The Neoclassical Theory of the Firm (6 Basic Assumptions)

The basic assumptions of the neoclassical theory of the firm may be outlined as follows:

1. The entrepreneur is also the owner of the firm.

2. The firm has a single goal, that of profit maximization.

3. This goal is attained by application of the marginalist principle

MC = MR

4. The world is one of certainty. Full knowledge is assumed about the past per­formance, the present conditions and the future developments in the environment of the firm. The firm knows with certainty its own demand and cost functions. It learns from past mistakes, in that its experience is incorporated into its continuous appraisal (estimation) of its demand and costs. The costs are U-shaped both in the short and in the long run, implying a single optimum level of output.

5. Entry assumptions vary according to the particular model (for example, in mono­poly entry is blockaded ex hypothesis).

The common elements regulating entry in all models of the neoclassical theory of the firm are the following:

(a) Entry refers to actual entrants in an industry; no account of potential entrants is taken.

(b) Entry in the short run is practically impossible entry can take place only in the long run.

6. The firm acts with a certain time-horizon which depends on various factors, such as the rate of technological progress, the capital intensity of the methods of produc­tion, the nature and gestation period of the product, etc. The firm aims at the maximization of its profit over this time-horizon: the goal of the firm is long-run profit maximization.

This is attained by maximizing profits in each one period of the time-horizon of the firm, because the time periods are independent in the sense that decisions taken in any one period do not affect the behaviour of the firm in other periods. The rule MC = MR is applied in each period, and profits are maximized with this behaviour both in the short run and in the long run.

Let us examine these assumptions in some detail.

1. The single owner-entrepreneur:

The traditional theory of the firm assumes a single owner-entrepreneur. There is no separation between ownership and management. The owner-entrepreneur takes all the decisions. All organisational problems are assumed resolved by payments to the factors employed by the firm. The entrepreneur is furthermore assumed to have unlimited information, unlimited time at his disposal, and unlimited ability to compare all the possible alternative actions and choose the one that maximizes his profit.

This behaviour is described by postulating that the entrepreneur acts with global rationality. There are no time, information or other constraints in pursuing the single goal of profit maximization. Clearly the above assumptions are unrealistic. In the modern business world the firm is a complex organisation, characterised by the divorce of ownership and manage­ment. This gives discretion to the managers to pursue goals other than profit maximization. Information is not unlimited. Its acquisition involves expenses. Further­more it is often distorted as it passes through the various hierarchical levels of adminis­tration.

The managers cannot act with the global rationality postulated by the traditional theory, not only because of the limited and/or distorted information, but also because they have neither unlimited time nor unlimited abilities to compare and evaluate all the possible alternative strategies open to them in any particular situa­tion. Such considerations, arising from the complexity of modern enterprises, have been incorporated in the theory of the firm by various writers and have been particularly stressed by the behavioural theories of the firm.

2. The goal of profit maximization:

The attack here was twofold. Firstly, it was argued that firms cannot attain the goal of profit maximization because they do not have the necessary knowledge, information or ability. Firms do not know with certainty their demand and cost curves, hence they cannot apply the marginalist principle MC = MR. This sort of attack will be examined in the next paragraph. Secondly, it was argued that firms, even if they could pursue profit maximization, do not want to. In particular it has been argued that the firm does not pursue a single goal. There is a multitude of goals, and profit is only one of them. Several alternative goals have been suggested.

We may group them as follows:

Managerialism: Maximisation of the managerial utility function:

Managerial theories postulate that the divorce of ownership and management allows some discretion to the managers in goal-setting. The managers select such goals which maximize their own utility function. Factors that usually enter the managerial utility function are salaries, prestige, market share, job security, quiet life, and so on.

There is no consensus among the managerial theorists as to how the maximisation of the utility of managers will be attained. Baumol postulated that the managerial utility is maximised when the growth of sales revenue is maximised. Marris is more sophisticated. He ingeniously suggests that the managers pursue the maximum ‘balanced growth,’ that is, the balanced increase of both the sales and the capital assets of the firm. If this is attained, then both the utility of managers and of the owners of the firm (shareholders) is maximised.

Behaviourism: satisficing behaviour:

Some writers have suggested that given the un­certainty in the real world, the lack of accurate information, the limited time and limited ability of managers to process information, and other constraints, firms cannot act with the global rationality implied in the traditional theory of the firm. Indeed uncertainty makes impossible the maximisation of anything. Given these conditions firms do not seek the maximisation of profits, sales, growth or anything else.

Instead they exhibit a satisficing behaviour they pursue ‘satisfactory profits,’ ‘satisfactory growth’ and so on. This behaviour is considered rational given the uncertainty of the real world. Firms act with bounded rationality firms have constraints in pursuing their goals, set by factors internal and external to the firm.

Long-run survival and market-share goals:

Some writers have suggested that the primary motive of the entrepreneurs is long-run survival. Thus managers take action which aims at the maximisation of the probability that they will survive over the indefinite future. Still other writers have reported that many firms set as their goal the attainment and retention of a constant market share. It can easily be proved that such policy is compatible with marginalistic behaviour.

Proof:

(a) The price elasticity of market demand is defined

e_D = dQ / dp  P/Q

(b) Assume that the firm has a constant share of the market

q = k. Q

Where q = demand for the product of the firm

k = constant share

Q = market demand

(c) The price elasticity of the demand of the firm is defined

e_q = dq / dp P/q

Substituting q = k.Q, we obtain

e_q = d(kQ) / dp P/kQ

Given that k is constant and does not affect the derivative, we may write

e_q = k dQ/dp P/kQ = e_Q

(d) The market demand is assumed known, and from this the firm can estimate its own demand curve. Given that the firm also knows its costs, it can apply the marginalistic rule MC = MR. Whether this behaviour leads to profit maximization in the long run is not certain. The firm in this model maximizes its profit given its desired constant market share. Different target market-shares clearly yield different ‘maximum’ level of profit. If the firm is a profit maximiser it would choose the maximum maximorium; that is, the share that yields the highest profit. Thus the goal of constant market share does not necessarily imply maximization of long-run profits.

Entry-prevention and risk-avoidance:

Several writers in recent years have suggested that the goal of the firm is to prevent new entrant firms coming into their market. Firms set the price at such a level as to make entry unattractive (limit-pricing). It is not clearly stated why firms want to prevent entry. Some economists argue that the real goal behind entry prevention is long-run profit maximisation.

Others suggest long-run survival or constant market share as the ultimate goal behind limit-pricing. Finally, others have suggested that the firms want to prevent entry as a means of avoiding the risk associated with the unpredictable reactions of new entrants: a firm learns by experience how ‘to live’ with other existing competitors and can anticipate their reactions to a certain decision of the firm; but the attitude of new entrants is completely uncertain, and by preventing their entry in the market the established firms avoid this uncertainty.

The interesting question is how far can managers deviate from profit maximisation. What is the discretion of managers in goal-setting? There is no consensus among writers regarding the degree of managerial discretion. The following discussion may illustrate the existing disagreement.

There is some empirical evidence that profits are higher in owner-controlled firms than in firms where management is divorced from ownership. This supports the view that managers have at least some discretion in pursuing goals other than profit maxi­misation. However, the evidence is far from conclusive. In any case such empirical findings do not imply that managers have unlimited discretion, or that the goal of profit maximisation is not valid.

The supporters of the profit-maximisation hypothesis resort usually to arguments resembling the Darwinian theory of the survival of the fittest. They argue that in the long run only the profit maximisers survive, because they are the fittest. By maximising profits, the survival argument runs, firms can accumulate financial assets which allow them to grow faster than the non-profit maximisers, whose share gradually shrink and eventually are eliminated. The economic environment selects the profit maximisers as the fittest and eliminates the rest.

Some supporters of the profit-maximisation hypothesis concede that other goals are actually pursued by firms. But they argue that managers can attain such ‘subsidiary’ goals easier if they maximise profits.

Those who object to the profit-maximisation goal argue that the ‘economic selection’ mechanism does not work uninhibited in practice. Firstly, if all firms deviate from profit maximisation, there is no ‘fittest’ to survive. If, for example, all firms satisfice, there is no reason to believe that any one of them has, ceteris paribus, a higher probability of surviving.

Secondly, in a dynamic world of continuous change in techniques and products, firms can avoid their ‘elimination’ by differentiation and diversification, so that a firm which deviates from profit maximisation can survive for a long period of time. Thirdly, it has also been suggested that when firms are large and have monopoly power the ‘selection process’ does not work smoothly because competition is weak in this case.

Others, however, argue that the competition is keen among large firms due to the continuous change and the uncertainty of the environment. Under these conditions, even in highly concentrated industries firms cannot deviate from the goal of profit maximisation if they want to survive in the long run. Such arguments for and against the profit-maximisation hypothesis cannot be resolved on a priori grounds, and the empirical evidence regarding the goals of firms is by no means conclusive in one direction or another.

What has been found from most empirical studies is that:

(a) There is a multiplicity of goals in the modern enterprise;

(b) Managers have not unlimited discretion in setting their goals. All models accept that there is a minimum profit constraint which limits the other goals of the firm. How high the profit constraint is depends on how strong the competition in the environ­ment of the firm is. If there are barriers to entry (strong preferences, government laws, absolute cost advantage, absolute capital requirements, strong economies of scale) firms can survive in the long run even if they are not profit maximisers.

3. The treatment of uncertainty in the traditional theory:

In the early stages of the theory of the firm it was assumed that the firm had perfect knowledge of its cost and demand functions and of its environment. The theory was not concerned with the way in which this knowledge was acquired. In effect, uncertainty was not allowed to influence the decisions of the firm the firm proceeded to maximise its profits after it had acquired the relevant information on costs and revenues. Yet in the real world uncertainty influences the estimation of costs and revenues, and hence the decisions of the firm.

Later it was recognised that firms have no perfect knowledge of their costs, revenues and their environment and they operate in a world of uncertainty. Economists used a probabilistic approach to deal with this uncertainty. They assumed that the firms have perfect knowledge only up to a probability distribution of all possible outcomes.

The idea that the profit in any one period was a single-valued magnitude known with certainty by the firm was abandoned. Instead it was assumed that the profit expected from the adoption of any action may assume any value within a certain range of values, each value having an associated probability of being realized.

These probabilities are assumed known to the firm subjectively. The decision-maker assigns these subjective probabilities to the possible effects (profits) of each strategy and estimates its mathe­matical expectation (that is, he assumes that ‘the profit’ of any action is the sum of the possible profitability values, each multiplied by the corresponding probability.) Having done such computations for all alternative actions, the entrepreneur chooses the action with the highest expected value in each period.

These net profitability’s are discounted with a subjective discount rate, and their present value is estimated. The firm then chooses the strategy that maximises the present (discounted) value of the future stream of net profits over its specific time-horizon (which constitutes its long-run operational period).

The above probabilistic treatment of uncertainty, which implies the formulation of definite subjective expectations about the cost, revenues and changes in the environment, has been attacked on several grounds.

Firstly, it has been argued that this procedure requires a lot of knowledge, information and computational ability from entrepreneurs, which they clearly do not possess.

Secondly, the adoption of the decision rule of choosing the alternative which has the highest expected value (expected profit) does not adequately describe the behaviour of firms in the real world. Entrepreneurs’ attitudes towards risk plays an important role in actual decision-making.

A project with a high expected profit may have a higher risk of bankruptcy as compared to another with a lower expected profit. If the entre­preneur is a risk-avoider he will not choose the projects which have a high risk, even if their expected profitability is high. Unless we know the risk attitudes of entrepreneurs we cannot say what their actual decisions will be by looking only at the expected profitability of the various alternatives.

Thirdly, the length of the time-horizon is also crucial in decision-making. Some firms may prefer a shorter time-horizon, having a high aversion towards the uncertainty of more distant periods. Yet the traditional theory does not deal with the determination of the time-horizon, the long-run period in entrepreneurial life.

Fourthly, additional difficulties arise in the estimating process of future costs and future revenues, implied in the maximisation of the present value of future stream of profits. Choice of a high discount rate implies a short time horizon, while a low discount rate of future profits implies a long time horizon.

Fifthly, conventional theory treats expectations of entrepreneurs (who determine their subjective probabilities) as exogenous to the firm. It does not explain their formation within the firm. Yet expectations are influenced to a great extent by factors internal to the firm. These factors play an important role in the behavioural theories of the firm.

In summary:

The probabilities of future events are subjectively determined. They are influenced by the time-horizon, the risk attitude and the rate of change of the environ­ment. Thus businessmen’s expectations cannot come close to objective reality. Different firms will have different time-horizons, different risk attitude and will form different assessments of uncertain future events.

Consequently firms will respond differently to the same (given) conditions of the environment. The interactions among uncertainty, risk-aversion and the time-horizon of the entrepreneurs are not dealt satisfactorily with by the probabilistic approach adopted in the traditional theory of the firm.

4. The static nature of traditional theory:

Time enters into the traditional theory in three respects. Firstly, the distinction between the short and the long run implies time considerations. However, the theory does not really answer the question how long is the long run in actual decision-making. Secondly, it is assumed that the firm has some time-horizon over which it attempts to maximise its profits. The discounting of future costs and revenues implicit in the long-run profit maximisation clearly involves the time element.

But again the length of the time-horizon and its interaction with uncertainty and risk-aversion is not adequately dealt with. Thirdly, the analysis of the timing of demand relative to the production flow implies a period analysis. Considerations of the gestation period of investment and the final product also imply time considerations.

However, the traditional theory is basically static. The time-horizon of the firm consists of identical and independent time-periods. Decisions are treated as temporally independent, and this is probably the most important shortcoming of the traditional theory. It is clear that decisions are temporally interdependent decisions taken in any one period are affected by the decisions in past periods, and will in turn influence the future decisions of the firm.

This interdependence is ignored by the traditional theory, which postulates that the long-run profits are maximised as the firm maximises its short-run profits in any one period, by equating its marginal cost to its marginal revenue (MC = MR).

5. Entry considerations:

In the traditional theory entry considerations differ, depending on the type of market structure. The common features of the treatment of entry in traditional theory are two: firstly, only actual entry is considered; secondly, entry is assumed to take place only in the long run it is a long-run phenomenon.

In pure competition entry is free. The same is assumed in the model of monopolistic competition. In both models entry can occur only in the long run.

In monopoly entry is blockaded by definition.

The traditional models of oligopoly are implicit, cryptic or silent so far as entry is concerned. The classical duopoly models are ‘closed’ models in that they do not allow for entry. These models can be extended to larger numbers of sellers, but the numbers remain unchanged in the final market equilibrium as they were at the initial situation.

In the theory of cartels it is implicitly assumed that the entrants, if any, will join the cartel. Without this implicit assumption the inherent instability of cartels becomes even greater. Similar assumptions are made in the traditional price-leadership models: the entrant is assumed to be either a small firm which can be coerced to follow the leader, or is assumed to accept the status quo of the established leader.

Potential entry and its effects on decision making are not dealt with in traditional theory.

6. The marginalist principle:

The behavioural rule postulated by the traditional theory in actual decision-making is described by the so-called ‘marginalist principle’

MC = MR

In each period the firm maximises its (short-run) profit by setting its output and price at the level defined by the intersection of the MC and MR curves. Given the temporal independence of decisions, such short-run profit maximisation implies also long-run profit maximisation.

This behavioural rule has been attacked on several grounds. One line of argument is that although the goal of the firm is long-run profit maximisation, this is not necessarily attained by equating the short-run marginal cost (SRMC) to the short-run marginal revenue (SRMR).