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Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

Compiler Press

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h.h.chartrand@compilerpress.ca

215 Lake Crescent

Saskatoon, Saskatchewan

Canada, S7H 3A1
 

Curriculum Vitae

 

Launched  1998

 

 

Introduction to Industrial Organization

MBA 7003

3.0 Conduct

3.0 Conduct

3.1 Collusion

3.2 Game Playing

3.3 Legal Tactics

Copyright & Patent Abuse

Legislative Collusion

Patent Thickets & Wars

Trolls

Summary Survey of Intellectual Property

   in the Global Village

3.4 Price Competition

3.5 Product Differentiation

3.6 Product/Process Innovation

3.7 Satisficing Behaviour & the Problem of Agency

3.8 International Trade: A Positive Sum Game?    

In Industrial Organization firms in a given industry tend to follow identifiable patterns of Conduct or behavior in adapting and adjusting to a changing and evolving marketplace.  Key mainstream variables include pricing, advertising and product differentiation, capacity, legal tactics, quality of output as well as process/product innovation.  In policy terms, Conduct constitutes the strategy of the firm.

Pricing strategy includes the choice between short- or long-run profit maximization as well as between single and tied goods, e.g., selling printers cheap but ink at a high price.  Advertising is intended to persuade consumers – final or intermediary – to buy a particular brand.  Sometimes brands are technically similarly but advertising can differentiate them in the minds of consumers.  Capacity refers to the ratio of actual to potential output expressed as a percentage, e.g., 80-85% capacity is generally considered ‘full’ capacity allowing downtime for maintenance and ‘recreation’ of workers.  Legal tactics includes the tendency to litigate or use other legal means rather than the market to settle or foreclose disputes with consumers, suppliers and competitors, e.g., the EULA software agreement that limits liability, e.g., downtime suffered by users .  Quality, among other things, refers to whether the target market is upscale or downscale, e.g., tailor products to each customer or sell mass produced goods & services.  Process/product innovation refers to whether firms tend to rely on the continual production and application of new knowledge or on ‘traditional’ ‘tried-and-true’ methods and products.

 

3.1 Collusion

Conduct also includes collusive behaviour among sellers as well as buyers especially in oligopolistic and oligopsonistic industries.  The small number of majors makes collusion relatively easy and while usually illegal it is well rooted in history.

 “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”  

Adam Smith, The Wealth of Nations, 1776

Such Conduct includes price fixing which involves agreement to buy or sell a good only at a fixed price and to manipulate supply and/or demand to maintain that price.  The result of such cartels approximates the outcome of monopoly.  It also includes agreements to geographically divide up markets.  Maintaining discipline among members of the cartel is, however, often difficult because of the incentive to cheat.  It should be noted that imperfect knowledge is involved.  Cartel members know prices are fixed but the public does not.

A recent example of such collusive behaviour occurred in 2012 with the rate rigging scandal concerning the Libor, the London Interbank Offer Rate.  Some fifteen blue-chip banks ‘guess’ their borrowing costs, throw out high and low, and use the resulting rate as the benchmark against which to mark up riskier loans.  These firms have already been fined billions of dollars for manipulation of the Libor rate.  Such behaviour has recently, included price fixing of integrated chips, dynamic random access memory (DRAM) chips, liquid crystal display panels, lysine, citric acid, graphite electrodes, bulk vitamins, perfume as well as airlines in various countries around the world.  The result of collusive industrial behaviour has been the institutionalization of government anti-trust and anti-combines policies around the world beginning in the United States with the Sherman Anti-Trust Act of 1890.

3.2 Game Playing

As will be seen, a profit maximizing price/quantity solution for oligopoly cannot be found within the Standard Model of Market Economics.  To treat the indeterminacy of oligopoly, economists, beginning with Cournot in the 1830s, have struggled for a solution.  The outcome, however, depends not only on the decisions of a given firm but also the reaction of its competitors.  To get around the problem Cournot suggested a firm should guess what competitors would do.  If it guessed correctly it would maximize profits; if not, then it would guess again and again until it guessed right.  Hardly an elegant solution!

What I call the dance of the oligopolists with one step being matched by a counter-move also led in the 1950s to the Nash-Cournot solution which involves page upon page of mathematical equations (the Nash Program) that generates a solution if the underlying assumptions are correct.  If not, the search for a solution also begins again.

The ‘action-reaction’ nature and the complexity of oligopoly with a variety of possible ‘profit maximizing’ outcomes led economics to ‘spin off’ a whole new sub-field called Game Theory.  For a brief history of Game Theory please see: An Outline of the History of Game Theory by Paul Walker http://www.econ.canterbury.ac.nz/personal_pages/paul_walker/gt/hist.htm.

Today it is sometimes claimed that video games, as an industry, is larger than the motion picture and music industries combined.  Apps for smart phones are being designed around game theory to encourage everything from weight loss and exercise to saving.  Modern corporations and the military actively engage in game playing including role playing to anticipate outcomes of competition, bargaining and other actions. Even the Arts are involved in that actors are often hired by businesses, governments, medicine, the military and other institutions to ‘role play’ in games to hone the skills of personnel.  For example, actors are used to prepare physicians for the range of possible reactions of a patient being told they have terminal cancer.  In many ways the contemporary ethos or zeitgeist is game playing.  This sentiment is summed up in the neologism ‘gamification’. This has resulted from economic game theory developed in response to the indeterminancy of oligopoly.

3.3 Legal Tactics

As noted in Introduction, legal tactics includes the tendency to litigate or use other legal means rather than the market to settle or foreclose disputes with consumers, suppliers and competitors, e.g., the EULA software agreement that limits liability, e.g., downtime suffered by users.  Legal tactics embrace contract law, non-contractual liabilities or the law of torts as well as intellectual property rights and property rights in general. 

It is important to note that Law is a cultural artifact that varies between countries.  Thus in the Anglosphere world of Common Law legal persons (bodies corporate) are assumed to enjoy the same rights as natural persons, i.e., flesh and blood human beings.  Under European Civil Code, they do not.  Similarly torts under Common Law are treated by precedent while under Civil Code they are treated by principle.

Law, in all Nation-States, is made at four levels: international, statutory, regulatory and case.  International law is made by Nation-States and International Organizations through the treaty-making process.  For our purposes what is important is that to ratify a multilateral instrument often requires changing domestic law. 

Statutory law is made by domestic legislators in parliaments, legislatures, congresses, etc.  Regulatory is made by bureaucrats – domestic and international - interpreting and implementing a statute or treaty.  Case law is made by judges – domestic and international - interpreting and enforcing international, statutory and/or regulatory law.  

Complicating matters, however, is that when judges make Law it is by setting precedent.  In the Anglosphere this body of precedent is called the Common Law.  If a similar case was resolved in the past, a current court is bound to follow the reasoning of that prior decision under the principle of stare decisis.  The process is called casuistry or case-based reasoning.

If, however, a current case is different then a judge may set a precedent binding future courts in similar cases.  Often such precedents compel legislators and bureaucrats to change statutory and regulatory law.  This is especially true with respect to intellectual property rights like copyright. 

Rapidly changing technology, among other things, increasingly brings novel cases before the lower courts forcing legislators and bureaucrats to keep up or allow casuistry to run its course.  The problem is that a court decision in a specific case can, for better or worse, establish ‘path-dependency’ for emerging techno-economic regimes (David 1990), e.g., in biotechnology, software, etc.  This reflects the more general psychological Law of Primacy: That which comes first affects all that comes after.  In Law it is called precedent; in Economics it is called path dependency. 

Furthermore, precedent established in one jurisdiction may spill-over into others.  This is especially true of IPR precedents set by courts in the United States.  These have great influence in other Common Law countries including Canada.  The sheer scale of the American economy insures that case law is greater in volume if not better thought out than in smaller jurisdictions. 

Over the last few decades State-sponsored intellectual property rights or IPRs have increasingly become a tool of  predatory competition as opposed to an incentive for innovation.  It has been claimed that major American corporations now spend more on the legal defense of IPRs than on research & development.  The spectacular number of cases filed by Apple against Samsung in courts around the world is only the tip of the iceberg.  So what are IPRs?

While economics is poor at prediction it is extremely good at ex poste rationalization, e.g., it cannot accurately predict the Depression but can explain it very well after the fact.  Thus intellectual property rights (IPRs) have evolved over the course of centuries (Chartrand 2011) but as economist Paul David: observed, they have not been created “by any rational, consistent, social welfare-maximizing public agency” (David 1992).  The resulting regime is “a Panda’s thumb”, i.e., “a striking example of evolutionary improvisation yielding an appendage that is inelegant yet serviceable” (David 1992). 

In economic theory, IPRs today are justified by market failure, e.g., when market price does not reflect all benefits to consumers and all costs to producers, e.g., pollution costs.  These are known as external costs and benefits, i.e., external to market price.

IPRs, in this view, are created by the State as a protection of, and incentive to, the production of new knowledge which otherwise could be used freely by others (the so-called free-rider problem).  In the knowledge industries the average total cost curve is not ‘U’ shaped but rather ‘L’ shaped.  The first unit of Windows 8 may have cost $250 million or more but the second and all subsequent copies cost the price of a blank disc – 99 cents.  After all knowledge is a public good.  Without enforcement of State sponsored IPRs no rational firm would make such an investment.

In return, the State expects creators (usually a corporate 'proprietor' of an author's copyright - the 1709/10 Statute of Queen Anne, the first 'modern' copyright act allowed the full and total assignment of all author's rights, unlike the French tradition [Chartrand 2011]) to make new knowledge available and that a market will be created in which it can be bought and sold.  But while the State wishes to encourage creativity, it does not want to foster harmful market power.  Accordingly, it builds in limitations to the rights granted to creators.  Such limitations embrace both Time and Space.  They are also granted only with full disclosure of the new knowledge, and only for:

a fixed period of time, i.e., either a specified number of years and/or the life of the creator plus a fixed number of years; and,

fixation in material form, i.e., it is not ideas but rather their fixation or expression in material form (a matrix) that receives protection. 

Eventually, however, all intellectual property (all knowledge) enters the public domain where it may be used by anyone without charge or limitation.  In other words a public good first transformed by law into private property is transformed back into a public good.  Growth of the public domain is, in fact, the historical justification of the short-run monopoly granted to creators of intellectual property.  In the case of copyright, for example, the full title of the Statute of Queen Anne is: AN ACT for the Encouragement of Learning by vesting the Copies of printed Books in the Authors or Purchasors of such Copies during the Times therein mentioned.  Inside the Act, purchaser is named proprietor, a.k.a., printer or publisher.

Even while IPRs are in force, however, there are exceptions such as ‘free use’, ‘fair use’ or ‘fair dealing’ under copyright.  Similarly, national statutes and international conventions permit certain types of research using patented products and processes.  And, the Nation-State retains the sovereign right to waive all IPRs in “situations of national emergency or other circumstances of extreme urgency” (WTO/TRIPS 1994, Article 31b), e.g., following the anthrax terrorist attacks in 2001 the U.S. government threatened to revoke Bayer’s pharmaceutical patent on the drug Cipro (BBC News October 24, 2001).  Statutory IPRs include:

Copyrights - protecting the expression of an idea but not the idea itself;

Patents - protecting the function of a device or process but only after disclosure of all knowledge necessary for a person normally skilled in the art to replicate the device or process;

Registered Industrial Designs – protecting the aesthetic or non-functional aspects of a device; and,

Trademarks – protecting the name, reputation and good will of a Maker, Legal or Natural, as well as Marks of Origin such as Okanagan Made.

Contractual rights to knowledge include Know-How and Trade Secrets.  These take the form of non-disclosure and/or confidentiality clauses in commercial contracts as well as contracts of employment, e.g., Chrysler & Volkswagen Case.

Copyright & Patent Abuse

Legislative Collusion

Patent Thickets & Wars

Trolls

Summary Survey of Intellectual Property in the Global Village

3.4 Price Competition

Pricing strategy includes the choice between short- or long-run profit maximization as well as between single and tied goods, e.g., selling printers cheap but ink at a high price.  Strict price competition, however, is restricted to perfect competition.  Under imperfect competition firms are price makers rather than price takers.  Microsoft Windows 95 to XP

3.5 Product Differentiation

Advertising is intended to persuade consumers – final or intermediary – to buy a particular brand. Sometimes brands are technically similarly but advertising can differentiate them in the minds of consumers, e.g., Tide vs. Cheer, effectively splitting off part of the industry demand curve as its ‘owned’ share.  In the Standard Model of Market Economics only factual product information qualifies as a legitimate expense. Attempting to ‘persuade’ or influence consumer taste is ‘allocatively inefficient’ betraying the principle of ‘consumer sovereignty’, i.e., human wants, needs and desires are the roots of the economic process.

This mainstream view connects with consumer behaviour research which calls this approach the ‘information processing’ model.  A consumer has a problem, a producer has the solution and the advertiser brings them together. It is a calculatory process.  An alternative consumer behavior school of thought, ‘hedonics’ argues that people buy products to fulfill fantasy, e.g., people do not buy a Rolls Royce for transportation but rather to fulfill a lifestyle self-image (Holbrook & Hirschman 1982; Holbrook 1987).  Thus product placement, i.e., placing a product in a socially desirable context, enhances sales (McCracken 1988). In this regard the proximity of Broadway and especially off- and off-off-Broadway (the centre of live theatre) and Madison Ave. (the centre of the advertising world) in New York City is no coincidence.  Marketeers search the artistic imagination for the latest ‘cool thing’, ‘style’, ‘wave’, etc.  Such pattern recognition is embodied in the new professional ‘cool hunter’ (Gibson 2003).  In fact peer-to-peer brand approval is consumer business success in the age of Blog.

Take the case of advertising biotechnology.  The ‘advertising & marketing’ of GM products, specifically food vs. medicine, highlights these divergent approaches.  In reaching out to the final consumer GM food advertising and marketing generally takes the form of well researched and well meaning ‘risk assessments’.  Such cost-benefit analyses are presented to a public that generally finds calculatory rationalism distasteful and the concept of probability unintelligible, e.g., everyone knows the odds of winning the lottery yet people keep on buying tickets. It would appear that the chances of winning are over-rated. By contrast the even lower probability of losing the GM ‘cancer’ sweepstakes are similarly over-rated. Attempts have been made to place this question within the context of known/unknown contingencies such as GM food safety within Kuhn’s ‘normal science’ (Khatchatourians 2002). The labeling debate also illustrates the ‘information processing’ view. At a minimum it would require all GM food products to be labeled as such. At a maximum it would require that all GM food products be traceable back to the actual field from which they grew.

While attempts have been made to highlight the health and safety of GM foods little has been done to demonstrate that they ‘taste’ better. This may be the final hurdle, maybe not. Observers have noted, however, that the GM agrifood industry has been rather inept in its ‘communication’ with the general public (Katz 2001). For whatever reasons, to this point in the industry’s development, GM foods appear to feed nightmares, a.k.a., Frankenfood, not fantasies in the mind of the final consumer.

By contrast the ‘advertising & marketing’ of medical GM products and services has fed the fantasies of millions with the hope for cures to previously untreatable diseases and the extension of life itself. Failed experiments do not diminish these hopes. Even religious reservations appear more about tactics, e.g., the use of embryonic or adult stem cells, rather than the strategy of using stem cells to cure disease and extend life.

Given that intermediate rather than final demand currently feeds the biotechnology sector one must also consider what might be called ‘intermediate advertising & marketing’. Such activities are conducted by trade associations and lobbyists. The audience is not the consumer but rather decision makers in other industries and in government. Such associations exist at both the national, e.g., BIOTECanada, and regional level, e.g., Ag.West Bio Inc.

Beyond advertising another technique to achieve product differentiation in the minds of consumers is ‘design’.  Apple is the outstanding example today.  In effect design technology involves making the best looking thing that works.  Picture going into a computer store and seeing two technically identical systems, one is ugly, the other attractive.  Which do you buy?  Economist  Robert H. Frank’s economic guidebook unlocks everyday design enigmas.  An explanation of his findings is available on a YouTube a lecture at Google HQ.

What is important to realize is that product differentiation through advertising or design require an investment that a lean, mean perfectly competitive firm cannot afford.  It is excess or economic profit that allows a firm to make such investments.

 

3.6 Process/Product Innovation

With respect to process/product innovation I begin with a distinction between invention and innovation.  Invention involves creating something new; innovation involves successfully bringing it to market.  To paraphrase Einstein: it is 1% inspiration (invention) and 99% perspiration (innovation). 

Process/product innovation forms part of what economist Joseph Alesoph Schumpeter called creative destruction or the:

… process of industrial mutation - if I may use that biological term - … that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new … Creative destruction is the essential fact about capitalism.  It is what capitalism consists in and what every capitalist concern has got to live in. (p.83)

… Every piece of business strategy acquires its true significance only against the background of … the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull. (pp. 83-84)

From this observation, and other evidence, Schumpeter concluded that the Standard Model of Market Economics missed the point.  Competition was not about long run lowest average cost per unit output but rather about innovation and surviving the perennial gale of creative destruction. 

In 1962, economist Robert Solow published “Technical Progress, Capital Formation and Economic Growth” in the American Economic Review.  In it he presented what is known as the Solow Residual.  It begins with a symbolic equation for the production function: Y = f (K, L, T) which reads: national income (Y) is some function (f) of capital (K), labour (L) and technological change (T). 

Technological change in the standard model of Market Economics refers to the impact of new knowledge on the production function of a firm or nation.  The content and source of that knowledge is not a theoretical concern; what matters is its mathematical impact on the production function. 

Over the last hundred years, depending on the study, something like 25% of growth in national income is measurably attributable to changes in the quantity and quality of capital and labour while 75% is the residual Solow attributed to technological change.  Yet we have no idea of why some things are invented and others not; and, why some things are successfully innovated and brought to market and other are not.  The Solow Residual is known in the profession as ‘the measure of our economic ignorance’.  It is why I became an economist.

The effects of technological change in the orthodox model can be broken out into two dichotomous but complimentary categories: disembodied & embodied and endogenous & exogenous technological change.

Implicitly disembodied technological change dominated economic thought since the beginning of the discipline.  It refers to generalized improvements in methods and processes as well as enhancement of systemic or facilitating factors such as communications, energy, information and transportation networks.  Such change is disembodied in that it is assumed to spread out evenly across all existing plant and equipment in all industries and all sectors of the economy.  It is what Victorians would have called ‘Progress’.

Also implicitly, the concept of embodied technological change traces back to Adam Smith’s treatment of invention as the result of the division and specialization of labour (1776).  It refers to new knowledge as a primary ingredient in new or improved capital goods.  The concept was refined and extended by Marx and Engels (1848) in the 19th and by Joseph Schumpeter in the 20th century with his concept of creative destruction (1942).  No attempt was made, however, to measure it until the 1950s (Kaldor 1957; Johansen 1959).  And it was not until 1962 that Solow introduced the term ‘embodied technological change’ into the economic lexicon, and by default, disembodied change was recognized (Solow May1962).

Formalization of embodied technological change arguably emerged out of ‘scientific’ research and development (R&D) during the Second World War followed by the post-war spread of organized industrial R&D.  This demonstrated that new scientific knowledge could be embodied in specific products and processes, e.g., the transistor in the transistor radio.  Conceptual development of embodied technological change has, however, “lost its momentum” (Romer 1996, 204).  Many theorists, according to Romer, have returned to disembodied technological change as the force locomotif of the economy meaning: “Technological change causes economic growth” (Romer 1996, 204).

While embodied/disembodied refers to form, endogenous and exogenous refers to the source of technological change.  The source of exogenous technological change is outside the economic process.  New knowledge emerges, for example, in response to the curiosity of inventors and pursuit of ‘knowledge-for-knowledge-sake’.  Exogenous change, with respect to a firm or nation, falls from heaven like manna (Scherer 1971, 347).

By contrast, endogenous technological change emerges from the economic process itself - in response to profit and loss.  For Marx and Engel, all technological change, including that emanating from the natural sciences, is endogenous.  Purity of purpose such as ‘knowledge-for-knowledge-sake’, like religion, was so much opium for the masses cloaking the inexorable teleological forces of capitalist economic development.  The term itself, however, was not introduced until 1966 (Lucas 1966) as was the related term ‘endogenous technical change’ (Shell 1966).

Endogenous change is evidenced by formal industrial research and development or R&D programs.  It therefore includes what are usually minor modifications and improvements – tinkering - to existing capital plant and products called ‘development’ (Rosenberg & Steinmueller 1988, 230).  In this way industry continues the late medieval craft tradition of experimentation.  R&D varies significantly between firms and industries.  At one extreme, a change may be significant for an individual firm but trivial to the economy as a whole.  On the other hand, ‘enabling technologies’ such as computers or biotechnology may radically transform both the growth path and the potential of an entire economy.  How to sum up the impact on the economy of the endogenous activities of individual firms remains, however, problematic.

With respect to the Nation-State, endogenous and exogenous technological change has a different meaning.  They refer to whether the source is internal, i.e., produced by domestic private or public enterprise, or external to the nation, i.e., originating with foreign sources. 

Furthermore, in the 1980s a ‘New Economic Geography’ arose inspired by the work of Nobel Prize winning economist Paul Krugman (Martin & Sunley 1996).  A central feature is the ‘industrial cluster’ such as ‘Silicon Valley’.  While economies of scale and scope are available within a single firm, external economies are available only outside.  High tech firms operating in the same sector benefit from physical proximity.  Such clusters, in turn, crystallize around the University as a nucleating agent or prime attractor.  The success of Government sponsored ‘clusters’, however, remains problematic (Economist Oct. 11, 2007).

A key industrial example of the role of the University as an exogenous source of technological change is biotechnology.  With the decoding of DNA a new enabling or transformative technology was unleashed. Its leaders are generally University-based (Zucker et al 1998, 293).  It is they who take new knowledge and commercialize it. It is they who attract the best students.  Often they establish new firms within an existing cluster or start a new cluster with the assistance of the University which shares in patent royalties.  Many new biotech firms are in fact founded with the intent of selling them to large established firms (Arora & Gambardella 1990, 362).

3.7 Satisficing Behaviour & the Problem of Agency

Dangers of monopoly were a concern to Marx whose solution was public ownership of the means of production.  The extremity of this solution fuelled Alfred Marshall efforts in the 1920s to set out a model of perfect competition and demonstrate the comparative costs of monopoly.  According to Marshall, the monopolist was like a tree in the forest; it would grow but eventually fall.  Reasons included the idea that inheritors to the monopolist’s power would be less able than the founder until eventually the firm died –

Following a series of Harvard Law Review articles written by Adolf A. Berle, Jr. and E. Merrick Dodd, Jr., in 1932 the authors published their influential book, The Modern Corporation and Private Property.  This text established the concept of separation of ownership and control of the ‘modern’ corporation and laid the foundation for John Kenneth  Galbraith’s concept of the ‘technostructure’, i.e, large firms can become self-perpetuating or ‘immortal’ through the self-genesis of management.

Findings by Berle and Means exposed the problem of agency in the widely held public corporations that have come to dominate the economy.  The Standard Model of Market Economics assumes a one produce, profit maximizing firm with the owner in the store.  When ownership is spread out by share equity the owners are not in the store but rather hire employees entrepreneurial and managerial to run the firm.  This raise the question of whether or not the objective function of the owners, i.e., profit maximization, is the same as their agents? 

In 1956 Herbert Simons introduced the concept of satisficing vs. maximizing behaviour.  Thus managers of a widely held public corporation have to satisfy not only the owners but also workers, customers and the government.  To do so they do not pursue profit maximization but rather satisfying all these various stakeholders.  If successful management is then able to satisfy its own needs for things like corporate jets, oak-lined board rooms and other perks of office.

3.8 International Trade: A Positive Sum Game?    

 

 

to 4.0 Performance