In this chapter we introduced the notion that models of the firm’s pricing behavior can be characterized under seven assumptions. The four structural assumptions relate to number of sellers, cost conditions, number of buyers, and degree of product differentiation. The three behavioral assumptions refer to the firm’s objective function, its strategic variables, and its conjectural variation. The models of pricing behavior differ from each other only to the extent that one or more of the seven basic assumptions is different. The difference in one or more of the underlying assumptions, however, leads to a different pattern of behavior of the firm. Thus the price and output levels chosen by a firm depend upon the structural and behavioral conditions under which the firm operates.
The four basic market forms were analyzed for the pricing and output behavior of the firm in each of those market situations. Under conditions of pure competition, monopolistic competition, and monopoly, the pricing and output decision was based on a ceteris paribus demand curve because of the expectation that a firm’s price or output adjustment would not induce any changes in any other variables. Under oligopoly we introduced the mutatis mutandis , or “joint action,” demand curve. In the kinked demand curve model of oligopoly the firm envisages no reaction for price increases but expects rivals to match any price reductions. Given these expectations, the oligopolist faces a kinked demand curve, since the ceteris paribus section for price increases will be more elastic than the mutatis mutandis section for price reductions. The kinked demand curve offers an explanation for price rigidity despite changes in the cost and demand conditions, within limits. Outside these limits of cost and demand movements the firm will change price or output levels.
Conscious parallelism is the process by which firms separately but collectively raise prices in response to common cost or demand changes. This process allows price adjustments to be coordinated, so that no firm expects to suffer loss of market share because each firm is anticipating the price changes of its rivals. Price leadership may be provided by a firm that has a keen awareness of industry cost and market demand conditions, as well as a willingness to risk loss of market share by being the first to adjust price. The price followers accept the leader’s judgment and raise prices to the same level (or by a similar proportion). The price followers thus avoid the risk of market share loss, as well as the search costs which might otherwise be spent to ascertain
the price change required. Barometric, low-cost, and dominant-firm-price-leadership situations were discussed, and the pricing implications were examined.
When the firm’s time horizon falls beyond the present period, a change in the objective function is indicated. The appropriate objective function for the firm facing uncertainty in future periods is the maximization of the expected present value of future profits. Given the search costs involved, however, we expect firms to pursue short- run objective functions which are, in effect, proxies for long-term profit maximization. Sales maximization subject to the attainment of a profit target, limit pricing, and satisficing were each argued to be short-run policies which could approximate the maximization of the firm’s EPV of future profits over its planning period. Given the search costs avoided, of course, these policies do not need to indicate the actual prices and outputs which would maximize the EPV of future profits; they merely need to get sufficiently close to the optimal price and output levels, so that at least as much profit is earned.
With this grand tour of the theory of the firm behind us, we are now in a position to move to pricing and output decisions in actual business situations. The solution of actual business pricing and output problems is generally facilitated by, and optimized with the aid of, a sound understanding of the models of firm behavior covered in this chapter.