INTRODUCTION, DEFINITION AND MAJOR THEORETICAL AND EMPIRICAL DEVELOPMENTS IN INDUSTRIAL ORGANIZATION: BY: EDWARD LEMAN (MA Econs, B.Soc. Sc. Econs) 1. INTRODUCTION TO INDUSTRIAL ECONOMICS PRELUDE • Have you ever wondered why the telecommunications industry is dominated by two players (TNM and Airtel)? • Access came and is almost nowhere to be seen • There were rumors of MTN but nothing materialized • Have you ever wondered why some banks seem to be more powerful than others to an extent that the rest follow their steps? • Have you ever wondered why we only have a single main supplier of electricity in the country? • Why are some firms surviving despite offering poor services? • What types of markets prevail in Malawi? Monopolies? Oligopolies? • What effect does the type of market have on the way the firms behave? • Does the conduct of the firm affect its performance and the performance of the whole industry and economy? • What strategies do firms employ? • These are some of the questions that we ask under Industrial Economics or Industrial Organization (look at the course outline) DEFINITIONS and HISTORY • Industrial Economics or Organization (IO) is the application of microeconomic theory to the analysis of firms, markets and industries • It is a branch of economics that concerned with the behavior of firms, in the respective industries and markets and the outcomes of these behaviours • Unlike microeconomic theory, IO puts emphasis on empirical work and on implications for public policy • IO is therefore more of testing the various theories about firms and markets in the real world • IO is not a new concept, the study of IO can be traced from the work of Chamberlin in the early 1930s on the theory of monopolistic competition • Edward Chamberlin developed the theory of monopolistic competition • Chamberlin's work sought to fill the gap between the traditional models of perfect competition and monopoly • Key feature in the Chamberlin’s theory is emphasis on that in many real-world markets, firms do not sell identical products, as assumed in the model of perfect competition but instead offer differentiated products, which are similar but not perfect substitutes for each other • The implication of this is that firms have monopoly power as they sell distinct products yet the power is limited due to presents of similar products • A market that is a combination of the two extreme markets: monopoly and perfect competition • However, the broad descriptive model of IO was developed by Edward Mason in the late 1930s and elaborated by his student, Joe S. Bain in the 1950s • Mason and Bain associated with the Harvard school developed the basic concept of IO, known as the structure-conduct-performance (SCP) paradigm or framework that has been the central hypothesis in the development of IO as a separate discipline of economics • The foundations of the SCP framework is the neoclassical theory of the firm especially models of perfect competition, monopoly and monopolistic competition together with oligopoly models • Although the SCP paradigm has remained the central concept in industrial organisation, there are alternative schools of thought including 1. the Chicago school that relies heavily on standard competitive economic theory and oppose government intervention in markets; 2. the Austrian school that believes that competition is dynamic process and cannot be modelled using standard static economic models (Clarke, 1985; Ferguson and Ferguson, 1994) 3. the New industrial organization or New industrial economics focusing more on oligopolistic independence in the markets and the use of game theory to understanding the behaviour of firms Ultimately the study of IO should influence government policies and regulations 2. THE SCP BASIC FRAMEWORK • The basic framework of analysis of industrial economics emphasizes the linkage between market structure and business conduct in determining the performance (SCP) • paradigm is associated the Harvard school of thought through E.S. Mason and his student J. S. Bain both of Harvard University • The approach developed from mainly institutional and case study work on firms and industries • The Harvard approach also assumes that barriers to entry into an industry, with market concentration and product differentiation are key elements of market structure • Generally, the SCP gives a relationship between: 1. Basic conditions: These basic conditions define the market environment and shape market or industry (issues of demand and supply) 2. Market Structure: a selected number of organizational characteristics of a market that establishes inter-relationships between sellers and buyers of a particular product. These are attributes of the market that influence the nature of the competitive process 3. Conduct: behaviour of firms in the market including acts, practices and policies of the sellers in arriving at and coordinating their decisions relating to the level of prices, output, sales promotions, product design, and what actual and potential competition to discourage in the industry. 4. Performance: the degree of success in achieving stated objectives. Measures of performance include profitability, output growth, efficiency (productive and allocative efficiency), growth of employment, price and equity, product quality, productivity and technical progress 5. Government or Public Policy: Proper market structure and conduct should lead to good economic performance. However, in reality markets fail to operate efficiently and the need arises for governments to intervene in order to improve performance. The policy measures may affect the basic conditions, market structure, conduct and performance. Some of the public policies that affect the operation of industrial markets include regulation, antitrust laws, institutional barriers to entry, taxes and subsidies, investment and employment incentives and macroeconmic policies • In Bain’s traditional SCP paradigm there is a causal relationship running from market structure to conduct which affects performance in the traditional or neoclassical theory of the firm • In effect, the SCP paradigm was based on two extreme cases of market structure conceived by neoclassical economist: monopoly and perfect competition In highly concentrated markets such as a monopoly, firms tend to set prices above marginal cost and tend to control output, which in turn lead to higher profits (above normal profits). On the other hand, in less concentrated markets such as perfect competition firms are assumed to be price takers and prices are set equal to marginal cost, which in turn lead to low profits (normal profits) • The SCP paradigm is an important tool of analysis in industrial economics 1. First, it assists in explaining the observed behaviour and performance of firms operating within markets and industries 2. Secondly, it helps in identifying public policy to improve overall performance of industry through modification of existing structural characteristics – policy implications 3. Thirdly, it helps in explaining characteristics of firms or industries which determine business performance 2.1. CRITIQUE OF THE SCP 1. 2. 3. 4. 5. Endogeneity: The theoretical basis of the SCP envisage a one way causal relationship and it has been criticized for failing to recognize the feedback effects. However, recent research stresses the possibility that conduct and performance may in turn affect structure and may be jointly determined in a given market situation The Chicago School and the Case of Oligopolistic Markets: criticized the SCP on grounds that the policy issues that emerge from the traditional framework lead to unnecessary government intervention in the markets and the fact that the hypotheses fail to conform to the basic neoclassical profit-maximising assumptions Measurement Problems: Market structure as well as industry performance involve multiple dimensions in terms of measurements. However, research has concentrated on one dimension of market structure which has been studied in depth - seller concentration and one dimension of performance - profitability. In this case, most empirical studies are ad hoc and do not give a comprehensive analysis of the SCP relationship The Effect of Cross-Subsidization: In the SCP framework each market is analysed independently of all other markets. Most firms are multi-product firms whose behaviour cannot be handled within the SCP paradigm The Austrian School and Dynamic State: The central concern of the Austrian school is the competition process and is therefore interested in the ways by which economies evolve over time and how decisions are made in conditions of uncertainty and limited information. They argue that SCP framework assumes that market structure is stable over time or changes slowly, and competition as a process can therefore not be analysed in a static environment. 6. New Industrial Organization: The new industrial organisation (Bresnahan, 1989) criticizes the traditional SCP framework for not rigorously using the neoclassical theory in its theoretical foundation. The new IO has moved away from emphasizing on market structure, and advocates of this approach argue that conduct is the key element, interacting both with structure and performance The central focus of the new IO is the study of oligopoly models using neoclassical theory, particularly game theoretic frameworks such as Cournot models. Nonetheless, the new IO though strongly grounded in economic theory, the complex models (with restrictive assumptions) that are used in the analysis, has raised questions about the empirical applicability of such models in real world situations applicability 7. Applicability to Developing Countries: applicability of the SCP to developing countries has been questioned on three level: (a) Data that can be used to test such models is not readily available and not consistently collected, in some cases due to the smallness of the industrial sector (b) available data in such countries is likely to ignore the informal sector, which forms a significant part of economic activities (c) in most countries many enterprises are owned by the government (state-owned enterprises) that pursue objectives other than profit maximization. The SCP therefore has to take into account the role of public enterprises in less developed countries Papers to read • https://ipl.econ.duke.edu/seminars/system/files/seminars/3754_paper.pdf • https://www.researchgate.net/publication/322165461_The_Structure_Conduct_Performance _Model_and_Competing_Hypothesis-_a_Review_of_Literature • https://www.researchgate.net/publication/5105565_The_Structure-ConductPerformance_Paradigm_and_its_Relevance_to_the_Indian_Industry • https://www.researchgate.net/publication/263011921_Structure_Conduct_and_Performanc e_of_Groundnuts_Markets_in_Northern_and_Central_Malawi_Case_Studies_of_Mzimba_and_ Kasungu_Districts • https://massp.ifpri.info/files/2019/09/MaSSP-WP29_Structure-Conduct-and-Performance_3008-2019.pdf • https://www.researchgate.net/publication/356189161_Determinants_of_commercial_banks'_ performance_in_Malawi_An_Autoregressive_Distributed_Lag_ARDL_Approach • https://aercafrica.org/old-website/wp-content/uploads/2018/07/RP108.pdf EXERCISE 1. Pick any sector (industry) in Malawi and conduct a thorough analysis by applying the SCP framework i.e. assess the basic conditions that shape the market, determine the structure of the market, conclude on why the firms in the industry behave in the way they do, and assess the performance of the industry 2. In literature there are two competing frameworks namely SCP and Efficient Market Hypothesis. Read more about the Efficient Market Hypothesis and discuss (compare and contrast and pick a side) the two frameworks and their applicability to any Malawian industry of your choice. 3. “It’s not the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest” Adam Smith. Using this narrative, pick two industries in Malawi (a monopoly and “perfect” competition) and analyze why they behave in the way they do and the implication on their performance (quality of the goods and services). END OF SLIDES
