Neoclassical Theory of the Firm

Parallel with the developments in industrial economics, the theory of the firm has evolved from viewing the firm as purely profit-maximising operating in a timeless vacuum. The firm is now seen as more complex, with a key distinction to be made between control and ownership.

The competitive equilibrium paradigm has dominant the representation of economic systems since the writings of Adam Smith. Central to this is the idea that, on all markets, supply and demand are equated. This equilibrium is achieved by price adjustments. Individuals react primarily to price signals

This is the basic building block of the neo-classical theory. Central to this view is the maximisation of profits. The firm purely exists to create a profit. It operates in an exogenous environment beyond its control. The firm will continue to increase output so long as the marginal (last) unit produced adds to total profit. When marginal revenue is equal to marginal cost, then profit maximisation has been reached.

Since the 1930s, much research has cast doubt on this static assumption of profit maximisation. One of the first challenges was presented by Hall and Hitch. They criticise the obscurity surrounding the precise content of the terms ‘marginal and average revenue’. Their major criticism however, relates to the idea that firms will equate marginal cost with marginal revenue. Firms they found, generally set their prices by taking into account overheads and adding a profit to form a ‘right price’. Profit maximisation, if it happened, was accidental.

Another critic was aimed at the idea that information was perfect.  Uncertainty as the outcome of a given strategy is hugely important to firms. In the future revenues and costs may depend on the actions of competitors, changes in technology, changes in consumer tastes, changes in the markets for inputs and government policies. Attitudes to risk are variable. Japanese firms for example, ranked improving their products as more important that profit, reflecting different time horizons.

As firms become larger, they also become more complex, and it becomes more difficult to enforce profit maximisation. The can also be cultural/psychological and technological reasons why a firm may not aim to maximise profit.

The decision about the appropriateness of assuming profit maximisation to be the objective of firms is inconclusive.

Managerial Theory

The neoclassical response to these criticisms was the formation of the Managerial Theory. A legal-economic view of the firm emerged, emphasizing the complex nature of the corporate firm. The diminishing influence of shareholders was contrasted with the rising power of managers, whose objectives could be different. His salary could be more important to him than the firm’s profit, meaning that growth with be a priority. Managers who increase sales generally earn higher salaries. The work of Baumol assumes  that the firm maximises sales revenue subject to a minimum profit constraint. The difference between the maximum level of profit and minimum constrained profit is called ‘sacrificeable’ and will be voluntarily given up to increase sales. This however will have to be done quietly, to lower the chance of attention from other firms.

Marris assumes that managers will want to maximise their utilities and that this will be achieved through growth rather than sales. The supply growth is the maximum growth of supply that can be generated from each profit rate. Supply growth is directly and constantly related to profit because a higher profit facilitates both more investment from retained earnings and more funds to be raised in the capital market. With demand growth, growth is seen as determining profits. Growth, which is diversification into new products leads to an increase in profit. As more new products are introduced (growth increases) more must be spent on R&D and advertising. At some point further growth will lead to a decline in profit.

The principle tenet of managerial theory is that ownership is distinct from control. Because of this, there may be a divergence of interests. However, empirical evidence has been inconclusive in showing the difference between owner –controlled and manager controlled firms. Douma and Schreuder suggest this is because there are no differences

There are three mechanisms which prevent managers from enriching themselves at the expense of shareholders. Where there is a market for corporate control, a decline in the performance of a management team can result in its replacement. This is especially true in regards listed companies. Thus managers are under pressure to perform.

The market for managerial labour is one in which shareholders are the buyers and managers the sellers of their expertise. The better this market works, the less likely is a top manager to enrich himself.

Even if there is no market for corporate control, a competitive market for the company’s product can ensure that managers act in the interest of the owners. Self-enrichment will increase a company’s costs, which will lead to a loss of market share. Thus a competitive product market can prevent a manager from enriching himself.

Principal Agent Theory

At its simplest, this theory examines situations in which there are two main actors; a principal who is usually the owner of an asset and an agent who makes decisions which affect the value of that asset, on behalf of the principle. The principal is usually the owner while the agent the manager, but the manager could easily be a principal while his employees could be agents.

It introduces a contract view of the firm. There are two main such approached; monopoly which views contracts as a means of obtaining or increasing their monopoly power and efficiency, which views contracts as a means of economizing. PAT belongs in the efficiency branch nad this agency theory is the theory that focuses on the design and improvement of contracts between principles and agents. With its emphasis on eventualities over different time frames, it adds a time dimension to the neo-classical theory.

Among the major concerns of principal-agent theory is the relationship between ownership and control. PAT sees the firm as a legal enity with a production function, contracting with outsiders and also insiders. Their concerns are with owners and managers problems of coping with asymmetric information, measurement of performance and incentives. How to formulate a contract such that the shareholders will have their interests advanced by their the manager despite a divergence of interests is a major problem for them. A moral hazard may arise, when the principal cannot tell whose interests the manager is acting in.

They believe a managers salary be equal to the expected value of his marginal product, and to ensure there is an incentive for the manager to act in the shareholder’s best interests. PAT is concerned with shirking, that is a reduction in effort by an agent who is part of a team. There may be a slight decline in output, but the cause will be unidentifiable. Thus a moral hazard arises.

To control moral hazard, PAT suggests paying a manager a salary plus a bonus based on performance. An obvious solution to this problem of conflict of interests is for the principal to become their own agent

By and large, neoclassical theory failed to explain the ‘new economy’ of the nineties and did not predict the Great Recession. Its major weakness is its inability to deal with technology and innovation.