MASTER IN MANAGEMENT AND INDUSTRIAL STRATEGY

Industrial Organization

Cap. I - Scope and Concepts

2023/24

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I. Scope and Concepts

I. Scope and concepts

1. Object and associated concepts

2. Industrial Organization approaches
3. Costs and income sources

II. Firms and Market Structure

III. Strategic analysis of the firm

IV. Enterprises, markets and Public Policies

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 I. Scope and Concepts

1. Scope and associated concepts

1.1. Definitions
1.2. Object of Industrial Organization
1.3. Typology of market structures

2. Industrial Organization approaches

2.1. S-C-P Paradigm
2.2. Criticism of SCP approach
2.3. Other approaches and policy trends

3. Costs and income sources

3.1. Typology of costs and scale efficiency
3.2. Typology of returns and sales efficiency
3.3. Alternative sources of increasing returns

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 1. Scope
I. Scope and Concepts 2. Approaches
3. Costs / Efficiency

1. Scope and Associated Concepts

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 Industrial Organization versus 1. Scope
2. Approaches
Economics 3. Costs / Efficiency
Object and Designations
 Designations (more frequent)
- Industrial Economics
- Industrial Organization
 Relativization of the "industrial" field:
- Comes from "industry", economic activity producing goods and services
- Set of agents producing and selling a good or service in a given market
 Object of study:
- Markets, systems, sectors and firms
- Structures, behaviors/conducts, performances and their interactions
 More appropriate designations:
- “Market Economics (Organization)”
- “Non perfect Markets (Organization)”
 Emphasis:
1. Positive: What is (diagnostic basis) - scientist attitude
2. Normative: What must be (public policy basis) - political attitude

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 1. Scope
Industrial Organization 2. Approaches
Definitions 3. Costs / Efficiency

1. The study of oligopoly theory, concentration, barriers to entry, pricing policy,

product differentiation, innovation, vertical integration, diversification,
competition policy and regulation (Lipczinsky, Wilson, Goddard)
2. The study of market structures situated between perfect competition and
monopoly, in addition to government policies to improve the efficiency of the
functioning of markets (Luis Cabral)
3. Study of how companies and markets are organized and their interactions
(Carlton and Perloff)

4. Field of economics that studies the functioning of markets and economic

activities (industries) in a given institutional, legal and business environment
(Andreosso and Jacobson)
5. Science that seeks to explain how markets are organized, why they are organized
in a certain way and what effects on performance caused by this form of
organization (Clarkson and Miller) as well as how they should be organized and
the policies to influence this organization

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 1. Scope
2. Approaches
Firm and its aggregates 3. Costs / Efficiency

 Firm: microstructure or microeconomic organization that represents the

decision cell, that assures the production and sale in the market
 Aggregates of companies:
• Market:
o set of sellers / buyers who organize transactions of a given product
(Pricing and Market Power).
o any situation in which buyers (demand) and sellers (offer) of a
particular good or service accept the price and quantity to be traded.
• Sector: set of agents (producers / sellers) who produce or offer a good or
service with a certain degree of homogeneity.
• Dynamic Aggregate: associates companies from one market / sector with
other entities (Universities, technological structures, etc.), assuming various
designations (Cluster, Industrial District, Network, etc.), fostering
agglomeration economies

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 1. Scope
Typologies of Market Structures 2. Approaches
3. Costs / Efficiency

 Associated directly with market organization

– Number and dispersion of companies (Horizontal concentration)
– Business mobility: barriers to entry and exit
– Costs and technological determinants
– Differentiation of products and consumer preferences
– Cost and Financial Structures
– Other type of concentration: Vertical and conglomerates
 Associated with rivalry and the competitive environment

─ Perfect competition: extensive diversity of producers (and buyers) and

lack of effective market power
─ Non perfect competition: monopoly, oligopoly and monopolistic
competition (on the supply side); monopsonies in the demand side

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 1. Scope
Perfect Competition 2. Approaches
3. Costs / Efficiency
(Perfect Competitive Industry)
 Pure and Perfect Competition is characterized by the following assumptions:
a. Market atomicity, i.e., the existence of a multitude of sellers and buyers who decide
independently, without each being able to affect the price level or the global quantity
traded.
b. Homogeneity of the product in which all companies on the market produce the same
good.
c. Transparency of the market, having all buyers and sellers a perfect knowledge of all
significant market information.
d. Perfect mobility of production factors from industry to industry, with free entry into the
industry, i.e., any new unit wishing to enter the industry has the possibility to do so
without any restriction.
Conditions a), b) and (c) define Pure Competition, let’s say. Without any element of
monopoly, all these conditions characterize Perfect Competition.

 Equilibrium
• Maximum quantities traded at minimum competitive price
• Normal profit: price tends towards marginal cost
• Otherwise (issue of inefficiency), the firm exits the market

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 1. Scope
Perfect Competition 2. Approaches
3. Costs / Efficiency
Real Situation
 Features
• There is (almost) always a small number of large companies
• Some companies have enough Market Power to influence their price
• There is (usually) product differentiation
• Some (or all) companies tend towards an abnormal profit on long-term
• Information is imperfect (asymmetric)
• Sales are conditioned by the competitive capacity of companies
• Market Power (or Monopoly Power): ability to influence supply conditions
(not just price) and sometimes, demand

 Efficiency
• Consumer preference and technology determine the most efficient
organization on the market
• Companies grow and exploit economies of scale and average costs fall
• Cost reduction can be passed to the consumer through lower prices

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 1. Scope
2. Approaches
Non-Perfect Markets 3. Costs / Efficiency
Structures

 Monopoly: one firm

 Oligopoly: two or more companies that recognize interdependence and their
strategies affect the price and profit of the rest
 Monopolistic Competition:
• Differentiated goods (monopoly) are produced, but close substitutes are
available
• There are many companies on the market, but they offer products or
services that are not fully homogeneous and therefore not entirely
replaceable

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 1. Scope
2. Approaches
Non-Perfect Markets / Competition 3. Costs / Efficiency
Dynamic and evolutionist approach of markets

 Austrian School
• Dynamic view of the market (refuses the static view of markets)
• The company having an abnormal price has no evidence of abuse of
market power
• The Monopolist’s profit can be channeled into technological evolution
and innovation (Schumpeter)
 Contestable Markets
• Determinants: technology and consumer preference
• Efficiency determines several acceptable solutions of market
structures

• What is important to ensure is the contestability, i.e., the

competitiveness and the access to the markets

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 1. Scope
I. Scope and Concepts 2. Approaches
3. Costs / Efficiency

2. Industrial Organization Approaches

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 1. Scope
IO Evolution 2. Approaches
3. Costs / Efficiency

• The first years / Classic Approach:

– Empirical approach (market structure, effects of concentration and market power) and more
normative (antitrust policy)
– Some pioneers:
– Alfred Marshall (1842-1924) initiates "industrial" studies and normative action
– Edward Mason (1899 – 1992) e Joe Bain (1912-1991) create the S-C-P model
• Marginalist/Neoclassical approach:
– Theoretical approaches (models) and more positive (opposite to normative)
– Some pioneers:
– Antoine August Cournot / (1801-1887) e Joseph Bertrand / 1822-1900 (Duopoly)
– Edward Chamberlin: / 1899-1967 (The Theory of Monopolistic Competition, 1933)
– Joan Robinson / 1903-1983 (The Economics of Imperfect Competition, 1933)
• Consolidation period:
– Mixed and broader approaches of a systemic, empirical and conceptual nature
– Interactions with other sciences such as management (organization, investment, innovation)
and law (contracts, property rights, regulation, institutional analysis)
– Frederic Scherer, William Baumol, John Clark, Ronald Coase, Oliver Williamson, Alexis
Jacquemin, Yves Morvan, Joseph Schumpeter, Jean Tirole, Jefrey Perloff

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 Relationship between S-C-P 1. Scope
The Trichotomic Paradigm or Methodological 2. Approaches
3. Costs / Efficiency
Trichotomy

 Backbone of the Industrial Economy, assumed the existence of a

predominantly unidirectional linear relationship of the type:

Structure Conduct Performance

 Evolution:
o Progressively adopted a more multi-directional view
o Feed-back admission between different levels of the model
o Integrated other factors / explanatory levels

 Utility:
o It is consistent with neoclassical theory, not denying, but completing (Mason)
o Reduces model to major categories (Joe Bain)
o Accepts the notion of workable competition (John Clark)

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 1. Scope
Relationship between S x C x P 2. Approaches
3. Costs / Efficiency

Basis Conditions
S/D, Resources &
Technology

Structure
Rivalry (current and Public Policy
Static and Dynamic
potential) Analysis Competition Policy,
Perfect Competition Regulation,
Macroeconomic Policy,
Oligopoly Conduct investment incentives,
Monopoly Strategies and Market and so on
Power

Performance
Static and Dynamic
Efficiency

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 1. Scope
Relationship among Structures, Conduct 2. Approaches
3. Costs / Efficiency
and Performance

 BASE CONDITIONS / LEVEL OF COMPETITION: raw materials, technology, products,

price elasticity, substitutes, working conditions, growth rate, buy and sell, market size, etc.
 CONTESTABILITY: Competition, Monopoly, Oligopoly and Monopolistic Competition
 STRUCTURE: number of sellers and buyers, barriers to entry and exit, cost structure,
Product differentiation

 CONDUCT / STRATEGIES: pricing policy, vertical integration, diversification, product policy,

investment policy, R&D and innovation policy

 RESULTS / PERFORMANCES
• Aggregate effectiveness: Competitiveness, Production, Allocation of Resources,
Technical Progress, Employment, Income Redistribution
• Business Effectiveness: Competitiveness, Productivity, Quality, Unit Costs, Income
 PUBLIC POLICIES

o Market intervention: Regulation and Competition

o Structural: sectorial/vertical, specialization upgrading, horizontal

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 1. Scope
SCP Criticism 2. Approaches
3. Costs / Efficiency

 Criticisms of previous IO approaches:

¾ Theoretical limits of microeconomics in understanding and applying the
relationships between S-C-P (simple S->C->P)
¾ Difficulty in deciding the allocation of variables in S-C-P
¾ Complexity of performance analysis (different objectives)
¾ Focus the Structure on concentration (easier) and Strategies in prices
¾ Static model (does not consider changes in variables)

 Greater analytical rigor but greater abstraction

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 1. Scope
The market engine 2. Approaches
3. Costs / Efficiency

Performan
ce Business
Environment

Structures
Strategies

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 1. Scope
Other Approaches (dynamic) 2. Approaches
3. Costs / Efficiency

 Institutionalist approach
• Associated with Firm Theory.
• Precursor: Ronald Coase (1930s) transaction costs.
• More recent developments featured by Oliver Williamson.
• Transaction cost: incurred when using market mechanisms to affect resources, in
imperfect competition, resulting from the acquisition of information, negotiation,
monitoring or application of contracts.

 Evolutionary perspective
• Darwin inspiration: analogy between economic system and biological systems in
which selection (and cooperation) mechanisms lead to evolution
• Herbert Simon: defense of "limited rationality" in the processing of information,
involving uncertainty (decisions are not optimal, they are satisfactory)
• Joseph Schumpeter: consideration of innovation in the economic system, leading to
"creative destruction"
• William Baumol, John Panzar and Robert Willig: theory of "contestable markets"
based on technology and consumer preference and maximizing efficiency (of sales)
and accessibility to markets
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 1. Scope
The Normative Dimension 2. Approaches
3. Costs / Efficiency

 Integration of new developments in the microeconomy:

¾ Asymmetric information
¾ Uncertainty
¾ R&D and innovation
¾ Product differentiation
¾ Game theory
¾ Transaction costs

 Policy Trends:
• Compensation for market failures and systemic failures
• Improving the competitive environment to stimulate efficiency
• Reduction of barriers to mobility; stimulating resource mobility
• Regulatory adjustment (environment)

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 1. Scope
I. Scope and Concepts 2. Approaches
3. Costs / Efficiency

3. Costs and Income Sources

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 1. Scope
Relações de eficiência e tipologia de 2. Approaches
Custos
3. Costs / Efficiency

 Cost level and fixed and variable behavior of functions

¾ Total, average and marginal costs
¾ Short-Term (fixed and variable) and Long-Term (variable) costs
¾ Recoverable fixed costs (avoidable cost) and unrecoverable (sunk cost)

 Return and Cost Efficiency

¾ Total, average and marginal revenues
¾ Productivity/profitability
¾ Efficiency ratio (Fixed and variable costs and Break-Even Point)
¾ Economies of Scale (Evolution of cost-scale ratio)

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 1. Scope
Fixed Cost x Variable Cost versus Results 2. Approaches
3. Costs / Efficiency

€ S
TC Break Even Point:
+π (S x FC) / (S - VC)
VC

Economic Safety Margin:

ESM1 = (S - BEP) / BEP

ESM2 = (S - BEP) / S
-π
FC
BEP = Break Even Point
S = Sales
FC = Fixed Costs
0 BEP q VC – Variable Cost
ESM = Economic Security Margin
Π = Profit

BEP = Fixed Costs / Contribution Margin (as a % of Sales) 24

Contribution Margin = Sales - Variable Costs
 1. Scope
Fixed Cost x Variable Cost versus Results 2. Approaches
3. Costs / Efficiency

Sales Variable Costs BEP ESM/BEP ESM/S

Fixed Costs
Average
Quant. Price Value Average VC Total VC

250 856 214.000 43.077 645 161.250 174.758 22% 18%

165 856 141.240 43.077 645 106425 174.758 -19% -24%

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 1. Scope
Average Cost versus Marginal Cost 2. Approaches
3. Costs / Efficiency

Average Total Cost

TC (q) €
ATC (q) =
q
Average Variable Cost
MC AC
VC (q)
AVC (q) =
AVC
q
Average Fixed Cost

FC
AFC (q) =
AFC
q
Marginal Cost q
∆ TC (q) or ∆ VC (q)
MC (q) =
ATC = AVC + AFC
∆q
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 1. Scope
2. Approaches
Cost Curves Long and Short Run 3. Costs / Efficiency

AC LR

AC SR

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 1. Scope
Incomes and economies of scale 2. Approaches
3. Costs / Efficiency

 In the short term it makes sense to think that there is a predetermined set of
production factors that are fixed. In this context, firms analyze the possibility of
maximizing their profits by acquiring additional amounts of a variable input to
produce more of their products.
This analysis perspective brings up the concepts of marginal cost and income.

 In the long run there are no fixed factors; all inputs can be variable and
adjustable. The analysis is now focused on the effects on the performance of
the company resulting from a simultaneous variation of all productive factors.

This perspective points out the importance of the economies of scale (when
there is only one output).

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 1. Scope
Average Cost and Marginal Cost versus 2. Approaches
Economies of Scale 3. Costs / Efficiency

Economy of Scale MC
Wing
AC

Diseconomy of Scale
Wing

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 1. Scope
Monoproduction Laws of Returns 2. Approaches
3. Costs / Efficiency

 CLASSICS:
o Increasing incomes: Adam Smith, 1723-1790 (“An investigation into the
nature and cause of wealth of nations”, 1776)
o Decreasing incomes: David Ricardo, 1772-1823 (“Principles of Political
Economy and Taxation”, 1817, 19 and 21)

 NEOCLASSICS: non-proportional incomes

>
f [ (  (y1, y2, .... , yn) ) ] = q
<

 The notion of physical performance is linked to the production function,

expressing the effect of the variation of factors on the volume of production,
being measured in quantities.
 The notion of economies of scale is linked to the cost function, expressing the
same effect, but measured in terms of values

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 1. Scope
Demonstration of economies of scale 2. Approaches
3. Costs / Efficiency

 Demonstration of economies of scale: economies of scale are verified

when the Scale (production in the unit of time) grows more proportionally
than the costs (operating or investment)

 Sources of economies of scale: economies of increased size, effect of

minimum nominal scale balances, labor division and specialization,
standardization and serial production or advanced management
techniques

 Sources of diseconomies of scale: technical reasons related to

technology, organizational and management factors, causes related to
labor relations or issues on sales and distribution

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 1. Scope
Economies of Scale measures 2. Approaches
3. Costs / Efficiency

- Comparison between average cost and marginal cost

S = AC/MC EoS when S > 1
- Comparison between unit or average costs
S = AC2/AC1 There is EoS when S < 1 (with Q2 > Q1)
- Technical relationship between the evolution of costs and production
quantities ("S" ="Scale Factor")

S = Ln (C1/C0) / Ln (Q1/Q0)

– economies of scale, when S<1;

– diseconomies of scale, when S>1; and
MARGINAL COST is always inferior than the – neither economies nor diseconomies of scale if
AVERAGE COST in case of EoS S=1

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 Minimum Efficient Size (MES) 1. Scope
2. Approaches
ATC and AVC variation 3. Costs / Efficiency

 In the neoclassical formulation, the value of the MES would be that of the
productive capacity corresponding to the ‘beginning’ of the (lower) level of
that curve (the beginning of constant returns to scale area).
€

Increasing Decreasing
returns Constant returns
returns

MES q

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 1. Scope
Other sources of rising incomes or the notion of
2. Approaches
Global Economies" 3. Costs / Efficiency

 Other manifestation of economies

o Scope Economies (variety)
o Learning Economies
o Organizational Economies
o Agglomeration Economies
o Network Economies

 In a global effect, it’s very difficult to distinguish economies from

one another

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