Industrial Economics and Organisation: Conventional and Islamic Perspectives

By Prof. Dr. Wan Sulaiman Bin Wan Yusoff

Prof. Dr. Wan Sulaiman Bin Wan Yusoff
Deputy Rector of Student Affair, Internationalization and Alumni
INSANIAH UNIVERSITY COLLEGE
ALOR STAR KEDAH, MALAYSIA.

• Language: English
• Publisher: Xlibris AU
• Release date: Mar 5, 2014
• ISBN: 9781493133871

Prof. Dr. Wan Sulaiman Bin Wan Yusoff

Prof. Dr. Wan Sulaiman Bin Wan Yusoff Deputy Rector of Student Affair, Internationalization and Alumni INSANIAH UNIVERSITY COLLEGE ALOR STAR KEDAH, MALAYSIA.

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Copyright © 2014 by Prof. Dr. Wan Sulaiman Bin Wan Yusoff.

Library of Congress Control Number:           2014902550

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Contents

Foreword

About the Author (WS)

Preface

Acknowledgements

Chapter 1 Three Approaches to the Study of Industrial Economics and Organisation

1.1 Introduction

1.2 Three Approaches to the Study of Industrial Organisation

1.2.1 The Structure-Conduct-Performance (SCP) Paradigm

1.2.2 The Chicago School Approach

1.2.3 The Islamic Economic Approach

1.3 What Chicago and Islamic Approaches Have in Common?

Chapter 2 Objectives of the Firms

2.1 Conventional Objectives

2.1.1 The Neoclassical Firm

2.1.2 The Structure of Modern Firms

2.1.3 Separation of Ownership and Control

2.1.3.1 Managerial Objectives

2.1.3.2 Satisfying and Rules of Thumb

2.1.3.3 Constraints on Managers

2.2 Islamic Economics Objectives

2.2.1 Major objectives of Islamic Firms

2.2.2 Profit in the Islamic Perspective

2.2.3 Real-World Activities in Islamic Economics

Chapter 3 Monopoly or Market Power

3.1 Introduction

3.2 Characteristics of Monopoly

3.3 Price and Output Determination in Monopoly Market

3.4 Price Discrimination

3.4.1 First-Degree Price Discrimination

3.4.2 Second-Degree Price Discrimination

3.4.3 Third-Degree Price Discrimination

3.5 Deadweight Welfare Loss or Social Cost of Monopoly

3.6 Economic Efficiency and Monopoly

3.7 Market Power and Performance

3.8 Monopoly in Islamic Perspective

3.8.1 Economists and Jurists’ Concepts

3.8.2 Monopoly with Islamic Values

3.8.2.1 Pricing Principle Consistent with Islamic Values

3.9 Positive Roles and Sincere Devotion to Islamic Spirit

Chapter 4 Market Concentration

4.1 Introduction

4.2 Nature and Measurement of Market

Concentration

4.2.1 Measurement Criteria

4.2.2 Concentration Curve

*4.2.3 Concentration Ratio

*4.2.4 Hirschman-Herfindahl Index

*4.2.5 Hannah and Kay’s Indices

*4.2.6 Entropy Index

*4.2.7 Inequality Measures

4.3 Theories of Concentration

4.3.1 Scale Economies and Market Concentration

(Deterministic Approach)

4.4 Evidence on Market Concentration

4.5 Market Concentration in Islamic Perspective

4.5.1 Concentration of Wealth and Economic Growth

4.5.2 Reducing Concentration of Wealth

4.5.3 Concentration and Profitability

4.5.3.1 Shari’ah Deals with Market Price and Concentration

4.5.4 Concentration and Market Failures (Negative Internalities and Externalities)

Chapter 5 Mergers

5.1 Introduction

5.2 History of Mergers

5.3 Objectives of Mergers

5.4 The Effect of Mergers on Competition and Welfare

5.5 Public Policy

5.5.1 UK Approaches of Merger Policy

5.5.1.1 Horizontal Mergers: A Welfare Framework

5.5.2 US Approaches of Merger Policy

5.6 Merger in Islamic Perspectives

5.6.1 Merger Forms of Established Monopoly

5.6.2 Practical Applications of Merger in Islamic Perspective

5.6.2.1 Value Destroying and Enhancing Action

5.2.2.2 Defensive Strategy

5.6.2.3 Counter-Attack Strategies

5.6.2.4 Frameworks for Ethical Analysis of Merger

Chapter 6 Entry and Exit

6.1 Introduction

6.2 Entry

6.2.1 Barriers to Entry

6.2.1.1 Static or Structural Barrier to Entry

6.2.1.1(A) Economies of Scale

6.2.1.1(B) Absolute Cost Advantage

6.2.1.1(C) Capital Costs

6.2.1.1(D) Product Differentiation

6.2.2 Aggregate Barrier to Entry

6.2.3 Incentive to Enter

6.2.3.1 Expected Profitability

6.2.3.2 Market Growth

6.3 Empirical Evidence on Entry

6.4 Price Policy or Limit Price Theory of Incumbent Firms

6.4.1 Limit Pricing under the Sylos Postulate

6.5 Exit

6.5.1 Barrier to Exit

6.5.2 Incentives to Exit

6.6 The Interaction of Entry and Exit

6.7 Another Recent Theoretical Development: Contestable Markets

6.7.1 Contestable Markets

6.7.2 Strategic Entry Deterrence

6.7.3 Product Proliferation as a Deterrent to Entry

6.8 Entry and Exit in Islamic Frameworks

6.8.1 Barrier to Entry Based on Shari’ah Views

Chapter 7 Product Differentiation

7.1 Introduction

7.2 Objectives of Product Differentiation

7.3 Theoretical Analysis of Product Differentiation

7.3.1 The Bertrand Model on Product Differentiation: Potential Impact on Price

7.3.2 The Theoretical Impact of Increased Product Differentiation on Social Welfare

7.3.3 A Representative Consumer Model with Differentiated Products

7.3.4 Location Models

7.3.5 Product Differentiation and Advantage of First Mover

7.3.6 Product Differentiation and Entry Barriers

7.4 Product Differentiation in Islamic Perspective

Chapter 8 Advertising

8.1 Introduction

8.2 Theories or Models of Advertising

8.2.1 The Elasticities Approach

Inputting demand and technology data

8.2.2 Advertising and Oligopoly Behaviour

8.2.3 Nature of the Product

8.2.4 Advertising and Market Concentration

8.3 Advertising and Competition

8.3.1 Theory

8.4 Advertising and Product Differentiation

8.5 Advertising and Consumer Behaviour

8.6 Advertising and Barriers to Entry

8.7 Other Aspects of Advertising

8.8 Advertising Technology and Equilibrium

8.9 Effect of Advertising on Welfare

8.10 False Advertising

8.11 Ethics in Advertising

8.11.1 Benefits and Harms of Advertising Based on Ethics

8.11.1 (A) Positive Effect of Advertising on the Economy

8.11.1 (B) Negative Effects of Advertising on the Economy

8.11.1 (C) Benefits of Political Advertising

8.11.1 (D) Harms of Political Advertising

8.11.1 (E) Moral and Religious Benefits of Advertising

8.11.1 (F) Moral and Religious Harms of Advertising

8.11.2 Some Ethical and Moral Principles of Advertising

8.11.3 Ethical Suggestions for Advertising

8.12 Advertising in Islamic Perspective

8.12.1 Advertising is Permissible in Islam

8.12.2 Advertising Is Not Permissible in Islam

8.12.3 The Implication of Islamic Advertising Messages

Chapter 9 Price Discrimination

9.1 Introduction

9.2 Incentive and Condition for Price Discrimination

9.2.1 Profit Motive for Price Discrimination

9.2.2 Resales

9.3 Types of Price Discrimination

9.3.1 First Degree of Price Discrimination

9.3.2 Second Degree of Price Discrimination

9.3.3 Third Degree of Price Discrimination

9.4.1 Welfare Effect of Price Discrimination

9.4.1.1 Based on Linear Demand Curve

9.4.1.2 Based on Nonlinear Demand Curve

9.4.2 Income Effect of Price Discrimination

9.5 Some Ethical Views of Price Discrimination

9.6 Price Discrimination in Islamic Framework

Chapter 10 Rate of Return Regulation: An Indirect Approach

10.1 Introduction

10.2 Theory of Monopoly and Direct Regulation

10.3 Indirect Regulations

10.4 Comparison of the Indirect Methods

10.5 Comparison between the Direct and Indirect Methods

10.5.1 Output under the Direct Method

10.5.2 Output under Indirect Method

10.6 Conclusion

Chapter 11 Rate of Return Regulation Under Cournot Oligopoly

11.1 Introduction

11.2 The Basic Model

11.3 Cournot Oligopoly with Regulation

11.4 Two-Stage Game under Duopoly

11.4.1 Without Regulation

11.4.2 With Regulation

11.5 Conclusion

Chapter 12 The Forces behind Privatisation and Globalisation

12.1 Introduction

12.2 The Forces Promoting Privatisation and Globalisation

12.2.1 Technological and Political Factors

12.2.2 The Nature and Role of Multinational Enterprise (MNE)

12.2.3 Global Competitive Advantage

12.2.3.1 Factor Conditions or Factors of Production

12.2.3.2 Demand Conditions

12.2.3.3 Supporting Industries are Those ‘Dynamic Externalities’

12.2.3.4 Firm Strategy, Structure, and Rivalry Involve Corporate Goals and Management Systems

12.2.4 Government Policy and the Multinational Enterprise

12.2.5 Four Stages of Economic Development

12.3 The Impact of Globalisation on Muslim Country (e.g. Malaysia Is a Successful Muslim Country in Economic Development in a Multi-Ethnic Society)

12.4 The Economic Barriers between the Islamic World and the West

12.5 Suggestions and Solutions

12.5.1 Cooperation, Competition, and Integration

12.5.1(A) International Economic Integration among Muslim Countries

12.5.1(B) Changing Image and Correction of Misunderstanding between the Muslim World and the West

12.5.1(C) Build a Better Future for the Muslim World and the West

12.6 Conclusion

Chapter 13 The Role of Ethics, Maqasid Al-Shari’ah, Morality, and Altruism in Economic Life

13.1 Introduction

13.2 Ethics and Islamic Economics

13.3 Conventional and Ethical Dimensions

13.4 Maqasid Al-Shari’ah and Islamic Economics

13.5 Morality and Islamic Economics

13.6 Altruism and Islamic Economics

13.7 Conclusion

References

Foreword

It is indeed a pleasure for me to write a foreword to this book. This is one of the pioneer books in this nature published during the author’s time in Insaniah University College (KUIN). This work has been completed for easier reading.

This book on industrial economics and organisation based on conventional and Islamic approaches or microeconomics is one step forward in implementing the teaching of philosophy of Insaniah University College (KUIN), Alor Star, Kedah, whereby Islamic perspectives are seriously given a first look in the market structure of industrial organisation in order to develop a comprehensive paradigm of Islamic economics, banking, and finance. It is hoped that there will be further progress in the form of materials and textbooks to complement this book in the teaching of Islamic economics, banking, and finance in KUIN, as well as in other universities in the country and the academic world at large. It is therefore not expected that this book is one for all solutions to the reading materials and references. Further workshops, seminars, research, and conferences for the teaching on Islamic economics, banking, and finance need to be held to provide additional informative and educative knowledge. Constructive criticism of the existing materials is also needed to carry out a collective effort towards the development of Islamic economics, banking, and finance as a discipline. In addition, greater efforts in research and empirical exercise will be needed to develop facts of theoretical analyses and practical applications of principles in order to introduce the subject matter cogently.

It is hoped that this book will spark greater attention and interest in scholarly work and will be highly sought after in this university particularly and in the Muslim world in general. Moreover, it is highly expected that Islamic-based institutions will come out with a proper funding system to provide financial and logistical support towards the preparation of this type of materials for teaching and research on Islamic economics, banking, and finance so that further efforts can be undertaken to expedite the production of this kind of materials at all levels of education in the Muslim world.

Finally, it is also hoped that the discipline of Islamic economics, banking and finance will rapidly grow in this university and attain the level of maturity and development, sufficient for it to be seriously studied and appreciated, not only in the Muslim World but also by scholars worldwide, who may find the alternative that it presents to be more pragmatic, viable, and fulfilling to human nature as a servant of Allah Almighty.

Prof. Dato’ Wira Dr Hj. Jamil Bin Hj. Osman DPMK, DIMP,

Rector, Insaniah University College (KUIN),

Lebuhraya Sultanah Bahiyah,

05350, Alor Star, Kedah Darul Aman,

Malaysia.

About the Author (WS)

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Wan Sulaiman Bin Wan Yusoff is Associate Professor of Economics and Senior Researcher at the Islamic Economics Research Centre (IERC), King Abdul Aziz University (KAU), in Jeddah. He has taught various topics in economics (e.g. principles and intermediate subjects of micro—and macroeconomics, economics for engineering, Islamic economics, industrial economics and organisation) for under—and postgraduate students. He has also supervised some masters and Ph.D theses and dissertations at the Kulliyyah of Economics and Management Sciences (KENM), at the International Islamic University Malaysia (IIUM) (June 1984-July 2003), and at Qatar University (QU), State of Qatar (October 2003-July 2005). From October 2005 to date, he has been working at IERC, KAU, as a senior researcher. In the last twenty-four years, he has worked as Head of the Department of Economics, Deputy Dean of Student Affairs, College Principal (Abu Bakar, Umar, and Bilal colleges), and Acting Dean at KENM, IIUM.

Before serving at higher educational institutions such as IIUM, QU, and KAU, he had received outstanding teaching and administrative experiences in opening private schools (Akademi Kenali) in Kubang Kerian, Kelantan with Dato’ Hassan Bin Harun, Datin Fatimah Bt. Mat Saad, and Tuan Hj. Mustapha Bin Che Wahab (MUHAFA). Armed with his master’s degree from Karachi University, Pakistan, he started his career as an academician at Akademi Kenali Private School in Kubang Kerian, Kelantan. He was assigned to teach principle of micro—and macroeconomic subjects to pre-university students (lower and upper six classes) with the lowest emolument in the human history of the 1970s,¹ which was RM 50 plus loan RM 30 = RM 80 per month for a period of six months. However, he went through this materialistic challenge, for he fully believed that whatever money that he received it was his rezqi from Almighty Allah SWT to His servant. Alhamdulillah, with that genuine faith, he was able to develop his career in teaching. After a year, he was appointed as the Disciplinary Master at the school. His next position was Vice Principal, and finally he held the post of principal of the school for a period of eight years (1975-1983). Prof. Wan Sulaiman received a B.A (Hons.) and master’s degree in economics from Karachi University, Pakistan, under the Scholarship of Jamiaatul Al-Islami (Mawlana Abul Alam Mawdudi) and Ismailiah Foundation for a period of four years (1969-1973), a second master’s degree in Islamic economics from National University of Malaysia (UKM) under MARA loan and IIUM scholarship for two years (1983-1985), and Ph.D in Industrial Economics and Organisation (Privatisation, Regulation and Efficiency) from University of Essex, Colchester, Essex, London, United Kingdom, under Jabatan Perkhidmatan Awam (JPA) scholarship for three and half years (1989-1993).

He is the co-author of Macroeconomics Applications in South East Asian Countries: Conventional and Islamic Perspectives, as well as the author of various articles, comments, proceeding papers, paper presentations, and book reviews. He is also a renowned speaker in forums, sermons, etc. Prof. Wan was also a consultant for ‘National Economic Planning Unit of Malaysia’ (1996-2003) and was an Islamic expert consultant to the Great Eastern Life Assurances for Islamic Fund (2003-2005). The fields of consultation that he specialises in are privatisation, efficiency, Islamic economics, and economic regulations for both the government and private firms.

In addition to teaching, supervising, and researching for a wide variety of courses and projects at IIUM, QU, and KAU, Prof. Wan has taught courses in Islamic economics as a part-time visiting professor for (postgraduate study) Pasca Sarjana Ekonomi Islam IAIAN, Medan, Universitas Sumatera Utara, Indonesia. Prof. Wan originally was from Pattani (southern part of Thailand) and immigrated to Kelantan, and he now resides in the area of Putra Jaya (3047, Jln. Mawar Puteh, Kg. Dato’ Abu Bakar Baginda, 43,000, Bandar Baru Bangi, Kajang Selangor (DE), Gate No. 1 Putra Jaya, Malaysia) with his wife and ten children, four of whom are sons, two daughters-in-law, and seven grandchildren. There are twenty-five family members altogether at the moment.

BISMILLAHIRRAHMANIRRAHIM And seek by means of what Allah has given you the future abode, and do not neglect your portion of this world, and do good (to others) as Allah has done good to you, and do not seek to make mischief in the land, surely Allah does not love the mischief-makers.

(Al-Qassas 28: 77)

Preface

According to Hodgson and Marshall (1977, Vol. 3, p. 441), if Islam can be shown to be capable of providing fruitful vision to illuminate the modern conscience, then all mankind, and not only Muslims, have a stake in the outcome.

In our pursuit of collective struggles in political, social, and economic arenas, we may sometimes ignore our primary religious responsibilities in favour of the ‘higher’ struggle. This statement may help us to set our priorities right: The economic endeavour is a duty after the primary duties. And let us remember that in economics, as well as in religion, getting the priorities right is part of being right.

Industrial Economics and Organisation: Conventional and Islamic Perspectives presents the essentials of both modern conventional industrial economics and organisation with an Islamic economic approach. My principal goal is to educate students about the conventional and Islamic economist’s way of thinking about the market structures and public policy issues in industrial economics and organisation. The heart of this process involves the practice of model building which includes Islamic values and which is a way of contracting rational arguments whose applications are, in principle, empirically verifiable. The text consistently reflects my main belief that both model building and model testing as well as Islamic injunctions related to economics are significant. The setting of my analysis is in the field of Industrial Economics and Organisation: Conventional and Islamic Perspectives. Consequently, I place considerable emphasis on understanding the relationship among firms in an industry or across industries and on the nature of strategic interaction among firms and industries which are governed by Sharia’ah principles.

For a variety of reasons, in most conventional textbooks, the modelling of strategic interaction makes only a cameo appearance and all the modelling details are often relegated to an appendix. Moreover, it is very rare to find moral, ethical, and religious principles discussed in the same model. This is, in our view, a great loss and leads to inconsistencies because a major contribution that economics can make to undergraduate education are instructions in the ability to understand the models and principles and even, more importantly, to develop an analytical argument. Thus, I have tried to fashion a text that makes transparent the critical role of modelling and gives a clear picture of moral, ethical, and religious principles in the creation of a coherent economic argument’s confirmation or rejection. That is typically meant when people talk about ‘thinking like an Islamic economist’.

Industrial economics and organisation whether within conventional or Islamic framework is a particularly appropriate area to convey the economist’s perspective because examples of the tactical considerations and public policy issues that such a course must, by definition, address can be found every day in the business press. Monopoly power; market concentration; product differentiation; discriminatory pricing; mergers; advertising; economic regulation; moral, ethical, and religious issues; and allegations of predation and/or pattern infringement are constantly observed on the corporate battlefield. People in the street and students in the classrooms form opinions about these events and also whether any public policy response is appropriate. However, I have kept the conventional models quite simple—working almost exclusively with either the Cournot-Nash equilibrium model or the Bertrand-Nash model and analysis with relevant Islamic economic principles. In some chapters, I have provided simple numerical illustrations of the model at hand and consistently relate the model to the real-world activities. I hope that industrial economic students are able to react favourably to this approach. It will enable them to think and understand both conventional and Islamic economic theories and issues—even relate to the practical reality of the real life job markets—in a new and more meaningful manner.

Goal and Intended Audience

I wish to emphasise that my book is about industrial economics and organisation from conventional and Islamic perspectives. I have discussed the details of conventional approaches, and at the end of each chapter, I have highlighted the Islamic principles and have given some intuitive comments on the same issues. Wherever possible, I have also attempted to introduce any consensus between conventional and Islamic approaches based on Islamisation of knowledge. One of the disappointments with the ‘new IO’ is the lack of empirical examples in these analytical frameworks. Yet I believe that there are enough numerical tables and figures in the text to convince readers that the analysis is far from mere ivory tower speculation. Indeed, I think that my presentation is a unique approach of Islamic input in this particular discipline and makes clear those corporations, students, lecturers, judges, and antitrust officials, among others, have ample opportunity to put the insights of contemporary industrial economics into practice.

The book is primarily intended for undergraduate and postgraduate students who have completed intermediate microeconomics and foundation Islamic economics courses which have solid ground in the basic models of competition and monopoly. For the most part, I do not assume familiarity with calculus. But I do rely heavily on the ability to work through algebraic equations. The text could also be used in a managerial economics and applied economics class in a graduate business study programme. In addition, it might serve as a foundation text for those who are taking a first graduate course in industrial economics and foundation of Islamic economics for the Islamic parts of each chapter. This book may be described as a more accessible version of advanced text in industrial economics and organisation along with moral, ethical, altruistic, and religious principles.

Organisation of the Book

A particular strength of the text is that each chapter attempts to build on the ones that precede it. Thus, Chapter 1 begins with an introduction to the three approaches to the study of industrial economics and organisation. Along the way, I have presented the structure-conduct-performance (SCP) approach, the Chicago School approach, and the Islamic economics approach as well as what Chicago and Islamic approaches have in common. I have also made clear that the objectives of firms are different in conventional and Islamic approaches. This sets in Chapter 2, in which I have discussed the conventional objectives related to neoclassical firms, structure of the modern firms and managerial objectives. In Islamic objectives, I have highlighted the major objectives of Islamic firms, policy implication, profit motives, and real-world activities in Islamic economics.

Chapter 3 introduces students or readers to the basic understanding of monopoly power and monopoly distortions, deadweight loss, and social cost of monopoly in terms of price and output determination. I have also presented the monopoly from Islamic perspectives based on economists and jurists’ concepts, monopoly with Islamic values, and positive roles and sincere devotion to Islamic spirit.

Chapters 4-9 discuss the theoretical aspects of monopoly power in the economy; how a monopolist can create its power through market concentration is discussed in Chapter 4, mergers in Chapter 5, barriers to entry and exit in Chapter 6, product differentiation in Chapter 7, and advertising and price discrimination in Chapters 8 and 9, respectively. In each of these chapters, Islamic inputs are provided for the students and readers to make a comparative study and provide bland knowledge for their own practical reality in economic activities.

The remaining four chapters, 10-13, of the book provide two alternative approaches of indirect regulation through two types of taxations: Adverlorenz and sales taxes discussed in Chapter 10 and rate of return regulation under Cournot oligopoly presented in Chapter 11. And with regard to the last two chapters, the book highlights in Chapter 12 the general concepts of forces behind privatisation and globalisation and the economic barrier between the West and Muslim world and in Chapter 13 the role of ethics, maqasid Al-shari’ah, morality, and altruism in economic life.

Acknowledgements

I am grateful to ‘Allah Almighty’ who gave me the ability to think and put in collective effort to write this type of textbook and bring it to successful completion. The author has only one source for texts with this nature. I fully rely on my colleagues Prof. Dr Mohammad Saeed Bin Sidiq from KENM, International Islamic University Malaysia (IIUM), who proofread Chapters 1 and 2, Prof. Dr Abdul Rahim Al-Saati from IERC, King Abdul Aziz University (KAU), who proofread Chapter 3, Assistant Prof. Dr Abbderrazak Belabes from IERC, KAU, who proofread Chapter 4, Prof. Dr Ahmad Saeed Bamakhramah from IERC, KAU, who proofread Chapter 5, Assistant Prof. Dr Abdullah Saidu from IERC, KAU, who proofread Chapter 6, Assistant Prof. Dr Ahmed Belouafi from IERC, KAU, who proofread Chapter 7, Prof. Dr Rafiq Yunus Al-Masri from IERC, KAU, who proofread Chapter 8, Prof. Dr Abdul Azim Islahi from IERC, KAU, who proofread Chapters 9-11 from my own Ph.D’s thesis, and Assistant Prof. Dr Abdel Kader Chachi from IERC, KAU, who proofread Chapters 12 and 13. I owe them all and would like to give special thanks to this group of senior researchers in Islamic Economics Research Centre, King Abdul Aziz University.

Apart from the above names, I shall not forget my present and the ex-director of the Islamic Economics Research Centre, KAU, Assistant Prof. Dr Abdullah Qurban Turkistani and Associate Prof. Dr Mohammad Najeeb Ghazali Khayat, respectively, and give them special thanks and gratitude for allowing me to work in the centre for two years to concentrate on writing this book.

Above all else, I wish to thank all my family members, especially my beloved father, Allah Yarham Haji Wan Mohammad Noor Bin Wan Yusoff (who passed away during the time I was in a foreign country), my mother, Hajjah Maimunah Bt. Haji Kechik, and my wife, Hajjah Che Minah Bt. Haji Daud, for they gave me full support and provided me all the inspiration and encouragement that I needed to keep going and finish writing this book. For these and countless other reasons, I lovingly and sincerely dedicate this book to them all.

Chapter 1

Three Approaches to the Study of Industrial Economics and Organisation

1.1 Introduction

1.2 Three Approaches: SCP, Chicago and Islamic Approaches

1.2.1 What Chicago and Islamic Approaches Have in Common?

1.1 Introduction

The field of industrial organisation developed as an offshoot or branch of traditional microeconomics. Microeconomics subjects examine the interactions among producers, consumers, and government, with an emphasis on two traditional models: perfect competition and monopoly, and later on developed the model of imperfect or monopolistic competition and oligopoly. The field of industrial organisation recognises that the models of perfect competition and monopoly do not accurately depict most real-world markets. The field has its roots in the traditional theory of firms developed by Adam Smith and Alfred Marshall in the eighteenth and nineteenth century, respectively. In the nineteenth century, Augustine Cournot and Joseph Bertrand developed theoretical advance in the area of oligopoly theory. In the early 1920s, Edward Chamberlain developed an important theoretical advance in the field of monopolistic competition and it is characterised by relatively large number of buyers and sellers, heterogeneous product or product differentiation, free entry and exit. Chamberlain’s theory differed from the theories of Adam Smith and A. Marshall by focusing attention on product differentiation (e.g. differences in locations, physical products, services, and qualities). One of the driving forces behind Chamberlain’s model was the belief that previous models were poor predictors of the real world. Chamberlain believed that real-world firms competed not only based on price but also based on product differentiation. Chamberlain’s model provided the first theoretical link between perfect competition and monopoly and ultimately led to renewed interest in oligopoly theory and development of the traditional industrial organisation paradigm connecting structure, conduct, and performance (SCP).

Another important point to see is that the difference between microeconomics and industrial organisation is in dynamic performance and static models. Industrial organisation emphasises dynamic performance whereas most microeconomic courses emphasise static models. Static models deal with a moment in time. Dynamic models are strategic and tend to emphasise technological change more than static models do. Static efficiency requires price to be equal to marginal cost and long-run average cost. Dynamic efficiency requires an optimal rate of technological advance and can exist even if price exceeds marginal and average costs. Courses in industrial organisation tend to emphasise dynamic models and efficiency. Its analysis becomes more complex and intricate than traditional microeconomics analysis; it provides valuable insight into what really constitutes efficient performance.

The evolution of industrial economics into a major area of economics has also been closely linked to modern theory and in this book more importantly to the Islamic theory of firms. In standard models of perfect competition and monopoly, the firm has no discretion over its behaviour. In both models, the main motive is that all firms should maximise profit. Industrial case studies in the 1920s suggested that real-world firms did not respond in such mechanistic ways, but the findings indicated that firms had considerable discretion over price, output, and advertising costs. Berle and Means,² for example, found that oligopolist followed behavioural objective rather than profit maximisation.

Once economists recognised that firms have discretion over key choice variables, the discretionary freedom of firms often rejected the profit-maximising