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Industrial Organization



A specialized field of economics called industrial organization investigates how industries are organized, how they work, and how their organization affects how they work. Economists who study industrial organization concentrate on three main areas: (1) structure, (2) behavior, and (3) performance. All three affect one another in many ways.

Structure describes the way in which individual businesses together form an industry. It includes such factors as the number of firms in an industry, their sizes, and how difficult it is for new firms to enter the industry. An important characteristic of industrial structure is called concentration-that is, the proportion of an industry's total output supplied by a few firms. For example, a few large companies produce nearly all the aluminum and most of the laundry detergents sold in the United States. A highly concentrated industry, which is dominated by a few large businesses who control the supply, is known as an oligopoly. In a monopoly, one business controls the supply of a particular product or service for which there is no close substitute available.

The degree of concentration in an industry depends partly on how much increased production will lower the cost per unit of making the product. Some of a firm's costs stay the same whether it produces 100 items a day or 1,000. Its property taxes probably will not rise, nor will the cost of heating or cooling the factory. The machinery will wear out faster with increased use but not 10 times faster. If the cost per unit of making the product declines as the output increases, the business benefits from a condition called economies of scale. In this case, smaller firms have higher costs than do larger firms. As a result, new firms may have difficulty entering the industry, and small firms may be forced out of business.

In some industries, established firms have advantages over a new company trying to enter the industry. For example, many types of manufacturing require such large factories and such expensive equipment that it is difficult for new businesses to begin production. Established firms may also control the supply of raw materials, or one company may own patents covering the manufacturing process. Obstacles that discourage newcomers are called entry barriers. A type of business structure in which one company operates at more than one stage of production is called vertical integration. A vertically integrated steel company might produce raw materials at its own coal and iron mines and make finished products at its own steel mills. Vertical integration sometimes reduces shipping costs and other expenses. For example, a steel mill may not only make steel from iron ore but also roll the steel into sheets before it cools. This operation saves the cost of reheating the metal.

A firm that produces a number of largely unrelated goods and services is said to be diversified. A diversified company might make silverware, zippers, and a variety of other products. Diversification gives a company more financial security than it would have if it produced only one kind of product. Because a diversified company operates in various industries, it can sometimes offset declines in one industry with advances in another.

Behavior refers to how businesses act in relation to one another and in response to economic conditions. It includes such factors as what prices companies charge, what advertising and other sales promotion they do, and how much each firm spends to develop new products.

Industrial behavior is related to industrial structure. For example, if an industry includes many firms, the competition among them will often be intense. Each will try to offer a better or cheaper product than the others. The competitors may even spend large sums on advertising, packaging, customer service, and other means of sales promotion. The fewer the number in an industry, on the other hand, the easier it is for them to act together to set prices. In an oligopoly, few companies supply a good or service so that each of them can influence the price, with or without a definite agreement among them.

Entry barriers also influence behavior. By discouraging new firms from entering an industry, entry barriers enable established firms to charge higher prices and to be less efficient. A company's degree of diversification can also affect its behavior. A diversified business may be more likely than a nondiversified business to spend money developing new technologies that can be used for the various products it produces.

Performance refers to the results of industry behavior and structure. It refers to how well an industry meets the needs of a society in producing high-quality products, setting low prices, and providing employment. The performance of all industries together determines the performance of a nation's economy.

Three measures of an industry's performance are its technical efficiency, allocative efficiency, and dynamic efficiency. Technical efficiency is the ability to produce an output without waste. Allocative efficiency is the degree to which an industry produces the type and level of output that consumers want. Dynamic efficiency describes the extent to which an industry succeeds in developing new and improved products and in reducing costs and prices.

Contributor: William S. Comanor, Ph.D., Professor of Economics, University of California, Santa Barbara; Professor of Health Services, University of California, Los Angeles.
Source : World Book 2005




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