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Nov 20

Industrial organization

Industrial Organization is the economic field that studies the strategic behaviour of firms, and their interaction to determine the structure of markets. Knowing their evolution helps to understand them. The traditional neoclassical theory made the relation between “industrial” and “manufacturing”, making the manufacturing market the main target of studies focusing in the technological result. It left aside aspects, such as organization, management and property. This perspective was criticized for using unrealistic assumptions and because it failed to explain a series of phenomena such as imperfect competition and asymmetric information amongst others.

During the 1930s, a new perspective started to take shape, especially from ideas coming from the Harvard school, and theory began to focus in the behaviour of agents in the industry and in the structure of both firms and industry. In his book “The Theory of Monopolistic Competition”, 1933, Edward H. Chamberlin wrote about imperfect competition and found that many markets were differentiated, thus turning markets into unique. There were many works and papers produced on how markets were arranged in terms of the concentration of suppliers, describing how some markets were dominated by a relatively small number of firms.

In his book “Industrial Organization”, 1959, Joe S. Bain Jr. provided the Structure, Conduct and Performance paradigm (SCP), which is used as an analytical framework, to make relations amongst market structure, market conduct and market performance. The market structure will determine its conduct and thereby its performance.

As implications of all this, regarding economic policies, Harvard School recognizes market power as being dangerous, and establishes a relation between, the concentration ratio, and the harmful effects on social welfare. The dynamic behaviour of buyers and sellers have an effect on the markets, making it harder to predict and establish fixed market structures. Difficulties arise when trying to explain the paradigm and this is due to data shortage, and the multiple definitions and extension of markets.

The Chicago school criticized the “empiricism without theory” of the SCP paradigm, and so returned to the Neoclassical pricing theory, having a more benign view of the market’s results, and having a theoretical (rather than empirical) approach. They start from the framework of perfect competition, and consider interventionism as being the source of monopolies. From Chicago’s point of view, the market’s efficiency guarantees the achievement of social welfare, and therefore firms are encouraged to seek efficiency in their production and distribution. As to the implications regarding economic policies, government intervention is considered undesirable, as the market’s forces should be left to act, and the cost of the intervention is believed to be higher than the social benefit, producing a deadweight loss.

The Austrian school also contributed to the development of the Industrial Organization theory, breaking with the Neoclassical approach. From the same school we can distinguish two main views: von Mises and his disciples’ view and Schumpeter‘s.

Mises describes the structure of the market as a dynamic process of exploration of new methods and opportunities to improve the use of resources, and thus competition is beneficial, as it encourages efficiency and innovations. Therefore, markets have to be free, and it dismays government intervention, although some regulation is praised when innovation is promoted.

From Schumpeter’s point of view, technical progress comes from a process of creative destruction, in which innovations make prior technology out-dated and originate from the innovative entrepreneur. Monopolies have a positive consideration, as they carry out the function of promoting innovation and investments, and government intervention should guarantee both of these.

Contestable markets came up as an alternative approach to the problems concerning market power. These ideas were first introduced by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982. In contestable markets there are no entry or exit barriers, no sunk costs and firms have access to the same level of technology. All this makes the number of firms irrelevant, as many will access it and then leave, following different strategies. This view has important limitations: for instance, its starting assumptions are quite restrictive; the definition of cost is not fully suitable; and that, in the real world, a market with such characteristics, is unconceivable.

Between the 1970s and 1980s, a series of theoretical models formulated using game theory in a framework of imperfect competition, made obsolete previous models, such as the SCP paradigm. As a result, there is more emphasis in imperfect information, in firms’ behaviour and, also, in mathematical tools used to calculate social or optimal equilibrium and market equilibrium. In general, there is a shift towards analysing the internal structure of firms, and different views of the firm arose.

Ronald H. Coase, described businesses as being a series of contracts amongst its workers, and explains that it is more beneficial to form firms, since there are a number of transaction costs that can be reduced or even eliminated.

When a business grows in size, there will normally be a distinction between managers and owners. Olivier E. Williamson took notice of the internal boundaries that firms have, and distinguished between decision-making, management and business ownership. The agency theory describes and explains the issues that arise between business managers and owners, as their respective objectives differ.

George Stigler’s contributions to industrial organization must also be mentioned, even though they were more focused on the economical aspect of the theory, rather than opening a debate on how firms interact with each other. Stigler stressed the importance of economies of scale, since it would make a big difference when concentration in the market and firms’ size increased. Furthermore, Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939 (see Stigler’s cost analysis theory), which moved slightly away from neoclassical cost analysis. When considering the size of firms, economies of scope are also a possibility, as Baumol pointed out in his co-authored book “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982.

To conclude, it is necessary to clarify that, nowadays, the industrial organization theory accepts multiple perspectives. This theory has not only grown within its field, but also in others, such as applied microeconomics and business management, and, as we have seen during the last years, the boundaries of business and markets have become less clear, and many new definitions and shapes are appearing. This explains the flexibility and the relevance of the industrial organization theory.

Nov 18

Lope Gallego

Economies of scope

The concept of economy of scope is very similar to that of economies of scale. When we talk about economies of scope, we mean that average costs are reduced by introducing another product into our portfolio that can share some of the infrastructure or know-how, thus reducing overall average cost per product. It is essentially the same concept as economies of scale, but based on producing more than one product instead of producing more of the same one.

This can happen for various reasons. Firstly, because fixed costs do not increase proportionally with production but rather in stages, we can introduce a second production line that benefits from the common infrastructure whilst reducing average cost per unit.

We can also see a reduction in average variable costs. Employees can benefit from shared know how or from a certain skill set that can be transferred to a much wider range of products, raising productivity across the board. In this way, labour need not increase proportionally with production output, as it is the case for economies of scale. What we can also see here are skills being transferred from one production range to another, resulting in synergies that are unique to economies of scope instead of economies of scale.

In the adjacent figure we see the case of two multi-product firms. The fact that the lower production possibility frontier (PPF) is concave rather than a straight line means that firm B will enjoy economies of scope, and be able to produce two goods for a lower average cost than when producing only one. Therefore, economies of scope exist if, for two goods, we have:

C(x₁,x₂) < C(x₁,0) + C(0,x₂)

Nov 15

Lope Gallego

Ludwig von Mises

Ludwig Heinrich Edler von Mises, 1881-1973, was an Austrian economist and Professor at the universities of Vienna, Geneva and New York. Mises greatly contributed to neoclassical economics and was one of the leaders of the Austrian school.

Mises was a staunch advocate of economic liberalism, based on the idea that demand and supply theory will lead to the resources’ most efficient allocation. He believed socialism would fail due to economic calculation problems, as it wouldn’t be able to produce an efficient price system. In his “Human Action: A Treatise on Economics”, 1949, he analyses both economic systems. His defence of the classical school led him to argue that any separation from orthodoxy would lead to socialism and the end of capitalism.

Mises also worked in the analysis of economic cycles, particularly in the monetary aspects, and his influences were clearly felt in two of the most notable members of the Chicago school: Friedrich A. von Hayek and Milton Friedman.

Nov 14

Lope Gallego

Long run cost analysis

In the long run, no cost is fixed. We can determine our production level and adjust plant sizes, investment in capital and labour accordingly. As we can see in the diagrams below, this gives us unlimited options. Depending on the scale we choose to implement, each level of production will be associated to new, short run cost curves. When we exhaust the infrastructure these provide us, we can upgrade to a new production level and so forth. The actual long run cost curve is made up of all of these individual scenarios, built up year after year.

If we look at average costs, the curve these draw is also the build up of the individual short run curves. These form a U shape, as we can see in the diagram. When average cost is decreasing with each additional investment, we are enjoying economies of scale, but not yet working at maximum efficiency. We reach this maximum efficiency at the minimum point, before the average cost per unit begins growing again.

Marginal costs only really make sense in the long run for each individual level of production. At optimal levels of production for each level, they intersect the long run average cost curve where this meets the short run average cost curve. This is what determines our optimal level of production. In summary, at our optimal level of production:

AC_SR = AC_LR = MC_SR = MC_LR

which is known as Le Châtelier’s principle.

The other important lesson to take away from this is the fact that, when we reach the optimal point where efficiency is at its best, average and marginal costs are the same, as happened in the short run (see detailed graph below these lines). At this point, the slope of the tangent line, that is, the derivative, of the short run total cost (TC_SR) is equal to zero, which is consequent with the fact that we are operating at maximum efficiency. What we can also glean from the graph is the fact that TC_SRand TC_LRare tangent where short run average cost (AC_SR) and AC_LR also meet, which is not necessarily an optimum. In fact, the only time where these junctions do suppose an optimum is in case 2.

Nov 14

Lope Gallego

Short run cost analysis

In the short run, fixed costs include capital, K, whereas labour, L, is considered variable. Fixed costs are represented as a horizontal line and do not vary whatever level of production we achieve.

The two graphs show how the two phases pan out. In the first phase (I), variable costs (and therefore total costs, seeing as fixed costs are a constant) grow slower than growth at first, before reaching a point of inflection (II) and beginning to grow much faster than the output they are capable of generating.

This is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

If we translate this into average and marginal costs, an optimal level is reached along the stretch between which marginal costs are equal to average variable and fixed costs respectively. This coincides with the stretch just before costs begin to grow exponentially.

Nov 11

Lope Gallego

Eugen von Böhm-Bawerk

Eugen von Böhm-Bawerk Eugen von Böhm-Bawerk, 1851-1917, was an Austrian economic theorist, a public servant and Professor in different Austrian universities. He is considered to belong to the Neoclassical school of economics and was a leading figure inside the Austrian school. Böhm-Bawerk’s work had a great influence in other Austrian economists, such as Joseph Schumpeter and Ludwing von Mises.

His studies focus in the nature of capital and interest, and wrote a three-volume work, “Capital and Interest”, whose three volumes where entitled “History and Critique of Interest Theories”, 1884, “Positive Theory of Capital”, 1889 and “Further Essays on Capital and Interest”, published after his death, in 1921.

In his main theory he distinguishes between three different types of goods: first order goods, for final consumption. Second order goods, that are intermediate or capital goods. Third order goods, which are the goods in their original state. The relation between capital and goods is that capital allows goods to reduce their order, turning third order goods into first order goods. Regarding interest, he justified its existence with technical and subjective reasons, being the second ones where he provided new theories. He assumed people have a preference for present consumption over future and thus underestimate future goods.

Nov 10

Lope Gallego

Average and marginal cost

Average costs are those associated to one unit of production. Costs per unit grow quicker as production increases, so we find the arithmetic average as the sum of costs divided by the sum of production:

Av. fixed costs:		Av. variable costs:		Av. total costs:

Marginal costs are a very important concept in Economics because they show costs at a very specific point in time: they show the cost associated with producing one additional unit at any given production level.

They are the partial derivative of total or variable costs. This is an important point: because the partial derivative as respects quantity is zero for fixed costs (as these are independent of production levels), the partial derivative of variable and total costs is the same. Marginal costs, as any derivative, are tangent to total and variable cost curves at each point.

Nov 9

Lope Gallego

Fixed and variable costs

When analysing costs, the first thing to know is that there are fixed and variable costs:

Fixed costs: fixed costs cannot be altered in short run. They mainly include things like rent, repayments on technology, etc… which require time to change, and are often associated with indirect production costs (all that which is not a direct input). They do not depend on the level of production and cannot be adjusted accordingly.

Variable costs: variable costs depend on the level of production, and can include things such as direct inputs (raw materials) and contracted labour hours (not fixed salaries).

As seen in the graph, fixed costs are represented by a straight horizontal line, independent of quantity. Variable costs follow a curve as they grow slower than production at first (phase I) before reaching a point of inflection (II) and beginning to grow exponentially (phase III). Total costs are simply the sum of fixed and variable costs, as can be seen on the graph.

The way in which fixed and variable costs affect production is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

Nov 7

Lope Gallego

Nikolai Kondratiev

Nikolai D. Kondratiev Nikolai Dmitrievich Kondratiev, 1892-1938, was a Russian economist and founder and first director of The Institute of Conjecture between 1920 and 1928.

Kondradiev is mainly known for his studies on business cycles, specially for his major work “The Major Economic Cycles”, 1925. Kondratieff identified a long business cycle in capitalist economies with a duration of 50 to 60 years, the so-called Kondratiev cycle. He explained that they were due to re-investment cycles, of capital goods with a long lifetime.

Nov 7

Lope Gallego

Subadditivity

Subadditivity is an important concept because it is often used to justify imperfect competition, the classic nemesis of neo-classicists. The only real way to justify less than perfect competition is the kind of sector which lends itself to natural monopolies. Natural monopolies are those where barriers to entry are so high that it is worth making the investment only once, and where one producer will operate more efficiently than two. Traditionally, natural monopolies are state-run, generally in energy or communication sectors, although current trends are leaning towards privatisation.

When a large investment is required in order to begin production, these costs must naturally be passed on to the consumer. What differentiates natural monopolies is that generally, once the investment is made, marginal costs are infinitely small. In these cases, if there is only one company in the market, prices for consumers may actually be lower than if there are rivals, because of the way average costs drop with additional users.

So what exactly is the difference between subadditivity and economies of scale? Subadditivity is a more generic concept which encompasses economies of scale. We say subadditivity exists when:

That is, when the costs function (including initial investment) for the sum of all units at a given level of production is actually smaller than the sum of the various cost functions (given multiple companies) at the same given level. If we look at the diagram, we can see the traditional long run costs functions for two companies. We only consider economies of scale when additional units provide a lower average cost, but costs per unit begin to rise after a certain level. Subadditivity simply means that it is cheaper to produce the same production level when only company one is producing, and that the same production level is more expensive when company two joins the market.

This is why subadditivity is considered a necessary but insufficient conditionfor a natural monopoly to be considered optimal, whereas if economies of scale exist, this is a sufficient but not necessary condition for a natural monopoly to be sustainable. The cyan demand curve, within the economy of scale region, indicates a viable natural monopoly. The red line would indicate a non sustainable natural monopoly. The black line indicates the frontier of a profit generating monopoly (which would attract competitors) and the green line indicates a viable duopoly.