Industrial Organization - Structure, Conduct, Performance

Structure, Conduct, Performance

According to the structure-conduct-performance approach, an industry's performance (the success of an industry in producing benefits for the consumer) depends on the conduct of its firms, which then depends on the structure (factors that determine the competitiveness of the market). The structure of the industry then depends on basic conditions, such as technology and demand for a product. For example: in an industry with technology that the average cost of production falls as output increases, the industry tends to have one firm, or possibly a small number of firms.

Components that make up the structure, conduct, and performance model for industrial organization include:

• basic conditions: consumer demand, production, elasticity of demand, technology, substitutes, raw materials, seasonality, unionization, rate of growth, product durability, location, lumpiness of orders, scale of economies, method of purchase, scope economies
• structure: number of buyers and sellers, barriers to entry of new firms, product differentiation, vertical integration, diversification
• conduct: advertising, research and development, pricing behavior, plant investment, legal tactics, product choice, collusion, merger and contracts
• performance: price, production efficiency, allocative efficiency, equity, product quality, technical progress, profits
• government policy: government regulation, antitrust, barriers to entry, taxes and subsidies, investment incentives, employment incentives, macroeconomic policies

Industrial organization The subject of industrial organization applies the economics’ model of price theory to the real world industries. The goal of industrial organization study is to increase the understanding of how industries operate, improve the industries contribution to the economic welfare, and to improve government policy toward these industries.

Structure Conduct Performance Paradigm (SCPP) SCPP is an approach used to analyze the relation among market performance, market conduct, and market structure. The SCPP indicates that market structure determines the market conduct, and thereby sets the level of market performance. Working backward, we find that market performance is determined by market conduct, which in return depends on market structure. SCP has been applied to a diverse range of problems, from helping businesses become more profitable to helping understand the subprime mortgage crisis in the United States.

Economists are especially interested in studying the SCPP because they tend to believe that seller concentration affects the industry’s social performance. The economic theorists express that effect in terms of higher profits earned by the monopoly. On the other hand, Industrial Organization economists express the effect in terms of locative inefficiency. However, economists who use the Structure Conduct Performance (SCP) approach disagree on the emphases that they give to each of the three elements. Some give market structure and market conduct an equal importance in determining market performance. Others argue that market conduct is largely determined by market structure, hence, market performance depends heavily on market structure, and that leads them to pay little attention to market conduct.

Market Structure Conduct and Performance SCP framework was derived from the neo-classical analysis of markets. The SCPP was the brainchild of the Harvard school of thought and popularized during 1940-60 with its empirical work involving the identification of correlations between industry structure and performance. This SCP hypothesis has led to the implementation of most anti-trust legislation. The Chicago school of thought followed this from 1960 to 1980. They emphasized on the rationale for firms becoming big, price theory and econometric estimation. During 1980-90 game theory took center stage with emphasis on strategic decision-making and Nash equilibrium concept. After 1990, empirical industrial organization with the use of economic theory and econometrics led to complex empirical modeling of technological changes, merger analysis, entry-exit and identification of market power.

Market structure The Market structure consists of the relatively stable features of the market environment that influence rivalry among the buyers and sellers operating within this market. The main elements that influence market structure are, seller concentration, product differentiation, barriers to entry, barriers to exit, buyer concentration, and the growth rate of market demand. Other elements of market structure exist, but they are usually unstable and therefore ignored either because they can’t be measured or because they are hard to observe.

Elements of market structure

Seller concentration

Refers to the number and size distribution of firms in the market. The most widely used device is determining seller concentration is the Concentration Ratio. To compute the concentration ratio, the firms are ranked in order of size “usually measured in terms of sale”, starting from the largest in the industry at the top and going down to the smallest firm at the bottom. Concentration ratios are usually given for the largest 4, largest 8, and sometimes the largest 20 firms. Usually industries that are highly concentrated in one advanced economy tend to be highly concentrated in another.

Product differentiation A differentiation or distinguishing a product from the products of other competing firms. Differentiation of products along key features and minor details is an important strategy for firms to defend their price from leveling down to marginal cost.

Horizontal differentiation When products are different according to features that can't be ordered in an objective way, or in other words, at the same price, some consumers would prefer the product while others would prefer a different substitute Horizontal differentiation can be differentiation in colors (different color version for the same good), in styles (e.g. modern/antique), or in tastes. A typical example is the ice cream offered in different tastes. Chocolate is not better than Mango.

Vertical differentiation Vertical differentiation occurs in a market where the several goods that are present can be ordered according to their objective quality from the highest to the lowest. It's possible to say in this case that one good is "better" than another.

Mixed differentiation Certain markets are characterized by both horizontal and vertical differentiation. For instance, apparel, and shoes have a rich combination of shapes, colors, materials, and appropriateness to social events. In such markets, the differences in colors or shapes are horizontal differentiation, while the quality of the materials is usually perceived as vertical differentiation.

Barriers to entry A set of economic forces that create a disadvantage to new competitors attempting to enter the market. These forces could be government regulation such as IP rights, or patent, or they could be large economies of scale in a specific industry, or high sunk costs required to enter the market. Sometimes firms within a specific industry adopt certain pricing strategies to create barriers to entry, one of the most widely adopted strategy is limit pricing by lowering prices to a level that would force any new entrants to operate at a loss, this strategy is especially effective when the existing firms have a cost advantage over potential entrants.

Barriers to exit A set of economics forces that influence the firms decision of exiting the market, such forces make it cheaper for the existing firm to stay in the market than to exit the market. Although sunk costs could be barriers to entry, especially when the sunk costs are too large, sunk costs could be a huge barrier to exit as well, because large investments in fixed plant and equipments commits the firm to stay in the market. Barriers to exit increase the intensity of competition in an industry because existing firms have little choice but to stay and fight when market conditions have deteriorated. The loss of business reputation and consumer goodwill, could be a barrier to exit especially if the firm is planning on reentering the market later, or when the firm exits a specific market but still operating in other markets. In such a situation, the decision to leave the market can seriously hurt the reputation of the firm among current consumers in other markets, and affect the goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.

Buyer concentration The number of buyers in a market. Buyer concentration is as equally important as seller concentration, especially in markets with a few buyers. The term was used by Michael E. Porter in 1979 in his “Five Forces Analysis”. Porter’s analysis proposes that in markets with high buyer concentration, the firms earn lower level of profits than in markets with low buyer concentration

The growth rate of market demand The market structure in industries with a relatively static demand or low growth rate of demand is different from the market structure in industries with an accelerated demand growth. That’s because when the demand grows fast enough, the firms have their hands full just expanding their production capacities, in this case, if new entrants are coming in, there will be little incentive to fight for market share. Also, firms are likely to honor oligopolistic agreements with each other, and profits tend to be high. All these elements of market structure tend to be stable over time. However, they are all interrelated. Any change in one tends to bring about changes in another. By realizing this relation among the different elements of market structure, it becomes easier to understand why market structures change over time.

Conduct Conduct means what firms do to compete with each other. It includes pricing, advertising, research and development investment, decisions on product dimensions, merger and acquisition, etc. Conduct also can include collusion both explicit or tacit.

Performance The performance of an industry or firm is measured by profitability. Profit is the difference between revenue and cost, and revenue is determined by price. Thus performance can be influenced through changing costs or prices. Profitability can also be affected by a firm’s agility (i.e. ability to adjust to things like changes in market demand). Research and development, and availability of capitol and resources are factors that greatly influence whether or not a firm is agile. The ability to measure performance between industries is important in understanding the SCP relationships. For example, if an industry is dominated by one firm or cartel does not see higher costs than a competitive industry yet has monopoly prices, then that non-competitive industry will see higher profits, whereas if costs increase, then profitability levels will be relatively similar. This comparison is the driving force behind anti-trust legislation. SCPP predicts that performance increases with concentration of the industry. This is in contrast with the efficiency hypothesis that states that a firms performance is based on how well and efficiently it produces its product for the consumer.

SCP Interaction Overview There are two competing hypotheses in the SCP paradigm: the traditional “structure performance hypothesis” and “efficient structure hypothesis”.

The structure performance hypothesis states that the degree of market concentration is inversely related to the degree of competition. This is because market concentration encourages firms to collude. This hypothesis will be supported if positive relationship between market concentration (measured by concentration ratio) and performance (measured by profits) exist, regardless of efficiency of the firm (measured by market share). Thus firms in more concentrated industries will earn higher profits than firms operating in less concentrated industries, irrespective of their efficiency.

The efficiency structure hypothesis states that performance of the firm is positively related to its efficiency. This is because market concentration emerges from competition where firms with low cost structure increase profits by reducing prices and expanding market share. A positive relationship between firm profits and market structure is attributed to the gains made in market share by more efficient firms, but not to the collusive activities, as the traditional SCP paradigm would suggest (Molyneux and Forbes, 1995).

Relationship of structure to performance

Early studies by Bain (1951; 1956) hypothesized a positive relationship between industry concentration, barriers to entry and profits. Though his studies are flawed in the measurement of profit rates and choice of industries (Brozen 1971), later papers supported this hypothesis (Mann 1966; Weiss 1974).

However, the differential in the performance measures between concentrated and non-concentrated industries fell substantially overtime (Brozen 1971; Hubbard and Petersen 1986). Moreover, studies based on more recent data tend to find only a weak relationship or no relationship between the structural variables and performance (Salinger 1984; Kwoka and Ravenscraft 1985). As a result, some econometric studies began to look at other factors impacting industry performance. These studies commonly found that high rates of return and industry growth are related.

Other researchers studied the structure-performance relationship using alternative measures of performance, for example, the speed of adjustment of capital. They found that the capital-output ratio is positively related to concentration. The explanation for this phenomenon has not been verified, but it is possible that in highly concentrated markets, there are more specialized capital which is more difficult to adjust, thus in these markets high profits take longer to fall back to the industry average. Similarly, if concentrated industries take longer time to react to demand changes, then, all else equal, good economic news should raise the value of a company more in a concentrated industry than in an non-concentrated industry (Lustgarten and Thomadakis 1980).

Relationship between structure and conduct

Conduct is influenced by market structure since firm strategies differ with competition. Inversely, conduct can influence market structure because firms can make entry cost endogenous by choosing different levels of quality, advertising and so on, thus affect the potential entrant number.

Relationship between conduct and performance

Conduct is related to performance. For example, advertising expenditure is usually higher in highly profitable industries, because firms with more profits can afford higher advertising costs, and in order to keep their profits and prevent new entrants into the profitable market, these firms would use advertising investments as endogenous sunk costs. Econometric studies linking profit to market structure often conclude that measured profitability is correlated with the advertising-to-sales ratio and with the R&D expenditures-to-sales ratio.

Conclusion

In essence, with the SCPP we seek to find the answer to how firms interact and compete with each other in different situations, and the results of these interactions, and are these results consistent with an ideal competition or not. That way, an argument can be supported on whether or not action should be taken to alter the market structure or regulate market conduct. It is interesting there is such a debate on the emphasis on market structure vs. market conduct on the influence of performance since it is clear that structure and conduct are themselves influenced by each other. Joseph Bain was one of the first to realize this and his work led to the re-evaluation of public policy that had been fostered by the SCP framework. In industrial organization, real world, imperfect competition is studied, and there are so many different examples that the way markets are evaluated is continually evolving and changing. Thus every school of thought must be constantly re-evaluated as more data is generated.

Reference:

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