WOLKITE UNIVERSITY

FACULTY OF BUSINESS AND

ECONOMICS

INDUSTRIAL ECONOMICS
Theory and Policies

Learning material for regular Students

MODULE I

Prepared by

AMSALU B. (MSc.)

Department of Economics
Faculty of Business and Economics
wolkite University

January, 2012
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 Introduction
Dear Readers

This material presents a general and brief introduction to the subject of Industrial
Economics. The main focus is on understanding the behaviour of business firms under
different market situations. This material emphasizes on topics like Industrial Efficiency,
Diversification, Market Concentration, Advertising debate, Industrial location, the
process innovation, and Industrial Policy. We have tried our level best to give theoretical
discussion and empirical research outcomes.

The knowledge in Industrial economics has become a must to all students who perused
the study of Economics. As we know very well the country like Ethiopia need a greater
consideration in the development of Industrial sector. Still majority of our population
rests on the output of Agriculture. In order to realize economic development
industrialization along with agricultural development is a must. For the complete
understanding of the process of economic development, it imperative to know the issues
to be considered in the industrialization process. Especially the case for industrial policy
is very important. We hope, after taking this course you will get a clear picture about the
theoretical and empirical content of Industrial Economics.

The material has divided into two modules. The first module consists of five chapters,
viz; Scope and conceptual framework of Industrial Economics, Industrial efficiency,
Market concentration, Approaches to Industrial location and Demand analysis and
forecasting. The second module includes the remaining four chapters such as;
Advertising debate, Invention innovation and diffusion, Diversification, vertical
integration and merger, and Industrial policy. The review questions for chapters are also
given at the end of each chapter.

We would like to thank all the officials who have assigned the duty of this material
preparation to us. We have tried our level best to prepare this material at most care and
quality, even then we are happy to here from you about all your suggestions and
criticisms.

Wish you all the best

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 CHAPTER ONE

Scope and Conceptual Framework of Industrial

Economics

Prompting Questions:

 Why industries are made the center of study? What is industrial economics?
 Mention some of the industries in your country and explain their structural
characteristics?
 Is there any need to study the subject industrial economics as a separate
discipline?
 “Market structure governs behaviour and performance. The causation runs only
one direction” True?
 How do you evaluate performance of textile industry in Ethiopia? What criteria
do you employ to measure the performance?

Desired Objectives

The reader will get acquainted with

 The meaning and scope of industrial economics

 The definitions and elementary description of some basic concepts used in industrial
economics such as firm, industry, market, market structure, market conduct, and
market performance;
 The paradigm of SCP
 The framework for the study of industrial economics.

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1.1 What is industrial economics?

Industrial economics is a distinctive branch of economics, which deals with the economic
problems of firms and industries, and their relationship with society.

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.
For example, the income (i.e. resources) of a consumer is generally limited but his wants
are unlimited. In this situation he has to adopt some criterion to achieve maximum gain
from his limited income. This is the problem of utility maximization in the theory of
consumer behavior. Similarly, for a producer, the sources like land, raw materials, labor,
capital, etc., are scarce. 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 should produce, what should be the level
output of each, what type of technology he should adopt, where should he produce the
goods, what should be the size of his factory, what price he should charge, how much
wages should pay, how much he should spend on advertisement, should he borrow from
banks or elsewhere, etc., etc. All such decisions explain the producer's behavior in the
different market situations, which we endeavor to study in industrial economics.

In microeconomics also we study producer‘s behaviour in relation to scarcity of

resources. Because of this fact, some economists would regard industrial economics as
being primarily an elaboration of, and development from, the traditional theory of the
firm taught under microeconomics. Industrial economics is best defined as the application

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of micro economic theory to the analysis of firms, markets and industries. Stigler (1968)1
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.

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 behaviour and draw normative implications. However, there are
some differences between the two. Microeconomics is a formal, deductive and abstract
discipline. Industrial economics on the other hand is less formal, more inductive in
nature. Microeconomics by and large assumes profit maximization as the goal of the firm
tells us to maximize it subject to given constraints. It is passive in approach. Industrial
economics does not believe in single goal of profit maximization. It searches the goals of
the firm from the revealed facts. It concentrates on the constraints which impede the
achievement of the goals and tries to remove them. It is an active discipline in this sense.
Microeconomics, being abstract, does not go into operational details of production,
distribution and other aspects of the firms and industries. Industrial economics does go
into the depth of such details. Public policy implications are taken care of in industrial
economics but microeconomics may shun them if necessary. It is true that the theory of
firm (i.e. microeconomics) provides the main theoretical basis for the study of industrial
economics. But several important influences from outside have given a totally different
character to industrial economics. In the light of such influences the conventional theory
of the firm is bound to be revised.

So far, we were looking at 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. With scarce
resources, the problem is to produce varieties of goods and services in-the current period

1
Paul R. Ferguson and Glenys J. Ferguson: Industrial Economics: Issues and perspectives, second edition
1994, page2
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and in future also. What goods should be produced: consumer or capital? If capital good
are preferred, then the series of problems 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. The decisions in the context of society as a whole may be at variance with the
decisions by an individual producer. If this is so, a state will clearly specify the policy
framework in which the individual producers will function. In other words, to achieve the
broader policy objectives, a state will regulate industries through varieties of ways such a
nationalization, privatization, anti-trust policies, control on prices and outputs, credit
controls, taxes, etc. A study of all such instruments of industrial regulation is an integral
part of industrial economics. How they affect the performance of the firms is a crucial
aspect to be examined under industrial economics. Such information is useful for the
regulatory agency of the government to assess the success of its industrial policy.

The term industrial organization is commonly viewed as synonymous with industrial

economics. Carlsson (1989)2 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. 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. Carlsson argues that there are four main
themes which encompass the subject matter of industrial dynamics:

1. The nature of economic activity in the firm and its connection to the dynamics of
supply and therefore economic growth, particularly the role of knowledge.

2. How the boundaries of the firm and the degree of Interdependence among firms

2
Ibid , page2
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change over time and what role this interdependence plays in economic growth.

3. The role of technological change and the institutional framework conducive to

technological progress at both macro and micro levels.

4. The role of economic policy in facilitating or obstructing adjustment of the economy to

changing circumstances (domestically as well as internationally) at both micro and macro
levels - industrial policy

When the economist turns the attention to industrial dynamics the area of investigation is
widened to analyze topics where change is central (such as innovation) and a different
perspective is taken on many of the issues of industrial organization. For instance, where
industrial organization would be concerned with the extent to which the presence of
monopoly in the economy reduces society's welfare, industrial dynamics addresses itself
to the reasons why monopoly has developed, and the question of how long it might
persist.

Coming to the conclusion of this section, we may say that 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.

Elements of industrial economics

There are two broad elements of industrial economics:

 Descriptive and

 Analytical elements.

Descriptive element is concerned with the information content of the subject. It is aimed
at providing the industrialist or businessman with a survey of the industrial and
commercial organizations of his own country and of the other countries with which he
might come in contact. It gives businessman full information regarding the natural

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resources, industrial climate in the country, situation of the infra-structure, supplies of
factors of production, trade and commercial policies of the governments, and the degree
of competition in the business in which he operates. 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 of the subject is concerned with the business policy and decision-
making. It deals with topics such as market analysis, pricing, choice of techniques,
location of plant, investment planning, hiring and firing of labour, financial decisions,
product diversification and so on. It 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. The two
elements are interdependent, since without adequate information no one can take proper
decision about any aspect of business.

1.2 Some Basic Concepts in the Study of Industrial Economics

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.

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 definition has no operational sense. A better approach to define the industry

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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. The competition among the firms as well as among their
products is implicit here. It is not necessary that the substitute goods always come from
the same industry. Two goods having similar end-use may come from two different
industries. For example, woolen blankets and electric room heaters are used for removal
of cold but they cannot be taken together as output of one industry. The nature of these
products is different; they are based on different technologies, so one can easily conceive
them as outputs of different industries. Similarly, a firm producing two different
unsubstitutable goods need not be classified under only one industry.

A business is conceived as operating within an industry consisting of all businesses those

operate processes of a sufficiently similar kind and possessing sufficiently similar
backgrounds of experience and knowledge so that each of them could produce the
particular commodity under consideration and would do so if sufficiently attractive. This
is a comprehensive definition which may serve our purpose best. However, still we have
to get a much precise definition of the industry where technical aspects related to
products and processes heterogeneity, organizational heterogeneity and the institutional
aspect of the industry are incorporated together. However, it is difficult to define industry
precisely. The definition depends more or less on the purpose of use of the industry.
There is a wide disparity in defining industry across the countries and so the United
Nations had to evolve a standard international classification of the industries for bringing
some uniformity, particularly when the industries are to be grouped together into some
sectors for the purpose of comparable industrial analysis. A clear demarcation of the
boundaries of the industries is very much needed in the empirical analysis since it is the
industry which is the primary focus of the competitive forces. Its structure constrains the
conduct and performance of the firms within it. Also, public policies are designed to
regulate industries; so making the industry a unit for study is quite natural and logical.

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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 will be 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. Within
the market, the good will be treated as uniform. In practice it may be difficult to define
the precise boundary for a market. A market is said to be imperfect if there is lack of
information about it, there are entry barriers to it and the product is not uniform.

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.

Contestable market

Contestable market- 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. Contestable markets are characterized by 'hit and
run' entry. If a firm in a market with no entry or exit barriers raises its prices above
marginal cost and begins to earn abnormal profits, potential rivals will enter the market to
take advantage of these profits. When the incumbent firm(s) responds by returning prices
to levels consistent with normal profits the new firms will exit. In this manner even a
single-firm market can show highly competitive behaviour.

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1.3 The Structure-conduct –performance paradigm

Industrial economists have developed generally accepted principles applicable to all

markets, all industries, and all economies. The central questions addressed by industrial
economics are

(1) is there market power and if so, how do you measure it?

(2) How do firms acquire and maintain market power?

(3) What are the implications of market power?

(4) What is the role of public policy as regards market power?

To do a complete analysis of an industry, market, or economy, there is a three-part

paradigm consisting of market structure, conduct, and performance sometimes used by
industrial economists. With this model, an independent investigator can assess whether
sufficient market power exists for any firm or groups of firms to complete successfully
any challenged market conduct abuse. The market structure of an industry is concerned
with the number and size distribution of buyers and sellers (concentration ratios), the
nature of the product (differentiated or homogeneous), and conditions of entry (cost
structure and barriers to entry). Market conduct is the pricing behavior (independent or
collusive), the product strategy and policy (independent or collusive), and the
promotional activities, (advertising, research, and development) operating within the
market. Market performance is the productive and allocative efficiency (price, cost, and
profit levels and trends) and the industry progressivity (technological change) of the
market. Now let as discuss the elements of this model in detail.

Market Structure

Refers to the organizational characteristics of buyers and sellers in a particular market. It

means the pattern or form or manner in which the constituent parts of a market (i.e.
buyers and sellers) are arranged/ linked together. It is specified in terms of the
organizational characteristics which determine the relations:

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(a) of sellers in the market to each other;

(b) of buyers in the market to each Other;

(c) of the sellers to the buyers; and

(d) of sellers established in the market to the new potential firms which might enter the
market.

These characteristics of the organization of a market exercise a strategic influence on the

nature of competition and pricing within the markets. The following four main features of
the market structure have been suggested by Bain, which are important to understand the
concept precisely and to measure it:

1. The Degree of Seller Concentration: This is the number and size distribution of
firms producing a particular commodity or types of commodities in the market.
2. The Degree of Buyer Concentration: This shows the number and size distribution
of buyers for the commodities in the market.
3. The Degree of Product Differentiation: This shows the difference in the products of
different firms in the market.

4. The Condition of Entry to the Market: This shows the relative ease with which new
firms can join the category or sellers (i.e. firms) in the market. When significant
barriers to entry exist, competition may cease to become disciplining force on
existing firms, and we are likely to see performance that departs from the competitive
ideal.

Each of the different dimensions or features of the market structure is important in

determining the behaviour of the firms which in turn will be affecting their performance
as well as the performance of the industry as a whole. We already know how the number
of sellers is a crucial variable determining the structure of the industry in microeconomics
theory II. If there is only one firm then we get the form of monopoly market; if few then
oligopoly; and if there large then we encounter with the perfect competition. In each case
the process of output and price determination will be different. Similarly, how
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differentiated goods and the large number of sellers generate the conditions for mono-
polistic competition is another example showing the importance of the market structure.
Looking at the absolute size of the sellers as another feature of the market structure, there
will be interesting problems to find how the large one will be more efficient than the
smaller one or vice versa; and when we take into account the size distribution of the
sellers in the market, we will have to find whether the concentrated industries arc more
efficient than the others. Similarly, the buyers' concentration in the market will have
considerable impact on the actions of the sellers and their performance. Product
diversification and the entry conditions in the market play their own roles in the real life
situation

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 behaviour and performance of the firms.

All such characteristics constitute a set of "the economically significant features of a

market, which affect the behaviour of firms supplying that market. Market structure is a
multidimensional concept. So it is difficult to measure it through a single variable. In
practice a set of variables related to different aspects of it are used simultaneously to
measure the market structure. All such measures will be discussed in the appropriate
chapters of this module.

Market Conduct

Market conduct is defined as the patterns of behaviour that firms follow in adopting or
adjusting to the market in which they operate to achieve the well defined goal or goals.
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, product design and quality standards, advertisement, etc. Firms may also
devise the ways for interactions, cross-adaptation and coordination among the competing
group of sellers in the market.
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In general, market conduct includes the pattern of behavior followed by firms in the
industry when adapting to a particular market situation. It includes:

1. 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.
2. 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?
3. 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?
4. 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?

5. 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? Attempts to get use rights to new technology to
establish and defend some degree of monopoly power.

For example, take the situation of two- firm industry (i.e. duopoly). Assume that the
firms intend to maximize profit. How would they conduct their business? Naturally
given such conditions we have to examine how the firm will be taking decisions about
the prices, quantity of outputs, etc. in the market. They may ignore each other and pursue
their objective independently. They may join together and share the total profits of the
industry in some mutually arrived at agreement. Or they may be involved in the dirty
games of competing with each other such as indiscriminate price-cuts, product
disparagement, disturbing the supply line of raw materials of each other, bribing of the
government officials and so on. They may follow more honorable tactics such as product

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diversification, effective advertisement and sales campaigns and favorable credit terms to
the customers. All these activities reflect the conduct of the firms in the market. Such
activities can be extended from a two-firm industry to the one which is having large
number of competing sellers. The choice of the tactics, or strategies in a better word,
reflects the behaviour of the firm in the given market situation. This is a very important
aspect in the organization of the firm. How such strategies are to be chalked out and how
to implement them effectively is the task of the management. The entire process of
reacting to the market situation in pursuit of the desired goal is called market conduct

Market Performance

Market performance is the end result of the activities under taken by the firms in pursuit
of their goals. High profitability, high rate of growth the firm, increase in the sales,
increase in the capital turnover, increase in the employment etc are some variables on the
basis of which we can judge the market performance of the individual firms depending on
their respective goals.

Generally, good market performance is a multidimensional concept which includes the

following elements:

1. 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? This gets at opportunity cost to the economy of having misallocation of too
few or too many resources devoted to a particular activity.
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?

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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. This affects allocative
efficiency by inducing adjustments in consumption and production as supply and demand
change. Allows matching of supply and demand and adjusts consumption to social
scarcity.

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. We are usually concerned with
underproduction, but can also have situations of overproduction. Key question becomes
one of allocative efficiency--whether more or fewer resources are allocated to this

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industry than are warranted by their social opportunity cost. i.e., the premise from welfare
economics is: ―a `reasonable relation' between marginal cost and product price and
between value of marginal product and input price‖ judged in relation to other industries.

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. Progressiveness indicates the
extent to which an industry is generating and rapidly adopting new technologies and new
organizational arrangements that reduce costs or improve products and services relative
to consumer wants

7. Product Suitability- involves matching products with consumer preferences. The

performance and safety characteristics of products that are supplied have to be reliable.
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. Although the notion of equity is a valve –laden concept, we
can say that profits should be no higher in the long-run than necessary to invoke the
productive use of resources in a particular endeavor. In addition, price stability
should be encouraged because of the perverse ways in which inflation changes the
distribution of income.
9. Producers should operate in a manner that encourages continued full employment of
productive resources. It can be argued that unused resources are wasted resources,
especially when they are perishable as in the case of human capital.

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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. Condemns both exhaustion of renewable resource to the point where it
cannot be sustained or wasteful extraction of nonrenewable resources.
12. Labor Relations- covers equal opportunity, working conditions, wage levels and
wage structure, work 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

Other aspects of good performance can be enumerated including external effects and
costs of sales promotion. For the society as a whole, performance of an industry may be
judged on the basis of its contribution in increasing the welfare of the masses.

The relation ship between Structure, conduct and performance

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The material presented in the above section clearly indicates the existence of prior
relationship between the three main concepts of industrial economics viz. Market
structure, market conduct and market performance. The link between these three which
is evident in the theory of the firm 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.

Traditional SCP approach argues that performance is determined by conduct of firms,

which in turn is determined by the structural characteristics of the market (Fig. 1.1)

Figure 1.1 the traditional SCP approach

Structure Conduct Performance

The traditional SCP approach asserts that market structural condition yields sufficient
information to deduce how firms should behave and performance can be directly
predicted from conduct.

But the traditional premise that unidirectional running from structure-conduct-

performance is unsound. In some cases, analysis of conduct is superfluous. Example in
perfectly competitive market, given large number of firms competition leaves firms with
no choice but to act independently in determining price and output levels. Individual
firms will be unable to influence the price determined by the market. Price will tend to
towards marginal cost and in the long-run firms will earn normal profits; production is
allocatively and productively efficient to the greater benefit of current economic welfare.

However, by passing conduct in all situations can lead to misleading influence where
markets display the features of oligopoly or monopoly in some situations. It may also
operate in the reverse way or may be segmented showing crosslink between any two of
the three aspects. For instance mergers directly affect the number and size distribution of
19
firms in the market, innovation and advertising may raise entry barriers, predatory pricing
could force competition out of the market. If there is excess profitability for a monopoly
seller, it will generate discontent in the minds of the policy markets. They will devise
regulatory mechanism to control the monopoly which may include change in the market
structure by introducing some type of workable competition. High profitability may thus
be taken as a cause for the change in the market structure in this situation.

Fig. 1.2 shows how the SCP approach may be adapted to incorporate these more complex
linkages, but the essential causality still flows from structural criteria.

Structure Conduct Performance

Figure1.2. More complex relationship between structure, conduct and

performance.

It can summarized that, While industrial economics has traditionally emphasized the
causal flows running from exogenous market structure and/or the exogenous basic
conditions to conduct and performance, there are important feedback effects from
performance to structure (e.g., high profits from efficiency increase market share and
affect structure), performance to conduct (reinvested monopoly profits can finance
greater R&D, advertising, or predation and low profits encourage collusion), and from
conduct to structure (R&D, mergers, predation, strong product differentiation,
advertising, and patents affect structure).

1.4 The conceptual Framework of Industrial Economics

Market structure, conduct and ultimately performance are also influenced by certain
fundamental market and environmental conditions. These may be divided into factors
primarily influencing the supply or input side of the production equation and those whose
primarily impact is on the demand side. The supply side includes the location and
ownership distribution of essential raw materials, the durability of the product, the
20
available technology and production techniques, the degree to which labor inputs are
readily available and organized, and the extent to which the firm‘s activities are
regulated by government. On the demand side, such factors as the, price elasticity of
demand, number of close substitutes that are available (measured by the cross elasticity
of demand), growth prospects of the industry, type of good or service being produced
(intermediate, consumer, specialty, convenience and so on), method of purchase by
buyers (list price acceptance, negotiation or haggling, sealed bid) must be included in an
analysis of fundamental conditions influencing market structure, conduct, and
performance.

Fundamental Market and

Environmental Conditions
Supply Demand
 Location & ownership  Price elasticity
of raw materials  Cross elasticity
 Product durability  Growth prospectus
 Technology  Market of product
 Labor organization  Method of purchases
 Regulation
 Government polices

Market structure Market Conduct Market performance

 Sellers and buyers
concentration
 Actual or imagined product
differentiation
 Condition of entry
 Diversification or
conglomeration
 contestability
 Pricing behavior
 Product policy
 Sales promotion and
advertising
 Research, development and
innovation strategies
 Legal tactics
 Efficient allocation of resources
 Technologically progressive
 Full employment
 Equitable income distribution
 Resource conservation
 Satisfactory product
 Satisfactory product performance
and safety characteristics

Fig. 1.3 Frame work of Industrial Economics

The link between market structure, conduct and performance gives us the basic
framework for the study of the economic behaviour of the firms and industry in the

21
market. The solid arrows in figure 1.3 indicate flows that are primarily causal in the
model, resulting ultimately in some observable market performance. As the dotted
arrows, however, some secondary and feed back flows are also involved.

The basic framework as we have argued above is shown in the flow-diagram (Figure1.3).
At the top there are a set of environmental and market variables or determinants which
influence the market structure and market conduct directly. The market structure block in
the diagram contains factors such as concentration, diversification vertical integration,
barriers, etc., as defined earlier. Similarly, the other two blocks showing market conduct
and market performance shows their respective elements. The major concern of studies in
the field of market structure, conduct and performance is to develop the capability to
predict market performance, based on observations of fundamental market and
environmental condition, market structure and conduct, or on some contemplated and
controllable changes in these factors. The task of industrial economics is to find how
strong these linkages are. Once this is known, the next step would be to use them
independently or jointly in a model form for policy purposes. Say, suppose the goal is
profit maximization, then we have to take the appropriate linkages between the blocks as
constraints or strategies for this and solve the model. One can derive many operational
models from this simple suggestive framework of industrial economics. The model, its
size, etc., would be depending on the purpose of analysis. A model may be developed just
using the deductive reasoning but its operational validity can be established only when its
structural hypotheses or end results are testable using empirical data. This is what we
have to do in industrial economics.

Questions for review and discussion

Attempt the following questions. Write your answer in your own words. Do not directly
copy from the module.
1. What is industrial economics? Explain the similarities and differences between
industrial economics and microeconomics theory.
2. Why does industrial economics emerge as a separate branch in the family of
economics?

22
3. Mention and discuss macro aspects of industrial economics
4. Explain the basic nature and area of concern of industrial dynamics
5. Discuss the SCP paradigm in detail and show the importance of the model in the
study of markets.

CHAPTER 2

Industrial Efficiency Concepts and Measurements

Prompting Questions:

 How can you say that a particular industry is running efficiently or not?

 What are the measuring tools?

 Are there any specific conditions for this?

Desired Objectives

The reader will get acquainted with

 The meaning of industrial efficiency.

 Determinants of efficiency level.

 Methods to measure the Efficiency level.

 Important conditions of efficiency.

 Efficiency and decision making.

23
Introduction

As we know very well the main motive of an industrialist is to maximize his profit. For
this he has to maximize the efficiency of the firm. In this chapter we are going to discuss
in detail about the meaning and measuring mechanism of industrial efficiency.

2.1 Meaning

Since our objective is to study the economic behavior of the firm and industries, we will
therefore examine the term efficiency from their point of view and call it as 'industrial
efficiency'. The term 'efficiency' or 'performance', being so important, is to be defined and
understood properly right at the beginning of our discussion. Industrial efficiency has
many dimensions which are to be examined.

Let us take a firm as a technical unit engaged in production of a commodity. Its job is to
transform a set of given inputs into some output defined by the production function. In
this case, the emphasis will be on achieving maximum productive efficiency. If we define
the firm as an organizational unit, engaged in production and disposal of a commodity for
some desired purpose, then the emphasis will be on achieving business or economic
efficiency. Let us define these concepts further before taking up the others.

Productive efficiency can be defined terms of two main components:

 Technical efficiency and

 Factor price efficiency.

The former is a purely a technical term. It may have anyone of the following meanings.
24
 We can say that a machine or appliance or organization, is technically efficient if it is
adequate to the demands made on it, or it lives up to the claims made for it. For example,
reliability and quickness of a postal system in its deliveries.
 The technical efficiency may be assessed on the basis of some quantitative standard
of performance such as the 'degree' to which a domestic heating appliance converts the
potential heat contained in a unit of fuel into units of actual heat.
 Technical efficiency may mean doing a job in the cheapest possible way, that is,
production of a given level of output from the lowest possible combination of inputs.

As far as the -second and the third concepts of the technical efficiency are concerned, we
may say that they are linked together, since avoidance of loss or wastage is one way of
maximizing output from the given set of inputs; but there may be conflict between the
first and the third one, e.g., according to the first definition gold would be best material
for rustproof plating of garden gates but according to the third it is not. In practice,
however, we may keep the satisfying attributes of a product at a fixed level and then
define the technical efficiency as the degree of economy in the input utilization used to
produce a given level of output of the product.

The second element of the productive efficiency, that is, factor price efficiency,
measures the skill in achieving the best combination of the inputs by taking into
account their relative prices. This is very important when one input can be substituted
for another in the process of production. To have a clear idea of the two elements of the
productive efficiency, consider Fig 2.1

25
Fig 2.1 Technical and productive efficiency

I I' is an isoquant which shows the most efficient combinations of the two factors X1and
X2 used to produce a given level of output of a commodity. Most efficient, means the
minimum combinations of the factors required according to the 'best practice' production
function for the commodity. In practice, a firm may deviate from the II' curve and thus
causing inefficiency in the factor uses. Let us take P as the actual situation where the firm
uses OD and OC quantities of the two factors X1 and X2 respectively to produce that
specified level of output. The technical efficiency of the firm at P in relation to the 'best
practice' frontier I I' can be measured by the ratio OQ/OP.AB is the isocost line in the
diagram indicating the combinations of the two factors that can be purchased from a
given amount of money and given factor prices. The factor price efficiency for the firm
can be measured by the ratio OQl/OQ. This is because any combination of the two factors
beyond AB line will not be possible when the amount of total resources and factor prices
are fixed.

The productive efficiency of the form at point P can be measured by the product of the
two ratios, i.e,

Productive Efficiency = OQ/OP X OQl /OQ = OQl /OP

The nearer this ratio moves to unity, the higher, will be the productive efficiency. The
productive efficiency will be maximum at point R. This is the familiar tangency condition
26
in the isoquant analysis.

The emphasis on the productive efficiency in business is only a partial requirement. In

practice, a firm may look for something more than merely minimum cost of production.
A broader concept that takes care of productive efficiency as well as other things is the
economic efficiency which may also be called 'business efficiency' from a firm's point of
view.

The propositions on which the concept of economic efficiency depends are:

 Resources at the disposal of the firm are scarce; and

 They can be put on alternative uses.

Men, machines, materials, money and time are the scarce resources from which, one can
produce, say, product A or product B or product C. If one product, say A, is preferred,
then the alternative foregone is the cost of product of A in terms of the familiar concept
of opportunity cost. Given the scarcity of resources and their alternative uses, it is quite
natural for a rational firm to get the best from them.

Based on this fact, we may define the concept of economic efficiency as follows:

An economic system is economically efficient if it is technically efficient and if it

succeeds in rationing out its scarce resources, and the scarce products of these
resources, in the most desirable way.

The phrase in the most desirable way, in this definition has normative connotation.

 In the case of a society as a whole, we may take it as maximization of the social

welfare or some aspect of that.
 In the case of an individual consumer, we may take it as utility maximization, and
similarly,
 In the context of a firm, it is to be interpreted as maximization of the goal or objective
chosen by it.
27
The goals of the firm may be either:

 Profit maximization;
 Sales maximization;
 Maximization of the growth rate;
 Maximization of the value of the firm;
 Earning some satisfactory level of profit;
 Survival in the business for long period, etc., or any combination of them.

Thus, the meaning of the economic efficiency varies according to whose viewpoint we
are considering and what is the goal chosen for maximization. Further, technical
efficiency is a prerequisite for economic efficiency. This is because technological aspects
being exogenous variables in the economic system. For the entire economic system of a
community, economic efficiency means efficient selection of goods to be produced,
efficient allocation of resources in the production of these goods and efficient choice of
the methods of production, and efficient allotment of the goods produced among the
consumers. Economists argue that correct application of the economic principles will
bring about optimal efficiency in the allocation and utilization of all resources, their
products, and in competition with another desires of the community. We hope that now
you got a concrete idea about the meaning of efficiency in general and industrial
efficiency in particular, having this idea now let us go to the determinants of efficiency

2.2 The Determinants of Economic Efficiency

A discussion on the various determinants of industrial efficiency may be worthwhile in

order to have a clear perspective of economic efficiency and related concepts. For the
sake of simplicity, we may put the determinants in two categories:

(i) Internal forces Includes all those activities which define the managerial function of a
firm. As we know for economic efficiency one must have

 Efficient planning and regulation of the operations,

28
 A willingness to accept changes in the policies related to the conduct of the business
including technological innovations,
 A smooth flow of work,
 Proper supervision,
 Adequate facilities for work including fair pay, etc.

It is the task of the management to do a1l these jobs. If there is inefficiency on their part,
the entire operations will be inefficient and so ultimately there will be low economic
efficiency. (ii)External forces-Includes the organizational or structural conditions
prevailing in the industry.

 Short-term fluctuations in the market for inputs and output of the firm
 Trade union activities
 Government regulations, etc.

The first set of these factors define the market-structure which shows

 The number and size distribution of the firms in the industry;

 The number and size distribution of the buyers in the market for the products of the
industry;
 The number of competing products;
 The conditions of entry in the industry, etc.

If the market is very much competitive for the firm, the inefficiency may be very low or
not at all in this situation. It is because the inefficient factor or product will be thrown out
of the industry because of the strong competition. On the other hand, if there is only one
firm in the industry (i.e. monopoly), then it will not be subjected to market competition.
Its performance may be poor. It may use its resources inefficiently. There may not be any
check for that.

The other factors mentioned in this category are self-explanatory. For example, if there is
power breakdown; production will be affected adversely, sales or profits will decline, and

29
so the efficiency of the firm will be poor. Similarly, we can postulate the impact of all
other probable short-term factors on the economic efficiency of a firm. All external forces
together may create conditions for the market is perfection which eventually affects the
allocative efficiency of the firm. The allocative efficiency is defined through a set of
general equilibrium conditions. It occurs when output is at that level where marginal cost
equals price in each product for each firm. Deviations from such a situation will have
important implications for the economic efficiency of the firm, particularly from the
social point of view.

A review of the factors, both internal and external ones, affecting the economic efficiency
of a firm is a difficult task. The present theory of the firm provides only few guidelines
for this. The bulk of the information on this aspect comes from the empirical analysis of
the economic forces operating at the firm and industry levels. This requires an
understanding of the entire industrial economics which is one of the objectives behind us
to introduce this course to you.

2.3 Measurement of the Efficiency Levels

Now let us discuss how to measure the efficiency conditions. Measurement means
quantification which is essential in industrial economics in order to make it empirically
relevant. There is no unique method of measurement for the industrial efficiency or its
components. For example, one can measure the technical efficiency through some
physical indicators such as capital-output ratio, capital-labor ratio, or actual cost-standard
cost ratio, etc. The detailed discussions about all these ratios are given in the ninth
chapter of this learning material. Generally we are using two methods for the purpose of
measuring industrial efficiency

 Optimization model such as the linear programming and

 Ratios like total productivity or profitability

As you know very well in the linear programming method, a firm has to specify in
quantitative terms the objective function as well as the constraints faced to achieve that
30
and then apply the standard mathematical tools to solve the problem. To explain the
method, let us take a simple linear programming problem.

Situation

Suppose a manufacturer is planning to make two products using three inputs, say, labor,
machine-hours and one raw material. One unit of Product 1 requires one man-hour one
machine-hour and two units of the raw material. Similarly, one unit of Product 2 requires
three man-hours, one machine-hour and one unit of the raw material. The total amounts
of the inputs are fixed and given as 18 man-hours, 8 machine hours, and 14 units of the
raw material per day. The manufacturer expects Birr 10 and Birr 20 as price for the two
products in the market and will be actually able to sell them. What should be the most
efficient level of output of the two products?

Mathematical Model Formation

Let us take that q1 and q2 are the levels of output of the two products: 1 and 2,
respectively at the optimality situation. In this example the objective of the manufacturer
will be to maximize the total sales (i.e. revenue) as nothing else is given regarding the
objective except product prices. The sales or revenue equation for the manufacturer is:
Objective Function
R = 10q1 + 20q2
To produce q1 and q2 levels of the outputs the input demand-supply equations will be
as: Constraints: q1 + 3q2 ≤ 18
q1+ q2 ≤8
2q1+ q2 ≤ 14
Each of the equations shows that the utilization of the input cannot be more than the
availability. It may be less of course, and we know
q1≤ 0, q2 ≤ 0

Now the problem is to maximize total revenue subject to the constraints .Here we can do
it graphically. By plotting all constraints on a two-dimensional graph

31
Graphical Solution

Each of the constraints, in this graph, shows a boundary which the manufacturer cannot
cross because of the fixity of the input. The area bounded by all the constraints, that is
ODCBA, is defined as the feasible area from which the combination of (q1, and q2)
output can be chosen. Any point inside this area will be feasible but inefficient since
resource utilization will not be full. Any point on the boundary DCBA will be feasible
and technically efficient showing full utilization of at least one input. This boundary
cannot be crossed. It is called 'Production Possibility Front'. There will be only one point
on this boundary which will be economically most efficient from the manufacturer's point
of view. At this point the objective function will be tangent to the boundary.

Final Result

Point Coordinates q1,q2 Revenue (R = 10q1 + 20q2)

D 7,0 Birr 70
C 6,2 Birr 100
B 3,5 Birr 130
A 0,6 Birr 120

32
The manufacturer is getting maximum revenue at point B showing three units of product
I and five units of product 2. Economically, this is the most efficient situation for the
manufacturer.

The graphical solution as described above is possible if there are only two products to be
produced. Since you are very familiar with all other methods of linear programming we
are not going in detail abut it.

It is true that the programming techniques are ideal for determination of the efficiency
conditions but there is a big question mark about their actual uses in the business circles.
Few large corporations having sophisticated planning machinery may, of course, be
adopting them, but by and large the firms, in general, adopt their own ad-hoc methods for
the efficiency maximization. They will select some performance indicators consistent
with their desired intentions in the business. For example, firms may set some target for
total factor-productivity or profitability for themselves. If they achieve that one; then they
may be called efficient, otherwise not.

2.4 Efficiency Conditions in the Theory of Production

In the coming discussion we are just highlighting some theoretical derivation of the
efficiency conditions for a firm as we studied in microeconomics. An understanding of
such conditions may be helpful in integrating the empirical findings of industrial
economics with the main body of the theory of the firm.

CASE 1: Constrained Output Maximization

Let us assume that the entrepreneur is interested in getting the maximum output for a
given cost outlay. His maximization problem in this case can be specified as
Maximize q = f(x1 x2)........................1
Subject to c = rl x1+ r2 x2.................. 2
The first equation is the production function and the second equation shows, the
distribution of the fixed outlay among the two inputs x1 and x2. rl and r2 are the input

33
prices for x1 and x2 respectively. Using the Lagrange Method for optimization, the final
equilibrium condition for the solution can be expressed as:
Marginal product of x1 / Price of x1 = Marginal product of x2/ Price of x2
= Marginal resource productivity (dq/dc)

This condition says that marginal product per unit of money spent on different inputs
must be identical and equal to the resource productivity. This is the condition for
maximum productive efficiency. This condition can also be written as:

Marginal product of x1 / Marginal product of x2 = Price of x1 / Price of x2

Further, we assume that one input can be substituted for another. At the optimality we
can see that Marginal rate of substitution of x1 for x2 = Price of x1 / Price of x2

CASE 2: Constrained Cost Minimization

This is dual of the problem discussed under Case 1. Here, we assume that the
entrepreneur is interested in minimizing the total cost of production for a given level of
output. The problem is: Minimize c = rl x1+ r2 x2.................. 1

q = f(x1 x2)........................2

The equilibrium condition for the optimality in this case will be same as in Case I, The
right hand side of the equilibrium condition in case 1 will appear as inverse of the
marginal cost. This is not surprising since 'marginal resource-productivity (dq/dc) can be
expressed as 1/ (dc/dq) where dc/dq is the marginal cost of production.

CASE 3: Profit Maximization

Now let us assume that the goal of the entrepreneur is the maximization of profit rather
than the output maximization. He will choose that level of output at which his profit will
be maximum. To get this level of output and the attached efficiency condition, let us
define the profit function for the entrepreneur as:

34
 Π= P.q -C

Where P is the product price, q, level of output and C; total cost of production.

We have specified q = f(x1, x2) and C = rl x1+ r2 x2

Substituting them in profit function it can be rewritten as:

Π = Pf (x1, x2) — rl x1— r2 x2

Let us assume that product price (P) is fixed. This will be the situation under perfect
competition. Taking partial-derivatives of Π with respect to x1 and x2, we get

δп/δ x1= Pf1—rl = 0

δп/δ x2= Pf2—r2 = 0

This reveals that: rl = Pf1; r2 = Pf2

f1 and f2 are marginal products of the two inputs x1and x2 respectively. This condition
says that the value of the marginal product of an input be equal to the factor price. The
inputs should be utilized at the level when this condition is satisfied. The entrepreneur
can increase his profit as long as the addition to his revenue from the employment of an
additional unit of a factor exceeds its cost.

CASE 4: Revenue Maximization

For this we postulate situations when in put quantities are fixed and the entrepreneur
produces more than one product. The simplest case is of one input, say X and two goods ql
and q2. The utilization of the fixed input X is a function of the levels of output of the two
goods, i.e., X= h (ql, q2)

This is the equation of the Production Possibility Front (PPF) for the entrepreneur. Let
the total revenue that the entrepreneur gets from ql and q2 levels of output be expressed

35
as R = P1ql + P2q2

P1 and P2 are output prices.

Assume that the objective of the entrepreneur is to maximize total revenue for the
optimum utilization of the input.

The problem can be expressed as

Maximize R = P1ql + P2q2

Subject to X= h (ql, q2)

Using the Lagrange Maximization Method, the final equilibrium conditions can be
expressed as [δ X/δ q1] / [δ X/δ q2] = P1/P2.................. (a)

And - dq2/dql = P1/P2.................. (b)

Equation (a) says that the ratio of the marginal costs of the two products must be equal to
the product prices ratio; and equation (b) says that the slope of the PPF at the optimum
point must be equal to the slope of the revenue line. In other words, the revenue line must
be tangent to the PPF at the optimum. This will be the most efficient situation for the
entrepreneur. It is shown by the point M in Fig. 2.2

36
Figure2.2Revenue maximization in the PPF framework

The shape of the PPF is concave towards the origin. It is a general case. In the case of
more than one input the PPF will be the common boundary covered by the PPF's for the
inputs .This principle of efficiency has wide applications in practice. It is the basis for
programming techniques. The profit-maximization situation in this case can be expressed
as the value of the marginal product of the factor of production for each output must be
equal to the factor price, that is,

r = P1 [δ q1 /δ X] = P2 [δ q2 /δ X]

Where r is the factor price, P1 and P2, product prices, and [δ q1 /δ X] and [δ q2 /δ X] are
marginal products of X for the two products ql and q2 respectively.

We have examined the efficiency conditions in the above few cases only and that too in a
very sketchy way. In depth analysis of these cases and the other left-out ones is the task
of the economic theory. An understanding of such theory is essential on the part of the
readers in order to get a clear perspective of the analysis of the efficiency conditions in
industrial economics.

2.5 Efficiency and Decision-making Process

It is argued that appropriate decision-making and efficient implementation of the

decisions are the vital determinants for the efficiency conditions in business. Let us
examine the process of decision making in the economy as well as at the firm level in
detail in order to understand its implication for the efficiency.

There are two basic methods by which a society can make its economic decisions.

 Free market mechanism

 The central planning.

Free market mechanism

37
The responsibility of making efficient decisions lies on the prices prevailing in the
economy. It is a situation when there is perfect competition. The prices in the economy
are determined through interaction of the demand and supply curves for the commodities
and services at the market level. Individual, consumer or firm, being very small, cannot
influence the prices.

The central planning

In this method, all major decisions about consumption, production and distribution of the
wealth are taken by the Government with or without use of the money prices. The
decision will be by and large administrative in nature. They are deliberate and conscious,
conforming to the overall goals of the society. Out of these two methods which one is
better is a debatable question. Each one has its own merits and demerits.

 Free market mechanism is ideal in principle to achieve the optimum economic

efficiency, but its operational side is very weak in the sense that there is no regulatory
mechanism to keep its basic foundation intact. Once the basic foundation of the system is
disturbed, it becomes non-competitive, causing all kinds of inefficiencies in the economy.

The central planning is generally supportive and which is perhaps more popular because
of its political implications. However, this system has its own limitations such as

 Delays in administrative decision-making,

 Low participation of masses in the achievements of the social goals,
 Influence of the pressure groups on the decision-making process,
 Personal biases of the decision makers, and so on.

The planning process at the firm level will generally consist of the following elements:

 Setting of goals, i.e., objectives;

 Identification of the alternative strategies for achievement of the goals;
 Making the choice of the strategy from the alternatives;
 Execution of the strategy;
38
  Evaluation of the results; and
 Revisions in the plans, if necessary.

The authority of the decision-making or planning may be vested in the top management
or the board of directors in the case of a company. Alternatively, there may be
decentralization in the decision-making process and the job of the top management is to
coordinate the decisions taken at the lower levels. We emphasize again that for the
optimum performance in business the management of the firm must be very much
efficient and well coordinated. Whatever is the pattern of the economy, the society
expects the business managers to produce the goods and services for consumption at the
lowest possible cost. Thus, the responsibility for the optimum efficiency rests largely on
them.

If we accept the proposition that planning and centralized decision making are necessary
at the firm level operations, it does not mean that the market mechanism is totally
irrelevant. The prices fixed by the free market mechanism control the decision-making in
other aspects such as production, sales, inventories, finances, expansion, etc. A rational
business manager will be cautious for all such things while he makes the plans for
running his business.

Questions for review and discussion

Attempt the following questions. Write your answer in your own words. Do not directly
copy from the module.
1. Explain the relevance of the concept Industrial efficiency in the modern economic
situations.
2. Compare and contrast the usefulness of different methods used to measure Industrial
efficiency in the present field of industry.
3. What are the different efficiency conditions in the theory of production?
4. The programming techniques are ideal for determination of the efficiency conditions,
but their actual uses in the business circle are questionable.Comment on this
statement.
39
 CHAPTER 3

Market Concentration

Prompting Questions:

 Some firms are enjoying abnormal profit in the market for a long time: how it

happens?

 Why does governments entering to control monopoly power of firms?

 Is there any relation between market concentration and performance?

 Is there any method to measure the monopoly power of firms?

Desired Objectives

40
The reader will get acquainted with

 The meaning of market concentration

 Market concentration and structure

 Measurement of market concentration.

 Concentration and market performance

Introduction

In this chapter we are going to discuss various concepts associated with market
concentration, its measurement, policy aspects and its roles on profitability of a firm. In
the coming discussion we will deal with the positive aspects of market concentration,
leaving the regulatory or normative side for a later chapter. This chapter will have
different sections, each one dealing with a specific aspect of the market concentration.
The first section will be devoted to some basic concepts and theoretical implications of
concentration, the second one will deal with its measurement aspect, the next two will be
devoted to concentration and its impact on firm's behaviour and performance and finally
the policy implications will be analyzed in brief.

3.1 Meaning

Market concentration means the situation when an industry or market is controlled by a

small number of leading producers who are exclusively or at least very largely engaged in
that industry. It is also known as degree of seller's concentration in the market. It is an
important element of the market structure which plays a dominant role in determining the

41
behaviour of a firm in the market. Two variables that are of relevance in determining
such situation are:

(i) The number of firms in the industry, and

(ii) Their relative size distribution.

How these two dimensions cause different forms of the market structure having vital
consequences for the pricing and output decisions of the firms, has been discussed in
your micro economics course. In the context of industrial economics, however, the
implications of market concentration are far wider than whatever we find in the theory of
the firm. It will be our attempt in this chapter to focus on such implications in the
framework of 'market structure-conduct-performance' link or any subset of this. The
major elements of market concentration, such as

 Concentration in the ownership of the industry,

 Concentration of decision-making power, and
 Concentration of the firms in a particular location or region, etc may have
considerable impact on the market performance of the firms such as profitability, price-
cost margin, growth, technological progress and content. These links are to be understood
properly, because all of them are very much relevant from the point of view of decision-
making and regulation of industries.

3.2 Measurement of Market Concentration and Monopoly Power

Various quantitative indexes have been suggested for the measurement of market
concentration, which we are going to summaries in this section. Some of them are used to
measure the monopoly power of the firms and some for market concentration. These two
terms, i.e. monopoly power and market concentration, are closely interrelated and cannot
be separated from each other in the measurement process. The degree of market
concentration would vary with the monopoly power in a particular industry, or we may
also say that existing firms acquire monopoly power if market is concentrated. The

42
indexes that we are going to discuss here would therefore be indicating to us almost
similar things with a minor difference. The measures for monopoly power would be more
appropriate at firm level. They indicate the actual monopoly power exercised by the
firms. The measures of concentration on the other hand would give us the potential
monopoly power in the market or industry as a whole. Obviously some firms would be
having monopoly power in the situation of market concentration. If the number of firms
and their relative sizes in the market are changing we expect a change in the monopoly
power of the firms. The concentration is therefore a necessary condition for the monopoly
power although it is difficult to say that there is one to one proportionality between them.

Before discussing the indexes it will be useful here to mention some general conditions or
requirements which should be satisfied by each one of them. This helps us in screening
the indexes while marking the final choice for empirical work. The conditions are:

(a) The measure must yield an unambiguous ranking of industries by concentration.

Consider Fig. 3.1 in which concentration curves, i.e. the graphs between cumulative
number of firms from largest to smallest and cumulative percentage of market supply are
shown by It. hand h for three industries separately. II is above hand 13 every where. It
means the industry which is represented by it is more concentrated than the other two.
However, there is ambiguity in the ranking of the second and third industries represented
by 12 and 13 respectively.

Fig. 3.1; Hypothetical cumulative number of firms

43
(Largest to smaller concentration' curves)

(b) The concentration measure should be a function of the combined market share of the
firms rather than of the absolute size of the market or industry.
(c) If the number of firms increases then concentration should decrease. However, if the
new entrant is large enough, then concentration may go up.
(d) If there is transfer of sales from a small firm to a large one in the market, then
concentration increases
(e) Proportionate decrease in the market share of all firms reduces the concentration by
the same proportion.
(f) Merger activities increase the degree of concentration.

There are several measures suggested for the measurement purpose. All are equally good
or bad. Let us review them briefly before making a final comment in this regard.

A. The Concentration Ratio

The most popular and perhaps simplest index for measurement of market concentration
or monopoly power is the use of the concentration ratio, that is, the share of the market or
industry held by some of the largest firms. The market share of such firms may be taken
either in production or sales or employment or any magnitude of the market. In symbolic
form the concentration ratio is written as

m
C   pi, m  4,8,10,12, , ..., 20, ..
i 1

Where; Pi = market share of ith firm in descending order.

The normal practice is to take the four-firm (m = 4) concentration ratio but if the total
number of firms operating in the market is large enough then one has to compute the 8-
firm or even 20-firm concentration ratio to assess the situation. The higher the
concentration ratio the greater the-monopoly power or market concentration existing in
the industry.
44
B. The Hirschman-Herfindahl Index

It is the sum of the squares of the relative sizes (ie; market shares) of the firms in the
market, where the relative sizes are expressed as proportions of the total size of the
market.

n
Symbolically, Herfindahl Index ( H )   ( pi) 2
i 1

Where; Pi = qi/Q, qi is output of ith firm and Q is total output of all the firms in the
market, and n is the total number of firms in the market.

This index takes account of all firms in the market (i.e. industry). Their market shares are
weighted by the market share itself. The larger the firm more will be its weight in the
index. The maximum value for the index is one where only one firm occupies the whole
market. This is the case of a monopoly. The index will have minimum value when the n
firms in the market hold an identical share. This will be equal to l/n, that is

n
1 1
(H )   ( ) 2 
i 1 n n

H decreases as n increases. The index is simple to calculate and it is popular in use and
consistent with the theory of oligopoly because of its similarity to measures of monopoly
power.

C. The Rosenbluth Index

This index is based on the rank of each firm in the market and its market share. It gives
more weight to the number of the firm and importance of small firm. It is computed as,

R 1 n
[( 2 i * pi )  1];
i 1

45
 1/n ≤ R ≤ 1

Where;

n = number of firms,

Pi = market share of ith firm.

This index has the apparent properties as the H index but it is rarely used in practice.

D. The Entropy Index

This index has been suggested quite recently to measure the degree of market
concentration. It uses the formula

n
1
E   pi log
i 1 pi

0 ≤ E ≤ log n

Where;

E is defined as 'Entropy Coefficient',

Pi is the market share of ith firm and

n the number of firm.

This coefficient in fact measures the degree of market uncertainty faced by a firm in
relation to a given customer. This will be the situation when number of firms is large
enough, i.e. market is not concentrated. For a monopoly firm (n = 1) the entropy
coefficient takes the value of zero which means no uncertainty and maximum concen-
tration. Thus we find opposite (inverse) relationship between the entropy coefficient E
and the degree of market concentration

46
The entropy coefficient is a useful measure of market. concentration in the sense that the
population of the firms for which the entropy coefficient is to be computed can be
decomposed or disaggregated into several groups, say on the basis of sizes, regions,
products and the classification of industry etc.

E. The Horvath Index

This index is called as a 'comprehensive concentration index' (CCI) in the sense that it
takes into account the share of the largest firm in the market in a discrete manner and of
the other firm's market shares in a weighted form conforming with other summary
measures of the concentration (a summary index is one which takes all firms in account
while measuring the concentration).

The formula Horvath suggested is,

n
CCI  pi  p j [1  (1  p j )],
2

j 2

j = 2, 3,...................., n

The upper limit for the CCI is unity when there is only one firm, and the lowest limit is
(3n2 - 3n + 1)/n3 provided n ≠ 2. For n = 2, i.e. for duopoly, CCI comes out to be equal to
0.875. PI is the discrete part of the concentration and remaining portion of the formula is
the summary part. The index is not popular in use as it does not provide either theoretical
or computational advantages over the other indexes discussed so far.

F. The Learner Index

There are some other indexes which are mainly used to measure monopoly power of a
firm but some of them can be applied to the market as a whole with little modification or
by simply reinterpreting the variables concerned. The Lerner index is the best known of
them. It is expressed as;

47
 P  MC
I
P

Where;
P = Price
MC = Marginal Cost

We know, under perfect competition price will be equal to marginal cost. If there is a
difference between the two, such that price > marginal cost, this is because of market
imperfection or what we call as the monopoly power of the firm. Greater the deviation
between price and marginal cost, a higher the monopoly power of a firm. The steps to
derive the index are straightforward. Writing the expression for marginal revenue (MR)
for a monopoly firm we get

1
MR  p(1  )
ep

ep = price elasticity of demand, and for profit maximization we have the familiar
condition,
MR = MC

From these two equations we get the Lerner index as,

P  MC 1
I 
P ep

that is, the index is inverse of the price elasticity of demand. Remember,

1
ep < 0, so  >0
ep

G.The Elasticity Index

The ratio of 'own elasticity of demand and cross-elasticity of demand' for a firm could be
48
used as a measure of monopoly power or market concentration in terms of 'number-
equivalent',

eii eii
ie; e ji   or n 1  
n 1 e ji

Where;

eii = own elasticity of demand and

eji = cross elasticity of demand

An increase in the ratio means lesser number of firms in the market and a decrease
means higher number. Under pure monopoly the cross elasticity will be zero. Greater the
number of firms and products, higher will be the cross elasticity.

H. The Profit Ratio

This was suggested by Bain. According to him, when a firm persistently earns excess
profit for a long period of time, then it should be attributed to its monopoly power.
Monopoly power and profit rate are assumed to be linked positively. The profit rate is
defined as "that rate which, then used in discounting the future rents of the enterprise,
equates their capital value to the cost of those assets which would be held by the firm if it
produced its present output in competitive equilibrium. This rate of profit is then
compared with the normal rate of profit to assess the mono poly power of the firm. There
is some operational significance of this index but it is not always true that profits accrue
because of monopoly power. A firm without any such thing may manage its business
well and earn profits for a long time. Moreover, estimation of the conceived profit rate is
itself very much complicated. The profit rate index for monopoly power is, thus, a weak
proposition. It is unsatisfactory as well as unreliable.

Now we have reviewed the common indexes, used for measuring market concentration
and monopoly power .Which one is to be used is a matter of judgment and convenience.
49
All are merely approximations based individually on some specific property of the
concentrated market. It may be difficult to develop a comprehensive index for measuring
the market power.

3.3 Concentration and the Market Performance of a Firm

The important behavioral hypotheses about concentration and market performance are
going to discuss in brief in this section. As we study in microeconomics, a firm with
substantial monopoly power will tend to charge high price, produce and sell less output,
make high rates of profit, grow faster than others, capable of doing anything it wants in
connection with its business such as R&D, advertisement and so on. Let us presume that
concentration is an 'appropriate measure of such power, we are then in a position to
verify the various propositions of the economic theory which reflect the relationships
between concentration and market performance of the firm.

A. Concentration and Profits

A firm derives market power or monopoly power in the' situation of concentration. Such
market power, via market conducts activities or directly leads to an increase in the
profitability of the firm. It is frequently assumed that persistency of high rates of profits
over a long period is the consequence of high degree of intra industry concentration. J. S.
Bain was the first to make an empirical study of this proposition, who found it valid for
the U.S. industries. The relationship was found so strong that Bain was to argue for the
profit rate as an index to measure the concentration. Since then there has been a flood of
studies on the relationship which by and large supported his argument.

B. Concentration and Price-cost Margins

Price-cost margin is another way to define profitability. This is a short term view of
profitability based on current sales and cost figures. Say, the average price-cost margin is
just a ratio of these two magnitudes. Empirical studies particularly those conducted by

Collins and Preston supported the positive relationship between concentration and the
50
price-cost margin for the American four digit industries. Shepherd also confirmed the
positive relationship between them for most of the U.S. industries. Koch and Fenili,
however, looked at concentration acting as a surrogate for other determinants of price-
cost margins because of its being causally linked with them.They found it as .an
insignificant predictor of price-cost margins when other relevant indicators of market
structure like product differentiation, rate of technological change etc., were also
considered side by side.

C. Concentration and Growth of the Firm

Here we will just mention how concentration is relevant for the growth of the firm. There
are two different streams of thoughts to explain the causal relationship between the two
variables. According to one view, a firm with market power, as a consequence of
concentration, may prefer to maintain its high rate of profit by restricting the output and
charging high price. If it grows, it has to sacrifice some profit margin, and lower price
which may not be in its interest. Moreover, there will be all kinds of restrictions imposed
by the government to stop further growth of such firm. Thus, we expect that higher the
monopoly power of the firm lesser may be its growth. The few firms in the concentrated
industry may be dominant enough to restrict the growth of the other firms and to stop the
entry of new ones because of the various barriers to entry at their disposal. There is, thus,
very little prospective for the growth of the firms in a concentrated industry and so for the
overall growth of the industry itself. There are some empirical studies where the inverse
relationship between initial market, concentration and, subsequent market growth has
been verified.

The second view about the concentration and growth of the firm and hence of the market,
is a positive one. In order to maximize the long-term profit, firms may like to grow over
time even under market concentration. They may prefer to create excess capacity to meet
the future growing demand and to discourage new entry in the market. They may have
some short-term sacrifice of profit in order to stimulate long-term benefits. So, we find a
case for the positive relationship between initial market concentration and growth of the

51
firms. The firms with market power may be finding themselves at ease regarding finances
and other requirements of growth.

D. Concentration and Technological Change

Now let us look into, whether concentrated industries are the most research oriented and
technically progressive. It is true that the few firms who enjoy monopoly power in a
concentrated industry will be large enough. They will be having stability, financial
resources and ability to initiate the processes of R&D and gain the benefits from them.
Dasgupta and Stiglitz, clearly showed the situation when market concentration and
innovative activities are positively correlated. There is no conclusive empirical evidence
to prove such proposition. In fact studies conducted by Williamson have shown quite
opposite results. Doubts about this have also been expressed by Blair. It may not be the
concentration but the other attributes of market structure like size of firm, product
differentiation possibilities etc., which may be having collinearity with concentration and
thus causing a spurious positive correlation between concentration and technological
change.

Questions for review and discussion

Attempt the following questions. Write your answer in your own words. Do not directly
copy from the module.

1. Explain the different methods used to measure market concentration and monopoly
power?

2. Market concentration is good or bad? Give your answer from the society point of view.

3. Explain the role of market concentration in the performance of a firm. Support your
answer with some empirical examples.

52
 CHAPTER 4

Industrial Location Analysis

Prompting Questions:

 Why Messobo Cement Factory does select their location in Mekelle?

 Is it only because of the availability of raw material or some other factors?

 Are their any scientific approaches in the selection of industrial location?

Desired Objectives

The reader will get acquainted with

 The meaning of industrial location analysis

53
 The importance of industrial location in the performance of a firm.

 The determinants of industrial location.

 The scientific approaches to industrial location.

Introduction

Industrial location plays a vital role in the performance of a firm. In Ethiopia, since we
are far behind in infrastructural matters than other developing countries, the place where
an industry is located is one of the major determinants of its performance. In this chapter
we are going to discuss about the need, importance and approaches of industrial location
analysis in detail.

In setting up a factory a manufacturer has to take three interrelated decisions

simultaneously:

 The scale of operation;

 The technique to be adopted, which involves the selection of the appropriate
combination of the factors of production; and
 The location of the factory.

As you know very well the conventional theory of the firm provides the rules or norms
for taking the first two types of decisions, but it ignores the third one completely. Now a

54
days especially in developing countries like ours needs a separate branch of economics
bordering with the discipline of geography, which is known as industrial Location or
Location Analysis, deals with the elements of locational or spatial decision-making. In
the coming discussion we will study this branch of economics in detail.

The task of decision-making about industrial location is not very simple. A manufacturer
has to consider several technical, economic and institutional factors for this. Our first step
in this chapter will be to identify such factors. Following this, we have to examine how
individual firms react in locating their factories under different physical and economic
circumstances. This implies a review of the theoretical approaches to industrial location
analysis.

4.1 The General Determinants of Industrial Location

Suppose a factory, with whose location analysis we are concerned, is a technical unit
whose function is to convert a set of raw materials into some output with the help of men
and machines, i.e., the factors of production. The raw materials and other inputs required
by the factory for production will be rarely available at a place. The owners of the factory
will have to procure them from different places which involve transportation and other
procurement costs. Similarly, the output of the factory will be rarely sold at a single
place. It has to be sent to different places which involve transportation and selling costs.

Given the spatial distribution of the inputs and outputs markets, the owners of the factory
will have to take the decision about the place where the factory should be located.

All potential locations for the factory will not be equally economical. Only one of them is
to be chosen which will be the most economical.

How to make the choice for this?

55
A large number of factors have to be considered simultaneously while taking the
decisions of industrial location, such as

a) Technical,

b) Economic and Infrastructural Factors

c) Other factors

Which exert pull and pressure on location of the factory in varying magnitudes.

a) Technical Factors

These are the physical factors which are more or less geographical in nature related to
soil, raw materials, people, climate, etc. The important factors in this category are:

 Availability of land.
 Nature and quality of raw materials from land, e.g. forest products,
agricultural inputs, minerals, and semi-finished products from existing
industries.
 Geographic situation of the factory site in relation to the transport facilities by
rail, road, water and air.
 Quantity and quality of human resources.
 Energy resources.
 Availability of water for drinking and industrial uses.
 Waste disposal facilities.
 Climate

b) Economic and Infrastructural Factors

Input prices, taxes, markets, skills of labor forces, availability of adequate infra-structural
facilities, finance, etc., constitute together the category of economic factors. The general
list of factors for this would be as follows:

56
  Local markets.
 Situation in relation to export markets.
 Costs of land and buildings.
 Costs of infra-structural facilities such as transport charges, power tariffs, water-
rates, etc.
 Salaries and wages in relation to skills.
 Local cost of living.
 Taxes and subsidies.
 Cost and availability of finance.
 Structure of existing industries.
 Industrial relations and trade union activities around the proposed location sites.
 Demographic factors such as age and sex composition of local population,
 literacy, professional skills, etc.
 Local medical facilities.
 Housing facilities.
 Cultural facilities such as schools, clubs and other recreation
 Communication facilities.

c) Other Factors
All other miscellaneous location factors may be put in this category, viz;
1. Government policies towards location of new plants, and
2. Personal factors.

Most of the governments pursue the policies of rapid industrialization of their states.
They provide several facilities for locating new plants in some places or regions. An
entrepreneur has to evaluate the facilities given by the government very carefully before
taking a decision on location of his factory.

Personal factors also play important role in location decision, a manufacturer may prefer
to locate his factory at his birth place-disregarding all economic factors. Again may set
up his factory close to a golf-club in order to keep up his interest of playing golf.

57
Industrial location based on such personal factors will entirely be a matter of chance or
which is called as historical accident.

Most of the factors, mentioned above are self-explanatory. In some industries firms are
located near sources of major raw materials such as iron and steel, and pulp etc, while in
other industries, they are located near markets. All factors together provide a spatial
configuration which is to be analyzed very carefully for the optimum location of a
factory. The choice of location will not be independent of the scale of production and the
technique to be used for that. They are interrelated aspects which are to be decided
together.

4.2 Approaches to Industrial Location Analysis

There are several theoretical and applied approaches for location analysis based on the
above-mentioned factors. In order to understand the precise relevance of the various
location factors and the interactions among themselves, let us examine the leading
theoretical approaches to industrial location analysis. In this regard significant
contributions were made by geographers and the economists; their approaches however
were different.

The geographers, by and large, adopted intuitive conceptual base and case studies
approach to arrive at some generalization about the industrial locational patterns.

The economists, on the other hand, followed a more formal, abstract or deductive
approach for location analysis, an integration of these two diversified approaches led to
develop some operational models for location studies.

1. The Geographical Contributions

The discipline geography examines the form of the earth, its physical features, natural
and political divisions, climate, production, and population, etc. Industries appearing on
the earth's source do make some changes in its physical features and production patterns.

58
Recognizing this fact, the geographers considered industrial location as a part of their
discipline and we are trying to present a brief review of a few selected works having
some theoretical relevance, they are

 The Central Place Theory

 Renner's theory
 Rawstron's Principles

a. The central Place Theory

This was the first systematic geographical theory of location. It was developed by Walter
Christaller mainly to determine the number, size, and distribution of town and. cities.
Using certain simplified assumptions, Chris taller was able to demonstrate graphically the
spatial arrangement between hinterland and central places, mainly service centers.

In simplest terms, his theory proposed that towns with lowest level of specialization
would be equally spaced and surrounded by hexagonally shaped hinterlands. Although,
empirical testing of this theory is doubtful yet it is regarded as valuable theoretical
contribution in urban geography. It has relevance for location of a manufacturing industry
in a special case where production tends to be centralized and the market is areally
extended.

The major limitation of this theory is that it fails to encompass the development of belts
of industrial concentration and the agglomerative tendencies which are common features
of the modern industrial structures.

b. Renner's Theory

Renner developed some general principles concerning industrial location. He classified

industry into four categories viz;

 Extractive  Fabricative
 Reproductive  Facilitative
59
To undertake anyone of these, six ingredients are required raw material, market, labor
and management, power, capital and transportation. Keeping in mind these ingredients,
Renner postulated the law of location for fabricative (i.e. manufacturing) industry
according to which any manufacturing industry tends to locate at a point which provides
optimum access to its ingredients.

It will, therefore, locate near to:

Raw Materials, if it uses perishable or highly condensable raw substances, or
Market, where the processing adds fragility, perishability, weight, or
Bulk to the raw materials or where its products are subject to rapid changes in
style, design, or technological character; or
Power, where the mechanical energy costs of processing are the chief items in the
total cost; or
Labor, where its, wages to skilled workers are a large item in the total cost.

Apart from the above tendencies or laws, Renner gave a scheme for, industrial symbiosis.
Three different types were mentioned for this:

(a) Disjunctive symbiosis where different industries having no organic i.e. economic or
technical connections among themselves, gain advantages by existing together at a
particular place;

(b) Conjunctive symbiosis where different industries with some organic connection
among themselves (i.e. inter-connections) are located together; and

(c) Conindustrialization which is an advance stage of the conjunctive symbiosis leading

thereby to a huge industrial belt of interconnected industries.

Renner's approach on industrial location is quite realistic as it tries to bring together the
major determinants for that. However, he has not been able to go into deep in analyzing
the effects of spatial cost variation and industrial symbiosis, i.e. agglomeration on
industrial location. He merely describes the tendencies of industrial location based on
these factors.

c. Rawstron's Principles

Rawstron has developed his theory of industrial location in terms of three restrictions
which impede the choice of location for a factory. The restrictions are the principles of
location in his model. These are:

 Physical restriction,
 Economic restriction, and
 Technical restriction.

The physical restriction will be operative when some raw materials mainly natural
resources are to be produced or procured at the proposed site for the plant.

The economic restriction embodies the concept of spatial margins to profitability. The
cost of production, i.e. the sum of expenditure on labor, materials, land, marketing and
capital, varies from place to place resulting in a spatial variation in profitability for a
firm. Unlike most authors, Rawstron does not identify transport as a separate cost item
but takes it as a factor for spatial variation in the cost of other items and hence of
profitability. The sum of costs arising solely from the choice of location is defined as the
location cost by Rawstron. It plays crucial role in locational decision making.

The technical restriction examines the effect of the level of technology on location. The
decision on the choice of technique for production is one of the three interrelated
decisions as we have mentioned earlier. Location decision is one of them. So Rawstron's
emphasis on technical restriction to location is consistent with this. Location decisions
will be important with stable technology. In the case of changing technology it may be
difficult to link the choice of plant location with the choice of technology since the latter
is uncertain. Generally, the effect of technological change is felt through some change in
input requirement and hence on cost of production. Such change is taken into account by
the second restriction in Rawstron's model. On the whole, Rawstron's contribution to the
52
geographical studies on industrial location has been a pioneering one. The emphasis on
cost-structure for industrial location makes his approach more important than the other
geographical studies on the subject of industrial location based on minimum transport
cost.

2. The Economic Theories of Industrial Location

Some of the pioneering works from some celebrated economists in the field of industrial
location are discussed in this section, such as

a) Weber's Theory

b) Tord Plander's theory of Market Area

c) Losch's Theory of Central Place

a) Weber's Theory

Weber's main interest was to construct a general theory of location which could be
applied to all industries at all times. In his theory he followed Launhardt's principle of
industrial location based on minimum transport cost. For this he has taken into account
the general factors of location which were relevant to all industries. The factors
considered by him were divided into two groups;
Those influencing inter-regional location of industries (i.e. regional factors) and
Those influencing intra-regional location (i.e. agglomerating factors).

He found three general factors which vary regionally;

 Raw material costs,

 Transport costs and
 Labor costs.

53
The fluctuations in raw material costs were however included within transport costs. The
approach followed by Weber was to explain industrial location in terms of transport cost
first and then to examine the effects of changes in labor cost and agglomerative factors on
it. He made some simplifying assumptions for his analysis such as

 The locations of raw materials including fuel are fixed

 Situation and size of consuming canters are given; and
 There are several fixed labour supply centers; labor is immobile
and unlimited in supply at fixed wage rate.
 The institutional factors like taxation, interest, insurance, etc., are
insignificant locational factors.
 The economic culture and political system are treated to be
uniform and stable across the locations.
 On the whole Weber assumed perfect competition for his model.

Weber started his analysis with the proposition that a manufacturing unit tends to locate
at the place where cost of transportation is minimum, i.e. the location where the number
of ton-miles of raw materials and finished product to be moved per ton of product would
be minimum. Weber used the locational triangle of Launhardt to find the place of
minimum transport cost. He assumed a simple spatial situation in which there is only one
consumption Center(C) and two fixed supply centers (M1 and M2) for two most
important raw materials

54
Fig.4.1The location Triangle

There may be other consumption points and raw material supply centers but Weber did
not consider all of them together. According to him, the least cost point will be located
within the triangle CMM2 such as the one shown by P. The three corner points of the
triangle will be pulling the location point (P) towards themselves. The position of the
point will depend on the balance of the pulls exercised by them. If the pull of anyone
corner is greater than the sum of the pulls of the other corners, production will be located
at the point or corner of origin of the dominant force. The force exerted by each corner on
production point is in the form of ton-mile weight to be moved from that point (M1 and
M2) and to the point (C). Let x and y be the requirements of materials M1 and M2, in
tons per ton of output and let one unit of output, i.e. finished product be transported from
point P to C. The distances of the corner points from the production point (P) are
unknown. Let them be a, b and c between P and M1, M2, and C points respectively.

The total ton-miles of transport per unit output would then be ax + by + c. This is to be
minimized in order to find the position of point P, i.e. the location of production. The
distances a, b and c and hence the point P are easy to be found by applying the theorem of
parallelogram of forces in geometry.

An industry may be material-oriented or market-oriented from location point of view.

Weber used the 'material index' for identifying such nature of the industry.
55
The material index (M I) is defined as:

MI= Weight of localized material / Weight of finished product

Industries displaying a high material index i.e., MI > I are attracted towards the sources
of raw materials such as iron and steel industry,

Industries displaying a material index less than one i.e., MI < I are attracted towards the
place of consumption.

The assumption of a uniform transportation rate, was relaxed by Weber by converting the
weight to be transported into an ideal weight which is defined as a product (or a function)
of actual weight and the rate of transportation cost, for a material or finished product. Let
t1, t2 and t3 be the transportation rates per ton-mile for material M1, M2 and finished
product respectively, which is explained in the figure 4.1.The total transport cost per ton
of finished product would be then equal to t1ax + t2by + t3c. The location of production
point (P) within the triangle CM1M2 can be determined now by minimizing this cost
instead of the sum of ton-miles as mentioned earlier.

According to Weber an industry will choose a cheap labour site if the labour cost saving
is greater than the increment in transport cost at this site above the minimum possible
transport cost. Weber used the isodapanes to explain the effect of labor cost on the least-
transport-cost location of a plant. An isodapane is the locus of the points having equal
additional transport cost around the least-transport cost location. There will be several
isodapanes forming rings around the location fill different levels of incremental transport
cost as shown in Fig. 4.2. Let P1be the least-transport-cost location and L1be a cheap
labor site.

56
Figure 4.2 Isodapanes and equilibrium location with cheap source of labour

Further, let us presume that there will be a saving of labour cost by Birr. 4 if plant is
located at L1 instead of at P1. Should the location be shifted from P1 to L1? For
illustration, the isodapanes around P1 are drawn for incremental transport cost of Birr.1,
Birr. 2, Birr. 3, Birr. 4 and Birr.5. Point L1 lies with the isodapane of Birr. 4. It implies
that it is economical to shift the location from P1 to L1. If labor source making a saving
of Birr. 4 in cost of production lie outside the isodapane of Birr. 4, such as shown by L2,
it would mean a loss in shifting the location from the least-transport-cost location P1 to
the labour centre L2. In general, let d1and d2 be the total ton-miles of transport services
per ton of product at P1 and L1 sites respectively, and let W1 and W2 be the hourly wage
rates at these two sites respectively,' h' is the number of man-hours required to produce
one ton of product and 't' is the cost of transportation per ton-mile. The cost of production
and transport at site P1 would be (tdl +W1h) and at site L1 it would be (td2 + W2h).

The cheap labor site (L1) would be chosen if(tdl +W1h) > (td2 + W2h)

Or(w1-w2) h > t (d2 - dl) i.e., saving in labour cost exceeds the increment in
transportation cost. For every level of saving in labour cost there will be a critical
isodapane within which the cheap labour cost site must lie for economic viability from
location point of view.

57
To measure the importance of labour as a location factor, Weber used the average cost of
labour per unit weight of product as an index. Greater the labour cost index more will be
the industry's susceptibility to move from the least transport-cost site. As an improvement
over the simple labour Cost index. Weber suggested to use the industry's coefficient of
labor. This is defined as the labour cost per ton of location weight, where

Location weight = Weight of material and product/Weight product

= Material index (MI) + 1

A high coefficient of labour means a strong attraction to the cheap labour location.

Weber's analysis of industrial location is indeed a pioneering one. It has paved the way
for development of programming models for industrial location. Many economists have
used this analysis as the basic framework for their location theory and empirical works.
Even then this theory is not free from criticisms.

b) The Market Area Theory of Tord Palander

Tord Palander started his market area theory of industrial location analysis by posing two
different but interrelated questions.

 Given the price and location of materials and the situation of the market, where will
production take place?
 Given the place of production, the competitive conditions, factory costs, and
transportation rates, how does price affect the extent of the area in which a particular
producer can sell his goods?

To demonstrate how the market boundary between firms can be determined, Palander
took a simple case of two firms making the same product and selling that in a linear
market, which is depicted in figure. 4.3, the firms are located at two different places, A
and B, which are on a horizontal line which defines the market area of the firms. Let the
prices charged by the firms at their locations be and respectively These are shown by the
58
vertical distance AA' for firm A and BB' for firm B The consumers who are situated
away from the location points of the firms will be paying higher prices for the product of
the firms. The addition in price will be the transportation cost Let ta and tb be the average
transport costs for the product per unit distance for the two firms respectively. The price
for the product at a point other than location would be α + ta da for firm A and β+ tb db
for firm B, da and db are the distances of the point from the location of firm A and firm B
respectively. The transport cost is a function of distance for each firm. The gradients of
total price paid by the consumer for the product are shown by the lines forming cones at
points A' and B' for the two firms in Fig. 4.3.

Figure 4.3 Determination of market boundary for two firms in a linear market

The gradients are linear because of fixed transport rates for the product over distance.
Just above point X, the gradient lines of firm A and firm B intersect. This implies that
consumers would be paying same price for the product of the firms. The point X defines
the boundary between the market areas of the two firms.

Algebraically, at point X we have:

α + ta (AX) = β + tb (BX)

Since AX + XB =AB, i.e. the distance between the firm, we can therefore write

59
α + ta (AX) = β + tb (AB-AX) Or

AX = [(β - α)/ (ta+tb)] + [(tb)/ (ta+tb)]. AB

Example
Let α = Birr.100, β = Birr. 90, ta = ta = Birr. 2 and AB = 100 km.
So, AX = [(90 – 100) / (2+ 2)] + [2/ (2+2)] [100]
= -2.50 + 50
= 48.5 km.

Firm A can sell only up to 48.50 kilometers toward firm B. The rest of the distance
between- them, i.e. 51.50 kilometers defines the market area of firm B. The determinants
of market boundary or area for the firm are prices at the locations, transport rates, and the
distance between the firms. Given the location of the firms and hence the distance
between them, the boundary of their market areas will depend on the relative magnitudes
of the location price (α and β) and the transport rates (ta and tb). There may be several
combinations of these variables. For each combination there will be one boundary
between the firms. For example if α > β and ta = tb, it will give us one boundary, and if α
> β and ta > tb, then we will have the other, and similarly various other situations can be
examined for determination of the market areas of the firms.

On relaxing the assumption of linear market, the market boundary for the firms will be
defined by a line showing the locus of the points of equal delivered prices for both the
firms.

The gradients of delivered prices for the firms will be spreading in all directions in the
horizontal plane from their respective locations. The intersections of the gradients of the
two firms will give the market boundary line for them. Palander calls such boundary line
as 'isotante'. The shape and situation of the isotante depend on the relative magnitudes of
location prices and transport rates for the firm.

60
The market area of a firm will be extended to greater distance if its factory price and
transport cost are lower or decline. The size of market area will influence the profit of the
firm. Given the production cost and the rate of profit per unit output, larger the market
area more will be the total sales and hence total profits of the firm. The market area and
hence sales and total profits of anyone firm will be influenced by the locational decisions
and other actions of the competing firms.

Palander's analysis is not a mere extension of the Weber's work. He made valuable
contribution to locational analysis by adding the market area dimension to it. He did not
accept the agglomeration analysis of Weber but emphasized much on dynamic aspects of
locational factors.

c). Central Place Theory of Losch

The advocator of central place theory August Losch started his analysis on a broad
homogeneous plain with uniform resource endowment. This rejects all cost difference
factors affecting industrial location. In such situation, the right approach to decide about
the location is to maximize total revenue. An individual locates his plant at that
particular site, where revenue is maximum. The maximization of revenue implies profit
maximization because of the assumption of uniform cost conditions across the locational
plain in Losch model. To explain his theory, let us take a simple situation in which there
is only one producer who is located at a central place. He sells his product around the
location point in circular belt, the extent of which depends on the economies of scale
accruing to the producer and the transportation, i.e. distribution cost of the product. The
demand for the product falls with distance. The maximum extent of the market area for
the producer is given by the distance when demand falls to zero because of high price for

61
the product. This is shown by OF in Fig.

4.4.

Fig. 4.4.Market area of firm (Losch Model)

The circle with OF as radius defines the market area for the producer. 0 is the location of
the producer at which OQ is the demand for his product. The producer being only one in
the market makes profits. This attracts other competitors in the industry. They put up
their plants in the area. There is no restriction for that. The resources are available. The
entry of new producers gradually reduces the market area of the existing firms. Their
markets will not continue to be circular but somehow irregular in shape. However, when
distribution of the firms in the plain is uniform the market area for each one of them will
be hexagonal. The profits for each firm will be minimal at this stage. Each industry will
have a system of hexagons of its own. The superimposition of hexagons of different
industries produces a common production centre surrounded by the sub-centers of
productions in orderly sequence. Losch's theory is a general spatial equilibrium theory,
and it is not giving any thing about the factors which determine the location of individual
firms. The rejection of cost differences as locational factors is a major weakness of
Losch's theory.

Questions for review and discussion

62
Attempt the following questions. Write your answer in your own words. Do not directly
copy from the module.
1. Why Messobo Cement Factory does select its location in Mekelle? Is it only because
of the availability of raw material? Give your answer based on the theoretical
knowledge you have acquainted from this chapter.
2. Explain the different factors to be considered while taking the decision of location for a
factory.
3. Discuss briefly the different approaches to industrial location. In your opinion which
approach is more important. Why?
4. Explain all the methods coming under economic approaches of industrial Location.
Compare the merits of each method with Weber's Theory.

CHAPTER 5

Demand Analysis

Prompting Questions:

63
  What is the purpose of developing industries in any country?
 What are the important economic factors that should firms consider for the
demand analysis
 Explain the concept of elasticity of demand and it implications for business
decision making.
 What are demand forecasting and its importance?
 Mention some of the chief variables to be taken into account for demand
forecasting
 what are the techniques of demand forecasting you are familiar with

Chapter Objectives
After studying this chapter the students will be able to
1. Explain theory of demand
2. Describe the concepts elasticity and its determinants and the importance of
elasticity in decision-making
3. Discuss demand for the firm's products and its determinants
4. Describe the requirements for demand forecasting
5. Understand about different demand forecasting techniques

Introduction

The purpose of developing industries in any country is ultimately to make goods and
services available for human uses. Some goods and services are needed directly to satisfy
consumption needs of people (such as cloth, soap, medicines, food stuffs, etc). These are
known as 'consumer goods'. Some goods and services are needed to produce consumer
goods such as machines, trains and motors, etc. They are called 'capital goods'. If goods
64
and services are capable to satisfy human wants and there is willingness and capacity to
buy them then the industries will come into existence to produce them. In the
terminology of economics, we use the term 'demand' for this. That is, if there is demand
for a commodity, then only it will be produced in the market. Knowing the demand for
goods and services is a prerequisite for the firms supplying them since all other activities
like procurement of raw material, scheduling of production, capital requirement and
marketing, etc., are eventually linked with it. It is the demand that plays a crucial role in
making the firms more or less efficient. In view of such importance of the demand, it is
quite obvious for anybody concerned with the conduct of the business to ask for details
about the concept, its theories and techniques of measurement This is what we plan to do
in this chapter under the heading 'demand analysis'. Such analysis will provide us the
basis for analyzing the factors which influence the demand for the firms‘ products and the
extent to which they can be adopted in manipulation of the demand. The first section
deals with the theory of demand and elasticity concepts; it is followed in sequence with
the sections on demand for the firm's products and demand forecasting.

5.1 The Theory of Demand

The demand analysis that we intend to do in this chapter requires a review of the theory
on which it is based. The theory is quite comprehensive having different streams of
thoughts and procedures. But the whole of that is not relevant for us in the context of
industrial economics. Our interest is a limited one - to find the determinants of demand
for a commodity in the market and to find the factors which affect the demand for the
products of the individual sellers in that market. Once we are able to do so, the next step
will be to find a framework to measure the demand using the plausible determinants. For
this, a simple theory of demand based on the utility maximization principle will be
adequate. The utility maximization principle is the basic approach used to analyze the
equilibrium of a consumer in the market. A consumer needs so many goods and services
at a time to satisfy his different needs. The usefulness of a commodity for the consumer is
defined in economics in terms of utility. That is, a consumer will buy the commodity only
when it has some utility to him. Suppose, the consumer has limited resources (i.e.
65
income) at his disposal and he wants to buy some finite number of goods and services by
that. What should be the criterion to choose the quantities of goods and services?
Naturally, he cannot buy whatever he wants since his income does not allow this. The
utility maximization principle shows us a way for this. We simply argue that the
consumer tries to maximize his total utility that he derives from the goods and services
subject to the constraint imposed by his income. Formally, we say that there is a utility
function for the consumer which may be written as:

U =f ( q ,q , q ..... q ) (5.1)
1 2 3 n

Where U = Total utility, q1 , q , q 2 3

..... q are quantities of goods and services
n

bought by the consumer; and f is the functional form of the relationship between the two
sides of this equation.

This function is assumed to be continuous having first and second order partial

derivatives. The first order derivatives defined as (i = 1,…,n) are called
 qi
marginal utilities which are further assumed to be positive and declining with the level of
consumption (quantity) of the commodity concerned. This is what 'we know as the law of
diminishing-marginal utility in the consumer equilibrium theory.

The consumer spends his income on all these goods. His income expenditure equation
can be written as:

Yo = Plql + P2P2 + P3q3 + ….. pnqn (5.2)

where Yo is the fixed income and Pi (i = 1,…… .,n ) are fixed prices of the commodities
qi (i = 1,……, n) respectively.

The utility maximization principle says that a rational consumer maximizes (5.1) subject
to the constraint shown by equation (5.2). To solve the problem we write the standard

66
Lagrange Function for this as:

L=f(q ,q , q ..... q ) +  [y0- Plq1 - P2P2-P3q3- ….. -pnqn] (5.3)

1 2 3 n

Taking the partial derivatives of this function with respect to q1, q2…..,qn and  ,we get
the following equations:

L f 
  p1  0 
q1 q1 
L f 
  p 2  0  (5.4)
q1 q 2 
L f 
  pn  0 
qn qn 

These are the first order maximization conditions. We can solve them for q1, q2, . . . qn,
and  provided the second order conditions for maximization are satisfied.

f
The derivatives (i  1, . . . , n) are the marginal utilities of the commodities ql
 qi

to qn respectively. The solution of this set of equations gives us the equilibrium condition
as

f / q1 f / q 2
  ....   (5.5)
P1 P2

This shows that for maximum total utility the consumer should spend his income in such
a way that marginal utility per init of money spend on each commodity is identical and
equal to the marginal utility of money (). When this condition is satisfied, we express
the solution for q1, q2…qn in terms of y0, p1,p2,and pn, that is

q1 = 1 f ( p1, p 2, , ...... Pn, Y 0

2
q1 = f ( p1, p 2, , ...... Pn, Y 0 (5.6)

67
 n
q1 = f ( p1, p 2, , ...... Pn, Y 0

These are demand relations for the different commodities in which we are concerned
here. These relations are showing that the demand for each commodity depends on its
price, prices of other goods and services which the consumer buys and his income. 1f, 2f, .
. . , nf are the functional forms of the demand relations.

If the function U = f(q1. q2, . . . , qn) is specified in functional form then we will
automatically get the forms of the demand relations (or functions) shown above.
Unfortunately, we cannot measure utility since it is a subjective concept. But can estimate
the demand equations empirically using the statistics, on quantity demanded, prices and
income.

We have taken income (YO) and prices Pi (i = 1, . . . ,n) as exogenous variables as

determinants of the demand for commodities by a consumer. However, one may take
'taste and preferences' also into account and enlarge the specification of the demand
functions. as:

qi = 1f(Pl, P2, . . . , Pn, Yo, T), i = 1, . . . , n (5.7)

Where T indicates some measurement for taste and preferences of the consumer, other
variables have already been defined earlier.

Let us take a simple example to show how one can get the demand functions for the
goods and services using the utility maximization approach.

Assume that the utility function is given as: U= q11q2 2

and income-expenditure
equation is given as:
Yo=p1q1 + p2q2
Forming the Lagrange Function we get:
L= q1 1q2 2 + ( Yo- p1q2 - p2q2)
Taking partial derivatives with respect to q1, q2 and A, we get
68
 L 
q
1

  1q 1 2
 p 0
 q1 1 2 1

(5.8)
L 
q2  
1

 2q 1 2
p 0
 q2 1 2

From first two equations, we get

 
 q q q
1 1
1

2
2

2

p 1
 
q q q
2 1
1

2
2
1
p 2

Or
q1 2

p 2

q2 1
p 1

Or p q  p q
2
1

2 1
2

1
0 (5.9)

Solving equations (5.8) and (5.9) for q1 and q2 we get

1 Y 0 
q1   
1   2  P1 
2 Y 0 
q1    (5.10)
 2   1  P2 

These are two demand functions which show the quantity demanded for either good as a
direct function of income (Y0) and inverse function of its price (p).

We have considered the derivation of the demand function for a consumer. There will be
such demand functions for each of the consumers in the market. The total market demand
for a commodity will be the horizontal sum of the demand functions for the individual
consumers. Horizontal summation means adding up the total demand for the commodity
at a given price.

The general determinants of market demand will be:

69
(1) Price of the commodity concerned (PQ);
(2) Prices of other commodities which may be substitutes or complements to the
commodity (Ps and Pc);
(3) Purchasing power of consumers which means absolute level of community's income
and its distribution (Y);
(4) Number of customers which may be represented by population (N);
(5) Tastes and preferences of the customers (T);
(6) Expectations about income and/or prices, and
(7) All other factors which may influence the demand like product characteristics,
advertisement (A).

5.2The Elasticity Concept

From decision-making perspective the firm needs to know the effect of changes in any
one of the independent variables in the demand function on the quantity demanded. Some
of these variables are under the control of management, such as price, advertising,
product quality and customer service. For these variables decision makers must know the
effects of changes on quantity to assess the desirability of instituting the change. Other
variables, including income, prices of competitors‘ products, and expectations of
consumers regarding future prices, are outside the direct control of the firm.
Nevertheless, effective forecasting of demand requires that the firm be able to measure
the impact of changes in these variables on the quantity demanded. The simplest way
devised for this is the use of the elasticity concepts. It is used to measure the
responsiveness of the quantity demanded (dependent variable) of a commodity to the
changes in anyone of its explanatory variables, say price or income or something else in
the case of demand. More precisely, the elasticity in the case of demand analysis is -
defined as the percentage change in quantity demanded attributable to a percentage
change in an independent variable symbolically:

70
 % changein quantityQ
Elasticity 
% changein any independent var iable X (5.15)

Q / Q  X 100  Q  X
X / X  X 100 X Q

(i) Price Elasticity

This is a very important concept having wide applications in the theory of the firm.
Through this concept, a businessman can measure the responsiveness of demand to
changes in price of the commodity concerned.

The change in the quantity demanded is Q2 – Q1 = Q and change in price is P2 – P1=

P. So the price-elasticity of demand is

 Q  Q1   P2  P1  Q P1
eP   2     (5.16)
 Q1   P1  P Q1

The range of variation of elasticity coefficient will be between zero and infinity. The
following are the sub ranges for this variation.

a) eP = , this shows infinite change in quantity demanded when there is one per cent
change in price. It is called 'perfectly elastic demand. The demand schedule will be
straight line parallel to the quantity axis.

(b) ep> 1, this is what we call as elastic demand.

(c) ep = 1, this is unitary elasticity.

(d) ep < 1, this is in elastic demand situation.

(e) ep = 0, this is called as 'perfectly inelastic demand, showing no change on quantity

demanded by a change in price. Some life-saving medicines may show this situation.

For most of the essential goods the price elasticity will be less than one and for luxury
71
goods it will be more than one. Such variations in the price elasticity take place because
of five reasons.

1.Greater the number of close substitutes more will be the price-elasticity since
whenever there is a change in the price of the commodity it will be substituted by and for
the substitutes depending on -the increase and decrease of the price respectively. The
responses of the quantity change will thus be more, making the elasticity higher.
2.The nature of the commodity used whether it is for luxury or necessity is another
important determinant of the elasticity. For necessities like food, medicines etc., the
elasticity will be low enough since such goods being essential for life are to be consumed
or used in the required amount. Changes in their prices are not going to change the
quantities for consumption appreciably. For luxuries, however, one can postpone the
consumption, and because of their non-necessity nature the response of the quantity
change will be considerably more with changes in their prices. The elasticity in general
will be higher than for them as compared to the necessities.
3.Another factor that determines the elasticity is the number of uses of the commodity.
Greater the number of uses, greater will be the elasticity.
4. The durability of goods particularly household goods like TV, car, washing
machines, radios, etc., also affects the elasticity of demand. These goods are used for
longer periods. Normally they are replaced by new one before completion of their service
lives. When a user should replace them depends on their prices. If prices fall, there may
be considerable replacement activities causing an increase in the quantity demanded,
making the elasticity higher. If so, it will be lower in the opposite case of increase in their
prices.
5. The last factor is the proportion of income spent on the commodity. If it is
extremely low, the consumer may not feel the impact of price changes on the
consumption of the commodity. The elasticity will in general be low in such cases, e.g.
match boxes, newspapers, etc.

All these factors are not independent of each other. They affect the elasticity of demand
jointly in actual practice.

72
Price elasticity has important applications in business decision making. It is an
important factor which determines the shape of the demand curve for the firm. The shape
and position of the demand curve affect the price cost margin for the firm. The most
common use of price elasticity, we may cite here, is in pricing policy formulation. How
much increase in total revenue a firm can get by reducing price of its product depends on
price elasticity of demand. If demand curve is elastic the firm will get an increase in the
total revenue, otherwise not. This can be shown through the following derivation of the
marginal revenue-price-elasticity relationship.

As we know, TR = p. Q where P = price and Q = output.

Taking derivative of TR with respect to Q, we get

dTR
Marginal Revenue (MR) =
dQ

dQ
= PQ ………………………….a
dP

dQ P
We know that price elasticity of demand equal to e p
 
dP Q
…………..b

dQ P
which means, Q 
dP e p

Substituting this in equation (a), we get.

P
MR = P 
e p

 1 
MR= P 1 

 pe 

73
Since for a downward sloping demand curve, e p
will be negative, so we can modify this

 
 1 
formula as MR  P 1 
 
 ep 

Where e p
is the absolute value of e p .

This shows that MR will be less than price P if e p

 .

1
If e p
> 1, then < 1, so MR > 0;
e p

1
and if e p < 1, then > 1, so MR < O.
e p

This has implication for price reduction policies. A firm should not reduce price for its
product if the price elasticity is less than I. It will not get any addition in its total revenue
which will, in fact, decline because of negative marginal revenue. The total revenue will
increase only if the elasticity is more than 1.

The price elasticity is an important determinant to find the impact of taxes. Generally we
do not find a government imposing indirect taxes on necessities because their incidence
ultimately will fall on the consumers. But, in the case of luxuries the burden of such tax
'will be shared by the producers and consumers. How much on each, depends on the
elasticity.

Similarly, we find the use of the price elasticity in adaptation of a new technology.
Assuming that the new technology reduces the average cost of production for a firm.
Because of the reduction in average cost, there may be a reduction in the price of product
in the market. Either the market forces itself or public intervention will ensure this. A
reduction in price will be beneficial to the firm only if it faces elastic demand for its
74
products. If the demand curve is inelastic, there will not be any gain in new technology
from price side. Empirically, we find considerable technological progress in the
industries producing luxury goods (i.e. elastic demand categories) as compared to those
producing necessities.

We may now sum up the discussion on price elasticity by saying that it is very useful
from the practical point of view for the firm in decision making. The firm cannot ignore
the implications of the price elasticity of demand on its price and product policies.

(ii) Income Elasticity of Demand

The income elasticity shows the percentage change in quantity demanded when income
of the consumer changes by one per cent, that is we may write it as:

Q Y Q Y
ey  Q

Y
 
Y Q 5.17

Where Y= income and Q= quantity

For most of the goods the income elasticity of demand will be positive. There may be
some goods for which it turns out to be negative. Such goods are called inferior goods in
the economic literature. For luxury goods, we may find ey > 1 and for necessities and

semi-luxury goods it may vary between zero and one.

To compute income elasticity of demand one has to take the appropriate measure of
'income' into account. Income may be measured on an aggregate or on an individual per
capita or per household basis. The aggregate concepts are like gross national product,
gross disposable income, and personal income and so on. Generally, per capita disposable
income is taken in practice since it indicates the income along with its distribution among
the consumers.

The knowledge of income elasticity of demand is a vital piece of information for a

75
firm. A firm whose demand functions show high income elasticity will have good
opportunities for business particularly for expansion. For certain goods, there may be
consumption ceiling from the consumers' point of view. A firm supplying such goods
will be stagnant if it continues to produce them. There will be no opportunities of growth
for that. The firm in such situation can grow only through diversification of its business.
The income elasticity helps in making such decisions even for future assessment of
demand the firm will take income elasticity into account. In fact, in planning, the target
rate of growth of income and income-elasticity of demand are used together to forecast
future consumption of goods and services.

(iii) Cross-elasticity of Demand

The cross-elasticity is used to measure the responsiveness of quantity demanded of a

good say X, when there is a change in the price of some other good say Y. The two goods
X and Y, may be either substitute or complementary to each other. Few examples of
substitute goods are tea and coffee; butter and margarine; coal and gas; gas cookers and
electric cookers and so on. Similarly, some examples of complementary goods are: sugar
and tea; petrol and car; electricity and electric cookers; pen and ink; and so on. Some
goods may be related together through the derived demand mechanism, that is, they are
used as inputs to produce some other commodities. If prices of those commodities go up
then the derived demand for the inputs may go up, such as buildings and bricks. Greater
the prices of buildings more will be the incentive to build them and hence more will be
the demand for bricks.

The formula for the cross-elasticity is similar to the one we have used above, i.e.

Q P
Cross elasticity of demand (e x. y
)
P Q
x
 Y

Y X

76
 dQ p y
ex , y  dP Q
x

y x

Where Qx = quantity of commodity X

Py = price of commodity Y

For substitute goods ex. y will be positive and for complementary goods it will be
negative. It will be positive in the case of derived demand also, that is, when X is used in
production of Y. If ex y is zero then the two goods will be unrelated to each other.

The knowledge of cross elasticity is very much essential when the goods are competing
with each other or when they are required in some combination with others. Now-a-days,
there are different 'brands' competing' in the market. It is obvious for a firm, therefore, to
find the effect of prices of other brand of commodities supplied by the competitors on its
own. In oligopolistic and monopolistic markets the cross elasticities play vital' roles in
the business decisions regarding prices and products.

(iv) Promotional Elasticity of Demand

This is relevant in that situation when a firm tries to increase its sales through sales
promotion activities like advertisement. The responsiveness of demand for the
commodity can be measured in the same way as we have described above by taking the
promotional activity as an independent variable just like income or price

Combined Effect of Demand Elasticities

When two or more of the factors that affect demand change simultaneously, one is often
interested in determining their combined impact on quantity demanded. For example,
suppose that a firm plans to increase the price of its product next period and anticipates
that consumers' incomes will also increase next period. Other factors affecting demand,
such as advertising expenditures and competitors' prices are expected to remain the same
in the next period. From the formula for the price elasticity (Equation 5.16), the effect on
quantity demanded of a price increase would be equal to
77
%QD  ED (%P) )

Similarly, from the formula for the income elasticity (Equation 5.17), the effect on
quantity demanded of an increase in consumers' incomes would be equal to

%QD  EY (%P)

Each of these percentage changes (divided by 100 to put them in a decimal form) would
be multiplied by current period demand (Ql) to get the respective changes in quantity
demanded caused by the price and income increases. Assuming that the price and income
effects are independent and additive, the quantity demanded next period (Q2) would be
equal to current period demand (Ql) plus the changes caused by the price and income
increases.

Q 2  Q1  Q1ED (%P)  Q1. Ey (%Y )

Q 2  Q1 1  ED (%P)  Ey (%Y ) (5.18)

An example can be used to illustrate the application of this concept. Consider the case of
a firm that is planning to increase the price of its product by 10 percent in the coming
year. Economic forecasters expect real disposable personal income to increase by 6
percent during the same period. From past experience, the price elasticity of demand has
been estimated to be approximately -1.3 and the income elasticity has been estimated at
2.0. These elasticities are assumed to remain constant over the range of price and income
changes anticipated. The firm currently sells two million units of its product per year.
Determine the forecasted demand for next year (assuming that the percentage price and
income effects are independent and additive). Substituting the relevant data into Equation
5.18 yields:

Q2 = 2,000,000 [1 + (-1.3)(.10) + (2.0)(.06)

= 1,980,000 Units
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The forecasted demand for next year is 1.98 million units assuming that other factors that
influence demand, such as advertising and competitors' prices, remain unchanged. In this
case, the positive impact of the projected increase in income is more than offset by the
decline in quantity demanded associated with a price increase.

5.3. Demand for the Products of Individual Firms in an Industry

The knowledge of total market demand for the products of an industry is very much
useful for a firm operating in that industry. But the more important for the firm is the
knowledge of the demand for its own products. In other words, what is its share in the
total sales by the industry? Higher the market demand for the products of an industry,
higher would be the demand for the products of individual firms in that industry if they
are able to maintain their market shares.
The market share for an individual firm can be defined as:

S
M i
 n
i

S
i 1
i

Where Mi = market share of ith firm

n = number of firms in the industry
Si = Sales by ith firm
n

S
i 1
i
= total sales by industry

The market share need not be identical for all firms since some of them may be bigger in
size while others smaller. How can a firm increase its share in the total market demand?
Obviously, if the firm is able to sell more relative to other competitors, its market share
will go up. An increase in sales or what is the same thing, an increase in the demand for
the firms' products depends on the general factors (i.e., income, prices, tastes and pre-
ferences) affecting the total demand for the products of the industry as a whole plus
marketing efforts by the firm. In fact, we can say that it depends on a set of exogenous
factors as well as some internal factors clubbed together as sales promotion activities

79
which determine the demand for individual firm's products or its market share. Let us
take the main factors into consideration and see how they affect the sales of a firm.
Incomes, prices and tastes are the generic determinants of the total market demand. The
attempts to increase sales by a firm ultimately become operative through one or more of
these factors. Income is an exogenous factor. The firm would not be able to influence it.
Similarly, the prices of other goods and services, either Substitutes or complementaries,
can not be controlled by the firm as they are also exogenously determined by someone
else. The prices of its own products may be manipulated by the firm in order to increase
sales. Say, it can reduce prices and thus attract more customers in the market. How can
the firm do this? This depends on the market structure prevailing where the firm is
operating and the marketing activities such as advertisement, branding or product
variations, packaging, point-of-purchase displays and trade shows. The non-price
competition in marketing which includes all these elements plus others like credit sales,
discounting, hire-purchase facilities, after-sales services, etc., is the way to increase
individual company sales in a competitive industry at present. All such activities will be
under the control of the firm which can make proper choice from them depending on the
situations for increasing its sales.

The success of a firm in increasing its sales in the market depends upon its marketing
management strategies. The concept of marketing management is a comprehensive one.
It involves the analysis, planning, implementation and control of programmes designed to
bring about desired exchanges with target audiences (i.e. the customers). The crucial role
of the marketing management is to determine or identify the marketing decision variables
or strategies which will maximize the sales of the firm in the light of the expected
behaviour of exogenous demand variables.

In general the decision variables that are controlled by the firm will be related to the
product quantity and quality attributes, sales promotion activities such as advertisement,
place of marketing including pattern of distribution channels, and prices. The exogenous
demand variables include (a) consumer variables such as number of buyers, types of uses
of the goods, etc.; (b) environmental variables like technology, public policies and

80
culture; and (c) competitive variables which are controlled by the competitors.

5.3 Demand Forecasting

In the preceding sections we have discussed the concepts and determinants of demand in
the theoretical framework. The more important aspect of demand is its measurement and
forecasting for a future date. A businessman in industry produces goods for future
consumption or use. An assessment of the future demand for the products of the
industrialist is the basic information. His current level of output, and so, uses of the
inputs, requirement of finances, level of inventory, etc., depend on the future level of
demand for his products. The demand forecasting is, therefore, a crucial requirement in
business. It reduces the uncertainly about the future so that more effective decisions can
be taken right now. A forecast is a prediction or estimation of a future event. Nearer a
forecast is to its true value, higher will be its acceptability or accuracy. An industrialist
therefore aims at getting as accurate as possible forecast for future sales of its products.

(i) The Requirements for Demand Forecasting

The demand forecasting for any commodity cannot be made merely through guess work.
It requires a thorough understanding of the current and probable future conditions of the
market in which the firms supplying the commodity operate. For convenience, we may
list major elements together which come under the following categories:

(A) Elements related to consumers

 Total number of consumers

 Distribution of consumers/products
 Total purchasing power and per capita/household income
 Income elasticities
 Consumer tastes, social customs, etc.
 Consumers' marketing details: where they do buy and when, etc.
 Effect of design, colour, etc., on consumers preferences

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(B) Elements concerning the suppliers

 Current levels of sales

 Current stocks of goods
 Trends in sales and stocks
 Market share
 Pattern of seasonal fluctuations
 Research and development trends
 Company strength and weaknesses
 Product life cycle (age)
 New product possibilities

(C) The elements concerning the market (i.e. industry)

 The effect of prices; price elasticity

 Product characteristics
 Identification of competitive and complementary products
 Number and nature of competitors
 Forms of market competition (price, advertisement, brand policy etc.)
 General price levels
 Prices of similar goods

(D) Other exogenous elements

 Economic environment in the country showing levels of economic

activities, employment, trends in income, national income, population,
education, etc.
 Government policies
 Taxation
 International economic climate

The above list provides a comprehensive picture of a market profile which can be used as

82
a base for demand forecasting. The quantitative information about various elements and
their implication for the demand analysis can observed carefully. Once this is done, we
can proceed with the further for demand forecasting in three stages. The first stage is
concerned with the assessment of the general economic and national situation in the
future. This means estimation of future population, future changes in income,
employment, price levels technology, productivity, international trade and government
policies, etc. All such estimations will be having considerable implications for the market
demand for goods and services. The second stage is to estimate or forecast the future total
market demand for the commodity in which the forecaster is interested. All demand
factors are to be considered for this. The third stage is to find the firm's share in the total
market demand. The firm may assess the impact of its own marketing policies while
forecasting its share in the market demand for the product(s).

(ii) The Techniques of Demand Forecasting

There is no unique method for demand forecasting. Several methods have been devised
for this purpose but which one is the best, i.e. gives accurate forecast is difficult to find.
Usually, a forecaster looks for a method which is simple to use, and for which necessary
data is available. The other variables like cost of forecasting, degree of accuracy, and
purpose of forecast will also constrain the choice of the method. There are objective as
well as subjective methods of demand forecasting. An objective method gives us the
prediction and projection of demand using a statistical or mathematical approach. In
subjective method; conclusions are drawn about the demand using intuition which makes
its base on experience, intelligence and judgment. In ideal forecasting, both these
approaches will be combined together with varying degrees depending on the situations.
Say, in the absence of appropriate quantitative data, a firm may rely on the subjective
methods more than the objective ones. Further, the cost of time and money may also
force it to use the subjective methods. The important objective methods for demand
forecasting includes: Trend Method; Regression Method, Leading Indicator Method,
Simultaneous Equation Models, and Input-Output Method. In the subjective category the
important techniques are: Experts‘ Opinion Survey Method, Consumers Interview

83
Method and Historical Analogy Method. Some these methods are discussed
systematically with the emphasis on their merits and demerits for demand forecasting in
practice.

(a) Survey Methods

These methods are designed to know the intentions of the buyers to buy a product given
its price, quality standards and other properties. There are two ways to do this. One may
ask the buyers directly a set of well-defined questions to find their willingness to buy the
product at different prices, and what changes in the product would induce them to buy it
or to buy more of it. This may be done either through interviewing them individually or
via mail questionnaire method. In either case one may get the responses of all customers
(complete enumeration method) or a few of them chosen on sample basis (sample-survey
method). The complete enumeration method is ideal since in this case there is no scope of
any bias from the forecaster's side regarding the choice of the buyers to get the desired
information. His job in this case would be just to aggregate the collected information
from the survey. This method is not feasible when the number of consumers is very large
and they are scattered over a wide area. The alternative for this is to take few selected
consumers on sample basis and get their responses about the demand for the product. The
results of such responses are, then, blown up to get the responses for the total number of
consumers. This is a simple method. It has wide applicability and the cost of data
collection in the survey can be put under control by making appropriate changes in the
sample size.

Apart from the cost and time elements involved in consumer survey methods, there are
some serious defects which make them less reliable. Consumers picked up for survey
may not take the interview or questionnaire seriously as they have to gain nothing from
this. As a result they may give vague responses without much thought behind them. Their
responses may be biased and random, created just by the interview itself. They may give
inflated magnitudes for their purchases just to please the interviewer though in reality
they buy less or not at all. Sometimes to keep the formalities completed they may answer

84
as 'do not know' which is difficult to analyze. Their purchase plans may change in future
making the survey out of date. There may be false recording of responses by the
interviewer himself and even the selection of sample may be biased. Seeing all these
possibilities, one has to be very careful in using the consumer survey methods for
demand forecasting.

Another way for finding the consumers' intention to buy a commodity is to take the
opinion of person other than buyers. Such persons may be the salesmen, distributors and
retailers who deal with consumers and so are able to assess their needs indirectly. If a
company relies exclusively on its own sales staff for this, there may be convenience and
saving of forecasting costs but the estimates are likely to be biased normally in an
optimistic direction. There may be undue subjectivity in the estimates since some
salesmen will be optimistic either by nature or because of their desires to please their
bosses by giving inflated figures; some will be pessimistic by nature or will prefer to give
low estimates for saving their burden of selling more. This method will be useful only
when the salesmen are fully knowledgeable about the market situations, they are
cooperative and unbiased or their biases can be corrected, any they are given incentives
for their honest participation in the forecasting exercise. An alternative to the internal
sales force is to take the opinion of the outsiders like wholesale dealers and retailers.
Such outsiders, because of their experience, and judgment, may be able to give a better
feeling of the future demand for the products they deal with. However, there is no
guarantee that their assessment of the demand will be free from personal biases and
subjectivity. They may look at future in their own way making the process of
reconciliation extremely difficult. Whatever be the weaknesses of the experts, their
opinion cannot be overlooked in the exercise of demand forecasting. After all, they are
the persons like sales staff of the firm who deal with the sales directly in the market. They
are definitely better equipped for demand forecasting rather than anybody else.

To conclude the survey methods discussed above are useful in demand forecasting for
existing and new products. They are simple in use but less reliable and less accurate
because of the subjectivity attached with them. However, for quick estimates and cost

85
saving in forecasting one has to use them in practice in spite of their limitations.

(b) Historical Analogy Method

This method is applicable in demand forecasting for a new product or some existing
product in a new area. Since there will be no past data on consumption of that product in
the new area, its consumption pattern elsewhere may be taken as a basis for demand
forecasting. What will be the demand for television say in Mekelle city town may be
extracted from the TV demand pattern in Adama city where it has already been
introduced. Similarly, what will be the demand for St. George Beer in Ethiopia may be
studied from its demand pattern in France or Kenya or elsewhere. In the case of such
cross-country comparison one has to be very careful about the socio-economic as well as
psychological differences between the countries. Such differences are to be accounted
fully while making the demand comparisons. Attempts are to be made to select the
countries or areas with almost similar socio-economic background or situations. If the
product has not been in use anywhere, then past consumption pattern of some other
similar product may be taken as a basis for forecasting the demand for the product.

There are difficulties in the application of this method. It is very difficult to find a similar
country or area for the analogy. There may be considerable differences in the standard of
living, income, national characteristics and technology, etc., between the two situations.
It is extremely difficult to account for such differences and so the forecasts based on the
historical analogy may have subjective bias. Similarly, it may be difficult to find a similar
product for comparison. Further, the course of economic and technological development
between the countries may be quite different making the demand comparison for the
product less valid.

A variant of the historical analogy is' the method of test marketing. It involves selecting a
test area, which can be regarded as a true sample of the total market. The product is then
launched in the test area in the same mariner as that which is intended to be used if and
when the product is launched nationally. All marketing devices like package design, sales
force, TV and press advertisements, price, and so on, must be selected with this in mind.
86
If the product is successful in the test area, it can be forecast that similar level of success
will be achieved when it is launched nationally.

There are disadvantages of this method also, although it looks to be simple and attractive.
It is costly and times consuming in the sense that full scale marketing efforts are to be
made for a small area. The product is to be manufactured in smaller amount having
considerable unutilized capacity for longer time. The testing is to be continued for longer
period, otherwise there may be false or incomplete feeling about the sales. Selection of
the test area is also difficult. Moreover, the sales performance results in that area may not
be comparable with other parts of the country because of socio economic disparities. To
counteract this difficulty more than one test areas are needed to represent the nation as a
whole. Further, once the test marketing is launched competitors will be raising their
necks for imitation of the product

(C) The Trend Method

This method is used to forecast the demand of a product whose past sales records are
available for a number of years. The time series of sales of the product may show some
variation over time because of some systematic forces. The most important of these may
be the ‗trend‘ which shows effect of certain basic developments in population, capital
formation or technology, etc:, over time affecting the demand for the commodity. If the
trend turns out to be significant, it becomes very useful tool for long-term demand
forecasting for the commodity. The second one may be the cycles, that is, up and down
movements of sales over time showing constant amplitude and periodicity of variation.
This will be showing the business cycles in the market for the commodity. Capital goods
industries generally show such pattern. The third element of time variation in sales comes
through 'seasonality' depending on weather, holidays, festivals, etc. Such variations will;
be observed in short periods. The last one will be the 'random' variations because of
unforeseen future events like strike, riots, fires, thefts and so on.

(D) Regression Method

87
In this method, both economic theory and statistical methods of estimation are used
together to estimate the demand for a commodity. The economic theory is used to
identify the demand factors for the commodity and the expected shape of its demand
function. Once the determinants are identified, the least squares method can be used to fit
the relationship between them and the sales of the commodity. For example, we may
argue that the sale of a commodity depends on price of the commodity, personal
disposable income, rivals' prices, advertisement; visits to retailers by salesmen and time
trend taking are on the changes in tastes and preferences etc. In equation form we may
specify this relationship as:

Sales = ao + al (price) + a2 (personal disposable income) + a3 (rivals prices) + a4

(advertisement) + a5 (visits to retailers) + a6 (time)

This is a multiple regression equation which on fitting with the time series data will tell
us about the magnitudes and signs of the coefficients ao to a6 and their significance, i.e.
being different from zero, together with the overall power of the equation to explain the
variation in the sales.

Let us take simple equation which explains the demand for news print Ethiopia
According to this equation,

NPD = 2.84932 + 1.3591 Y - 0.5133Pn, R 2 = 0.950

(8.44) (-2.35)
Where NPD = Newsprint paper demand in Ethiopia
Y = National income at current prices
Pn = Index of import price for newsprint

This is a simple equation. Both the determinants are significant and have correct signs. If
we know the future values for Y and Pn then the demand for newsprint can be estimated
through this equation.

The regression method for demand forecasting essentially has three steps:

88
(i) The specification of the demand equation;

(ii) Fitting it to data, i.e. estimation of the regression coefficients and summary statistics
like R 2, t etc., and

(iii) Estimation or knowledge of future values for the determinants and through them to
compute the demand forecasts using the fitted equation.

Looking from the scientific requirements this is the best approach. We can get the
explanation for the "short-term as well as long-term variation in the demand using such,
approach. There are some difficulties with the method however. There are some
statistical problems with this. Sometimes the data may be inadequate; there may be multi-
collinearity, autocorrelation, heteroscedasticity, etc. in the estimation process which make
it very much complex and less reliable. However, a trained econometrician can handle
these difficulties, so this limitation has no weight. The second serious difficulty arises
because of non availability of the direct estimates for the future values of the explanatory
variables used in the demand equation. These in general are to be estimated. And if there
is bias or error in that, the demand forecast based on them will also be biased or
erroneous.

Questions for Review and Discussion

Attempt the following questions. Write your answer in your own words. Do not
directly copy from the module.
1. What is the relationship between the price elasticity of demand and the effect of price
changes on the total revenues received by a firm?
89
2. Given your knowledge of factors that influence the price elasticity of demand, how
would you describe the price elasticity of demand for the following items (Justify
your answer?)
a. Salt c. New automobiles
d. Vacation air travel d. Bread
3. What would you expect the advertising elasticity of demand to be for a firm in a purely
competitive market? What would you expect it to be in an oligopoly market
characterized by highly differentiated products, such as automobiles?
4. The price elasticity of demand for personal computers is estimated to be -2.2. If the
price of personal computers declines by 20 percent, what will be the expected
percentage increase in the quantity of computers sold?
5. Discuss some of the primary shortcomings of consumer surveys as an approach to
gathering information for demand forecasting.
6. The demand for tea has been estimated as
Q = 7000 – 550P + 210I + 425Pc
Where Q = thousands of pounds of tea sold
P = price per pound of tea
I = per capita disposable personal income in thousands of dollars
Pc = price per pound of coffee
a. If next year‘s tea price is forecast to be $3, percapita disposable personal income is
estimated to be $15,000(that is 15), and the price per pound of coffee is estimated to
be $4, compute the expected quantity demanded for the coming year.
b. Economic forecasters think there is a high probability of a major recession next year
that would reduce percapita income to $13,000. In addition, a frost in Brazil is likely
to increase the price of coffee to $7 per pound. What impact would these changes in
the economic out look have the demand for tea?

90