Industrial Organization Economics

The Economic Foundations of Strategy post set the stage to discuss more deeply how economics has shaped the study of strategy. Here, I will discuss Industrial Organization Economics (IO).

In broad terms, IO examines the structure of the firm and market. In order to do so, researchers typically use the Bain/Mason Structure-Conduct-Performance Paradigm. The main takeaway for this paradigm is that the industry structure leads to certain enterprise conduct which leads to performance. For example:

  • Structure: Industries became concentrated due to advantages of large firm size
    • Economies of Scale, Product Differentiation, Strategic Behavior
  • Conduct: In concentrated industries there was a tendency towards (tacit) collusion
    • Price wars were to be avoided (prisoners dilemma)
    • Price signaling, price leadership, emphasis on non-price competition
  • Performance: Collusive behavior led to maximization of joint returns.
  • Implications: Underlay antitrust policy

This paradigm was modified to look at how enterprise performance leads to industry structure which then leads to firm performance. Here the example is different:

  • Conduct: Firms pursue strategies to build entry barriers, forestall entry, or limit competition in other ways (Gilbert, 1989; Shapiro, 1989).
    • Limit pricing, product proliferation, credible investment commitments, strategic pre emption, etc.
    • Vertical Integration to control access to inputs or limit access to distribution
    • Diversification (cross-subsidization and multipoint competition)
  • Structure:  Some industries become concentrated due to network effects (Arthur, 1989)

The key question in IO is “what industry structure is in the best interests of society.” This is clearly an an economic welfare question. Porter, however, changed the question to “what strategies are in the best interests of the firm.” This second question clearly looks at the conduct and performance link within an industry.

Not all economists agreed with the Structure-Conduct-Performance paradigm. Some relevant critics include:

  • Demsetz (1973)
    • Industries become concentrated due to enterprise efficiency, not anti-competitive practices.
  • Stigler (1965)
    • Even if firms want to collude, information costs and enforcement issues make collusion very difficult if not impossible.
  • Schumpeter (1950)
    • Competition is a process driven by the “perennial gale of creative destruction.”
  • Christensen (1997)
    • The advantages of large scale can be and are nullified by innovation.

Some papers that have been mentioned above and that are relevant to IO include:

  • Caves & Porter (1977)
    • Entry barriers can apply in subgroup structures; entry decisions involve strategies of targeting groups and moving into specific segments over time.
  • Gilbert (1989)
    • Strategic behavior can exploit mobility barriers to the advantage of an established firm.
  • Shapiro (1989)
    • Overview of recent IO research that includes game theory; emphasizes the dynamics of strategic actions and the role of commitment in strategic settings, not possible to determine an overall theory of oligopoly.
  • Arthur (1989)
    • Examine the dynamics of allocation under increasing returns in a context where agents choose between technologies competing for adoption.
(Adapted from course notes)
(Flashcards and other resources here)

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