No.

THEORETICAL FOUNDATIONS OF COMPETITION POLICY：

LOGIC AND APPLICATIONS OF INDUSTRIAL ORGANIZATION ECONOMICS

Purpose and Guideline of the Program

1. Economic Development and Competition: Entrepreneurship and

Industrial Organization

2. From Micro Economics to Industrial Organization Economics: Logic,

Concepts, and Limits

3. Development of Industrial Organization Economics: Diversity

4. From Industrial Organization Economics to the Theory of Competition

Policy: Micro Economic Policy

5. Economic Development and Competition Policy

【Starting Questions】
1. What kind of image do you have on the inter-firm competition in Japanese
industries? Which is better, ”Japan INC.” ( the closed and cooperative relationships
between firms and government, and between firms) or “Japan: the land of fierce
competition”? Or another one?

2. Explain why Sony has obtained its dominant position in the game machine market.

3. Are new principles and laws needed to deal with the new network-externality-based
monopolies ? And also new economic approach ?

4. Do you agree with Porter’s argument that

“Few roles of government are more important to the upgrading of an economy
than ensuring vigorous rivalry"
---- M. Porter, 1990, The Competitive Advantage of Nations, Free Press, p.662.

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 Chapter 1 Economic Development and Competition: Entrepreneurship and
Industrial Organization Economics

1. Market Economy, Entrepreneurship and Economic Development

Major players in a developing or transitional economy should be entrepreneurial

firms. Entrepreneurial activity is closely related to competition in many contexts,
although the former is not the same thing as the latter. It is because;
(1) Competition or competitive behavior entails entrepreneurship of some kind, and
(2) Entrepreneurial activity induces competition.

2. Preserving Rewards and Fostering Opportunities for Entrepreneurship

Economic development requires institutions which preserve rewards from

entrepreneurial activity, and foster its opportunities. For example, legal and
regulatory systems, taxation system, contract system, competition system, fair and
speedy system for resolving disputes among parties, and so on. If sufficient
frameworks do not work, then entrepreneurs can not have access to markets,
due to institutional barriers or foreclosures.

3. Entrepreneurship and Industrial Organization Economics

As suggested, competition policy is necessary for promoting entrepreneurship.

Thus, for example, entrepreneurship, competition, access (entry, growth) and foreclosure
referred to earlier, are critical organizing ideas for competition policies in developing
and transitional economies. These words are standard concepts of industrial organization
economics.
Therefore, now turn to the industrial (organization) economics.

Discussion:
(1) What are the possible determinants of entrepreneurship ?
Strategy and Incentives of the firm
↓ ↑

Entrepreneurial Response → Innovation → Value Added → Economic Development

↑ ↓
Competitive Market Conditions

Chapter 2 From Micro Economics to Industrial Organization Economics:

Why the Industrial Organization Economics ?
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 Industrial organization economics is the field which combines microeconomics
and the investigation of real-world industries.

I. Explanation in Standard Economics Textbook

Standard economics (microeconomics) textbooks explain the following theory.

market structure pricing results

Perfect competition price＝average costs profits＝0

(many sellers & buyers) average costs＝minimum

Oligopoly price＞average costs profits＞0

(a few sellers) average costs≧minimum

Monopoly price＞average costs profits＞0

(single seller) (monopoly price＞ average costs≧minimum

oligopoly price)
(Note: monopolistic competition is not referred to; marginal costs = average costs)

The explanation has 3 implications;

(1) An industry can be captured by three aspects or dimensions:

environment facing firms, behavior of firms and its results. The first aspect is called
market structure, the second market behavior, and the third market performance.

(2) Also, market structure affects market behavior, and its results are captured by
market performance; market structure(S) → conduct/behavior(C) → performance(P).

(3) Oligopoly may induce an unique or a limited scope of firm behavior and
performance.
↓
Industrial (Organization) Economics
(applied microeconomics; policy-oriented field)
↑

↑
II. Diversified, Complicated and Dynamic Industries in a Real-World Economy
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 (1) Real world oligopoly is not a simple structure, and includes diversified
industries like competitive and near-monopoly industries. It is expected
that different structures of oligopoly are likely to lead to different firm
behavior and performance.

(2) Market structure, behavior and performance respectively include more elements.
For example, market structure involves more competitive elements as well as
number and size distribution of firms; Also business behavior includes non-price
strategies such as R&D, advertising, M&A as well as price-output decision.

(3) Public policy authority is necessary to look at actual industries, of which the firm
behavior and performance are beyond the explanations of the economics textbooks.

Discussion：

(1) Explain pricing decision in three types of market structure graphically.

III Economic Efficiency: Why the Competitive Economic System ?

The public understand intuitively that an industry with (1) the possible minimum level
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of prices, and (2) of costs, and (3) an increasing number of development of new products
and processes is socially desirable from the viewpoint of public interest; They enjoy a
cheaper and better-quality product or service. The first condition is concerned with
allocative efficiency in economics term; the second with technical efficiency (X-efficiency),
and; the third with technological progress efficiency (or dynamic efficiency). These 3
concepts of efficiency are called collectively economic efficiency.
↓
The economic efficiency is improved by the decentralized,
competitive and entrepreneurial economic system.
↓
The primary goal of policy-makers is to create and preserve
the system, which leads to improved economic efficiency.
▼

▼
The industrial organization economics present and emphasize the logic of the process
in a theoretical and empirical way, using the concept of economic efficiency.

Discussion:

(1) Explain the three concepts of efficiency using graphical techniques.

(2) Show the best market performance of an industry graphically.

Chapter 3 Development of Industrial Organization Economics:

Industrial Organization Economics Explained (1)

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 I. Basic Concepts: Market Structure, Market Behavior and Market Performance

(1) Market structure: the relatively long-run and stable elements of the environment
of a firm, which affect market behavior.
Two types of structural elements are;
1) strategic in that firms can influence structural elements; concentration, entry
and mobility barriers, product differentiation, international competition.
2) exogenous in that elements are beyond the control of firms. The elements are
sometimes called basic conditions, separated from strategic elements; demand
growth, price elasticity of demand, product durability, legal framework, and
cost structure (the extent of fixed costs).

(2) Market Behavior: Firm behavior in an industry. It includes: pricing, sales

promotion, input and cost control, and R&D activity, and also their intra-industry
coordination. Also, mergers and investment are included.
Two types of behavior are;
1) passive in that firms behave passively under a given structure;
behavior → performance.
2) strategic in that firms affect market structure (strategic structural elements) to
gain performance favorable to themselves; behavior → structure / performance.
ex. mergers, predatory pricings

(3) Market Performance: the results of market behavior. The results include; profits
(for pricing), sales promotion costs (for sales promotion activity), productive
efficiency (for input and cost control), and R&D (for R&D activity). An
industry's performance elements reflect the extent of allocative efficiency, technical
efficiency(cost efficiency), and technological progress efficiency.
Effective competition or effectively competitive performance includes:
1) greater allocative and technical efficiency
2) sales promotion expenses kept to reasonable level
3) being responsive to possibilities for improving products and processes
4) that profits should be sufficient to reward investment and encourage innovation
▼

▼
These concepts permit economists and policymakers to analyze the
determinants of firm behavior and the results in an industry, and then
evaluate the industry, and further propose remedies when necessary.

II. Relationships among 3 basic concepts and public policy.

(1) SCP Economics ( Harvard )

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 Basic
Conditions
↓ ←→ Behavior ←→ Performance → Public Policy
Structure
(narrow)

Structure
(broad)

If economists and policymakers evaluate the performance to be socially undesirable

from the viewpoint of economic efficiency, then they propose public actions (public
policy), examining the sources of poor performance. Then, the policies may affect
directly market structure as well as behavior; policies toward behavior are concerned
with cartels and restrictive practices, and competition-promoting policies toward structure
with anti-merger and divestiture.
▼

▼
The industrial organization economics explains the structure-behavior-performance
relationships in a theoretical and empirical way, and then proposes public policies.

(2) Alternative Approaches: SCP Economics(Harvard) Vs. Chicago/Austrian School

Two views on the effect of competition/market power

S-C-P SCP Economics Chicago School
Concentration unreasonable level efficient level
Product
differentiation large not large
Pricing collusive reasonable
Profits market power(collusion) technical efficiency
disequilibrium state (temporary)
robust competition
Advertising persuasive informative
product differentiation
Technical X-inefficient X-efficient
Efficiency
R&D the quiet life hypothesis Schumpeterian hypothesis

(3) New Development of Industrial Organization Economics

1) Theoretical (in particular Game-theoretic) IO economics:

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 suggests various patterns of market behavior in oligopoly (from collusion
to rivalry), consistent with Porter’s strategic competition theory.
2) New Empirical IO (NEIO):
analyzes an industry econometrically (case study), providing new evidence
supporting market power; yes for the Harvard School, and no for the
Chicago School.

→ The rule of reason is better than the per se legal or illegal principle.

→ larger significance of economic analyses in competition policy enforcement

A Spectrum of the Degree of Confidence in Market Competition

Highest - Austrian School

↑ - Contestability Theory
- Chicago School (no policy except for cartel and big mergers)
- Game-theoretic School (New IO, → NEIO) → ”Rule of Reason”

- Strategic Competition Theory (M. Porter) → ”Rule of Reason”

Lower - Harvard School (Orthodox, Sophisticated) Neo Harvard, Post-Chicago

Discussion:

(1) Explain each of the schools.

III The Structure-Behavior-Performance Relationships Observed

(1) Shown is the summary of the determinants of behavior and performance in Japan,
which are from existing studies.
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 Evidence 1 Summary of Determinants of Behavior / Performance in Japan

Factors Profit Rate Price Change Costs

Concentration ＋ ＋ ＋

Mobility − −

Market Share ＋

Absolute Firm Size* ＋

Advertising ＋

Exports ＋ & − −(when stronger yen)

Imports − −

Tariff ＋

Buyer Concentration −

Consumer Goods* ＋

Distribution Network ＋

Firm Groupings ×(no effect)

Note: (1) ＋（or −）suggests that industries or firms with larger ratio of a determinant
tend to gain higher (or lower) profit rate, price change and costs than industries
or firms with smaller ratio. All factors except absolute firm size and consumer
goods are in percentage.
(2) Costs include; wages, and sales promotion and administrative expenses.

Discussion:

(1) Explain the effects of determinants listed above.

Evidence 2:
Concentration, Firm Size and Number of Innovations in the US; 1970-78

4-firm Number of Major Innovations for;

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concentration Small firms Large firms Totals
(CR4) (＜500 employees) (≧500 employees)

0＜CR4≦20 49( 21.7%) 63( 18.7%) 112( 19.9%)

20＜ ≦40 98( 43.4) 125( 37.1) 223( 39.6)

40＜ ≦60 67( 29.6) 104( 30.9) 171( 30.4)

60＜ ≦80 9( 4.0) 38( 11.3) 47( 8.3)

80＜ ≦100 3( 1.3) 7( 2.0) 10( 1.8)

Totals 226(100.0) 337(100.0) 563(100.0)
(40.1) (59.9) (100.0)
Source; Gellman Research Associates, 1982, The Relationship between
Concentration, Firm Size and Technological Innovations.

Discussion:

(1) Explain the relationship between innovations and market structure.

IV Remarks on Policy Implications

The IO economics may provide a theoretical and empirical foundation for

competition policy. Therefore, it is necessary and useful to examine market structure,
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behavior and performance, and their interrelationships in an industry.
However, it has two important reservations.
(1) the SCP economics never indicates that high concentration always and uniquely leads
to collusion. The economics prepares policy menu for preventing collusion or market
power, and proposes the proper one, when necessary.
(3) alternative approaches like the Chicago and the Austrian Schools suggest significant
insights, as well; real-world competition includes multi-vectored (multi-dimensional)
and dynamic aspects. No doubt, as the Chicago School suggests, there are many
factors which are likely to affect competition in an industry. It is necessary to
examine the S-C-P relations and policy proposals, taking into account those aspects.
It is possible that those factors are successfully introduced within the framework of
the SCP economics. In fact, market structure has been redefined and broadened to
include the new learnings and the suggestions of alternative approaches.
Thus, the IO economics takes into account many factors affecting competition, and
can propose public policy to realize effective competition. Public policy includes various
policies toward industries such as international economic policy and regulation /
deregulation as well as antimonopoly policy. There should be consistency among these
policies.
Also, policy energy in a country is usually limited. Therefore, it is necessary to
select industries which have larger social costs, and then allocate energy to those
industries in a preferential way. The IO economics plays an important role for the
allocation.

Chapter 4 Development of Industrial Organization Economics:

Industrial Organization Economics Explained (2)

I Economic Analyses of Major Monopoly Problems

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 What kind of problems do the current issues suggest ?；
How do you evaluate and solve those problems as a policy officer ?
(1) Market Structure: Evolutionary, Global
1) Flexible Production and Network Externality
2) Dominant Firm Oligopoly: Performance and Public Policy

(2) Market Behavior: Dynamic, Multi-vectored, Co-ordinated, Unilateral

1) Mergers & Acquisitions (M&A)
2) Cartels
3) Strategic Behavior: Predatory
4) Vertical Restraints (VRs): SCM may have the effects of VRs ?

(3) Market Performance

1) 3 types of welfare trade-offs ? :
1) Static Trade-off: Market Power vs. Cost Efficiency (O.E. Williamson)
2) Dynamic Trade-off: Market Power vs. Innovation (M.E. Porter)
3) Network Externality and Trade-off: Market Power vs. Consumer Utility /
Cost Efficiency

II Corporate Governance and Competition Policy

Question: Please explain your view on the argument that
“ Because large firms are struggling to survive under the pressures from

shareholders, the public emphasis is from competition policy to corporate

governance, and the latter is an effective substitute for the former.”

III Competition Policy and Consumer Protection Policy : Micro-Economic Policy

Chapter 5 Economic Development and Competition Policy

→ Please discuss this problem、referring to private firms, entrepreneurship,
industrial policy, small and medium-sized business.

(1) How evaluate the role of “industrial policy” in Japanese economic development ?
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(2) Economists are divergent in the evaluations for “industrial policy”. Most of
economists criticize the policy, because the policy is not justified by the market
failure theory. But, some economists such as Cowling (UK) emphasize the
significance of the policy in economic development, since the policy includes
development strategy: better allocation of limited economic resources into targets.

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No.2

THEORETICAL FOUNDATIONS OF COMPETITION POLICY：

LOGIC AND APPLICATIONS OF INDUSTRIAL ORGANIZATION ECONOMICS

“Few roles of government are more important to the upgrading of an economy

than ensuring vigorous rivalry"

− M. Porter, 1990, The Competitive Advantage of Nations, Free Press, p.662−

Introduction: Market Economy and Economic Efficiency

The importance of decentralized, competitive and entrepreneurial economic system is increasing

throughout the world. Why ? The system is likely to provide greater economic efficiency. Economic
efficiency includes three sub-concepts; (1) allocative efficiency [★], (2) technical efficiency, and (3)
technological progress efficiency (also called dynamic efficiency).
Economists and policymakers, studying the behavior and performance of an economy, concern themselves
about many features of industries and firms. For it is the behavior of those industries and firms that
profoundly influences the extent to which desirable goals for the economy are achieved. Then, our primary
goal is improving economic efficiency. To look at the influences, they examine firm behavior and its results
in a market. The sellers participating in a given market are called collectively industry.
Therefore, industrial economics deals with the ways in which the organization of these sellers in an
industry affects the performance of the industry and then the nation's economic welfare. The industrial
economics is the investigation of real-world industries, which is often called industrial organization (hereafter
IO economics).
Micro economics, a major branch of economics, deals with markets and industries. It suggests that
structure of an industry (like perfect competition, monopolistic competition, oligopoly and monopoly) affects
the price-output decision, which in turn determines profits. Therefore, it suggests the concepts of structure,
behavior and performance as an analytical framework. But, real-world industries have much more diverse,
complicated and dynamic aspects. The field which combines the investigation of real-world industries
and micro economics is IO. Thus, IO economics investigates real-world industries, using the basic concepts
of structure, behavior and performance, within the framework of micro economics.

[★] Economic resources (i.e., factors of production =land, labor, capital, information / knowledge, and
entrepreneurial talent) should go into industries where people value the output more than others.

Part I Basic Framework for Analyzing Market Economy

I Definition of an Industry

Before discussing IO economics, we will refer to the definition of industry used in IO economics.
Where an industry's boundary should be drawn is of crucial importance for both economists and policy
makers, because the efinition of an industry may affect the evaluation of the performance of a particular
industry. In principle, the economists' concept of an industry corresponds to the way we speak of industries in
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everyday life.
However, there are some difficulties in the definition for the empirical research and/or policy-making.
They come from boundaries between products, and also boundaries in geographical spaces. SIC 4-digit
industry is usually used. The 4-digit industry means, for example products like Whisky, motor vehicle and
watch.

II The Structure-Conduct-Performance Approach Explained

Next, we will discuss the essence of IO economics. It is above suggested that the activity and function
of an industry is captured by the concepts of market structure, conduct (or behavior) and performance.
The structure-conduct-performance (SCP) approach (hereafter we call the approach SCP economics) is
central to the study of IO. It was formulated from both microeconomics and earlier empirical works, and
has been used to provide the theoretical justification for competition policy. The SCP economics may be
the orthodoxor first-runner economics of IO, which introduces new developments. But, the economics has
received many criticisms, reflecting its shortcomings. In these senses, the economics is worth being discussed
first.
The approach postulates causal relationships between the structure of a market (called market structure),
the behavior of firms in the market (called market conduct or behavior), and the industry's economic
performance (called market performance); performance is determined by the behavior of firms, which in
turn is determined by structural characteristics of the market. When the performance is against the public
interest, public actions designed to improve the performance are proposed. The actions may influence directly the
structure of particular industries as well as market behavior. The relationships are shown in Figure 1.
Market structure (broad) here includes both basic conditions and structure (narrow).

Figure 1 SCP Economics

Structure(broad)
Basic
Conditions
↓
Structure ←→ Behavior ←→ Performance → Public Policy
(narrow)

However, market structure is not always exogenously determined. Performance and conduct may affect
structure.If firms do not satisfy performance, they may affect structure to gain performance favorable to
themselves. For example, mergers, predatory behavior, innovation and advertising may influence structure.
Therefore, structure is defined as the relatively long-run and stable elements of the environment of a firm,
which affect market behavior.
Now, the three basic concepts will be talked about in turn.

III Market Structure as the Key Determinant of Firm Behavior

Market structure (broad) describes the characteristics of a market such as; (1) the number and size
distribution of sellers and buyers, (2) nature of product, (3) ease of entry and exit (collectively called
narrow structure), and (4) demand / supply conditions exogenous or external to firms (sometimes called
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basic conditions).
These structural factors will be explained in turn. The first factor is concentration ratio.

(1) Market Concentration Ratio

1) Measurement
As the number of firms in an industry decreases, recognized interdependence among firms[★1]
Increases. And the probability of successful collusion - implicit or explicit - likewise increases. Also, the
greater the size skewness, the more likely it is that collusion is successful, since large firms can impose their
will on smaller firms.
The number and size distribution of sellers and buyers are captured by concentration ratio. The ratio is
usually measured by (1) cumulative ratio and (2) Herfindahl index; the former is ＣＲn＝ΣSi (i=1,..,n)

for a fixed number of the largest firms、and the latter is Ｈ＝Σ(Si)２ (i=1,..,m) for all firms, where Si is
market share of firm i. The two measures are used by Japan Fair Trade Commission.
Then, firms include foreign firms (importers and foreign-affiliated firms) as well as domestic firms. If
exports and / or imports are large, then the level of concentration ratio may be different between before and after
adjustment of international trade; The ratio based on output may be different from the ratio based on shipments in
a domestic market.
Both of the measures have qualifications. But, the latter is better than the former, since the latter can
capture both the number and size distribution of firms in an industry. Also, concentration is a static indicator,
which can not capture market mobility- changes in firms’ market positions and shares.
Finally, oligopoly may include some patterns like symmetrical and asymmetrical oligopolies; Many of
Very highly-concentrated oligopolies are frequently “dominant firm oligopoly”.

《Problem #1》
What are qualifications of cumulative ratio and Herfindahl index ?

2) Concentration Is Justified By Economies of Scale and Innovation?

There is a debate over whether high concentration is justified by technical efficiency like economies of
scale, learning effect and innovation. Also, the importance of scale economy in demand side, which is called
network externality, is receiving increasing interest; virtual and real networks. Industries with network
externality tend to be more concentrated; electronics and information industries. The externality raises new
interesting problems.
The SCP economics argues that current concentration is beyond the reasonable level justified by
economies of scale, offering the evidence of minimum optimal size in major industries [★2]. Rather, in
particular brand loyaltyor preferences for leading firms are emphasized as an important determinant.
On the other hand, some economists (the Chicago School) indicate that high concentration is sufficiently
justified by economies of scale. But, this discussion is not supported by empirical evidence.

(2) Product Differentiation - Nature of Product and Brand -

Consumers often have strong preferences for some products that have been promoted for long periods.
In Japan, it is said that many consumers may have strong preferences for particular firms and products.
The preferences or brand loyalty are called product differentiation. Firms with strong buyer preferencehave
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advantages over firms with weaker preference, and thereby in turn can increase their market shares, and also set
higher prices, because there are less brand switching away from them to rivals. This was found in Japanese piano
industry; There was a definite difference in price of the same type of piano between the top and second
firms.
The extent of product differentiation is usually measured by advertising expenses/sales ratio as a proxy,
since preferences are based on the accumulated effects of promotion like advertising, and the ratio is easily
available. The ratio may affect firm behavior.

(3) Entry and Intra-industry Mobility Barriers: Ease of Mobility

Collusion can succeed only when significant entry barriers are present. Entry barriers deter potential
competition (potential pressure from possible entry). The barriers include; (1) economies of scale in various
stages, (2) product differentiation, (3) absolute cost advantages, and (4) sunk costs. These factors may force
potential entrants to have disadvantages against incumbents (i.e., existing firms), which deter the decision to
enter; when an entrant predicts that post-entry price ≦ post-entry unit costs (i.e., post-entry profits ≦ 0 ),
he gives up the undertaking.
Now, these barriers will be explained in turn.
First, large economies of scale are likely to induce cost disadvantages or price reduction facing entrants.
There are two cases where post-entry profits are not positive in an industry. If the operation size of an
entrant is below the optimum or efficient size, then he will incur higher cost than incumbents' level. Also,
if the production size of an entrant is the optimum size, then he has no cost disadvantage, but he incurs
greater price reduction induced by his entry. If before entry, a firm can predict non-positive post-entry profits
which result from either of the two cases, then he will not decide to enter the industry.
Second, entrants can not gain sufficient share which leads to efficient production, due to product
differentiation, or they must incur greater sales promotion costs to overcome existing preferences. Then,
entrants are at a cost disadvantage. Also, entrants may have a disadvantage against incumbents, due to
network externality. Third, incumbents have cost advantages over entrants, which result from some source
s;exclusive ownership of scarce resources; patents; access to capital market at lower interest rates; control
offavored distributive outlets; learning effect. These advantages may deter potential entrants.
Finally, sunk costs are costs which once spent are no longer recoverable. For example, suppose
Machinery which costs Ｋo when new, but which has a resale or scrap value of only Ｋ, as soon as it has
been installed. In this case, Ｋo -Ｋ is sunk costs. Large sunk costs result from peculiarity of assets. If
sunk costs are large, then firms may incur larger disadvantages when they exit, and therefore do not decide
to enter. In other words, if sunk costs are zero or small, then firms can enter, with no fear of damages due
to exit.
However, the above explanations are static. If industry demand expands, or technological innovations take
place, then actual entries may occur. If possible, please show the cases in graph.
Also, these advantages suggest that among existing firms in an industry, large firms are likely to have
advantages over smaller firms. Therefore, these are the factors which determine the level of concentration and
its change. These elements are called intra-industry mobility barriers, which deter the growth of smaller
firms in an industry. When the barriers are high, large firms can set higher prices with no fear of the
aggressive reaction of smaller firms.

(4) Basic Conditions

These elements of market structure are strategic in that firms can influence these structural elements.
Structure which affects behavior includes the exogenous elements beyond the control of firms. They are
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sometimes called basic conditions, separated from strategic elements (in this lecture structure includes both
the elements); demand growth, price elasticity of demand, product durability, legal framework, and cost
structure (the extent of fixed costs). These factors affect firm behavior.

(5) International Competition - Foreign Trade and Direct Investment-

Firm behavior may be affected not only by the factors referred to above, but also by other structural
factors. The primary factor is international competition. One of the major development in modern
economies is the global shift. No doubt, the shift affects industrial organization.
Foreign trade and foreign direct investment affect competition in domestic and foreign markets. Also,
world oligopolies are increasing, which raises an important international policy issue.
Imports and inward direct investment (entry of foreign-affiliated subsidiaries), as many empirical works
suggest, are likely to have a competition-promoting effect. Those behaviors mean new entry. But, it is
worth noting that their effects are not significant enough to offset domestic market power. One of the
interesting characteristics in Japanese industry is that in general the presence of foreign-affiliated firms is small,
though increasing in recent years.
On the other hand, the effect of exports varies, depending on other conditions like exchange rate and
trade barriers. In fact, in Japan, during 1970s, exports led to higher profit rates, but after large yen
appreciation, exports led to lower profit rates. Also, there is no clear-cut theoretical and empirical consistency
for outward investment.

[★1] Recognized interdependence means the following relation. Firms do not take aggressive actions,
expecting counter-actions from their rivals and resultant damages, since Ｐ＝Ｐ（Ｐr）＝Ｐ｛Ｐr（Ｐ）｝,
where Ｐ is price of a firm, and Ｐr price of its rivals; Ｐ→Ｐr→Ｐ.
[★2] As output increases, unit costs decrease. This relationship is called economies of scale. The lowest
level of unit costs is called minimum optimal size. Also, as output increases, firms may improve
manufacturing and administrative processes under a fixed technology. The latter case is called
learning by doing or experience effect. Thus, firms with larger output are more efficient and
therefore gain larger share

IV Market Behavior

Firm behavior includes: pricing, sales promotion, input and cost control, R&D activity, and mergers
& acquisitions (M&A). These behaviors may be affected by market structure discussed above. Firm
behavior in concentrated industries is likely to be different from counterparts in less-concentrated industries.
First, firms, and in particular large firms, because of recognized interdependence and the presence of entry
and intra-industry mobility barriers, may engage in either implicit or explicit collusion. The collusion results
in anti-competitive pricing, which are set above costs. The level of price is set by anti-competitive and
discretionary principles like the target profit pricing [★], and is coordinated among firms in a collusive way
; cartels and implicit mutual understandings. In Japan, there were many illegal cartels. For example, in
Japanese photo film industry with only 3 firms, price leader set price, and other 2 firms followed the same
price. This example is a case of implicit mutual understandings.
Second, when price competition is restricted, non-price competition like advertising may take place in
Consumer goods. Advertising competition may be excessive and wasteful. These strategies may affect
market structure, promoting buyer preferences for large firms. Also, vertical restraints such as RPM and
distributional keiretsu, may be adopted, which are likely to exert anti-competitive effects. Supply chain
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management (SCM) may have anti-competitive aspect, because the practice is similar to vertical restraints.
Third, as competitive pressures to minimize costs are reduced, managerial slack may develop, permitting
less-efficient operations and associated higher costs and (probably) higher prices. The slack also may lead to
delayed R&D-activity.
Also, firm behavior may be affected by other factors. Firm behavior may vary between
vertically-integrated and non-integrated firms, and also between diversified firms and non- or less diversified
firms.

[★] The target profit pricing is like this;

Ｐ＝ＡＣ＋｛Ｋ／Ｑf｝・｛Π／Ｋ｝／｛Ｑ／Ｑf｝
where P is price, AC average costs, K capital, Ｑf output at the full operation rate, Π profits, Q
preferred output. Π／K is target profit rate (which is strategically determined), K／Ｑf
capital-output ratio (which is technologically given), and Ｑ／Ｑf operation ratio (which is
strategically selected).
This pricing practice is said to be prevalent among large oligopolists. Firms with market power
can set higher target profit rate, and therefore higher price in a discretionary way. The level is
recognized as a reference price through explicit or implicit coordination among firms such as cartels
and implicit mutual understandings. Target profit rate is likely to be affected by the degree of
competition and therefore market structure.

V Market Performance

The results of market behavior is called collectively industry performance. The results include; profits,
sales promotion costs, production efficiency, and R&D. An industry's performance is normally judged on the
basis of allocative efficiency, technical efficiency (X-efficiency), and technological progress efficiency.
The SCP economics argues that structure elements like high concentration, large product differentiation,
and high entry barriers is likely to induce very poor performance; high profits, higher production costs than
the minimum possible level, excessive advertising, and sub-optimal level of R&D. If an industry has these
results in the long-run, then economists and policy makers evaluate the performance to be socially undesirable
from the viewpoint of economic efficiency, and then propose public actions (public policy), examining the
sources of poor performance. Then, the policies may affect directly market structure as well as behavior;
policies toward behavior are concerned with cartels and restrictive practices, and competition-promoting
policies toward structure with anti-merger and divestiture.

《Problem #2》
The great economist Adam Smith indicates the following sentence (partly revised) in The Wealth of
Nations (1776); "Monopoly is a great enemy to good management, while free and universal
competition forces everybody to have resources to it for the sake of self-defence". Explain the
implication of this sentence
.

Part II Competition, Market Power and Economic Efficiency

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VI Empirical Tests of the SCP Economics

Next, we will look at the empirical tests of the relations suggested by the SCP economics. The tests
have been tried by individual industry studies and cross-industry econometric studies.
All economists do not provide support for the SCP economics. In particular, the Chicago School
economists suggest an alternative view on competition; "Competition is robust". This stance is supported
by the Austrian School and the contestability theory. The two approaches are summarized in Figure 2.
The better approach, an eclectic one, includes both the views; Oligopolists sometimes engage in
collusion, and sometimes compete fiercely for their advantages. This stance is shared by the strategic
competition theory and the game-theoretic theory.

(1) Profit Analyses: Allocative Efficiency

1) Empirical results

Figure 2 Two views on the effect of competition/market power

S-C-P SCP Economics Chicago School
Concentration unreasonable level efficient level
through product differentiation
Pricing collusive reasonable
Profits market power(collusion) technical efficiency
disequilibrium state
robust competition
Advertising persuasive informative
product differentiation
Technical efficiency X-inefficient X-efficient
R&D the quiet life hypothesis Schumpeterian hypothesis

The first test is about profit rate. Profits are a primary problem, since they may reflect the extent of
allocative efficiency. In free and competitive markets, capital moves in and out of industries, following the
inter-industry differentials in profitability. As a consequence, resources are allocated efficiently among
industries, increasing social welfare. Resources move away from industries with low profit rate to industries
with higher profit. As a consequence, profit rate tends to reach the competitive level. High abnormal profits
in an industry may suggest that the resource allocation mechanism works imperfectly.
It is necessary to examine the profits-pricing-structure relation. But, most of the existing analyses have
tested the short-circuited version of the relationship, i.e., the association between profits and structure. The
pioneering study is the simple analyses by Bain (US) and Matsushiro (Japan), which are shown in Table １.

Table 1 Concentration and Rate of Return on Equity: US and Japanese Manufacturing

US: Bain Study Japan: Matsushiro
1936-40 Period 1960-65
…………………………………………………………………………………………………………………………
Top 8 firms Concentration Ratio Top 3 firms
Average Rate No. of Industry Concentration Class Average Rate No. of Industry
12.7 % 8 90-100 % 12.6 % 8
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 10.5 11 80-89.9 15.5 3
16.3 3 70-79.9 9.3 2
5.8 5 60-69.9 10.9 3
5.8 4 50-59.9 9.8 6
3.8 2 40-49.9 7.4 7
6.3 5 30-39.9 7.3 6
10.4 2 20-29.9 0.7 2
17.0 1 10-10.9 − −
9.1 1 0-9.9 − −

Source: Bain, J.S., 1951, “Relations of Profit Rates to Industry Concentration: American Manufacturing, 1936-
1940,” Quarterly Journal of Economics, Vol.65, No.3, p.313
Matsushiro, K, 1970, “Industry Concenration and Profit Rate in Japan: 1961-1965,” Sanken Ronshu,
Vol.1, p.51.

The table shows that there is a positive correlation between the two variables, supporting the effect of
market power in concentrated industries. But, the analyses have some qualifications; (1) the sample has small
size and May include biased selection; (2) although there are some possible determinants of profits, the analys
is does not take into account other factors (see Problem # 3); (3) the time period examined may involve a
disequilibrium state, not an equilibrium state assumed in the micro economics.
Sophisticated econometric analyses have examined the association, using larger number of industries,
multi-variables, and different time periods. The findings show that; (1) there is still a significant, positive
correlation between seller concentration and profits across industries; (2) larger mobility tends to lead to
more competitive pricing and profits, (3) there are wider inter-firm differentials in profit rate for concentrated
industries than for less concentrated industries; (4) product differentiation(+), entry barriers(+), international
competition(+,−), buyer concentration(−), distributive outlets (+) have a significant influence on profits
respectively. Also, tariffs(+) have a positive effect on profit rate, implying restricted import competition due
to tariffs.
Furthermore, there is a positive relationship between market share and profit rate cross firms. The
finding suggests that large firms have market power due to intra-industry mobility barriers, relative to smaller
firms.
The relations between profit rate and its possible determinants observed in Japan are summarized in
Table 2.

Table 2 Summary of Determinants of Performance in Japan, from Existing Studies

Factors Profit Rate Price Change Costs

Concentration ＋ ＋ ＋
Mobility − −
Market Share ＋
Absolute Firm Size* ＋
Advertising ＋
Exports ＋& − −(when stronger yen)
Imports − −
Tariff ＋
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Buyer Concentration −
Consumer Goods* ＋
Distribution Network ＋
Firm Groupings ×(no effect)
Note: (1) ＋（or −）suggests that industries or firms with larger ratio of a determinant tend to
gain higher (or lower) profit rate, price change and costs than industries or firms with
smaller ratio. All factors except absolute firm size and consumer goods are in percentage.
(2) Costs include; wages, and sales promotion and administrative expenses.

《Problem #3》
What kind of sources do high profits come from ?

2) Sources of High Profits - Market Power vs. Technical Efficiency -

The SCP economists conclude that the positive association between concentration and profits provides
Empirical support for the concentration→collusion→profits relation (the collusion hypothesis). But, Chicago
School economists question the direction of causality and the persistence of the relation throughout time.
First, economies of scale and innovation result in both high concentration and high technical efficiency, which
in turn lead to a positive correlation between concentration and profits. Therefore, high profits capture high
technical efficiency, not collusion.
Second, the positive association may imply that markets are in disequilibrium, and therefore is temporary,
not persistent throughout time.
Therefore, the positive relationship does not capture market power. Rather, the school concludes that
competition is robust. Thus, Ｓ−x→ Ｃ → Ｐ. Such reasoning is largely shared by the Austrian School.
The reasoning is summarized in Figure 3.
However, there are significant findings against the Chicago's interpretations; The actual levels of
concentration and profits are both beyond the extent of which the level can be explained by economies of
scale; high profits are persistent in the long run. Also, we can confirm the direct evidence of collusive
pricing; there has been found a positive association between concentration and un-competitive change in prices
(the capacity to control prices). Also, we frequently find the evidence of restrictive competition or market
power. For example look at the problem # 4. These findings provide significant support for the SCP
economics.

Figure 3 The Chicago School's Reasoning

Economies of scale / Innovation → concentration → robust competition

Economies of scale / Innovation → high technical efficiency → high profits

《Problem #4 》
We can find the speeches of company presidents in newspapers. Sometimes the speeches are
interesting from the viewpoint of IO economics. The president of a large firm told; "If price is raised,
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 then imports will increase. Now, it is difficult to stabilize prices in an artificial way." What are the
implications of his speech ?

(2) Technical or Cost Efficiency

Resources should be utilized efficiently within an industry. This aspect is concerned with efficiency
in the popular sense of producing output at the lowest possible cost; output should be produced by the most
efficient firms. It is an important work to identify technical inefficiency as social loss, and then examine
structural factors generating inefficiency.
Inefficient performance includes; (1) firms do not realize economies of scale（minimum optimal size); (2)
they have excessive idle capacities; (3) they incur higher manufacturing and administrative costs like high
wages and social expenses, which are induced by managerial slack and labor slack (this inefficiency is called
X-inefficiency).
Market power and limited competition may have a negative influence on technical efficiency; market
power and high prices may protect firms with suboptimal size, and also idle capacity; firms in a
concentrated industry are likely to be less cost-conscious, due to weaker competitive penalty.

《Problem #5》
In real world, a puzzling case may take place; economies of scale raise productive efficiency,
but enhance market power due to increased concentration. Concentration (for instance through mergers)
increases welfare (social benefits) by economies of scale, but reduces welfare by market power. This
case is called welfare trade-off. What kind of policy do you propose ?

(3) Sales Promotion Costs: Advertising

Advertising has two functions; (1) informative, and (2) persuasive. The former provides useful
information like the prices and quality of products for consumers, while the latter only increases brand loyalty
among consumers. The informative advertising is not a waste of resources, since consumers have to inform
themselves some how about the products or services offered in the market. If an industry spends too much
on persuasive advertising, then we will give it poor marks for performance.
The SCP economics argues that actual advertisings are beyond the level of informative type in some
industries, but the Chicagoans suggest that advertisings are all informative. But, many studies suggest that
brand loyalty is present among consumers, and that it has an influence on firm behavior like pricings, sales
promotion, new entry and the growth of small firms. However, it is difficult to determine empirically the
critical line between the two types of advertising. The effects of advertising are summarized in Figure 4.

Figure 4 Functions of Advertising

(1) Reducing information-collecting costs(search costs) by consumers→

increasing disposable income of consumers → increasing demand →
increasing social benefits (informative, quality-warranting function)
(2) Generating buyer loyalty for a particular brand → increasing share of firms with
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 Larger loyalty → increasing concentration → generating market power and
mobility barriers (persuasive function)

- persuasive ⇒ monopolistic pricing,

(unreasonable) higher entry barriers
higher mobility barriers
higher concentration
Advertising wasteful advertising
(IO economics is concerned with
this function)

- informative ⇒ reducing search costs

(reasonable)

(4) Technological Progress

In general, resources should be allocated to research and development (R&D) in sufficient quantity to
Generate the optimal rate of technological progress within an industry. We find general agreement that
market structure has some influence. The SCP economics suggests the quiet life hypothesis that market
power / concentration and the resultant high profits slow R&D activity, since firms prefer the quiet life to the
risky undertakings, and therefore concludes that strong incentives to innovate take place from competitive
pressure of rivals in less concentrated industries.
But, firms, and in particular large firms, in concentrated industries may be better placed to undertake
R&D activity than firms in less concentrated industries, since market power permits firms to recoup their
R&D expenditures, enjoy economies of scale in R&D, and bear risk. The argument is usually called the
Schumpeterian hypothesis.
The hypotheses have been examined, using some R&D measures; productivity, sales of new products,
the count of new major inventions, patent count, and R&D expenditures and staff. The findings are
divergent on the relationship between concentration/firm size and R&D. We have no easily-available findings
for Japanese industries. Therefore, findings observed in the US are shown. Table 3 shows the distribution
of major innovations during 1970-78 in the US, according to concentration and firm size.

Table 3 Concentration, Firm Size and Number of Innovations in the US; 1970-78

4-firm Number of Major Innovations for;

concentration Small firms Large firms Totals
(＜500 employees) (≧500 employees)
0＜ ≦20 49( 21.7%) 63( 18.7%) 112( 19.9%)
20＜ ≦40 98( 43.4) 125( 37.1) 223( 39.6)
40＜ ≦60 67( 29.6) 104( 30.9) 171( 30.4)
60＜ ≦80 9( 4.0) 38( 11.3) 47( 8.3)
80＜ ≦100 3( 1.3) 7( 2.0) 10( 1.8)
Totals 226(100.0) 337(100.0) 563(100.0)
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 (40.1) (59.9) (100.0)
Source; Gellman Research Associates, 1982, The Relationship between
Concentration, Firm Size and Technological Innovations.

The table suggests that there is an eclectic relationship (i.e., an inverted U-shape). Therefore, there is an
optimal concentration level or its range. Also, it is worth noting that smaller firms are responsible for larger
share of innovations. Now, the role of independent and vital smaller firms (which are called venture
business in Japan) in innovations is among the contemporary research interest. The recognition of small
business as an innovative and competition-promoting unit is of an importance for public policy.
Further theoretical and empirical studies are necessary, since technological opportunities change over time.

Part III Policy Implications

VI The SCP Economics and its Implications for Competition Policy

Finally, we will refer to policy implications of IO economics.

The SCP economics provides a theoretical and empirical foundation for industrial economics and
competition policy. Therefore, it is necessary and useful to examine market structure, behavior and
performance in an industry and cross-industry, and their interrelations.
However, it has two important and mutually-related reservations. First, the SCP economics never
indicates that high concentration always and uniquely leads to collusion. In other words, as econometric
methodology literally suggests, the relation between concentration and collusion is of probability, not unique.
The economics prepares policy menu for preventing collusion or market power, and proposes the proper one,
when collusion takes place.
Second, alternative approaches like the Chicago and the Austrian Schools suggest significant insights, as
well; real-world competition includes multi-vectored (multi-dimensional) and dynamic aspects. No doubt, as
the Chicago School suggests, there are many factors which are likely to affect competition in an industry. It
is necessary to examine the S-C-P relations and policy proposals, taking into account those aspects. It is
possible that those factors are successfully introduced within the framework of the SCP economics. In fact,
market structure has been redefined and broadened to include the new learning and the suggestions of
alternative approaches.
Also, there are structural elements which are specific to a particular country. For instance,
subcontracting and keiretsu network are Japan-specific. It is necessary to analyze them within the SCP
framework. Subcontracting and Keiretsu are related to vertical integration and diversification referred to,
because these Japan-specific elements are variations of them.
Thus, the SCP economics takes into account many factors affecting competition, and can propose public
Policies to realize effective competition or effectively-competitive performance. Effective competition or
effectively-competitive performance includes:
(1) larger productive (i.e., X-) and allocative efficiency
(2) sales promotion expenses kept to reasonable level
(3) responsive to possibilities for improving products and processes
(4) profits should be sufficient to reward investment and encourage innovation
Public policy or micro economic policy includes: competition policy, international economic policy,
regulation and consumer protection policy. There should be consistency among these policies.
Also, policy energy in a country is usually limited. Therefore, it is necessary to select industries which
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have larger welfare costs, and then allocate energy to those industries in a preferential way. One of the
ways to determine the priority is to calculate welfare costs (or loss) of an industry. Japan Fair Trade
Commission provides the list of the "target industries" which are candidates receiving policy actions, implicitly
reflecting such policy action.
Thus, we conclude that;
(1) IO economics may provide reasonable foundations for competition policy.
(2) IO economics does not always assume the unique causal relation, for example between
concentration and competition
(3) Also, IO economics does not necessarily assume that business practices which are indicated as
anti-competitive in the Anti-monopoly law may always have such effects.
(4) IO economics prepares proposals of possible public policies when competition restriction takes
place.
The staff of the US antitrust policy authority emphasized that the office as well as universities was at
the center of IO economics. The suggestion is reasonable. I hope that you are interested in the field and
will apply it to industries of your home countries.

(NOTE: My lecture will start, refering to the contents of this text, and then discuss higher level
of issues )

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