how successful is the reported equation in explaining the observed variation in the dependent variable under examination? The value of the standard error attached to each explanatory variable‟s coefficient and of the R2 for the reported equation as a whole is the statistical basis for making these assessments.

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Next lecture…

1. AN INTRODUCTION TO INDUSTRIAL ECONOMICS

2. THE STRUCTURE – CONDUCT – PERFORMANCE

PARADIGM

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L1 - Introduction to Industrial Economics

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