CHAPTER 2: THEORY OF THE FIRM & COSTS I. Effective Competition II.

Firms, Firm Strategy, and Competitive Policy III. Theory of the Firm IV. Costs

EFFECTIVE COMPETITION
Effective competition which leads to good performance is the central concept in I/O. Virtues to look for in I/O: 1. Efficiency (static) Internal efficiency (X-efficiency) Allocative efficiency 2. Technical progress

Innovation yields dynamic efficiency (increases in the PV of welfare)

3.

Equity in distribution Open opportunity Rewards to effort & skill

4. Competitive process

5. Other Freedom of choice

Support for democratic processes

Decentralized structure

Firms, Firm Strategy, and Competitive Policy

1.

The perfectly competitive model serves as an important

reference point, especially for an understanding of the competitive process. A principle feature of a competitive process is free entry. The theory implies that free entry exhausts all opportunities for making an economic profit. That free entry dissipates profit is one of the most powerful insights in economics, and it has profound implications for business strategy and public policy. The key to business strategy is creation of competitive advantage (positive economic profits) and sustaining a competitive advantage in which a firm must secure a position in the market that protects itself from imitation and entry (need some barriers to entry to earn positive economic profits that are the reward for innovation). Public policy views the competitive process as desirable because prices and profits are regulated by the invisible hand resulting in an approximation to marginal cost pricing that maximizes welfare (consumer surplus + producer surplus). This notion of efficiency (maximizing CS + PS) is static, although we may use CS and PS when evaluating a dynamic situation of innovation. Monopoly, on the other hand, is characterized as a market

2.

structure with barriers to entry and the market power to price

profitably above marginal cost. As a result, less is purchased than if the market was perfectly competitive and society suffers a deadweight loss, again in a static sense. The study of barriers to entry is very important in IO. When the barrier to entry is due to economies of scale, a natural monopoly (declining long-run average total costs throughout the range of demand) exists and it may be desirable to have only one firm produce the markets output. Public policy usually dictates that the natural monopoly be regulated to achieve better pricing and more efficiency. A patent is a government sanctioned barrier to entry that allows the innovator to reap rewards for the investment from monopoly pricing. Many business behaviors that result in a monopoly may violate antitrust laws. The justification for such laws is the inefficiency of the deadweight loss. Government intervention may be justified to achieve efficiency.

3.

For example, government intervention may be helpful if some of the assumptions of perfect competition do not hold (property rights not clearly defined or the existence of externalities like pollution a situation referred to as market failure). In addition, regulation may be needed to restore effective competition. However, intervention in competitive markets (even when they are not perfectly competitive, but the competitive process is viable) will

tend to reduce efficiency in these markets (a situation referred to as government failure). Economic theory is not clear on how many firms are necessary

4.

to achieve a viable competitive process. In some models (Bertrand price competition) only two firms are needed to attain competitive outcomes. In other models (contestable markets) no competitors are required (just the threat of entry) to attain competitive outcomes. On the other hand, in some oligopoly models (cartels, price fixing), price is well above marginal cost and an inefficient outcome results. Economics of scale are problematic, allowing more efficient

5.

outcomes with fewer firms with market power than a competitive market structure. The economies of scale achieved by a few firms in the market result in price higher than marginal cost, but prices lower than from a competitive market. More lenient public policy would be advantageous. Similarly, firms pursuing a competitive strategy to achieve a

6.

competitive advantage by developing new innovative products (a product differentiation strategy) or more efficient production techniques (a cost leadership strategy), will result in price above

marginal cost, but more efficient outcomes with consumers and society better off (an increase in CS and PS). The conclusion from monopolistic competition based on product differentiation is that inefficiency, in a static sense, results. But in a dynamic sense, markets with product differentiation may be more efficient than without the innovation that leads to market power.

THEORY OF THE FIRM

Objective of a Firm: The objective of the firm is to maximize (present) value, i.e., maximize the discounted value of profits. However, the standard assumption is simply to maximize the firms profits. In a one-period model this is sufficient. In the static one-period model, the profit maximizing firm produces where MR = MC. Ownership and Control: The dominant business form is the corporation, whose capital is divided up into shares. An important development in the growth of the corporation is limited liability for the shareholders or equity owners. Separation of Ownership and Control: This became a problem as corporations grew in size and the owners were not longer the managers. Corporate governance issues Principal agent problem

Alternative Theories of the Firm

Note that structure is not a sufficient factor to explain conduct, but may be necessary in some cases. Problems: 1. Which structure is worse? (fraction indicates market share) 1/3 1/3 Or 1/3 1/9 1/9 1/9 1/27 1/27 1/27 1/27 1/27 1/27 1/27 1/27 1/27 1/3

Structure is not sufficient to determine Conduct/Behavior. Need more information on barriers, contestability, economies of scale & scope, infrastructure, and regulation Structure is not sufficient to determine Performance. Large firms may be more innovative than small firms Conduct was the unsatisfactory part of S-C-P model

2. Neoclassical view of the firm is a Black Box.

BLACK Inputs BOX

Outputs

Neoclassical Theory of the Firm: 1. Model utilizes comparative statics 2. Assumptions Maximize profits (SR view) Perfect information assumption implies all firms have access to same technology (hence cost structures as well) Changing technology and innovation are external to the firm (technology assumed fixed) Limited scope single product

Modern Theory of the Firm 1. Ronald Coase in Nature of the Firm (1937) explained that a firm and a market are alternative means of organizing economic activity 2. Input Output relationship is a series of contracts 3. Differences in contracts lead to different organizational structures and hence different technologies 4. Look inside the black box. May find multi-divisional, multi-plant firms with varying arrays of boundaries 5. Firms maximize value (LR view) 6. Strategic thinking 7. Technological & organizational change may be primarily endogenous May yield competitive advantage, higher efficiency, and positive economic profits Exogenous technological change will not yields higher profits. Why? May overcome barriers to entry Consider two industries i) ii) Electric utilities Telecommunications

FIRM BOUNDARIES Horizontal Boundaries: 1. Horizontal boundaries identify the quantities and varieties of products and services that a firm produces 2. Economies of scale and scope are important in determining a firms horizontal boundaries
3.

Mergers that most often impact the horizontal boundaries of the firm concern antitrust authorities the most

Vertical Boundaries: 1. The vertical boundaries of a firm define the activities that a firm performs itself (MAKE) as opposed to purchases from independent firms (BUY) 2. Involves the MAKE-OR-BUY decision 3. The are numerous ways of organizing 4. Outsourcing alters the firms vertical boundaries

EXAMPLES of Vertical Organization Virtual Corporation: BUY everything Vertically Integrated: MAKE everything Make or Buy: MAKE at some stages, BUY at others Tapered Integration: MAKE and BUY at some stage Strategic Alliances and Joint Ventures: Transacting parties are legally independent, but entails closer cooperation and coordination (possibly explicit contracts) than an arms length, off-the-shelf (BUY) exchange Keiretsu: Japanese subcontracting networks relying on longterm, semiformal and formal relationships (usually implicit contracts)

In considering the MAKE versus BUY decision, need to look at the Benefits and Costs (in particular, the firm wants to minimize costs to obtain a given benefit) Cost of Making: Cost of purchased inputs + Labor costs + Organizational Costs Agency costs (e.g., shirking) Influence costs (e.g., internal lobbying) Opportunity costs Inability to exploit economies of scale Inability to exploit learning economies

Cost of Buying: Cost of good or service + Transaction costs Cost of negotiating, writing, and enforcing contracts

Cost of coordinating production flow through vertical chain

Leakage of private information Problem with incomplete contracts

Advantage of Market (BUY): [Williamson] 1. 2. 3. 4. Market specialist can exploit economies of scale Market specialist can exploit economies of scope Reduction of risk transfer of risk Invisible hand of the market will impose discipline (high-powered incentives) Advantage of Firm (MAKE): Transaction costs of using the market are too high. 1. Contracts incomplete due to bounded rationality 2. Principal agent problems opportunism bad incentives Higher propensity to MAKE when: 1. Increased frequency of purchase with high transaction cost per purchase (BUY if transaction cost are fixed costs) 2. 3. Greater uncertainty (more incomplete contracts) Higher the degree of asset specificity (market

that the visible hand of management may not

specialist more likely to hold-up with higher incentives for opportunistic behavior

Four general rules for managers of when to rely on the market and when to perform tasks in-house. 1. Rely on the market for routine items; produce in-house items which require specific investments in design, engineering, or production know-how. 2. Asset specificity is high -- vertical integration is best. Asset specificity is low -- reliance on the market is best.

Rely on market for items that require large upfront investments in physical capital or organizational capabilities that outside firms already have. When outside specialists benefit from significant economies of scale, reliance on the market is best. When in-house division can capture nearly all economies of scale in activity, vertical integration is best.

3.

Vertical integration is usually more efficient for bigger firms than for smaller. Larger scale of product market activities -- vertical integration is best. Smaller scale of product market activities -- reliance on the market is best.

4.

Technological advances in telecommunications and data processing have tended to lower coordination costs, making reliance on the market more attractive. High coordination costs -- vertical integration is best.

Low coordination costs -- reliance on the market is best. STRUCTURE OF MODERN FIRMS History

1840: 1. Poor infrastructure 2. Technology changing but industrial revolution in its infancy 3. Business is risky (difficult for large operations to succeed) 4. Firms are small and family operated, relying on market specialist for distribution and market makers 1910: 1. Limited liability for corporations 2. Improved infrastructure especially transportation (railroad) 3. Innovations in production technology made large scale production more efficient 4. Large investments in large-scale operations made assurance of throughput vital 5. Manufacturing firms vertically integrated into raw materials acquisition, distribution, and even retailing 6. Vertically integrated firms was the efficient structure 1920s:

1. Manufacturing firms expanded product offerings, creating new divisions & M-form organizational structure (General Motors) 2. Professional managers with little ownership interest required to run new hierarchical structure 3. Separation of ownership and control Modern Era: 1. Significant improvements infrastructure: transportation (highways, airports), communications, finance, technology 2. New technologies reduced the advantages of large, hierarchical, vertically integrated firms 3. Smaller may be better 4. Separation of ownership and control is still a major problem

PRINCIPAL AGENT PROBLEM With the separation of ownership and control we get the principal agent problem in which the objective of the principal, who delegates responsibility or control to an agent, may diverge from the agents objective. A poorly shaped incentive structure creates this problem. Examples: Principal employer shareholder owner Cast General Objective Specific Objective Agent employee manager players Agent Managers Maximize Utility Maximize Profit Maximize Sales Maximize Perks Maximize Power Max Personal Wealth Satisficing Behavior

Principal Shareholders Maximize Utility Maximize Value

Feasibility of Profit (Value) Maximization The argument is sometimes made that the organizational size and complexity of modern firms makes it difficult to maximize value precisely, and that managers rely rules of thumb or satisficing behavior to make decisions due to bounded rationality. Claim: Rules of thumb, such as mark-up pricing, may not deviate much from profit maximization. In addition, rules that deviate greatly from profit maximization will be unsuccessful in a competitive marketplace. CONTRAINTS ON MANAGERS Despite principal-agent problem and feasibility of profit maximization, managers do face constraints to maximize the value of the firm. They include: 1. Stockholder revolt 2. Threat of takeover market for corporate control 3. Market discipline competitive pressure 4. Incentives bonuses & stock options

MERGERS One factor affecting concentration is mergers. The main motive for mergers is to increase profitability. However, we are interested in understanding which of the following scenarios might occur. 1. Reduced Efficiency merger concentration 2. Increased Efficiency merger efficiencies good performance bad performance

Types of Mergers: Vertical: Combination with a supplier Combination of unrelated firms

Horizontal: Combination of firms in same market Conglomerate: Mergers based on economies of scope

History of Mergers: Merger activity has coincided with stock market booms, which facilitates the financing of mergers, despite the high price of shares. 1st Wave: Turn of the 20th century (around 1900) Merger to Monopoly Achieve economies of scale Avoid antitrust entanglements (collusion illegal mergers were not) Ended with the 1904 Northern Securities Supreme Court case and recession 2nd Wave: 1920s Merger to Oligopoly Did not create monopoly or even largest firm in market Strategy not clear (efficiency or market power)

3rd Wave: 1960s Conglomerate Merger Movement Produced conglomerate firms or holding companies 4th Wave: 1980s - ? No common name Based on pure number or nominal values, numbers are high

Relative to the size of the economy, the 1st wave is larger

MOTIVES FOR MERGERS 1. Market power reduce efficiency create deadweight loss foreclosure or squeeze on suppliers 2. Increase efficiency Economies of scale Economies of scope Improve management 3. Others Risk reduction bad reason let investors do their own diversification Tax codes (ITC) Empire building Financial

Static Trade-off A merger is likely to increase market power and create an inefficient deadweight loss. However, a merger may result in a significant reduction in cost so the there is an increase in welfare ( CS + PS )

Empirical Evidence: 1. Stock market evidence suggests that mergers improve efficiency and create value (lots of problems with analysis using stock market data; self-fulfilling prophecy) 2. Shareholders of target firms are the primary beneficiaries 3. Little increase in market concentration and power 4. Economies of scope, without culture clashes, are needed to get conglomerate mergers to work

COST CONCEPTS S-R Costs of Production: (some factors are fixed in the S-R) Fixed Costs (FC) Expense that does not vary with output Sunk Costs Portion of FC that is not recoverable Note: FC that is not sunk should influence decisions. Variable Costs (VC) Costs that change with output, q. Total Costs (TC) = FC + VC Average Total Cost (AC) = AFC + AVC Marginal Cost (MC) = (TC/q) = (VC/q) The S-R cost curves impart information about the production technology. Without economies of scale, the cost curves take on the usual U-shaped pattern. Long-run versus Short-Run 1. In the S-R some factors of production cannot be costlessly varied. Firms make production decisions.
2.

In the L-R all inputs are variable. Firms make investment decisions. LRAC is the envelope of SRAC curves

3.

Economies of Scale: AC falls: economies of scale (or increasing returns to scale) AC constant: constant returns to scale) AC rises: diseconomies of scale (or decreasing returns to scale) Economies of scale will be important in determining firm size and may be a barrier to entry if large capital expenditures are required. Depending on the size of the market it may result in a natural monopoly. Minimum Efficient Size (MES) also important. Reasons for Economies of Scale: 1. Fixed setup costs 2. Labor can specialize 3. Firms with several plants can avoid switchover costs 4. Holding inventories 5. Physical properties (double radius of pipe more than doubles volume through pipe) Reasons for Diseconomies of Scale:
1.

Scarcity of some inputs (managerial ability)

2. Transportation cost

Economies of Scope: 1. Economies of scope exist when it is cheaper to produce two products together (joint production) rather than separately.
2.

This is an important concept for multiproduct firms. It is a justification for mergers due to resulting efficiencies.

3. Formal definition: C( A , B ) C( A , 0 ) + C( 0 , B ) Media Examples: Disney and ABC AOL and Time Warner Other examples: Daimler and Chrysler Trane and American Standard Note: Economies of Scope are often not exploited well in mergers.