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• 2 major approach: -Structure conduct performance [SCP] developed by Mason and Bain] -Price theory • . Structure (number and size of firms, their cost and demand conditions, the nature of their products, condition of entry and degree of regulation) • Conduct (decision about pricing and output, investment, marketing, and product design)

• Performance (allocative efficiency, profitability, equity, employment effects and rate of innovation)

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Basic Market Conditions Demand Condition Supply Conditions Price elasticity technology Substitutes Raw Materaials Market Gorwth Unionization Type of Good Product Durability Method of Purchase Location Market Structure Number of sellers and buyers Product differentiation Barriers to entry and exit Vertical integration Diversification Coast structures Conduct Pricing strrategies Product strategies Advetising Research and development Plant investment Collusion Mergers Legal Strategies Performance Allocative efficiency Production efficiency Rateof technological advance ch-1 Quality and service Equity

Government policies Antitrust policies Regulation Taxes and subsidies Trade Regulations Price controls Wage regulation Investment incentives Employment incentives Macroeconomic policies

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• Price Theory: the following three specific theoretical applications have helped to explain SCP. -Transaction cost [TC] analysis -Game theory -Contestable market analysis • Transaction cost : expenses of trading with others and above beyond the price. The following are the four basic concepts that underlie this theory
– Markets and firms are alternative means for completing related sets of transaction. A firm can either buy or produce a product or service] – The relative cost of using the markets’ or a firm’s own resources should determine the choice. – The TC of writing and executing complex contract vary across markets as the human behavior of the writers vary. – Human and environmental factors affect the TC across markets and within firms.
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– Environmental factors: uncertainty and number of firms – Human factor: Bounded rationality [limited human capacity to anticipate or solve complex problem] • Reliance on market when -less uncertainty reduces cost or difficulty of contract. -presence of many firms which reduce the possibility of opportunistic behavior • Game theory: models conflicts and cooperation between firms and individuals. firms plan strategies to determine output and hence profit. • Contestable markets: Few firms , easy entry and exit

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• • •

Firm’s primary objective is to maximize profit . Target of a manager is to produce efficient level of output. Managers must be provided with incentive like share or bonus to be motivated. Forms of ownership:
 Sole proprietorship single owner]-personally liable for the debt.  Partner ship multiple owner]-personally liable for the debt . If one partner leaves the partnership dissolves . New partnership is requires to continue the business.  Corporation capital is divided into shares hold by individuals]-shareholder has limited liability . The corporation can raise money either through share or debt . Debt [les risky and low return] is repaid first . A firm becomes highly leveraged as the ration of debt to equity increases. As debt to equity ratio rises the expected return to equity holders rises. Companies with high debt to equity ratio faces more fluctuating share price ceteris peribus.

• • •

Size of a firm depends upon the trade off between advantage and disadvantage of expansion. A firm can expand either by investing or by merging A merger is a transaction in which the assets of one or more firms are combined in a new firm.

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• Size of a firm depends upon the trade off between advantage and disadvantage of expansion. • A firm can expand either by investing or by merging • A merger is a transaction in which the assets of one or more firms are combined in a new firm. • There are three types of mergers: i) vertical merger –firm combines with its suppliers ii) horizontal merger- firms that compete within the same market combine. iii) conglomerate mergers-firms in unrelated business combine.

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• Costs • Accounting cost versus economic costs • Short run versus long run - Variable (VC): Vary with output level - Fixed (FC): Do not vary with output level - Sunk costs: Cannot be recovered no matter what – Not all FC’s are sunk, but all sunk costs are FC’s • Total (TC): FC + VC • Average Variable (AVC): VC / Q • Average Fixed (AFC): FC / Q • Average cost (AC): TC / Q – TC = AC * Q • What happens to AVC,AFC & AC as Q rises? • Marginal Costs Marginal Costs (MC): The incremental costs associated with an incremental increase in output

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Returns to Scale • Positive economies: AC falls as Q rises – Also called increasing returns to scale (IRTS) – Common cause: large fixed costs • Constant returns: AC constant as Q rises – If no fixed factors (long-term), firm could increase all factors to achieve CRTS • Diseconomies: AC increases as Q rises – Some fixed factor of production (short-term)or managerial ability or entrepreneurship] - Transportation cost Minimum Efficient Scale • Minimum efficient scale (MES): The smallest level of output that can be produced such that the long-run average costs are minimized – Long-run average costs is the average cost curve when there are no factors that are fixed due to insufficient time to change them
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Economies of Scope: When it is cheaper to produce two products together - when two firms use common inputs; beef and hide. -Knowledge is another common input Firms often produce many products to gain economies of scope in marketing and distribution.

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Measures of scale economics: S=AC/MC • If S>1 economics of scale • If S<1 diseconomies of scale • If S=1 constant returns to scale If p=MC , S=Cost/Revenue [find it by yourself] Ray average cost: let a firm produces two output q1 and q2 . Both these output are produced as a proportion of total output . Let λ1 and λ2 be the proportion of total output at which each output is produced. qi= λiq.
RAC then defined by RAC(q)=C(λ1q, λ2q)/q RAC falls rises or equal to 1 if S is above , below or equal to 1.[show the proof]

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Perfect competitive market ; a bench mark model Main assumption: i) homogenous good ii) perfect information iii) price taking iv) No transaction cost[ no participation cost in the market] v) no externalities [ firms bear full cost of their action] vi) free entry or exit vii) perfect divisibility of output. The assumption of large number of sellers and buyers is redundant as ther is already the assumption of free entry or exit.

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As the demand curve of the firm in a pc market is horizontal , INDUSTRIAL ORGANIZATION how much output a firm should produce depends upon the profit maximizing condition. Max Λ=pq-C(q) δΛ/δq=p-C`(q)=0 p= C`(q) [necessary condition] -C``(q) [sufficient condition]

P profit

MC

AC

AVC

Q

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• • • • • • • • • •

Shutdown condition=AVC [graph] Quasirent : payment above the minimum amount necessary to keep a firm operating in the short run. When p> VC , firms earn quasirent. Firm’s supply curve -rising portion of MC above the minimum point of AVC. Industry’s supply curve: horizontal summation of firms' supply curves. Graph ; Long run : firms will enter if p> AC and exit p<AC. Firms can enter at the optimal scale ie, the minimum point of AC. In the long run firms earn normal profit, ie they operate at the minimum point of the Ac. Firms can enter at the optimal scale .
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• If there are n firms in the industry all having the same cost structure and no sunk cost then the long run supply curve is horizontal at the optimal plant. This is because each one of many firms can operate at very close to its efficient output. • LRSC is rising – when output is expanded some of the input become expensive. • Some inputs are fixed even in the long run –eg. Fertile land. Their price tends to grow as output expands . • LRSC falls if input price falls. • LRSC increases because there are only few low cost firms . To expand output les efficient firms enter. graph]

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• Elasticity and the demand curve: – Price elasticity of demand and supply –shows how an industry responds – Residual demand curve3- how a firm responds. • Since in PC market firms are price taker the demand is perfectly elastic. • Residual demand curve: let Dr(p)=residual demand D(p)= market demand So(p)=supply of other firms Dr(p)=D(p)-So(p) If So(p)> D(p) then Dr(p) =o • Residual demand curve is flatter than the market demand curve. [graph] • If there are n identical firms in an industry then the elasticity of demand of any firm is εi= ε n-ηo(n-1) where ε=market elasticity η0=elasticity of supply ,(n-1) number of other firms.
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Efficiency-No one can be made better off without making other worse off. -two desirable efficincy-i) production efficency ii) consumption efficiency[p=mc] -Welfare is calculated by the sum of consumer surplus and producer surplus. This sum is maximized at PC -dead weight loss: the cost to a society of a arkets not operatinf efficiently. - If demand curve is linear than area of DWL is calculated by -1/2ΔP. ΔQ

If ε= [ΔQ/Qo]/[ΔP/Po] t=percentage change in price due to tax=ΔP/Po ε=[ ΔQ/Qo]/t =-1/2 [ΔP/Po] Po Qo[[ΔQ/Qo]/[ΔP/Po]] [ΔP/Po] =-1/2t2R ε
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In a competitive market entry restriction works like a tax. It raises the price above the market level. Here the restriction transfer the consumer surplus from the consumer to the few suppliers in the market. -Entry restriction: I) absolute cost advantage ii) Economies of large scale production that require large capital expenditure. iii) product differentiation

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Monopoly-Single seller -faces a downward sloping demand curve –the market demand curve. -can either control the price or the quantiiy. - always charges a price in the elastic region of the linear demand curve. -MR=P[1+1/ε] -Lerner index of market power=[P-MC]/P= -1/ε -differnce between market powe and monopoly power. Cost of Monopoly: DWL -as the demand curve less elastic people are less willing to do without the good. Monopoly profit increases as DWL increases.
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Sources of Monopoly: i) a firm has special knowledge about the production technique of a new better product that cannot be imitated ii) firm has special knowledge about a the production technique that can be produced a a lower average cost. iii) patent right. iv) government law v) strategic actions taken by firms cam stop entry like controlling the key inputs . Alternatively the size of the firm is so large compared to the market that only one firm can exist. vi) firms can prevent access to key input .
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Externality: When a market failure occurs monopoly may be socially preferable to PC.
MCs

MCp Pm P* Pc

Marginal pollution cost

MR Qm Q* Qc

D

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Monopsony: A single buyer in the market . -Monopsony occurs in the market where resources are special to a few uses. This may hot persist in long run as that will provide a depressed return.
MO

S DWL Wc Wm

Lm

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Lo

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.

Dominant firm with competitive fringe: Dominant firm – lower cost firm , they are the price setter and control a large share of the market. Fringe-higher cost firms. Two conclusions:- i) it is generally not in a profit maximizing dominant firm’s best interest to set its price too low so that it drives all competitive fringe firms out of the market. ii) the threat entry by new firms keep a dominant firm’s price below monopoly price. -dominant firm’s price should not exceed the minimum AC of the fringe firms. - Reason for dominance: i) DF has lower cost than fringe firm because more efficient than rival , early entrance lower cost due to learning by experience, early entrance helped to grow large optimally. ii)DF has asuperior product-achieved through advertising or due to good will developed due to long time existence in the market. iii) group of firms may act as DF.
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.

Two alternative models: i) no entry model ii) free instantaneous entry. -No entry model-Assumptions; i) one firm that is much larger than any other firm because of its lower production cost. ii) Fringe firms are price taker iii) number of fringe firms are fixed. iv) DF knows industry's demand curve. v) DF can predict how much output the fringe will produce at any given price. -to find the profit maximizing output DF first determines its residual demand curve and then w.r.t that act as a monopoly.

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.
MCf ACf

S(p)

MCd

ACd

P* P

P

MCd

D(p)

Qf

Qd

Qd*

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Free instantaneous entry: Here number of fringe firms are not fixed. In the long run ff do not enjoy positive profit . The either break even or exit .

MCd

S(p) P

MCd

D(p)

MRd Qd Q QD*

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