Monday, January 20, 2014

Time For A New Theory Of The Firm?

This article argues that our current theory of the firm is flawed.  It is necessarily flawed in order to support a flawed theory of markets.  This is a direct attack on fundamental principles in microeconomics.  It also raises questions about macroeconomic models that assume the correctness of microeconomics.  If we don't really understand what drives the investment decisions of firms, the assumptions contained about agent behavior in the models are way off base.  For example, we assume that firms operate to maximize profits.  The maximization of profits, however, is very different from what firms really do.  They operate to maximize the rate of return on investment.  Since the outcome of investments is laden with uncertainty, they are made with great care.  For example, I worked for a very large computer that had a very high hurdle rate for making investments.  The hurdle rate was a 25% return on investment.  We set a very high hurdle rate because the technology and market conditions were in a constant state of flux. We knew that many would fail. We needed big payoffs to fund the losers. The hurdle rate was not set in stone, however.  If the CEO had a pet project in mind, it would get funded. We spent over $1 billion on a failed project that our CEO insisted upon because he believed that it was necessary to overtake the largest firm in the the industry.  He was not content at the number two position. Also our pricing decisions had nothing to do with our marginal costs.  We had no idea what our marginal costs would be.  Our prices were usually a markup over the cost of the first product that we manufactured.  Some firms engage in value pricing.  That is, they estimate the value of the product to the consumer and try to capture the largest share of that value as they can.  In other words, the textbook treatment of the pricing behavior of firms is a gross simplification of the varied and complex processes that actually exist in practice.

This article gets a bit technical but it makes a point worth considering.  The prevailing theory of the firm is inadequate.  It is no wonder that there is no good explanation of the business cycle that has any predictive power.

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