Organizational choices for efficiency and market power

Economics Letters North-Holland

18 (1985) 79-82

ORGANIZATIONAL

Marcel BOYER

CHOICES

79

FOR EFFICIENCY

AND MARKET

POWER

*

Uniuersitk de MonthI,

Montrtbl,

Alexis JACQUEMIN

Que., Canada H3C 3J7

*

Unioersit6 de Louunrn, 1348 Louoain -la Neuue, Belgium Received

21 August

1984

We examine the role of strategic consideration in the choice of organizational structures characterizing large corporations. These considerations bridge the gap between the research on transaction costs and organizational forms and the research on strategic entry deterrence and threats. An illustrative model is presented and we derive propositions which look promising for providing empirical benchmarks.

1. Strategic

actions

at the organizational

level

The purpose of this note is to examine the role of strategic considerations in the choice of the organizational structures characterizing large corporations. The existence, predominance and persistence of these large industrial corporations can be explained by a model in which firms are seen as maximizing profits by taking actions from four different subsets (see table 1): first the set of actions concerned with efficiency-oriented industrial or production processes, second the set of actions concerned with efficiency-oriented organizational structures, third the set of actions concerned with the strategic industrial or production interactions and finally fourth the set of actions concerned with strategic organizational aspects. Most of the industrial organization literature has concentrated on the industrial or production level: economies of scale and economies of scope in (EP) and strategic entry barriers in (SP). There is also an important literature on efficiency-oriented organizational actions in (EO). Moreover if one stresses the actions of firms in subsets (EP) and (EO) then the structure of an industry will be seen as the result of ‘innocent’ cost minimization of both production and transaction costs. In this context, one is led to consider any such structure - competition, oligopoly and even monopoly - as realizing a first best, given the alternatives as indicated by the leitmotiv of that ‘school’: what is, is reasonably efficient [see McGee (1974), Baumol(1982) Demsetz (1982)]. If on the other hand one emphasizes the actions of firms in subsets (SP) and (SO), then the structure of an industry will be seen as endogenously and strategically determined by the firms operating in that industry. It is our contention that the analysis of the strategic type of actions at the organizational

* We would like to thank D. Encaoua, G. Gaudet, E. Graham, A. Hollander and P. Geroski criticisms. Of course, we remain solely responsible for the content of this article. 0165-1765/85/$3.30

0 1985, Elsevier Science Publishers

B.V. (North-Holland)

for helpful

comments

and

80

M. Bqver, A. Jacquemrn

/ Orgoniratronal

choices/cr

rffiicwxy

und murkrt

power

Table 1 Level

Type

Production(P)

Organization

(0)

Efficiencyoriented (E)

Strategic

Efficiency production

Strategy in production (SP)

in (EP)

Efficiency in organization (EO)

(S)

Strategy in organization

(SO)

level (SO) has been neglected by industrial organization theorists. It represents in our view the missing link between on the one hand, the research on transaction costs und orgunizationul forms und, on the other hand, the research on strategic entry deterrence and credible threats. Our basic assertion is that even if a given organizational form is able to achieve internal efficiency, more complex and costly modes could prevail in response to a quest for controlling the markets as long as they have a net positive effect on profits. When selecting an effective organizational arrangement the two dimensions will then interact. As it is the case for the (SP) subset of actions, a feature of the (SO) subset is the degree of commitment in the organizational structure chosen: irreversibility is a matter of both technology and organizations. Examples of organizational structures which are obtained through actions in (SO) are not difficult to observe. Many of those would fall into the category of intra- and interindustry coordination [Adams (1974)] and of predatory uses of vertically directed practices [see Salop (1981) Bork (1978)].

2. A simple model of strategic organizational choice Consider our 2 X 2 matrix; the large corporation will choose a combination of actions from the four subsets, two types of actions at two levels, in order to maximise the corporate goal, say profits. Let us concentrate here on the choices at the organizational level (SO) of the large corporation under consideration and consider as giuen the choices in (EP), (SP) and (EO). Let us suppose that the choice under consideration is the level of vertical backward integration into a key input market where some market power can be achieved. In doing so, the large corporation will be able to raise the price of the input in order to raise the cost of its competitors, which we can assume, again for the sake of presentation, to be a competitive fringe. Even if this pricing policy combined with the vertical integration raises the organizational cost of the large corporation, it may increase its profits because of the reduction in the fringe supply and the implied price increase in the product market. [See Salop and Scheffman (1983).] An illustrative model of this approach is the following one. Let us measure the monopoly power of the dominant large corporation under study by the Lerner index L = (p - c)/p where p is the the numerator and equilibrium product price and c is its average variable cost. Multiplying denominator of L by the quantity produced x we can rewrite the index in terms of net profit I1 and fixed costs F, with p( .) being the inverse of the industry demand function Q(p) and Y = Y( p) being the fringe output supplied: L,p-c

p= P

p(x+

Y)x-cx

P(X + Y>x

=- IT+F z

’

(1)

M. Bayer, A. Jocquemin

where z =p(x II = L(x,

choices

/ Orpnizatmxd

+ Y)x is the sales level of the dominant

forefficiency

81

and market power

firm. Hence we have

Y)z - F,

(2)

and the level of profit can be increased for a given sales level z either by an increase in the degree of monopoly power L or by a decrease of the fixed costs F, eq. (2) suggests that a given level of profit can be defined for a given level of production x by various combinations of monopoly power L and fixed costs F although not all those combinations will be feasible. To characterize the feasible combinations of monopoly power index L and fixed costs F, we can first recall that F will in general be the sum of different fixed costs, namely those costs of actions in (EP), (EO), (SP) and (SO) which are independent of the production level x. In the context of our (dominant firm, competitive fringe) example, the dominant firm’s action will, for a given production level X, increase z due to the increase in p following the reduction in fringe production Y. It will also increase L if the increase in average variable cost c is smaller than (c/p)dp. On the other hand, the cost of the integration itself can be considered as an increase in fixed costs. The increase in F generates an increase in L. We will therefore define an attainable set giving the feasible (L, F) pairs. From (l)-(2), the set of attainable combinations (L, F) will depend on x, the production level, and we can therefore usefully represent it as the set D which we will assume to be convex. D=

{(L,

F, x)/(L,

F, x)>Oand

g(L.

F, x)
(3)

The production level x can be increased if L is reduced and/or if F is increased; L is reduced when the firm accepts a lower profit margin, that is a lower price; F is increased by the strategic vertical integration into the key input market where a larger F means a stronger hold on the input market. The problem of the dominant firm can be formulated as follows when T(X) is the inverse of the residual demand x(p) = Q(p) - Y(p) facing the dominant firm: maxII(L,

s.t.

F, x)=Lr(x)x-F

g(L,

F, x)=0.

L.F,x

From

the first order conditions

aF

g,

z=-ii== ;=

L-l=

for L, F and x, we get

-[r(x)+xr~(x)]$=&,

(4)?(5)

Y

[r(x)+xrqx)]~=g. \

Defining

e,_, as the elasticity

(6)

of i with respect to j, we get from (5)

(7) and from (6) er.L

= -1.

(8)

Conditions marginal

(4), (7) and (8) are a priori empirically

rate at which the dominant

firm

can increase

testable

hypotheses.

its monopoly

power

Condition index

(4) says that the L through

strategic

82

M. Bayer, A. Jacquemm

/ Organizutronal

choices for efficiency and mcrrket powr

organizational structure costs F will, at the optimal choice of the firm, be equal to the sales level z. Condition (7) says that the elasticity of sales z with respect to strategic organization&fixed costs F should at the optimum be equal to the rutio of F to variable profits z - cx = Il + F, a ratio less than 1. Condition (8) says that the elasticity of the sales level z with respect to the Lerner index of monopoly power L should at the optimum be equal to - 1. This note is an attempt to show the potentially important role of organizational choices in the growing strategic-investment literature, and, through a simple illustrative model, to derive some relevant relationships. Available empirical studies have not been directly devised to look at the questions raised here, and their findings to not allow us to test, even indirectly, the above hypotheses [see, however, Encaoua and Jacquemin (1982)]. Direct appropriate tests based on reliable measures of the variables involved could be developed stressing the role of strategic organizational activities, as opposed to efficiencyoriented organizational structures, as suggested in relationships (4) (7) and (8).

References Adams, W.. 1974, Market structure and corporate power: The horizontal dominance hypothesis reconsidered, Columbia Law Review 74, 1276-1297. Baumol, W.J., 1982, Contestable markets: An uprising in the theory of industry structure, American Economic Review 72, l-15. Bark, R.H., 1978, The antitrust paradox (Basic Books, New York). Demsetz, H., 1982, Entry barriers, American Economic Review 72, 47-57. Encaoua, D. and A. Jacquemin, 1982, Organizational efficiency and monopoly power: The case of French industrial groups, European Economic Review 19, 25-51. McGee, J., 1974, Efficiency and economies of size, in: H. Goldschmid, H. Mann and J. Weston. eds., Industrial concentration: The new learning (Little Brown, Boston, MA) 55-113. Salop, S.. ed., 1981, Strategy, predation and antitrust analysis (F.T.C., Washington. DC). Salop, S. and D.T. Scheffman, 1983, Raising rivals’ costs, American Economic Review 73. 267-271,