The Economic Theory of The Firm

The Economic Theory of The Firm

The Economic Theory of the Firm

There are five basic assumptions upon which the traditional economic theory of the firm is based:

1. Profit maximization: The only goal of the firm is to earn the largest possible profit.
2. Complete rationality: The firm rationally pursues its profit objective.
3. Perfect knowledge: The firm knows what its costs and revenues will be.
4.Identity of firm and entrepreneur: For purposes of analysis there is no difference between the firm and its owner-manager.
5. Competition: The only external influence on the firm's behaviour is market competition.

On the basis of these assumptions, economists construct models of the real world situations in which firms function.

The market structure in which the firm operates is the "given" in the model. There are five types of market structure:

Perfect competition: many sellers dealing in the same good Monopolistic competition: many sellers dealing in similar goods Pure oligopoly: few sellers dealing in the same good

Differentiated oligopoly: few sellers dealing in similar goods Monopoly: one seller dealing in a good

Variables in the models (i.e., those elements that can take different values) are prices, inputs of resources, costs, and products. By relating these variables to one another within the framework of the given market structure, economists can make predictions about the number of units the firm will produce and the selling price.

The market structure in which the firm operates plays a crucial role in determining the level of price and output. In a perfectly competitive market, the firm has no control over its selling price. Since many perfectly substitutable products already are available on the market, there is no chance of getting more than the going market price. On the other hand, since the firm can sell all it wants at the going market price, there is no advantage in selling for less.

Therefore, the only decision to be made is at which level of output to produce. Firms in imperfectly competitive markets have some control over their prices because there are no perfect substitutes for their products. Thus they must take into account the changes in their prices and revenues which occur at various levels of output and sales. The same decision-making rule applies for them, how-ever, as for the firms in perfectly competitive markets: Profit is maximized at that level of output where marginal revenue equals marginal cost.

He concluded that businessmen do not consider marginal analysis to be a practical operating principle because it is too difficult to apply in the complex modern business world.

2 Robert Anthony described several business practices which are incompatible with profit maximization (e.g., separation payments for discharged workers, capital budget-ing by businessmen, pricing policies).

3 Robert Gordon has emphasized the impossibility of businessmen adjusting marginally for the continuous changes that confront them and gives this as the reason why they develop shortcuts in real life situations.


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