Theory of the Firms Neoclassical Theory Learning Objectives

Theory of the Firms (Neoclassical Theory)

Learning Objectives Historical development of the neoclassical theory of the firm Perfect competition, monopoly and monopolistic competition Allocative and productive efficiency Welfare properties of perfect competition and monopoly

Historical Development of Theory of the Firm Adam Smith in the 1770 s output is related to its cost of production Augustin Cournot in the 1830 monopolist and duopolists behaviour Stanley Jevons (1871) value of products depends on the level of demand (demand function) Alfred Marshall in the 1890 s market equilibrium (demand supply), price elasticity Frank Knight (1921) competition is fundamentally a force for good in economy, perfect competition Edward Chamberlin and Joan Robinson (1930 s) imperfect competition, marginal revenue

Theories of perfect competition and monopoly

Perfect Competition

Equilibrium in Perfect Competition

Monopoly There are large numbers of atomistic buyers, but there is only one seller. Therefore the selling firm’s demand function is the market demand function, and the firm’s output decision determines the market price Barriers to entry are insurmountable. If the monopolist earns an abnormal profit, there is no threat that entrants will be attracted into the industry. The good or service produced and sold is unique, and there are no substitutes. There is complete product differentiation. The buyers and the seller may have perfect or imperfect information. Geographical location could be the defining characteristic which gives the selling firm its monopoly position. In a spatial monopoly, transport costs are sufficiently high to prevent buyers from switching to alternative sellers located in other regions or countries. The selling firm seeks to maximise its own profit.

Long-run equilibrium in Monopoly

Allocative Inefficiency of Monopoly Abnormal profit Fails to produce at the minimum LRAC

Lerner Index – Market Power

Why Monopolist is not allocatively (economically) efficient

Why Monopolist is allocative inefficient and productive inefficient

Monopolistic Competition There are large numbers of atomistic buyers and sellers. Firms are free to enter into or exit from the industry, and a decision to enter or exit does not impose any additional costs on the firm concerned. In other words, there are no barriers to entry and exit. The goods or services produced and sold by each firm are perceived by consumers to be similar but not identical. In other words, there is some product differentiation. There could be real differences between the goods or services produced by each firm, or the differences could be imagined, with consumers’ perceptions of differences reinforced by branding or advertising. The buyers and the sellers may have perfect or imperfect information. If the product differentiation is perceived rather than real, this suggests that the buyers’ information is in some sense imperfect. Geographic location could be the characteristic that differentiates the product or service produced by one firm from those of its competitors. In this case, transport costs may to some extent deter buyers from switching to alternative sellers located elsewhere. However, each firm’s market is not completely segmented geographically. Any firm that raises its price too far will find that its customers start switching to other sellers. Each selling firm seeks to maximise its own profit.

Equilibrium of Monopolistic Competition