This article focuses on industrial organization and finance. Industrial organization and corporate finance have evolved into two distinct fields of study. Both topics are concerned with the strategic relationship between internal economic decisions and external market decisions. There is an exploration of market structures. Market structures take into consideration: The number of firms in an industry, the relative size of the firms (industry concentration), demand conditions, ease of entry and exit, and technological and cost conditions. Profit and wealth maximization is discussed. In addition, the value of firm-bank relationships is introduced.
Keywords Bank-firm Relationships; Capital Structure; Market Structures; Monopolistic Competition; Monopoly; Oligopoly; Perfect Competition; Profit Maximization; Wealth Maximization
Finance: Industrial Organization
In the past, the field of industrial organization has not focused on corporate finance, and vice versa. However, a working knowledge of both fields may assist scholars in understanding “how product markets perform when firms participating in a market are constrained financially, and for understanding how capital structure and corporate governance contribute to product market strategy” (Riordan, 2003, p. 1). Industrial organization and corporate finance have evolved into two distinct fields of study. Brander and Lewis (1986) suggested that the research on financial structures and oligopoly have something in common. Both topics are concerned with the strategic relationship between internal economic decisions and external market decisions. Harris and Raviv (1991) identified the industrial organization effects of capital structure as one of the four major topics when studying the theory of capital structure.
Roe (2001) asserted that “the relative value of shareholder wealth maximization for a nation is partly a function of that nation’s industrial organization. When much of a nation’s industry is monopolistically organized, maximizing shareholder wealth would maximize the monopolist’s profits, induce firms to produce fewer goods than society could potentially produce, and motivate firms to raise price beyond that which is necessary to produce the goods” (p.1).
Profits are very crucial to a firm’s bottom line. When a firm is able to make a profit, there is an assumption that the company has done a good job of being effective and efficient in controlling the cost while producing a quality product or performing a quality service. However, there are different types of profits. Two types of profits are accounting profits and economic profits.
- Accounting profits are the difference between the total revenue and the cost of producing products or services; they appear on the firm’s income statement.
- Economic profits are the difference between overall revenue and the total amount of opportunity costs. The opportunity costs tend to be higher than accounting and bookkeeping costs.
Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs. Five of the most discussed theories in this area are:
- Risk-Bearing Theory. When the owners of a company make investments into the firm, they take on a certain amount of risk. In order to compensate them for their investment, the company will need to have an above average return on economic profits. An example would be a firm that has investors such as venture capitalists or angel investors.
- Dynamic Equilibrium Theory. Every firm should strive to have a normal rate of profit. However, each firm has the opportunity to earn returns above or below the normal level at any time.
- Monopoly Theory. Monopoly Theory. There are times when one firm many have the opportunity to dominate in its industry and earn above average rates of return over a long period of time. These firms tend to take control of the market as a result of economies of scale, dominate the ownership of essential natural resources, control crucial patents and influence government regulations. An example would be utility companies.
- Innovation Theory. A firm may earn above normal profits as a reward for its successful innovations such as patents. An example would be a pharmaceutical organization such as Astra Zeneca.
- Managerial Efficiency Theory. A firm may be able to earn above average profits based on its strong leadership team. This type of organization gains profits as a result of being effective and efficient. An example would be General Electric under Jack Welch’s leadership.
Wealth maximization is a long term operational goal. Shareholders continue to exert a claim on a firm’s net cash flows even after anticipated contractual claims have been paid. All other stakeholders (i.e. employers, customers) have contractual expected returns. There tends to be a preference for wealth maximization because it takes into consideration (Shim & Siegel, 1998):
- Wealth for the long term.
- Risk or uncertainty.
- The timing of returns.
- The stockholders’ return.
Criterion for this goal suggests that a firm should review and assess the expected profits and or cash flows as well as the risks that are associated with them. When conducting this evaluation, there are three points to keep in mind.
- First, economic profits are not equivalent to accounting profits.
- Second, accounting profits are not the same as cash flows.
- Lastly, financial analysis must focus on maximizing the current value of cash flows to firm owners when attempting to maximize shareholder benefit.
Market structures take into consideration:
- The number of firms in an industry.
- The relative size of the firms (industry concentration).
- Demand conditions.
- Ease of entry and exit.
- Technological and cost conditions.
The preferred structure is dependent on the type of industry. Therefore, the financial management team of each firm determines which of the above-mentioned factors will be a part of the decision making process.
The level of competition tends to be dependent on whether there are many (or a few) firms in the industry and the firm’s products are similar or different. Given this information, four basic approaches…