Eco 403: Industrial Organization Economics, Fall Dr. Abdel-Hameed H. Nawar. Preliminaries

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1 Eco 403: Industrial Organization Economics, Fall 2012 Dr. Abdel-Hameed H. Nawar Preliminaries What is Industrial organization economics? Industrial organization economics is the field in economics which combines both microeconomic theory and the investigation of real-world- especially imperfectly competitiveindustries. How Does IO investigate real-world industries? Structure-Conduct-Performance (SCP) Paradigm In the 1960 s, there was a school called the Structure-Conduct- Performance (SCP) paradigm.

2 Figure 1: The Structure-Conduct-Performance Paradigm Source: Scherer and Ross (1990), p.5

3 Typical Example: Deadweight loss The typical example is in highly concentrated market with a small number of firms (Structure), we typically suspect that this implies collusive or higher pricing (Conduct) which results in deadweight losses relative to the efficient competitive solution (Performance). The SPC paradigm is interpreted as saying, at least in theory, that market structure(s) conduct (C) performance(p). Based on empirical inter-industry cross-section studies of the relationship between industry profits and market concentration, the SCP argued that high profit measures poor performance. The Chicago School Beginning in the 1970s, the Chicago School voiced skepticism over the implications of the SCP paradigm rigorous application of mainstream price theory in microeconomic analysis. They pointed out that the causality relationships indicated by the arrows ( ) are not exclusively one-sided but rather the line of causality can go either way ( ). For example the

4 existence of potential entry makes the incumbents not price too high because higher profits invite entry. This conduct affects the number of firms (from which structure we were perhaps drawing conclusion about conduct?). A lot of conduct is specifically engaged in order to affect the structure of the market. Based on the relationship between firm s profits and firm s size, the Chicago School counter-argued that high profits measure good performance, i.e. low cost. From the debate between the SCP paradigm and the Chicago School we can conclude the following: o It is not clear if one should conclude that higher profits imply poor or good performance (conflicting interpretations) o Both approaches are based on the assumption that: Economic profit-cost margins (or profits) can be observed in accounting data. Cross-section variations in an industry can be captured by a small number of observable measures such as the Lerner Index. Other conflicting conclusions: Conduct SCP Paradigm Chicago School Concentration unreasonable level reasonable level through product differentiation Pricing Collusive Reasonable

5 Profits Advertising Technical efficiency R&D market power (collusion) Persuasive product differentiation X-inefficient: the observed behavior of firms in practice differs from efficient behavior implied by economic theory. the quiet life hypothesis (QLH): large firms with monopoly power are less likely to undertake risky activities as innovation technical efficiency disequilibrium state robust competition Informative X-efficient Schumpeterian hypothesis: large firms with monopoly power are more innovative Technical efficiency means that the firm minimizes cost or maximizes output quality by using the best available technology. Technology includes not only plant and equipment, but also scientific methods used to coordinate activities of the firm value chain and to enhance performance.

6 Game Theoretic (GT) Approach From late 1970s, the development of game theory models has been applied to the analysis of oligopolistic strategic behavior such as commitment, repeated games with imperfect monitoring, entry deterrence; asymmetric-information games and the associated theories of limit pricing and predation, reputation, and price wars etc. GT models have practical motivations with connection to the real world industries. mathematical rigor and the investigation of real-world issues mingled together. In game theory, a solution concept known as Nash equilibrium may not be Pareto optimal. *HM Emperor of modern economic analysis, Math, imposes a discipline on modeling. The contribution of game theory to the mainstream literature industrial organization has been tremendous. New Empirical Industrial Organization (NEIO) From the late 1980s A typical NEIO research is characterized by: o An industry case study with time-series data or panel data.

7 o Behavioral equations of pricing or quantity setting in oligopoly o Use of sensible proxy rather than direct measures. Experimental Industrial Organization (EIO) is emerging since the new millennium. In an experiment individual decision makers interact in controlled settings defined by a specific set of rules (the economic environment and market institutions.) The 2002 Nobel Prize laureate Vernon smith conducted the first experiment in 1956 at which he looked to financial and commodity exchange for the rules by which buyers and sellers interact and implemented the so-called oral double auction. Basic application of game theory in IO can be called modern IO or the post-chicago IO, whereas the application of the SCP paradigm can be called old IO. Renowned economist who influenced the development of industrial organization: Harvard (SCP): o Joe S. Bain o Edward S. Mason Chicago School:

8 o Harold Demsetz o Samuel Peltzman o Richard A. Posner Game Theory and NEIO o Jean Tirole o Drew Fudenberg o Richard L. Schmalensee Experimental IO o Vernon Smith Industry Structure and Firms: Empirical Evidence from the US Industries Firm size can be measured by: (a) Capital, (b) employment, (c) output level (market share) or (d) stock market value In the 1990, the US economy had about 10 million firms and nearly 90% of them had 20 employees. the majority of the US firms are small. The top 200 firms (in terms of output levels/shipments) accounted for 21% of non-farm employees and about 39% (capital) assets of the non-financial corporations.

9 But the very small number of big firms plays a major role in the US economy. The share of employment and assets of the largest US firms has fallen since the 1970s because machines have become more productive. There has been little increase in the aggregate levels of concentration (the share of output produced by the largest firms in an industry). Industrial Organization Economics and Public Policymaking Industrial organization economics explores both theoretical and empirical real-world issues that are highly relevant to public policies and therefore have implications for them. Here is where law and economics intersect. Namely, antitrust law sets rules and regulations governing business practices and the organization of the industry. In having to do with the Egyptian markets, IO Economists testify in antitrust cases Antitrust Law No. 3 in 2005 amended in July 2008 Egyptian Competition Authority ( Egyptian Economic Courts Consumer Protection Agency (

10 Example: Cement Industry in Egypt Total cement supply comes from 12 firms. Antitrust Law enforcement in the cement industry case is justified. Price-fixing behavior is per se illegal, a violation of the economic policies established in Egypt. The Court (September 2008) did not have to establish that a cartel was effective but rather only that a conspiracy existed to restrain and suffocate the market.