Ideas and Solutions

Firm Theory

n contrast to the theory of perfect competition, the 80/20 theory of the firm is both verifiable (and has, in fact, been verified many times) and helpful as a guide to action. In any market, some suppliers will be much better than others at satisfying customer needs. These suppliers will obtain the highest price realizations and also the highest market shares. In any market, some suppliers will be much better than others at minimizing expenditure relative to revenues. In other words, these suppliers’ products will cost less than other suppliers, for equivalent output and revenue; or, alternatively, they will be able to generate equivalent output with lower expenditure. Some suppliers will generate much higher surpluses than others. Higher surpluses will result in one or more of the following:

  • 1. greater reinvestment in product and service, to produce greater superiority and appeal to customers.
  • 2. investment in gaining market share through greater sales and marketing effort, and/or takeovers of other firms.
  • 3. higher returns to employees, which will tend to have the effect of retaining and attracting the best people in the market.
  • 4. higher returns to shareholders, which will tend to raise share prices and lower the cost of capital, facilitating investment and/or takeovers.

Over time, 80 per cent of the market will tend to be supplied by 20 per cent or fewer of the suppliers, who will normally also be more profitable. At this point it is possible that the market structure may reach an equilibrium, although it will be a very different kind of equilibrium from that beloved of the economists’ perfect competition model. In the 80/20 equilibrium, a few suppliers, the largest, will offer customers better value for money and have higher profits than smaller rivals. This is frequently observed in real life, despite being impossible according to the theory of perfect competition. We may term our more realistic theory the 80/20 law of competition. But the real world does not generally rest long in a tranquil equilibrium. Sooner or later, there are always changes to market structure caused by competitors’ innovations.

Both existing suppliers and new suppliers will seek to innovate and obtain a high share of a small but defensible part of each market. Segmentation of this kind is possible by providing a more specialized product or service ideally suited to particular types of customer.

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