Industrial Organization

Economics is the study of scarcity. If every person had all they needed, there would be no need for this subject; however, we already know that this situation will never happen. Human beings have unbounded desires with very limited resources. Therefore, we must optimize what we can produce from these resources.

We need a system which makes it harder for us to use goods which are more scarce. So how do we do this? The answer may seem obvious to those of us in the 21st century- we use the price system. Scarce items are more expensive just because of the restriction on their availability.

For example, although we had not discovered any particular use for diamonds in the earlier days, they were still costly just because of their rarity. Now that we have brought forth the pricing system, there is one more term to introduce- markets. We generally associate this term with the supermarkets where we buy our groceries and everyday items. In economics, however, markets are all places where people can exchange goods, services, and information- so grocery stores are just an example of markets.

We can categorize markets into three types based on how competitive the firms operating in the markets are:

1) Monopoly: these are the markets where there is only one seller. That is, there is no competition- the one seller influences the entire market. Example- IRCTC

2) Competitive market: these markets are categorized by many small sellers fighting to provide their goods to us. In this market, no single seller can influence the market; they just sell their goods according to the price set in the market Example- Rice market(No single farmer can change the price at which this market operates)

3) Oligopoly: While both of the above situations do occur in real life, they are extreme cases. There is a more moderate situation possible. In an oligopoly, a small number of suppliers have significant individual influence in the market.

Industrial Organization is the field of economics concerned with the workings of markets and industries, particularly the way firms compete with each other. The main reason for considering industrial organization as a separate subject(than microeconomics) is its emphasis on the study of the firm strategies that are characteristic of market interaction: price competition, product positioning, advertising, research and development, and so forth.

Industrial organization adds real-world complications to the fully competitive model; these complications associated with imperfect competition include information asymmetry, restriction to the entry of new firms into the market. While microeconomics focuses on the first two types of markets(the extreme cases), Industrial Organization is mainly concerned with the intermediate case-oligopoly. Here, the firms are affected by one another's decisions.

Therefore, it may be defined as the "economics of imperfect competition."

Game theory, which, in recent times, has been one of the best hits of economics, has been used extensively in industrial organization. This use has led to the export of game theory as a tool to other microeconomics branches, such as behavioral economics and corporate finance.

The development of industrial organization as a separate field owes much to Edward Chamberlin,  Joan Robinson, Edward S. Mason, J. M. Clark, Joe S. Bain, and Paolo Sylos Labini.

We discuss three broad approaches to this subject:

1) The first approach is used to provide an overview of the industry through measures of competition and concentration ratios of firms in an industry

2) A second approach uses microeconomic models to explain the internal firm organization and market strategy.

3) The third aligns with public policy related to economic regulation, antitrust law, and more.

A major objective of industrial organization is to understand "market power." Let me define the term- market power refers to a firm's ability to set its price above the incremental cost of producing one extra unit of output. That is, if a firm can produce a pen for Rs.5 and can sell it for Rs.30, that firm is said to have a substantial degree of market power.

One of the Chicago school's central tenets is that as long as there is free entry into each industry, the extent of market power is never significant. This matches a famous study that the extent of market power in the American economy is very low. However, further information clarifies that although firms hold little market power in a large number of industries, there are some industries where market power exists to a significant extent.

A firm will always want more market power. This is because market power implies greater profits and greater firm value. For social welfare, however, market power is not so great. The first-order- effect of a high price is more money being transferred from the buyers to the sellers. Regulators who put more weight on consumer welfare than on profits would view this transfer as a negative outcome.

This is the motivation behind antitrust and competition policies.

In addition to a transfer effect, a higher price indicated by market power also leads to inefficient allocation of resources(many people who would buy things for their cost price now won't because of higher prices.)

The primary role of the 3rd industrial organization approach (which we discussed above) is to avoid these negative consequences of market power. Pubic policy here can be broadly divided into two categories: regulation and antitrust.

To finish up, I give a few examples of firms trying to retain/gain market power through different methods:

1) Restricting other firms from entering their markets through various ways such as patents-this is what Xerox did after it developed the photocopy technology. Pharmaceutical companies also use this method to prevent generic versions(chemical equivalent drugs) of their drugs from entering the market for as long as possible.

2) Although the pharmaceutical companies try very hard to prevent generic versions of their drugs from their market, the inevitable will eventually happen. To maintain their market power, these companies spend vast amounts of money to create a better perception of their drugs through advertisements. In fact, large pharmaceutical companies' advertising budgets are almost as large as their research budgets.

3) By offering a very lucrative offer to the consumers and operating at enormous losses for months, Jio was able to gain a sizable market share.

However, creating market power is only one part of the story. A successful firm also must be able to maintain market power. Patents expire. Imitation takes place. Protected industries are deregulated. All the while, the regulatory bodies will be trying to prevent monopolies from coming into existence.

If navigating through such a strategic/logical field interests you, well, good news for you- our college does offer this course under the name Industrial Economics. Do try it out.

PS: It is advised to everyone interested in this course to study microeconomics and game theory before opting for this course.