2022 Spring Mid-Term Exam Solution on an Overview of Models of the Firm as A Whole from the University Of Oxford
Exam Question: explain the origin of the two theories of the firm and address the common concerns of the models of the firm
Origins: the Theory of the Firm
Origins: Firms' Models of Themselves
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.