UNIT 13 ALTERNATIVE THEORIES OF

FIRM -II
Structure
13.0 Objectives
13.1 Introduction
13.2 Bain’s Limit Pricing Model
13.3 Model of Sylos-Labini
13.4 Behavioural Theories
13.5 Behavioural Model of Firm
13.6 Game Theoretic Models
13.7 Let Us Sum Up
13.8 Key Words
13.9 Some Useful Books
13.10 Answer or Hints to Check Your Progress
13.11 Exercises

13.0 OBJECTIVES
After going through this unit, you will be able understand:
• the optimum decision of firms regarding pricing, output and other policy
variables through framework different from traditional theory where
pricing decisions are based on marginalistic concepts.

13.1 INTRODUCTION
In the traditional theory of the firm, the profit maximisers set their price equal
to the marginal cost. But in a paper by Hall and Hitch, 1939, it has been
shown that the firms set the price equal to the average cost. In the following
sections, we would see under what conditions or as to why the firms set the
price equal to average cost. This issue would be dealt within the Bain’s model
where the firms in an industry set their price so as to bar the entry of new
firms in the market. The Sylos-Labini model is also built on the same lines as
the Bain’s model. The behavioral theory of the firm is a bit different from the
previous two in the sense that it deals with how the firms arrive at an optimum
decision regarding any policy variable. Finally, the game theoretic model,
though has the same theoretic flavour as the Behavioural theory, provides a
new dimension into such behaviourist approach and incorporates the
interdependence among the firms to provide solution to their decision
problem.

13.2 BAIN’S LIMIT PRICING MODEL

Bain formulated his ‘limit-price’ theory in an article published in 1949. The
theory explains as to why firms do not set the price following MR = MC
principle, at a level where MR < 0. He concluded that traditional theory failed
to explain this because it suppressed an important factor in the pricing
66 decision, namely, the threat of potential entry. Traditional theory was
concerned with actual entry, which resulted in the long-run equilibrium of the Alternative Theories of
Firm – II
firm and industry. Bain argued that price was not set at the minimum point of
LAC. His explanation was that the firms deliberately set a price above
minimum LAC in order to keep the potential entrants away. Thus, ‘limit price’
was the highest price, which the established firms believed they could charge
without inducing entry.

Bain considers entry as the establishment of a new firm, which builds or

introduces new productive capacity that was not used for production in the
industry before. The ‘condition of entry’ was defined as the margin by which
established firms could raise their price above the competitive price level
persistently without attracting entry. That is,

PL = PC ( 1 + E ) ,

where PL = limit price.

PC = competitive price under pure condition.

E = ‘Condition of entry’. It is the premium accruing to the established

firms in an industry from charging a price PL > PC .

Bain distinguishes four main barriers to entry – product differentiation barrier,

absolute-cost advantage of established firms, economies of scale and large
initial capital requirements. In addition to these, there could be legal barriers.
These are exogenous and if they exist, firms can charge any price without the
fear of attracting new entrants. In the analysis, we would deal with first four
barriers only.

Product-differentiation Barriers

The preference of buyers, attached to various existing brands, creates barriers

to the entry of a new firm. An entrant is at a disadvantage because she has to
make her product known and attract some customary buyers from the
established firms. As a result, the new firm has to sell at a lower price or
spend more on advertising or undertake both. Hence, the cost of the new
entrant goes up.

Absolute Cost Advantage

The established firms enjoy an absolute cost advantage due to (a) skills of
expert management personnel who are experienced (b) patents and superior
techniques (c) control of the supply of raw materials and (d) lower cost of
capital markets.

If any type of absolute cost advantage exists, then the LAC of the entrant
would be higher at every scale of production than that of the established firms,
as shown in Figure 13.1. As a result, an entry-preventing price like PL would
be set at a level just below the cost of the potential entrant.

In the figure, DD is the market demand curve. The entrants demand curve, dd,
is AD. At any level of output beyond OX L , the entrant’s faces a loss, so that
entry becomes unattractive. The difference, PL − PC , is the entry gap and
67
Price and Output shows the amount by which the established firms can raise the price above
Determination–II
LAC without attracting entry.

P, C

LAC of entrant
PL
A
PC LAC of established firm

D
X
O X L XC
Fig. 13.1: Absolute Cost Advantage of Established Firm
Barriers from Initial Capital Requirements
New firms require an initial capital outlay, which could be difficult to acquire.
Banks may be reluctant to finance new business and the capital market could
be almost inaccessible to the new firms.
Economies of Scale
Economies of scale may be real or pecuniary. Real economies are technical,
arising out of efficient large-scale machinery or managerial or labour-related
or greater specialisation of labour. Pecuniary economies arise from bulk
buying at preferential lower prices: Lower transport costs when output is
large, lower advertising etc.
Irrespective of the nature, the economies of scale create an important barrier
to the entry. The effects on the level of the limit price depend on the
expectations of the (i) entrants about the reactions of established firms after
entry and (ii) established firms about the behaviour of entrants. Bain states the
following, on whose basis he analyses his model:
1) The potential entrant expects the established firms to keep the post-entry
price constant.
2) The potential entrants expect that established firms to retain their output at
the pre-entry level.
3) The entrants expect that established firms will partly increase their output
and will allow price to fall.
Assumptions of Bain’s Model
1) For each industry there exists a minimum optimal scale of plant, say x
2) LAC is L-shaped i.e., costs remain constant beyond the minimum optimal
68 scale
3) LAC is the same for all, the established firms and the potential entrant Alternative Theories of
Firm – II
4) The market-demand curve DD is known to all firms
5) All firms produce similar products, so that the preference-barrier is ruled
out from this model
6) All firms have equal market shares. This implies that eventually the old
and new firms will get an equal share of the pie
7) The flat part of the LAC curve determines the long-run (LR) competitive
price, PC and output XC as given by the intersection of the two and is
shown in the following Figure 13.2

P, C

PC LAC

D
X
O XC

Fig. 13.2: Price and Output Determination with Flat LAC

Model A

In this model, the entrant expects the established firms to keep their price
constant at the pre-entry level and allow the entrant to secure any share it can
have at this price.

The established firms will set the price at a level, which will make entry
unattractive as per the following:

PL = PC ( 1 + E )
The premium E by which the limit price will exceed the competitive price,
depends on four factors:
a) Initial share (d) of the entrant relative to the minimum optimum scale (say,
x ).
If d > x , then there is no barrier to entry.

If d < x , then the established firms will manipulate an E such that PL > PC
which is shown in Figure 13.2.
69
Price and Output b) If entry occurs, then for all firms (new and old), the share of the
Determination–II
market would be reduced. Therefore, greater the number of existing
firms, N, the greater is E and higher will be PL . This is shown in
Figure 13.3.

P, C d2′ d1′ d2 d1

PL2

PL1

PC

X
O X
Fig. 13.3: Limit Price and Number of Entrants
In Figure 13.3, d1 is the pre-entry share of each firm. In the post-entry period,
it shifts to d1 . Therefore, the entry-preventing price is set at PL1 . If N is large,
then the share of the firms (pre-entry) is d 2 and hence limit price will be
higher at PL 2 .
c) The steepness of LAC
The steeper the LAC curve is, the higher will be the premium and higher
would be the limit price. This is shown in Figure 13.4 with steeper LAC curve
LAC2, and the higher limit price PL2.
d1′ d1
LAC2
P, C LAC1

PL2

PL1
PC LAC
d1′ d1

X
O X
X
Fig. 13.4: Limit Price Setting with Steeper LAC

d) The elasticity of the market DD Curve.

70
 Let us assume that the demand curve of the individual firms (d) has the Alternative Theories of
Firm – II
same elasticity as the market demand curve DD. In that case, the
greater the price elasticity, the higher is the premium and higher is the
limit price.
d1′
P, C d2 d1
d2′

PL2

PL1
PC LAC

X
O X

Fig. 13.5: Limit Price Setting and Elasticity of Demand

The individual demand curve d2 is more elastic than d1. Accordingly, the limit
price PL2 > PL1.

In Figure 13.2, we see that if share of the entrant is d1 or any other to the right
of d1, then no limit price would exist. For any share to the left of d1, there will
be limit price (Figure 13.6).
P, C

d1

PL2
PL1
PC

X
O X

Fig. 13.6: Existence of Limit Price and Entrant’s Market Share

Model B

In this model, the entrant expects that the established firms to retain their
output constant, thus permitting industry price to fall as a consequence of the
71
Price and Output entry. The existing firms expect that entry will not occur if the price falls
Determination–II
below the minimum range of the LAC curve.

Assuming that the entrant enters with the minimum optimal plant size (i.e.,
producing x ), the limit price will be set at b determining the total level of
entry preventing output of the existing firms. The established firms will
produce a quantity XL such that, if the entrant adds a minimum optimal output
x , the market price will fall just below the LAC = PC. This is shown in the
following diagram.

PL

PC LAC

O XL XC

Fig. 13.7: Minimum Efficient Scale Plant and Limit Price Setting

If X L = X C − x , then the entrant would just break-even, because p=LAC.

If XL is such that, X L + x > X C , then the entrant would be making a loss.

Check Your Progress 1

1) What is meant by “limit price”?

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

2) What is a premium?

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………
72
3) Enlist some common barriers to entry. Alternative Theories of
Firm – II
………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

………………………………………………………………………………

13.3 THE MODEL OF SYLOS-LABINI

Sylos-Labini developed a model of limit pricing based on scale-barriers to
entry. He concentrated on the case of oligopoly whose technology is
characterised by technical discontinuities and economies of scale.

Assumptions
1) The market demand is given and has unitary elasticity
2) The product is homogeneous
3) The technology consists of three types of plant size: small, medium and
large. Thus, we would have three cost lines corresponding to each plant
size.
4) The price is set by a leader who is the largest firm operating at the lowest
cost. The cost level is low enough to prevent entry. The leader does not act
at free will and sets a price acceptable to all firms in the industry which
also prevents entry
5) A normal rate of profit exists in each industry
6) The leader knows the cost structure of all plant sizes and the market
demand
7) The entrant comes into the industry with the smallest plant size
8) The existing firms expect that the potential entrant would not enter if post-
entry p rice falls below LAC
9) The entrant expects that the established firms will continue to produce the
same level of output post-entry
Price Determination in Sylos-Labini’s Model
The price is set by the largest, most efficient firm. The equilibrium price must
be such as to be acceptable by all firms in the industry and be at a level
preventing entry.

Given that the firms have different costs, there are as many minimum
acceptable prices as plant sizes. For each plant, the minimum acceptable price
is given by:
Pi = TACi (1 + r)
where Pi ⇒ minimum acceptable price for the ith plant size.
TACi ⇒ total average cost for the ith plant size
r ⇒ normal profit rate of the industry
73
Price and Output The price leader is assumed to know the cost structure of all plant sizes and
Determination–II
the normal (minimum) profit rate of the industry. Given this information, the
leader will set the price that is acceptable by the smallest, least efficient firms
and will deter further entry. The price has to be such that, even the least
efficient firm earns some profit. Otherwise, there could be government
intervention, so that the leader has all the reasons to appease all firms, big and
small. With all these considerations, given the market demand at the minimum
acceptable price of the smallest least efficient firm, the price leader would set
the price at such a level that post-entry the market price would fall below the
minimum acceptable price.
In the following diagram, the market demand at the minimum acceptable price
PS of the smallest, least efficient firm is X. The leader will set the limit price
PL > PS. PL corresponds to output XL. PL is the equilibrium price because it is
acceptable to all firms, since at PL, all firms earn abnormal profit. Secondly, at
PL, entry is deterred owing to the fact that post-entry output would be:
X L + X S = X ' , whereby price would fall just below Ps' the minimum
acceptable price of the entrant (PS)

P
D

PL

PS AC small plant
PS′ XS

PM AC mediumplant

PL AC large plant

6 7XS8 D
____
O XL XX′

Fig. 13.8: Limit Price and Equilibrium in Sylos Model

DD ⇒ market demand carve, PL ⇒ limit price.
PL is indirectly determined by the determination of the total output that the
established firms will sell in the market. The leader determines the output at
which all established firms use their plants upto capacity. Next, the leader
determines the total output XL to be sold, so as to prevent entry. XL has to be
such that, once the entrant enters with output Xs (since by assumption, she
enters with the smallest plant size), the total supply in market would exceed
X. The price would fall below PS, which is the minimum acceptable price of
the least efficient firm in the industry. The entrant being a small firm would
incur a loss. Now given XL, the limit price PL is determined from the market
demand curve. It is to be noted that any output smaller than XL will not
prevent entry.

In Sylos model the determinants of PL are:

a) The absolute size of the market X.
74
 The larger the market size the lower would be the entry-preventing price. Alternative Theories of
Firm – II
b) The elasticity of market demand.
The more elastic the demand the lower is the price that the established
firms can charge without attracting entry.
c) The technology and technical change.
The larger the minimum viable plant size, the higher will be the limit
price.
d) The prices of factors of production
An increase in the factor prices will lead to an increase in the costs and the
limit price in the industry.
Check Your Progress 2
1) Who determines the limit price in Sylos-Labini model?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) How is the price set in the market is Sylos limit price model?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
3) What are the determinants of limit price in the Sylos-Labini model?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

13.4 BEHAVIOURAL THEORIES

The behavioural theories of the firm started developing during the 1950s. One
important model in these as developed by Cyert and March originated from
the concern about the organisational problems cropping up from the internal
structure of the firms and the need to investigate their effect on the decision-
making process. In this theory, a firm is conceived as a coalition of different
groups, which are connected with its activity in various ways: managers,
workers, shareholders, customers, suppliers, bankers, tax inspectors and so on.
Each group has its own set of goals or demands.
75
Price and Output The demands of various groups of the coalition-firm change continuously over
Determination–II
time given the limited resources of the firm. In any period, all demands
confronting the top management cannot be satisfied. Hence, there is a
continuous bargaining process between the various members of the coalition-
firm and inevitable conflict. Generally, the means for resolution of conflicts
are money payments.

The goals of the firm are set by the top management, which can be seen in
five groups viz., (1) production goal (2) inventory goal (3) sales goal (4)
share-of-the –market goal (5) profit goal.

Decisions are taken at various levels of the administration (or hierarchy),

given the goals, and the available resources. The allocation to various
departments is decided by the top management. Once the budget-shares are
allocated, each manager spends them on her department at her own discretion.
This involves the decision process at lower levels of administration.

13.5 BEHAVIOURAL MODEL OF FIRM

In this section, a brief presentation of a simple model by Cyert and March is
made to illustrate the decision-making process within a modern large
corporation.

The model deals with duopoly, where each firm produces a homogeneous
product. As a result, a simple price would prevail in the market and once both
firms decide on their outputs, price is determined by the market. It is also
assumed that there are no changes in inventories.

The steps leading to a decision-making of such a firm (as described above) are
given below:

1) Rivals reaction: The forecast of the rivals reaction is made by a

straightforward extrapolation of the past observed reactions.
2) Firm’s demand: This is obtained as an estimate of the demand function
from the past observations. Future demand is thus an extrapolation of the
past sales of the firm.
3) Cost of the firm: Current cost is assumed to be the same as in the past
period. But then if the firm had achieved the project goal in the past
periods, then the average unit costs are increased by a certain percentage
to allow for slack payments.
4) Goal specification of the firm: In this model, project is the only goal of
the firm. The aspiration level of project is some average of the projects
of past periods.
5) Comparison of goals and results: From the information in steps 1-3, a
solution is obtained on the level of output, price, cost and projects. The
levels of profit ( π ) are then compared with the target level of projects.
If the goals are satisfied, then the firm adopts it; otherwise, the firm
proceeds to the next step.
6) Re-examination of costs: As costs are directly under the control of the
firm, if the goals are not met, firms start re-examining the costs first. It
76 generally involves a cut in slack and other expenses.
7) Evaluation of the new solution: If the new solution arrived at due to the Alternative Theories of
Firm – II
down-ward adjustment of costs leads to the target project, then that
solution is adopted otherwise the firm moves to step 8.
8) Re-examination of demand: This process consists of change in the sales
strategy (i.e., more market research, more advertising, more salesman
etc.)
9) Re-evaluation: If the new solution with the revised cost and demand
attains target project, then it is adopted, otherwise the firm moves to
step 10.
10) Readjustment of aspiration levels: If with the revision of costs and
demand, the goal is not met, then the firm opts for a re-adjustment in the
aspiration level of the firm (which is project in this model).
The firm has multiple goals, which takes the form of aspiration levels. The
firm is satisfier rather than a maximiser. The goals change over time
depending on past attainments, aspirations, demands of groups and
expectations. The criterion of choice for goal setting is that the alternative
selected meets the demands (i.e., the goals) of the coalition. The firm adopts
the procedure of sequential consideration of alternatives. The first satisfactory
alternative evoked is accepted, when there is failure, the search is intensified.

The organisation seeks to avoid uncertainty. The uncertainty originating from

the competitors is avoided by creating a negotiated environment, that is, by
some sort of collusive strategy.

The firm also uses standard operating procedures such as task-performance

rules, continuous records, and reports, information-building rules, planning
devices, budgeting, investment planning and long-run planning. It also uses
blue-print-rules-of-thumb for on-costing pricing rules, slack-absorbed-in-cost
rules, equipment-expansion rules. The operating procedures and the ‘blue-
print’ rules aim at implementing the goals that help the lower hierarchical
levels and act in some way, which is consistent with the goals set by the top
management.

Check Your Progress 3

1) What does the coalition of the firm mainly consist of?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) What are the common goals set by the management?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
77
Price and Output 3) Enlist the steps leading to a decision-making of a firm in behaviorial
Determination–II
model.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

13.6 GAME THEORETIC MODELS

The theory of games developed by Neuman and Morgensten is an alternative
approach that has been applied to market situations where there is
interdependence in the course of action. Many decision problems of
oligopolistic firms have been solved by applying the method of game theory.
We will discuss with same details of game theory in Block 8. Before it is
done, let us get familiar with some of its concepts to be able to appreciate the
solution mechanism offered in the select models of alternative theories of
firm. In a game, there are two participants called players, and it is assumed
that each player knows all the possible course of action of all. Each particular
course of action is called a “strategy” and associated with each strategy is a
“pay-off”.

Definitions
1) Strategy: In game theory, a strategy is a specific course of action with
clearly defined values for the policy variables. For example, a strategy
may consist of setting a price of X, spending of Y on advertising, making
a change in packaging of product etc. In game theory these strategy are
generally devoted by alphabets or alphanumeries (A1, A2, ….). strategies
can be of two types: pure strategies mixed strategies.
a) Pure strategies – In this format, the players choose a particular strategy
with probability 1.
b) Mixed strategies – In this case, each player plays her strategies
accordingly to a predetermined set of probabilities.
2) Pay-off – The pay-off of a strategy is the ‘net gain’ it will bring to the firm
for any given counter-strategy of the competitor. This gain is measured in
terms of the goals of the firm. For example, if the goal of the firm is to
maximise its profits, then the pay-off of a strategy will be measured in
terms of project levels that yield the maximum.
The pay-off matrix of a firm would be a table showing the gains accruing to
the firm as a result of each possible combination of strategies adopted by it
and its rival. Suppose there are two firms – A and B. A has three strategies
while B has four. Thus, there will be 3 × 4 = 12 pay-offs, as shown in the
following
B1 B2 B3 B4 Strategies of B.

A1 P11 P12 P13 P14 Pay-off.

A2 P21 P22 P23 P24

A3 P31 P32 P33 P34

78 Strategies of A
2) Equilibrium of a game – It is a strategy combination consisting of the best Alternative Theories of
Firm – II
strategy for each player, when neither one has any incentive to deviate. It
is called a Nash-equilibrium.

Let us now consider two types of games depending upon the moves of the
players – simultaneous move game and sequential move game

Simultaneous Move Game

It means that there are players with their pay-offs and the strategy chosen
which have an impact on their net gains. And importantly, all the players in
the game simultaneously choose their strategies and pay-offs. Cournot model
of duopoly is an example of a simultaneous move game.

Example: Duopoly model in a game theoretic set-up:

1) Number of players – 2 firms (A, B)

2) Strategies – Each duopolist anticipates a cut in price by 5%

The sum of the pay-offs is given in thousand rupees by the following matrix:

⎛ −140 −20 ⎞
⎜ ⎟
⎝ −40 0 ⎠

A common decision rule in game theory is the maximin. It says to choose that
strategy which maximises the minimum pay-off. In the present discussion, this
rule means that each firm expects its rival to respond in a manner that ensures
the worst possible outcome to realise.

Suppose A’s strategy s to cut its price. Assuming that B responds to cause A
to do its worst, A will end up with a loss of Rs.60, 000. If A’s strategy is not
to cut price then assuming that B reacts, causing A to do its worst, A will lose
Rs.80, 000. Since A would be worse off with the second strategy, A will
choose to cut its price.

Similarly, consider B’s two strategies. If B cuts the price and A responds to
cause B to do its worst, B loses Rs. 100,000. Thus, B is better off cutting the
price by 5%.

Thus, both A and B end up cutting prices by 5%, and they both lose – total
loss being Rs. 140000. The best joint strategy is not to change the prices.
However, players individually choose strategies that harm both. This problem
is known as the prisoner’s dilemma and we will discuss it in Block 8.

Sequential Move Game

In this game, players instead of choosing their strategies simultaneously,
choose them sequentially.

Example: Stackelberg model in a game theoretic set-up

Let the demand function be p = p (q) where q = ∑q

i = A, B
i and let cost function be

c = ci(qi), where i= A, B. We assume that firm A is the leader and B is the

follower, in the sense that, firm A can predict or foresee the strategy of firm B
perfectly. Thus, firm B moves first without knowing the strategy of firm A 79
Price and Output and given the strategy undertaken by firm B, firm A chooses the strategy to
Determination–II
maximise her project. Therefore, from profit-maximising exercise of the firm
B, we get,
∂π B
= P + P 'q B − C'B (q B ) = 0
∂q B
c'B − p ∗
⇒ qB = = qB
p'

C'B − P
Firm A incorporates the optimum strategy chosen by firm B i.e., q∗B =
p'
into the production function and thus we have,

π A = p(q A + q∗B ) q A − CA (q A )

∂π A
∴ = p (q A + q∗B ) + q A P ' (q A + q 'B ) − C'A (q A ) = 0
∂q A

Solving the above equation, we get q∗A. . (q∗A , q∗B ) representing the Stackelberg
equilibrium.

Check Your Progress 4

1) What are the defining features of any game? Define them.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) What is a zero sum game?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
3) What is the difference between a sequential and a simultaneous game?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
80
 Alternative Theories of
13.7 LET US SUM UP Firm – II

The marginalist approach considered maximisation of profit to be the only

objective of the firms. Accordingly, the MR = MC principle was used to
arrive at the equilibrium which in the long run occurred at the minimum point
of AC curve. Then this did not match with reality. Consequently, some
alternative theories have been proposed. In this unit on we have dealt with
some of the theories which show how firm arrive at the equilibrium not
through the MR = MC route.

Bain in his theory has shown as to why firms set their price above the long run
optimum. He showed that this was possible because the existing firms set their
prices higher in order to prevent entry of new firms into the market.

Sylos-Labini model was also built on the same line. It is showed how scale
economies and better techniques of production lead to the emergence of a
leader who then sets the price for the existing firms at a level, which brings
profit to the existing firms and also prevents entry.

The behavioural theory shows how a firm arrives at a particular decision by

simultaneously maintaining the objective of each group of which the firm is
comprised.

The game theoretic models show how the strategic interaction of the rival
firms lead to the determination of an equilibrium. This type of an approach is
useful in oligopolistic markets where there is interdependence among the
firms.

13.8 KEY WORDS

Efficient Firm: The firm with the lowest cost of production.
Limit Price: The ‘limit price’ is the highest price which the established firms
charge without inducing entry.
Minimum Acceptable Price: The price at which the firms break even.
Payoff: It is the outcome of a game after the players have chosen their
strategies.
Premium: The difference between the competitive price and the limit price
charged by the existing firms in an industry.
Sequential Game: When the players in a game and choose their strategies
one after the other.
Simultaneous move game: When the players in a game choose their
strategies simultaneously.
Strategy: A strategy is a specific course of action undertaken by a player in a
game.

13.9 SOME USEFUL BOOKS

Koutsoyiannis, A. (1979), Modern Microeconomics, Second edition, London:
Macmillian.

G.S. Maddala and E. Miller (1989), Microeconomics: Theory and

Applications, McGrow-Hill, New Delhi. 81
Price and Output
Determination–II 13.10 ANSWER OR HINTS TO CHECK YOUR
PROGRESS
Check Your Progress 1

1) It is the maximum price charged by the existing firms to prevent entry of

new firms into the market.

2) It is the difference between the competitive and limit price (denoted by E).

3) Product differentiation barrier, absolute – cost advantage of established

firms, economies of scale, large initial capital requirements and legal
barriers.

Check Your Progress 2

1) The price is set by the largest, most efficient firm in the market.
2) Stepwise this is how the price determination takes place in the market.
i) The price leader is assumed to know the cost structure of all plant sizes
and the normal (minimum) profit rate of the industry. Given that the
firms have different costs, the minimum acceptable price of each firm
is given by Pi = TACi (1 + r)
ii) Given this information, the leader will set the price that is acceptable
by the smallest, least efficient firms and will deter further entry. The
price has to be such that, even the least efficient firm earns some
profit.
iii) Given the market demand at the minimum acceptable price of the
smallest least efficient firm
iv) Price leaders would set the price at such a level that post-entry, the
market price would fall below the minimum acceptable price.
3) In Sylos model the determinants of PL are:
a) The absolute size of the market X.
b) The elasticity of market demand.
c) The technology and technical change.
d) The prices of factors of production
Check Your Progress 3
1) A firm is conceived as a coalition of managers, workers, shareholders,
customers, suppliers, bankers, tax inspectors and so on.

2) The goals of the firm set by the top management can be grouped as (1)
production goal (2) inventory goal (3) sales goal (4) share-of-the –market
goal (5) profit goal.

3) (1) Analysis of rival’s reaction (2) Determination of firm’s demand (3)

Determination of cost of the firm (4) Goal specification of the firm (5)
Comparison of goals and results (6) Re-examination of costs (7)
Evaluation of the new solution (8) Re-examination of demand (9) Re-
evaluation (10) Readjustment of aspiration levels.
82
Check Your Progress 4 Alternative Theories of
Firm – II
1) Strategy, Pay-off and the Players.
2) A game where the pay-offs of the players add upto zero.
3) Do yourself after reading Section 13.5

13.11 EXERCISES
1) What happens to the premium E, if the initial share (d) of the entrant is:
i) d ≥ x ii) d < x , where x is the minimum optimum scale.
2) Supposing the relating share of the firms to be at a point such that d = x , if
number of firms (N) increases, what would be the effect on E and hence
on PL.
3) Show graphically how PL depends on the steepness of LAC.
4) How does the elasticity of the demand curve affect PL?
[Solutions to these questions have been discussed earlier]
5) In Sylos model explain why
i) The larger the market size the lower would be the entry-preventing
price.
ii) The more elastic the demand is the lower the price that the established
firms can charge without attracting entry.
iii) The larger the minimum viable plant size, the higher will be the limit
price.
iv) The higher are the prices of factors of production, higher would the
limit price be.

83