Industrial Organization
The main goal in industrial organization is to understand
how firms strategically interact in well-defined markets
Ideally, we want to be able to use observable variables to
predict firm behavior, profits, and social welfare at the
level of particular markets
IO is particularly concerned with how government
intervention influences firm behavior and market
performance
Antitrust policy, regulatory policies, patent policies, etc.,
are all important
Main Approaches
The typical approach in theoretical IO is to use a formal
game theoretic model with profit maximizing firms
The firm as a strategic agent is the unit of analysis; the
implications for market performance are critical outcomes
IO approaches often downplay differences in resources and
capabilities at the firm level and focus on the implications
of pure strategic interaction
This is in contrast to the strategy literature, where much of
the focus is on how differences in resources and
capabilities influence strategic choices
Market Boundaries
1. What is the relevant product?
Most large firms produce several different products
Even if we focus on a particular product it is difficult to
draw industry boundaries
For example, should desktop computers be in the same
industry as laptops?
In practice, we need to determine how substitutable the
products are and how similar the production processes are
The boundaries are often determined by data availability
Market Boundaries
2. What is the relevant geographic area?
Often data is available only within the U.S. at the national
level, and it may include only domestic firms
This is problematic for several reasons:
First, in many industries the largest U.S. firms sell products
all over the world their market is not confined to the U.S.
For example, many banks argue that they need to be large
in order to compete effectively in the international market
for loans
Market Boundaries
3. What about dynamics?
Suppose we follow an industry over time
There may be substantial turnover in the leading firms, the
products sold, the product processes employed, etc.
Consider video games or computers
Even in non high-tech industries the environment evolves
over time
Industry Structure
Because oligopolies vary substantially, it is important to describe the structural
features of these industries
Key aspects of industry structure include:
The number and relative size of large firms
The degree of product differentiation
The barriers to entry and expansion
How much production processes vary
Structure-Conduct-Performance
Industrial Organization emerged as a distinct field of economics in the late
1930s, beginning with case studies of industries
The SCP paradigm led economists to make comparisons across industries;
it continues to influence economists and policy makers
The basic idea of SCP is that industry Structure determines Conduct (how
the firms behave, particularly with respect to pricing), and Conduct
determines Performance (measured using rates of return or price-cost
mark-ups)
In practice, the main link explored was between structure and performance
Barriers to Entry
Barriers to entry are important in the SCP paradigm because it
takes an essentially static view of an industry: perfect
competition is ideal and monopoly is associated with the
largest welfare losses
If entry and exit can occur easily, then it is difficult for the
established firms to collude or maintain prices above marginal
costs
A barrier to entry is a cost of producing which is borne by
new entrants but not by established firms
Determining whether something is a barrier to entry can be
tricky; assessing the welfare implications of a particular
barrier is even more tricky (consider patents)
Criticisms of SCP
Empirical studies have as a whole been inconclusive: at best there is weak
evidence of a link between market structure and performance
Game theory establishes that conduct is not determined completely by structure:
firm behavior must be considered independently of industry structure
Further, structure and performance both change over time
Causation is not just one-way:
High performance encourages entry through innovation or differentiation, which
affects structure
Low performance encourages exit or capacity reduction
Dynamics
The most interesting current approaches to industry
analysis focus on dynamics
In a dynamic world, innovation becomes important, and
providing profit incentives for innovation is critical
In a dynamic world, it is no longer the case that perfect
competition is ideal; it is essential for firms to obtain
profits above the norm when they innovate in order for
them to have the incentive to innovate in the first place
Analyses of the links between market structure (or any
observable variables) and conduct and performance
become more difficult and more complex
Types of Entrants
They distinguish between three types of entrants:
1.
2.
3.
New firms
Existing firms that diversify into an industry by opening
a new plant
Existing firms that enter by altering the mix of outputs
they produce in their existing plants
Key Results
On average, 93.4% of firms are single-plant firms, but they
account for only 17.1% of the value of production
After deleting the smallest firms (those that together produce
1% of the industrys output), the average entry rate varies
from .31-.43; the exit rate varies from .31-.39
On average, 38.6% of firms are new to the industry each
census year
Entrants and exiting firms are small: entrants account for
15.8% of output, and the market share of exiting firms varies
from .144 to .191
An entrant produces 35.2% of what an incumbent does on
average
Entry by Type
New firm, new plant entrants are
55.4% of the number of entrants
50.0% of entrant output
28.4% as large as incumbents
Diversifying firm, new plant entrants are
8.5% of the number of entrants
14.4% of entrant output
87.1% as large as incumbents
Diversifying firms who are changing their product mix in an old plant are
36.1% of the number of entrants
35.6% of entrant output
34.9% as large as incumbents
Exit by Type
Of entrants that exit, new firms that construct new plants are
the largest group of exiters
A relatively high proportion of diversifying firms who
constructed new plants survive over time
On the whole, entrants and exits tend to be smaller than
continuing firms
New firms that entered with new plants in the period 19631977 period were the majority of exits during 1963-1982
Variation
There is a lot of variation in entry and exit rates within 2-digit sectors
and between 2-digit sectors: industries differ
We can characterize how industries differ. It is not random, but
systematic:
High entry rates today imply high entry rates tomorrow (the same
relationship holds for exit rates; high exit rates persist)
Further, entry and exit rates are positively correlated
This implies that there are high entry/exit industries and low entry/exit
(turnover) industries
After correcting for industry effects by looking at deviations from
mean entry/exit rates, periods with above average entry are associated
with below average exit
Entry Cohorts
The market share of an entry cohort is highest when it first
enters; then it declines
Survivors tend to grow and failures are small
The average size of survivors relative to the average size
of firms in the industry rises over time
So the trend in market share is due to exit
Exit rates for entry cohorts are quite high, with most of the
exit occurring in the first 5 years after entry
Alliances
Alliances are an important phenomena in modern hightech industries and in other industries where globalization
is important
In the biotechnology industry there are complex webs of
alliances
So far, few authors have attempted to study these
overlapping networks of alliances
For example, research on biotechnology alliances could
clarify the roles that small biotechnology firms and large
pharmaceutical firms play in these networks
Additional Topics
IO is too broad to summarize the various topics,
approaches and results in a simple way; corporate finance,
strategy, and the theory of the firm are relatively narrow
pursuits by comparison
Instead, I will briefly review some of the main topics and
some interesting open questions; the list is by no means
exhaustive
We have already talked about market structures and the
importance of understanding dynamic competition; I will
emphasize other topics
Pricing
IO is concerned with pricing behavior; much of the analysis
is based on microeconomic price theory
Price discrimination, nonlinear pricing, tie-in sales, pricing
durable goods, predatory pricing, and limit pricing have all
received attention in the literature
Much of this work is quite mature and dates back to the
1950s and 1960s
Recent research on pricing has focused on new environments
like the Internet that raise new issues: bundling information
goods (like software or music), designing subscription
models, considering micropayments, etc.
Technological Change
Much of modern IO is particularly concerned with
technological change and policies that influence
technological change
Patents, copyrights, and trademarks are important objects
of analysis
Joint ventures and alliances
The effects of regulatory policies on technological
progress
Reaction
One reaction to this problem is to simply abandon the
study of strategic interaction, but this is too extreme
A useful approach is to combine theory with empirical
work
Avoid theories that depend heavily on specific assumptions
about intricate strategic thinking and concentrate on those
that can be tied to observable data
It is also important to try to verify assumptions as much as
possible talk to industry participants if possible
Few economists have produced useful insights in the
absence of data to guide them