Introduction 1 17 July 2019 - PowerPoint Presentation

1. Introduction117 July 20191

2. 1 Two Approaches to the Study of Industrial Organization 1.1.1 The Structure-Conduct-Performance (SCP) ApproachEmpirical approach developed by Edward Mason and Joe Bain in the 1940s and 1950s. Hypothesized a direct relationship between market structure, market conduct, and market performance. In perfectly competitive markets, an atomistic market structure results in efficient economic performance with price equal to marginal cost.With a monopolistic market structure, economic performance is poor: Price exceeds marginal cost, inefficient firms can survive in the long run, and economic profits are greater than zero.The SCP paradigm extends the structure-conduct-performance relationship to oligopoly. 17 July 20192

3. 1 Two Approaches to the Study of Industrial Organization 1.1.1 The Structure-Conduct-Performance (SCP) Approach17 July 20193Figure 1.1 depicts the paradigm. Basic market conditions determine market structure.Market structure determines conduct.Conduct determines performance. Government policies have a direct impact on structure, conduct, and performance. The thin arrows on the left depict the feedback effects of conduct on structure and of performance on conduct and structure.

4. 1 Two Approaches to the Study of Industrial Organization 1.1.1 The Structure-Conduct-Performance (SCP) ApproachExample: the ready-to-eat cereal industry. In terms of market structure, the cereal industry is an oligopoly, with Kellogg’s, General Mills, Pepsico (Quaker Oats), and Post Holdings dominating the market. Small number of sellersProduct differentiation is important. Product differentiation results in conduct that includes a great deal of advertising and a product strategy where each firm is constantly attempting to develop new brands. This conduct results in performance that has historically been characterized by price being greater than marginal and average cost, with the cereal industry commonly ranked among the most profitable industries in the United States.Feedback:Profits may result in increased advertising and increased investment in new product development, so performance may have an impact on conduct. High advertising expenditures may make entry into the market more difficult and reduce the number of sellers, and so conduct may have an impact on structure. 17 July 20194

5. 1 Two Approaches to the Study of Industrial Organization 1.1.1 The Structure-Conduct-Performance (SCP) ApproachIn the 1960s and 1970s, SCP industrial organization economists studied these relationships empirically using case and statistical studies.Common questions addressed included the following:Is there a relationship between market structure and profitability?Do increased entry barriers result in increased profits?What are the most important entry barriers?How does market structure affect the rate of technological advance?What market structure(s) are associated with effective collusion?How does market structure affect pricing strategies?How does government regulation affect economic efficiency?What is the impact of mergers on economic efficiency?Does increased market power result in increased advertising, or does increased advertising result in increased market power?Should the law permit collusion?Should the government regulate monopolies?17 July 20195

6. 1 Two Approaches to the Study of Industrial Organization 1.1.2 The Chicago School ApproachEconomists associated with the Chicago School of economics have long argued that price theory models should be the primary tool for analyzing markets. In the 1960s and 1970s, Chicago School economists questioned many of the major empirical conclusions reached by followers of the SCP approach. For example, SCP economists claimed that there was strong empirical evidence suggesting a positive relationship between monopoly power and profits with increases in market power resulting in increased profits. Chicago School economists, however, argued that the true relationship might well be that increased efficiency led to increased market power and increased profits. Over the past 35 years more consensus has developed, often called the new industrial organization.17 July 20196

7. 1 Two Approaches to the Study of Industrial Organization 1.1.2 The Chicago School ApproachA key part of the new industrial organization is the use of game theory to model the behavior of firms within an oligopoly. Game theorists view competition among oligopolists as a game. This text relies heavily on the use of game theory to provide a theoretical framework for understanding oligopoly. However, the empirical tradition of industrial organization is important.The text also makes extensive use of empirical evidence to support the theoretical conclusions, including the New Empirical Industrial Organization (NEIO), which relies on the empirical study of the behavior of individual firms within industries to understand conduct and performance.17 July 20197

8. 1 Two Approaches to the Study of Industrial Organization 1.2 Static and Dynamic ModelsMost microeconomics courses emphasize static models that deal with a moment in time. Dynamic models deal with changes over time. Dynamic models are strategic and tend to emphasize technological change more than static models do.Static efficiency requires price to equal marginal cost and long-run average cost. Dynamic efficiency requires an optimal rate of technological advance and can exist even if price exceeds marginal and average cost. Courses in industrial organization tend to place considerable emphasis on dynamic models and dynamic efficiency. Most economists recognize that even if an industry achieves static efficiency, its performance may be poor if it fails to invest in research and development at an optimal rate.17 July 20198

9. 1 Two Approaches to the Study of Industrial Organization 1.3 Theory and EmpiricismMany major questions in industrial organization yield ambiguous theoretical conclusions. For example, economic theory hypothesizes that increased advertising could have a positive economic impact by providing increased information or that increased advertising could have a negative economic impact by making entry more difficult. Cannot use theory to prove which relationship is dominant. Industry studies have shed important light on the economic impact of advertising. Statistical studies of the advertising-competition relationship have also provided important evidence, suggesting that the relationship is different depending on the types of goods being considered. Important to bear in mind that the field requires a thorough understanding of both theory and empirical work. The modern approach to industrial organization tries to balance theory and empirical evidence.17 July 20199

10. 1 Two Approaches to the Study of Industrial Organization 1.4 Government and Industrial OrganizationGovernments often attempt to limit the negative effects of market power, particularly through antitrust policies and direct regulation. It is relatively easy to understand the political pressures that led to the passage of the first U.S. antitrust law, the Sherman Act, in 1890. Before the Civil War, the United States was mainly an agrarian society in which high transportation costs kept the geographic size of most industrial markets small. After the Civil War, the organization of American industry changed, with growth of national markets for many products due to:mass production,a national railroad system,the development of modern capital markets,the liberalization of the laws of incorporation in many states. Due to economies of scale, many national producers threatened local companies.In 1888, Republican Senator John Sherman introduced the first Senate antitrust bill to fight the power of large companies, often called “trusts”. In 1890, the Sherman Antitrust Act, the basis for most U.S. antitrust law, was signed into law.17 July 201910

11. 1 Two Approaches to the Study of Industrial Organization 1.5 The Global Economy and Industrial OrganizationUntil recently, courses on industrial organization ignored international trade theory, and courses on international trade characteristically ignored industrial organization theory and dealt strictly with models of perfect competition. The recent trend toward a global economy, where American companies produce and sell abroad and foreign companies produce and sell in the United States, has dramatically changed this view. Chapter 22 considers the integration of international economics and industrial organization.17 July 201911

12. 1 Two Approaches to the Study of Industrial Organization 1.6 The Approach of This BookThis text combines the SCP and price theory approaches to the field, with an emphasis on game theory. Chapter 2 explores the theory of the modern firm, including cost concepts. Chapter 3 reviews the economic theories of perfect competition and monopoly and examines antitrust policy toward monopoly. Chapter 4 discusses the structure of markets in the United States, and market entry and exit, while Chapter 5 examines mergers. Chapters 6 through 8 introduce the framework of game theory and some foundational models of industrial organization and some important models of monopoly behavior. Chapters 9 through 16 examines conduct largely from a game theoretic perspective, including price discrimination, product differentiation and advertising, vertical relationships, entry deterrence, and technological change. Chapters 17 through 23 turn to public policy and globalization issues. 17 July 201912