Theories of the firm - neoclassical and managerial decision making

TABLE OF CONTENTS

Introduction

SECTION ONE

1. Abandoning traditional key assumptions
1.1 Growth in oligopoly
1.2 The growth of managerial capitalism
1.3 Difficulties surrounding profit maximisation
1.4 The organisational complexity of firms

SECTION TWO

2. Merits and insights of the new theories of corporate behaviour
2.1 Principal-agent theory
2.2 Managerial theories
2.2.1 Sales revenue maximisation
2.2.2 Managerial utility maximisation
2.2.3 Corporate growth maximisation

Conclusion

Bibliography

Introduction

For a long time, economists have seen the firm as a black box, arguing that firms maximise profits. Without following this ultimate goal, economists say that organisations would not survive in competitive markets (Makamason, 2004). In order not to be replaced, managers would have to comply with the objective of profit (value) maximisation. Hart (1989) says that this "neoclassical" view of the firm has been challenged considerably over the last three decades due to theoretical developments and increasing empirical evidence that managers may not pursue shareholder interests.

The key assumptions of the traditional theory of the firm are maximisation of profit and decision making under conditions of perfect knowledge (Nellis and Parker, 2002). By ignoring many other involved complexities, this neoclassical approach has the ability to predict corporate behaviour in perfectly competitive and monopoly market structures. The maximisation assumption portrays the firm as a “single market, single product asset of the owner who adapts a production plan in response to changing market conditions” (Makamason, 2004). Its prolonged survival is due to the useful analysis of how a firm's production choices respond to exogenous change in the environment. Such an example being an increase in wages or a sales tax (Loasby, 1989).

1. Abandoning traditional key assumptions

Hart (1989) says that the neoclassical approach is frequently criticised for solely concentrating on the prediction of real-world production and pricing decisions. Realistically, companies are rarely faced with perfect competitive and monopoly markets, the central assumptions of the traditional theory have been abandoned by new, alternative theories. Nellis and Parker (2002) opine that these have the capability to produce more adequate and meaningful information about corporate behaviour. The above authors name five reasons for abandoning one or both of the neoclassical key assumptions:

- Growth in oligopoly
- Growth of managerial capitalism
- Difficulties surrounding profit maximisation in practise
- The organisational complexity of firms
- Decision making in the face of incomplete information

1.1 Growth in oligopoly

The market form oligopoly is dominated by a small number of sellers, namely oligopolists. The degree of market concentration is very high, namely a large percentage of the market being taken up by leading firms (Wikipedia, 2004). In industrialised countries oligopolies are found in many sectors of the economy. This arises from unprecedented levels of competition, fuelled by increasing globalisation (Wikipedia, 2004). Moreover, current statements by the EU domestic market commissioner, Frits Bolkestein, concerning transfrontier company take-overs in Europe, show that in spite of all obstacles, the integration of the European economic area is proceeding (Frankfurter Allgemeine Zeitung, 26. 10. 2004).

Nellis and Parker (2002) argue that in this economic environment and structure, the adaptation of the traditional key assumptions, namely, perfect knowledge and profit-maximising behaviour, are out of place and do not succeed in adequate explanation of market behaviour. An initial reason for this being that oligopolistic markets are characterised by interactivity and interdependence between firms. Because there are only few participants in this market, each oligopolist is aware of the actions of the others. This means that each firm must take into account the likely reactions of other firms in the market, when deciding on pricing and investment.

Logically, this creates uncertainty and ‘economics is much like a game in which the players anticipate one another’s move’. Today, economists seek to model through with the use of the game theory. It may be applied in situations in which decision makers must take into account the reasoning of other decision makers (Stanford Encyclopaedia, 2004). The weakness of traditional theory is well displayed in situations of oligopoly. Within the traditional framework, the solution depends on the behaviour of individuals, and the theory has no way of handling this behaviour (Loasby, 1967).

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