Overview of Industrial Economics: Scope, Evolution, and Challenges

CHAPTER ONE
INTRODUCTION
Chapter objectives: 
After reading this chapter you
must be able to know
The meaning and scope of industrial economics
The definitions and elementary description of some
basic concepts used in industrial economics
The paradigm of SCP
The framework for the study of industrial economics
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Definition and Scope of Industrial Economics
What is industrial economics?
It is one of the disciplines in economics that deals
with the 
economic problems of firms 
economic problems of firms 
and
and
 industries
 industries
,
and 
their relationship with society
their relationship with society
.
It is also called:
Economics of Industry
Economics of Industry
“Industry and Trade”
Industrial Organisation and Policy
Industrial Organisation and Policy
“Commerce and 
Business Economics
Business Economics
’ and so on.
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1.0. Overview on historical Evolution of Industrial
Economics
The early theory of the firm which we might regard
as the mother of the contemporary industrial
economics was born as at this stage as an integral
part of the classical economics. Many of the issues in
this area of economics date back to Adam Smith in
the eighteenth century.
More recently, Cournot in the first half, and Marshall
in the 2
nd
 half of the nineteenth century laid
foundations that which , remain appropriate
concerns in industrial economics of today.
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There have been 
two major traditional
 concerns of
industrial economics.
First,
 there has been a focus on the functioning of
firms, and their performance; the determinants and
consequences of different market structures”, and
the relationship between behavior and performance
of firms) and the market structure within which firms
operate.
Second, the role of government in influencing the
organization of industry.
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Although difficult to know the true beginning of
industrial economics because of non-availability of
data, it has come up to the present stage mainly
during the last 40 to 50 years.
The subject has not yet grown to its maturity. In
recent years, industrial economics has changed
dramatically. Theories have been extended &
developed, partly in response to new ideas such as
commitment, to new empirical findings and partly to
the arrival of new tools such as computer
simulations.
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How decision-making problems arise in industries?
To answer this question, we have to go back to the
core of Economics.
Economics is the science that studies human
behavior as a relationship between ends and scarce
means that have alternative uses.
As implicit in this definition, an economic problem
arises because of scarcity of means and their
alternative uses in relation to the needs of an
individual or a group or society as a whole.
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For example, the income of a consumer is generally
limited but his/her wants are unlimited. In this
situation he/she has to adopt some criterion to
achieve maximum gain from his/her limited income.
This is the problem of utility maximization in the
theory of consumer behavior.
Similarly, for a producer, the resources 
like land, 
raw
materials, 
labor, 
capital, etc., are scarce.
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Given such scarcity, the producer has to take
decisions about production and distribution. There
are several basic issues on which the producer will be
taking decisions such as:
what commodities he/she should produce,
 what should be the level output of each input,
what type of technology he/she should adopt,
where should he/she produce the goods,
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what should be the size of his/her factory,
what price he/she should charge,
how much wages should pay,
how much he/she should spend on advertisement,
 should he/she borrow from banks or elsewhere,
etc…
All such decisions explain the producer's behavior in
the different market situations, which we endeavor
to study in industrial economics.
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In microeconomics 
also we study producer’s
behavior in relation to scarcity of resources. Because
of this fact, some economists would regard industrial
economics as being primarily an elaboration of, and
develop­ment from, the traditional theory of the firm
taught under microeconomics.
 Industrial economics is best defined as the
application of micro economic theory to the analysis
of firms, markets and industries.
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Stigler (1968)  argues that industrial economics does
not really exist as a separate discipline, that it is
simply differentiated microeconomics. But this
misses some points. The distinction arises from the
overriding emphasis, in industrial economics, on
empirical work and on implications for policy.
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What makes industrial economics different from
microeconomics?
Of course to view industrial economics as a
development of microeconomics is quite
understandable. Both are concerned with the
economic aspects of firms and industries seeking to
analyses their behavior and draw normative
implications.
However, there are some differences between the two.
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Microeconomics is a formal, deductive and abstract
discipline where as Industrial econo­mics on the other
hand is less formal, more inductive in nature.
Micro­economics assumes profit maximization as the goal
of the firm given constraints where as Industrial
economics does not believe in single goal of profit
maximization.
Microecono­mics, being abstract, does not go into
operational details of production, distribution and other
aspects of the firms and industries where as Industrial
economics does go into the depth of such details.
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Public policy implications are taken care of in
industrial economics but micro­economics may shun
them if necessary.
industrial economics with the concern of decision-
making in an industry from micro angle, but it has
macro dimension also. For a society as a whole the
resources for production are scarce just as in the
case of a producer.
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With scarce resources, the problem exists to produce
varieties of goods and services in-the current period and in
future also.
What goods should be produced: consumer or capital? If
capital good are preferred, then the series of prob­lems
faced by the society may be: what types of capital goods;
what type of factory (large vs. small scale); where to
produce (locational problem); how to distribute them; etc.
These are the questions which have been posed earlier for
an individual producer also. But, here we have to examine
them from the social angle.
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The term 
industrial organization
 is commonly viewed as
synonymous with industrial economics.
But,Carlsson (1989) made clear distinction between them.
He reasons that the main concern of industrial organization
has become the structure of industries at a particular point
of time.
By contrast, industrial economics encompasses both
industrial organization and industrial dynamics.
Industrial dynamics is primarily concerned with the
evolution of industry as a process in time both at the macro
level, the sector or industry level, and the firm level.
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It differs from industrial organization in that
its main focus of attention can vary from
the firm, to relationships between firms, to
the links between microeconomics and the
macro economy.
When the economist turns the attention to
industrial dynamics the area of
investigation is widened .
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Conclusion:
Industrial economics is predominantly an
empirical discipline having micro and macro
aspects.
It has a strong theoretical base of
microeconomics.
It provides useful applications for industrial
management and public policies.
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There are 
two
two
 
broad
 elements in industrial economics.
Descriptive element
Analytical part
Descriptive Element
Descriptive Element
: 
is concerned with the information
content of the subject. It would provide 
industrialist or
businessman 
full information regarding:
 the availability of natural resources
 industrial climate in the country
situation of the infrastructure including lines of
traffic
supplies of factors of production,
trade and commercial policies of the governments,
and
the degree of competition in the business in which
it operates.
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In short, it deals with the information about the
competitors
competitors
, 
natural resources 
natural resources 
and 
factors of production
factors of production
and 
government rules
government rules
 and 
regulations
regulations
 related to the
concerned industry. 
Analytical element:
is concerned with 
business policy and
decision making.
market analysis
Pricing
choice of techniques
location of plants
investment planning
hiring and firing of labour
financial decisions
product diversification and so on. 
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Analytical element 
Analytical element 
: is a vital part of the
subject and much of the received theory of
industrial economics is concerned with this.
However, this does not mean that the first
element, i.e., descriptive industrial economics,
is less important.
NB
. The two elements are 
interdependent
interdependent
,
since without adequate information no one can
take 
proper decision about any aspect of
proper decision about any aspect of
business
business
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While the descriptive element of industrial economics
is concerned with the information content of the
subject, the analytical element is concerned with the
business policy and decision making.
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Moreover, industrial economics:
analyses industries,  markets, and the behaviour of
firms within those markets.
It deals with supply side economics.
Thus, it is concerned with the 
economic problems
of the firms
 and their 
economic behaviour in
utilising economic resources 
at their disposal
.
The interdependence between firms within markets
and the links that exist between market conditions
and firm’s performance 
 
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Industrial Economics addresses the basic question
of:
 what to produce
for whom to produce and
how to produce in the context of industries or firms
 Industries face such problems because resources
are scarce and hence the industrialist has to take
decisions about production and distributions of
goods and/or services as they cannot produce
everything they want to produce at single firm
level or at higher aggregate level of the economy. 
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The Rationale for Studying Industrial Economics
i. It is instrumental to the formulation and
implementation of industrial policies that are
essential for 
sustainable development of a nation
sustainable development of a nation
.
For example, it helps us:
 to choose between private and public enterprises
 to design strategies to promote investment in
industrial sector
to regulate and/or deregulate public utility industries
It also assists policy makers as how they can stimulate
technological progress through 
patent rights
patent rights
 and
subsidies
subsidies
.
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ii. Studying industrial economics is useful for
generating research questions such as:
why do some firms advertise their products while
others do not?
Why do some firms expand while others contract
or keep their size constant?
Are barriers to entry more serious in some
branches of industry than in others?
The questions are essential for further research
and development and hence deserve attention.
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1.2. Some Basic Concepts in the study of
Industrial Economics
i. The Firm
A firm is an organization owned by one or jointly
by a few or many individuals which is engaged in
productive activity of any kind for the sake of
profit or some other well-defined aim.
 Most of the firms owned by private individuals in
manufacturing trade and services will aspire for
profits but there may be some other such as
government companies where profit motivation
will be secondary or missing altogether.
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ii. The industry
The conventional definition of the term industry is a
group of firms producing a single homogeneous
product and selling it in a common market. However,
the restriction of a single homogeneous product is not
met in practice.
Most of the firms produce many outputs which may or
may not be substitutable for each other. In this
situation, the conventional defini­tion has no
operational sense.
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A better approach to define the industry is to call it
“a group of sellers or of close substitute outputs who
supply to a common group of buyers”.
 In other words, we may take it in simpler terms as a
group of firms producing closely substitute goods for
a common group of buyers.
 In the terminology of the monopolistic competition
we are essentially talking about the “product group
"
as a substitute word for the industry.
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iii. The Market
This is defined as a closely interrelated group of sellers
and buyers for a commodity. The term is not equivalent
to the industry since in the latter case we are looking
only at the seller’s side of the market.
By including the buyer's side, the term becomes more
comprehensive connoting the composition of the
buyers and their geographical location along with the
industry.
 A heterogeneous group of closely substitute goods will
have a market, but there may be markets within the
market for every homogeneous good.
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Contestable market: 
is a market where barriers
to entry and exit, not market structure,
determine price and output decisions and a
competitive price is set.
 It is a market 
in which competitive outcomes
can be observed.
Its fundamental feature is low barriers to entry
and exit;
 A perfectly contestable market would have no
barriers to entry or exit.
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iv. Market power
Market power- refers to the influence that any particular
buyer or seller can exercise over the price of a product.
It indicates the degree to which a business firm is able to
earn larger than normal profits.
Market structures range from highly competitive, in which
there are so many buyers or sellers that none can influence
the market price, to the other extreme in which a single
buyer or seller faces no competition and therefore wields
great market power.
Market power is inversely related to both the degree of
competition in the market and the ease of entry and exit.
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1.3.Approaches to Industrial Economics 
1.3.1.
The Market Structure-Conduct- Performance
paradigm (SCP paradigm)
Joe Bain and Edward Mason developed the
concept “Structure-Conduct- Performance”
paradigm in 
1936, dealing with 
the pricing
the pricing
policies of large-scale enterprises
policies of large-scale enterprises
.
It is also called Harvard tradition
According to this paradigm, there is a 
priori
priori
relationship
relationship
 between the three concepts of
industrial economics, market 
structure
, market
conduct
 and market 
performance
.
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The link between these 
three
three
  is that market
structure of an industry determines or strongly
influences the crucial aspects of its market
conduct which in turn directly or indirectly
determines certain important dimensions of its
performance.
This link gives us the basic framework for the
study of the 
economic behaviour of the firms 
economic behaviour of the firms 
and
industry in the market
industry in the market
.
As per this paradigm, the 
industrial structure
industrial structure
,
which is 
exogenously
exogenously
 given, determines the
conduct of firms and the performance of the
industry.
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SCP approach state the 
unidirectional
 and
linear relationship 
linear relationship 
between the three
variables:
Functionally, the
 
relationship on which the Harvard Tradition
of the SCP paradigm is based is given as:  P =ƒ(C) and, C=ƒ(S).
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Basic Conditions
The concept of the 
basic conditions 
basic conditions 
operates
on 
both sides
both sides
 of the market, supply and
demand.
On the demand side, the basic condition
includes:
the size of the market
the growth of the market as well as its dependence
on seasons and the business cycle
the elasticity of demand and
the availability of substitutes are also among the
basic demand factors acting as the basic condition.
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On the supply side:
 the basic condition encompasses the nature of
relevant technology-divisible or not
high or low elasticity of input substitution; the
durability of the product, business attitudes, the
value-to-weight ratio, location and ownership of
essential raw materials
number and location of firms, distribution,
advertisement, marketing
degree of work force unionisation
the legal and social factors such as regulatory
framework and availability of vital inputs may be
included.
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Jointly, there are 
public policies 
public policies 
that affect
both the supply and demand sides.
These include:
taxes and subsidies
international trade rules
regulation and antitrust laws and price controls
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                     Market Structure
Market structure refers to how the different sellers
and buyers are 
linked
 
together
.
The major elements of market structure describe
ways in which markets depart from the conditions
that describe perfect competition.
Market structure has certain basic aspects;
internal aspects (the number and size of buyers and
sellers) and
External aspects (the conditions of entry and exit)
To understand the 
market structure
market structure
, one needs to
be first familiarised with the following concepts:
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The degree of seller concentration
: this refers to
the number and size distribution of firms
producing a particular commodity or types of
commodities in a market.
 In perfectly competitive market model, we
assume that there are very large number of buyers
and sellers, standardized product, free entry, free
exit and complete and perfect knowledge.
Thus, no single firm is able to influence the price
of the product in such a market.
A competitive industry will in the long run supply
a product at a price equal to its average cost and
marginal cost. That is, P = AC=MC.
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In contrast, a monopolised market is supplied by a
single
 
seller
, who is able to restrict output and
hold the price above the marginal  cost of
production i.e. P > MC.
There is only one seller in the market with zero or
almost negligible cross elasticity of demand for
its products.
In this case, there is full market power over price
and quantity decisions.
This implies that from the view point of the
society, imperfect markets such as Monopoly are
inefficient
 unlike the perfect competition model.
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The degree of buyer concentration:
this shows the 
number
number
 and 
size
size
 distribution of
buyers of the commodities in the market.
The essence of the matter is that concentration of
power in one part of a market will evoke balancing
concentrations of power in other parts of the
market.
When a 
few large buyers 
few large buyers 
bargain with a 
few large
sellers
, it will be more difficult for sellers to hold
the price above the cost, keeping all other factors
constant.
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The degree of product differentiation:
 
this shows the 
difference
 in the products of different firms
in the market.
In competitive market, rivals sell a 
homogeneous
 product.
 This is never the case in the real world. Products are always
differentiated in some way.
As differentiation increases, the products of different
suppliers become 
poorer substitutes 
for one another and
hence the producer becomes more and more like a
monopolist.
This would increase the power of the producer to control its
selling price.
Thus, we can say that there is a trade-off between market
power – the power to control prices – and product variety.
More variety imply more power to control prices so likely
to get P > Mc
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The condition of entry to or exit from the market:
this shows the relative ease with which new
firms can join the category of sellers in the
market or leave it.
The role of entry is important in that with entry
even the most 
complete monopoly
 is open to
competition from new entrants.
Entry conditions explain the number and size
distribution of firms that operate in a market.
So entry condition affects conduct and
performance in its own right.
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Other related aspects of market structure relate to
The extent to which firms one vertically integrated
back to their sources of supply or forward to the final
markets,
The degree of diversification of individual firms,
Technological, geographical and institutional factors
present in the market and conditioning the behavior
and performance of the firms.
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Market Conduct
Market Conduct refers to the 
pattern of
behaviour
 that 
firms follow in adopting or
firms follow in adopting or
adjusting 
adjusting 
to the market in which they operate
to achieve well defined goal(s).
That is it is all about:
pricing and output determination
 investment, marketing and
 product design by a firm or industry
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Given the market conditions and the goals to be
pursued, the firm will be acting alone or jointly to
decide about:
 the price levels for the products
the types of products and their quantities
their design and quality standards
advertisements and so on.
Generally, market conduct refers to:
 the decisions, policies and strategies of firms and or
producers with regards to pricing behaviour and or
policies, investment, Research and Development and
various forms of strategic alliances with other firms.
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The  entire 
process of reacting to the market
situation 
in pursuit of the desired goal is called
the ‘market conduct’
. 
Market conduct is a subject that becomes
interesting 
only when competition is imperfect
only when competition is imperfect
.
Under perfect competition, a firm can sell all its
products at the market price.
In such circumstances, a firm has no incentive to
advertise, to react to what rivals do, or to attempt
to discourage entry. When the competition is
imperfect, however, the behaviour or conduct of
the firm is quite different
.
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In general, market conduct includes the pattern of
behavior followed by firms in the industry when
adapting to a particular market situation.  It includes:
i. Pricing behaviors of the firm or group of firms
:-  This
includes a consideration of whether price charged tend
to maximize individual profits, whether collusive
practices in use tend to result in maximum group
profits or whether price discrimination is followed.
ii. Product policy of the firm or group of firms
 - For
example, is product design frequently changed?  Is
product quality consistent or variable? What variety of
products is made available?
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iii. Sales promotion and advertising policy of the firm or
group of firms –
 how important are sales promotions
and advertising in the firm or industry’s market policy?
How is the volume of this activity determined?
iv.Research, development, and innovation strategies
employed in the firm or group-
 how substantial are
expenditures for these purposes? To what extent is
new technology available to smaller firms?
v. Legal tactics used by the firm or group-
 Legal actions
to gain competitive advantage. Are patent and trade
mark rights strictly enforced or defended?  Are patent
rights licensed to others at fair rates?
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Market performance
Market performance is the end result of the activities
under taken by the firms in pursuit of their goals. 
Market performance 
is all about allocative 
efficiency
,
profitability
, 
equity
, 
employment effects
 and 
rate of
innovation 
of a firm
.
Society wants good performance from producers of
goods and services.
Good performance is multidimensional embodying
many variables.
Performance refers to 
whether or not firm’s
whether or not firm’s
operations 
operations 
enhance economic welfare – Pareto
optimality where firms set prices equal to marginal
cost.
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Generally, good market performance is a
multidimensional concept which includes the
following elements:
Resources should be
 allocated in an efficient
manne
r
 within and among firms such that these
resources are not needlessly wasted and that they
are responsive to consumer desires. How effectively
are resources allocated across industries and
products?
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2. Technical or operational efficiency
--how closely do
existing firms, as a group, achieve lowest possible
costs?
Are they large enough to capture scale economies?
Is there too much unused capacity?
Are they located to minimize transport costs?
Is there labor efficiency?
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3.
 
Exchange Efficiency-
refers to the costs of arranging
transactions (
transaction costs
), v such as
Inspection of goods to pair buyers and sellers--this is
reduced if there are grades and standards that allow
trading on the basis of description.
Information flows (related to 
market transparency
)
Ability to trade openly
Various forms of vertical coordination, including
vertical integration.
Include pricing efficiency--i.e., the degree to which
prices accurately and rapidly transmit changes in
supply and demand to participants in the market.
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4. 
Profit Rates: 
normal profit is the indicator good market performance.
Profit serves as the:
Returns to management and risk taking
Returns to capital investment
Signal to guide resource allocation in the economy.
Chronic excess profits representing a failure of the market system:
Indicate too few resources are flowing into the industry
May be a result of concentrated market structure and high barriers to
entry.
May have undesirable income distribution
Chronic sub-normal profits may indicate a sick or declining industry.
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5. 
Level of Output
The level of output is separate from profit levels
because output level not necessarily directly related
to profit levels in real world.
6.Producers should be technologically progressive;
that is, they should attempt to develop and adopt
quickly new techniques that will result in lower costs,
improved quality, or greater diversity of new and
better products.
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7
. 
Product Suitability- 
involves matching products with
consumer preferences.
The quality level of products should be neither too high
nor too low relative to consumer desires. It is also
related to progressiveness--designing new products
and new handling methods to satisfy better changing
consumer demands.
For example for Food industry
Freshness condition of food--food not deteriorated if
consumers are willing to pay for the extra care to
assure the freshness.
Safety of food products
Nutritional integrity of products
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8.Production resources should be organized in
such a way to encourage an
 equitable
distribution of income
.
9. Producers should operate in a manner that
encourages continued
 full employment of
productive resources
.
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10. 
Participant Rationality-
deals with adequate market
information to make rational choice and avoidance of
misinformation.
The need to provide market participants with a reasonable
opportunity to make comparisons may require certain
mandatory coordination and impartial types of information.
E.g., Inspection, Grading, Standards of identity, Standardized
containers and packing (truth in packaging law), Standardized
quotations (e.g., unit prices, standard mileage estimates),
price posting, market news, product tests.
Participants in the market should have a reasonable
opportunity to be well informed and should exercise freedom
of choice rationally in their own interests (except when
private advantage obviously conflicts with social welfare).
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11.Conservation- 
refers to the extent to which a
firm or industry promotes the conservation of
natural resources. No needless depletion or
inefficient extraction plus exploration.
12. 
Labor Relations- 
covers equal opportunity,
working conditions, wage levels and wage
structure, working rules. Norm includes fair
treatment (no race, sex discrimination), mutual
fair treatment, reasonable communication and
respect.
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13.Unethical Practices: 
firms should not engage in
the production and distribution of undesirable
products/services.
What is ethical is culturally determined, which
poses problems when different cultures try to
trade, either within a country across ethnic
groups or internationally. Examples
Undisclosed danger--related to food safety
Fraud and misrepresentation--related to
advertising
Adulteration
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Critics and Alternative Theories
             
Critics from Within the SCP Paradigm  
the linearity of the relationship among S, C and P.
The linear S-C-P model assumes a very simple direct
and one-way causal relationship.
 In actual world, however, industrial relationships
are not so simple and linear.
It need not be unidirectional running from the
structure to the performance but may operate in
some situations in the complete 
reverse
 way or
may be segmented or 
partial
 
reversal
 showing
cross links between any two of the three aspects. 
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The relationships among 
structure
, 
conduct
 and
performance
 are 
complex
 and 
interactive
.
There is partial reversal of the direction of causality in
the sense that 
product differentiation
product differentiation
 may exclude
some firms and may thus alter market structure.
In fact Scherer (1970) introduced the notion of a
simultaneous interdependence of the three elements of
the harmony. There are 
two
 
aspects
 of such critics:
Reverse causation
, which may be complete reversed
causation, P→C→S or partial reversal, like P→C or
P→S or C→S;
Simultaneous causation
, where C→S and at the same
time S → C.
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 Framework of Industrial Economics
Since the proponents of the Harvard tradition (the first
wave of industrial economics) accorded structure as
influential or even determinant role, their view came to
be known as 
a structuralists’ conception of Industrial
Economics
.
The essence of the structuralists approach (SCP
approach) is a presumption that industries having fewer
firms will tend to engage in conduct inconsistent with
the norms of perfect competition.
 Thus we observe, P > MC, strategies to deter the entry
of new firms, evidence of implicit or explicit collusion
among industry members, and so on.
64
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65
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A major defect of the structuralists model is
that it is 
too
too
 
simplistic
simplistic
, ignoring many of the
linkages, which can be argued to exist between
the elements.
The problem is that it is based on 
linear
linear
determinism
determinism
.
 A general theme is that conduct is very often
not wholly determined by structure; firms have
a wide degree of discretion over their conduct,
and the decisions they make affect the
structure of the industry and indeed the basic
conditions.
66
Compiled by: Abdi T.
1.3.2.The Chicago School of Thought
The Chicago School gives high accord to
Conduct. 
The method of analysis of this school
relies on the traditional standard perfect
competition model. 
Criticized the SCP model for being 
non-
theoretical 
and for having diverged too great an
extent from the basic neoclassical price theory.
The school argues that even if their (SCP)
empirical work was based on 
more realistic
assumptions
, it came up with nothing more
powerful in predictive ability than the traditional
perfect competition model.
67
Compiled by: Abdi T.
 
In the SCP paradigm, high concentration was believed to be
collusion and enhance high profit implying the need for
government intervention.
But the Chicago school argues that when concentration is
high, firms tend to be large. Larger firms tend to be more
efficient and this greater efficiency leads to higher profit.
Thus, nullifying (making void) the reason as to how
government should intervene.
For thinkers of this school, competition is an ever – present
reality. This school is more antipathetic (strong dislike to
government intervention).
According to this school, government may intervene only if
the reason to higher profit is the act of collusion of firms.
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68
1.3.3.Institutional Economics
The central message of the New Institutional
Economics is that 
institutions
institutions
 matter for economic
performance.
 The fundamental idea is that 
transaction costs do
exist
, are significantly large and they can shape the
structure of institutions 
and the specific economic
choices people make (i.e. Economic behavior of
economic agents such as firms).
According to the transaction cost school, institutions
that lower the costs of transactions are the key to the
performance of the economies. These costs include
those of 
information
, 
negotiation, monitoring,
coordination
 and 
enforcement of contracts
. 
69
Compiled by: Abdi T.
 
Under what circumstances will transaction costs be
lower when internalized than when left to be
negotiated in an external market?
The factors can be either environmental factors or
human factors. The key environmental factors are
uncertainty
 and the 
number of firms w
hereas, the key
human factors are 
bounded rationality
 and
opportunism
.
Bounded rationality is the limited human capacity to
anticipate or solve complex problems. Problems arise
when uncertainty is combined with bounded
rationality, or where the managers of the few firms in
an industry behave opportunistically.
Compiled by: Abdi T.
70
Thank you for your stay
@being committed!!!!
71
Compiled by: Abdi T.
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Industrial economics delves into economic issues of firms and industries, exploring their interactions with society. This chapter discusses the meaning and scope of industrial economics, its historical evolution from classical to contemporary theories, traditional concerns like firm performance and market structures, and the role of government. The subject has evolved over the years, incorporating new ideas and empirical findings. Decision-making problems in industries are examined through the lens of economics as the study of human behavior in allocating scarce resources.


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  1. CHAPTER ONE INTRODUCTION Chapter objectives: After reading this chapter you must be able to know The meaning and scope of industrial economics The definitions and elementary description of some basic concepts used in industrial economics The paradigm of SCP The framework for the study of industrial economics Compiled by: Abdi T. 1

  2. Definition and Scope of Industrial Economics What is industrial economics? It is one of the disciplines in economics that deals with the economic problems of firms and industries, and their relationship with society. It is also called: Economics of Industry Industry and Trade Industrial Organisation and Policy Commerce and Business Economics and so on. Compiled by: Abdi T. 2

  3. 1.0. Overview on historical Evolution of Industrial Economics The early theory of the firm which we might regard as the mother of the contemporary industrial economics was born as at this stage as an integral part of the classical economics. Many of the issues in this area of economics date back to Adam Smith in the eighteenth century. More recently, Cournot in the first half, and Marshall in the 2nd half of the nineteenth century laid foundations that which , remain appropriate concerns in industrial economics of today. Compiled by: Abdi T. 3

  4. There have been two major traditional concerns of industrial economics. First, there has been a focus on the functioning of firms, and their performance; the determinants and consequences of different market structures , and the relationship between behavior and performance of firms) and the market structure within which firms operate. Second, the role of government in influencing the organization of industry. Compiled by: Abdi T. 4

  5. Although difficult to know the true beginning of industrial economics because of non-availability of data, it has come up to the present stage mainly during the last 40 to 50 years. The subject has not yet grown to its maturity. In recent years, industrial economics has changed dramatically. Theories have been extended & developed, partly in response to new ideas such as commitment, to new empirical findings and partly to the arrival of new tools such as computer simulations. Compiled by: Abdi T. 5

  6. How decision-making problems arise in industries? To answer this question, we have to go back to the core of Economics. Economics is the science that studies human behavior as a relationship between ends and scarce means that have alternative uses. As implicit in this definition, an economic problem arises because of scarcity of means and their alternative uses in relation to the needs of an individual or a group or society as a whole. Compiled by: Abdi T. 6

  7. For example, the income of a consumer is generally limited but his/her wants are unlimited. In this situation he/she has to adopt some criterion to achieve maximum gain from his/her limited income. This is the problem of utility maximization in the theory of consumer behavior. Similarly, for a producer, the resources like land, raw materials, labor, capital, etc., are scarce. Compiled by: Abdi T. 7

  8. Given such scarcity, the producer has to take decisions about production and distribution. There are several basic issues on which the producer will be taking decisions such as: what commodities he/she should produce, what should be the level output of each input, what type of technology he/she should adopt, where should he/she produce the goods, Compiled by: Abdi T. 8

  9. what should be the size of his/her factory, what price he/she should charge, how much wages should pay, how much he/she should spend on advertisement, should he/she borrow from banks or elsewhere, etc All such decisions explain the producer's behavior in the different market situations, which we endeavor to study in industrial economics. Compiled by: Abdi T. 9

  10. In microeconomics also we study producers behavior in relation to scarcity of resources. Because of this fact, some economists would regard industrial economics as being primarily an elaboration of, and development from, the traditional theory of the firm taught under microeconomics. Industrial economics is best defined as the application of micro economic theory to the analysis of firms, markets and industries. Compiled by: Abdi T. 10

  11. Stigler (1968) argues that industrial economics does not really exist as a separate discipline, that it is simply differentiated microeconomics. But this misses some points. The distinction arises from the overriding emphasis, in industrial economics, on empirical work and on implications for policy. Compiled by: Abdi T. 11

  12. What makes industrial economics different from microeconomics? Of course to view industrial economics as a development of microeconomics understandable. Both are concerned with the economic aspects of firms and industries seeking to analyses their behavior implications. However, there are some differences between the two. is quite and draw normative Compiled by: Abdi T. 12

  13. Microeconomics is a formal, deductive and abstract discipline where as Industrial economics on the other hand is less formal, more inductive in nature. Microeconomics assumes profit maximization as the goal of the firm given constraints where as Industrial economics does not believe in single goal of profit maximization. Microeconomics, being abstract, does not go into operational details of production, distribution and other aspects of the firms and industries where as Industrial economics does go into the depth of such details. Compiled by: Abdi T. 13

  14. Public policy implications are taken care of in industrial economics but microeconomics may shun them if necessary. industrial economics with the concern of decision- making in an industry from micro angle, but it has macro dimension also. For a society as a whole the resources for production are scarce just as in the case of a producer. Compiled by: Abdi T. 14

  15. With scarce resources, the problem exists to produce varieties of goods and services in-the current period and in future also. What goods should be produced: consumer or capital? If capital good are preferred, then the series of problems faced by the society may be: what types of capital goods; what type of factory (large vs. small scale); where to produce (locational problem); how to distribute them; etc. These are the questions which have been posed earlier for an individual producer also. But, here we have to examine them from the social angle. Compiled by: Abdi T. 15

  16. The term industrial organization is commonly viewed as synonymous with industrial economics. But,Carlsson (1989) made clear distinction between them. He reasons that the main concern of industrial organization has become the structure of industries at a particular point of time. By contrast, industrial economics encompasses both industrial organization and industrial dynamics. Industrial dynamics is primarily concerned with the evolution of industry as a process in time both at the macro level, the sector or industry level, and the firm level. Compiled by: Abdi T. 16

  17. It differs from industrial organization in that its main focus of attention can vary from the firm, to relationships between firms, to the links between microeconomics and the macro economy. When the economist turns the attention to industrial dynamics investigation is widened . the area of Compiled by: Abdi T. 17

  18. Conclusion: Industrial economics is predominantly an empirical discipline having micro and macro aspects. It has a strong microeconomics. It provides useful applications for industrial management and public policies. theoretical base of Compiled by: Abdi T. 18

  19. There are two broad elements in industrial economics. Descriptive element Analytical part Descriptive Element: is concerned with the information content of the subject. It would provide industrialist or businessman full information regarding: the availability of natural resources industrial climate in the country situation of the infrastructure including lines of traffic supplies of factors of production, trade and commercial policies of the governments, and the degree of competition in the business in which it operates. Compiled by: Abdi T. 19

  20. In short, it deals with the information about the competitors, natural resources and factors of production and government rules and regulations related to the concerned industry. Analytical element:is concerned with business policy and decision making. market analysis Pricing choice of techniques location of plants investment planning hiring and firing of labour financial decisions product diversification and so on. Compiled by: Abdi T. 20

  21. Analytical element : is a vital part of the subject and much of the received theory of industrial economics is concerned with this. However, this does not mean that the first element, i.e., descriptive industrial economics, is less important. NB. The two elements are interdependent, since without adequate information no one can take proper decision about any aspect of business Compiled by: Abdi T. 21

  22. While the descriptive element of industrial economics is concerned with the information content of the subject, the analytical element is concerned with the business policy and decision making. Compiled by: Abdi T. 22

  23. Moreover, industrial economics: analyses industries, markets, and the behaviour of firms within those markets. It deals with supply side economics. Thus, it is concerned with the economic problems of the firms and their economic behaviour in utilising economic resources at their disposal. The interdependence between firms within markets and the links that exist between market conditions and firm s performance Compiled by: Abdi T. 23

  24. Industrial Economics addresses the basic question of: what to produce for whom to produce and how to produce in the context of industries or firms Industries face such problems because resources are scarce and hence the industrialist has to take decisions about production and distributions of goods and/or services as they cannot produce everything they want to produce at single firm level or at higher aggregate level of the economy. Compiled by: Abdi T. 24

  25. The Rationale for Studying Industrial Economics i. It is instrumental to the formulation and implementation of industrial policies that are essential for sustainable development of a nation. For example, it helps us: to choose between private and public enterprises to design strategies to promote investment in industrial sector to regulate and/or deregulate public utility industries It also assists policy makers as how they can stimulate technological progress through patent rights and subsidies. Compiled by: Abdi T. 25

  26. ii. Studying industrial economics is useful for generating research questions such as: why do some firms advertise their products while others do not? Why do some firms expand while others contract or keep their size constant? Are barriers to entry more serious in some branches of industry than in others? The questions are essential for further research and development and hence deserve attention. Compiled by: Abdi T. 26

  27. 1.2. Some Basic Concepts in the study of Industrial Economics i. The Firm A firm is an organization owned by one or jointly by a few or many individuals which is engaged in productive activity of any kind for the sake of profit or some other well-defined aim. Most of the firms owned by private individuals in manufacturing trade and services will aspire for profits but there may be some other such as government companies where profit motivation will be secondary or missing altogether. Compiled by: Abdi T. 27

  28. ii. The industry The conventional definition of the term industry is a group of firms producing a single homogeneous product and selling it in a common market. However, the restriction of a single homogeneous product is not met in practice. Most of the firms produce many outputs which may or may not be substitutable for each other. In this situation, the conventional operational sense. definition has no Compiled by: Abdi T. 28

  29. A better approach to define the industry is to call it a group of sellers or of close substitute outputs who supply to a common group of buyers . In other words, we may take it in simpler terms as a group of firms producing closely substitute goods for a common group of buyers. In the terminology of the monopolistic competition we are essentially talking about the product group" as a substitute word for the industry. Compiled by: Abdi T. 29

  30. iii. The Market This is defined as a closely interrelated group of sellers and buyers for a commodity. The term is not equivalent to the industry since in the latter case we are looking only at the seller s side of the market. By including the buyer's side, the term becomes more comprehensive connoting the composition of the buyers and their geographical location along with the industry. A heterogeneous group of closely substitute goods will have a market, but there may be markets within the market for every homogeneous good. Compiled by: Abdi T. 30

  31. Contestable market: is a market where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set. It is a market in which competitive outcomes can be observed. Its fundamental feature is low barriers to entry and exit; A perfectly contestable market would have no barriers to entry or exit. Compiled by: Abdi T. 31

  32. iv. Market power Market power- refers to the influence that any particular buyer or seller can exercise over the price of a product. It indicates the degree to which a business firm is able to earn larger than normal profits. Market structures range from highly competitive, in which there are so many buyers or sellers that none can influence the market price, to the other extreme in which a single buyer or seller faces no competition and therefore wields great market power. Market power is inversely related to both the degree of competition in the market and the ease of entry and exit. Compiled by: Abdi T. 32

  33. 1.3.Approaches to Industrial Economics 1.3.1.The Market Structure-Conduct- Performance paradigm (SCP paradigm) Joe Bain and Edward Mason developed the concept Structure-Conduct- paradigm in 1936, dealing with the pricing policies of large-scale enterprises. It is also called Harvard tradition According to this paradigm, there is a priori relationship between the three concepts of industrial economics, market structure, market conduct and market performance. Performance Compiled by: Abdi T. 33

  34. The link between these three structure of an industry determines or strongly influences the crucial aspects of its market conduct which in turn directly or indirectly determines certain important dimensions of its performance. This link gives us the basic framework for the study of the economic behaviour of the firms and industry in the market. As per this paradigm, the industrial structure, which is exogenously given, determines the conduct of firms and the performance of the industry. is that market Compiled by: Abdi T. 34

  35. SCP approach state the unidirectional and linear relationship variables: between the three Basic Condition Structure Conduct Performance Functionally, therelationship on which the Harvard Tradition of the SCP paradigm is based is given as: P = (C) and, C= (S). Compiled by: Abdi T. 35

  36. Basic Conditions The concept of the basic conditions operates on both sides of the market, supply and demand. On the demand side, the basic condition includes: the size of the market the growth of the market as well as its dependence on seasons and the business cycle the elasticity of demand and the availability of substitutes are also among the basic demand factors acting as the basic condition. Compiled by: Abdi T. 36

  37. On the supply side: the basic condition encompasses the nature of relevant technology-divisible or not high or low elasticity of input substitution; the durability of the product, business attitudes, the value-to-weight ratio, location and ownership of essential raw materials number and location of firms, distribution, advertisement, marketing degree of work force unionisation the legal and social factors such as regulatory framework and availability of vital inputs may be included. Compiled by: Abdi T. 37

  38. Jointly, there are public policies that affect both the supply and demand sides. These include: taxes and subsidies international trade rules regulation and antitrust laws and price controls Compiled by: Abdi T. 38

  39. Market Structure Market structure refers to how the different sellers and buyers are linked together. The major elements of market structure describe ways in which markets depart from the conditions that describe perfect competition. Market structure has certain basic aspects; internal aspects (the number and size of buyers and sellers) and External aspects (the conditions of entry and exit) To understand the market structure, one needs to be first familiarised with the following concepts: Compiled by: Abdi T. 39

  40. The degree of seller concentration: this refers to the number and size distribution of firms producing a particular commodity or types of commodities in a market. In perfectly competitive market model, we assume that there are very large number of buyers and sellers, standardized product, free entry, free exit and complete and perfect knowledge. Thus, no single firm is able to influence the price of the product in such a market. A competitive industry will in the long run supply a product at a price equal to its average cost and marginal cost. That is, P = AC=MC. Compiled by: Abdi T. 40

  41. In contrast, a monopolised market is supplied by a single seller, who is able to restrict output and hold the price above the marginal cost of production i.e. P > MC. There is only one seller in the market with zero or almost negligible cross elasticity of demand for its products. In this case, there is full market power over price and quantity decisions. This implies that from the view point of the society, imperfect markets such as Monopoly are inefficient unlike the perfect competition model. Compiled by: Abdi T. 41

  42. The degree of buyer concentration: this shows the number and size distribution of buyers of the commodities in the market. The essence of the matter is that concentration of power in one part of a market will evoke balancing concentrations of power in other parts of the market. When a few large buyers bargain with a few large sellers, it will be more difficult for sellers to hold the price above the cost, keeping all other factors constant. Compiled by: Abdi T. 42

  43. The degree of product differentiation: this shows the difference in the products of different firms in the market. In competitive market, rivals sell a homogeneous product. This is never the case in the real world. Products are always differentiated in some way. As differentiation increases, the products of different suppliers become poorer substitutes for one another and hence the producer becomes more and more like a monopolist. This would increase the power of the producer to control its selling price. Thus, we can say that there is a trade-off between market power the power to control prices and product variety. More variety imply more power to control prices so likely to get P > Mc Compiled by: Abdi T. 43

  44. The condition of entry to or exit from the market: this shows the relative ease with which new firms can join the category of sellers in the market or leave it. The role of entry is important in that with entry even the most complete monopoly is open to competition from new entrants. Entry conditions explain the number and size distribution of firms that operate in a market. So entry condition affects conduct and performance in its own right. Compiled by: Abdi T. 44

  45. Other related aspects of market structure relate to The extent to which firms one vertically integrated back to their sources of supply or forward to the final markets, The degree of diversification of individual firms, Technological, geographical and institutional factors present in the market and conditioning the behavior and performance of the firms. Compiled by: Abdi T. 45

  46. Market Conduct Market Conduct refers to the pattern of behaviour that firms follow in adopting or adjusting to the market in which they operate to achieve well defined goal(s). That is it is all about: pricing and output determination investment, marketing and product design by a firm or industry Compiled by: Abdi T. 46

  47. Given the market conditions and the goals to be pursued, the firm will be acting alone or jointly to decide about: the price levels for the products the types of products and their quantities their design and quality standards advertisements and so on. Generally, market conduct refers to: the decisions, policies and strategies of firms and or producers with regards to pricing behaviour and or policies, investment, Research and Development and various forms of strategic alliances with other firms. Compiled by: Abdi T. 47

  48. The entire process of reacting to the market situation in pursuit of the desired goal is called the marketconduct . Market conduct is a subject that becomes interesting only when competition is imperfect. Under perfect competition, a firm can sell all its products at the market price. In such circumstances, a firm has no incentive to advertise, to react to what rivals do, or to attempt to discourage entry. When the competition is imperfect, however, the behaviour or conduct of the firm is quite different. Compiled by: Abdi T. 48

  49. In general, market conduct includes the pattern of behavior followed by firms in the industry when adapting to a particular market situation. It includes: i. Pricing behaviors of the firm or group of firms:- This includes a consideration of whether price charged tend to maximize individual profits, whether collusive practices in use tend to result in maximum group profits or whether price discrimination is followed. ii. Product policy of the firm or group of firms - For example, is product design frequently changed? Is product quality consistent or variable? What variety of products is made available? Compiled by: Abdi T. 49

  50. iii. Sales promotion and advertising policy of the firm or group of firms how important are sales promotions and advertising in the firm or industry s market policy? How is the volume of this activity determined? iv.Research, development, and innovation strategies employed in the firm or group- how substantial are expenditures for these purposes? To what extent is new technology available to smaller firms? v. Legal tactics used by the firm or group- Legal actions to gain competitive advantage. Are patent and trade mark rights strictly enforced or defended? Are patent rights licensed to others at fair rates? Compiled by: Abdi T. 50

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