CHAPTER ONE

1. Scope and Conceptual Framework of Industrial Economics

1.1 What is industrial economics?

Industrial economics is a distinctive branch of economics, which deals with the economic
problems of firms and industries, and their relationship with society.
How decision-making problems arise in industries? To answer this question, we have to
go back to the core of economics. Economics is the science that studies human behavior
as a relationship between ends and scarce means that have alternative uses. As implicit in
this definition, an economic problem arises because of scarcity of means and their
alternative uses in relation to the needs of an individual or a group or society as a whole.
For example, the income (i.e. resources) of a consumer is generally limited but his wants
are unlimited. In this situation he has to adopt some criterion to achieve maximum gain
from his limited income. This is the problem of utility maximization in the theory of
consumer behavior. Similarly, for a producer, the resources like land, raw materials,
labor, capital, etc., are scarce. Given such scarcity, the producer has to take decisions
about production and distribution. There are several basic issues on which the producer
will be taking decisions such as:

 What commodities he should produce?

 What should be the level of output of each? (quantity)
 What type of technology he should adopt? (labor intensive or capital-intensive
technology
 Where should he produce the goods? (problem of location)
 What should be the size of his factory? (small scale or large scale)
 What price he should charge?
 How much wages should pay? etc.

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All such decisions explain the producer's behavior in the different market situations,
which we endeavor to study in industrial economics.
In microeconomics also we study producer’s behavior in relation to scarcity of resources.
Because of this fact, some economists would regard industrial economics as being
primarily an elaboration of, and development from, the traditional theory of the firm
taught under microeconomics. Industrial economics is best defined as the application of
micro economic theory to the analysis of firms, markets and industries. Stigler (1968) 1
argues that industrial economics does not really exist as a separate discipline, that it is
simply differentiated microeconomics. But this misses some points. The distinction arises
from the overriding emphasis, in industrial economics, on empirical work and on
implications for policy.

Of course, to view industrial economics as a development of microeconomics is quite

understandable. Both are concerned with the economic aspects of firms and industries
seeking to analyses their behavior and draw normative implications. However, there are
some differences between the two. Microeconomics is a formal, deductive and abstract
discipline. Industrial economics on the other hand is less formal, more inductive in
nature. Microeconomics by and large assumes profit maximization as the goal of the firm
tells us to maximize it subject to given constraints. It is passive in approach. Industrial
economics does not believe in a single goal of profit maximization. It searches the goals
of the firm from the revealed facts. It concentrates on the constraints which impede the
achievement of the goals and tries to remove them. It is an active discipline in this sense.
Microeconomics, being abstract, does not go into operational details of production,
distribution and other aspects of the firms and industries. Industrial economics does go
into the depth of such details. Public policy implications are taken care of in industrial
economics but microeconomics may shun them if necessary. It is true that the theory of
firm (i.e. microeconomics) provides the main theoretical basis for the study of industrial
economics. But several important influences from outside have given a totally different
character to industrial economics. In the light of such influences the conventional theory
of the firm is bound to be revised.

1
Paul R. Ferguson and Glenys J. Ferguson: Industrial Economics: Issues and perspectives, second edition
1994, page2

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So far, we were looking at industrial economics with the concern of decision-making in
an industry from micro angle, but it has macro dimension also. For a society as a whole
the resources for production are scarce just as in the case of a producer. With scarce
resources, the problem is to produce varieties of goods and services in-the current period
and in future also. What goods should be produced: consumer or capital? If capital good
are preferred, then the series of problems faced by the society may be: what types of
capital goods; what type of factory (large vs. small scale); where to produce (locational
problem); how to distribute them; etc. These are the questions which have been posed
earlier for an individual producer also. But here we have to examine them from the social
angle. The decisions in the context of society as a whole may be at variance with the
decisions by an individual producer. If this is so, a state will clearly specify the policy
framework in which the individual producers will function. In other words, to achieve the
broader policy objectives, a state will regulate industries through varieties of ways such a
nationalization, privatization, anti-trust policies, control on prices and outputs, credit
controls, taxes, etc. A study of all such instruments of industrial regulation is an integral
part of industrial economics. How they affect the performance of the firms is a crucial
aspect to be examined under industrial economics. Such information is useful for the
regulatory agency of the government to assess the success of its industrial policy.

The term industrial organization is commonly viewed as synonymous with industrial

economics. Carlsson (1989) 2 made clear distinction between them. He reasons that the
main concern of industrial organization has become the structure of industries at a
particular point of time. By contrast, industrial economics encompasses both industrial
organization and industrial dynamics. Industrial dynamics is primarily concerned with the
evolution of industry as a process in time both at the macro level, the sector or industry
level, and the firm level. It differs from industrial organization in that its main focus of
attention can vary from the firm, to relationships between firms, to the links between
microeconomics and the macro economy.

2
Ibid , page2

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♦ Carlsson argues that there are four main themes which encompass the subject matter
of industrial dynamics:
1. The nature of economic activity in the firm and its connection to the dynamics of
supply and therefore economic growth, particularly the role of knowledge.
2. How the boundaries of the firm and the degree of Interdependence among firms
change over time and what role this interdependence plays in economic growth.
3. The role of technological change and the institutional framework conducive to
technological progress at both macro and micro levels.
4. The role of economic policy in facilitating or obstructing adjustment of the
economy to changing circumstances (domestically as well as internationally) at
both micro and macro levels - industrial policy
When the economist turns the attention to industrial dynamics the area of investigation is
widened to analyze topics where change is central (such as innovation) and a different
perspective is taken on many of the issues of industrial organization. For instance, where
industrial organization would be concerned with the extent to which the presence of
monopoly in the economy reduces society's welfare, industrial dynamics addresses itself
to the reasons why monopoly has developed, and the question of how long it might
persist.
Coming to the conclusion of this section, we may say that industrial economics is
predominantly an empirical discipline having micro and macro aspects. It has a strong
theoretical base of microeconomics. It provides useful applications for industrial
management and public policies.

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1.1.2. Elements of industrial economics
There are two broad elements of industrial economics:
• Descriptive and
• Analytical elements.
A. Descriptive element is concerned with the information content of the subject. It is
aimed at providing the industrialist or businessman with a survey of the industrial and
commercial organizations of his own country and of the other countries with which he
might come in contact. It gives businessman full information regarding the natural
resources, industrial climate in the country, situation of the infra-structure, supplies of
factors of production, trade and commercial policies of the governments, and the degree
of competition in the business in which he operates. In short, it deals with the information
about the competitors, natural resources and factors of production and government rules
and regulations related to the concerned industry.

B. Analytical element of the subject is concerned with the business policy and decision-
making. It deals with topics such as market analysis, pricing, choice of techniques,
location of plant, investment planning, hiring and firing of labour, financial decisions,
product diversification and so on. It is a vital part of the subject and much of the received
theory of industrial economics is concerned with this. However, this does not mean that
the first element, i.e. descriptive industrial economics, is less important. The two
elements are interdependent, since without adequate information no one can take proper
decision about any aspect of business.

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1.1.2. Some Basic Concepts in the Study of Industrial Economics
i. The Firm
A firm is an organization owned by one or jointly by a few or many individuals which is
engaged in productive activity of any kind for the sake of profit or some other well-
defined aim. Most of the firms owned by private individuals in manufacturing trade and
services will aspire for profits but there may be some other such as government
companies where profit motivation will be secondary or missing altogether.
ii. The industry
The conventional definition of the term industry is a group of firms producing a single
homogeneous product and selling it in a common market. However, the restriction of a
single homogeneous product is not met in practice. Most of the firms produce many
outputs which may or may not be substitutable for each other. In this situation, the
conventional definition has no operational sense. A better approach to define the industry
is to call it “a group of sellers of close substitute outputs who supply to a common group
of buyers”. In other words, we may take it in simpler terms as a group of firms producing
closely substitute goods for a common group of buyers. In the terminology of the
monopolistic competition we are essentially talking about the “product group" as a
substitute word for the industry. The competition among the firms as well as among their
products is implicit here. It is not necessary that the substitute goods always come from
the same industry. Two goods having similar end-use may come from two different
industries. For example, woolen blankets and electric room heaters are used for removal
of cold but they cannot be taken together as output of one industry. The nature of these
products is different; they are based on different technologies, so one can easily conceive
them as outputs of different industries. Similarly, a firm producing two different non-
substitutable goods need not be classified under only one industry.

A business is conceived as operating within an industry consisting of all businesses those

operate processes of a sufficiently similar kind and possessing sufficiently similar
backgrounds of experience and knowledge so that each of them could produce the
particular commodity under consideration and would do so if sufficiently attractive. This
is a comprehensive definition which may serve our purpose best. However, still we have

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to get a much precise definition of the industry where technical aspects related to
products and processes heterogeneity, organizational heterogeneity and the institutional
aspect of the industry are incorporated together. However, it is difficult to define industry
precisely. The definition depends more or less on the purpose of use of the industry.
There is a wide disparity in defining industry across the countries and so the United
Nations had to evolve a standard international classification of the industries for bringing
some uniformity, particularly when the industries are to be grouped together into some
sectors for the purpose of comparable industrial analysis. A clear demarcation of the
boundaries of the industries is very much needed in the empirical analysis since it is the
industry which is the primary focus of the competitive forces. Its structure constrains the
conduct and performance of the firms within it. Also, public policies are designed to
regulate industries; so making the industry a unit for study is quite natural and logical.

iii. The Market

This is defined as a closely interrelated group of sellers and buyers for a commodity. The
term is not equivalent to the industry since in the latter case we will be looking only at the
seller’s side of the market. By including the buyer's side, the term becomes more
comprehensive connoting the composition of the buyers and their geographical location
along with the industry. A heterogeneous group of closely substitute goods will have a
market, but there may be markets within the market for every homogeneous goods.
Within the market, the goods will be treated as uniform. In practice it may be difficult to
define the precise boundary for a market. A market is said to be imperfect if there is lack
of information about it, there are entry barriers to it and the product is not uniform.
iv. Market power
Market power- refers to the influence that any particular buyer or seller can exercise over
the price of a product. It indicates the degree to which a business firm is able to earn
larger than normal profits. Market structures range from highly competitive, in which
there are so many buyers or sellers that none can influence the market price, to the other
extreme in which a single buyer or seller faces no competition and therefore wields great
market power. Market power is inversely related to both the degree of competition in the
market and the ease of entry and exit.

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v. Contestable market
Contestable market- is a market in which competitive outcomes can be observed. Its
fundamental feature is low barriers to entry and exit; a perfectly contestable market
would have no barriers to entry or exit. Contestable markets are characterized by 'hit and
run' entry. If a firm in a market with no entry or exit barriers raises its prices above
marginal cost and begins to earn abnormal profits, potential rivals will enter the market to
take advantage of these profits. When the incumbent firm(s) responds by returning prices
to levels consistent with normal profits the new firms will exit. In this manner even a
single-firm market can show highly competitive behavior.
1.2. Approaches to Industrial Economics
1.2.1. The Structure-conduct –performance paradigm
Industrial economists have developed generally accepted principles applicable to all
markets, all industries, and all economies. The central questions addressed by industrial
economics are
a) Is there market power and if so, how do you measure it?
b) How do firms acquire and maintain market power?
c) What are the implications of market power?
d) What is the role of public policy as regards market power?
To do a complete analysis of an industry, market, or economy, there is a three-part
paradigm consisting of market structure, conduct, and performance sometimes used by
industrial economists. With this model, an independent investigator can assess whether
sufficient market power exists for any firm or groups of firms to complete successfully
any challenged market conduct abuse. The market structure of an industry is concerned
with the number and size distribution of buyers and sellers (concentration ratios), the
nature of the product (differentiated or homogeneous), and conditions of entry (cost
structure and barriers to entry). Market conduct is the pricing behavior (independent or
collusive), the product strategy and policy (independent or collusive), and the
promotional activities, (advertising, research, and development) operating within the
market. Market performance is the productive and allocative efficiency (price, cost, and
profit levels and trends) and the industry progressivity (technological change) of the
market. Now let as discuss the elements of this model in detail.

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 A. Market Structure
Market Structure refers to the organizational characteristics of buyers and sellers in a
particular market. It means the pattern or form or manner in which the constituent parts of
a market (i.e. buyers and sellers) are arranged/ linked together. It is specified in terms of
the organizational characteristics which determine the relations:

a) Of sellers in the market to each other;

b) Of buyers in the market to each Other;

c) Of the sellers to the buyers; and

d) Of sellers established in the market to the new potential firms which might enter
the market.
These characteristics of the organization of a market exercise a strategic influence on the
nature of competition and pricing within the markets. The following four main features of
the market structure have been suggested by Bain, which are important to understand the
concept precisely and to measure it:
1. The Degree of Seller Concentration: This is the number and size distribution of
firms producing a particular commodity or types of commodities in the market.
2. The Degree of Buyer Concentration: This shows the number and size distribution
of buyers for the commodities in the market.
3. The Degree of Product Differentiation: This shows the difference in the products of
different firms in the market.
4. The Condition of Entry to the Market: This shows the relative ease with which new
firms can join the category or sellers (i.e. firms) in the market. When significant barriers
to entry exist, competition may cease to become disciplining force on existing firms, and
we are likely to see performance that departs from the competitive ideal.

Each of the different dimensions or features of the market structure is important in

determining the behavior of the firms which in turn will be affecting their performance as
well as the performance of the industry as a whole. We already know how the number of
sellers is a crucial variable determining the structure of the industry in microeconomics
theory II. If there is only one firm then we get the form of monopoly market; if few then

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oligopoly; and if there large then we encounter with the perfect competition. In each case
the process of output and price determination will be different. Similarly, how
differentiated goods and the large number of sellers generate the conditions for mono-
polistic competition is another example showing the importance of the market structure.
Looking at the absolute size of the sellers as another feature of the market structure, there
will be interesting problems to find how the large one will be more efficient than the
smaller one or vice versa; and when we take into account the size distribution of the
sellers in the market, we will have to find whether the concentrated industries arc more
efficient than the others. Similarly, the buyers' concentration in the market will have
considerable impact on the actions of the sellers and their performance. Product
diversification and the entry conditions in the market play their own roles in the real life
situation.

Other related aspects of market structure relate to the extent to which firms one vertically
integrated back to their sources of supply or forward to the final markets, the degree of
diversification of individual firms, technological, geographical and institutional factors
present in the market and conditioning the behavior and performance of the firms. All
such characteristics constitute a set of "the economically significant features of a market,
which affect the behavior of firms supplying that market. Market structure is a
multidimensional concept. So it is difficult to measure it through a single variable. In
practice a set of variables related to different aspects of it are used simultaneously to
measure the market structure. Some of such measures will be discussed in the appropriate
chapters of this module.

B. Market Conduct
Market conduct is defined as the patterns of behavior that firms follow in adopting or
adjusting to the market in which they operate to achieve the well-defined goal or goals.
Given the market conditions and the goals to be pursued the firm will be acting alone or
jointly to decide about the price levels for the products, the types of products and their
quantities, product design and quality standards, advertisement, etc. Firms may also
devise the ways for interactions, cross-adaptation and coordination among the competing
group of sellers in the market.

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In general, market conduct includes the pattern of behavior followed by firms in the
industry when adapting to a particular market situation. It includes:

1. Pricing behaviors of the firm or group of firms: - This includes a consideration of

whether price charged tend to maximize individual profits, whether collusive
practices in use tend to result in maximum group profits or whether price
discrimination is followed.
2. Product policy of the firm or group of firms - For example, is product design
frequently changed? Is product quality consistent or variable? What variety of
products is made available?
3. Sales promotion and advertising policy of the firm or group of firms – how
important are sales promotions and advertising in the firm or industry’s market
policy? How is the volume of this activity determined?
4. Research, development, and innovation strategies employed in the firm or
group- how substantial are expenditures for these purposes? To what extent is new
technology available to smaller firms?
5. Legal tactics used by the firm or group- Legal actions to gain competitive
advantage. Are patent and trade mark rights strictly enforced or defended? Are patent
rights licensed to others at fair rates? Attempts to get use rights to new technology to
establish and defend some degree of monopoly power.
For example, take the situation of two- firm industry (i.e. duopoly). Assume that the
firms intend to maximize profit. How would they conduct their business? Naturally
given such conditions we have to examine how the firm will be taking decisions about
the prices, quantity of outputs, etc. in the market. They may ignore each other and pursue
their objective independently. They may join together and share the total profits of the
industry in some mutually arrived at agreement. Or they may be involved in the dirty
games of competing with each other such as indiscriminate price-cuts, product
disparagement, disturbing the supply line of raw materials of each other, bribing of the
government officials and so on. They may follow more honorable tactics such as product
diversification, effective advertisement and sales campaigns and favorable credit terms to
the customers. All these activities reflect the conduct of the firms in the market. Such

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activities can be extended from a two-firm industry to the one which is having large
number of competing sellers. The choice of the tactics, or strategies in a better word,
reflects the behavior of the firm in the given market situation. This is a very important
aspect in the organization of the firm. How such strategies are to be chalked out and how
to implement them effectively is the task of the management. The entire process of
reacting to the market situation in pursuit of the desired goal is called market conduct.
C. Market Performance
Market performance is the end result of the activities under taken by the firms in pursuit
of their goals. High profitability, high rate of growth the firm, increase in the sales,
increase in the capital turnover, increase in the employment etc are some variables on the
basis of which we can judge the market performance of the individual firms depending on
their respective goals.
Generally, good market performance is a multidimensional concept which includes the
following elements:

1. Resources should be allocated in an efficient manner within and among firms such
that these resources are not needlessly wasted and that they are responsive to
consumer desires. How effectively are resources allocated across industries and
products? This gets at opportunity cost to the economy of having misallocation of too
few or too many resources devoted to a particular activity.
2. Technical or operational efficiency--how closely do existing firms, as a group,
achieve lowest possible costs?
 Are they large enough to capture scale economies?
 Is there too much unused capacity?
 Are they located to minimize transport costs?
 Is there labor efficiency?
3. Exchange Efficiency-refers to the costs of arranging transactions (transaction costs), v
such as

 Inspection of goods to pair buyers and sellers--this is reduced if there are grades and
standards that allow trading on the basis of description.
 Information flows (related to market transparency)

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 Ability to trade openly
 Various forms of vertical coordination, including vertical integration.
Include pricing efficiency--i.e., the degree to which prices accurately and rapidly transmit
changes in supply and demand to participants in the market. This affects allocative
efficiency by inducing adjustments in consumption and production as supply and demand
change. Allows matching of supply and demand and adjusts consumption to social
scarcity.
4. Profit Rates: normal profit is the indicator good market performance. Profit serves as
the:
 Returns to management and risk taking
 Returns to capital investment
 Signal to guide resource allocation in the economy.
Chronic excess profits representing a failure of the market system:
 Indicate too few resources are flowing into the industry
 May be a result of concentrated market structure and high barriers to entry.
 May have undesirable income distribution
Chronic sub-normal profits may indicate a sick or declining industry.

5. Level of Output

The level of output is separate from profit levels because output level not necessarily
directly related to profit levels in real world. We are usually concerned with
underproduction, but can also have situations of overproduction. Key question becomes
one of allocative efficiency--whether more or fewer resources are allocated to this
industry than are warranted by their social opportunity cost. i.e., the premise from welfare
economics is: “a `reasonable relation' between marginal cost and product price and
between value of marginal product and input price” judged in relation to other industries.

6. Producers should be technologically progressive; that is, they should attempt to

develop and adopt quickly new techniques that will result in lower costs, improved
quality, or greater diversity of new and better products. Progressiveness indicates the
extent to which an industry is generating and rapidly adopting new technologies and new

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organizational arrangements that reduce costs or improve products and services relative
to consumer wants

7. Product Suitability- involves matching products with consumer preferences. The

performance and safety characteristics of products that are supplied have to be reliable.
The quality level of products should be neither too high nor too low relative to consumer
desires. It is also related to progressiveness--designing new products and new handling
methods to satisfy better changing consumer demands. For example, for Food industry
• Freshness condition of food--food not deteriorated if consumers are willing to
pay for the extra care to assure the freshness.
• Safety of food products
• Nutritional integrity of products

8. Production resources should be organized in such a way to encourage an equitable

distribution of income. Although the notion of equity is a valve –laden concept, we
can say that profits should be no higher in the long-run than necessary to invoke the
productive use of resources in a particular endeavor. In addition, price stability
should be encouraged because of the perverse ways in which inflation changes the
distribution of income.
9. Producers should operate in a manner that encourages continued full employment of
productive resources. It can be argued that unused resources are wasted resources,
especially when they are perishable as in the case of human capital.
10. Participant Rationality-deals with adequate market information to make rational
choice and avoidance of misinformation. The need to provide market participants
with a reasonable opportunity to make comparisons may require certain mandatory
coordination and impartial types of information. E.g., Inspection, Grading, Standards
of identity, Standardized containers and packing (truth in packaging law),
Standardized quotations (e.g., unit prices, standard mileage estimates), price posting,
market news, product tests. Participants in the market should have a reasonable
opportunity to be well informed and should exercise freedom of choice rationally in
their own interests (except when private advantage obviously conflicts with social
welfare).

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11. Conservation- refers to the extent to which a firm or industry promotes the
conservation of natural resources. No needless depletion or inefficient extraction plus
exploration. Condemns both exhaustion of renewable resource to the point where it
cannot be sustained or wasteful extraction of nonrenewable resources.
12. Labor Relations- covers equal opportunity, working conditions, wage levels and
wage structure, work rules. Norm includes fair treatment (no race, sex
discrimination), mutual fair treatment, reasonable communication and respect.
13. Unethical Practices: firms should not engage in the production and distribution of
undesirable products/services. What is ethical is culturally determined, which poses
problems when different cultures try to trade, either within a country across ethnic
groups or internationally. Examples
 Undisclosed danger--related to food safety
 Fraud and misrepresentation--related to advertising
 Adulteration
Other aspects of good performance can be enumerated including external effects
and costs of sales promotion. For the society as a whole, performance of an
industry may be judged on the basis of its contribution in increasing the welfare of
the masses.

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[Link]. The relationship between Structure, conduct and performance
The material presented in the above section clearly indicates the existence of prior
relationship between the three main concepts of industrial economics viz. Market
structure, market conduct and market performance. The link between these three which
is evident in the theory of the firm is that market structure of an industry determines or
strongly influences the crucial aspects of its market conduct which in turn directly or
indirectly determines certain important dimensions of its performance.

Traditional SCP approach argues that performance is determined by conduct of firms,

which in turn is determined by the structural characteristics of the market (Fig. 1.1)

Figure 2.1 the traditional SCP approach

Structure Conduct Performance

The traditional SCP approach asserts that market structural condition yields sufficient
information to deduce how firms should behave and performance can be directly
predicted from conduct.

But the traditional premise that unidirectional running from structure-conduct-

performance is unsound. In some cases, analysis of conduct is superfluous. Example in
perfectly competitive market, given large number of firms, competition leaves firms with
no choice but to act independently in determining price and output levels. Individual
firms will be unable to influence the price determined by the market. Price will tend to
towards marginal cost and in the long-run firms will earn normal profits; production is
allocatively and productively efficient to the greater benefit of current economic welfare.

However, by passing conduct in all situations can lead to misleading influence where
markets display the features of oligopoly or monopoly in some situations. It may also
operate in the reverse way or may be segmented showing crosslink between any two of

16
the three aspects. For instance, mergers directly affect the number and size distribution of
firms in the market, innovation and advertising may raise entry barriers, predatory pricing
could force competition out of the market. If there is excess profitability for a monopoly
seller, it will generate discontent in the minds of the policy markets. They will devise
regulatory mechanism to control the monopoly which may include change in the market
structure by introducing some type of workable competition. High profitability may thus
be taken as a cause for the change in the market structure in this situation.

Fig. 2.2 shows how the SCP approach may be adapted to incorporate these more complex
linkages, but the essential causality still flows from structural criteria.

Structure Conduct Performance

Figure1.2. More complex relationship between structure, conduct and

performance.

It can summarized that, While industrial economics has traditionally emphasized the
causal flows running from exogenous market structure and/or the exogenous basic
conditions to conduct and performance, there are important feedback effects from
performance to structure (e.g., high profits from efficiency increase market share and
affect structure), performance to conduct (reinvested monopoly profits can finance
greater R&D, advertising, or predation and low profits encourage collusion), and from
conduct to structure (R&D, mergers, predation, strong product differentiation,
advertising, and patents affect structure).

2.4 The conceptual Framework of Industrial Economics

Market structure, conduct and ultimately performance are also influenced by certain
fundamental market and environmental conditions. These may be divided into factors
primarily influencing the supply or input side of the production equation and those whose
primarily impact is on the demand side. The supply side includes the location and
ownership distribution of essential raw materials, the durability of the product, the

17
available technology and production techniques, the degree to which labor inputs are
readily available and organized, and the extent to which the firm’s activities are regulated
by government. On the demand side, such factors as the, price elasticity of demand,
number of close substitutes that are available (measured by the cross elasticity of
demand), growth prospects of the industry, type of good or service being produced
(intermediate, consumer, specialty, convenience and so on), method of purchase by
buyers (list price acceptance, negotiation or haggling, sealed bid) must be included in an
analysis of fundamental conditions influencing market structure, conduct, and
performance.

Fundamental Market and

Environmental Conditions
Supply Demand
 Location & ownership  Price elasticity
of raw materials  Cross elasticity
 Product durability  Growth prospectus
 Technology  Market of product
 Labor organization  Method of purchases
 Regulation
 Government polices

Market structure Market Conduct Market performance

 Sellers and buyers  Pricing behavior  Efficient allocation of resources
concentration  Product policy  Technologically progressive
 Actual or imagined product  Sales promotion and  Full employment
differentiation advertising  Equitable income distribution
 Condition of entry  Research, development and  Resource conservation
 Diversification or innovation strategies  Satisfactory product
conglomeration  Legal tactics  Satisfactory product performance
 contestability and safety characteristics

Fig. 2.3 Frame work of Industrial Economics

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The link between market structure, conduct and performance gives us the basic
framework for the study of the economic behavior of the firms and industry in the
market. The solid arrows in figure 1.3 indicate flows that are primarily causal in the
model, resulting ultimately in some observable market performance. As the dotted
arrows, however, some secondary and feed back flows are also involved.

The basic framework as we have argued above is shown in the flow-diagram (Figure1.3).
At the top there are a set of environmental and market variables or determinants which
influence the market structure and market conduct directly. The market structure block in
the diagram contains factors such as concentration, diversification vertical integration,
barriers, etc., as defined earlier. Similarly, the other two blocks showing market conduct
and market performance shows their respective elements. The major concern of studies in
the field of market structure, conduct and performance is to develop the capability to
predict market performance, based on observations of fundamental market and
environmental condition, market structure and conduct, or on some contemplated and
controllable changes in these factors. The task of industrial economics is to find how
strong these linkages are. Once this is known, the next step would be to use them
independently or jointly in a model form for policy purposes. Say, suppose the goal is
profit maximization, then we have to take the appropriate linkages between the blocks as
constraints or strategies for this and solve the model. One can derive many operational
models from this simple suggestive framework of industrial economics. The model, its
size, etc., would be depending on the purpose of analysis. A model may be developed just
using the deductive reasoning but its operational validity can be established only when its
structural hypotheses or end results are testable using empirical data. This is what we
have to do in industrial economics.

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