THEORY OF FIRMS

Introduction

The theory of the firm is the microeconomics concept founded in neoclassical economics that states that
a firm exists and makes decisions to maximize profits. The firm's goal is to determine pricing and
demand within the market and allocate resources to maximize net profits. The theory of the firm consists
of a number of economic theories that explain and predict the nature of the firm, company, or corporation,
including its existence, behaviour, structure, and relationship to the market.

Market structure refers to the nature and degree of competition in the market for goods and services. The
structures of market both for goods market and service (factor) market are determined by the nature of
competition prevailing in a particular market.

The term “market” refers to a particular place where goods are purchased and sold. But, in economics,
market is used in a wide perspective. In economics, the term “market” does not mean a particular place
but the whole area where the buyers and sellers of a product are spread. In addition, market can be seen
as any contact between buyers and sellers.

This is because in the present age the sale and purchase of goods are with the help of agents and
samples. Hence, the sellers and buyers of a particular commodity are spread over a large area. The
transactions for commodities may be also through letters, telegrams, telephones, internet, etc. Thus,
market in economics does not refer to a particular market place but the entire region in which goods are
bought and sold. In these transactions, the price of a commodity is the same in the whole market.

According to Prof. R. Chapman, “The term market refers not necessarily to a place but always to a
commodity and the buyers and sellers who are in direct competition with one another.” In the words of
A.A. Cournot, “Economists understand by the term ‘market’, not any particular place in which things are
bought and sold but the whole of any region in which buyers and sellers are in such free intercourse with
one another that the price of the same goods tends to equality, easily and quickly.” Prof. Cournot’s
definition is wider and appropriate in which all the features of a market are found.

On the basis of competition, a market can be classified in the following ways:

1. Perfect Competition

2. Monopoly

3. Duopoly

4. Oligopoly

5. Monopolistic Competition

1. Perfect Competition Market:

A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged
in buying and selling a homogeneous product without any artificial restrictions and possessing perfect
knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect competition is a market structure
characterised by a complete absence of rivalry among the individual firms.” According to R.G. Lipsey,
“Perfect competition is a market structure in which all firms in an industry are price- takers and in which
there is freedom of entry into, and exit from, industry.”

Characteristics of Perfect Competition:

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The following are the conditions for the existence of perfect competition:

(1) Large Number of Buyers and Sellers:

The first condition is that the number of buyers and sellers must be so large that none of them individually
is in a position to influence the price and output of the industry as a whole. The demand of individual buyer
relative to the total demand is so small that he cannot influence the price of the product by his individual
action.

Similarly, the supply of an individual seller is so small a fraction of the total output that he cannot influence
the price of the product by his action alone. In other words, the individual seller is unable to influence the
price of the product by increasing or decreasing its supply.

Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer or seller
can alter the price by his individual action. He has to accept the price for the product as fixed for the whole
industry. He is a “price taker”.

(2) Freedom of Entry or Exit of Firms:

The next condition is that the firms should be free to enter or leave the industry. It implies that whenever
the industry is earning excess profits, attracted by these profits some new firms enter the industry. In case
of loss being sustained by the industry, some firms leave it.

(3) Homogeneous Product:

Each firm produces and sells a homogeneous product so that no buyer has any preference for the product
of any individual seller over others. This is only possible if units of the same product produced by different
sellers are perfect substitutes. In other words, the cross elasticity of the products of sellers is infinite.

No seller has an independent price policy. Commodities like salt, wheat, cotton and coal are homogeneous
in nature. He cannot raise the price of his product. If he does so, his customers would leave him and buy
the product from other sellers at the ruling lower price.

The above two conditions between themselves make the average revenue curve of the individual seller or
firm perfectly elastic, horizontal to the X-axis. It means that a firm can sell more or less at the ruling
market price but cannot influence the price as the product is homogeneous and the number of sellers very
large.

(4) Absence of Artificial Restrictions:

The next condition is that there is complete openness in buying and selling of goods. Sellers are free to sell
their goods to any buyers and the buyers are free to buy from any sellers. In other words, there is no
discrimination on the part of buyers or sellers.

Moreover, prices are liable to change freely in response to demand-supply conditions. There are no efforts
on the part of the producers, the government and other agencies to control the supply, demand or price of
the products. The movement of prices is unfettered.

(5) Profit Maximisation Goal:

Every firm has only one goal of maximising its profits.

(6) Perfect Mobility of Goods and Factors:

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Another requirement of perfect competition is the perfect mobility of goods and factors between
industries. Goods are free to move to those places where they can fetch the highest price. Factors can also
move from a low-paid to a high-paid industry.

(7) Perfect Knowledge of Market Conditions:

This condition implies a close contact between buyers and sellers. Buyers and sellers possess complete
knowledge about the prices at which goods are being bought and sold, and of the prices at which others
are prepared to buy and sell. They have also perfect knowledge of the place where the transactions are
being carried on. Such perfect knowledge of market conditions forces the sellers to sell their product at the
prevailing market price and the buyers to buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of product from one place to another. This
condition is essential for the existence of perfect competition which requires that a commodity must have
the same price everywhere at any time. If transport costs are added to the price of the product, even a
homogeneous commodity will have different prices depending upon transport costs from the place of
supply.

(9) Absence of Selling Costs:

Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all firms
produce a homogeneous product.

2. Monopoly Market:

Monopoly is a market situation in which there is only one seller of a product with barriers to entry of
others. The product has no close substitutes. The cross elasticity of demand with every other product is
very low. This means that no other firms produce a similar product. According to D. Salvatore, “Monopoly
is the form of market organisation in which there is a single firm selling a commodity for which there are
no close substitutes.” Thus the monopoly firm is itself an industry and the monopolist faces the industry
demand curve.

The demand curve for his product is, therefore, relatively stable and slopes downward to the right, given
the tastes, and incomes of his customers. It means that more of the product can be sold at a lower price
than at a higher price. He is a price-maker who can set the price to his maximum advantage.

However, it does not mean that he can set both price and output. He can do either of the two things. His
price is determined by his demand curve, once he selects his output level. Or, once he sets the price for
his product, his output is determined by what consumers will take at that price. In any situation, the
ultimate aim of the monopolist is to have maximum profits.

Characteristics of Monopoly:

The main features of monopoly are as follows:

1. Under monopoly, there is one producer or seller of a particular product and there is no differ ence
between a firm and an industry. Under monopoly a firm itself is an industry.

2. A monopoly may be individual proprietorship or partnership or joint stock company or a co operative

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3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a
monopolist’s product is zero.

4. There is no close substitute of a monopolist’s product in the market. Hence, under monopoly, the cross
elasticity of demand for a monopoly product with some other good is very low.

5. There are restrictions on the entry of other firms in the area of monopoly product.

6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker.

7. Pure monopoly is not found in the real world.

8. Monopolist cannot determine both the price and quantity of a product simultaneously.

9. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can increase his
sales only by decreasing the price of his product and thereby maximise his profit. The marginal revenue
curve of a monopolist is below the average revenue curve and it falls faster than the average revenue
curve. This is because a monopolist has to cut down the price of his product to sell an additional unit.

3. Duopoly:

Duopoly is a special case of the theory of oligopoly in which there are only two sellers. Both the sellers are
completely independent and no agreement exists between them. Even though they are independent, a
change in the price and output of one will affect the other, and may set a chain of reactions. A seller may,
however, assume that his rival is unaffected by what he does, in that case he takes only his own direct
influence on the price.

If, on the other hand, each seller takes into account the effect of his policy on that of his rival and the
reaction of the rival on himself again, then he considers both the direct and the indirect influences upon
the price. Moreover, a rival seller’s policy may remain unaltered either to the amount offered for sale or to
the price at which he offers his product. Thus the duopoly problem can be considered as either ignoring
mutual dependence or recognising it.

4. Oligopoly:

Oligopoly is a market situation in which there are a few firms selling homogeneous or differenti ated
products. It is difficult to pinpoint the number of firms in ‘competition among the few.’ With only a few
firms in the market, the action of one firm is likely to affect the others. An oligopoly industry produces
either a homogeneous product or heterogeneous products.

The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated oligopoly.
Pure oligopoly is found primarily among producers of such industrial products as aluminium, cement,
copper, steel, zinc, etc. Imperfect oligopoly is found among producers of such consumer goods as
automobiles, cigarettes, soaps and detergents, TVs, rubber tyres, refrigerators, typewriters, etc.

Characteristics of Oligopoly:

In addition to fewness of sellers, most oligopolistic industries have several common

(1) Interdependence:

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There is recognised interdependence among the sellers in the oligopolistic market. Each oligopolist firm
knows that changes in its price, advertising, product characteristics, etc. may lead to counter-moves by
rivals. When the sellers are a few, each produces a considerable fraction of the total output of the industry
and can have a noticeable effect on market conditions.

He can reduce or increase the price for the whole oligopolist market by selling more quantity or less and
affect the profits of the other sellers. It implies that each seller is aware of the price-moves of the other
sellers and their impact on his profit and of the influence of his price-move on the actions of rivals.

Thus there is complete interdependence among the sellers with regard to their price-output policies. Each
seller has direct and ascertainable influences upon every other seller in the industry. Thus, every move by
one seller leads to counter-moves by the others.

(2) Advertisement:

The main reason for this mutual interdependence in decision making is that one producer’s fortunes are
dependent on the policies and fortunes of the other producers in the industry. It is for this reason that
oligopolist firms spend much on advertisement and customer services.

As pointed out by Prof. Baumol, “Under oligopoly advertising can become a life-and-death matter.” For
example, if all oligopolists continue to spend a lot on advertising their products and one seller does not
match up with them he will find his customers gradually going in for his rival’s product. If, on the other
hand, one oligopolist advertises his product, others have to follow him to keep up their sales.

(3) Competition:

This leads to another feature of the oligopolistic market, the presence of competition. Since under
oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So each seller is
always on the alert and keeps a close watch over the moves of its rivals in order to have a counter-move.
This is true competition.

(4) Barriers to Entry of Firms:

As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit from it.
However, in the long run, there are some types of barriers to entry which tend to restraint new firms from
entering the industry.

They may be:

(a) Economies of scale enjoyed by a few large firms; (b) control over essential and specialised inputs; (c)
high capital requirements due to plant costs, advertising costs, etc. (d) exclusive patents and licenses; and
(e) the existence of unused capacity which makes the industry unattractive. When entry is restricted or
blocked by such natural and artificial barriers, the oligopolistic industry can earn long-run super normal
profits.

(5) Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns differ considerably in
size. Some may be small, others very large. Such a situation is asymmetrical. This is very common in the
American economy. A symmetrical situation with firms of a uniform size is rare.

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(6) Demand Curve:

It is not easy to trace the demand curve for the product of an oligopolist. Since under oligopoly the exact
behaviour pattern of a producer cannot be ascertained with certainty, his demand curve cannot be drawn
accurately, and with definiteness. How does an individual seller s demand curve look like in oligopoly is
most uncertain because a seller’s price or output moves lead to unpredictable reactions on price-output
policies of his rivals, which may have further repercussions on his price and output.

The chain of action reaction as a result of an initial change in price or output, is all a guess-work. Thus a
complex system of crossed conjectures emerges as a result of the interdependence among the rival
oligopolists which is the main cause of the indeterminateness of the demand curve.

If the oligopolist seller does not have a definite demand curve for his product, then how does he affect his
sales. Presumably, his sales depend upon his current price and those of his rivals. However, a number of
conjectural demand curves can be imagined.

For example, in differentiated oligopoly where each seller fixes a separate price for his product, a
reduction in price by one seller may lead to an equivalent, more, less or no price reduction by rival sellers.
In each case, a demand curve can be drawn by the seller within the range of competitive and monopoly
demand curves.

Leaving aside retaliatory price movements, the individual seller’s demand curve under oligopoly for both
price cuts and increases is neither more elastic than under perfect or monopolistic competition nor less
elastic than under monopoly. It may still be indefinite and indeterminate.

This situation is shown in Figure 1 where KD 1 is the elastic demand curve and MD is the less elastic
demand curve. The oligopolies’ demand curve is the dotted kinked KPD. The reason is quite simple. If a
seller reduces the price of his product, his rivals also lower the prices of their products so that he is not
able to increase his sales.

So the demand curve for the individual seller’s product will be less elastic just below the present price P
(where KD1and MD curves are shown to intersect). On the other hand, when he raises the price of his
product, the other sellers will not follow him in order to earn larger profits at the old price. So this
individual seller will experience a sharp fall in the demand for his product.

Thus his demand curve above the price P in the segment KP will be highly elastic. Thus the imagined
demand curve of an oligopolist has a comer or kink at the current price P. Such a demand curve is much
more elastic for price increases than for price decreases.

(7) No Unique Pattern of Pricing Behaviour:

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The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Each
wants to remain independent and to get the maximum possible profit. Towards this end, they act and
react on the price-output movements of one another in a continuous element of uncertainty.

On the other hand, again motivated by profit maximisation each seller wishes to cooperate with his rivals
to reduce or eliminate the element of uncertainty. All rivals enter into a tacit or formal agreement with
regard to price-output changes. It leads to a sort of monopoly within oligopoly.

They may even recognise one seller as a leader at whose initiative all the other sellers raise or lower the
price. In this case, the individual seller’s demand curve is a part of the industry demand curve, having the
elasticity of the latter. Given these conflicting attitudes, it is not possible to predict any unique pattern of
pricing behaviour in oligopoly markets.

5. Monopolistic Competition:

Monopolistic competition refers to a market situation where there are many firms selling a differentiated
product. “There is competition which is keen, though not perfect, among many firms making very similar
products.” No firm can have any perceptible influence on the price-output policies of the other sellers nor
can it be influenced much by their actions. Thus monopolistic competition refers to competition among a
large number of sellers producing close but not perfect substitutes for each other.

It’s Features:

The following are the main features of monopolistic competition:

(1) Large Number of Sellers:

In monopolistic competition the number of sellers is large. They are “many and small enough” but none
controls a major portion of the total output. No seller by changing its price-output policy can have any
perceptible effect on the sales of others and in turn be influenced by them. Thus there is no recognised
interdependence of the price-output policies of the sellers and each seller pursues an independent course
of action.

(2) Product Differentiation:

One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are heterogeneous
rather than homogeneous so that each firm has an absolute monopoly in the production and sale of a
differentiated product. There is, however, slight difference between one product and other in the same
category.

Products are close substitutes with a high cross-elasticity and not perfect substitutes. Product
“differentiation may be based upon certain characteristics of the products itself, such as exclusive
patented features; trade-marks; trade names; peculiarities of package or container, if any; or singularity in
quality, design, colour, or style. It may also exist with respect to the conditions surrounding its sales.”

(3) Freedom of Entry and Exit of Firms:

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Another feature of monopolistic competition is the freedom of entry and exit of firms. As firms are of small
size and are capable of producing close substitutes, they can leave or enter the industry or group in the
long run.

(4) Nature of Demand Curve:

Under monopolistic competition no single firm controls more than a small portion of the total output of a
product. No doubt there is an element of differentiation nevertheless the products are close substitutes. As
a result, a reduction in its price will increase the sales of the firm but it will have little effect on the price-
output conditions of other firms, each will lose only a few of its customers.

Likewise, an increase in its price will reduce its demand substantially but each of its rivals will attract only
a few of its customers. Therefore, the demand curve (average revenue curve) of a firm under monopolistic
competition slopes downward to the right. It is elastic but not perfectly elastic within a relevant range of
prices of which he can sell any amount.

(5) Independent Behaviour:

In monopolistic competition, every firm has independent policy. Since the number of sellers is large, none
controls a major portion of the total output. No seller by changing its price-output policy can have any
perceptible effect on the sales of others and in turn be influenced by them.

(6) Product Groups:

There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing similar products.
Each firm produces a distinct product and is itself an industry. Chamberlin lumps together firms producing
very closely related products and calls them product groups, such as cars, cigarettes, etc.

(7) Selling Costs:

Under monopolistic competition where the product is differentiated, selling costs are essential to push up
the sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers for window
displays, free service, free sampling, premium coupons and gifts, etc.

(8) Non-price Competition:

Under monopolistic competition, a firm increases sales and profits of his product without a cut in the price.
The monopolistic competitor can change his product either by varying its quality, packing, etc. or by
changing promotional programmes.

The features of market structures are shown in Table 1.

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