Theories of the Firm Third Edition Demetri Kantarelis Publisher's website: www.inderscience.com ISBN (Print): 0-907776 - 53-1 ISBN (Online): 0907776-5*-X Copyright 2010 Inderscience Enterprises Ltd No part of this publication may be reproduced stored or transmitted in any material form or by any means (including electronic, mechanical, photocopying, recording or otherwise) without the prior written permission of the publisher, except in accordance with the provisions of the Copyright Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd or the Copyright Clearance Center Inc. Published and typeset in the UK by Inderscience Enterprises Ltd.
CONTENTS Chapter 1: The business environment in the first quarter of the 21st century 1 1 Globalisation 1 1.1 Legal restrictions 3 1.2 Global concentration 5 1.3 Excess capacity 6 1.4 Insourcing and urbanisation in developing economies 7 1.4.1 Development views: 'romantic', 'parasite' and 'dual economy' 10 2 The increasing relevance of auctions 11 2.1 Bidders (or buyers) 11 2.2 Auctioneers (or sellers) 14 2.2.1 Risk preference 14 2.2.2 Information structure 14 2.3 Other actions 15 2.4 Ethical issues 17 3 Ethical constraints 19 3.1 Teleological ethics 20 3.2 Deontological ethics 22 3.3 Virtue ethics 23 3.4 System development ethics 24 3.5 Ethics theories as foundations of other theories that affect business... 24 4 Summary 26 Chapter 2: The firm as a decision-maker 28 1 Rationality 30 2 Satisficing 34 3 Additional factors that affect decisions 35 3.1 Economic decisions and cost/benefit analysis 35 3.2 Groups 37 3.3 Variety of evaluative frameworks 37 3.4 Bayesian decision-making 38 4 Fairness, gaming and risk preference 38 4.1 The risk-averse firm 40 4.2 The risk-loving firm 41 5 Uncertainty 42 6 Behavioural decisions 44 7 Summary 46
Chapter 3: The neoclassical theory of the firm 48 1 The skeletal features of the neoclassical monopoly firm and the principle of profit maximisation 48 2 A formal model of the neoclassical theory of the monopoly firm: 53 3 The firm in various market structures 56 3.1 Competitive advantage, market segmentation, contestability and relevant competitors 56 3.2 The perfectly competitive firm 61 3.2.1 The perfectly competitive firm in the short-run 62 3.2.2 The perfectly competitive firm in the long-run 63 3.3 The monopolistically competitive firm 66 3.3.1 Monopolistic competition in the short-run 67 3.3.2 Monopolistic competition in the long-run 68 3.4 The Hotelling-type (spatially differentiated) firm 68 3.4.1 The spatial firm 69 3.4.2 The spatially differentiated industry in the short-run 70 3.4.3 Entry and the industry in the long-run 71 3.4.4 Efficient distance 72 3.5 Intra-industry trade theory 75 3.5.1 Industry structure 76 3.5.2 Two industries and two countries 77 4 Summary 79 Chapter 4: The strategic firm 80 1 Kinked-demand mentality 80 2 Reversed-kinked-demand mentality 81 3 Dominant strategy 81 4 Nash equilibrium 82 5 Cartel solution 82 6 Games with mixed strategies 86 7 Incomplete information games 89 7.1 Pure-strategy Bayes-Nash equilibria 90 7.2 Mixed-strategy Bayes-Nash equilibria 91 8 Evolutionary games < 93 9 The Cournot model 96 9.1 N-firm Cournot model..., 97 9.2 Industry concentration measures 98 9.3 Cournot duopolists 101 10 Stackelberg duopolists 102 11 Live and let live philosophy :.. 103 12 Stochastic duopoly 103 13 A case for more competition and higher prices 104 14 Entry deterrence 104 14.1 The Sylos-Labini postulate 104 14.2 The Dixit model of entry deterrence 105 15 Summary 110
Chapter 5: The price-discriminating firm and the regulated firm 111 1 The price-discriminating firm 111 1.1 Two-part tariff. 112 1.2 First-degree price discrimination 112 1.3 Second-degree price discrimination 114 1.4 Third-degree price discrimination 116 2 The regulated firm 118 2.1 Natural monopoly 118 2.2 Natural monopoly and subaddivity 121 2.3 Regulation 122 2.4 Ramsey prices 124 2.5 Peak-load pricing and capacity-based subsidy 126 2.6 Rate-of-return constraint regulation 128 2.7 Regulators' motives 131 2.8 Alternatives to regulation 132 2.9 Safety 134 2.10 Environment 136 2.11 Internalisation of costs, liability and negligence 142 2.12 FDA and product screening regulation 147 3 Summary 150 Chapter 6: The money-managing firm 152 1 The capital asset pricing model 152 2 The impact of a risk-free asset and the Sharpe ratio 156 3 The relationship between a security's risk and its expected rate of return 159 4 Summary 161 Chapter 7: The transaction cost theory of the firm 163 1 Model I: the firm according to Coase 163 1.1 The answer to question (a) 163 1.2 The answer to question (b) 164 2 Model II: the firm as a minimiser of transaction costs subject to a given output level 165 3 Critical dimensions of transacting 167 3.1 Bounded rationality 167 3.2 Opportunism 167 4 Model II: modified 169 5 Model III: the firm according to Williamson 171 6 Model IV: vertical integration and asset ownership 173 7 The firm as a function of deals 174 7.1 Factors that govern the effectiveness and efficiency of deals 177 7.2 Strategic nucleus 183 7.3 Mergers 184
7.3.1 The vertically integrated firm 184 7.3.2 The horizontally integrated firm 188 7.3.3 Conglomerate mergers 189 7.4 Strategic alliances and joint ventures 190 8 Summary ; 195 Chapter 8: The principal-agent theory of the firm 197 1 The principal-agent problem 197 1.1 Private information, opportunism and remedies 198 1.2 Mechanism design and incentives' engineering 200 1.2.1 Coordination Mechanism 1: split-the-difference plan 200 1.2.2 Coordination Mechanism 2: symmetric mediation plan 201 2 The conflict between the principal and the agent 204 2.1 Divergence of interests: Model 1 205 2.2 Divergence of interests: Model II 206 3 Incentive compatibility 207 4 The profit share (or bonus) incentive 210 4.1 Risk-sharing between owner and manager 211 5 The firm without employees 213 6 The firm with a monitored employee 214 7 The leisure model 217 8 Partnership 219 8.1 Non-opportunistic 219 8.2 Opportunistic 220 9 'Team' and the minimisation of free riding 221 10 A theory of the banking firm 222 10.1 Loan limits and moral hazard 224 10.2 Equilibrium 224 10.3 Heterogeneous clients and adverse selection 225 10.4 Theory versus reality 226 10.5 The recent financial crisis 228 11 Microfinancing 230 11.1 Microfinancing and adverse selection 232 11.2 Group-lending and the mitigation of adverse selection problems 233 11.3 Group-lending and the mitigation of moral hazard 234 12 Summary 236 Chapter 9: The evolutionary theory of the firm 238 1 Introduction 238 2 Creative destruction 238 3 The essence of Schumpeter 239 4 Styles of entrepreneurship 243 5 Entrepreneurial capitalism 245 6 Habitat for entrepreneurs 247 7 The architecture of the US entrepreneurial economy 249
8 Market structure and innovation 253 8.1 Schumpeter's assertion 254 8.2 Process invention 256 8.3 Patents, copyrights and trademarks 257 9 Strategy and firm structure 259 10 Summary 266 Appendix I: The evolution of industrial concentration due to luck: an extension 268 1 Introduction 268 2 Gibrat'sLaw 269 3 The Gibrat process with periods of decline 269 3.1 The effect of a decline 269 3.2 The effect of fluctuations 270 4 Examples 271 4.1 Prais-type experiments 271 4.2 Scherer-type experiments 272 5 Conclusions 274 Appendix II: Buyer concentration and countervailing power 277 1 Introduction 277 2 Measuring buyer concentration 278 3 Correlation between buyer and seller concentration 280 4 Summary and conclusions 284 Appendix III: Buyers, sellers, and price cost margins in manufacturing industries 287 1 Sample selection 288 2 Links between buyer and seller power and PCM 289 2.1 Herfindahl measures 289 2.2 Concentration ratio measures 291 3 Summary and conclusions 293 Appendix IV: Live and let live type behaviour in a multi-market setting with demand fluctuations 297 1 Introduction 297 2 The live and let live philosophy 298 3 Live and let live behaviour in a two-market duopoly model 298 4 Results of computer simulations 301 5 Comparison with other oligopoly models 303 5.1 Crippled optimisation 303 5.2 Multiple goal decision-making 304 6 Concluding comments 304
Appendix V: Stochastic duopoly and learning to cooperate 306 1 Introduction 306 2 A stochastic duopoly game 308 3 Learning 310 4 A numerical example 310 5 Summary and conclusions 311 APPENDIX VI: Captive and common markets without price discrimination 313 1 Introduction 313 2 Literature review 314 3 The model's theoretical environment 316 4 The model 318 5 Summary and conclusions 319 Appendix VII: Pairing industries and firms for optimum portfolio performance 322 1 Introduction 322 2 Classification of publicly traded firms and industries 324 3 Paired aggregate efficient frontiers (PAEFs) 328 4 Empirics regarding the CAPM 331 5 Summary and conclusions 332 Epilogue 335 Bibliography 339 Subject Index 347