L2 - Alternative & managerial theories of the firm, non-collusive oligopoly

Question 1

Describe Schumpeter’s dynamic view of competition

Answer 1

Innovation creates disequilibrium in the market – market power and abnormal profit for the innovator

Other competitors forced to exit or whole industry disappears (creative destruction)

Imitation follows, abnormal profit and market share of innovator declines – normal profit and equilibrium will be restored

The fact that a firm earns an abnormal (monopoly) profit does not constitute evidence that the firm is guilty of abusing its market (monopoly) power at the expense of consumers.

Instead, monopoly profits play an important role in the process of competition, motivating and guiding entrepreneurs towards taking decisions that will produce an improved allocation of scarce resources in the long run.

Question 2

Describe the Austrian school’s view of competition

Answer 2

Entrepreneurs respond more quickly, discover new information to adjust plans and improve outcomes

With new information and trading opportunities, other entrepreneurs appear, and resources are reallocated to them

According to Austrian economists, a monopoly position is attained through the originality and foresight of the entrepreneur; and, as Schumpeter suggests, monopoly profits are unlikely to be sustained indefinitely. As information arrives and new trading opportunities open up, other entrepreneurs appear, who by their actions help propel the economy towards a further reallocation of resources

Question 3

What is the difference between the Austrian School and Schumpeter?

Answer 3

Austrian - passive entrepreneur

For Schupeter - active

Question 4

What are 3 managerial theories of the firm?

Answer 4

Baumol’s sale revenue maximization model

Marris’s growth maximization model

Williamson’s theory of managerial utility maximization

Question 5

What is Baumol’s sale revenue maximization model?

Answer 5

Maximizing organizations sales revenue subject to a minimum profit constraint

A minimum profit constraint is included as the manager’s job security might be compromised if profit is too low.

Question 6

What is Marris’s growth maximization model?

Answer 6

Managers tend to strive for growth rather than profit maximization

Expanding the activities under their command and in general is a natural way for managers to enhance their reputation.

Question 7

What are the growth constraints in Marris’s growth maximization model?

Answer 7

For a given product range, growth is constrained

Managerial constraint: rapid growth through diversification (economies of scope) may lead to declining profitability

Financial constraint: growth of capital requires financing and it is limited

o Borrowing: increase debt-equity ratio and risk

o Issue new share capital: needs acceptable present and future profitability to be able to sell shares

o Retained profit: trade-off with dividends

Question 8

How does Marris’s growth maximization model look?

Answer 8

A graph with profit rate on the y-axis and growth rate on the x-axis

A straight line which is the max growth of capital -
firm’s rate of profit and the
maximum rate at which capital grows

Curved line which is growth of demand - firm’s chosen growth rate of demand and
its profitability

Intersection is growth max

Question 9

Why does the growth of demand start to slope downward at some point (Marris)?

Answer 9

As the rate of growth of demand is increased, at first profitability increases, because it is possible for the firm’s managers to identify and successfully exploit profitable diversification opportunities. If the rate of growth increases beyond a certain point, however, profitability starts to fall as the managerial profit constraint on growth begins to bite.

Question 10

What is Williamson’s theory of managerial utility maximization?

Answer 10

Managerial utility function: U = f (S,M,π_D)

This says: managers derive personal utility from things other than profits or sales:

Staff S: likes to have power over many employees (empire building)

Perks M: likes large office, expensive dinners, etc.
Discretionary profit π_D: the higher this profit, the higher the pay-out to owners, the more secure the manager’s job (that is why the manager likes it, he doesn’t care about owners)

Williamson concludes that a managerial firm tends to overspend on its staff in comparison with a profit-maximizing firm.

Question 11

What constraint do the managers face (Williamson)?

Answer 11

The manager faces the following constraint:

π_D= π(S) − (M+T ) − π_0where T = tax and π_0= the owners’ minimum acceptable profit

Question 12

What does Williamson’s theory of managerial utility maximization look like?

Answer 12

A curve - the constraint the managers face

Diminishing returns: π(S) first increasing in S then eventually declines

Utility functions

Utility maximization is where utility function is tangent to the curve

Profit maximization is at the curve’s max

Question 13

What is oligopoly?

Answer 13

Recognises the number of firms in the industry and the degree of product differentiation

A small number of firms account for substantial share of
industry sales

Closely substitute products imply rivalry between competitors

Question 14

What are 4 important concepts of oligopoly?

Answer 14

Conjectural variation: Each firm makes assumptions on the actions rival firms take in response to the firm’s own actions

Interdependence: Each firm’s action depends on what it thinks about what actions the other firms will take

Collusion: Can arise when two or more rival firms recognize the interdependence of their actions) might lead to formulation of joint action

Independent action:
Firm acknowledges that actions are interdependent but reaches conclusion that taking a unilateral decision is better for her (not contacting rivals)

Question 15

What are 4 non-collusive oligopoly models?

Answer 15

Bertrand, Edgeworth, Price leadership models – Dominant and barometric

Question 16

Describe the Bertrand model

Answer 16

There are two firms A and B

Market barriers to entry exist

Firms produce identical product – consumers buy only from the firm with the lowest price

There are no transaction or search costs – consumers are indifferent between firms given same price

Both firms face a constant marginal cost: MC_A = MC_B

Firms have no capacity constraint

Question 17

What are the three strategy assumptions of the Bertrand model?

Answer 17

Zero conjectural variation – each firm takes the rival’s price as fixed and does not expect any reaction by the rival

Firms act independently after assessing the rival firm’s strategy

Firms set their price sequentially

Therefore, customers flow effortlessly to the firm that is currently offering the lowest price.

Question 18

What is the Bertrand equilibrium?

Answer 18

Firms set price P_C = MC_A = MC_B. Bertrand equilibrium corresponds to perfectly competitive equilibrium.

Assumed each firm captures 50% of the market share.

The point at which the two firms’ reaction functions intersect corresponds to the point at which both firms maximise their own profits subject to a zero conjectural
variation assumption, that the other firm will maintain its price at the current level. In the Bertrand duopoly model, PA and PB are said to be strategic complements. If one firm alters its price, the other firm reacts by adjusting its price in the same direction.

Question 19

What is the Edgeworth model?

Answer 19

Same assumption as in Bertrand model but with capacity constraint

Capacity constraint implies firms cannot serve the entire market individually

At Bertrand equilibrium, firms are producing at their maximum capacity

Firms have incentive to increase price and earn more profits without fear of losing all their customers

Equilibrium: not stable

Question 20

What is the criticism of the Edgeworth model?

Answer 20

As before, Edgeworth’s model can be criticised for its reliance on the zero conjectural variation assumption. The model seems to be built on the idea that firms’
conjectures are always wrong. The model can also be criticised for the assumption that firms can continually and effortlessly adjust their prices and outputs.
A charitable assessment of the model is to see it as an improvement on some of the previous models discussed, because it identifies the possibility of instability in oligopoly.

Question 21

What is the dominant price leadership model?

Answer 21

The market is characterized by one large firm (dominant) and a large number of small firms (competitive fringe)

Leader firm has complete information about its demand and cost conditions and that of the competitive fringe. And it sets the price and others follow

The competitive fringe are price takers and face perfectly elastic demand at the price set by the dominant firm

Equilibrium:
Dominant firm: MR_Leader = MC_Leader

Competitive fringe: dominant firm price equals their marginal costs

Question 22

What is the Barometric price leadership model?

Answer 22

A firm announces a price change and the market reacts

Leader serves as a barometer for the industry and is not necessarily the dominant one

There are two types of barometric price leadership

(1) Competitive type

 frequent changes in the identity of the leader

 no immediate, uniform price response to price changes

 variations in market share

(2) Monopolistic type

 a small number of large firms

 large entry barriers

 limited product differentiation

 low price elasticity of demand, deterring price-cutting

 I similar cost functions