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IDE 2r

IDE 2r

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Published by Arina Farihan Azhar

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Published by: Arina Farihan Azhar on Dec 08, 2011
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CHAPTER 2:THEORY OF THE FIRM & COSTSI.Effective CompetitionII.Firms, Firm Strategy, and Competitive PolicyIII.Theory of the FirmIV.CostsEFFECTIVE COMPETITION
competition which leads to good performance is the central concept in I/O. Virtuesto look for in I/O:1.Efficiency (static)
Internal efficiency (X-efficiency)
Allocative efficiency2.Technical progress
Innovation yields dynamic efficiency (increases in the PV of welfare)
“Equity” in distribution4.Competitive process
Open opportunity
Rewards to effort & skill5.Other
Freedom of choice
Support for democratic processes
Decentralized structureFirms, Firm Strategy, and Competitive Policy
1.The perfectly competitive model serves as an important reference point, especially for anunderstanding of the competitive process. A principle feature of a competitive process isfree entry.The theory implies that free entry exhausts all opportunities for making an economic profit. That freeentry dissipates profit is one of the most powerful insights in economics, and it has profoundimplications for business strategy and public policy. The key to business strategy is
 of competitive advantage (positive economic profits) and
a competitive advantage in which afirm 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 policyviews the competitive process as desirable because prices and profits are regulated by the invisiblehand 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 useCS and PS when evaluating a dynamic situation of innovation.2.Monopoly, on the other hand, is characterized as a market structure with barriers to entryand themarket power to price profitably above marginal cost. As a result, less is purchased than if the marketwas 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 toeconomies of scale, anatural monopoly (declining long-run average total costs throughout the range of demand) exists and itmay be desirable to have only one firm produce the market’s output. Public policy usually dictatesthat the natural monopoly be regulated to achieve better pricing and more efficiency. A patentis agovernment sanctioned barrier to entry that allows the innovator to reap rewards for the investmentfrom monopoly pricing. Many business behaviors that result in a monopoly may violateantitrustlaws. The justification for such laws is the inefficiency of the deadweight loss.3.Government intervention may be justified to achieve efficiency. For example, governmentintervention may be helpful if some of the assumptions of perfect competition do not hold (propertyrights not clearly defined or the existence of externalities like pollution – a situation referred to asmarket 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 asgovernmentfailure). 4.Economic theory is not clear on how many firms are necessary to achieve a viable competitive process. In some models (Bertrand price competition) only two firms are needed to attain competitiveoutcomes. 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.5.Economics of scaleare problematic, allowing more efficient outcomes with fewer firms withmarket power than a competitive market structure. The economies of scale achieved by a few firms inthe market result in price higher than marginal cost, but prices lower than from a competitive market.More lenient public policy would be advantageous.6.Similarly, firms pursuing acompetitive strategyto achieve a competitive advantage by developingnew 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 withconsumers and society better off (an increase in CS and PS). The conclusion from monopolisticcompetition – based on product differentiation– is that inefficiency, in a static sense, results. But in adynamic sense, markets with product differentiation may be more efficient than without theinnovation that leads to market power.
THEORY OF THE FIRMObjective 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 firm’s profits. In a one-period model this is sufficient. In the static one-period model, the profit maximizing firmproduces where MR = MC.Ownership and Control:The dominant business form is the corporation, whose capital is divided up into shares. Animportant development in the growth of the corporation islimited liabilityfor the shareholdersor equity owners.Separation of Ownership and Control:This became a problem as corporations grew in size and the owners were not longer themanagers.
Corporate governance issues
Principal agent problemAlternative Theories of the Firm
 Note that structure is not a
factor to explain
, but may be necessary in some cases.
Problems:1. Which structure is worse? (fraction indicates market share)1/31/31/3Or1/31/91/271/271/271/91/271/271/271/91/271/271/27

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