Neo Classical Theory of Firms

Readers Question: A. The standard criticisms of the neo-classical theory of firms?
B. Assess the value, if any of these criticisms, and then attempt estimate the value of the neo-classical theory, if any still remains.

Neo Classical Theory of Firms makes the following assumptions

• Firms are profit Maximisers. Firms will maximise profits where MR=MC
• In the short run, firms are subject to diminishing returns. In the short run capital is fixed, therefore MC is upwardly sloping after diminishing returns sets in.

Criticism of Neo Classical Theory of Firms

1. Firms often seek to maximise the size of the firm and market Share, rather than profit.
2. Profit Satisficing. Firms have a principle agent problem. The owners may wish to maximise profits, but the workers don’t. Therefore, the workers do enough to keep the owners happy, but then pursue other objectives such as enjoying themselves at work. This is also known as a problem of separation of ownership and control
3. Other Objectives such as environmental, cultural and social objectives. Humans are not just profit maximisers but consider other non-financial objectives .

The Value of Neo Classical Theory

It could be argued that when firms pursue other objectives, they have in the back of their mind profit maximisation. E.g. a firm may engage in a price war to maximise market share. However, the reason is that in the long run, the firm hopes that this increased market share enables higher monopoly power and therefore higher profits in the future. The same could be said of environmental objectives, these give a better corporate image and therefore boost long run profitability

Profit satisficing can be overcome through share deals and performance related pay. Therefore neo classical theory is useful because it show how and why firms should make sure workers have sufficient incentives to maximise profits like the owners.

See also: Objectives of firms