Traditional Theory of Firm

Four main lines of arguments have been put forward by various writers in defence of the traditional theory of the firm.

The first line of defence is launched in terms of Friedman’s methodological issue, that realism of assumptions of a theory is not the main criterion for its acceptance.

A theory should be judged not on the basis of the realism of its assumptions but on the basis of its predictions. Friedman says, without providing any conclusive empirical evidence, that the traditional theory of the firm has produced reasonably good pre­dictions, and on this basis it should be judged as being a satisfactory theory. We do not believe that such arguments launched in abstract terms can be taken seriously.

The second line of defence includes empirical studies which provide evidence that firms do in fact apply marginalistic rules in their decision-making. Such studies have been conducted by J. S. Earley, who reported (from a sample of 110 ‘excellently man­aged’ companies in the U.S.A.) that modern accounting methods provide information on marginal costs and marginal revenues, and this information is actually used by well organised firms in their decision-making.

This evidence is in contradiction to the Hall and Hitch study, which covered ‘well organised firms’ in the U.K. Furthermore Earley’s results cover only 110 large firms which apply modern accounting and management techniques. It may well be that other firms do not have the required information for marginalistic behaviour, or that they do not want to apply marginalistic rules in each period in order to maximise their short- run profits for various reasons (e.g. because this would endanger their long-run profits, or because they want to avoid government intervention, to have a good public image, and so on).

The third line of defence is based on the Darwinian principle of the survival of the fittest. It is argued that the fittest firms are those which maximise their profits, because in this way they can accumulate assets and grow faster than firms which are not profit maximisers. This is a process of ‘economic natural elimination of the weaker firms’ (de­fined as the firms which do not maximise profit).

The defects of this line of defence have been examined in section I above. They may be summarised as follows. The process of natural economic selection does not work un­inhibited in the modern industrial world, because even firms which are not profit maximisers can adopt various policies (e.g. diversity) which will allow them to survive in the long run. Furthermore one should hardly expect that the fittest firms today will also be the fittest tomorrow, given the continuous change in products and techniques. And of course there would be no fittest if all firms are not profit maximisers but pursue other goals (e.g. if every firm adopts satisficing behaviour).

The fourth line of defence of marginalism attempts to establish in an abstract theoreti­cal way that the assumptions of the marginalist theory are ‘fairly realistic’. The main writer who has adopted this line of defence is F. Machlup. His arguments are of three kinds. Firstly, he argues that the empirical evidence against marginalism (e.g. Lester’s work, Hall and Hitch’s study, etc.) has too many weaknesses and, hence, is not conclusive. Secondly, he argues that the basic assumptions and postulates of marginalism are plausible.

Thirdly, he argues that there has been a misunderstanding regarding the purpose of the traditional theory; this theory is a theory of markets, constructed to explain resource allocation via the price mechanism; the theory predicts well the effects on resource allocation of various changes in the environment (shifts in demand, changes in costs, tax changes); hence the traditional theory does well the job for which it has been designed.

Machlup has criticized the studies of Lester, Hall and Hitch and other empirical evidence against marginalism on the following grounds. There was a lack of communication between businessmen and economic researchers, due to the differences in their terminology. Economists speak in terms of MC, MR and elasticities, concepts with which businessmen are not familiar. Businessmen’s statement, that they set price equal to their average cost, is not incompatible with the marginalistic rule MC = MR which is used by economists.

The majority of businessmen are not economists and do not know the calculus technique of MC = MR at equilibrium. An economist, however, applying the marginal tools with which he is equipped from his university training will reach the same unique (tangency) solution as the businessman. Thus in these conditions either of the rules will lead to the same unique price-output combination which maximises profits.

P = AC

or

MC = MR

To this criticism Hall and Hitch replied by saying that their questionnaires were followed by intensive interviews with entrepreneurs and managers, during which the economic researchers made sure that the persons being interviewed would understand what they were questioned about.

There are psychological reasons (Machlup argues) explaining businessmen’s answers that maximisation of profit was not their goal. A businessman being interviewed wishes to appear as pursuing ‘fair’ policies, which do not yield maximum (monopoly) profits, but just a ‘fair’ profit. Furthermore firms were afraid to admit that they were charging the monopoly price (the price which maximises profits), preferring to state that they set price equal to their AC, since in law average costs are taken as a basis for fair prices.

Firms need not apply calculus continuously, since pricing and output decisions, Machlup argues, become routine. Thus the ‘pricing practices’ reported by businessmen (that is, the setting of P equal to AVC plus a profit margin) reflects their routine rules applied in decision-making, and are not incompatible with marginalist calculations. This argument of Machlup is not valid, unless he can establish that these pricing routines have originated from marginalistic rules, applied at the initial stages of the working of the firm.

Regarding the attack on the basic assumptions of marginalist theory, Machlup attemp­ted to argue that these assumptions were fairly plausible. He agreed that MC and MR were not objectively known to businessmen. However, he argued that this is not a serious problem, since a subjective assessment of these schedules by businessmen is adequate for the application of marginalism.

What matters is the beliefs of firms as to what their MC and MR are, and not their objective values. Costs and revenues are based on beliefs and hunches of businessmen. Arguing on these lines Machlup failed to see that subjective definitions of MC and MR render marginalism a tautology, since any action of firms may be explained as marginalistic, based on such subjective ‘hunches’.

Machlup argued that firms may not understand the concept of demand elasticity, but surely elasticity considerations were implicit in their pricing procedures the elasticity of demand for the product of any firm, he argues, depends on the availability of sub­stitutes and on the supply elasticity of such substitutes; the best guide to the elasticity of supply of competitors is provided by the firm’s own costs, because competitors are expected to have similar costs; thus the elasticity of demand is ‘guessed’ from the know­ledge of the costs of the firm.

This argument of Machlup’s is valid, but does not, as it stands, provide evidence for the application of marginalism. We will show, however, that average-cost pricing implies an estimate of the elasticity of demand if the average variable cost is constant over a certain range (and the empirical evidence from cost studies shows that this shape of AVC is generally found in the real world). Under these conditions average-cost pricing leads to the same equilibrium solution as mar­ginalist behaviour.

Regarding the goals of the firm Machlup argues that the firm has as its (single) goal the maximisation of its long-run profit. This is attained by using long-run cost and long- run demand curves, which incorporate expectations of future conditions and changes in the market environment. Machlup failed to see that this treatment of expectations (which implies ‘doctored’ demand and cost curves) again reduces marginalism to a tautology, since any observed behaviour can be compatible with profit maximisation, with appropriately constructed cost and demand curves in which future uncertainty is ex ante eliminated.

Machlup rejected the suggestion that other goals of the firm can be incorporated in the calculation of the cost and demand curves. He recognised that this treatment of other goals would make any action of the firm compatible with profit maximisation, and this, he accepted, would render profit maximisation a tautology.

It is surprising that Machlup recognised the danger of tautology when other goals would be incorporated in long-run cost and demand schedules, yet he did not perceive this danger when he was arguing in terms of cost and revenues being subjective ‘hunches’, and uncertainty being realistically possible to incorporate into the long-run demand and costs.

From the above discussion it should be clear that the marginalist controversy cannot be considered as resolved.

Three main points need stressing:

Firstly:

The application of the marginalistic rule to maximise short-run profits re­quires that businessmen make continuous adjustment to price as demand and costs change continuously. The observed ‘stickiness’ of prices in the face of changing con­ditions of the environment suggest that marginalism is not applied, at least in the short- run.

Secondly:

Marginalism faces the dilemma of either being unrealistic, or being in danger of becoming merely tautological if one attempts to incorporate time and uncertainty or additional goals in a single set of appropriately ‘doctored’ long-run demand and long- run costs schedules.

Thirdly:

However, it is not certain that the ‘pricing practices’ reported by businessmen in the context of various studies are inconsistent with marginalism, or that the average- cost pricing theories, based on this evidence, provide an alternative to the model of marginalism.