The Theory of the Firm

It is appropriate to begin this book with a brief résumé of the development of economic thought relating to the theory of the firm.¹ Deciding where to begin, however, immediately presents problems. Whereas it is universally agreed that the work of Chamberlin and Robinson dining the 1930s, to which we will shortly return, constitutes a cohesive theory of the firm, no such agreement exists with respect to the writings of late-nineteenth and early-twentieth century economists. In order to suggest why this is so however, we need to begin with the writings of Adam Smith in 1776, so that the reader can best be left to judge this issue for himself.

In order to construct a model of how firms behave under perfectly competitive conditions we need to begin by making the following set of assumptions:

Dissatisfaction with the ability of the model of perfect competition to act as an ideal market structure for policy purposes led to various attempts to replace it with the operationally more valid concept of workable competition. This phrase originated with J. M. Clark¹ who argued that perfect competition ‘does not and cannot exist, and has presumably never existed’. He therefore set out to develop alternative criteria to those of perfect competition for use in assessing how well competition is working.

A monopoly is held to exist where a firm is the sole supplier of a particular good or service. Such a firm therefore has no existing competitors, and is protected by barriers to entry (see pp. 71–82) from the encroachment into its markets of potential competitors.

The model of monopolistic competition retains many of the assumptions of the model of perfect competition, but differs from it in one major respect. Whereas the industry is assumed to consist of a large number of small firms each of which is run by an entrepreneur who pursues the goal of profit maximisation using marginal analysis under conditions of perfect knowledge, and whereas there is freedom of entry into, and exit out of, the industry, each firm can no longer be treated as a price-taker. This stems from the fact that each firm produces a product which is regarded by consumers as being in some meaningful way different from the products made by all other producers. Such differences between products may be either real or imagined, but this distinction is unimportant provided that consumers treat the products of different firms as being less than perfect substitutes for one another.

We have argued in the course of the preceding sections that neither the model of perfect competition nor that of monopoly reflects adequately the reality of present-day industrial organisation. In practice most industries appear currently to be characterised by competitive behaviour which typically reflects elements of both models. We have also seen that the model of monopolistic competition provided a worthy attempt to trace out a middle path, but that it also foundered largely on the basis of the unreality of its assumptions.

The origins of theoretical models of oligopolistic behaviour date back to the appearance of simplified models of duopoly during the mid-nineteenth century. The best-known of such models was developed by Cournot¹ who discusses a situation of rivalry between two proprietors of mineral springs each selling identical bottles of spring water. Cournot assumes for simplicity that there are no costs of production, and also that no additional sellers of spring water are permitted by the local authorities to set themselves up in competition.

Relatively little attention has been paid to this approach to the oligopoly problem, perhaps because it cannot be expected to yield many insights into oligopolistic behaviour until much more empirical information has been gathered together. A useful summary of progress in this direction appears in Lipsey,¹ who selects as his central hypothesis that of qualified joint profit maximisation.² He defines this as follows:³

Firms that recognise that they are in rivalry with one another will be motivated by two opposing forces; one moves them towards policies that maximise the combined profits of the existing group of sellers, the other moves them away from the joint profit-maximising position. Both forces are associated with observable characteristics of firms, markets and products, and thus we can make predictions about market behaviour on the basis of these characteristics.

We have already noted that when a firm is planning its future strategy it must make allowances for the response of its competitors to any action which it takes. A strategy must therefore include not merely a set of opening moves but also further sets of counter moves which can be brought into play in order to redirect the firm towards the attainment of its original objectives after competitors have responded to its opening gambit. It is evident however that a similar line of reasoning can also be applied to each of its competitors since each of them in turn will need to develop a strategy which makes allowances for various alternative opening and counter moves by all other firms within the market.

The literature on entry has become very extensive over the years.¹ Although the question of entry-preventing behaviour was first raised by Kaldor,² the main discussion arose out of the basic prediction of the model of monopolistic competition that firms would earn only normal profits in the long run, and that each firm would be operating with excess capacity (see p. 37). Harrod argued³ that firms would forgo some potential profit in the short run by setting a price lower than that which would maximise their profits in order to discourage new entrants into the industry. Subsequently, the discussion of the role of entry has largely evolved into an attempt to provide an answer to the question as to whether it is more profitable for a firm to maximise short-run profits in the knowledge that this will attract new entrants and hence erode the firm’s market share in the long run, or for a firm to deter entry by holding down prices in the short run in the expectation that it will be able to retain a substantial share of the market over time. These possibilities are illustrated in Figure 10.1.

As we have seen in the preceding sections that most of the models which together comprise the theory of oligopoly draw heavily upon the concepts and relationships between variables which constitute the basic building blocks of the traditional models of the firm. Of particular importance in this respect was the continued adherence of oligopoly models to the objective of profit maximisation despite the accumulation of contradictory evidence.

The shape of the average-cost curve is determined by the relationship between total cost and the scale of output. The U-shaped average-cost curve which appeared in the traditional models of perfect competition and monopoly reflected the assumption that a firm would initially have access to economies of scale, but that after a time any further expansion of output would cause average cost to rise as diseconomies of scale set in.

The crux of the problem has been expressed by Margolis as follows:¹

The information and calculability necessary for the management of a firm to move to its equilibrium profit-maximising price-output combination are clearly not available. Uncertainty and ignorance are omni-present. No matter how pleasing may be the prospect of an activity with the greatest possible profits, the choice for management is rarely on the agenda.

There exist a number of theories which set out to explain the devices used to control corporations. Some amongst them, such as the theory of ‘People’s Capitalism’ which claims that ownership, and hence control, is vested in the large numbers of ordinary people who own shares, and the theory of the ‘Corporate Rich’ which claims that control is vested in a coalition of the old propertied rich and the new managerial classes,¹ have never really caught on. Two other theories, however, are worthy of note; the first claims that control is vested in financial intermediaries of all kinds such as banks and unit trusts,² while the second claims that control is vested in the management of the corporation itself.

Baumol¹ has put forward the idea that a firm has as its objective the maximisation of sales revenue subject to a profit constraint. He claimed that firms give precedence to the pursuit of maximum sales revenue over the pursuit of maximum profit because managers believe that their salaries, power and standing, both within their own company and within the business community at large, are more closely related to the attainment of the former than the latter objective.

A number of models have been developed which stress the objective of growth. One of these had its origins in Baumol’s dissatisfaction with his static sales-revenue-maximisation model,¹ to which he made two main modifications.

A number of theories of the firm have their roots in the physical sciences, particularly in biology. Such theories can be divided into two groups consisting of (1) theories of homeostasis which emphasise short-run changes, and (2) theories of viability which emphasise long-run changes.¹ In both cases the underlying analogy is that firms, like organisms, start small, then mature and produce offspring, and eventually die.

The term ‘utility maximisation’ is customarily applied to those models which hypothesise that managers set out to maximise their own utility rather than that of shareholders. Whereas shareholders are supposed to derive utility almost exclusively from profits, managers may derive utility from pursuing a whole range of possible objectives. Most obviously, managers can attempt to maximise their monetary rewards. Alternatively, they can set out to increase their leisure time and to make their lives generally as easy as possible. In so far as the term ‘utility’ is, in practice, more than a little vague it is possible to argue that any non-profit-maximising theory of the firm is a utility-maximising model. It is customary, however, to restrict the usage of the term to exclude, for example, the model of sales-revenue maximisation.

We have already referred on several occasions to the need for a firm to earn sufficient profits in order to satisfy its shareholders. In those cases we regarded satisfactory profits as an objective which ran alongside, but which was subsidiary to, other objectives. There are, however, a number of theories which regard the achievement of satisfactory profits as the firm’s primary objective, this objective replacing that of profit maximisation which is regarded as impossible of achievement in a world of uncertainty.

Dissatisfaction with the traditional theory of the firm has led certain commentators to branch out in a new direction which borrows heavily from the behavioural sciences.