Introduction Introduction

Class 1Class 1

Economics of I-OEconomics of I-O

Industrial economics is a branch of applied Industrial economics is a branch of applied microeconomics which seeks to microeconomics which seeks to understand the causes and effects of understand the causes and effects of various market structures on pricing and various market structures on pricing and product choices. product choices.

As such, the aim is to teach you how to As such, the aim is to teach you how to apply economic theory to analyze various apply economic theory to analyze various industries in the economy.industries in the economy.

OLigopoly, concentration, barriers to entry, OLigopoly, concentration, barriers to entry, pricing, product differentiation and pricing, product differentiation and advertising, research and development.advertising, research and development.

All affect performance of the industryAll affect performance of the industry

Today’s class:Today’s class:– Static and dynamic views of competitionStatic and dynamic views of competition– SCP paradigmSCP paradigm– Strategic managementStrategic management

Static view of competitionStatic view of competition

Neoclassical theory of the firm:Neoclassical theory of the firm:– Perfect competitionPerfect competition– Monopolistic competitionMonopolistic competition– OligopolyOligopoly– MonopolyMonopoly

Perfectly Competitive IndustryPerfectly Competitive Industry

6 main characteristics6 main characteristics– Large number of buyers and sellersLarge number of buyers and sellers– Perfect knowledgePerfect knowledge– Identical productIdentical product– Independently acting firmsIndependently acting firms– Free entry and exit conditionsFree entry and exit conditions– Can sell as much output as they wish at Can sell as much output as they wish at

current market pricescurrent market prices

Competitive equilibriumCompetitive equilibrium

Normal profitsNormal profits

All surviving firms are forced to produce as All surviving firms are forced to produce as efficienly as possibleefficienly as possible

Inefficient firms drop outInefficient firms drop out

Abnormal profits are forced to be reduced Abnormal profits are forced to be reduced down due to market conditionsdown due to market conditions

Reality …Reality …

Competition forces the structure to include relatively Competition forces the structure to include relatively small number of large firmssmall number of large firmsMarket powers and abnormal profitsMarket powers and abnormal profitsCompetition leads to a decrease in the number of firms Competition leads to a decrease in the number of firms in the long run beacuse:in the long run beacuse:– As firms grow, firms enjow economies of scale and average As firms grow, firms enjow economies of scale and average

costs fallcosts fall

Marshall (1890); Sraffa (1920): Theory of monopolyMarshall (1890); Sraffa (1920): Theory of monopolyChamberlein (1933); Robinson (1933): Theory of Chamberlein (1933); Robinson (1933): Theory of imperfect competition.imperfect competition.– Monopolistic competitionMonopolistic competition– Oligopoly Oligopoly

Dynamic view of CompetitionDynamic view of Competition

Austrian schoolAustrian schoolSchumpeter (1928), (1942)Schumpeter (1928), (1942)The fact that a firm earns an abnormal profit does not The fact that a firm earns an abnormal profit does not imply that the firm is abusing its market power at the imply that the firm is abusing its market power at the expense of its consumersexpense of its consumersKnowledge or information is imperfectKnowledge or information is imperfectCompetition is driven by innovation: new products, new Competition is driven by innovation: new products, new processes, etc.processes, etc.Innovator becomes monopoly, earns monopoly profitsInnovator becomes monopoly, earns monopoly profitsOthers catch upOthers catch upNot capable of sustaining long run equilibriumNot capable of sustaining long run equilibrium

S-C-PS-C-P

Structure conduct performanceStructure conduct performance

Bain (1951)Bain (1951)

Structure affects conduct which in turn Structure affects conduct which in turn affects performanceaffects performance

Why is the structure–conduct–performance paradigm so widely used in order

to study the conduct and performance of firms and industries?

The SCP paradigm allows the breakdown of complex industry-level data into meaningful categories.

It is grounded within the neoclassical theory of the firm, which assumes direct links between market structure, firm conduct and performance.

By defining a workable or acceptable standard of performance, it is useful for policy analysis.

Forward and reverse causation between structure, conduct

and performance.

Forward causation assumes that market structure is determined exogenously by the basic supply and demand conditions. Firms are seen as passive entities, leading performance to flow directly from conduct.

Reverse causation implies that firms make strategic choices, such as building new factories and investing in innovation, which not only influence performance but also have longlasting effects on market structure.

Chicago School and SCP ParadigmChicago School and SCP Paradigm

In contrast to SCP proponents, markets and industries have a natural tendency to revert to competition without the need for intervention or assistance from government policy.

Collusion Hypothesis and Efficiency Collusion Hypothesis and Efficiency HypothesisHypothesis

The collusion hypothesis argues that a positive association between concentration and pro tability is evidence of collusion or other abuses of market power designed to enhance profits.

The efficiency hypothesis argues that a positive relationship between concentration and profitability reflects a natural tendency for efficient firms to be successful and to become dominant in their industries.

Strategic ManagementStrategic Management

Porter’s diamond modelPorter’s diamond modelValue chainValue chainDistinctive capabilities; core competenciesDistinctive capabilities; core competenciesThe strategic management literature emphasises the distinctive internal characteristics of firms in order to explain how a competitive advantage can be acquired and sustained.The focus of the firm is to maximise firm value through the choice of effective management strategies.

Figure 1.2  Porter’s five forces model Source: Adapted from Porter (1980), p. 4.

With reference to case study 1.1, assess the extent to which competition has

increased in European banking in recent years. What effect has this had on

the performance of banks?

Competition in European banking has increased in recent years. Deregulation, which created the single market in financial services and the Euro, reduced the barriers to trading in financial services.Consequently, foreign-owned banks and non-bank institutions such as supermarkets and telecommunications firms have entered the European Banking industry.The increased competition has led to increased pressure on banks to maximise shareholder value. Banks have sought to achieve this by lowering costs and finding new ways of increasing revenues with the introduction of new types of products and services.