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Chapter 4 Theories of Firms

Meaning of Theories of Firm :


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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

The importance of the Concept of an Industry


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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.

Objectives of Theories of the Firm


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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.

Importance of the Theories of Firm


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1. To know about perfect competition


Short run equilibrium Long run equilibrium Dynamic changes and equilibrium

3. To know effect of price discrimination and the existence of the industry. 4. To know about monopoly

2. To know about monopolistic competition

Demand and revenue Cost Equilibrium of the monopolist

Product differentiation and demand curve Equilibrium of the firm Comparison with pure competition

5. To know about sales revenue maximization.

Classification of the Theories of the Firms

Theories of the firms have been divided into three classes :


1. 2. 3.

Economic Theories . Managerial Theories . Behavioral Theories .

Economic Theories
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Economic theories have been divided into four types : A. Perfect competition . B. Monopoly . C. Monopolistic competition . D. Oligopoly .

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

Assumptions of perfect competition are as followings :


1.

2.
3. 4. 5. 6. 7. 8. 9.

Large number of sellers and buyers . Product homogeneity . Absence of artificial restriction . Freedom of entry and exit of firms . Perfect mobility of factor of production . Perfect knowledge . Absence of transport cost . Profit maximization . No government regulation.

B. Monopoly
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Its a one seller product market Product has no close substitute Firms can fixed a high price for its product It has own channel of distribution

Monopoly Emerges For


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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.

Assumptions of Monopoly
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1.

2. 3.

4.

There is one seller producer of a homogeneous product There are no close substitute for the product There is pure competition in the factor market so that the price of each input he buys is given to him The monopolist is a rational being who aims at maximum profit with the minimum of cost

Assumptions of Monopoly (Cont.)


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5.

6.

7.
8.

There is no threat of entry of other firms. There may buyers on the demand side but none is in a position to influence the price of the product by his individual actions. The monopoly price is uncontrolled. The monopolist does not charge discriminating price

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

Assumptions:
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Chamberlin has given some basic assumptions which are as following


1. 2. 3. 4.

Large number of sellers and buyers in the groups. Sellers are differentiated Free entry and exit of firms in the group. Goal of the firm is profit maximization

5.
6.

Prices of factors and technology are given.


Firm is assumed to behave as if it knew its demand and cost curve with certainty. The long run consists of a number of identical short run period Both demand and cost curve of all products are uniform throughout the group.

7. 8.

Features of monopolistic competition


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The following are the main features of monopolistic competition1. Large number of sellers 2. Product differentiation. 3. Freedom of entry and exit of firms 4. Nature of demand curve

D. Oligopoly
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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.

Characteristics of oligopoly:
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In addition to fewness of sellers , most oligopolistic industries have several common characteristics which are explained below1. 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

Managerial Theories of Firm


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Three models of Managerialism: 1. Baumols model of sales revenue maximization 2. Marris model of managerial enterprise 3. Williamsons model of managerial discretion

1. Baumols model of sales revenue maximization


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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

Baumols Static Models: Basic Assumptions


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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

Baumols Dynamic Models: Basic Assumptions


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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

2. Marriss Model of the Managerial Enterprise


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The Goal of the firm in Marriss 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]

Marriss Model of the Managerial Enterprise (cont.)


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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

3. Williamsons Model of Managerial Discretion


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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

3. Williamsons Model of Managerial Discretion (cont.)


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The managerial utility function includes such variables as:


Salary Security

Power
Status Prestige

Professional excellence

The Behavioral model of Cyert and March


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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.

The Behavioral model of Cyert and March


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The model of cyert and March can developed in the following sequences:
The firm as a coalition of groups with conflicting goals. Process of goal formation- goals from different groups within the firm Definition of the goals of the firm by top management.Satisfying behaviour of the firm Means for the resolution of the conflicting demands and interests of the various groups of the firm-coalition The process of decision making for the implementation of goals set by the management. The environment of the firm and the treatment of uncertainity in the behavioral theory.

o o o

The Behavioral model of Cyert and March


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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

Criticisms of the theories of the firm


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

Implications of Industrial theories


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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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