Industrial Organization
Industrial organization refers to how the markets and industries are organized. In this case, the workings of such markets and/or industries are studied, particularly the way the firms in such industries compete with each other. Industrial organization is widely considered as a subject of microeconomics. However, it is imperative to consider it as a separate entity since it tends to emphasize on the study of strategies that firms utilize as a characteristic of interactions in the market. Such market interactions include product positioning, competition in pricing, research and innovation, advertisements, among many other factors. Further, it is important to note that industrial organization majorly focuses on the transitional model of oligopoly unlike microeconomics. Microeconomics tends to concentrate on the intense monopolistic and perfect competition scenarios. In other patterns of thinking, one may consider industrial organization as that subject or arm of economics that focuses on imperfect competition.
Usually, there exist two types of industries in the market: monopolistic and oligopolistic industries. The monopoly industries utilize a direct intervention style where it sounds like it is the ‘only company’ in the market. Monopolistic firms can affect the prices at their discretion without any competition or customer migration. They therefore disregard the interests of other firms and eliminate the possibilities of studying externalities between and/or among different firms. The monopolistic model cannot be utilized in the study of structural changes since it does not allow the incorporation of any structures of competition in a market. On the other hand, an oligopolistic model usually involves an industry that has got only a few producers. In an oligopolistic market, firms tend to form strategic interactions amongst themselves in order to avoid a monopoly kind of outcome. Strategic interactions often arise due to the fact that there are few firms in the market (Lahiri & Yoshiyasu, 2004, 46). Therefore, the elasticity of demand will always depend on each firm’s output. In this case, whatever one firm charges on its products has a direct impact on the other firms’ prices. This is contrary to the monopolistic model where such interactions are absent. Industrial organization focuses on such interactions to address the issue of imperfect competition. Therefore, this essay will focus on the oligopolistic models in the market as well as the firms in this industry and analyze their concentration and market power. Specific interactions will be identified where possible and the firms’ cost structure examined, including how the firms set their prices.
The Cournot competition model emphasizes a competition structure where two firms in an oligopolistic market choose their product quantities simultaneously. In this case, the firms act in a monopolistic manner since they consider the effects that they will bring by deciding on the quantity. In the same vein, however, the firms will also consider the other firm’s decision on quantity since output from the other’s decision also leads to price affectation (Pepall et. al., 2008, 578). In summary, therefore, one may consider the Cournot equilibrium to be a Nash equilibrium where each firm does its very best according to what its rivals in the market are also doing. Usually, Nash equilibriums are non-cooperative in nature. This means that every firm chooses its own strategy in order to maximize profits according to what the competitors are doing. When the competition equilibrium is reached in such a scenario, incentives to strategy change cease to exist. This is because the firms cannot improve their payoffs (Boeri et. al., 2008, 28).
The Cournot model tends to concentrate on one-period situations where two firms in a market produce one undifferentiated product that has a demand curve that is well-known. Consequently, the two firms compete by deciding on their own output level in a simultaneous manner. In simpler terms, every firm in the Cournot model chooses their own quantity by assuming that their competitors’ quantity is fixed. Equilibrium in the Cournot competition model is achieved when every firm in the market chooses a quantity that maximizes its profits. From this perspective, there is no room for any incentive to either disrupt this equilibrium or change from it. Given a demand in the market of D (P) and levels of production by two firms of Q = D1 + D2, in order for a given firm to maximize its profits, it has to do the following procedures:
- The firm has to compute the marginal returns, which should be a function of D1 and D2.
- The firm can then lay down the marginal returns equivalent to the marginal cost.
- Once the above are done, a solution for the firm’s quantity can be generated. In so doing, the optimum quantity level of the firm can be determined by solving an equation that is a function of the competitor’s product quantity. The functional equation obtained as a result is referred to as the reaction curve equation. This equation usually demonstrates the optimum quantity level of each firm involved in competition. The equation, thus, comes to:
Q* 1 = f (Q2) and Q*2 = f (Q1).
In the Cournot equilibrium, the firms’ product quantities constitute the strategic objects. Therefore, each of the firms in the model solves the following:
In this case, yi becomes the chosen quantity of firm i. On the other hand, yj represents the firm’s competitor’s quantity choice. Therefore, firm i clearly considers its competitor’s quantity choice and what that brings to the overall market price (Boeri et. al., 2008, 35). This is a good example of a strategic effect. To show the simultaneous nature of the Cournot competition model, it is important to consider the following reaction function equations which give the optimal quantity of firm i as a function of the quantity of firm j:
YS1 = a – c1 – by2 / 2b.
And, YS2 = a – c2 – by1 / 2b.
YS1 and YS2 are optimal quantities for both firms 1 and 2. In this case, YS1, YS2 functions as profit maximization equation for firm 2 while YS2, YS1 serves as a functional equation for firm’s 1 profit maximization. In the event that both firms 1 and 2 are identical, then, the Cournot quantities will be determined by the following equation:
ySi = a – c / 3b, for firm i = 1, 2. On the other hand, the total quantity which is delivered amounts to:
YS = 2 (a – c) / 3b. In conclusion, the Cournot competitors usually sell their products at the following price:
pS = a + c / 3. Therefore, the competitors’ profits will be equal to:
πSi = (a – c)2 / 9b.
A good example of firms exhibiting the Cournot model is the pharmaceutical giants, Glaxo Wellcome and SmithKline. Glaxo Wellcome produces the famous ulcer drug by the name Zantac while SmithKline has Tagamet as their ulcer drug. Although the two drugs have been confirmed to possess similar acting potentials and activities, Zantac commands the largest market. Not only does Zantac command the largest market power of the two drugs, but also amongst all other well-known ulcer drugs in the market. As a result, Glaxo Wellcome has increased the price of Zantac by about seven and a half times that of Tagamet. Still, it continues to lead in the world sales volume by accumulating approximately $1.6 billion in sales. The cost of production of Zantac, on the other hand, is very little. This means that the price margin set by Glaxo Wellcome is very high in order to maximize its profits. Glaxo Wellcome is thus able to choose and set the price of the drug in the market since it has got a significant degree of market power. Consequently, SmithKline and other companies respond by considering the price and quantity chosen by Glaxo Wellcome and finally make their decision. However, the decision on quantity and price is usually simultaneous. This means that as Glaxo Wellcome makes its choice on the quantity, SmithKline also does it. In this case, SmithKline assumes that Glaxo Wellcome’s quantity is fixed in order to set their quantity. This results in the Cournot equilibrium similar to the Nash equilibrium, where Glaxo Wellcome and SmithKline each select their own output level in order to compete. Both firms produce their own products through research and development and continually improve their products. This means that they are the product manufacturers and therefore do not have an upstream product supplier. Their downstream customers are the pharmaceutical mega chains and stores and wholesale distributors as well as retail outlets.
The Stackelberg model, on the other hand, involves two firms in an oligopolistic market, where competition is sequential. The leader in the market is usually the first to select the quantity and set the price while the competitor responds out of this. Assuming that every firm in the Stackelberg competition model has a marginal cost of ten (10) dollars, then, the total demand will be determined using the following inverse equation:
P = 100 – q1 – q2.
Computing the Stackelberg equilibrium (p*, q*), the first step involves the calculation of the response of the follower, firm 2, to the leader’s (firm 1) decision (Reiss et. al., 1989, 37). Given that the quantity of firm 1 is q1, then, the total returns of firm 2 will be:
TR2 (q1, q2) = p x q2
= (100 – q1 – q2) x q2
Consequently, the marginal returns of firm 2 are equal to:
M R = 100 – 2q2 – q1
Now, given the quantity of firm 1, firm 2 will maximize its profits by setting the Marginal Returns equal to the Marginal Cost; that is MR = MC. Therefore,
100 – 2q2 – q1 = 10.
Consequently, q*2 (q1) = 45 – 0.5 q1.
Firm 1 will consider firm 2’s choice when making its own decisions on quantity of products to be produced. Given firm 2’s best choice of quantity, then, firm 1’s total returns are:
TR1 (q1, q2) = (100 – q1 – q*2 (q1)) q1
(100 – q1 – 45 + 0.5q1) q1
Firm 1’s Marginal Returns, on the other hand, are:
M R = 100 – 2q1 – 45 + q1.
Firm 1 selects the quantity that will put the Marginal Returns equal to the Marginal Cost. In this case,
100 – 2q1 -45 + q1 = 10
Therefore; q*1 = 45.
q*1 represents firm 1’s optimal decision. Therefore, q*2 can be determined through the use of firm 2’s best response selection as follows:
q*2 (q*1) = q*2 (45)
= 45 – 0.5 x 45
= 22.5
The Stackelberg competition model differs considerably from the Cournot equilibrium in that the leader ends up giving more output in the former than in the latter model (Pepall et. al., 2008, 586). Consequently, the follower gives less output in the former competition model compared to the Cournot competition equilibrium. This is referred to as the advantage of the first mover. A perfect example of firms exhibiting this model is the British Sky Broadcasting Group, BSkyB, and ONdigital Group. BSkyB is a satellite broadcasting company that has been a major player in the digital television market in Britain. On the other hand, ONdigital Group is a terrestrial-based broadcasting company. BSkyB started an insistent advertizing campaign in May of 1999 that sought to make it the number one choice for the digital television consumers. It started advertizing that it could offer free digital set-top decoders, discounts of up to 40% on its basic television charges, and free access to the internet on its platform. The original intent of BSkyB was to prevent its major competitor, ONdigital Group as well as other cable operators in the country from taking the full control of the market. The move did trigger a substantial migration of consumers from other companies that failed to offer the above incentives. Immediately after their advertisement, its shares skyrocketed by a whopping 12%. ONdigital, on the contrary experienced a hard time since they could not match BSkyB’s strategy. Consequently, the company’s shares dropped a significant margin of about 1.8%. This effect resulted in price wars that made ONdigital Group respond by introducing a similar incentive. In its strategy, ONdigital started providing free digital set-top boxes having learnt from the market leader, British Sky Broadcasting Group. Both companies in this case are first level producers, meaning that they are the original producers of digital content. Its consumers are the public and corporate customers who require digital television installations. This shows the sequential nature of the Stackelberg competition model as compared to the simultaneous Cournot competition model.
The Bertrand competition model is the final model of importance that dictates how firms in imperfect competition react, based on their product prices (Calcagnini & Enrico, 2010, 10). The firms involved in competition usually set their own prices. In this case, the Nash equilibrium in this model has to be achieved in a way that the prices are equivalent to the firms’ marginal costs. That means that the Nash equilibrium (p*1, p*2) will be such that p*1 = MC while p*2 = MC. In this model, we will reflect on all prices that tend to differ from the two equations above and show why they cannot attain equilibrium. The steps in this are as follows:
- We need to set the prices in a way that p < MC. This does not represent equilibrium because one firm in this case earns negative profits. Therefore, the firms involved will have to deviate from a certain incentive.
- In the second situation, we have to set the prices in a way that MC = p1 < p2. Still, this does not represent equilibrium. This is because firm 1 is in a position to deviate from any incentive by setting its own prices to satisfy MC < p’1 <p2. In such a way, firm 1 will have made higher profits than its competitor. Indeed, at the new price, p’1, firm 1 stability is assured because it does not lose any clients even though it is selling its products at a higher price.
- The third situation involves setting the prices in a way that MC < p1 <p2. Again, this does not achieve equilibrium. Here, firm 1 already has an incentive to deviate from by selecting p1 < p’1 < p2, so that no customers are lost as the firm increases its prices and hence more profits. In the same vein, firm 2 can also set the prices at MC < p’2 < p1. This means that firm 2 will acquire the whole market share and even sell its products above its Marginal Cost.
- The last situation is where we set the prices in a way that MC < p1 = p2. In this case, firm 1 will have an incentive to deviate from when it sets MC < p’1 < p1. This new scenario shows that firm 1 is selling its products at a lower price compared to the earlier cases. Therefore, it will tend to accumulate the whole market share. This is the real Nash equilibrium of the Bertrand competition model. It indicates that by both firms setting their prices equivalent to the Marginal Cost, the Bertrand model is satisfied (Pepall, et. al., 2008, 590). In the earlier scenarios, both firms set their prices at other values that could not constitute equilibrium. In every case, each firm had an incentive to deviate from what they had chosen. Therefore, we can conclude that for the Bertrand competition model to achieve its equilibrium, the Nash equilibrium, the prices set by firms must be equal to the Marginal Costs of the firms. Any other value does not bring the equilibrium.
A good example of the Bertrand competition model at work involves two airlines in Japan, Japan Airlines and All Nippon Airlines. For over 35 years, these companies have dominated the Japanese airline industry due to the regulation by Japanese that was in place prior to 1998. After deregulation of the industry, Japan Airlines (JAL) and All Nippon Airlines (ANA) could now face other competitors who would be interested in the Japanese market. True to this, Air Do and Skymark Airlines entered the market immediately after the deregulation.
As a competition strategy, both Japan Airlines and All Nippon Airlines decided to lower their airfares and profits by setting a price that was equal to the firms’ Marginal Costs. This created opened advantages to the consumers since they had more options to choose from both companies. This further meant that if the marginal cost of any firm was less, then their air fares would be equal to the Marginal Cost. In this way, competition wars were rife with both companies reducing fares based on their Marginal Costs. In the end, it was the consumers or travelers that were in delight. The firms may be considered as first-level producers since they generate the airfares without any third party involvement. The downstream customers are the general public who are the travelers and corporate. Any firm that had its prices kept lower than the other would hence take majority of the market share. All Nippon Airlines was perfect in this. This enabled it to acquire much of the market share compared to Japan Airlines or the entrants.
In summary, it is worth noting the importance of industrial organization in the study of imperfect competition. By analyzing the forces in this industry or market, one gets a clear picture of imperfect competition and how it affects the whole market structure. Of importance are the three well-known models that have been discussed in the essay. These models analyze competition in the oligopolistic industry in the context of quantity and prices of products which are the main factors to be considered in any market. All the models discussed have got equilibrium requirements that have to be achieved in order for the firms to maximize their profits while reducing their costs. As has been observed, any values below or beyond the Marginal Costs does not satisfy equilibrium and profit maximization.
Works Cited
Boeri, Tito, and J C. Ours. The Economics of Imperfect Labor Markets. Princeton: Princeton University Press, 2008. Print.
Calcagnini, Giorgio, and Enrico Saltari. The Economics of Imperfect Markets: The Effects of Market Imperfections on Economic Decision-Making. Berlin: Physica-Verlag, 2010. Internet resource.
Lahiri, Sajal, and Yoshiyasu Ono. Trade and Industrial Policy Under International Oligopoly. New York: Cambridge University Press, 2004. Print.
Pepall, Lynne, George Norman, and Dan Richards. Industrial Organization: Contemporary Theory and Empirical Applications. Malden, MA: Blackwell Pub, 2008. Print.
Reiss, Peter C, and Richard C. Levin. Cost-reducing and Demand-Creating R & D with Spillovers. Cambridge, Mass: National Bureau of Economic Research, 1989. Internet resource.
