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2022 Spring Mid-Term Exam Solution on an Overview of Models of the Firm as A Whole from the University Of Oxford
We address a question on models of the firm examined on the 2022 spring mid-term exam from the University of Oxford. The solution is an overview of the theories related to these models. Nevertheless, we can take your economics exam
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Exam Question: explain the origin of the two theories of the firm and address the common concerns of the models of the firm
Exam Solution: In Chapters 4 to 9, we shall look at how economists and firms have produced models that attempt to predict the firms' future performance. In this chapter, we shall look briefly at the origins of the most popular models and then turn to the basic stages of building a managerial model. We can then summarize the main features of all the most successful models.
Origins: the Theory of the Firm
We can trace economists' interest in modelling the firm back to Marx, Adam Smith and beyond, but it was not until the 1870s that the 'neoclassical' theory of the firm described in Chapter 5 was laid out systematically. Smith and his followers had assumed that firms could be classified as monopolies or competitive, with monopoly being bad and competition good. The importance of profit, motivating the competitive firm to higher output and the monopoly to restrict output, was only fully explained when the 'marginalist' analysis showed why pursuing profit could lead to such divergent results.
It was not until the 1930s that more realistic pictures of firms began to creep in, with references to branded goods and competition between a few large firms. Should the 'marginalist' theory with its 'perfectly competitive' firm be abandoned? Could it predict how firms would respond to problems such as falls in demand? Empirical studies of how firms fixed their prices appeared to cast doubt on the profit-maximizing assumption; their main aim appeared to cover costs.
Similar problems were caused by the realization that many firms were now run by managers rather than their owners and that they might thus pursue goals other than profit.
Thus from relatively simple beginnings, the economists' theory of the firm branched out in many directions. Our knowledge of the models used by firms themselves to predict and measure performance is less well documented.
Origins: Firms' Models of Themselves
A fertile field for research would be to examine how decision-takers saw the firm for which they were taking decisions. Managerial accountants have recently drawn attention to the advances made over the last couple of decades in the usefulness and character of accounting information available to management. They have particularly stressed the emergence of genuine 'management accounting', the provision of information geared towards decision-making rather than fulfilling obligations to the law or shareholders. In other words, until recently, the most prolific creator of models of the firm, the accountant, has seen the need to change these models or at least some of them.
More directly related to economists' models are the large number of models created by and for firms from the late 1950s onwards. Management accountants, managerial economists and systems analysts are the new professionals that have created - them, and most have involved computers. Their main characteristics, and changing nature, are discussed in Chapter 9.
34 Managerial Economics
Building Models of the Firm In the previous three chapters, we have seen some of the different models used in managerial economics and how they might be built up and used. We now turn to the building process more formally, showing how the individual components or equations are assembled.
The first stage is identifying the variables that affect the firm we are modelling. We can rely on economic theory, expert witnesses and managers in the field. We might compile a list such as in Table 4.1.
Table 4.1. Variables affecting a TV-game firm.
- Price of TVs
- Price of computer 'chips.'
- Wage rates in Taiwan, Singapore and Hong Kong
- Cost of advertising (news media/TV)
- Time of year (larger sales near Christmas)
- Economic conditions
- Personal disposable income
- Sales target
- Markup (over cost)
- Level of interest rates
Next, we have to chart the linkages between our variables. Does 'personal disposable income" affect sales directly or only through its effect on game sales in general? Does the markup have to vary with interest rates? We can gradually assemble the variables into 'functional relationships', often suggested by economic theory or managers in the field. Two examples are shown in Table 4.2.
Table 4.2 Model of a firm: functional relationships
- Price = f (wage rates, chip cost, markup)
- Sales = f(price, sales target, personal disposable income)
Logically the next step is to say what we expect the direction of the relationships to be. Again we rely on what economists call a priori knowledge, economic theory or the evidence of those working in the area. Many directions seem obvious costs rise and push up prices, incomes rise, and sales are expected to rise, but what effect do price rises have on sales?
The next stage is to test the model that we have built. To do so, we have to lay out our model in the form of equations which can be tested econometrically. This is beyond this book's scope: some of the difficulties of testing a very simple model are discussed in Chapter 13. What will eventually result is a model of the form shown in Table 4.3.
Table 4.3 Model of a firm: equations
- S=a-bW + cP-dM
S = supply (in units)
W = wage level P = price
M = cost of 'chips Y disposable income
This formulation gives us the variables which affect demand and supply and records that we expect supply to fall if wages or 'chip' costs rise (indicated by the minus sign before the parameter belonging to the variable in question) and that if price rises, we should expect supply to rise. Similarly, we expect price rises to reduce demand (-g before Pin the demand equation) and a rise in disposable income to raise demand (+f before Y). a to g are the parameters of this model. Their values will be found when the model is econometrically tested.
Not all models of the firm are built and tested in such a thorough way, and until the advent of computers, much theorizing was done without extensive data analysis. Moreover, it is not always the best theories and models produced in a 'textbook' way; nevertheless, a conscientious attempt to see whether available evidence supports a model is part of the attempt to make managerial models more 'scientific'.
Readers interested in the problems involved are referred to the Further Reading and econometrics texts.
Common Concerns of Models of the Firm
- However, they may have originated from, in sight, the experience of firms or detailed investigation -all models of the firm as a whole deal with the following seven common concerns.
- They contain assumptions about the demand conditions that the firm faces. They may be summed up in a simple demand curve or a complex function, but in each case, the demand conditions are specified clearly. For example, the profit-maximizing theory in Chapter 5 emphasizes the importance of different demand conditions in determining a firm's price and output.
- The model must specify the conditions under which inputs are supplied to the firm. The assumption might be that inputs are freely available at known prices, or there might be limits on the use of certain inputs, as assumed in the linear-programming model. 3. Decision-making must be explicitly accounted for, explaining who takes decisions and, in some models, how the structure of the firm influences how they are taken. Chapter 7 looks at theories that stress this aspect in particular.
- Following decision-making comes the identification of the firm's objective. Simple models assume a single objective, such as profit-maximizing; others assume multiple objectives which may have to be 'traded off against each other. Again Chapter 7 examines how multiple objectives can be incorporated into a model.
- A good model will also explain how a firm chooses which product to make or when to enter or leave a particular industry. Lastly, we have two overall assumptions about the firm's situation.
- The first concerns its state of knowledge: does it know things with certainty, risk or uncertainty? As we saw in the previous chapters, most models use the assumption of certainty. Are we wrong to assume that firms will not treat the world in a probabilistic or uncertain manner? In some cases, we shall have to deal directly with risk and uncertainty, but in many cases, firms treat their knowledge as certain. They work with numbers as though they are certain rather than just probabilities. Thus, in many cases, we are fully justified in using models which assume certainty. We are, after all, trying to model firms as they are rather than as they should be!
- The last assumption is whether or not decisions are taken under conditions of strategic interdependence. If we have to consider rival firms' actions when making decisions, then we are said to be in a situation of strategic interdependence with them. The outcome of our decisions is affected by what they do. If they did one thing rather than another, the result of our possible 'strategies' would be different. This complication can be avoided when we know how rival firms will act. The classical economic theory overcame this problem very ingeniously by assuming either 'perfect competition' where no firm could affect any other, or "monopoly, where there was no rival to worry about. Other solutions to this problem are considered in Chapter 8.
The remaining chapters in Part II deal with different aspects of modelling the firm, beginning with the most ambitious model in terms of its scope, the 'neoclassical' or 'marginalist' theory.