The Firm and the Market

The struggle for survival tends to make those organisations prevail, which are best Ötted to thrive in their environment, but not necessarily those best Ötted to beneÖt their environment, unless it happens that they are duly rewarded for all the beneÖts which they confer, whether direct or indirect. ñAlfred Marshall, Principles of Economics,

considered the economic problem of the Örm in splendid isolation. The Örm received signals (prices of inputs, prices of outputs) from the outside world and responded blindly with perfectly calculated optimal quantities. The demand for inputs and the supply of output pertained only to the behaviour of this single economic actor. It is now time to extend this to consider more fully the rÙle of the Örm in the market. We could perhaps go a stage further and characterise the market as ìthe industryî, although this arguably sidesteps the issue because the deÖnition of the industry presupposes the deÖnition of speciÖc commodities.

To pursue this route we need to examine the joint e§ect of several Örms responding to price signals together. What we shall not be doing at this stage of the argument is to consider the possibility of strategic game-theoretic interplay amongst Örms; this needs new analytical tools and so comes after the discussion in chapter 10. We extend our discussion of the Örm by introducing three further developments:  We consider the market equilibrium of many independent price-taking Örms producing either an identical product or closely related products.  We look at problems raised by interactions amongst Örms in their production process

We extend the price-taking paradigm to analyse situations where the Örm can control market prices to some extent. What are these? One of the simplest cases ñbut in some ways a rather unusual one ñis that discussed in section 3.6 where there is but a single Örm in the market. However this special case of monopoly provides a useful general framework of analysis into which other forms of ìmonopolistic competitionî can be Ötted (see section 3.7). We shall build upon the analysis of the individual competitive Örmís supply function, as discussed on page 30 above, and we will brieáy examine di¢ culties in the concept of market equilibrium. The crucial assumption that we shall make is that each Örm faces determinate demand conditions: either they take known market prices as given or they face a known demand function such as (3.7).

The market supply curve

How is the overall supply of product to the market related to the story about the supply of the individual Örm sketched in section 2.3.1 of chapter 2? We begin with an overly simpliÖed version of the supply curve. Suppose we have a market with just two potential producers ñlow-cost Örm 1 and high-cost Örm 2 each of which has zero Öxed costs and rising marginal costs. Let us write q f for the amount of the single, homogeneous output produced by Örm f (for the moment f can take just the values 1 or 2). The supply curve for each Örm is equal to the marginal cost curve ñ see the Örst two panels in Figure 3.1. To construct the supply curve to the market (on the assumption that both Örms continue to act as price takers) pick a price on the vertical axis; read o§ the value of q 1 from the Örst panel, the value of q 2 from the second panel; in the third panel plot q 1 + q 2 at that price; continuing in this way for all other prices you get the market supply curve depicted in the third panel.

of individual supply curves involves a kind of ìhorizontal sumî process. However, there are at least three features of this story that strike one immediately as unsatisfactory: (1) the fact that each Örm just carries on as a price taker even though it (presumably) knows that there is just one other Örm in the market; (2) the Öxed number of Örms and (3) the fact that each Örmís supply curve is rather di§erent from that which we sketched in chapter 2. Point 1 is a big one and going to be dealt with in chapter 10; point 2 comes up later in this chapter (section 3.5). But point 3 is dealt with right away. The problem is that we have assumed away a feature of the supply function that is evident in Figure 2.12. So, instead of the case in Figure 3.1, imagine a case where the two Örms have di§erent Öxed costs and marginal costs that rise everywhere at the same rate. The situation is now as in Figure 3.2. Consider what happens as the price of good 1 output rises from 0. Initially only Örm 1 is in the market for prices in the range p 0 p < p00 (left-hand panel). Once the price hits p 00 Örm 2 enters the market (second panel): the combined behaviour of the two Örms is depicted in the third panel.

ever get an exact match between demand and supply. These simple exercise suggests a number of directions in which the analysis of the Örm in the market might be pursued. Market size and equilibrium. We shall investigate how the problem of the existence of equilibrium depends on the number of Örms in the market.  Interactions amongst Örms. We have assumed that each Örmís supply curve is in e§ect independent of any other Örmís actions. How would such interactions a§ect aggregate market behaviour?

 The number of Örms. We have supposed that there was some arbitrarily given number of Örms nf in the market ñ as though there were just nf licences for potential producers. In principle we ought to allow for the possibility that new Örms can set up in business, in which case nf becomes endogenous.

Product Di§erentiation:We have supposed that for every commodity i = 1; 2; :::; n there is a large number of Örms supplying the market with indistinguishable units of that commodity.

In reality there may be only a few suppliers of any one narrowly-deÖned commodity type although there is still e§ective competition amongst Örms because of substitution in consumption amongst the product types