Market-Based Theory

Conceptual Overview

The major elements of MBT are expounded in Alfred Marshall's 1947 Principles of Economics. While Marshall himself had a more nuanced approach to firms and their internal operations and capabilities, subsequent developments in microeconomics and IO focused on the industry as the unit of analysis. The main economic question raised by this perspective is how the price-output decision (equilibrium) of firms operating in industries (collections of firms producing similar products, e.g., cars) impacts the efficient allocation of scarce resources and therefore impacts the optimality of the market system as a whole.

The method used to answer this question involves the assumption of optimizing behavior (firms are assumed to maximize profits). Given this objective, all one needs to determine the price-output equilibrium in an industry is knowledge of the cost structure, the demand conditions, and the type of industry structure. The last mentioned can be perfectly competitive or imperfectly competitive. Perfect competition exists when firms are numerous, produce homogenous products, and there exists free entry and exit in the industry. Under these assumptions, firms can only make normal (or zero economic) profits; that is, they will simply cover their average costs (defined to include compensation for all factors of production, including managers and entrepreneurs).

Imperfect competition refers to all types of nonperfectly competitive markets, such as monopolies (a single seller in the industry) or oligopolies (few sellers whose actions impact on each other—there exists interdependence). A limiting case of oligopoly is duopoly (two firms in the industry). In the case of a monopoly, profit-maximizing behavior leads to prices in excess of the perfectly competitive ones and therefore to monopoly profits.

...