The Neoclassical Theory of the Firm


The focus of the neoclassical theory of the firm is the entrepreneur who is assumed to be the single owner of the firm, who as such enters: 0 into contract with each of the employees, who supply productive services, which specifies the nature and duration of those services and the remuneration for them;

..either takes decisions or has the right to insist that decisions are taken in its interest subject to its contractual obligations;

..has the right to the residual income from production – i.e. profits/losses.

can transfer its right in residual income from production, and obligations. under contracts with suppliers of productive services to another individual;

..has the power to direct the activities of the suppliers of productive services subject to the terms and conditions of their contracts;

..can change the membership of the production group not only by terminating existing contracts but also by entering into new contracts and adding to the group. Thus, the essential feature of the classical firm is the entrepreneur with whom all contracts are concluded and who controls and directs in its own interest, subject to constraints arising out of the terms of the contracts it has made with a view to maximizing its residual income – the excess of revenue over costs of production. Other basic assumptions of the neoclassical theory of the firm are about the objective function of the firm and the marginalist rule for attaining its goal, the nature of the world and the market in which the firm operates and time horizon. The theory assumes that the single goal of the firm is profit maximization – a goal, which is attained when marginal cost is equated to marginal revenue. It is also assumed that the firm has full knowledge about the past, the current conditions and future developments in the environment in which it operates. In other words, the firm knows with certainty its demand and cost functions. Thetotal cost ‘of production is assumed to be a cubic function of output while the unit cost functions are U-shaped in both the short and long run, implying the existence of a unique optimal level of output. Entry assumptions vary according to the model under discussion (for example in the case of monopoly entry is completely closed. The common factors regulating entry in all models of the neoclassical theory of the firm are

(a) ,definition of entry which refers to actual entrants in an industry; and

(b) entry is a long run phenomenon – it is assumed that in the short run, it is practically impossible and can therefore take place only in the long run.

It is further assumed that the firm acts within a certain time horizon given the state. of the art – technology and the capital intensity of production, the nature and the gestation lag involved, etc. Given these, the firm aims at the maximization of profits – the excess of v: revenue over all opportunity costs, including those associated with the supply of capital , and entrepreneurial functions. This is attained by maximizing profits in each one time period because the time periods may be considered independent in the sense that decisions taken in anyone period may not affect the behaviour of the firm in other periods.,;

So that the marginalist principle which states that marginal cost equals marginal revenue  (MC = MR) is applied in each time period to maximize profits both in the short- and long run. Based on this set of assumptions, it is obvious that the classical/neoclassical theory of the firm is highly abstract. In its basic formulation, the firm is assumed to know with certainty the market conditions and the nature of technology. Given this, then the theoretical problems become ‘

(a) to formalize the firm’s optimization problem subject to the set of market and technological realities;

(b) examine the nature of the solution, and theway in which the solution varies with changes in the parameters-of the problem;

(c) and the translation of the results into explanations and predictions of the behaviour of the firm. This approach to the study of the behaviour of the firm has many flaws and consequently has been criticized based on the underlying assumptions. It is therefore advisable to critically examine the assumptions of the neoclassical theory of the firm.

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