Chapter – 4Theories of Firms

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Meaning of Theories of Firm :

Theory of Firms goes along with the theories of consumer. A microeconomic concept founded in neoclassical economics that states that firms(corporations) exist and make decision in order to maximize profits

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The importance of the Concept of an Industry

• It reduces the complex interrelationship of all

firms of an economy.

• It makes possible to derive a set of general rules

to predict about the behavior of group

constituting the industry.

• It provides a framework for analyzing the effect

of firms behavior on price and output.

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Objectives of Theories of the Firm• Analyze markets at the level of the firm .• Apply the theories at the firm level.• To be clear about perfect competition was no

longer adequate.• Show institution and market as a possible form

of economic transaction coordinator .• Understanding motivating factors of firms

choice.• Find different drivers of firms action and

performance.

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Importance of the Theories of Firm

1. To know about perfect competition– Short run equilibrium– Long run equilibrium– Dynamic changes and

equilibrium

2. To know about monopolistic competition– Product differentiation and

demand curve– Equilibrium of the firm– Comparison with pure

competition

3. To know effect of price discrimination and the existence of the industry.

4. To know about monopoly– Demand and revenue– Cost– Equilibrium of the monopolist

5. To know about sales revenue maximization.

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Classification of the Theories of the Firms Theories of the firms have been divided into

three classes :1. Economic Theories .2. Managerial Theories .3. Behavioral Theories .

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Economic Theories

Economic theories have been divided into four types :

A. Perfect competition .B. Monopoly .C. Monopolistic competition .D. Oligopoly .

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A. Perfect competition .

Perfect competition is a market structure where there is no rivalry among the individual firms.

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Assumptions of perfect competition are as followings :1. Large number of sellers and buyers .2. Product homogeneity .3. Absence of artificial restriction .4. Freedom of entry and exit of firms .5. Perfect mobility of factor of production .6. Perfect knowledge .7. Absence of transport cost .8. Profit maximization .9. No government regulation.

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B. Monopoly

It’s a one seller product market Product has no close substitute Firm’s can fixed a high price for its product It has own channel of distribution

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Monopoly Emerges For Ownership of strategic raw material of exclusive model of

production technique . Patent right for a product or for a production process Govt. licensing or the impositions of foreign trade barrier

to explored foreign competitors The size of the market may not support more than one

plant of optimum size The existing firm adopts a limit pricing policy to prevent

next entry.

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Assumptions of Monopoly

1. There is one seller producer of a homogeneous product

2. There are no close substitute for the product

3. There is pure competition in the factor market so that the price of each input he buys is given to him

4. The monopolist is a rational being who aims at maximum profit with the minimum of cost

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Assumptions of Monopoly (Cont.)

5. There is no threat of entry of other firms.6. There may buyers on the demand side but

none is in a position to influence the price of the product by his individual actions.

7. The monopoly price is uncontrolled.8. The monopolist does not charge discriminating

price

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C. Monopolistic Competition

It refers to a market situation where• many firms selling a differentiated product• competition which is keen• competition among larger number of sellers

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Chamberlin has given some basic assumptions which are as following

1. Large number of sellers and buyers in the groups.

2. Sellers are differentiated

3. Free entry and exit of firms in the group.

4. Goal of the firm is profit maximization

5. Prices of factors and technology are given.

6. Firm is assumed to behave as if it knew its demand and cost curve with certainty.

7. The long run consists of a number of identical short run period

8. Both demand and cost curve of all products are uniform throughout the group.

Assumptions:15

The following are the main features of monopolistic competition-

1. Large number of sellers

2. Product differentiation.

3. Freedom of entry and exit of firms

4. Nature of demand curve

Features of monopolistic competition16

D. Oligopoly

Oligopoly is a market situation where Few firms selling homogeneous or differentiated product. Difficult to pinpoint the number of firms in oligopolistic market. There may be three, four or five firms. Also known as competition among the few. It produces either a homogeneous product or heterogeneous

product. The former is called pure or perfect oligopoly, and the latter is called imperfect or differentiated oligopoly.

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Characteristics of oligopoly:

In addition to fewness of sellers , most oligopolistic industries have several common characteristics which are explained below-

1. Interdependence

2. Advertisement

3. Competition

4. Barriers to entry of firm

5. Lack of Uniformity

6. Demand curve

7. No unique pattern of pricing behavior

8. Managerial Theories of firm

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Managerial Theories of Firm

Three models of Managerialism:

1. Baumol’s model of sales revenue maximization

2. Marri’s model of managerial enterprise

3. Williamson’s model of managerial discretion

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He presented two basic models:

A) Static single-period model

B) Multi-period dynamic model of growth of sales revenue maximization

1. Baumol’s model of sales revenue maximization

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Baumol’s Static Models: Basic Assumptions

The time horizon of a firm is a single period During this period the firm attempts to maximize

its total sales revenue The minimum profit constraint is exogenously

determined by the demands & expectations of the shareholders , the banks and other financial institutions.

Conventional cost & revenue functions are assumed

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Baumol’s Dynamic Models: Basic Assumptions

Attempts to maximize the rate of growth of sales over its lifetime

Profit is the main means of financing growth of sales

Demand &costs have the traditional shape Profit is not a constraint but an instrumental

variable

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2. Marris’s Model of the Managerial Enterprise

The Goal of the firm in Marris’s model is:-the balanced rate of growth of the firm

[-the maximization of the rate of growth of demand for the products; and

-the growth of its capital supply]

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Marris’s Model of the Managerial Enterprise (cont.)

In pursuing this maximum balanced growth rate the firm has 2 constraints: Firstly, a constraint set by the available managerial

team & skills Secondly, a financial constraint set by the desire of

managers to achieve maximum job security

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3. Williamson’s Model of Managerial Discretion

Williamson argues that managers have discretion in pursuing policies Maximizing their own utility rather than attempting

the maximization of profits Maximizes the utility of owner shareholders Profit acts as a constraint to the managerial

behavior The job security of managers may be endangered

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The managerial utility function includes such variables as: Salary Security Power Status Prestige Professional excellence

3. Williamson’s Model of Managerial Discretion (cont.)

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The Behavioral model of Cyert and March

They Placed emphasis on explaining how decisions are taken within the firm.

Goes beyond neo classical economics. The behaviour of an organization is the

collaborative result of the behaviour of the parties involved in it.

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The Behavioral model of Cyert and March

The model of cyert and March can developed in the following sequences:

o The firm as a coalition of groups with conflicting goals.o Process of goal formation- goals from different groups within the firmo Definition of the goals of the firm by top management.Satisfying

behaviour of the firmo Means for the resolution of the conflicting demands and interests of

the various groups of the firm-coalitiono The process of decision making for the implementation of goals set by

the management.o The environment of the firm and the treatment of uncertainity in the

behavioral theory.

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A simple model of behaviorism model:[ Illustration of decision making process within modern large corporations] The steps are as follows,

Forecast of competitors' reaction Forecast of firms demand Estimation of cost Specification of goals of the firm Evaluation of results by comparing them with the goals If goals are not attained the firm reexamines the estimate of the cost Evaluation of the new solution by comparing it to goals If goals are not attained the firm reexamines the estimate of its demand

The Behavioral model of Cyert and March

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Criticisms of the theories of the firm

As there is three kind of theory in firm the main critics of theories of the firm are the inadaptability of any one of the theories with the organization or the firms. The theories of the firm may not be applicable in following circumstances-

Unskilled Labor Lack of Technology Unfavorable environment Lack of support from the Government Political Violence

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Implications of Industrial theories

The theories of the firms serves some major purposes within the framework of economic theory

It describes How individual firms make decisions in a market system.

The theory prescribes how individual business firms should make decisions in a market system.

The theory is a basis for describing the behaviour of certain aggregates of firms especially for an industry for a particular sector of the economy.

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Thank You

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