Critique of the Neoclassical Theory of the Firm


Comparing a factual description of. the firm with the abstract description presented by the classical/neoclassical view of the firm, it is noticeable that there are many features of the modern real firm that are not captured by the “orthodox” view. This has motivated as noted earlier certain criticisms against the neoclassical theory of the firm and the advancement of alternative explanations of the behaviour of the firm. We may now examine the specific issues raised. Ownership Structure: The neoclassical view of the firm assumes that it is owned by a single owner – the entrepreneur. Whereas, in reality, a firm may be owned by a single individual and managed by the single owner in the case of the sole proprietorship (the one-man business) or by several individuals and may be jointly managed by the owners in the case, of partnerships or may be controlled by a board of directors on behalf of the stockholders and managed by salaried management staff in the case of the public limited liability company – the typical modern corporation. In the cases of sole preprietorships and partnerships, the single owner or each partner is liable for the debts of the firm to the complete extent of its wealth. Whereas in the case of the modern corporation the liability of each shareholder forthe debts of the firm is limited only to the value of its own shares, Which are also exchangeable on a stock market. The possibility of the firm being owned by more than one person introduces organizational problems which are ignored or assumed to be resolved by payments to factors of production by the traditional model of the firm.

Control Structure: The record of historical experience suggests that at the early stages of development, production can be purely individualistic and carried out by one person workingwoman raw materials.Some commodities are still producing this way,for example giving someone a hair cut, painting a picture but the majority of commodities in the modern world are produced by team work – i.e. co-operating groups of individuals. The reason is specialization of individuals in parts of the modern complex mass production process.The attractions of team work include increases in productivity and hence output. The co-operating teams have diverse organizational structures and sector property rights, some of which such as co-operatives, non-profit organizations and some government organizations do not fit the description of the firm in the traditional view. In the Cases of sole proprietorships and partnerships, the overall control is likely to be exercises by the owner or the owner with the largest shares.While in the case of the public limited liability company,overall control is exercised by a group, the board of directors in principle as representatives of the shareholders,the management staff as welling as outside directors In the case of subsidiary firms. Though, it is arguable that the share holders have the ultimate control through their voting rights during the Annual General Meetings (AGMs), Thus, for these forms of business organizations ownership is divorced from management contrary to the assumption of the neoclassical theory.

Global Rationality: The entrepreneur,at least by implication is further assumed to have full information, unlimited time at its disposal as well as unlimited ability to compare all the possible alternatives and choose the one that maximize sits profits. Thus, the entrepreneur is an “omniscience” assumed to pursue the single goal of profit maximization without any constraints,which may be interpreted as implying that the entrepreneur acts with global rationality. In contrast to the real world situation, it is practically impossible to have full information. To begin with,it is costly to acquire information. Secondly, it is.often distorted as it is passed through the levels of the hierarchical administration of the firm. Admittedly, information will normally be generated by the operations of the firm in the form of reports from salesmen on demand conditions;from production workers on production and production processes,etc.Also activities will be undertaken to acquire it (such as market research,technological research and development),which may then be transmitted to points where it is required for decision-making. This information,will, however,rarely be complete and perfect so that decisions will generally be taken under varying degrees of uncertainty as opposed to the assumption of the traditional view. Furthermore,neither unlimited time nor unlimited ability to compare and evaluate all the possible alternatives is at the disposal of the entrepreneur or the management of a firm.The lack of these invariably introduces complications and constraints such that the entrepreneur or the management of the firm can be rarely expected to act with global rationality.

Organizational Structure: The modem firm be it sole proprietorship or a partnership of the corporation involves an hierarchical structure with layers of command,authority and control between the spectrum of management and operational staff dealing directly with the basic operations of production such as buying of inputs,operation of machinery and equipment and the selling of output(s).This structure is intended to: , translate broad policy objectives formulated by management and policy-makers into specific plans; . co-ordinate the separate activities at the lower levels and ensure consistency of plans; . monitor performance, identify weak links in the organizational structure and constraints. and transmit information on these to inform the formulation of overall policy objectives. The larger the scale and the greater the diversity of the basic production and selling activities of the organization, the more extended and complex the hierarchical structure will be.

Conflict of Objectives, Plans and Decisions: In general, objectives, plans and decisions may be formulated or taken by more than one individual. It is therefore conceivable that conflicts may arise among the various individuals for one or more reasons: a because of lack of objective information; o differences in beliefs about possible outcomes which may arise out of the first reason above and/or differences in the outlook of the individuals in such dimensions, as optimism and pessimism or risk aversion or otherwise, and o differences in their preferences of individuals, Which may arise, from differences in ‘ perceived benefits to the decision-makers. In the latter case, conflict m y be avoided only if decision-takers subordinate their personal interests to some common goal such as the goal of the shareholders as articulated by the beard of directors. Besides, the behaviour of other groups such as workers who can and often do insist on certain decision on wages, hours and conditions of work and/or shareholders who may react by selling their shares i-f profits are below expectations will exert their own influences.

Furthermore, the consumers of the commodity, the/society in general and the government in particular may for various reasons have stake and interest in the decisions of the management of a firm or group of firms. It is highly probable that these group interests may clash with each other. All these carry implications for conflicts in decision-making.

The Objective Function of I the Firm; “The aims and objectives of the firm are fundamental to its decision-making. For, as Baumol (1977: 377) pointed out, even when the basic data for analysis and decision taking are available knowledge of the firm’s goals is still necessary to determine what decisions are optimal. In appreciating this need the classical economists assumed that the objective of the firm is to maximize profits. This simple, sensible, realistic, and quantitative assumption is amenable to equilibrium analysis has remained the basic assumption of the theoryof the firm for more than two centuries even though it has in recent times been criticized. What the assumption says/is that the entrepreneur’s goal is to maximize profits subject to technological and market realities. Some writers have queried this presumption of a single goal orientation or the firm. For example, Baumol (1977: 377), claims/ that empirical research indicates that very often business executives want multiple globals, which may not be all compatible with one another such as sales maximization, cost minimization and maximization of total profit. It seems that multiplicity pf goals as Ola (13993) observes is inherent in the modern milieu in which business’s operate. To begin with there are many groups which have Interest in and contribute to its continued survival. They are called stakeholders. They include the consumers and their general public at ‘large that patronize the organization by buying its good: Indoor services. the government which granted the certificate at incorporation without which it (fault! not have been and prode the other cum infrastructural facilities. without Much the firm cannot take off. neither can it can operations Without land uttered by the community; it workers refuse to work. it willing nothing, it consumers refuse to patronize it. it will fail, neither can it stay mat it shareholders. creditors and suppliers tail to provide the funds. raw materials, etc it ism to conceive that the interests of all these groups are compatible Usually, they norm complexity. Thus. the rational objective ol enterprises within this milieu is to slim to maintain equitable balance among the interests of the various groups that are relevant in Its continued survival. A number of empirical studies have reported that firms do pursue multiple goals,like retaining the labour force smoothly employed and trained for eltective and efficient performance. acquire and maintain good will of the populace. etc. For sure, goals suchas these carry implications for the level of profits. Unfortunately, however. it is not clear whether such goals are compatible or competitive with profit maximization. Evidence suggest thattvmanagerstend to concentrate at any one time on local problemsarisingin particular sections of the firm and find solutions for such problems withoutapplying marginalist rules. For example, bottlenecks, such as shortages of essential inputsand/or breakdown of some major part of the production process will naturally attract management’s attention. The solution by parts approach usually adopted in practice in dealing with local problems may not necessarily lead to profit maximization. Furthermore,the first-ordernecessaryconditionfor profit maximization is the equality between marginal cost and marginal revenue. While the secondordersufficientcondition requires that at the profit maximizing output, the rate of change in the marginalcost(MC) be larger than the rate of change in the marginal revenue (MR). Geometricallyinterpreted this means that the slope of the MC curve should be greater than the slope of the MR curve. Some researchers such as Hall and Hitch (1939) among others report that some entrepreneurs had never heard of marginal revenue and marginal cost and as such their pricing and profit calculationshave not be based on the MC = MR rule.Still,otherssuch as Simon (1959) have arguedthat businessexecutivesdo nothaveenoughinformationto maximizeprofitin practice.Indeed,there are several reasons why MR may not equal MC in practice such as indivisibility of commodities.For example, there isthe minimumsizeof the commoditythat cannotbe furtherdivisible. Whereas the profitmaximizinglevelof output may liemid way between two units of the product,say 5.5 units.Butifwearetalking abouta commoditysuchas an automobile,itdoes notmake senseto talkaboutthe5.5th unit of a car. For these and other reasons,it is arguedthat average costrule calledfullcostpricing (thoughconceptuallywrongly)basedon some normallevelof output is morerealisticsince it stresses the importance of maintainingproductionat an adequate level to satisfy demand rather than maximizingprofit.The empirical evidence advanced has shownthat average cost pricingis widelyused. is argued that it is the secondbest alternativeto marginalistparadigm,especiailvfor multi-prooucifirms, where changesin marginalcostsare practicallyimpossibleto estimateforeachproduct.However,themajor difference between the neoclassicalperspectiverinclthe alternativeViewis that firmsdo not aim at shortrun maximizationbutratherwith long run profitmaximization.Theyset their priceon averagecostprinciple – is. set theirprincipleto coveraveragevariablecost (AVC), the average fixed cost (AFC) and a ‘normalprofitmarginas perceivedby I… management as shown below. P = + 4- Normal Prof-n margin Equation (9.1) is sometimes also written as P = AVC + Gross Profit Margin (GPM) = Average Cost (AC) (92) The premises behind equation (9.2) is not clear but it does not appear to be the best representation of average cost pricing-since GPM = AFC + Net Profit Margin (NPM). (9.3) Even though’ the two components Wl” vary in the same direction with P, different forces determine their influences on P. The relationship between P and AVC, AFC and NPM may be characterized as P = P(AVC, AFC, NPM) (94) Equation (9.4) postulates that it may be possible to predict a priori the directibn of variation between P and AVC particularly without, information on the level of output produced on the co-ordinate point on the AVG curve; In general, since AVC is a quadratic function of output, initially as output increases AVC decreases to a minimum and then rises as output increases further. Thus, Whether P varies inversely, directly or even neutrally with AVC depends on the level of output. But then, the sign of the correlation coefficient indicates where the firm is on its AVC curve. While P and both AFC and NPM vary directly, AFC is determined by the level of output but NPM is arbitrarily determined by the perception of management of what constitutes a “normal” profit, the opportunity cost of resources deployed in the activities of the firm. That is, there is no general principle guiding the application, of the mark-up rule in practice. Still other writers haVe argued that firms practice limit pricing to mean that they set theirptices to limit the entry of new entrants. ‘Bain (1949) claimed or alleged that firms for over long periods of time keep their prices at’points on the demand curve where the price elasticity of demand is less than unity. They do so in order to wade off the threat of potential entry. The’implication is that firms are neither profit nor revenue maximizers. The model assumes an oligopolistic market structure in which (i) there is effective collusiOn among the established firms; (ii) the established firms are capable of computing a limit price, below which entry will not occur; (iii) there is a determinate – long run demand curve for the industry output, which is independent of price; adjustments and/or of entry; (iv)? above the limit price, entry is attracted and there is considerable uncertainty concerning the sales of the established firms after new entries; and (v) the established firms seek the maximization of their own long run profits. Again, the difference between this and the traditional theory is the assumption of short and long run maximization of profit in the latter as opposed to the maximization of long run profits only by the former. Uncertainty: The traditional theory of the firm assumed, albeit without explaining how, that the firm had perfect knowledge of’ its cost and demand functions and of its environment. So that, in effect, uncertainty has no influences on these relationships, and hence the decisions of firms. There are several reasons why uncertainty is crucial to the decisions of the firm. First, the real world in which the firm operates is extremely complex with numerous variables that determine revenue and costs. Secondly, different situations may require different strategies and policy variables such as price, product differentiation, advertising, diversification, etc. are normally in the play. Thirdly, the determinants of the market conditions change continuously and do so simultaneously, it may therefore be proposed that under such conditions marginal adjustments involving the equation of the relevant marginal magnitudes will be extremely difficult, if not, completely beyond the ability of the firm given that under conditions of complexity, past experiences may be largely irrelevant to decisions about the future. Lack of accurate information about future demand and cost conditions introduces uncertainty which can only be realistically handled within a dynamic framework requiring information and knowledge about the attitudes to and the formation of expectations of businessmen. It is therefore possible that businessmen resort to multiple Goals in an attempt to avoid uncertainty or at least to minimize it. Clearly, marginal analysis in its traditional formulation is inadequate for dealing with the process of expectation formation and additional goals of the firm. The Static Nature of the Neoclassical Theory: As Horowitz (1970: 322) noted time enters the traditional theory in three respects. First, there is the distinction between short and long run which implies timeconsiderations. Second, it is assumed that the firm has some time horizon over which it attempts to maximize profits. Thirdly, the analysis of the timing of demand relative to the flow of production suggests a period analysis. In addition, the discounting of future receipts and costs implicit in the assumption of long run future receipts and costs implicit in the assumption of long run profit maximization involves time element. But so also is the consideration of the gestation lag between investment expenditures and the coming on stream of the final product or service. Yet, the traditional theory of the firm is basically static. Since, the time – horizon of the firm is assumed temporally independent whereas decisions taken in anyone time period is most likely to affected by the ‘decisions’ in’past periods which will in turn influence future decisions of tli pg ‘ firm. This interdependence between temporal decisions is ignored by the neoclassical theory which postulates that long run profits. are maximized as the firm maximizes its short run profits in any one period, by equating its marginal costo marginal revenue (MC = MR): Entry Considerations: In the neoclassical theory of the firm entry considerations differ for different market structures. There are two common features to the neoclassical approach to the entry problem. They are: 0 only actual entry is considered; and _ 0 entry is assumed to be a long run phenomenon -i.e. it can only occur in the long run. in pure competition and monopolistic competition entry is unrestricted but cannot only obcur in the short run. in the case of pure monopoly entry is completely blockaded by definition. While the traditional models of oligopoly are implicitly silent as far as entry and number of firms are concerned except in the limiting ‘case of duopoly to refer to models of competition between two firms, which do not allow for entry. in general, the number of fir”)? in Oligopolistic markets can be extended except in the case of duopoly with the upper limiting case being monopolistic competition. In the case of cartels, the traditional theory implicitly assumes that new 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 neoclassical models of price leadership. For, it is implicitly assumed that the new entrant is either a small firm, which can be coerced to follow the leader, or isassumed to accept the status quo of the established leader. it thus follows that potential entry and its effects on decision making are not accommodated by the traditional theory.

On account of the alleged weaknesses of the conventional theory, some of its critics have advanced competing theories as- indicated earlier. The alternative formulations are reduced to two major categories, which are examined briefly.

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