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C H A P T E R 1
What Is Industrial Organization?
What is industrial organization? It might help to start by clarifying the meaning of “indus- trial.” According to Webster’s New World Dictionary, “industry” refers to “manufacturing productive enterprises collectively, especially as distinguished from agriculture” (defi- nition 5a). “Industry” also means “any large-scale business activity,” such as the tourism industry, for example (definition 4b). This double meaning is a frequent source of confusion regarding the object of industrial organization. For our purpose, “industrial” should be interpreted in the sense of Webster’s definition 4b. That is, industrial organization applies equally well to the steel industry and to the tourism industry; as far as industrial organization is concerned, there is nothing special about manufacturing. Industrial organization is concerned with the workings of markets and industries, in particular the way firms compete with each other. The study of how markets operate, however, is the object of microeconomics; it has been said that “there is no such subject as industrial organization,” meaning that industrial organization is nothing but a chapter of microeconomics.^1 The main reason for considering industrial organization as a separate subject is its emphasis on the study of the firm strategies that are characteristic of market interaction: price competition, product positioning, advertising, research and development, and so forth. Moreover, whereas microeconomics typically focuses on the extreme cases of monopoly and perfect competition, industrial organization is concerned primarily with the intermediate case of oligopoly, that is, competition between a few firms (more than one, as in monopoly, but not as many as in competitive markets). For the preceding reasons, a more appropriate definition of the field would be something like “economics of imperfect competition.” But the term “industrial organization” was adopted and we are not going to change it.
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1.1 AN EXAMPLE
Examples are often better than definitions. In this section, we examine the case of a pharmaceutical firm, Glaxo Wellcome. This example touches on a number of issues of interest to industrial organization. It thus provides a useful introduction to the next section, where we look in a more systematic way at the main questions addressed by industrial organization. Zantac, the well-known ulcer and heartburn medicine produced by Glaxo Well- come, is the largest-selling prescription drug in the world, with sales of $1.6 billion. It costs relatively little to produce Zantac. However, the drug is sold at a very high price— that is, the price margin set by Glaxo Wellcome is very high. Why? An obvious answer is that the seller wants to maximize profits and is able to do so by increasing price. This begs a second question: Why is Glaxo Wellcome able to increase prices without losing a significant number of customers? One possible answer is that there are relatively few substitutes for Zantac. In other words, Glaxo Wellcome has a significant degree of market power in its therapeutical area (ulcers). If Glaxo Wellcome’s Zantac is so successful, why have other firms not imitated it? In part, because Glaxo Wellcome holds a number of patents that protect its blockbuster drug—or better, used to hold. As the following news item suggests, the years of Zantac’s exclusivity have gradually come to an end.
Novopharm has won permission from the U.S. Federal Court of Appeals to market a generic version of Glaxo Wellcome’s ulcer drug Zantac. The court ruled against Glaxo Wellcome’s claim that Novopharm’s drug infringes its patent rights. Glaxo Wellcome is fighting seven other cases against generic versions of Zantac.^2
A generic is a chemically equivalent drug that is sold under the generic chemical name (ranitidine, in the case of Zantac) rather than under the brand name. Notwith- standing innumerous claims that generic Zantac has the same effect as branded Zantac, the latter still manages to command a large market share while selling at a much higher price. In July 1999, RxUSA, a discount drug seller, was quoting a 30-tablet box of 300- mg Zantac at $85.95. For a little more than that, $95, one could buy a 250-tablet box of 300-mg generic Zantac (ranitidine)—that is, for 7.5 times less per tablet. Zantac, moreover, is not the only drug in its therapeutical area; there are several alternatives to Zantac, such as SmithKline’s Tagamet. Reviews of clinical trials indicate that there is little difference in the success rates of one drug over the others; in other words, one drug can easily be substituted for any of the others. Why then isn’t price competition more intense? The following quote offers a possible answer.
BELLYACHE BATTLES. We knew that the battle for your bellyaches would be big, but we had no idea it would be so bloody. Hundreds of millions of dollars are being poured into
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1.2 CENTRAL QUESTIONS
The example in the previous section suggests a number of issues, all centered around the notion of market power. In this section, we attempt to formulate the object of industrial organization in a more systematic way. One can say that the goal of industrial organization is to address the following four questions: (1) Is there market power? (2) How do firms acquire and maintain market power? (3) What are the implications of market power? (4) Is there a role for public policy regarding market power? Because all of these questions revolve around the notion of market power, it may be useful to make this notion more precise. Market power may be defined as the ability to set prices above cost, specifically above incremental or marginal cost, that is, the cost of producing one extra unit.a^ So, for example, if Glaxo Wellcome spends $10 to produce
a (^) A rigorous definition of marginal cost and other cost concepts is given in chapter 2. If costs are proportional to output, then marginal cost is equal to unit cost.
a box of Zantac and sells it for $50, then we say that it commands a substantial degree of market power.
Is There Market Power?
Understandably, this is an important question, in fact, a crucial one. If there is no market power, then there is little point in the study of industrial organization. Over the years, many empirical studies have attempted to measure the extent of market power. Assuming that costs are proportional to output, a good approximation of the extent of market power can be obtained from data on prices, output, and profit rates.b^ One famous study along these lines found that the extent of market power in
b (^) The profit rate is given by revenues minus cost divided by costs: r = ( R − C )/ C. If costs are proportional to output, then costs are given by unit cost times output, UC · Q ( Q is output), whereas revenues are given by R = P · Q ( P is price). It follows that r = ( P − UC )/ UC , so r is a good measure of the gap between price and unit cost (which in this case is also equal to marginal cost).
the American economy is very low, a conclusion that follows from observing relatively low profit rates.^5 This finding is consistent with one of the central tenets of the Chicago school: As long as there is free entry into each industry, the extent of market power is never significant. If a firm were to persistently set prices above cost, a new firm would find it profitable to enter the market and undercut the incumbent. Therefore, market power cannot persist, the argument goes.c
c (^) The theory of contestable markets formalizes this argument.^6
Not every economist agrees with this view, either at a theoretical or at an empirical level. From an empirical point of view, an alternative approximation to the value of marginal cost is obtained by dividing the increase in cost from year t to year t + 1 by the increase in output in the same period. Based on this approach, a study estimates that prices may be as much as three times higher than marginal cost.^7 Evidence from particular industries also suggests that the extent of market power may be significant. Take, for example, the U.S. airline industry. A 1996 U.S. government report analyzed average fares in 43 large airports. In ten of these airports, one or a few airlines hold a tight control over takeoff and landing slots. The report found that, on average, fliers were paying 31% more at these airports than at the remaining 33 airports.^8 In other words, the report provides evidence that airlines that manage to control the critical asset of airport access hold a significant degree of market power. More recently, in response to a proposed merger between Staples and Office Depot, the Federal Trade Commission examined prices of office supplies in areas with one, two, or more competing
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superstores. In areas where only one chain operates, the study concludes, prices can be up to 15% higher than in other areas. Further examples could be supplied. These would not necessarily be representative of what takes place in every market. To be sure, in a large number of industries, firms hold little or no market power (see chapter 6). The point is that there are some industries where market power exists to a significant extent.
How Do Firms Acquire and Maintain Market Power?
Market power translates into higher profits. Creating and maintaining market power is therefore an important part of a firm’s value-maximization strategy. How do firms acquire market power? One way is through legal protection from competition, so that high prices can be set without new competitors entering the market. For example, in the 1960s, Xerox developed the technology of plain-paper photocopying and patented it. Given the legal protection provided by Xerox’s patents, it could raise prices to a significant level without attracting competition (see box 16.1). Firm strategy may also play an important role in establishing market power. Take, for example, the case of the British Sky Broadcasting Group (BSkyB). BSkyB, which broadcasts by satellite, is one of the contenders for the British digital TV market. Its competitors include ONdigital, which is based on terrestrial broadcasting, and a con- sortium of cable operators. In May 1999, BSkyB introduced an aggressive package that includes a free set-top decoder box, free Internet access, and a 40% discount on tele- phone charges.^9 The idea of BSkyB’s marketing plan is to preempt its rivals by creating an early lead in installed base of subscribers, a lead that eventually will give BSkyB a persistent advantage over the competition. In fact, following the announcement of the new package, BSkyB’s shares were up by 12%, whereas ONdigital’s slid by 1.8%. Still, there is concern that BSkyB’s move may trigger a price war that could hurt the profits of every firm in the industry. In fact, ONdigital reacted by saying it also will provide free set-top boxes. Creating market power is only one part of the story. A successful firm also must be able to maintain market power. Patents expire. Imitation takes place. Protected industries are deregulated. What can incumbents do to maintain their position? The airline industry provides an example. In 1998, Japan deregulated its airline industry. Skymark Airlines and Air Do entered a market that, for 35 years, was dominated by incumbents Japan Airlines (JAL) and All Nippon Airlines (ANA). The latter have responded to this entry by engaging in an aggressive price war—to the delight of consumers. But the incumbents’ response goes beyond this. ANA and JAL carry out maintenance of the upstarts’ planes, for there are no independent servicing companies in Japan. There is a fear that ANA and JAL will refuse to service additional planes introduced by Skymark and Air Do and that, eventually, the industry will return to its old ways—high fares and high profits.^10 In the United States, American Airlines is fighting a court battle over alleged predatory pricing against entrants into its Dallas/Forth Worth hub. American did manage to drive out three competitors: Vanguard, Sun Jet, and Western Pacific. Fares on the route
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the following news article regarding AT&T’s effort to maintain its position in the cable television market:
This summer, AT&T Corp. faced the specter of cities around the country requiring it to open its cable television lines to rival Internet companies.... The threat never really materialized. Why not? It depends on whom you ask. AT&T attributes its success to its ability to explain the issues to local officials... [Others have a different opinion:] “It comes down to bribery or threats,” says Greg Simon, co-director of Opennet Coalition, a group of companies that has launched its own lobbying effort to promote open access.^13
Another example of large amounts of resources spent in attempting to influence decision makers is the recent Microsoft case. Netscape, Sun Microsystems, and Microsoft itself would not have spent the vast amounts that they did if the operating system industry were not as profitable as it is—thus the idea that rent seeking is a consequence of market power. The preceding discussion supports the view that market power, good as it might be for firms, is bad for society. First, it makes firms richer at the expense of consumers. Second, it decreases economic efficiency (allocative and productive efficiency). Third, it induces firms to waste resources to achieve and maintain market power. However, from a dynamic point of view, an argument can be made in favor of market power:
As soon as we go into the details and inquire into the individual items in which progress was most conspicuous, the trail leads not to the doors of those firms that work under conditions of comparatively free competition but precisely to the doors of the large concerns.^14
This argument is one of the central points of the Austrian school, led by its greatest exponent, J. Schumpeter, author of the preceding quotation. It is examined in greater detail in chapter 16. Like the Chicago school, the Austrian school is quite radical when it comes to market power. However, whereas a Chicago economist would argue that market power does not exist, a Schumpeterian would rather say that market power exists—and it’s a good thing that it does, for market power is a precondition for technical progress.
Is There a Role for Public Policy Regarding Market Power?
In the context of industrial organization, the primary role of public policy is to avoid the negative consequences of market power. Public policy in this area can be broadly divided into two categories: regulation and antitrust (or competition policy).g^ Regulation refers gmore common in the United States,^ The terminology “antitrust” is
whereas “competition policy” is the corresponding European term.
to the case in which a firm detains monopoly or near-monopoly power, and its actions (e.g., the price it sets) are directly under a regulator’s oversight. For example, until 1996,
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AT&T needed regulatory approval each time it changed its long-distance telephone rates. Antitrust policy (or competition policy) is a much broader field. The idea is to prevent firms from taking actions that increase market power in a detrimental way. A couple of examples may help.
In May 1999, shareholders of Exxon Corp. and Mobil Corp. overwhelmingly approved the plan to merge the two companies. Lee Raymond and Lucio Noto, the two chairmen and chief executives, claim that size and market power are not the motivation for the merger, rather it’s the cost savings that will be achieved—$2.8 billion annually, they estimate.^15 “If anybody thinks that this company will have monopolistic power in this environment, when we have less than 4% of world production and 11% of world sales, they are dreaming,” says Mr. Noto. U.S. antitrust regulators don’t seem to share the same opinion. They are expected to require Exxon and Mobil to divest some refineries and retail outlets, especially in areas where the two companies hold a greater market share. On the other side of the pond, U.K.’s Office of Fair Trading (OFT), one of Britain’s competition watchdogs, has recently examined the actions taken by The Times news- paper. Over a period of six or seven years, The Times followed very aggressive pricing strategies that nearly drove some of its rivals to bankruptcy. Although the “victims”— The Independent , The Daily Telegraph , and The Guardian —survived the alleged predatory attacks, The Times’ market share increased significantly. The OFT decided not to impose any penalty, as there was insufficient evidence of intent to drive rivals out of the market. However, it mandated The Times to inform the OFT of future plans to reduce prices, and to justify the rationale for such price cuts.
The previous two examples provide an idea of the variety of situations that may fall under the scope of public policy. The overall rationale is to prevent and remedy situations where market power may reach unreasonable levels, to the detriment of society—consumers in particular. Over the course of the next chapters, we examine several other areas for policy intervention motivated by the goal of curbing market power. As was stated before, the Chicago school takes a very different approach. The claim is that, in a world of free competition, market power is never very significant. In fact, the few situations where market power does exist result precisely from government inter- vention. In other words, the Chicago school reverses the order of causation: It’s not that market power prompts government intervention but the exact opposite—government intervention creates market power, protecting the interests of firms and not those of con- sumers. As Milton Friedman, a leader of the Chicago school, stated:
Because we all believed in competition 50 years ago, we were generally in favor of antitrust. We’ve gradually come to the conclusion that, on the whole, it does more harm than good. [Antitrust laws] tend to become prey to the special interests. Right now, who is promoting the Microsoft case? It is their competitors, Sun Microsystems and Netscape.^16
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beyond the simple pricing and output decisions examined in part three. These include price discrimination (chapter 10), vertical relations (chapter 11), product differentiation (chapter 12), and advertising (chapter 13). Throughout most of the text, we assume a given industry structure. Part five takes one step back and looks at the endogenous determinants of industry structure. We begin by looking at how technology and demand conditions influence market structure (chapter 14), and then move on to examine the role played by firm strategy (chapter 15). Part six concludes the text by focusing on technology-intensive industries. In chapter 16, we study how firms compete in research and development (R&D) and how this influences market structure. In chapter 17, we examine industries where networks and standards play an important role.
A Note on Methodology Most economists analyze industries with reference to a framework known as the structure-conduct-performance (SCP) paradigm.^18 First, one looks at the aspects that characterize market structure: the number of buyers and sellers, the degree of product differentiation, and so forth. Second, one pays attention to the typical conduct of firms in the industry: pricing, product positioning and advertising, and so forth. Finally, one attempts to estimate how competitive and efficient the industry is. Underlying this system is the belief that there is a causal chain between the preceding different components: Market structure determines firm conduct, which in turn determines industry and firm performance. For example, in an industry with very few competitors, each firm is more likely to increase prices or collude with its rivals. And higher prices have the performance implications discussed in the previous section. Causality also works in the reverse direction. For example, a firm that does not perform well exits the market, so performance influences market structure. Likewise, a firm may price very low to drive a rival out of the market, an instance where conduct influences structure. Finally, government intervention and basic demand and supply conditions also influence the different components of the SCP paradigm. In chapters 9 and 14, we look at the relation between the different components in the structure-conduct-performance paradigm. However, most of the text centers on the analysis of firm conduct and how it influences firm and industry performance as well as market structure.h
h (^) It should be clear that the SCP paradigm is not a model that directly provides answers to the questions listed previously. It is best thought of as a guide that allows one to analyze and understand the workings of different industries. Alternative frameworks have been proposed for the same or similar purposes. Examples include Michael Porter’s five-forces framework for the analysis of industry competition. The five forces are suppliers, buyers, substitute products, potential entrants, and competition between incumbent firms.^19
Summary
. (^) Industrial organization is concerned with the workings of markets and industries, in particular, the way firms compete with each other.
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. (^) Specifically, the central questions addressed by industrial organization are (1) Is there
market power? (2) How do firms acquire and maintain market power? (3) What are the implications of market power? (4) Is there a role for public policy as regards market power?
Key Concepts
. (^) market power . (^) efficiency . (^) regulation . (^) rent seeking . (^) antitrust and competition policy . (^) industrial policy . (^) Chicago school . (^) Austrian school . (^) structure-conduct-performance paradigm
Review and Practice Exercise
1.1 ∗^ Empirical evidence from a sample of more than 600 U.K. firms indicates that, when controlling for the quantity of inputs (i.e., taking into account the quantity of inputs), firm output is increasing in the number of competitors and is decreasing in market share and industry concentration.^20 How do these results relate to the ideas presented in the chapter?
