Industrial Organization

.Industrial Organization

Competition, Strategy, Policy 2nd Edition

An imprint ofwww.pearson-books.com

Lipczynski

Wilson

Goddard

Dr John Lipczynski is Principal Lecturer in the Department of Business and Service SectorManagement at London Metropolitan University, specializing in microeconomics and industrialeconomics.

Professor John Wilson is in the School of Management at the University of St Andrews,specializing in industrial organization and banking.

Professor John Goddard is in the School of Business and Regional Development at the Universityof Wales, Bangor, specializing in financial economics, industrial economics and the economics ofprofessional sports.

Key Features:

Written from a European perspective, with anemphasis on European businesses and industries.

A wealth of case studies and examples bring thesubject to life with vivid and entertaining stories ofreal world applications. Leading UK, European andUS businesses are covered, including Microsoft,eBay, BSkyB and English Premier League football.

Only a basic prior knowledge of economic theory atan introductory level is assumed.

Extensive coverage of current empirical researchthroughout the text, and an extensive bibliography,provide a springboard for students intending tostudy industrial organization at a higher level.

New To This Edition:

New chapters on pricing, auctions and product differentiationbring you up to date with the latest thinking.

Improved coverage of microeconomic foundations and thetheory of the firm provides a broader understanding of thesetopics.

Expanded coverage of seller concentration incorporatesgeographic concentration, specialization, horizontal integrationand industry clusters in Europe.

Fully updated chapter on market structure, firm strategy andperformance includes expanded coverage of current empiricalresearch in industrial organization.

New Mathematical Methods appendix provides derivations of important results, allowing technically minded students to develop their understanding, without compromising the non-technical style of the main text.

Praise from adopters of the first edition of this successful text:

my students have been happy with this textan admirablebook David Paton, Nottingham University, UK

nicely pitched at the intended audienceit covers the coursewonderfully Michael Wood, London South Bank University, UK

the written style is definitely student friendly, which I highlyappreciate Sophie Reboud, Burgundy School of Business, Dijon, France

A text that gets a consistently goodreaction from students, IndustrialOrganization: Competition, Strategy,Policy has a balance of content that isspot-on for courses taught in the UK andthe rest of Europe. It is specially writtenfor the growing number of studentsstudying industrial organization atintermediate to advanced undergraduatelevels on degree courses in economics,business and management.

Industrial Organization

John Lipczynski

John Wilson

John Goddard

Competition, Strategy, Policy 2nd Edition

www.pearson.co.uk/lipczynski

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IndustrialOrganization

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IndustrialOrganizationCompetition, Strategy, Policy

Second edition

John Lipczynski, John Wilson and John Goddard

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.Pearson Education LimitedEdinburgh GateHarlowEssex CM20 2JEEngland

and Associated Companies throughout the world

Visit us on the World Wide Web at:www.pearsoned.co.uk

First published 2001Second edition published 2005

Pearson Education Limited 2001, 2005

The rights of John Lipczynski, John Wilson and John Goddard to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording or otherwise, without either the prior written permission of thepublisher or a licence permitting restricted copying in the United Kingdom issued by theCopyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP.

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.For my family, Nicole, Sonya, Mark and Anna JL

For my daughters, Kathryn and Elizabeth JW

For my parents, Chris and Les JG

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.Preface xxiiiAcknowledgements xxvii

Part I: Theoretical Foundations

1 Industrial organization: an introduction 3

1.1 Introduction 31.2 Static and dynamic views of competition 41.3 The structureconductperformance paradigm 61.4 Strategic management: a short diversion 161.5 Structure of the book 19

Discussion questions 21Further reading 21

2 Microeconomic foundations 23

2.1 Introduction 242.2 Production and costs 242.3 Demand, revenue, elasticity and profit maximization 412.4 Theory of perfect competition and monopoly 512.5 Efficiency and welfare properties of perfect competition

and monopoly 562.6 Theory of monopolistic competition 622.7 Summary 65

Discussion questions 67

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Contents

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.3 Theories of the firm 693.1 Introduction 703.2 The neoclassical theory of the firm: historical development 713.3 Critique of the neoclassical theory of the firm 733.4 Separation of ownership from control: managerial theories

of the firm 763.5 The behavioural theory of the firm 883.6 The Coasian firm and the transaction costs approach 903.7 Other approaches to the theory of the firm 993.8 Strategic and knowledge-based theories of the firm 1033.9 Summary 108


Part II: Structural Analysis of Industry

4 Oligopoly: non-collusive models 1154.1 Introduction 1164.2 Interdependence, conjectural variation, independent action

and collusion 1174.3 Models of output determination in duopoly 1204.4 Models of price determination in duopoly 1334.5 The kinked demand curve and models of price leadership 1384.6 Game theory 1444.7 Summary 157


5 Oligopoly: collusive models 1615.1 Introduction 1615.2 Collusive action and collusive forms 1625.3 Collusive institutions 1665.4 Economic models of price and output determination

for a cartel 1735.5 Other motives for collusion 1805.6 Factors conducive to cartel formation 1835.7 Influences on cartel stability 1895.8 Summary 202


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.6 Concentration: measurement and trends 205

6.1 Introduction 2056.2 Market and industry definition 2066.3 Official schemes for industry classification 2106.4 Measures of concentration 2116.5 Interpretation of concentration measures 2286.6 Trends in concentration and the location of industry 2306.7 Summary 241


7 Determinants of seller concentration 245

7.1 Introduction 2457.2 Seller concentration: systematic determinants 2467.3 Horizontal mergers: theoretical motives 2587.4 Horizontal mergers: some empirical evidence 2627.5 The random growth hypothesis 2647.6 Summary 273


8 Barriers to entry 277

8.1 Introduction 2778.2 Classification of barriers to entry 2798.3 Structural barriers to entry 2798.4 Entry-deterring strategies 2868.5 Potential entry and contestability 3068.6 Entry and industry evolution 3088.7 Empirical evidence on entry 3098.8 Summary 313


9 Market structure, firm strategy and performance 317

9.1 Introduction 3179.2 Empirical tests of the SCP paradigm 3189.3 Strategic groups 3269.4 Sources of variation in profitability: industry, corporate and

business unit effects 3289.5 The new empirical industrial organization (NEIO) 332

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.9.6 The persistence of profit 3419.7 Summary 346


Part III: Analysis of Firm Strategy

10 Pricing 35310.1 Introduction 35310.2 Cost plus pricing 35410.3 Price discrimination 35710.4 Peak-load pricing 37110.5 Transfer pricing 37410.6 Summary 382


11 Auctions 38711.1 Introduction 38711.2 Auction formats, and models of bidders valuations 38911.3 The pure common value model and the winners curse 39011.4 Optimal bidding strategies and revenue equivalence in

the independent private values model 39411.5 Extensions and additional topics in auction theory 40111.6 Empirical evidence 40611.7 Summary 412


12 Product differentiation 41512.1 Introduction 41512.2 Types of product differentiation 41612.3 Monopolistic competition revisited: the socially optimal

amount of product differentiation 42012.4 Lancasters product characteristics model 42212.5 Hotellings location model 43212.6 Salops location model 44612.7 Summary 449


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.13 Advertising 45313.1 Introduction 45313.2 Determinants of advertising expenditure 45613.3 Advertising and product characteristics 46613.4 Advertising and profit maximization 46813.5 Advertising as a barrier to entry 47313.6 Advertising, information search and quality signalling 47513.7 Is there too much advertising? 47913.8 Empirical evidence 48213.9 Summary 490


14 Research and development 49314.1 Introduction 49314.2 Market structure, firm size and the pace of

technological change 49414.3 Investment in research and development 50914.4 Diffusion 51514.5 Patents 52714.6 Empirical evidence 53314.7 Summary 540


15 Vertical integration and restraints 54515.1 Introduction 54515.2 Motives for vertical integration: enhancement of

market power 54615.3 Motives for vertical integration: cost savings 55315.4 Vertical integration: some empirical evidence 56215.5 Agency and vertical relationships 56615.6 Motives for vertical restraints 57115.7 Types of vertical restraint 57715.8 Summary 587


16 Diversification 59116.1 Introduction 59116.2 Types of diversification 59216.3 Motives for diversification 594

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.16.4 Corporate coherence 60316.5 Corporate focus and deconglomeration 60516.6 Empirical evidence 61016.7 Summary 616


Part IV: Analysis of Public Policy

17 Competition policy 62317.1 Introduction 62317.2 Competition policy: theoretical framework 62417.3 Competition policy: practical implementation 63317.4 Competition policy in the UK 63617.5 Competition policy in the EU 64417.6 Assessment of UK competition policy 65217.7 Summary 654


18 Regulation 65918.1 Introduction 65918.2 The problem of natural monopoly 66018.3 Nationalization 66418.4 Privatization 66518.5 Regulation 67318.6 Franchising and competitive tendering 68218.7 Summary 686


Appendices: Analytical Tools

Appendix 1 Mathematical methods 693Appendix 2 Econometric methods 715

Glossary 725References 735Index 771

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.2.1 Short-run production and costs: numerical example 262.2 Demand, revenue, price elasticity and profit maximization:

numerical example 412.3 The neoclassical theory of the firm: typology of market structures 516.1 The UKs SIC 1980, by division 2106.2 The UKs SIC 1992 and the EUs NACE, by section 2116.3 The EUs NACE, by division 2126.4 Comparison between the UKs SIC 1992 and the EUs NACE 2136.5 Firm size distribution (sales data): six hypothetical industries 2156.6 Seller concentration measures: six hypothetical industries 2166.7 Calculation of three-, four- and five-firm concentration ratios 2166.8 Calculation of HerfindahlHirschman and HannahKay indexes 2196.9 Calculation of entropy coefficient 221

6.10 Calculation of variance of logarithmic firm sizes 2226.11 Calculation of Gini coefficient 2256.12 Five-firm concentration ratios for selected industries, UK, 1992 2316.13 Firm size distribution for selected industries, EU, 1997

(distribution of sales by employment size class) 2336.14 Specialization in European manufacturing 2346.15 Location of EU science-based (S) and traditional (T) clusters 2387.1 Trend in seller concentration with random firm growth 2667.2 Simulated evolution of industry structure and concentration

under the random growth hypothesis 2687.3 Tests of the Law of Proportionate Effect (LPE): a selective review 2708.1 Economies of scale as a barrier to entry 2819.1 Rates of return by size and concentration (weighted by assets) 3259.2 Firm and industry effects in determining profitability 3339.3 Summary of firm level persistence of profit studies 346

10.1 How UK firms set their prices 35711.1 Relationship between N, the number of bidders, and d(N) 39311.2 Optimal bidding strategies and revenue equivalence for the

independent private values model 40013.1 Advertising as a percentage of gross domestic product

(at market prices) 457

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List of tables

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.13.2 Advertising-to-sales ratios of selected UK product groups, 2001 46113.3 Top 10 advertisers and brands in the UK, 2002 46214.1 Expenditure on corporate research and development as

percentage of GDP, 19922001 52515.1 Enhancement of market power through a price/profit squeeze 57316.1 Calculation of Goreckis T-value 61116.2 Direction of diversification in UK top 200 manufacturing

enterprises, 1974 61316.3 Measures of diversification, large EU manufacturing enterprises 61518.1 Selected UK privatizations by industry and year of first sale 66818.2 Privatization proceeds for OECD countries (US$ million) 669

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xiv List of tables

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.1.1 The structureconductperformance paradigm 71.2 Porters five forces model 172.1 Short-run relationship between total, marginal and average

product of labour 272.2 Short-run total cost, marginal cost, average variable and

fixed cost, and short run average cost 292.3 Increasing, constant and decreasing returns to scale 302.4 Long-run average cost and long-run marginal cost 312.5 Short-run and long-run average cost functions 322.6 Isoquant and isocost functions 332.7 Surface area and volume of small and large storage tanks 362.8 Long-run average cost functions with constant returns to scale 392.9 Total, average and marginal revenue 42

2.10 Short-run pre-entry and post-entry equilibrium in perfect competition 54

2.11 Long-run post-entry equilibrium in perfect competition 552.12 Long-run equilibrium in monopoly 562.13 Allocative inefficiency in monopoly 592.14 Allocative inefficiency and productive inefficiency in monopoly 592.15 Natural monopoly 622.16 Short-run pre-entry and post-entry equilibrium in monopolistic

competition 643.1 Baumols sales revenue maximization model 823.2 Marriss growth maximization model 853.3 Williamsons managerial utility maximization model 873.4 Unitary or U-from organizational structure 963.5 Multidivisional or M-form organizational structure 973.6 The science of choice and the science of contract 983.7 Modes of governance and the degree of asset specificity 994.1 Market average revenue, marginal revenue and marginal

cost functions, Cournots duopoly model 1214.2 The Cournot model: sequence of actions and reactions 1224.3 Derivation of firm As isoprofit curves 1234.4 Firm As isoprofit curves and reaction function 125

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List of figures

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.4.5 CournotNash equilibrium 1264.6 Cournot model: sequence of actions and reactions, shown using

reaction functions 1274.7 CournotNash equilibrium and joint profit maximization 1294.8 CournotNash equilibrium and Stackelberg equilibria 1314.9 Equilibrium values of qA, qB, pA, pB: duopoly with linear market

demand and zero marginal cost 1324.10 Equilibrium in the Bertrand duopoly model 1344.11 Price-setting in the Edgeworth duopoly model 1354.12 Sweezys kinked demand curve model 1394.13 The reflexive kinked demand curve 1414.14 Dominant firm price leadership 1424.15 Payoff matrix for firms A and B 1454.16 Payoff matrix for firms A and B: prisoners dilemma example 1464.17 Payoff matrix for Jeffrey and Jonathan: classic prisoners dilemma 1474.18 Isoprofit curves for firms A and B: CournotNash versus

Chamberlins prisoners dilemma 1484.19 Payoff matrix for firms A and B: CournotNash versus

Chamberlins prisoners dilemma 1494.20 Payoff matrix for firms A and B: mixed strategies example 1514.21 Expected payoffs for firms A and B and mixed strategy

Nash equilibrium 1524.22 Sequential game: strategic form representation 1534.23 Sequential game: extensive form representation 1545.1 Joint profit maximization in a three-firm cartel 1735.2 Equilibrium with K cartel firms and N K non-cartel firms 1745.3 Fogs cartel model 1775.4 Osbornes model of cartel stability and instability 1916.1 The Lorenz curve 2246.2 Diamond framework of competitive advantage 2397.1 The industry life cycle 2547.2 Distribution of firm sizes 2678.1 Economies of scale as a barrier to entry 2808.2 Absolute cost advantage as a barrier to entry 2818.3 Limit pricing to deter entry: absolute cost advantage 2888.4 Limit pricing to deter entry: economies of scale 2898.5 Sequential entry game 2949.1 Effect of an increase in factor input prices on long-run

post-entry equilibrium in perfect competition 3369.2 Effect of an increase in factor input prices on equilibrium

in monopoly 3369.3 Short-run and long-run persistence of profit 345

10.1 First-degree price discrimination 36010.2 Second-degree price discrimination (two-part tariff ) 36210.3 Third-degree price discrimination 36410.4 Intertemporal price discrimination 36910.5 Peak-load pricing: full capacity production in both periods 372

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xvi List of figures

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.10.6 Peak-load pricing: spare capacity in off-peak period 37310.7 Transfer pricing: no external market for intermediate product 37510.8 Transfer pricing: profit maximization for the distributor 37610.9 Transfer pricing: profit maximization for the producer 377

10.10 Transfer pricing: perfectly competitive external market (price below P1) 378

10.11 Transfer pricing: perfectly competitive external market (price above P1) 378

10.12 Transfer pricing: imperfectly competitive external market (price above P1) 380

11.1 Bidding strategies: first price sealed bid auction (independent private values model) 396

12.1 Monopolistic competition: too much product differentiation 42112.2 Monopolistic competition: insufficient product differentiation 42212.3 Lancasters product characteristics model 42312.4 Discontinuous demand function for brand C 42512.5 Positioning of new brand B 42612.6 Product characteristic space for breakfast cereals 43212.7 Hotellings location model with fixed prices and

endogenous locations 43712.8 Hotellings location model with fixed locations and

endogenous prices: joint profit maximization 44012.9 Derivation of firm As isoprofit curves 441

12.10 Firm As reaction function 44212.11 Hotellings location model with fixed locations and

endogenous prices: Bertrand (or Nash) equilibrium 44412.12 Hotellings location model with fixed locations and

endogenous prices: summary of results 44612.13 Salops location model with three firms 44712.14 Salops location model: effect of changes in firm As price

with three firms 44812.15 Salops location model: firm As demand function 44813.1 Advertising and profit maximization in monopoly 46913.2 Advertising, market structure and concentration 47313.3 Advertising response functions 47413.4 Optimal search time 47613.5 Welfare analysis of an increase in advertising expenditure

in monopoly 48114.1 Arrows incentive to innovate: small cost-saving innovation 49914.2 Arrows incentive to innovate: large cost-saving innovation 50014.3 Demsetzs incentive to innovate: large cost-saving innovation 50114.4 The optimal development time 50414.5 Market structure and the optimal development time 50514.6 Growth over time in the proportion of firms that have adopted

an innovation 51614.7 Number of patents per million population, 1998 52514.8 Welfare implications of patenting 529

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List of figures xvii

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.15.1 Competitive producers, competitive retailers 54715.2 Competitive producers, monopoly retailer 54815.3 Monopoly producer, competitive retailers 54815.4 Monopoly producer, monopoly retailer 54915.5 Input substitution following forward vertical integration 55115.6 Backward vertical integration: case 1 55115.7 Backward vertical integration: case 2 55215.8 One seller, many buyers 55915.9 Many sellers, one buyer 560

15.10 Vertical integration to avoid a sales tax 56215.11 Directional bias of value added-to-sales ratio 56415.12 Robertson and Langlois two dimensions of integration 57117.1 Consumer and producer surplus: perfect competition versus

a monopolist with a cost advantage 626A.1 Sample regression line for advertising-sales model 717A.2 Agression models with different degrees of explanatory power 721

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xviii List of figures

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.7.1 Estimation of cost functions and minimum efficient scale 2478.1 Does it pay to be a pioneer? 2968.2 What are the options for later entrants? 3029.1 Measurement of company profitability 319

12.1 The essence of building an effective brand 42614.1 The pace of technological change: some international comparisons 52417.1 Competition policy in the United States 64918.1 Regulation of privatized industries in the UK 679

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List of boxes

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.1.1 Structure, conduct and performance in European banking 112.1 Economies of scale and hospitals in Scotland 372.2 The demand for spectator attendance at professional football 463.1 Bread and circuses from the Emperor Rupert: Chairmans

pugnacious AGM performance 793.2 The Walt Disney crisis: Rise of the corporate crusaders 803.3 Lessons from Railtrack: The collapse has demolished some of

the untested assumptions about outsourcing 933.4 Business schools share the blame for Enron 1064.1 Oligopoly price wars 1364.2 BSkyB offer set to spark digital television price war: group to

give away set-top boxes in battle for subscribers 1374.3 The prisoners dilemma in practice: tit-for-tat in the

First World War trenches 1565.1 EU bursts into price-fixing cartels cosy club 1655.2 Watchdog gets shirty with companies over strip price-fixing 1976.1 The media concentration debate 2256.2 Industrial clusters and competitive advantage 2367.1 Industry life cycle for the credit union sector 2568.1 Legal barriers to entry in UK industries 2858.2 Predatory competition 2918.3 Switching costs as a barrier to entry 293

10.1 Price discrimination in ticket price structures for English Premiership football 365

10.2 Intertemporal price discrimination by book publishers 36810.3 Tax avoidance through transfer pricing 38111.1 The auction of the UK 3G mobile telephone spectrum licences 40711.2 What determines the prices of goods traded in online auctions? 41112.1 Planned obsolesence 41912.2 Product differentiation at the movies 43312.3 Hotelling in the air 43513.1 For what its worth Whats in a name? Quite a lot, it seems.

Brands are like any other asset: they require investment, but they can also boost the value of a company 459

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List of case studies

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.13.2 Running a top campaign. Television advertisements featuring hairy marathon men have left The Numbers directory inquiry competitors gasping for breath 463

13.3 Advertising campaigns 46514.1 Strategy for creativity 51314.2 Universityindustry links in the EU 51914.3 Economics of open source 53115.1 Big media lack creativity 55615.2 Profits in the age of an audience of one 57415.3 UK retail group seeks review of PC pricing 58015.4 BSkyB and vertical restraints 58416.1 Diversification as a growth strategy 59616.2 The myth of the mega-bank: after the failures of diversification,

wary lenders scale back their global ambitions 60817.1 The Microsoft monopoly in the US 62917.2 Competition in the airlines industry 63117.3 The end of RPM in medicines 63917.4 Banking for small business 64317.5 ABB fined heavily over role in cartel 64617.6 Not so sweet: abuse of dominant position by Irish Sugar 64717.7 Microsoft got what it deserved in Europe 64818.1 Government and regulation 66118.2 Reforms that have failed to work a power of good 666

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Supporting resourcesVisit www.pearsoned.co.uk/lipczynski to find valuable onlineresources

Companion Website for studentsn Links to relevant sites on the webn Online glossary of key terms

Password protected resources for instructors onlyn Complete, downloadable Instructors Manual containing answers to

end-of-chapter questionsn PowerPoint slides of the figures in the book that can be downloaded

and used as OHTs

For more information please contact your local Pearson Education salesrepresentative or visit www.pearsoned.co.uk/lipczynski

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.Industrial Organization: Competition, Strategy, Policy, second edition, is a textbookin industrial organization. It provides coverage of the latest theories of industrialorganization, and it examines empirical evidence concerning the strategies, beha-viour and performance of firms and industries.

In selecting material for inclusion in Industrial Organization: Competition, Strategy,Policy, second edition, we have attempted to provide readers with a flavour of thehistorical development of industrial organization. The book reflects the developmentof this subject area from its origins in the classical theories of the firm, followed by its emergence as a recognized subdiscipline within economics around the mid-twentieth century, right through to the present. Today, industrial organization drawson an impressive array of contributions from fields of economic inquiry as diverseas game theory, information theory, organization theory, agency theory and trans-action cost analysis. At various stages throughout the book, we examine the work ofresearchers in the closely related field of strategic management, in order to emphasizethe relevance of industrial organization to readers who are approaching the subjectprimarily from a business or a management standpoint, rather than from a traditionaleconomics perspective.

Industrial Organization: Competition, Strategy, Policy, second edition, contains47 case studies, which are used to illustrate real world applications of theoreticaland empirical research in industrial organization. Many of the case studies have beenselected from reports originally published in the Financial Times; while others havebeen compiled from alternative sources. Many of the case studies have been chosennot only for their relevance to industrial organization, but also because they arelively, newsworthy and topical. The case study material certainly bears little or noresemblance to the subject matter of a traditional industrial economics programme of 20 or 30 years ago, when much greater emphasis would have been placed on traditional manufacturing and heavy industry. Instead the case studies focus on keysectors of the modern-day economy, such as IT and telecommunications (Microsoft,eBay, 3G mobile phones technology, open source); banking and financial services(commercial banking, the credit union movement); and sport and leisure (Hollywoodmovies, English Premier League football).

Industrial Organization: Competition, Strategy, Policy, second edition, is aimedprimarily at undergraduate students. The book is intended for use on modules inindustrial organization, industrial economics or business economics, by students

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Preface

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xxiv Preface

studying for degrees in economics, business studies, management and other relateddisciplines. It can also be used as a preparatory, background or reference text by students taking graduate courses in the same subjects. The only prior experience of economics that is assumed is the completion of an introductory Principles ofEconomics module, or a one-semester module in Microeconomics.

The style of presentation is non-technical throughout. No knowledge of calculusis required. However, for readers requiring a more rigorous treatment of certain topics, a Mathematical Methods appendix provides formal derivations (using calculus) of a selection of the most important theories and results presented in themain text. Empirical research in industrial organization is also presented through-out the text in a non-technical style. No knowledge of statistics or econometrics is assumed. For readers requiring a primer in the fundamentals of regression analysis, an Econometric Methods appendix provides a brief and non-technicalintroduction to some of the basic tools, such as regression coefficients, t-statisticsand goodness-of-fit.

Structure of the book

Industrial Organization: Competition, Strategy, Policy, second edition, is divided intofour parts. In Part I, Theoretical foundations, Chapter 1 introduces some of the keyelements of industrial organization, starting with the structure-conduct-performanceparadigm, which provided the intellectual foundation for the early development of industrial organization as a separate subdiscipline within economics. Chapter 2reviews the core microeconomic theory from which many of the early and moderntheories of industrial organization have developed. Chapter 3 examines a number of alternative theories of firm behaviour, including the neoclassical, managerial andbehavioural theories, as well as perspectives drawn from transaction cost analysisand agency theory.

Part II, Structural analysis of industry, discusses the approach within the field of industrial organization which emphasizes the role of the structural attributes of an industry in explaining the conduct of the industrys constituent firms. Chapters 4 and 5 examine non-collusive and collusive theories of oligopoly, a market structurewhose most important characteristic is the small number of interdependent, com-peting firms. Chapter 6 examines practical aspects of industry definition, and themeasurement of the number and size distribution of an industrys constituent firms,summarized by measures of industry or seller concentration. Chapter 7 examines thedeterminants of seller concentration. Chapter 8 examines another important structuralattribute of industries: barriers to entry. Finally, Chapter 9 provides a link betweenParts II and III of the book, by describing the evolution of industrial organizationbeyond the confines of the structure-conduct-performance paradigm, and the develop-ment of new approaches and methods, which are conveniently summarized underthe banner of the new industrial organization.

In Part III, Analysis of firm strategy, the focus shifts away from industry structure,and towards the newer theories of industrial organization that emphasize conduct or strategic decision making at firm level. Chapter 10 examines a number of pricing

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.practices, including price discrimination and transfer pricing. In recognition of thegrowing use of auctions as a method for allocating resources and awarding contractsin the commercial and public sectors, Chapter 11 examines the economic theory of auctions. In the rest of Part III, the emphasis shifts towards various non-pricestrategies that can be adopted by firms, in an attempt to improve their profitability orgain a competitive advantage over their rivals. Chapters 12 and 13 examine productdifferentiation and advertising. Chapter 14 examines research and development,innovation and technological progress. Chapter 15 examines vertical integration andvertical restraints. Finally, Chapter 16 examines diversification, conglomerate mergerand deconglomeration.

Part IV, Analysis of public policy, concludes the book, by drawing together theimplications for public policy of many of the key findings of Parts I, II and III.Chapter 17 examines competition policy, including government policy towardsmonopolies, restrictive practices and mergers. Chapter 18 examines the topic of regulation, with particular emphasis given to public scrutiny of the activities andbusiness practices of the recently privatized utilities and other natural monopolies.

Changes for the second edition

We have been gratified and encouraged by the responses to the first edition we havereceived from instructors and students. However, a new edition provides a welcomeopportunity to make improvements, and to update and extend the material that was covered previously. For the second edition, six new chapters have been addedto the twelve chapters that comprised the first edition. Chapter 2 Microeconomicfoundations and Chapter 3 Theories of the firm are new to the second edition. Thesetwo chapters provide a basis within mainstream microeconomic theory for the material that is covered throughout the rest of the book. Chapter 10 Pricing andChapter 11 Auctions are also new to the second edition. Between them, these twochapters cover a range of traditional and more recent economic theories of price formation and resource allocation. The chapter from the first edition covering thetopic of concentration has been split into two second edition chapters: this topic is now handled in Chapter 6 Seller concentration: measurement and trends andChapter 7 Determinants of seller concentration. Finally, Chapter 12 Product differ-entiation provides full coverage of a topic that was dealt with more concisely, withinthe chapter on advertising, in the first edition.

In addition to the new chapters, we have revised and updated our coverage ofmany theoretical and empirical topics in industrial organization throughout the book.We have improved the technical presentation of many of the theories of industrialorganization, by grounding our coverage more explicitly within a microeconomictheoretic framework.

The first editions extensive bibliography has turned out to be a highly popularfeature with instructors, and with students wishing to read beyond the confines of acore textbook, perhaps with a view towards choosing a dissertation topic, or towardsstudying industrial organization at graduate level. Accordingly, in the second editionwe have taken the opportunity to extend and fully update our previous bibliography.

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.We have retained or updated the most interesting and relevant case studies fromthe first edition, and we have added many more completely new case studies to the second edition. Most of the new case studies describe recent events, which have occurred since the publication of the first edition in 2001. We have signifi-cantly increased the number of end-of-chapter discussion questions. Finally, we haveextended our website www.pearsoned.co.uk/lipczynski, which contains support-ing material for instructors in the form of PowerPoint slides and outline answers to discussion questions. The website also contains links to other relevant websites for instructors and students.

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We would like to thank colleagues and students at the Department of Business andService Sector Management at the London Metropolitan University, the School ofManagement at the University of St. Andrews, the School of Business and Eco-nomics at University of Wales Swansea, and the School of Business and RegionalDevelopment at University of Wales, Bangor for their direct, and at times unknow-ing help towards the development of this project. We would like to give specialthanks to Rick Audas, Chris Carter, Steve Dobson, Derek Eades, David Glenn, BobGreenhill, Peter Grinyer, Paul Latreille, Donal McKillop, Alan McKinlay, DaveMcMillan, George Milios, Phil Molyneux, George Panagiotou, Carlyn Ramlogan,Jeremy Stangroom, Manouche Tavakoli, Riette van Wijnen and Mark Wronski forall of their advice, support and helpful comments. Finally, thanks are due to MarcJegers and Peter Mottershead for useful feedback on the first edition.

Thanks are due to a number of staff at Pearson Education who have provided excel-lent support at all stages as this project has progressed. We are especially indebtedto Justinia Seaman (Commissioning Editor), Rachael Daily (Editorial Assistant) and Stephanie Poulter (Editorial Assistant) for all of their advice and encourage-ment during the commissioning stage, and while the preparation of the manuscriptwas underway. For keeping things on track and reminding us of deadlines during the editing, typesetting and production stages, we are indebted to Georgina Clark-Mazo (Desk Editor). We are also grateful for the assistance provided by Jenny Oates(Copy Editor), Mary Dalton (Proof Reader) and Margaret Binns (Indexer). Anyremaining errors are, of course, the authors joint responsibility.

Finally and most importantly, we would like to thank our families, for their patience,encouragement and support.

We are also grateful to those who have allowed the reproduction of copyrightedmaterial.

Publishers acknowledgements

We are grateful to the following for permission to reproduce copyright material:

HMSO for an extract from National Review of Resource Allocation for the NHS inScotland: Fair Shares For All Technical Report published on www.scotland.gov.uk Crown Copyright 1999; Basic Books, a member of Perseus Books LLC, for an

Acknowledgements

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.extract adapted from Evolution of Cooperation by Robert Axelrod, Copyright 1984 by Robert Axelrod; Sharon Beder for an extract adapted from Is plannedobsolescence socially responsible? by Sharon Beder published in EngineersAustralia, November 1998; Euroabstracts European Commission for material fromDirectorate General for Enterprise Euroabstracts European Commission, vol. 41,August 2003; and Blackwell Publishing and Journal of Industrial Economics for an extract adapted from Some Simple Economics of Open Space by J. Lerner and J. Triole published in Journal of Industrial Economics, 50, 2002.

Figure 3.6 and Figure 3.7 from The science of choice and the science of contract.The theory of the firm as governance structures: from choice to contract, Journal of Economic Perspectives, 16, pp. 173 and 181, American Economic Associationand Oliver Williamson (Oliver Williamson 2002); Figure 15.4 from OFT, BSkyB:The outcome of the OFTs Competition Act investigation, December 2002(OFT623) Office of Fair Trading; Tables 13.1, 13.2 and 13.3 from The AdvertisingAssociations Advertising Statistics Yearbook 2003, World Advertising ResearchCentre (www.warc.com).

We are grateful to the Financial Times Limited for permission to reprint the follow-ing material:

Brand-building: decisions and actions, from FT Mastering Management, Financial Times, 18 December 2000; Case Study 3.1 Bread and circuses from theEmperor Rupert Chairmans pugnacious AGM performance, Financial Times, 15 November 2003; Case Study 3.2 The Walt Disney crisis: Rise of the corporatecrusaders, Financial Times, 5 March 2004; Case Study 3.3 Lessons from Railtrack:The collapse has demolished some of the untested assumptions about outsourcing, Financial Times, 9 October 2001; Case Study 3.4 Business schools share theblame for Enron, FT.com, The Financial Times Limited, 17 July 2003; Case Study 4.2BskyB offer set to spark digital TV price war: group to give away set-top boxes inbattle for subscribers, Financial Times, 6 May 1999; Case Study 4.3 The prisonersdilemma in practice: tit-for-tat in the First World War trenches, Financial Times,18 October 1999; Case Study 5.1 EU bursts into price-fixing cartels cosy club, Financial Times, 12 June 2002; Case Study 5.2 Watchdog gets shirty with com-panies over strip price-fixing, Financial Times, 2 August 2003; Case Study 6.2Industrial clusters and competitive advantage, Financial Times, 6 November 2001;Box 8.1 Does it pay to be a pioneer?, Financial Times, 19 October 1998; Box 8.2What are the options for later entrants?, Financial Times, 19 October 1998; Box 12.1 The essence of building an effective brand, Financial Times, 18 Decem-ber 2000; Case Study 13.2 Running a top campaign, Financial Times, 11 November2003; Case Study 14.1 Strategy for creativity, Financial Times, 11 November 1999;Case Study 15.1 Big media lack creativity, Financial Times, 10 September 2003;Case Study 15.2 Profits in the age of an audience of one, Financial Times, 16 April 2004; Case Study 15.3 UK retail group seeks review of PC pricing, Financial Times, 9 April 2000; Case Study 16.2 The myth of the mega-bank: afterthe failures of diversification, wary lenders scale back their global ambitions (abridged), Financial Times, 6 January 2004; Case Study 17.3 The end of RPM in medicines:medicine prices set to tumble after court ruling, Financial Times, 16 May 2001;

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.Case Study 17.5 ABB fined heavily over role in cartel: European Commission, tencompanies penalized for fixing prices of insulated steel heating pipes, FinancialTimes, 22 October 1998; Case Study 18.2 Reforms that have failed to work a powerof good: liberalisation of the market has brought the UK industry to crisis point, Financial Times, 7 September 2002.

We are grateful to the following for permission to use copyright material:

Case Study 6.1 The media concentration debate, The Financial Times Limited, 31 July 2003, Eli Noam; Case Study 13.1 For what its worth: whats in a name?Quite a lot it seems, The Financial Times Limited, 3 February 2004, reproductionsby Lauren Henderson and FutureBrand, Lauren Henderson; Case Study 13.3Advertising campaigns, The Financial Times Limited, 14 November 2000, MarcNohr; Case Study 17.7 Microsoft got what it deserved in Europe, The FinancialTimes Limited, 29 March 2004, William Bishop and Robert Stillman; Case Study 18.1 Government and regulation: the past 20 years have seen a marked shiftin regulators role towards helping businesses and markets to function, 28 August2002, Colin Mayer.

In some instances we have been unable to trace the owners of copyright material,and we would appreciate any information that would enable us to do so.

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PA R T

1 TheoreticalFoundations

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.2 Chapter 1 n Industrial organization: an introduction

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.1.1 Introduction

This book deals with the economics of industrial organization. Specific topics thatare covered include oligopoly theory, concentration, barriers to entry, pricing andauctions, product differentiation and advertising, research and development, verticalintegration, diversification, competition policy and regulation. The aim of this intro-ductory chapter is to provide an overview of some of this subject material, for boththe specialist and the non-specialist reader.

The chapter begins in Section 1.2 by examining static and dynamic views of competition in economic theory. The view of competition found in the neoclassicaltheory of the firm (incorporating the textbook models of perfect competition, mono-polistic competition, oligopoly and monopoly) is essentially static. In contrast, amore dynamic approach can be found in the writings of Schumpeter and economists

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C H A P T E R

1 Industrial organization: an introductionLearning objectives

This chapter covers the following topics:

n static and dynamic views of competition

n the structureconductperformance paradigm

n the Chicago school approach to the study of competition

Key terms

Austrian schoolChicago schoolCollusion hypothesisDistinctive capabilitiesEfficiency hypothesis

Five forces modelNew industrial organizationStructureconductperformance

paradigmValue chain

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.identified with the Austrian school. Section 1.3 describes the structureconductperformance (SCP) paradigm, which laid the foundation for the original developmentof industrial organization as a separate sub-discipline within economics. The keyelements of structure, conduct and performance are introduced, and some of the mainlimitations of the SCP paradigm are discussed. Section 1.4 makes a short diversioninto the related sub-discipline of strategic management. Finally, Section 1.5 providesa brief overview of the contents of the rest of this book.

1.2 Static and dynamic views of competition

In microeconomics, the neoclassical theory of the firm considers four main theoret-ical market structures: perfect competition, monopolistic competition, oligopoly andmonopoly. These underpin much of the subject matter of industrial organization. Aperfectly competitive industry has six main characteristics: there are large numbersof buyers and sellers; producers and consumers have perfect knowledge; the pro-ducts sold by firms are identical; firms act independently of each other and aim tomaximize profits; firms are free to enter or exit; and firms can sell as much output asthey wish at the current market price. If these conditions are satisfied, a competitiveequilibrium exists in which all firms earn only a normal profit. If any particular firmis unable to earn a normal profit, perhaps because it is failing to produce at maximumefficiency, this firm is forced to withdraw from the market. In this way perfect com-petition imposes discipline: all surviving firms are forced to produce as efficiently as the current state of technology will allow.

In reality, however, competition often gives rise to a market or industry structurecomprising a relatively small number of large firms. Each firm has sufficient marketpower to determine its own price, and some or all firms are able to earn an abnormalprofit in the long run. One reason competition tends to lead to a decrease in the num-ber of firms in the long run is that as firms grow, they realize economies of scale andaverage costs tend to fall. In the most extreme case of natural monopoly, a single firmcan produce at a lower average cost than any number of competing firms. Amongothers, Marshall (1890) and Sraffa (1926) formulated the theory of monopoly. Thetendency for average costs to fall as the scale of production increases might be abeneficial aspect of monopoly, if the cost savings are passed on to consumers in theform of lower prices. However, if a monopolist exploits its market power by restrict-ing output and raising price in order to earn an abnormal profit, then monopoly mayhave damaging implications for consumer welfare.

Influenced by Marshall and Sraffa, Chamberlin (1933) and Robinson (1933) broughttogether the previously separate theories of monopoly and perfect competition, toformulate the theory of imperfect competition, which can be subdivided into the casesof monopolistic competition and oligopoly. The theory of monopolistic competitionretains the assumption that the number of firms is large, but emphasizes non-price as well as price forms of competition. In the theory of oligopoly it is assumed thenumber of firms is small (but greater than one). The firms recognize their inter-dependence: changes in price or output by one firm will alter the profits of rival firms,

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.causing them to adjust their own prices and output levels. Forms of competition underoligopoly vary from vigorous price competition, which can often lead to substantiallosses, through to collusion, whereby the firms take joint decisions concerning theirprices and output levels.

Essentially, the neoclassical theory of the firm is based on a static conception of competition. In all of the models outlined above, the main focus is on long-run equilibrium.

In the end-state conception of equilibrium, the focus of attention is on thenature of the equilibrium state in which the contest between transactingagents is finally resolved; if there is recognition of change at all, it is changein the sense of a new stationary equilbrium of endogenous variables inresponse to an altered set of exogenous variables; but comparative statics is still an end-state conception of economics.

(Blaug, 2001, p. 37)

In the twentieth century, some researchers rejected this static view of competition,and sought to develop a more dynamic approach. According to both Schumpeter(1928, 1942) and the Austrian school of economists, the fact that a firm earns anabnormal (monopoly) profit does not constitute evidence that the firm is guilty ofabusing its market (monopoly) power at the expense of consumers. Instead, monopolyprofits play an important role in the process of competition, motivating and guidingentrepreneurs towards taking decisions that will produce an improved allocation ofscarce resources in the long run. Schumpeter and the Austrian school both recognizethat knowledge or information is always imperfect.

According to Schumpeter, competition is driven by innovation: the introductionof new products and processes, the conquest of new markets for inputs or outputs,or the reorganization of existing productive arrangements (for example throughentry or takeover). By initiating change by means of innovation, the entrepreneurplays a key role in driving forward technological progress. Innovation destroys old products and production processes, and replaces them with new and better ones.The successful innovator is rewarded with monopoly status and monopoly profits for a time. However, following a brief catching-up period, imitators are able to move into the market, eroding the original innovators monopoly status and profits.Alternatively, another innovator may eventually come along with an even better pro-duct or production process, rendering the previous innovation obsolete. According tothis dynamic view of competition, monopoly status is only a temporary phenomenon,and is not capable of sustaining a stable long-run equilibrium, as is assumed in theneoclassical theory of the firm.

The Austrian school also views competition as a dynamic process, and sees themarket as comprising a configuration of decisions made by consumers, entrepreneursand resource owners (Kirzner, 1973, 1997a,b). Entrepreneurs play a crucial role bynoticing missed opportunities for mutually advantageous trade to take place. Entre-preneurs discover and act upon new pieces of information. By observing the actionsof entrepreneurs, other decision makers are able adjust their trading plans and arrive

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1.2 Static and dynamic views of competition 5

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.at improved outcomes. Disequilibrium reflects imperfect information or ignoranceon the part of buyers and sellers. The entrepreneurial function adds to the flow ofinformation, and helps lubricate the process of adjustment towards a new and superiorallocation of scarce resources. Whereas the Schumpeterian entrepreneur actively initiates change, the role of the entrepreneur in Austrian thinking is more passive:the Austrian entrepreneur merely responds more quickly than other agents to newinformation that is generated exogenously. According to Austrian economists, amonopoly position is attained through the originality and foresight of the entre-preneur; and, as Schumpeter suggests, monopoly profits are unlikely to be sustainedindefinitely. As information arrives and new trading opportunities open up, otherentrepreneurs appear, who by their actions help propel the economy towards a furtherreallocation of resources (Young et al., 1996; Roberts and Eisenhardt, 2003).

1.3 The structureconductperformance paradigm

The static and dynamic theories discussed above have found an empirical counter-part in the field that has become known as industrial organization. Early work in thisarea, based predominantly on the structureconductperformance (SCP) paradigm,concentrates on empirical rather than theoretical analysis (Bain, 1951). In the main,the field of industrial organization analyses empirical data and, by a process ofinduction, develops theories to explain the behaviour and performance of firms andthe industries to which they belong (Schmalensee, 1988).

Outline of the structureconductperformance paradigmSeminal early contributions in industrial organization include Mason (1939, 1949)and Bain (1951, 1956, 1959). Mason and Bain are credited with the development ofthe SCP paradigm. According to this approach, the structure of a market influencesthe conduct of the firms operating in the market, which in turn influences the per-formance of those firms. The field of industrial organization is concerned with theinvestigation of the size structure of firms (one or many, concentrated or not), thecauses (above all the economies of scale) of this size structure, the effects of con-centration on competition, the effects of competition on prices, investment, innovationand so on (Stigler, 1968, p. 1).

The SCP paradigm is useful in a number of ways:

n It allows the researcher to reduce all industry data into meaningful categories(Bain, 1956).

n It is consistent with the neoclassical theory of the firm, which also assumes thereis a direct link between market structure, and firm conduct and performance,without overtly recognizing this link (Mason, 1949).

n By defining a workable or acceptable standard of performance, it may be possibleto accept an imperfect market structure, if such a structure produces outcomesthat are consistent with the acceptable standard (Clark, 1940). By implication,market structure can be altered in order to improve conduct and performance(Sosnick, 1958).

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.A schematic representation of the SCP paradigm is presented in Figure 1.1. In accordance with the fundamental logic of SCP, the main linkages are shown as running from structure through conduct to performance. However, various feedbackeffects are also possible: from performance back to conduct; from conduct to struc-ture; and from performance to structure (Phillips, 1976; Clarke, 1985). These arerepresented in Figure 1.1 by dotted arrows. Several specific types of feedback effectare identified in the following discussion of the main components of the structure,conduct and performance categories.

Structure

Structural characteristics tend to change relatively slowly, and can often be regardedas fixed in the short run. Some of the more important structure variables are as follows:

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1.3 The structureconductperformance paradigm 7

Figure 1.1 The structureconductperformance paradigm

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.n The number and size distribution of buyers and sellers is an important deter-minant of the market power exercised by the leading firms in the industry, andthe discretion these sellers exercise over their own prices. In consumer goodsindustries it is normally the case that there are large numbers of small, atomisticbuyers. Accordingly, the main focus is on the number and size distribution of sellers. Seller concentration is typically measured using data on the share of total industry sales, assets or employment accounted for by the largest firms inthe industry. In capital goods industries, however, it is possible that the numberof buyers is also small. If so, there may be market power on the demand side, as well as on the supply side: buyers may exercise discretion over the prices theypay. In such cases, a full assessment of the distribution of market power mightrequire measurement of buyer concentration as well as seller concentration.

n Entry and exit conditions include barriers to entry, which can be defined looselyas anything that places a potential entrant at a competitive disadvantage relative toan incumbent firm. The important issue is the relative ease or difficulty that firmsmay experience when entering an industry: if entry is difficult, then incumbentsare sheltered from outside competition (Neven, 1989). Entry barriers may be eithernatural, deriving from basic characteristics of the product or production techno-logy and cost structure; or strategic, deriving from deliberate actions taken byincumbent firms to discourage or prevent entry. The analysis of entry barriers has shifted from the simple classification developed by Bain (1956) to complexmodels of strategic behaviour which incorporate threats and irreversible commit-ments (Dixit, 1982). Irreversible commitments involve an incumbent making sunkcost investments that cannot be recovered in the event of subsequent withdrawalfrom the market. By raising barriers to exit in this way, an incumbent can signalits intention to stick around and fight in order to preserve its market share. Thesignal may in itself be sufficient to deter a potential entrant from proceeding.

n Product differentiation refers to the characteristics of the product. How similar iseach firms product to those of rival firms? To what extent is each firms productunique? Any change in the characteristics of the product supplied by one firm,whether real or imagined, may affect the shares of the total market demand thateach firm is able to command.

n Vertical integration and diversification. Vertical integration refers to the extentto which a firm is involved in different stages of the same production process.Diversified firms produce a variety of goods or services for several distinct markets. The extent to which a firm is vertically integrated or diversified is likelyto have implications for conduct and performance. Vertically integrated firms havegreater certainty in obtaining supplies of raw materials, or guaranteed distributionoutlets. They have opportunities to engage in certain types of anticompetitivepractice (vertical restraints), which may be damaging to non-integrated rivals.Diversified firms may benefit from economies of scope, and are less exposed torisk than their non-diversified counterparts, because losses realized in one marketcan be offset against profits earned elsewhere. In the long run, of course, firmsmake their own choices concerning vertical integration and diversification; there-fore in the long run these can also be interpreted as conduct variables.

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.Conduct

Conduct refers to the behaviour of firms, conditioned, according to the SCP para-digm, by the industrys structural characteristics identified above. Conduct variablesinclude the following:

n Business objectives. The objectives that firms pursue often derive from struc-tural characteristics of the industry, in particular the firm size distribution. Theneoclassical theory of the firm assumes profit maximization; while managerialtheories, developed primarily with large corporations in mind, emphasize themaximization of non-profit objectives such as sales revenue, growth or manage-rial utility (Baumol, 1959; Marris, 1964; Williamson, 1963).

n Pricing policies. The extent of a firms discretion to determine its own pricedepends to a large extent on the industrys structural characteristics. Possiblepricing policies include cost plus pricing, marginal cost pricing, entry-deterringpricing, predatory pricing, price leadership and price discrimination (Phlips,1983). For oligopolists in particular, it may be imperative to avoid direct pricecompetition leading to mutually destructive price wars.

n Product design, branding, advertising and marketing. Natural or inherent charac-teristics of the firms basic product are likely to influence the scope for non-pricecompetition centred on product design, branding, advertising and marketing.Although product differentiation is cited above as a structural characteristic, tosome extent this is an oversimplification: the extent of product differentiation is at least partly endogenous, influenced or determined by strategies consciouslyimplemented by incumbent firms.

n Research and development. Together with advertising and marketing, investmentin research and development provides an obvious outlet for non-price competitionbetween rival firms. The extent and effectiveness of research and developmentinvestment, and the pace of diffusion (the speed at which a new idea is adoptedby firms other than the original innovator), are critical determinants of the paceof technological progress (Kamien and Schwartz, 1982).

n Collusion. Another option open to firms wishing to avoid direct forms of price or non-price competition is to collude with one another, so as to reach collec-tive decisions concerning prices, output levels, advertising or research and development budgets. Collusion may be either explicit (through an arrange-ment such as a cartel), or implicit or tacit (through a less formal agreement or understanding).

n Merger. Horizontal mergers (between firms producing the same or similar products) have direct implications for seller concentration in the industry con-cerned. Vertical mergers (between firms at successive stages of a production process) affect the degree of vertical integration. Conglomerate mergers (betweenfirms producing different products) affect the degree of diversification. Thereforeeach type of merger decision provides an example of a conduct variable that has a feedback effect on market or industry structure.

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.Performance

Important indicators of performance, the final component of the SCP trichotomy,include the following:

n Profitability. The neoclassical theory assumes high or abnormal profits are theresult of the abuse of market power by incumbent firms. On the other hand, it hasalso been argued by the Chicago school (see below p. 14) that abnormal profitmay be the consequence of cost advantages or superior productive efficiency on the part of certain firms, that have consequently been able to achieve mono-poly status by cutting price and driving rivals out of business. If this is the case,it is not obvious that market power and abnormal profit should be viewed asdetrimental to consumer interests. Similarly, according the the Schumpeterian or Austrian views, abnormal profit is a reward for successful past innovation, or the exercise of superior foresight or awareness by an entrepreneur. To theextent that profitability influences firms decisions to continue or exit from amarket, this performance indicator has direct implications for future structure(the number and size distribution of sellers).

n Growth. Profitability is a suitable performance indicator for a profit-maximizingfirm, but may be less relevant for a firm that pursues other objectives, such assales, growth or managerial utility. Growth of sales, assets or employment mightrepresent a useful alternative performance indicator, by which the performanceover any period of firms that were unequal in size at the start of the period canbe compared.

n Quality of products and service might be considered an important performanceindicator by individual consumers or consumer groups, regulators or governments.

n Technological progress is a consequence of the level of investment in researchand development, and the pace of technological progress may be considered arelevant performance indicator. In the long run, technological progress producesperhaps the most fundamental type of feedback effect shown in Figure 1.1, dueto its impact on the basic conditions of demand (consumer tastes and preferenceschange when new products are introduced) and supply (technology and cost struc-tures change when new and more efficient production processes are developed).

n Productive and allocative efficiency. Productive efficiency refers to the extent towhich a firm achieves the maximum technologically feasible output from a givencombination of inputs, and whether it chooses the most cost effective combina-tion of inputs to produce a given level of output. Allocative efficiency refers towhether social welfare is maximized at the market equilibrium. Productive andallocative efficiency are both regarded by economists as important performanceindicators.

The role of government policy

As Figure 1.1 suggests, government policy can operate on structure, conduct andperformance variables. According to the SCP paradigm, if an industry comprises onlya few large firms, the abuse of market power is likely to lead to the level of output

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Structure, conduct and performance inEuropean bankingThe banking sector is of central strategic importance for economic growth, capital allocation,financial stability, and the competitiveness and development of the manufacturing and servicesectors. In Europe in 2000, bank assets were valued at the equivalent of 206 per cent ofEurope-wide GDP.

The nature of competition in European banking has changed significantly since 1990. Follow-ing deregulation (via the Second Banking Directive), the creation of the EU single market infinancial services, and the launch of the euro, barriers to trade in financial services have beensignificantly reduced. Banks are able to trade not only in their own countries, but also else-where throughout Europe. Banks have increased the range of products and services they offerto customers, leading to the distinction between banks, building societies, insurance companiesand other financial institutions becoming blurred. The arrival of foreign-owned banks in manyEuropean banking markets has caused competition to intensify. Furthermore, a wide range of non-bank institutions, including supermarkets and telecommunications firms, now offerfinancial products and services as well. This has placed additional pressure on establishedbanks to lower costs, limit their risk exposures, improve their management and governancestructures, and find new ways of generating revenues from new forms of banking business.

Structure

During the period 19902002, there was a decline in the number of banks trading in mostEuropean countries. This trend is similar for mutual savings banks, cooperative banks and com-mercial banks. Table 1 shows data on the total number of banks (domestic and foreign-owned)trading in selected European countries in 1990, 1995, 1998 and 2002. In most (but not in all)countries, there has been a pronounced decline in bank numbers. Over the same period, branchnumbers have also declined, as banks have sought to rationalize their branch networks.

This is part of an overall trend towards consolidation in the financial services sector, whichhas been accompanied by an increase in seller concentration. In 2002, seller concentrationmeasured by the five-firm concentration ratio (the share of the five largest banks in the totalassets of the banking sector as a whole) exceeded 60 per cent in Belgium, Denmark, Greece,Netherlands, Portugal, Finland and Sweden. Concentration has also increased, but has remainedat lower levels, in Italy, Germany and the UK (where the 2002 five-firm concentration ratioswere 31 per cent, 20 per cent and 30 per cent respectively).

However, the number of foreign-owned banks trading in every country included in Table 1increased over the period 19902002. In the UK in 1998, there were 254 foreign banks witha 57 per cent share of total banking sector assets. In Belgium, there were eight foreign bankswith a 48 per cent share; in France there were 280 foreign banks with a 15 per cent share; andin Portugal there were 16 banks with a 35 per cent share. In other European countries (exceptLuxembourg), foreign banks accounted for less than 10 per cent of total banking sector assets.

Case study 1.1

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Conduct

In response to competitive pressure (brought about by the entry of foreign banks and newfinancial services providers), many established banks have consolidated by means of mergerand acquisition. This strategy has enabled some banks to achieve the large size (or criticalmass) required to operate effectively throughout the European single market. Significantrecent mergers in the UK include the Royal Bank of Scotlands acquisition of NatWest in2000, and the merger between the Bank of Scotland and the Halifax in 2001. Cross-bordermergers include the Dutch bank INGs acquisition of the Belgium Banque Bruxelles Lambertin 1999, and the acquisition of the UKs Abbey by Spains Banco Santander in 2004. In 1999,11 of the 20 largest banks in Europe had achieved top 20 status as a result of large-scalemerger deals (Pescetto, 2003).

Many banks have also implemented strategies of diversification and financial innovation.Banks now offer their customers telephone and internet banking services, online share dealing,letters of credit, pensions and insurance, and a wide range of investment services. This hasresulted in an increased reliance on revenues from non-traditional banking activities. Non-interest bearing income as a proportion of the total income of European banks increased from28.3 per cent in 1992 to 42.5 per cent in 2001 (European Commission, 2004).

Performance

Table 2 shows that the average profitability (measured by return on equity) of banks in mostEuropean countries improved between 1990 and 2002. Given that competition has becomemore intense, it seems likely that increased profitability is a consequence of revenues having

Table 1 Number of banks by country (selected countries, 19902002)

Country 1990 1995 1998 2002

Austria 1,210 1,041 898 823Belgium 157 145 123 111Denmark 124 122 212 178Finland 529 381 348 369France 2,027 1,469 1,226 989Germany 4,720 3,785 3,238 2,363Italy 1,156 970 934 821Luxembourg 177 220 212 184Netherlands 111 102 634 539Portugal 260 233 227 202Spain 696 506 402 359Sweden 704 249 148 216UK 624 564 521 451EU Total 12,582 9,896 9,260 7,751

Source: Central Bank reports, European Central Bank (various).

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.being restricted, and prices being raised. This stifling of competition is likely havedamaging implications for consumer welfare. This suggests there is a role for govern-ment or regulatory intervention to promote competition and prevent abuses of market power.

n Competition might be promoted by preventing a horizontal merger involving twolarge firms from taking place, or by requiring the break-up of a large incumbentproducer into two or more smaller firms. Such measures operate directly on marketor industry structure.

n Intervention might instead be targeted directly at influencing conduct. A regulatormight impose price controls, preventing a firm with market power from setting a profit-maximizing monopoly price. Legal restrictions on permissible forms of

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been generated from a wider variety of sources (diversification), and of the more efficient useof technology (such as consumer databases and call centres). This means banks are able tooffer a wider variety of products at lower cost than was previously the case. Some of theincrease in profitability has been driven by aggressive cost-cutting strategies, includingbranch closures and manpower reductions.

Overall, the level of competition, both between banks and other banks, and between banksand other financial sector institutions, continues to intensify. Deregulation and technologicalprogress have lowered entry barriers and made banking more competitive. However, con-tinued consolidation has resulted in a larger proportion of the banking sectors assets becom-ing concentrated in the hands of a relatively small number of institutions.

Table 2 Return on equity, 19902001 (various European countries, %)

Country 1990 1995 1998 2001

Austria 8.63 8.15 9.48 11.29Belgium 8.29 12.89 14.76 15.31Denmark 3.34 18.5 14.60 16.53Finland 5.61 7.93 9.86 n.aFrance 10.15 3.63 9.93 11.76Germany 11.93 12.57 17.38 5.12Italy 16.40 5.91 13.17 14.01Luxembourg 6.17 19.95 24.67 18.50Netherlands 12.30 15.81 14.30 15.23Portugal 12.54 7.65 7.56 6.31Spain 13.58 9.17 11.07 9.26Sweden 3.65 22.08 17.33 19.48UK 14.45 28.59 28.31 20.05EU Average 10.56 15.24 12.33

Source: Various Central Bank reports and OECD (2003) OECD Bank profitability statistics. Paris: OECD.

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.collusion might be strengthened, or punishments for unlawful collusion might be increased.

n Finally, a wide range of government policy measures (fiscal policy, employmentpolicy, environmental policy, macroeconomic policy, and so on) may have implica-tions for firms performance, measured using indicators such as profitability,growth, productive or allocative efficiency.

In common with the Austrian school, the Chicago school argue vehemently againstgovernment intervention in markets in order to promote competition (Reder, 1982).The Chicago school are a group of prominent academic lawyers and economists,whose pro-market, pro-competition and anti-government views were perhaps at theirmost influential during the 1970s and 1980s. The Chicago school are identified withthe argument that large firms are likely to have become large as a result of havingoperated efficiently, and therefore more profitably, than their smaller counterparts.Therefore punishing the largest firms because they are also the most profitable firmsis tantamount to punishing success. Even if certain abuses of market power do takeplace in the short run, these are likely to be self-correcting in the long run, when com-petition will tend to reassert itself. For example, there is little point in passing lawsagainst collusive agreements, since such agreements are inherently unstable and areliable to break down in the fullness of time (Posner, 1979). Markets and industrieshave a natural tendency to revert towards competition under their own steam, withoutthe need for any intervention or assistance from government.

The strident views of the Chicago school have not gone unchallenged. Blaug(2001), for example, accuses the Chicago school of promoting ideology rather thanscience.

The Chicago school does not deny that there is a case for antitrust law butthey doubt that it is a strong case because most markets, even in the presenceof high concentration ratios, are contestable. How do we know? We knowbecause of the good-approximation assumption: the economy is never faraway from its perfectly competitive equilibrium growth path! Believe it ornot, that is all there is to the antitrust revolution of the Chicago school.

(Blaug, 2001, p. 47)

Beyond structureconductperformanceAlthough the SCP paradigm was highly influential in the early development ofindustrial organization as a sub-discipline within economics, SCP has been subject tofierce criticism from a number of different directions. Below, we provide a checklistof criticisms of the SCP paradigm. Many of these points recur, and will be examinedin greater depth, in later chapters of this book.

n The SCP paradigm draws heavily on microeconomic theory and the neoclassicaltheory of the firm. However, the theory does not always specify precise rela-tionships between structure, conduct and performance variables. For example,oligopoly theory is largely indeterminate, and sometimes fails to produce clearand unambiguous conclusions.

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.n It is often difficult to decide which variables belong to structure, which to conduct and which to performance. For example, product differentiation, verticalintegration and diversification are structure variables; but they are also strategiesthat firms can consciously choose to adopt, and can therefore also be interpretedas conduct variables.

n What exactly do we mean by performance? Performance is some measure of the degree of success in achieving desired goals. Is it possible to have a set ofuniform performance indicators? Differences between the objectives of differentfirms may render SCP relationships tenuous. For example, if firms are sacrificingpotential profits in order to reduce risk by making more secure investments,researchers should be more concerned with variability in profitability than withthe profit rate as such (Schwartzman, 1963).

n As we have seen, the definition of market or industry structure has a number ofdimensions. However, many empirical studies based on the SCP paradigm measurestructure solely by seller concentration. This is mainly because concentration iseasier to measure than other dimensions of structure, such as entry barriers andproduct differentiation. Consequently there is a danger of overemphasizing the roleof concentration. More generally, many of the variables in all three categories ofstructure, conduct and performance are difficult to measure (Grabowski and Mueller,1970). How do we quantify the degree of vertical integration in an industry? Howdo we quantify the extent of collusion, or how do we even know if collusion istaking place? How do we measure the pace of technological progress? How dowe determine whether firms are achieving maximum productive efficiency?

We have concentration measures for most manufacturing markets inmany economies for instance, but little comprehensive information isavailable on more subtle aspects of market structure, and essentially no systematic data aside from accounting profit rates is available onconduct and performance. This leaves a factual vacuum in policy debates that is quickly filled by beliefs and assumptions.

(Schmalensee, 1990, p. 138)

n Empirical research based on the SCP paradigm often finds associations in the anti-cipated direction between structure, conduct and performance variables. However,such relationships are often quite weak in terms of their statistical significance.Much of the early SCP literature examines the relationship between industrystructure and performance, taking conduct as given. For example, in industrieswith only a few large firms, collusion was simply assumed to take place.

n The SCP paradigm has been criticized for overemphasizing static models of short-run equilibrium (Sawyer, 1985). No explanation is offered as to the evolution ofthe structure variables, and the influence of current conduct and performance onfuture structure. This criticism echoes our previous discussion of feedback linkswithin the SCP framework. At best the SCP paradigm is capable of providingonly a snapshot picture of the industry and its constituent firms at one particularpoint in time.

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.n Most early empirical research based on the SCP paradigm focused on the rela-tionship between seller concentration and profitability. According to the collusionhypothesis, a positive association between concentration and profitability wasinterpreted as evidence of collusion or other abuses of market power designed toenhance profits. Later researchers emphasized the possibility that high profitabilitywas achieved through the exploitation of economies of scale, or other cost savingsachieved by the managers of large firms. According to the efficiency hypothesis(which is closely identified with the Chicago school, discussed above), a positiverelationship between concentration and profitability reflects a natural tendencyfor efficient firms to be successful, and to become dominant in their industries.During the 1970s and 1980s, a large body of literature attempted to resolve thecollusion-versus-efficiency debate using tests based on empirical data.

Several of these criticisms, especially the realization that a number of conduct andperformance variables have feedback effects on structure, and that causality withinSCP is a two-way and not just a one-way process, led eventually to a shift away fromthe presumption that structure is the most important determinant of the level of com-petition. Instead, some economists argued that the strategies (conduct) of individualfirms were equally, if not more, important (Scherer and Ross, 1990). Theories that focusprimarily on strategy and conduct are subsumed under the general heading of thenew industrial organization (NIO) (Schmalensee, 1982). According to this approach,firms are not seen as passive entities, similar in every respect except size. Instead theyare active decision makers, capable of implementing a wide range of diverse strategies.Game theory, which deals with decision making in situations of interdependence and uncertainty, is an important tool in the armoury of the NIO theorists. Theorieshave been developed to explore situations in which firms choose from a plethora ofstrategies, with the choices repeated over either finite or infinite time horizons. Someeconomists believe game theory has strengthened the theoretical underpinnings ofindustrial organization (Tirole, 1988). Others, however, are highly critical of the gametheoretic approach. Schmalensee (1990), for example, complains that just aboutanything can happen! when game theory is used to analyse competition:

Game theory has proven better at generating internally consistent scenariosthan at providing plausible and testable restrictions on real behaviour . . .Until game-theoretic analysis begins to yield robust, unambiguouspredictions or is replaced by a mode of theorizing that does so, any majorsubstantive advances in industrial organization are likely to come fromempirical research.

(Schmalensee, 1990, p. 141)

1.4 Strategic management: a short diversion

A number of tools developed in the industrial organization literature have contributedto the growth of the sub-discipline of strategic management. Highly influential in theearly development of this literature is Porter (1979a, 1980, 1985, 1996), whose fiveforces model of the firms competitive environment is heavily SCP-influenced. Portersfive forces are: the extent and intensity of competition; the threat of entrants (new

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.competitors); the threat of substitute products and services; the power of buyers; andthe power of suppliers. The five forces are illustrated schematically in Figure 1.2.

n Extent and intensity of competition. The intensity of competition depends on thenumber and size distribution of the industrys incumbent firms. If there are largenumbers of similarly sized firms, competition is expected to be more intense thanit is if one or a few firms are dominant. Other influences on the extent of competi-tion include the rate of growth of industry sales; incumbent firms cost structures;and the availability of spare capacity to meet potential increases in demand.

n Threat of entrants. Incumbent firms that are threatened by entry behave differentlyto those in industries that are sheltered from competition. The perceived threat ofentry is likely to be higher in industries where incumbents are highly profitable,and incumbents may search for ways of raising entry barriers. Government regulation also plays a part in determining the ease of entry. The size of the entrythreat depends on the importance of economies of scale, the extent of productdifferentiation and brand loyalty, the level and specificity of capital investments,and the availability of access to distribution outlets.

n Threat of substitute products and services. The availability of substitute productsand services naturally tends to increase the intensity of competition. The avail-ability of substitutes increases the price elasticity of demand for existing products,reducing the market power of incumbent firms. Incumbents may respond byseeking to differentiate their products more strongly from those of rivals, throughbranding or advertising. The attractiveness of substitute products to consumersdepends on the prices and quality of the competing products, and the size of anyswitching costs.

n Power of buyers. The power of buyers of a firms product depends on their number and size distribution, and their level of dependence on the firms output.If there are only a few buyers, or if close substitutes are available, buyers arelikely to wield significant market power. In order to secure their own supplies,large buyers may seek to integrate backwards (by taking over an input supplier),reducing their reliance on external suppliers.

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1.4 Strategic management: a short diversion 17

Figure 1.2 Porters five forces modelSource: Adapted from Porter (1980), p. 4.

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.n Power of suppliers. If suppliers of important inputs into a firms production pro-cess are large in size and small in number, these suppliers can exercise marketpower by raising price, reducing quality, or even threatening to withhold supplies.

Porters five forces identify the sources of competition that may confront a firm atany point in time. The firms strategies and conduct are conditioned by the presenceand strength of the five forces. In common with the SCP paradigm, however, Portersapproach is essentially static, and perhaps tends to underemphasize the problem ofuncertainty caused by change in the competitive environment.

In contrast to many economists, management strategists tend to emphasize thedistinctive internal characteristics of firms, in order to explain how a competitiveadvantage can be acquired and sustained. In the strategic management literature, thefocus is on maximizing firm value thro

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Industrial Organization