Industrial Organization

Studies in economics focus on consumer and firm behaviors. On the supplier side of the equation, a substantial amount of time and effort are devoted to the determination of price. Costs weigh heavily on that process in perfectly competitive situations, but many factors come into play in other situations. Firms may compete through price or some other mechanisms depending on the market structure in which they operate. Sometimes their pricing and output strategies generate too many problems for society in an arena where limited resources face unlimited wants. According to a dominant school of thought in industrial organization, market structure and market conduct jointly determine market performance. Evaluations of the consequences of those elements center on production levels and allocative efficiency. Those evaluations require analysts to examine the levels and trends in production volume and resource utilization. A lot of attention focuses on profit levels, concentration ratios, and the nature of any statistical association between them. This essay closes with brief mention of regulatory sanctions and antitrust laws that arise from economic analyses, societal perceptions, and/or firm behaviors when markets are less competitive than desirable. Consequently, economists, policy makers, and/or lawyers frequently specify price-output combinations or other courses of action in order to embed noncompetitive situations with some features commonly found in competitive markets.

Keywords Allocative Efficiency; Antitrust; Barriers to Entry; Concentration Ratio; Economic Profit; Economies of Scale; Fair Return Price; Herfindahl Index; Industrial Organization; Market; Market Conduct; Market Performance; Market Structure; Merger; Monopolist; Natural Monopoly; Oligopolist; Perfect Competition; Predatory Pricing; Price Fixing; Profit levels; Socially Optimal Price

Economics > Industrial Organization

Overview

This essay introduces the reader to the field of industrial organization. This field deals generally with the structure, the conduct, and the performance of firms as they interact in markets. More specifically, industrial organization focuses attention on market dominance, pricing strategies, and resource utilization. Economists and policy makers tend to emphasize employment, output, and profit levels and express concern when markets are less competitive than possible. By extension, industrial organization provides a foundation for the study of other fields that require an understanding of interactions among firms in an economy. Antitrust laws, policies, and regulations are examples of areas that employ industrial organization as a lens through which to examine how market conditions and firm behaviors affect consumer and societal well-being.

The question of whether monopolistic market structures are harmful to consumers is one worth keeping in mind. In order to provide assistance in forming answers to that question, this essay will offer contrasts using pure competition as a point of reference. In addition, it will offer a description of how imperfect market structures frequently generate worker unemployment and excessive corporate profit. Sometimes those structures also achieve a concentration of market power while driving competitors out of the marketplace or preventing their entry. Laws and regulations exist to protect firms and consumers from abuses of that kind. Historically, antitrust laws and related regulations represent developments that delineate the appropriate scope for governmental intervention in markets when business strategies have gone too far while achieving competitive advantage.

An initial task in forming a governmental intervention or beginning a legal investigation is defining the industry, the product, and the market. Consider, for instance, what constitutes those dimensions with respect to soft drinks. Many beverages exist including those that take the form of fruit-intensive juice varieties, caramel-colored carbonated sugar-water concoctions, or the filtered water available in plastic bottles. Some questions may come to mind. Which do you drink? Is it a colored cola, a cola carrying a name brand, or a clear cola? What characteristics describe buyers and sellers as they interact in the marketplace? Does a geographic boundary, a population segment, an advertising campaign, or some other dimension define the market of interest? These questions are more than rhetorical in the sense that courts will likely address them applying many of the basic concepts and relationships found in this essay.

Applications

The Demand Side

Students of microeconomics often begin by focusing their attention on relationships between the possible prices of an item and the quantities consumers are willing and able to purchase at each price and, likewise, the quantities suppliers are willing and able to produce. On the consumer or demand side, students learn very early in their coursework that an inverse relationship exists between price and quantity in accordance with the Law of Demand. Relatively speaking, smaller amounts are in demand at higher prices and vice versa. Furthermore, the higher the price for any item the more sensitive consumer purchases become.

Elasticity is a concept that concerns itself with measuring consumer sensitivity to price hikes. Calculations of the price elasticity of demand allow economists to determine precisely in percentage terms how much a consumer's purchases of an item will decrease in response to an increase in its price. In some instances, good or service providers will succeed in segmenting buyers according to their demand elasticities. Almost anyone who travels by air is subject to that type of segmentation. For instance, air fares are usually higher for business persons who need the greatest flexibility in their travel schedules. In contrast, leisure travel affords the air traveler the option of shopping around for the lowest air fares for any given travel plan.

The Supply Side

On the producer or supply side, students learn early in their course work that a positive relationship exists according to the Law of Supply. From a producer perspective, the price at which they sell their goods and services may be a simple function of costs and/or the complex actions of other suppliers. In terms of the former, the relationship between market prices and producer costs often influences whether item production will occur. Firms certainly incur a variety of costs in the production of goods and services. More uncertain, however, is how they determine prices when they operate in market structures lacking competition. Therefore, it is instructive to begin that exploration by understanding the market structure, conduct, and performance elements.

The Structure-Conduct-Performance Approach to Organization

It is also beneficial to recognize those three elements are essential components of a dominant school of thought in economics on industrial organization. The structure-conduct-performance paradigm comprises a set of assumptions that frame how economists, policy makers, and lawyers tend to view the workings of a market-based economy. Market power presumably benefits producers more than consumers. Sometimes its presence suggests there is a potential for abuse whether some firms operating within an industry take advantage of other firms and/or whether they fail to exercise stewardship over society's scare resources. The next three sections of this essay address those main elements and introduce additional concepts as appropriate to further the reader's understanding of industrial organization as a topic of study within economics.

Market Structure

Depending on the market structures in which they operate, some firms may influence the market price and others may merely accept the market price for their outputs. Market structure is a continuum that takes into account the extent of competition in a market for a specific output or item. The book ends of that continuum are perfect competition and monopoly (or imperfect competition). Industrial organization tends to focus on the latter because it is most problematic at times for some groups within larger society. In addition to price setting, the determinants of market structure include items like the number of sellers and buyers in a market, the concentration of sales among those two parties, the relative ease at which firms can enter or exit a market, the cost structure, the amount of advertising, and the type of profit (Martin, 2012).

Market Power

The main problem from a societal view is that firms with market power usually produce lower quantities and charge higher prices than would perfectly competitive firms. Moreover, their prices are higher than in the competitive case as are their cost margins; more about costs will follow later in this section. An examination of price in relation to cost structure reveals a great deal of information. According to microeconomic theory, economic profit accrues when prices are higher than average total cost, thereby inviting new firm entry into a market. Economic profits will diminish with entries of new suppliers into the market, and increases in quantity supplied will propel prices downward toward the point at which a normal profit occurs.

Economic profit is sustainable, however, when there are barriers to entry. For example, a producer's entry in a market may be difficult due to constraints such as patents and licensing or franchise requirements. The amount of advertising can create differences (whether real or perceived) in product lines, which by definition is product differentiation. Brand name recognitions and customer loyalties present difficulties for firms contemplating entrance. Economic profit, entry barriers, and product differentiation are likely to result in a concentration of market power among a few firms. As a feature common to non-competitive market structures, there are at least two techniques applicable to measurements of market power.

In order to understand their applicability, a reader first needs to know that imperfect competition occurs when a few sellers or producers exist within a given market. Though four or five market structures exist in economics textbooks, a major portion of this essay is devoted to two of them due to the nature of industrial organization topic. Both structures place at the high end in terms of market power. A monopolist (mono prefix means one) is one firm that supplies an item to the entire market. An oligopolist (oligo prefix means few) is one firm among a very few that supplies an entire market; for example, readers could consider MicroSoft a monopolist in the computer operating systems market and Pepsi, Coca-Cola, and Royal Crown as oligopolists in the soft drink market.

Measuring Market Power

Measures of market power include the concentration ratio and the Herfindahl Index (HI). Calculating the concentration ratio for the four largest firms (the CR4) involves dividing the dollar amount of their sales by the total dollar amount of market sales. For example, the CR4 in the soft drink market could be somewhere around a 95, after multiplying the result by 100, meaning that the four largest firms account for 95 percent of product sales within a given market. For a monopolist, the CR1 would be 100 percent, which is the maximum value of a concentration ratio. Calculating the HI involves squaring the market share of each firm in the market and then adding them together; it would be the highest at 100 squared, or 10,000, in the case of a monopolist.

Mergers

Concentration ratios and the HHI as well as levels of profit, price, and output are especially useful in examining industry proposals for merger.

• A vertical merger occurs when a firm buys one or more of its suppliers; for example, a soft drink manufacturer buys an aluminum can producer.
• A horizontal merger occurs when a firm buys a competitor; for example, a restaurant owner buys another restaurant.
• A conglomerate merger occurs when a firm buys a firm in a separate but related industry; for example, a soft drink manufacturer buys a fast food restaurant.

Industrial and antitrust regulations center their attention on market power and define markets according to product and/or geographic location while, on the one hand, attempting to protect consumers from high prices and restricted choices and, on the other hand, pursuing stability for firms facing intense competition.

Cost Considerations

An examination of prices in relation to cost patterns will reveal whether a firm is earning an economic or normal profit. Costs take various mathematical forms and some are interrelated by definition. Total costs are the sum of fixed and variable costs. Fixed costs are those that exist even without any production. Furthermore, they are constant as they do not vary with the scale of production. Some examples of fixed costs include monthly installments paid for machinery, buildings, and land. Variable costs are those that vary with production. Some examples of variable costs include wages, materials, and supplies.

The allocation of costs across a larger volume of production results in a variety of cost curve shapes. Graphs depicting these functions show cost on the vertical axis and quantity on the horizontal axis. Average total cost and average variable cost form important U-shaped curves. Their calculation involves dividing them by the production quantity. The lowest points on those curves are significant in at least two ways.

• First, it is the point at which the marginal cost curve, which is J-shaped, intersects them. Marginal cost is the change in total costs that arise from producing one additional unit.
• Second, the lowest point on the average total cost curve defines the region where economies of scale occur. As output levels increase, average total costs decrease to that lowest point after which they begin to increase. These scaled economies are a barrier to entry because entrants are usually unable to achieve costs structures as low as those of existing firms.

Cost & Revenue

Firms incur costs by virtue of their production and they receive revenues by selling each unit of production and charging a price for it. In the pages ahead, the essay will convey how firms may conduct price determination strategies as they operate under imperfectly competitive market structures. For now, consider that total revenue is the mathematical product of price times the quantity sold at each price. Marginal revenue is the change in total revenue that arises from selling one additional unit. As a point of departure here, readers should make a point to remember that price is equal to marginal revenue in competitive market structures and it is greater than marginal revenue in other market structures.

A key relationship exists where marginal revenue equals marginal cost and where these two curves intersect. The intersection determines the profit-maximizing amount of output. Most, if not all, firms attempt to set production to that amount as they exhibit profit-maximizing behaviors. However, that amount of output is lower for firms exhibiting market power in comparison to those operating in highly competitive market structures. Lower output levels, by extension, when viewed from a societal standpoint are unfavorable. Relatively speaking, some consequences of that lower volume may include higher unemployment, lower incomes, higher marginal costs, or some combination of these.

Another key reference point is the break-even point. It occurs where the marginal cost curve intersects the average total cost curve and at the latter's lowest point. The break-even point also marks the location at which those costs are equal and the firm earns a normal profit. The term is misleading as it seems to indicate an absence of profit. However, profits become part of an operating cost if the owner is to be consistent with the notion of opportunity costs, which is the value the decision maker assigns to the best foregone alternative. In summary, firms operating in imperfectly competitive market structures usually accrue market power due to their ability to restrict entry, to earn profits exceeding the normal level, and to be strategic in how they conduct themselves in determining prices.

Market Conduct

The conduct of firms operating within a market economy usually exhibits various strategies. Those strategies may center on price determination or something else. Firms' strategies can also address product line content, research and development, plant investment, marketing, and legalities. All these strategies are elements that illustrate market conduct, which is the second of three dimensions of the dominant model of industrial organization.

Price Determination

Firms conduct their operations in predictable ways when they are oligopolists. A key behavior is the perpetual search to set prices in relation to the market price. The following question will prove to be useful in this section: How do firms know when the price is indeed right? The application of game theory to economics provides some insight regarding firm pricing strategies; readers are encouraged to consult other sources to obtain details about that application. In short, price search processes frequently resemble games in which each player pursues a strategy that may be interactive, collusive, or reactive in nature at any point in time. According to the game perspective, the main objectives of the game are to set a high price, maximize a market share, and earn a profit while attempting a correct anticipation of the other player's moves. Player interactions involve varying degrees of cooperation and presumably lead to a set of joint outcomes that are favorable to all if not most of the game participants.

Three additional perspectives on price determination also deserve brief mention here. They provide oligopolists with a basic method by which they can assess their chances for success. Those methods range from methods that resemble an informal follow-the-leader strategy to a formal agreement that fixes prices at a specific amount. Cartel theory asserts that firms, which are formal members of a relatively small group, agree in advance regarding the price and/or the output of their goods and services. Kinked demand theory and price leadership theory assert that firms set or change their prices in relation to what other firms are doing.

Price Fixing & Predatory Pricing Activities

Cartels are illegal in the United States and some other countries. Also illegal are price fixing and predatory pricing activities. In order to gain market power, two or more rival firms may conspire to fix the price of an item at a specific amount. This action effectively diminishes competitiveness between and among these firms. Unfortunately, it erodes the benefits consumers receive by virtue of their having to pay a higher price. Furthermore, conspirators are able to preserve their market share. Another illegal tactic to gain market power occurs when one firm temporarily lowers its price below cost in order to force its rival competitor(s) to lower prices. In predatory pricing schemes, a few rounds of price cuts can force a competitor into a shut-down situation crafted entirely through some intentional actions undertaken by the predatory firm(s). Once the rival firm exits the market, the surviving firm will gain share and market power thereby raising its price and realizing economic profit especially when entry into the market is difficult in the first place.

The strategies by which firms maximize profits are significant indicators of market conduct. Consider now that most firms, if not all, face a downward sloping demand curve regardless of the market structure in which they operate. However, a lower profit-maximization output level carries prices into the upper reaches of the demand curve, which is also its elastic region. This means that consumer purchases are more responsive to changes in price, but the absence of competitors offering close substitutes for the good is likely the result of entry barriers. Furthermore, these conditions also enhance the likelihood that some firms will discriminate among buyers by charging them different prices for the goods. Price discrimination, by definition, is the act of segmenting buyers and charging them prices that reflect the buyer's price elasticities of demand.

Non-Price Competition

Factors other than demand elasticities and price may affect firm conduct in the marketplace. Aside from the degree to which firms with market power interact with each other, non-price competition is the most visible factor. It consists of heavy doses of advertising or product differentiation strategies. In sum, competition may appear to occur on the basis of price, but advertising generates images that diminish buyer indifference toward a product and enhance their preferences. For example, soft drink manufacturers are notorious for crafting perceived differences among their carbonated caramel-colored sweetened beverages through advertising expenditures and marketing campaigns. In reality, the amount of product differentiation masks the degree of competition between firms whether products are truly quite similar if not identical.

The soft drink industry provides an effective reference point in conveying various dimensions of market conduct as it exists within the realm of industrial organization. Drink flavor concoctions and innovative product varieties also help delineate market conduct. They are a result of research and development expenditures. Firms can maintain market power and bolster their cutting-edge positions and competitive advantage appearances. Legalities such as patents, trademarks, and trade secrets add to the growing list of features that signify market conduct. At the very least, these characteristics alone are likely to inhibit the entry of potential suppliers.

A couple other non-price dimensions of competition need mention before this essay turns attention toward items for evaluating market structure and market conduct. Inventory practices can become a strategic factor with adequate planning and effective implementation. Consider that Wal-Mart's initial claim to fame and fortune stems from its purchases of items in huge amounts achieving significant cost reductions at the wholesale level which converts them into lower prices at the retail level. Furthermore, rolling warehouses (trailer trucks) carry a significant portion of that inventory sometimes bound for stores and locations unknown at loading time. In summary, firms operating in imperfectly competitive market structures can accrue market power though planning acquisition and storage, organizing legal counsel and mechanisms, managing product innovation and marketing. The results of these behavioral aspects and structural dimensions are measurable in terms of the degree and manner to which firms and industries employ society's scarce resources.

Market Performance

Market conduct and market structure are joint determinants of market performance, which is the last of three dimensions, according to the dominant school of thought in industrial organization. Performance evaluation may include a focus on the statistical association between profit levels and market concentration ratios; one would expect to find a strong, positive correlation between the two. In general, evaluations of the consequences of firms' conduct focus on the levels and trends in production volume and resource utilization.

Efficiency

Analysts need to consider a few forms of efficiency in order to examine performance (Tremblay, 2012). The narrowest measure is firm efficiency. Its observation requires decreases in average total costs as production volume increases. Furthermore, those costs decrease up to a point and then they begin to increase; readers may recall that the average total cost curve is u-shaped. Moreover, consider that pattern in a context of consumer and larger society preferences for more of something as opposed to less of it.

Performance in competitive markets typically exhibits production of the greatest amount for which average cost is the lowest. In relative terms, outputs, employments, and incomes are higher in a competitive market than a noncompetitive market although profit maximization occurs in each situation. Allocative efficiency, by definition, occurs when society's scarce resources, especially labor, are employed in the largest and most efficient amount. By extension, an industry that is efficient in its resource allocations tends to exhibit job creation. However, noncompetitive industries and markets constrain or inhibit job creation.

Firms operating in oligopolistic, monopolistic, and other forms of noncompetitive market structures restrict output; forcing prices upward, creating unemployment, and generating lower incomes than possible otherwise. In essence, they produce less and employ fewer workers than do firms operating in competitive markets. Moreover, the high price is the result of the profit-maximizing output occurring at lower level of production than it would be in other market structures. Most importantly, average total costs are higher with lower levels of output and are greater than a competitive market level.

For these reasons, many economists, public policy analysts, and other individuals interpret market power as something that is generally bad for society. In the next and final section, readers will find a brief presentation on regulations that aim to maintain competition. As we move toward conclusion of this essay, the table below serves as a summary of the points covered thus far. Consistent with the structure-conduct-performance approach to industrial organization, the table provides some key elements for drawing contrasts between a competitive and a noncompetitive market.

Scope for Government Intervention

As interventions arising from unfavorable perceptions, analyses, or behaviors are commonly exhibited in noncompetitive markets, laws and regulations typically address price-output combinations. They represent an effort to infuse some characteristics of competitive markets whether existing structures and conducts are artificial or natural. Enter the case of a natural monopoly.

Economists classify electric power companies, communications providers, and other utility companies as natural monopolies. The prices frequently imposed on utilities by regulatory commissions take one of two forms. First, regulators may pursue the socially optimal price, which by definition is set to equal marginal cost. This type of pricing intervention artificially generates the largest amount of output and the lowest price, which is characteristic of a perfectly competitive market structure.

In the other form of regulated prices, regulators may pursue a fair return price, which by definition, is set as equal to average total cost. This pricing strategy forces firms to accept a normal profit, which essentially diminishes or eliminates economic profit. This strategy also generates higher outputs and lower prices, but it provides a return to the firm with a fair return on its capital investment. Utility providers usually depend on generators, transmission lines, and other equipment in supplying electric power and transporting natural gas.

Antitrust policy and related laws exist to control economic behaviors and inhibit monopolistic inclinations. Readers of this essay should be aware that the key pieces of federal legislation are the Sherman Act, the Clayton Act, the Federal Trade Commission Act, and the Celler-Kefauver Act. Some of these are instrumental in examining potential market power when firms propose a merger. In short, industrial organization provides a framework with which to examine mergers and issues regarding market power.

Conclusion

Industrial organization as a topic of study in economics highlights how market power may be favorable from a supplier's standpoint, but it is unfavorable from consumer, worker, and societal standpoints. This essay is a summary of a conceptual framework preparing students and others to examine the defining characteristics of and the interrelationships among market structure, conduct, and performance. In closing, this essay purports to illuminate the complexities and the components of a dominant of model of industrial organization.

Terms & Concepts

Allocative Efficiency: When the profit-maximizing level of output generates the largest employments and incomes for society; a feature of competitive situations.

Antitrust Policy: Legislation and analysis that focus on the growth of market power.

Barriers to Entry: Legal, marketing, and scale factors that prevent or inhibit potentially rival competitors from supplying a good or service to a market.

Concentration Ratio: A metric that estimates the concentration of market power among a small number of firms.

Economic Profit: When market price exceeds average total cost; invites rival firm entry into a market in the absence of barriers.

Economies of Scale: Occurs when average total costs decline as output increases.

Fair Return Price: A price set by regulators at which average total cost is the amount charged for a profit-maximizing level of output.

Herfindahl Index: Result of multiplying the total sum of the market shares held by individual firms in a market by 100; at a maximum of 10,000 in the case of monopolist.

Market: A virtual space where consumers and producers interact while exchanging a specific item in accordance with their demand and supply schedules.

Market Conduct: The behavior of firms in setting prices and pursuing non-price competition.

Market Performance: Measured in terms of allocative efficiency.

Market Structure: The degree of competition that exists among firms within a market.

Merger: Occurs when firm ownership expands combining firms that may be competitors, suppliers, or buyers of an item within a given market or different industries.

Monopolist: The firm that is the sole supplier of a good or service within a market, which can determine output level and price and prevent entry of new suppliers; holds market power.

Natural Monopoly: Usually the sole supplier of electric power, natural gas, or communications.

Oligopolist: A small number of firms that supply a good or service within a market, which can determine output level and price and prevent entry of new suppliers; holds market power.

Perfect Competition: The condition of a market in which several buyers and sellers exist, but none of them can influence price though entry and exit are easy to accomplish.

Predatory Pricing: The act of pricing items temporarily below cost to drive competitors out of business.

Price Fixing: The act of conspiring with competitors to establish prices alleviating competition and preserving market share.

Socially Optimal Price: Price set through regulation at which marginal cost intersects the demand curve.

Summary of Components in a Dominant Model of Industrial Organization

Bibliography

Arnold, Roger A. (2005). Economics (7th ed.) Mason, OH: Thomson South-Western.

Guell, R. C. (2007). Issues in economics today (3rd ed.). Boston, MA: McGraw-Hill Irwin.

McConnell, C. R. & Brue, S. L. (2008). Economics (17th ed.). Boston, MA: McGraw-Hill Irwin.

Martin, S. (2012). Market structure and market performance. Review of Industrial Organization, 40, 87-108. Retrieved on November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=71882985&site=ehost-live

Tremblay, V. (2012). Introduction: Market structure and efficiency. Review of Industrial Organization, 40, 85-86. Retrieved on November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=71882988&site=ehost-live

Suggested Reading

Bartlett, R., & Fletcher, D. (1986). A survey of textbooks for industrial organization and public policy. Journal of Economic Education, 17, 141-151. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5422323&site=ehost-live

Boyle, S. (1972). Industrial Organization: An empirical approach. New York: Holt Rinehart and Winston, Inc.

JEL classification system. (2006). Journal of Economic Literature, 44, 1153-1165. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24354629&site=ehost-live

Kwoka Jr., J., & Snyder, C. (2004). Dynamic adjustment in the U.S. higher education industry, 1955-1997. Review of Industrial Organization, 24, 355-378. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=14518201&site=ehost-live

Pashigian, B., & Self, J. (2007). Teaching microeconomics in wonderland. Journal of Economic Education, 38, 44-57. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24660433&site=ehost-live

Reid, G. C. (1987). Theories of industrial organization. New York: Basil Blackwell, Inc.

Winston, G. (2004). Differentiation among US colleges and universities. Review of Industrial Organization, 24, 331-354. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=14518200&site=ehost-live