Strengths and Limitation of Neoclassical Theory

Describe about the Business Macroeconomics for Neoclassical Theory.

The paper intends to discuss the limitations and strengths of neoclassical theory on the one hand and assesses the managerial theories contribution to the firm’s behavior and performance understanding on the other hand. The paper comprise two parts with the first part delving into a deeper understanding of how neoclassical theory of the firm has helped economist understand how it enhances the behavior of the firm. Both limitation and strengths of the neoclassical theory are discussed and a decision is made on how such a theory is helpful in comprehending the behavior and the firm and its performance. In the second part, a detailed discussion is provided that illustrates a deeper assessment of the contribution of the managerial theories in understanding both performance and behavior of a firm. Part two are gives a detailed explanation of the possible ways that can be employed to test the hypothesis of sales revenue as assumed by Baumol.

The neoclassical perspective of the firm remains predominant despite the numerous building blocks put forward by various scholars for a new approach. Neoclassical assumed that a firm enjoys perfect information alongside certainty regarding the outcomes of the environment. It also assumes that a firm suffers no control and adaptability problems (Rosenzweig 2010). The neoclassical theory also believed that a firm maximizes profit and faces no dysfunctional allocation of resources problems. The theory further assumed that the strategies as well as performance of the firm are predictable and that the firm manufactures as well as assembled components that are tangible. It also posit that the firm subsequently sells the outputs produced in the final product market (Mabry and Siders 2013). The neoclassical theory’s assumption given for a simple reason as well as manageable treatment of the firm that can be incorporated into neoclassical price theory. However, this was never an effective abstraction of the internal organization of the firm (Knight, Loayza. and Villanueva 2013). Accordingly, the model use by neoclassical theory did not acknowledge the heterogeneity, performance as well a strategic behavior (Ferguson 2008). The neoclassical perspective, however, was effective in addressing the firm as its basic unit as well as predicted the behavior of the firm based on pricing, output as well as allocation of resources decisions as its objective. Even though the theory was successful in these two elements, it terribly failed to take the firm as an explicit emphasis on the real process of making decision in the organization as the firm’s basic research commitment. 

Strengths

Discussions pertaining to theories of the firm have to begin with the neoclassical theory perspective hence theory is tagged “the staple diet of contemporary” economists. Despite being formulated a hundred years ago, the neoclassical theory is still pre-dominant in the contemporary textbooks. The theory rationally perceives a firm as a set of feasible plans of production with the manager presiding over this production set as he buys and sells inputs and outputs within a spot market as well as selecting the plan which optimizes the welfare of the owner of the firm (Jensen and Meckling 2012). In neoclassical theory, the profit denotes the welfare and hence in case of uncertain profit so that profit-optimizing is not definite, the anticipated net present value of the upcoming profit or by the market value. The neoclassical theory of the firm is, therefore, the caricature of the contemporary firm even though rigorous it remains rudimentary.

The theory has a lasting survival which can be explained using three different reasons. The neoclassical has lent itself to the elegant as well as general formulation of mathematics. It has also remained useful in the analysis of how production choices of the firm respond to the external fluctuations in the environment including for instance, how a rise in a wage and tax sales will be tackled. Neoclassical theory is also useful in the analysis of the implications of strategic interaction between firms operating under the imperfect competition. For instance, the theory is helpful in understanding the connection between the levels of concentration in a given industry as well as the levels of output and price of the industry.

Neoclassical theory has some value in understanding the behavior of the firm. The profit satisficing may be surpassed via share deals as well as performance-oriented pay. Accordingly, neoclassical theory remains useful since it indicates how as well as why firm need to ensure that the workers have adequate incentives for maximization of the profit like owners. One could argue that in case a firm is pursuing other objectives, in the back of their minds, profit maximization is alive. For example, a firm can involve in a price war for market share maximization (Sobel 2008). Nevertheless, the reason for such engagement could be that the firm expects that such an increase in market share in the long run would allow higher monopoly power and hence a high profit in the future. The same can be argued of an environmental objective where neoclassical theory hold that there would be a long run profitability resulting from a better corporate image.

Limitation

The neoclassical theory of the firm has clearly manifested limitations. The theory does not explicate the organization of production within the firm. It also has a limitation since it is silent on how conflicts of interest between the various aspect of the firm such as managers, consumers, owners and workers are engaged or how the profit maximization goal is attained. Neoclassical theory begs the question of determines or defines a particular firm as well as what determines the boundary of the firm (Rumelt 2008). The theory is also silent on the issue of individual size of the firm and extent. In this regard, the neoclassical theory fails to explicate the consequences of two firms agreeing to merge or one firm deciding to split itself into two or multiple smaller entities (Hart 2012). The theory uses the rudimentary approach to describe the functionality or operation of the firm. Surprisingly, neoclassical theory offers little contribution to any meaningful image of the structure of such firms described rudimentarily.   

The neoclassical hold that firms seek to maximize profits which is not a true assumption. It has been proven that firms always seek for maximization of the size of the firm as well as market share than profit. There is also the problem of a principle agent when it comes to profit satisficing. The owners of the firm can wish for maximization of the profits. However, the worker do not wish for profit maximization. Accordingly, the employees will put concerted effort to keep the owners happy, however, they will pursue other objective like enjoying themselves at work (Grant 2012). Such a problem is called the problem of separation of control and ownership. Other objectives including cultural, environmental as well as social objectives will be pursued by a firm rather than profit maximization. The neoclassical did not acknowledge human as not merely profit maximizers but still consider additional non-financial objectives. 

Various managerial theories have helped understand the behavior and performance of the firm. The three known managerial theories include Baumol’s Model of sales revenue maximization, the Williamson’s Theory of Managerial Discretion as well as Marris’ theory of managerial enterprise. According to Baumol, the maximization of the revenue arising from sales is the primary objective of the firm and the alternative objective to neoclassical’s profit maximization. Baumol’s theory, therefore, contributes to the understanding of firm’s conduct and performance by holding that managers solely make sure acceptable profit levels but pursues an objective that enhance their individual utility (Baumol et al. 2012). According to Baumol, the hypothesis is rational since there is a distinction between ownership and management in the contemporary world.

Assessment of Managerial Theories Contribution to Firm’s Conduct and Performance Understanding

Managers presently have authority and powers that help them pursue individual goals instead of the owners’ goals. Accordingly, managers only make sure a minimum acceptable profit levels for shareholders’ satisfaction but pursue an objective that facilitate individual utility. Baumol hold that managers attempt to pursue sales’ maximization because incomes of top executives remain closely linked to sales than profits (Hayashi 2010). Managers also do this to impress banks and financial institutions as they perceive the amount of sales as good performance indicators. Managers are motivated to maximize sales since large as well as continuing sales facilitate their prestige thus guaranteeing regular dividends’ distribution. Baumol assumes that firms will solely try the revenue maximization instead of physical sales volume as decision making of a firm remains restricted to one period.

Marris acknowledges the structural separation of management and ownership thus allowing managers to formulate certain goals that need not to conform to owners or shareholders’ goals. The utility function of managers include market share, capital size, public image, output size and profits. Managers also incorporate other ideas including salaries security of jobs and status and power. Whereas the shareholders wish to maximize their utility, manager always try to maximize individual utility (Ding, Akoorie and Pavlovich 2009). These utilities may not necessarily clash as various variables of both utilities show firm connection with only one variable (size of the firm). The owners are interested in the firm’s growth and hence push for supply of capital growth assumed to maximize utility of the owners (Diamond 2011).  Managers, conversely, advocate firm’s growth rate and not absolute firm’s size with a strong belief that demand for commodities’ growth indicates firm’s growth. Marris has, therefore, significantly contributed by incorporating financial policies into the process of making decision by corporate firms (List 2004). The theory suggest that there is a possibility of finding solutions that maximize utility of both owners and managers. It explains why owners are ready to sacrifice certain levels of profit because they prefer rate of growth’s maximization.

Williamson’s discretion theory’ anchors the view that contemporary business firm managers structured as corporate unit maximize individual utility by using discretion. The managers try to make sure of minimum profits to owners to guarantee job security in the form of dividends. The managers view profit a constraint to their discretion. The utility of the manager’s anchors variables including job security, prestige, job satisfaction, power, salary as well as professional excellence. Since the only salary is quantifiable, Williamson utilizes such measurable variables as a discretionary investment, staff spending as well as managerial emoluments in the utility function based on the assumption that such variables remain their source of security of the job as well as manifestations of status, professional excellence, power, as well as prestige.             

Baumol rejects the assumption that the primary objective of leaders of a huge corporation is to maximize profits but rather that the predominating goal is to maximize revenue. Baumol, therefore, holds that increased sales will always be pursued by these leaders even at the expense of reduced profits in both long- and short-run. As reflected in his model, the total sales are perceived as a function of prices and output in the short run as well as advertising in the long-run. Baumol holds that output will be enlarged as prices decline past the maximum profits point in the long-run up to a point in which revenue is maximized with a particular demand curve. He further holds that, in the case of a persistent rise in total revenue, the said changes in prices and output will continue until a point where the constraints of profit are at their minimum ((Alchian, and Demsetz 2012)). For Baumol’s hypothesis to hold water or show empirical significance then it has to be discovered in the objective behavior of a large firm manifested by a marked tendency to enlarge sales in the absence of the growing profits. Surprisingly, Baumol Model displays a contrary link between profits and sales at various levels of the advertising outlays as depicted in the derived comparative static model by Sandmeyer.    

Conclusion

The paper has presented a detailed discussion of the neoclassical theory of the firm and three managerial theories. It is clear that neoclassical is still dominating as a theory of the firm based on its lasting strengths that have been extensively discussed. However, certain weakness of neoclassical theories was identified and discussed at length. It is clear from the discussion that neoclassical theory is helping in understanding the behavior of the firm. Similarly. Williamson, Baumol as well as Marris Managerial theories have been alongside individual theory’s contribution to both conduct and performance of a firm.

References

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