Contestable Market Theory: Its Impact on Industrial Organization, Lecture notes of Life Sciences

Download Contestable Market Theory: Its Impact on Industrial Organization and more Lecture notes Life Sciences in PDF only on Docsity! The Applied Research of Contestable Market Theory in the Development of the Theory of Industrial Organization Shan Chen School of Economics and Management Beijing Jiaotong University Beijing , China mm19530208@hotmail.com Abstract—With the theory of industrial organization continuing to mature, theory of contestable markets which was created in 1975, by analyzing perfectly contestable markets and the sunk cost, illustrated the question of the relationship between the size of the enterprise and the degree of competition. It makes industrial organization theory develop to some extent, and provides a new thinking way for the system reform. Keywords- the theory of industrial organization; theory of contestable markets; fully contestable marke; sunk costs. I. INTRODUCTION Industrial organization theory is an important part of modern economics, it is one of emerging applied economic theory used to analyze and study the economic operation under the conditions of market economy. Industrial organization theory is based on price theory. Through analyzing the relationship and contradiction of competition, monopoly and economies of scale among the Intra-industry enterprises in the development of modern market economy, it researches and explores their impact on efficiency of resource allocation within the industry, in order to provide a theoretical basis and measures for maintaining a reasonable market order and economically efficient. Up to 1980s, along with the advent of the theory of Contestable Market, which was proposed by W.J.Baumol, J.C.Panzar and R.D.Willing, industrial organization theory has been developed. II. DEFINITION OF INDUSTRIAL ORGANIZATION THEORY AND ITS DEVELOPMENT A. Definition of Industrial Organization Theory Industrial organization theory can be broadly defined as a kind of economic theory connected with the market ,which is not easy to be analyzed with the model of compete in the standard textbook. Industrial organization theory appeared in 1930s and has been developed in Western countries since then, it is a microscopic applied Economics. Its main object of study is market structure, market behavior, market performance and their internal relations in special industry to reveal the inherent regularity of the activities of industrial organization. Its aim is to provide decision-making basis for real economic activity participants and to provide policy recommendations for policy- makers. B. Development of Industrial Organization Theory The development of the economic theories is always linked to specific historical period. In the 15th and 16th centuries, Western Europe was in the late feudal society, this period was the era of pirate colonialism, in which the rise of mercantilism reflected the interests and requirements of the commercial and it played active role in rapid development of industry and commerce of Western Europe capitalism. From 17th century to the early 19th century, capitalism got rid of constraints from feudalism, at that time the theory of the division of labor and competition theory of Adam • Smith, who was the representative of classical economists, played a positive role in promoting the early development of capitalism. To the late 19th and early 20th century, the capitalism transited from free competition to monopoly capital period. During this period the monopoly has become a common phenomenon. In 1890, United States passed its first Anti- Monopoly law - the Sherman Act, the practice of anti- Monopoly provoked scholars’ debate about the pros and cons of monopolies. During late 19th century, neo-classical economics which representative is Marshall firstly gave a comprehensive exposition to so-called perfectly competitive market, noting that the monopoly will bring monopoly profits or the rising of equilibrium prices, which will impede optimal allocation of resources. However, they still considered that monopoly is just a temporary phenomenon in competition process; long-term main force to regulate the market equilibrium is still the invisible hand of the market mechanism. Until 1933, Chamberlain and Robinson respectively published "Imperfect competition economics" and "Theory of monopolistic competition", which studied monopolistic competition issues more deeply. In the theory of monopolistic competition, they put forward: Because of differentiation of product, in the real typical market structure there really is the monopolistic competition, not perfectly competitive. In market structure of monopolistic competition, firms have “market force” to determine the certain price, which can guarantee that long-term monopolistic profits is more than zero. Therefore, the International Conference on Global Economy, Commerce and Service Science (GECSS 2014) © 2014. The authors - Published by Atlantis Press 26 spontaneous role of market mechanisms alone is not enough to achieve the optimal allocation of resources, in this case the government must intervene the monopolistic power in order to ensure proper market competition. In 1938, Mason established industrial organization research group at Harvard University and proposed analysis system of the theory of industrial organization and its research directions. J.S. Bain in 1956 began to study the barriers of entry to the market, and in 1959 published "industrial organization ", in which he summarizes the existing research results and at first noted comprehensively and systematically theoretical system of the industrial organization, which marked the forming of the theory of industrial organization as a branch of economics; at the same year, economists Kaisen and jurists Turner co- published " Antitrust Policy" [1]. The theory of monopolistic competition sparked to think deeply about a series of practical problems. In studying and resolving these issues, theory of industrial organization was created and developed. The traditional industrial organization theory and new industrial organization theory The earliest theory of industrial organization was found in the related study by Harvard Mason professor and his disciples Bain (J. Bain). In 1959,in his first textbook about the theory of industrial organization "Industrial Organization "，Bain clearly explained the purpose and measure of research of industrial organization, implying that the Harvard School was officially formed. Harvard School used evidence- sectional analysis methods to derive that there is a one-way causal link between market structure, market behavior and market performance: concentration determines the level of the company's market behavior, in turn the latter determines the quality of performance of enterprise market. This is the analysis paradigm of the theory of industrial organization, namely "structure- conduct-performance " (in short SCP) . The original form of this paradigm is two phase paradigm of Bain (1956). The popular SCP syllogism paradigm in Modern mainstream industrial organization theory was what Scherer evolved on the basis of two phase paradigms of Bain. According to this analysis paradigm, highly concentrated enterprises of industry tend to raise prices and set obstacles in order to reap monopolistic profits, and impede technological progress resulting in inefficient resource configuration. To get a good market performance, the most important thing is to adjust and improve the irrational market structure through public policies, limiting the development of monopolistic power to maintain market moderate competition[2-4]. The forming of SCP paradigm marks the initial maturity of the system of industrial organization theory. However, in the subsequent development, the connotation of SCP analysis paradigm has changed greatly. In 1960s to 1970s, the U.S. economy in the international competition forces tended to decline, there was "stagflation" phenomenon in its economy, many researchers and analysts mainly attributed it to tough anti-monopoly policy proposed by Harvard School. From the late 1970s, Stigler (J. Stigler), representing the University of Chicago, attacked the views of Harvard School scholars and formed " Chicago School "in the theory of industrial organization. They proposed that the problem of industrial organization should be illustrated with the theory of perfect competition rather than the theory of monopolistic competition. Accordance with the theory of the scale of economy, the size of the enterprise’ scale economy will expand with rising of technological level; meanwhile the average cost will be constantly reduced. Therefore, as long as the expansion of business scale is consistent with the rising of technological level, that is necessary and reasonable. Thus they concluded that expansion of business scale not only does not cause waste of resources, but it will improve resource utilization efficiency because of the decrease of the average cost [5]. For the problem of relationship between enterprise scale and the degree of competition, they described it according to "contestable market theory". Contestable market theory thinks that as long as market entry is completely free, there will not be any special cost into and out of the market; the potential competitive pressures will force every company in market structure to adopt competitive behavior, even if a company fully monopolizes the market [6]. Meanwhile , as long as potential competitors enter and exit the market at that time fully accessibly , manufacturers available on the market - whether it is just a business or has many active vendors, always faced competition from potential entrants pressure .Thus in order to avoid attracting more competitors, pricing and yield selection of the original enterprise will always be forced to be in a " equilibrium constraints of no significant excess profits " ( Baumol, 1988).This is not like what the Harvard School said, namely that large firms can arbitrarily set prices and access high monopolistic profits. "Contestable market theory "describes that expansion of business scale or increasing of concentration does not mean the increasing of degree of monopoly and the declining of the degree of competition. On the basis of above two aspects of analysis, Chicago School proposed that when people judge whether a company is monopoly or not, they cannot judge it according to the level of concentration and the size of a business, and should still not implement tougher anti-monopoly policy without distinction to large enterprises. It states that the criterion should be what corporate performance is good or bad, and unnecessary controls of the large enterprises should be relaxed. Traditional research has been concerned about which policy measures were taken to prevent competitors from entering the market. After contestable market theory was proposed, more research has turned to the potential competition and market structure with accessible features, which to some extent improved the theory of industrial organization. III. CONTESTABLE MARKET THEORY In 1982, in the "Contestable Market and Industry structure theory ", Baumol, Panzar and Wiling systematically proposed the theory of contestable markets, marking the formation of the theory of contestable markets. The contestable market refers to those markets in which there is the pressure from potential entrants and a strong constraint to existing manufacturer’s behavior. Contestable market theory is around the concepts such as fully contestable market and sunk costs; it derives the basic trend of an efficient, sustainable industrial organization and its endogenous formation process. Contestable market 27