Price Analysis and Theory of the Firm

To understand the concept of market and its various conditions, it is necessary to study the  theory  of the firm. This is discussed as follows:

The basic, assumptions of the theory of the firm are as follows:

  • The objective of a firm is to  maximize  net revenue in the face of given prices and technologically determined production function.
  • A price  increase  far a product raises its supply, whereas prices increase for a factor  reduces  its demand.
  • The theory of the firm deals with the role of business firms in the resource allocation process. It uses aggregation as a tactic and attempts to specify total market supply and demand curves.
  • The firm operates with perfect knowledge of all relevant variable involved in making a decision and it acts rationally while doing so.
  • Originally the theory assumed that the firm is operating within a perfectly competitive market. But it has now been extended to cover other market  situations.

The theory has been  criticized  in the context that profit  maximization  is not the only objective of a firm. It has been suggested that long-run survival is the primary motive of an entrepreneur. Though the importance of profit has not been denied, many economists have argued that profit  maximization  should be replaced with a goal of making satisfactory profits. However, there is a general agreement that the theory or the firm explains at a general level, the way in which resources are allocated by the price system, when profit is the main criterion used by the firms.

From the viewpoint of price analysis, it is very important for business management to gain a proper understanding of the nature and process of competition in the modem industrial society. The management should understand the rationale of the free enterprise system within which its own business decisions have to be made and the purpose and limitations of that system. Next it must have full knowledge of the markets and market situations in which its own business operates. It should be aware of the policies appropriate to those market situations. The management should also have an understanding of the competitive process and the way variables involved in the process such as price; product innovation and promotional activity may be manipulated in enlarging the firm’s market share. The firms having monopoly power should be familiar with the nature and purpose of the law relating to monopoly and restrictive practices. The management must also be alert and should be able to  recognize  when market conditions change. Experienced executives cannot gain the intimate knowledge of the ways or their competitors. Consequently it is necessary to obtain, an understanding of the nature of competition, which can provide an insight into the probable  behavior  patterns of the competitors.

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