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Chapter – 4 Theories of Firms

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

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.

Objectives of Theories of the Firm 4 • • • • • • Analyze markets at the level of the firm . Find different drivers of firms action and performance. Apply the theories at the firm level. Understanding motivating factors of firms choice. . Show institution and market as a possible form of economic transaction coordinator . To be clear about perfect competition was no longer adequate.

Importance of the Theories of Firm 5 1. To know about sales revenue maximization. To know about monopoly – – – 2. 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 monopolistic competition – – – Demand and revenue Cost Equilibrium of the monopolist Product differentiation and demand curve Equilibrium of the firm Comparison with pure competition 5.

Managerial Theories . . 2. Economic Theories . Behavioral Theories . 3.6 Classification of the Theories of the Firms  Theories of the firms have been divided into three classes : 1.

. Monopoly . Perfect competition . Oligopoly . B. C. D. Monopolistic competition .Economic Theories 7  Economic theories have been divided into four types : A.

A. . 8  Perfect competition is a market structure where there is no rivalry among the individual firms. Perfect competition .

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

B. Monopoly 10     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 .

Patent right for a product or for a production process Govt.Monopoly Emerges For 11      Ownership of strategic raw material of exclusive model of production technique . . 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.

4. 2. 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 12 1. 3.

Assumptions of Monopoly (Cont. 8.) 13 5. 6. The monopoly price is uncontrolled. There may buyers on the demand side but none is in a position to influence the price of the product by his individual actions. There is no threat of entry of other firms. The monopolist does not charge discriminating price . 7.

C. Monopolistic Competition 14  • • • It refers to a market situation where many firms selling a differentiated product competition which is keen competition among larger number of sellers .

3. 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. Large number of sellers and buyers in the groups. Prices of factors and technology are given. 6. Goal of the firm is profit maximization 5. 2.Assumptions: 15 Chamberlin has given some basic assumptions which are as following 1. Sellers are differentiated Free entry and exit of firms in the group. 4. 7. Firm is assumed to behave as if it knew its demand and cost curve with certainty. . 8.

Features of monopolistic competition 16 The following are the main features of monopolistic competition1. Product differentiation. Nature of demand curve . Freedom of entry and exit of firms 4. 3. Large number of sellers 2.

 Difficult to pinpoint the number of firms in oligopolistic market. Oligopoly 17 Oligopoly is a market situation where  Few firms selling homogeneous or differentiated product.  There may be three. .D.  Also known as competition among the few.  It produces either a homogeneous product or heterogeneous product. and the latter is called imperfect or differentiated oligopoly. The former is called pure or perfect oligopoly. four or five firms.

Lack of Uniformity 6. Advertisement 3. Demand curve 7.Characteristics of oligopoly: 18 In addition to fewness of sellers . most oligopolistic industries have several common characteristics which are explained below1. Competition 4. Interdependence 2. Barriers to entry of firm 5. No unique pattern of pricing behavior 8. Managerial Theories of firm .

Marri’s model of managerial enterprise 3. Baumol’s model of sales revenue maximization 2. Williamson’s model of managerial discretion .Managerial Theories of Firm 19 Three models of Managerialism: 1.

Baumol’s model of sales revenue maximization 20 He presented two basic models: A) Static single-period model B) Multi-period dynamic model of growth of sales revenue maximization .1.

Baumol’s Static Models: Basic Assumptions 21     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 .

Baumol’s Dynamic Models: Basic Assumptions 22     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 .

Marris’s Model of the Managerial Enterprise 23  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] .2.

a financial constraint set by the desire of managers to achieve maximum job security .) 24  In pursuing this maximum balanced growth rate the firm has 2 constraints:  Firstly. a constraint set by the available managerial team & skills  Secondly.Marris’s Model of the Managerial Enterprise (cont.

Williamson’s Model of Managerial Discretion 25  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.

Williamson’s Model of Managerial Discretion (cont.) 26  The managerial utility function includes such variables as:  Salary  Security  Power  Status  Prestige  Professional excellence .3.

.The Behavioral model of Cyert and March 27    They Placed emphasis on explaining how decisions are taken within the firm. The behaviour of an organization is the collaborative result of the behaviour of the parties involved in it. Goes beyond neo classical economics.

goals from different groups within the firm Definition of the goals of the firm by top management. o o o o o o .The Behavioral model of Cyert and March 28  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.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.

The Behavioral model of Cyert and March 29  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 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 .Criticisms of the theories of the firm 30      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 theory prescribes how individual business firms should make decisions in a market system.Implications of Industrial theories 31    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 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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