Industrial organization and finance

This article focuses on industrial organization and finance. Industrial organization and corporate finance have evolved into two distinct fields of study. Both topics are concerned with the strategic relationship between internal economic decisions and external market decisions. There is an exploration of market structures. Market structures take into consideration: The number of firms in an industry, the relative size of the firms (industry concentration), demand conditions, ease of entry and exit, and technological and cost conditions. Profit and wealth maximization is discussed. In addition, the value of firm-bank relationships is introduced.

Keywords Bank-firm Relationships; Capital Structure; Market Structures; Monopolistic Competition; Monopoly; Oligopoly; Perfect Competition; Profit Maximization; Wealth Maximization

Finance > Industrial Organization & Finance

Overview

In the past, the field of industrial organization has not focused on corporate finance, and vice versa. However, a working knowledge of both fields may assist scholars in understanding "how product markets perform when firms participating in a market are constrained financially, and for understanding how capital structure and corporate governance contribute to product market strategy" (Riordan, 2003, p. 1). Industrial organization and corporate finance have evolved into two distinct fields of study. Brander and Lewis (1986) suggested that the research on financial structures and oligopoly have something in common. Both topics are concerned with the strategic relationship between internal economic decisions and external market decisions. Harris and Raviv (1991) identified the industrial organization effects of capital structure as one of the four major topics when studying the theory of capital structure.

Roe (2001) asserted that "the relative value of shareholder wealth maximization for a nation is partly a function of that nation's industrial organization. When much of a nation's industry is monopolistically organized, maximizing shareholder wealth would maximize the monopolist's profits, induce firms to produce fewer goods than society could potentially produce, and motivate firms to raise price beyond that which is necessary to produce the goods" (p.1).

Profit Maximization

Profits are very crucial to a firm's bottom line. When a firm is able to make a profit, there is an assumption that the company has done a good job of being effective and efficient in controlling the cost while producing a quality product or performing a quality service. However, there are different types of profits. Two types of profits are accounting profits and economic profits.

• Accounting profits are the difference between the total revenue and the cost of producing products or services; they appear on the firm's income statement.
• Economic profits are the difference between overall revenue and the total amount of opportunity costs. The opportunity costs tend to be higher than accounting and bookkeeping costs.

Profit Theories

Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs. Five of the most discussed theories in this area are:

• Risk-Bearing Theory. When the owners of a company make investments into the firm, they take on a certain amount of risk. In order to compensate them for their investment, the company will need to have an above average return on economic profits. An example would be a firm that has investors such as venture capitalists or angel investors.
• Dynamic Equilibrium Theory. Every firm should strive to have a normal rate of profit. However, each firm has the opportunity to earn returns above or below the normal level at any time.
• Monopoly Theory. Monopoly Theory. There are times when one firm many have the opportunity to dominate in its industry and earn above average rates of return over a long period of time. These firms tend to take control of the market as a result of economies of scale, dominate the ownership of essential natural resources, control crucial patents and influence government regulations. An example would be utility companies.
• Innovation Theory. A firm may earn above normal profits as a reward for its successful innovations such as patents. An example would be a pharmaceutical organization such as Astra Zeneca.
• Managerial Efficiency Theory. A firm may be able to earn above average profits based on its strong leadership team. This type of organization gains profits as a result of being effective and efficient. An example would be General Electric under Jack Welch's leadership.

Wealth Maximization

Wealth maximization is a long term operational goal. Shareholders continue to exert a claim on a firm’s net cash flows even after anticipated contractual claims have been paid. All other stakeholders (i.e. employers, customers) have contractual expected returns. There tends to be a preference for wealth maximization because it takes into consideration (Shim & Siegel, 1998):

• Wealth for the long term.
• Risk or uncertainty.
• The timing of returns.
• The stockholders' return.

Criterion for this goal suggests that a firm should review and assess the expected profits and or cash flows as well as the risks that are associated with them. When conducting this evaluation, there are three points to keep in mind.

• First, economic profits are not equivalent to accounting profits.
• Second, accounting profits are not the same as cash flows.
• Lastly, financial analysis must focus on maximizing the current value of cash flows to firm owners when attempting to maximize shareholder benefit.

Application

Market Structure

Market structures take into consideration:

• The number of firms in an industry.
• The relative size of the firms (industry concentration).
• Demand conditions.
• Ease of entry and exit.
• Technological and cost conditions.

The preferred structure is dependent on the type of industry. Therefore, the financial management team of each firm determines which of the above-mentioned factors will be a part of the decision making process.

The level of competition tends to be dependent on whether there are many (or a few) firms in the industry and the firm's products are similar or different. Given this information, four basic approaches to market structure and the types of competition have been established.

Perfect (Pure) Competition (Many sellers of a standardized product)

Characteristics of perfect competition are:

• Large number of buyers and sellers.
• Homogeneous product.
• Complete knowledge.
• Easy entry and exit from the market.

A firm using this approach tends to be small relative to the total market, and it will offer its product at the going market price. A firm in this format operates at an output level where price (or marginal revenue) is equal to the marginal cost and profit maximized. This format is more theoretical because there is no firm that operates at this level.

Monopolistic Competition (Many sellers of a differentiated product) Characteristics of monopolistic competition are:

• One firm.
• No close substitutes.
• No interdependence among firms.
• Substantial barriers to entry.

In addition, there tends to be many buyers and sellers, there is product differentiation, easy entry and exit and independent decision making by individual firms. An example of a firm fitting this profile would be a small business selling differentiated, yet similar, products. These firms will utilize three basic strategies in order to obtain their principal goal of maximum profits. The strategies are:

• Price changes.
• Variations in the products.
• Promotional activities.

Oligopoly (Only a few sellers of either standardized or differentiated products)

Characteristics of oligopoly are:

• Few firms.
• High degree of interdependence among firms.
• Product may be homogenous or differentiated.
• Difficult entry and exit from market.

The market fits this approach when there are a small number of firms supplying the dominant share of an industry's total output. Oligopolists are interdependent based on all levels of competition — price, output, promotional strategies, customer service policies, acquisitions and mergers, etc. Therefore, decision makers may have a hard time anticipating what rivals will do in reaction to their position, which makes the process complex. Two popular models are Cournot's duopoly model and kinked demand curve. An example would be the NCAA. This organization controls the revenues and costs of its member schools. It has the power to limit the number of games and times that a school can have its games televised. The NCAA retains control over costs through its restrictions on the compensation of student athletes.

Monopoly (A single seller of a product for which there is no close substitute)

A monopoly occurs when one firm produces a highly differentiated product in a market with significant barriers to entry. It may be large or small, and it must be the only supplier. In addition, there are no close substitutes. Since the monopoly is the only producer, it is equivalent to the overall industry and its individual demand curve is the same as the industry demand. An example would be an electric utility company in a specific geographic area.

What is the difference between the monopoly and pure approach? A profit-maximizing monopoly firm will produce less and charge a higher price than firms collectively in a purely competitive industry. However, both demand and cost may be different for a monopoly firm (i.e. a monopoly may be able to take advantage of economies of scales).

Viewpoint

Firm-Bank Relationships

There tends to be a variety of information problems in the financial markets and those responsible for overseeing the processes attempt to find different ways to address the issues that arise. One such attempt explores long-term relationships between firms and banks. Some believe that these types of relationships are crucial to the structure of credit markets. As a result, Degryse and Ongena (2002) reviewed the firm-bank relationship and the structure of banking markets on a global level. In addition, Yafeh and Yosha (2001) conducted a study where they reviewed how standard industrial organization tools could be used to analyze the relationship between competition in financial markets and the prevalence of bank-firm relationships.

Benefits

A firm-bank relationship is established when the two entities have a close interaction and the banker is allowed to observe and collect a variety of information about the firm. The banker has the opportunity to evaluate whether or not the firm can meet future financial obligations. Although the banker has a chance to observe how the relationship will benefit the lender in the long term, there are some advantages for the firm as well. For example, the firm can increase its access to credit at a lower cost and with less collateral if it has established a relationship with a bank. Also, the firm may have the opportunity to enter into complex and high risk projects as a result of having an established relationship with a bank. Finally, a firm's reputation and image may be seen as favorable due to an established and credible relationship with a bank (Dass & Massa, 2011).

Negatives

Although this is seen as a positive endeavor, there is a down side. There may be some individuals who will become concerned with the type and amount of information a bank knows about a firm. "The ability for a bank to privately observe proprietary information and maintain a close relationship with its customer can also impose costs on the customer" (Degryse & Ongena, 2002, p. 404). For example, a bank can devise a campaign that will lock customers into maintaining a relationship with it and prevent customers from receiving competitive financing from another bank. This will lead to the original bank having a monopoly over the market as a result of having privileged client information. One solution to this type of problem would be for firms to enter into more than one bank relationship. The banks will offer competitive services, which will minimize the possibility of any one bank getting the upper hand and creating a monopoly situation.

World-Wide Bank-Firm Relationships

Firms can diversify their financial portfolio by entering into relationships with banks across the world. There will be opportunities for banks to form consortiums and market to a variety of firms. The banks could come together and establish rules and regulations for different types of organizational projects around the world. The Second European Banking Directive and the 1994 United States Riege-Neal Act created large international banking markets. Established bank-firm relationships are critical to the present development process for financial systems worldwide (Degryse & Ongena, 2002).

Conclusion

Industrial organization and corporate finance have evolved into two distinct fields of study. Brander and Lewis (1986) suggested that the research on financial structures and oligopoly have something in common. Both topics are concerned with the strategic relationship between internal economic decisions and external market decisions. Harris and Raviv (1991) identified the industrial organization effects of capital structure as one of the four major topics when studying the theory of capital structure.

Market structures take into consideration: The number of firms in an industry, the relative size of the firms (industry concentration), demand conditions, ease of entry and exit, and technological and cost conditions. The preferred structure is dependent on the type of industry. Therefore, the financial management team of each firm determines which of the above-mentioned factors will be a part of the decision making process.

A firm-bank relationship is established when the two entities have a close interaction and the banker is allowed to observe and collect a variety of information about the firm. The banker has the opportunity to evaluate whether or not the firm can meet future financial obligations. Although the banker has a chance to observe how the relationship will benefit the lender in the long term, there are some advantages for the firm as well. For example, the firm can increase its access to credit at a lower cost and with less collateral if it has established a relationship with a bank. Also, the firm may have the opportunity to enter into complex and high risk projects as a result of having an established relationship with a bank. Finally, a firm's reputation and image may be seen as favorable due to an established and credible relationship with a bank.

Terms & Concepts

Bank-Firm Relationships: The prolonged close interaction between a firm and a bank that can provide lenders with more information about, and influnce in, firm affairs.

Capital Structure: The various long-term debt and equity money used to finance a business endeavor. These finances can include long-term debt, common stock, preferred stock, warrants, pensions, and lease liabilities. The more leveraged a capital structure is, the more debt it has relative to its equity.

Market Structures: The pattern formed by the number, size, and distribution of buyers and sellers in a market.

Monopolistic Competition: A market structure where a number of different sellers each produce similar yet slightly different products. Each seller sets its own price and quantity without having an affect on the marketplace as a whole.

Monopoly: A market structure where one company owns all or almost all of the market for a certain type of product or service. This situation arises when there is an entry barrier into the industry that allows the monopolistic company to produce without the threat of competition. Possible entry barriers can include vast economies of scale or governmental regulation. In this type of market structure the single producer will often produce an amount of the product that is less than market demand because then prices can be raised and revenue increased.

Oligopoly: A market controlled by a small number of participants who together are able to dominate product supply and market prices.

Perfect Competition: A market structure characterized by a free exchange of information, no entry barriers, and a large number of buyers and sellers. These characteristics create a market in which no individual participant can dominate or influence prices or supply.

Profit Maximization: A hypothesis that the goal of a firm is to maximize its profit.

Wealth Maximization: In an efficient market, it is the maximization of the current share price.

Bibliography

Brander, J., & Lewis, T. (1986). Oligopoly and financial structure: The limited liability effect. American Economic Review, 76, 956-970. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4498297&site=ehost-live

Dass, N., & Massa, M. (2011). The impact of a strong bank-firm relationship on the borrowing firm. Review of Financial Studies, 24, 1204-1260. Retrieved on November 14, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=59962417&site=ehost-live

Degryse, H., & Ongena, S. (2002). Bank-firm relationships and international banking markets. International Journal of the Economics of Business, 9, 401-417. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=8797206&site=ehost-live

Harris, M., & Raviv, A. (1991). The theory of capital structure. Journal of Finance, 46, 297-355. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4653270&site=ehost-live

Riordan, M. (2003, December). How do capital markets influence product market competition?. Review of Industrial Organization, 23(3/4), 179-191. Retrieved October 16, 2007, from Business Source Premier database. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14156611&site=ehost-live

Roe, M. (2001). The shareholder wealth maximization and industrial organization. Retrieved October 16, 2007, from http://www.law.harvard.edu/programs/olin%5fcenter/corporate%5fgovernance/papers/No339.01.Roe.pdf

Yafeh, Y., & Yosha, O. (2001, January). Industrial organization of financial systems and strategic use of relationship banking. European Finance Review, 5, 63-78. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18661426&site=ehost-live

Suggested Reading

Andreani, E., & Neuberger, D. (2006). Corporate control and relationship finance by banks or by non-bank institutional investors? A review within the theory of the firm. Corporate Ownership & Control, 3, 9-26. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24766948&site=ehost-live

Birt, J., Bilson, C., Smith, T. & Whaley, R. (2006). Ownership, competition and financial disclosure. Australian Journal of Management, 31, 235-263. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24275071&site=ehost-live

Castelli, A., Dwyer, Jr., G., & Hasan, I. (2006). Bank relationships and small firms' financial performance. Working Paper Series (Federal Reserve Bank of Atlanta), , 1-26. Retrieved October 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20960850&site=ehost-live