Classification of Firms into Industries (2 Criteria’s)

Two criteria are commonly used for the definition of an industry, the product being produced (market criterion), and the methods of production (technological criterion).

According to the first criterion firms are grouped in an industry if their products are close substitutes. According to the second criterion firms are grouped in an industry on the basis of similarity of processes and/or of raw materials being used.

Which classification is more meaningful depends on the market structure and on the purpose for which the classification is chosen. For example, if the government wants to impose excise taxes on some industries the most meaningful classification of firms would be the one based on the product they produce. If, on the other hand, the government wants to restrict the imports of some raw material (e.g. leather), the classification of firms according to similarity of processes might be more relevant.

1. Market Criterion: Similarity of Products:

Using this criterion we include in an industry those firms whose products are suffici­ently similar so as to be close substitutes in the eyes of the buyer.

The degree of similarity is measured by the cross-elasticity of demand, which we defined as:

e_c = dq_j / dp_i. p_i / q_j

Where q_j = quantity produced by the jth firm

P_i = price charged by the ith firm.

What is the required value of the cross-elasticity in order to classify the ith and jth firms in the same industry? The answer to this question cannot be based on a priori theoretical grounds if the products are differentiated. In this event the degree of closeness or simil­arity is defined on an empirical basis, depending on the purpose of the study in each particular case. For some purposes a broad definition of products is more appropriate, while for other purposes a narrower definition based not only on the technical sub­stitutability but also on the economic substitutability (in the sense of similar price ranges) of commodities, may be more desirable.

For example, the motor-car industry would include all types of motor-cars, from the cheapest Mini to the most expensive Rolls- Royce and the specialized sports cars. This classification is used by the tax authorities in Britain where car taxation is uniform for all types of cars. However, this classification is not appropriate if one wants to analyze the pricing decisions of the car manufacturers. For this purpose one should use a narrower definition of an industry, for example the ‘popular’ models, the ‘luxury’ models and the ‘sports’ models. In each such ‘group’ the products are both technical and economic substitutes.

It is useful to examine the concept of an industry as applied in the different traditional market structures, so as to illustrate the importance of substitutability. In pure competition the application of the product criterion for the definition of an industry is straightforward. In this market structure the product is assumed to be homogeneous and the number of sellers is large. Under these conditions the cross- elasticity of demand for the product of each firm is infinite. There is perfect substituta­bility between the products of the various firms and this leads to a unique price in the market, since no buyer would be prepared to pay a higher price for a product technically identical with that of other firms.

In monopolistic competition products are differentiated by design, quality, services associated with its supply, trademarks, etc. Thus the products are not perfect sub­stitutes in the eyes of the buyer, and the question arises of how close substitutes the commodities must be if they are to be grouped in the same ‘industry’. Both Chamberlin and Joan Robinson recognized that with differentiated products each firm has its own market, and hence some degree of monopoly power in setting its own price.

However, they both recognized the necessity of retaining the concept of an industry in order to give their theory the required degree of generality, and develop it within the partial- equilibrium framework. Joan Robinson defined the product as ‘a consumable good, arbitrarily demarcated from other kinds of goods, but which may be regarded for practical purposes as homogeneous within itself’.

Thus, she views products as forming a chain of substitutes, the continuity of which is broken by gaps between successive products along the chain. Products thus isolated by such gaps can be classified in an industry despite their minor differences. Basically this definition of the industry uses the measure of price cross-elasticity.

An industry includes the firms whose demand curves exhibit high price cross-elasticity. She brushed aside the problem of how high this cross- elasticity should be by assuming that there would be gaps in the values of cross-elasticity and these gaps would demarcate the industrial groups.

A similar definition was adopted by Kaldor. He views products as occupying a given position on a scale, with products on either side being more close substitutes as compared with products further away on this scale

Each ‘product’ can be conceived as occupying a certain position on a ‘scale’; the scale being so constructed that those products are neighbouring each other between which the consu­mer’s elasticity of substitution is the greatest (a ‘product’ itself can be defined as a collection of objects between which the elasticity of substitution of all relevant consumers is infinite). Each producer then is faced on each side with his nearest rivals; the demand for his own product will be most sensitive with respect to the prices of these; less and less sensitive as one moves further away from him.

Chamberlin, in his original formulation of the Theory of Monopolistic Competition (Harvard University Press, 1933) defined his large ‘group’ as comprising firms which produce very similar although differentiated commodities:’… The difference between (the varieties of products) are not such as to give rise to differences in cost. This might be approximately true where say similar products are differentiated by trade marks’. The conceptual and empirical difficulties implied in the above definition of an industry lead Triffin to preach the abandonment of the concept of the industry as being incon­sistent with the notion of ‘product differentiation’ and the unique character of each firm’s product.

The monopolistic competition writers resorted to the limping device of keeping intact, for the purpose of analysis, that concept of an industry, which their study of differentiation showed to be untenable. Triffin argued that all goods are to some degree substitutable for one another in that they compete for a part of the income of the consumer. Every firm competes with all the other firms in the economy, but with different degrees of closeness. Thus, he concluded, the concept of an industry is irrelevant as a tool of analysis. The best way for analyzing the economic relationships of firms is to adopt a general equilibrium approach. This view was later adopted by Chamberlin.

Andrews has severely criticized the abandonment of the concept of an industry. He argued that the rejection of the concept of the industry is both unnecessary and un­desirable. The concept is of great importance both in economic analysis and in real- world situations. Andrews advocated the classification of industries on the basis of similarity of processes, arguing that this classification is more relevant for analyzing the pricing decisions of the firm (see below).

Edwards in dealing with oligopolistic markets, has attempted to retain the definition of an industry in terms of the product. He argues that the retention of the concept of an industry as a tool of analysis is essential to the economist as well as to the businessman and the government. He says that product differentiation does not necessitate the aband­onment of the concept of an industry. He accepts Chamberlin’s view that a ‘group’ or ‘industry’ is not a definite economic entity (with definite edges) like the Marshallian concept of an industry, but an analytical tool which should be used with all degrees of generality.

In a broad definition an industry includes all the range of products which are technical substitutes in that they satisfy the same need (for example the motor-car industry includes all firms which produce all types of cars). Within this broad group of products there are definite subgroups (popular models, luxury models, sports cars) which tend to have very similar technical characteristics.

Thus, for each subgroup there will be a unique price in the long run (because the products are technically identical or very similar and there will be no cost differences), but consumers’ preferences create a separate market for each firm. For the broad group of products there will be a cluster of prices in the long term reflecting the differences in the technical characteristics and therefore the differences in costs of the different varieties.

Edwards argues that there is a tendency in British manufacturing for the pattern of production within an industry (in the broad definition) to stabilize (in normal conditions) into a conventional product-pattern with a corresponding conventional price-pattern (Edwards, Monopoly and Competition in the British Soap Industry).

If the price-quality pattern is strictly stable then the various subgroups of products can be treated as one for demand purposes. Edwards recognizes that in the real world the price-quality pattern does not in fact remain strictly stable. However, he argues that the degree of stability is sufficient to justify the assump­tion that the price-quality is approximately constant and can be treated as such for all practical purposes.

2. The Technological Criterion: Similarity of Processes:

According to this criterion, an industry is defined so as to include firms which use similar processes of production. The similarity may lie in the methods of production, the raw materials used, or the channels of distribution. Chamberlin, before Triffin’s attack on his ‘large group’ model, attempted the extension of the concept of the industry to cover the supply aspects of a market. He said that the ‘group’ need not necessarily be defined on the basis of the substitutability between pro­ducts. Industry classifications based upon technological criteria rather than upon the possibility of market substitution were perfectly legitimate for all purposes.

Andrews also advocated the definition of an industry on the basis of similarity of processes. Joan Robinson in her later writings recognized that her original definition of the industry was not adequate for oligopolistic market structures and suggested a rede­finition of the industry based on the technological criterion of similarity of processes

The concept of an industry, though amorphous and impossible to demarcate sharply at the edges, is of importance for the theory of competition. It represents the area within which a firm finds it relatively easy to expand as it grows. There are often certain basic processes required for the production of the most diverse commodities (tennis balls, motor tyres and mattresses) and economies in the utilization of by-products under one roof.

The know-how and trade connections established for one range of products make it easier to add different commodities of the same technical nature to a firm’s output than it is to add mutually commodities made of different materials, or made or marketed by radically dif­ferent methods. It should be noted that the technological criterion of similarity of processes suffers from the same defects as the product-substitutability criterion. How similar should the processes employed by various firms be in order to group them in the same industry? The advocates of the technological criterion do not discuss such problems.

In conclusion we can say that in markets where the product is differentiated the ‘industry’ concept cannot be as definite as in markets where the product is homogeneous. The definition of the borderlines between industries will be to some extent arbitrary, irrespective of the criterion used for the classification of firms into industries.

Regarding the two criteria traditionally used for industrial classifications, no general conclusion can be drawn as to which is better. The choice depends on the purpose of the classification. It seems, however, that the integration of the two criteria (substitutability of products and technological similarity of processes) is most desirable in analyzing the behaviour of the firm in oligopolistic market structures which are typical of the modern business world.

It is generally accepted that entry considerations are important in explaining the observed behaviour of firms. Entry can­not be satisfactorily analysed unless both the demand substitutability and the supply conditions are simultaneously considered. It is via substitutability of the products that the entry of additional firms can affect the demand of established firms. Thus the effects of entry cannot be analysed on the basis of technological similarity alone.

In general all decisions of firms (pricing, level of output, changes in style, selling activi­ties, financial policies, investment decisions) are taken in the light of actual as well as of potential competition by new entrants. This suggests that product considerations as well as technological similarities of processes should be integrated in analyzing the behaviour of firms.