Industrial Organization

Industrial Organization                                                Minor 2013

1. Introduction

Two approaches to studying Industrial Organization

• Structure-Conduct-Performance paradigm

The SCP paradigm concentrates on empirical rather than theoretical analysis.

• Chicago School approach

Characterized by a strong belief in efficient markets & rationality of market participants

Static vs. Dynamic models

In most microeconomics courses strong focus on static models: all decisions are made simultaneously, time plays no role → advantage: relatively simple. Industrial Organization also considers dynamic models, which deal with changes over time → more realistic, but more complex.

1. The firm and its costs

Transaction costs economics; some transactions are done on markets, some within firms.

Coase’s proposal; using the market mechanism costs transaction costs for searching price/product information and negotiating contracts. Within the firm these costs are not incurred. However, an entrepreneur’s skills are also limited → using managerial decision making also comes at a cost, which increases in the size of the firm. Therefore, an optimal firm size exists, beyond which the cost within the firm exceeds the transaction cost of the market.

Coase; transaction costs before a contract is signed. Williamson; transaction costs after contract is signed. Most contracts are incomplete. It is impossible to specify all contingencies. This creates opportunities for opportunistic behavior (=to act in self-interest).

One solution; integration. (= extending the boundaries of the firm to include this transaction within the firm) = merger/takeover. Ex. Specific investment in human capital/knowledge of one worker, which can only be used within that firm.

The resource-based theory of the firm is complementary to transaction cost theory, not a substitute. A firm governs two types of resources; property-based and knowledge-based resources (tacit vs. explicit). The more unique a resource is, the higher the rent it generates.

Forms of firms;

• Sole proprietorships & partnerships. Owner = manager. Problems; unlimited liability of owners and finite lives. →hard to get outside financing
• Corporation. Professional managers employed, overseen by board of directors. Separate legal entity, created by government charter. Owned by shareholders

Managerial problems; people usually maximize their own utility, managers too. Managers might go for revenue, perks or quiet life, instead of chasing the goals of the owners. Managers may also be too risk averse or use simple rules-of-thumb & own experience to produce a satisficing profit.