- The goods being sold must be homogenous in nature.
The short and the long run
In the short run the number of firms is fixed. Depending on its costs and revenue, a firm might be making large profits, small profits, no profits or a loss and in the short run
In the long run however the level of profits will affect entry into the exit from the industry. If profits are high, new firms will be attracted into the industry.
Short run equilibrium of the firm.
The determination of price, output and profit in the short run under perfect competition can best be shown in a diagram.
Figure 1 shows a short –run equilibrium for both industry and a firm under perfect competition, both parts of the diagram have same scale for the vertical axis. The horizontal axis therefore has different scales.
Firm Industry
Price
The price is determined in the industry by the intersection of demand and supply. The firm faces a horizontal demand curve at this price. It can sell all it can produce at they market price (Pe) but nothing at a price above Pe.
Out put
The firm will maximise profit where marginal cost equals marginal revenue (MR=MC) at an output of Qe. Since the price is not affected by the firm’s output, marginal revenue will equal price. The reason is that the firm is not having to reduce its price in order to sell more. An extra unit produced will therefore earn its full price for the firm. Therefore the firms MR curve and D curve are the same horizontal straight line.
Profit
If the average cost (AC) curve which includes normal profit dips below the average (AR) curve the firm will earn supernormal profit. Supernormal profit per unit at Qe is the vertical differences between AR and AC at Qe. Total supernormal is shaded rectangle.
Long run equilibrium of the firm
In the long run, if typical firm are making supernormal profits, new firms will be attracted into the industry. Likewise, if existing firms can make supernormal profits by increasing the scale of the operations, they will do so, since all factors of productions are variable in the long run.
The effect of the entry of new firms and or the expansions of existing firm is increase industry supply. As shown in figure 2
Industry Firm
The industry supply curve shifts to the right. This in turn leads to fall in price. Supply will go on increasing, and price falling, until firms are making only normal profits. This will be when price has fallen to the point where demand curve for the firm just touches the bottom of its long run average cost curvre. Q is therefore the long run equilibrium output of the firm with Pl the long run equilibrium price.
Since LRAC curve is tangential to all possible short run AC curve. The full long run equilibrium will be shown in figure 3
LRAC=AC=MC=MR=MR
Market structure (Monopolistic competition)
Monopolistic competition is a common . Many markets can be considered as monopolistically competitive, often including the markets for , , , and service industries in large cities.
Assumptions of monopolistic competition
There are quite a large number of firms. As results each firm has an insignificantly small share of the market and therefore its actions are unlikely to affect its rival to any great extent.
It assumes that what its rivals choose to do will not be influenced by what it does. This is known as the assumption of independence. We assume that firms believe that their decisions do affect their rivals, and that their rival’s decisions will affect them.
There is freedom of entry of new firms into the industry.
In these two respects therefore monopolistic competition is like perfect competition.
- Unlike perfect competition however each firm produces a product or provides a service that is in some way different from its rivals. As results it can raise price without losing all its customers. However its demand curve is downward sloping, albeit relatively elastic given the large number of competitors to whom customers can turn.
Petrol stations, chemist shops, are examples of monopolistic competition.
- A typical feature of monopolistic competition is that, although there are many firms in the industry, there is only one firm in a particular location. This applies particularly in retailing. There may be many greengrocers in a town, but only one in a particular street. In a sense, therefore it has a local monopoly
Equilibrium of the firm
Short run
As with other market structures, profits are maximised at the output where MC=MR the diagram will be the same as for the monopolist, except that the AR and MR curve will be more elastic. This is shown in figure 4 (a). AS with perfect competition, it is possible for the monopolistically competitive firm to make supernormal profit in the short run. This is shown in shaded area.
Just how much profit the firm will make in the short run depends on the strength of demand. The position and elasticity of the demand curve. The further to the right the demand curve is relative to the average cost curve, and the less elastic the demand curve is the greater will be the firms short run profit. Therefore a firm facing little competition and whose products are considerably differentiated from its rival may be able to earn considerable short-run profits.
Take the case of a petrol station near a new housing estate. If it is the only one in the neighborhood, it will have considerable market power. It may face a relatively high and inelastic demand. Motorists may have to travel a long way to get to the next filling station. Some motorists may be prepared to do just that if the price of its petrol is high. Others, however may find it inconvenient to go to another station, or may have to use extra petrol to do so. In the short run therefore it may be able to charge a high price and make large supernormal profits.
Long run
If typical firms are earning supernormal profits, new firms will enter the industry in the long run. In the case the petrol station , new one are likely to open in the neighborhood not necessarily in the same place but maybe at the other end of the estate.
As new firms enter, they will take some of the customers away from the existing firms, the demand for the existing firms will therefore fall. Their demand (AR) curve will shift to the left, and will continue doing so as long as supernormal profits remain and thus firms continue entering.
Long run equilibrium will be reached when only normal profits remain. When there is no further incentive for new firms to enter. This is shown in figure 5. The firms curve settles at Dl, where it is tangential to the firm’s LRAC curve. Output will be Ql where ARl=LRAC (at any other output, LRAC is greater that AR and thus less than normal profit would be made.
Alternative theories to the firm
Non-maximizing goals
Traditional economic theory assumes there is a single goal. Behavioral economists argue differently any corporation is an organization with various groups
- Employees
- Managers
- Shareholders
- Customers
Each of these groups is likely to have different objectives or goals. The dominant group at any moment in time can give greater emphasis to their own objectives - for example the main price and output decisions may be taken at local level by managers.
Sales Revenue Maximisation
This objective was initially developed by the work of Baumol (1959). Baumol's research focused on the behaviour of manager-controlled businesses - where the day-to-day decisions taken by managers are divorced from the shareholders. Baumol argued that annual salaries and other perks might be more closely correlated with total sales revenue rather than bottom line profits. An alternative view was put forward by Williamson (1963), who built a model based on the concept of managerial satisfaction (utility). This can be enhanced by success in raising sales revenue.
Total revenue is maximised when marginal revenue = zero. The shareholders of a business may introduce a constraint on the price and output decisions of managers - this is known as constrained sales revenue maximisation. They may introduce a minimum profit constraint designed to underpin the market valuation of their shares and maintain a dividend (Alan Griffiths & Stuart Wall 2004) figure 6
“While Baumol is correct in noting that uncertainty plays an important role in his revenue Maximizing hypothesis, he fails to point out that uncertainty exists precisely because of the Existence of time. Decision makers plan for what they believe will be an accurate picture of the future, and if they are correct, they are likely to be well-rewarded, and if they are incorrect, they must pay for their mistakes” ( William L Anderson)
Williamson also identified a number of factors that would determine manager’s utility. These included the following (John Sloman and Mark Sutcliffe 1998)
- Salary
- Security
- Dominance –including status, power and prestige
- Professional excellence
Of these variables only salary was directly measurable. The rest would have to be measured indirectly through other variables that reflected them. For this purpose Williamson developed the concept of expenses preference. This was a means of illustrating the satisfaction that managers gained from spending money in particular on staff, on perks and on discretionary investment he suggested that such spending reflected the manager’s power, status, prestige, security and professional excellence.
Constrained sales revenue maximisation
Both baumol and Williamson recognize that some constraint on managers can be exercised by shareholders. Maximum sales revenue is usually considered to occur well above the level of output which generated maximum profits. The shareholders may demand a least a certain level of distributed profit, so that sales revenue can only be maximized subject to this constraint.
The difference a profit constraint makes to firm output is shown in figure 7. If Pr is the minimum profit required by shareholders’ then Qs is the output which permits the highest total revenue whilst still meeting the profit constraint, any output beyond Qs up to Qs would raise total curve TR the major objective but reduce total profit TP below the minimum required (Pr). Therefore Qs represents the constrained sales revenue maximising output. (Alan Griffiths & Stuart Wall 2004)
Growth maximization
Marries (1964) argues that the overriding goal which both managers and owners have in common is growth. Managers seek a growth in demand for the firm’s products or services, to raise power or status. Owners seek a growth in the capital value of the firm to increase personal wealth. (Alan Griffiths & Stuart Wall 2004)
Managers may take a longer perspective and aim for growth maximisation in the size of the firm. They may gain utility directly from being part of a rapidly growing ‘dynamic’ organization, since new posts tend be created large firms may pay higher salaries mangers may obtain greater power in a large firm.
Growth is probably best measured in terms of a growth in sales revenue, since sales revenue or turnover is the simplest way of measuring the size of a business.
If a firm is to maximise growth, it needs to be clear about the time period over which it is setting itself this objective. For example, maximum growth over the next tow or three years might be obtained by running factories to absolute maximum capacity, cramming in as many machines and workers as possible, and backing this up with massive advertising campaigns and price cuts. Such policies, however, may not be sustainable in the longer run. The firm may simply not be able to finance them. A longer term perspective (say, 5-10 years) may therefore require the firm to ‘pace’ itself and perhaps to direct resources away from current production and sales into the development of new products that have a potentially high and growing long – term demand.
Satisficing
Simon who suggested that in practice managers are unable to ascertain when a marginal point has been reached, such as maximum profit with marginal cost equal to marginal revenue. Consequently managers set themselves minimum acceptable levels of achievement. Firms which are satisfied in achieving such limited objectives are said to satisfice rather than maximise this is not to say the satisficing lead to some long term performance which is less that would otherwise be achieved . The achievement of objectives has long been recognized as an incentive to improving performance and is the basis of the management technique known as management by objectives. (MBO). Figure 6 show how the attainment of initially limited objectives might lead to an improved long-term performance.
At the starting point 1 the mangers sets the objectives and attempts to achieve it. If after evaluation it is found that the objective has been achieved, then this will lead to an increase in inspirational level (3B). A new and higher objective (4B) will then emerge. However by setting achievable objectives, what might be an initial minimum target turns out to be prelude to a series of higher targets, perhaps culminating in the achievement of some maximum target, or objective. If on the other hand, the initial objective is not achieved then inspirational level are lowered (3A) until achievable are set. (Alan Griffiths & Stuart Wall 2004) figure 8
Coalitions and goal formation
Cyert and March (1963) were rather more specific than Simon in identifying various groups or coalitions within an orgainstions. A coalition is any group which, at a given moment shares a consensus on the goals to be pursued.
Workers may form one conditions and some job security, managers want power and prestige as well as high salaries, shareholders want high profits. These differing goals may well result in group conflict. E.g. higher wages for workers may mean lower profits for shareholders. Cyert and March along with Simon, doesn’t then view the firm as having one outstanding objective (e.g. profit maximisation but rather many, often conflicting objectives. (Alan Griffiths & Stuart Wall 2004)
Its not just internal groups which need to be satisfied there is an increasing focus by leading organization on stakeholders, the range of both internal and external groups which relate to the organisation. Freeman (1984) defined stakeholders as any group or individual who can affect or is affected by the achievement of the organistions objectives. Cyert and March suggest that the aim of top management is to set goals which resolve conflict between opposing groups.
Conclusion
Harvard Referencing
Books
Davies, H (2001) Managerial Economics Pitman
Griffiths, A and Wall, S (2002) Applied Economics (10th Edition) Longman
Sloman J and Sutcliffe M (1998) Economics for Business Prentice Hall Page 174 to 204
Worthington, I Britton C. and Rees A (2005) Economics for Business (2nd Edition) Prentice Hall Chapters 5, 6, 7
Internet
2005 Perfect competition[online]http://www.oswego.edu/~atri/eco302lec.html[Accessed on 05th November 2006]
2006 Monopolist competition [online] wikipedia [Accessed on 03rd November 2006]
2004 Perfect Competition[online]http://www.investopedia.com/terms/p/perfectcompetition.asp[7th November 2006]
2006 Profit Maximisation[online] www.mises.org/asc/2003/asc9anderson.pdf - [12th November 2006]
