Managerial Economics: Neoclassical Theory and Baumols model - Assignment Example

I. Criticism of Neo ical Theory The standard neo ical assumption is that a business firm seeks to maximize profits from producing and selling an output in a market. What happens in real life, however, is that there are other objectives firms might decide to pursue and this has implications for price, output and economic welfare. Another flaw of the neoclassical assumption, actually brought on by the complexity of market behavior, is that it is difficult for firms to identify their profit maximizing output, as they cannot accurately calculate marginal revenue and marginal costs. Traditional economic theory suggests that the firm has a single goal. However, many behavioral economists argue that since a corporation is an organization with various groups such as the employees, managers, shareholders and customers, they may likely have different objectives or goals. The dominant group at any moment in time can give greater emphasis to their own objectives - for example the main price and output decisions may be taken at local level by managers - with shareholders taking only a distant view of the companys performance and strategy. II. Compare and Contrast Neoclassical Theory and Baumol’s model 1. Introduction Business firms have been traditionally viewed as a profit-maximizing entity which should set the amount of output where marginal cost equals marginal revenue in the quadratic curve shown in the Unit 1 study guide. The use of mathematical formulas- especially that of the derivative- have influenced many scholars to adapt the view. Mainstream economics literature has been dominated by this idea for a long time and has since earned its distinction as the Neo-Classical theory of the firm. However, William J. Baumol (1967) argues that the theory is flawed. In real life, the firm will look to set prices at revenue maximizing levels. The standard marginal cost/marginal revenue paradigm, according to him, is unrealistic and fails to take time (along with many factors) into consideration. In this paper, we try to identify the elements of both theories hoping to effectively compare and contrast them. 2. The Neoclassical Theory For many years, this theory has been at the forefront of economic analysis. The basic underlying principle behind this principle is that in an ideal market, firms should be characterized by the desire to maximize profit. In the handout, this was mathematically and graphically represented. The illustration is shown below: Figure 1: Revenue/Cost vs. Quantity Plot ( McNutt, 2006a) From the figure, the theory states that the firm should be concerned with finding out where Profit Maximization occurs. With the help of tangential lines and derivatives, the quadratic curve of the Total Revenue(TR) and the sinusoidal shape of the Total Cost (TC) were analyzed and it turned out that profit is maximized at q1. Inspecting the graph, we note that this where the differential between the TR and the TC is largest. For firms to stay in the business, they must be able to determine that critical point. Profit Maximization is the most defining aspect of this theory. Hirshleifer (1980) writes, “According to the classical formulation, the aim of the firm as a decision- making agent is to maximize (economic) profit.” (p. 265) Due to the seemingly elegant mathematical formulation, the theory has gain many adherents. Besides from this aspect, the theory also makes the following assumptions: a. Economic actors (individuals, community groups, government) have complete information about all aspects of production, exchange and distribution activities, including market opportunities, available technology, costs of production and the likes. b. No buyer or seller is large enough to influence the market price of the good or service being transacted c.Goods that are bought and sold in a given market are identical in all important respects, including quality. d. Actors can enter and withdraw from all markets without cost. e. No Economies to Scale or Production Externalities. This ensures that all production takes place so as to equate (private and social) marginal cost and marginal benefit. It also means that large producers do not enjoy any competitive advantage over smaller firms. Perfect markets exist for all commodities, including goods to be exchanged in the future and insurance against all risks. From having read the assumptions, one can say that almost all of them are quite unrealistic. As we have pointed in the first part of the assignment, many scholars now are questioning the validity of the theory and one of the rather persuasive is that of William Baumol. 3. Baumol’s Model Basing his model in real life experiences, Baumol (1967) writes that his observance of firm behavior demonstrated that firm management often would seem most interested in total revenue or sales and not actually in profit maximization. Businessmen are, for the most part, concerned with making the level of sales go higher. Baumol suggested that the managers’ interests are best served by maximizing sales after achieving a minimum level of profit which satisfies shareholders Baumol adds that: “…when firms are uncertain about the demand curve they actually face or when they have no reliable notion of the marginal costs of their output (as may be especially true in multiproduct firms), the decision to try to maximize sales may be a reasonable rule of thumb for assuring their long-term survival. Indeed, a number of management consulting firms stress to their clients the importance of maximizing their “market share” as a way of protecting themselves against the fluctuations of the market. In the light of incomplete information, as is almost the case with market, the construction of the graph in figure 1 is easier said than done. Many factors do affect the behavior of the curves. Because of this, firms would actually try to generate as much sales as possible and not bother to waste their time trying to construct a quadratic equation (the total revenue curve) that is very sensitive in real life. To do that, the firm will also try to maximize output and therefore maximize production costs as well. Baumol, however, adds one condition in his model that makes its necessary still to at least to come up with the TR curve. That is, a minimum profit to which the shareholders will be happy must be achieved. It is only logical that this must be the case because from what we can see from Figure 1, maximizing sales leads to an increasing cost of production and decreasing profit. The Study Guide provides the following graph: Figure 2. The Baumol Model (McNutt, 2006a)  represents a level of profit that has to be attained by the firm in order to satisfy the shareholders or owners of the firm. If the shareholders agree that they are satisfied at π1 then the firm can increase their production and their revenue up to that point in the TR Curve in the upper graph. Note that π3 corresponds to the differential between TC and TR where profit maximization occurs. Note also that no firm is expected to increase sales or revenue to the point that the total cost of production is higher than that of the TR. 4. Differences between the Two Models In the profit maximization model, the firm is expected to stand by the production output where the vertical differential between TR and TC is highest wherein the Baumol model states that firms are actually behaving in the range where the difference is not maximized. The difference between the two models is the approach that they pursue in modeling firms. Neoclassical theory takes more of an ideal and mathematical modeling while Baumol assumes a more realistic, behavioral approach. The Baumol model also takes into consideration the effects of differing goals managers may have regarding the firm’s success. In the first place, why would managers increase sales to the point that profit is lessened? This is because the manager’s goals are to attract more investment or to enable the firm to expand its operation. It becomes apparent, therefore, that output in the two models will differ. Sales maximization will also result to a lower profit as we have already shown in Figure 2. Price will also be lower due to the simple rule of supply and demand. The Baumol model also takes into consideration the lack of information and the goals that the manager may have. These are what set it apart from the Neoclassical theory. 5. Similarity of the Two Models The Baumol model and the Neoclassical model have one thing in common and that is they both fail to place time within the model. This non-inclusion has some important ramifications in predicting firm behavior as Rothbard (1993) and Hoppe (1999) argued in their models. Essentially, they argue that estimating costs precedes estimates revenues. Future conditions may render past calculations ineffective. Both models assume that costs, production, and sales occur concurrently, or at least one can assume that no more than a nanosecond passes from when costs are incurred during production to the sale of the final good. In such a state, the decision making process is quite easy, as the producer always has the latest information for the setting of output in order to be able to maximize profits. 6. Firms with Baumol Model Behavior There are many examples of sales maximizing firms. From my own observation, many firms such as those involved in medicine, garments manufacturing, soap construction supplies, transportation services and many more do tend to focus on maximizing sales. With higher sales in medical supplies, a firm gains a more solid reputation and is one way of attracting more investors. Suppliers tend to gather as much orders as they can. From my observation, prices don’t actually go down as technology and innovative ideas continue to contribute to lower production costs. One example of that is the Just-In-Time (Patrick Mcnutt, 2006b) strategy which enabled Toyota to enter and compete in the American Market. Directors would actually first ask what the sales figures are. Companies who are interested in attaining growth set as one of their targets the boost of sales although profits are also important. At the end of the day, I can say that the Baumol model presents a more complete view of the nature of business firms. I have read of other models such as Rothbard’s which includes time consideration which seems to presents a more complete view although it is out of the scope of this paper. Models usually start from the very basic. They then progress, attaining much more complexity. The process is continuous and indefinite. The ingenuity of man will always ensure this. Sources: Mcnutt, Patrick (2006a). Study Guide Unit 1Management Objectives and Stakeholder Value. Manchester Business School Worlwide: UK. Retrieved February 16, 2007 from http://support.mbs-orldwide.ac.uk/study_guides/ME/sgu1.pdf Mcnutt, Patrick (2006b). Study Guide Unit 2 Cost-Leadership and theProduction Process Value. Manchester Business School Worlwide: UK. Retrieved February 16, 2007 from http://support.mbs-orldwide.ac.uk/study_guides/ME/sgu2.pdf Baumol, William J. (1967) Business Behavior, Value and Growth, rev. ed. New York: Harcourt, Brace & World. Hoppe, Hans H. (1999) “Murray Rothbard: Economics, Science, and Liberty. 15 Great Austrian Economists, Randall Holcombe, ed., 223-244. Rothbard, Murray N. (1993) Man, Economy, and State, Auburn, Alabama: Ludwig von Mises Institute. Read More