Industrial Organization & Finance
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
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.
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.
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).
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....
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