The firm in a competitive market

In Chapter 4 we examined the determinants of market demand. Now we ask

what lies behind the market supply curve. This involves a study of the motivation

of firms and their cost structure. We maintain the assumption of market

competition, but this will be relaxed in later chapters.

    It is easy to see why a demand curve is downward-sloping. The reasons for a

supply curve being upward-sloping are less straightforward. In one scenario the

upward slope can be explained easily. A rise in price will induce firms to supply

more. A rise in price may even be a necessary condition of more output in the

short run, since employees may have to be paid overtime and material inputs

may have to be purchased on less favourable terms. As output increases, so too

does unit cost, and hence the firm’s supply curve slopes upwards. By adding

together the supply curves of the individual firms we derive the market supply

curve, and it too slopes upwards.

    Complexities arise if increases in output lead to a fall in unit cost. This happens

quite often because of economies of scale, and it is especially likely in the long run.

As markets expand, the scope for exploiting economies of scale expands. To be

able to exploit scale economies and to have vigorous competition at the same

time requires even larger markets. Scale economies have implications for the

competitiveness of national industries and for the viability of national markets, as

well as for the slope of the supply curve.

    The textbook model of competition assumes that all firms are profit maximisers,

that they all produce the same product and that each firm accounts for a

small fraction of the total market. Thus, the individual firm has no market power.

This assumption is rather extreme, but approximates the position facing many

firms which operate in highly open and competitive markets. Exposure to global

competition means that they have to supply at world market price or else lose

sales. By assuming zero market power initially, we are able to explore important

features of the market system. One such feature, familiar to business strategists, is

the tension between the individual firm’s efforts to acquire market power and the prevalence of market forces tending to undermine that power.

Profit maximization

    Firms seek to maximise profits. Like the assumption of utility maximisation, this

assumption has to be interpreted as a general tendency, a reasonable hypothesis,

rather than a statement that all firms are guided only by this consideration. In the

short term, the acquisition or defence of market share may often necessitate

taking price and quality decisions which conflict with profitability and may even

involve short-term losses. Also, opportunistic behaviour is rarely the best foundation

for long-term profits. The firm that avails itself of every opportunity to take

maximum advantage of its customers, employees and suppliers will sooner or

later ruin its reputation and lose business.

    When originally conceived, the idea of profit maximisation applied to a world of

owner-managers of small firms. Provided the owner-manager did not have too

strong a preference for leisure and the good life, the assumption that he or she

would try to maximise profits seemed reasonable. Difficulties arose with the growth

of the public limited liability company and the replacement of owners by professional

management. Owners might still safely be presumed to want maximum profits. But managers might want to maximise something different – their salaries, for instance, or their executive power. Since, in a typical limited liability firm, ownership is often fragmented, shareholders are unable to monitor and judge performance as closely as the executives. With the possibility of conflicting objectives between owners and managers, the firm might not always behave in the way one would expect on the basis of the profit-maximisation assumption. In the words of Herbert Simon, a pioneer in the theory of organisational behaviour:

    The divorce in objectives between owners and managers gives rise to a principal

agent problem A firm’s profits are assumed to be related to managerial effort, but owners are unable to monitor and measure this effort. Hence they must think of ways of motivating executives to maximise profits rather than their own utility.

    One start to resolving this problem is to appoint a Board of Directors, elected by

and answerable to the shareholders. But this redefines rather than resolves the

principal_–_agent problem since non-executive directors, like any other agent, may

have their own agenda .They have limited time to devote to board business and their financial stake in the company may be relatively modest.

    There are two further ways of tackling the problem. First, owners ,

through the Board of Directors, can devise ‘price’ incentives which will

motivate executives to pursue the principal’s objectives of profit maximisation. Second, if they are unable to do this, owners can sell their shares to other owners who will find ways of utilising the firm’s assets more profitably.The threat of a takeover, and the consequent prospect of a new management team, can be a powerful spur to performance by executives. We consider each of these possible solutions in turn.