FIRMS Ch 1 Ch 2 Firms Ch 1

FIRMS Ch 1 & Ch 2

Firms: Ch 1: Modeling the Firm -This chapter illustrates the importance of competition and market pressure in forcing firms to change and response. -It considers the neoclassical analysisof firms’ behaviour. -It illustrates the importance of mergers and acquisitions in influencing industrial structure. -It examines an influential theory of the boundaries of the firm.

Ch 1: Modelling the Firm How do we start? Please read the case study listed in Firms textbook, page 3 : The case of Digital Equipment Corporation

Digital Equipment Corporation (DEC): Founded in 1957. -Claims to believe in core values that made it a great company: integrity, valuing individuals and their diversity, fiscal conservatism innovation and technical excellence. -Employed over 4000 people. -DEC was founded upon advanced and innovative technology. -During 1960 s and 1970 s, computing was technical, expensive and the province of experts. -By 1983, the company employed over 70 K people and grew to over 125 K in 1989. -In 1990 -91, the company posted its first loss of $617 million, then $2796 million in 1991 -92, and by 1995, total employees declined to 61700 -In 1993, Digital was down-sizing and shifted towards less hardware requirement and more user-friendly, and more on analysis of the business needs of the customers. -The area of expertise was in teleworking. -Telecentre opened in 1994 containing small coordinating staff. -In 1995, Digital became in unenviable position with no expertise no longer seen in the market. The next sections ask you to consider these events in the light of alternative theories of the firm.

Neoclassical theories of firms’ behaviour The neoclassical model identifies the firm’s profitmaximizing output given the demand cost conditions it faces. The firm is a price taker in markets for its products and for its factors of production. The firm chooses the output which maximizes profits and the mix of inputs required to produce the output at lowest cost. A firm that displays economies of scale has a downwardsloping long-run average cost curve. The more the firm expands the more its costs fall, and therefore the more competitive it becomes with other firms. Economies of scale are likely to lead to monopoly.

Price, Cost Supernormal profit P 1 LRMC LRAC=LRMC P 2 Demand MR Q 1 LRAC 2 Quantity This monopolistic competition analysis illustrates two key features of neoclassical analysis of the firm. 1) the method of comparative statics, and 2) the model is an example of partial equilibrium analysis. The graph shows that Digital is making supernormal profits. How? The entry of new competitors will shift the AR curve to the left. The shift in AR causes a loss! Why? To cut costs and regain profitability by lowering the firms’s average cost curve to a position like LRAC 2

Risk – neutrality: An economic agent is risk neutral if she is indifferent between actions with identical expected returns. Risk – aversion: An economic agent is risk-averse if, faced with two actions with identical expected returns, she chooses the actions with the lower risk. Risk – seeking: An economic agent is a risk seeker if, faced with two actions with identical expected returns, she chooses the action with the greater risk. Uncertainty: An economic agent faces uncertainty if she is unable to attach probabilities to future outcomes from an action.

Firms Ch 2: Contracts, information and firms’ behaviour -This chapter introduces the analysis of market behaviour understood as a diverse forms of contracting. Economics of contracting has been developed to explore market behaviour in conditions of imperfect information. The British Gas story raises a number of issues: 1) It illustrates the close interrelationship between market structure and contracting behaviour. 2) It illustrates the limits of legally binding contracts. 3) It illustrates how the structure of market contracting affects the organization and objectives of firms.

Short and long-term contracting: Spot Contract: is a contract for a single rapidly completed transaction. They are very short-term contracts, and External conditions will not change during the transaction. Complete contract: would be one which specified the actions of the contracting parties in all the circumstances which could arise including all of each other’s possible actions. Implicit contract: is a set of shared expectations about each other’s behaviour which the paries consider binding. Sunk costs: are a firm’s fixed and irrecoverable costs.

There are two ways in which market information may be incomplete. 1) Both parties to a contract may share the same incomplete information. 2) Information may be asymmetric as well as incomplete: one party may know more than the other, or parties may have different private information or assessments of risk. 3) . Nash equilibrium: is a set of strategies, one for each player, such that each player is choosing the best strategy given the strategies of the others.