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Organizational Industrial Organization

Final Report Summary - OIO (Organizational Industrial Organization)

The main goal of this project was to develop a new theory of industrial organization (IO) based on a richer view of the firm, one in which non-trivial conflicts of interest among shareholders, workers, managers, and consumers will shape firm boundaries. A leading example of a conflict of interest is when decisions that increase productivity impose a (private) cost on other individuals and when this cost cannot be measured and contracted upon. We develop a “value theory” in which individuals are more likely to relinquish control over decisions that can increase their private cost when the monetary value of the outcome of these decisions is important. We show theoretically and empirically, three foundational implications of a value theory.

First, the force (higher value) that induces suppliers to integrate more often under a common authority also implies that this authority will relinquish control more often to them. The internal organization and the boundaries of firms are therefore jointly determined, and more decentralization across firm boundaries goes along with less decentralization within firm boundaries.

Second, IO establishes a causal relationship between higher market power and higher prices, shaping the way regulators intervene, either by forcing firms to divest assets or preventing firms to merge. A value theory suggests that firms become big when product demand increases, and, if this is the case, integration increases productivity. Hence, by ignoring why the firm has achieved its size and by forcing divestment of assets, a regulator may induce a market structure that generates higher prices for consumers.

Third, the value theory provides a mechanism for the emergence of oligopolies (how many firms exist and how much market power they have) even if there are no fixed costs of entry. If there is a high concentration (few oligopolistic firms), the output is low but firms in the fringe generate a higher monetary profit per-individual than firms in the oligopoly. However, because oligopoly firms produce less than firms in the fringe, individuals in oligopolistic firms have a quieter life, bear a lower private cost, than individuals in a fringe firm. There are therefore two opposite forces: being an outsider is good from a monetary point of view but is bad from a private cost perspective. We show that there are upper and lower bounds on concentration consistent with "hold-out" stability and that market power emerges because of incomplete contracting (with complete contracting the unique stable structure is a competitive market where firms do not have market power). In sharp contrast with standard entry models of IO, equilibrium concentration generally increases rather than decreases with the size of the market, suggesting a demand-side driver of the recent documented trends of increased concentration and profit margins.

Another important outcome of the project is related to the production of talents in the education market. There high schools and colleges are the “firms”, and the transactions between these firms and the students are difficult to govern by complete contracts. The project shows that such incompleteness yields segregation of students (based on socio-economic background and prior achievement) within colleges and high schools. This segregation has dynamic consequences: it may discourage some individuals and over-encourage other individuals to acquire human capital before applying to college. Affirmative action policies combining admission rules (based on both background and prior performance) with inclusion policies that facilitate interactions of students across socio-economic backgrounds within the college walls can reduce segregation and increase economic efficiency. Changes in the internal organization of colleges are crucial, without it, using only priority policies for admission will not have the desired effects on efficiency.