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Criticism of Neoclassical Theory - Essay Example

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 company's performance and strategy.
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 ...Show more
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The standard neo-classical 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…
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