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CHAPTER 2:THEORY OF THE FIRM & COSTS

I. Effective Competition

II. Firms, Firm Strategy, and Competitive Policy

III. Theory of the Firm

IV. Costs

EFFECTIVE COMPETITION

Effective competition which leads to good performance is the central concept in I/O. Virtues

to look for in I/O:

1. Efficiency (static)

Internal efficiency (X-efficiency)

Allocative efficiency

2. Technical progress

Innovation yields dynamic efficiency (increases in the PV of welfare)

3. Equity in distribution

4. Competitive process

Open opportunity

Rewards to effort & skill

5. Other

Freedom of choice

Support for democratic processes

Decentralized structure

Firms, Firm Strategy, and Competitive Policy

1. The perfectly competitive model serves as an important reference point, especially for an

understanding of the competitive process. A principle feature of a competitive process is free entry.

The theory implies that free entry exhausts all opportunities for making an economic profit. That free

entry dissipates profit is one of the most powerful insights in economics, and it has profound

implications for business strategy and public policy. The key to business strategy is creation of

competitive advantage (positive economic profits) andsustaininga competitive advantage in which a

firm must secure a position in the market that protects itself from imitation and entry (need some

barriers to entry to earn positive economic profits that are the reward for innovation). Public policy

views the competitive process as desirable because prices and profits are regulated by the invisible

hand resulting in an approximation to marginal cost pricing that maximizes welfare (consumer surplus

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+ producer surplus). This notion of efficiency (maximizing CS + PS) is static, although we may use

CS and PS when evaluating a dynamic situation of innovation.

2. Monopoly, on the other hand, is characterized as a market structure withbarriers to entry and the

market power to price profitably above marginal cost. As a result, less is purchased than if the market

was perfectly competitive and society suffers a deadweight loss, again in a static sense. The study ofbarriers to entry is very important in IO. When the barrier to entry is due to economies of scale, a

natural monopoly (declining long-run average total costs throughout the range of demand) exists and it

may be desirable to have only one firm produce the markets output. Public policy usually dictates

that the natural monopoly be regulated to achieve better pricing and more efficiency. A patent is a

government sanctioned barrier to entry that allows the innovator to reap rewards for the investment

from monopoly pricing. Many business behaviors that result in a monopoly may violate antitrust

laws. The justification for such laws is the inefficiency of the deadweight loss.

3. Government intervention may be justified to achieve efficiency. For example, government

intervention may be helpful if some of the assumptions of perfect competition do not hold (property

rights not clearly defined or the existence of externalities like pollution a situation referred to as

market failure). In addition, regulation may be needed to restore effective competition. However,

intervention in competitive markets (even when they are not perfectly competitive, but the competitive

process is viable) will tend to reduce efficiency in these markets (a situation referred to as government

failure).

4. Economic theory is not clear on how many firms are necessary to achieve a viable competitive

process. In some models (Bertrand price competition) only two firms are needed to attain competitive

outcomes. In other models (contestable markets) no competitors are required (just the threat of entry)

to attain competitive outcomes. On the other hand, in some oligopoly models (cartels, price fixing),

price is well above marginal cost and an inefficient outcome results.

5. Economics of scale are problematic, allowing more efficient outcomes with fewer firms with

market power than a competitive market structure. The economies of scale achieved by a few firms in

the market result in price higher than marginal cost, but prices lower than from a competitive market.

More lenient public policy would be advantageous.

6. Similarly, firms pursuing a competitive strategy to achieve a competitive advantage by developing

new innovative products (a product differentiation strategy) or more efficient production techniques (a

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cost leadership strategy), will result in price above marginal cost, but more efficient outcomes with

consumers and society better off (an increase in CS and PS). The conclusion from monopolistic

competition based onproduct differentiation is that inefficiency, in a static sense, results. But in a

dynamic sense, markets with product differentiation may be more efficient than without the

innovation that leads to market power.

THEORY OF THE FIRM

Objective of a Firm:

The objective of the firm is to maximize (present) value, i.e., maximize the discounted value of

profits. However, the standard assumption is simply to maximize the firms profits. In a one-

period model this is sufficient. In the static one-period model, the profit maximizing firm

produces where MR = MC.

Ownership and Control:

The dominant business form is the corporation, whose capital is divided up into shares. An

important development in the growth of the corporation is limited liability for the shareholders

or equity owners.

Separation of Ownership and Control:

This became a problem as corporations grew in size and the owners were not longer the

managers.

Corporate governance issues

Principal agent problem

Alternative Theories of the Firm

Note that structure is not asufficientfactor to explain conduct, but may be necessary in some cases.

Problems:

1. Which structure is worse? (fraction indicates market share)

1/3 1/3 1/3

Or

1/3

1/9 1/27 1/27 1/27

1/9 1/27 1/27 1/27

1/9 1/27 1/27 1/27

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Structure is not sufficient to determine Conduct/Behavior. Need more information on

barriers, contestability, economies of scale & scope, infrastructure, and regulation

Structure is not sufficient to determine Performance. Large firms may be more

innovative than small firms

Conduct was the unsatisfactory part of S-C-P model

2. Neoclassical view of the firm is a Black Box.

Neoclassical Theory of the Firm:

1. Model utilizes comparative statics

2. Assumptions

Maximize profits (SR view)

Perfect information assumption implies all firms have access to same technology

(hence cost structures as well)

Changing technology and innovation are external to the firm (technology assumed

fixed)

Limited scope single product

Modern Theory of the Firm

1. Ronald Coase in Nature of the Firm (1937) explained that a firm and a market are

alternative means of organizing economic activity

2. Input Output relationship is a series of contracts

3. Differences in contracts lead to different organizational structures and hence different

technologies

4. Look inside the black box. May find multi-divisional, multi-plant firms with varying

arrays of boundaries

5. Firms maximize value (LR view)

6. Strategic thinking

7. Technological & organizational change may be primarily endogenous

May yield competitive advantage, higher efficiency, and positive economic profits

BLACK

BOX

Inputs Outputs

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Exogenous technological change will not yields higher profits. Why?

May overcome barriers to entry

Consider two industries

i) Electric utilities

ii) Telecommunications

FIRM BOUNDARIES

Horizontal Boundaries:

1. Horizontal boundaries identify the quantities and varieties of products and services that a

firm produces

2. Economies of scale and scope are important in determining a firms horizontal

boundaries

3. Mergers that most often impact the horizontal boundaries of the firm concern antitrust

authorities the most

Vertical Boundaries:

1. The vertical boundaries of a firm define the activities that a firm performs itself (MAKE)

as opposed to purchases from independent firms (BUY)

2. Involves the MAKE-OR-BUY decision

3. The are numerous ways of organizing

4. Outsourcing alters the firms vertical boundaries

EXAMPLES of Vertical Organization

Virtual Corporation: BUY everything

Vertically Integrated: MAKE everything

Make or Buy: MAKE at some stages, BUY at others

Tapered Integration: MAKE and BUY at some stage

Strategic Alliances and Joint Ventures: Transacting parties are legally independent, but entailscloser cooperation and coordination (possibly explicit contracts) than an arms length, off-

the-shelf (BUY) exchange

Keiretsu: Japanese subcontracting networks relying on long-term, semiformal and formal

relationships (usually implicit contracts)

In considering the MAKE versus BUY decision, need to look at the Benefits and Costs (in

particular, the firm wants to minimize costs to obtain a given benefit)

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Cost of Making:

Cost of purchased inputs + Labor costs +

Organizational Costs

Agency costs (e.g., shirking)

Influence costs (e.g., internal lobbying)

Opportunity costs

Inability to exploit economies of scale

Inability to exploit learning economies

Cost of Buying:

Cost of good or service +

Transaction costs

Cost of negotiating, writing, and enforcing contracts

Cost of coordinating production flow through vertical chain

Leakage of private information

Problem with incomplete contracts

Advantage of Market (BUY): [Williamson]

1. Market specialist can exploit economies of scale

2. Market specialist can exploit economies of scope

3. Reduction of risk transfer of risk

4. Invisible hand of the market will impose discipline that the visible hand of

management may not (high-powered incentives)

Advantage of Firm (MAKE):

Transaction costs of using the market are too high.

1. Contracts incomplete due to bounded rationality

2. Principal agent problems

opportunism

bad incentives

Higher propensity to MAKE when:

1. Increased frequency of purchase with high transaction cost per purchase

(BUY if transaction cost are fixed costs)

2. Greater uncertainty (more incomplete contracts)

3. Higher the degree of asset specificity (market specialist more likely to

hold-up with higher incentives for opportunistic behavior

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Four general rules for managers of when to rely on the market and when to perform tasks in-house.

1. Rely on the market for routine items; produce in-house items which require specific

investments in design, engineering, or production know-how.

Asset specificity is high -- vertical integration is best.

Asset specificity is low -- reliance on the market is best.

2. Rely on market for items that require large upfront investments in physical capital ororganizational capabilities that outside firms already have.

When outside specialists benefit from significant economies of scale, reliance on the

market is best.

When in-house division can capture nearly all economies of scale in activity, vertical

integration is best.

3. Vertical integration is usually more efficient for bigger firms than for smaller.

Larger scale of product market activities -- vertical integration is best.

Smaller scale of product market activities -- reliance on the market is best.

4. Technological advances in telecommunications and data processing have tended to lowercoordination costs, making reliance on the market more attractive.

High coordination costs -- vertical integration is best.

Low coordination costs -- reliance on the market is best.

STRUCTURE OF MODERN FIRMSHistory

1840:

1. Poor infrastructure

2. Technology changing but industrial revolution in its infancy

3. Business is risky (difficult for large operations to succeed)

4. Firms are small and family operated, relying on market specialist for distribution and market

makers

1910:

1. Limited liability for corporations

2. Improved infrastructure especially transportation (railroad)

3. Innovations in production technology made large scale production more efficient

4. Large investments in large-scale operations made assurance of throughput vital

5. Manufacturing firms vertically integrated into raw materials acquisition, distribution, and even

retailing

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6. Vertically integrated firms was the efficient structure

1920s:

1. Manufacturing firms expanded product offerings, creating new divisions & M-form

organizational structure (General Motors)

2. Professional managers with little ownership interest required to run new hierarchical

structure3. Separation of ownership and control

Modern Era:

1. Significant improvements infrastructure: transportation (highways, airports), communications,

finance, technology

2. New technologies reduced the advantages of large, hierarchical, vertically integrated firms

3. Smaller may be better

4. Separation of ownership and control is still a major problem

PRINCIPAL AGENT PROBLEM

With the separation of ownership and control we get the principal agent problem in which the

objective of the principal, who delegates responsibility or control to an agent, may diverge from the

agents objective. A poorly shaped incentive structure creates this problem.

Examples: Principal Agent

employer employee

shareholder manager

owner players

Principal Agent

Cast Shareholders Managers

General Objective Maximize Utility Maximize Utility

Specific Objective Maximize Value Maximize Profit

Maximize Sales

Maximize Perks

Maximize Power

Max Personal Wealth

Satisficing Behavior

Feasibility of Profit (Value) Maximization

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The argument is sometimes made that the organizational size and complexity of modern firms makes it

difficult to maximize value precisely, and that managers rely rules of thumb or satisficing behavior

to make decisions due to bounded rationality.

Claim: Rules of thumb, such as mark-up pricing, may not deviate much from profit maximization. In

addition, rules that deviate greatly from profit maximization will be unsuccessful in a competitivemarketplace.

CONTRAINTS ON MANAGERS

Despite principal-agent problem and feasibility of profit maximization, managers do face constraints to

maximize the value of the firm. They include:1. Stockholder revolt

2. Threat of takeover market for corporate control

3. Market discipline competitive pressure4. Incentives bonuses & stock options

MERGERS

One factor affecting concentration is mergers. The main motive for mergers is to increase

profitability. However, we are interested in understanding which of the following scenarios

might occur.

1. Reduced Efficiency

merger concentration bad performance

2. Increased Efficiency

merger efficiencies good performance

Types of Mergers:

Vertical: Combination with a supplier

Horizontal: Combination of firms in same market

Conglomerate: Combination of unrelated firms

Mergers based on economies of scope

History of Mergers:

Merger activity has coincided with stock market booms, which facilitates the financing of

mergers, despite the high price of shares.

1st Wave: Turn of the 20th century (around 1900)

Merger to Monopoly

Achieve economies of scale

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Avoid antitrust entanglements (collusion illegal mergers were not)

Ended with the 1904 Northern Securities Supreme Court case and recession

2nd Wave: 1920s

Merger to Oligopoly

Did not create monopoly or even largest firm in market

Strategy not clear (efficiency or market power)

3rd Wave: 1960s

Conglomerate Merger Movement

Produced conglomerate firms or holding companies

4th Wave: 1980s - ?

No common name

Based on pure number or nominal values, numbers are high

Relative to the size of the economy, the 1st wave is larger

MOTIVES FOR MERGERS

1. Market power reduce efficiency

create deadweight loss

foreclosure or squeeze on suppliers

2. Increase efficiency

Economies of scale

Economies of scope Improve management

3. Others

Risk reduction bad reason let investors do their own diversification

Tax codes (ITC)

Empire building

Financial

Static Trade-off

A merger is likely to increase market power & create an inefficient deadweight loss. However, a

merger may result in a significant reduction in cost so the there is an increase in welfare (CS+PS)

Empirical Evidence:

1. Stock market evidence suggests that mergers improve efficiency and create value (lots of

problems with analysis using stock market data; self-fulfilling prophecy)

2. Shareholders of target firms are the primary beneficiaries

3. Little increase in market concentration and power

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4. Economies of scope, without culture clashes, are needed to get conglomerate mergers to

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COST CONCEPTS

S-R Costs of Production: (some factors are fixed in the S-R)

Fixed Costs (FC) Expense that does not vary with output

Sunk Costs Portion of FC that is not recoverable

Note: FC that is not sunk should influence decisions.

Variable Costs (VC) Costs that change with output, q.

Total Costs (TC) = FC + VC

Average Total Cost (AC) = AFC + AVC

Marginal Cost (MC) = (TC/q) = (VC/q)

The S-R cost curves impart information about the production technology. Without economies of

scale, the cost curves take on the usual U-shaped pattern.

Long-run versus Short-Run

1. In the S-R some factors of production cannot be costlessly varied. Firms make

production decisions.

2. In the L-R all inputs are variable. Firms make investment decisions.

3. LRAC is the envelope of SRAC curves

Economies of Scale:

AC falls: economies of scale (or increasing returns to scale)

AC constant: constant returns to scale)

AC rises: diseconomies of scale (or decreasing returns to scale)

Economies of scale will be important in determining firm size and may be a barrier to entry if

large capital expenditures are required. Depending on the size of the market it may result in a

natural monopoly. Minimum Efficient Size (MES) also important.

Reasons for Economies of Scale:

1. Fixed setup costs

2. Labor can specialize

3. Firms with several plants can avoid switchover costs

4. Holding inventories

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5. Physical properties (double radius of pipe more than doubles volume through pipe)

Reasons for Diseconomies of Scale:

1. Scarcity of some inputs (managerial ability)

2. Transportation cost

Economies of Scope:

1. Economies of scope exist when it is cheaper to produce two products together (joint

production) rather than separately.

2. This is an important concept for multiproduct firms. It is a justification for mergers due

to resulting efficiencies.

3. Formal definition:

C( A , B ) C( A , 0 ) + C( 0 , B )

Media Examples:

Disney and ABC

AOL and Time Warner

Other examples:

Daimler and Chrysler

Trane and American Standard

Note: Economies of Scope are often not exploited well in mergers.