Whilst demand and cost information are crucial to the firm’s decision-making process, the extent and nature of competition define the external environment in which the firm operates. An understanding of this competitive environment will enable cost and demand analysis to be put together to determine an economic theory of the firm, which can offer significant insights into the decision-making process. Each and every business decision must be made in the light of anticipations about competitors’ actions and reactions. The extent of competition influences the nature of both cost and demand conditions. Moreover, the competitive environment defines the discretion that the firm’s managers have over pricing, marketing, input purchase and other decisions. An understanding of that decision environment is essential for both describing the limitations of market behaviour, and analysing the opportunities available in the market. The competitive environment is not stable, but rather is continuously changing. The relationship of the firm to its environment is both reactive and proactive — reactive in that the firm must respond to changes in that environment, and proactive in that the firm, by a judicious choice of policies, may influence that environment in ways that can increase the market opportunities available.
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