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 relationship with society.

The term industrial organization is commonly viewed as synonymous with industrial

economics. Carlsson (1989) 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
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

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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
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

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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
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

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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.

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.

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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 behavior.

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?

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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:

(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:

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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 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

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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.

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?

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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
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

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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), 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.

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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
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

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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).
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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

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)

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 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 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.

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 performance.
Structure Conduct Performance
Figure1.2. More complex relationship between structure, conduct and

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
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.

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 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
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,

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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.

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 CHAPTER TWO
THE THEORY AND GROWTH OF THE FIRM

2.1 The Theory of the Firm

There are two approaches to the theory of the firm:

 the neoclassical approach, and
 The modern approach.

2.1.1 The Neoclassical Approach

The theory of the firm has evolved from representing the firm as a purely profit
maximizing automation, operating in a space less and timeless environment (neoclassical
theory). Thus, central to the neoclassical view of the firm is that the objective
determining the behavior of the firm is maximization of profits. That is, the firm is an
abstraction, an idealized form of business, whose existence is solely explained by the
purely economic motive of generating a profit.

The Neoclassical firm is thus a profit-maximizing (or cost-minimizing) entity operating

in an exogenously given environment, which lies beyond its control. Profit is also
maximized under conditions of perfect knowledge (information) about demand (which
yields marginal revenue, MR) and cost conditions (from which marginal cost, MC, is
derived). When the last unit no longer adds to profit – i.e., when MR = MC – then profit
is maximized.
The neoclassical theory of the firm is sometimes called a ‘black box’. What this means is
that the firm is seen as a monolithic entity; there is no attempt to probe inside the box and
explain why firms exist in the first place, or how the individuals who constitute firms are
motivated and interact.
Neoclassical theory was criticized on:
 Firms may not aim at profit maximization by equating MR and MC instead the
right price might be based on recovering full cost (including a conventional
allowance for profit).

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  Imperfect information, and thus uncertainty, is not taken as a relevant factor in
this theory since the firm operates in a timeless environment.
 The organizational complexity of firms may impede the application of the profit
maximization principle. The motivation and decision-making of individuals are
more fundamental than that of the organizations which they form.

2.1.2 The Modern Theories of the Firm

The assumption of profit maximization has come under repeated criticism. Many
economists have argued that this behavioral assertion is too simplistic to describe the
complex nature and managerial thought processes of the modern large corporation. Two
distinguishing characteristics of the modern corporation weaken the neoclassical
assumption of profit maximization. To begin with, the modern large corporation is
generally not owner operated. Responsibility for the day-to-day operations of the firm is
delegated to managers who serve as agents for shareholders.

In contrast to the neoclassical approach firms in modern approach are considered to have
multi-products and multi-techniques. Multi-plant operations are structured into several
divisions such as the production, sales, advertising, R and D, and finance departments.
The firm is not necessarily limited to a particular market or industry. Because of the
complex structure of firms, it becomes very difficult to ensure that information is
communicated rapidly and accurately between the different departments. Hence,
decisions that might be consistent with profit-maximization are more difficult to
implement. In addition, studies have shown that the principle of profit maximization may
not be the conscious goal of firms.

In contrast to the passive behavior of neoclassical view, the modern firm rather adopts an
active behavior. Active behavior involves the attempt by the firm to modify or to remove
the constraints it faces thereby permitting a better achievement of the firm's goal.
Advertising, R and D, product diversification, merger and take-over are all forms of
active behavior aimed at relaxing the external constraints.

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There are many areas of economic theory that are involved in the examination of the
nature of the firm. Three of the main ones are discussed below: the managerial theory, the
transaction cost theory, and the agency theory.

A. Managerial Theory of the Firm

The managerial theory emphasized the complex nature of the modern corporate firm.
Most research work described a diminishing influence of shareholders in the decision-
making process of large corporations. Much of the decision making process were left to
the manager, whose objectives could be different from those of the owners of the firm.

William Baumol has argued that sales or market share maximization after shareholders’
earnings expectations have been satisfied more accurately reflects the organizational
objectives of the typical large modern corporation. Size of firm is more important than
profitability for the manager (in terms of its influence on managers' salaries). Other
reasons why hired managers might be more preoccupied by sales- or revenue-
maximization rather than by profit-maximization include (according to Baumol):
1. If sales fail to rise, then market share and hence market power is going to be
reduced. This leads to increased vulnerability to the actions of competitors.
2. Sales also indicate the way the company performs.
3. The financial market and retail distributors are more responsive to a firm with
rising sales.

The model developed by Baumol attempts to reconcile the behavioral conflict between
profit-maximization and the maximization of the firm's sales (i.e., its total revenue).
Figure below depicts the firm's total sales revenue (TR), total cost (TC) and total profit. It
assumes that the firm maximizes sales revenue subject to a minimum profit constraint.

20
 Figure 2.1: Baumol’s Managerial Theory of the Firm

In the diagram, maximum profit is attainable at the output shown as Profit Max Output
where the vertical distance between TR and TC is maximum and TR > TC. The profit
maximizing firm would produce the level of output shown as Profit Max Output. If the
minimum acceptable profit is at the level marked with operational profit constraint, the
firm will not be able to produce at sales-maximization profit level.

However, in Baumol’s model the firm is sales-maximizer and hence will produce at the
revenue-maximizing level of output, i.e., the level at which the marginal revenue is zero
(and the elasticity of demand is unity). The Sales Max output is that which is produced by
the revenue-maximizing firm when constrained by the non-operative profit constraint.

21
Non-operative profit constraint is set by the owners/shareholders of the firm who looks
for minimum acceptable profit from the firm. Under this constraint, the manager would
like to set the output at sales-maximizing level where MR is zero.
The managerial theory of the firm was further developed by a number of writers,
particularly by Marris whose formulation has become the standard one for analysis of the
(the growth of) the managerially controlled firm. Marris's model is dynamic in the sense
that it incorporates growth. Like Baumol’s model, it assumes that managers will act to
maximize their utilities rather than, profits; but in contrast to Baumol, it assumes that this
will be achieved through growth rather than sales.

B. Principal Agent Theory

Principal-agent theory examines situations in which there are two main actors. The
principal usually happens to be the owner of an asset, the agent who makes decisions
which affect the value of that asset on behalf of the principal. As applied to the firm, the
theory often identifies the owner of the firm as a principal, and the manager as agent, but
the principal could also be a manager, and an employee nominated by the manager to
represent him in some aspect of the business could be the agent. According to this theory,
the firm may be seen as a nexus of contracts between principals and “stakeholders”
(agents).

This principal–agent problem arises when there are inadequate incentives for agents
(managers or workers) to put forth their best efforts for principals (owners or managers).
This incentive problem arises because principals, who have a vested interest in the
operations of the firm, benefit from the hard work of their agents, while agents who do
not have a vested interest, prefer leisure. In Williamson's perspective, principal-agent or
agency theory is the theory that focuses on the design and improvement of contracts
between principals and agents.

Like the neoclassical theory, the principal-agent theory sees the firm as a legal entity with
production function, contracting with outsiders (including suppliers and customers) and
insiders (including owners and managers). There is information asymmetry between
principals and agents but there is assumed to be unbounded rationality. Unbounded

22
rationality refers to the ability of those designing the contract to take all possible,
relevant, future events into consideration. The agency theorists differ from neoclassical
theorists in that their concerns are with "owners" and "managers" problems of copying
with asymmetric information, measurement of performance, and incentives.

As stated earlier, agency theory examines situations where agents are charged with
carrying out the desires of principals. Since we have now seen that different individuals
are generally attempting to maximize their own individual utilities, there is often a
conflict of interest between principal and agent. The nature of the resulting problem is a
misalignment of incentives, and much of agency theory is concerned with designing
incentives so as to correct for this situation in the most efficient manner. The agency
problem characterizes situations where asymmetric information implies hidden
information and hidden action. Hidden information and hidden action are both aspects of
asymmetric information, but the first relates to behavior prior to the contract, while the
latter relates to behavior after the contract.

One of the main implications of the agency problem is that managers tend to pursue
revenue maximization rather than profit maximization. This is because the remuneration
of managers often depends more on the revenues of the firm than on its profits. There
may be a profit constraint affecting this objective, in that managers may feel that they
have to make a certain minimum profit to keep the shareholders content.

C. Transactions Cost Theory

One alternative to neoclassical theory based on the assumption of profit maximization is
transaction cost theory, which asserts that the goal of the firm is to minimize the sum of
external and internal transaction costs subject to a given level of output. According to
Ronald Coase, who is regarded as the founder of the transaction cost theory, firms exist
because they are excellent resource allocators. Thus, consumers satisfy their demand for
goods and services more efficiently by ceding production to firms, rather than producing
everything for their own use.

23
A transaction refers to an exchange of goods or services. Transactions can be performed
in one of the following three ways:
1. trading in spot markets,
2. long-term contracts, or
3. internalizing the transaction within the firm.
Each of these has certain advantages and disadvantages related to the transaction costs
involved.

Costs will occur whichever method of transaction is used, spot markets, long-term
contracts or internalization within the firm, but they will vary according to the method.

Transactions costs refer to costs not directly associated with the actual transaction but
enable the transaction to take place. The costs associated with acquiring information
about a good or service (e.g., price, availability, durability, servicing, safety) are
transaction costs. Other examples of transaction costs include the cost of negotiating,
preparing, executing, and enforcing a contract.

Transaction costs are related to the problems of co-ordination and motivation.

1. Co-ordination costs: these costs are sometimes referred to as Coasian costs, since
Coase was the first economist to examine them in detail. The following categories
of costs can be determined here:
a. Search costs: both buyers and sellers have to search for the relevant
information before completing transactions. Such information relates to
prices, quality, delivery and transportation. In markets this search is external,
while within organizations, information held in different parts of the
organization must be transmitted through the relevant channels to the
decision-makers. Even in highly efficient markets like stock exchanges a large
amount of resources, in terms of physical assets like buildings and computers
and human assets in the form of brokers, is devoted to providing the relevant
information.
b. Bargaining costs: these are more relevant when markets are involved, where
negotiations for major transactions can be protracted, but even within the firm,

24
 salary and wage negotiations can also be costly in terms of the time and effort
of the parties involved.
c. Contracting costs: these are costs associated with drawing up contracts; these
take managerial time and can involve considerable legal expense.
2. Motivation costs: these costs are often referred to as agency costs. This area has
been discussed in subsection 2.1.2.2 on the agency problem, but at this stage we
can observe that there are two main categories of such costs.
a. Hidden information: one or several parties to a transaction may have more
information relevant to the transaction than others. A classic example of this is
the secondhand car market, where sellers have a big advantage over buyers.
This has many consequences for the market, but one obvious effect is that
buyers may have to devote resources to obtaining more information (for
example, paying for an engineer’s inspection of a car).
b. Hidden action: even when contracts are completed the parties involved often
have to monitor the behavior of other parties to ensure that the terms of the
contract are being upheld. Monitoring and supervision are costly, and there is
a further problem because this behavior is often difficult to observe directly.
This problem is known as ‘moral hazard’. The situation is even more costly if
legal action has to be taken to enforce the terms of the contract.

Transactions have a number of attributes which affect the above costs and therefore affect
the way in which they are conducted, in particular asset specificity, frequency,
complexity and relationship with other transactions.

Asset specificity refers to how easy it is for parties in a transaction to switch partners
without incurring sunk costs, meaning costs that cannot be recovered. For example, a
firm that commits itself to building a facility designed for a specific customer will usually
want to be protected by a long-term contract. Again, transactions that are repeated
frequently may most easily be conducted by having a long-term contract instead of
negotiating individual spot transactions, as with obtaining cleaning and catering services.
One of the main implications of transaction cost theory is that there is an optimal size of
the firm from the point of view of minimizing transaction costs.

25
Generally, as the firm increases in size and incorporates more transactions internally as
opposed to transacting in the market, those costs associated with using the market
decrease, while those costs associated with co-ordination increase as the amount of
administration and bureaucracy increases. There is thus a trade-off situation, with the
optimal size of the firm being at the point where ‘the costs of organizing an extra
transaction within the firm become equal to the costs of carrying out the same transaction
by means of an exchange on the open market or the costs of organizing another firm’.

It should be realized that the optimality situation described above is only optimal from
the point of view of transaction costs. In practice, there are a number of other
considerations that will be relevant in determining the actual size of the firm.

Although these alternative theories of firm behavior stress some relevant aspects of the
operation of a modern corporation, they do not provide a satisfactory alternative to the
broader assumption of profit maximization. Competitive forces in product and resource
markets make it imperative for managers to keep a close watch on profits. Otherwise, the
firm may lose market share, or worse yet, go out of business entirely. Moreover,
alternative organizational objectives of managers of the modern corporation cannot stray
very far from the dividend-maximizing self-interests of the company’s shareholders.

Check your progress

1. How does the transactions cost theory differ from the neoclassical theory of the
firm?
2. Discuss the basic differences between the modern and the traditional theories of
the firm.

2.2 Growth of the Firm

Most large firms were small when they were established. They grew continuously and
attained their highest status in the course of time. For instance, being multinationals or
Giant Corporation has assets or annual turnover of income much more than many nations

26
of the world. Why firms grew at all? Is this growth a natural process as the biological
growth of organisms? Are there certain market forces, which compel a firm to grow over
time?

There is no doubt that every country acquires rapid economic growth. That is, economic
growth an important objective for every country. The increase in the production of goods
and services (or GNP) may come in two ways: Either by establishing new factories (or
new firms) or by expanding the existing factors (or existing firms). There is also strong
case for growth of firm under competitive pressure. Through growth, the firm will be able
to enlarge in its size and the larger the firm the more perfect the control it assumes over
its environment and the higher the efficiency with which it plans its overall activities.
Growth is desirable for a firm to stay in a business. Growth is a long-run survival
condition for the firm particularly in uncertain and constantly changing environment.

In the context of growth theories of the firm a broader definition of the firm has been
suggested. For example, Marris defined the firm as an administrative and social
organization capable, in principle, of entering almost any field of material activities, i.e.,
there is no restriction in the product produced by the firm. The firm is not necessary
limited to particular markets or industries in a country. Under the concept of
conglomerate approach, the firm has multiple products, multiple market and multiple
techniques.

There will not be any single scale on the basis of which the optimum size of such firm
can be determined. The lowest point of long-run average cost curve has no relevance to
determine the optimum size of the firm, i.e., no unique long-run average cost for the firm.
The potential of the firm has several long-run average cost curves and several demand
curves because there is no restriction on the number of products manufactured by the
firm. The optimum size of the firm is indeterminate using the conventional cost curves.
Thus, what determines the growth of the firm is the task addressed by growth theorists.
We will see four such theories:
a. The life cycle of a firm (managerial diseconomies due to aging)
b. Downie's theory (the theory of profit constraints)

27
 c. Penrose's theory (the theory of management constraint) and
d. Marris's theory (the integrated theory of growth)

2.2.1 The Life Cycle of a Firm

Young firms allow management-economies, meaning it is easier to handle and transmit
information regarding the companies' product or idea. If successful the firm's growth rate
accelerates, profit rises and managerial and shareholder objectives coincide (because
profit is rising). Growth may continue not only through expansion but also through
diversification of new products.
But gradually managerial diseconomies tend to become more important than managerial
economies. Thus, growth slows down after some years. At this stage, the interest of
shareholders diverges from that of managers – conflicting interest arises. Shareholders
may prefer decentralization of the company to a new set of young companies. Managers,
on the other hand, oppose decentralization and have interest in (or desire for) continued
growth because their salary is directly related to the size (or age) of the company. So, the
life cycle approach suggests that growth of a firm declines as firms get older.

This theory of growth is criticized on the following grounds:

1. Growth at any point in time may be exogenously given, i.e., growth may not be
determined from within the firm (by the age). For example, growth of market demand
may provide opportunities for expansion.
2. In most real world cases many (particularly the case for MNCs), many firms are old
but have continued to grow.

2.2.2 Downie's Theory

This theory is concerned with analyzing the ways in which alternative forms of the
market are structured and business conduct affect the dispersion of efficiency and the rate
of technical progress among firms. Some firms have greater efficiency than the industry-
average and some less. This variation in efficiency is attributed to their technical
progress. Those firms who have access to superior technology are taken to be more
efficient than those who don't. So the process of growth of the firms in Downie's model

28
starts with the postulation (or hypothesis) of the steady encroachment on the market share
of the less efficient firms by the more efficient firms.
The means of growth are capacity expansion and increase in the number of customers. To
expand capacity finance is needed, which in turn depends on the rate of profit. Thus, the
rate of growth of capacity is positively related to profit. Efficient firms are assumed to
have higher profit and hence have enough finance to expand their capacity.

On the customer side an efficient firm is able to sustain a price reduction for its product
and thus attract new customers (which affects the market for less efficient firms
adversely). The attraction of customers for the expansion of market by the efficient firms
through a price reduction strategy will be possible only up to a certain limit, i.e., as long
as the firm is operating in the elastic zone of the demand curve. Beyond the elastic zone
further reduction in price for expanding the market may lead to reduction in the rate of
profit for the firm. This implies an inverse relationship between the rate of customer
expansion and the rate of profit for the firm (beyond some point).

Hence there are two opposite trends in the growth the firm. These two opposing forces
will set the upper limit on the rate of growth of the firm.

The limitations of Downie’s growth model include the following.

1. The theory ignores the possibility that inefficient firms may act positively and
aggressively to declining market share. They may be forced to initiate innovation, and
hence reverse the efficiency difference. If this was not the case, then the implication
of the theory is that there will be ever growing concentration in the industry; that is,
firms starting with more efficiency might eventually control the whole market.
2. The argument that new customers are attracted through price reduction ignores non-
price competition strategy like advertisement or sales promotion and quality
improvements. The focus on innovation as a competitive strategy is inadequate.
3. The model has not considered diversification as a way to remove market constraint on
the growth of the firm.
4. The theory has not taken into account the managerial restraint which plays an
important role in limiting the growth of the firm.

29
 2.2.3 Penrose's Theory
Penrose suggested that the firm continues to make investment as long as it gets positive
return from it. The firm takes the advantage of production expansion in which it thinks
profitability. Growth of the firm continues unless some restraints limit expansion
opportunity. The set of activities which the firm is aware of and is able to undertake at a
profit, defines its "productive opportunity." This concept (productive opportunity) is
conceived of as the basic element in the theory of the growth of the firm by Penrose.

There are two restraints on the growth of the firm identified by Penrose: internal and
external factors.

A. Internal Factors
Managerial capacities: the growth of the firm is no automatic in the Penrosian
framework. It is a deliberate and conscious choice of management. If managerial
capabilities (both entrepreneur and administrative) are inadequate, the firm cannot sustain
high rate of expansion. The managerial restraint puts an upper limit to the growth of the
firm even if there is a change in management as it takes time for the new manager to get
an experience for expansion of the firm.

The financial restraints: adequate financial resources are needed for investment in growth
of a firm. However, financial restraints are treated as insignificant as compared to
management restraint. She emphasized on the management restraint.

B. The External Factors

Competition from rivals, patents or other restrictions on the adoption of new technology,
scarcity of any input etc are the constituents of the external factors which restrain the
expansion of firms.

A natural process of growth in Penrose model is diversification. Through the process of

diversification the firm will be able to utilize the productive opportunity fully and grow
further. Diversification neutralizes the effects of the demand restraint on firms' growth
until it is restrained by the availability of certain managerial services. Merger or

30
acquisition is also a mechanism for growth of the firm. When a firm has achieved the
maximum rate of profitable growth by means of internal expansion and constrained by
the managerial restraint, it may still grow further through external expansion of the firm
or merger or acquisition.

The major limitation of this theory is that it gave marginal attention to financial and
external constraints.

2.2.3 Marris's Theory

An integrated theory of the growth of the firm has been developed by Marris. His theory
is applicable to corporate firms owned by shareholders but controlled by managers.
Shareholders, being owners of the firm, are assumed to have the objective of maximizing
the return on their investment in the firm. Managers of the firm, on the other hand, aspire
to maximize their own interest (like higher pay, perks, power, prestige, etc).

Here the firm is perceived as a coalition of suppliers, stockholders, customers, etc, whose
member have conflicting goals that must be reconciled. The basic characteristics of this
model are the separation of ownership from management. The firm is aimed at the
maximization of the balanced rate of growth of the firm (g), i.e., the maximization of the
rate of growth of demand for the product of the firm (gd) and the growth of its capital
supply (gc).

The growth of demand for the product of the firm (gd) depends on the diversification rate
(the number of addition product produced), and the percentage of successful new
products. The growth rate of the corporate capital (gc) is represented by the asset base of
the firm. This is taken as the measure of the size of the firm. It is the sum of fixed assets,
inventories and cash registers.

For the managers the objective is the joint maximization of gd and gc. This is said to
enable managers achieve maximization of their own utility as well as the utility of
shareholders.

31
In pursuing maximization of balanced growth rate, the firm has two constraints:
managerial and financial.

A. Managerial Constraints
Marris adopted Penrose's thesis of the existence of a definite limit on the rate of efficient
managerial expansion. There is a ceiling to the growth of the firm set by the capacity of
the managerial team. The R and D department set a limit a growth of a firm. This
department is a source of new ideas and new products, which in turn affects gd. Thus, the
managerial constraint and the R and D capacity set limits to the growth of demand (or
gd).

Managers also want job security. They attach a definite disutility to the risk of being
dismissed. They have also preference for generous pension schemes. As a result, they
adopt prudent financial policy, that is, avoid financial failure or bankruptcy. In general,
the risk of dismissal is avoided largely by non-involvement in risky investment (financial
security constraints), and choosing prudent financial policy. Managerial constraints limit
both demand expansion and capital supply.

B. Financial constraints

According to Marris, is the most important source of finance for the Growth of capital is
retained earnings. However the firm is not free to retain as much as it might wish,
because distributed profit must be adequate enough to satisfy the shareholders/owners. It
cannot issue too many shares since it should avoid the fall of the price of share in the
market. Falling price of share may cause raid by take-over raiders. The financial security
constraint sets a limit to the rate of growth of capital supply (gc).
As more and more new products are introduced (i.e., as the rate of growth increases) so
more has to be spent on R and D for the next lot of products and on advertising for the
sale of the current new products. In addition, other costs will increase as a result of the
need for more complex management of increasing numbers of products. Thus, at some
point, further growth will lead to a decline in the rate of profit. Only when gd = gc does

32
the rate of growth of demand match the rate at which investment in the firm provides the
volume and range of products required to meet this demand.

Marris gives large emphasis to financial constraints for growth of the firm unlike that of
Penrose's analysis. The problems with Marris’s theory are the assumption of continuous
growth and its heavy reliance on the assumption that firms have their own R and D
department.

CHAPTER Three

Market Concentration

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
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

33
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
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

34
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

(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

35
 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.

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
( H )= ∑ ( pi )2
i =1

Symbolically, Herfindahl Index

36
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,

1
R= n
[ ( 2 ∑ i∗ pi )−1 ] ;
i=1

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.

37
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

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

38
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= p i ∑ p 2 [1+( 1−p j ) ],
j =2 j

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;

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

39
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
ep < 0, so >0

G.The Elasticity Index

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

eii eii
e ji=− n−1=−
n−1 e ji
ie; or

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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.
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
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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
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.

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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
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.

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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.

CHAPTER Four

Industrial Location Analysis

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.

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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
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.

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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?

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.

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  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:

 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

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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.
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.

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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.
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.

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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
 Reproductive
 Fabricative
 Facilitative

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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

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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

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the second restriction in Rawstron's model. On the whole, Rawstron's contribution to the
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.

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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

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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.

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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.

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.

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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.

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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

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prices charged by the firms at their locations be and respectively These are shown by the
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)

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

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

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as 'isotante'. The shape and situation of the isotante depend on the relative magnitudes of
location prices and transport rates for the firm.

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
the product. This is shown by OF in Fig. 4.4.

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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.

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CHAPTER SIX

Advertisement
Introduction

Advertising is a mass paid communication, the ultimate purpose of which is to impart

information, develop attitudes and induce action beneficial to the advertiser. It can take
many forms: media advertisements, direct mail, leaflets, or sponsorship. The content of
an advertisement can vary considerably. It can simply display the name of the product or
it may compare the product with that of rivals. It may provide detailed information about
the product's attributes, or may simply enhance its image.

Advertising is one of many forms of promotional activity. Instead of advertising, a firm

might promote sales by employing more sales representatives, by altering the product's
packaging, or by widening wholesale and retail margins. Advertising can be either a
substitution for a complement to, other forms of promotional activity. This complicates
the economic analysis of its effects since it is difficult to separate them from those of
other promotional activities. Indeed, some economists refer to 'advertising' when they are
really discussing promotional activity in general. They recognized the fact that different
promotional activities overlap. Given that the effects of advertising and other promotional
activity are similar, empirical work which considers only advertising will give misleading
results.

6.1 Why advertise?

Whereas marketing aims to identify markets that will purchase a product (business) or
support an idea and then facilitate that purchase, advertising is the paid communication
by which information about the product or idea is transmitted to potential consumers.

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In general, advertising is used to convey availability of a "product" (which can be a
physical product, a service, or an idea) and to provide information regarding the product.
This can stimulate demand for the product, one of the main objectives of advertising.
More specifically, there are three generic objectives of advertisements:

(i) communicate information about a particular product, service, or brand (including

announcing the existence of the product, where to purchase it, and how to use it),
(ii) persuade people to buy the product, and
(iii) Keep the organization in the public eye (called institutional advertising).

Most advertising blends elements of all three objectives. Typically new products are
supported with informative and persuasive ads, while mature products use institutional
and persuasive ads (sometimes called reminder ads). Advertising frequently uses
persuasive appeals, both logical and emotional (that is, it is a form of propaganda),
sometimes even to the exclusion of any product information. More specific objectives
include increases in short or long term sales, market share, awareness, product trial, mind
share, brand name recall, product use information, positioning or repositioning, and
organizational image improvement. Examples of the ideas, informative or otherwise, that
advertising tries to communicate are product details, benefits and brand information.

6.2 How much advertising?

A profit maximizing firm engages in advertising up to the point at which the expected
marginal benefit from advertising equals the expected marginal cost of advertising. The
intensity of advertising varies according to the nature of product to be advertised and the
market characteristics that affect the efficiency and cost-effectiveness of advertising.

Explanations for variations in the levels of advertising between industries therefore turn
on differences in product and market characteristics. Advertising is more suitable for
promoting consumer goods than industrial products because it involves mass
communication. The markets for consumer products are generally larger and

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geographically scattered. Industrial buyers are likely to be smaller in number and require
more detailed information than can be provided by an advertisement.

Consumer durable goods have a longer life, are often more complex products, and tend to
involve a greater outlay than consumer non durables. An error of judgment in purchasing
a durable good has a greater effect on the consumer's welfare. Consequently, consumers
require more information than can be communicated effectively via advertising. The
more complex the product, the greater the use consumers make of alternative information
sources. Consumers have evolved 'rules' that influence their purchasing behavior seek out
information for durable goods, do not bother for non-durable goods. With durable goods,
advertising is also likely to be less effective in promoting sales than competition on the
basis of price products.

The importance of product type can be illustrated by introducing the concept of search
(Stigler, 1961). When knowledge is imperfect, consumers can improve their decisions by
searching for information on product characteristics, product availability and alternative
prices. Search can take 'several forms - visiting or telephoning sales outlets, surveys of
available literature, and verbal enquiries. However, the incremental benefit received by
the consumer is likely to decline as the amount of search increases. This can be illustrated
by considering a consumer wishing to purchase a car. Assume he has already decided
upon the make and model, but wishes to buy the car at the 'best' price. The greater the
number of dealers already contacted (searched), the less likely it is that contacting an
additional dealer will locate a better offer and, even if a better offer is found, it is likely to
be only marginally better. In other words, both the prospect of making savings from
identifying a lower price, and their size, will fall with the number of dealers contacted.
Recognizing also that the collection of information is costly, search is worthwhile only up
to the point where the expected marginal benefits equal the expected marginal costs.

The optimal levels of search for durable and non-durable goods are compared in Figure
6.1. For exposition, it is assumed that the marginal costs of search (CC) are constant and
the same for both types of good. The marginal benefit functions differ (DD for the

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durable good, NN for the non-durable) since the potential discounts on the durable goods
are likely to be much larger in absolute terms. Given the higher unit price and the larger
expected savings from identifying a lower priced source, the optimal level of search for
the durable good will be higher (OY compared to OX).

The optimal amount of search may also be lower for goods that are purchased frequently,
or which account for a relatively low proportion of a consumer's total expenditure. For
inexpensive goods, efforts to use sources of information other than advertising are
unwarranted - and, in the case of frequently purchased goods, the consequences of a
mistaken purchase are relatively short-lived. Therefore, in both cases, it is often rational
for the consumer to make a decision between products with unknown characteristics on
the basis of advertising messages.

N D
Marginal
Cost &
Benefit of
C’ C’
Search
C C
N D
O X Y quantity of search
Figure 6.1 the optimal level of search

Nelson (1974) takes the analysis further. Search goods are those consumer goods whose
qualities can be evaluated effectively before purchase (such as books or compact discs).
The qualities of experience goods can only be evaluated effectively after purchase (such
as food at restaurant, shampoo and photographic film). Whilst advertising has a role in
informing consumers about the features of search goods, it can only signal the existence
of experience goods. Higher levels of advertising are likely in the latter case since
advertising may be the only source of information available to the consumer.

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Higher levels of advertising for experience goods should also be positively associated
with product quality. This behaviour can be explained from the perspective of the new
institutional economics1. Individuals or groups evolve procedures (or 'rules') to simplify
complexity. They will repeat their purchases if an experience good prove to be of high
quality. This will encourage firms offering good quality products to advertise more
heavily because of the prospect of earning larger returns on their advertising outlays.
High advertising may be interpreted by consumers as evidence of product quality and a
firm's intention to remain in the market. The more volatile is the market (for whatever
reason), the greater the level of advertising. Where there is a rapid turnover of customers
(as in the baby food market) there will be heavy advertising to inform the new consumers
(although customer turnover above some critical level actually reduces the returns to
advertising, making it less attractive). Furthermore where product characteristics change
rapidly, there will be a need to advertise to increase consumers' awareness.

Advertising levels will also be relatively high where the entry of new firms is rapid. New
entrants must counteract the influence of past advertising by existing firms: heavy
advertising is required to inform consumers of the attributes of their own products.

6.3 Debates on advertising

Advertising is a prominent feature of modern economic life. Consumers encounter

advertising messages as they watch TV, read magazines, listen to the radio, surf the
internet, or simply walk down the street. And the associated advertising expenditures can
be huge. What, then, do economists have to say about advertising?

The traditional view of advertising is that it persuades people to buy a firm's product, so
increasing the firm's market power. Advertising not only distorts consumer choice, but
uses resources which could have been used elsewhere. Society's welfare is reduced firms

1
The new institutional economics is interested in the social, economic and political institutions that govern
everyday life. it is concerned with rules and customs that make up the institutional environment are
primarily economy-side phenomena and focuses on agreements made by specific individuals to govern
their own relationships.

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enhance their profits at the expense of consumers. Many firms advertise their goods or
services, but they are wasting economic resources. Some economists reckon that
advertising merely manipulates consumer tastes and creates desires that would not
otherwise exist. By increasing product differentiation and encouraging brand loyalty
advertising may make consumers less price sensitive, moving the market further from
perfect competition towards imperfect competition (see monopolistic competition) and
increasing the ability of firms to charge more than marginal cost. Advertising is
economically wasteful and damaging to welfare as it distorts consumers' preferences, thus
creating monopoly power for firms that produce heavily advertised brands. Heavy
spending on advertising may also create a barrier to entry, as a firm entering the market
would have to spend a lot on advertising too.

However the traditional view of advertising is increasingly questioned. The alternative

school of thought takes a broader view of competition and stresses the informative role of
advertising. Advertising may perform a valuable role, enabling consumers to make better
informed choices and promoting the operation of the competitive process. In a world
characterized by uncertainty and ignorance, it is argued that advertising has a key role to
play in providing consumers with information, reducing search costs and enabling them
to make better informed choices. Advertising is economically valuable because it
increases the flow of information in the economy and reduces the asymmetric
information between the seller and the consumer. This intensifies competition, as
consumers can be made aware quickly when there is a better deal on offer. In general
there two main divergent views of advertising emerged, including the persuasive view,
and informative view.

The 'advertising as persuasion' view

Advertising will not only bring benefits to the firm in the form of increased sales, it will
also have an impact on the environment within which the firm operates and the prices
charged to consumers. The traditional view - advanced, among others, by Bain (1968)
and Comanor and Wilson (1974) –is that advertising works by persuasion, and results in

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increases in both market power and prices (the process is summarized in the following
figure)

Consumers: Performance:
Advertising Preferences altered Higher prices and costs;
in favor of heavily increased non-price
advertised goods competition; higher profits

Market Entry barriers:

structure Heightened

Figure 6.2 ‘advertising as persuasion' view

The advertising as persuasion view implicitly assumes that advertising distorts

consumers' preferences. This may cause consumers to make wrong choices, selecting
advertised goods instead of those which would give them greater satisfaction or buying a
product in the mistaken belief that it is better than its rivals. By altering consumers'
preferences to favour the advertised product, demand for the 'product becomes less
sensitive to price changes. Advertising also has the effect of reducing the cross elasticity
of demand between the advertised product and its close substitutes. This makes
consumers less responsive if rival firms reduce prices or increase their promotional
activity.

Advertising can create first-mover advantages which confer entry barriers. Since
customers display a greater attachment to the products of existing firms, there will be
fewer people switching between brands, and hence likely to try a new product. To
overcome brand loyalty an entrant must either advertise more heavily or offer substantial
price discounts. In either case, the entrant's profitability is adversely affected. Moreover,
advertising is a sunk cost to the extent that it is product-, rather than firm-, specific. The
more the new entrant has to engage in advertising whose benefits are limited to the

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promotion of the product in question, the less attractive entry to that market will be.
Consumers are reluctant to try new products of unknown quality, and this experience-
based asymmetry between established and new products may be exacerbated in the
presence of heavy advertising by established firms.

Existing firms will be able to exercise their market power once the threat of new entry
has been reduced. This will result in higher prices for consumers and higher profits for
producers. If the market has become more concentrated - because either economies of
scale or threshold effects in advertising confer a cost advantage on large firms - then the
effect on prices and profits will be particularly marked.

The 'advertising as information' view

This alternative view, adopted by Stigler (1961), Telser (1964) and Nelson (1974b,
1978), stresses the role of advertising in providing information. In an environment where
knowledge is imperfect and uncertainty abounds, advertising plays an important part in
reducing consumers' ignorance. As in the 'advertising as persuasion' view, it is recognized
that advertising influences consumers behaviour, but it is not regarded as having adverse
consequences for consumers' welfare. For consumers to make the 'best' choices they need
to be fully aware of all possible alternatives. Stigler's analysis shows that, for any
product, there is an optimal amount of search - or, in other words, an optimal amount of
knowledge. Although all decisions will be made on the basis of incomplete information,
advertising reduces this incompleteness by effectively reducing transaction costs through
lowering the costs of search. Consumers benefit by being able to choose those products
that match more closely their preferences.

The informative view holds that advertising primarily affects demand by conveying
information. The advertised product thus faces a more elastic demand. This elasticity
effect suggests that advertising causes lower prices, an influence which is reinforced
when production scale economies are present. Advertising (and other forms of
promotional activity) can make consumers more responsive to price changes and price

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differentials, increasing their concern to buy the 'right' alternative. With demand more
price-elastic, it follows that the profit-maximizing price will be lower. If consumers are
more responsive to price signals, firms will be under more pressure to offer attractive
prices. Prices will also be lower because of the increased competition brought about by a
reduction in entry barriers. Entry is facilitated because advertising offers an effective
means whereby new firms can make potential customers aware of their existence and of
the attributes of their products.

The informative view suggests further that advertised products are generally of high
quality, so that even seemingly uninformative advertising may provide the indirect
information that the quality of the advertised product is high. There are three reasons.
First, the demand expansion that advertising induces is most attractive to efficient (low-
cost) firms, and such firms are likewise attracted to demand expansion achieved by
offering low prices and high-quality products. Second, the product experience memories
that advertising regenerates are most valuable to firms with high-quality products, since
repeat purchases are then more likely. Third, a firm sensibly targets its advertising toward
consumers who would value its product most. The informative view holds further that
advertising is not used by established firms to deter entry; instead, advertising facilitates
entry, since it is an important means through which entrants provide price and quality
information to consumers.

Advertising helps the competitive process: by supplementing other sources of

information, it facilitates entrepreneurial action by economic agents. Taking the view of
advertising as information, rather different conclusions emerge as to the effects of

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advertising on market structures and prices (summarized in figure 6:3)

Advertising Consumers: Performance:

Better informed Lower prices; increased
enabling better competition; efficient
purchases firms enabled to expand

Market Entry barriers:

structure Reduced

Figure 6.3 ‘The advertising as information’ view

CHAPTER FIVE
DIVERSIFICATION, VERTICAL INTEGRATION
AND MERGER

8.1 Definitions

A. Diversification

In order to define the concept diversification, let us start with a simple situation. Suppose
a firm produces some varieties of a product which are close substitutes for each other in
the market, if the firm adds one more variety of the product then it is not diversification.
We may simply call it product variation or differentiation. However, if the firm produces
a totally different product which is not a substitute for the existing products in the
market then it is called diversification. A firm producing margarine starts producing
soap, for example. This comes under diversification. Similarly, when a leather tanning
firm starts manufacturing boots and other leather goods, we will then call it

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diversification because here the products are different as a result of which the market
'area' for the firm expands from one class of consumers to another one. Diversification is
thus "the spreading of its operations by a business over dissimilar economic activities".
According to Penrose, a firm is said to diversify, whenever, without entirely abandoning
its old lines of product, it embarks upon the production of new products, including
intermediate products, which are sufficiently different from the other products it produces
to imply some significant difference in the firm's production and distribution
programmes. In the process of diversification, a firm makes significant changes in its
'areas' of operations related to technological base, market areas and productive activities
in which it has acquired experience or knowledge in the past. Four different possibilities
have been mentioned by Penrose for this:

(i) When there are additional products within the firm's existing technological bases
and market areas;
(ii) When there are products involving the existing technological bases but destined
to new market areas;
(iii) When there are products which involve altogether new technological bases for
the existing markets; and
(iv) When there are new products with new technological bases for new market areas.

When a firm introduces new products there will be a change in productive services and
marketing areas or activities. Diversification thus cannot be conceived of changes in
the products only; it implies the other two aspects of the change also, i.e. changes in
the technological base and market areas.

B. Vertical Integration

It refers to operations by a firm in two or more industries representing successive stages

in the flow of materials or products from an earlier to a later stage of production or vice
versa. Thus, it is a type of diversification but it may be looked as 'vertical concentration',
and if the process takes place by merging of two different firms then it is 'vertical

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merger'. How ever, vertical integration is a popular term for all these. Essentially, it is the
integration among the intermediate products used introduction of a commodity. It may be
initiated in either way i.e. a firm itself starts manufacturing all of them or different firms
producing goods at different stages of the process merge together.

C. Merger

The term merger refers to amalgamation or integration of two or more firms. The firms
under different ownership and management controls come under a unified one through
merger. The terms 'acquisition' and 'takeover' are also used for merger, which implies
that a firm acquires assets or stocks in part or full, of other firm or firms to get
operational control over them. In legal sense, there is difference between these terms but
from the point of view of the economic analysis they are alike. The important feature of
merger is the transfer of control of business activity from one firm or firms to another.

Situations of merger:

(1) A horizontal integration or merger of firms whose products are viewed by buyers as
identical that is their products have high cross elasticity of demand and supply;

(2) A vertical integration or merger of firms where there is a successive functional link
between their products, that is, the output of a firm is input for the output of another firm
at higher stage of production. There may be such integration between a producing and a
marketing firm for the same commodity or commodities; and

(3) A conglomerate integration or merger of firms which are producing altogether

different products, i.e., which are not substitutes for each other (zero cross elasticity of
demand and supply) such as merging of a cloth making firm and a drug manufacturing
one. The amalgamated firm in this situation will be a market-diversified firm.
Diversification is also implied in the situation of vertical merger.

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The terms 'diversification', 'vertical integration' and 'merger' have been defined above in
brief. We have to examine now the motives behind them. The next section deals with
this.

8.2. Motives for Diversification, Vertical Integration and Merger

I. Diversification

Motives for diversification depend on its types. It will be thus convenient for us to
examine the motives for different types of diversification and then synthesize them
together. The types of diversification as observed in practice and motives for them are the
following:

1. Lateral Diversification: When a firm produces different goods which diverge from the
same process or source or which are used as materials for the same process or market.
For example, a leather tanning firm will have lateral diversification when it starts making
boots and shoes leather garments and suitcases itself, because all such businesses diverge
from leather tanning business. Similarly, a meat seller will have lateral diversification if it
starts selling hides, horns, bones and even raw wool. A soap manufacturer may start
margarine and chemical manufacturing itself which are used in soap making and thus
indulge in lateral diversification.

Reasons for lateral diversification

A firm may resort to lateral diversification because of the following reasons:

 When production of one commodity necessarily involves production of another,

say, in by-products form, there would be a natural scope for lateral diversification in
order to avoid wastages and gain advantages from the business. Production of
mutton and wool, bitumen, lubricants, paraffin, raw chemicals, etc., together with
petroleum refining, coal, coke, and their by-products such as benzene, etc., is few
examples of this situation.

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 When market demand for the existing products is declining or stagnant, a firm
has to diversify its business laterally in order to maintain its earnings or to increase
it.
 Better utilization of existing facilities such as managerial talents, R&D activities
and certain categories of machines, etc., may be looked as a motive for lateral
diversification.
 The market complementarity or interlocking pattern in seasonal demands also leads
to lateral diversification say, for example, one may produce colours and water
sprayers together for festivals. This type of diversification when done through
merger brings more market power by reducing competition and through extension
of operations in different industries.
 To maintain the rate of growth, without being accused of monopolizing. This type
of diversification is very much suitable and actually being followed all over the
world.
 Lateral diversification is an effective barrier to entry to reduce potential
competition.

2. Conglomerate Diversification: In this type of diversification, the products need not to

have diverged from the same product or source, or converge at the same process or
market as is the situation in the case of lateral diversification. The products will be quite
unrelated. At this stage we can simply express that all motives of lateral diversification
will also be motives of conglomerate diversification.
In brief, it
 Helps in extension of market power of the firm
 Brings stability in earnings through cross-subsidization, i.e. loss of one product is
covered by the gain from other
 Causes an increase in the barriers to entry
 Provides more options for risk taking for the sake of profits
 Maintains the process of growth
 Gives pecuniary gains to the firm

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 Provides better utilization of some facilities, etc.

3. Vertical Diversification: This is vertical integration in fact. It involves diversification

into process of manufacturing or distribution which precedes or succeeds those in which
the firm is already engaged. It can be either 'backward integration' or 'forward
integration'.

Backward integration is seen where a firm starts manufacturing products previously

purchased from others in order to use them in making its original product line. A milk
product company may have its own dairy farm and similarly, a bakery may have its own
flour mill and so on.

Forward integration occurs when the firm moves nearer to the final market for its
product and carries out a function which was previously undertaken by its customers. A
shoe making firm may start its own distribution or selling shops, a flour mill may start
making its own bakeries; a spinning mill may also start weaving activities and like that-
are few examples of forward integration.

Vertical diversification, whether initiated by a firm itself or occurring by merging of two

or more firms has several motives some of which are as follows:

 It provides security to the firm. Say, a firm integrates backward in order to have
assured sources of supplies. The intensity of such integration will be more when
demand conditions for the final product of the firm are very bright. Similarly, the
firm integrates or diversifies in forward direction in order to assure market for its
product.

 Vertical diversification or integration provides economies of linked processes and,

thus, the efficiency of the firm goes up due to improvements in capacity utilization.

 There will be economies in marketing such as saving of transportation,

advertisement, procurement and selling costs.

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 There may be saving by eliminating 'the middle man' and his 'unnecessary' profit
margin in the process of production.

 On the whole the firm gets more market power through its size or absolute cost
advantages or pecuniary gains through vertical integration. It gives strength to the
barriers to entry and, therefore, reduces competition in the market.

4. Diagonal Diversification or Integration: It consists of the provision within same

organization of auxiliary goods and services required for the several main processes or
lines of production of the organization. For example a firm may have its own power
house to generate electricity or machine tool making units since such things are required
for running almost every processing activity. The motives of diagonal diversification or
integration will be more or less the same as for lateral and vertical diversification. Among
them the major one will be:
 mopping up of excess capacity
 Reduction of the risks.

The motives of all types of diversification can now be summarized in condensed form as:

(i) Profitability or earning motive which implies fuller utilization of

resources/capacities at the disposal of the firm;
(ii) Stability motive which implies reduction of risks and uncertainties through assured
supplies of resources and markets for main line of production;
(iii) Growth motive which means expansion of productive capacities without being
charged for being monopolizing, and in the face of market limitations; and
(iv) Market power motive which is assured through increase in barriers to entry as a
result of diversification.

In general, a new industry will have higher degree of diagonal and vertical integration but
a mature industry will resort to more lateral diversification. This is because, in the case of
a new industry, auxiliary services may not be available at all, so the firms have to make
for their provision within its organization. For a mature industry like textiles the demand

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for such services will be large enough, so independent units may come into existence for
their supplies in an efficient way.

II. Vertical Integration

The motives for vertical integration have already been discussed above under vertical
diversification. One point we must make clear here, whenever there is vertical integration
between two or more firms, it means vertical integration between their products. Such
integration between products exists in the situation of vertical diversification which we
have discussed earlier. The condition of vertical integration between the firms for vertical
integration in the products may not necessary. However, when we talk of vertical inte-
gration, in reality it implies integration between the firms. The integration in their
products is implicitly obvious here. Increase in profits or profitability either by fuller
utilization of resources and saving of costs through backward or forward integration may
be looked as principal motives pf vertical integration. The other two general motives, i.e.,
stability and growth are equally sustained through vertical integration. The motives of the
firms involved in vertical integration play important role in determining the price and
quantity of output of the industry to which they belong.

III. Merger

As indicated earlier, merger implies diversification except horizontal integration between

the firms. The motives of diversification will therefore be equally applicable to merger
also. However, there are some other important motives of merger -which are not linked
with diversification as we will see below in the list of general motives for all types of
merger.

 Increase in Profitability: This may be possible either through increased degree of

diversification of the combined firm or through other consequences of merger such
as increased efficiency and market power.

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 Stability in Earnings: Profit rates of individual firms whether they are in the same
industry or in others may fluctuate widely as they are exposed to a greater degree of
risks. When they merge together there may be little variation in their combined
profit rate. This means the get stability in earnings by merger. The variability of
profit rates is generally measured through their variance or standard deviation. The
variance of profit rates of the combined or merged firms will be lower than the
variance of the profit rates for individual firms. A simple situation for this is when
one firm is having negative profit rate, the other one positive. When both merge
together, there will be likely a stable positive profit rate for them. This is what we
may take as cross-subsidization motive for the sake of stability and reduction of
risks. It may be emphasized here that a reduction in variability of profit rate is a
possible but not a necessary outcome, of merger. There may be situations when
there is an increase in it as it consequence of unforeseen business uncertainties after
merger.
 Stock market gains: firms would like to merge together if there is a difference in
the earning-price ratio or market price for there shares in the stock market. There
will be mutual gain for them by merger in this situation.
 Efficiency Motive: This motive may be stronger in the case of horizontal and
vertical mergers. As a result of such integration one can expect economies of scale
in a variety of ways, such as reduction in inventory requirements, transportation and
distribution costs, duplicate R&D activities, cheaper raw materials due to increased
size of purchases, better management, etc. In the case of conglomerate merger such
economies of scale are doubtful but there may be better management and more
pecuniary gains.
 Market Power Motive: This may be a major motive of merger, as fulfillment of the
other motives like profitability, reduction in risks, growth, etc., which are
complementary to the market power motive becomes easier and almost certain.
Market power is a command over pricing and output decisions by the firm. It
certainly goes up in the case of horizontal merger as potential competition is

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reduced in this situation through merger. Similarly, vertical merger in either
direction can increase market power.

For conglomerate mergers the following factors are mentioned as sources for market
power:
 extended monopoly power,
 encouraged cross-subsidization,
 increased deep pocket advantages,
 increased entry barriers,
 increased non-economic reciprocity arrangements,
 increased macro-concentration, and
 increased size of power groups.

 Growth Motive: This is a possible outcome of merger. A firm grows by expanding

itself in the market or by acquiring some existing firm or through merger.
Combined firm after merger will command more assets, more sales and more
market power.

8.3 Implication for Public Policies

Diversification and integration, whether vertical, horizontal or conglomerate, are

important market strategies which affect the competitive environment of an industry and
economy as a whole. When a firm diversifies, it has certain well-defined motives for that.
Its actions will not be unnoticed by its rivals. They will also have countermoves in order
to maintain their market shares particularly when the products are closely related. Thus,
we expect an increase in the competitive climate in the industry by diversification. The
firms as well as their products compete for scarce resources and markets under such
situation. The question now arises whether such competition involves all firms in the
industry or only a few of them. Common observation is that such competition will be
between large firms only. They find diversification a way to maintain their growth and
market power without being charged for monopolizing in the market. But when only few

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large firms control the market and put barriers to entry for new competitors, it leads to an
increase in market concentration so that we may say that diversification explicitly or
implicitly causes market concentration. Under such situation there is a direct implication
of diversification for public policy as no welfare state will allow concentrating market for
a commodity or commodities in the hands of few firms.

Similar situation arises in the case of vertical and horizontal integration among the firms.
It is generally agreed that vertical integration does have the potential to increase market
power either by reducing the competition or through economies of scale. But there is a
counter-argument for this according to which vertical integration does not harm
competition. In fact it helps in increasing competition by bypassing monopolistic
suppliers. There is thus a controversy about the effect of vertical integration on
competition but from policy point of view there is again a strong need to regulate such
phenomenon. For horizontal and conglomerate mergers, there is greater probability of
their causing market concentration, so, they are strictly regulated through-public laws. A
public policy is designed to achieve some chosen objectives or goals.

These may be, say, for example:

(1) To diffuse economic power;

(2) To have efficient allocation of scarce resources; and
(3) To ensure economic freedom of mass participation in the economy.

All mergers and diversification policies of the individual firms in the market are to be
evaluated in the light of such social goals. If the policies are in conflict with such goals
they are to be checked and controlled effectively. Most of the governments appoint
Antitrust or Monopoly and Restrictive Trade Practices Commissions for this purpose.
There will be a set of rules or guidelines which will be implemented by such
commissions to regulate mergers and diversification strategies of the firms by
maintaining a balance between private and public interests

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CHAPTER SEVEN

INVENTION, INNOVATION AND DIFFUSION

Introduction

In this chapter we are going to discuss about the analysis of innovation and research
and development (R&D) activities which are quite prevalent in manufacturing and
other business circles. Innovation is one of the several strategies through which a firm
could change its situation in the market in pursuit of its objectives. It is an instrument,
which the firm uses to enhance its competitive power in the market. It provides a basis
for greater degree of diversification and hence growth of the firm. The major elements
of innovation or technological change, such as,

 New products,

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 New methods of production,
 New markets and
 New forms of industrial organization etc,

These make the firms and industries to run efficiently over time. Recognizing such
role J.A. Schumpeter took innovation as "the fundamental impulse that sets and keeps
the capitalist engine in motion". He found innovation as the outstanding fact in the
economic history of capitalistic society. Innovation is not confined to such a society
only. It is a common feature in almost every economic system whether capitalistic or
socialistic or something else. Science and technology become operative through
innovation.

In the modern world,

An individual wants to be more creative,

A firm or corporation strives for the progressiveness of its business and

A government works for the collective security and welfare of masses.

Innovation is an important weapon for all these. In fact, survival of mankind depends
to a great extent on innovation, particularly in the fields of material requisites of life.

What are the sources of innovation?

Innovation in business is achieved in many ways, with much attention now given to
formal (R&D) for "breakthrough innovations." But innovations may be developed by
less formal on-the-job modifications of practice, through exchange and combination of
professional experience and by many other routes. The more radical and revolutionary
innovations tend to stem from R&D, while more incremental innovations may emerge
from practice - but there are many exceptions to each of these trends. Another key
source of innovation is user innovation, innovations developed by individuals when

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existing products do not meet their current needs.

There are different aspects of innovation (i.e. stages of technological change) for study
to be examined as follows.

7.1 The process of innovation: Concepts and Relationships

The terminology of innovation consists of a set of interrelated terms. The first and
perhaps the most important one is the concept of invention.

An invention is the creation of the new technology. By 'technology' we mean any tool
or technique, any product or process, any physical equipment or method of doing or
making, by which human capability is extended. It is an intellectual act which involves a
perception of a new image, of a new connection between old conditions, or of a new area
for action. All inventions, big or little, are made for some practical uses. The process of
adopting an invention in a practical use is called innovation. It is the implementation of
a new or significantly improved idea, good, service, process or practice that is intended to
be useful.

If the existing product line is changed by a firm, i.e. it introduces a new product with or
without displacement of the old ones, and then it is defined as product-innovation. If a
new method is initiated to produce existing products then it is process innovation. Both
of these are the elements of 'technological innovation'. When a firm makes changes in
its marketing strategy we define that as 'market-innovation'.

Similarly, there may have innovation in organizational practices, financing and any other
aspect of business conduct. The concept of innovation is, thus, very broad. The
entrepreneur or manager when performs the act of innovation is called 'innovator'. He
invests resources for the innovation and takes the risks involved in that. This is a very
important role, indeed a pivotal one, for the growth of industries. Innovation occurs

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when the entrepreneur believes that it is worthwhile to commercialize the invention.
Schumpeter identifies five types of innovation, viz

1) The introduction of a new good —that is one with which consumers are not yet
familiar—or of a new quality of a good.

2) The introduction of a new method of production, which need a discovery

scientifically new, and can also exist in a new way of handling a commodity
commercially.

3) The opening of a new market that is a market into which the particular branch of
manufacture of the country in question has not previously entered, whether or not this
market has existed before.

4) The conquest of a new source of supply of raw materials or half-manufactured

goods, again irrespective of whether this source already exists or whether it has first to be
created.

5) The carrying out of the new organization (the reorganization of methods of

operation) of any industry, like the creation of a monopoly position or the breaking up of
a monopoly position.

Another useful concept related to the innovation process is 'imitation'. It is a situation

when an innovation is copied by others. That is, the innovation spreads across the
market. In other words, we call it 'diffusion of the innovation'. Such diffusion may be
rapid or slower depending on the market situation, but it will be easier or safer than the
act of innovation.

The three terms -invention, innovation and diffusion -are the successive stages of the
process of innovation or technological change. Diffusion is not possible without
innovation which in turn is not possible without invention. The entire process of change,
i.e. from invention to imitation, comes under research and development (R&D) activity
of the firm.

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7.2 Stages of Technological Change

Let us examine each stage in the process of change in some details for full
understanding.
The first stage (Invention) is carried on by individuals or corporate bodies like research
institutes, universities, government bureaus and companies- the source of invention. It is
just like any other corporate activity such as sales or production where certain inputs are
used to get some output in a broad sense; we may call invention as output of the research
industry. If so, an invention will be a goal-oriented activity. A government or
corporation will be making invention for solving some social problem or for the sake of
extra profits or money. To achieve the goal of invention a series of steps will be taken
beginning from the definition of the problem, the alternative routes to its solution and
finally the output in the form of the invention. It is an orderly sequence, a matter of
applying conscious intelligence to the solution of the problems. The ‘output’ of the
process may not come during the stipulated time. There may be frustration, delay,
failures, etc., but the process of invention goes on. In general invention can be taken as
an orderly, intellectual, goal oriented process, a fundamental one, for the innovation or
technological change in a society. It does not usually move in a straight line according to
the plan, but takes unexpected twists and turns to reach the destination.

The Second stage (innovation) is a logical extension of invention. When an invention is

made, its fruits are made available to the society through innovation. An entrepreneur or
corporation comes forward, makes the required investments for the innovation. As
mentioned earlier, innovation may be in product or process of manufacturing or any other
activity of the corporation. It involves risks and uncertainties. An innovator bears them
and it is precisely on this ground that economists justify existence of excess profits for
him. Process-innovation and product-innovation are two important types of innovation.

Process innovation arises when relative prices of factors of production change. If labour
becomes costly, the firm may think of cost saving by adopting capital intensive technique
and vice-versa. In the familiar isoquant framework, it implies a movement along the

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isoquant when the input prices change. There will not be any R&D expenditure involved
in this, as technology will not change. Only the equilibrium situation for the least cost
combination of inputs changes. Further, if technology changes this means a new
production function causing a shift of the isoquants. In this situation, the need for process
innovation is obvious. The input proportions to produce a given level of output will
change if there is technological change giving rise to the process innovation.

Product innovation is necessitated because of a variety of reasons. Primarily, a product

change may be stimulated either by a new technology or by a change in relative prices of
existing products. Changes in consumer preferences and cost of production- are the
sources of change in relative prices of the products. If a product is costly for the firm and
at the same time its price declines in the market because of unfavorable circumstances, it
will be less profitable and, hence, is likely to be replaced by a new one.

The process of innovation has a well defined goal and the adaptation of the new
technology or product to achieve the goal is an orderly management function of the firm.

The third stage (Diffusion) is the imitation of innovation. The innovation, initiated by
an innovator, spreads in the market. The rate of diffusion depends on market structure. If
there are rigid patent practices and the government assistance in technological progress is
negligible, then we expect a low rate of diffusion of the innovation. On the other hand, if
technology is freely available, there are no rigid patent practices and investment
requirements for the new technology are not alarming, then the rate of diffusion will be
fairly high. From social point of view diffusion or spread of the innovation is desirable
but from an individual firm & point of view it is not, as the firm would not be able to
maintain its gains through innovation when it is imitated by its rivals.

7.3 Measurement of Innovation Activities

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We need precise measurement of innovation like any other economic activity. There is no
unique method for this. Researchers in the field tackled the problem by measuring either
the inputs (i.e. total cost or some component of it in money or physical terms) put in the
process of R&D or the output of this activity. The most simple and widely used method
is to take the statistics of R&D expenditure, absolute or a proportion of total annual
budget of the firm, as a measure of innovation activity. The assumption for this method is
that larger the volume of R&D expenditure more will be the activities in innovation. This
method is useful if all R&D activities are in organized form. There may be significant
contribution by the individuals or departments of the firm which do not come under R&D
unit. How to measure their contribution is a problem. At present it is generally ignored
and available statistics on R&D is used simply to measure the innovational activities.

There is another method in which the number of scientists and engineers in the R&D
department is taken as a measurement of innovational activities. The assumption in this
case is that the greater the number of such personnel the more will be the R&D activities
of the firm or research organization. This measure has limitations similar to the R&D
expenditure. Contributions made by non-scientists or non-engineers are not captured by
this index.

From the output side one may use either the number of patents issued or sale of new
product as appropriate measurements of innovation or R&D activities. Taking number
of patents as a measure of innovation has some draw backs. Patenting generally refers
to invention stage. It does not reflect innovation and diffusion stages properly. Further,
all inventions are not patentable equally. Large firms doing research may avoid
patenting of their inventions in order to escape from monopoly regulation practices.
They may keep their inventions secret for long time, as we observe in drug industry, by
not registering the patents since a patent can be bought or copied by rivals. Further,
patenting is more appropriate for product innovation. In the case of process innovation it
does not fit properly. Patent system does not reflect the quality of innovation also. On
the whole, taking number of patents as a measure of R&D activities is a partial index. In

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spite of its drawbacks the index is popular for empirical studies.

The index of sales of new product is another measurement of R&D output. But this is
again a partial index reflecting the side of product innovation. It does not take into
account changes in the process of manufacturing and saving of costs arising as a result of
innovation.

7.4 The Theory of Technological Innovation

Attempts are being made by economists to identify the conditions (or determinants)
which encourage initiation and adaptation of a new technology. To begin with the
identification of such conditions, we may pose a simple but basic question related to the
technological innovation.
Why do scientists or engineers or anybody else make invention?
In a different way, we may ask this question as:
Why is a huge amount of money being spent on R&D activities all over the world?

The answer to this question is straight forward, that is, inventions are made because there
is a need for them. Fast moving modes of transportation came into existence because
there was need for them. Radio, television and hundreds of other inventions were made
with some purpose. Through inventions and their commercial exploitation man controls
his environment. An invention without commercial exploitation for personal or social
uses cannot be viable. Given this basic proposition of need which backs up inventions,
that, makes them goal oriented, we have to identify the conditions which are conducive or
which accelerate the pace of invention and innovation or broadly the technological
change in economy. Since we are concerned with the study of the economic behavior of
firms, and industries in this course, we will therefore examine the determinants of R&D
intensity in this context.

The first and most intensively debated determinant of R&D is the market structure of the
industry. Particularly, the elements of market structure such as the degree of market

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power and absolute size of firms were used in theory and empirical work on R&D
behaviors of the firms and industries. Perfect competition and monopoly were taken as
two extreme contrasting situations to analyze the link between innovational motivation
and market power. To test this link, the major hypothesis was put forward by Schumpeter
who argued that a monopoly firm has a greater demand for innovations because its
market power increases its opportunity to gain from them. This assertion has not been
accepted by the economists unanimously. At present they are divided into two opposite
schools, such as

 Competitive pressure school and

 Monopoly profit school.

The competitive pressure school argues that in an atomistically competitive situation,

with its strong tendency for a uniform normal rate of profit, there will be great pressure
and hence inducement for making cost-saving innovations. Such pressure diminishes as
market power of the firm increases and so the rate of innovation will be inversely related
to the degree of market power.

The monopoly profit school does not agree with such contention. It argues that since
innovation is risky, it will not be undertaken in atomistically competitive markets where
the gaps from innovation will be momentary. According to this school, the conditions for
sustained R&D activities are best provided by the monopoly or concentrated markets.
Through R&D activities a firm gains and acquires monopoly power over its rivals. The
firm would like to perpetuate its monopoly power by undertaking new innovational
activities. There is thus a positive relationship between the rate of innovation and the
degree of monopoly power as conceived by the monopoly profit school. Normally, large
firms in industries will be having considerable monopoly power. They will be capable of
providing adequate resources for R&D and taking the associated risks. The monopoly
power and large absolute size are thus complementary attributes which are relevant
determinants for R&D activities. Taking this view in mind we may summarize the stand
of the monopoly profit school as “… the greater the profits and the degree of market

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power or firm size, the greater should be the efforts to innovate.”

Another important factor that affects the rate of innovation is the nature of the elasticity
of demand for the product or products of an industry. Rapid technological changes are
seen in the industries' having elastic demand. Most of the luxury goods industries fall in
this category.

We know the link MR = P [1-1/ed]

Where;
MR is marginal revenue,
P is price and

ed is price elasticity of demand.

This equation shows positive marginal revenue when elasticity of demand is greater
than unity and negative marginal revenue when ed is less than unity. MR will be zero
when ed = 1.

Suppose there is process innovation such that cost of production reduces. By a

reduction in cost of production the firm position to reduce product price in order to get
more revenue (i.e. positive MR) if elasticity of demand is more than one. The firm will
do so. It is beneficial to the firm as well as to the consumers of the firm since they pay
less price for the product now and the firm gets more revenue. Thus, there will be more
inducement for innovation when price elasticity of demand for the products of the firm
or industry is elastic.

R&D intensity also depends on diversification. The basis for this relationship is that a
more diversified firm will be in a better position to exploit unexpected research outputs
than the one having a narrow base of operations.R&D activities also show strong
positive association with growth of output of a number of industries. R&D activities
are committed intensively where the growth prospects are good and profits are likely to
be high. However, there may be an upper limit for such positive relationship. A stage
will come when a product reaches ‘maturity’ stage of its life cycle with no more

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growth prospects. At this stage, the firm has to go through intensive R&D activities in
search of a new product or products to replace the old one. The relationship therefore
may not hold true or it may be negative after such stage is reached. Yet another factor
that we may mention here as a determinant of R&D behaviour of the firm. We have
discussed the general factors that determine the R&D behaviour of a firm or industry.In
brief, we may say that R&D activities of a firm depend on

(i) market structure,

(ii) size of the firm,
(iii) technological opportunities,
(iv) nature of elasticity of demand for the products of the firm,
(v) the degree of diversification,
(vi) growth of market, and
(vii) Expected return on R&D investment.

The list of determinants is not exhaustive. There may be more depending on specific
situations. The material presented above gives us a fairly good description of the
theoretical determinants of R&D activities of the firms. There are many analytical models
suggested by the economists for determinants of R&D. let as review one of them.

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CHAPTER NINE

INDUSTRIAL POLICY
What is industry policy?
Most government action has some effect on the industrial sector of the economy. In many
instances, this is simply a consequence of policy elsewhere for example, import controls
to help the balance of payments, prices and incomes policies to counter inflation and
increases in interest rates to control the money supply or to halt an exchange rate
depreciation. In other instances, government action has a more deliberate effect on the
operation of industry, but would generally still not be considered as 'industry policy'. This
is because the main objective is to influence some other aspect of the economy, as is
often the case with expenditure on infrastructure and on education.

Industry policy usually relates to those policies whose main direct effect is upon
individual firms and industries, or on industry as a whole. As Lindbeck2 defines the term:

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By industry policy is meant political actions designed to affect either the general
mechanisms of production and resource allocation or the actual allocation of resources
among sectors of production by means other than general monetary and fiscal policies
which are designed to influence various macro-economic aggregates.

9.2The theoretical case for industry policy

Economists normally argue that intervention in industry is justified if it results in a net

increase in economic welfare. Most change benefits some people, and adversely affects
others. As long as those who gain could, in principle, compensate those who lose, whilst
still deriving benefit from the change, welfare is enhanced (this is the potential Pareto
improvement criterion). Although a theoretically sound objective, changes in economic
welfare are difficult to quantify. Proxies such as improved employment, increased output
or a more favourable balance of trade must be rejected because they are often poorly
related to economic welfare. For instance, measures to increase employment or output
could lead to the production of a quantity, quality and mix of goods and services which
reduces society's welfare.

The time dimension adds a further complication, because there is a trade-off between
current and future levels of welfare. Assuming full employment, more resources devoted
to the production of goods and services in the present implies fewer resources devoted to
investment aimed at enhancing future production. Society will be willing to forgo current
welfare if it is compensated by a sufficient increase in future welfare. The rate of
compensation depends on the rate at which society discounts future benefits (the social
time preference rate); the lower the rate of discount the greater the quantity of resources
that should be devoted to investment and to research and development (R&D) activity.
While the market rate of interest can be used to derive an individual's willingness to forgo
marginal changes in current benefits in exchange for future benefits, this may not apply
to society as a whole.

It is argued that government intervention can improve welfare in cases where markets fail

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to provide an efficient utilization of resources. Five circumstances are cited where
markets produce levels of output that are not optimal from the viewpoint of society:
1. Monopoly;
2. Public goods, such as defense;
3. Externalities, such as pollution or congestion;
4. Common property rights;
5. Differences between private and social time preference rates.

An analysis of the exact circumstances in which markets fail is a prerequisite to the

examination of corrective policy measures. It is crucial to recognize that the case for
industry policy depends on uncertainty, imperfect information and as a result the
presence of transaction costs. This means that neoclassical economic theory is an
inappropriate basis for policy prescriptions. Furthermore, when it is recognized that the
governments too may fail, it becomes even more difficult to provide an economic
rationale for industry policy.

A large literature on public choice theory suggests that many political acts can be
understood by assuming that the objective of politicians is to maximize chances of re-
election. Such acts may be inconsistent with welfare maximization. A vote-enhancing
strategy causes politicians to intervene in cases where market failure arguments do not
apply. The consequence is that governments may be willing to implement industry
support programmes even where the result is to reduce the overall level of welfare.

The ability of politicians to pursue non-welfare maximizing objectives stems from the
presence of imperfect information. This also explains how, where competitive forces are
weak, managers in private sector firms are able to pursue objectives of which the
shareholders would disapprove. If the electorate were fully aware of the costs of
intervention as well as its benefits, then any policy that failed to enhance overall welfare
would lead to a net loss of votes.

Even where motives are altruistic, government intervention to correct market failure may

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not be merited. Government intervention is unlikely to be warranted where few parties
are involved, property rights are clearly assigned and transaction costs are low. In such
circumstances market failure is unlikely. For instance, with just one party involved, the
brewery is easily able to identify the source of polluted water and arrive at an optimal
solution by negotiation. However, with air pollution, market failure is more likely, even
where inhabitants have been assigned a right to clean air. The costs to an individual of
enforcing his rights will be high in relation to the benefits to be gained from clean air.
Here legislation and effective enforcement procedures to limit pollution, commonly
found in advanced economies, may increase economic welfare.

The government may find it difficult to identify cases of market failure. In the absence of
perfect knowledge, costs are incurred in acquiring the necessary information to intervene
successfully.

In the neoclassical literature it has been traditional to presume that if some decision
maker is at an informational disadvantage, optimality can be rescued through the
intervention of some omniscient policy maker with privileged access to informational
secrets.

Even when a case of market failure has been correctly identified, the government faces a
further problem in that it cannot know with certainty the most appropriate form of
intervention. A decision widely perceived as 'correct' in the current time period may lead
to an undesirable outcome in the future. For example, controls on a monopoly to improve
the current allocation of resources may lead to reduced innovation. Only where the
optimal prices, products and technologies of the future are currently known could
intervention be guaranteed to bring an improvement in welfare.

Another reason why the presence of market failure is not a sufficient condition to support
intervention is that government action uses scarce resources. Resources are used in the
administration of the policy; furthermore, intervention may take the form of transferring
resources towards favoured areas. There is also a dynamic impact. Government actions

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may induce changes elsewhere in the economy. Taxation to finance grants to small firms,
for instance, may deter other firms from undertaking the investment required to maintain
their own future competitiveness.

It is impossible ever to know whether industry policy has been successful. Intervention
itself alters the future state of the world, but is not the only force leading to economic
change. In order to evaluate the impact of policy, those changes which are the result of
intervention need to be identified. However, this requires knowledge of the state of the
world which would have prevailed in the absence of intervention. Consequently, the
success of a policy can only be judged qualitatively.

These problems leave governments with a dilemma. The type of policies that are more
acceptable politically are those directed at improving the dynamic performance of the
economy. Such policies cannot be addressed under neoclassical theory. The theories of
the new institutional economics can give support to intervention that is designed to
improve the workings of the market economy and to remove impediments to the
competitive process. This intervention would include measures aimed at improving
information flows, at strengthening legal rights and improving the framework for their
enforcement.

9.3 Different approaches to intervention.

Given the limited theoretical basis for industry policy, government involvement is very
much a matter of judgment and it is not surprising that there are many differences of
opinion about the best approach to adopt. Moreover, these approaches cannot be precisely
evaluated. Nevertheless, certain desirable features of an industry policy can be specified.
First, any policy should be capable of performing well in an environment where
transaction costs are the norm, and where economic agents lack knowledge and are
continually having to adapt to change. Secondly, the opportunity cost burden of the
policy must not exceed any perceived, potential benefits, having regard to its static and
dynamic effects on the industries involved and also on the rest of the economy.

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Four distinct approaches to industry policy can be identified:
1. Laissez-faire
2. Supportive
3. Active
4. Planning

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The laissez-faire approach is founded on the presumption that information flows are perfect, and
holds that the market is a better judge of desirable actions than government agencies. Most types
of intervention commonly pursued under the name of industry policy are rejected. Appropriate
policies are those aimed at strengthening and promoting a competitive environment (for instance,
through the control of monopoly or measures to remove ambiguities in the assignment of
property rights).

The supportive approach also believes in the underlying superiority of market forces, but
acknowledges the presence of imperfect information and transaction costs. Proponents of the
supportive approach would agree with the laissez-faire approach in advocating policies to help
markets function more effectively, but would often disagree over the form of desirable measures.
In particular, the supportive approach would argue for intervention to improve the allocation and
enforcement of property rights, to encourage education and entrepreneurship in order to foster
the process of economic change. This approach also recognizes that external constraints may
force the adoption of less desirable, or 'second-best', policies. For example, if Japan were to
adopt protectionist measures then Ethiopia would be justified in adopting similar policies, with
the ultimate intention of enforcing trade liberalization.

The active approach argues for wider and more direct government involvement in the industrial
sector. This approach differs crucially from the previous ones in that market judgments are often
supplanted by those of government agencies. Selected industries would typically be given
financial support to promote restructuring and be protected from external competition by tariff
and non-tariff barriers. Although protected from external competition, measures would again be
taken to promote competition domestically.

The planning approach is a more extreme version of the active approach. Its rationale is that
welfare can be improved through centralized planning. It argues that central planners are in a
better position - because of their superior, economy-wide information - to make welfare-
enhancing decisions than individual firms. This advantage is greater where information flows are

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imperfect and where the economy is changing rapidly. Intervention is much wider-ranging and
more comprehensive than under the active approach.

These policy prescriptions vary because of different perceptions about the efficiency of markets
and the ability of government agencies to identify and to correct market failures. The basic
dichotomy in these views is between advocacy of non-interference (the laissez-faire and
supportive approaches) and advocacy of a large element of government involvement which
includes targeting policies to particular firms, sectors or activities (the active and planning
approaches). In the laissez-faire and supportive approaches, the state is acting as an adjunct to
the market, working at the edges of the market system whilst in the other approaches the state
acts to shape the industrial landscape, taking a leading role in the industrial economy - a
proactive rather than a reactive role. The greater is the belief in the efficacy of the market and in
the impotence of government agencies, the greater the tendency to reject intervention and to
favour an essentially 'hands off' industry policy. Similarly, the greater is the doubt that the
principal objective of politicians is the enhancement of society's welfare, the greater the tendency
to advocate an industry policy that involves minimal government intervention.

The choice between the laissez-faire-supportive approaches and the active-planning approaches
therefore turns on views as to which uses information more efficiently, state agencies or the
market. Whilst it is undoubtedly true that state agencies have the ability to be better informed
about government intentions and have wider sources of information than an individual agent, this
does not necessarily imply that they have an informational advantage. One of the main strengths
of the market mechanism is its ability to collate and to make full use of widely dispersed
information. Although each agent commands but a tiny fraction of total information, by
responding to price signals from the market each agent reacts as if he were much better
informed.

Even so, most governments have chosen to intervene heavily in the operation of industry. In
some cases, intervention has taken the form of accelerative policies designed to improve the
speed at which the market operates. In others, a decelerative policy stance has been used to retard
the operation of the market. More commonly, both stances have been adopted simultaneously for

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different areas of the economy. Few governments have chosen to make use solely of neutral
policies (aimed simply at reinforcing the efficiency of the market). These would be more
consistent with a laissez-faire or supportive approach, although they have sometimes been
included as part of an active or planning approach. Table 9.1 summarizes the types of policy
consistent with these different approaches.

Accelerative industry policy

The objective of accelerative industry policy is to speed up the innovation process by providing
financial support to the most promising firms, markets or technologies. The premise behind such
a policy is that an economy benefits from adopting innovations ahead of its trading rivals. This
owes little to traditional arguments about intervention to correct market failure. Moreover, the
essentially dynamic nature of the intervention proposed means that neoclassical theory has little
to contribute.

Table 9.1 Taxonomy of industrial policy

Policy approach Policy form

Laissez faire Very limited intervention through neutral policies

Supportive Neutral policies

Active Accelerative and/or decelerative policies

Planning Accelerative and/or decelerative policies

However it is doubtful whether such government intervention to accelerate the introduction of

desirable new products and processes is worthwhile. Three main problems can be identified.
First, uncertainty and information costs make the correct anticipation of market trends,
technological developments and new market opportunities very difficult. In an uncertain

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environment the greatest chance of success comes from those who are best able to gather
relevant information. These are the entrepreneurs most closely involved with a particular area.
Government agencies are less likely to have the necessary specialist information about particular
market developments. Secondly, having identified areas to support, how should the policy is
implemented? General support to all new firms in a favoured area would lead to a considerable
waste of resources given the high failure rate of new firms. Directing funds to potential 'winners'
is ruled out by the absence of a mechanism to identify such firms. Advocates of selective
intervention may argue that uncertainty can be reduced by supporting firms with a proven record,
but past success is not a reliable guide to future performance. Thirdly, the opportunity cost of
accelerative policy must be taken into account. While favoured firms are nurtured, the
development of other sectors is hampered. Extra taxes or higher interest rates are imposed on
firms and their customers to finance industry policy, resulting in an overall reduction in the
demand for goods and services. These other sectors, although not apparently promising, may turn
out to be the real winners.

Decelerative industry policy

Decelerative policies can be of two types. If an essentially viable concern is facing temporary
financial difficulties, bankruptcy or liquidation may be avoided by providing assistance to help it
rationalize production methods or to improve its product range. In the case of a firm facing
permanent problems, the intention of decelerative industry policy is to moderate the externality
effects of its closure and to attain a better utilization of resources. Proponents argue that, while
economic forces may quickly lead to a firm's collapse, markets operate too slowly in re-
absorbing displaced resources. Instead of suggesting intervention designed to enhance market
forces they seek to maintain the employment of resources in their current use. They propose
intervention because of the length of time markets will take to re-establish equilibrium.
Neoclassical theory can give little support to this because it implicitly assumes that adjustment is
instantaneous.

Decelerative policies have been justified on social grounds, the argument being that preventing
(or slowing down) firm closure leads to the attainment of a more equitable and less divided

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society. However, the most frequent justification for support to failing firms is that their collapse
will lead to adverse effects on economic welfare. Externalities may arise from the closure of a
major employer in a particular locality, causing a large proportion of the population to become
unemployed with consequent ill effects on the rest of the community. There may also be domino
effects on other companies. For instance, the failure of a motor manufacturer will harm firms
supplying components to the motor vehicle industry. It would also lead to difficulties among
firms involved in the distribution of motor vehicles. These domino effects would also follow
from the failure of a small firm although, in most cases, decelerative policies have been biased in
favour of large firms. The explanation for this is probably political, stemming from the
widespread publicity given to the failure of large firms. Moreover, smaller firms are generally
less experienced in lobbying for government assistance.

Despite the externalities generated by the premature collapse of a potentially viable firm, the
economic case for government intervention to help it through its temporary difficulties is
dubious. If financial markets are efficient, a basically sound company should be able to obtain
financial support from the private sector. Conversely, if a firm cannot convince lenders of its
basic soundness, then government resources should not be advanced to try to improve its
operation. Even if financial markets do sometimes fail to recognize an inherently successful
company (for example, because of transaction costs) this does not invalidate the basic argument.
The government is likely to be at an informational disadvantage compared with firms already
operating in similar lines of business. Such firms are more likely to possess the information on
future demand relevant to identifying a failing company, taking it over and turning round its
performance. Furthermore, financial support from the government may fail to promote
efficiency, for it enables management, which has demonstrated its incompetence, to retain
control of the company.).

As with firms in temporary difficulties, support cannot be given to every firm in terminal
decline, otherwise the economy would strengthen and become progressively uncompetitive.
Since funds are likely to be limited, selection is required and here the government encounters
another information problem. Choice of unsuitable subjects will lead to a waste of resources.

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In most cases, it is expected that financial support will be required for a short period, but the
process of readjustment is often protracted. Devoting resources (particularly over long periods)
to the pursuit of decelerative policies incurs significant opportunity costs. Again, the success of
companies elsewhere in the economy will be hampered by higher taxes or higher interest rates
causing a reduction in demand for their goods and services. In other words, the financing of
decelerative policy generates its own domino effects leading to the contraction, reduced growth
or even accelerated failure of companies in the unsupported sector. In principle, it is impossible
to say how the domino effects of government policy on the employment of labour and capital
compare with the domino effects consequent on the natural decline of firms. However, the
overall effect is to reduce welfare because resources are switched from areas where revenues
exceed costs of production to areas of failure, implying revenues below cost. There is also the
cost incurred in the administration and implementation of the policy.

There is a real opportunity cost - in the form of a burden placed on the rest of the economy -
incurred by the pursuit of decelerative industry policies and their 'success' or 'failure' can be
established only after taking these costs into account.

What is the alternative to decelerative policies? In the absence of government support the assets
of the failing firm would be sold to the highest bidder. It can be argued that this would be a better
way of ensuring an efficient use of resources because the entrepreneur willing to pay the most for
the firm will be the one (often already operating in a similar area) which sees the most profitable
uses for the resources of the failed company. Company failure is an important' aspect of the
competitive process, serving to transfer resources from the hands of a management which has
incorrectly predicted market developments.

Neutral industry policy

Neutral policy seeks to improve the market framework within which economic agents operate.
This type of policy is consistent with economic theories that explicitly recognized the presence
of transaction costs. It is often advocated by those who recognize the difficulties involved in
trying to pursue accelerative and decelerative policies. The task of government should be to try

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to create an economic, social and political environment that is conducive to efficiency and new
initiatives. The government may not be responsible for picking 'winner' industries, but for
increasing labour mobility, improving long-run employment prospects, and hence reducing the
resistance to change. Specific examples of neutral policy include attempts to ensure that property
rights are clearly assigned. The more certain it is that the legal system will enforce such rights
(and the cheaper it is to seek legal remedy against infringement), the greater the incentive for
citizens to acquire private property. Similarly, the easier and cheaper it is to transfer rights over
property, the more desirable it is to own property. Following Coase’s work, clearly assigned
property rights would help to eliminate many cases of market failure. The pursuit of increased
competition - for instance, by the elimination of institutional barriers which prevent the entry of
new firms - could also be regarded as a neutral policy. Stimulating competition within the legal
profession might be particularly beneficial. This would improve the efficiency of the system for
enforcing property rights.

Conclusion

In developing their industry policies governments have often paid little attention to economic
arguments. One reason is because of a difference in objectives. Economists are concerned with
the enhancement of economic welfare, but this may not ensure re-election for the politician.
Secondly, neoclassical economics has little contribution to make to many of the issues which
governments usually consider vital. This is because traditional analysis is unsuited to problems
where change is endemic because of its generally static thrust and tendency to ignore problems
of uncertainty and lack of information. Thirdly, the approach of the new institutional economics,
which can explicitly deal with such an environment, is generally hostile to the type of unplanned
intervention favoured by politicians.

Many governments have adopted an active or planning approach to industry. Evidence from
particular countries appears to suggest that accelerative industry policies have been more
successful than decelerative ones. For instance, some of the strength of Japan's successful
industries stems from that country's willingness to phase out less successful ones

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However, it is impossible to say categorically whether these successes and failures are directly
attributable to government policies. It is also impossible to judge how successfully an economy
might have developed without the opportunity cost burden imposed by the operation of industry
policies. The opportunity costs associated with accelerative and decelerative policies are likely to
be high. Given that markets fail and that there is a need for some government intervention in
industry, neutral policies as part of a supportive policy aimed at improving the operation of
market forces would appear to be the most promising.

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