Industrial Organization PGDMM501

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Industrial Organization PGDMM501

• Rajith Lakshman

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Contact Details

• Secretariat for coordinating the peace
  processLevel 10, West Tower,World Trade Center
• Consultation by appointment at SCOPP
• Tel [phone] 2260274 (after hours)
• rajith_at_scopp.gov.lk
• www.bad-sports.com/rajith

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Purpose of Introductory Lecture

• Focus of Industrial Organization
• Relationship to Economics
• Course Outline, Assessment, texts and other
  learning material
• Essential background
• The firm
• Cost curves
• The demand function and revenue curves

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Focus of Industrial Organization

• Behaviour of (a) firms in (b) industries
• Firms What are the policies/strategies of firms
  to rivals, customers
• Firms How are activities organised inside and
  outside firms
• Industries Why industries are more or less
  concentrated
• Industries Why industries are more or less
  competitive

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Focus of Industrial Organization

• Oligopolistic Markets on a spectrum
• Exogenous features of market
• Interactions between incumbants
• Interactions between incumbants / entrants
• Role of Government Policy in Markets
• Competition and Regulation Policy promotes
  competition
• Distinguish from Industrial Policy Policy which
  interferes with the competitive process in markets

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Origins of Industrial Orgn

• Micro-theory of the firm PLUS
• Barriers to entry such as product differences and
  technology differences
• Limited information
• Costs of adjusting prices
• Transactions costs
• Government actions
• Strong empirical focus linked to theory/policy

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The Theoretical Base

• Structure Conduct Performance (SCP) Approach
  Descriptive
• Price Theory Explains the firm and market
  behavior using microeconomic theory. More
  rational and logical?
• Both will be used in PGDMM501

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SCP Framework

• An idea based on empirical observations that,
  given basic conditions in an industry, the
  following linear relationship holds
• Linear vs. dynamic SCP model

Structure of an industry
Conduct of firms
Industry performance
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Price Theory

• Data availability made this approach popular
• Advances in microeconomic theory
• Transactions cost analysis Markets and firms as
  alternative institutions
• Game theory Models conflict and coordination
  using formal models. Few firms
• Contestable Market model Threat of entry could
  be as good as entry itself.

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Growth and Competition

• Competition facilitates growth effective and
  efficient use of resources
• Growth facilitates competition
• Size of market
• Rebalancing in interests from concentrated
  producers to dispersed consumers

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Course Outline

• The Firm
• Perfect Competition
• Monopoly
• Oligopoly
• Monopolistic competition
• SCP

• Strategic behavior and vertical integration
• Information, advertising and patents
• Innovations
• Market Clearing
• International Trade

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Available material

• Carlton, D. W. and J. M. Perloff (2000). Modern
  Industrial Organisation, Pearson Education
  International.
• Douma, S. and H. Schreuder (2002). Economic
  Approaches to organizations, Pearson Education
  Limited.
• Also see the course web page and
• http//www.sp.uconn.edu/langlois/courses.html

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Assessment
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The Firms

• Maximize profits ? Production efficiency
• Ownership sole, partnerships, corporations
• Corporations
• Limited liability
• Financing equity and debt
• Separation of ownership and control
• A firm or an industry?

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Specialization
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The division of labour

• Improvement in skill and dexterity.
• Learning by doing.
• Spread fixed set-up costs.
• Less sauntering between tasks.
• Increased innovation.
• Operative focused on and benefits from abridging
  labour.
• Specializing in invention.
• Assign operatives according to comparative
  advantage.

Charles Babbage (1791-1871).
Adam Smith (1723-1790). Author of the Wealth of
Nations (1776). Picture courtesy of the Warren J.
Samuels Portrait Collection at Duke University.
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The problem of organization.

• But the division of labor by itself doesnt say
  anything about the boundaries of the firm.
• Are the stages of production each a separate
  firm, or are some stages within a single firm?
• Vertical integration.

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Why are there firms?

• The main reason why it is profitable to
  establish a firm would seem to be that there is a
  cost of using the price mechanism.
• Cost of discovering the relevant prices. These
  are not completely eliminated by intermediaries.
• Costs of negotiating and concluding a separate
  contract for each exchange. Employment contract
  vs. spot contract.
• Costs of coordinating when tasks are uncertain.

Ronald H. Coase (1910-)
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The nature of the firm

• But is a firm something different from a market?
  
• Telling an employee to type this letter rather
  than to file that document is like my telling a
  grocer to sell me this brand of tuna rather than
  that brand of bread. (Alchian and Demsetz 1972,
  p. 777.)
• The firm as a nexus of contracts.

Armen Alchian (1919-)
Harold Demsetz (1930-)
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The size of the firm.

Costs of administrative coordination.
CPS CAC
Costs of the price system.
T
Number of transactions (ordered from most to
least costly to execute through the price
mechanism).
Size of the firm.
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Mergers that increase efficiency

• Reduce duplications
• When the optimal firm size increases due to lower
  transport, communication and financing cost.
• Transaction cost can be lowered
• Economies of scope
• Replace bad management
• Management buy outs

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Mergers that reduce efficiency

• Tax incentive loss making firm profit making
  firm
• Merges that lead to market power and hence
  eliminate competition
• The merged firms comprise a powerful political
  lobby ? influence legislation

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Theory of the firm

• Models the profit maximizing behavior of the firm
• Profit Total Revenue Total Cost
• Costs
• Fixed
• Variable
• Cost behavior is related loosely the inverse of
  productivity behavior

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Production Funcn and Cost Curves
Q/L dQ/dL

• Production Function with labor (L) and capital
  (K) as the only inputs.
• Increasing L holding K constant yields the labor
  productivity functions APL and MPL.
• Prod_to_cost.xls

APL
L
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More on cost curves

• Factors (other than Q) which affect cost
• Speed of production
• Variations in the rate of production
• Seasonality

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More on cost curves (contd)

• Short run vs. Long run
• LR at least one factor cannot be varied because
  of prohibitive costs i.e. cost gt benefits

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Opportunity costs

• Opportunity cost the value of best foregone
  alternative
• The opportunitycost of doing yourstudies
• Econ. Profit vs.Accounting Profit

Accounting Profits
Implicit
OC
Explicit
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Cost curves and economies of scale

• Q ? ? AC ?
• Exists if sgt1 where s AC/MC
• Reasons
• Fixed cost gets distributed
• Specialization of labor
• Reduced switching (between different product
  runs) costs
• Reduction of inventory as a fraction of sales
  (law of large numbers)

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Empirical cost curves

• MES and market structure
• Multi-product and multi-function firms
  complicates AC calculations
• Read up on Economies of scope (pp.44-47)

MES1 MES2
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The Demand curve

• The inverse relationship between price and
  quantity demanded of a good
• Because of
• Income effect
• Substitution effect
• P and Q trade-off
• AR and MR
• Revenue.xls

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End of Introductory Lectures

• Focus of IO
• Relationship to Economics
• SCP and Price theory
• Essential background
• The firm
• Cost curves
• The demand function and revenue curves