CHAPTER 1: INTRODUCTION

1.

Industrial Organization (IO) or Industrial Economics is a study of imperfect competition. Perfect competition and perfect monopoly are useful models, but it is like studying physics w/o gravity and friction. Also stressed is the notion of effective competition. Roots trace back to Mason (1939) and Bain (1949), making it a relatively new field in economics.

2.

3. Mainstream models from Adam Smith to Alfred Marshall were primarily perfect competition & Monopoly. 4. First mainstream model of imperfect competition was Chamberlains model of monopolistic competition (1933) 5. IO regarded as a branch of price theory. 6. Earliest model was Structure-Conduct-Performance More empirical than theoretical Central issue is barriers to entry Perceived as descriptive, static, and nonanalytical

7.

Modern IO based more on theory, particularly game theory and price theory Formal oligopoly theory More theoretical than empirical Strategic (dynamic) analysis is important Consider dynamic efficiency

Structure Conduct Performance (S-C-P) Paradigm Market Structure (competitiveness of the market) Number of firms (CR, HHI) Barriers to entry Cost structures (economies of scale) Demand conditions (elasticity) Product differentiation, Vertical integration, and Diversification Conduct (behavior) Price and output decisions Advertising R&D Collusion Merger and Contract Performance (success in producing benefits for consumers) Allocative and production efficiency (static) Price and profits Equity Quality and Technical progress (dynamic)
Market
Perfect Competition Monopoly

Structure
Many firms, CR and HHI low One firm, CR=100, HHI=10,000

Conduct
Marginal Cost Pricing MR=MC (P > MC) Restrict output, P

Performance
Static Efficiency [max (CS + PS)] P = MC = min(AC) Inefficient Deadweight Loss

Bad Structure Bad Conduct Bad Performance

Notes on S-C-P Paradigm 1. Market better with more firms 2. Entry barriers are central issue 3. Conventional wisdom is that S C P ( means causes )

Problems: (Discuss)
1.

Causal flows are very complex, e.g., good P bad S

2. Conduct is often strategic only loosely associated with structure. 3. What are the implications of the following? Product differentiation Vertical integration Bundling or tie-in sales Must consider economic incentives.

4.

Modern or New IO Paradigm 1. The more recent approach has been more concerned with developing and testing explanations of firm conduct 2. Key features are: Emphasis on specific industries Focus on developing models of firm behavior

Empirical work based on well-founded theory

3. Models are based on price theory analyzing economic incentives to explain market phenomenon. Three specific theoretical applications are:

Transaction cost analysis (firm & market are alternative means of organizing economic activity MAKE versus BUY) Game Theory (models of business strategy) Contestable Markets (not much empirical evidence)

Strategic thinking is the art of outdoing an adversary, knowing that the adversary is trying to do the same to you. The science of strategic thinking is called game theory
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Dixit & Nalebuff, Thinking Strategically

FIRM ORGANIZATION AND BOUNDARIES Vertical Integration (hierarchical in make mode at every stage of the vertical chain) Raw Inputs Intermediate Goods Assemblers Transportation/Warehousing Retailers

MAKE: Relying on the visible hand of management to produce or make. BUY: Relying on the invisible hand of the marketplace to obtain products or services.

Make-or-Buy (Modern Automobile Companies) Raw Inputs Intermediate Goods Assemblers Transportation/Warehousing Retailers

Make-and-Buy: Do both (make and buy) at one stage Virtual: Buy at all stages Issues: 1. Vertical Restraints Resale price maintenance
2.

Double marginalization

3. Foreclosure Firestone tires

SHORT HISTORY 1880s: Modern study of competition & monopoly 1920s: Current ideas of degrees of monopoly, oligopoly, economies of scale, innovation, & efficiency 1930s: (1) More complex theoretical models (monopolistic competition) and (2) SCP model. 1940s-1950s: (1) Beginnings of game theory (2) Empirical testing of S-C-P model (3) Chicago school rising 1960s: Chicago school challenging S-C-P. Deregualtion and monopoly may be good 1970s: Beginnings of New IO based on game theory. New Chicago school (monopoly good, collusion always collapses) 1980s: Contestability 1990s: Some fusion. New Empirical IO based on theoretical oligopoly models.