Chapter 1

Thursday, May 25, 2023 2:04 PM

- Industrial Economics is the study of firms, industries, markets and the policies that influence them.
It is the application of microeconomic theory to the analysis of firms, markets, and industries.
- Industrial Economics defers from Microeconomics in that it is a more active disciple, more
informal and inductive, it discards the single goal of profit maximization, and takes policy into
consideration.
- Industrial Econ also as a macro dimension in the sense that what should be produced are
examined from the social angle as well, and the decisions made (by the government etc) with that
in mind can influence the performance of firms so they must be studied.
- Industrial Econ encompasses both industrial organization (which is more concerned with structure
of industries at a time) and industrial dynamics (which is more concerned with the evolution of
industry as a process in time at all levels).
- The four main themes that encompass Industrial Economics: The role of knowledge, the role of
the degree of interdependence among firms, the role of technological change and institutional
framework, and the role of economic policy.
- The two elements in Industrial Econ:
○ Descriptive: The information about competitors, natural resources, factors of production,
and government rules/ regulations.
○ Analytic: Business policy and decision-making.
- Firm: Any organization engaged in productive activity with a certain goal in mind.
- Industry: A group of sellers of a homogenous output or of close substitute outputs who supply to
a common group of buyers.
- Market: A closely interrelated group of sellers and buyers for a commodity. In practice, it is
difficult to define the precise boundary for a market.
○ A market is said to be imperfect if there is: lack of information, barriers to entry, and non-
uniform product.
○ Market power is inversely related to both the degree of competition in the market and the
ease of entry and exit.
○ Contestable market is a market in which competitive outcomes can be observed.
Characterized by 'hit and run' entry.
- Studying Industrial Economics is instrumental to the formulation and implementation of industrial
policies that are essential for sustainable development of a nation.
- Approaches to Industrial Economics:
a. Structure-Conduct-Performance paradigm/ Harvard tradition/ Structuralists: There is a
linear relationship between the 3 concepts in IE and they follow the progression of SCP. The
traditional SCP approach asserts that market structural condition yields sufficient
information to deduce how firms should behave and performance can be directly predicted
from conduct
□ Structure -- Four main features: concentration ratios (Buyer and Seller),
differentiation of products, and conditions to entry.
□ Conduct -- Pricing behavior, product strategy and policy, promotional activities,
Research and Development, and Legal Tactics.
□ Performance -- productive and allocative efficiency, exchange efficiency,
industry progressivity, profit rates, level of output, product suitability,
§ The SCP paradigm implies that the fewer the firms in a market (structure), the more
likely that they will collude (conduct), which will mean that P>AC=MC thus leading to
these firms' high profits (performance) and the likely strategy of blocking entry.
§ Fundamental market and environmental conditions can be divided into supply side
factors and demand side factors.
□ Supply side factors include: Location and ownership of raw materials, product
 durability, tech, labor organization, government policies, etc. These affect the
market structure and are also affected by it in return.
□ Demand side factors include: price elasticity, cross elasticity, growth prospects,
market of product (tastes), method of purchases, etc. These affect the market
conduct and are also affected by it in return.
□ Structure and Conduct affect each other and they also affect Performance as
well.
□ There are also public policies (taxes, subsidies, int'l trade rules. Price controls,
etc) that affect both supply and demand sides.
§ Generally, Basic Supply and Demand conditions -> Structure -> Conduct ->
Performance
§ Criticisms of the Harvard school: Assumption that firms will be able to adjust quickly
to changes is unrealistic, it is also too simplistic because it is based on linear
determinism. A critic from within the SCP paradigm is against the unidirectional
relationship among S, C, and P. This critique can be of 2 aspects - either reverse
causation or simultaneous causation.
b. The Chicago School of Thought: gives high accord to conduct. Criticized the SCP model for
diverging too greatly from the basic neoclassical price theory. They also noted that the
empirical association between the SCP variables don't suggest causation.
§ The Chicago school argued that where concentration was high, firms tended to be
larger and that larger firms tended to be more efficient, which is what actually led to
higher profits. So government intervention would be counter productive.
§ They believe that monopolies may be harmless or even advantageous.
c. New Institutional Economics: Institutions matter for economic performance bc transaction
costs not only exist but are also significantly large and can shape the structure of institutions
and economic behavior.
§ Institutions represent a third constraint (besides price and technology).
§ The institutional environment comprises those political, social and legal ground rules
that underpin production, exchange and distribution. Institutional arrangements exist
and evolve within the institutional environment.
Chapter two
Friday, May 26, 2023 9:52 AM

Legal forms of business: Sole proprietorship, Partnership, Corporation

- Five main aims that represent the organizational goals of the firm.
a. Production goal
b. Inventory goal
c. Sales goal
d. Market share goal
e. Profit goal
- Theories of the firm. There are two broader classifications:
a. Classical Theory: from the microeconomic theory of the firm, hence behavior aligning with
profit maximization. MC=MR. Divides production time periods into 3 classes: The market
period (where output cannot be altered), the short run (when all but one factor of
production can be altered), and the long run (when all factors can be altered).
§ Criticisms: Firms may not be profit maximization, imperfect information and
uncertainty are not accounted for, organizational complexity might impede profit
maxing and this isn't considered, decisions of individuals are more fundamental than
of the organizations which they form.
b. Modern Theory: developed bc some questions are left unanswered in the neoclassical
theory. Can be further classified into three:
i. Managerial Theory: The focus is on the relationship between owners and managers
and their likely possible deviation of objectives, even if there isn't necessarily a
deviation of interest. Thus it is based on 2 major principles: There is separation of
ownership and control and Firms are active entities that make a difference in their
economic performance. Two managerial theory models among others:
1. Baumol's Model: Managers are more preoccupied by sales or revenue
maximization (MR=0 & ed=1. This is because sales performance is equated with
performance in market share. But, the model also attempts to reconcile
behavioral conflict between profit maximization and sales maximization by
assuming a firm maxes its sales revenue subject to a minimum profit constraint.
2. Marris's Model: Managers are more occupied with growth as an objective. Has
two curves, one representing supply growth and the other representing demand
growth. There will be a unique state of growth and profit equilibrium when
these relationships are satisfied.
ii. Principal-Agent Theory: Two main actors, the principal (owner) and the agent
(decision-maker). The key feature is that the principal knows less than the agent about
something important and this leads to two types of problems:
1. Moral Hazard/ Effort Aversion: Agent can improve outcome but principal can't
observe action. (Hidden Action)
2. Adverse Selection: Agents and principals can't express the difference among
them. (Hidden Type)
The principal-agent contract should be: risk-sharing and incentive-including
iii. Transactions Cost Theory: Transactions costs are costs of running the economic
system that arise from the establishment, use, maintenance, change of institutions
(law and rights), and informal activities connected with operating basic formal
institutions. There are 3 types of transaction costs:
a) Market Transaction Costs: cost of screening and selecting a buyer or
seller; the cost of preparing contracts which includes the cost of obtaining
information on the good or service; the cost of bargaining & negotiating a
contract; cost of monitoring & enforcing the contractual obligations.
b) Managerial Transaction Costs: The costs of setting up, maintaining or
 changing an organizational design; of running an organization, or
information, of physical transfer of goods and services
c) Political Transaction Costs: the costs of setting up, maintaining and
changing a system’s formal and informal political organization; costs of
establishment of the legal framework; the administrative structure; the
military; the educational system; the judiciary; and so on.
- Characteristics of Transactions: Uncertainty, Frequency of transactions, and
Degree to which transaction specific investments are involved
- Policy Implications: The role of the state is significant, New Institutional
Economics is a useful tool in developing countries.
The Growth of the Firm
- Proposed reasons for the reasons of growth:
1. Growth as a Natural Process
2. A Response to External Pressure: Mainly, the development of needs and dynamism of
competition.
3. The Drive for Market Power
The determinants of the growth of a firm are attempted to be explained by 4 theories:
1. Life Cycle Theory: Birth, growth and maturation, death. Captured by the product-life cycle or the
Sigmoid (S) curve. States that a young firm has a short hierarchy and allows management
economies, thus it is easy to handle and transmit information, and there is high communication at
the early stages of a firm which allows for prompt and flexible decision making. However, a firm
becomes wider and older, managerial diseconomies of older firms arise and leads to stagnated
growth due to the inefficacy of large and complex hierarchy.
Criticisms: Growth may be exogenously given at any point, developments in the supply side
could trigger high growth rates, needs develop over time instead of dying, management can
change growth patterns.
2. Downie's Theory: the alternative forms of market structures and the “rules of the game” lead to
the divergences in efficiency and the rate of technical progress among firms. Some firms have
greater efficiency while others have lower efficiency and this variation is attributed to technical
progress. More efficient firms grow by steadily stealing market share from the less efficient ones.
There are two opposite forces in the growth process of the firm: The supply side (capacity growth
curve) which varies positively with the rate of profit (bc investment in tech comes from profits)
and the demand side (market growth curve) which varies inversely with the rate of profit after
some level (bc an efficient firm must offer price discounts to attract new customers which means
lower profits to them). The point of these two curves' intersection is called Downie's Equilibrium
Point.
Criticisms: Downie's theory ignores the possibility that inefficient firms might become
efficient over time, the argument that new customers are attracted through price-reduction
ignores non-price competition strategies, the model hasn't taken managerial restraint into
account, the model undermines the role of other sources of financing.
3. Penrose's Theory: Growth continues unless internal and/or external restraints constrain it.
Internal constraints include: managerial capacities and financial constraints. While external
constraints include: fall in demand for product, competition from rivals, patent or other restriction
to the adoption of new tech, shortage of inputs, etc.
Penrose believed the internal factors were more important in the issue of expansion bc strong
management can handle external factors as well as financial limitation.
Criticisms: Gave marginal attention to all non-managerial constraints, and management is
not in reality a perfect substitute to other inputs.
4. Marris's Theory: Earlier Managerial theory. It is also referred to as the integrated theory of growth
bc it integrates Downie's and Penrose's theories. All the three constraints (financial, market
demand, and managerial) are made operative here.
○ g=gd=gc is the equilibrium condition where g is balanced growth rate and gd is the rate of
growth of demand for the products and gc is the rate of growth of its capital supply.
○ By jointly maximizing the rate of growth of both, managers achieve maximization of their
own utility as well as that of the utility of the owners.
○ The utility function of the owners, Uo = f(gc). Utility function of the managers, Um = f(gd, s)
where s represents job security and is measures by a weighted average of three ratios: the
liquidity ratio (must be low), the leverage-debt ratio (must be sufficiently high, not too high),
and the profit retention ratio.

○ The long-run objectives and decisions for growth, sales, and profit maximization are virtually
identical policies that maximize the long-run growth of a variable.
○ Sources of growth: the diversification (of product) rate on the demand side and an increase
in the asset-base of the firm on the supply side.
○ Growth constraints: Management and Financial.
○ To ease financial constraints: Retained earnings, borrowing, and issuing new equity shares
○ The desire for job security for the managers makes them have disutility over time, making
the goal of the firm defined as the maximization of balanced growth while subject to
managerial constraints.
Criticisms: Doesn't recognize agency and moral hazard problems, it is based on the strong
assumptions of neoclassical theory, it relies heavily on the restrictive assumption that firms
have their own R&D departments, it fails to explain oligopolist interdependence in non-
collusive markets, it narrows the scope of economic analysis to a micro-macro level, and it
doesn't explain how price is determined in the market (the last three criticisms are levied at
all managerial theories)