Industrial Economics Lecture Note Department of Economics

CHAPTER ONE: INTRODUCTION

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 relationships with society. The question is what is
a firm? What is an industry? What is the relationship between a firm and an industry?
A firm (enterprise, company or organization) is the basic decision making entity. It converts
inputs (capital, labour, raw materials and/or entrepreneurship) generally into marketable
outputs. It may comprise many establishments and divisions. On the other hand, an industry
is the aggregation of units of production selling goods that are in some sense similar. In other
words, an industry is a group of firms producing similar products. The firm earns the
difference between what it receives as revenue and what it spends on inputs, which are used
in manufacturing and selling.
In economic literature industrial economics is known by several names such as Economics of
Industries, Industry and Trade, Industrial Policy and Organization, Commerce and Business
Economics, etc.
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.
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

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Industrial Economics Lecture Note Department of Economics

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 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 per-
formance 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.
Industrial Economics encompasses both Industrial Organization and Industrial Dynamics,
which includes four themes:
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 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.
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.

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Industrial Economics Lecture Note Department of Economics

1.2 Historical Evolution of Industrial Economics

Although difficult to know the true beginning of industrial economics because of non-
availability of data, it has come up to the present stage mainly during the last 40 to 50 years.
The subject has not yet grown to its maturity. The early theory of the firm which we might
regard as the mother of the contemporary industrial economics was born as at this stage as an
integral part of the classical economics.

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 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.

1.3. Approaches of Industrial Economics

1.3.1. The Market Structure-Conduct- Performance (SCP)

Joe Bain and Edward Mason developed the concept “Structure-Conduct- Performance”
paradigm in 1936, dealing with the pricing policies of large-scale enterprises and it is also
called Harvard tradition.
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

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Industrial Economics Lecture Note Department of Economics

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 us 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:
(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 differentiated
goods and the large number of sellers generate the conditions for monopolistic 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.

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Industrial Economics Lecture Note Department of Economics

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.
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.
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

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Industrial Economics Lecture Note Department of Economics

follow more honorable tactics such as product 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?
3. Exchange Efficiency-refers to the costs of arranging transactions (transaction costs), 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.

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Industrial Economics Lecture Note Department of Economics

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 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.
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.

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Industrial Economics Lecture Note Department of Economics

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 relationship between Structure, conduct and performance
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 firms in the market,
innovation and advertising may raise entry barriers, predatory pricing could force competition

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Industrial Economics Lecture Note Department of Economics

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

Figure 1.2. 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).

1.3.2. The Chicago School of Thought

 The Chicago School gives high accord to Conduct.
 Criticized the SCP model for being non-theoretical and for having diverged too great an
extent from the basic neoclassical price theory.
 The school argues that even if their (SCP) empirical work was based on more realistic
assumptions, it came up with nothing more powerful in predictive ability than the
traditional perfect competition model.
 The logic of the Harvard Tradition is the empirical association that exist between
performance and structure.
 It should, however, be noted that such empirical association does not suggest causation
between the variables.
 According, to the SCP, high concentration (a small number of firms accounting for a
large part of market) was believed to lead to collusion and hence, higher profits thereby
calling for some sort of intervention to counter collusion (antitrust legislation).
 The Chicago school argued that where concentration was high, firms tended to be large
and larger firms tended to be more efficient and it was this efficiency that led to
higher profits.
 So, if greater efficiency was the cause for higher profits, there is a need for government
intervention. In fact, intervention would be counter-productive.
 The school sees the world as one in which competitive forces generally holds way and
argue that monopoly may be benign, or even beneficial to economic welfare.

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Industrial Economics Lecture Note Department of Economics

 They highlight monopolistic excess in various degrees. Thus the Chicago school differs
from the Harvard school with respect to:
 Methodological front, Chicago school relies much more heavily in their analysis on
standard (often competitive) economic theory, which contrasts with the sometimes
crude theoretical analysis employed by early Harvard writers.
 The fact that the Chicago writers have been skeptical of arguments advanced for policy
intervention in private industry, frequently arguing that elements of conduct and
structure viewed with concern by some economists in fact offer no real case for
government intervention. Hence, there is very little scope for government anti-trust
policy. Therefore, the Chicago School has conservative attitude to government
intervention.

1.3.3. Institutional Economics

 The central message of the New Institutional Economics is that institutions matter for
economic performance.
 The fundamental idea is that transaction costs do exist, are significantly large and they
can shape the structure of institutions and the specific economic choices people make
(i.e. Economic behavior of economic agents such as firms).
 It constitutes a radical development over the neoclassical theory.
 The price and technology constraints recognised by the neoclassical approach, a third is
introduced: institutions, which are the „formal and informal social rules’.
 They are humanly devised constraints that shape human interaction so that when we wish
to buy oranges, borrow money, form a business, we know or can learn how to do these
things.

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