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Managerial Economics Neoclassical Theory and Baumols model

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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 the 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- has influenced many scholars to adopt the view. The 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.

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:
From the figure, the theory states that the firm should be concerned with finding out where Profit Maximization occurs.