In The Wealth of Nations, Adam Smith (1776) argues that the value of the firm’s output is related to its costs of production (a notion which constituted the orthodox view at that time). Costs include an allowance for profit, interpreted as a reward to the firm’s owner. Owners maximize profit by attempting to minimize the other costs incurred by the firm. One of the most widely quoted passages is a description of Smith’s visit to a Nottingham pin factory, where he observed the potential for the division of labour to increase labour productivity and generate large cost savings.
To take an example, from . . . the trade of a pin maker; a workman not educated to this business . . . nor acquainted with the use of the machinery employed in it . . . could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head . . . ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day.
(Smith, 1776, pp. 4 –5) Augustin Cournot (1838) was one of the first economists to attempt a formal mathematical analysis of the behaviour of monopolists and duopolists. Although Cournot was a mathematician by background, he was the first to apply calculus to an analysis of the pricing decisions of firms. Cournot’s analysis is considered in detail in Chapter 4, in which we examine the theory of oligopoly.
The idea that the value of a firm’s output is dependent on production costs lasted till the late nineteenth century, when this notion was seriously challenged for the first time. According to the new view, the value of the product determines the rewards paid to the factors of production. Firms earning high profits by selling pro-ducts that are in demand for a high price can pay higher rents, wages and interest.
In other words, the price and therefore the value of the product depends ultimately on the level of demand. Stanley Jevons (1871) argued that the value a consumer places on a product depends on utility at the margin, which implies value is judged against all other past units of the product consumed. If marginal utility declines as 3.2 The neoclassical theory of the firm: historical development 71
consumption increases, cuts in price are required to induce an increase in the quantity demanded. This relationship provides an explanation for the downward sloping demand function.
Alfred Marshall (1890, 1892) is considered to have been the first economist to draw the link between costs of production and market demand. Accordingly, value is determined by interactions between the conditions surrounding both supply and demand. Marshall developed the tools of economic analysis that are still familiar to first-year undergraduates: the upward sloping supply function and downward sloping demand function which combine, scissor-like, to determine an equilibrium price and quantity demanded and supplied. If price is set above or below this equilibrium, then firms are faced with excess supply or excess demand. In the case of excess supply or a glut of goods, price tends to fall, encouraging more buyers into the market. Some firms that are no longer able to cover their costs of production are forced to reduce their supply or leave the market. In the case of excess demand or a shortage of goods, price tends to rise, discouraging some buyers who withdraw from the market. Some incumbent firms respond to the price signal by increasing their production, and some entrants are attracted into the market for the first time.
Marshall also introduced the concept of price elasticity of demand, and drew the distinction between the short run and the long run. Like Smith before him, Marshall recognized that in the long run firms benefit from economies of large-scale production. However, this does not necessarily lead to the emergence of monopoly, because there is still the possibility that other producers can compete with a large incumbent, by exploiting distinctive entrepreneurial skills or external economies of scale. To Marshall the dominant market structure seemed to be a variant of competi-tion, although not the textbook perfect competition model of later years. Marshall recognized the importance of rivalry, and that this creates the potential for collusion.
However, Marshall viewed oligopoly as a form of quasi-monopoly, and therefore as an exception to the normal competitive market structure.
The theory of perfect competition was developed by John Bates Clark (1899), who believed that competition is fundamentally a force for good in the economy.
In competitive markets, everyone receives a reward equivalent to their marginal contribution to production. Accordingly, Clark sought to analyse those forces that have the potential to frustrate competition, especially monopoly and associated restrictive practices. The theory was refined by Frank Knight (1921), who lists a number of conditions required for a market to conform to the model of perfect com-petition. The most important are that no one buyer or seller is sufficiently powerful to influence prices, that no entry barriers impede the flow of resources into the market, and that all agents have perfect knowledge. Knight explains why perfect competition does not necessarily eliminate abnormal profit in situations where there is a degree of uncertainty. According to Knight, uncertainty describes a situation in which the probabilities that should be assigned to possible future events cannot be determined. Risk, on the other hand, describes a situation in which probabilities can be assigned, and future events can be insured against. Knight argues that even in long-run equilibrium, firms might earn an abnormal profit as a payoff for dealing with uncertainty.
As we have seen in Section 2.6, in the 1930s Joan Robinson and Edwin Chamberlin coined the term imperfect competition to describe the middle ground 72 Chapter 3 n Theories of the firm
between perfect competition and monopoly. Robinson (1933) introduces the con-cept of marginal revenue, and shows that in perfect competition marginal revenue equals price. For a firm in imperfect competition, the marginal revenue function is downward sloping. At some levels of production (where marginal revenue is negative), it may be possible to increase total revenue by producing and selling less output. Robinson argues that the tendency for imperfectly competitive firms to restrict production and operate below full capacity helps explain the high unemployment experienced in the UK in the 1930s. In contrast, high unemployment is not consistent with the theory of perfect competition. Robinson’s analysis of price discrimination represents another important contribution to the theory of the firm. Chamberlin (1933) developed the theory of monopolistic competition to describe a market in which there are many firms producing goods that are similar but not identical. Accordingly, the firms exercise some discretion in setting their prices. Chamberlin also contributed to the theory of oligopoly. Oligopolists recognize that their actions are interdependent:
a change in output by one firm alters the profits of rival firms, perhaps causing them to adjust their outputs as well. Forms of competition under oligopoly vary from vigorous price competition to collusion.
3.3 Critique of the neoclassical theory of the firm
A common criticism levelled at the neoclassical theory of the firm is that it is insufficiently realistic. The theory is largely based on outdated views of competition and entrepreneurial activity. The concept of competition that was developed in the nineteenth century was based on a presumed model of reality. The rise of the textile industry and the growing international trade in staples provided early economists with concepts which dominated early economic thought. Price competition was seen to be both intense and instantaneous, goods were homogeneous, no trade secrets existed, and markets were populated by many buyers and sellers. This model of the firm can be criticized from a number of directions.
n Organizational goals. The neoclassical theory assumes that firms seek to maximize profit. In reality, however, firms may pursue other objectives, such as the maximization of sales, growth or market share, or the pursuit of status or job security by the firm’s managers, or perhaps the simple enjoyment of a quiet life. Simon (1959) argues that the firm’s managers may aim for a satisfactory or sufficient profit to allow the managers to pursue other objectives. By analogy, do firms really search for the sharpest needle in the haystack, or are they content with finding a needle sharp enough to do the job in hand?
n Uncertainty and imperfect information. In practice all economic decisions are based on assumptions or predictions about near or future events. Implicit in the neoclassical theory is an assumption that the firm’s decision makers can somehow make accurate predictions, or at least be able to assign probabilities to the various possible future events. Therefore decision makers need to be able to anticipate changes in consumer tastes, changes in technology, changes in factor markets and the likely reactions of rivals. In practice, any of these events may be extremely difficult to forsee.
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n Organizational complexity. Modern firms are complex hierarchical organizations, bound together by complex communications networks. In practice, breakdowns in communications occur frequently. The greater the number of levels, the greater the likelihood that information is distorted, either deliberately or accidentally.
Misinformation reduces the ability of the firm’s decision makers to reach correct decisions.
n Decision making. According to the neoclassical theory of the firm, the firm’s decision makers solve the problem of which inputs to purchase and how much output to produce by applying the rules of marginal calculus. However, empirical evidence has shown that businessmen and women do not employ such methods;
instead, they tend to rely on simpler decision-making conventions or rules-of-thumb. In a seminal article, Hall and Hitch (1939) report the outcomes of interviews with decision makers at 38 firms. Very few had even heard of the concepts of marginal cost and revenue, or price elasticity of demand; instead, most set their prices by calculating their average cost, and adding a mark-up that included a margin for profit. This pricing method is known as cost plus pricing.
It is examined in more detail in Chapter 10. Neoclassical profit maximization requires that both demand and costs are taken into account in determining price and quantity; cost plus pricing appears to consider only cost while ignoring demand. Hall and Hitch also asked their interviewees why they based their prices on average cost. Some respondents felt that this policy was fair to both producers and consumers. Some claimed not to know the true nature of their demand conditions; they had insufficient information about consumers’ pre-ferences or their rivals’ reactions. Finally, some felt that frequent changes in price were a nuisance to consumers and their sales teams. For this reason it was preferable to adhere to conventional prices, unless there were significant changes in cost conditions.
In defence of the neoclassical theory, Friedman (1953) argues that some critics miss the point by attacking the validity of the assumptions on which the theory is constructed. The objective of any science is to develop theories or hypotheses which lead to valid and accurate predictions about future outcomes. The only relevant test of the validity of a theory is whether its predictions are close to the eventual outcome. Friedman argues that the proper test of an assumption such as profit maximization is not whether it is realistic, but whether it enables accurate predictions to be generated from the theory on which it is based (Rotwein, 1962;
Melitz, 1965).
Machlup (1946, 1967) argues for the essential validity of the profit maximiza-tion assumpmaximiza-tion, even if it does not provide a literal descripmaximiza-tion of reality. Most decision makers have an intuitive feel for what is required to come close to a profit-maximizing outcome, even if they are unable to articulate their practices using the same terminology or with the same precision as economists. The practical imple-mentation of marginal analysis should not require anything more difficult than an ability to formulate subjective estimates, hunches and guesses. By analogy, whenever we drive a car we execute complex manoeuvres such as overtaking intuitively, rather than precisely using complex mathematical formulae. From experience, we can judge 74 Chapter 3 n Theories of the firm
the speeds and distances needed in order to overtake successfully; fortunately, it is not necessary that any driver wishing to overtake should solve the problem using differential calculus. Using similar reasoning but adding a Darwinian slant, Alchian (1965) argues that firms that survive in the long run are those that have come close to long-run profit maximization, either deliberately or intuitively, or perhaps even in-advertently. Accordingly, the neoclassical theory accurately describes the behaviour of surviving firms.
An essentially static conception of competition is emphasized in the neoclassical theories of perfect competition, monopolistic competition and monopoly. In the neoclassical theory, the entrepreneur is the personification of the firm, but other-wise plays a rather unimportant role, because at the long-run equilibrium, all buyers and sellers have perfectly anticipated all variations in supply and demand. Price competition is the only form of rivalry. In contrast, Schumpeter (1942) and the Austrian school both give the entrepreneur a central role within a more dynamic model of competition. By initiating technological change by means of innovation, the Schumpeterian entrepreneur is the main driving force behind economic pro-gress. Innovation revolutionizes economic conditions by replacing old production methods with new and superior ones. Successful innovation is the fundamental source of monopoly status and abnormal profit. Abnormal or monopoly profit is only a temporary phenomenon, however, because eventually the market for a new product will be flooded by imitators, or the original innovation will be superseded by further technological progress. This Schumpeterian view of the entrepreneur as innovator is examined in more detail in Chapter 14.
The Austrian school also emphasizes the role of the entrepreneur. Here the entre-preneur is seen as crucial in the interaction of decisions made by consumers and resource owners. The entrepreneur spots missed opportunities for trade or investment, by acquiring and processing new pieces of information more quickly than other decision makers. Through his or her actions, the entrepreneur contributes to the spread of new information among other market participants, who are able to adjust their trading plans accordingly.
The overambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market (i.e. in consumer tastes, technological possibilities, and resource availabilities), the decisions made in one period of time generate systematic alterations in the corresponding decisions for the succeeding period. Taken over time, this series of systematic changes in the interconnected network of market decisions constitutes the market process.
(Kirzner, 1973, p. 10) In this process the entrepreneur once again plays a central role, by remaining alert to missed opportunities and initiating changes that propel the economy towards a new equilibrium. ‘The entrepreneur . . . brings into mutual adjustment those dis-cordant elements which resulted from prior market ignorance’ (Kirzner, 1973, p. 73).
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Essentially, disequilibrium results from the ignorance of buyers and sellers. Potential buyers are unaware of potential sellers and vice versa. Scarce resources are sometimes used to produce goods for which there is no market; on other occasions, resources that could be used to produce goods for which a market exists are left idle. However, the alert entrepreneur can step in and remedy the situation by noticing these missed trading opportunities, and bringing potential buyers and sellers together.
Casson (1982) develops a synthesis of several of these theories of entrepreneurship.
The entrepreneur’s main function is the management, coordination and allocation of other scarce resources, using key or privileged information. If this is done effici-ently, and the key information remains secret, the entrepreneur is rewarded with profit or income. However, as in the Schumpeterian and Austrian views, in the long run there is a tendency for the entrepreneurial reward to be dissipated. Casson models the entrepreneurial function using a neoclassical-style demand and supply framework. The demand for entreprenuers depends most crucially on the pace of technological change, which determines the level of opportunity for entrepreneurial initiative. The supply of entrepreneurs depends on the educational system and qualifications, social networks, institutions and the general culture of the society, all of which influence the propensity for entrepreneurial behaviour and the avail-ability of capital to finance new ventures. Entrepreneurial rewards tend to be higher when the demand for entrepreneurs is high (due to a high level of technological opportunity) and when the supply of active entrepreneurs is scarce.