ManagerialEcon - Lecture02-The Nature of The Firm 11-11-2020

San Beda University
College of Arts and Sciences

Department of Economics
Managerial Economics
MNGRECO
C. B. Mendoza, Jr.
50 Years of Excellence in Economics
Nature and scope of
Analytical Framework
and Application
Analytical Framework: Theory of the Firm
Overview
The Theory of the Firm try to provide a

framework of Analysis that will explain
the behavior of the Firm relative to:
1. Industry and Market Structure
2. Conduct
3. Performance
Structure
This refers to the construction, formation and
the makeup of an industrial organization. It also
describes the kind of environment in which an
organization or market operates.
• Economic of Demand and Supply

• Industry chain economics
Conduct
This describes the behavior or comportment of
buyers and sellers to the structure of a market.
It also refers to the way buyers and sellers
interact with each other and the way they
behave.
• Strategies and Tactics
• Future Plans
Performance
This refers to the achievement or
accomplishment or results of a particular
market or industry.
Performance variables that are considered in
the market include product quantity, product
quality, and production efficiency.
Nature and scope of
The Theory of the Firm
Theory of Production
The Nature of the Firm
• What is a business firm?
• An organization, owned and operated by private individuals,
that specializes in production
• The firm must deal with a variety of individuals and
organizations
• Sells its output to customers
• Receives revenue from them in return
• Where does the revenue go?
• Much of it goes to input suppliers
• The total of all of these payments makes up the firm’s costs of
production
• When costs are deducted from revenue, what remains is the firm’s
profit
• Profit = Revenue – Costs
• Every firm must deal with the
government
• Pays taxes to the government
• Must obey government laws and
regulations
• Receive valuable services from the
government
• Public capital
• Legal systems
• Financial systems
Internal (Goals of the Firm)

• Production Analysis
• Cost Analysis
External (Competitivness)
• Market and Industry Analysis
Figure 1: The Firm and Its Environment
Owners
Initial Financing Profit After Taxes
Input Costs Taxes

Input The Firm
Government
Suppliers (Management)
Inputs Government Services
Government Regulations
Output Revenue
Customers
Theory of the Firm
Understanding Business Cycles
Peak
Peak
Trough
Understanding the Goals of the
Firm
• To earn Profit
• To increase its own value as an
economic activity
• To improve the quality of life in the
community
❖ Earning Profit
• It is the difference between the income an entrepreneur
receives from the sale of his goods and services and the
expenses he incurs to produce them; (income – expenses).
❖ Increasing its own Value as an Economic
Activity
• A firm always strives for its growth and stability in the
economy
❖ Improving the Quality of Life in the
Community
• A business entity provides job or employment
opportunities to the economy.
Theory of the Firm
• Expected Value Maximization
• Owner-managers maximize short-run profits.
• Primary goal is long-term expected value
maximization.
• Constraints and the Theory of the Firm
• Resource constraints.
• Social constraints
• Limitations of the Theory of the Firm
• Alternative theory adds perspective.
• Competition forces efficiency.
• Hostile takeovers threaten inefficient managers.
Decision-making Model
❖ The decision making of every manager is
considered as the heart and soul of any
enterprise.
❖ Its success and failures depends on how the
manager makes a sound decision when it comes
to utilizing his available resources (capital,
technology, human etc.) on the business.
Contextualizing Competitiveness
• An idea that initially was about

being the best - to cooperating to
produce the best
Porter’s competitiveness
• Michael Porter’s concept is instructive:

• It is about long run productivity of a location as
a place to do business
• Good for firms
• Jobs and higher living standards for workers
(not low wages and weak currencies)
What Kind of Prosperity?
The key determinant of
competitiveness
• Endowments, including natural

resources, geographical location,
population, and land area, create a
foundation for prosperity, but true
prosperity arises from productivity in
the use of endowments
Framework of competitiveness
Porter diamond:
quality of business environment
Owners
Input Costs Taxes

Input The Firm
Government
Output Revenue
Customers
Meaning of Production
❖ Production is a process by which

goods and services are made
available to the consumer.
Production process simply means
the physical relationship between
inputs (labor, materials, capital, etc)
used and the resulting output.
Thinking About Production
• Production naturally brings to mind inputs
and outputs
• Inputs include resources
• Labor
• Capital
• Land
• Raw materials
• Other goods and services provided by other
firms
• Way in which these inputs may be
combined to produce output is the firm’s
technology
Thinking About Production
• A firm’s technology is treated as a
given
• Constraint on its production, which is
spelled out by the firm’s production
function
• For each different combination of inputs,
the production function tells us the
maximum quantity of output a firm can
produce over some period of time
The Theory of the
Firm
Profit Measurement
Role of the Profit
❖ Risk-Bearing Theory of Profit
❖ Temporary Disequilibrium Theory of
Profit
❖ Monopoly Theory of Profit
❖ Innovation Theory of Profit
❖ Managerial Efficiency Theory of Profit
Profit Measurement
• Business Versus Economic Profit
• Business (accounting) profit reflects
explicit costs and revenues.
• Economic profit.
• Profit above a risk-adjusted normal return.
• Considers cash and noncash items.
• Variability of Business Profits
• Business profits vary widely.
Why Do Profits Vary Among
Firms?
• Disequilibrium Profit Theories
• Rapid growth in revenues.
• Rapid decline in costs.
• Compensatory Profit Theories
• Better, faster, or cheaper than
the competition is profitable.
Profit Maximization
❖ The Shareholder Wealth-Maximization Model of
the Firm
❖ Goals in Public Sector and Non-Profitable
Enterprises
❖ Non-Profitable Objectives
❖ Understanding the Markets
❖ Consumer – Producer Rivalry
❖ Consumer – Consumer Rivalry
❖ Producer – Producer Rivalry
❖ Government and the Market
Profit Maximization
Goals in Public Sector and Non-Profitable Enterprises
❖ The following points highlight the seven crucial

objectives of public sectors in a mixed economy.
1. Transformation of the Economy
2. Redistribution of Income and Wealth
3. Source of Capital Formation
4. Development of Socio-Economic Infrastructure
5. Achievement of Balanced Regional Development
6. Reduction of Concentration of Wealth and
Economic Power in Private Hands
7. Attainment of the Planned Resource Allocation
Profit Maximization
Non-Profitable Objectives
❖ The shareholder wealth maximization theory

presumed that the firm should try to maximize
the return to shareholders, as measured by the
total of capital gains and dividends, for a certain
level of risk.
❖ On the other hand, the firm should minimize the
risk to shareholders for a given rate of return
Profit Maximization
The Shareholder Wealth-Maximization Model of the Firm
❖ The shareholder wealth maximization theory

presumed that the firm should try to maximize
the return to shareholders, as measured by the
total of capital gains and dividends, for a certain
level of risk.
❖ On the other hand, the firm should minimize the
risk to shareholders for a given rate of return
Profit Maximization
• Goal of firms
➢ In all market models, we assume that the goal of
firms if profit maximization
➢ Profits = Revenues – Cost
➢ Profits act as a signal (of success) in a market
economy
➢ It is the standards by which firms are judged
➢ If an industry is profitable, many enter until the
profits are competed away to its
optimal/sustainable level
Profit Maximization
• Why are profits/is profitability important? –
➢ Affects stock prices
➢ Affects how investors view a company in terms of
attractiveness
➢ Affects investor decisions
➢ But achieving profitability is a constant
challenge
➢ Managers face many market uncertainties, lack
of information, poor strategies
Assume Profit Maximization
• What about?
• Stakeholders
• Social concerns
• Environmental concerns
• Do these concerns influence profits?
Short or long run profit
maximization?
• This is a false choice
• Maximize the value of the firm
• The value of the firm is equal to the present
value of the future stream of profits
• Emphasis on short or long term will depend
on:
• Time value of money (cost of funds)
• Market structure
• Uncertainty
Economic Forces that Promote
Long-Run Profitability
Maximizing the Value of a Firm
• Value of a firm
• Price for which it can be sold
• Equal to net present value of expected
future profit
• Risk premium
• Accounts for risk of not knowing future
profits
• The larger the risk, the higher the risk
premium, & the lower the firm’s value
Maximizing the Value of a Firm
• Maximize firm’s value by maximizing

profit in each time period
• Cost & revenue conditions must be
independent across time periods
• Value of a firm =
1 2 T T
T
+ + ... + =
(1 + r ) (1 + r ) 2
(1 + r )
T
t =1 (1 + r ) t
Profits Possible Profit Streams
Limit Pricing
0 Time
Economic Profits
• Economic profits are not accounting

profits
• Economic profits are equal to
revenues minus economic costs
• All economic costs are measured in
terms of opportunity costs
• Choices represent foregone opportunities
Economic Cost of Resources
• Opportunity cost of using any

resource is:
• What firm owners must give up to use the
resource
• Market-supplied resources
• Owned by others & hired, rented, or
leased
• Owner-supplied resources
• Owned & used by the firm
Total Economic Cost
• Total Economic Cost

• Sum of opportunity costs of both market-
supplied resources & owner-supplied
resources
• Explicit Costs
• Monetary payments to owners of market-
supplied resources
• Implicit Costs
• Nonmonetary opportunity costs of using
owner-supplied resources
Types of Implicit Costs
• Opportunity cost of cash provided by

owners
• Equity capital
• Opportunity cost of using land or
capital owned by the firm
• Opportunity cost of owner’s time
spent managing or working for the
firm
Economic Cost of Using
Resources
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Total Economic Cost

= The total opportunity costs of
both kinds of resources
Economic Profit vs.
Accounting Profit
Economic profit = Total revenue – Total economic cost
Economic profit = Total revenue – Explicit costs –
Implicit costs
Accounting profit ? = Total revenue – Explicit costs
• Accounting profit does not subtract implicit costs

from total revenue
• Firm owners must cover all costs of all resources
used by the firm
• Objective is to maximize economic profit
Brady’s Explicit Costs
Total operating costs and expenses $ 100,000
Interest expense 14,000
Non-recurring expenses 8,000
Income taxes 16,000
Total Explicit Costs $138,000
Opportunity Cost of Brady’s Capital
Personal Savings $ 50,000

Annual rate of return 12%
Opportunity cost of equity capital $ 6,000
Implicit Cost of Brady’s Owner
Supplied Resources
Opportunity cost of equity capital $ 6,000

Opportunity cost of own salary 45,000
Opportunity cost of building 24,000
Total opportunity cost of own resources $ 75,000
Total Opportunity Cost of All
Resources
Opportunity cost of owners resources $75,000

Opportunity cost of explicit expenses 138,000
Total opportunity cost $213,000
Brady’s Total Accounting Profit
Total revenue $ 210,000

Total explicit cost 138,000
Net income $ 72,000
Brady’s Economic Profit
Total revenue $ 210,000

Total economic cost 213,000
Economic profit $ (3,000)
Based on his profit in 2007, did Terry Brady increase his wealth by
quitting his job at Mattoon High and opening Brady Advantage?
Infinite Annuity
• R = constant dollar annual return

• I = risk adjusted expected rate of
return
• V = present value of future returns
R
V =
i
Present Value and the Discount
Rate
Economic Profit
Discount 0% 16% 10%
rate
Year
1 $700,000 $603,448 $636,364
2 $800,000 $94,530 $661,157
3 $500,000 $320,329 $375,657
Total $2,000,000 $1,518,307 $1,673,178
Present value is negatively related to the discount rate.
Some Common Mistakes
Managers Make
• Never increase output simply to reduce
average costs
• Pursuit of market share usually reduces
profit
• Focusing on profit margin won’t
maximize total profit
• Maximizing total revenue reduces profit
• Cost-plus pricing formulas don’t produce
profit-maximizing prices
Separation of Ownership &
Control
• Principal-agent problem
• Conflict that arises when goals of
management (agent) do not match goals of
owner (principal)
• Ex. Mortgage brokers
• Moral Hazard
• When either party to an agreement has
incentive not to abide by all its provisions &
one party cannot cost effectively monitor the
agreement
• Ex. Preexisting conditions
Corporate Control Mechanisms
• Require managers to hold stipulated

amount of firm’s equity
• Increase percentage of outsiders
serving on board of directors
• Finance corporate investments with
debt instead of equity
Price-Takers vs. Price-Setters
• Price-taking firm
• Cannot set price of its product
• Price is determined strictly by market
forces of demand & supply
• Price-setting firm
• Can set price of its product
• Has a degree of market power, which is
ability to raise price without losing all
sales
The Theory of the
Firm
Market and Industry
Analysis
What is a Market?
• A market is any arrangement through

which buyers & sellers exchange
goods & services
• Markets reduce transaction costs
• Costs of making a transaction other than
the price of the good or service
Market Structures
• Market characteristics that determine

the economic environment in which a
firm operates
• Number & size of firms in market
• Degree of product differentiation
• Likelihood of new firms entering market
Owners
Input Costs Taxes

Input The Firm
Government
Output Revenue
Customers
Theory of the Firm
Industry Analysis
Why Industry Analysis?
o Analysis means taking a closer look at the
composition, features and behavior of firms
in an industry.
o How firms behave.
o What leads to them to behave as such
What is Industry Analysis for?
o Investment decision-making
o Corporate planning
Industry Analysis
Investment decision-making
o Strong Linkages: Backward or forward

o Attractive: Profitable and growing
market demand
o Government support
o Infrastructural support
o Financial sector support
Industry Analysis
Corporate Planning
o Corporate planning is a total system of
planning which involves the determination
of the objectives for the company as a whole
o Formulation of strategies for the attainment
of these objectives (all this being done
against the background of SWOT analysis)
o Conversion of strategies into tactical plans
(or operational plans)
o Implementation of tactical plans and a
review of the progress of tactical plans
against the corporate planning objectives.
Theory of the Firm
SCP Analysis
o Theories of the firm try to explain supply relative to:
1. Structure
2. Conduct
3. Performance
o SCP Analysis is Pioneered by Harvard Economist
Edward Mason, 1930’s and his doctoral student
Joseph Bain in the 50s.
o Became popular in the 1980’s when used by Michael
Porter (Competitive Strategy) as a business tool to
strive and compete in the market.
Theory of the Firm
SCP Analysis
o Look at the structure of the industry and how it is

organized into different markets
o Firm’s conduct is determined by the nature of the
structure
o Given the behavior, analyze performance
o Used to understand formulation of competition policy
Theory of the Firm
Framework of Analysis
Structure
Performance Conduct
Theory of the Firm
Market Structure
• Theories of the firm are organized around
the different kinds of market forms in which
firms can operate.
• In this course, the market forms are
grouped this way:
• Perfect competition
• Monopoly
• Monopolistic competition, and
• Oligopoly
Theory of the Firm
Market Structure
Markets
❖ Are institutions and mechanisms used for
the buying and selling of goods and services
❖ Vary in structure in terms of the number of
participants
❖ Market structure affect the ability of a firm to
influence the price for its product/s and
exert market power
❖ Managers respond differently to different
market types where their businesses operate
Theory of the Firm
Market Structure
• Market types influence the strategic
decisions that managers make (price of
the product and productivity)
• Type of Market Structure
➢ Number of sellers and buyers
➢ Barriers to entry
➢ Product differentiation
➢ Cost structures
➢ Vertical integration
Theory of the Firm
Market Structure
• Perfect Competition
Market Structure
Many
Firms • These market structure
can be arranged along
Many
• Monopolistic
Competition
a continuum where at
Firms the top (Perfect
Competition) there are
Few • Oligopoly a large number of
Firms firms in the market,
and at the
Single • Monopoly bottom(Monopoly),
Firm there is only 1 firm
Theory of the Firm
Market Structure
Each of these markets are

characterized by the following:
❖ No. of firms competing with one another that
influences the firm’s control over its price
❖ Whether products are differentiated or
undifferentiated (or homogenous)
❖ Whether entry into/exit from the market by
other firms is easy or difficult
❖ The amount of information available to market
participants
Theory of the Firm
Market Structure
❖ Perfect competition and monopoly

are 2 market types are Extreme
cases and Hypothetical
❖ In the real world, these markets
don’t exist/rare cases
❖ In the real world, markets are a
combination of these 2 extreme
models
Theory of the Firm
Market Structure
Why is market analysis important?
❖ Managers need to know the market structure
where their firms operate
❖ Market structure could indicate to managers
the strategic variables that they can use to face
its competition (or exert market power)
❖ Market power is the ability to influence price
and develop other competitive strategies that
allow them to earn large profits over longer
periods of time
Theory of the Firm
Perfect Competition
o A market form with these characteristics:
1. Large number of firms or sellers.
2. No one is powerful enough to influence the price
3. Homogeneous product.
4. Easy entry and exit of firms- No artificial
restraints on price, supply and demand
5. Mobility of goods and resources, ease of entry
and exit
6. Complete knowledge of market conditions
o Some economists add to this list that consumers and
firms also have cheap, accurate information about
prices.
Theory of the Firm
Perfect Competition
• What the assumptions boil down to is that
each firm in perfect competition is a price
taker.
• NO FIRM HAS ANY CONTROL OVER

MARKET PRICE.
• This means that the demand curve the firm

sees for its product is infinitely elastic.
Theory of the Firm
Perfect Competition
• Infinitely elastic demand curve of
a perfectly competitive producer of
copra in Sariaya, Quezon:
price
P0 is the current
market price.
P0
quantity
(hundred dried coconut kernels)
Theory of the Firm
Perfect Competition
Warning!
• The market demand curve is still
negatively sloped:
MARKET FIRM
price S price
P0 P0
D
quantity quantity
(million dried coconut kernels) (hundred dried coconut kernels)
Theory of the Firm
Perfect Competition
• In competitive markets, market price

is determined by supply and demand.
• If a firm were to raise its price above

market price it would lose all its sales.
It would never be silly enough to
charge less because it can sell all it
wants at the going market price.
Theory of the Firm
Perfect Competition
Market Structure: Perfect Competition
No of Firms Large number
❑ Recall our concern--Behavior
Product None of firm vs outcomes for entire
differentiation market/industry
❑ In a perfectly comp market, no
Market Entry Easy
single firm has any influence
on the price of the product
Information Complete ❑ Firms are price takers (i.e. firm
Buyers and cannot influence the price (its
sellers have own price, the market price)
equal access to but can sell any amount of its
information output at the price established
by the market/all players)
Theory of the Firm
Other Market Forms Defined
• MONOPOLY: a market with only one seller of

a product for which there are no close
substitutes.
• MONOPOLISTIC COMPETITION: a market
with many firms, easy entry, and product
differentiation. (Each firm produces a
slightly different version of the product.)
• OLIGOPOLY: a market with a small number
of firms.
Theory of the Firm
Imperfect Competition
Market Structure: Imperfect Competition

❖ Firms have some degree of market power
❖ Market power
The ability of the firm to influence the prices of its
products and develop other competitive strategies that
enable it earns large profits over longer periods of time.
Theory of the Firm
Market Structure: Monopoly

No of Firms Single firm ❑ A single firm only producer
❑ Product produced is that
Product None where there is no close
differentiation substitute or is very highly
differentiated. Thus,
Market Entry Blocked Consumers are willing to pay
more for this product
Information Imperfect
❑ Barriers to industry entry exist:
structural, legal, or regulatory
- keeping other firms from
easily producing same item at
same cost
Theory of the Firm
Market Structure: Monopoly

No of Firms Single firm ❑ Monopolist has market power
to influence price and earn
Product None larger profits.
differentiation
❑ Monopolist cannot sell any
Market Entry Blocked
amount of output at a given
market price as in perfect
Information Imperfect competition. Thus if he raises
the price, less output will be
sold; if he lowers the price,
more output will be sold
Theory of the Firm
Market Structure: Oligopoly

No of Firms Small number of ❑ In oligopolistic markets – a
large firms smaller number of larger firms
Product Firms may produce dominate so they exert a larger
differentiation similar or highly
degree of market power, but
how they use it is limited by the
differentiated action and reaction of their
products competition
❑ Barriers to entry:
Market Entry Difficult Structural/legal/regulatory
Significant barriers characteristics of a firm and its
to market that keep other firms
new entry from easily producing the same
Information Imperfect
or similar products at the same
costs.
information
Theory of the Firm
Market Structure: Monopolistic Competition
No of Firms Large number of small ❑ Firms produce
firms
Product Differentiated
differentiated products
differentiation Each firm produces a so they exert a degree
good or service that, in of market power, but
some significant way, is there are many firms
different
competing too, thus
Market Entry Highly competitive/
Relatively easy for new
limiting their ability to
firms to enter the earn above average
market profits
Information Imperfect information
Theory of the Firm
Characterist PC MC O M
ics
Number of Large Large Small Single Firm
firms number number Number
competing
Nature of Undifferentia Differentiated Undifferentia Unique
the product ted ted or
differentiated
Entry
Information Complete Relatively Asymmetric Asymmetric
Availability good
Firm’s None Some Some Substantial
control over
price
Theory of the Firm
Determining structure
❖ Profitability and market share

❖ Degree of concentration and the Number
of rivals
❖ Conditions of entry
➢ barriers preventing potential entrants from
becoming actual competitors
Theory of the Firm
Determining market share
❖ Market Share = share of the biggest

firm as a proportion of market size
❖ Market share is usually an indicator
of market power.
Theory of the Firm
Determining market size
Sales Value in 2005

Manufacture of
bakery products P42.6 Billion
Source: Annual Survey of Establishments 2005, NSO
Department of Economics 10
Theory of the Firm
Determining Concentration
❖4 firm concentration ratio

❖ Herfindahl Index (H-Index)
Theory of the Firm
4-firm concentration
❖ The 4 firm CR takes into account the

market share of the 4 largest firms in the
industry
❖ CR = Summation of market share of top
four firms
Theory of the Firm
❖A value close to 0 indicates that the

largest 4 firms supply only a small share
of the market. A value of 100% indicates
a single supplier.
Theory of the Firm
Restaurants, cafes and fast food centers

Industry Total Sales in 2005 (000’s) = P58,003,588
Jollibee Foods Corp. & Subd. 15,885,739
Golden Arches Dev. Corp. 9,332,864
Chowking Food Corp. 5,398,709
Greenwich fried chicken 2,918,342
Corp.
58%
Share of Top Four
Source: Top 7,000 Corporations, 2006-2007 Phil. Business Profiles & Perspectives, Inc.
Theory of the Firm
❖ The H-Index takes into account the

number of firms in an industry and
their size differences
❖H = Summation of (market of share
of firms)2
Theory of the Firm
Herfindahl Index (H-Index)
❖ The H-Index tends towards 1.0 when

there are few firms and/or greater
degree of inequality in market share
❖ The H-Index tends towards 0 when
there is a greater degree of quality in
market shares.
Theory of the Firm
H-Index: Guide notes

Structure Range of H-Index
Pure Monopoly 1.0
Dominant Firm 0.5-1.0
Oligopoly 0.2-0.5
Monopolisitc Competition 0.1-0.2
Pure Competition Close to 0.0
Theory of the Firm
Share of top
Industry Description H-Index # of Firms
4 firms
Restaurants, cafes
0.12 58% 140
and fast food centers
Source of basic
Department data: Top 7,000 Corp. 2006-2007 Phil. Bus. Profiles & Perspectives
of Economics 18
Theory of the Firm
H-Index: Retailing
Industry Share of top Number
Description H-Index 4 firms, in % of Firms
Dept Stores 0.15 92 11
Bookstores 0.20 58 3
Supermarkets 0.11 59 4
Drugstores 0.51 75 2
Groceries 0.24 69 2
Appliances 0.06 41 3
Source: NSO
Department of Economics 19
Theory of the Firm
Relationships
Structure Conduct Performance

Perfect Price taker Low margins
Competition Cost leadership Efficient markets
Price maker High margins
Monopoly High entry barriers Inefficient markets
Limited differentiation Quality issues
Advertising
Wide product ranges
Oligopoly Mutually dependent
behavior
Theory of the Firm
Industry characteristics
Number Individual Firm Market Product Entry

Structure characteristic
of sellers share barriers
Perfect
Competition Many Insignificant Homogeneous Low
Partially
Monopoly One 100% market share differentiated High
Monopolistic Few players each with Highly

competition Few small market share differentiated Low
Few players each with Highly

Oligopoly Few large market share differentiated High
Structure
Performanc
e Conduct
Theory of the Firm
Conduct or Strategy
Elements Description
Pricing Key variable in industry conduct

Do firms concentrate on a narrow range of
Product
products or are they wiling to diversify into new
strategy
areas of production?
Can we expect that a different structure will
Research &
produce more or less R &D activity to enhance the
innovation
prospects of economic growth
Advertising What are the determinants of advertising spending?
Structure
Perform
ance
Conduct
Theory of the Firm
Performance
Profitability How profitable firms depends largely on their pricing behavior
How cost efficient and how allocative efficient firms are depends
Efficiency
partly on their pricing behavior & on other aspects of conduct
Economic How successful firms are in increasing real output over time
growth depends upon various conduct goals like R&D?
Full Do different kinds of market behavior make the attainment of full
employment employment easier?
Does a different market structure lead to a different distribution of
Equity
income?
Theory of the Firm
Performance
❖ Production and allocative

efficiency: Consistent high
growth, profits
❖ Progress
❖ Full employment
❖ Equity
Theory of the Firm
Public Policy
❖ Evaluate social implications of strategies

❖ Enhance contestability
❖ Promote social welfare
❖ Ensure stability of policy
Theory of the Firm
Impact of regulation of Public policy
❖ Taxes and subsidies

❖ Regulation
❖ Price controls
❖ Antitrust
❖ International trade rules
❖ Information and education
❖ Public ownership
Theory of the Firm
Re-evaluation
❖ Current environment standards?

❖ Lessons from the past?
❖ Are conclusions from quantitative
analysis consistent with qualitative
analysis?
❖ Advice from players?
❖ Tips from others?
Theory of the Firm
Relationships
Structure Conduct Performance

Perfect Price taker Low margins
Competition Cost leadership Efficient markets
Price maker High margins
Monopoly High entry barriers Inefficient markets
Limited differentiation Quality issues
Advertising
Wide product ranges
Oligopoly Mutually dependent
behavior
Theory of the Firm
SCP Framework
Basic Demand Basic Supply

Conditions Conditions
CONDUCT
Pricing behavior
Product strategy
Research & innovation
Advertising
Theory of the Firm
Basic conditions
• SUPPY DEMAND
• Raw Materials • Price/income
• Technology elasticity
• Unionization • Substitutes
• Product • Rate of growth
durability • Cyclical & seasonal
• Value/weight character
• Business • Purchase method
attitudes • Marketing type
• Public Policies
Theory of the Firm
Industry Characteristics
Number Individual Firm Market Product Entry

Structure characteristic
of sellers share barriers
Perfect
Competition Many Insignificant Homogeneous Low
Partially
Monopoly One 100% market share differentiated High
Monopolistic Few players each with Highly

competition Few small market share differentiated Low
Few players each with Highly

Oligopoly Few large market share differentiated High
Theory of the Firm
Conduct / Strategy
Pricing Key variable in industry conduct
Do firms concentrate on a narrow range of products

Product
or are they wiling to diversify into new areas of
strategy
production?
Can we expect that a different structure will produce

Research &
more or less R &D activity to enhance the prospects
innovation
of economic growth
Advertising What are the determinants of advertising spending?
Theory of the Firm
Performance
Profitability How profitable firms depends largely on their pricing
behavior
How cost efficient and how allocative efficient firms
Efficiency
are depends partly on their pricing behavior & on
other aspects of conduct
Economic How successful firms are in increasing real
growth output over time depends upon various
conduct goals like R&D?
Full Do different kinds of market behavior make the
employment attainment of full employment easier?
Does a different market structure lead to a different

Equity
distribution of income?
Theory of the Firm
Perfect Competition
Elements Implication or Performance

Profitability Zero economic profits but with positive normal
profits
Efficiency Resource allocation is determined by market
signals
Economic Economy is driven by industries that strive to
growth compete
Employment levels will grow according to
Full
growth of the industries and macro policy
employment moves
Known to allocate wealth equitably but can
Equity
suffer from market failures due to
externalities

ManagerialEcon - Lecture02-The Nature of The Firm 11-11-2020

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ManagerialEcon - Lecture02-The Nature of The Firm 11-11-2020

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San Beda University

College of Arts and Sciences

The Theory of the Firm try to provide a

• Economic of Demand and Supply

Internal (Goals of the Firm)

Initial Financing Profit After Taxes

Input Costs Taxes

• An idea that initially was about

• Michael Porter’s concept is instructive:

• Endowments, including natural

Initial Financing Profit After Taxes

Input Costs Taxes

❖ Production is a process by which

❖ The following points highlight the seven crucial

❖ The shareholder wealth maximization theory

❖ The shareholder wealth maximization theory

• Do these concerns influence profits?

• Maximize firm’s value by maximizing

• Economic profits are not accounting

• Opportunity cost of using any

• Total Economic Cost

• Opportunity cost of cash provided by

Total Economic Cost

• Accounting profit does not subtract implicit costs

Personal Savings $ 50,000

Opportunity cost of equity capital $ 6,000

Opportunity cost of owners resources $75,000

Total revenue $ 210,000

Total revenue $ 210,000

• R = constant dollar annual return

Present value is negatively related to the discount rate.

• Require managers to hold stipulated

• A market is any arrangement through

• Market characteristics that determine

Initial Financing Profit After Taxes

Input Costs Taxes

o Strong Linkages: Backward or forward

o Look at the structure of the industry and how it is

Each of these markets are

❖ Perfect competition and monopoly

• NO FIRM HAS ANY CONTROL OVER

• This means that the demand curve the firm

• In competitive markets, market price

• If a firm were to raise its price above

• MONOPOLY: a market with only one seller of

Market Structure: Imperfect Competition

Market Structure: Monopoly

Market Structure: Monopoly

Market Structure: Oligopoly

❖ Profitability and market share

❖ Market Share = share of the biggest

Sales Value in 2005

Source: Annual Survey of Establishments 2005, NSO

❖4 firm concentration ratio

❖ The 4 firm CR takes into account the

❖A value close to 0 indicates that the

Restaurants, cafes and fast food centers

❖ The H-Index takes into account the

❖ The H-Index tends towards 1.0 when

H-Index: Guide notes

Structure Conduct Performance

Number Individual Firm Market Product Entry

Monopolistic Few players each with Highly