UNIT 1

Concept, Evolution and Approaches of Industrial economics

1.1. Industrial Economics: Definition and Its link with other branches of Economics

Industrial economics is a distinctive branch of economics, which deals with the economic
problems of firms and industries, and their relationship with society.

For a producer, the sources like land, raw materials, labor, capital, etc., are scarce. Given such
scarcity, the producer has to take decisions about production and distribution. There are several
basic issues on which the producer will be taking decisions such as:

 What commodities he/she should produce?

 What should be the level output of each?
 What type of technology he/she should adopt?
 Where should he/she produce the goods?
 What should be the size of his/her factory?
 What price he/she should charge?
 How much wages should pay?
 How much he/she should spend on advertisement?
 How much should he/she borrow from banks or elsewhere?, etc.,

All such decisions explain the producer's behavior in the different market situations, which we
endeavor to study in industrial economics.

In microeconomics also we study producer’s behavior in relation to scarcity of resources.

Because of this fact, some economists would regard industrial economics as being primarily an
elaboration of, and development from, the traditional theory of the firm taught under
microeconomics. Industrial economics is best defined as the application of micro economic
theory to the analysis of firms, markets and industries. However, there are some differences
between the two,

o Microeconomics is a formal, deductive and abstract discipline/

 Industrial economics on the other hand is less formal, more inductive in nature

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 o Microeconomics by and large assumes profit maximization as the goal of the
firm and tells us to maximize it subject to given constraint. It is passive in
approach.
 Industrial economics does not believe in single goal of profit maximization. It searches the
goals of the firm from the revealed facts. It concentrates on the constraints which impede the
achievements of the goals and tries to remove them.
It is an active discipline in this sense.
o Microeconomics, being abstract, does not go into operational details of
production, distribution and other aspects of the firms and industries
 Industrial economics does go into the depth of such details.
o The conclusions derived from the microeconomics may not be testable and
therefore we may not assess their predictive efficiency.
 Industrial economics is free from such limitations because of its emphasis on empiricism.
o Microeconomics may shun public policy implications if necessary
 Public policy implications are taken care of in industrial economics.

So far, we were looking at industrial economics with the concern of decision-making in an

industry from micro angle, but it has macro dimension also. To achieve the broader policy
objectives, a state will regulate industries through varieties of ways such a nationalization,
privatization, anti-trust policies, control on prices and outputs, credit controls, taxes, etc. A
study of all such instruments of industrial regulation is an integral part of industrial economics.
How they affect the performance of the firms is a crucial aspect to be examined under industrial
economics. Such information is useful for the regulatory agency of the government to assess the
success of its industrial policy.

The term industrial organization is commonly viewed as synonymous with industrial

economics. But Carlsson (1989) differentiate them as industrial organization is the structure of
industries at a particular point of time while, industrial economics encompasses both industrial
organization and industrial dynamics. Industrial dynamics is primarily concerned with the
evolution of industry as a process in time both at the macro level, the sector or industry level,
and the firm level. It differs from industrial organization in that its main focus of attention can
vary from the firm, to relationships between firms, to the links between microeconomics and the
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macro economy.

Carlsson argues that there are four main themes which encompass the subject matter of
industrial dynamics:

1. The nature of economic activity in the firm and its connection to the dynamics of supply and
therefore economic growth, particularly the role of knowledge.

2. How the boundaries of the firm and the degree of Interdependence among firms change over
time and what role this interdependence plays in economic growth.

3. The role of technological change and the institutional framework conducive to technological
progress at both macro and micro levels.

4. The role of economic policy in facilitating or obstructing adjustment of the economy to

changing circumstances (domestically as well as internationally) at both micro and macro levels
- industrial policy

In general, we may say that industrial economics is predominantly an empirical discipline having
micro and macro aspects. It has a strong theoretical base of microeconomics. It provides useful
applications for industrial management and public policies.

Elements of industrial economics

There are two broad elements of industrial economics:

Descriptive and

Analytical elements.

Descriptive element is concerned with the information content of the subject. It is aimed at
providing the industrialist or businessman with a survey of the industrial and commercial
organizations of his own country and of the other countries with which he might come in contact.
It gives businessman full information regarding the natural resources, industrial climate in the
country, situation of the infra-structure, supplies of factors of production, trade and commercial
policies of the governments, and the degree of competition in the business in which he operates.

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In short, it deals with the information about the competitors, natural resources and factors of
production and government rules and regulations related to the concerned industry.

Analytical element of the subject is concerned with the business policy and decision-making.
It deals with topics such as market analysis, pricing, choice of techniques, location of plant,
investment planning, hiring and firing of labor, financial decisions, and product diversification
and so on. It is a vital part of the subject and much of the received theory of industrial economics
is concerned with this. However, this does not mean that the first element, i.e. descriptive
industrial economics, is less important. The two elements are interdependent, since without
adequate information no one can take proper decision about any aspect of business.

1.2 Some Basic Concepts in the Study of Industrial Economics

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The Firm: A firm is an organization owned by one or jointly by a few or many individuals which
is engaged in productive activity of any kind for the sake of profit or some other well-defined
aim. Most of the firms owned by private individuals in manufacturing trade and services will
aspire for profits but there may be some other such as government companies where profit
motivation will be secondary or missing altogether.

The industry: The conventional definition of the term industry is a group of firms producing a
single homogeneous product and selling it in a common market. However, the restriction of a
single homogeneous product is not met in practice. Most of the firms produce many outputs
which may or may not be substitutable for each other. In this situation, the conventional defini -
tion has no operational sense. A better approach to define the industry is to call it “a group of
sellers or of close substitute outputs who supply to a common group of buyers”. In other
words, we may take it in simpler terms as a group of firms producing closely substitute goods for
a common group of buyers.

The Market: This is defined as a closely interrelated group of sellers and buyers for a
commodity. The term is not equivalent to the industry since in the latter case we will be looking
only at the seller’s side of the market. By including the buyer's side, the term becomes more
comprehensive connoting the composition of the buyers and their geographical location along
with the industry. A heterogeneous group of closely substitute goods will have a market, but
there may be markets within the market for every homogeneous good. Within the market, the
good will be treated as uniform. In practice it may be difficult to define the precise boundary for
a market. A market is said to be imperfect if there is lack of information about it, there are entry
barriers to it and the product is not uniform.

Market power: - refers to the influence that any particular buyer or seller can exercise over the
price of a product. It indicates the degree to which a business firm is able to earn larger than
normal profits.

Contestable market: It is a market in which competitive outcomes can be observed. Its

fundamental feature is low barriers to entry and exit; a perfectly contestable market would have
no barriers to entry or exit. Contestable markets are characterized by 'hit and run’ entry. If a firm

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in a market with no entry or exit barriers raises its prices above marginal cost and begins to earn
abnormal profits, potential rivals will enter the market to take advantage of these profits. When
the incumbent firm(s) responds by returning prices to levels consistent with normal profits the
new firms will exit. In this manner even a single-firm market can show highly competitive
behavior.

1.3. Approaches of Industrial Economics

1.3.1 The Structure-conduct –performance paradigm

Market Structure: Refers to the organizational characteristics of buyers and sellers in a

particular market. It means the pattern or form or manner in which the constituent parts of a
market (i.e. buyers and sellers) are arranged/ linked together. It is specified in terms of the
organizational characteristics which determine the relations:

 Of sellers in the market to each other;

 Of buyers in the market to each Other;
 Of the sellers to the buyers; and
 Of sellers established in the market to the new potential firms which might enter the
market.

These characteristics of the organization of a market exercise a strategic influence on the nature
of competition and pricing within the markets. The following four main features of the market
structure have been suggested by Bain, which are important to understand the concept precisely
and to measure it:

1. The Degree of Seller Concentration: This is the number and size distribution of firms
producing a particular commodity or types of commodities in the market.
2. The Degree of Buyer Concentration: This shows the number and size distribution of buyers
for the commodities in the market.
3. The Degree of Product Differentiation: This shows the difference in the products of
different firms in the market.

4. The Condition of Entry to the Market: This shows the relative ease with which new firms

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 can join the category or sellers (i.e. firms) in the market. When significant barriers to entry
exist, competition may cease to become disciplining force on existing firms, and we are
likely to see performance that departs from the competitive ideal.

Market Conduct: It includes the pattern of behavior followed by firms in the industry when
adapting to a particular market situation. It includes:

1. Pricing behaviors of the firm or group of firms:- This includes a consideration of whether
price charged tend to maximize individual profits, whether collusive practices in use tend to
result in maximum group profits or whether price discrimination is followed.
2. Product policy of the firm or group of firms
3. Sales promotion and advertising policy of the firm or group of firms
4. Research, development, and innovation strategies employed in the firm or group of
firms

5. Legal tactics used by the firm or group- Legal actions to gain competitive advantage.

Market Performance: - It is the end result of the activities under taken by the firms in pursuit
of their goals. High profitability, high rate of growth the firm, increase in the sales, increase in
the capital turnover, increase in the employment etc are some variables on the basis of which we
can judge the market performance of the individual firms depending on their respective goals.

Generally, good market performance is a multidimensional concept which includes the following
elements:

1. Resources should be allocated in an efficient manner within and among firms such that
these resources are not needlessly wasted and that they are responsive to consumer desires.
2. Technical or operational efficiency--how closely do existing firms, as a group, achieve
lowest possible costs?

3. Exchange Efficiency-refers to the costs of arranging transactions (transaction costs

 Include pricing efficiency--i.e., the degree to which prices accurately and rapidly transmit
changes in supply and demand to participants in the market.

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4. Profit Rates: normal profit is the indicator of good market performance. Profit serves as the:

 Returns to management and risk taking

 Returns to capital investment
 Signal to guide resource allocation in the economy.
Chronic excess profits representing a failure of the market system:

 Indicate too few resources are flowing into the industry

 May be a result of concentrated market structure and high barriers to entry.
 May have undesirable income distribution
Chronic sub-normal profits may indicate a sick or declining industry.

5. Level of Output: It is separate from profit levels because output level not necessarily directly
related to profit levels in real world. We are usually concerned with underproduction, but can
also have situations of overproduction.

6. Producers should be technologically progressive; that is, they should attempt to develop and
adopt quickly new techniques that will result in lower costs, improved quality, or greater
diversity of new and better products.

7. Product Suitability- involves matching products with consumer preferences. The

performance and safety characteristics of products that are supplied have to be reliable. The
quality level of products should be neither too high nor too low relative to consumer desires.

8. Production resources should be organized in such a way to encourage an equitable

distribution of income.
9. Producers should operate in a manner that encourages continued full employment of
productive resources. It can be argued that unused resources are wasted resources,
especially when they are perishable as in the case of human capital.
10. Participant Rationality-deals with adequate market information to make rational
choice and avoidance of misinformation.

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11. Conservation- refers to the extent to which a firm or industry promotes the
conservation of natural resources. No needless depletion or inefficient extraction plus
exploration.
12. Labor Relations- covers equal opportunity, working conditions, wage levels and
wage structure, work rules. Norm includes fair treatment (no race, sex discrimination),
mutual fair treatment, reasonable communication and respect.
13. Unethical Practices: firms should not engage in the production and distribution of
undesirable products/services. What is ethical is culturally determined, which poses problems
when different cultures try to trade, either within a country across ethnic groups or
internationally.

Other aspects of good performance can be enumerated including external effects and costs of
sales promotion. For the society as a whole, performance of an industry may be judged on the
basis of its contribution in increasing the welfare of the masses.

The relationship between Structure, conduct and performance

The link between these three which is evident in the theory of the firm is that market structure of
an industry determines or strongly influences the crucial aspects of its market conduct which
in turn directly or indirectly determines certain important dimensions of its performance.

Traditional SCP approach argues that performance is determined by conduct of firms, which in
turn is determined by the structural characteristics of the market (Fig. 1.1)

Figure 1.1 the traditional SCP approach

Structure Conduct Performance

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.

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Fig. 1.2 shows how the SCP approach may be adapted to incorporate more complex linkages, but
the essential causality still flows from structural criteria.

and performance.
Figure1.2. More complex relationship between structure, conduct

Structure Conduct Performance

It can summarized that, While industrial economics has traditionally emphasized the causal
flows running from exogenous market structure and/or the exogenous basic conditions to
conduct and performance, there are important feedback effects from performance to structure .

1.3.2 The Chicago School of thought

The method of analysis of this school relies on the traditional standard of perfect competition
model. For thinkers of this school, competition is an ever – present reality. This school is more
antipathetic (strong dislike to government intervention). In the SCP paradigm, high concentration
was believed to be collusion and enhance high profit implying the need for government
intervention. But the Chicago school argues that when concentration is high. Firms tend to be
large. Larger firms tend to be more efficient and this greater efficiency leads to higher profit.
Thus nullifying (making void) the reason as to how government should intervene enhance high
profit. According to this school, government may intervene only if the reason to higher profit is
the act of collusion of firms.

1.3.3 Institutional Economics

In this world institutional arrangements give the process of exchange arrangement of

transactions. These transactions have costs. Transaction costs are the expenses of trading with
others above and beyond the price, such as the cost of writing and enforcing contracts.

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According to the transaction cost school, institutions that lower the costs of transactions are the
key to the performance of the economies. These costs include those of information, negotiation,
monitoring, coordination and enforcement of contracts. When transaction costs are absent, the
initial assignment of property rights does not matter from the point of view of efficiency. This is
because the property rights can be voluntarily adjusted and exchanged to promote increased
production. The problem is when transaction costs are substantial. Indeed, usually, the
transaction costs are substantial. In the case of substantial transaction costs, the allocation of
property rights is critical.

In the historical growth process there is a trade-off between economies of scale and
specialization, on the one hand, and transaction costs on the other. In a small, closed, face-to-face
peasant economy, transaction costs are low. However, the production costs are high in a small
economy because specialization and division of labor are severely limited by the extent of
market defined by the personalized exchange process in the small community. In a large
complex economy as the network of interdependence widens the impersonal exchange process
gives considerable scope for all kinds of opportunistic behavior (cheating, shirking, and moral
hazard) and the costs of transacting can be high. In western societies, complex institutional
structures have been devised (for property rights, formal contracts and guarantees, corporate
hierarchy, vertical integration, limited liability, bankruptcy laws, and so on). This reduces the
uncertainty of social interaction, and prevents the transactions from being too costly and thus
allows the productivity gains of large scale and improved technology to be realized.

In recent development literature, the institution of interlocking of transactions (in labor, credit
and land relations) has been rationalized as a device to save transaction costs and to substitute for
incomplete or nonexistent credit and insurance markets. In general, institutions can be obstacles
if they are not suitably reorganized in tune to development.
The question is how these institutions affect market structure and, then, the existence and
performance of firms? According to Coase, the use of the market place involves costs. These
costs help to determine market structure. For example, where the cost of buying from other firms
is relatively low, a firm is more likely to buy supplies from others than produce the supplies
itself. There are four concepts related to transactions. These are:

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1. Markets and firms are alternative means for completing related sets of transactions. For
example, a firm can either buy a product or a service or produce it.
2. The relative costs of using markets or firms’ own resources should determine the choice.
3. The transaction cost of writing and executing complex contracts across a market vary with
the characteristics of the human decision makers who are involved with the transaction on
the one hand, and the objective properties of the market on the other.
4. These human and environmental factors affect the transaction costs across markets and
within firms.
Under what circumstances will transaction costs be lower when internalized than when left to be
negotiated in an external market? The factors can be either environmental factors or human
factors. The key environmental factors are uncertainty and the number of firms. Whereas, the key
human factors are bounded rationality and opportunism. Bounded rationality is the limited
human capacity to anticipate or solve complex problems. Problems arise when uncertainty is
combined with bounded rationality, or where the managers of the few firms in an industry
behave opportunistically.

Thus, in a world of great uncertainty, it may be too difficult or costly to negotiate contracts that
deal with all possible contingencies. As a result, firms may produce internally even though it
would be cost effective to rely on markets.

When the number of firms is small and individuals are opportunistic, firms may not want long
term contracts for fear of being victimized in the future. For example, a firm that relies on
another to supply a factor that is essential to its production may be vulnerable to blackmail
became it cannot operate if its supply is stopped. This problem is likely to be important if there
are few alternative supplies. Thus, reliance on markets is more likely when (1) there is little
uncertainty and (2) there are many firms (competition) and limited opportunities for
opportunistic behavior. When these conditions are reversed, firms are more likely to produce for
themselves than to rely on markets.

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UNIT2. AGENT, OWNERSSHIP, CONTROL AND GOAL OF THE FIRMS
2.1 Legal forms of the business
The organizational form (legal forms of the business) may influence the choice of the goal or
motive to be pursued by the firm. For example, a small firm run by a sole proprietor may intend
to pursue the motive of profit maximization but for a large corporation this objective may not
have any validity in view of the separation of the management from the ownership. The
managers in this situation may be interested in maximizing their own utility rather than the
profits. Thus, it is the goal to be pursued that determines the choice of the legal form for a firm.

2.1.1 Types of Organizational Forms

In industrial economics, a business firm can be identified based on the type of business it is
doing, its size, the pattern of ownership and etc. The pattern of ownership is commonly used to
describe the type of organizational form for the firms. According to this, we can classify firms
as proprietorship, partnership and corporation. This kind of classification is a largely
recognized institutional pattern within which business firms operate all over the world. This
classification enables us to understand the possibility of separation of the management from the

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ownership, as is the phenomenon in the corporate sector now a days. This helps one to
understand the decision-making process in reality. The legal organizational pattern of the firm
based on their ownership is as follows.

 All firms engaged in business can be first classified into three categories.
 private sector
 Public sector and
 Joint sector
In private sector ownership is exclusively in the hands of the private individuals, where as in the
public sector, the government owns the firm. In the joint sector, the government, the private
entrepreneur and the public together share the ownership, management and control of the firm.

Figure 2.1: Different organizational forms of firms

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 2.1.1.1 Private Sector

 There are four private forms of business ownership. These are;

i. Sole proprietorship: Sole proprietorship is the simplest kind of business organization
which is owned and controlled by a single individual. Alternatively, it is called one-man
business. The sole proprietor may have any number of persons working for him/her but
they will be just paid employees or family members having no share in the ownership of
the business.
In terms of numbers, this is the most common form of business organization and is found mainly
in the retail trade, service industries, cottage and small industries and the professions. This form
of ownership has its own advantages and disadvantages.

Advantages of sole proprietorship

 It is easy to establish
 Incentive to earn more by exerting one’s own effort.
 Independence of control over business
 Decision-making is very fast
 Secret of business can be maintained
 Can bring efficiency because of direct contact to the owner
 Flexible operation
 Equal opportunity to everyone to use ones talents
Disadvantages of Sole Proprietorship
 There may be limitation both in resource mobilization and management.
 Sole proprietor liable for all kinds of risks (unlimited liability)
 The life of the firm is uncertain. After the death of the proprietor there is no
guarantee whether the business will continue.
 All qualities required for success in business are rarely found in one man.
Sole proprietorship is suitable when the markets are limited and highly localized and the
commodity or service is provided according to individual requirements.

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 ii. Partnership: In this form of ownership the firm is owned or managed or controlled
jointly by more than one person. All of them agree to share the profits of the firm.
In fact, the sharing of profits is the basis for defining partnership. It is not necessary
for the partners to own the capital jointly or to manage the firm jointly. The
contribution of the partners in running the business need not be the same. The
minimum number of partners is two and the upper limit is twenty in most cases.
Partnership is created by mutual consent and voluntary agreement.

The liability of the partners in the business is unlimited. The limitation of the liability through
mutual agreement is not possible legally under partnership. The head of the family manages the
business, other members help him. Profits are shared by all members of the family according to
their share or contribution in the business. The family members are free to leave the joint
business whenever they like to do so. This type of business continues, since after the death of
the head of family new head will take over to keep the business going. Joint ownership of the
property is the basis for such an organization. The liability of the numbers of family except the
head will be limited.

There are many types of partnership depending upon their specific role in business. There are
active partners who bring in capital and take active interest in the conduct of the business. There
are sleeping partners who bring in capital, share profit gains but do not take active interest in the
conduct of the business. There is a category of interest which is called secret partners being
unknown to the public. There are nominal partners who just lend their names and credit to the
firm without contributing any capital or without any active interest in the business. In the eyes of
the law such partners are equally responsible for the liabilities of the firm. A person who is not a
partner actually, but acts as a partner which is called quasi-partner or estoppel-partner. Such a
partner does not share any personal liability of the firm.

The advantages of the partnership are;

 Ease of formation
 Large financial resources
 Combined managerial abilities and judgment
 Flexibility and elasticity in operation

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  Combination of management and ownership
 mutual cooperation,
 Protection of minority (in the sense of partnership) interests secrecy in business and
 Adequate credit availability because of unlimited liabilities of the partners.
The main disadvantages are:
 Unlimited liability of each partner
 Risks from dishonest co-partners
 Uncertain life
 Lesser public confidence,
 Non-transferability or restricted transferability of the partners' interest in the business, and
 Liability of the partner even after his retirement from the firm.
Note: Like a sole-proprietorship the main motive of partnerships firm will be profit
maximization. This is clear since the very basis of defining partnership is the sharing of the
profit. Survival in business may be looked upon as an alternative goal for such a firm.

iii. Joint-stock company or corporation: This is the most important form of organization
in the modern world. A joint-stock company is a legal entity with a perpetual
succession and a common seal. It is a voluntary association of certain persons formed
to carry out a particular purpose in common. It is just like an artificial man created by
the law whose life is independent of the lives of the members of its association.

The essential characteristics of a joint-stock company are the following.

 Legal Entity: - A joint-stock company is created by low. It is a legal entity distinct
and independent of the existence of its members who own it. It is the official seal and
signatures that matter in the dealings of a joint-stock company.
 Corporate Existence:- According to the law, the mode of incorporation and
dissolution of the company and the rights of the members to transfer shares guarantee
the existence of the company quite independent of the life & tenure of the members.
It, therefore, enjoys perpetual succession.
 Corporate finance: - A joint-stock company raises its basic capital for investment in
the form of shares. The shares are purchased by the public who become owners of
the company.
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  Centralized and Delegated Management:- A joint-stock company can have a large
number of shareholders. All of them cannot take active part in the management of the
company. Actual control and management is, therefore, delegated by the
shareholders to their elected representatives called directors.
 Transferability of shares: - The shares of a joint-stock company are freely
transferable. They can be sold and purchased just like a commodity, in the share or
stock-exchange market.
 Large number of members: - The number of shareholders of a joint-stock company is
quite large except in one type where it is restricted to maximum of 50.
 Limited Liability: - The responsibility or liability of the members of a joint-stock
company is limited to the extent of the nominal value of the shares held by them. The
liability of the company as a whole of course remains unlimited.
 Statutory Regulations and Controls:- The law regulates the company or corporation
for the benefit of the public in general
 Publicity and compliance to various Legal Formalities: - A joint stock company has
to file a set of documents with the Registrar of companies and publish them for the
information of the public such as Memorandum and Articles of Association, Balance
Sheet and Profit loss accounts and Annual Reports.
All companies limited by shares may be classified, as a ' private limited' company and as a
"public limited" company. A Private limited company is one which by its Articles of
Association
 Restricts the right of the members to transfer shares.
 Limits the number of members to fifty excluding past or present employees of the
company and
 Prohibits any invitation to the public to subscribe for its shares or debentures. Minimum
number of shareholders for a private limited company is two.
The public limited company is one which has no restrictions as mentioned in the case of a private
company. It will have a minimum of seven shareholders and the upper limit is open for any
number.
There are advantages and disadvantages of the joint-stock companies.
The Advantages of the joint-stock company are:

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 Limited liability which reduces the risks in business from individual investor's point of view
 Perpetual succession guarantees continuity of business for longer period.
 Transferability of shares which secures freedom to withdraw from the business and to
increase wealth through shares.
 Financial strength because of the contribution of shares.
 Centralized team, management through board of directors ensures better decision-making.
 The scope for expansion improves due to better financial and managerial resources.
 Better confidence from the creditors as a result of a better position of the company.
The disadvantages of joint-stock company are:
 Too much legal formalities right from the time of formation as well as its day-to-day
working.
 Separation between ownership and management. This is a serious limitation.
 Few shareholders having greater number of shares at their credit may not care about minority
shareholders.
 Fraud is possible because of lack of control
 Speculation in the stock exchange market about the company may spoil its good will in the
goods market.
 Delays in the decision-making
If we weigh the advantages and the disadvantages of the joint-stock companies the balance tilts
towards the advantages and that is why this system is gaining more and more popularity.
IV. Cooperative society: A cooperative society is a form where people associate voluntarily
for the furtherance of their common economic interest. Some of the cooperatives
societies are: consumers' cooperatives societies, producers' cooperatives societies,
marketing cooperatives, cooperative credit societies, cooperative farming societies, and
housing cooperatives.
In general, there are four forms of business ownerships. These are Cooperative society, Joint-
stock company or corporation, Partnership and Sole proprietorship. These all have their own
advantage and dis-advantage.

2.1.1.2 Public Sector companies

The public sector plays a vital role in the socialistic and mixed economics mainly for three
reasons:

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  To gain control of the commanding heights of the economy,
 To promote critical development in terms of social gains or strategic value rather than
primarily on consideration of profits, and
 To provide commercial surplus with which to finance the economic development of the
country. Some of the important types of government companies are the following
1. Departmental organizations- (like Post, Tele, Railways, Broadcasting, and Defense
undertakings in the country).
2. Public corporations- these companies are established under the specific Acts of the
parliament or state Legislature. They are called statutory corporations such as Airlines,
Insurance Corporation, etc.
3. Government Companies- A government company is any company in which not less than
fifty one percent of the share capital is owned by the government. It is organized under
the existing provision of the companies Act like any other joint-stock company.
2.1.1.3 Joint-Sector Public Sector Companies
The concept of joint sector implies the participation of both the government and the private
sector in the business. Under this organization, a firm is owned and run jointly by the
government and a private entrepreneur. The public sector and the private one work together
under the same roof and put a mutual check on each other.
Public sector companies are which are owned jointly by private sector and government. For
examples different privately owned vehicles which provide transportation services according to
rules and regulation of the government.

2.2 Organization, Ownership, Control and goals of Firms

2.2.1 Organization of Firm

An organization is coalition. It is a coalition of individuals, some of them organized into sub-
coalitions. In a business organization the coalition of members include managers, workers,
stockholders, suppliers, customers, lawyers, tax collectors, regulatory agencies etc. In the
governmental organizations the members include administrators, workers, appointive officials,
elective officials, legislators, judges, clienteles, interest group leaders, etc. In the voluntary
charitable organization there are paid functionaries, volunteers, donors, etc.

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However, the idea of an organizational goal and the conception of an organization as a coalition
are implicitly contradictory. Basic to the idea of coalition is the expectation that the individual
participates in the organization may have substantially different preference orderings (i.e.
individual goals). That is to say, any theory of organizational goals must deal successfully with
the obvious potential for internal goal conflict inherent in a coalition of diverse individuals and
groups.

2.2.2 Ownership and Control of Firms

The traditional theory of the firm viewed control as being exercised solely by the individual
owner, who was the sole claimant on profitability. Starting in the 1930s, however, the
management school argued that ownership through the holding of shares had become highly
dispersed, particularly in large companies; that salaried managers who controlled firms
operations held few shares. Because of this type of ownership of shares, they were only loosely
motivated or constrained by owners to pursue profit maximization.

OWNER BOARD OF TOP

MANAGEMENT
SHARE DIRECTORS
HOLDERS

Majority of the firms are share companies. With regard to the extent of managerial shareholding,
separation of ownership and control in large companies is typical. In this case, ownership is
widely dispersed, and management control is therefore, largely independent of the owners.

Owner's, in order to impose their own views and ensure behaviors consistent with them, would
need first to know in some detail the performance of the company, the extent to which it was
below the maximum possible, and the extent to which management was possible for this.
Second, they would need to know whether the existing management could rectify the problem,
and to compare this potential with the extent to which new management could improve upon the
situation. This would entail assessing not only current performance was in fact merely a
prerequisite for better long-term performance e.g. as a result of entry costs, long-term research
and development costs, carrying out defensive investment, etc.

21
Third, any shareholder seeking to remove a management board member would need to mount
and win a vote of shareholders. This would often be expensive both in time and money with no
great certainty of victory. All these costs, financial and otherwise, are generally referred to as
enforcement costs.

For all these reasons such shareholdings may create a much tighter constraint on management
than an equivalently sized shareholding held by an individual. These types of consideration all
suggest significantly less scope for managerial discretion than was previously thought. Given
substantial dispersion of shareholdings, this frequently enables the board to regard itself as the
group most likely to win a shareholder vote. Besides this, board does not have to rely purely on
their own shareholding. Normally, mangers will make arrangements whereby any shareholder
can place his voting rights at the disposal of a proxy voter amenable to the views of management.

Note: Organization a coalition and there are some factors which determine the markets structure.
Separation of ownership and control remains significant characteristic of large modern
corporations. The effect of it depends on the extent to which managers objectives differ from
those of owners, and on the effectiveness of the constraints if any, on manages' decision-taking
discretion.

2.2.3 Goals of Firms

We have seen the potential conflict between the shareholders who own the company and the
managers who direct it. In addition to this, there is potential conflict of interests between
different groups of managers charged with responsibilities for different parts and functions
within the firm. The basis for this argument is that a firm is a coalition of individuals, some
organized into groups and sub-coalitions. In a firm these include managers, workers,
shareholders, suppliers, customers, etc.

Explicitly or implicitly, a process of bargaining occurs continuously. This results in side-

payments such as salaries, commitments to particular lines of business or specific policies, etc- in
order to induce others to join a particular coalition. The bargaining process, however, does not
eliminate all conflict within the managerial group.

There are five main aims that well represent the organizational goals of the firm.

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 I. Production goal- The production department is largely concerned with matters of output and
employment. The desire primarily of the production side for stable employment, ease of
scheduling, maintenance of adequate cost performance, and growth are all largely met by
requiring that production does not fluctuate too much or fall below an acceptable level. Even
if sales are poor the production department will want an increase in inventories rather than a
cut in output.
II. Inventory goal- The desire primarily of the sales staff and their customers for there to be at
all times a complete and convenient stock of inventory is largely met by keeping the level of
inventory above a certain minimum figure. The holding of inventories pleases both sales and
production department, but conflicts with the interests of the financial managers who regard
the holding of excessive inventories as unprofitable since it ties up valuable working capital.
III. Sales goal- The importance of sales for the stability and survival of the firm makes it an
important goal for all firm members but practically for the sales staff, whose effectiveness is
judged partly by their success in maintaining and expanding sales.
IV. Market Share goal - This may be an alternative to the sales goal, particularly if market
growth is important. Management may adhere to it more because of the comparative
performance measure element contained in it. This reflects an interest in the firm’s
performance because no better index of efficiency exists. Furthermore, it is possible to make
inter firm profit comparisons.
V. Profit goal - Investment, dividends, and further resources for sub-units of the firm all require
adequate profit. In addition, profit is an important performance measure for top
management.
It is clear that these goals may conflict irreconcilably when it comes to choosing price and output
levels. Sales goals may require a lower price, the profit a higher one. Both sales and production
goals may favor high inventories, profits a lower level, and so on. The question is how are these
conflicts solved? Cyert and March identify four mechanisms to solve these conflicts.

i. Given bounded rationality, objectives are stated in terms of satisfying or aspiration levels.
At any one time only one objective will be operative in the sense of needing attention
because it is not currently being achieved.
ii. As this implies, decision taking is sequential. Performing different objectives at different
times reduces substantially the perceived conflict between different objectives.

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iii. Organizational slack exists. This is the difference between the resources available and those
necessary to meet the current demands of members of the coalition of the firm. If
performance becomes inadequate in terms of a particular objective, it is generally possible
for organizations to increase efficiency by utilizing slack resources.
iv. The use of standard operating procedures. Many decisions are standardized and then
operated by the department responsible for them. Acceptance of these standard procedures
then avoids much latent conflict.
Note: Even though, all firms have no common goals and objectives, majority of
them has five major goals. These are Production goal, Inventory goal, Sales goal, Market
Share goal and Profit goal.

2.3. Modern Theories of the Firm

2.3.1. Managerial Theory of the Firm (sales maximization theory)

Profit maximization is the most conventional and widely used business motives in the theory of
the firm and industrial economics. The case for the profit maximization as a goal of the firm is
based on the assumption that firm is an economic unit owned and managed by an entrepreneur
who is an ‘economic man’ working for the profit.

The traditional theory of the firm has been following this approach ever since its birth. Looking
at the reality of the business in the present-day situation, we may get enough evidence to support
the profit maximization objective. Even today when business is very much dynamic and
diversified a firm is treated to be efficient if it makes sufficient profits. The firms which get
eliminated from the market are basically those whose profitability situation is not satisfactory.

The objective of profit maximization seems to be all right but there are a number of attacks
on its operational validity.
1. If the industry to which the firm belongs is highly competitive then profits will be frittered
away because of the forces of competition and only normal profit will be left which makes
the firm survive in the business.
 Now, suppose the industry is state-owned and controlled, then firms will not bother about
profits as it is treated immoral under socialism. In both the situations – competition and

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 socialism – there is no scope for profits, in one case because of the market forces and in the
other case because of the institutional requirements.

 Under imperfect competition and full of uncertainties, the occurrence of the profit will be
linked with such uncertainties. If we take profit as an uncertain gain then it cannot be taken
as a basis for maximization in order to assess the efficiency of the firm. Under this situation
the appropriate goal can be conceived as the long-run survival in the business with
satisfactory entrepreneurial income (normal profit + excess profit.)

2. Another limitation to the profit maximization goal is related to its correct measurement.
The firm may select the criteria for valuation of these things in such a way that profit figures
are understated in order to save taxes. This may make profit maximization has a “hidden”
objective rather than explicit.
3. Yet another serious difficulty with the profit maximization goal is with respect to its
relevance in the context of modern joint-stock companies where management and
ownership is completely separate. It is hard to believe that managers, who control the
business, act primarily in the interest of their owners. Instead, they may work more in their
own interest by maximizing their utility rather than profit. In the sole proprietorship and up to
some extent under partnership, we may argue that management and control is combined, so
profit maximization goal is relevant for them.
 This left much of the decision making to the manager whose objectives could be different
from those of the owners of the firm. Hence, in terms of its influence on managers’
salaries, size of firm’s profitability, the growth could be a more important objective of
firms than profit.
 Other reasons why the hired managers may be more preoccupied by sales or revenue
maximization than by profit maximizing include the following.

a. If sales fail to rise, it indicates reduced market share and then it leads to increased
vulnerability to the actions of competitors.
b. The firms’ sales are considered as an indicator of companies’ performance.
c. Financial markets and distributors are responsive to rising sales.

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 Baumol attempts to reconcile the behavioral conflict between profit maximization and the
maximization of the firm’s sales (i.e. its total revenue). Baumol assumed that firms
maximizes sales revenues subject to a minimum profit constraint, but it may also be
viewed in a “Pure” form when there is no such profit constraint. The figure 2.2 below
illustrates the hypothesis in its various forms along with the profit maximizing situations.

TC
TR

TC, 
TR

A
∏1

∏2
C
∏3 B Total profit curve
D

0 Output
Q1 Q2 Q3

P, AC,
MC

P2 MC

AC
P1

AR

Q1 Q3
0 Q2 Output

Figure 2.2 MR

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In the above diagram the output level that corresponds to the maximum profit situation is OQ1.
The normal condition for profit maximization, i.e., MR = MC at this level of output with rising
MC curve. The maximum profit is shown by O1 in the upper loop of the diagram.

Now if the objective is sales maximization and there is no constraint attached to it, then output
level will be OQ3 where MR becomes zero as a condition for maximization. At this level of
sales the firm is getting O3 level of profit which is positive. The occurrence of the positive
profit at the unconstrained sales maximization should not be taken for granted. It may be positive
or negative depending whether r the TR and TC curves intersect each other after or before the
maximum revenue position.
If the owners of the firm are satisfied with this level of profit (O3), then they will continue to
produce OQ3 level of output and there is no reason for deviating from this.
Suppose they are not satisfied, then they can increase the level of profit at the cost of sales.
Let O2 be the minimum acceptable level of profit. This is the constraint the firm puts for sales
maximization. The level of output corresponding to this level of profit is OQ 2 which is greater
than profit maximizing output OQ1 but less than OQ3. The firm is sacrificing AB level of profit
to get Q1Q2 extra output for sales, because of this increase in output price level that the firm
charges reduces from P1 to P2 as shown in the lower loop of the diagram.
In order to support the sales maximizing objective Boumol has given the following intuitively
appealing and observable facts from the real life situation of the firm:
a. Declining sales may mean reduced market power and consequently increased vulnerability
to the actions of competitor firms.
b. Executive salaries have been found to be more highly correlated with the scale of
operations of the firm than with its profitability.
c. In response to the question, “How’s business?” an executive will typically reply in terms
of what his firm’s sales levels are.

The model suggested by Baumol for sales maximization is yet to be established fully through
empirical verification. However, its theoretical base is strong enough which cannot be
disbelieved easily.
2.3.2. The Principal-Agent Theory

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At its simplest, principal - agent theory examines situations in which there are two main
actors, a principal who is usually the owner of an asset, and the agent who makes decisions
which affect the value of that asset, on behalf of the principal. As applied to the firm, the
theory often identifies the owner of the firm as principal and the manager as agent, but the
principal could also be a manager, and an employee nominated by the manager to represent him
in some aspect of the business could be the agent. In this case the asset, which the agent’s
decisions could enhance or diminish, is the manager’s reputation.

To explain the relationship between the principal-agent (or agency) theory, we turn to
Williamson’s theory. There are two main such approaches or branches; monopoly which views
contracts as a means of obtaining or increasing monopoly power; and efficiency which views
contracts as a means of economizing. Among the major concerns of principal agent theory is the
relationship between ownership and control. Principal-agent theory can be seen as a new
industrial economics version of sub-set of managerial theory.

Principal-agent theory sees the firm as does neoclassical theory as a legal entity with a
production function, contracting with outsiders (including suppliers and customers) and insiders
(including owners and managers). There is information asymmetry between principals and
agents but unlike in transaction cost theory (which usually assumed bounded rationality) there is
often assumed to be unbounded rationality. Unbounded rationality refers to the ability of those
designing the contract to take all possible, relevant, future events into consideration. The
principal many know various things not known to the agent (in relation, for example, to the
prospects of the firm), and vice versa (the agent may have a lower commitment to the firm than
he needs the principal to believe).

The major difference between principal-agent and transaction cost theories is that the former
(principal-agent theory) focuses on the contract, the later (transaction cost theory) on the
transaction. The problem for principal-agent theory is how to formulate a contract such that the
shareholders (the principal) will have their interests advanced by the manger (the agent). In fact,
the manager’s interests may diverge from those of the shareholders. Or, is there any class of
reward for the manager (the agent) such as that can yield Pareto efficient solution for any pair
utility functions both for the agent and the principal. Pareto efficient means making one party
better off without making the other party worse off.

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Where the objectives of the agent are different from those of the principal, and the principal
cannot easily tell to what extent the agent is acting self-interestedly in ways diverging from the
principal’s interests, and then the problem of moral hazard arises. Principal agent theorists have
attempted, by specifying conditions such as that the manager’s salary be equal to the expected
value of his or her managerial product, to design contracts on the basis of which there will be an
incentive for the manager to act in the interests of shareholders. However, the importance of the
team element in managerial jobs discredits the notion of a managers’ marginal product.

In the context of relations between principals and agents, moral hazard refers to the possibility
that, once there is a contract, the agent may behave differently from how he or she would have
behaved had he or she not had the contract.

There are a number of ways to control moral hazard. Rather than attempting to circulate the
value of each manager’s marginal product, managers could each be paid a salary plus a bonus
based on the performance of the company. Other example to solve employment contract
problems include the development of efficient ways of monitoring the performance of individual
managers (or management teams), providing incentive contracts which reward agents only on the
basis of results, bonding (where the agent makes a promise to pay the principal a sum of money
if inappropriate behavior by the agent is detected) and mandatory retirement payments. It should
be emphasized that to the extent that managers want to keep their jobs, the free markets (for
corpora rate control, managerial labor and the firms’ products) can control moral hazard.

The most obvious solution to the problems of conflict of interest between the principal and agent
is for the principal to become his or her own agent. Where there is team production, and the
existence of a monitor can reduce shirking by enough to pay his or her own salary, then it may be
appropriate for that monitor to be the owner of firm. If he or she is not the owner then there
should be a need to monitor the monitor, to ensure that he or she does not shirk.

2.3.3. Transaction Cost Theory

Rights of ownership (or property rights) to a good or service must be able to be established
before a market for that good or service can exist. Transaction costs are those incurred in
enforcing property rights, locating trading partners, and actually carrying out the transaction. If
property rights over a good cannot be established, then transaction cost theory is inappropriate.

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Apart from reducing transaction costs, firms obtain additional benefits by internalizing
transactions. The internalization of transactions enables the exploitation of economics of scale or
economies of scope. The extent to which economies of scale can be exploited determines the size
of a firm. Under what circumstances will transaction costs be lower when internalized than when
left to be negotiated in an external market?

To answer this question Williamson identified bounded rationality, opportunism and asset
specificity. Bounded rationality refers to the imperfect ability to solve complex problems. This
takes place when there is imperfect ability to process the available information, and/or when the
information itself is imperfect (i.e. there is uncertainty), both in relation to the present and future
events.

Opportunism relates to how people will respond to conflicts, given the existence of bounded
rationality. They will behave opportunistically if they act in their self-interests by, for example,
finding loopholes in contracts. If there was unbounded rationality, the potential opportunistic
behavior would be known, and avoided.

Asset specificity refers to assets, involving non-trivial investment, that are specific to particular
transactions (e.g. skills in an employer-employee contract). Asset specificity refers either to
physical or human elements in the transaction. Market contracting gives way to bilateral
contracting, which in turn is supplanted by unified contracting internal governance, as asset
specificity is deepened.

If there was no opportunism, there would be no need for internalization. Without opportunism,
the transaction would take place within the market rather than within a hierarchy market. But,
bounded rationality is a precondition for opportunism. So, opportunism and bounded rationality
are likely to give rise to internalization. This, however, is still only part of explanation for why
and where internal governance will be preferable to market governance.

2.4 FIRM GROWTH

To bring growth in the country, it is necessary to create the production capacity. This production
capacity can be increased via the establishment of new factories owned by new entrepreneurs
or by expanding the existing factories in an industry. When new firms join an industry it

30
implies an increase in competition among the sellers. The market power of individual sellers
decreases with an increase in competition (i.e. number of sellers) in the industry.

This eventually leads to a situation when every firm losses its market power completely as we
find in perfect competition. The existing firms will expand themselves and block the entry of
new firms in order to maintain or increase their market power for greater profits in future
provided there are no institutional restrictions for this. Hence, it is a natural inducement which
the market provides to the existing firms for growth. Through growth, the firm will be able to
enlarge its size. The larger the firms, the more perfect the control it assumes over its environment
and the higher the efficiency with which it plans its overall activities.

A growing firm may be able to increase its market share in the industry. It may acquire more
market power which will have effects on earnings of the firms. Introduction of new products,
new production processes and organizational techniques as parts of the growth strategy of the
firm will enhance the competitive power of the firm as a result of which it will be able to
withstand or survive in the creative destruction.

At macro level, every country aspires for rapid economic growth – growth of GDP – one
important means for increasing the production of goods and services is expansion of existing
firms – the other being establishment of new factories. Economic growth is largely based on
expansion of firm.

This theory of growth of the firm has been contributed by Downie, Penrose & Marris.

2.4.1 Downie’s Theory

According to him, in an industry, which he defined as a group of firms having similarity of

technical process, there will be a dispersion of efficiency across the firms, i.e., some firms have
greater efficiency than the industry average while some have lower efficiency.

The source of variation in efficiency (measured in terms of unit costs) across the firms is
attributed to variation in technical progress. Firms with technologically superior process or
product are assumed to be more efficient.

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The process of growth, according to Downie model, starts with the steady encroachment on the
market share of less efficient firm by more efficient firms. That is, the efficient firms having
advantageous access to the means of growth will be able to encroach (trespass) on the market
shares of the less efficient firms more or less rapidly. Downie used the concept of the “transfer
mechanism” for this.

The means of growth that Downie takes into account are:

ï capacity expansion: investment in new technology (supply side)

- To expand capacity, finance is needed which in turn depends on the rate of profit. The
efficient firm is assumed to have high rate of profit. They will thus be able to raise finance
for capacity expansion.
- i.e., the rate of capacity expansion is positively related to the rate of profit or efficiency.
ï Increase in the number of customers:
- An efficient firm, according to Downie, must offer price discount for its product (because it
can sustain a price reduction) to attract new customers which in turn affects the markets for
the less efficient firms adversely. Lower price mean lower  for the firm.
Hence, there are two opposite forces in the growth process of the firm – the capacity side of
growth which varies positively with the rate of profit and the market side (i.e., customer
expansion) which varies inversely with the rate of profit.

Rate of
profit

Capacity growth curve

G
Market growth curve

0 Growth Rate
R*

Fig.2.3 Optimum Growth Rate of the Firm (Downie’s Equilibrium point)

32
These two opposing forces will set the upper limit on the rate of growth of the firm. At that
limiting point, the rate of profit and the product price of the firm are such as to enable capacity
and market of the firm to grow at the same rate. Such optimum situation for the rate of growth of
the firm is indicated by point G in the diagram above (Fig. 2.3) where the capacity and the
market growth curves intersect.

The rate of profit is an important determinant of growth but the level of profit cannot be very
high if customers are to be attracted. Sometimes high profit may be accompanied by loss of
customers.

The financial (funds for creating capacity) and market demand (i.e., customers) restraints play
the crucial role in the process of the growth of the firm in Downie’s framework.

Criticisms:

ï The model has not considered diversification as a way to remove the market restraints on
growth of the firm.
ï The argument that new customers are attracted through price-reduction ignores non-price
competition strategy such as advertisement or sales-promotion.
ï It has not taken into account the managerial restraint which plays very important role in
limiting the growth (size) of the firm.
ï Downie’s theory ignores the possibility that inefficient firms might react positively and/or
aggressively to declining market share.
ï The inefficient firms might be compelled to initiate innovations- reversing the efficiency
difference. Inefficient firms may become efficient overtime and vice versa. If Downie was
right, there would have been ever growing concentration in the industry. Market controlled
by one efficient firm – no chance for inefficient firms to catch up.
2.4.2 Penrose’s Theory: (The theory of management constraint)

She assumes a desire to increase total long-run profits as the goal for the firm. To achieve this
objective, the firm continues to make investment as long as it gets positive return form that. It
takes the advantages of the productive opportunities for expansion which it thinks profitable.
Penrose considers the firms as a pool of productive resources organized within an administrative
framework.

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ï How does the growth process proceed in the Penrosian framework?

The process of growth is not automatic in the Penrosian framework. It is a deliberate and
conscious choice of the management.

- Penrose suggested that growth of a firm continues unless some factors restrain opportunities
for expansion. These restraints can be of two types:

a) Managerial restraints:

Both administrative and entrepreneurial capacities may be inadequate hence the firms cannot
sustain high rate of expansion.

It may be possible to recruit new managers, but newly appointed managers require time to gain
experience and run the firm efficiently. The existing managerial resources of the firm would not
be increased significantly by such recruitments immediately. Its rate of expansion is very much
limited which will put a restraint on the expansion of the firm also.

The managerial restraints limit the productive opportunity of the firm at any given time which in
turn puts an upper limit to its growth. i.e., it not only affects the efficiency of the firm but
regulates its future growth. The effect of the managerial restraint on growth of the firm as
postulated by Penrose is well known as the “Penrose effect”

b) Financial and Market restraints:

Adequate resources required to invest in expansion. Penrose, however, treated them as

insignificant, as compared to management restraint, in limiting the growth rate of the firm. She
emphasized only on the managerial restraint for this.

In what direction will a firm grow? To find the answer of this question, Penrose analyzed the
possible external and internal inducements and obstacles for expansion of the firm.

(i) External inducements: include

- changes in demand,
- technological innovations
- other changes in market conditions which help the firm to improve its competitive position,

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External obstacles includes:

- competition from rivals

- patent or other restrictions on the adoption of new technology,
- barriers to entry,
- lack or shortage of inputs, etc.
As Penrose argued external factors can be easily handled if the management is strong.

(ii) Internal inducements: Such as:

- Unused productive services and other potentials of the firm

The internal obstacles to expansion will be, by and large,

- The scarcity of specific managerial services.

NB: It is the balance of the external and internal inducements and obstacles which determines the
direction and method of expansion of the firm.

Penrose placed much emphasis on the internal factors. The internal inducements such as unused
capacities including managerial services are quite dominating in her growth theory. i.e., the most
important constraint to growth is shortage of suitable managers, according to Penrose. The firm,
having used managerial skills, will utilize them in new areas of productivity which gives new
experience and new skills to its managerial team on the basis of such new experience, the firm
can venture into other new areas of productivity. The process continuously goes on till some
internal managerial restraints limit it.

Penrose’s work is an important contribution in the theory of the firm. Her analysis is very much
complex but not vigorous and formal. The following is limitation in her work:

- She gave marginal attention to financial and external constraints on growth of the firm. This
is not justified.
In practice, we do find firms unable to grow due to lack of finance and other market restraints.
Because of the partial approach she followed for an explanation of the growth process of the
firm, her work can be called as an organizational theory of the growth of the firm rather than an
economic theory of the firm as argued by Marris.

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2.4.3 Marris’s Theory: (The integrated theory of growth)

A coherent and integrated theory of the growth of the firm has been developed by Marris. His
theory is applicable to a corporate firm owned by shareholders but controlled by managers.
Shareholders, being owners of the firm, are assumed to have the objective of maximizing the
return on their investment in the firm. Managers of the firm, on the other hand, aspire to
maximize their own interests which are taken care of by higher pay, power, prestige, and job
security etc. All such things are postulated to be positively correlated with the growth of the firm
in Marris model.

The goal of the firm is then defined as the maximization of the balanced rate of growth of the
firm subject to a stock-market valuation constraint called ‘the security constraint’ since it
provides security of profit to the shareholders and security of jobs to the managers of the firm.

- Maximization of the rate of growth of demand for its products

- Maximization of the growth of its capital supply
In other words,

g = gD = gc

where g: is balanced growth rate

gD: is growth of demand for firm’s product

gc: is growth of supply of capital.

The joint maximization of gD and gc is said to maximize utility for the management and
shareholders.

Balanced growth is necessary to avoid excess capacity or excess demand (as well as shortage).
Unless gD and gc are equalized, there would be a problem of spare capacity or excess demand.

How would a firm maximize a growth of demand and supply of capital?

* Growth of demand (gD) depends on:

- the diversification rate, d, and

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- Number of successful new products introduced
If demand for a product reaches its saturation point, Marris advocated diversification and/or new
product (innovation) as the most effective way to grow further continous growth is thus possible.

* Growth of supply side (gc) is represented by the asset base of the firm. i.e., the growth of
supply means an increase in the assets (fixed as well as current) of the firm.

 A firm can raise finance for expansion through three sources:

- retained earnings
- Borrowing
- Issuing new equity shares
 In pursuing balanced growth rate, the firm faces two constraints.

- A constraint set by the available managerial team and its skills. i.e., managerial capacity an
behavior is limited
- A financial constraint set by the limit to the amount of capital a firm can mobilize.

(i) Managerial constraint: Marris adopted Penrose’s thesis of the existence of a definite limit on
the rate of efficient managerial expansion – deterioration in efficiency of managers as the firm
expands rapidly. Competent management has the capacity to generate new ideas and introduce
diversification to overcome demand constraint and find ways to overcome capital constraints.
But managers want job security – have disutility for dismissal and look for generous pay and
pension. That is, they are not willing to take risks and therefore, they adopt prudent financial
policy. That is,

- Cautious in financial decisions: - conservative and less innovative, risk averse, avoid
expansion unless they are certain of the returns.
- avoid risky investment (eg, investment on R and D)
The job security constraint sets a limit to the growth of capital supply (gc), not just demand
expansion.

(ii) Financial constraint: Marris believed that there is a definite limit to the growth of capital
supply (gc). Each of the different sources have its own drawback.

37
- Retained earnings: possible only up to certain limits, need to pay dividends.
- Borrowing: too much debt makes the firm vulnerable to takeover too much borrowing means
high interest charges and low share prices.
- Issuing new equity shares: too many shares lower share prices and may trigger takeovers.
Criticism:

a. The assumption that continuous growth is possible by creating new market – by developing
new products and diversification – can be questionable. If one or two products prove
unsuccessful, it is highly likely that consumer will not be willing to try other new products
of the firm, launched after the earlier failures.
b. Marris model relies heavily on the restrictive assumption that firms have their own research
and development departments. In reality, most firms do not have such departments but rely
on imitation of the inventions of other firms. When this is not successful, firms pay royalties
for using a patented invention.

38
Unit 3: Market/Firm Concentration and Industry Structure

3.1 Market Concentration: Concept

Market concentration means the situation when an industry or market is controlled by a small
number of leading producers who are exclusively or at least very largely engaged in that
industry. It is also known as degree of seller's concentration in the market. It is an important
element of the market structure which plays a dominant role in determining the behavior of a
firm in the market. Two variables that are of relevance in determining such situation are:

(i) The number of firms in the industry, and

(ii) Their relative size distribution.

Market concentration has its own influence on the ownership of the industry, concentration of
decision-making power, concentration of firms in a particular location or region, etc. These
elements of market concentration may have considerable impact on the market performance of
the firms such as profitability, price-cost margin, growth, technological progress and content.

3.2. Theories of concentration

Market concentration is a feature of the imperfect competition where one or few firms dominate
the entire industry. To understand the mechanism by which market concentration determines the
economic behavior of such firm’s vis-à-vis that of others in the industry, we have to examine
some theoretical models or deductions.

1. Let’s assume that there are few large firms along with many smaller firms selling a
homogeneous product at a uniform single price. This is called homogeneous oligopoly. The large
firms will be having interdependence among themselves in the sense that variations in the price
or supply of any one of them will have significant effect of the market supply, equilibrium
market price and revenue of all other firms. This is certainly a situation of market concentration
affecting the firms. This situation of market concentration can be presented mathematically as
follows.

Assume total supply= Q units and market demand function be

P= f(Q) = f(q1+q2+----------qi+--------qn) ----------------------------------(1)

Where P=product price, qi=output of ith firm, i = 1, - - - - n and ∑ qi =Q

39
The revenue function for the ith firm is given by
Ri=P.qi ------------------------------------ ------------------------------------------ (2)
Differentiating equation (2) with respect of qi, the marginal revenue for the ith firm will be
∂ Ri ∂ p ∂Q
=P+qi .
∂qi ∂Q ∂qi --------------------------------------------------------------- (3)
∂Q
Where ∂qi = 1, since an increase in one unit of output by the firm means one unit increase in the
total market supply.

Equation (3) can be written as

∂ Ri qi Q dp
=P (1+ . . )
∂qi Q P dQ ---------------------------------------------------------- (4)
qi
Where, Q is the market share of the ith firm.
Assume that eQ is the market quantity elasticity of price. This is defined as the percentage change
in market price with a marginal percentage change in the market quantity supplied, that is, e Q =
dp Q
.
dQ P --------------------------- (5)
Substituting equation (5) in equation (4), we get
∂ Ri qi
(1+ . e )(i=1,−−−−n , )
∂qi = P Q Q --------------------------------------------(6)

This equation shows that marginal revenue for the i th firm depends on product price (p), market
qi
( )
share in output for the firm Q and quantity elasticity of price (eQ).

If the firms are of uneven sizes then the average marginal revenue for the firm in the industry be
given as
q1 q2 qn
MR= Q (MR1) + Q (MR2) + ---- Q (MRn) +- - - - - - - - - - ----------------(7)
Substituting MR1, MR2, ------- from equation (7) in equation (6), we get
n

[ 1+ ∑(
i=1
qi
Q ) e ¿ ¿] ]¿
2
Q

MR = P or MR = P (1 + H. eQ) ----------------------------------------------(8)
n
qi
∑ ( Q ¿ ) )¿ 2
Where i=1 ¿ = H is the Herfindahl Index of Concentration

40
This equation indicates that average marginal revenue depends on product price (p),
concentration index (H) and the elasticity coefficient (eQ).
1
If all n firms are of equal size then H= n which tends to zero as n becomes greater and greater
as in competitive situation. In this case, MR will be almost equal to price (p) i.e. MR=P(1+0.e Q)
MR=P(1)=P
1
If there is only one firm, then, H= 1 = 1. This is the case of monopoly, extreme of market
concentration.

2. Let’s assume the situation when firms are selling differentiated products with different prices.
If a large firm among few firms makes changes in the price and /or quantity of all other firms in
the market. How the relative sizes of firms are determined? R.L. Bishop provides the following
price and cross elasticity for this.

According to Bishop, when a firm makes changes in its price, all other prices remaining the
same, the quantity of output supplied by the firm as well as by other firms will change. The
responsiveness of changes in quantity of outputs as a result of the price change is given the price
elasticity of demand for the firm and the cross elasticity of demand for the other firms.
∂ qi pi
.
Price elasticity of demand = ep = ∂ pi qi
∂ qj pi
.
Cross price elasticity = eij = ∂ pi qj -------------------- ------------------------ (1)
Where j stands for remaining n-1 firms

When total market demand for the closely substituted goods is constant, an increase in the supply
of any variety means a decrease in the total supply of all other varieties by the same magnitude.
Thus, when the firm gets 5 percent increase in its sales, it means 5 percent reduction in the sales
5
of all other firms. And if there are n-1 remaining firms so each one will get ( n−1 ) percent
5
decrease in the sales by one percent decrease in the price of i firm. This means eij = - ( n−1 ) .
th

ep
This shows the relationship between own elasticity and cross elasticity, as eij= - n−1 where n
is the number of firms assumed to be equal in size.

If n is very large, e ij will be very low tending towards zero. The impact on other firms becomes
negligible. However, for a small group of firms i.e. concentrated industries, e ij will be
considerably high.

41
 3.3. Measure of concentration
In order to test empirically the behavioral hypotheses about the firms and industries, we need a
measurement of market concentration. Various quantitative indexes have been suggested for this
purpose which we are going to summarize in this section. Some of them are used to measure the
monopoly power of the firms and some for market concentration.
3.3.1. Concentration Ratio
The most popular and perhaps simplest index for measurement of market concentration or
monopoly power is the use of the concentration ratio. This ratio indicates the share of the
market or industry held by some of the largest firms. The market share of such firms may be
taken either in production or sales or employment or any other magnitude of the market.

M
∑ pi ,
In symbolic form the concentration ration is written as C= i=1 m = 4, 8, 10, 12, - - 20. Where
th
pi=market share of i firm in descending order. The normal practice is to take the four-firm
(m=4) concentration ratio but if the total number of firms operating in the market is large enough
then one has to compute the 8-firm or even 20-firm concentration ratio. The higher the
concentration ratios, the greater the monopoly power or market concentration exists in the
industry.

There are some limitations of this index. It does not take the entire concentration curve into
account; it rather indicates market concentration of a point of the curve. Moreover, the
concentration ratios depend on how the market is defined. A broad market would tend to reduce
the computed concentration ratio where as a narrow one would usually have the opposite effect.
Still, it may not be comparable with other industries or countries data. The other limitations are
the ratios do not reflect the presence of or absence of potential entry of firms. The ratios do not
indicate any thing about the monopoly power of the individual firms in the market and ignore the
role of imports in the domestic market.

In spite of the limitations, the ratios are widely used in industrial economics. They are simple to
compute, really available for the manufacturing sectors and capable of measuring market
concentration with a finer classification of the industries. They are consistent with economic
notion of monopoly theory.

3.3.2. The Hirschman-Herfindahl Index

It is the sum of the squares of the relative sizes (i.e. market shares) of the firms in the market,
where the relative sizes are expressed as proportions of the total size of the market.
n
∑ ( pi )2
Herfindahl Index (H) = i=1

42
 qi
Where pi = Q , qi is output of ith firm and Q is total output of all the firms in the market, and n
is the total number of firms in the market. This index takes account of all firms in the market (i.e.
industry). Their market shares are weighted by the market shares itself. The larger the firm more
will be its weight in the index. The maximum value for index is one where only one firm
occupies the whole market. This is the case of monopoly, that is,
n
∑ ( 11 ) =1
2

H= i=1
The index will have minimum value when the n firms in the market hold on identical share. This
n

is equal to
1
n ()
1 2 1
∑ n = n
that is H= H= i=1
H decreases as n increases. The index is simple to calculate. It takes account of all firms and their
relative sizes. It is, therefore, popular in use and consistent with the theory of oligopoly because
of its similarity to measures of monopoly power.

3.3.3. The Entropy Index

This index is the recent index of market concentration. The formula is
n
1
∑ pi
E= i=1 log p i , 0≤ E≤ logn
Where E is defined as Entropy Coefficient, pi is the market share of i th firm and n the number of
firms. This coefficient measures the degree of uncertainty faced by the firm in the market. For a
monopoly firm (n=1) the Entropy Coefficient takes the value of zero which means no
uncertainty and maximum concentration. Thus, we find opposite (inverse) relationship
between the Entropy Coefficient, E, and the degree of market concentration.
If there are n firms, all equal in size, then,
n
∑1n
E= i=1 x log n = log n
The entropy coefficient is a useful measure of market concentration in the sense that the
population of the firms for which Entropy Coefficient is to be computed can be decomposed or
disagreement into several groups, such as on their basis of sizes, regions, products and the
classification of the industry, etc.

3.3.4. The Dispersion Measures

These measures take into account the dispersion of the market shares across the firms in the
industry. One of these types of measures is the Lorenz Curve. The Lorenz Curve shows the
variation in cumulative percentage distribution of market share (using sales or output or assets or
employment, etc as a variable for this. This is the cumulative percentage distribution of firms
from smallest to largest firms in the market.

43
If the firms are equal in size Lorenz Curve would be a straight line as shown by 00’ diagonal. If
there is inequality in the distribution of the market share the Lorenz Curve would then bend away
from the diagonal towards x-axis.

% of shares (Cumulative By sales)

0’
100 Line of perfect
80 equality
60
40
20 Lorenz
% of firms
Curve
0 X (cumulative from
smalls)
20 40 60 80 100
Fig3.1.The Lorenz Curve for dispersion of the firms and their market shares
The coefficient, which is called Lorenz Coefficient or Gini Coefficient, is obtained by dividing
the area bounded between the Lorenz Curve and the diagonal (00’) i.e. the bounded area by the
area of the triangle 00’X. This coefficient varies between 0 to1.

The index has limitations as well as advantages. The first limitation is that sufficient and accurate
data about the market share of every firm in market may not be available. The other limitation is
that two entirely different Lorenz Curves may give the same Gini Coefficient. If there are two
firms with 50% market share each or 1000 firms with 0.001% share each in the market, the result
would be the same.

The advantage of the index is that it takes into account all firms in the industry unlike the
concentration rations which suffer from this limitation.

3.3.5. The Lerner Index

There are some other indexes which are mainly used to measure monopoly power of a firm but
some of them can be applied to the market as a whole with little modification of the existing
variables.

The Lerner index is a good example in this case.

Pr ice−M arg inalCost P−MC
=
I= Pr ice P
We know that under perfect competition price is equal to marginal cost (P=MC). If there is a
difference between the two, such that price > marginal cost, this is because of market
imperfection or what we call as the monopoly power of the firm.

44
 1
Marginal Revenue (MR) for the monopoly firm is MR=P (1+ ep ),
Where ep=price elasticity of demand. For profit maximization, we have the familiar condition
1 1 P
P(1+ )=MC
MR = Mc eP P (1 + ep ) = P+P/ep=MC eP = MC – P
1 MC−P
ep = p
P  Mc 1
From these two equations we get the Lerner Index. I = P =- eP That is the index is
1
inverse of price elasticity of demand. Remember, ep < 0, so, - ep > 0
The greater the market concentration the greater will be the average Lerner Index for firms.
Example, assume P=100 and MC=50, then
100−50 1 1
I = 100 = ep = 2 . This indicates higher concentration.
Assume P= 100 and MC=96, then
100−96 4 1 1
= =−
I = 100 =
100 25 e p this indicates less concentration
The common indexes of measuring market concentration are reviewed above. The question,
however, is which is to be used. It is a matter of convenience to judgment which measure to use.
It looks that the Herfindahl Index, the Concentration Rations and the Lerner Indexes are
comparatively better than other indexes for practical application.
3.3.6. The Elasticity Index

The ratio of 'own elasticity of demand and cross-elasticity of demand' for a firm could be used as
a measure of monopoly power or market concentration in terms of 'number-equivalent',

e eii
e ji=− ii n−1=−
n−1 e ji
ie; or

Where; eii = own elasticity of demand and eji = cross elasticity of demand

An increase in the ratio means lesser number of firms in the market and a decrease means higher
number. Under pure monopoly the cross elasticity will be zero. Greater the number of firms and
products, higher will be the cross elasticity.

45
3.3.7 The Profit Ratio

This was suggested by Bain. According to him, when a firm persistently earns excess profit for a
long period of time, then it should be attributed to its monopoly power. Monopoly power and
profit rate are assumed to be linked positively. The profit rate is defined as "that rate which, then
used in discounting the future rents of the enterprise, equates their capital value to the cost of
those assets which would be held by the firm if it produced its present output in competitive
equilibrium. This rate of profit is then compared with the normal rate of profit to assess the mono
poly power of the firm. There is some operational significance of this index but it is not always
true that profits accrue because of monopoly power. A firm without any such thing may manage
its business well and earn profits for a long time. Moreover, estimation of the conceived profit
rate is itself very much complicated. The profit rate index for monopoly power is, thus, a weak
proposition. It is unsatisfactory as well as unreliable.

3.4. The Determinants of Concentration

Different studies have tested different variables as the determinants of the long-run level of
concentration.

The two studies by Martin suggest that minimum efficient scale is a significant factor
determining market concentration. According to this study an increase of 10 percentage points in
minimum efficient scale would, on average, result in an increase of 3 percentage points in the
four-firm seller concentration ratio. This is b/c it controls for differences across industries in the
average number of plants per firm. It is to be expected that the concentration of sales will be
larger, for any level of minimum efficient scale, the more plants the average firm operates. The
concentration of an industry with two plants on average per firm is higher than that industry with
the average number of plants per firm is one. The absolute capital requirements will have their
greatest effect on entry conditions when the minimum efficient scale is large.

Moeller and Rogers found a fairly large and significant effect of all advertising on concentration.
They were able to split advertising expenses into two components, one for television and the
other for other media. The significant impact of advertising on concentration is seen to be
entirely due to television advertising. This implies that a small entrant competing with national
firms has to advertise nationally in order to market its product effectively.

A recent study by Kessides makes a careful attempt to distinguish procompetitive and

anticompetitive effects of advertising. According to Kessides, advertising will discourage entry
because its cost is sunk. The larger the advertising campaign necessary for entry, the greater the
sunk investment is risked by a decision to enter. In this sense, advertising will discourage entry.

Advertising can also alter the probability that entry will be successful. The structure conduct
performance school believes that entry is less likely to be successful in industries where

46
advertising is important. According to this analysis, advertising encourages brand loyalty,
increases minimum efficient scale and reduces the odds of successful entry.

Product differentiation can also discourage entry. This will occur if the effects of sales efforts
endure overtime, if there are economics of scale in advertising and if the expense of advertising
is a sunk cost.

The combination of impacted information and opportunism, under the uncertainty that
characterizes real-world capital markets, means that established firms will enjoy an absolute cost
advantage over potential entrants. Market concentration thus reflects a combination of technical
factors and factors (such as cost fixity and product differentiation) that are under the control of
established firms.

Unit 4. Measurement, Determinant, Prone and Cons of Market power

4.1 Measurement of Market Power
Market Power: A firm has market power if it finds it profitable to raise price above marginal
cost. The ability of a firm to profitably raise price above marginal cost depends on the
extent to which consumers can substitute to other suppliers.

A firm with market power is often called a price maker. A price maker realizes that its output
decision will affect the price it receives. If they want to sell more, they will have to lower their
price. Conversely, if they decide to sell less, they can raise their prices. The demand curve that a
price-making firm faces is downward sloping. This contrasts sharply with the horizontal demand
curve (at the level of the market price) of a price taker.

To identify the factors those determines the extent of a monopolist’s market power, let’s
consider the following hypothetical concepts:

 If we consider a marginal increase in output starting from any Q, we

determine marginal revenue by summing the direct and indirect effects:
dP(Q)
MR(Q) = P(Q) + .Q (4.1)
dQ
where dP(Q)/dQ is the rate of change of price with respect to quantity & MR(Q) is marginal
increase in output.

To find the profit-maximizing volume, we set its marginal revenue function equal to its marginal
cost function. This means that Qm, the profit-maximizing output level, is
47
defined by equating (4.1) with the marginal cost function:
m
m dP(Q ) Q m
P(Q )+ = MC(Q m ) (4.2)
dQ 1

If we factor Pm out of the left-hand side, we can rewrite (4.2) as

m
dP(Q ) Qm
Pm (1+ ) = MC(Qm) (4.3)
dQ Pm

The price elasticity of demand measures the responsiveness of demand to a change in price. It is
the percentage change in quantity demanded from a percentage change in price:

%∆Q dQ dP dQ P
ε=- = (- )/( ) = - (4.4)
%∆P Q P dP Q

Substituting the elasticity of demand into (4.3) yields

( 1ε )=MC (Q )
Pm 1− m
(4.5)

Rearranging (4.5) yields the Lerner index (L ):

m m
P MC (Q ) 1
L= ( ¿ = (4.6)
P
m ε

Which is defined as the ratio of the firm’s profit margin P m −MC(Qm )and its price. It is a
measure of market power since it is increasing in the price distortion between price and marginal
cost. It shows that the market power of a firm depends on the elasticity of demand ε.

 The more elastic of demand, the larger is the demand elasticity ε and the smaller the price
distortion. This arises because the greater ε, the greater the reduction in quantity
demanded when price rises.

The key determinant of a firm’s market power therefore is the elasticity of its demand. In
considering a monopolist, we did not have to distinguish between the market demand curve and

48
the demand curve of the firm they were the same. However, in general a firm may have market
power and not be a monopolist. The extent to which a firm in imperfectly competitive markets
can exercise market power depends on the elasticity of its demand curve. The greater the number
of competitors (for homogeneous goods) or the larger the cross-elasticity of demand with the
products of other producers (for differentiated products), the greater the elasticity of the firm’s
demand curve and the less its market power.

 The extent of the inefficiency associated with market power also depends on the time
frame. In the long run, a firm’s elasticity of demand is likely to be larger for three reasons:
1. Consumer Response: Long Run vs. Short Run. The long-run response of consumers to a
price increase is often greater than their short-run response. For instance, homeowners who
use electricity to heat their homes are unlikely to switch to natural gas when the price of
electricity rises. That switch would require a substantial investment in a new furnace and hot
air ducts. In the long run, however, when the existing system requires extensive maintenance
or replacement expenditures, it may pay to replace it with hot air ducts and a natural gas fired
furnace.
2. New Entrants. If economic profits are positive, then other firms may try to enter the market.
Entry of any magnitude increases the elasticity of the firm’s perceived demand curve,
reducing its market power. A monopolist may even become a price taker if entry is
sufficiently extensive.
3. New Technology. Technological change can generate new products and services, and the
introduction of these products reduces the market power of producers of established
products.

These last two factors suggest that the ability of a firm to exercise market power in the long run
will depend on barriers to entry. If entry is easy, then we would not expect firms to have
significant market power in the long run. Entry and competition from other products (demand
side substitution) and other producers (supply side substitution) will limit, if not eliminate, a
firm’s market power if entry barriers are insignificant. On the other hand, if entry barriers are
significant, then a firm will be able to exercise market power even in the long run.

4.2 Market Power and Pricing

49
A firm is a monopolist if it believes that it is not in competition with other firms. A monopolist
does not worry about how and whether other firms will respond to its prices. Its profits depend
only on the behavior of consumers (as summarized by the demand function), its cost function
(which accounts for technology and the prices of inputs), and its price or output. A firm will be a
monopolist if there are no close substitutes for its product. More formally this means that the
cross-price elasticity of demand between the product of the monopolist and other products are
small (and vice versa). The cross-price elasticity ε ij is the percentage change in the quantity
demanded of product i for a percentage change in the price of product j :

εij = % ∆qi/%∆pj (4.7)

If the cross-price elasticity between the monopolist and other firms are small, then changes in the
price charged by the monopolist will have very little effect on the demand for the products
supplied by other firms. Hence it is unlikely that they will respond. Moreover, if the cross-price
elasticity between the other firms and the monopolist is small the effect of any response on the
demand for the monopolist’s product will be sufficiently trivial that it can be ignored by the
monopolist.

4.3 Sources of Market Power and entropy deterrence

4.3.1 Economies of Scale and Seller Concentration

When there are economies of scale there are obvious cost advantages to being large. Indeed to
minimize production costs a single firm is efficient. If the cost disadvantage associated
with being relatively small is significant, then the market is likely to be dominated by a few
large firms. Economies of scale mean that marginal cost is less than average cost. If increases in
the number of firms imply that prices are more likely to reflect marginal costs, price-marginal
cost margins sufficient for firms to earn normal profits (break even) require limits on the number
of firms that is, a lower bound on concentration. If the industry is initially characterized by
concentration less than this minimum bound then prices will not be at a level that allows firms
to recover their average costs. In the long run concentration will increase through exit or
merger and consolidation until price-marginal cost margins are sufficient for firms to at least
break even. When there are economies of scale the exercise of market power is necessary for a

50
viable industry: market power is created by reducing the number of firms and increasing the size
of those that survive.

4.3.2 Government Restrictions on Entry

Governments create entry barriers when they grant exclusive rights to produce to the incumbent
and use their monopoly on the legal power of coercion to prevent entry by other firms. For
instance, until recently entrants were barred by law from entering many telecommunications
markets. Instead the government created and maintained a monopoly franchise. This applied not
only to local service, but in many countries it also applied to domestic long-distance service and
international calling as well.

Similarly, monopoly franchises are often granted to other public utilities that provide gas,
electricity, sewer, cable television, and water service.

 Governments grant exclusive franchises for a number of reasons:

1. Natural Monopoly. The typical justification to protect public utilities from competition is that
the market is a natural monopoly. This means that restricting production to a single firm
minimizes production costs.
2. Source of Revenue. On occasion, indeed some would argue more often than not, governments
grant exclusive production rights to create and share in monopoly profits.

3. Redistribute Rents. The government also uses legal restrictions on entry to create and
transfer monopoly profits. In many countries governments traditionally maintained entry barriers
into the supply of telecommunication services. Typically prices were set such that monopoly
power was exercised in some services to provide a pool of profits to subsidize other services.

4. Intellectual Property Rights. Exclusive rights to produce are also created through intellectual
property rights. Governments grant the creators of new ideas and new expressions of ideas
protection from imitation and competition by granting innovators intellectual property rights in
their creations. The two main forms of protection are patents, which grant innovators exclusive
use of new innovations and new products, and copyright, which protects an artist’s (author,

51
songwriter, computer programmer, etc.) particular expression of an idea. The extent to which
patents or copyrights translate into market power depends on the existence of substitutes. In
many cases intellectual property protection can be circumvented or invented around.

Competitors can enter and produce demand side substitutes—products that are functionally
similar, though not identical. As a result the extent of market power created by intellectual
property rights is reduced. However, this is not always the case: sometimes intellectual property
rights do result in substantial market power.

4.3.3 Structural Characteristics and strategic behavior by incumbents (limit pricing,

dominant firm and biometric pricing)
I. Structural Characteristics
Structural characteristics in an industry protect the market power of incumbents without
attracting entry. They are characteristics that reduce the profitability of entry. Entry deterrence
requires that an entrant anticipate negative profits post entry. An entrant’s profits post entry will
depend on structural characteristics and the nature of competition post entry. The nature of
competition post entry will clearly be a function of the behavior of the incumbent. The more
credible threats by the incumbent to act aggressively post entry, the lower the entrant’s profits.
By credibility we mean that it is profit-maximizing when faced with actual entry for the
incumbent to behave aggressively either by maintaining production levels or charging low
prices. The credibility and profitability of aggressive behavior will depend on the structural
conditions of the industry.

 The four structural characteristics that are often thought to be entry barriers are:
1. Economies of Scale. If economies of scale are extensive, then in order to enter on a cost
competitive basis, a new entrant requires significant market share. This is likely to depress prices
and make it more likely that entry is not profitable. Entering on a small scale will have a
relatively small effect on price, but the entrant’s average costs will then be relatively high, again
contributing to negative post entry profits.

52
2. Sunk Expenditures of the Entrant. To the extent that the investments required for entry are
sunk, entrants might be reluctant to enter if they anticipate that these expenditures will not be
recovered. Sunk investments mean that any remaining investment is not recoverable upon exit
from the market. Many sunk expenditures are fixed costs which also are responsible for
economies of scale.
3. Absolute Cost Advantages. It may be the case that the incumbent firm has lower costs of
production than potential entrants: at any common scale of operation, the average cost of the
entrant exceeds the average cost of the incumbent. Fundamentally, the source of such an
advantage must be that the entrant is denied access to, or pays a higher price for, some factors of
production. If the entrant had access at the same price as the incumbent, the costs of the entrant
would be identical to the incumbent’s.

II. Strategic Behavior by Incumbents

Because the profitability of entry depends on the nature of competition post- entry and therefore
the behavior of the incumbent, it is possible that the pre- entry behavior of the incumbent can
contribute to the height of entry barriers or entry deterrence by reducing the profitability of entry.

 The strategies available for incumbents to raise the height of barriers to entry generally fall
into one of the following three categories:
1. Aggressive Post-entry Behavior. Incumbent firms can act strategically to commit to
aggressive behavior post- entry. This is typically done by reducing economic costs post- entry by
making sunk investments prior to entry. Reducing the marginal cost of production will typically
make threats by the incumbent to act aggressively post entry credible. Examples include
investments in sunk capacity or deliberately choosing a technology of production that substitutes
sunk fixed costs for avoidable variable costs. In some industries marginal cost depends on
accumulated experience this is called learning by doing. An incumbent can lower its costs by
overinvesting in learning by doing. By producing more than the monopoly output prior to entry.

2. Raising Rivals’ Costs. Incumbent firms can act strategically to raise the costs of a potential
entrant, thereby putting them at a competitive disadvantage and reducing the profitability of
entry.

53
3. Reducing Rivals’ Revenues. Incumbent firms can act strategically to reduce the revenue of a
potential entrant, once again reducing the profitability of entry. Strategies that reduce the revenue
of rivals work by lowering the demand for an entrant’s product.
 A Dominant Firm with a Competitive Fringe
Monopolies are easy to work with in theory, but harder to find in practice. Much more common
are “near monopolies” firms that have a market share of less than 100%, but are still large
enough that they dominate the industry in terms of price setting. In other words
a dominant firm still possesses considerable market power.

Let the supply function of the competitive fringe be given by Q f =Qf(p)where p is the price
charged by the dominant firm. Suppose that the market demand function is Q M =QM(p). Then the
residual demand of the dominant supplier is the difference between market demand and the
supply of the fringe:

D M f
Q ( P )=Q ( P )−Q ( P) (4.8)
The residual demand for the dominant firm shows its sales for any price it charges. It is an
example of a firm’s demand function: the difference between market demand and the
dominant firm’s demand is the supply response of the competitive fringe.

The profits of the dominant firm are

Π D=P Q D ( P )−C ( Q D (P) ) (4.9)
As usual, profits equal total revenue (price time’s quantity) less total costs. The dominant firm’s
cost function is C (QD) and its quantity supplied at price p is Q D (p). The profit-maximizing
dominant firm chooses its price to maximize (4.9). The rate of change of its profits with respect
to its price is
D D D
dΠ dQ dC d Q
= QD + P − (4.10)
dP dP d QD dP
When the firm increases its price by $1 its profits go up from the extra revenue that it earns on
the infra-marginal units - all Q D of them. However, when it raises its price, its demand falls at the
rate dQD /dp and for every unit it no longer sells it suffers a loss equal to the margin on that unit:

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price less marginal cost ( p −dC/dQD ). A profit-maximizing firm would set its price such that
(4.10) equals zero, or
D
dC d Q
QD + (P - D
¿ =0 (4.11)
dQ dP
 Increase in its price leads to a reduction in demand for two reasons:
1. Increasing the price makes it profitable for the price-taking fringe to expand their
output, reducing the residual demand of the dominant firm.
2. The quantity demanded in the market decreases as the price increases.
 Recognizing this and using (4.8), we find that
M f
d Q D d Q (P) d Q ( P ) (4.12)
= −
dP dP dP
and (4.11) becomes

( )( )
M f
dC d Q ( P) d Q ( P)
Q D + P− − =0 (4.13)
d QD dP dP
Where dQm (p)/dp is the reduction in market demand from a price increase and dQ f(p)/dp is the
increase in fringe supply. This can be rewritten as
¿ ¿
D P −MC (Q ) S
D
L = ¿ = f f (4.14)
P εs . s + ε
where LD is the Lerner index for the dominant firm, MC(Q *)its marginal cost at the profit-
maximizing price ( p*) and quantity (Q*), sD its market share, sf the market share of the fringe, ε fs
=%∆ Qf /%∆ p the elasticity of supply of the fringe, and ε=−%∆ QM /%∆ p the elasticity of market
demand.

 The market power of the dominant firm is determined by three factors:

1. The elasticity of market demand. The greater the elasticity of demand, the less market power
the dominant firm can exercise since consumers’ willingness to
substitute to other products is greater.
2. The elasticity of supply of the fringe. The greater the supply response of the competitive
fringe, the lower the market power of the dominant firm. Attempts by the dominant firm to
raise price are less profitable the greater the ability of the fringe to provide consumers with
opportunities for supply substitution. The elasticity of fringe supply depends on the behavior

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 of marginal cost: the more it is inelastic with respect
to output the less it increases as output increases the larger the fringe elasticity of supply.
3. The more efficient the dominant firm vis-a-vis the fringe the lower its marginal
costs the greater its market power. There is also an endogenous relationship between market
power and market share. From (4.14) the larger the dominant firm’s market share the greater
its market power, holding everything else constant. This model provides some support for the
proposition that large market shares suggest market power, provided it is understood that
such a comparison involves holding constant the elasticity of demand and the fringe’s
elasticity of supply. If there is no fringe, the profit-maximizing quantity and price for the
dominant firm given by (4.14) are the same as the monopoly solution. If there is no fringe,
then sf =0, sD =1, and εfs =0 and (4.14) reduces to the usual condition for profit maximization
by a monopolist: the Lerner index equals the inverse of the market elasticity of demand. The
presence of a competitive fringe increases the elasticity of the dominant firm’s demand
relative to a monopolist and its market power is reduced.
4.3.4 Other Forms of Entropy Deterrence’s (i.e. The Role of Investment in Entry Deterrence)
There are two different versions of the hypothesis that an incumbent might use capacity to
deter entry.
 The first is that an incumbent will invest in excess capacity which it then holds in
reserve until entry. If an entrant should dare enter, the incumbent uses this capacity to meet
demand when it launches a price war, so excess capacity is a signal of post entry aggression.
 The second version is more subtle. An incumbent might overinvest in capacity to lower its
short-run marginal costs of production. This provides it with a commitment to produce the
limit output if there is entry.

However, this variant does not necessarily imply that the firm has excess capacity in the absence
of entry. Given that capacity costs are sunk, even a monopolist might find it profitable to produce
at capacity. The first version has been criticized on theoretical grounds: the threat to utilize
capacity post entry may not be credible. Entry likely means that an incumbent will find it profit
maximizing to reduce its output, not increase it. The key issue in entry deterrence is the ability of
an incumbent to maintain or increase its output post entry.
4.4 Prone and Cons of Market Power

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 4.4.1 Benefits of Monopoly (The advantage of being large)
 There are also some benefits associated with market power: these are economies of
scale and incentives for R&D
4.4.1.1 Scale Economies
Market power results in allocative inefficiency since too little output is produced. Oliver
Williamson (1968) has suggested that if a merger to monopoly results in a decrease in industry-
wide costs, these cost savings could easily compensate for any increase in allocative inefficiency.
Thus, Williamson’s point is that it does not take very
large cost savings to compensate for the allocative inefficiency.

4.4.1.2 Research and Development

Schumpeter (1965) argued that market power is a necessary incentive for research and
development. Schumpeter contended that without the lure of monopoly profits firms would have
insufficient incentives to undertake research and development. Moreover, it was a mistake to
focus on allocative inefficiency if that inefficiency made possible innovation of new products
and technologies. For this kind, innovation is responsible for economic growth and substantial
qualitative increases in living standards.

4.4.2. The disadvantages of market power: In this section we take a broader view of the costs
of market power. We consider two other costs associated with monopoly: X-inefficiency and rent
seeking. Both of these may significantly increase the costs associated with market power.
V.4.2.1X-Inefficiency
The concept of X-inefficiency is due to Leibenstein (1966). Leibenstein postulated that
there existed a positive relationship between external pressures on a firm and effort exerted by
employees. In particular, Leibenstein conjectured that a significant social cost of market power is
that a firm’s costs would rise because its employees perceived that effort maximization is not
necessary. Leibenstein’s articulation of this relationship is similar to the quip by Hicks (1935)
that “the best of all monopoly profits is a quiet life.” The quiet life hypothesis is that managerial
slack, or X-inefficiency, is larger the greater the market power of a firm. If this is true, then the
costs associated with monopoly could increase by an order of magnitude.
4.4.2.2 Rent Seeking

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The rent-seeking hypothesis is that additional social costs arise from market power due to the
efforts of firms to acquire and maintain monopoly positions. In this view of the world, monopoly
profits are viewed as a “prize” to be won in a contest and rent seeking refers to the efforts of
firms to win this contest. The rent-seeking hypothesis consists of two components:

1. Rent-seeking expenditures are wasteful. Expenses incurred by firms to win the contest are
socially wasteful. The resources utilized by firms to acquire the prize are wasted. Instead of
producing goods and services that can be consumed, resources expended on rent seeking produce
monopoly profits and no other socially useful by-product.
2. Complete rent dissipation. In total, firms are willing to incur costs up to the value of the
rents and the entire value of monopoly profit is wasted.
If both of these are true, then the social costs of monopoly are not just the deadweight loss of
monopoly pricing. In addition, the value of monopoly profits is a measure of productive
resources wasted on unproductive activities. Whether the two propositions hold depends very
much on the particular source of market power— the nature of the entry barrier that protects the
rents—and the nature of the competition for the rents. Rent-seeking behavior can consist of
lobbying the government, bribing a government official, intervening before regulatory
authorities, investing in capacity, advertising and other non-price competition, research and
development expenditures, etc.

2.5 Market Power and Public Policy

ï Public policy towards market power takes one of two forms.
 Concerns regarding the inefficiency associated with the exercise of market power typically
result in regulation. Regulation involves government intervention to limit the exercise of
market power, typically by constraining or limiting prices.
 Antitrust laws, on the other hand, are supposed to limit the acquisition, protection, and
extension of market power. They do so by making certain kinds of behavior illegal. The
economic rationale for determining the legality of behavior is to assess its effect on market
power.

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Unit5. Consolidation of Market Power: Diversification, Integration & Merger.

5.1. Vertical Integration and Vertical Restriction

A firm that participates in more than one successive stage of the production or distribution of
goods or services is vertically integrated. No vertically integrated firms buy the inputs or
services they need for their production or distribution processes from other firms. A
nonintegrated firm may write long term binding contracts with the firms with which it deals, in
which it specifies price, other terms, or forms of behavior. Such contractual restraints are called
vertical restrictions. For example, manufactures commonly restrict their distributors by
determining their sales territories, setting inventory requirements, and, where legal, setting the
minimum retail price they can charge.

5.1.1 Motives for Vertical Integration : The condition of vertical integration between the firms
for vertical integration in the products is not necessary. However, when we talk of vertical
integration, in reality it implies integration between the firms.

- increase in profits or profitability either by fuller utilization of resources,

- Saving of costs through backward or forward integration and
- Stability and growth are equally sustained through vertical integration.

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ï The motives of the firms involved in vertical integration play important role in determining
the price and quantity of output of the industry to which they belong.
There are at least six major advantages to integrating.

 Integration to lower Transaction costs

 Integration to assure supply
 Integration to Eliminate Externalities
 Integration to avoid Government intervention
 Integration to increase Monopoly profits
 Vertical Integration to Monopolize another Industry
5.2 Merger and takeover

Mergers and Acquisitions (takeover): refers to consolidation or amalgamation or integration

of two or more firms. The firms under different ownership and management controls come under
a united one through merger. The terms ‘acquisition’ and ‘takeover’ are also used for ‘merger’,
which implies that a firm acquires assets or stocks in part or full, of other firm or firms to get
operational control over them. In legal sense, there is difference between these terms but from
the point of view of the economic analysis they are like. The important feature of merger, that is
relevant to us, is the transfer of control of business activity from one firm or firms to another.

There are three broad merger categories. These are: horizontal, Vertical and conglomerate.
i. Horizontal mergers involve firms that are direct competitors. The firms must compete
in both the same product market and the same geographic Mkt.
ii. Vertical mergers involve firms that produce at different stages of production in the
same industry. For example steel producing industry.
iii. Conglomerate mergers involve companies that operate in either different product
markets or the same product market but different geographic markets.
ï Conglomerate mergers are usually subdivided in to three types:
 product extension mergers between companies that produce different but related
products (e.g., laundry detergent and liquid bleach);
 Geographic extension mergers between companies that produce the same product in
different location (e.g. a Midwestern beer producer purchases a north eastern beer
producer); and

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  Pure conglomerate mergers between firms operating in entirely separate markets (e.g.,
a telephone company purchases a rental car company.)

5.2.1 Motives for Merger

ï Several major reasons are commonly advanced to explain mergers. Seven of the most
commonly advanced reasons are listed below.
 Market power
 Efficiency gains
 Financial Motives
 Risk Reduction
 Empire Building (encouraging the desire of an individual to build a financial empire)
 Failing Firm (it help to motivate failing firm)
 Aging owners (permits the owner to retire on the anticipated future earnings of the
firm)

5.3 Diversifications

A firm produces some varieties of a product which are close substitutes for each other in the
market. If the firm adds one more variety of the product, then it is not diversification. However,
if the firm produces a totally different product which is not a substitute for the existing products
in the market then it is called diversification. A firm producing margarine starts producing soap,
for example. This comes under diversification. Similarly, when a leather tanning firm starts
manufacturing boots and other leather goods, we will then call if diversification because here the
products are different as a result of which the market ‘area’ for the firm expands from one class
of consumers to another one.

Diversification is thus ‘the spreading of its operations by a business over dissimilar economic
activities. In the process of diversification, a firm make, significant changes in its ‘areas’ of
operations related to technological base, market areas and productive activities in which it has
acquired experience or knowledge in the past. When a firm introduces new products there will be
a change in productive services and marketing areas or activities. Diversification thus cannot be
conceived of changes in the products only, it implies the other two aspects of the change also,
i.e., changes in the technological base and market areas. Introduction of new products means

61
enlarging the technological bases and marketing areas and strategies as well as the administrative
expertise since all these aspects are interlinked.

5.3.1 Motives for Diversification

Motives for diversification depend on its types. It will be thus convenient for us to examine the
motives for different types of diversification and then synthesize them together. The types of
diversification as observed in practice and motives for them are as following:

A. Lateral Diversification: when a firm produces different goods which diverge from the same
process or source, or which are used as materials for the same process or market. For
example, a leather tanning firm will have lateral diversification when it starts making boots
and shoes, leather garments and suitcases itself, because all such businesses diverge from
leather tanning business. Similarly, a meat seller will have lateral diversification if it starts
selling hides, horns, bones and even raw wool. A soap manufacturer may start margarine and
chemical manufacturing itself which are used in soap making and thus indulge in lateral
diversification.
ï A firm may resort to lateral diversification because of the following reasons:

1. When production of one commodity necessarily involves production of another, say, in by-
products form, there would be a natural scope for lateral diversification in order to avoid
wastages and gain advantages from the business. Production of mutton and wool, bitumen,
fabricants, paraffin, raw chemicals, etc., together with petroleum refining, coal, coke, and
their by-products such as benzene, etc. , are few examples of this situation.
2. When market demand for the existing products is declining or stagnant a firm has to
diversify its business laterally in order to maintain its earnings or to increase it.
3. Better utilization of existing facilities such as managerial talents, research and development
activities and certain categories of machines, etc., may be looked as a motive for lateral
diversification.
4. The market complementarily or interlocking pattern in seasonal demands also leads to
lateral diversification say, for example, one may produce colors and water sprayers together
for Holy festival.

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 5. This type of diversification when done through merger brings more market power by
reducing competition and through extension of operations in different industries.
6. To maintain the rate of growth, without being accused of monopolizing this type of
diversification is very much suitable and actually being followed all over the world.
Lateral diversification is an effective barrier to entry to reduce potential competition.

B. Conglomerate Diversification: in this type of diversification, the products need not to have
diverged from the same product or source, or converge at the same process or market as is
the situation in the case of lateral diversification. The products will be quite unrelated. All
motives of internal diversification will also be motives of conglomerate diversification.

In brief,

- it helps in extension of market power of the firm,

- it brings stability in earnings through cross-subsidization, i.e., loss of one product is covered
by the gain from other,
- it causes an increase in the barriers to entry,
- it provides more options for risk taking for the sake of profits, maintains the process of
growth,
- it gives pecuniary gains to the firm,
- it provides better utilization of some facilities, and so on.
C. Vertical Diversification: It involves diversification into process of manufacturing or
distribution which precedes or succeeds those in which the firm is already engaged. It can be
either ‘backward integration’ or ‘forward integration’.
 The first one is seen where a firm starts manufacturing products previously purchased form
others in order to use them in making its original product line. A chocolate firm, for
example, may have its own coca plantation farm. A milk product company may have its
own flour mill and so on.
 The second type, i.e., ‘forward integration’ occurs when the firm moves nearer to the final
market for its product and carries out a function which was previously undertaken by its
customers. A shoemaking firm may start its own distribution or selling shops, a flour mill
may start making its own bakeries; a spinning mill may also start weaving activities and
like that are few examples of forward integration.

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ï Vertical diversification, whether initiated by a firm itself or occurring by merging of two or
more firms has several motives some of which are as follows:

1. It provides security to the firm. Say, a firm integrates backward in order to have assured
sources of supplies. The intensity of such integration will be more when demand conditions
for the final product of the firm are very bright. Similarly, the firm integrates or diversifies
in forward direction in order to assure market for its product. When demand conditions are
slacking, such integration is likely to be more intensive.
2. Vertical diversification or integration provides economies of linked processes and, thus, the
efficiency of the firm goes up due to improvements in capacity utilization.
3. There will be economies in marketing such as saving of transportation, advertisement,
procurement and selling costs.
4. There may be saving by eliminating ‘the middle man’ and his ‘unnecessary’ profit margin
in the process of production.
5. On the whole the firm gets more market power through its size or absolute cost advantages
or pecuniary gains through vertical integration. It gives strength to the barriers to entry and,
therefore, reduces competition in the market.
D. Diagonal diversification or Integration: It consists of the provision within same
organization of auxiliary goods and services required for the several main processes or lines
or production of the organization. For example, a firm may have its own power house to
generate electricity or machine-tool making units since such things are required for running
almost every processing activity.
ï The motives of diagonal diversification or integration will be more or less the same as for
lateral and vertical diversification. Among them the major one will be:

1. mopping up of excess capacity, and

2. reduction of the risks
ï The motives of all types of diversification can now be summarized in condensed form as:

i) Profitability or earning motive which implies fuller utilization of resources/ capacities at the
disposal of the firm;
ii) Stability motive which implies reduction of risks and uncertainties through assured supplies
of resources and markets for main line of production,

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 iii) Growth motive which means expansion of productive capacities without being charged for
being monopolizing,
iv) Market power motive which is assured through increase in barriers to entry as a result of
diversification.
In general, a new industry will have higher degree of diagonal and vertical integration but a
mature industry will resort to more lateral diversification. This is because, in the case of a new
industry, auxiliary services may not be available at all, so the firms have to make for their
provision within its organization. For a mature industry like textiles the demand for such services
will be large enough, so independent units may come into existence for their supplies in an
efficient way.

UNIT 6. ADVERTISMENT, RESEARCH & DEVELOPMENT AND TECHNOLOGICAL

PROGRESS

6.1 INFORMATION ASYMMETRY AND ADVERTISMENT

6.1.1 Definition of Advertisement

- According to Thomas Jefferson “advertising is a racket… its constructive contribution to

humanity is exactly minus zero.”
- According to Scott Fitzgerald, “Advertising has many purposes. An advertisement may
inform consumers that a firm has a new product or the lowest price, or it may help to
differentiate the firm’s product from that of its rivals. A firm uses advertisements to inform
consumers of its product’s strengths but not its weakness. In this unit we will examine
information and advertising, advertising and market structure; advertising and profitability
and the social benefits of advertising.”

6.1.2 Information and Advertising

Advertising may convey hard facts, vague claims, or try to create a favorable impression of a
product. Some advertisements list a store’s prices. If consumers learn that a firm has the lowest
prices in town, the demand for its products increases. In contrast, other advertisements merely
show a product being used in a pleasant setting. An attractive person consuming a soft drink near

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a water fall may convey to consumers the impression that this product is refreshing. By
convincing consumers that its product has certain desirable traits, a firm can differentiate it from
other products. As its product becomes differentiated, a firm may face a higher and less elastic
demand curve, so that it can charge a higher price and earn greater profits. For example, one
heavily promoted brand of bleach sells at a much higher price than many other bleaches that are
physically identical.

Promotions

Advertising is only one of many ways to promote a product; firms also use price discounts and
sales staffs. When it is hard to describe a product, a firm may include discount coupon in its
advertisement of encourage consumers to try the product. Sales people act like living
advertisements. In addition to advertising in news papers, on radio, and on television, firms may
advertise indirectly by establishing a brand name or otherwise establishing a positive reputation.

For example, some agricultural firms now sell their fruits and vegetables under brand names.
Unlike sellers of unbranded produce, these farmers are trying to develop a reputation for
producing a particular quality of produce.

‘’Search’’ versus’ Experience’’ Goods

The informational content of advising depends on whether consumers can determine the quality
of a product prior to purchase. If a consumer can establish a product’s quality prior to purchase
by inspection, the product has search qualities, Examples are furniture, closeting (determine
style), and other products whose chief attributes can be determined by visual or facile inspection.
If a customer must consume the product to determine its quality, it is said to have experience
qualities. Examples are processed foods & soft ware programmers.

Advertising provides direct information about the characteristics of products with search
qualities; advertisements for search products often include photographs. In some cases a
consumer cannot directly observe a physical attribute, but it can be concisely described. For
example, food and drink advertisements may claim that their products are low in calories. In
contrast, for experience goods, the most important information may be conveyed simply by the
presence of the advertising, some advertisement do little more than mention the name of the firm

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to enhance the firm’s reputation. Such advertisers hope that consumers infer the quality of
reputability of a firm by the frequency of its advertising and the expense involved. Fly-by-night
firms may be less likely to advertise in expensive publications or on national television.

Some firms claim that all their products are excellent. Their advertisements contend that if you
have experienced and liked one of their products, you will like all of them. Such advertisements
may do little more than show the company’s name; they do not describe the properties of each of
its product. Alternatively, a firm may try to convince consumers that its product is different and
superior to other, similarly brands-that is, it attempts to differentiate its product from competing
brands.

Informational versus Persuasive Advertising

Some economists distinguish between informational advertising, which describes a product’s

objective characteristics, and persuasive advertising, which is designed to shift consumer’s
tastes. For example, informational advertising may cite the price of a product, compare the
advertising store’s price of its rival’s prices, describe the features of the product, or list its uses.
Persuasive advertising may explicitly or implicitly make claims such as ‘’smoke these cigarettes
to look more mature and sexier.’’

Some companies may try to change consumers’ perceptions of their product using persuasive
advertising, when they could not truthfully change their informative advertising. For example,
the share of coke grew by about a tenth in 1992 over 1991 when it altered its image.

6. 1. 3 WELFARE IMPLICATION OF ADVERTISEMENT

Advertising may be described as the science of arresting human intelligence long enough to get
money from it. Substantial empirical evidence indicates that advertising about relative prices can
increase competition and raise welfare. Advertising that provides relative price information tends
to lower the market price. Truthful advertising lets consumers know where to buy at the lowest
price. Because it is costly to advertise, however, firms do not engage in it unless the costs are at
least covered by the additional revenues from an increase in demand. Many empirical studies
show that advertising about price lowers the average price consumers pay for products.

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In some markets, firms cannot profitably sell high-quality products because consumers are
unable to distinguish between –high quality and low-quality products. If firms can use guarantees
or warranties to signal high quality, the problem of distinguishing between law quality and high
quality can be avoided. Similarly, advertising may solve the problem if it signals quality.

Suppose, for example, a firm wants to start selling a high-quality experience good. It behaves
that, if consumers try its product, they will like and purchase it repeatedly. That is, the firm’s
incentive to provide high-quality goods is to induce repeat sales. The firm hopes to make large
profits by signaling its high quality and getting consumers to try its product.

To keep this example simple, let us make two additional assumptions.

 First, assume that consumers can only find out about product’s quality by trying the good,
otherwise, the firm could produce a few items, give them away to some consumers, and rely
on word-of-mouth to sell its product.
 Second, we assume that the firm’s marginal and average variable costs of production are the
same as those of firms that produce law-quality goods. As a result, if the high-quality firm
sells more units than low-quality firms at the same price, it makes higher profits on these
sales.

The high-quality firm has a greater incentive to advertise than does the low-quality firm. The
high –quality firm’s advertising leads to repeated sales only in the current period. Because both
types of firms have the same costs of production and advertising and because the rewards to
advertising are greater for the high quality firm, it engages in more advertising.

6.2 TECHNOLOGICAL PROGRESS

6.2.1 RESEARCH AND DEVELOPMENT

The followings are the determinants of research and development:

i) The first and most intensively debated determinant of research and development is the market
structure of the industry. Particularly, the elements of market structure such as the degree of
market power and absolute size of firms were used in theory and empirical work on research and
development behavior of the firms and industries. Perfect competition and monopoly were taken

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as two extreme contrasting situations to analyze the link between innovational motivation and
market power. In this regard there are two opposite schools at present: one is the ‘competitive
pressure school’ and the other ‘monopoly profit school’.

The competitive pressure school argues that in an automatically competitive situation, with its
strong tendency for a uniform normal rate of profit, there will be great pressure and hence
inducement for making cost-saving innovations. Such pressure diminishes as market power of
the firm increases and so the rate of innovation will be inversely related to the degree of market
power.

The monopoly profit school does not agree with such contention. It argues that since innovation
is risky, it will not be undertaken in automatically competitive markets where the gains from
innovation will be momentary. According to this school, the conditions for sustained research
and development activities are best provided by the monopoly or concentrated markets.
Thorough research and development activities a firm gains and acquires monopoly power over
its rivals. The firm would like to perpetuate its monopoly power by undertaking new
innovational activities. There is thus a positive relationship between the rate of innovation and
the degree of monopoly power as conceived by the monopoly profit school. In short, the stand of
the monopoly profit school can be summarized as ‘… the greater the profits and the degree of
market power of firm size, the greater should be the efforts of innovate.’

ii) Monopoly and perfect competition are the extreme forms of market structure. Both of them,
because of different reasons, may not provide significant incentive for innovation. Therefore, the
intermediate form of market structure, having both competition and monopoly power, is
considered as a realistic market setting for effective innovational activities. The reference here is
to the oligopoly market structure which provides both monopoly power and competitive
environment for innovation. In oligopoly only few firms will be having effective control over the
market. Such firms will be large enough and competing among them for greater market power.
Being small in number they will be unable to keep their plans or strategies unnoticed by the
rivals and so eventually they will be in a situation of interdependency. They will be unable to
compete with themselves through manipulation in prices. So research and development
expenditure together with advertisement provide an alternative made of competition. Each firm
will try to have either product or process innovation. In this way, there will be all kinds of

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innovational activities in oligopolistic market situation. Competition among few leading firms
induces them to innovate while the monopoly power and large absolute size of such firms
provide the threshold conditions for undertaking research and development activities, both with
respect to resource availability and risk bearing ability.

Smaller firms, even under oligopoly, are unlikely to undertake research and development
activities because of their inability to take the risks associated with research and development
and lack of adequate finances.

iii) The threshold or what we may call alternatively, minimum level of investment for research
and development activities, varies between industries and between different types of products in
the same industry. Greater the requirement of money for the threshold level of research and
development lesser will be the incentive for innovation by the firms. The scientific and
technological basis of the industries to a great extent determine the threshold levels of research
and development expenditure for them. Differences in the scientific and technological nature of
the industries are likely to influence the rate of innovation independently. Greater the
technological opportunity of the industry, i.e., more scope for advancement of scientific and
technical knowledge, higher we expect the rate of innovation irrespective of market structure of
firm size.

iv) Another important factors that affects the rte innovation is the nature of the elasticity of
demand for the product or products of an industry. Rapid technological changes are seen in the
industries having elastic demand. Most of the luxury goods industries fall in this category.
Suppose there is process innovation such that cost of production reduces. By a reduction in cost
of production the firm will be in a position to reduce product price in order to get more revenue
(i.e., positive MR) if elasticity of demand is more than one. The firm will do so.
[ Recall, MR =P ( 1- 1/ ledl ) ] . It is beneficial to the firm as well as to the consumers of the firm
since they pay less price for the product now and the firm gets more revenue. Thus, there will be
more inducement for innovation when price elasticity of demand for the products of the firm or
industry is elastic.

v) Research and development intensity also depends on diversification. It has been postulated
that a firm’s degree of diversification will positively influence its profit expectations from

70
research and development. The basis for this relationship is that a more diversified firm will be
in a better position to exploit unexpected research outputs than the one having a narrow base of
operations. There is another aspect of this relationship. If a firm contemplates diversification of
its operations because of some reasons then it may also contemplate simultaneously to have a
research and development unit for being technologically independent.

vi) Research and development activities also show strong positive association with growth of
output of a number of industries. R & D activities are committed intensively where the growth
prospects are good and profits are likely to be high. However, there may be an upper limit for
such positive relationship. A stage will come when a product reaches ‘maturity’ stage of its life
cycle with no more growth prospects. At this stage, the firm has to go through intensive R & D
activities in search of a new product or products to replace the old one. The relationship therefore
may not hold true or it may be negative after such stage is reached.

vii) Yet another factor that we may mention here as a determinant of research and development
behavior of the firm, is the return on research and development investment itself. Greater the
expected return from such investment more will be the current volume of investment, committed
to research and development activities. It is undertaken either for increased profits and/or to
stabilize the position of the firm in the market.

6.2.2 INVENTION, INNOVATION AND DIFFUSION

6.2.2.1 INTRODUCTION TO INNOVATION

Innovation is one of the several strategies through which a firm could change its situation in the
market in pursuit of its objective. It is an instrument, which the firm uses to enhance its
competitive power in the market. It provides a basis for greater degree of diversification and
hence growth of the firm. New products, new methods of production, new markets and new
forms of industrial organization etc., which are elements of innovation or technological change,
make the firms and industries to run efficiently over time. Innovation is a common features in
almost every economic system whether capitalistic or socialistic or something else. Science and
technology are the instruments for rapid economic progress of a society. They become operative
through innovation. An individual wants to be more creative, a firm or corporation strives for the
progressiveness of its business and a government works for the collective security and welfare of

71
masses. Innovation is an important weapon for all these. In fact, survival of mankind depends to
a great extent on innovation, particularly in the fields of material requisites of life.

6.2.2.2 THE PROCESS OF INNOVATION

To understand the process of innovation in a clear perspective, we have to define first its
terminology. The terminology consists of a set of interrelated terms. The first and perhaps the
most important one is the concept of ‘invention’. An invention is the creation of the new
technology. By ‘technology’ we mean ‘any tool or technique, any product or process, any
physical equipment or method of doing or making, by which human capability is extended. All
inventions, big or little, are made for some practical uses. The process of adopting an invention
in a practical use is called ‘innovation’. It is the second important concept which is the focus of
the study in this unit. Innovation is a multi-dimensional concept. If the existing product line is
changed by a firm, i.e., it introduces a new product with or without displacement of the old ones,
then it is defined as ‘product-innovation’; if a new method is initiated to produce existing
products then it is “Process-innovation’. Both of these are elements of ‘technological
innovation’. When a firm makes changes in its marketing strategy we define that as ‘market
innovation’. The entrepreneur or manager when performs the act of innovation is called
‘innovator’. He invests resources for the innovation and takes the risks involved in that. This is a
very important role, indeed a pivotal one, for the growth of industries.

The third useful concept related to the innovation process is ‘imitation’. It is a situation when an
innovation is copied by others. That is, the innovation spreads across the market. In other words,
we call it ‘diffusion’ of the innovation. Such diffusion may be rapid or slower depending on the
market situation, but it will be easier or safer than the act of innovation.

The three terms-inventions, innovation and imitation are the successive stages of the process of
innovation or technological change. Imitation is not possible without innovation which in turn is
not possible without invention.

The entire process of innovation, i.e., from invention to imitation, comes under ‘research and
development (R & D) activity of the firm. Each stage of this process is a process itself. Let us
examine them in some detail for full understanding.

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 (i) The first stage of the process, that is, invention, is carried on by individuals or corporate
bodies like research institutes, universities, government bureaus and companies. It is just
like any other corporate activity such as sales or production where certain inputs are used to
get some output. In a broad sense, we may call invention as ‘output’ of ‘the research
industry’. If so, an invention will be a goal-oriented activity. A government or corporation
will be making invention for solving some social problem or for the sake of extra profits or
money. By and large, we have to take invention as an orderly, intellectual, goal oriented
process. It does not usually move in a straight line according to the plan, but takes
unexpected twists and turns to reach the destination.
(ii) The next stage, i.e., innovation is a logical extension of the first one. When an invention is
made, its fruits are made available to the society through innovation. An entrepreneur or
corporation comes forward, makes the required investments for the innovation. As
mentioned earlier, innovation may be in product or process of manufacturing or any other
activity of the corporation. It involves risks or uncertainties. An innovator bears them and it
is precisely on this ground that economist justify existence of excess profits for him.

Process-innovation and product-innovation are two important types of innovation. The necessity
of process innovation arises:

a) When relative prices of factors of production change. If labour becomes costly, the firm
may think of cost saving by adopting capital intensive technique and vice-versa. In the
familiar isoquant framework, it implies a movement along the isoquant when the input
prices change. There will not be any R & D expenditure involved in this, as technology will
not change. Only equilibrium situation for the least-cost combination of inputs changes.
b) If technology changes. This means a new production function causing a shift of the
isoquants. In this situation, the need for process innovation is obvious. The input
proportions to produce a given level of output will change if there is technological change
giving rise to the process innovation.

Product innovation is necessitated because of a variety of reasons. Primarily, a product change

may be stimulated either by a new technology or by a change in relative prices of existing

73
products. Chances in consumer preferences and cost of production are the sources of change in
relative prices of the products. If a product is costly for the firm and at the same time its price
declines in the market because of unfavorable circumstances, it will be less profitable and, hence,
is likely to be replaced by a new one.

The stage of innovation is a planned one. It has a well-defined goal and the adaptation of the new
technology or product to achieve the goal is an orderly management function of the firm. The
process of innovation takes time and costs money.

(iii) The third stage of the process of technological change

or innovation is imitation or diffusion. The innovation, initiated by an innovator, spreads in
the market. The rate of diffusion depends on market structure. If there are rigid patent
practices and the government assistance in technological progress is negligible, then we
expect a low rate of diffusion of the innovation. On the other hand, if technology is freely
available, there are no rigid patent practices and investment requirements for the new
technology are not alarming, then the rate of diffusion will be fairly high. From social point
of view diffusion or spread of the innovation is desirable but from an individual firm’s point
of view it is not, as the firm would not be able to maintain its gains through innovation
when it is imitated by its rivals.

The process of technological change constituting the above three stages-invention, innovation
and imitation may be different in different industries. Some industries provide better
opportunities for innovation or change as compared to others. Why is this so? What determines
innovation? These are important questions which we would like to discuss in this unit. But,
before taking them, we deal with the problems of measuring innovation activity in the following
section.

6.2.2.3 MEASUREMENT OF INNOVATION ACTIVITIES

Like any other economic activity we need precise measurement of innovation in order to
estimate its extent in reality at firm and industry levels, and to establish its behavioral relations
quantitatively with its determinants. There is no unique method for this. Researchers in the field

74
tackled the problem by measuring either the inputs put in the process of R & D or the output of
this activity.

 The followings are some of the measurements:

a) The most simple and widely used method is to take the statistics of research and development
expenditure, absolute or a proportion of total annual budget of the firm, as a measure of
innovation activity.

b) The other method is to take the number of scientists and engineers in the research and
development department as a measurement of innovational activities.

c) From the output side one may use either the number of patents issued or sale of new product
as appropriate measurements of innovation or research and development activities.

d) An alternative method of measuring this is, therefore, to take the number of major or
significant inventions and/or innovations in a particular industry or within a given time period.

e) The index of sales of new product is another measurement of research and development
output.

f) The frequency of publications in scientific or trade journals, and

g) Estimating savings of inputs per unit output of an industry or sector

NB: The final choice of the method to be used for measuring innovation is left to the
convenience and judgment of the researchers. There is nothing much on the basis of which we
can discriminate the methods.

6.2.2.4 THE THEORY OF TECHNOLOGICAL INNOVATION

The theory dealing with the process of technological innovation has not yet taken proper shape.
Attempts are being made by economists to identify the conditions (or determinants) which
encourage initiation and adaptation of a new technology. To begin with the identification of such
conditions, we may pose a simple but basic question related to the technological innovation.
Why do scientists or engineers or anybody else make invention? In a different way, we may ask
this question as: why is a huge amount of money being spent on research and development

75
activities all over the world? The answer to this question is straight forward, that is, inventions
are made because there is a need for them. Through inventions and their commercial exploitation
man controls his environment. An invention without commercial exploitation for personal or
social uses cannot be viable. Given this basic proposition of need which backs up inventions, that
is, makes them goal oriented, we have to identify the conditions which are conducive or which
accelerate the pace of invention and innovation or broadly the technological change in economy.

 The followings are the determinants of research and development:

i) The first and most intensively debated determinant of research and development is the market
structure of the industry. Particularly, the elements of market structure such as the degree of
market power and absolute size of firms were used in theory and empirical work on research and
development behavior of the firms and industries. Perfect competition and monopoly were taken
as two extreme contrasting situations to analyze the link between innovational motivation and
market power. In this regard there are two opposite schools at present: one is the ‘competitive
pressure school’ and the other ‘monopoly profit school’.

The competitive pressure school argues that in an automatically competitive situation, with its
strong tendency for a uniform normal rate of profit, there will be great pressure and hence
inducement for making cost-saving innovations. Such pressure diminishes as market power of
the firm increases and so the rate of innovation will be inversely related to the degree of market
power.

The monopoly profit school does not agree with such contention. It argues that since innovation
is risky, it will not be undertaken in automatically competitive markets where the gains from
innovation will be momentary. According to this school, the conditions for sustained research
and development activities are best provided by the monopoly or concentrated markets.
Thorough research and development activities a firm gains and acquires monopoly power over
its rivals. The firm would like to perpetuate its monopoly power by undertaking new
innovational activities. There is thus a positive relationship between the rate of innovation and
the degree of monopoly power as conceived by the monopoly profit school. In short, the stand of
the monopoly profit school can be summarized as ‘… the greater the profits and the degree of
market power of firm size, the greater should be the efforts of innovate.’

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ii) Monopoly and perfect competition are the extreme forms of market structure. Both of them,
because of different reasons, may not provide significant incentive for innovation. Therefore, the
intermediate form of market structure, having both competition and monopoly power, is
considered as a realistic market setting for effective innovational activities. The reference here is
to the oligopoly market structure which provides both monopoly power and competitive
environment for innovation. In oligopoly only few firms will be having effective control over the
market. Such firms will be large enough and competing among them for greater market power.
Being small in number they will be unable to keep their plans or strategies unnoticed by the
rivals and so eventually they will be in a situation of interdependency. They will be unable to
compete with themselves through manipulation in prices. So research and development
expenditure together with advertisement provide an alternative made of competition. Each firm
will try to have either product or process innovation. In this way, there will be all kinds of
innovational activities in oligopolistic market situation. Competition among few leading firms
induces them to innovate while the monopoly power and large absolute size of such firms
provide the threshold conditions for undertaking research and development activities, both with
respect to resource availability and risk bearing ability.

Smaller firms, even under oligopoly, are unlikely to undertake research and development
activities because of their inability to take the risks associated with research and development
and lack of adequate finances.

iii) The threshold or what we may call alternatively, minimum level of investment for research
and development activities, varies between industries and between different types of products in
the same industry. Greater the requirement of money for the threshold level of research and
development lesser will be the incentive for innovation by the firms. The scientific and
technological bases of the industries to a great extent determine the threshold levels of research
and development expenditure for them. Differences in the scientific and technological nature of
the industries are likely to influence the rate of innovation independently. Greater the
technological opportunity of the industry, i.e., more scope for advancement of scientific and
technical knowledge, higher we expect the rate of innovation irrespective of market structure of
firm size.

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iv)Another important factors that affects the rte innovation is the nature of the elasticity of
demand for the product or products of an industry. Rapid technological changes are seen in the
industries having elastic demand. Most of the luxury goods industries fall in this category.
Suppose there is process innovation such that cost of production reduces. By a reduction in cost
of production the firm will be in a position to reduce product price in order to get more revenue
(i.e., positive MR) if elasticity of demand is more than one. The firm will do so.
[ Recall, MR =P ( 1- 1/ ledl ) ] . It is beneficial to the firm as well as to the consumers of the firm
since they pay fewer prices for the product now and the firm gets more revenue. Thus, there will
be more inducement for innovation when price elasticity of demand for the products of the firm
or industry is elastic.

v) Research and development intensity also depends on diversification. It has been postulated
that a firm’s degree of diversification will positively influence its profit expectations from
research and development. The basis for this relationship is that a more diversified firm will be
in a better position to exploit unexpected research outputs than the one having a narrow base of
operations. There is another aspect of this relationship. If a firm contemplates diversification of
its operations because of some reasons then it may also contemplate simultaneously to have a
research and development unit for being technologically independent.

vi) Research and development activities also show strong positive association with growth of
output of a number of industries. R & D activities are committed intensively where the growth
prospects are good and profits are likely to be high. However, there may be an upper limit for
such positive relationship. A stage will come when a product reaches ‘maturity’ stage of its life
cycle with no more growth prospects. At this stage, the firm has to go through intensive R & D
activities in search of a new product or products to replace the old one. The relationship therefore
may not hold true or it may be negative after such stage is reached.

vii) Yet another factor that we may mention here as a determinant of research and development
behavior of the firm, is the return on research and development investment itself. Greater the
expected return from such investment more will be the current volume of investment, committed
to research and development activities. It is undertaken either for increased profits and/or to
stabilize the position of the firm in the market.

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6.2.2.5 DIFFUSION OF NEW TECHNOLOGY

This is an important aspect of the innovation process. A new technology invented by a firm is
likely to be less diffusible as its adaptation by the rival firms will be restricted through patent
right. However, when such technology is developed by a government research institute for
common use, the rate of its diffusion or adaptability may be slow or fast depending on certain
economic factors such as

- reduction in cost of production,

- improvement in the quality of output of the technology,
- requirement of capital amount for new technology,
- the skills needed to make if operational,
- malleability or the case of disposal for the existing obsolete capital stock,
- the nature of demand elasticity for the products of the new technology,
- the rate of growth of the market,
- size of individual firms,
- the structure of industry,
- cost involved in getting the right to use the technology, (e.g., royalty or license fee)

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UNIT. 7 CONCEPTS OF FIRM PERFORMANCE MEASURE

7.1 PROFITABILITY

7.1.1 INTRODUCTION TO PROFITABILITY

Profitability is a simple and widely used index of assessing business efficiency of a firm. Often
we find inter-industry and inter-firm differences in profitability. There are several factors to
which such variations in profitability may be linked. Some of these factors:

ï Constitute elements of ‘market structure’, specifically,

- absolute size of the firm
- market concentration
- product diversification
- vertical integration
ï Constitute the elements of ‘Market conduct’ of the firm such as:
- R&D
- Advertisement
- Marketing policies
- Pricing
- Collusion etc., have considerable implications for profitability
ï Also outside constraints such as,
- changes in cost of production

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 - market demand
- government policies, etc, affects profitability
7.1.2 THE CONCEPT OF PROFITABILITY AND ITS MEASUREMENT

The concept of profitability often shows ambiguity and limitations when expressed in
quantitative terms. The term profitability in abstract sense may be defined as the quality of being
profitable, i.e., yielding profit or advantage.

Profit is usually interpreted as the difference between the total expenses involved in making or
buying of a commodity and the total revenue accruing from its sales. This difference when
expressed as a proportion of invested capital or current outlay or sales shows the profitability of a
business.

Profitability may also be expressed as the proportion by which the price per unit sold; (average
revenue) would be greater than the average or marginal cost. This is a rate on turnover which is
called ‘price-cost margin’.

Both these approaches to conceive the term profitability are not free from ambiguity. The major
difficulty lies with the definition of the term ‘profit’ itself. There are differences in the view-
points of economists and accountants on this aspect. Among economists also, there is no
consensus about the definition and conditions for occurrence of profit. Let’s see some of them:

ï Some economists, like F. A. Walker, treat profit as an implicit return to any service(s) and/or
resource(s) supplied by the owner(s) himself. i.e., Walker treats profit as a rent for superior
entrepreneurial ability.
For his personal services in his own business an entrepreneur is supposed to get implicit wage,
for the money he puts in he gets implicit interest, and for his own property used in his own
business he gets implicit rent. Economists treat all such payments as elements of cost in business.

ï Another group of economists led by F. B. Hawley treat profit as a reward for risks and
responsibilities that the entrepreneur puts himself to.

There may be varieties of risks, some associated with technological changes, business cycles and
price levels, and marketing, etc. some risks can be anticipated in advance so they are insurable,

81
but, in general, most of the risks in business cannot be insured so the entrepreneur is justified a
reward in the form of profit to face them.

ï Frank Knight (and also J. B. Clark) links the occurrence of profit as a reward for another
category of risks which arise as a result of future uncertainties, rather than the risks which
are known in advance and therefore insurable.
ï Schumpeter (also Joel Dean and Peter Drucker) sees the origin of profit as a reward to the
entrepreneur for the services of innovation (This theory is called ‘innovational theory of
profit.’)
ï The strongest case for occurrence of profit is attributed to the monopoly power.

Uneven size distribution of the firms in industries, economies of scale, barriers to entry, product
diversification, patent rights, licensing, advertisement etc., together make market structure of the
industry imperfect as a result of which some firms having greater share in the industry will be
able to control prices and market supply in such a way that they get maximum profit (surplus).

Monopoly is the extreme case of monopoly power where we expect maximum profits. The
concentrated markets having either ‘homogenous’ or ‘differentiated’ Oligopolistic structures
would come in the next order as far as monopoly power is concerned and so would be having
considerable impact on occurrence of surplus profit.

The perfect competition would be the extreme polar case for monopoly power in lower order and
thus there will be no scope for surplus profit in such situation from economists’ point of view
except in the short-run.

NB: Whatever be the sources of profit, whether the implicit earnings of the entrepreneur and/or
reward for risks, uncertainties, and innovations, or a return due to monopoly power of the firm, it
is essential for a business firm for survival, satisfaction, stability, and growth even when it tries
to achieve a goal other than the profit maximization. In fact, as Dean Joel remarked, “a business
firm is an organization designed to make profit, and profit is the primary measure of its success.”

The ambiguity about the definition of profit still persists. Whether the definition adopted by the
accountants is to be followed or the one given by the economists is not clear.

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Example: When the size of the firm comes into the picture, for a small firm managed by a
proprietor himself the implicit costs will be part of his profit but in large corporations where
there is a complete divorce between ownership and management, there will not be any implicit
costs and therefore the concept of profit resembles with the one given by the economists.

Further, there are other controversies about the definition of profit such as: whether it is the short
term profit or the long-term one with which the business firms are concerned much.

Example If actual interest payments have been deducted before the calculation of profit, then
comparison of profit between firms will be affected by their debt-equity ratio. If, on the other
hand, interest is not deducted, then the comparison of profit will be affected by the inter-firm
differences in capital intensity.

Similarly, provision of depreciation and taxes create serious conceptual and measurement
problems in profit analysis as they are likely to vary from firm to firm depending on the method
of estimation and taxation laws respectively. A large firm may follow different method for
depreciation accounting than a smaller one. Moreover, it may pay higher rate of tax than the
smaller firm, so the profits of such firms will not be comparable directly.

7.1.4 THE THEORY OF PROFITABILITY: A SUMMARY

There is no standardized theory of profitability as we find for other economic magnitudes like
cost, production and prices. However, there are some important theoretical considerations related
to profitability analysis.

The major theoretical development in the field of profitability analysis has been on establishment
of the link between market structure and profitability.

1. The market structure is a multi-dimensional concept. Its primary constituents, that have
considerable theoretical and empirical implications for profitability at firm as well as industry
levels, are:
- concentration
- scale in relation to industry size, and
- product differentiation

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Let us examine the various combinations of high and low values of these structural variables in
order to identify the market conditions most favorable for profitability.

The relevant combinations are as follows:

(i) ‘Low’ scale, ‘Low’ concentration and ‘Low’ product differentiation.

This is a limiting case. By ‘Low’ we mean zero or insignificant magnitude of the structural
variables. The size of individual firm is very small having no influence on market output and
prices. There is no concentration and product is homogenous. Obviously this is a perfect
competitive situation and hence profit will be either zero or very low depending on long and
short-run equilibrium situations.

(ii) ‘Low’ scale, ‘Low’ concentration and ‘High’ differentiation.

This reflects monopolistic competition in chamberlain’s sense. There will be some product
differentiation in the industry. Individual firms will be able to earn profit in the short run due to
price variation or non-price competition.

(iii) ‘High’ scale, ‘High concentration and ‘Low’ differentiation

This is a situation of homogenous oligopoly. Few large firms will have effective control over the
industry. Through their collusive tactics they will be able to keep the price-cost margin at a high
level, so we generally expect high profitability under this situation.

(iv) ‘High’ scale, ‘High’ concentration and ‘High’ differentiation:

This is the situation of differentiated oligopoly in the sense that the products of the few large
competing firms having effective market power are not identical but closed substitutes for each
other.

The firms will be competing with each other on the basis of their marketing and product
diversification policies. Through advertisement they may be able to create ‘goodwill’ for their
products which would be a powerful deferent to entry. The overall impact of such market
situation on profitability is seen to be positive on a priori ground.

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NB: The other combinations of scale, concentration and differentiation attributes of market are
ruled out on a priori ground. This is because concentration and scale are complementary
attributes. Existence of either one of them without the other is unlikely to be seen in practice.

In general, for a meaningful study of the relationship between market structure and profitability
all the constituents of market structure are to be taken into account rather than any one of them.

7.2 PARTIAL AND TOTAL FACTOR PRODUCTIBITY

The performance concept that we are going to discuss in this section involve some basic terms of
economics such as marginal product, marginal cost, marginal revenue, and marginal revenue
product. A brief explanation of these terms is needed here in order to understand the efficiency
conditions in which they appear.

The marginal product of a factor of production is defined as the increment in total output of a
commodity when one more extra unit of the factor is employed in production of that commodity,
the quantities of other factors remaining the same. In discrete terms, the MP of a factor can be
ΔQ
expressed as ΔX where Q is an output and X is an input. For a continuous production

function, the first order partial derivatives of the factors of production would give us their
marginal products.

ï The marginal cost of a commodity is the increment in total cost of production by producing
one more extra unit of the commodity.
ï The marginal revenue is the increase in total revenue by producing and selling one more
extra unit of output of a commodity.
ï The marginal revenue product of a factor, which is the product of marginal revenue and
marginal product of a factor (i.e., MR x MP), is the extra revenue a firm obtained by
employing one extra unit of a factor.
Case 1. Constrained output Maximization

Let us assume that the entrepreneur is interested in getting the maximum output for a given cost
outlay. His maximization problem in this case can be specified as:

Maximize Q = f(x1, x2) ……………………..(1)

85
 Subject to Co = r1x1 + r2x2 …………………..(2)

The first equation is the production function and the second equation shows the distribution of
the fixed outlay (Co) among the two inputs x1 and x2. r1 and r2 are the input prices for x1 and x2
respectively. Using the Lagrange method for optimization, the final equilibrium condition for the
solution can be expressed as:

Marginal Product of x 1 Marginal Product of x 2 Marginal Resource Productivity

= =
Price of x 1 Price of x2
( )
dq
dc ..…(3)

This condition says that marginal product per unit of money spent on different inputs must be
identical and equal to the resource productivity. This is the condition for maximum productive
efficiency. This condition can also be written as:

Marginal Product of x 1 Price of x1

=
Marginal Product of x 2 Price of x 2 …………………………(4)

that is, the ratio of the marginal products of inputs must be equal to the ratio of their prices.
Further, we assume that one input can be substituted for another. At the optimality we can see
that

Price of x 1
Marginal rate of substitution of x1 for x2 = Price of x 2 ……………………(5)

All these conditions are satisfied at point R in Fig 3.1 where the isocost line is tangent to the
isoquant. It is further assumed that the second order condition for this maximization problem is
satisfied so that the equilibrium condition in equation (3) is not interpreted otherwise.

Case 2. Constrained Cost Minimization

This is dual of the problem discussed under case 1. Here, we assume that the entrepreneur is
interested in minimizing the total cost of production for a given level of output. In symbolic
terms, the problem is:

Minimize C = r1x1 + r2x2………………………..(1)

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 Subject to qo = f(x1, x2) …………………………(2)

The equilibrium condition for the optimality in this case will be the same as in case 1, i.e.,
equation (3). The right hand side of the equilibrium condition (3) in case 1, will appear as

( dq
‘inverse of the marginal cost’. This is not surprising since marginal resource-productivity dc
)
dc dc
1/
can be expressed as dq where dq is the marginal cost of production.

Mp1 MP 2 dc
= =1/
: - r1 r2 dq

Case 3: Profit Maximization

In the first two cases, we have examined the productive efficiency conditions. Let us now
assume that the goal of the entrepreneur is the maximization of profit rather than the output
maximization. He will choose that level of output at which his profit will be maximum. To get
this level of output and the attached efficiency condition, let us define the profit function for the
entrepreneur as:

 = p.q – c ………………………(1)

where p is the product price, q is level of output and c is total cost of production

We have specified q = f(x1, x2) and c = r1x1 + r2x2 in equation (1) and (2) under case 1 above.
Substituting them in equation (1) above, the profit function can be rewritten as:

 = pf(x1, x2) – r1x1 – r2x2 ……………………………….(2)

Let us assume the product price (p) is fixed. This will be the situation under perfect competition.
Taking partial-derivatives of  with respect to x1 and x2, we get

∂π
=Pf 1 −r 1 =0
∂ x1 …………………………(3)

∂π
=Pf 2 −r 2 =0
∂ x2 ………………………..(4)

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Assuming that the second order conditions for maximization are satisfied, the solution of (3) and
(4) reveals that:

r1 = pf, ; r2 = pf2 …………………….(5)

r1 = VMP1 ; r2 = VMP2

The above condition in equation (5) says that the input should be utilized at the level when this
condition is satisfied. The entrepreneur can increase his profit as long as the addition to his
revenue from the employment of an additional unit of a factor exceeds its cost. For a maximum
economic efficiency, the entrepreneur has to comply with these conditions.

Let us write the profit function (1) again:  = p.q – c

For optimum profit,

dπ dc d2 π
= p− =0 2
<0
dq dq ; and dq ………………………(6)

P, AC, P = MC, and MC is rising

MC

MC
AC

R
P1

AC P = MC = AC

Output
Q1
0 Q2

Fig. 7.1 Profit Maximization under perfect competition

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This shows that a firm will get maximum profit under perfect competition when price of the
product equals its marginal cost and marginal cost is rising. This is the situation at point R in
fig.7.1,

This is short-run situation for the entrepreneur. He will be economically efficient at the level of
output corresponding to point R. In the long-run, as we know, there will not be any profit for a
competitive firm which is the direct result of the free entry assumption for the industry. The
long-run equilibrium condition will be given by the lowest point of the average cost curve, i.e.,
point S when P = MC = AC. This is the most efficient situation and there will not be any conflict
between productive efficiency and economic efficiency for the entrepreneur.

For a non-competitive entrepreneur, we take price of the product varying with the level of
output. This means a downward sloping demand curve for its product. The efficiency conditions
for such an entrepreneur can be derived exactly as in the case of a competitive entrepreneur. The
conditions are:

(i) Marginal revenue must be equal to marginal cost, and marginal cost curve intersects the MR
curve from below, i.e., MR = MC, and

d2 C d2 R
>
dq 2 dq 2 …………………….(7)

(ii) Marginal revenue product of a factor must be equal to its price, that is,
dR dq dR dq
⋅ =r ⋅ =r
dq dx 1 1 and dq dx 2 2 ……………….(8)

P, AC, MRP1 = r1 and MRP2 = r2

MC
The position of the most efficient level of
output under these conditions is given by point
X.
Y

MC

P
AC

Z
Total
Profit
89
 o x AR
MR
Output
Fig. 7.2 Profit Maximization for a Monopoly firm

Case 4: Revenue Maximization : For this, we assume a situation when

i) Input quantities are fixed, xo, and

ii) The entrepreneur produces more than one product, q1 and q2.
The utilization of the fixed input xo is a function of the levels of output of the two goals, i.e.,

xo = h(q1, q2) ……………………..(1)

This is the equation of the production possibility frontier (PPF) for the entrepreneur.

Let the total revenue that the entrepreneur gets form q1, q2 levels of output be expressed as

R = p1q1 + p2q2 ……………………..(2) where p1 and p2 are output prices

Assume that the objective of the entrepreneur is to maximize total revenue for the optimum
utilization of the input. The problem can be expressed as,

Maximize R = p1q1 + p2q2 ………………………..(3)

Subject to xo = h(q1, q2) …………………………..(4)

Using again the lagrange maximization method, the final equilibrium conditions can be

∂ x o ∂ x o P1
/ =
expressed as ∂ q1 ∂ q2 P 2 ……………………………..(5)

−dq 2 P1
=
dqq21 P2 ………………………………………….(6)

Revenue line

PPF

90
 q1
0

Fig. 7.3 Revenue maximization in the PPF framework.

Equation (5) says that the ratio of the marginal costs of the two products must be equal to the
product prices ratio; and equation (6) says that the slope of the PPF at the optimum point must be
equal to the slope of the revenue line.

In other words, the revenue line must be tangent to the PPF at the optimum. This will be the most
efficient situation for the entrepreneur. It is shown by the point M in the figure above.

We have examined the efficiency conditions in the above few cases. An understanding of such
theory is essential on the part of the readers in order to get a clear perspective of the analysis of
the efficiency conditions in industrial economics.

7.3 TECHNICAL, ALLOCATIVE AND ECONOMIC Efficiency

7.3.1 MEANING OF THE CONCEPT

The core of any economic activity, whether it is consumption or production or anything else, is
to strive for the maximum possible efficiency. Since the objective in industrial economics is to
study the economic behavior of the firm and industries, we will therefore examine the term
“efficiency” from their point of view and call it “industrial efficiency.”

Industrial efficiency has many dimensions which are to be examined before it can be properly
understood. Let us take a firm as a technical unit engaged in production of a commodity. Its job
is to transform a set of given inputs into some outputs defined by the production function. In this
case, the emphasis will be on achieving maximum ‘productive efficiency.”

If we define a firm as an organizational unit, engaged in production and ‘disposal’ of a

commodity for some desired purpose, then the emphasis will be on achieving ‘business’ or
‘economic efficiency’.

Productive efficiency has been defined by farell in terms of two main components:

a) technical efficiency, and

b) factor price efficiency

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a) Technical efficiency

It is a purely technical term. It may have any one of the following meanings:

I. We can say that a machine or appliance or organization is technically efficient if it is

adequate to the demands made on it, or it lives up to the claims made for it. For example,
reliability and quickness of a postal system in its deliveries.
II. The technical efficiency may be assessed on the basis of some quantitative standard of
performance.
III. Technical efficiency may mean doing a job in the cheapest possible way, that is,
production of a given level of output from the lowest possible combination of inputs.
NB: In general, we may define technical efficiency as the degree of economy in the input
utilization used to produce a given level of output of the product.

(b) Factor price efficiency

It measures the skill in achieving the best combination of the inputs by taking into account their
relative prices. This is very important when one input can be substituted for another in the
process of production.

To have a clear idea of the two elements of the productive efficiency, consider the following
diagram. (Fig. 7.4)

X2

C P

A Q

Q1

R
92
 H I'

X1
0 D N B

Fig. 7.4 Technical and Productive Efficiency

II' is an isoquant which shows the most efficient combinations of the two factors X 1 and X2 used
to produce a given level of output of a commodity.

In practice, a firm may deviate from the II' curve and thus causing inefficiency in the factor uses.
Let us take P as the actual situation where the firm uses OD and OC quantities of the two inputs
X1 and X2 respectively to produce that specified level of output. The technical efficiency of the
firm at P can be measured by the ratio OQ/OP.

AB is the isocost line in the diagram indicating the combination of the two factors that can be
purchased from a given amount of money and given factor prices. The factor price efficiency for
the firm can be measured by the ratio OQ 1/OQ. This is because any combination of the two
factors beyond AB line will not be possible when the amount of total resources and factor prices
are fixed.

The productive efficiency of the firm at point P can be measured by the product of the two ratios,
i.e.,

OQ OQ1 OQ 1
× =
Productive Efficiency = OP OQ OP

The nearer this ratio moves to unity, the higher will be the productive efficiency. At point R the
productive efficiency will be maximum. This is the familiar tangency condition in the isoquant
analysis.

The desirability of the productive efficiency cannot be questioned. The following are essential
requirements for the achievement of the productive efficiency:

- Good planning and fore thoughts of the managers responsible for production
- Adequate coordination of the complex operations
- Good knowledge of the ‘best’ in the current practices as well as of the factor prices.

93
The emphasis on the productive efficiency in business is only a partial requirement. In practice, a
firm may look for ‘something’ more than merely minimum cost of production.

A broader concept that takes care of productive efficiency as well as other things is the economic
efficiency which may also be called ‘business efficiency’ from a firm’s point of view.

The propositions on which the concept of economic efficiency depends are:

I. resources at the disposal of the firm are scarce; and

II. they can be put on alternative uses.
Given the scarcity of resources and their alternative uses, it is quite natural for a rational firm to
get the best from them. Based on this fact, we may define the concept of economic efficiency as
follows:

An economic system is economically efficient if it is technically efficient and if it succeeds in

rationing out its scarce resources, and the scarce products of these resources, in the most
desirable way.

The phrase ‘in the most desirable way’ in this definition has normative connotation.

- in the case of a society as a whole, we may take it as maximization of the social welfare
- in the case of an individual consumer, we may take it as maximization of utility
- In the context of a firm, it is to be interpreted as maximization of the goal chosen by it (eg. ,
sales, growth rate etc.)
Thus, the meaning of the economic efficiency varies according to whose viewpoint we are
considering and what is the goal chosen for maximization.

NB: Technical efficiency is a prerequisite for economic efficiency, If there is inefficiency in this
regard, it is sound to create economic inefficiency in due course.

To conclude, for the entire economic system of a community, economic efficiency means
efficient selection of goods to be produced, efficient allocation of resources in the production of
these goods and efficient choice of the method of production, and efficient allotment of the
goods produced among the consumers.

7.3.3 THE DETERMINANTS OF ECONOMIC EFFICIENCY

94
For the sake of simplicity, we may put the determinants in two categories:

(i) internal forces, and

(ii) external forces
(i) Internal forces

In this category we may include all those activities which define the managerial function of a
firm. As we know, for economic efficiency one must have,

ï efficient planning and regulation of the operations,

ï a willingness to accept changes in the policies related to the conduct of the business
including,
- technological innovations
- a smooth flow of work
- proper supervision
- Adequate facilities for work including fair pay etc.
It is the task of the management to do all these jobs. These are responsible for making proper
policies and to execute them. If there is inefficiency on their part, the entire operations will be
inefficient and so ultimately there will be low economic efficiency (called ‘internal inefficiency’
or ‘x-inefficiency’.)

(ii) External forces

The second category of forces affecting economic efficiency includes:

ï The organizational or structural conditions (i.e., market structure) prevailing in the industry
to which the firm belongs.
- this defines the market structure which shows,
- the number and size distribution of the firms in the industry,
- the number and size distribution of the buyers in the market for the products of the industry,
- the number of competing products,
- the conditions of entry in the industry etc.

95
If the market is very much competitive for the firm, then the inefficiency may be very low or not
at all in this situation. It is because the inefficient factor or product will be thrown out of the
industry because of the strong competition.

On the other hand, if there is only one firm in the industry (i.e., monopoly), then it will not be
subjected to market competition. Its performance may be poor. It may use its resources
inefficiently. There may not be any check for that.

- Whatever may be the situation, it is strong proposition that the market structure exerts
considerable influence on the economic efficiency (eg., performance) of a firm.

ï Short term fluctuations in the market for both inputs and outputs of the firm.
Example: if there is a power breakdown, production will be affected adversely, sales or
profits will decline, and so the efficiency of the firm will be poor.

ï Trade union activities and government regulations etc.

NB. All external forces together may create conditions for the market imperfections which
eventually affect the allocative- efficiency of the firm.

7.3.4 MEASURMENT OF THE EFFICIENCY LEVEL

Measurement means quantification which is essential in industrial economics in order to make it

empirically relevant. There is no unique method of measurement of the industrial efficiency or
its components. For example, one can measure the technical efficiency, through some physical
indicators such as capital – output ratio, capital-labour ratio, or actual cost-standard cost ratio,
etc. The last ratio, i.e., actual cost-minimum possible cost, may also be used to measure the
internal efficiency of the firm.

The overall efficiency of the firm, whether we take the productive efficiency or economic
efficiency, may be difficult to measure precisely. Two methods are generally used for this
purpose:

(i) Optimization model such as linear programming

(ii) Ratios like total productivity or profitability or so on.
(i) Optimization model

96
In this method, a firm has to specify in quantitative terms the objective function as well as the
constraints faced to achieve that and then apply the standard mathematical tools to solve the
problem. To explain the method, let us take a simple linear programming problem.

Let us say, a manufacturer is planning to make two products using three inputs, say, labour,
machine hours and one raw material. One unit of product 1 requires one man-hour, one machine-
hour and two units of the raw material. Similarly, one unit of product 2 requires three man-hours,
one machine-hour and one unit of the raw material. The total amounts of the inputs are fixed and
given as 18 man hours, 8 machine-hours, and 14 units of the raw material per day. The
manufacturer expects birr 10 and birr 20 as price for the two products in the market and will be
actually able to sell them. What should be the most efficient level of output of the two products?

Let us take that q1 and q2 are the levels of output of the two products: 1 and 2, respectively at the
optimality situation. In this example the objective of the manufacturer will be to maximize the
total sales (i.e., revenue) as nothing else is given regarding the objective except product prices.
The sales or revenue equation for the manufacturer is:

R = 10q1 + 20q2 ………………………..(1)

To produce q1 and q2 levels of the outputs the input demand-supply equations will be as:

q1 + 3q2  18 …………………………..(2)

q1 + q2  8 ……………………………..(3)

2q1 + q2  14 …………………………..(4)

Each of these equations shows that the utilization of the input can not be more than the
availability. It may be less of course. Further, we take that there is no negative output of either
product since it has no meaning in economics, that is,

q1  0

q2  0 ……………………………(5)

Now the problem is to maximize total revenue expressed by equation (1) subject to the
q2
constraints expressed by equations (2) to (5).

97
 2q1 + q2 = 14
Fig. 7.5 Linear Programming Problem: Graphic solution

q1 + q2 = 8

A
B E q1 + 3q2 = 18

0 D q1
We may use the standard algebric methods for the solution but here we can do it graphically. By
plotting all constraints on a two-dimensional graph we get the shape shown in the fig above,

Each of the constraints, in the above graph, shows a boundary which the manufacturer cannot
cross because of the fixity of the input. The area bounded by all the constraints, that is ODCBA,
is defined as the feasible area from which the combination of q 1 and q2 output can be chosen.
Any point inside this area will be feasible but inefficient since resource utilization will not be
full. Any point on the boundary DCBA will be feasible and technically efficient showing full
utilization of at least one input. This boundary cannot be crossed. It is called ‘Production
Possibility Frontier’. There will be only one point because the PPF is not continuous rather it is
discrete on this boundary which will be economically most efficient from the manufacturer’s
point of view. At this point the objective function will be tangent to the boundary. (i.e., at one of
the corner points say D, C, B or A).

We just note down the coordinates (q 1, q2) of these points. By substituting the coordinates in the
revenue equation we can get the best one. The calculations are as follows:

Point Coordinates Revenue

(q1, q2) (R = 10q1 + 20q2)

D 7, 0 birr 70

C 6, 2 " 100

B 3, 5 " 130

98
 A 0, 6 " 120

The manufacturer is getting maximum revenue at point B showing three units of product 1 and
five units of product 2. Economically, this is the most efficient situation for the manufacturer.

The graphical solution as described above is possible if there are only two products to be
produced. Suppose, there are n products and m constraints; then the linear programming problem
can be formulated as:

Maximize R = p1q1 + p2q2 + … + pnqn……………………….……(i)

Subject to a11q1 + a12q2 + … + a1nqn  b1

………………..…(ii)
a21q1 + a22q2 + … + a2n + qn  b2

am1q1 + am2q2 + … amnqn  bm

q1  0, q2  0, ……, qn  0 …………………....(iii)

Some of the m constraints may be related to allocation of the inputs, some to sales potential for
the products and some to the other things which the firm encounters in connection with its
business. The objective function needs not be revenue maximization only. It may be profit
maximization or cost minimization or anything else which is to be maximized or minimized. To
solve such a problem, there is an algebraic method known as simplex method.

(ii) Ratios : The linear programming method for determination of the efficiency conditions may
be applied in few large corporations having sophisticated planning machinery, but by and large
the firms, in general, adopt their own ad-hoc methods for the efficiency maximization. For
example, firms may set some target for total factor-productivity (TFP) or profitability for
themselves. If they achieve that one, then they may be called efficient, otherwise not. TFP is a
ratio of the gross revenue divided by the total cost of production. Profitability is the return on the
capital invested in the business.

NB: The choice of the indicators for the efficiency or performance measurement depends on the
goals of the firm.

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UNIT 8: INDUSTRIAL LOCATION ANALYSIS

8.1 THE GENERAL DETERMINANTS OF INDUSTRIAL LOCATION

Given the spatial distribution of the inputs and output markets, the owners of the factory will
have to take the decision about the place where the factory should be located. All potential
locations for the factory will not be equally economical. Only one of them is to be chosen which
will be the most economical. How to make the choice for this? It is not very simple. A large
number of technical, economic, and institutional factors which exert pull and pressure on
location of the factory in varying magnitudes are to be considered simultaneously. A general list
of such factors is given below.

A. Technical Factors

100
These are the physical factors which are more or less geographical in nature related to soil, raw
materials, people, climate, etc. The important factors in this category are:

1. Availability of land
2. Nature and quality of raw materials from land, eg. Forest products, agricultural inputs,
minerals, and semi-finished products from existing industries.
3. Geographic situation of the factory site in relation to the transport facilities by rail, road,
water and air.
4. Quantity and quality of human resources
5. Energy resources
6. Availability of water for drinking and industrial uses
7. Waste disposal facilities
8. Climate
B. Economic and Infrastructural Factors

Input prices, taxes, markets, skills of labour forces, availability of adequate infrastructural
facilities, finance, etc, constitute together the category of economic factors. The general list of
factors for this would be as follows:

1. Local markets
2. Situation in relation to export markets
3. Costs of land and buildings
4. Costs of infrastructural facilities such as transport charges, power tariffs, water-rates, etc.
5. Salaries and wages in relation to skills.
6. Local cost of living
7. Taxes and subsidies
8. Cost and availability of finance
9. Structure of existing industries
10. Industrial relations and trade union activities around the proposed location sites.
11. Demographic factors such as age and sex composition of local population, literacy,
professional skills, etc.
12. Local medical facilities
13. Housing facilities

101
 14. Cultural facilities such as schools, clubs and other recreation centers.
15. Communication facilities.
C. Other factors

All other miscellaneous location factors may be put in this category. Two of them are:

1. Government policies towards location of new plants, and

2. Personal factors
Most of the government pursues the policies of rapid industrialization of their states. They
provide several facilities for locating new plants in some places or regions. An entrepreneur has
to evaluate the facilities given by the government very carefully before taking a decision location
of his factory.

Personal factors also play important role in locational decision. A manufacturer may prefer to
locate his factor at his birth place disregarding all economic factors. Industrial location based on
such personal factors will entirely be a matter of chance or what is called as ‘historical accident’.

Most of the factors mentioned above are self-explanatory. The weights assigned to individual
factors depend on the prevailing circumstances and nature of the industry. In some industries
firms are located near sources of major raw materials such as iron and steel, and pulp and paper,
while in other industries they are located near markets. All factors together provide a spatial
configuration which is to be analyzed very carefully for the optimum location of a factory. The
choice of location will not be independent of the scale of production and the technique to be used
for that. They are interrelated aspects which are to be decided together. Some of the locational
factors will be operative via their effect on the scale of production, some on the technique of
production and some will be place-specific.

There are several theoretical and applied approaches for locational analysis based on the above
mentioned factors. They are however partial in nature in the sense that they take into account
only a few major locational factors assuming all other factors either constant or irrelevant. In
order to understand the precise relevance of the various locational factors and the interactions
among themselves, in the section that follows, the leading theoretical approaches to industrial
locational analysis will be examined.

102
8.2 APPROACHES TO INDUSTRIAL LOCATION ANALYSIS

The theoretical material on industrial location is very much diversified. Significant contributions
were made to it by geographers and the economists. Their approaches however were different.
The geographers, by and large, adopted intuitive conceptual base and case studies approach to
arrive at some generalization about the industrial locational patterns. The economists on the other
hand, followed a more formal, abstract or deductive approach for locational analysis. An
integration of these two diversified approaches led to develop some operational models for
location studies. Some important contributions to location theory made by the people of the two
disciplines are as follows.

8.2.1 The Geographical Contributions

Geography provided several studies on this subject. A complete review of all geographical
studies on industrial location is not intended here. We will rather present the runner’s theory
which has some theoretical relevance.

Renner’s Theory

The objective of Renner was to develop some general principles concerning industrial location.
He classified industry into four categories: ‘extractive’, ‘reproductive’, ‘fabricative’, and
‘facilitative’. To undertake any one of these six ingredients are required: raw materials, market,
labour and management, power, capital and transportation. Keeping in mind these ingredients,
Renner postulated the law of location for fabricative (i.e., manufacturing) industry according to
which any manufacturing industry tends to locate at a point which provides optimum access to
its ingredients. It will, therefore, locate near to:

a) Raw materials, if it uses perishable or highly condensable raw substances; or

b) Market, where the processing adds fragility, perishability, weight, or bulk to the raw
materials, or where its products are subject to rapid changes in style, design, or
technological character; or
c) Power, where the mechanical energy cost of processing are the chief items in the total
cost; or
d) Labour, where its wages to skilled workers are a large item ion the total cost.

103
Apart from the above tendencies or ‘laws’, Renner gave a scheme for industrial symbiosis. There
different types were mentioned for this:

i) disjunctive symbiosis: where different industries having no ‘organic’ i.e., economic or

technical connections among themselves, gain advantages by existing together at a
particular place;
ii) Conjunctive symbiosis: where different industries with some ‘organic’ connection among
themselves (i.e., inter-connections) are located together; and
iii) Co-industrialization: which is an advance stage of the conjunctive symbiosis leading
thereby to a huge industrial belt of interconnected industries.

Renner’s approach on industrial location is quite realistic as it tries to bring together the major
determinants for that. However, he has not been able to go deep in analyzing the effects of
spatial cost variation and industrial symbiosis, i.e., agglomeration an on industrial location. He
merely describes the tendencies of industrial location based on these factors.

8.2.2 The Economic Theories of Industrial Location

The major theories of industrial location were developed by the economists. Some of them which
we consider pioneering and useful in understanding the locational behavior of the firm are as
follows:

Weber’s Theory : Alfred Weber, a German economist, has developed one of the earliest
approaches to explain the location of manufacturing industry. Earlier to Weber, another German
economist Launhardt has given a simple principle of industrial location based on minimum
transport cost. Weber followed Launhardt’s principle in his theory made it more rigorous and
analytical. Ever since his theory is being used in practice.

Weber’s main interest was to construct a general theory of location which could be applied to all
industries at all times. For this he has taken into account the general factors of location which
were relevant to all industries. The factors considered by him were divided into two groups:
those influencing inter-regional location of industries (i.e., regional factors) and those
influencing intra-regional location (i.e., agglomerating factors). He found three general factors

104
which vary regionally: raw material costs, transport costs and labour costs. The fluctuations in
raw material costs were however included within transport costs. The approach followed by
weber was to explain industrial location in terms of transport cost first and then to examine the
effects of changes in labour cost and agglomerative factors on it. He made some simplifying
assumptions for analysis such as:

i) the locations of raw materials including fuel are fixed;

ii) situation and size of consuming centers are given; and
iii) there are several fixed labour supply centers, labour is immobile and unlimited in supply
at fixed wage rate.
Apart from these assumptions, Weber implicitly assumed the institutional factors like taxation,
interest, insurance, etc., as insignificant locational factors. The economic culture and political
system are treated to be uniform and stable across the locations. On the whole Weber assumed
perfect competition for his mode.

Weber started his analysis with the proposition that a manufacturing unit tends to locate where
the number of ton miles of raw materials and finished product to be moved per ton of product
would be minimum. Weber used the ‘locational triangle’ of Launhardt to find the place of
minimum transport cost. He assumed a simple spatial situation in which there is only one
consumption center (c) and two fixed supply centers (M 1 and M2) for two most important raw
materials (see fig. 8.1)

2 2

M2
M1

Fig 8.1 The Location Triangle

105
There may be other consumption points and raw material supply centers but Weber did not
consider all of them together. According to Weber, the least cost point will be located within
triangle CM1M2 such as the one shown by P. The three corner points of the triangle will be
pulling the location point (P) towards themselves. The position of the point will depend on the
balance of the pulls exercised by them. It the pull of any one corner is greater than the sum of the
pulls of the other corners, production will be located at the point or corner of origin of the
dominant force.

Central Place Theory of Losch: August Losch developed a general theory of location. He
assumed a broad homogeneous plain with uniform resource endowment. This implies virtually
rejection of all cost difference factors affecting industrial location. In such situation, the right
approach to decide about the location is to maximize total revenue. An individual locates his
plant at that particular site, where revenue is maximum. The maximization of revenue implies
profit maximization because of the assumption of uniform cost conditions across the locational
plain in losch model. To explain his theory, let us take a simple situation in which there is only
one producer who is located at a central place. He sells his product around the location point in
circular belt, the extent of which depends on the economies of scale accruing to the producer and
the transportation, i.e., distribution cost of the product. The demand for the product falls with
distance. The maximum extent of the market area for the producer is given by the distance when
demand falls to zero because of high price for the product. This is shown by OF in Fig. 8.2

Output

DEMAND
GRADIENT
DEMAND
GRADIENT

F' F

DISTANDE DESTANCE

106
Fig. 8.2 Market area of firm (Losch model)

The circle with OF as radius defines the market area for the producer. O is the location of the
producer at which OQ is the demand for his product. The producer being only one in the market
makes profits. This attracts other competitors in the industry. They put up their plants in the area.
There is no restriction for that. The resources are available. The entry of new producers gradually
reduces the market area of the existing firms. Their markets will not continue to be circular but
some who irregular in shape.

Losch’s theory is not giving anything about the factors which determine the location of
individual firms. In fact, the assumptions of the theory are such that the location is indeterminate.
The rejection of cost differences as locational factors is a major weakness of losch’s theory. The
theory being too much abstract in nature has limited usefulness for practical purposes.

NB: We may say that the economic theories of industrial location broadly fall into three
categories:

- The least-cost school: which emphasize on cost factors neglecting the effect of the demand.
- The market-area school: It is the opposite of the above school. It considers the demand
factors neglecting the cost factors.
- The interdependence school: concerned with finding the factors which attract producers
towards each other.

8.2.3 OPERATIONAL APPROACHES TO INDUSTRIAL LOCATION

A manufacturing firm takes location decision right at the planning stage of its business. Once a
factory is set up it cannot be shifted to any other place very easily. The firm therefore has to be
very careful in making the locational choice for its factory. If there are mistakes in such decision
the firm would not be able to correct them. There are several mistakes in such decision the firm
would not be able to correct them. There are several geographical and economic approaches for
location analysis, the important of which we have discussed above.

From operational point of view there are two general methods which may be used for locational
decisions.

107
 1. The linear programming framework
In this method the objective of cost-minimization or revenue or profit maximization is pursued
subject to a set of constraints, related to location of a plant. The specification of the objective
function and constraints and solution of such programming model for location analysis may not
be simple enough. The investor who makes the location decision may therefore ignore this
method in spite of its operational usefulness.

2. Project appraisal criteria

In this method, the investor identifies the location sites for its plant. Obviously, there will be only
a few alternative sites and not infinite form which the investor will make the choice. Through a
comparative study of costs and benefits at each site, the firm can make the optimum choice of
location for its plant. This is simpler approach free from computational complexities. What the
firm has to do is to estimate the costs and benefits carefully by considering the technical,
economic and other locational factors at the sites. There may be some subjectivity in assessing
the benefits and costs of alternative locations but subjectivity is a normal feature of a business so
one need not worry very much in this regard.

In general, at present there is not unique or complete operational method for such decision-
making. The application of the cost-benefit analysis is the only practical approach.

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UNIT 9. INDUSTRIAL POLICY

9.1 Industrial Policy: Concepts and basic elements

Industrialization defined as “the process of economic development in which a growing part

of the national resources is mobilized to develop technically up- to- date diversified
domestic economic structure characterized by dynamic manufacturing sector having and
producing means of production and consumer goods and capable of assuring a high rate
of growth for the economy as a whole and of achieving economic and social progress”.
This definition states that industrializing is a sustained process. It requires the application of
modern science and technology to the production process. In the process of industrialization
manufacturing sector plays the leading and dynamic role. It also brings about structural
transformation of the entire economy in terms of the composition of output and pattern of
employment.

Industrialization is advocated on the ground that it can strengthen the economy and offer
substantial dynamic benefits that are important for changing the traditional economic structure of
the less developed economies. Industrialization is regarded as an important policy to affect
fundamental economic and social changes in least developed countries (LDC S), which are taken
as a necessary condition to improve their growth potentials. It is taken as a basic strategy for
achieving a faster rate of economic growth and a higher standard of living in many developing
countries. LDCs should establish their own industries in order to produce consumer goods,
capital goods and other essential materials instead of highly being dependent on imported goods.

Industrial development can also provide a base for rapid and continuous increase in the income
of the people. Through industrialization LDCs can improve their terms of trade. The income
elasticity of demand for agricultural goods is (mostly the export of LDCs) low while the income
elastic ties of demands for manufacturing goods is (which are the imports LDCs) very high. As a
result of these disparities in export and import elasticity, LDCs will face a chronic balance of
payment deficit and the term of trade goes against these countries. Industrialization provides job
opportunity for an excessive population of LDCs. It is sometimes regarded as the major way of

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solve the problem of unemployment and under-employment in developing countries. It is
possible to expand and diversify other sector of the economy of LDCs through industrialization.

In general Industrialization can alter the present economic and social structure of many LDCs;
which is not conducive for achieving a higher level of economic development. It can reduce the
problems of raw materials, unemployment, capital goods, foreign currency and the like,
industrialization is considered as necessary condition for attaining higher level of economic
growth.

Industrialization is capable of generating these all because of its some unique features. A number
of distinct features of the manufacturing industry enable it to play a dynamic role in terms of
economic development. This includes among others,

Economies of Scale: Industrial production is particularly subject to economies of scale. The cost
per unit of production is inversely related to the volume of production. Large firms incur less
unit cost than smaller ones. But this is not true to the some extent in agriculture, or indeed in
many services. So the move to industrialize would significantly increase the production
efficiency of developing economies, thereby accelerating growth.

Externalities and linkages: Another reason for supposing that industry is particularly important
for economic development is that externalities are more significant than in other sectors. The
setting up of one activity creates benefits for others, thereby introducing positive externalities. A
more specific application of this is the notion of linkages. The setting up of an industry creates
both backward and forward linkages. While the demand for inputs creates backward linkages,
the provision of services downstream, such as whole selling and retailing, maintenance, etc.,
form forward linkages. Industry, particularly manufacturing, creates more linkages than other
sectors (particularly agriculture) and can therefore give a much greater impetus to economic
development. Productivity increases: Industry is also characterized by more scope for increases
in productivity than other sectors. It has been historically observed that the faster manufacturing
output increases, the greater the rate of productivity growth, reflecting increased learning and the
incorporation of new, higher productivity technology, which depends on the rate of growth of
output. Also, since the industrial sector provides machinery and equipment for other sectors,

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increases in productivity in manufacturing can reduce costs elsewhere in the economy, thus
contributing to the development of other sectors.

9.2 THE WAYS AND MEANS OF GOVERNMENT REGULATION OF INDUSTRIES

A government regulates economy in general and industries in particular, through a set of

measures or instruments. An instrument is defined as something which the government itself can
change in order to produce an economic effect. It may be any economic quantity such as a
change in the bank rate, or may be a part of some institutional framework such as nationalization
of an industry. An instrument used to regulate economy, in fact, functions as a ‘means’ to
achieve a social goal. There are various categories of instruments at the disposal of a government
for regulation of the economy. Some of them are as follows.

Instruments of public finance

Through changes in government revenue and expenditure patterns it is possible to control the
economy to a great extent. The annual budget of a nation or state reflects the measures initiated
by its government to regulate the economy through the instruments of public finance. The major
steps in this direction would be

- government investment,
- government purchase of goods and services,
- subsidies,
- transfers to enterprises and households,
- changes in taxation both direct and indirect,
- custom duties,
- control on wages and salaries.

For example, if a government feels that consumption of alcohol is undesirable from social point
of view, it may increase the excise duty on production of alcohol and, thus, make it costlier for
private consumption. Similarly, if there is inadequate private investment in any industry, the
government may have its own investment in that or give several concessions to the private
investors in order to induce them to invest more in the industry.

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Instrument of money and credit

This category includes the instruments like:

- government borrowing and lending,

- government operation in existing debts,
- changes in interest rates,
- changes in the reserve ratios for banks,
- legal imposition of ceilings on credits,
- changes in the patterns of credits,
- control on company finances,
- exchange rates
- devaluation and revaluation of currency,
- deficit financing, etc.
Some of the instruments in this category are directly relevant for regulation of industries such as
credit control; interest rate manipulations etc. while others will have indirect effects.

Instruments of Direct controls

Normally we find several direct controls used to regulate industries, such as:

- controls on private imports,

- state export-import trading,
- exchange control,
- control on prices,
- rent control,
- credit controls,
- profit and dividend controls,
- control on allocation of goods and raw materials,
- power controls,
- control on investment,
- quality and quantity controls,
- employment and wage controls,
Changes in the institutional framework

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The purpose of such changes will be to bring reforms in the economy. Some of the changes that
come in this category of instruments are:

- changes in the public transfers to households and enterprises,

- reforms in taxation structure,
- changes in credit mechanism,
- creation of nationalized institutions,
- administrative reforms,
- industrial reforms etc.
For example, say, a change fro private ownership of an industry to social ownership is a kind of
reform that a society may feel desirable for achieving its goals.

Many of the instruments listed above are directly relevant for regulation of industries as we find
in practice. There will be a package of instruments used simultaneously to achieve most of the
social goals. Which instruments are to be chosen and what will be their effectiveness in the goal
achievement is to be evaluated very carefully as there may be a situation when one instrument
affects a particular objective positively but some other objective is adversely affected by it.

9.3 Approaches/scopes of government intervention (Free Market, Supportive, Planning and

Commanding)

Given the limited theoretical basis for industry policy, government involvement is very much a
matter of judgment and it is not surprising that there are many differences of opinion about the
best approach to adopt. Moreover, these approaches cannot be precisely evaluated. Nevertheless,
certain desirable features of an industry policy can be specified.

 First, any policy should be capable of performing well in an environment where

transaction costs are the norm, and where economic agents lack knowledge and are
continually having to adapt to change.
 Secondly, the opportunity cost burden of the policy must not exceed any perceived,
potential benefits, having regard to its static and dynamic effects on the industries
involved and also on the rest of the economy.

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ï There are four distinict approaches to industrial policy can be identified:
1. The laissez-faire approach is founded on the presumption that information flows are
perfect, and holds that the market is a better judge of desirable actions than
government agencies. Most types of intervention commonly pursued under the name
of industry policy are rejected. Appropriate policies are those aimed at strengthening
and promoting a competitive environment (for instance, through the control of
monopoly or measures to remove ambiguities in the assignment of property rights).

2. The supportive approach also believes in the underlying superiority of market forces,
but acknowledges the presence of imperfect information and transaction costs.
Proponents of the supportive approach would agree with the laissez-faire approach in
advocating policies to help markets function more effectively, but would often
disagree over the form of desirable measures. In particular, the supportive approach
would argue for intervention to improve the allocation and enforcement of property
rights, to encourage education and entrepreneurship in order to foster the process of
economic change. This approach also recognizes that external constraints may force
the adoption of less desirable, or 'second-best', policies. For example, if Japan were to
adopt protectionist measures then Ethiopia would be justified in adopting similar
policies, with the ultimate intention of enforcing trade liberalization.

3. The active approach argues for wider and more direct government involvement in the
industrial sector. This approach differs crucially from the previous ones in that market
judgments are often supplanted by those of government agencies. Selected industries
would typically be given financial support to promote restructuring and be protected
from external competition by tariff and non-tariff barriers. Although protected from
external competition, measures would again be taken to promote competition
domestically.

4. The planning approach is a more extreme version of the active approach. Its
rationale is that welfare can be improved through centralized planning. It argues that
central planners are in a better position - because of their superior, economy-wide

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 information - to make welfare-enhancing decisions than individual firms. This
advantage is greater where information flows are imperfect and where the economy is
changing rapidly. Intervention is much wider-ranging and more comprehensive than
under the active approach.

These policy prescriptions vary because of different perceptions about the efficiency of markets
and the ability of government agencies to identify and to correct market failures. The basic
dichotomy in these views is between advocacy of non-interference (the laissez-faire and
supportive approaches) and advocacy of a large element of government involvement which
includes targeting policies to particular firms, sectors or activities (the active and planning
approaches).

 In the laissez-faire and supportive approaches, the state is acting as an adjunct to the
market, working at the edges of the market system whilst in the other approaches the state
acts to shape the industrial landscape, taking a leading role in the industrial economy - a
proactive rather than a reactive role. The greater is the belief in the efficacy of the market
and in the impotence of government agencies, the greater the tendency to reject
intervention and to favor an essentially 'hands off' industry policy. Similarly, the greater
is the doubt that the principal objective of politicians is the enhancement of society's
welfare, the greater the tendency to advocate an industry policy that involves minimal
government intervention.

The choice between the laissez-faire-supportive approaches and the active-planning approaches
therefore turns on views as to which uses information more efficiently, state agencies or the
market. Whilst it is undoubtedly true that state agencies have the ability to be better informed
about government intentions and have wider sources of information than an individual agent, this
does not necessarily imply that they have an informational advantage. One of the main strengths
of the market mechanism is its ability to collate and to make full use of widely dispersed
information. Although each agent commands but a tiny fraction of total information, by
responding to price signals from the market each agent reacts as if he were much better
informed.

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Even so, most governments have chosen to intervene heavily in the operation of industry. In
some cases, intervention has taken the form of accelerative policies designed to improve the
speed at which the market operates. In others, a declarative policy stance has been used to retard
the operation of the market. More commonly, both stances have been adopted simultaneously for
different areas of the economy. Few governments have chosen to make use solely of neutral
policies (aimed simply at reinforcing the efficiency of the market). These would be more
consistent with a laissez-faire or supportive approach, although they have sometimes been
included as part of an active or planning approach.

9.4 Seminar on Ethiopian Industrial Policy (Industrial Strategy, SME Strategy,

Competition Policy etc)

9.4.1An Overview of Industrial Problems and Strategies

Ethiopia's industrial base and economic development are the lowest even by African standard.
There are various constraints to the country's industrial development. Among the many
constraints the most notable ones are:

While, the sector has been dominated by capital-intensive technology, and it is fully dependent
on foreign capital goods and to a large extent for raw materials, its foreign currency earning
capability has been limited; the foreign currency earning of Ethiopia is based upon primary
agricultural outputs but as the country is by and large a price-taker in the international market for
these products, the country finds it difficult to generate all the foreign currency required for its
industrial development; obsolescence of machinery and equipment, and the low level of local
technological development; lack of technological information; lack of skilled labor; low demand
for Industrial goods which emanate from low level of income; low quality of locally
manufactured goods and hence consumer bias against local products; lack of well-developed
infrastructure and under capacity performance. Manufacturing sector of Ethiopia is structurally
unbalanced and technologically backward, resulting in a state of declining productivity and
deteriorating competitiveness. The policies pursued in the past failed to initiate appreciable
industrialization in the country. On the other hand, experiences of successful industrializes,
clearly underline the need for a guided industrial policy.

To enhance industrial development the governments of Ethiopia have been pursuing different

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development strategies. In the Imperial era import-substitution strategy was formally pursued.
Industrialization of the time was characterized by the promotion of foreign investment, the
establishment of large and medium scale foreign-owned enterprises active in import substitution
production and strong growth.

A series of policies were formulated to promote foreign investor participation. These incentives
included 5 to10 years tax holidays, low duties 'for imported raw materials and export value-
added goods, tax exemption on dividends and the expatriation of profits and proceeds obtained
from sale of assets etc. As the effort was concentrated on large and medium scale industries the
small-scale industry was almost neglected.

The trend of the industrial development took a new turn since the mid 1970’s when the strategy
for industrial development was pursued by the sole involvement of the government and the
private sector was discouraged. The 1974 coup has made it possible for all major industrial
operations to come under the direct control of the government and the private sector was
discouraged. This led to restructuring, reorganizing and centrally planning of industrial
development. Private ownership was mainly limited to small-scale and handicraft industries. The
import-substitution strategy adopted by the Imperial government, however, was further pursued.

In the post 1991 period the change in government brought about significant change in industrial
policy in favor of liberalization and privatization of the Industrial sector especially the
manufacturing sub-sector. The current industrial development strategy is based upon the overall
economic development strategy known as ADLI. The major goals of the ADLI are the use of
labor-intensive technology and local resources; promotion of economic efficiency; achievement
of international competitiveness in areas of clear comparative advantage in Industrial exports;
development of domestic technological capabilities for the production of intermediate Inputs,
spare parts and capital goods etc.

9.4.2 Industrial Competition Policy

Competition policy includes measures aiming at

I) Promotion of competitive environment in the industrial sector

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II) Prevention of forces that reduce the competitiveness in industrial sector

The competition policy aims at breaking up or regulating monopolies. It aims at preventing all
those activities of a firm which put barriers to entry of new firms in the market. The dominant
firm in the market may practice many anti-competitive practices such as resale price
maintenance or price agreements by the group of firms etc. Competition policy is expected to
remove all barriers to competition and encourage the development of new products and the entry
of new firms in the market. According to some economists, the competition policy not only
should focus on the elimination of barriers imposed by the dominant firms, but also on the
removal of government actions that restrict competition. These actions may include import
restrictions, or any other kind of licensing requirements that limit the entry of new firms in the
market.

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